In computing taxable profits, taxpayers are generally entitled to deduct expenses that are incurred for the purpose of generating the profits, provided that the expenses meet the test for deductibility and do not come within the category of expenses that are statutorily non-deductible. An expense that is incurred wholly and exclusively for the purpose of generating taxable profits would ordinarily be deductible. However, even where an expense meets this test, it would only be deductible if deduction is not statutorily disallowed. One category of expenses that is expressly disallowed is penalties and fines. The question, however, is whether payments made in lieu of penalties or fines, even though not expressly disallowed, would be deductible.
Tax treatment of penalties
Prior to 2020, there was no express statutory prohibition on the deduction of penalties in the computation of taxable profits in Nigeria. The prohibition was first introduced by the Finance Act, 2019 which amended Section 27 of the Companies Income Tax Act (‘CITA’) by inserting provisions expressly disallowing deduction of penalties and fines. The Petroleum Industry Act, 2021 (‘PIA’) also enacted a similar prohibition.
However, even before the introduction of statutory provisions to prohibit deduction of penalties and fines, such payments were treated as non-deductible expenses by the Federal Inland Revenue Service (‘FIRS’), and this position was affirmed in Mobil Producing Nigeria Unlimited v. FIRS where the Court of Appeal held that gas flaring fees paid by the appellant qualified as penalties and were therefore not deductible under Section 10 of the Petroleum Profits Tax Act.
The reason for disallowing deductions of penalties as expressed by Lord Hoffman in McKnight (Inspector of Taxes) v. Shephard is that the purpose of a penalty is to punish the taxpayer and that ‘. the legislative policy would be diluted if the taxpayer were allowed to share the burden with the rest of the community by a deduction for the purposes of tax.’ Another reason for disallowing the deduction of penalty is that ‘. a penalty is not a loss connected with the business, but . a fine imposed upon the company personally.’ Therefore, both under the current statutory regime, and as a matter of public policy, penalties and fines are not deductible for tax purposes even if they arise inevitably in the carrying on of a trade, as it was the case in Mobil v. FIRS.
Payments in lieu of penalties
There are, however, certain payments, which, even though cannot be properly classified as penalties or fines, may have the characteristics of a penalty. Such payments do not suffer an express prohibition from deduction. But the question may arise whether they are intrinsically connected to or inexorably arising from the business of the company as to be considered to have been made wholly and exclusively for the purpose of generating taxable profits. Such payments may arise from an agreement between a regulator and a taxpayer to settle regulatory or statutory infractions for which a penalty may be imposed. However, instead of imposing the prescribed penalty, a regulator may, in exercise of an administrative discretion, direct the payment of sums to remedy any damage that may have resulted from the infraction. In such cases, the payments may not qualify as penalties but would serve a similar purpose as a penalty. The question is whether such payments being made in lieu of penalties would be subject to the same tax treatment as penalties.
This question was considered in ScottishPower (SCPL) Ltd v. The Commissioners for His Majesty’s Revenue and Customs. The summary of the facts of the case is that between 2013 and 2016, ScottishPower entered into agreements with the UK Gas and Electricity Markets Authority in settlement of investigations into certain regulatory breaches such as mis-selling, complaints handling and cost transparency. The agreements led to the payment of penalties for the regulatory breaches in nominal amounts of £1 and payments to consumers and consumer organisations of a total sum of £28m. The Commissioners for His Majesty’s Revenue and Customs (‘HMRC’) considered the £28m as payments in lieu of penalties and disallowed the deduction of the payments.
The First-tier Tribunal (‘FTT’) took the view that payments in respect of a penalty or in lieu of penalty are not deductible, but that compensatory payments are deductible. The FTT concluded that only the sum of £554,013 paid to customers affected by mis-selling was compensatory while the remainder of the payments were in lieu of penalty. It therefore dismissed ScottishPower’s appeal against the decision of HMRC disallowing the deductions, except the appeal on the compensatory element of the payments. Both ScottishPower and HMRC appealed to the Upper Tribunal (‘UT’) which held that all the payments were in the nature of penalty and were non-deductible. On further appeal by ScottishPower to the Court of Appeal, the Court of Appeal held that the payments were deductible.
In reaching this conclusion, the Court of Appeal, per Falk LJ reasoned that while penalties and fines are non-deductible, there is no basis for extending the rule prohibiting deduction of penalties and fines to payments ‘. which are not, in fact, fines or penalties.’ She rejected HMRC’s case which was accepted by the FTT and UT that the disputed payments were in lieu of penalties and should therefore be treated as having the same nature or character as penalties because even if the payments were accepted as replacing penalties, there was no authority supporting ‘. any general proposition that the deductibility of a payment should be determined by reference to the nature of a payment which it replaces.’
Falk LJ formulated the necessary question to consider as ‘. whether the payment actually made is deductible or is to be denied a deduction, whether because it is of a capital nature, because it was not in fact an expense incurred wholly and exclusively for the purposes of the trade, or for some other reason.’ She further considered that where a regulator imposing a penalty or fine contemplates agreeing to alternative forms of redress, such a regulator can be assumed to have taken ‘. account of the fact that such an alternative may attract a more beneficial tax treatment’ and that:
‘. there is no need for judges to step in to ensure that differences in tax treatment between penalties or fines and alternative forms of redress are avoided. The policy imperative for a rule that would deny a deduction for amounts that are not in fact penalties or fines is simply not there. Further, I cannot see that it would properly be a matter for the courts, rather than Parliament, to develop such a rule.’
The Court concluded that the payments were expenses wholly and exclusively incurred for the purposes of ScottishPower’s trade and that they were deductible in the absence of any rule prohibiting deduction of the payments.
In treating the payments as deductible, the Court of Appeal focused on the nature or character of the payments in line with Lord Hoffmann’s decision in McKnight v. Shephard and took the view that the payments were by nature, deductible and a deduction cannot be denied based on a judge-made rule. By this approach, the Court of Appeal limited the rule in von Ghlen and McKnight to payments that qualify as penalties or fines imposed under a statute, thereby excluding payments that are similar to or in lieu of penalties and fines, even if the latter category were made under a statutory regime and for the purpose of remedying a statutory or regulatory breach.
The question may however arise whether allowing a deduction of payments made in lieu of penalties to settle statutory or regulatory breaches would not dilute the legislative policy prohibiting the offending conducts as determined by Lord Hoffmann in McKnight. One answer would be that the legislative policy referred to by Lord Hoffmann was the policy under which a penalty is imposed and not a policy under which an alternative form of redress is made. Another justification for allowing a deduction for payments in lieu of penalties and fines made pursuant to an agreement between a regulator and a taxpayer is that the payments in such case would have the character of contractual payments and not statutory penalties or fines.
Agreements for such alternative forms of redress would typically take into consideration mitigating factors such as the conduct of the defaulting person during the investigation and commitment to improve future conduct, and the public interest and policy benefits of such payments as against penalties and fines. For instance, the legislative framework under which the Federal Competition and Consumer Protection Commission (‘FCCPC’) may reduce a penalty and possibly order an alternative form of redress, the FCCPC Investigative Cooperation/Assistance Rules and Procedures 2021, provides that:
In considering any benefits with respect to reduced monetary penalties, the Commission will depend on the totality of the circumstances including but not limited to the:
(i) timing and stage at which the Candidate enters into cooperation/assistance;
(ii) extent and value of the cooperation/assistance;
(iii) the procedural and administrative efficiencies gained by the Commission in the investigation; and
(iv) the entire facts and circumstances of the case.
Payments in lieu of penalties made pursuant to an agreement would carry different implications for a taxpayer, including a reduced reputational impact on the taxpayer. Such payments are therefore inherently more beneficial to a taxpayer than penalties and fines, and the point may be made that allowing a deduction for such payments would amount to an undue compensation for the breach that is intended to be remedied by the payment.
However, a negotiated settlement of statutory breaches benefits not only the defaulting company but also the regulator. Establishing statutory or regulatory breaches may entail protracted and costly investigations and sometimes, litigation that could span years. And there is no guarantee that such protracted investigations or judicial proceedings would produce a favourable or desirable outcome for a regulator. A negotiated settlement will ordinarily save a regulator valuable time and resources that would have otherwise been spent on investigations or judicial proceedings, while ensuring that the offending conduct is remedied. In addition, a regulator may also gain a deeper understanding of an industry through the collaborative efforts of a taxpayer during the settlement process and be better equipped to more effectively fulfil its regulatory mandate. Therefore, payments in lieu of penalties made under such negotiated settlements provide mutual benefits to a regulator and a defaulting company, and ought not to be subjected to the same rules of deductibility that apply to penalties and fines. There is, indeed, a strong policy basis for allowing deductions of such payments.
One point to note, however, is that payments in lieu of penalties, even if not automatically disallowed as penalties and fines, would still need to satisfy the general test for deductibility by being an expense incurred wholly and exclusively for the purpose of generating taxable income. In ScottishPower, the FTT, UT and Court of Appeal all considered that the payments were expenses incurred wholly and exclusively for the purpose of the trade.
However, this conclusion was informed by the facts of the case and does not appear to establish a general rule that payments in lieu of penalties would be deemed to be made in connection with the trade in all cases. Where the activities leading to the investigations and ultimately the payments, are not commercial activities with a close connection with the business of the taxpayer, the payments may not satisfy the deductibility test and would therefore not be deductible.
It should be noted that at the time of this publication, HMRC has obtained permission from the Supreme Court to appeal the decision of the Court of Appeal. That means that the jury is still out, and the outcome of the appeal will definitively determine whether payments that are made in lieu of penalties will automatically suffer the same tax treatment as penalties.
Conclusion
Ultimately, the deductibility of payments in lieu of penalties would depend on the facts and circumstances of each case, particularly on the question of whether the activities giving rise to the agreement or direction for such payments are closely linked to the business of the taxpayer such that the payments could be considered as expenses incurred wholly and exclusively for the purpose of generating taxable income. Where the payments are so closely connected with the trade, they should be deductible, notwithstanding the fact that they were made to remedy statutory or regulatory breaches.