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Business Income Manual

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Wholly and exclusively: expense of earning or application of profits?: legal costs in connection with an appeal

S34 Income Tax (Trading and Other Income) Act 2005 (ITTOIA 2005), S54 Corporation Tax Act 2009 (CTA 2009)

Costs of appeal to the Tribunal

You should allow the normal professional costs incurred in preparing and submitting tax computations and supporting accounts. This follows the long-standing practice as approved by the courts in the Smiths Potato Estates Ltd v Bolland [1948] 30 TC 267 case (see BIM37850).

In the case of Allen v Farquharson Bros & Co [1932] 17 TC 59, the firm claimed legal costs in connection with an appeal to the Special Commissioners. The Special Commissioners allowed the deduction as:

`…having been expended to ascertain the true profits of the business distributable amongst the partners and assessable on the firm…’

The High Court concluded that the legal costs were not an allowable deduction.

Finlay J began by saying that there is a difference between what is now S34 (1)(a) ITTOIA 2005 and what is now S34(1)(b) ITTOIA 2005. These references apply to unincorporated businesses. The relevant references for companies are S54(1)(a) CTA 2009 and S54(1)(b) CTA 2009 respectively.

The first provision is concerned with disbursements for which the taxpayer has a degree of choice in the matter. The second provision covers losses that happen to the taxpayer and over which the taxpayer may not have the same degree of control. In many cases the distinction will have no practical effect but it may be useful nevertheless to determine which provision is involved.

Finlay J having decided that the issue involved consideration of what is now S34(1)(a) ITTOIA 2005 goes on to describe what is required for the expenditure to be ‘wholly and exclusively for the purposes of the trade’. Not every expense, which a prudent trader meets, is deductible.

Finlay J relies on the House of Lords dicta in Strong & Co of Romsey Ltd v Woodifield [1906] 5 TC 215 (see BIM37300). Finlay J says that the statutory test means that it is not enough that the expense should arise out of, or be connected with, the trade, but the expense should be for the purpose of earning the profits of the trade. In passing, Finlay J observes that the result on the facts of this case is the same whether the issue is decided under what is now S34(1)(a) ITTOIA 2005 / S54(1)(a) CTA 2009 or S34(1)(b) ITTOIA 2005 / S54(1)(b) CTA 2009.

Finlay J finally turns to the specific facts of this case and also comments on the Revenue’s practice with regard to the allowably of ‘normal’ accountancy charges (on which subjects the Courts had more to say in Smith’s Potato Estates Ltd v Bolland, see BIM37850). On the facts as found by the Commissioners, Finlay J said that it was impossible to say that the expenditure was for the purpose of earning the profits. The answer seems to him to be simple. Finlay J could not see that the profits were in the slightest degree altered, either decreased or diminished, as the result of the expenditure. He felt compelled to hold that this was an application of profits after they have been earned and was not expenditure incurred to earn the profits.

The part of Finlay J’s judgment distinguishing what is now S34(1)(a) ITTOIA 2005 / S54(1)(a) CTA 2009 from what is now S34(1)(b) ITTOIA 2005 / S54(1)(b) CTA 2009 is set out below, updated to show the current legislative references:

`…no doubt they do run rather close to each other, but I cannot help thinking that there is a distinction between [S34(1)(a) ITTOIA 2005 / S54(1)(a) CTA 2009] and [S34(1)(b) ITTOIA 2005 / S54(1)(b) CTA 2009]. Now a case might be put in which it was not very easy to say whether a thing was a disbursement or expense or was a loss. It is conceivable - such things sometimes happen - that there may be cases in which a thing might fall alternately - it might be either within [S34(1)(a) ITTOIA 2005 / S54(1)(a) CTA 2009] or within [S34(1)(b) ITTOIA 2005 / S54(1)(b) CTA 2009], but, none the less, I do think that there is a distinction to be drawn between the two. [S34(1)(a) ITTOIA 2005 / S54(1)(a) CTA 2009] relates to disbursements; that means something or other which the trader pays out; I think some sort of volition is indicated. He chooses to pay out some disbursement; it is an expense; it is something which comes out of his pocket. A loss is something different. That is not a thing which he expends or disburses. That is a thing which, so to speak, comes upon him ab extra. It is not very easy to formulate the thing, but it is easy enough to put illustrations falling on one side or the other of the line which may show what is, I think, the distinction, and the real distinction, between these things. Take the case of money being stolen from a till: I should say that that, quite plainly, was not a disbursement or an expense and, equally plainly, I should say it was a loss. Take, on the other hand, a sum of money expended, let us say, for legal expenses. I am not, of course, on the immediate question in this case. A trader thinks that he requires legal advice, or he thinks he wants a conveyance, or something of that sort; that, I should say, could not possibly and properly be said to be a loss, but obviously was a disbursement or expense. Although, in some cases, there may be a difficulty in deciding under which head it comes and, although it is true to say that in most cases it does not particularly matter, and the things may be conveniently considered together, none the less, I think that it is perhaps useful just to consider the two things as being distinct and, if I am right in the distinction which I have suggested, it becomes reasonably plain, whether it is important for the decision of the case or not, that the question here is not really a question under [S34(1)(b) ITTOIA 2005 / S54(1)(b) CTA 2009], because there was not here any loss. There was a sum of money expended and I do not think that is a loss. There was a sum of money expended because the taxpayer conceived, and I dare say very wisely conceived, that it was a wise and judicious thing for him to expend the money. That, I think, is not a loss; on the other hand, it is a disbursement or expense.’

The part of Finlay J’s judgment giving the explanation of what is required for an expense to fall within what is now S34(1)(a) ITTOIA 2005 / S54(1)(a) CTA 2009 is set out below, again updated to show the current legislative references:

`…the question, of course, comes to be whether this, is a disbursement or expense which is “money wholly and exclusively laid out or expended for the purposes of the trade, profession, employment, or vocation.” If I were wrong in the view I take, and if [S34(1)(b) ITTOIA 2005 / S54(1)(b) CTA 2009] is either alone applicable or applicable as alternative to [S34(1)(a) ITTOIA 2005 / S54(1)(a) CTA 2009], that would not really matter, for, in my opinion, the question, the test to be applied, would be just the came if one were considering whether there was a “loss not connected with or arising out of the trade, profession, employment or vocation.”

That brings me to the real point in this case. A large number of authorities, not the least too many, but still a substantial number of authorities, were cited to me. It is of course quite clear - there is ample authority for it and there is no doubt about it - that not every expenditure which a prudent trader makes can be deducted. There are prohibitions and they have got to be observed. The thing has been put in a very large number of cases. I shall refer - and it is as good a case as any other - to the case of Strong & Co of Romsey v Woodifield [see BIM37300]. In that case, the speeches both of the Lord Chancellor (Lord Loreburn) and Lord Davey make it perfectly clear that there may be, indeed there are, disbursements which cannot be deducted, disbursements which a prudent trader might very well think proper to make, which cannot be deducted. What Lord Davey says (I take a sentence from him; it will do as well as any other; several others might be cited) is this [5 TC at page 220]: “It is not enough that the disbursement is made in the course of, or arises out of, or is connected with, the trade or is made out of the profits of the trade. it must be made for the purpose of earning the profits.” If I may say so with the utmost respect for the learned judge who uttered those words, it is probably easier to lay down a principle of that sort than to apply it directly in the numerous cases which arise, but applying as well as we can the principle which Lord Davey laid down, what one has to consider is this: It not being enough that it should arise out of, or be connected with, the trade, was it an expenditure made for the purpose of earning the profits of the trade? That, I understand, to be a slight expansion by Lord Davey of the words in the Statute which are: “not being money wholly and exclusively laid out or expended for the purposes of the trade, profession, employment or vocation”.’

The part of Finlay J’s judgment commenting on the Revenue’s long standing practice concerning the deduction of accountancy fees is set out below:

`Now the difficulty arises - it nearly always does arise in these sorts of cases - in drawing the line. I do not doubt that there are expenditures connected, for example, with the accounts, which are habitually allowed and rightly allowed; I do not doubt that the expenditure of keeping an accountant or, it may be, in the case of some of the very great businesses with which we are familiar keeping a whole accountants’ department, is a proper deduction to be made. I do not doubt, further, that the accountants’ department will deal with matters of Income Tax in the sense that they will prepare the accounts for Income Tax and, as I suppose, sometimes discuss questions with the Inspector of Taxes or representatives from Somerset House which arise, and I do not suppose it would be sought to say that, by reason of that, the expenses of the accountants’ department were not proper to be allowed. I have got to decide the case, in spite of the invitation which has to some extent been given to me from both sides of the Bar, on the facts as they are found in the case, and in this case it seems to me that it is impossible to say that this was an expenditure for the purpose of earning the profits. The answer seems to me to be simple, that it was not an expenditure for the purpose of earning the profits and could not be. I cannot see that the profits were in the slightest degree altered, either decreased or diminished, as the result of this expenditure. I feel compelled, on these facts as they are set out in this Case, to hold that this was an application - I should think, as far as I can judge, an exceedingly proper application - of profits after they have been earned and was not an expenditure necessary to earn the profits. I do not think that the distinction which at one stage was a good deal pressed upon me by the learned Attorney, the distinction between a partnership and a company, or an individual, matters. As I conceive the thing, the question would be exactly the same if this, instead of being, as it was, a partnership firm, had been a company or had been an individual.’