Deductibility of a penalty in computing taxable profits

This case constituted an appeal by HMRC to the Upper Tribunal (UT) against the First Tier Tribunal’s (FTT’s) September 2012 decision which held that a £32 million fine imposed on McLaren Racing Limited was tax deductible.

Background

HMRC appealed against the decision of the FTT. The only issue that had been before the FTT was whether a penalty paid by McLaren Racing Limited (“McLaren”) for a breach of Article 151(c) of the International Sporting Code (“ISC”) of the Federation Internationale de l’Automobile (“FIA”) was deductible in computing its taxable profits. The FTT allowed McLaren’s appeal by casting vote of the Judge.

The key facts found by the FTT are summarised as follows and were not disputed by either party:

• McLaren is a well-known Formula One motor racing team which designs, develops, manufactures and races Formula One cars at grand prix events throughout the world and derives its income from sponsorship, advertising and payments under the Concorde Agreement.
• Under the Concorde Agreement, Formula One teams agreed to accept the Sporting Regulations of the Formula 1 Championship laid down by the FIA which were deemed to be imported into the ISC, the document by which the FIA prescribes rules for the conduct of its motor sports events.
• The ISC confers on members the right to issue licences to participate in motor sports competitions such as the Formula One World Championship. By accepting a licence, the holder agrees to be bound by the provisions of the ISC.
• The ISC provided for a range of penalties for breach of the Code.
• The FTT found that each Formula One team took an interest in the construction of its competitors’ cars and spent a lot of time in viewing recordings of races and trying to discover the details of their construction. The FTT had no doubt that each team would take whatever practical and legal steps it could to keep its designs secret.
• Further, some teams sought to employ persons who had been employed by other teams in order to learn details of their competitors’ cars or methods.
• Starting in 2006, an employee of a rival Formula One team, Ferrari, passed detailed plans and information about Ferrari’s cars to the chief designer at McLaren. In 2007, Ferrari discovered what had happened and asked the FIA to investigate. McLaren did not dispute that their chief designer had the information but argued that it was not disseminated within its engineering team and that possession of the information was not authorised by McLaren.
• Following a meeting in mid-2007, it was found that McLaren had breached article 151c of the ISC.
• It was concluded that McLaren had obtained some degree of sporting advantage although it was impossible to quantify how much. A penalty was imposed on McLaren consisting of exclusion from and withdrawal of all points awarded to them in all rounds of the 2007 constructors’ championship and a sum of $100 million (less any sum that would have been payable to them on account of McLaren’s results in the 2007 constructors championship had it not been excluded).
• The effect of the decision was that, because it lost its points, McLaren lost that share of its income under the Concorde Agreement which depended on its place in the World Championship. That resulted in a loss of income of $35.6m. The amount of the penalty payable by McLaren was $100m less the lost income, i.e. $64.5m or £32,313,341.

Decision

The relevant tax legislation was section 74(1) of the Income and Corporation Taxes Act 1988 (“ICTA”). Whether McLaren could deduct the £32 million penalty in computing its taxable trading profits depended on whether the penalty fell within the relevant paragraphs of that sub-section.

Section 74(1) ICTA provided as follows:

“74 General rules as to deductions not allowable

1. Subject to the provisions of the Corporation Tax Acts, in computing the amount of the profits to be charged to corporation tax under Case I or Case II of Schedule D, no sum shall be deducted in respect of –

1. any disbursements or expenses, not being money wholly and exclusively laid out or expended for the purposes of the trade, or profession;

• (e) any loss not connected with or arising out of the trade or profession;

• …”

Therefore if the penalty fell within either (a) or (e) then it was not deductible.

The rule in section 74(1)(a) raised the following questions:

1. What were the purposes of McLaren’s trade;
2. Was the penalty paid for the purposes of McLaren’s trade; and
3. Was the penalty paid wholly and exclusively for the purposes of McLaren’s trade?

If the answer to question (2) or (3) was ‘no’ then the penalty was not deductible.

In relation to the rule in section 74(1)(e), the following questions arose:

1. Was the loss connected with McLaren’s trade;
2. Did the loss arise out of the trade?

If the answer to both questions was ‘no’ then the penalty was not deductible.

The argument then proceeded on the basis that the payment of the penalty was either (i) a disbursement or expense or (ii) a loss.

The question whether a fine should be regarded as a disbursement or expense or as a loss arose in McKnight v Sheppard (1999) 71 TC 419 which involved a non-statutory penalty imposed on a stockbroker in a case where the broker was guilty of gross misconduct. In that case it was held that “the payment of both the fees and fines, as it appears to me, fall within the term disbursement, and the payment of legal fees is also clearly a payment of (legal) expenses.” The UT agreed with the views expressed in that case stating that the payment of the penalty is more properly to be seen as a disbursement or expense.

Before considering whether the penalty was not allowable as a deduction by McLaren under the rules in section 74(1)(a) or (e) ICTA, it was necessary to determine what McLaren’s trade was or, more specifically, whether it included cheating. The FTT decision held that the activities which gave rise to the penalty were not a normal or ordinary part of McLaren’s trade. But they were activities “so closely associated with the mainstream of McLaren’s trade that I cannot say they were not part of it”.

The FTT judge’s reasons for holding that cheating was included among the activities of McLaren’s trade were that:

1. It was an ordinary part of McLaren’s activities to seek information on its competitors’ designs and strategy;
2. Employing other teams’ employees, and correspondingly taking steps to ensure that the damage which could result as the result of an employee defecting, were part of that activity;
3. Renault did the same; and
4. The Word Motor Sporting Council (WMSC) held that McLaren, by the activities of its employees, had obtained a sporting advantage, namely an advantage in the activity that gave rise to its income.

The UT examined each of these reasons in turn.

1. It was undoubtedly an ordinary part of McLaren’s activities to seek information on its competitors’ designs and strategy.

This was explicitly acknowledged in the WMSC Decision. Obtaining information about competitors was one of the activities carried out by a Formula One team but there were limits placed on the way in which that activity could be carried out by the rules in the Concorde Agreement and the ISC. The WMSC Decisions show that the governing body, which included representatives of the Formula One teams, did not regard deliberately acting outside the rules (i.e. cheating) as acceptable or normal behaviour in the competition.

The fact that it was an ordinary part of McLaren’s activities to seek information did not, in the UT’s view, support the conclusion that a deliberate flouting of the relevant rules under the ISC or a deliberate breach of the Concorde Agreement is to be seen as an activity in the course of the trade.

2. The UT stated that the FTT failed to distinguish between employing another teams’ employees, which is allowed and unobjectionable, and improperly using the products of unauthorised disclosure by a competitor’s current or former employees.

The possibility that an employee of another team might be employed lends no support to the view that deliberate cheating is properly to be seen as an activity in the course of the trade once it is recognised that it would not be proper for such an employee to use confidential information for the benefit of his new employer.

3. The fact that Renault also obtained confidential information in breach of the rules did not legitimise McLaren’s actions and amounts to no more than a justification of “they were all at it”.
4. The fact that McLaren obtained a sporting advantage by the misuse of Ferrari’s confidential information, ignores the fact that the confidential information and consequent sporting advantage were improperly obtained and, for that reason, any advantage was liable to be (and, indeed, was) cancelled by the loss of points and the penalty.

Further, McLaren could have been excluded from the following season’s championship which would have destroyed the company.

In the UT’s view, a deliberate activity which is contrary to contractual obligations and the rules and regulations governing the conduct of the trade, not an unavoidable consequence of carrying on a trade, and which could lead to the destruction of the trade, is not an activity carried on in the course of that trade.

However, the fact that the cheating activities carried out by McLaren were not carried out in the course of its trade did not dispose of the issue in this appeal. Although the UT dealt with the question whether cheating activities can form part of the trade McLaren submitted that it had never been argued that cheating was within the scope of its trade. Rather, McLaren’s trade was the design, manufacture and racing of motor cars. It employed designers and engineers as part of that. Part of the designers’ job was to obtain information about rivals’ cars but they had to do so within the rules. It was an occupational hazard that employees might sometimes overstep the mark and act outside the scope of their employment. McLaren was vicariously liable for the actions of its employees but that liability arose in the course of McLaren’s trade because it related to the actions of its employees.

The UT did not agree with that line of argument. In its view, the liability of an employer for the acts of its employee and what activities fall within the scope of the employer’s trade are two different and largely unrelated issues. It cannot be said that simply because an employer incurs liability as the result of the acts of an employee, the liability is incurred in the course of the employer’s trade. The UT considered that, on the facts of this case, wrongfully obtaining and using confidential information belonging to a rival team, was not a normal or ordinary activity in the course of its trade, and it does not become such an activity simply because it is carried out by an employee.

In this case, it was clear that the chief designer’s conduct was not within the proper scope of his employment even if the conduct occurred while he was employed: nor was it within the scope of the activities of the trade to do what he did. However this does not mean that the payment of the penalty is not deductible.

The statutory question is not whether the payment was brought about as the result of an activity in the course of the trade, but whether the payment was “wholly and exclusively laid out for the purposes of the trade”. It was said on behalf of McLaren that the payment was wholly and exclusively for the purposes of the trade. In this context, it is to be noted that the Concorde Agreement was entered into by McLaren in the furtherance of its trade; payment properly made under that Agreement might therefore be said to be seen as being made wholly and exclusively for the purposes of the trade. In any case, the payment of the penalty had to be made, otherwise, in practice, McLaren would have been excluded from the F1 championship altogether.

The UT did not consider that these points resolved the matter in favour of McLaren. The WMSC imposed the penalty because it held McLaren to be responsible for the conduct of its then chief designer who disseminated the information within the McLaren team. His conduct was not in the course of McLaren’s trade and was not in the furtherance of that trade.

Although the UT accepted that one reason why McLaren paid the penalty was in order to avoid the far worse consequence of being excluded from the World Championship, which might have destroyed its business, it was not paid for that purpose alone. The penalty was also paid because McLaren, through its employees, had engaged in conduct that was not in the course of its trade and incurred a liability to the penalty as a result.

In the UT’s view, although the payment may have had to be made a matter of commercial necessity, it had, at least as one of its purposes, the satisfaction of a legal obligation – a contractual obligation – arising as a result of activities which were not in the course of McLaren’s trade. The penalty was a disbursement or expense but it was not money wholly and exclusively laid out or expended for the purposes of McLaren’s trade. Accordingly, the penalty was not an allowable deduction for computing the amount of McLaren’s profits to be charged to corporation tax.

Even if it could be argued that the penalty was unenforceable as a matter of law, the payment of the penalty was at least the satisfaction of a possible liability and would therefore have had a dual purpose.

On the alternative view (which the UT did not favour) that the penalty was not a disbursement or expense within section 74(1)(a) but was a loss within section 74(1)(e), it was apparent from the earlier discussion that the UT considered that the penalty did not arise out of McLaren’s trade and nor was it connected with the trade. The chief designer’s activities were not in the course of McLaren’s trade and the fact that he may have rendered McLaren liable to the penalty does not result in the penalty being a loss connected or arising out of the trade.

The UT was of the view that their conclusion on this point was sufficient to dispose of the appeal in favour of HMRC. But even if that was not the case and the penalty was paid wholly and exclusively for the purposes of McLaren’s trade, the UT stated that it would not be deductible for reasons similar to those given by Lord Hoffmann in the McKnight case.

It was further submitted that the penalty in the present case was not a punishment but was simply intended to address any sporting advantage that McLaren had obtained by reason of its employee’s conduct. The UT did not accept this submission.

The FIA was unable to calculate the sporting advantage that McLaren had gained but the employee’s conduct led to McLaren losing all the points awarded to it in the 2007 World Championship as well as paying the penalty. That meant that McLaren lost more than the major part of any sporting advantage (the points which it had gained) because it had to pay the penalty in addition to losing all of its points. The size of the penalty, the fact that it exceeded the value of the championship points taken from McLaren and the fact that it was an alternative to exclusion from the World Championship in the future all lead to the conclusion that the penalty was intended to punish McLaren.

This in particular was important: it could not be maintained that exclusion from the championship would be other than a punishment; the payment of a large fine to avoid that punishment could only be seen as acceptance of an alternative punishment. That view was not undermined by the fact that the FIA calculated the penalty to be proportionate to the resources of McLaren. In the UT’s view, the only conclusion that the FTT could have reached, on the facts as found by them, was that the £32 million penalty was intended to punish McLaren.

Therefore in the UT’s view, and by further parity of reasoning along the same lines as that of Lord Hoffmann in the McKnight case, the penalty was not deductible. One of the purposes of the ISC is to ensure that the sport is conducted fairly and one of the sanctions available to achieve that policy is the imposition of penalties. Even if the penalty in the present case was to be viewed as simply a contractual matter between the FIA and the F1 competitors, the UT consider that the ISC demonstrates a clear policy to punish their contravention and thus the actual penalty was indeed a punishment. The penalty was intended to punish McLaren personally. The penalty was not “money wholly and exclusively laid out for the purposes of the trade” and nor was it a loss “connected with or arising out of the trade”.

However the UT did not think that it was right to regard the penalty as simply a contractual matter. The FIA also has a regulatory function over motor sport and F1 in particular: a regulatory function which goes beyond the mere enforcement of contractual arrangements between the FIA and participating teams. Spectators and some others have an interest in seeing that the sport is conducted fairly. Further, the fine imposed in the present case did not accrue for the benefit of the F1 teams but was instead to be utilised in more general ways for the benefit of the sport. These factors reinforced the view that the penalty was neither “money wholly and exclusively laid out for the purposes of the trade” nor a loss “connected with or arising out of the trade”.

In addition previous cases did not seek to make any distinction between fines or penalties imposed by statute or other legislative authority and those that arose under other arrangements, such as the rules and regulations of the Stock Exchange. There is no reference in section 74(1)(a) or (e) ICTA or in McKnight or any of the other cases discussed to a requirement forserious public interest. The UT thus rejected the conclusion that a fine or penalty imposed to punish a taxpayer would only be non-deductible if deduction would be contrary to a serious public interest in the conduct that gave rise to the fine or penalty.

The UT considered that on the facts as found by the FTT, the FTT should have concluded that the activities which gave rise to the penalty were not carried out in the course of McLaren’s trade. Deductibility of the penalty could not therefore be justified as an expense of carrying out an activity in the course of the trade. The penalty was not deductible on the basis that its payment was necessary to preserve McLaren’s trade since that was not its sole purpose. Accordingly, the penalty was not wholly and exclusively laid out or expended for the purposes of McLaren’s trade and was not an allowable deduction for tax. Even if the sole purpose of the payment had been to preserve McLaren’s trade, it still would not satisfy the statutory requirement because the nature of the payment was such as to prevent its deductibility, namely that it was designed to punish McLaren for a breach of the ISC.

The full text of the case is available at http://www.financeandtaxtribunals.gov.uk/

The case, as before the FTT, was reported in the November 2012 issue of tax.point.