BIM37965 - Wholly & exclusively: expenditure having an intrinsic duality of purpose: costs of defending against a charge of gross misconduct
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 by the taxpayer as to
purpose gives little scope to overturn the decision in the High
Court following the decision in Edwards v Bairstow & Harrison
[1955] 36TC207
BIM37045.
In the case of McKnight v Sheppard [1999] 71TC419, 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. 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 of £30,000 and £20,000 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 Sheppard for admission to the register of directors, but the Association’s appeal tribunal allowed 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.
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 Sheppard
from membership of the Stock Exchange, or suspension for six month,
would have been the end of his firm. In fighting the proceedings
and appeal and incurring the legal fees, 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
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 ICTA88/S74 (1)(e)] 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 Sheppard’s appeal against the disallowance
of the fines. 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 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
Sheppard’s trade, because:
- 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;
- 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 Hoffman rejected
both. He explained why both arguments failed.
The Crown’s first argument was that the expenditure
served a dual purpose, the preservation of:
- Sheppard’s business, and
- Sheppard’s personal reputation.
In the House of Lords, Lord Hoffman 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 Hoffman thought that the Special Commissioner and
the Judge were quite right in not allowing the fines to be
deducted. But he goes on to explain that it does not follow that
the costs are 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 Hoffman distinguishes between damages that
are compensatory (and which may be allowed) and damages which are
punitive (and which are not allowed).
Lord Hoffman explains the policy reasons for not allowing
punitive damages and clarifies 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
Commissioners to infer the protection of same as one of the
purposes of such expenditure.
There will be an inevitable private purpose in trying to
avoid a criminal conviction, particularly one where the punishment
includes the possibility of imprisonment.
For those who do not have ready access to tax case volumes,
the part of Lord Hoffman’s judgement where he identifies the
significance of the taxpayer’s uncontested evidence as to
purpose is set out below, 71TC450B to 451D:
My Lords, on an appeal from the Special
Commissioner by way of Case Stated, the only question, as Nourse L.
J. 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 [1956] AC 14; 36TC207. Mr.
Grabiner Q.C. 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 [57TC330, 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 [57TC330, see BIM37910] 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 [57TC330, see BIM37910], 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 ICTA88/S74 (1)(a)]. ’
If Lord Brightman’s consultant [see BIM37910] 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.
For those who do not have ready access to tax case volumes, the part of Lord Hoffman’s judgement where he describes the policy reasons for not allowing penalties is set out below, 71TC452E to 452G:
I think with great respect that the Court of Appeal had difficulty in identifying exactly what this was because they were looking in the wrong place. They hoped to find the answer in the broad general principles of what counts as an allowable deduction. But the reason in my opinion is much more specific and 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. This, I think, is what Lord Sterndale M.R. meant when he said that the fine was imposed ‘upon the company personally’.
For those who do not have ready access to tax case volumes, the part of Lord Hoffman’s the judgement explains why the fines were not allowable but the defence costs are is set out below, 71TC452G to 453B:
…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. This explains the divergent answers given by the Courts in the various cases on fines, penalties, damages and costs to which your Lordships were referred. So, for example, in The Herald and Weekly Times Ltd. V. Federal Commissioner of Taxation (1932) 48 C.L.R. 113 the High Court of Australia decided that damages for defamation payable by a newspaper company were a deductible expense. This seems to me correct: as Gavan Duffy C.J. and Dixon J. said in their joint judgment, at page 119, such claims against a newspaper are a‘‘ regular and almost unavoidable incident of publishing it’’ and the damages are compensatory rather than punitive. There would seem no reason of policy why a rule which allows recovery of damages by plaintiffs defamed in the course of carrying on the business should prohibit deduction of those damages as an expense. In von Glehn, Scrutton L.J. expressed some anxiety lest the broad principles he thought he was applying should exclude the deductibility of civil damages for negligence. But the relevant principles are in fact a great deal more specific and can accommodate both von Glehn and The Herald and Weekly Times Ltd. V. Federal Commissioner of Taxation (1932) 48 C.L.R. 113 without inconsistency.
