Anonymized Summary of Court of Appeal (Civil Division) Judgment

Factual and Procedural Background

This is an appeal from the Upper Tribunal (Tax and Chancery Chamber) concerning the tax treatment of payments made by regulated energy companies in settlement of regulatory investigations. The four companies that were appellants in the original proceedings will be referred to collectively as "Company A". The respondents, the tax authority, will be referred to as "Company B".

Company A generate and supply gas and electricity under licences governed by statutory regulators (the regulatory body is referred to in the judgment by its established name; hereafter it is described as "the regulator"). Between October 2013 and April 2016 Company A entered into a series of settlement agreements with the regulator to resolve investigations into matters described in the judgment as mis-selling, cost-reflectivity, energy-saving (CO2/CESP) obligations and complaints handling.

The settlement package included nominal penalties of £1 and substantial payments to consumers, charities and consumer organisations totalling approximately £28 million. Company A claimed deductions for these payments in computing taxable trading profits; Company B denied those deductions.

Procedurally: the First-tier Tribunal (FTT) dismissed Company A's appeal against the denial of deductions except for a limited element (£554,013) which it treated as compensatory. Both parties appealed to the Upper Tribunal (UT), which held that all the payments were non-deductible. Company A obtained permission to appeal to the Court of Appeal. The Court of Appeal heard the appeal and delivered the lead judgment through Judge Falk, with Judges Zacaroli and Snowden concurring.

Legal Issues Presented

1. Whether a judicially recognised rule (derived from case law such as von Glehn and explained in McKnight v Sheppard) that payments "in the nature of penalties" incurred in the course of trading activities are not deductible applies to the payments made by Company A to consumers and consumer organisations pursuant to settlement agreements with the regulator.
2. Whether, applying s.54(1)(a) of the Corporation Tax Act 2009 (expenses must be incurred "wholly and exclusively for the purposes of the trade") or otherwise, the particular payments made by Company A were deductible when they were made as part of settlement packages negotiated under regulatory pressure and accompanied by nominal £1 penalties.

Arguments of the Parties

Appellants' Arguments (Company A)

• Company A argued that McKnight v Sheppard was much more limited than Company B asserted and does not establish a rule preventing deduction of the types of payments at issue.
• Company A submitted that the payments were incurred in the course of the trade and, on the factual findings of the FTT, were made "wholly and exclusively" for the purposes of the trade and therefore deductible under s.54(1)(a) CTA 2009.
• They contended that the UT erred in treating McKnight as establishing a broad non-deductibility rule and in applying a "global assessment" that treated the whole £28m package as non-deductible rather than analysing identifiable parts separately.
• Company A emphasised that the settlement payments were not in fact fines or penalties and that there is no authority for treating a payment's deductibility by reference to the nature of a payment it might replace.

Respondents' Arguments (Company B)

• Company B relied on the principle explained in McKnight v Sheppard and on von Glehn: that sums which are penalties or have the character of penalties imposed under a statutory regime are not deductible, even if incurred in the course of trading activities.
• Company B relied on s.54(1)(a) CTA 2009 (expenses not incurred wholly and exclusively for the purposes of the trade are non-deductible) as the statutory basis for denying deductions and advanced the view that the payments were made "in lieu" of penalties and therefore should be treated as non-deductible penalties.
• Company B also placed emphasis on the regulator's published policy and correspondence suggesting that redress payments were substitutes for monetary penalties, and on the UT's treatment that the entire package was put together under the threat of penalty.

Table of Precedents Cited

Precedent	Rule or Principle Cited For	Application by the Court
Commissioners of Inland Revenue v Alexander von Glehn & Co Ltd [1920] 2 KB 553	Established that penalties/fines imposed under a statutory regime are not deductible in computing trading profits.	The court accepted von Glehn as correctly decided and treated it as the origin of the principle that fines/penalties imposed by statute are non-deductible; but it emphasised that von Glehn applies to payments that are actually penalties.
McKnight (HM Inspector of Taxes) v Sheppard [1999] STC 669 (House of Lords)	Explained why fines/penalties should be non-deductible (legislative policy would be diluted if taxpayers could deduct such payments) and distinguished legal costs from fines.	The court considered McKnight authoritative for the explanation of von Glehn but rejected extending the principle beyond payments that are themselves penalties; the judgment treats McKnight as supporting non-deductibility of actual fines and as explaining policy, not as authorising a broad new rule to catch substitute payments that are not penalties.
The Herald and Weekly Times Ltd v The Federal Commission of Taxation (1932) 48 CLR 113	Held that damages paid in defamation context were deductible as they arose from the business activity and were "necessary or a natural consequence" of publishing the newspaper.	The court used Herald as an authority showing that payments arising inevitably from trading activity may be deductible; McKnight's approach did not require treating all such payments as non-deductible.
McLaren Racing Ltd v HMRC [2014] UKUT 269 (TCC), [2014] STC 2417	Considered penalties under a non-statutory regulatory regime and emphasised deductibility depends on whether acts were carried out in the course of trade.	The court noted McLaren as an example where a penalty was non-deductible because the underlying wrongful acts were not carried out in the course of the trade; McLaren did not justify a broad extension of the von Glehn rule to non-penalty payments.
NCL Investments Ltd v HMRC [2022] UKSC 9, [2022] 1 WLR 1829	Explained that adjustments to accounting profits are generally expected to be statutory and that a "judge-made rule" can only adjust profits if it is clear it does so.	The court relied on NCL to state the correct approach: judge-made rules that deny deductions must be clearly applicable; this supported treating von Glehn as an adjustment required by law where it clearly applies, but cautioned against judicially creating broad new rules.
Mallalieu v Drummond [1983] 2 AC 861	Authoritative on the test that expenditure must be incurred "wholly and exclusively" for the purposes of the trade (tax purpose/focus on taxpayer's purpose).	The judgment used Mallalieu to explain that the statutory s.54(1)(a) test focuses on the taxpayer's purpose; the court contrasted this focus with von Glehn's emphasis on the character of the payment.
Smith's Potato Estates Ltd v Bolland [1948] AC 508	Referenced in discussion of temporal/logical connection between expenditure and profits (context for deductibility analysis).	Mentioned as background in the analysis of when expenditure is logically and temporally subsequent to profits; it informed discussion but was not decisive in the outcome.
Commissioners of Inland Revenue v Warnes & Co Ltd [1919] 2 KB 444	Considered earlier statutory rules and treatment of penal liabilities as not being losses "connected with or arising out of the trade".	The judgment noted Rowlatt J's approach in Warnes and related cases as influential in later reasoning (von Glehn) but emphasised the Court of Appeal's more nuanced later analysis.
Strong & Co. of Romsey Ltd v Woodifield [1906] AC 448	Quoted for the proposition that expenditure must be for the purpose of enabling the trader to carry on and earn profits; not merely connected with the trade.	Cited in the historical discussion of how earlier authorities treated the "purpose" test and why penalties were treated as outside trading expenses.

Court's Reasoning and Analysis

The leading judgment (Judge Falk) undertook a careful, stepwise analysis focusing on (i) the statutory tax provisions, (ii) the statutory regime conferring penalty powers on the regulator, (iii) the case law origins of the rule that penalties are non-deductible, and (iv) the particular facts and documents surrounding the settlements.

Statutory framework and focal statutory tests

• The court rehearsed s.35, s.46 and s.54 of the Corporation Tax Act 2009. Section 54(1)(a) disallows deductions for expenses not incurred "wholly and exclusively for the purposes of the trade". Section 46(1) provides that profits must be calculated in accordance with generally accepted accounting practice subject to any adjustment required or authorised by law.
• The court noted that Company B relied on s.54(1)(a) (the taxpayer's purpose) and, alternatively, on the idea that the von Glehn rule is an "adjustment required…by law" within s.46(1).

Character of the von Glehn/McKnight principle

• The court recognised the established principle (von Glehn, as explained in McKnight) that fines and penalties imposed under a statutory regime are non-deductible. Lord Hoffmann in McKnight had explained this as avoiding dilution of the legislative policy underlying the penalty regime (i.e., taxpayers should not "share the burden" of fines with the community via tax deductions).
• Two analytical approaches to that principle were considered: (a) treating the non-deductibility as fitting within s.54(1)(a) by construing penalties as not being incurred "for the purposes of the trade", and (b) treating the von Glehn rule as an "adjustment required…by law" within s.46(1). The court preferred the latter analysis as being the better fit and consistent with NCL Investments, which emphasises that such judge-made adjustments must clearly have the effect of altering accounting profits.

Limits on any extension of the principle

• The court declined to accept Company B's submission that the von Glehn/McKnight principle should be extended beyond payments that are, in substance, fines or penalties. There is no authority supporting a general rule that a payment's deductibility should be determined by reference to the nature of a payment it replaces.
• The court emphasised that extending the rule to cover non-penalty payments would be legally uncertain and would improperly risk judges creating new restrictions on tax deductibility (a matter for Parliament if desired). The court warned against resorting to vague public policy justifications for such an extension.

Application to the regulatory settlements and factual analysis

• The court scrutinised the settlement documents and regulatory notices. It noted that the only penalties actually imposed were nominal £1 amounts; the regulator had not redirected statutory penalty receipts into third-party payments (the regulator had no power to do so under the statutory penalty regime and the payments were not levied into the Consolidated Fund).
• The regulator's statements show that it considered a number of factors in fixing a penalty level, including remedial steps taken by Company A and commitments to improve systems, not just the fact of consumer payments. The regulator described the consumer payments as delivering greater benefit to consumers than a substantial penalty; it used the term "consumer redress".
• The court highlighted practical difficulties with Company B's approach: many forms of voluntary or negotiated redress would, if Company B were correct, be at risk of arbitrary tax treatment depending on whether they could be linked to a notional penalty amount. The 2014 statutory power to make consumer redress orders (sections 27G-27N EA 1989) further complicated Company B's position because it demonstrates that payments to consumers may be a recognised form of regulatory redress.
• The court also emphasised that the statutory test in s.54(1)(a) focuses on the taxpayer's purpose in incurring the expenditure (Mallalieu v Drummond), not on the regulator's purposes; thus reliance on the regulator's enforcement purposes does not suffice to defeat deductibility unless the payments are in fact penalties or there is a clear rule otherwise.

Conclusion of analysis

• The court concluded that the von Glehn principle remains good law in relation to actual statutory fines and penalties, and that it is properly treated as an adjustment that may be required by law under s.46(1) where it clearly applies.
• However, the court rejected the argument that the principle must extend to payments that are not themselves fines or penalties merely because they were negotiated as alternatives to potential penalties. There was no clear legal basis to treat the challenged payments as penalties for tax purposes.
• Given the FTT's findings (which the court accepted) that the payments were incurred in the course of the trade and were taken into account in computing profits under accounting practice, and that they were made "wholly and exclusively for the purposes of the trade" absent the penalty question, there was nothing in law that prevented deduction of the payments that were not in fact penalties.

Holding and Implications

Holding: The Court of Appeal allowed the appeal. The lead judgment concluded that the established rule denying deduction for actual statutory fines and penalties remains confined to payments that are themselves fines or penalties and should not be extended by the courts to catch payments that are not, in substance, penalties. The lead judge stated: the appeal is allowed.

Implications:

• Direct effect: On the facts as found by the FTT and considered on appeal, the payments made by Company A that were not in fact statutory penalties are not prevented from being deducted for corporation tax purposes. The court allowed Company A's appeal on that basis.
• Scope of law: The judgment affirms the von Glehn/McKnight principle as applying to actual fines and statutory penalties but draws a clear limit: the principle does not automatically extend to substitute or alternative payments that are not themselves fines or penalties. The court emphasized caution about judicially extending deductibility rules and signalled that any broader change should be the province of Parliament.
• Practical consequence for regulators and taxpayers: Regulators may take account of the tax consequences of proposing redress as an alternative to penalties; but the fact that a regulator treats redress as a substitute for a penalty does not, by itself, convert the redress payment into a non-deductible penalty for tax purposes.
• No broad new precedent created: While the court clarified limits on the von Glehn principle and endorsed treating that principle as an adjustment required by law where applicable, it refused to create a wide new judge-made rule depriving deductions for payments that are not penalties.

Judges Falk, Zacaroli and Snowden (anonymized as Judge Falk, Judge Zacaroli and Judge Snowden) delivered the decision, with Judge Falk authoring the lead judgment and the other two judges concurring.