AB (a firm) v Revenue & Customs [2006] UKSPC SPC00572 (7 December 2006)
SPC00572

INCOME TAX – Appellant was a firm of solicitors and acted for one of its partners in connection with personal litigation – in one case the firm paid the costs of the other successful party – in that and five other cases the firm paid some of the disbursements  – whether such payments were wholly and exclusively laid out for the purposes of the profession of the firm –no – appeal dismissed – TA 1988 S 74(1)(a)

TIME LIMITS - amendments to partnership statements where loss of tax discovered – whether negligent conduct on the part of the representative partner – yes – appeal dismissed – TMA 1970 S30B(5) 

THE SPECIAL COMMISSIONERS

AB
(A FIRM)
Appellant

and

THE COMMISSIONERS FOR HER MAJESTY’S
REVENUE AND CUSTOMS
Respondents

Sitting in London on 31 October 2006 and 1, 2 and 9 November 2006

SPECIAL COMMISSIONERS:
STEPHEN OLIVER QC
DR A N BRICE

Conrad McDonnell, counsel, for the Appellant firm

Bruce Carr, counsel, instructed by the Acting Solicitor for HM Revenue and Customs, for the Respondents

© CROWN COPYRIGHT 2007

ANONYMISED 
DECISION

The appeal 
1.	Messrs AB (the Appellant) was, at the relevant time, a firm of solicitors. The Appellant appeals against amendments to the partnership statements in respect of the following periods of account and tax years:

Period of account	Tax year	
1 May 1994 to 30 April 1996	1996/97	
1 May 1996 to 30 April 1997	1997/98	
1 May 1997 to 30 April 1998	1998/99	

2.	The partnership statements were amended by the Commissioners for Her Majesty’s Revenue and Customs (the Revenue) because they were of the view that, in computing the amount of the profits of the Appellant, certain sums had been deducted which were not wholly and exclusively laid out for the purpose of the profession of the Appellant.

3.	The amendments were made on 14 July 2005 and notified to the Appellant on 26 September 2005. The Revenue accepted that the amendments were made outside the ordinary time limits but were of the view that the loss of tax was attributable to the negligent conduct of the representative partner. 

The legislation
4.	The legislation about the allowability of deductions is contained in section 74 of the Income and Corporation Taxes Act 1988 (the 1988 Act). The relevant parts provide:

“74	General rules as to deductions not allowable 
Subject to the provisions of the Tax Acts, in computing the amount of the profits or gains to be charged under Case I or Case II of Schedule D, no sum shall be deducted in respect of –
(a)	any disbursement or expenses, not being money wholly and exclusively laid out or expended for the purposes of the trade, profession or vocation …”

5.	The legislation about time limits is contained in section 30B of the Taxes Management Act 1970 (the 1970 Act) the relevant parts of which provide:

“30B	Amendment of partnership statement where loss of tax discovered
(1)	Where an officer of the Board or the Board discover, as regards a partnership statement made by any person (the representative partner) in respect of any period - …
(b)	that an amount of profits so included [in the partnership statement] is or has become insufficient …

the officer may, subject to subsections (3) and (4) below, by notice to that partner, so amend the partnership return as to make good the omission or deficiency … .
 
(4)	No amendment shall be made under subsection (1) above unless one of the two conditions mentioned below is fulfilled.

(5)	The first condition is that the situation mentioned in subsection (1) above is attributable to fraudulent or negligent conduct on the part of-
(a)	the representative partner or a person acting on his behalf; …” 

The issues
6.	Thus what we had to decide was:

(1)	whether the sums which had been deducted in computing the profits of the Appellant were money wholly and exclusively expended for the purpose of the Appellant’s profession within the meaning of section 74(1)(a) of the 1988 Act; and, if they were not

(2)	whether the insufficiency of the amount of the profits was attributable to the negligent conduct on the part of the representative partner within the meaning of section 30B(5) of the 1970 Act.   

The evidence
7.	Five numbered bundles of documents were produced (A/B, B, C1, C2, and D). A bundle of witness statements was produced and this also contained exhibits to the statements. There was also a statement of agreed facts. 

8.	Oral evidence was given on behalf of the Appellant by Mr A, the senior partner of the Appellant firm, and by a Chartered Accountant who had acted for both Mr A personally and also for the Appellant firm. 

9.	Oral evidence was given on behalf of the Revenue by Mr Peter John Chipperfield and Mr Robert Grant, both of whom at the relevant time were investigators in the Inland Revenue’s Special Compliance Office. Oral evidence was also given on behalf of the Revenue by two partners in the firm of Messrs XYZ, Solicitors, namely Mr X, the senior partner and Mr Y, a litigation partner.  

10.	Throughout the events which are the subject of our findings of fact Mr A acted in four capacities. He personally was the litigant in the litigation; he was also the partner at the Appellant firm who conducted the litigation; he was also the senior partner of the Appellant firm; and finally he was the firm’s representative partner for tax purposes. In acting simultaneously in all four capacities he did not avoid the conflicts which arose between his own personal interests on the one hand and the interests of the firm and the Revenue on the other. 

The facts	
11.	From the evidence before us we find the following facts 

The Appellant 
12.	At the relevant time the Appellant firm had a number of partners. Mr A was the senior partner and the representative partner for tax purposes. The way in which the profits of the firm were divided changed over the years but at the relevant time it was 50% to Mr A and 50% between all the other partners. . 

13.	The work done by the Appellant firm was mainly litigation and the sums at issue in the appeal relate to litigation conducted by the Appellant firm on behalf of Mr A personally. Mr A was the partner at the Appellant firm who was responsible for conducting each matter. The largest sum at issue amounted to £160,000 and was paid to Messrs XYZ as the costs of their client, Mr Z, who had been successful in proceedings brought against him by Mr A personally. The other sums were disbursements incurred in connection with proceedings initiated by Mr A personally.   

14.	The Appellant firm moved offices in September 2002 and the area occupied by the firm reduced from 4,000 square feet to 1,100 square feet. Furniture and papers had to be destroyed and Mr A told us that at that time he destroyed all the papers relating to his personal litigation. On 20 December 2004 the Appellant was first notified of the Revenue’s enquiry into its tax returns.

15.	We now consider separately each of the disputed payments.

(1)	The payment of costs 
16.	Shortly stated, the issue here is whether, as the Appellant firm contend, the sum of £160,000 was an amount laid out by Appellant firm wholly and exclusively for the purposes of its business on the grounds that that amount had to be paid to remove the real threat of a wasted costs order and the consequences such an order would have had on its business.  The Revenue say there was no such threat.  The liability to pay Mr Z’s costs had at all times been Mr A’s personal liability.  Mr A had, say the Revenue, created a liability for the Appellant firm where none had existed in order to enable himself as representative partner to present the £160,000 as a deductible expense of Appellant firm, and in so presenting it in the Appellant firm’s tax returns, the Appellant firm had been negligent. 

17.	We now give a chronological account of the events relied upon and, where appropriate, single out and explain the relevance of the contentious issues. 

18.	Mr A was a Name at Lloyds and suffered losses. He came to believe that he had been induced to become a Name because of pre-existing losses. He and Mr Z, who was then the senior partner of Messrs XYZ, set up an action group with a view to commencing litigation. The Appellant firm acted for the action group and issued the first writ. Mr Z and some other members of the action group then formed the view that they would prefer a larger firm of solicitors to conduct the litigation. They formed a Names Association which eventually included most members of the action group. As a result of a dispute Mr A was not permitted to join the Names Association. Thus the Appellant firm lost the future fee income which it would have earned for acting for the action group and Mr A personally was unable to join the Names Association. He said that he was also unable to bring proceedings on his own because of the potential cost.   

19.	Accordingly, Mr A and the Appellant firm brought proceedings against Mr Z and the new firm of solicitors based on allegations that Mr Z had breached the terms of an oral agreement with Mr A that the Appellant firm would conduct the litigation brought on behalf of the action group. The Appellant firm acted for itself and also for Mr A personally and instructed leading counsel to act in the proceedings. Mr Z was represented by  Messrs XYZ.  

20.	The Appellant’s claim was dismissed. Thereafter the action proceeded solely on the basis of a private and personal claim by Mr A against Mr Z. The Appellant firm continued to act for Mr A personally and to instruct their leading counsel.  Messrs XYZ continued to act for Mr Z. The main issue then was whether Mr Z had acted fraudulently by making representations to Mr A which he knew were untrue. Fraud was specifically pleaded in the claim.  

21.	 Mr A’s claim against Mr Z was dismissed and the court expressed the view that the fraud claim should never have been pleaded. Costs were awarded  against Mr A as the unsuccessful litigant; the costs were awarded partly on the standard basis and partly on the indemnity basis. Mr Z was also given leave to apply for a wasted costs order against the Appellant firm and the leading counsel, as Mr A’s legal representatives, the judge expressing the view that there might be ground for making such an application. We accept that this led Mr A to conclude that, if Mr Z were to apply for a wasted costs order, and if the matter were to go back before the same judge, there was a real possibility (but not a certainty) that a wasted costs order would be made against the Appellant firm. 

Mr  A’s personal means 
22.	Because the question of Mr A’s personal ability to pay the costs awarded against him became relevant we here interpose our findings of fact about Mr A’s personal means as in 1995. There was no evidence before us that there was any change after that date.  The relevance of Mr A’s means is this.  The Appellant firm’s case is that the threat of a wasted costs order against them came from Messrs XYZ because Messrs XYZ were concerned that Mr A personally did not have the means to discharge his own liability for Mr Z’s costs in the litigation. The Revenue say that Mr A was, during the course of negotiations with Messrs XYZ, deliberately giving Messrs XYZ a misleading impression of his own shortage of funds so as to drive Messrs XYZ into threatening to obtain a wasted costs order thereby enabling the Appellant firm to use that threat as the justification for the Appellant firm’s payment of Mr Z’s costs and claiming them as a tax deductible expense.    

23.	In 1995 Mr A applied for a loan facility and the lender corresponded with the Chartered Accountant who had acted for Mr A personally. The Chartered Accountant wrote to the lender to say that Mr A’s net means were in excess of £3M and his annual earnings were in the order of £150,000. The lender then prepared a list of Mr A’s assets and liabilities which showed assets of £3,065,000 with no liabilities. The assets included a house valued at £850,000 which was in the joint names of Mr A and his wife and an art collection valued at £1M. The assets excluded pension policies (valued at c£300,000) and a £2M deposit in a Swiss Bank in Mrs A’s name but of which Mr A was said to be the beneficial owner. Mr A wrote to the lender on 10 April 1995 confirming that the list of assets was correct but stating that he had a property loan of £650,000 (secured by the deposit of £2M in a Swiss Bank) and liabilities at Lloyds. At the hearing Mr A informed us that the deposit of £2M was his wife’s money and that he was not the beneficial owner. No evidence to support this statement was forthcoming nor did Mr A explain why he had not corrected the statement in the lender’s list that it was he who was the beneficial owner. 

The 1995 discussions
24	It will be recalled that when Mr A’s claim against Mr Z had been dismissed costs had been awarded against Mr A personally. Within the firm of Messrs XYZ there was some concern about Mr A’s ability to pay because it was thought that, although he had funds, he had also incurred losses through his involvement as a Name at Lloyd’s. On 21 April 1995 Messrs XYZ wrote to the Appellant firm and said that, if the firm could assure Messrs XYZ that Mr A was able to pay Mr Z’s costs, then an application for a wasted costs order would not be necessary. No reply to this letter was received. 

25.	Exchanges of internal memoranda within Messrs XYZ followed. These identified that the main advantage of a wasted costs order was that it would be met  by the Solicitors Indemnity Fund. It was originally thought that a decision to apply for such an order had to be made at an early stage. However, it was also thought that an application was likely to be a substantial task and so should not be undertaken unless there were an appreciable risk that Mr A himself would fail to pay the costs in full. Counsel was consulted by Messrs XYZ and he advised that it would be best to see if Mr A met the costs and, if he did not, that would be the time to apply for a wasted costs order. Within Messrs XYZ it was suggested that a letter be sent to the Appellant firm advising them that in order to save costs no application for a wasted costs order would be made at that stage but that Messrs XYZ reserved their rights pending confirmation that Mr A was able to pay the taxed costs. 

26.	Accordingly, on 25 July 1995 Messrs XYZ wrote to each partner in the Appellant firm. The letter stated that Messrs XYZ intended to apply for a wasted costs order against the Appellant firm if Mr A was unable to pay the taxed costs personally. However, in order to save costs (which could amount to £20,000) it was not the intention at that time to make an application for a wasted costs order but to wait until after the taxation of the costs and the enforcement (if necessary) of the award against Mr A to see if Mr A could pay the costs personally. 

The Solicitors Indemnity Fund
27.	The Appellant firm notified the Solicitors Indemnity Fund of the potential wasted costs claim and completed a report form saying that liability was ”possible” and that the amount of the claim or potential claim was £250,000. The report form was signed by Mr A as partner.  

28.	Later Mr A met with a representative of the Solicitors Indemnity Fund to see if the Fund would pay the costs which had been awarded against Mr A personally. A note recorded that Mr A had said that he was “on his knees” but also noted that there was no basis on which the Fund could meet costs awarded against Mr A personally. At the hearing Mr A said that the use of the phrase “on his knees” referred to the fact that he knew that he was asking for an ex gratia payment; he appreciated that until an order for wasted costs had actually been made there was no liability of the firm and so there could be no claim on the insurance.   

29.	Later the Solicitors Indemnity Fund wrote to Mr A, as senior partner of the Appellant firm, and said that the Fund had instructed another firm of solicitors to act and asked if future correspondence could be addressed to them. The Fund instructed their solicitors that a report was only required if the threatened application under RSC 062 Rule 11 [a wasted costs order] was proceeded with. On 10 August 1995 the Fund’s solicitors wrote to Messrs XYZ. They said that they acted for the Appellant firm on the instructions of the Solicitors Indemnity Fund and that if an application for a wasted costs order were made, a copy should be served on them. Attention was also drawn to the case of Ridehalgh v Horsefield [1994] 3 All ER 848.

30.	We add at this stage that no application was ever made by Mr Z for a wasted costs order and no such order was ever made. For that reason the insurance claim did not proceed. 

31.	On 17 January 1996 an article was published in the Law Society’s Gazette which stated that a recent consultation paper intended that practices with a good claims record would receive a discount of 20% but those with a poor claims record would have their contributions loaded by up to 200%.  (The relevance of this point will become apparent later.)

The application for judicial review
32.	Following his defeat in the action against Mr Z, Mr A brought proceedings for judicial review based on a claim that that the judge who had heard the case was beyond retirement age at the time of the hearing and so was prohibited from carrying out any judicial act under the Judicial Pensions and Retirement Act 1993.  The application for leave to apply for judicial review was refused and Mr A appealed to the Court of Appeal who dismissed his appeal 

33.	Mr A also applied for an extension of time in which to appeal from the judgment in his proceedings against Mr Z. He was granted such an extension and lodged an appeal with the Court of Appeal. That appeal was still proceeding in January 1997.   

The 1997 discussions
34.	Notwithstanding the appeal to the Court of Appeal, the detailed assessment of the costs awarded against Mr A personally proceeded. In January 1997 formal taxation proceedings were started  to assess the amount of the costs of Messrs XYZ which were payable personally by Mr A. Messrs XYZ served Mr A with a schedule of costs amounting to £269,000 and Mr A formed the view that the time had come for a meeting with Messrs XYZ to see if there were any scope for settling the amount of the costs. At that time it was expected that the taxation would take another five days and would be completed at about the end of February 1997. 

35.	On 27 January 1997 Mr A signed a letter from the Appellant firm addressed to Messrs XYZ suggesting a without prejudice meeting to see if an agreement could be reached about the amount of the costs. On 7 February 1997 Mr A met two partners of Messrs XYZ, namely Mr X (who was the senior partner) and Mr Y, (who was a litigation partner) to discuss the amount of the costs. By this time Mr Z had left Messrs XYZ but had given that firm authority to settle the amount of the costs.  It is in the circumstances of the 1997 discussions that the issue arises as to whether, as the Appellant firm argue, Messrs XYZ raised a real threat to seek a wasted costs order with the result that the Appellant firm assumed the liability to pay Mr Z’s costs, in place of Mr A, for reasons that were wholly in the interests of the Appellant firm’s business. It will be seen that the 1997 discussions ended with the Appellant firm agreeing to pay £160,000 to Messrs XYZ.  Obtaining a tax deduction for the payment had not, said Mr A in evidence, occurred to him until the meeting of 13 February 1997.

The meeting on 7 February 1997 
36.	At the meeting on 7 February figures for settlement were discussed. Mr A said that he did not have £270,000 immediately to pay the costs and had suffered losses at Lloyds of about £300,000. His only substantial income came from his practice. He was short of money and could only afford to pay out of taxed income and anything in addition which could be provided out of his business. He himself could afford to pay only £100,000 and would also offer £25,000 of free agency work to be undertaken by the Appellant firm making a total of £125,000. If the firm did free work then it would only cost Mr A the cost of doing the work and that would be tax deductible. Mr X and Mr Y offered to settle for £175,000 payable over three years but interest free. No final agreement was reached on 7 February and the meeting adjourned on the basis that there would be a further meeting in due course. 

37.	It was not suggested to us that there had been any substantial change in Mr A’s personal means after 1995. Mr A told us that what he had meant to say to Mr X and Mr Y was that he could not afford to pay £270,000 in cash. Mr X told us that, in describing his financial position, Mr A had not distinguished between cash and other assets. We prefer the evidence of Mr X which was confirmed by Mr Y’s note. We consider it to be highly improbable that two solicitors of the experience of Mr X and Mr Y would have misunderstood what was said to them. Mr A accepted in evidence before us that he would have been able to meet the amount. Although he did not have the cash available in his own name he would have been able to borrow it, or his wife would have given it to him, or it would have been paid somehow without his going bankrupt. He could have met the personal liability without any significant difficulty but would have preferred to pay it out of income. However, in the light of what they had understood, both Mr X and Mr Y concluded after the meeting that Mr A would be unable to pay the full £270,000 personally. That, we think, had been what Mr A had intended them to conclude.

38.	On 10 February 1997 Mr A wrote to Mr Y about the details of the costs being taxed and Mr Y replied on 12 February.

Was there a telephone conversation on 11 February 1997?
39.	The Revenue place reliance on a record of a telephone conversation between Mr A and Mr X as tending to support their case that Mr A had himself been engineering a threat of a wasted costs order so as to provide the Appellant firm with the basis for a claim for tax relief on the £160,000 payment. 

40.	There was a dispute at the hearing as to whether Mr A spoke to Mr X on the telephone on 11 February 1997. Mr A said that he did not have a conversation but Mr X produced a manuscript note which he had made of such a conversation. We found Mr X to be a reliable and credible witness and accept his evidence. Mr X’s manuscript note started with an office message to him dated 11 February 1997 to the effect that Mr A had telephoned and asked Mr X to call him back. Then appeared:

“Spoke: no problem with premium on insurance.
Unlikely that tax efficient
1)	Have to show genuine liability of the firm. 
a) claim – have leave. Never actually raised as at today.
b) been told by [the solicitors for the Solicitors Indemnity Fund]  under Ridehalgh v Horsefield [1994] Ch 205 must make it immediately 
Wasted costs orders
2)	If it is payable by instalments, it is a question of all due at different times maybe 25% ”

41.	Mr A suggested that Mr X had had this conversation with Mr Y but we do not agree. Mr X’s evidence was that the way in which he recorded the conversation indicated that it had been with Mr A. We prefer the evidence of Mr X.  The note had no apparent relevance to the affairs of Messrs XYZ. In our view the references to “tax efficient” and “have to show genuine liability of the firm” and “wasted costs orders” are most unlikely to be appropriate to any conversation other than one with Mr A. 

42.	We therefore find that on 11 February 1997 Mr A telephoned Mr X and raised for the first time in the discussions the possibility of a wasted costs order within the context of the fact that a payment by Mr A personally of the costs awarded against him would not be deductible for tax purposes but that the payment by the Appellant firm of a wasted costs order made against the firm would be so deductible.  Mr A’s denial of any participation in that telephone conversation, in the face of the clear evidence that he did, calls in question the credibility of his accounts of other relevant circumstances.  Moreover, the record of the conversation shows that tax efficiency was a priority in Mr A’s considerations.  And it explains how the matter of a wasted costs order arose at the meeting of 13 February to which we now turn.

The meeting on 13 February 1997
43.	A second meeting was held on 13 February 1997. That meeting started with a discussion of the figures in Mr Y’s letter of 12 February. Mr A proposed that the Appellant firm would pay £150,000 in six instalments over three years but interest free; that the Appellant firm would be instructed by Messrs XYZ to do agency work in London for one year; and that Messrs XYZ would write a letter to the Appellant firm about a wasted costs order. We accept the evidence of Mr X and Mr Y that these proposals were not discussed with Mr A in any detail because time was short as Mr X had to attend another meeting. In particular, there was no discussion with Mr A about why the £150,000 was to be paid by the firm rather than Mr A personally nor was there any discussion about why Messrs XYZ should write the letter about a wasted costs order. Mr X assumed that the firm wanted confirmation that if Mr A were unable to pay the costs personally an application for a wasted costs order would be pursued. The concern of Messrs XYZ was simply to recover as much as possible by way of costs. During the meeting Mr Y said that he thought that the agency business of Messrs XYZ in the previous twelve months had amounted to about £10,000. Mr Y confirmed that an arrangement for Messrs XYZ to use the Appellant firm as London agents on a fee paying basis could be part of the deal.  

44.	There was a dispute at the hearing as to whether, at the meeting on 13 February 1997, Mr X and Mr Y told Mr A that if no settlement were reached they would immediately apply for a wasted costs order against the Appellant firm. Mr A said that they did but Mr X and Mr Y denied making any such statement. Had there been a threat of imminent action against the Appellant firm on the part of Messrs XYZ, then the Appellant firm’s expenditure of £160,000 to settle it might have been more credibly presentable as tax deductible.  The Revenue’s case on the evidence was that there had been no such threat. The previous correspondence the Revenue point out, showed that Messrs XYZ would only have resorted to a wasted costs order if Mr A had defaulted.  We accept the evidence of Mr X and Mr Y who both said that they had wanted to bring the costs dispute to an end without further expense. And in any event the possibility of a wasted costs order did not, the Revenue pointed out, figure in the notes of the discussions with Mr A until the note of the 13 February 1997 meeting, and even then it is not referred to as “a threat”. We find that no threat to apply for a wasted costs order was made. Mr Y had prepared comprehensive attendance notes of the two meetings on 7 and 13 February 1997. Neither note mentioned any threat to apply for a wasted costs order and if such a threat had been made by Messrs XYZ then in our view it would have been recorded. We also accept the evidence of Mr Y that at that stage it was not the intention of Messrs XYZ to apply for a wasted costs order not least because matters had been settled by agreement. The position of Messrs XYZ remained as outlined in the letter of 12 July 1995, namely that a wasted costs order would only be pursued if Mr A personally was unable to meet the taxed costs. Also, Mr Y was of the view that an application could not be made until the appeal which was then outstanding had been heard.  Finally by way of footnote, Mr A’s assertion that a real threat of a wasted costs order caused the Appellant firm to spend £160,000 in buying it off is at odds with Mr A’s admission in oral evidence that had the matter gone to taxation followed by enforcement proceedings he personally could have paid up.

Did Mr A seek tax advice on 14 February 1997?
45.	The case for the Appellant firm that there had been no negligent conduct depends substantially on whether the partnership statement and the partnership return had been signed by Mr A acting in accordance with the Chartered Accountant’s advice.  The occasion of that advice, so the argument for Appellant firm goes, was a telephone conversation between Mr A and the Chartered Accountant on 14 February 1997 that took place just before the terms of the settlement were agreed.  Hence the relevance of that alleged conversation.  It bears on the present case in at least three respects.

46.	First, if Mr A had indeed consulted the Chartered Accountant and told him that the Appellant firm was to assume the liability to pay £160,000 in respect of Mr Z’s costs because otherwise it would have faced the threat of a wasted costs order had Mr A defaulted on his personal liability, and asked for tax advice, this  would indicate:

(i)	the scope of the tax advice sought by the Appellant firm and
(ii)	the likelihood of Mr A defaulting, bearing in mind the Chartered Accountant’s knowledge of Mr A’s means.

Second, given that the matter should have been of serious consequence to the Appellant firm, one would have expected Mr A to have given full and circumstantial instructions.  Third, if the Chartered Accountant had indeed been fully instructed and had given the unqualified advice that the £160,000 was a properly deductible expense, then the Appellant firm may be acquitted of negligent conduct.

47.	We have to address a conflict of evidence.  On the one hand we have been provided with the clear and unqualified accounts of the telephone conversation given by Mr A and the Chartered Accountant in their witness statements of 9 August 2006 and 15 June 2004 respectively; as will be seen those accounts match each other.  On the other hand, Mr Chipperfield’s notes of his meeting with the Chartered Accountant on 6 February 2003 present a significantly different account.

48.	Mr A’s evidence was that he had a conversation with the Chartered Accountant on 14 February 1997 in the course of which he had told the Chartered Accountant that he had been unsuccessful in a legal action against Mr Z and had been personally liable for the costs. His firm had, he had informed the Chartered Accountant, been acting for him in the litigation and had been threatened with a wasted costs order. The wasted costs claim had been settled by agreeing that the firm would pay £160,000 by six equal half yearly instalments. He said that he had told the Chartered Accountant that the risk was insured but he had decided not to claim on the insurance because of a possible future increase in the premium. He claimed that the Chartered Accountant had told him that the payments would be tax deductible and that that was not affected by the fact that the liability was insured. 

49.	The Chartered Accountant’s witness statement was dated 15 June 2004.  This stated that  he had spoken to Mr A in or about 14 February 1997 and that Mr A had told him that he had been unsuccessful in an action which he had brought against Mr Z and that costs had been awarded against him personally. The firm had been acting for him in the litigation and Mr Z’s lawyers had threatened to apply for a wasted costs order against the firm. A wasted costs order was, he had been told, equivalent to a negligence claim and was a risk which was insured by the Solicitors Indemnity Fund. Mr A had just settled the wasted costs claim by agreeing that the firm should pay £160,000 by six half-yearly instalments. Mr A had, according to the Chartered Accountant’s witness statement, asked if the payments of the instalments would be tax deductible bearing in mind that the risk was insured but that he did not want to make a claim on the policy as this would increase the premiums in future years. The Chartered Accountant had advised that the fact that the liability was insured did not affect the deductibility of the payments because it was open to a taxpayer to decide whether or not to make a claim on his insurers.  

50.	In considering this matter we bear in mind that Mr A told us that his papers had been destroyed in an office move in 2002; that the Chartered Accountant had no note of any such conversation; and that there was no other document recording such advice. We also bear in mind the evidence of Mr Chipperfield which was that when he interviewed the Chartered Accountant on 6 February 2003 the Chartered Accountant stated that he did not know any more about the payment of £160,000 than the information contained in Mr A’s letter of 1 December 1997 although he thought that Mr A had telephoned just before 1 December 1977 to say that there had been a misunderstanding about the payment. At the same interview, according to Mr Chipperfield’s evidence, the Chartered Accountant had said that he was unaware of the circumstances of the claim; that he was unaware that Mr A had been the litigant in the proceedings against Mr Z; and that he was unaware that the costs related to a personal action of Mr A. We have no reason to doubt the accuracy of Mr Chipperfield’s evidence. The Chartered Accountant also accepted in evidence before us that he had spoken to Mr A after 1997 and before the preparation of his witness statement dated 15 June 2004 and that Mr A had reminded him as to what had happened on 14 February 1997. That is confirmed by the similarity between the Chartered Accountant’s witness statement and that of Mr A.  The Chartered Accountant said that the reason why he thought that Mr A had spoken to him in February 1997 was because if Mr A intended to make an insurance claim he would make it at the same time as settling the negligence claim and would seek advice at that time. 

51.	We think that the Chartered Accountant’s account of the alleged telephone conversation of 14 February 1997 is too unreliable for us to be able to accept it.  There are no contemporary notes to substantiate it; we would have expected some record of his instructions and his advice to have been kept, bearing in mind the unusual and important subject-matter of the alleged conversation.  Moreover the witness statement containing the Chartered Accountant’s account of the conversation was signed nearly a year and a half after the interview with Mr Chipperfield; it gives a significantly different account of the alleged conversation.  To the extent that the contents of the Chartered Accountant’s witness statement vary from Mr Chipperfield’s note of the interview and come into line with Mr A’s account we do not accept them.

52.	On the evidence before us we are not satisfied that any conversation took place between Mr A and the Chartered Accountant on 14 February 1997. In our view such an important matter as the giving of tax advice would most probably have been recorded by the Chartered Accountant. Also, none of the subsequent documents confirm the giving of the tax advice and, if it had been given, we are of the view that it would have been mentioned in the letter of 1 December 1997 and that letter did not mention tax advice nor a personal liability nor the threat of a wasted costs order. It did mention negligence (and it was Mr A who had said that a wasted costs order was negligence). Finally, it is most probable that issues such as tax advice would be raised by the Appellant firm in writing at the time of the settling of the annual accounts and not during an unrecorded conversation in the middle of the tax year. 

53.	In the light of the evidence before us we are not satisfied that the Chartered Accountant did give tax advice to Mr A on the telephone on 14 February 1997. However, even if he did we are not satisfied that he was given all the relevant facts nor was he asked the right question. The relevant facts were that the payment of £160,000 was in discharge of a personal liability of Mr A and that the firm had no liability as there was no wasted costs order and no threat of a wasted costs order. As no application for a wasted costs order had been made the matter of insurance was completely irrelevant. From his discussions with the Solicitors Indemnity Fund Mr A knew that until an order for wasted costs had actually been made there was no liability of the firm and so there could be no claim on the insurance. The relevant question was not whether the payment was deductible as a liability of the firm which was insured although no claim on the insurance would be made. The relevant question was whether the discharge of a personal liability of Mr A by the firm was deductible for tax purposes. The advice said to have been given by the Chartered Accountant was the correct answer to the wrong question. 

The details of the settlement are finalised
54.	Following the meeting of 13 February 1997 there were further telephone negotiations between Mr A and Mr Y and the detailed terms of the settlement were set out in a letter dated 14 February 1997 from Mr A to Messrs XYZ. The terms were first that Messrs XYZ would write a letter to the Appellant firm referring to the leave to apply for a wasted costs order against the firm and claiming £260,000 in respect of those wasted costs; secondly, that the Appellant firm would pay the sum of £150,000 to Messrs XYZ over a period of three years such sum to be in settlement of all Mr Z’s claims against Mr A and the Appellant firm; and finally that Messrs XYZ would appoint the Appellant firm as its exclusive London agent for the period of one year. These terms were agreed by Messrs XYZ. 

55.	The letter from Messrs XYZ to the Appellant firm about the wasted costs order was originally sent on 14 February 1997 but amended on 17 February 1997. The letter noted that the offer to pay £160,000 in respect of costs had been made by the firm and not Mr A personally. It added that if it had not been possible to settle all aspects of the dispute between Mr Z and Mr A, Messrs XYZ would have pursued an application for a wasted costs order at the appropriate time. We accept the evidence of Mr Y that, in his view, the appropriate time was at the conclusion of the taxation and enforcement when it was known whether or not Mr A could pay the costs personally. 

56.	We also accept the evidence of Mr X and Mr Y that the only reason that this letter was sent was because it had been one of the matters stipulated by Mr A; it was Mr A who wanted the letter written. In the view of Mr Y the leave to apply for a wasted costs order provided an alternative route for the recovery of the costs if Mr A did not pay them. A wasted costs order would have had the advantage of being the liability of the firm and would probably have been payable by the Solicitors Indemnity Fund. If, however, the costs were paid by Mr A then there would have been both risk and expense in applying for a wasted costs order; also such an order was unlikely to have applied to the entire costs. As Mr X said: “I was quite happy to wait until after we had finished the taxation with Mr A to see whether he could pay”. 

The proposal to reduce the taxing fee
57.	On 20 March 1997 Mr Y wrote to Mr A with a draft minute of order in respect of the taxation procedure and with some suggestions as to how the taxing fee might be minimised. The fee was 5% of the sum taxed but Mr Y suggested that if one amount were apportioned to the costs of the appeal [to the Court of Appeal] and another amount to the stay of taxation, those amounts would reduce the sum of £160,000 and so the taxing fee. Mr A replied on 24 March 2007 and said:

“ … whilst I am of course willing to assist in any way I can, I think that you recognise that one thing I cannot do is to prejudice the potential tax deductibility of any of the payments.    

The problem about the apportionments to which you refer seems to me that it would be impossible for me to argue with the Revenue that my firm owed anything either in respect of the appeal or in respect of the stay of taxation. It has never been suggested that my firm acted improperly in either of those respects, so I cannot see why my firm should be able to deduct any payment made in respect thereof.”

58.	In the event and by consent the taxation procedure was withdrawn with no order as to costs and Mr A withdrew his appeal to the Court of Appeal with no order as to costs either on the appeal or on the application to appeal out of time.  

Payment of costs
59.	On 24 March 1997 the Appellant firm directed its bank to make payments each of £26,666.67 to Messrs XYZ at six-monthly intervals the last payment being on 27 September 1999. It is these payments which are one of the issues in the appeal. 

The treatment of the payment in the firm’s accounts
60.	On 11 July 1997 the Chartered Accountant wrote to Mr A asking various questions about the financial position of the firm for the year ending on 30 April 1997 for the purpose of preparing the annual accounts. On 1 December 1997 Mr A replied  to the Chartered Accountant and part of that letter read:

“There is one final matter which you should not forget for the purposes of the accounts. You will remember that I mentioned to you the firm’s agreement to pay to Messrs  XYZ on behalf of Mr Z the sum of £160,000, payment to be made by six half-yearly instalments of £26,666.67, the first payment being made on 27 March 1997.

The whole of this payment should be regarded as an expense of the practice. In fact, I know that the September 1997 payment has been debited to ledger 13201; it is not strictly speaking a disbursement, but rather the settlement of a claim for negligence against the firm.

It is also to be regarded as an “A” expense.”

This passage drives home the importance to Mr A of obtaining a tax deduction for the costs liability that he had incurred to Mr Z.

61.	An “A” expense was an expense to be borne by Mr A alone. (The arrangement was that if there were an expense of the firm which was the responsibility of only one of the partners that expense was debited to that partner’s account. So “A” expenses were debited to Mr A.) 

62.	On 14 January 1988 the Chartered Accountant wrote to Mr A with the draft accounts for the year ending on 30 April 1997 and invited comments. 

63.	In evidence which we accept Mr A said that after he received the draft accounts he telephoned the Chartered Accountant. The Chartered Accountant made a manuscript note of the call It recorded that there had been a misunderstanding. The payment of £160,000 to Messrs XYZ was not a disbursement but the costs of a negligence claim. The note also had the entry “Query 1996? Credit”. The note recorded in another hand instructions from the Chartered Accountant to his audit manager to move the sum of £26,667.67 from disbursements to “negligence claim” and treat it as an “A” expense and also to accrue £133,333,33.  Mr Chipperfield thought that this note pre-dated Mr A’s letter of 1 December 1997 but in our view it is most probably a note of the conversation with Mr A after the letter of 14 January 1998 and before 20 January 1998 and referred to in the letter of that date.  

64.	The Chartered Accountant replied to Mr A on 20 January 1998 to confirm the telephone conversation and to say that the claim by Messrs XYZ would be transferred from disbursements and treated as an “A” expense but he also advised that the full amount of the £160,000 would have to be accrued in the final accounts. On 30 March 1998 the relevant journal adjustments were made.

65.	As between the partners the whole of the liability for the £160,000 was allocated against Mr A’s partnership share and Mr A personally took the liability for the payment to Messrs XYZ which was used to reduce his drawings. In the Appellant’s profit and loss account for the year ending on 30 April 1997 an expense of £160,000 called “negligence claim” was recorded and deducted from the taxable profits of the firm for that year.

The agency arrangements
66.	It had been part of the final settlement that Messrs XYZ would instruct the Appellant firm to act as their London agents. Instructions were given in nine matters but the arrangements ceased after about three years. 

The treatment of the disbursements generally. 
67.	In six cases (including the proceedings against Mr Z) the Appellant firm acted for Mr A in litigation matters.  In each case disbursements were incurred and paid by the firm. The firm deducted the full amounts of the disbursements in its accounts and credited any sums recovered from Mr A. In the firm’s profit and loss account these amounts were shown as “disbursements paid” and “disbursements recovered” respectively. In each case the amount of the disbursements paid exceeded the amount of the disbursements recovered and the excess was deducted from the taxable profits of the firm for the relevant year.

The disbursements in the litigation against Mr Z   
68.	The amounts of the disbursements paid by the Appellant firm in relation to Mr A’s personal litigation against Mr Z were:

Tax year ending		Amount
30 April 1995			£      573.44
30 April 1996			£ 38,694.96
30 April 1997			£   3,846.50 
30 April 1998			£        20.00

69.	Thus the total amount over the four years was £43,134.90. No invoice was rendered by the firm to Mr A in relation to these sums and the firm was not paid by Mr A for any of these disbursements. 

The disbursements in the judicial review proceedings
70.	As mentioned, following his defeat in the action against Mr Z Mr A brought proceedings for judicial review based on a claim that the judge was too old to have been sitting. This action was unsuccessful. The Appellant’s disbursement ledger showed that the amount of disbursements paid when acting for Mr A in this litigation amounted in total to £28,796.99. The amount recovered from Mr A was £100.80 and so the amount not recovered was £28,696.19. That amount was deducted from the taxable profits of the firm for the relevant year.

The disbursements in the first litigation against a firm of auctioneers    
71.	Mr A purchased at auction for £25,000 what he thought was a watercolour. He later discovered that the work was not a watercolour but a drawing which had been coloured in by others. He then brought legal proceedings both against the auctioneers and the expert who had prepared the opinion as to authenticity which accompanied the supposed watercolour. The Appellant firm acted as Mr A’s solicitors. 

72.	The claim was set down for trial but prior to the commencement of the hearing the action was settled. The terms of the settlement were that Mr A would retain the work, that the auctioneers were to pay (1) damages of £65,000 and (2) costs of £60,000 plus value added tax of £10,500 being a total of £70,500. On 19 May 1995 the solicitors for the auctioneers sent to the Appellant firm a cheque for £135,500 in discharge of the sums due under the settlement. 

73.	Mr A wanted advice about his capital gains tax position and he therefore took the advice of Tax counsel. We were not shown a copy of the instructions but we did see a copy of Tax counsel’s advice.  Tax counsel first dealt with the amount of £65,000 paid as damages and then went on to consider the amount of £60,000 paid as costs which he said could be broken down into Mr A’s personal expenses; the disbursements paid by the firm; the costs which Mr A would have had to pay if he had not acted for himself, and an amount representing the commercial deal of the settlement. Tax counsel advised that if a payment made in respect of costs was matched by an actual payment made on account of costs then the payment for costs would drop out of the picture as it would be treated as a payment of expenditure. However, if the payment for costs was not met by actual expenditure then it would increase the amount of the damages and should be treated as such. If the costs attributable to work carried out by Mr A personally were invoiced to him by the firm then the amount should be treated as expenditure. However value added tax would have to be charged. If there were no invoice then it was most likely that the amount of the costs would increase the damages. Alternatively, the payment might be treated as a professional receipt and subject to income tax. Tax counsel  concluded:   

“11.	In summary, the full amount of the damages and costs are likely to be taxable in the hands of Mr A if the partnership does not bill him for any work carried out. The principal disadvantage in them not doing so is that it will be difficult for them to show that the expenses that the firm has incurred on Mr A’s claim has been incurred “wholly and exclusively” in carrying out the profession. From a tax perspective therefore there are grounds for [the firm] invoicing Mr A in respect of any costs … it has actually incurred. However, the principal disadvantage of rendering an invoice is that the firm would be obliged to charge VAT. Insofar as Mr A has received a payment of costs in respect of work which he did himself I can see the attraction of continuing to treat the matter as one personal to Mr A and not invoicing him for those costs. I can see no impropriety or illegality in the partners deciding to adjust the partners’ shares to reflect the time successfully spent by Mr A in the litigation against solicitors.”

74	In the event the firm did not send an invoice for costs to Mr A and so Mr A saved value added tax. Mr A chose to bring the full amount of the payment received from the auctioneers into his capital gains tax computation which first showed that the damages received were £135,500 and from this was deducted the sum of £6,693 as costs paid. (We were not informed how the £6,693 was derived.) After the application of the part disposal formula and the indexation allowance the net gain was £87,112. The computation went on to show that on the last day of that tax year Mr A subscribed £100,000 for shares under the enterprise investment scheme and claimed deferral of £88,512.21 to be set off against gains of £94,512.21 which meant that the net chargeable gains for the year were £6,000. The gains of £94,512.21 included the £87,112 for the auctioneers’ damages.

75.	The other partners in the Appellant firm decided that, as between the partners, the matter would be dealt with by dividing the amount received from the auctioneers on account of costs (£70,500) between the partners according to their profit shares after deducting the amount of the disbursements. Accordingly Mr A agreed to reduce his share of the partnership profits for the year and to increase the shares of the other partners.  

76.	The Appellant’s disbursement ledger showed that the amount of disbursements paid when acting for Mr A in this litigation amounted in total to £31,722.43. The amount recovered from Mr A was £3,766.95 and so the amount not recovered was £27,955.48. That amount was deducted from the taxable profits of the firm for the relevant year.
  
The disbursements in the second  litigation against the auctioneers    
77.	Later Mr A purchased at auction another watercolour at a hammer price of £75,000 plus a buyer’s premium of £7,500 plus value added tax making a total of £83,625. Later Mr A discovered that although the drawing was by the named artist the colouring was not. Mr A brought legal proceedings against the auctioneers claiming damages for negligence on the grounds that the auctioneers should have verified the genuineness of each element of the work. 

78.	The claim was compromised on the basis that the auctioneers would pay to Mr A the sum of £80,000 and that Mr A would return the drawing to them. The compromise was recorded in a consent order and a banker’s draft in the sum of £80,000 was drawn in favour of Mr A. Disbursements amounting to £17,583.88 were paid by the Appellant firm in relation to this action. The amount recovered was £481. Thus the amount not recovered was £17,102.88 and that amount was deducted from the taxable profits of the firm for the relevant year.

The disbursements in the litigation against the first surveyors
79.	Mr A and his wife purchased property on the basis that certain underpinning works would be completed prior to completion of the purchase. The works were completed and the purchase of the property was completed. Later Mr A and his wife began proceedings for negligence against the surveyors (the first surveyors) who had designed the underpinning works and against another firm of surveyors (the second surveyors) who had prepared a survey of the property at the time of the purchase

80.	The proceedings against the first surveyors were settled by consent order on the basis that the first surveyors would pay the sum of £40,000 in damages together with a further sum of £83,718 in respect of costs (including value added tax on the costs). As between themselves the partners of the Appellant firm agreed that from the sum of £83,718.75 the sum of £44,422.82, which had been paid as disbursements, should be deducted leaving the sum of £39,295.93 which was divided between the partners as to 50% to Mr A and 50% between the other partners. 

81.	The Appellant’s disbursement ledger showed that the amount of disbursements paid when acting for Mr and Mrs A in this litigation amounted in total to £44,564.14 The amount recovered was £1,364.87 and so the amount not recovered was £43,199.27 That amount was deducted from the taxable profits of the firm for the relevant year.
  
The disbursements in the litigation against the second surveyors
82.	After the settlement of the proceedings against the first surveyors the proceedings against the second surveyors continued. Mr and Mrs A were  unsuccessful. They had to pay substantial costs to the second surveyors and the amount exceeded the sum they had received from the first surveyors. They used the money they had received from the first surveyors (including the £44,564.14 for disbursements) in part payment of the money they had to pay to the second surveyors  

83.	The amount of disbursements paid by the Appellant when acting for Mr and Mrs A in this litigation amounted in total to £4,455.35. No amount was recovered from Mr and Mrs A and so £4,455.35 was deducted from the taxable profits of the firm for the relevant year.

The totality of the disbursements
84.	Our calculation of the total amount of disbursements at issue in the appeal is:

Litigation against
Mr Z							£43,134.90.
Judicial Review 					£28,696.19.
The auctioneers (first action)				£27,955.48.
The auctioneers  (second action)	. 		£17,102.88
The first surveyors		 			£43,199.27
The second surveyors		 			£  4,455.35

Total							£164,544.07

Reasons for decision -  Issue (1) – deductibility  
85. 	The first issue in the appeal is whether the sums which had been deducted in computing the profits of the Appellant were money wholly and exclusively expended for the purposes of the Appellant’s profession within the meaning of section 74(1)(a) of the 1988 Act. We first identify the legal principles to be applied to the deductibility of expenses and then apply them first to the payment of £160,000 to Messrs XYZ for costs and then to the payments for disbursements.

The legal principles
86.	From the authorities cited to us by the parties we have identified the following legal principles. First, that the question whether an expense of the firm is incurred wholly and exclusively for the purposes of the profession is a question of fact. Secondly, that the expenditure has to be made “for the purpose of enabling the trade to earn the profits” of the trade; Strong v Woodifield (1906) 5 TC 215 at 220 and Smith’s Potato Estates Limited v Bolland (1947) 30 TC 267 at 288. Thirdly, that the business [or professional] purpose must be the sole purpose; Bentley, Stokes & Lowless v Beeson [1952] 2 All ER 82; 33 TC 491.CA at 504. Fourthly, that the distinction between furthering the business interests of the firm on the one hand and the essentially private purposes of the partners on the other can be a fine one; MacKinlay v Arthur Young McClelland Moores & Co [1989] STC 898. 79. Fifthly, that in determining the purpose it is necessary to look at the taxpayer’s subjective intentions and although these are determinative they are not limited to conscious motives in his mind at the time of payment; consequences which are inevitably and inextricably involved in the payment must be taken to be a purpose for which the payment was made; Vodafone Cellular Limited and others v Shaw [1997] STC 734 at 742h. And, finally that if the taxpayer’s only conscious motive at the time of the expenditure is a business motive then the expenditure is deductible; McKnight v Sheppard [1999] STC 669, HL.

The payment for costs 
87.	It was Mr A’s case that his object in settling the matter with Messrs XYZ was to secure the best interests of the firm by avoiding a very large potential exposure on the threatened wasted costs claim. He also claimed that he had regard to the benefits to the firm from acting as the London agent of Messrs XYZ. . 

88.	In considering this matter we start at the beginning of February 1997, just before the discussions to settle the amount of costs began. At that time the stated position of Messrs XYZ was that, on the advice of Counsel, they intended to wait until after the completion of the taxation of the costs owed by Mr A personally, and until after enforcement of that costs order, before taking any action to apply for a wasted costs order. One reason was the expense of applying for a wasted costs order. Another reason was that Messrs XYZ thought that no application could be made until after the appeal had been disposed of and the appeal to the Court of Appeal was still current at the time. Another reason was that Mr A might be able to pay his costs personally. Indeed, the negotiations on 7 February proceeded on that basis and Mr A was able to secure a reduction in the amount of the costs by pleading his personal inability to pay (although he confirmed in evidence to us that he did have the funds to pay the full amount of the costs). On 7 February there was no threat of a wasted costs order and no potential exposure to it. The matter was not discussed at the meeting that day.

89.	We are confirmed in this view because we find that Mr A thought that there could be no application for a wasted costs order once the taxation was complete. It was his belief that an application for a wasted costs order had to be made to the same judge before the end of the trial and before the proceedings had been concluded by a costs order. We do not need to decide whether he was right to think that, or whether Messrs XYZ were right to think that they should or could apply later. The fact is that, if Mr A wanted to avoid the possibility of a wasted costs order, then he was aware that all he had to do was to wait until the end of the taxation (which was imminent) or, indeed to settle the taxation, after which no application could be made. Accordingly, we are of the view that Mr A did not think that there was even a threat of a wasted costs order.  

90.	That then brings us to the disputed telephone conversation of 11 February. We have already found that it did take place and it was the first occasion that the idea of a wasted costs order was mentioned in the negotiations. The idea was raised by Mr A, and not by Mr X, and it was raised within the context of making the payment of costs tax efficient. The telephone conversation of 11 February also explains why the subject of the wasted costs order was raised again at the meeting on 13 February. 

91	We find that at the meeting on 13 February the subject of wasted costs was not raised by Messrs XYZ but by Mr A. It was Mr A who wanted the letter from Messrs XYZ about wasted costs and that was the first condition of the settlement as mentioned in his letter of 14 February 1997. The only reason that Messrs XYZ wrote the letter was because Mr A had asked them to do it as a condition of the settlement. Also, the letter from Messrs XYZ of 17 February 1997 does not say that, if the settlement had not been agreed there would have been an immediate application for a wasted costs order; it says that an application would have been made at an appropriate time, namely at the conclusion of the taxation and enforcement. 

92.	We find that the liability to pay the costs was always the liability of Mr A personally and never the liability of the Appellant firm. There never was an application for a wasted costs order and  there never was such an order. Indeed, in February 1997 there was no current threat of such an application or order. For the Appellant Mr McDonnell argued that Mr A’s personal liability to pay the costs was contingent upon the firm not paying and that the firm’s contingent liability had been settled by the agreement to pay £160,000. We do not agree with this analysis. In our view the correct analysis is that the primary liability was that of Mr A. To the extent that the firm had any liability it was contingent upon a wasted costs order being applied for and granted, and that was contingent upon Mr A not being able to pay the costs personally which contingency Mr A accepted was so remote as not to exist.   

93.	Mr A argued that the liability was that of the firm rather than himself personally because if a wasted costs order had been made against the firm there was no liability on the client to pay the costs and he was the client. He accepted that he was the litigation partner at the Appellant firm with primary responsibility for the proceedings against Mr Z. We reject this argument for two reasons. First, because there was no wasted costs order and so there was no liability of the firm. Secondly, because, even if there were a wasted costs order, we think that it would be disingenuous for Mr A to regard himself as a client in such circumstances and so, in effect, absolve himself from the consequences of his own negligence. 

94.	We find that the reason why Mr A raised the issue of the wasted costs order was to enable him to claim a deduction in the firm’s accounts of the amount of costs payable by him personally. We are confirmed in this view by Mr X’s note of the telephone conversation on 11 February 1997 which mentioned that to be tax efficient the payment had to be for a genuine liability of the firm; by the fact that it was Mr A who stipulated that Messrs XYZ should write to the Appellant firm about the wasted costs order; and by Mr A’s reluctance to apportion the taxing fee as suggested by Mr Y as that would “prejudice the potential tax deductibility of the payments”. 

95.	Returning to the legal principles we find that the payment of the costs by the Appellant firm was not made for the purpose of enabling the firm to earn the profits of the firm; it was made to discharge a personal liability of Mr A. Even if a very small part was paid in return for the agency arrangements the business [or professional] purposes were not the sole purpose nor even the main purpose of the payment. We accept that in some cases the distinction between furthering the business interests of the firm on the one hand and the essentially private purposes of the partners on the other can be a fine one but we have no difficulty in this case in reaching a decision. We have looked at the subjective intentions of the taxpayer (who is the Appellant firm) and, in the light of the facts we have found, conclude that the consequences which are inevitably and inextricably involved in the payment (namely the discharge of a personal liability of Mr A) must be taken to be a purpose for which the payment was made. Finally, we find that the taxpayer’s only conscious motive at the time of the expenditure was not a business motive. 

96.	We conclude that the sum of £160,000 paid as costs, which was deducted in computing the profits of the Appellant, was not money wholly and exclusively expended for the purposes of the Appellant’s profession within the meaning of section 74(1)(a) of the 1988 Act. 

The disbursements
97.	Mr A gave evidence that his partners and himself had an arrangement that the firm would act on behalf of a partner in litigation matters but would only be paid fees if the litigation succeeded and costs were recovered from the other party in which case the firm would receive the recovered costs. He relied on the fact that that was what had happened in practice. For the purposes of this Decision we do not have to decide what the arrangement as between the partners was; we have found the facts relevant to what happened in practice and all we have to decide is whether the money paid by the firm to meet the disbursements was money wholly and exclusively expended for the purposes of the profession of the firm.   

98.	Mr A argued that the commercial purposes of the firm in paying the disbursements were first that the firm had a liability to pay disbursements and secondly that it was in the interests of the firm to win the litigation and so recover the fees. We are not persuaded by these arguments. Even if the firm had the professional liability to pay, say, counsel’s fees that professional liability could not convert what was essentially a personal liability of Mr A into a payment made for the purposes of the profession of the firm for tax purposes. The facts we have found also lead us to the conclusion that it was not in fact in the interests of the firm to conduct the litigation and so recover the fees. The litigation was only successful on two occasions and unsuccessful on four. In the first litigation against the auctioneers costs were recovered but not paid to the firm but included in Mr A’s capital gains tax computation. In the litigation against the first surveyors some of the amount recovered as costs was paid to the other partners but most of the payment for costs, and all the payment for disbursements, was used to pay the second surveyors. Overall it could not be said that it was in the interests of the firm to conduct any of this litigation.  

99.	Applying the legal principles we find that the payments of the disbursements by the Appellant firm were not made for the purpose of enabling the firm to earn the profits of the firm; they were made to discharge personal liabilities of Mr A. Even if a small benefit was received by the recovery of a small amount of costs, the business [or professional] purposes were not the sole purpose nor even the main purpose of the payments. We have looked at the subjective intentions of the taxpayer (who is the Appellant firm) and, in the light of the facts we have found, conclude that the consequences which are inevitably and inextricably involved in the payments (namely the discharge of personal liabilities of Mr A) must be taken to be a purpose for which the payments were made. Finally, we find that the taxpayer’s only conscious motives at the time of the expenditure were not business motives. 

100.	We conclude that the sums which had been deducted in computing the profits of the Appellant were not money wholly and exclusively expended for the purposes of the Appellant’s profession within the meaning of section 74(1)(a) of the 1988 Act.

Reasons for decision - Issue (2) – negligent conduct
101.	The second issue in the appeal is whether, if the sums were not deductible, the insufficiency of the amount of the profits in the partnership statements was attributable to the negligent conduct on the part of the representative partner within the meaning of section 30B(5) of the 1970 Act. We first consider the burden and standard of proof and then the meaning of negligent conduct after which we consider separately the payment of £160,000 to Messrs XYZ for costs and the payments for disbursements.

The burden and standard of proof 
102.	The Revenue accepted that the burden of proving negligent conduct was on them and that the standard of proof was the balance of probabilities; Hurley v Taylor [1999] STC 1; Mashood v Whitehead [2002] STC (SCD) 166, paragraphs 88 to 90; and Rowland v Boyle [2003] STC 855 at [3]. We also adopt the principle that the benefit of any doubt as to negligence should be given to the taxpayer; King v Walden [2001] STC 822 at [54].

The meaning of negligent conduct
103.	For the Appellant Mr McDonnell argued that the phrase “negligent conduct” meant conduct which was reckless or careless or, in the case of an intentional act, conduct which amounted to a complete failure to take reasonable care. It could include acts of commission or omission (for example, failing to disclose a source of income or leaving part of a return blank). He also argued that negligent conduct was more than just being wrong or taking a different view from the Revenue. Negligent conduct had to be serious first, because it was included in the phrase “fraudulent or negligent conduct”; secondly, because it could give rise to a penalty which would be a criminal charge for the purposes of Article 6 in the Convention at Schedule 1 to the Human Rights Act 1988; and thirdly, because its effect was to extend the ordinary time limits. In particular he argued that a taxpayer who took proper and appropriate professional advice with a view to ensuring that his tax return was correct, and acted in accordance with that advice (if it was not obviously wrong) could not have engaged in negligent conduct;  relying on Langham v Veltema [2004] EWCA Civ 193; [2004] STC 544. 

104.	For the Revenue Mr Carr argued that negligence was described in Blyth v Birmingham Waterworks Co (1856) 11 EX 781 at 784 as “the omission to do something which a reasonable man, guided upon those considerations which ordinarily regulate the conduct of human affairs, would do, or doing something which a prudent or reasonable man would not do”. Mr McDonnell distinguished this authority on the ground that it contained a definition of negligence within the context of tortious liability and not tax. 

105.	We are of the view that the question whether a taxpayer has engaged in negligent conduct is a question of fact in each case. We should take the words of the statute as we find them and not try to articulate principles which could restrict the application of the statutory words. However, we accept that negligent conduct amounts to more than just being wrong or taking a different view from the Revenue. We also accept that a taxpayer who takes proper and appropriate professional advice with a view to ensuring that his tax return is correct, and acts in accordance with that advice (if it is not obviously wrong), would not have engaged in negligent conduct.

The payment for costs 
106.	The Appellant firm’s answer to the allegation of negligent conduct was based on Mr A’s evidence that he had sought advice on the deductibility of the payment for costs from the Chartered Accountant on 14 February 1997 and that he had acted on that advice. We have already stated our finding that we are not satisfied that such advice was sought but that, even if it was, the relevant facts were not told to the Chartered Accountant and the wrong question was asked. We find that the partnership return was prepared by the Chartered Accountant on the basis of the instructions given in Mr A’s letter of 1 December 1997 when it was Mr A (and not the Chartered Accountant) who said that the whole of the sum had to be regarded as an expense of the practice being the settlement of a claim for negligence against the firm. This statement by Mr A was incorrect; the sum was not paid as the settlement of a claim for negligence against the firm but as the discharge of a personal liability of Mr A. (We accept that it was the Chartered Accountant who advised on 20 January 1998 that the full amount of £160,000 had to be accrued even though only one of the six instalments had been paid but that was on the basis that the amount was deductible and the Chartered Accountant had been told by Mr A that it was.)    

107. 	Mr A is a practising solicitor.  In evidence before us he said that he knew a little bit about tax law. In our view he knew, or should have known, that the only sums which could be deducted from the profits of the firm were sums which were wholly and exclusively laid out for the purposes of the profession of the firm. He knew that at the time of the payment of £160,000 the firm had no liability and that the liability was his personally. He had gone out of his way to engineer a state of affairs designed to make the Appellant firm pay the costs while the actual liability had remained with him. He should have known that the discharge of a personal liability of his was not deductible from the profits of the firm from which it follows that, in claiming the deduction, he engaged in negligent conduct. 

The disbursements
108.	As far as the disbursements are concerned Mr McDonnell argued that Mr A knew of the principles established in Mason v Innes [1967] Ch, 1079; 44 TC 326 CA and treated the disbursements which had been paid by the firm in the same way as the expenses had been treated in Mason v Innes, that is that they were deductible even though there was no corresponding receipt. Even though Tax counsel  had advised that the sums would not be deductible Mr A disagreed on the basis of Mason v Innes and so such disagreement was not negligent conduct. Further, Mr A had sought the advice of Tax counsel in connection with the tax treatment of the receipt from the auctioneers in relation to the first watercolour.  

109.	In Mason v Innes the taxpayer was an author who assigned to his father by way of gift his rights to a novel based on material gathered on a previous visit to the Persian Gulf. The expenses incurred in the preparation of the novel, including the cost of the visit to the Persian Gulf, had been allowed as deductions from his profits in earlier years. The issue was whether the market value of the assigned rights should be brought in as a receipt of the taxpayer’s profession. The Court of Appeal upheld the decision of the Special Commissioners that the value of the assigned rights was not taxable, upholding the basic principle that there is no liability to income tax in respect of income which might have been received but was not. The Court of Appeal distinguished Sharkey v Werner 36 TC 275; [1956] AC 58 as being one exception to the general rule and not a principle of general application. 

110.	We cannot find in Mason v Innes any authority for the view that any sum of money paid by the firm is deductible for tax purposes. The case deals with the taxability of receipts and not with the taxability of expenditure. Mr McDonnell relied upon a passage at 337H which stated that the expenses would have been allowable even if the material had never been utilised. However, this passage merely records the arguments for the taxpayer and not the judgment of the Court of Appeal. Also, it goes on to state that an expense properly incurred for the purposes of the trade cannot be adjusted afterwards which is not the same as saying that any expense paid by the firm is deductible. There was no discussion in Mason v Innes of the provisions of section 74(1)(a). We do not consider that Mr A was reasonable to conclude that Mason v Innes was authority for the view that any sum of money paid by the firm was deductible for tax purposes.  

111.	Further it is relevant that in this connection Tax counsel advised:

“In summary, the full amount of the damages and costs are likely to be taxable in the hands of Mr A if the partnership does not bill him for any work carried out. The principal disadvantage in them not doing so is that it will be difficult for them to show that the expenses that the firm has incurred on Mr A’s claim has been incurred “wholly and exclusively” in carrying out the profession. From a tax perspective therefore there are grounds for [the firm] invoicing Mr A in respect of any costs … it has actually incurred.

112.	From this Mr A knew that Tax counsel was of the view that if the firm did not bill him for costs and disbursements in personal matters the expenses and disbursements incurred in connection with his proceedings would be unlikely to be incurred wholly and exclusively for the purposes of the profession of the firm. In evidence before us Mr A said that he disagreed with Tax counsel . He said that after the Revenue had started their enquiries he had taken further advice from Tax counsel but we did not see the further advice. The fact is that, at the time the disbursements were claimed it was Tax counsel ’s earlier advice which was known to Mr A and not any later advice.  

113.	Like Tax counsel , we  can see an argument that the failure by a firm to bill a partner for work carried out for the partner personally (and to obtain payment from the partner) means that the overhead expenditure incurred in relation to those profit costs is not deductible. However, the position of overhead expenditure incurred in earning costs was not argued before us and so we do not express any view. What we have to decide is the position of the payment of disbursements. The disbursements paid by the firm were the personal liability of Mr A. The legal principles apply to the payment of the disbursements in the same way as they apply to the payment of costs.      

114.	We conclude that it was negligent conduct for Mr A, as representative partner, to claim as deductions from the profits of the firm the discharge of his personal liabilities. 

Decision
115	Our decisions on the issues in the appeal are:

(1)	that the sums which had been deducted in computing the profits of the Appellant were not money wholly and exclusively expended for the purpose of the Appellant’s profession within the meaning of section 74(1)(a) of the 1988 Act; and, 

(2)	that the insufficiency of the amount of the profits was attributable to the negligent conduct on the part of the representative partner within the meaning of section 30B(5) of the 1970 Act.   

116.	The appeal is, therefore, dismissed.

STEPHEN OLIVER QC

NUALA BRICE

SPECIAL COMMISSIONERS

7  December 2006

SC 3009/2006

Authorities cited in argument but not mentioned in the Decision

R v Havering Commissioners ex parte Knight [1973] STC 564; 49 TC 161 
Zim Properties v Proctor (1984) 58 TC 371
Manzanilla Limited v Corton Property and Investments Limited and others CA Transcript 23 April 1997 paragraph 6 
James Keith Robertson v Inland Revenue Commissioners [2002] STC (SCD) 182
McEwan v Martin [2005] STC 993
Medcalf v Mardell and others; [2002] UKHL 27; [2003] 1 AC 120 at 144 paragraph 58

Partnership – The modern law of trade, business and professional partnership in England and Wales by Mark Blackett-Ord and Conrad McDonnell – Butterworths 1997 – Chapter 8 Partnership Property