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HMRC internal manual

Business Income Manual

Wholly and exclusively: expense of earning or application of profits?: ‘compensation for loss of office’ on share sale

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

The cost of dismissing an employee for non-business reasons (for example to facilitate a share sale) is non-allowable>

The costs of hiring and firing employees are generally allowable. But where the employee’s departure is linked to a matter such as sale of shares in the business, the costs may be disallowed. It is a question of fact whether the expenditure was incurred in earning profits or was a payment out of profits. If expended in earning profits, it is also a question of fact whether it was wholly and exclusively for the purposes of the trade.

In the case of Overy v Ashford Dunn & Co Ltd [1933] 17 TC 497, the company, whose three directors were also the sole shareholders, was engaged in a trade in which the control of the raw materials and of markets had passed into the hands of another company, Slate Slab Products Ltd. Slate Slab Products Ltd agreed to purchase all the shares in Ashford Dunn & Co Ltd from the shareholders. In accordance with provisions in Ashford Dunn & Co Ltd’s Articles of Association the vendors, on completion of the sale, resigned their directorships.

The agreement, to which Ashford Dunn & Co Ltd was a party, provided, amongst other things, that the vendors:

  • were not to engage in a competing business within ten years of the sale
  • were to be entitled to all book debts and were to discharge all liabilities of the Ashford Dunn & Co Ltd up to the date of sale, and
  • were to keep indemnified both the Ashford Dunn & Co Ltd and the purchasers against all claims by directors, officers or servants for loss of fees or profits arising out of the agreement

At an extraordinary meeting that Ashford Dunn & Co Ltd held immediately before the completion of the sale of the shares, a resolution was passed providing for the payment to the retiring directors of £3,000 compensation for ‘loss of office’. This compensation, together with a further sum paid to the directors, under the same resolution, by way of remuneration, was the equivalent of the amount standing to the credit of the profit and loss account at the date of sale.

Evidence was accepted that the retirement of the directors was in the best interests of the Ashford Dunn & Co Ltd on the grounds that it enabled the trade to be conducted more economically, and that, in view of the controlling position of the purchasing company in the trade, Ashford Dunn & Co Ltd might in future be unable to earn profits.

Ashford Dunn & Co Ltd contended that the payment made in compensation for loss of office was a proper deduction in computing its profits for tax purposes, on the ground that it was a sum expended with a view to a direct and immediate benefit to the Ashford Dunn & Co Ltd’s trade. The General Commissioners allowed the deduction.

The Commissioners found that it was in the best interests of the company for the directors to retire for quite good business reasons. But there was no finding that the payment of £3,000 as compensation for loss of office was necessary to induce the directors to retire.

Finlay, J in the High Court held that the payment was not allowable because it was a distribution out of profits and not an expense incurred in earning profits.

Finlay J distinguishes the situation from that in Mitchell v Noble [1927] 11 TC 372 (see BIM38370) because there was no business reason to dismiss the directors in Ashford Dunn.

The part of Finlay J’s judgment on which the above guidance is based is set out below:

`…the question which arises is as to the £3,000 expressed to be compensation for loss of office…it is said that evidence (which was accepted) was called on behalf of the Respondents to the effect that it was in the best interests of the Company for the directors to retire, and reasons, which seem to be quite good business reasons, are given for that. It is found that it was in the best interests of the Company that the directors should retire; but there is no finding that this payment of £3,000 as compensation for loss of office was necessary to induce the directors to retire, or for any other reason, and that seems to me quite clearly to distinguish this case from a case which was, naturally and properly, pressed upon me by Mr Bowe, the case of Mitchell v Noble, reported in 11 TC 372 [seeBIM38370]. I need not go through the case in detail, but, if the facts there are looked at, the distinction between that case and this seems to me to be perfectly obvious. In Mitchell v Noble the point was this: there was a director who, the other directors thought, for valid business reasons, ought to be got rid of; for some reason or other, his remaining in office would have, or might have, caused some scandal likely to be injurious to the Company. Thereupon, he was induced to say that he would retire, but he made a claim, a claim, I think, for £50,000, as compensation for loss of office. That claim was compromised and compromised on the terms that he should receive a sum of £19,000, I think it was. In those circumstances, it was held that the £19,000 (which was to be paid in some instalments, but nothing turns upon that) was money laid out in the course of the carrying on of the business and was, therefore, deductible. The distinction between that case and this seems to me to be obvious. There the money was necessary for business purposes. It was necessary to pay that sum of money to get rid of a director, and it was necessary to get rid of a director, of course, for business reasons, and quite bona fide the other directors conceived that that was necessary in the best interests of the carrying on of the business. That case seems to me to be quite plainly distinguishable from this case. Here, what happened was this: it was thought in the best interests of this business that these directors should sell their shares and should retire from their directorships. Thereupon, the question arose as to what was to be done with the money accrued up to date, accrued, that is, before the transfer of the shares took place. The agreement provides for that, and the substance of what it provides for was this, that the directors were to have it, these three people, the directors and shareholders, were to have it and to have it by way of dividend or in such other manner as they might themselves resolve and determine. Now, supposing they had resolved and determined, as, indeed, it is rather suggested that they might or would in the agreement, to receive this by way of dividend, no question could possibly have arisen; it would have been perfectly clear, of course, that this dividend was paid out of profits and was not a deduction to be made before the profits were arrived at. How can it make any difference, that it was done in this way, that it was done by declaring a sum as being compensation for loss of office? I do not think it can. The substance of the thing remains exactly the same. It seems to me to be utterly different from the case where it is necessary, for business reasons, to get rid of a director and, in order to get rid of him, it is necessary to pay him a sum of money, which was the case of Mitchell v Noble [seeBIM38370].’