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HMRC internal manual

Business Income Manual

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Wholly and exclusively: fines, penalties and damages: payment to get director to withdraw legal action

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

The costs of getting out of a normal trading contract are allowable

A payment to bring an end to a trading relationship will usually satisfy the requirements of S34(1)(a) Income Tax (Trading and Other Income) Act 2005 for unincorporated businesses and S54(1)(a) Corporation Tax Act 2009 for companies. Similarly the costs of entering into or varying a trading relationship are likely to satisfy these rules. The cost of entering or leaving trading relationships may however be incurred on capital account (see BIM35530).

In the case of G Scammell & Nephew Ltd v Rowles [1939] 22 TC 479, the company’s directors acquired a controlling interest in another company (Blue Belle Motors Ltd), whose operations thereafter they carried on as directors. G Scammell & Nephew Ltd carried on the trade of motor engineers. Blue Belle Motors Ltd carried on the trade of running motor coaches. Blue Belle Motors Ltd became indebted to G Scammell & Nephew Ltd on trading account and issued debentures in its favour to secure the debt.

Mr Toms, the holder of the remaining shares of Blue Belle Motors Ltd, who had been a director of the Blue Belle Motors Ltd and claimed that he had never relinquished that office, issued a writ against the two companies and the new directors. The latter were advised that the arrangements they had made with G Scammell & Nephew Ltd as directors of the Blue Belle Motors Ltd, including the issue of debentures, could be impugned and avoided. This could have had the effect that some £12,000 owed by Blue Belle Motors Ltd to G Scammell & Nephew Ltd might be lost. A compromise was thereupon reached on terms that included, amongst other things:

  1. the sale of the directors’ shareholding in Blue Belle Motors Ltd to Mr Toms, the surrender of its debentures for cancellation and the settlement of its indebtedness to G Scammell & Nephew Ltd on agreed terms
  2. the payment of a contribution of £60 towards Mr Toms’ costs, and
  3. the withdrawal of a slander action commenced against Mr Toms by the directors (to one of whom, a Mr Hood Barrs, G Scammell & Nephew Ltd paid £7,500 to secure his assent to such withdrawal)

G Scammell & Nephew Ltd incurred costs of some £50 in connection with the compromise.

G Scammell & Nephew Ltd claimed a deduction for these amounts against its trading profits.

The Special Commissioners held that the compromise was effected, not for purposes of G Scammell & Nephew Ltd’s trade, but to enable it to terminate a trading relation which it found inconvenient with the minimum sacrifice of the balance of account resulting from that relationship. The payments made to secure the assent of the parties to the compromise and the legal costs of carrying it through were not money wholly and exclusively laid out or expended for the purposes of G Scammell & Nephew Ltd’s trade.

The High Court decided that the payments in question were made for the purposes of G Scammell & Nephew Ltd’s trade and accordingly they were allowable deductions in computing its profits for tax purposes. The Court of Appeal confirmed that the expenditure was deductible.

The Master of the Rolls, Sir Wilfrid Greene, found that the Commissioners had erred in finding that a payment to bring an end to a trading relationship could not be made for the purposes of the trade. He concluded that the payments were made to secure the recovery of as much as possible of the debt owed by Blue Belle Motors Ltd.

The part of Sir Wilfrid Greene MR’s judgment on which the above guidance is based is set out at pages 496-498:

`Now it seems to me that there is no real evidence upon which the Commissioners were justified in finding that Scammells entered into this compromise to enable them to determine a trading relation. If that view be correct, and if, as I think is the case, there is no evidence upon which the Commissioners could find that the object of the Appellant Company in entering into the compromise was anything except to obtain payment of as much of the balance of the account as they could persuade Mr Toms to agree to, and that account being, as I have said, a trading account, it seems to me that the compromise was a compromise effected for the purpose of the Company’s trade and for the purpose of enabling them to recover the payment of a trading debt owing to them from a customer, which would come into computation in their trading account. On that basis, payments made as a condition of obtaining that compromise which secured that payment to them would have been payments wholly and exclusively laid out or expended for the purposes of the Appellant Company’s trade…

… Therefore, we find this Company finding itself in a situation of trading relationship with another company which it wishes to get rid of because it is inconvenient to it. On that basis, and giving full force to the qualifying word “trading”, it seems to me that the conclusion to which the Commissioners have come, namely, that a compromise directed to obtaining the termination of such a relationship was not for the purposes of the Appellant Company’s trade, is, with all respect to them, a complete non sequitur. They seem to have thought that a transaction entered into to get rid of a trading relationship is one which, as a matter of law, could not be for the purposes of the trade. It looks as though they had thought that the compromise, if it had looked forward to some affirmative trading in the future, might have been regarded as for the purposes of the trade, but as, on the other hand, it was merely terminating the possibility of disadvantageous trading in the future, it could not be for the purposes of the trade. That seems to me, with all respect to them, to be quite a wrong method of dealing with the matter. The termination of a trading relationship in order to avoid losses occurring in the future through that relationship, whether pecuniary losses or commercial inconveniences, is just as much for the purposes of the trade as the making or the carrying into effect of a trading agreement.’