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Business Income Manual

HM Revenue & Customs
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Wholly and exclusively: commencement, cessation or sale of business: severance payments

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

‘Normal’ employee costs are allowable

Where the payment is part of the normal employee costs, the fact that they arise on the occasion of the cessation of business is not an automatic bar to allowance.

The Hong Kong case that follows was heard by the Privy Council. As explained in BIM24235, Privy Council decisions are only of ‘persuasive’ authority in the UK. Given that the Privy Council is composed of UK Law Lords and that they specifically referred to UK tax cases, there is no reason to believe that the decision on a UK case would differ.

The case of CIR v Cosmotron Manufacturing Ltd [1997] 70 TC 292 concerned a company that carried on the trade of manufacturing metal products from a factory in Hong Kong. In March 1991 it closed the factory, ceased its trade, and thereby made its employees redundant. The company was obliged under the employment ordinance to make severance payments to all employees who had been employed under a continuous contract for at least two years. It sought to deduct the payments pursuant to the Inland Revenue ordinance in ascertaining the profits to which it was chargeable to tax.

The Commissioner of Inland Revenue refused the deduction on the ground that the severance payments had not been incurred in the production of profits as required by the Inland Revenue ordinance. Nor had the payments been made for the purpose of producing profits as required by the Inland Revenue ordinance. The Commissioner took the view that the payments had been made for the purpose of discharging the employees and closing down the trade.

The Board of Review allowed the company’s appeal, accepting its contention that the severance payments were deductible because the company’s obligation to make them had arisen from the terms upon which the employees had been engaged. Therefore, the obligation had been incurred, together with the company’s other obligations towards its employees, for the purpose of producing profits throughout the period of their employment.

Findlay J upheld that decision, and his decision was upheld by the Court of Appeal. The Commissioner appealed to the Privy Council.

The Privy Council decided that the payments were allowable.

The Privy Council explained that a payment made to discharge an obligation entered into by a company as an ordinary incidence of its contract of employment was deductible in ascertaining the profits to which it was chargeable to tax. An obligation to make severance payments was not undertaken by a company in order to close up its trade; it was undertaken because the company wished to employ people with a view to making profits. While it was true that the event, which triggered the payment to the employee, was the dismissal by reason of redundancy because the trade was shut down, that was not the purpose for which the expense of the severance payments had been incurred. The purpose of such a payment was to produce profits. Accordingly, the severance payments in the instant case had been properly accepted by the Board of Review, by Findlay J, and by the majority of the Court of Appeal as representing expenditure both for the purpose of producing profits and in the production of profits.

Lord Nolan began by explaining that their Lordships saw no material difference between the Hong Kong legislation and the UK equivalent:

`The long-standing rule for the deductibility of payments under United Kingdom law, now set out in [what is now S54 CTA 2009], is that the payments, in order to be deductible, must be laid out wholly and exclusively for the purposes of the trade, but in the context of the present case their Lordships can see no material difference between this test and the test laid down in S16(1) and S17(1)(b) of the Hong Kong Ordinance.’

The facts in Cosmotron showed that the redundancy payments were normal employment costs and not incurred for the purpose of going out of business. There is now a specific statutory relief for certain redundancy payments (see S76-79 ITTOIA 2005 for unincorporated businesses, S76-79 CTA 2009 for companies and S309 Income Tax (Earnings and Pensions) Act 2003 for the treatment in the hands of the employee, see also BIM47200 onwards).