Wednesday Law Report: 23 June 1999 - Legal expenses are deductible for tax

THERE WAS no reason of policy which prohibited a taxpayer from deducting, under section 130(a) of the Income and Corporation Taxes Act 1970, legal expenses he had incurred as a result of defending penal or disciplinary proceedings arising out of the conduct of his business.

The House of Lords dismissed the appeal of the Inland Revenue against a decision of the Court of Appeal upholding a decision of the Special Commissioner, that the taxpayer was entitled, in computing his profits, to deduct legal expenses incurred as a result of disciplinary proceedings.

The taxpayer was a stockbroker who in 1986-87 incurred legal expenses of some pounds 200,000 in defending himself against proceedings, which could have resulted in his suspension or expulsion, before the disciplinary committee and the appeals committee of the Stock Exchange. He sought to deduct those legal expenses, and fines of pounds 50,000 which he had been required to pay, as expenses for the purpose of computing his profits under Case I of Schedule D.

The inspector disallowed both the legal expenses and the fines as being excluded by section 130(a) of the Income and Corporation Taxes Act 1970 on the ground that they were not "money wholly and exclusively laid out or expended for the purposes of the trade". The taxpayer appealed to the Special Commissioner, who allowed the appeal in respect of the legal expenses but not the fines.

The Special Commissioner found that the taxpayer was a sole trader; that expulsion or a period of suspension would have destroyed his trade; and that his exclusive purpose in laying out the legal costs was the preservation of his trade. Those costs could therefore properly be treated as wholly and exclusively expended for the purposes of the trade within section 130(a) of the Income and Corporation Taxes Act 1970.

The parties appealed to the High Court, where the Revenue's appeal against deducting the legal expenses was allowed and the taxpayer's appeal against the disallowance of the fines was dismissed.

The taxpayer successfully appealed to the Court of Appeal against the High Court's decision on the legal expenses.

David Goldberg QC and Hugh McKay (Davis Blank Furniss) for the taxpayer; Anthony Grabiner QC and Timothy Brennan (Solicitor of Inland Revenue) for the Crown.

Lord Hoffmann said that on an appeal from the Special Commissioner by way of case stated, the only question was whether, on the facts as the Commissioner found them, his conclusion was open to him as a matter of law.

It was argued for the Revenue that it was not, because the taxpayer had had the dual purpose in paying his legal expenses of preserving his business and his personal reputation; and that the expenditure had to be "in furtherance of the relevant commercial activity".

Morgan v Tate & Lyle Ltd [1954] 2 All ER 413 was authority for the proposition that money spent by a taxpayer for the purpose of preserving his trade from destruction could properly be treated as wholly and exclusively expended for the purposes of the trade within s 130(a) of the 1970 Act, and the Special Commissioner had been right to treat the present case as governed by that principle.

Although the Special Commissioner and the judge had been quite right not to allow the taxpayer to deduct the fines, since the purpose of a fine or penalty was to punish the taxpayer, and he should not be allowed to share that burden with the rest of the community by a deduction for the purposes of tax, it did not follow that the legal costs were not deductible.

The question was whether there was any reason of policy which prohibited the deduction of legal expenses incurred as a result of penal or disciplinary proceedings arising out of the conduct of the taxpayer's business. There was no such reason of policy: it was fundamental that everyone, guilty or not guilty, should be entitled to defend themselves.