Lee Ellis analyses the tribunal’s supplemental decision that ‘the rights’ to income from the investments made by the Ingenious LLPs were capital in nature and its likely contentious future.
Background
In a decision of 2 August 2016 (Ingenious Film Partners 2 LLP [2016] UKFTT 521 (TC)), the First-tier Tribunal (FTT) held that the various Ingenious LLPs (except for Ingenious Games LLP) were trading and that those trades were conducted with a view to the making of profit. In the view of the FTT, however, the LLPs were only trading and doing so with a view to profit on the basis that the trade involved only 30% (or 35% depending on the LLP) of the production cost of the relevant film(s) in return for a 30% (or 35%) share of the net receipts generated from the exploitation of the film(s), rather than the full amount claimed and accounted for by the LLPs.
In addition, the FTT determined that the accounts of the LLPs were not GAAP compliant and that various adjustments were required to them. Not least because the asset – i.e. the rights, which were not rights in a film but rather rights to payments from the distributor following exploitation of the film – should be treated as fixed intangible assets and therefore accounted for at cost less any impairment (or onerous contract provision). Various other adjustments were required, most notably in relation to the executive producer fee. As a result, the FTT adjourned the appeals (except that of Ingenious Games) and asked the parties to agree the revised computations for the purposes of the LLPs accounts in accordance with its decision.
(For a more detailed consideration of the FTT’s original decision and the contentious history of the case, see the article ‘Ingenious Film Partners 2: tribunal recharacterises commercial investments’ (Gideon Sanitt), Tax Journal, 23 August 2016.)
The parties were unable to agree the revised computations as they disagreed whether the rights (i.e. the rights to payments from the distributor, rather than the rights in the films as originally claimed) were capital or revenue in nature. In that regard, ITTOIA 2005 s 33 (formerly ICTA 1988 s 74(1)(f)) provides that for the purposes of ‘calculating the profits of a trade, no deduction is allowed for items of a capital nature’. Accordingly, if the rights are capital in nature no deduction is available in respect of the expenditure (as recorded in the adjusted/revised accounts) on the films, in respect of which income was received by the LLPs.
On consideration of written submissions, the FTT handed down its supplemental decision on 17 May 2017 (Ingenious Games LLP and others v HMRC [2017] UKFTT 429 (TC), reported in Tax Journal, 2 June 2017). With what was said to be ‘some misgivings and reluctance’, the FTT determined that the rights were capital in nature. This article explores the decision.
The parties’ arguments
In terms of the legal test to be applied, HMRC recognised (as did the Ingenious LLPs) that there was no single test or set of rules for determining whether expenditure is capital or revenue in nature. HMRC however relied heavily on Viscount Cave’s often quoted dictum in British Insulated and Helsby Cables Ltd v Atherton [1926] AC 205 that an expenditure made ‘not only once and for all but with a view to bringing into existence an asset or advantage for the enduring benefit of a trade is likely to be capital’ unless special circumstances existed. HMRC argued there were no special circumstances here.
HMRC went on to argue that on the facts as found by the FTT in its original decision, the LLPs had in effect provided a sum of money in return for a potential future financial reward (albeit in a complex way – perhaps something of an understatement even by tax standards); given that the commercial and legal reality was that the LLPs had acquired simply rights to income and that as they did not intend to dispose of them, the rights were therefore capital in nature. Accordingly, no deductions were available in respect of expenditure on those rights for the purposes of computing the LLPs’ taxable profit or loss.
HMRC also relied on the distinction drawn between fixed and circulating (or floating) capital in Anglo-Persion Oil Company v Dale (Inspector of Taxes) [1932] 1 KB 124. They argued that as the rights were not disposed of they could not be circulating capital; supporting a finding that they were capital in nature and thus the expenditure on them was capital expenditure and so not deductible for tax purposes.
The Ingenious LLPs contended that it would be absurd if the expenditure on the rights was disallowed as capital and the LLPs remained taxable on the gross amounts received, without any deduction for the cost of acquiring those amounts. They argued that the FTT’s finding that, for accounting purposes, the rights were not current assets did not inevitably lead to the conclusion that the expenditure on the rights was capital in nature, for, as Lord Upjohn said in Strick v Regent Oil (1965) 43 TC 1, it ‘is a question of fact and degree and above all judicial common sense in all the circumstances of the case’.
They relied in particular on Strick and on BP Australia v Commissioner of Taxation (Australia) [1966] 1 AC 224, arguing that both cases were authority for a wider consideration of the asset (i.e. the rights) in the context of the nature of the LLPs’ trade. This included the period for which the asset would last for the purposes of determining whether the rights and thus the expenditure were capital in nature.
The FTT summarised (at para 14) the Ingenious LLPs’ arguments as follows:
‘(1) that one relevant feature pointing towards revenue rather than capital is that the contracts were ordinary commercial contracts;
‘(2) that the distinction between revenue and capital was based on accounting concepts which are outmoded and surpassed by the GAAP requirements of [FA 1998 s 42]; and
‘(3) that the judgments [i.e. Strick and BP Australia] indicate that, whilst a payment for a 21 year tie would be capital in nature, a payment for a five year tie would not be and that the balance lies at about ten years. The nature of the rights held by the LLPs they say were such that they had a realistic life of only five years and were not capital.’
The Ingenious LLPs also relied on BP Australia for the purposes of arguing that the rights were circulating (or floating) capital and the description given therein of the difference between the two (emphasis added):
‘The test of whether these sums were payable out of fixed or circulating capital, referred to for example in John Smith & Son v Moore tends in the present case in favour of regarding these payments as revenue expenditure. Fixed capital is prima facie that on which you look to get a return by your trading operations. Circulating capital is that which comes back in your trading operations. The sums in question were sums which had to come back penny by penny with every order during the period in order to reimburse and justify the particular outlay’.
The FTT’s decision
The FTT acknowledged the ‘intellectual minefield’, as per Templemen J in Tucker v Granada Motorway Services [1979] STC 393, on which it was about to embark and noted that ‘the practice of judicial common sense is difficult in revenue cases’. It, however, gave short shrift to the Ingenious LLPs’ arguments of perceived absurdity or unfairness. It held (at para 22) that the question to be determined/asked is one required by the legislation and the legislation does, at times, provide for various capital allowances or specific reliefs, which reinforced how it should determine whether the rights and thus the expenditure were capital in nature.
The FTT also dismissed the argument (see para 24) that changes in accounting practice should be relevant or otherwise pause them to revise previous understanding as per the historical case law. This, like the previous issue, is a matter for Parliament.
The FTT’s supplemental decision begins with considering whether the expenditure on the rights is in respect of fixed or circulating capital. This arguably in the view of the author is the wrong starting point and it perhaps explains, at least in part, some of the ‘misgivings and reluctance’ the FTT ran into in reaching its decision.
In the author’s view, the correct starting point is the ‘enduring benefit’ dictum of Viscount Cave in British Insulated and Helsby Cables (as set out above). As the FTT suggests (see paras 51 and 52), this is developed (or glossed) by Lord Wilberforce in Strick such that it is necessary to consider the dictum of Viscount Cave in the context of the so called ‘business reality’. As stated by Lord Wilberforce (as recorded by the FTT at paras 51 and 52):
‘It is the endurability of this complex right which has to be considered and we must squarely face the question whether such an advantage is sufficiently enduring in the context of Regent’s trade to qualify as a capital asset or whether it has such transient qualities that it ought properly to be regarded as “day to day” or “current” and, so, revenue expenditure’.
‘If, on consideration, of the nature of the asset in the context of the trade in question, it is seen to be appropriate to classify it as fixed rather than as circulating capital, the brevity of its life is an irrelevant circumstance.’
In the light of the above and the ‘business reality’ of the LLPs trade (as determined by the FTT in its original decision), it appears relatively clear that the rights and thus the expenditure upon them were capital in nature: the activity and expenditure of the business of the LLPs was in respect of the rights obtained, the rights were not time limited (though any value to be gained from them likely was) and, importantly, there was no intention to dispose of them. In addition (and as the FTT itself records at paras 40 and 41), in considering why the expenditure was not in respect of circulating capital ‘the nature of the LLPs’ business as originally advertised did not involve the recycling of monies received. There was a separate LLP for each year; the monies which came in were to be distributed to the members … there was no circulation of capital’ and ‘there is a business cycle which is so long that the business cycle cannot displace the attraction to the annual nature of profit.’
Looked at this way, it is difficult to see how the FTT reached its view (at para 46) that ‘the nature of the trade weighs in favour of the rights being of a revenue nature but that is balanced by the lack of circulation’. Indeed, in the author’s view it is not necessary in the circumstances to consider ‘whether the rights in context have too long a life to be revenue’ as they are fixed capital and not floating capital – as per Lord Wilberforce stated in Strick (see above).
An argument against such a view, as the FTT considers (at para 58), is the demarcation as recorded by Viscount Ratcliffe in the Van den Berg case between expenditure on the permanent structure of a business (capital) and costs of earning income or profit (revenue). The FTT determined in its original decision that the contracts entered into for the rights were commercial and thus, on the basis of Van den Berg, the rights and the expenditure could be argued to be revenue in nature. The facts of Van den Berg were, however, very different, and as the FTT records (at para 58), Lord Reid in Strick considered the guidance of Viscount Ratcliffe in Van den Berg unhelpful. Indeed whilst not governing the whole conduct of the LLPs’ trade or their structure the contracts entered into for the rights and thus the expenditure upon them did form the vast majority of the activity and expenditure incurred and it is the rights upon which the LLPs secured a return, i.e. the entering into of the contracts for the rights were the trading operations of the LLPs.
Conclusion
The FTT in its supplemental decision, by a somewhat tortious journey through the ‘intellectual minefield’, determined that the LLPs’ rights were capital in nature and thus the expenditure upon them was capital in nature. In the author’s view, this is correct based on the facts as found by the FTT in its original decision as to the nature of the LLPs’ trade.
The effect of the supplemental decision is likely to be materially detrimental for investors as their tax claims for loss relief are further reduced to close to, if not, zero.
Appeals by the Ingenious LLPs and cross-appeals by HMRC now seem inevitable with no immediate end in sight.
This article first appeared in Tax Journal 22/06/17 – Ingenious Film Partners 2: whether deductions are capital or revenue in nature?
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