Payments in settlement of regulatory breaches tax deductible

The Court of Appeal has 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 into matters such as mis-selling, complaints handling and costs transparency were deductible for corporation tax purposes: ScottishPower v HMRC [2025] EWCA 3. 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 has also 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, would not therefore automatically attract the same tax treatment as such fines and penalties which they replaced.

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 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 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 it's 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.

Decision of the Court of Appeal

The decision of the Court of Appeal first seeks 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:

1. 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, or (b) losses not connected with or arising out of the trade;

2. 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 Upper Tribunal had considered that the basis for the exclusion was s.54(1). The Tribunal considered that the basis for the decision in McKnight was that a payment made by way of fine was not made "for the purposes of the trade". This was a matter of public policy that payments having the character of a fine or penalty are made to punish the taxpayer and it would be wrong in those circumstances if the taxpayer were allowed to share the burden with the rest of the community by deducting the payments for tax purpose. As such, the Tribunal considered that the reasoning in McKnight was that such payments were not for "the purposes of the trade" (even if made in the course of the trade).

Whilst recognising that some support can be found for that approach in the authorities, the Court noted that the alternative explanation is that the rule established should now be regarded as an "adjustment required...by law" within s.46(1). Indeed, the Court considered this to be the "better analysis". The Court considered that the general expectation is that adjustments to profits will have a statutory basis. However, a "judge-made rule" may exist which adjusts properly computed accounting profits, but only if it clearly has that effect.

Where a penalty or fine was imposed under a statutory regime (as in von Glehn), 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 noted that the same approach appeared possibly to have been applied to non-statutory fines by parity of reasoning, though since the fines in this case had a statutory basis, it was unnecessary to consider that aspect of the rule further.

However, it was important to understand that a rule that denies a deduction for expenses that are not only incurred in the course of trading activities but are taken into account in calculating profits in accordance with generally accepted accounting practice will generally be expected to be statutory rather than "judge-made". Any rule which does not have an express statutory basis needs to be clear in its effect. Whilst it was clear that such a rule exists in relation to the deduction of fines and penalties, at least where they are imposed under a legislative regime (von Glehn, as explained in McKnight v Sheppard), there was no support in the authorities for that rule to extend to amounts which are not, in fact, fines or penalties. Further, the scope of any such extension would be anything but clear. On the contrary, it would be highly uncertain.

In this case, the disputed £28m payments were not fines or penalties. The only fines were the nominal £1 fines. The regulator's basis for agreeing to nominal penalties was the requirement to have regard to all the circumstances when fixing their amount, but that does not mean that its agreement to

the disputed payments was itself an exercise of that power. This was not a case of a penalty payment simply being redirected to consumers and others. The regulator had no power to redirect a penalty payment and it did not do so.

HMRC's case, essentially accepted by the FTT and UT, is that the disputed payments in this case should be treated as having the same nature or character as penalties because that is what they replaced. However, even if the payments replaced penalties that would otherwise have been levied in fact, the Court disagreed with that premise. "No authority was cited to support any general proposition that the deductibility of a payment should be determined by reference to the nature of a payment which it replaces. Rather, it is necessary to consider whether the payment actually made is deductible or is to be denied a deduction, whether because it is of a capital nature, because it was not in fact an expense incurred wholly and exclusively for the purposes of the trade, or for some other reason." The Court rejected the argument that any general considerations of policy, whether legislative or otherwise, require a conclusion that a principle which prohibits a deduction for fines or penalties must extend to payments which are not in fact fines or penalties, even if they can be seen as replacing them.

This conclusion was supported by the lack of clarity about the scope of any such rule and the difficulties the Court considered would arise in applying any such principle. For example, the Court noted that the regulator took into account a large number of factors in the settlement, including not only the payments to customers but also significant improvements made to SP's billing performance and its customer service. There was an explicit statement that the penalty would have been higher if SP had not both agreed to pay £8.compensation and "taken steps to improve its systems and processes and to introduce new checks and procedures to improve compliance". Introducing those changes presumably incurred a great deal of expenditure and yet HMRC had not sought to argue that such expenditure would not be deductible on the basis that it replaced fines that would otherwise have been imposed.

Moreover, there was no reason in principle why a regulator or other body imposing a penalty or fine may not, if it is contemplating agreeing to some alternative form of redress, take account of the fact that such an alternative may attract a more beneficial tax treatment. As such, "there is no need for judges to step in to ensure that differences in tax treatment between penalties or fines and alternative forms of redress are avoided. The policy imperative for a rule that would deny a deduction for amounts that are not in fact penalties or fines is simply not there."

Moreover, the Court noted that HMRC's submissions relied heavily on the purpose of the regulator in requiring the payments. However, for the purposes of s.54(1)(a) (if that was the relevant test) the focus is on the purpose of the paying party, and "does not turn on the objective or intention of anyone else".

In conclusion, the Court held that the £28m payments made by SP in this case were not statutory fines or penalties and there was no basis to extend the principles restricting tax deductions for fines or penalties to payments which might generally be considered to replace such fines or penalties.

Comment

The Court of Appeal's decision highlights again the importance of accounting treatment to the calculation of corporation tax profits. For there to be a rule derogating from this principle, it must be clear and either have a statutory basis or basis in case law. In this case, there was no basis in case law for extending the exclusion for fines and penalties to payments which, viewed broadly, might replace such fines and penalties.

More generally, it appears that the Court of Appeal has largely rejected the existence of a broader "replacement principle" which applies to determine the deductibility of payments. In this regard, it may be seen as broadly in line with other cases, including HMRC v E.ON where the Court of Appeal also cautioned against an over-zealous application of the "replacement principle" (taxing a payment on the basis of the treatment of  payments it replaces), both on the grounds that it can be difficult to discern exactly what the payment replaces and on the basis that it is not necessarily clear that statutory provisions applying to a particular type of payment would automatically apply to a payment that replaces such payments.