This First-tier Tribunal (FTT) case examined arrangements for exploitation of intellectual property rights by several partnerships and the availability of loss relief for members of the partnerships. The case follows on from the Upper Tribunal decision in the Icebreaker case.

The First-tier Tribunal (FTT) has dismissed in part several partnerships’ appeals concerning arrangements entered into for the acquisition and exploitation of intellectual property rights. The FTT found that although each of the partnerships was carrying on a trade of the exploitation of intellectual property rights, the scheme substantially failed in its purpose to secure sideways loss relief for the partnerships’ members and to increase the amount of the relief by unnecessary borrowing, which was purported to be available for use in the exploitation of intellectual property rights, but was in reality used to service itself.

The FTT also concluded that in respect of a joint reference designed to ascertain whether, if the partnerships’ appeals had been successful, the individual members of the partnerships would have satisfied the conditions necessary for sideways relief to have been available, it held that they would not.

Background

Under examination in this case are arrangements in the tax years 2005–06 to 2009–10 during which several partnerships acquired for modest sums certain intellectual property rights, usually in the music or publishing industry, and agreed with an exploitation company that it would exploit the rights on its behalf in return for much larger payments.

The revenue was to be shared between the partnership and the exploitation company, which was also required, as part of the arrangements, to pay certain guaranteed sums to the partnership. In addition, each partnership entered into agreements with the promoter of the arrangements (Icebreaker Management Limited or IML) by which, in return for substantial payments, IML provided various services to the partnership.

One of the key features of the arrangements was the financing of the members’ capital injections; these were in each case derived in part from their own resources 20–25% and in part from secured bank borrowings 75–80%. In each case the expenditure was incurred in the partnership's first accounting period and the members were guaranteed returns sufficient to enable them to service and repay their secured borrowings.

The partnerships claimed that the expenditure incurred in the first year of trading gave rise to allowable losses which their members were entitled to set off by way of sideways loss relief against income or capital gains arising outside the trade.

HMRC accepted that the partnerships were trading with a view to profit and that none of the arrangements were a sham, however, they argued that the true purpose was the creation of artificial losses, the aim being to generate tax relief as part of tax avoidance schemes and the earning of trading profit was incidental to this. HMRC issued closure notices disallowing almost all of the supposed losses, against which the partnerships appealed.

HMRC argued that:

1. the schemes did not work: the expenditure which gave rise to the supposed losses was not incurred wholly and exclusively for the purposes of the partnerships’ trade; their accounts were not prepared in accordance with Generally Accepted Accounting Practice (GAAP); and the expenditure was in any event of a capital rather than revenue nature, (all referred to by the FTT as ‘the ineffective argument’); and
2. if the schemes did succeed in generating a tax advantage, the fiscal effect should be disregarded under the Ramsay principle.

Decision

The FTT looked at five key questions:

1.What were the relevant payments made for?

The FTT decided that the payments to the exploitation company were, to the extent they matched the amount borrowed, for a guaranteed income stream. The balance of payment was for exploitation services. Advisory fees paid covered a range of services but in the main were for a package of projects or pre-payments. Following the decision in Icebreaker 1, all of the administration fees paid on closure of the partnership represented the consideration for services rendered in the relevant tax year.

2.Was each of the payments of a revenue or capital nature?

The payments to the exploitation company which represented the purchase of a guaranteed income stream were of a capital nature while the remainder for exploitation services were of an income nature. The advisory fees depending on their purpose were either revenue or capital whereas the entirety of the administration services fee paid on closure of the partnership was of a revenue nature.

3.Did the appellant partnerships’ accounts reflect those conclusions?

The FTT found that the accounts were not compliant with GAAP. The recording of all of the amounts paid to IML and the exploitation company in the P&L AC was not correct. That approach did not satisfy the requirements of ITTOIA 2005, s. 25(1) and 26(1).

4.What were the tax consequences of the arrangements?

The FTT ruled that each partnership was entitled to treat as an allowable expense in the relevant year only so much of the payments it made as was of a revenue nature, and which did not represent a pre-payment. The remainder of the amount paid, however, could not be taken to the P&L AC in the relevant year and, never in the case of capital payments. Therefore, the true loss for the relevant year was considerably less than the amount claimed, although not as little as HMRC submitted. The FTT did not have all the relevant information to enable it to calculate the true loss in each case so could not determine how the closure notices needed to be amended.

5.Were the tax consequences to be disregarded on Ramsay grounds?

The FTT was not convinced that the Ramsay principle applied in these cases because the tax treatment of the transactions conformed with the purpose of the legislation: once the partnerships’ accounts had been redrawn to comply with GAAP, only those payments which were of a revenue nature and made in respect of expenses incurred for the purpose of the trade in the relevant year would be brought into the profit and loss account for that year.

If the FTT was wrong and the whole of the exploitation fee was, as the appellant partnerships argued, paid for exploitation services then, again, it did not see anything in the arrangement which offended the relevant taxing provisions. The exploitation fee would be properly deducted in computing each partnership's loss because it would be an expense of a revenue nature incurred for the purposes of the trade in and wholly referable to the relevant tax year.

If the partnerships had fully succeeded in their appeals, further conditions would have had to have been met for sideways relief to have been available to the members. The joint reference, therefore, referred questions to the FTT to ascertain if the individuals satisfied those conditions. In respect of these questions, the FTT found that:

1. The partnerships’ trades were not carried on on a commercial basis and with a view to profit. This was because only a small proportion of projects of the kind pursued by the Icebreaker Partnerships could have been expected to make significant profits. Further the partnerships embarked on their trades without income projections and no partnership could reasonably have expected to even recover the capital invested. It was considerably more likely that trading losses would be created rather than profits. The exploitation agreements allowed the exploitation company to alienate all of the income stream. When a member joined a partnership they could have had no genuine expectation that trading profits would be received.
2. The members’ activities did not advance the trade of any partnership and had no realistic prospect of ever doing so. Although the partnership agreements made it possible to acquire additional intellectual property rights, this did not seem to have been implemented and there were no examples of members identifying a new project adopted by an Icebreaker Partnership. Therefore none of the members were active partners.
3. The aim of the Partnerships (Restrictions on Contributions to a Trade) Regulations 2005 (SI 2005/2017) was to remove or restrict relief in those cases in which the borrower did not truly have any liability to repay the borrowing – so the provisions were aimed at arrangements in which there was the appearance but not the substance of a borrowing, or where the borrower is in some way fully indemnified without cost to himself. These Regulations did not apply to the individuals in this case.
4. For the one individual his primary motive for joining the partnership was to secure sideways relief. No other plausible conclusion was possible.

The partnerships’ appeals against the HMRC closure notices succeed in part, in that relief should be given for revenue expense incurred in the year to which the closure notice in each case relates. However, expenses found to be capital expenditure or to represent a pre-payment were not allowed. The FTT was not asked to determine the detail of the amendments required, however, the taxpayers were granted one year to appeal the amendments if they are unable to agree with HMRC.

The full text of the case is available at http://www.financeandtaxtribunals.gov.uk/Aspx/view.aspx?id=7741