It is a general rule that payments in the nature of penalties may not be deducted for the purpose of calculating taxable profits. The Court of Appeal recently considered whether the rule prevented payments made to consumers and consumer organisations in...
It is a general rule that payments in the nature of penalties may not be deducted for the purpose of calculating taxable profits. The Court of Appeal recently considered whether the rule prevented payments made to consumers and consumer organisations in settlement of a regulatory investigation from being tax deductible.
An energy provider had entered into agreements with the Gas and Electricity Markets Authority (GEMA) in settlement of an investigation into issues such as mis-selling, complaints handling and costs transparency. Substantial penalties had been proposed during the investigation process, but the energy provider ultimately paid only nominal penalties and made payments to consumers and consumer organisations of around £28 million. After HM Revenue and Customs (HMRC) denied Corporation Tax deductions on those payments, the energy provider appealed to the First-tier Tribunal (FTT).
The FTT found that the energy provider had agreed to the settlement in the expectation that greater penalties would otherwise have been imposed. The payments were in lieu of a penalty and therefore not deductible, except for £554,013 paid to customers affected by mis-selling, which was compensatory. However, the FTT also concluded that the payments were made wholly and exclusively for the purposes of the energy provider's trade.
On appeal, the Upper Tribunal concluded that none of the payments were deductible and the FTT had been wrong to draw a distinction between punitive and compensatory payments. The entire settlement had been put together under the threat of a penalty and the payments were made in lieu of a penalty.
Ruling on the company's further appeal against that decision, the Court noted that case law provided no support for extending the rule that fines and penalties are non-deductible to payments which are not, in fact, fines or penalties. HMRC's case was that the payments should be treated as penalties because that was what they replaced: however, no authority had been cited for the proposition that the deductibility of a payment should be determined by the nature of a payment it replaced. The Court did not consider that a regulator's position was undermined by the possibility that an alternative form of redress might be deductible. There was no need for judges to step in to ensure that differences in tax treatment between penalties and other forms of redress were avoided.
The Court noted that the energy provider's agreeing to make the payments was only one of a number of factors the GEMA had taken into account in determining the appropriate penalty. During the investigation, the energy provider had made significant improvements to its billing performance and customer service and had taken steps to avoid mis-selling. The GEMA had clearly considered that the payments were not penalties. It had no power to redirect a penalty payment to consumers, and it had not done so.
Allowing the appeal, the Court concluded that the payments were not in fact penalties and, as the FTT's finding that they were made wholly and exclusively for the purposes of the trade had not been challenged, they were tax deductible.