Vaines pursuit: HMRC’s successful appeal denies partner relief for personal business expenses

Mon 08 Feb 2016

The Upper Tribunal (UT) has reversed the decision of the First Tier Tribunal (FTT) in Revenue & Customs v Vaines [2016] UKUT 2,  ruling that Peter Vaines (PV) was not entitled to a deduction for the cost of settling a personal claim that could have bankrupted him and so forced him out of the LLP of which he was a member.

Peter Vaines (PV), a member of Squire Sanders & Dempsey LLP (SSD), made a compromise agreement with the bankers for another firm, Haarmann Hemmelrath (HH). PV had been a member of HH until it ceased trading, owing its bankers €17m, before he joined SSD.

The bank took legal action against the members of HH personally to recover monies owed and there was a risk that PV might have to settle the claim in full which would have bankrupted him. PV therefore reached a compromise settlement with the bank under which he paid €300,000. PV could have contested the bank’s claim but if he had been made liable for the full amount claimed and so bankrupted, he would have been unable to continue to practise as a member of SSD.

Although PV had paid the claim off personally and it was not included in SSD’s partnership return, PV claimed the cost personally as a business expense.

HMRC refused PV’s claim on the basis that

1.      PV was not entitled to claim the cost of settlement personally because the partnership tax rules in Income Tax (Trading and Other Income) Act 2005 (ITTOIA) Pt. 9 only permit deduction for expenses included in a partnership return, so there is no legal basis for personal claims;

2.      even if a personal claim was permitted, the expense was not incurred wholly and exclusively for the purposes of business because it had a strong duality of purpose in that the consequences of personal bankruptcy  were serious and far-reaching to PV personally and not only to his business; and

3.      the expenditure was capital in nature and not income.

Personal claims not possible

PV had argued that as a partnership (which includes any LLP carrying on a business) is not taxable as a separate entity but rather PV was taxable on his share of the (SSD) LLP’s profits as his own ‘notional trade’, he was also entitled to claim a deduction for expenses that he bore personally. He claimed that the effect of ITTOIA Pt. 9 was solely to determine that he, like all the other partners, was required to measure his profits by reference to the partnership’s accounting reference period. The UT held that the individual partner’s notional trade is taken into account only for the purposes of assessment :

“The actual trade remains that of the partners collectively and it is the profits of that collective trade that must be computed before being allocated or shared among partners . . .”.

Wholly and exclusively

The UT judges, having decided that PV was not able to claim expenses individually, did not strictly need to consider whether the expenses claimed were incurred wholly and exclusively for the purposes of the business (either his own or that of the SSD LLP). The fact that the expense was not directly incurred in the course of PV’s business as a partner in SSD LLP did not automatically prevent a deduction: the test is what the person’s purpose is in incurring the expenditure. Therefore expenditure to protect or prevent damage to a business may be allowable, including where the threat is indirect or affects the capital structure of the business. However, the wholly and exclusively rule requires exclusivity of purpose and the UT decided that the FTT had concluded that as the payment had the effect of protecting PV’s business that was sufficient but in doing so the FTT made a mistake of law. The UT considered the leading cases on the subject including Mallalieu v Drummond, in which a barrister’s purpose in buying clothing conforming to the requirements of the Courts was not wholly and exclusively to meet the court’s requirements but also to meet the requirements of “warmth and decency”.

The UTT observed that PV’s payment had arisen from his previous engagement with HH and had nothing whatsoever to do with the business of SSD.  PV had an unenviable choice: to concede the claim and be made bankrupt, to contest the claim and risk bankruptcy or to reach a compromise settlement, which is what he did, as bankruptcy would have posed too great a risk to his ongoing membership of SSD.  The UT found that whilst business preservation may have been uppermost in PV’s mind, it cannot have been his sole purpose, bearing in mind reputational and personal consequences that would also have flowed from bankruptcy.

Capital or revenue?

Because it had already decided that PV’s appeal could not succeed for the reasons already covered, the UT did not give a decision on whether the payment would also have been disallowed on the grounds that it was capital rather than revenue expenditure.

However, the Judges did confirm that if the payment had cleared the first two hurdles it was possible that it might have been accepted as being a revenue expense. They observed that payments designed to protect or preserve a person’s trade or profession may be deductible as revenue, citing Morgan v Tate &Lyle as one case providing authority for this possibility. Unfortunately, this was cold comfort to PV who was left with no tax relief on his payment.

Where next?

This has been a long drawn-out case, not least because it took so long for the UT to issue its decision and there is no guarantee that it will not drag on for longer: PV may appeal to the Court of Appeal but even there he would still have all three hurdles to clear.