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Capitalising a Legal Settlement 2

Follow on from previous question, with more details fleshed out

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My client's previous accountant has capitalised the settlement costs relating to a legal dispute with a director's old employer and claimed a tax deduction for the legal fees. The dispute arose due to a violation of the director's (d1) non-compete clause in his employment contract with his old employer (oldco). After leaving his employer, d1 set up his own company (newco) (together with a partner (d2)) and began doing business with customers of his old employer. Oldco brought legal action against d1, d2 and newco jointly as a result. I am trying to establish the correct accounting/tax treatment. 

I’d appreciate if anyone could: -

  • Expose holes in my logic/treatment
  • Advise on any relevant cases I have missed
  • Advise if the fact that the liability for the legal fees/settlement payment was “jointly and several” has any bearing on who the costs belong to
  • Any other advice

1 Issues

  • Who do the costs rightly belong to?
  • Does it meet the recognition criteria for an intangible asset?
    • If so, what proportion of the asset should be treated as goodwill
  • Should the accounting treatment of the legal fees follow the accounting treatment of the settlement payment?

2 Who do the costs rightly belong to?

There appears to be four outcomes of the settlement agreement: -

1 Lifting the injunction previously put in place

2 Imposing an 18 month restrictive covenant

3 Releasing the parties from any further legal actions or claims relating to the matter

4 Preventing either party from making disparaging remarks about the other party going forward

1 The main purposes of the injunction were to prevent further use of oldco's confidential information, and, to prevent further engagement with any of oldco's other clients through other means. The injunction was placed on the company, as well as the individuals themselves.

Given that the individuals had no intention of either using the confidential information nor approaching oldco's other clients on their own account, it seems to me that the only significant beneficiary of this part of the agreement was newco. Therefore, whatever proportion of the legal costs/settlement payments that are allocated to this outcome can justifiably be regarded as that of newco’s.

2 No one other than oldco appears to have benefitted from the restrictive covenant, and therefore it seems clear that this wasn’t what the settlement payments were paying for. Legal costs incurred in negotiating the covenant would appear to be the company’s, given the directors had no intentions of trading on their own account. 

3 My understanding of the matter is that oldco had potential claims against d1, d2 and newco for using its confidential information. It also would have claims against d1 for breeching the terms of his employment contract by obtaining its confidential information, as well as for breech of a non-complete clause. As a result of the agreement, all of these potential claims now are no longer valid and therefore it would appear that all three parties therefore benefitted from the legal costs/settlement payments. The payments should therefore arguably be split in this proportion of the benefit, with the portion relating to the benefits arising for the directors being recognised as amounts owed to the company in the directors’ loan accounts. It would be useful to have input from the solicitor on what the exposure for each party likely was, should the directors decide a split is required.

It could be argued that the benefits received by d1 and d2 in terms of the legal costs were simply a by-product of the legal advice that the company had paid for. It may be harder to argue this with regards to the settlement payment, given that the amount oldco could claim against d1 for the breech of his employment contract would be distinct from the other claims against the use of confidential information.

I would imagine that d2’s exposure would be limited, given that he was acting in capacity of director of the company when he used the information.

Should this treatment be pursued and a significant amount is recognised as owing from d1 to the company, it may be possible to recognise an amount for the client contact details and the goodwill that d1 brought to the business. The amount recognised would reduce the amount owed by d1 to the company. An indicator that the market rate of the list/GW is the same as d1’s share of the settlement costs is that d2 was aware of all this when he agreed to set up the business. Alternatively an independent valuation of the list/GW could be sought.

4 This appears to be a fairly trivial outcome of the agreement, but again, I would argue that the main beneficiary would be the company, given the directors’ personal intentions of trading through the company for the foreseeable future.

3 Does it meet the recognition criteria for an intangible asset?

The intangible assets appear to consist of the goodwill, the client list and the assurance that no further legal action will arise.

The goodwill was not acquired as a result of the legal action, and therefore it is hard to argue that the settlement payments and the legal fees relating to it can be capitalised on this basis. Instead, the goodwill may be able to be recognised as acquired from d1 where you originally set up the business (see 2.3 above).  

The client list was not acquired as a result of the legal action, however, the legal right to the client list was acquired as a result of the action. It is unclear what HMRC’s position would be with regards to this and either specialist advice will need to be taken, or a decision made given the potential risks.

The legal assurance that no further legal action will arise doesn’t on the face of it appear to be something that could be capitalised given that it would not result in the flow of economic benefits to the company.

4 If so, what proportion of the asset should be treated as goodwill?

It doesn’t appear as though any of the legal fees/settlement payments can be recognised as GW, as per section 3 above.

5 Should the accounting treatment of the legal fees follow the accounting treatment of the settlement payment?

It is normal that legal fees relating to the acquisition of an asset are capitalised along with the asset, rather than expensed. Therefore: -

  • Legal fees relating to the portion of the settlement that is capitalised should be capitalised
  • Legal fees relating to the portion of the settlement that is expensed should be expensed
  • Legal fees deemed non-business should be moved to the director’s loan accounts

6 Tax Treatment

A tax deduction can be made for settlements payments where the payment represents reimbursement of damages to the third party (here). The directors may wish to establish that the settlement was in substance for damages, and it would then be useful to get the solicitor’s opinion on this (my understanding is that the point of civil cases is to always reimburse the successful claimant, rather than punish the defendant). Where a portion of the settlement is deemed not to relate to the company (see 2.3 above), no tax deduction will be available.

Regarding the goodwill, since July 2015, it is no longer possible to receive a tax deduction.

The legal costs relating to the business may be allowable given the McKnight v Sheppard case. The reasoning behind the case appears to be that the costs were incurred wholly and exclusively for business purposes. If it can be argued that part of the fees were to defend the claims against d1 personally, then it may not be possible to rely on this case. It may, however, be reasonable to claim for the proportion of the fees exclusively relating to the company’s defence, if that can be determined. A further difference between this situation and the case referenced is that Sheppard categorically could not trade as a result of the ban by the disciplinary committee, whereas newco could still continue to trade (albeit potentially not with certain clients, or with a legal case to defend). I would not believe that this difference would be pertinient, however, if it can be argued that the expenses were incurred wholly and exclusively for business.  

Decision

It is ultimately the directors of a company that decide the accounting treatment that the company adopts, and therefore it is down to the directors to decide how the costs are treated.

As an accountant I am unable to associate myself with accounts that I know to be incorrect. However, in accountancy there are grey areas (including in valuations and accounting treatments), and therefore it isn’t uncommon for directors to take a view of certain decisions provided reasonable care has been taken.

The directors need to decide what they want to do, which may include seeking specialist advice, or may consist of taking a view given the known unknowns and the risks.

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