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Peter Vaines of Squire Sanders comments on the McLaren penalty case and also on a case where HMRC tried to assess National Insurance when there was no charge to Income Tax under the "benefits in kind" legislation.

Penalties Deductible Expenditure?

Those with an interest in Formula 1 will remember that a little while ago some confidential documents relating to Ferrari were found in the possession of an employee of McLaren. The FIA decided that there had been some impropriety and imposed a substantial fine on McLaren of approximately £32 million. The question was of course whether this £32 million was an expense wholly and exclusively laid out for the purposes of the McLaren trade.

HMRC said it was not. They said that the penalty arose from conduct outside the trade. Legitimate gathering of information was part of the trade but illicit gathering of information was not. The penalty was for improper conduct of McLaren’s employees and a punishment for a serious breach of the rules.

The Tribunal did not feel that any of these things were not for the purposes of McLaren’s trade. They went so far as to say that the profit making activity carried on by McLaren was not limited to acting within the confines of its contractual agreements and could include cheating. The penalty was a commercial penalty designed to affect McLaren in its commercial activity. It was not like a statutory penalty designed to be suffered by an individual. Furthermore, the penalty was not levied for the protection of the public but mainly for the regulation of a commercial activity. The penalty was something which arose from its trade, was connected with its trade and was incurred wholly and exclusively for the purposes of the trade.

The two Tribunal judges came to different conclusions and the dissenting view was that the payment was not laid out wholly and exclusively for the purposes of the trade and/or it was a loss not connected with or arising out of the trade. It was imposed because the conduct of McLaren fell way outside any normal and acceptable way of conducting their trade. Furthermore, if McLaren were seeking to preserve the whole structure of their profit making apparatus, it could be argued that the payment was capital. However, the dissenting view was overruled by the Chairman who had the casting vote and the £32 million was allowed.

Strong views have been expressed about this decision and instinctively it seems somehow wrong that conduct so wrongful and serious that it merited a £32 million fine should be entitled to a tax deduction. It is also perhaps a little extreme for Judge Hellier to suggest that fraud and deceit as well as cheating were part of McLaren’s trade.

However, I wonder whether the arguments here are distorted by the enormity of the figures and the particular circumstances. We are dealing here with a commercial contract between a number of substantial commercial bodies and the documents in possession of McLaren really only gave rise to impropriety because they were prohibited by the contract. If the contract had provided for a full disclosure of technical data between all Formula 1 teams, there would have been no issue. Accordingly, we are simply looking at one party to a commercial contract acting in breach of that contract and the other parties insisting on a particular sanction. The size should not matter.

Many commercial contracts contain penalty clauses, for example for failure to meet certain performance or delivery targets, and these are all in the nature of punishments for failing to meet the
agreed terms – or otherwise to encourage prompt performance. A person is still carrying on his trade even if in the course of that trade he does not necessarily adhere to every term of every contract he has entered into. He does not cease to be trading just because, for example, he fails to deliver his product on time.

There is considerable authority for the proposition that a penalty for a breach of the law cannot be allowed as a matter of policy, but we are not dealing with that here. Although there are some surprising elements in this decision, the conclusion to allow relief for this payment would not seem to be in conflict with existing authority nor able to be dismissed on policy grounds.

Benefits in Kind: NIC When no Tax?

An interesting debate took place in Marcia Willett Limited v HMRC TC 2301 relating to the application to a charge to NIC on benefits in kind in circumstances where there is no charge to income tax. The company provided benefits to the directors but the benefits were made good by the taxpayer and ITEPA 2003 s 203(2) applied to eliminate any change to income tax.

That is hardly unusual – so one might wonder what the problem was. It was because HMRC took the view that benefits in kind also give rise to Class 1A NIC but there is nothing in the NIC legislation which refers to making good, so irrespective of the income tax position, the Class 1A contributions remained payable.

The Tribunal concluded that there can be no charge to Class 1A NIC where there is no income tax charge. They dismissed HMRC’s arguments saying that they offended the principles of statutory interpretation. (Others might suggest that it offended against common sense and fairness as well.)

HMRC said that NIC refunds cannot be made when a subsequent event occurs which may alter the amount on which NIC is originally assessed. The Tribunal did not see why this should be the case. They observed that the general structure of UK tax legislation is that a tax liability can be affected by future events; losses can be carried back to an earlier period, tax returns can be kept open for 12 months or longer and HMRC can amend tax returns on the basis of facts discovered after the event. The Tribunal decided that the making good by the taxpayer meant there could be no chargeable benefit to which a charge to NIC could be imposed.

There was more in this case than a simple criticism of an unfair approach by HMRC. The issues surrounding “making good” were interesting. The benefits provided by the company to the directors had been made in the years 2002 to 2007 but it was only on 6 May 2008 that the directors made good the benefit by an adjustment to their directors loan accounts. There was no dispute that this had the effect of removing the income tax charge for each of the relevant periods.

The Employment Income Manual sets out the view of HMRC on this subject as under:

“The legislation does not set a time limit on the making good. This will usually happen shortly after the expense is incurred by the person providing the benefit. But you need not object to a belated making good if it is done within a reasonable time of the employee becoming aware that the chargeable benefit can be reduced in whole or in part by reimbursing the expense incurred by the provider. What constitutes a reasonable time will depend on the facts of the case. Do not allow a decision for making good which takes place after a charge to tax on the benefit concerned has become final and conclusive.”

It must obviously have been the case that these conditions were satisfied in the above tribunal case but it shows just how long you might have, to make good a benefit under ITEPA 2003 s 203.

Unfortunately, this will not always be the case. Completely different rules apply to earnings which arise from “notional payments” (such as payments by intermediaries, readily convertible assets or restricted securities) where there is a PAYE deduction obligation on the employer. This can be eliminated by the employee making good the relevant amount – but the making good has to be effected within 90 days (2003 s 222). And just to be helpful, HMRC adopt a different interpretation for “making good” for this purpose.