We go 'back to basics' as we examine what can be allowed in terms of legal costs.
In the course of trading or being in business generally, there will sometimes be incidents that lead to court actions or legal costs. It can be a minefield trying to establish whether or not a cost is deductible for tax purposes. Where it is not clear from the legislation or general principles, there is a host of case law to refer to.
When a business incurs legal fees, or is subject to other associated costs such as damages or penalties linked to court action, normal principles will apply in determining deductibility. The costs will not be allowable if they fail the 'wholly and exclusively' test, if they are capital rather than revenue in nature, or if they are a loss which is not connected with or arises from a trade. Whether the action is successful or not has no bearing on the allowability of the expense.
Legal costs in connection with leases can fall to be treated as revenue or capital expenditure. The general principle is that the initial purchase of a lease will be capital, so costs associated with that will not be deductible (unless there is a disposal of the asset in which case they will form part of the capital gains computation). Renewal of a lease may also involve legal and professional fees, and these will also be capital expenditure, though if the renewal is of a short lease the amount is likely to be small and may be allowed. Generally speaking though, leases aside,it is usually clear whether the transaction in question is of a capital or revenue nature.
The 'wholly and exclusively' test is slightly more difficult as there is perhaps a certain amount of subjectivity, which has led to there being rather a lot of case law in this area. The payment of compensation to a customer for injury would possibly be considered to be wholly and exclusively for the purpose of the trade, but it is not as straightforward as that. Certainly civil damages for injury to third parties caused by the day to day trading operations would be an allowable cost. However, the 1906 case Strong & Co of Romsey v Woodifield involved injury to a customer and a payment for damages that was considered not to be deductible.
Strong & Co of Romsey was a brewing company, and the customer was sleeping in one of their inns when he was injured by a falling chimney. The brewery had to pay him damages but was not allowed a deduction for them in its accounts. Lord Davy said: 'I think that the payment of these damages was not money expended “for the purpose of the trade”. These words are used in other rules, and appear to me to mean for the purpose of enabling a person to carry on and earn profits in the trade. I think the disbursements permitted are such as are made for that purpose. It is not enough that the disbursement is made in the course of, or arises out of, or is connected with the trade, or is made out of the profits of the trade. It must be made for the purpose of earning the profits.'
Infractions of the law
Fines, penalties, damages and the legal costs associated with them will not be allowed as deductions when the penalties are for infractions of the law. It is considered that in this case they are not a 'commercial loss'.
The amount of confiscation orders are sometimes calculated by reference to the turnover of the business, but this does not mean that they are an allowable deduction from turnover. A confiscation order is a penal measure and so cannot be a deductible amount. Costs incurred in settling an action for a breach of the law will not be allowable, even if the legal action takes place overseas or the breach relates to a jurisdiction other than the UK.
The costs of defending a libel action might be allowable, if, for example they were payable by a publication. However, in the case of Fairrie v Hall (1947) the costs were deemed to be not allowable. Mr Fairrie had to pay damages to Mr Rook in relation to malicious libels. These communications could have damaged Mr Rook's professional reputation and trade, but the High Court held that the expenditure was not laid out wholly and exclusively for the purposes of Mr Fairrie's trade, nor was it a loss connected with or arising out of the trade.
Costs associated with getting out of a normal trading contract will be allowable, including payments to compel a director to withdraw a legal action against a company (G. Scammell & Nephew Ltd v Rowles (1939)). When a business incurs costs in defending a charge of breach of contract, the costs will be deductible if the business is defending trade assets but will naturally not be an allowable deduction if the case is to defend a personal reputation. Similarly the costs of litigating a trade dispute are allowable while those relating to a private dispute - even if between two traders - are not.
The case quoted above, Strong & Co of Romsey v Woodifield, is over a hundred years old, but there are still cases heard today that deal with the types of issues mentioned in this article. Take, for example, the 2014 case P McMahon v HMRC, which dealt with the costs of defending an action by a former employer. Mr McMahon left his employment with Quantica plc and became self employed in the same field. The company later commenced proceedings against him, claiming that he had breached an agreement not to contact or canvass any of his former employer's clients. Mr McMahon agreed to pay £100,000 in settlement of Quantica's claim. He then claimed the £100,000 plus associated legal costs on his tax return. HMRC rejected the claim on the basis that the expenditure had not been wholly and exclusively incurred for the purpose of Mr McMahon's business.
The first-tier tribunal dismissed Mr McMahon's appeal and held that the expenditure had a dual purpose and that one of the purposes had arisen out of Mr McMahon's employment contract. Therefore the expenditure was not wholly and exclusively for the purpose of the business and could not be an allowable deduction.
The basic principles that apply when looking at the allowability of an expense, in particular the wholly and exclusively test and the capital/revenue distinction, must also be considered when deciding whether a legal or penalty or court cost can be a deduction for tax purposes. Luckily, when the particular nuances of a specific transaction defy easy decisions, there is a plethora of court cases to refer to, and the case law should hopefully provide guidance to confused business owners.
ACCA's website includes a section that details many useful tax cases on a variety of topics.