Landmark decision on tax deductibility of payments in lieu of penalties
In a significant ruling, the Court of Appeal has provided clarity on the tax treatment of payments made to settle regulatory investigations. The case of Scottish Power (SPCL) Ltd and others v HMRC [2025] EWCA Civ 3 considered whether payments made by Scottish Power (SP) to settle regulatory breaches were deductible for corporation tax purposes or should be treated as non-deductible on the basis that they were penalty payments. The amounts in question were made up of various payments to customers and customer groups in lieu of more substantial regulatory penalties, with only a minimal amount payable as a penalty to the regulator. This decision has important implications for companies navigating regulatory settlements and their tax implications.
Background
SP faced multiple regulatory investigations by the Gas and Electricity Markets Authority (GEMA), acting through the Office of Gas and Electricity Markets (Ofgem), for issues such as mis-selling, complaints handling, and other regulatory breaches. In lieu of substantial penalties, SP agreed to make payments of around £28 million to consumers, consumer organisations and associated charitable payments. SP sought to deduct these payments from its taxable profits, but HMRC denied the deductions, on the basis that the payments made in lieu of penalties should be non-deductible on the basis that the were penal in nature and therefore not incurred wholly and exclusively for the purpose of the trade.
The First-tier Tribunal had previously concluded that only a small part of the payment should be deductible and, on appeal, the Upper Tribunal had determined that the payments should be wholly disallowed. SP appealed further to the Court of Appeal.
Legal issues
The primary legal issue brought before the Court of Appeal was whether the payments made by SP were deductible under section 54(1)(a) of the Corporation Tax Act 2009 (CTA 2009) (s.54), which prohibits deductions for expenses not incurred “wholly and exclusively” for the purposes of the trade.
Interestingly, the Court of Appeal determined that, whilst the parties were contesting the application of s.54, this was the wrong starting point. The Court of Appeal stated that the correct analysis was firstly to consider whether amounts should be denied as a deduction under section 46(1) CTA 2009 (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 payments were in this case, included in the calculation of profits under generally accepted accounting practice and the question was whether the restriction on their deductibility was an “adjustment required or authorised by law”.
The particular focus in the Court of Appeal was to what extent earlier court decisions had established a principle that payments of a penal nature are non-deductible for corporation tax purposes, the scope and extent of that principle, and the extent to which that principle could be said to necessitate “an adjustment required or authorised by law”.
Court’s analysis
A key question was whether an “adjustment required or authorised by law” referred only to legislative adjustments. In the Court of Appeal’s view, such an adjustment could be mandated either by reference to case law and/or legislation. The Court concluded that in enacting s.46 (which significantly post-dated much of the case law in this area), Parliament had recognised that restrictions on tax deductibility could be found outside of legislation and that these restrictions should be integrated into the operation of s.46. However, in order to reconcile this conclusion with Parliament’s primacy as a law-making body, the Court of Appeal concluded that:
- In order for historical case law (such as those which have established the non-deductibility of penalties themselves) to constitute an adjustment required by law under s.46, such case law must clearly have that effect. In this case, the established case law was only clear to the extent that it established a restriction on the deductibility of penalties and fines imposed under a legislative regime. It was not at all clear, in the eyes of the Court of Appeal, that the principle could be extended beyond this narrow remit.
- The principle did not allow the courts to read in new restrictions on deductibility (ie restrictions not rooted in case law established before s.46 was enacted). Any such new restrictions remain, in the Court’s view, a matter for Parliament.
Applying this conclusion to the facts of the case, the Court of Appeal concluded that the penalties imposed by statute, in this case the £1 payable to the regulator, was disallowable. However, there was no overarching principle, either in case law or legislation, which would disallow payments which are not penalties and not imposed by legislation provided that those payments otherwise meet the “wholly and exclusively” test in s.54 CTA 2009. The payments by SP to customers and customer groups were, therefore, deductible.
The Court of Appeal did not give a conclusive answer on the treatment of payments which are in the nature of penalties, but not grounded in legislation, which were not at issue for SP. Significant question marks remain as to how these payments should be treated for tax purposes.
Practical implications
This case provides some level clarity on the tax treatment of payments made to settle regulatory investigations, distinguishing them from statutory penalties. Taxpayers should consider the nature of payments when assessing their tax deductibility and when negotiating the nature of payments that will be made for regulatory breaches. Following the decision, it may be the case that, for many companies, it would be more beneficial to agree with regulators to make charitable or redress payments where they are a viable alternative to penalties in order to obtain a corporation tax saving.
Importantly, whilst the Court of Appeal focused its analysis on s.46 CTA 2009 as a starting point, one must always go on to consider whether payments are incurred “wholly and exclusively” for the purposes of the trade as stipulated in s.54 CTA 2009. The wholly and exclusively test is still an important stipulation which must be considered as a motive test in assess the payments in addition to considering whether they excluded under s.46 CTA 2009.
The Court of Appeal chose not to comment on how its analysis affects the treatment of payments which are in the nature of penalties, but not grounded in legislation, which were not at issue for SP. There are, therefore, significant unanswered questions as to how the principles outlined in this judgment could affect existing caselaw in this area (e.g. McLaren Racing Ltd v HMRC [2014] UKUT 269 (TCC)). Given the Court of Appeal’s view that any further restrictions on redress payments or payments in lieu of penalties should be a matter for Parliament, it will be interesting to see whether Parliament decides to enact further legislation clarifying the scope of these principles.
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