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Key points * Brief history of employment expenses legislation. * Virtual impossibility of making a successful claim for expenses. * Special Commissioners analysis of airline pilot's training costs. * The law should be clarified so that employees know where they stand, rather than have their hopes raised with claims destined to fail.
THE NOTORIOUSLY STRICT rules for the deduction of expenses against income from an employment have been around for a very long time. There was section 51, 16 & 17 Vict. c34 which required expenses to be 'necessarily incurred in the performance of the duties' which features in the case of Cook v Knott (1887) 2 TC 246. There is also the early version of Schedule E found in the Income Tax Act 1918. In the modern era, many people will be familiar with TA 1988, s 198 and its predecessor TA 1970, s 189. Only a few people may now remember Income Tax Act 1952, Sch 9(7) which is perhaps a good place to start. This provision reads as follows:
'If the holder of an office of employment of profit is necessarily obliged to incur and defray out of the emoluments thereof the expenses of travelling in the performance of the duties of the office or employment or of keeping and maintaining a horse to enable him to perform the same, or otherwise to expend money wholly exclusively and necessarily in the performance of the said duties, there may be deducted from the emoluments to be assessed the expenses so necessarily incurred and defrayed.'
Galloped away
This is all extremely familiar because this wording continued almost identically until the FA 1998 when it was amended to accord with the recommendations of the Tax Law Rewrite Committee. However, with the exception of travelling expenses, the basic test remained the same, viz:
'If the holder of an office of employment is obliged to incur and defray out of the emoluments of the office of employment … any amount expended wholly exclusively and necessarily in the performance of the duties of the office of employment, there may be deducted from the emoluments to be assessed the amount so incurred and defrayed.'
I had been rather fond of the horse, but it was set free in 1998 and has not been seen again.
The latest version is found in ITEPA 2003, s 336 which recasts the test to allow a deduction from earnings for an expense if:
'the employee is obliged to incur and pay it as holder of the employment and the amount is incurred wholly exclusively and necessarily in the performance of the duties of the employment.'
The reason for this trip down memory lane is to emphasise the longevity of the rule and that the essential elements are still with us: the wholly, exclusively and necessarily test, and the quite separate requirement that the expenditure must be incurred in the performance of the duties.
An illusion
It might be thought that after all this time we would know broadly what qualifies for relief and what does not. The sad truth is that it is practically impossible to satisfy the tests for relief, and it is regrettable that this is not more widely appreciated. Taxpayers make claims and spend lots of money arguing these cases, but they are doomed. It could reasonably be assumed that if there is a relief provided for by the legislation, it ought to be capable of being claimed. Unfortunately, although it is possible to put forward circumstances where the tests could be satisfied, such examples are so divorced from reality that they merely add weight to the proposition that relief for expenditure under s 336 or its predecessors is just an illusion.
HMRC's manuals acknowledge the problem. The Employment Income Manual at paragraph 31637 specifically states that:
'Because the general rule for employee expenses is extremely restrictive it is tempting to conclude that no expense could ever be deductible.'
It goes on to say 'however, the rule is intended to permit some deductions', but does not give any indication what they might be. The manual refers to what appears to be the only case on the subject where relief was allowed, Elwood v Utitz 42 TC 482, but that case was not really about TA 1988, s 198 at all. The decision was based on the Special Commissioners finding that the expenditure (on subscriptions to London clubs) was no more than a retaining fee to secure inexpensive accommodation. It was not really a payment needing to satisfy s 198 and it does not help very much.
HMRC do allow a degree of concessionary treatment in respect of the wholly and exclusively rule, in a manner similar to that which they adopt for general Schedule D purposes, i.e. where an expense can be apportioned between part which is exclusively for business purposes and part which is not, they will allow a deduction for the business part. An example would be rent paid for the use of a building in which one room is used exclusively for business purposes; that proportion of the rent may be deductible. However, while this is welcome, it is of little practical use if the expenditure can never get past the second test of being incurred in the performance of the duties, and there is no concession for that.
The problems
The House of Lords decision in Fitzpatrick v CIR and Smith v Abbott [1994] STC 237 provides a useful summary of the problems facing a claimant. In each of these cases the taxpayer was a journalist who worked for a newspaper. He purchased and studied other newspapers as an essential part of his job. He claimed a tax deduction for the cost of the newspapers but the House of Lords said that the expenditure was not deductible because the taxpayer did not read the newspapers in the performance of the duties of his employment. The activity was merely preparatory and done in order to provide him with background information to do his job more effectively. Discussion ensued about whether it would have mattered if the taxpayer's contract of employment had required him to purchase and read the newspapers, but this was irrelevant according to Lord Templeman. The journalist's duties were in connection with the production of his employer's newspaper and he was not carrying out those duties when he was reading other newspapers.
Lord Templeman particularly approved the views of Mr Justice Rowlatt in Nolder v Walters 15 TC 380 in which the position was expressed as under (referring to the similar test imposed by the Income Tax Act 1918):
'In the performance of the duties means in doing the work of the office, in doing the things which it is his duty to do while doing the work of the office. A man who holds an office or employment has, equally necessarily, to do other things incidentally, and spend money incidentally, because he has the office. He has to get to the place of employment for one thing. Incidentally he is obliged to do that, but it is not doing the work of the office, which begins when he arrives and sets to work to perform his duties.'
On the strict wording of TA 1988, s 198 (or any of the other versions) I would respectfully suggest that the House of Lords could not have come to any other conclusion. Quite apart from the argument that the reading of the newspapers was an activity preparatory to the performance of the duties, the act of reading a newspaper (at least in these circumstances) did not give rise to any expenditure. He did not expend money by reading the newspapers; he expended money when he bought the newspapers. If a journalist calls into the newsagents on his way to work and buys a newspaper, the money is expended at or around the time he picks up the newspaper and makes payment to the shopkeeper. Before he has started to read the newspaper he has expended the money. When he expended the money he could not have been performing the duties of his employment, unless part of his job was, for example, to observe the behaviour of shopkeepers at the actual point of sale of their product.
Flying confirmation
The most recent case to confirm this position was that of Hinsley SpC 569 in which an airline pilot was obliged by the terms of his contract of employment with an airline to reimburse his training costs if he left the company's employment within a specified period. He claimed a deduction for the cost against his earnings.
The Special Commissioners went through the traditional analysis. The fact that the employee incurs the expenditure for the purposes of his job is not enough. The fact that he cannot do the job without incurring the expenditure does not entitle him to the relief. Every employee in that employment must need to incur the expenditure and it must necessarily be incurred wholly and exclusively and it must be incurred in the performance of duties. Mr Hinsley was required by his employer to take the training, because without the training he could not do the job, but his job was not going on training courses, it was flying aircraft. Furthermore it was not the case that every pilot would have had to incur this expense while doing his job; for example, a pilot who was already type rated for the aircraft he was to fly before he became employed by the airline would not be required to incur this expense. Mr Hinsley had to incur the expense and would have been prohibited from performing his duties, i.e. flying the company's aircraft, if he had not done so, but that was irrelevant. His duties were those of a pilot and the expenditure could not be described as either being in the performance of those duties or necessarily expended in their performance. While one might have sympathy with Mr Hinsley, it is difficult to challenge this analysis and he was doomed on the precise wording of ITEPA 2003, s 336.
Not essential enough
Perhaps the most interesting case in recent years on this subject is that of Consultant Psychiatrist SpC 557 where the taxpayer incurred expenditure on professional training which was an essential part of her job. The Special Commissioner confirmed that to the extent that it was required to satisfy the continuing professional development requirement which any holder of the job would need to satisfy, it would be necessarily incurred by virtue of her employment.
This is very helpful, but to satisfy s 336 the expenditure also needed to be incurred 'in the performance of the duties of the employment'. She was a consultant psychiatrist and the best that could be said about the training is that it put her in a position to do her job better. When she was on her training course she was not performing any duties under her contract of employment.
There is nothing earth-shattering here; she was doomed too, just like all the others. However, the interesting part of the decision is that the Special Commissioner drew attention to the HMRC manuals and in particular the Employment Income Manual at para 32545 which provides the following example in which HMRC provide an example of expenditure which would be deductible under s 336. This is what we have all been searching for all these years and it was in the manuals all the time. The relevant passage reads:
'A scientist is employed by a university department to carry out basic research in polymer chemistry. As part of her continuing research she attends a presentation at a different university of the findings of a scientist working in the same field. She is required to attend such presentations as part of the programme of research for which she is employed. The subject matter of the presentation directly influences the content and direction of her own research. The duties of this employment include research. In this case attendance at the presentation is an initial part of the research process and so is one of the duties of the employment. The costs of travel to the presentation are deductible.'
This example is intended to highlight the fact that the attendance at the seminar was part of the duties of her employment; that is what she was employed to do, as opposed to other occupations where attendance at a seminar may be required by the employment but merely places the employee in a position to perform his or her duties better.
Can this be right?
However, although one does not want to look a gift horse in the mouth, I cannot see how this example can possibly be right. The test is not whether attendance at the presentation was one of the duties of employment; the test is whether the expenditure was incurred in the performance in the duties of the employment. We therefore have to look at when the expenditure was incurred. It is very likely that the expenditure would be incurred when the scientist filled in the form and made the travel arrangements to go to the presentation. The expenditure was not incurred by her attendance (necessary or otherwise) but by her committing herself to attend. Accordingly, all this example shows is that the expenditure was incurred to enable her to go on the course, i.e. she was putting herself in the position to perform one of the duties of her employment. This is no different from the position with the consultant psychiatrist, the journalists and most of the other cases on the subject.
I would submit that HMRC's example is plainly wrong and contrary to all the established authority on the subject. But it is perhaps an excellent illustration of the impossible difficulty in satisfying the statutory test.
There appear to be two things wrong with the system in this context. The first is that where somebody is contractually bound to incur expenditure under his contract of employment, it is unfair that the statute does not permit any tax deduction for what on any objective assessment would be a valid business purpose. Secondly the existence of s 336 and its predecessors provides a clear indication that it is possible for expenditure to be allowable against employment income. Taxpayers are encouraged by a combination of common sense and the existence of a relieving section into making claims and incurring significant professional costs in an appeal which is doomed to failure from the outset. It would be so much better simply to abolish s 336 altogether; in fact it would be a public service because it would prevent well meaning and honest taxpayers from wasting their money in hopeless claims. Indeed, the ultimate irony is for the taxpayers to win before the Special Commissioners. This only makes their position worse because they are almost bound to lose on appeal and the substantial burden of costs will only increase their disappointment.
We're all doomed!
I would urge HMRC either to cause the rule to be amended, issue a statement of practice explaining under what circumstances a deduction can be allowed despite the strictness of the rule, or failing either of these, to make it plain that claiming relief under s 336 is futile because of the impossibly strict conditions. At least everybody would then know where they are.
Peter S Vaines is a partner with Squire, Sanders & Dempsey.
