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Business Income Manual

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Wholly and exclusively: expenditure having an intrinsic duality of purpose: costs of defending against a charge of gross misconduct

S34 Income Tax (Trading and Other Income) Act 2005 (ITTOIA 2005)

Non-allowable if (wholly or partly) to protect private reputation

In contesting a charge of misconduct there is no inevitable private purpose. So it is essential that you test any assertion of unconcern on the taxpayer’s part as to their personal reputation. Unchallenged evidence given at tribunal by the taxpayer as to purpose gives little scope to overturn the decision following the decision in Edwards v Bairstow & Harrison [1955] 36 TC 207 (see BIM37045).

In the case of McKnight v Sheppard [1999] 71 TC 419, a stockbroker, was found guilty by the Stock Exchange council’s disciplinary committee on four charges of gross misconduct and was suspended for six months on each charge. He was also reprimanded in relation to several findings of ordinary or minor misconduct.

In respect of one of the acts of misconduct, a finding of actual dishonesty was made. Mr Sheppard appealed to the disciplinary appeals committee. That committee allowed the appeal on one finding of gross misconduct, reduced another to ordinary misconduct, and upheld the other two findings of gross misconduct and all the findings of ordinary misconduct. The suspensions were replaced by fines and by a censure on the charge which involved a finding of actual dishonesty.

Shortly afterwards, the authorisation tribunal of the Securities Association refused an application by Mr Sheppard for admission to the register of directors, but the Association’s appeal tribunal allowed Mr Sheppard’s appeal, holding that he was a fit and proper person to carry on investment business. It was a clear inference from the decision that, if the fuller evidence before that tribunal had been made available to the disciplinary committee, there would not have been a finding of actual dishonesty.

Mr Sheppard incurred legal fees of over £200,000 in connection with the disciplinary proceedings and appeal. The Inspector declined to accept that the fines and fees were deductible.

The Special Commissioners found that expulsion of Mr Sheppard from membership of the Stock Exchange, or suspension for six months, would have been the end of his firm. In fighting the proceedings and appeal and incurring the legal fees, Mr Sheppard had not been concerned to protect his personal reputation but his sole object was to avoid the destruction of his business.

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, but held that the fines were a loss not connected with or arising out of the trade [what is now S34(1)(b) ITTOIA 2005] and were therefore not allowable as a deduction. The Crown appealed against the former conclusion and Sheppard appealed against the latter.

The parties appealed to the High Court where Lightman J allowed the Revenue’s appeal against deducting the expenses and dismissed the Mr Sheppard’s appeal against the disallowance of the fines. Mr Sheppard appealed against this decision on expenses but did not pursue the question of the fines. The Court of Appeal (Nourse, Potter and Mummery LJ) allowed Mr Sheppard’s appeal, finding that the legal costs were deductible.

The House of Lords decided that the legal expenses were expended wholly and exclusively for the purposes of Mr Sheppard’s trade, because:

  1. the facts found by the Special Commissioners did not lead inescapably to the conclusion that Sheppard had two purposes in paying the legal expenses, namely the preservation of his business and the preservation of his personal reputation. Although the Special Commissioners did not accept that Sheppard was unconcerned about the advantages which a successful defence would have for his personal reputation, they accepted that that was not the purpose for which the money was spent, because those advantages were an unavoidable effect of, rather than a reason for, the expenditure. There was, therefore, no inconsistency between their conclusion of law and their findings of fact
  2. a fine or penalty is not deductible because its purpose is to punish the person concerned and it may easily be concluded that the legislative policy would be diluted if that person were allowed to share the burden with the rest of the community by a deduction for the purposes of tax. It does not follow that the costs of defence are not deductible. Non-deductibility depends upon the nature of the expenditure and the specific policy of the rule under which it becomes payable, and the relevant considerations may be quite different in a variety of cases. In this instance, there was no clear policy which would be infringed by allowing the deduction of the legal expenses incurred in resisting the disciplinary proceedings arising out of the conduct of the business

The Crown advanced two lines of argument. Lord Hoffmann rejected both. He explained why both arguments failed.

The Crown’s first argument was that the expenditure served a dual purpose, the preservation of:

  • Mr Sheppard’s business, and
  • Mr Sheppard’s personal reputation

In the House of Lords, Lord Hoffmann explained why Sheppard was entitled to deduct the costs of defending himself, essentially, because Sheppard gave uncontested evidence that he did not care about his personal reputation, the only reason that he had fought the case was to defend his profession.

The Crown’s second point was that the words ’for the purposes of the trade’ meant that the expenditure must be ’in furtherance of the relevant commercial activity.’ There must be a sufficient connection with the earning profits in the trade. Lord Hoffmann thought that the Special Commissioner and the Judge were quite right in not allowing the fines to be deducted. But he went on to explain that it does not follow that the costs were not deductible. Once it is appreciated that, in a case like this, non-deductibility depends upon the nature of the expenditure and the specific policy of the rule under which it became payable, it can be seen that the relevant considerations may be quite different. Lord Hoffmann distinguished between damages that are compensatory (and which may be allowed) and damages which are punitive (and which are not allowed).

Lord Hoffmann explained the policy reasons for not allowing punitive damages and clarified the reasons for a number of earlier decisions. If the purpose of a penalty is to punish the taxpayer, a court may easily conclude that the legislative policy would be diluted if the taxpayer were allowed to share the burden with the rest of the community by a deduction for the purposes of tax.

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 tribunal to infer the protection of same as one of the purposes of such expenditure.

There will normally be a private purpose in trying to avoid a criminal conviction, particularly one where the punishment includes the possibility of imprisonment, whether or not this purpose is one of the taxpayer’s conscious objectives.

The part of Lord Hoffmann’s judgment where he identified the significance of the taxpayer’s uncontested evidence as to purpose is set out at pages 450-451:

`My Lords, on an appeal from the Special Commissioner by way of Case Stated, the only question, as Nourse LJ pointed out in the Court of Appeal, is whether, on the facts as the Commissioner found them, this conclusion was open to him as a matter of law: see Edwards v Bairstow & Harrison [[1955] 36 TC 207, see BIM37045]. Mr Grabiner QC who appeared for the Revenue, advanced two arguments as to why it was not.

First, he said that the facts found by the Special Commissioner led inescapably to the conclusion that the taxpayer had two purposes in paying the legal expenses. One was the preservation of his business and the other was the preservation of his personal reputation. It followed that he had a dual purpose and the trade purpose thus lacked the necessary exclusivity: see Mallalieu v Drummond [[1983] 57 TC 330,see BIM37910].

I do not think that the Special Commissioner’s careful findings of fact lend support to this criticism. He recorded the taxpayer as saying in evidence that he ‘did not care about his personal reputation’. While accepting the taxpayer as an honest witness 9 years after the event, he did not accept that this correctly reflected his attitude at the time. He said that the taxpayer would have had to be ‘extraordinarily thick-skinned not to have experienced feelings of personal distress’ at the effect of the charges upon himself and his family. But he went on to make the following important finding:

“However, the fact that I do not accept that the taxpayer was wholly unconcerned with his personal reputation does not necessarily mean that his purpose in laying out the legal costs was not exclusively concerned with preserving his trade. Purpose and effect are not the same (see Mallalieu v Drummond at page 365 per Lord Brightman).”

The Special Commissioner is here saying that although he does not accept that the taxpayer was unconcerned about the advantages which at successful defence would have for his personal reputation, he does accept that this was not the purpose for which the money was spent. The reference to Lord Brightman’s speech in Mallalieu v Drummond, at pages 365 - 366 is illuminating. The relevant passage is as follows:

“The object of the taxpayer in making the expenditure must be distinguished from the effect of the expenditure. An expenditure may be made exclusively to serve the purposes of the business, but it may have a private advantage. The existence of that private advantage does not necessarily preclude the exclusivity of the business purpose. For example, a medical consultant has as friend in the South of France who is also his patient. He flies to the South of France for a week, staying in the home of his friend and attending professionally upon him. He seeks to recover the cost of his air fare. The question of fact will be whether the journey was undertaken solely to serve the purposes of the medical practice. This will be judged in the light of the taxpayer’s object in making the journey. The question will be answered by considering whether the stay in the South of France was a reason, however subordinate, for undertaking the journey, or was not a reason but only the effect. If a week’s stay on the Riviera was not an object of the consultant, if the consultant’s only object was to attend upon his patient, his stay on the Riviera was an unavoidable effect of the expenditure on the journey and the expenditure lies outside the prohibition in [what is now S34(1)(a) ITTOIA 2005].”

If Lord Brightman’s consultant had said that he had given no thought at all to the pleasures of sitting on the terrace with his friend and a bottle of Côtes de Provence, his evidence might well not have been credited. But that would not be inconsistent with a finding that the only object of the journey was to attend upon his patient and that personal pleasures, however welcome, were only the effects of a journey made for an exclusively professional purpose. This is the distinction which the Special Commissioner was making and in my opinion there is no inconsistency between his conclusion of law and his findings of fact.’

The part of Lord Hoffmann’s judgment where he described the policy reasons for not allowing penalties is set out at page 452:

`…the reason in my opinion …relates to the particular character of a fine or penalty. Its purpose is to punish the taxpayer and a court may easily conclude that the legislative policy would be diluted if the taxpayer were allowed to share the burden with the rest of the community by a deduction for the purposes of tax.’

The part of Lord Hoffmann’s judgment explaining why the fines were not allowable but the defence costs were is set out at pages 452-453:

`…I think that the Special Commissioner and the Judge were quite right in not allowing the fines to be deducted. It does not follow, however, that the costs were not deductible. Once it is appreciated that, in a case like this, non-deductibility depends upon the nature of the expenditure and the specific policy of the rule under which it became payable, it can be seen that the relevant considerations may be quite different.’