Readers' forum - Framed?

My client, Mr M, is the managing director and controlling shareholder of his family company.
A company vehicle was stopped at point of entry to the UK and found to contain a significant quantity of contraband cigarettes. M was subsequently prosecuted by HMRC with being knowingly concerned in the fraudulent evasion of duty on cigarettes.
The essence of his defence, which the jury accepted, was that he was a wholly innocent party with no knowledge of or involvement in the matter. The vehicle in question was interfered with by a person or persons unknown for their own ends.
Significant legal fees (in excess of £200,000) were incurred by the company in securing the acquittal.
The company had previously passed a resolution indemnifying M in relation to the costs of his defence.
The Officer of Revenue and Customs who has been dealing with the accounts has made the following contentions.

• The expenditure is dual purpose in nature and fails under TA 1988, s 74(1)(a). There is an inevitable private purpose in trying to avoid a criminal conviction, particularly where the punishment includes the possibility of imprisonment.
• The expenditure is personal to Mr M and is therefore properly chargeable to his director's current account with the company.

Given the history of the matter, my client feels highly aggrieved and wishes to take the matter before the Appeal Commissioners.
Readers' comments as to the strength of HMRC's arguments and the likelihood of obtaining a successful outcome would be most appreciated.
Query T16,662        — Puffed Out.

Reply by S.W.I.:

Unfortunately, HMRC are almost certainly correct and the expenditure is disallowable. The criminal charges were brought against Mr M personally, not against the company. TA 1988, s 74(1)(a) prevents a taxpayer deducting expenditure in computing his profits under Schedule D, Case I unless it is incurred wholly and exclusively for the purposes of the trade, profession or vocation.
The legal expenses were not incurred wholly and exclusively for the purposes of the company's trade. The cost of avoiding a criminal conviction for a director will fail this test.
In the case of Spofforth & Prince v Golder 26 TC 310, a firm of accountants claimed a deduction for certain legal costs they had paid to successfully defend one of the partners in court proceedings. The partner had been charged with conspiracy to defraud the Inland Revenue and was acquitted.
The costs were held not to be allowable because they were not incurred for the purposes of the business of the partnership, but for the partner personally.
Puffed Out may be able to quote in aid the more recent case of McKnight v Sheppard [1999] STC 669, in which a stockbroker incurred legal fees in connection with Stock Exchange disciplinary proceedings. The Special Commissioners held that the legal fees were expended wholly and exclusively for the purposes of Mr Sheppard's trade and were therefore deductible. The House of Lords upheld this decision as one of fact and rejected the Revenue's arguments that the expenditure served a dual purpose. However, Puffed Out should refer to the comments in HMRC's Business Income Manual at paragraph BIM37965. 'In this case the Inspector did not challenge the taxpayer's assertion before the Commissioners that he did not care about his personal reputation. The courts were not persuaded that there was an inevitable private purpose in laying out the legal costs. You should therefore, under cross-examination, test a taxpayer's claim to being wholly unconcerned with their personal reputation and invite the Commissioners to infer the protection of same as one of the purposes of such expenditure.'
This case may therefore be considered exceptional and it may be difficult to place reliance on, particularly as the present case involved criminal charges.  

Reply by JJB:

I look at this and would agree with HMRC's analysis of TA 1988, s 74. There are various cases where expenses defending legal claims can be an allowable deduction in computing the trading profits. However, it would appear from what Puffed Out says that the allegations were personal allegations against the director of the company and not allegations against the company itself. The costs incurred were, in very simplistic terms, personal costs of the director defending a criminal prosecution and a potential criminal conviction.
What I would say is that all that the company has done is merely settle a pecuniary liability of a director. It appears that HMRC had made the allegations against the director and not the company. This is a vital element of the facts. How can a company justify that an expense is wholly and exclusively incurred in its trade, if the expense is not its expense, but one of its directors? The fact the company indemnified the director is irrelevant from a taxation point of view.
The question of whether this is a deductible expense of the trade would only be relevant if the proceeding were against the company. If the proceeding were against the company, HMRC's Business Income Manual at BIM46445 explains matters as follows.

'You need to establish the facts and need to examine the precise nature of the claims by the parties to the proceedings to consider the extent to which the fees are to be disallowed, either as capital expenditure, or by TA 1988, s 74(1)(a) or TA 1988, s 74(1)(e). The outcome of the proceedings (whether the taxpayer “wins” or “loses”) does not determine if the expense is deductible.'

A revenue payment, in settlement of a civil action arising out of a trade, may be allowed as a trading deduction where the allegations are neither admitted nor proved. Golder v Great Boulder Proprietary Goldmines Ltd 33 TC 75 held, where the liability was admitted or proved, a deduction may be allowed where the payment was restitutionary (i.e. compensation), but not if it was punitive (i.e. a fine).

Reply by New Road:

Traditionally, the Inland Revenue has not liked giving any allowance for anything connected with illegal or unlawful acts. That attitude is likely to continue into the merged departments. The thinking on these matters is often confused and I think that this is what we see here. The Officer of Revenue and Customs is trying to disallow the payment by whatever means he or she can, without thinking the matter through.
At least he or she has not used the case of CIR v Alexander von Glehn & Co Ltd 12 TC 232. That case concerned the allowance, or disallowance, of a fine for trading with the enemy during wartime was disallowed. One of the judges noted that there was 'a difference between a commercial loss in trading and a penalty imposed on a person or a company for a breach of the law which they have committed in that trading'. The cost of the fine was not an allowable deduction. I have seen that case used to deny the legal costs in defending such a claim. However, the case concerned the fine itself and not the costs of defending the claim.
HMRC's published Business Income Manual states that the costs of avoiding a criminal conviction are not allowable (BIM 37935). The manual refers to the case of Spofforth & Prince v Golder 29 TC 310. It is a shame that, although the manuals refer to the case of McKnight v Sheppard 71 TC 419, HMRC does not fully take on board the words of one judge in that case. He said, that a fine is not deductible because of 'the particular character of a fine or penalty. Its purpose is to punish the taxpayer'. The judge added that the costs of defending a claim could be different because 'it is fundamental that everyone, guilty or not guilty, should be entitled to defend themselves'. Refusing a deduction for those costs 'would in effect be an additional fine or penalty for which the regulatory scheme does not provide'.
I thought that I should mention those cases because it seems that that is way that the Officer of Revenue and Customs is arguing. However, I am guilty of going of at the wrong tangent. Those cases refer to the rules of what was then Schedule D, Case I for the company and I do not think that they are relevant. I am not sure why the Officer of Revenue and Customs is referring to the dual nature of the expenditure. The company has no private purpose here; it is paying the costs of a director. Surely, we should be talking about the provision of a benefit in kind for the director. As such, the payment is to be allowed in the company accounts but taxed on the director.
The case showing that the amount is to be taxed is Rendell v Went 41 TC 641. That is not the end of the matter. We then need to look at ITEPA 2003, s 346. That allows the employee to have a deduction for any costs or expenses or expenses incurred in connection with:

 (a) a claim that the employee is subject to a liability related to the employment; or
 (b) proceedings relating to or arising out of a claim that the employee is subject to a liability related to the employment.

There is a proviso that a deduction is not allowed if it would be unlawful for the employer to enter into a contract of insurance in respect of the liability or costs or expenses in question. I do not know enough about the insurance rules to give a definitive answer. I am pretty certain that it would be unlawful to enter into a contract of insurance to pay the fine. I would need to ask whether or not it would be lawful to enter into a contract of insurance to provide defence costs if the prosecution is unsuccessful. If it is, then the costs should be allowed in the company, but shown as taxable income for the director with an equal amount deducted.

Reply by Thicket:

Puffed Out's client (M) is not the first to have been faced with HMRC seeking to disallow this type of expenditure. The HMRC officer seems to be quoting form his manual in asserting that the expenditure is disallowable because it is dual purpose. HMRC's Busness Income Manual at BIM37035 discusses the meaning of the 'wholly and exclusively' test at TA 1988, s 74(1)(a). The test is seen as being in two parts:

1, Is the expense capable of satisfying the statutory rule? This is a question of law.
2, Having passed the first test, was it incurred wholly and exclusively for the purposes of the trade? This is a question of fact.

Certainly, legal costs to defend the company's name, reputation and goodwill are allowable as being wholly and exclusively for the purpose of the trade. The House of Lord's decision in Mc Knight v Sheppard [1999] STC 669 demonstrates this. A stockbroker was subject to fines totaling £50,000 by the Stock Exchange for breaches of their rules and regulations. He claimed to deduct the fines and associated legal costs against his profits. This was rejected by the Revenue, but on appeal the stockbroker argued that the expenditure had been incurred to prevent his suspension or expulsion, and thus to protect his business. The Revenue's argument was that the there was a difference between an ordinary commercial loss and a penalty imposed for a breach of the rules committed in that trading. The Commissioner accepted evidence that the taxpayer was wholly unconcerned with his personal reputation and held that it was not inescapable that the protection of his personal reputation was an object of the expenditure. Lord Hoffman in the House of Lords upheld the Commissioners decision, holding that everyone is entitled to defend themselves and that to refuse to allow a deduction for the legal expense 'would in effect be an additional fine or penalty'.
Here, whether HMRC's case against Mr M was threatening to the existence of his company, and the extent to which it was directed at the director shareholder personally is not clear from the question. In determining whether expenditure is incurred wholly and exclusively for the purpose of the trade, it is necessary to have regard to what the taxpayer had in mind at the time the expenditure was incurred. If a proportion of the expenditure can be identified as wholly and exclusively expended for business purposes, it may be deductible. This principle is found in a number of cases: Lochgelly Iron and Coal Co Ltd v CIR 6 TC 267, Copeman v Flood (Willliam) & Sons Ltd 24 TC 53 are perhaps the
best known.
Of course, if it is not possible to determine that there was a business purpose to the expenditure (or a part thereof), then as the company has agreed to indemnify Mr M's costs, any cost not relating to the business's trade will be part of M's emoluments upon which income tax is due. It is not down to HMRC to rewrite the company's accounts and debit the costs to the director's current account (with possible TA 1988, s 419 implications). Puffed Out is referred to Xi Software Ltd v Laing SpC 450 for a recent case in which the principle that legal expenses with a private element to their purpose was held to be a benefit in kind.
This type of case is one where the client and adviser should take a long hard look at the facts to see if a case can be substantiated before plunging in to take it to the commissioners. Can a business purpose to the expenditure be established separate from the private purpose? What evidence is there? It may be a victory if HMRC can be persuaded to recognise that a business purpose existed for part of the expenditure. It will then be a question of haggling over an allowable amount.

Reply by Fidalgo:

The second contention is the more interesting, since it indicates that the Officer may not be too confident as to his ground. On the face of it, the resolution passed by the company created either a direct payment or (more likely) an indemnity situation which would normally be considered either to be an emolument or a benefit of the managing director's employment, chargeable to income tax and National Insurance contributions, and probably under the PAYE system. There are, therefore, additional risks in taking the matter further.
Turning, then, to the TA 1988, s 74(1)(a) position, although VAT is not directly in point, the Officer is likely to be able to derive comfort from the attitude of the Court in relation to VATA 1994, s 24(1)(a) in HMRC v Jeancharm Ltd [2005] STC 918.
In circumstances such as these, it is, furthermore, not possible to identify a specific part of the expenditure which related only to the trade of the company. Some element of duality cannot be disputed. The issue for consideration is, therefore, whether the courts would be willing to have recourse to their implied power (as recognised by the House of Lords) to split expenditure into qualifying and disqualified portions in the absence of such a clear dividing line. This seems unlikely.

Issue: 4021 / Categories: