Mcknight (Her Majesty's Inspector of Taxes) v Sheppard

The House of Lords considered whether legal expenses of a sole trader stockbroker incurred in defending disciplinary proceedings were deductible when computing profits under Case I of Schedule D, or excluded by section 130(a) of the Income and Corporation Taxes Act 1970 as not "money wholly and exclusively laid out or expended for the purposes of the trade". The court held that such legal costs could be deductible where the primary and exclusive purpose of the expenditure was to preserve the trade, applying the principle in Morgan v Tate & Lyle Ltd and the distinction between purpose and effect in Mallalieu v Drummond. The Lords distinguished punitive fines and penalties (as in von Glehn) from legal costs of defence, observing that non-deductibility of fines rests on the punitive character and policy against sharing that burden by deduction, whereas there was no clear policy reason to deny deduction for defence costs and to do so would operate as an additional fine.

Background and facts:

• The respondent, a stockbroker, incurred about 200,000 in legal expenses (1986-87) defending disciplinary proceedings before the Stock Exchange disciplinary and appeals committees. He faced 17 charges, was found guilty on several counts including gross misconduct and dishonesty on one count, and was ordered suspended (suspension later converted to fines totalling 50,000). On subsequent proceedings before another tribunal the taxpayer was later exonerated of the imputation of dishonesty.

Procedural posture:

• The Inspector of Taxes disallowed deductions for both the fines and the legal expenses. The Special Commissioner allowed the appeal in respect of legal expenses but not fines. Lightman J (High Court) allowed the Revenue's appeal against the deduction of the expenses. The Court of Appeal allowed the taxpayer's appeal. The Revenue appealed to the House of Lords.

Nature of the claim and issues:

• (i) Whether legal expenses of defending disciplinary proceedings are "money wholly and exclusively" for the purposes of the trade within section 130(a) ICTA 1970 and therefore deductible from trading profits;
• (ii) Whether the taxpayer's alleged dual purposes (preserving trade and preserving personal reputation) precluded exclusivity of the trade purpose;
• (iii) Whether policy considerations that render fines and penalties non-deductible should also prohibit deduction of associated legal costs.

Court's reasoning and decision:

• The Special Commissioner's factual finding that the taxpayer's dominant and exclusive purpose in incurring the costs was the preservation of his trade was open to him as a matter of law. The House of Lords emphasised the legal distinction between purpose and effect (Mallalieu) and accepted that private advantages or feelings did not necessarily mean the expenditure lacked an exclusive trade purpose.
• The court accepted the established principle in Morgan v Tate & Lyle that expenditure to preserve the trade from destruction can be exclusively for the purposes of the trade. It distinguished the treatment of punitive fines (von Glehn) from legal defence costs: fines are penal and non-deductible as a matter of policy, whereas legal costs of defending disciplinary proceedings do not attract the same policy bar and, if incurred to preserve the trade, are deductible.
• The House of Lords therefore dismissed the Revenue's appeal and upheld the Special Commissioner's decision that the legal expenses were deductible. The fines issue was not pursued on this appeal.

Implications:

• The decision confirms that, on careful factual findings, legal expenses incurred to defend a trader's business may be deductible where the sole purpose is to preserve the trade; it also clarifies the policy-based distinction between non-deductible penalties and potentially deductible defence costs.

The appeal is dismissed. The House of Lords held that on the Special Commissioners findings the taxpayer's legal expenses were "wholly and exclusively" for the purposes of the trade and therefore deductible under section 130(a) ICTA 1970. The Lords distinguished punitive fines (non-deductible) from legal defence costs and accepted the Special Commissioner's finding that private advantages did not negate an exclusive trade purpose.

Special Commissioner: allowed deduction of legal expenses but not fines; High Court (Lightman J.): allowed the Revenue's appeal disallowing the expenses; Court of Appeal (Nourse, Potter and Mummery L.JJ.): allowed the taxpayer's appeal; House of Lords: Revenue's appeal to House of Lords dismissed. (House of Lords citation: [1999] UKHL 6.)