Payments in settlement of regulatory breaches

The Supreme Court has overturned the decision of the Court of Appeal in ScottishPower v HMRC [2026] UKSC 35 and held that payments by Scottish Power pursuant to agreements with regulators in settlement of various regulatory investigations into matters such as mis-selling, complaints handling and costs transparency were not deductible for corporation tax purposes. The Supreme Court has held that the reason that penalties are not deductible is not (as the Court of Appeal considered) due to some broader judge-made principle that penalties are not deductible as a matter of public policy, but simply because they are not made wholly and exclusively for the purposes of the trade.

Background

ScottishPower (SP) operated as a supplier and generator of electricity and gas regulated by the energy regulator, Ofgem. Between 2013 and 2016, SP entered into a number of settlement agreements with Ofgem under which it agreed to pay penalties in nominal amounts of £1, together with redress payments to consumers, consumer groups and charities totalling £28m. In each case, Ofgem opened an investigation, proposed penalties and, following negotiations, reached a settlement agreement.

SP sought to deduct the £28m for corporation tax purposes, but HMRC rejected that approach. HMRC took the view that the redress payments were not deductible based on the principles derived from earlier caselaw, including Inland Revenue v Alexander von Glehn & Co. Ltd [1920] 2 KB 553 and the House of Lords decision in McKnight v Sheppard [1999] STC 669. In the latter case a stock broker sought to deduct fines imposed by the Stock Exchange for breaches of the Stock Exchange rules and the House of Lords held that payments made in the nature of penalties are not deductible.

SP appealed, but its appeal was largely dismissed by the FTT, apart from in relation to one payment of £500,000 made directly to customers affected by mis-selling which the FTT considered was compensatory rather than penal and so fell outside the McKnight principle. The Upper Tribunal dismissed SP's appeal. The Upper Tribunal considered that the principle in McKnight that fines and penalties should not be deductible on public policy grounds also extended to payments, as in this case, made in lieu of fines and penalties. Furthermore, the Tribunal considered that the FTT had been wrong to separately consider each of the payments and consider if they were punitive or compensatory. The focus should have been on whether overall the payments bore the necessary punitive character. Where, as here, the payments were part of an overall package, the proper approach was to ask whether, on a global assessment of the evidence, the relevant payment has a punitive character. Once an assessment has been made of the characterisation of the overall package (taking into account the individual elements), one should not go back and consider whether individual elements are more compensatory or punitive. As such, the Tribunal allowed HMRC's appeal in relation to the payment of £500,000 made directly to customers.

The Court of Appeal overturned the decisions of the FTT and Upper Tribunal and held that payments made by Scottish Power pursuant to agreements with regulators in settlement of various regulatory investigations were deductible. The Court held that, on the facts, the payments were not fines or penalty payments and so did not fall within the scope of the reasoning in earlier jurisprudence that fines and penalty payments are not deductible.

The Court of Appeal had sought to elucidate the basis of the principle that payments made by way of fines and penalties are not deductible for tax purposes. The Court noted the general rule that the profits for corporation tax follows the accounting treatment except to the extent that there were statutory or judge made exclusions. In this case, there were two possible bases for the exception:

• s.54(1) which provides that: "In calculating the profits of a trade, no deduction is allowed for (a) expenses not incurred wholly and exclusively for the purposes of the trade"

• s.46 which provides that: "The profits of a trade must be calculated in accordance with generally accepted accounting practice, subject to any adjustment required or authorised by law in calculating profits for corporation tax purposes".

The Court of Appeal reached the conclusion that the rule preventing any deduction for penalties and fines should be regarded as an "adjustment required...by law" within s.46(1). The Court explained: "However, in enacting s.46 Parliament recognised that restrictions may exist which do not have an express statutory basis and which are instead found to exist by case law. In this case the principle established by von Glehn, many years before either s.46 or its statutory predecessor (s.42 of the Finance Act 1998) was enacted, may be regarded as a recognition by the courts that when computing profits for tax purposes an adjustment must be made to prevent a deduction being obtained for fines or penalties imposed by a statutory regime, notwithstanding that the expenditure would otherwise be taken into account in determining profits in accordance with generally accepted accounting principles. An adjustment is required because otherwise the "legislative policy [of the penalty regime] 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".

The Court rejected the existence of a broader principle, in this context at least, that a payment should attract the tax treatment of a payment that it replaces (the replacement principle). The payments in this case, even if they could be regarded as replacing fines and penalties, did not therefore automatically attract the same tax treatment as such fines and penalties which they replaced. In addition, since the exclusionary rule was a judge-made rule, it should be construed narrowly and not be extended to sums which were not strictly penalties or fines.

Decision of the Supreme Court

The Supreme Court analysed the earlier caselaw in cases including Alexander von Glehn and McKnight v Sheppard. In doing so, the Court has rejected the Court of Appeal's analysis that the departure from accounting practice for payments by way of penalty or fine is as a result of a judge-made rule. A proper analysis of the earlier caselaw indicated that the true basis for the exception was simply that payments by way of penalty or fine are not made wholly and exclusively for the purposes of the trade. Rather, the purpose of payment is "to satisfy a legal obligation which arises usually under statute to punish 

the taxpayer for infringing rules which bind him in the conduct of his trade. That is the taxpayer's purpose in making the payment and it is that purpose which, on the true construction of section 54(1)(a), is not a purpose of the trade".

"It is clear on the authorities that penalties are not deductible. In our view it is also clear that the reason they are not deductible is that they are not incurred for the purposes of the trade. They represent expenditure of a very different nature. They are punishments imposed because of wrongs which the taxpayer has committed. Their object is to punish the offender and to deter him and others from engaging in such behaviour. The taxpayer's object in paying the penalty is not to carry on the trade, but to answer for his breach."

In addition, the Supreme Court noted that there are policy reasons which support construing s.54(1)(a) as excluding penalties, including "that it would be unfair to the public for the taxpayer to be able to share the financial burden of the penalty with them, or, to put it another way, that it would dilute the effect of the penalty if it was not subject to tax".

Were the redress payments in this case to be treated the same as penalties and fines? Whilst the redress payments were part of a settlement and ScottishPower was not compelled to enter into that settlement arrangement, it was the case that if they had not done so then it would have faced fines of the same or similar amounts. As a matter of substance rather than form, the redress payments were akin to penalties. Moreover, the Court concluded that, on the basis of the caselaw, they were sufficiently akin to penalties for it to be clear that they were not expenditure incurred for the purposes of ScottishPower's trade. The Supreme Court pointed out that the payments made in von Glehn appeared equally to be made to avoid the imposition of penalties (under settlement agreements) rather than strictly being penalties or fines themselves.

Moreover, this analysis applied to all the payments made. It was not possible to treat payments to customers differently from the other payments under the settlement agreement. They were all part of the package negotiated as an overall deal.

Finally, ScottishPower had argued that some of the breaches were practically unavoidable and were an inevitable part of carrying on the business. In this context, ScottishPower relied on the Australian decision in Herald and Weekly Times, where it was held that defamation payments made by a newspaper were deductible as they were an unavoidable consequence of carrying on the business and as such wholly and exclusively incurred for the purposes of earning income. The Supreme Court were content to distinguish Herald and Weekly Times on the basis that it involved tortious payments rather than penalties or fines, commenting that: "Whatever may be its continued relevance to the deductibility of defamation damages, it has no place in assessing whether penalties or redress payments are tax deductible."

Comment

The Supreme Court has analysed the clear principle that penalties are not deductible as simply a function of the fact that such penalties are not incurred for the purposes of a trade. Whilst that analysis may be bolstered by considerations of public policy, the exclusion is not the result of a separate judge-made principle excluding penalties or fines from deduction.

Since fines and penalties are not deductible, it followed that the payment in this case, which was made in circumstances where a fine would otherwise have been imposed, were sufficiently akin to excluded payments that they were also not made wholly and exclusively for the purposes of the trade. There was no need to rely on a "replacement principle".