Fines and compensation for mis-selling financial products

Recent press comment has focused attention on the treatment for tax purposes of payments that arise as a result of bad practice or wrongdoing by companies in the financial sector, for example, fines imposed by regulatory authorities or compensation paid to disadvantaged customers.

Fines and penalties
The basic principle is that in calculating the profits of a trade for tax purposes, including a financial trade, a deduction is available for any expense incurred wholly and exclusively for the purpose of the trade, and that is not of a capital nature. In what follows, it is assumed that the amounts concerned are not capital in nature.

Following this principle, a fine incurred under criminal law, or a penalty imposed by a regulatory body for a breach of a business’ legal obligations, does not give rise to an allowable deduction, because the courts have held that activity that infringes the law cannot be undertaken for the purposes of the trade.

However, a liability to a regulatory body that is broadly intended to cover the regulator’s duties in relation to the business’s trading activities (for example, a levy to cover annual inspections) is normally allowable even if, in the event, the inspection reveals breaches of regulations.

By contrast to the treatment of fines and penalties, a payment that is intended to provide compensation for harm suffered by a customer in the course of normal trading operations will be allowable. At its simplest, this might be a refund of amounts paid for faulty goods, perhaps with an additional ‘goodwill’ payment.

Where the customer brings civil proceedings to recover damages and a payment is made to settle the case, this will be allowable if the customer’s allegations are neither admitted nor proved. If the liability is admitted or proved in court, the payment agreed between the parties or imposed by the court is allowable to the extent that it is restitutionary in nature but not if it takes the form of punitive damages, when it is more akin in nature to a fine or penalty.

It is important to note that a tax deduction is not disallowed merely because the business was at fault; occasional failures and errors of judgment are a normal incident of any trade. For example, a court has described damages for defamation as ‘a regular and almost unavoidable incident’ of publishing a newspaper.

Legal costs
Legal costs will normally follow the treatment of the underlying payment. Thus, the costs of unsuccessfully defending a criminal charge, or a charge before a disciplinary tribunal, will not normally be deductible. Even if the defence is successful, it will normally have been undertaken to defend an individual’s liberty, professional status or reputation, rather than for the purposes of the trade, and the costs will therefore not be allowable. Exceptionally, however, defence costs at a disciplinary tribunal have been held allowable where it was established that the sole motive for incurring the expenditure was to preserve the business rather than to defend the individual’s reputation.

By contrast, the costs of defending a claim for damages incurred in the course of the trade will normally be allowable (whether the defence is successful or unsuccessful).

It follows from the above that compensation paid by banks to customers for ‘mis-selling’ of financial products would be deductible under general principles as an expense of the banking trade, just as the profits from the original sales would have been brought into account in arriving at the taxable profit for earlier years.

However, under measures introduced in the Finance (No 2) Act 2015, and taking effect in general from 8 July 2015, no deduction is available for compensation payments made by banks under a general compensation scheme that is disclosed in the bank’s accounts, or in certain other statutory documents (with limited exceptions). In addition, 10% of the amount disallowed is brought into account as a notional receipt, in recognition of the fact that administration expenses relating to that compensation will have been allowed as a deduction under general rules.

If you would like further information or advice on this subject, please speak to your usual contact at Moore Stephens.