Accounting is a complicated business – there's a reason training takes so long, after all. Sometimes as a business owner what you consider to be common sense isn't reflected in the arcane pages of the big book of tax.

One especially finicky area is that of legal fees. If you run a business, you'll almost certainly have paid legal fees when acquiring your premises. If you're unlucky, you may have to pay fees to settle a legal dispute.

In these instances, can you claim those legal fees as tax-deductible expenses?

To tell the truth, it's a bit of a minefield, and one that gives even seasoned accountants a mild headache. It's an issue that gets contested in tribunals and over the phone to HMRC.

General principles apply to determine whether a fee is allowable as an expense or not – but there are some exceptions in case law that are referred to.

Every case is unique, so educated guesses don't cut it. You need an accountant's expertise to decide whether or not a legal fee is tax deductible.

What are the general principles?

There are two general principles for determining whether a legal fee is tax deductible. First, does it pass the "wholly and exclusively" test? And second, is the fee a revenue or capital expense?

In the case of legal action – as opposed to solicitor's fees when purchasing a lease, say – the outcome is irrelevant. Fees for a failed action can still be allowed as expenses.

What is the "wholly and exclusively" test?

This test is a rule of thumb that asks, "Were the legal fees spent wholly and exclusively for the purposes of the business?"

It gets murky, fast. But a clear-cut example would be that fees relating to a trade dispute are deductible, but those relating to a private dispute are not.

In the case of compensation given by a company to an injured party, the area is a little grey. It has to be established that the injury was caused by day-to-day trading operations. If it was, then those civil damages can be chalked up as an expense.

But if the injury was caused by something incidental to the day-to-day running of the business, it's non-deductible.

This is a distinction that can be hard to parse. Take, for example, the 1906 case of Strong & Co of Romsey Ltd v Woodifield.

Strong & Co was a brewing company that rented rooms at an inn. Woodifield was a guest who suffered an injury when a chimney fell on him.

Woodifield was paid damages – but Strong & Co wasn't able to count them as expenses. This is because the judge ruled that the damages weren't spent wholly and exclusively for the purpose of the trade.

It might have been a different story if Woodifield had slipped on some beer from one of the brewery's leaking barrels, for instance.

The general principle is considered alongside case law, which can make it a tough nut to crack.

Are the legal fees capital or revenue?

Capital expenses are large, one-off purchases of fixed assets that will generate revenue. If a pizzeria buys a pizza oven, that's a capital expense.

Revenue expenses, by contrast, are short-term expenses for day-to-day operations.

Capital expenses are generally not considered to be tax deductible. This can be an issue when businesses try to claim lease purchases as expenses.

Legal fees that could count as revenue expenses include those that relate to employment, rent reviews, trade disputes and debt collection.

Fines and penalties

Does breaking the law count as normal day-to-day trading? Not in the eyes of HMRC.

If you have to pay a fine, penalty or legal cost because you've broken the law – or you've had to settle an action for the same reason – it won't count as a tax-deductible expense.

Libel actions

As with other legal fees, those spent defending a libel action have to pass the "wholly and exclusively" test.

In the case of Fairrie v Hall (1947), the costs weren't deemed to be allowable because the damage to the plaintiff's reputation wasn't wholly and exclusively connected to his trade – it was also connected to his personal reputation.

A critic might argue that personal reputation and the ability to successfully run a business are linked. The point is that case law and general principles are sometimes in tension with one another.

There are two more contrasting cases here.

The first is Duckmanton v HMRC (2013), where a taxpayer tried to claim legal fees that he'd incurred while defending himself against a charge of gross negligence and manslaughter.

These fees weren't deemed to be tax deductible because, as with Fairrie v Hall, they weren't incurred wholly or exclusively for the purposes of his trade.

By contrast, there's the case of McKnight v Sheppard (1999). The taxpayer was a stockbroker who had incurred legal costs defending charges brought against him by the Stock Exchange.

The Special Commissioner ruled that these legal fees had been incurred wholly and exclusively to keep his business afloat, even though he was also concerned with his personal reputation.

These differing outcomes point to the reality of deciding whether legal fees are tax deductible or not. While general principles apply, each case is unique and will need to be considered in relation to existing examples of case law.

What if you're self-employed?

If you're self-employed, you can count accountancy, legal and other professional fees as business expenses. That includes hiring a solicitor, whether for property purposes or representation in court.

As with other types of business, however, you can't claim for capital expenses or fines for breaking the law.

Milners is an experienced law firm in Leeds, Harrogate and Pontefract. We offer expert legal guidance at affordable rates. Interested? Contact us today for a free, no-obligation consultation.