Corporation Tax: Regulatory Redress Paid in Place of Penalties Is Not Deductible Trading Expenditure

1. Introduction

The Supreme Court held that regulatory redress payments made under negotiated settlements were not deductible when calculating trading profits for corporation tax because, in substance, they were payments in place of penalties. Their description as redress, their distribution to consumers and charities, and the regulator’s imposition of only nominal formal fines did not change their punitive character.

The respondents, collectively described as ScottishPower, sought deductions for approximately £28 million paid following four investigations by the Gas and Electricity Markets Authority (GEMA) and the Office of Gas and Electricity Markets (Ofgem). The investigations concerned breaches of energy-sector obligations. ScottishPower Energy Retail Limited (SPERL) entered into settlement agreements requiring payments benefiting consumers and charities, alongside nominal penalties of £1 under each settlement. Some payments were borne by other group companies under an intercompany arrangement.

It was common ground that substantial fines imposed directly by GEMA would not have been deductible. The dispute was whether the alternative settlement payments should receive different tax treatment and, more fundamentally, why fines and penalties are excluded from deductible expenditure.

The central principle is that penalties are excluded by section 54(1)(a) of the Corporation Tax Act 2009 itself: expenditure incurred to answer for a regulatory breach is not expenditure incurred for the purposes of the trade. That principle also applies to settlement payments sufficiently akin to penalties. It does not depend on a separate, narrowly confined judicial rule overriding otherwise deductible expenditure.

2. Background: Four Investigations and Their Settlements

SPERL held gas and electricity supply licences. The other respondents held electricity generation licences. Ofgem, which undertakes GEMA’s day-to-day work and investigations, identified serious failures across several areas of ScottishPower’s operations.

The negotiations and formal decision notices linked these payments directly to the substantial penalties that GEMA would otherwise have sought. In the mis-selling investigation, ScottishPower itself described the proposed payments as being made “in lieu of” a financial penalty.

The First-tier Tribunal found that, without settlement, ScottishPower would probably have borne penalties of the same order of magnitude, even after allowing for possible appeals. Settlement avoided litigation risk, management distraction and the reputational consequences of large formal penalties. Those commercial advantages did not, however, determine the payments’ tax character.

A particularly important component was £554,013 paid directly to customers affected by mis-selling. The First-tier Tribunal initially treated this amount as deductible compensation. Whether it could be separated from the wider punitive settlement became a distinct issue on appeal.

3. The Statutory Framework

3.1 Accounting profits and the statutory restriction on expenditure

Section 46(1) of the Corporation Tax Act 2009 requires trading profits to be calculated in accordance with generally accepted accounting practice, subject to adjustments required or authorised by law.

Section 54(1)(a) provides that no deduction is allowed for expenses not incurred “wholly and exclusively for the purposes of the trade”. An expense may therefore be properly recognised in commercial accounts without being deductible for corporation tax.

The distinction between these provisions was central. The Court of Appeal located the exclusion of penalties in a judge-made adjustment recognised by section 46. The Supreme Court instead held that penalties fall outside the statutory trading-purpose requirement in section 54.

3.2 Regulatory obligations and enforcement powers

Under the Electricity Act 1989, GEMA’s principal objective includes protecting existing and future consumers. Electricity supply generally requires a licence, and licence conditions form part of a statutory regulatory framework.

Section 27A permits GEMA to impose reasonable financial penalties for specified contraventions and failures. Section 30A of the Gas Act 1986 provides a corresponding power. Formal penalties are paid into the Consolidated Fund. The legislation also provides procedures for notice, representations and challenges, while section 27B requires publication of a penalties policy.

The statutory framework distinguishes several regulatory responses:

• Enforcement orders under section 25, directed towards securing compliance.
• Compensation for failures to meet prescribed performance standards under section 39.
• Financial penalties under section 27A.
• Consumer redress orders under sections 27G to 27N, inserted by the Energy Act 2013 and brought into force in February 2014.

The statutory consumer-redress-order powers were not used in this case. The lawfulness of GEMA entering into the settlement agreements was accepted. The Supreme Court therefore decided the tax character of these particular negotiated payments, rather than the treatment of every payment that might be required under the statutory redress regime.

3.3 The regulatory policy context

The judgment examined GEMA’s November 2014 penalties policy and related enforcement guidance. These materials emphasised deterrence, removal of financial benefits from non-compliance, consumer detriment, seriousness, and aggravating or mitigating factors.

Settlement could reduce the penal element of overall liability, reflecting savings in resources and earlier benefits to consumers. It nevertheless required admissions of breach and agreement not to challenge the settled findings and sanctions. Guidance on voluntary redress also stated that companies should not derive financial or other benefits from such payments.

This context supported the conclusion that directing money towards consumers or charities could be an alternative method of delivering a regulatory punishment, rather than an abandonment of punishment.

4. The Decisions Below and the Supreme Court’s Disposal

The Supreme Court’s decision rested on two connected conclusions: penalties are not incurred for the purposes of a trade, and these redress payments were sufficiently akin to penalties to attract the same treatment.

5. Analysis of the Precedents

5.1 Trading connections do not establish a trading purpose

Strong & Co of Romsey v Woodifield [1906] AC 448, 5 TC 215

A brewery company sought to deduct damages and costs paid after a customer was injured by a falling chimney at its inn. The deduction was refused. The speeches distinguished liabilities arising in the taxpayer’s capacity as a trader from liabilities falling upon it in another capacity.

The enduring proposition came from Lord Davey: expenditure is not deductible merely because it arises during, results from, or is connected with a trade. It must be incurred for the purposes of earning the trade’s profits.

The Supreme Court relied on that distinction to explain why ScottishPower’s payments could arise directly from its energy business without being expenditure for its trading purposes. The decision does not, however, establish that every liability arising from negligent business conduct is non-deductible; the nature and purpose of the expenditure remain essential.

Mallalieu v Drummond (Inspector of Taxes) [1983] 2 AC 861

The House of Lords refused a barrister’s claim to deduct expenditure on clothing worn professionally because the expenditure also served personal needs for warmth and decency. A taxpayer’s stated professional motive did not exhaust the purposes objectively served by the expenditure.

This authority demonstrated why ScottishPower’s explanations about preserving reputation, avoiding litigation and freeing management time could not necessarily settle the statutory question. A conscious commercial motive is important, but it does not prevent the expenditure from having a legally significant character beyond that motive.

MacKinlay v Arthur Young McClelland Moores & Co [1990] 2 AC 239

The House of Lords disallowed expenditure on arranging and furnishing partners’ homes when they relocated for business reasons. The expenditure also served the partners’ personal interests. Some consequences are so inseparable from expenditure that they must be recognised as part of its purpose, whether consciously considered or not.

Together, these authorities supplied the general framework for examining purpose. The Supreme Court ultimately did not need to decide whether ScottishPower’s payments had dual purposes: their nature meant that they were not incurred for the purposes of the trade at all.

5.2 The foundational penalty decisions

Inland Revenue Commissioners v Warnes & Co [1919] 2 KB 444

This case concerned a settlement penalty arising from wartime export restrictions. Allegations of moral culpability were withdrawn, and the infringement was characterised as careless rather than deliberate. Nevertheless, the penalty and associated defence costs were held non-deductible.

Two features mattered to the present appeal. First, an absence of deliberate wrongdoing did not transform the penalty into a commercial trading loss. Secondly, the payment followed settlement rather than a fully contested determination. Its consensual origin did not remove its penal character.

Inland Revenue Commissioners v Alexander von Glehn & Co Ltd [1920] 2 KB 553

The Court of Appeal likewise disallowed a settlement payment and defence costs relating to breaches of wartime export requirements. Its judgments distinguished a commercial loss from a fine imposed on the taxpayer “personally” for violating the law.

The Supreme Court understood “personally” as identifying the taxpayer’s responsibility as the regulated legal person that committed the breach. For a company, this does not suggest liability of its directors or employees. It distinguishes answering for the company’s wrongdoing from incurring expenditure for its trade.

The case also established that accounting treatment does not determine statutory deductibility and that legal classification must be applied to the facts found by the tribunal.

Importantly, the payment had been agreed through settlement, apparently without a judgment recording the alleged infringements. The Supreme Court therefore regarded it as a strong answer to ScottishPower’s contention that negotiated redress should escape the treatment applicable to imposed fines.

5.3 Compensation and operational risks

Herald and Weekly Times v Federal Commission of Taxation (1932) 48 CLR 113 (HCA)

The High Court of Australia allowed deductions for damages, settlements and legal expenses arising from alleged libels published in newspapers. Publication generated both the business income and the liabilities, and the expenditure followed naturally from conducting the newspaper business.

The joint judgment distinguished penalties: punishment is imposed on the offender as a responsible person owing obedience to the law, and its nature separates it from trading expenses.

ScottishPower relied on the case to argue that mistakes were an almost unavoidable incident of running a large energy business, particularly during a complex systems transition. The Supreme Court rejected the analogy. The Australian case concerned tortious damages, not penalties or equivalent regulatory redress. It expressly left open the authority’s continuing relevance to defamation damages while holding that it did not assist with these regulatory payments.

Fairrie v Hall [1947] 2 All ER 141

Here, damages and costs arising from a malicious libel of a commercial rival were not deductible. The judgment cited it as illustrating the limits of reliance on the newspaper damages authority. It provided historical context, rather than a separate basis for deciding ScottishPower’s appeal.

G4S Cash Solutions (UK) Ltd v Revenue and Customs Commissioners [2016] UKFTT 239 (TC); [2016] STI 2207

A cash-delivery business argued that parking fines arose because its vehicles needed to stop close to customers’ premises for safety reasons. The tribunal accepted a connection with the business but held that the fines were not incurred for its trading purposes.

The decision reinforced the distinction between an expense being operationally connected with a business and satisfying the statutory purpose test. It did not establish that payments are non-deductible simply because there is a statutory obligation to make them; the relevant feature was their character as fines.

5.4 The central interpretive dispute

McKnight v Sheppard (1999) 71 TC 419; [1999] 1 WLR 1333

A stockbroker incurred fines and legal expenses in disciplinary proceedings. The appeal reaching the House of Lords concerned the legal expenses, not the fines. The expenses were deductible because the fact-finder had established that they were incurred exclusively to preserve the taxpayer’s trade.

Lord Hoffmann accepted that the fines were non-deductible. He explained that allowing a tax deduction could dilute punishment by permitting the taxpayer to share its burden with the community. The present dispute concerned how that explanation should be understood.

The Court of Appeal read it as supporting a separate policy-based rule which denied deductions even where expenditure otherwise satisfied the trading-purpose test. The Supreme Court disagreed. Lord Hoffmann was explaining why the nature of a penalty placed it outside that test, not introducing an independent judicial prohibition.

The Supreme Court thus clarified the doctrinal basis of non-deductibility without disturbing the distinction between penalties and legal expenses incurred to resist disciplinary proceedings. It expressly confined its consideration of this authority to the discussion of penalties. The present judgment does not establish that defending regulatory proceedings is itself non-deductible.

McLaren Racing Ltd v Revenue and Customs Commissioners [2014] UKUT 269 (TCC); [2014] STC 2417

This case concerned a penalty imposed on a Formula 1 team after confidential information belonging to a rival was wrongly obtained and used. The Upper Tribunal rejected the argument that such misconduct was merely an occupational hazard of the business.

It also treated payment of a substantial fine to avoid exclusion from the championship as acceptance of an alternative punishment. The authority illustrated why a payment can preserve a business while remaining punitive. The Supreme Court’s own decision, however, rested directly on the construction of section 54 and the character of ScottishPower’s settlements.

NCL Investments Ltd v Revenue and Customs Commissioners [2022] UKSC 9; [2022] 1 WLR 1829

The Court of Appeal relied on this authority’s recognition that adjustments under section 46 can arise from judge-made rules. That general proposition supported the possibility of its analysis but did not establish that the penalty exclusion was such a rule.

The Supreme Court rejected that classification of the penalty authorities. It did not deny that section 46 can recognise judicially established adjustments generally. Rather, it held that the present restriction already follows from section 54.

6. The Supreme Court’s Legal Reasoning

6.1 Penalties fall outside the trading-purpose test

The Supreme Court’s starting point was the nature of punishment. A penalty is imposed because the taxpayer has breached obligations binding upon it. Its objects are punishment and deterrence. The taxpayer pays it to answer for that breach, rather than for the purposes of carrying on the trade (paragraphs 81–86).

This reasoning reconciles the nature of the payment with the taxpayer-focused language of section 54. The regulator’s statutory objectives and intention help establish whether the payment is punitive. Once that character is established, the taxpayer’s purpose in discharging the liability is understood accordingly.

The Court therefore rejected the suggestion that examining a payment’s character improperly substitutes the regulator’s purpose for the taxpayer’s purpose. The two inquiries are connected, but distinct.

6.2 Public policy supports the interpretation; it does not replace it

Allowing a deduction would reduce the economic burden of punishment and transfer part of it to the public through reduced tax receipts. That consequence supports excluding penalties from trading expenditure.

However, the legal rule is statutory interpretation, not a free-standing judicial power to disallow expenses whenever public policy appears to favour that result. This distinction answered the Court of Appeal’s concern about extending a judge-made exception beyond formal fines.

The Court also rejected the suggested solution of regulators increasing redress payments to compensate for deductibility. It questioned whether that would be an appropriate public-law consideration and noted the practical difficulty of predicting the taxpayer’s accounting treatment and HMRC’s response.

6.3 Settlement did not make the payments substantively voluntary

SPERL was not compelled to enter into the agreements. Nevertheless, the choice was made against a credible prospect of substantial penalties. The tribunal found that penalties of broadly comparable magnitude would probably have followed without settlement.

The Supreme Court therefore rejected the characterisation of these payments as voluntary in a sense that distinguished them from punishment. Consensual resolution of an enforcement dispute does not necessarily change the substance of the resulting liability.

The Court also identified an anomalous consequence of ScottishPower’s position: a business admitting a clear breach and settling quickly could obtain deductions, whereas a business contesting a more arguable case and ultimately receiving a fine could not. This supported, but did not replace, the substantive assessment of what the payments represented.

6.4 Licence conditions were public regulatory obligations, not ordinary contracts

ScottishPower argued that the payments resembled compensation for breach of contract, treating its regulatory licence as analogous to an agreement with GEMA.

The Court rejected that analogy. Licence conditions were more akin to statutory obligations. The settlements were public enforcement outcomes, approved through GEMA’s procedures and recorded in published notices. They were not private-law remedies designed to restore contractual counterparties to the position they would have occupied without breach.

The decision notices linked payment amounts to findings of breach, seriousness, deterrence, compliance incentives and financial benefits obtained through non-compliance. The energy-saving obligations provided an additional difficulty for the contractual analogy because they arose directly under a statutory instrument.

6.5 Neither the recipient nor the accounting entry changed the result

Money paid to consumers or charities can still discharge a punitive regulatory liability. Payment into the Consolidated Fund is not an essential condition of the tax treatment applicable to penalties.

Similarly, recognition of the payments as expenses under generally accepted accounting practice did not establish deductibility. Section 46 expressly subjects accounting profits to the applicable legal restrictions, including section 54.

6.6 The £554,013 could not be detached from the overall package

The Supreme Court agreed with the Upper Tribunal that the direct payments to mis-selling victims formed part of the negotiated settlement as a whole. They were arrived at under regulatory auspices, under threat of substantial penalties, and in place of such penalties.

The Court consequently rejected the First-tier Tribunal’s treatment of this component as equivalent to ordinary tort damages. A payment’s benefit to an identifiable victim did not require it to be separated from the punitive package of which it formed part.

This is a contextual conclusion. The judgment does not establish that independently incurred compensation is always non-deductible merely because a regulator is investigating the same conduct.

6.7 Reduced culpability did not alter the tax classification

Some failures were not deliberate. The systems problems also involved reputable consultants and operational difficulties that the tribunal considered almost unavoidable in certain respects.

The Supreme Court held that culpability had already been considered when the regulatory liabilities were assessed. Accidental or inadvertent breaches could reduce their severity, but did not supply a separate reason to deduct the resulting punitive payments. The tax inquiry was not an opportunity to reassess the appropriate degree of punishment.

7. Impact and Limits of the Decision

7.1 Substance takes priority over settlement labels

The decision prevents a difference in tax treatment based solely on whether enforcement concludes with a substantial fine or a nominal fine accompanied by equivalent redress. Descriptions such as “voluntary redress” or “consumer compensation” are not decisive.

For future disputes, settlement agreements, decision notices, negotiation records and evidence about the alternative enforcement outcome will be important in establishing a payment’s character.

7.2 Mixed settlements require examination as a whole

The treatment of the £554,013 warns against assuming that payments to actual victims are automatically deductible. Where a component forms part of an integrated punitive bargain, its compensatory effect may not justify separate treatment.

Equally, the judgment does not eliminate the possibility of genuinely distinct liabilities within other arrangements. Whether separation is justified will depend on their substance and supporting evidence.

7.3 Wider regulatory relevance

Although the case concerns energy regulation, its reasoning may be relevant wherever regulators accept payments to customers, charities or other beneficiaries instead of substantial penalties. Its application elsewhere will depend on the legal framework and the character of the particular obligation.

The judgment does not automatically determine the treatment of every statutory redress order, restitutionary payment, compensation scheme or regulatory settlement.

7.4 Remediation and compliance expenditure remain distinct questions

The Court acknowledged possible difficulties in distinguishing settlement payments from expenditure incurred earlier to improve compliance or remedy customer-service problems. It held that those boundary questions did not arise here because the disputed settlement amounts were clearly identifiable.

Businesses should therefore distinguish punitive liabilities from expenditure on systems, staffing, compliance improvements and independently undertaken remediation. Such expenditure requires its own tax analysis; the judgment does not automatically disallow it.

In particular, the approximately £8 million of customer bills written off before the complaints-handling settlement negotiations was background evidence, not a separate deduction claim determined by the Supreme Court.

7.5 Legal defence costs are not assimilated to penalties

The Court expressly preserved the distinction between punishment and expenditure incurred in resisting disciplinary proceedings. The deductibility of legal costs remains subject to the applicable statutory test and the facts. It cannot be inferred solely from the non-deductibility of the eventual sanction.

8. Complex Concepts Simplified

“Wholly and exclusively for the purposes of the trade”

The statutory requirement that deductible expenditure be incurred entirely for trading purposes. A connection with the business, or a commercial advantage from paying, is not enough by itself.

Accounting expense versus tax deduction

An expense may properly reduce reported accounting profit but still be excluded when taxable profit is calculated.

Punitive versus compensatory payments

Punishment responds to wrongdoing and deters repetition; compensation repairs loss. A payment can benefit a victim while still forming part of a punitive regulatory settlement.

Substance over form

The court examines what a payment actually does, not merely what the agreement calls it or who receives it.

Duality of purpose

Expenditure serves both trading and non-trading purposes. The Supreme Court did not need to decide that issue here because it found that the disputed payments were not incurred for trading purposes.

A payment “in lieu of” a penalty

A payment accepted instead of a penalty. Where it retains the substantive character of punishment, changing the enforcement mechanism does not make it deductible.

Sharing punishment with the community

A deduction would reduce the taxpayer’s tax bill and therefore reduce the net burden of the sanction. The Court treated that consequence as supporting its interpretation of section 54.

9. Conclusion

The Supreme Court restored a consistent approach to fines and their substantive substitutes. ScottishPower’s redress payments were non-deductible because they discharged punitive regulatory liabilities, not because a separate judicial policy exception overrode otherwise allowable trading expenses.

The judgment’s significance lies both in its explanation of section 54 and in its treatment of integrated settlements. A nominal formal fine, consumer beneficiaries and compensatory features do not make a punitive package deductible. At the same time, ordinary compensation, compliance expenditure and legal defence costs remain separate questions requiring their own analysis.