McLaren Motor racing team cannot deduct a penalty not incurred wholly and exclusively for purposes of trade

The South African Revenue Service (SARS) released Interpretation Note 80 on 5 November 2014 which deals with the income tax treatment of stolen money. Apart from the fact that it is indicated in the Interpretation Note that stolen monies must be included in gross income in the year of receipt, it is indicated further that the stealing of money cannot be described as a trade and that the thief will thus not qualify for a deduction to the extent that the monies must be repaid. It has been indicated that, even though certain elements of a trade, for example the intention to make a profit, repeated activities, planning and organisation, may be present in the case of a thief, the thief’s activities lack the key commercial character of a trade when it comes to sourcing the goods. Stolen monies and/or other goods are not obtained through normal commercial means and are not received as a reward for the provision of any goods or services. On that basis the act of embezzlement, fraud or theft does not constitute a trade.

In a South African context a thief has another hurdle to cross, namely s23(o) of the Income Tax Act, No 58 of 1962 (Act), which provides that a taxpayer is not entitled to deduct expenditure that constitutes a fine charged or penalty imposed as a result of an unlawful activity carried out in South Africa or in any other country if that activity would be unlawful had it been carried out in South Africa.

The possibility of deducting penalties was recently considered by the Upper Tribunal (Tax and Chancery Chamber) in the United Kingdom in the case of McLaren Racing Ltd v Revenue and Customs Commissioners [2014] STC 2417. The McLaren motor racing team participates in the Formula One grand prix events that take place throughout the world. All teams participating in Formula One have concluded an agreement between themselves and the International Automobile Federation (the sport’s governing body) and the Formula One Association (a company engaged in the promotion of the Formula One world championship). This agreement is called the so-called Concorde Agreement.

McLaren was held to have breached the International Sporting Code as its chief designer allegedly received confidential information pertaining to another Formula One racing team. Pursuant to this allegation, the McLaren racing team was ordered to pay a penalty of US$100 million in respect of a breach, less income which was lost as a result of it losing points in the so-called Formula One constructors’ championship. The ultimate penalty that was paid amounted to approximately £32 million. The question arose whether this penalty was deductible by the McLaren racing team on the basis of it constituting a disbursement or expense wholly and exclusively laid out or expended for the purposes of its trade or profession.

In holding that the penalty was not wholly and exclusively laid out or expended for the purposes of McLaren’s trade, it was acknowledged that the penalty constituted a disbursement or expense. However, it was indicated that a deliberate activity which was not an unavoidable consequence of carrying on a trade did not constitute an activity carried on in the course of that trade. It was said:

"In our view, a deliberate activity which is contrary to contractual obligations and the rules and regulations governing the conduct of the trade, which is not an unavoidable consequence of carrying on a trade and which could lead to the destruction of the trade, is not an activity carried on in the course of that trade."

However, McLaren raised a different argument. It submitted that its trade constituted the design, manufacture and racing of motor cars. As part of such trade it employs designers and engineers. It was a so-called 'occupational hazard' that employees might sometimes overstep the mark and act outside their scope of employment. This argument was also dismissed. The court refused to accept that, because an employer incurs a liability as a result of the acts of an employee, such liability is incurred in the course of the employer’s trade. This was held on the fact that the use of the confidential information did not constitute a normal or ordinary activity of McLaren. It did not become such an activity simply because it was carried out by an employee.

It was furthermore held that the reason the McLaren racing team paid the penalty was not because it risked being excluded from the world championship (which might have destroyed its business operations) and because the McLaren racing team engaged in conduct that did not form part of its trade. Accordingly, the deduction of the penalty was refused.

It is probable that a South African court might come to the same conclusion even though s23(g) of the Act, which previously required deductible expenditure to have been laid out 'wholly and exclusively' for purposes of trade, similar to the requirement in the UK, has been amended. The section currently provides that expenses are deductible to the extent incurred for purposes of trade. Given the facts of the McLaren case, it would be unlikely that McLaren would be able to discharge the burden of proof that at least some amount was incurred for purposes of its trade. Since the penalty was intended to be a punishment, it still does not form part of the trade of the taxpayer.