A special commissioner decided that, in quantifying the capital allowances available where software had been purchased with the support of non-recourse loans provided indirectly by the vendor, the only expenditure treated as incurred at the outset was the 25 per cent paid out of the capital provided by partners to LLPs ignoring the element funded by the loans. However, further expenditure would be treated as incurred if and when but only to the extent that designated revenues were applied in paying off the non-recourse loans.

Facts

A company, M, had devised software intended to revolutionise the loyalty cards promoted by food and drink producers and supermarkets, providing, as its reward to customers, free air-time on mobile phones. Whilst it had already devised the software to enable the system to work satisfactorily, it required additional finance to roll-out the system, potentially involving negotiations with food and drink producers, supermarket groups and mobile phone companies in numerous parts of the world. M accordingly sought the assistance of T Group plc which had had experience of arranging finance for similar software companies. The scheme adopted by T involved the creation of four LLPs, each of which was to purchase software related to M's system, the aggregate price for the purchase by all four LLPs being £143 million. With a view to the LLPs claiming 100 per cent first year capital allowances for tax purposes under s. 45 of the Capital Allowances Act 2001 (‘CAA 2001’) the four LLPs entered into contracts to buy discrete elements of software on 31 March 2004, on the basis that the purchases would be completed before the expiry of a four-month period.

The contracts all envisaged that while the LLPs would pay the whole of the allocated slices of the £143 million total purchase price on completion, M would procure that two banks would be interposed in a chain to provide the investing partners with non-recourse loans to fund 75 per cent of their capital contributions to the LLPs, M providing the ultimate security and all of the funding to those intermediate banks. The effect of the contractual provisions in relation to the non- recourse loans was essentially that the loans were interest-free. M was to get no interest on its deposit and the balance of the loans at the end of a ten year period was effectively cancelled. By a closure notice issued by the tax inspector, the Revenue took the view that capital allowances were only available for 25 per cent of the price paid because that reflected the value of the software (and the capital provided otherwise than with loan assistance), the balance of the price being paid for the provision of beneficial finance, so that whether the loans were eventually paid off out of the revenues designated to pay off the non-recourse loans or not, no further allowances would be available. The taxpayers (LLP1 and LLP2) appealed.

Issue

What allowances were due if the Revenue were right in their contention that the value of the software was very materially less than the price paid for it.

Decision

The special commissioner (Howard M Nowlan) (dismissing the appeal of LLP1 and allowing the appeal of LLP2 in part) said that, whilst there might be no required statutory form for the giving of closure notices, it was clear in this case that the letter that referred only to denying the allowances under CAA 2001, s. 45 and denying the income losses was regarded as the letter that gave the conclusions and adjustments, and the statute required neither detail nor reasons to be given for that notice to be a valid notice. Accordingly the import of the notice was that it denied the allowances under the section under which they were claimed and it also denied the income losses. The Revenue were entitled to adduce other grounds for challenging the capital allowances when the covering letter alone referred to s. 45(5) and indicated that, but for the inspector being pressed to issue the notice by the taxpayers' representatives, he would have preferred to have had more time in order to indicate other grounds for the conclusions and adjustments. In an appeal the Revenue could raise any arguments in support of their conclusions and adjustments related to the transactions in question.

In order to sustain a valid claim for allowances for the tax year 2003-2004, LLP1 had to establish that it had commenced trading prior to the end of 5 April 2004, and since nothing material occurred by 5 April 2004 after LLP1 entered into the software licence agreement with M on 31 March, it was largely in reliance on that that LLP1 asserted that it had commenced trading. In the circumstances of the present case, LLP1 had not commenced any trade by 5 April 2004, with the result that its capital expenditure was deemed not to have been incurred in the tax year 2003-2004, for the purpose of actually claiming the allowances.

The market value of the software acquired by the taxpayers was very materially below the price ostensibly paid for it. If the present transaction had been framed as an instalment sale, in accordance with the economic reality, capital expenditure would plainly be incurred and capital allowances would be available, as each instalment of price was paid, and there would be no possible dispute that what was paid was the price for the software. However, the availability of non-recourse loans on the very extreme terms on which they were advanced in this case, had enabled the price for an untried asset to be ramped-up to a figure far in excess of its value. Accordingly, it was fictitious to say that the price given was truly all given for the acquired software. The taxpayers could not have it both ways. Framed on a contingent instalment basis, with allowances only arising when capital expenditure was truly given, all the deferred contingent price would have been the price given for the acquired asset. But if the transaction was re-framed as an outright purchase, with everything attributed to the asset, the total payment could not all be said to be the price given for the asset alone.

Furthermore, the loans were on uncommercial and non-arms' length terms, as demonstrated by the fact that it was initially projected that only 80 per cent of the loans would be discharged if all the revenues projected in the business plan were in fact received. The banks had been interposed to try to diminish the impression that the loans to the LLP members were simply a reversal of 75 per cent of the price just paid, or about to be paid. It was difficult to decide whether the transaction in the present case was a sham. It was clear that the parties paid no attention to verifying the real figures, because everyone knew that the non recourse loans would make everyone indifferent to whether the figures were correct or not. It was appreciated that in economic reality no-one was paying the price outright, and that the higher figure would simply increase the up front allowances. All factors related to the price at which the asset was sold, the terms of the loans to finance the capital contributions, and the supposedly cosmetic insertion of the banks into the lending chain were fictitious features designed to dress-up a contingent instalment sale as something that these transactions manifestly were not. The parties must all have known that the economic reality of the transactions was of a highly contingent instalment purchase; that the ceiling price payable on that basis had relatively little bearing on the true value of an asset and the price that might be paid outright for an asset, and that accordingly the ostensible payment of the full price outright was phoney. The result was that the court could not sensibly apply the tax provisions to the transactions by paying regard to the discredited form of the transactions, and to the discredited labels that the parties had attached to the transactions.

Finally, the contracts entered into on 31 March 2004 by the taxpayers were unconditional for the purposes of CAA 2001, s. 5(1). The realistic construction of M's obligation to procure the bank loans was that M should reverse the payment of most of the price, filtering that return of price through a highly-artificial banking chain in an effort to disguise that reality. The obligation on M to procure the finance was part of the consideration to be given by M, and not some third party condition that rendered the contracts conditional. Nothing had emerged in evidence or cross-examination that indicated anything at all about the contractual position between the parties for the purposes of CAA 2001, s. 5(5), so that it was not possible to decide whether the parties had agreed to change the terms of the contracts to include a period for completion of longer than four months.

(2007) Sp C 619.
Decision released 19 July 2007.