United Kingdom House of Lords Decisions

LORD HOFFMANN

My Lords,

The respondent ("the taxpayer") is a stockbroker who in 1986-87 incurred legal expenses of some £200,000 defending himself against proceedings before the disciplinary committee of the Stock Exchange and appearing before the appeals committee. The question is whether the deduction of these expenses for the purpose of computing the taxpayer's profits under Case I of Schedule D is excluded by section 130(a) of the Income and Corporation Taxes Act 1970 on the ground that it was not "money wholly and exclusively laid out or expended for the purposes of the trade."

The taxpayer was charged on 17 counts, of which 12 alleged gross misconduct, for which the penalty could be expulsion or suspension. He was found guilty on four charges of gross misconduct (including one finding of dishonesty) and 3 charges of ordinary misconduct. He was ordered to be suspended for 6 months. The suspension was itself suspended pending an appeal. The appeals committee confirmed two of the findings of gross misconduct (including the one involving alleged dishonesty), reduced one to ordinary misconduct and allowed the appeal against the fourth. All the findings of ordinary misconduct were affirmed. The order for suspension was set aside and fines totalling £50,000 were imposed instead. It is only fair to the taxpayer to record that in a subsequent appeal against a refusal of authorisation by the Securities Association, the appeal tribunal, chaired by Sir Godfray le Quesne Q.C., heard unchallenged oral evidence which had not been before the Stock Exchange committee and which resulted in the exoneration of the taxpayer from the imputation of dishonesty.

The taxpayer at first sought to deduct both the fines and legal expenses. The inspector disallowed both and the taxpayer appealed to the Special Commissioner. He allowed the appeal in respect of the legal expenses but not the fines. The parties appealed to the High Court where Lightman J. allowed the Revenue's appeal against deducting the expenses and dismissed the taxpayer's appeal against the disallowance of the fines. The taxpayer appealed against this decision on expenses but did not pursue the question of the fines. The Court of Appeal (Nourse, Potter and Mummery L.JJ.) allowed the taxpayer's appeal and against that decision the Revenue appeal to your Lordships' House.

The Special Commissioner found that the taxpayer was a sole trader and that expulsion or a period of suspension would have destroyed his trade. He found that his exclusive purpose in laying out the legal costs was the preservation of his trade. The well-known case of Morgan v. Tate & Lyle Ltd. [1955] A.C. 21 is authority for the proposition that money spent for the purpose of preserving the trade from destruction can properly be treated as wholly and exclusively expended for the purposes of the trade within the meaning of section 130(a). The Special Commissioner so found.

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. 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 [1983] 2 A.C. 861.

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 [1983] 2 A.C. 861, 870-871 per Lord Brightman)."

The Special Commissioner is here saying that although he does not accept that the taxpayer was unconcerned about the advantages which a 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 [1983] 2 A.C. 861, 870-871 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 a 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 section 130."

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.

Mr. Grabiner'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 of profits in the trade. This was not a case like of Morgan v. Tate & Lyle Ltd. [1955] A.C. 21. in which the taxpayer was defending his business against an external threat. This expenditure resulted from the taxpayer's own misconduct, that is to say, from behaviour outside the proper scope of his trade. Mr Grabiner referred to Inland Revenue Commissioners v. von Glehn [1920] 2 K.B. 553, in which the Court of Appeal disallowed the deduction of a penalty imposed upon a company during the First World War under the Customs (War Powers) Act 1915 for exporting goods without taking all reasonable care to secure that the ultimate destination should not be enemy territory. Lord Sterndale M.R. said that although the incurring of the penalty was connected with the trade, in the sense that it would not have happened unless the trade had been carried on, it was not for the purposes of the trade but because of a wrongful act on the part of the company.

I have no doubt that their decision was correct. But the Court of Appeal were curiously inarticulate about why the fine was not money expended for the purposes of the trade. Lord Sterndale M.R. said, at p. 566: "It is perhaps a little difficult to put the distinction into very exact language" but that the payment was not a "loss connected with the business but. . . a fine imposed upon the company personally." Warrington L.J. said, at p. 569, that the payment was not a loss "connected with or arising out of the trade" because it was a sum which "the persons conducting the trade have had to pay because in conducting it they have so acted as to render themselves liable to this penalty." Scrutton L.J. said, at p. 571, that the obvious answer to the question whether a trader could deduct penalties imposed for carrying on the trade in an unlawful manner was "Of course he cannot" but said that he did not find it easy to explain the reasons. He cited some well-known dicta about the criteria for allowable deductions and went on to say:

 ". . . [W]ere these penalties an expenditure necessary to earn the profits ? Were they paid for the purpose of earning the profits ? The answer seems to me to be obvious, that they were not; they were unfortunate incidents which followed after the profits had been earned."

To say that the payments "followed after the profits had been earned" is only another way of saying that they could not be deducted in the calculation of profits. It restates the question rather than explaining the answer. von Glehn was not a case like Smith's Potato Estates Limited v. Bolland [1948] A.C. 508 in which it would have involved an illogical circularity to treat the expenditure as a trade expense. In that case, the taxpayer claimed to deduct the legal costs of contesting an assessment to tax. The dispute was about the computation of the taxpayer's profits. It assumed that those profits were ascertainable, one way or another, at the time when the dispute arose. The costs of the dispute could not therefore have been an element in the computation. They were logically as well as temporally subsequent to the profits having been earned.

But there would have been no similar illogicality in treating the penalty in von Glehn as a trading expense. It was, as the Court of Appeal accepted, incurred in the course of the company's trade. There must therefore have been something in the nature of the expense which prevented it from being deductible. 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."

By parity of reasoning, 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, 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.

The question is then whether there is any reason of policy which prohibits the deduction of legal expenses incurred as a result of penal or disciplinary proceedings arising out of the conduct of the business. In von Glehn there was also a claim to deduct the incidental legal expenses associated with the penalty. No separate argument was addressed to this question and it was assumed to be governed by the decision on the deductibility of the penalty itself. But I do not think that this is right. The issues are different. What would have been the position if the allegations had proved to be groundless and the taxpayer had been acquitted? It would have seemed unfair not to allow any deduction for the taxpayer's legal expenses. In principle, however, the purpose of the payment will be the same whether the taxpayer's defence turns out to be successful or not. Can there be a distinction between the costs of a successful and an unsuccessful defence? It might be argued that, as a matter of policy, the unsuccessful defendant should have to bear his legal costs personally in the same way as the penalty itself. But I think there would be great difficulties about giving effect to such a rule. It might not be easy to tell which costs had been expended successfully and which unsuccessfully. The taxpayer may, as in this case, have been convicted on some counts and acquitted on others. He may have had substantial success in mitigation of the penalty. More important, it is fundamental that everyone, guilty or not guilty, should be entitled to defend themselves. I do not see that any clear policy would be infringed by allowing the deduction of the legal expenses incurred in resisting the disciplinary proceedings. On the contrary, I think that non-deductibility would be in effect an additional fine or penalty for which the regulatory scheme does not provide. The Special Commissioner was therefore right to treat the case as governed by the general principle in Morgan v. Tate & Lyle Ltd [1955] A.C. 21.

I would dismiss the appeal.

LORD MACKAY OF CLASHFERN

My Lords,

I have had the advantage of reading a draft of the speech prepared by my noble and learned friend Lord Hoffmann. For the reasons he has given I too would dismiss this appeal.

LORD CLYDE

My Lords,

I have had the advantage of reading a draft of the speech of my noble and learned friend Lord Hoffmann. For the reasons he has given I too would dismiss this appeal.

LORD HUTTON

My Lords,

I have had the advantage of reading a draft of the speech of my noble and learned friend Lord Hoffmann. For the reasons he has given I too would dismiss this appeal.

LORD HOBHOUSE OF WOODBOROUGH

My Lords,

I have had the advantage of reading a draft of the speech of my noble and learned friend Lord Hoffmann. For the reasons he has given I too would dismiss this appeal.