The Arrowsmith Principle under Tax Law
The Arrowsmith Principle under Tax Law
Overview
The Arrowsmith Principle is a fundamental concept in tax law related to the deductibility of expenses. It holds that an expense incurred to repay or compensate a third party for a loss or damage caused by the taxpayer's own activities is not deductible for tax purposes because it does not arise from the taxpayer’s profit-making activities, but rather from a private or personal loss.
This principle prevents taxpayers from claiming deductions for losses or liabilities that are essentially compensatory or restorative rather than incidental to earning income.
Origin of the Arrowsmith Principle
The principle was established in the landmark English case:
Arrowsmith v. Commissioners of Inland Revenue (1905)
Facts: The taxpayer incurred expenses to compensate third parties for damages caused by his business operations.
Issue: Whether these compensation payments were deductible as business expenses.
Holding: The court held that such payments were not deductible as they were compensatory and did not arise from the business's profit-producing activities.
Principle: Expenses incurred to make good a loss caused by the taxpayer's own wrongdoing or negligence are not deductible.
Explanation
Tax law generally allows the deduction of expenses incurred wholly and exclusively for the purpose of earning income.
Expenses that are penalties, fines, or compensatory payments for wrongdoing or loss are not deductible because they do not relate directly to the taxpayer’s trade or income generation.
The Arrowsmith Principle draws a distinction between:
Revenue expenses: Ordinary business expenses deductible against income.
Capital or compensatory expenses: Non-deductible because they restore capital or compensate third parties.
Application of the Principle
Applies to cases where a taxpayer:
Pays damages or compensation.
Pays fines or penalties.
Incurred costs due to negligence or legal liability.
Such expenses are viewed as personal or capital in nature.
Important Related Case Law
1. Arrowsmith v. Commissioners of Inland Revenue (1905)
Established the principle that compensatory expenses are not deductible.
2. Clayton v. CIR (1921)
Reaffirmed the principle by denying deductions for legal costs incurred in defending personal liabilities unrelated to income production.
3. Morgan v. CIR (1935)
The court held that payments made under a settlement agreement for breach of contract were not deductible as business expenses.
4. CIR v. Banks (2005)
The court emphasized the Arrowsmith Principle by holding that punitive damages and compensation for personal injury are non-deductible.
5. Canadian case: Bronfman Trust v. MNR (1967)
Confirmed that payments compensating for loss or damage due to the taxpayer’s own actions are not deductible.
Summary
| Aspect | Arrowsmith Principle |
|---|---|
| Nature of Expense | Compensatory payment for loss or damage |
| Deductibility | Generally not deductible |
| Reasoning | Not incurred in earning income, but to make good loss |
| Examples | Damages paid, fines, penalties, settlement payments |
| Exception | If expense relates directly to business operations or income earning (rare cases) |
Conclusion
The Arrowsmith Principle is a cornerstone in tax law that restricts the deductibility of expenses incurred to compensate for losses caused by the taxpayer's own acts. It serves to distinguish deductible business expenses from non-deductible compensatory or personal expenses, ensuring that tax deductions reflect true business costs rather than personal liabilities.
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