Has Post Office wrongly claimed tax relief for compensation?

Disputed tax relief

If you watched the recent TV drama you probably won’t need reminding about facts in the Post Office (PO) debacle. Subsequently, a tax expert has argued that the PO isn’t entitled to the tax relief it claimed for the cost of prosecuting the sub-postmasters or for the compensation it now expects to pay. This opinion was picked up by the media and has gained a lot of traction. If the tax expert’s view is correct many business owners will now be worried about the tax treatment of compensation payments they have or will make. In this article we explain when tax relief is and isn’t allowed for compensation payments using the PO case as an example.

Prosecuting fraudsters

In his statement the tax expert says that the PO was not entitled to a tax deduction for the cost of prosecuting sub-postmasters it believed were guilty of fraud or theft. Hundreds of sub-postmasters were found guilty and some went to prison.

Subsequent events culminating in a judgment in 2019 exonerated many sub-postmasters and many if not all of the original judgments are likely to be overturned. Regardless, in our view the PO was entitled to a tax deduction for the cost of identifying fraud against it and recouping income it believed had been stolen.

Costs incurred in the course of trade by a business to protect or recover its income, whether through the courts or by other means as long as they aren’t unlawful or illegal, are tax deductible.

Compensation payments

The tax expert also claimed that the PO wasn’t entitled to tax relief for a “provision” included in its accounts for the cost of compensation payable to sub-postmasters. Broadly, a provision for an expense is an amount that hasn’t been paid but is a current liability. It was suggested that the PO was being investigated by HMRC about the tax deductibility of the provision. The tax expert said the compensation was paid by the PO because of its wrongdoing which affected sub-postmasters.

The tax expert’s suggestion that because the compensation is for wrongdoing it’s not tax deductible isn’t logical. Wrongdoing by one party to another is the foundation of compensation. The correct test for tax deductibility is that compensation must be paid in the course of and for the purpose of a business’s trade.

Example. A business pays a customer compensation because its delivery van damaged the customer’s property. The compensation might consist of two elements: the cost of repairing the damage and payment for distress caused to the customer - a goodwill payment. Tax relief for the compensation for the repair is OK as is the goodwill payment as long as there’s a commercial reason for it. This is not to say that in the PO case there might be different reasons why HMRC would challenge the tax deduction. HMRC’s guidance says a “compensation payment incurred in the normal course of trading relates, for instance, to a trading contract will be an allowable deduction. ”