This case examined the tax distinction between trading and investment in the context of an interest in property. Like most cases involving this distinction, the decision was dependent on its particular facts, but demonstrated that a property developer is not necessarily a trader in relation to all of its assets if the facts show it is investing in a particular property. The decision was “finely balanced” in the words of the Tribunal but ultimately it found in favour of the taxpayer that the property was purchased as an investment. The issue was one of fact. When the property was acquired was it intended to be retained as an investment – or was it intended to be sold immediately for the best possible price?

Background and arguments

Key facts

Terrace Hill (Berkeley) Ltd (“the taxpayer”) was a special purpose vehicle (“SPV”) which had been formed to hold the Terrace Hill Group plc’s (“the Group”) 50% beneficial interest in a development of an office property in Mayfair (“the property”). The development was to be undertaken on a joint venture basis with the other 50% interest being held by another SPV. The Group had expertise in organising property developments while its SPV partner could obtain finance and conducted a trade in serviced office accommodation.

The property was acquired in August 2000 at which time the taxpayer proposed to demolish the existing building and replace it with a grade A office property. Construction work was completed in September 2003. It was expected that the property would be let in its entirety however, the rental market declined during the period that the property was being redeveloped. Accordingly, the building had to be let out on a floor by floor basis with disappointing average rentals achieved. Consequently, the investment value of the property was diminished because some of the tenants were not of the calibre that had originally been hoped for. The property was fully let by May 2005 and sold in July 2005 when an offer was made which was “too good to turn down”.

A capital loss scheme was undertaken to mitigate the “gain” on the development profit. Had the gain been treated as trading income the loss scheme would have failed. The expected effect of the scheme was that losses would be set against the gains on the beneficial interests in the property held by the joint venture parties, which would eliminate all tax due on the disposal.

Arguments

In evidence, the Chairman of the Group explained that his strategy was to retain completed developments where good rental growth was anticipated, so that the Group would have a steady net rental income. His aim, in particular, was to retain the completed development of the property following completion. It was hoped that the retained surplus of rentals over interest and amortisation of the long-term borrowings would provide the Group with steady (and hopefully rising) income.

Consistently with these objectives, the property was always treated as a capital asset for accounting purposes by the taxpayer. The development in question was sold because the offer was so attractive; particularly given rental growth was lower than originally envisaged.

The taxpayer treated the acquisition of the property as a capital investment on the basis that it intended to let the completed property in its entirety to one high calibre tenant. The property was thus treated as capital in the company accounts and capital allowances had been claimed in relation to the plant and machinery component of the development costs.

While it was accepted that the Group often had development properties on trading account and so held them when the developments had been pre-sold, the Group also held investment properties and was aiming to retain its stakes in suitable development properties as well.

The Group argued that its profits on the sale were capital profits covered by losses eligible for surrender by group relief.

HMRC rejected the claim, saying the company had held its interest in the property as a trading asset, rather than as an investment, and had always intended to sell it once it was fully let. HMRC challenged the arrangements and argued that each group had in fact held its respective interest in the property from the outset as a trading asset and not as an investment. Thus, the capital loss scheme failed to achieve its objective and the two groups were subject to corporation tax on their respective profits.

HMRC argued that the taxpayer had always intended to sell its interest in the property as soon as it had reached its maximum value, in other words, as soon as the development had been completed and the building fully let and thus the profit should be treated as a trading profit rather than capital.

In addition, it was claimed that the potential benefit of being able to claim capital allowances, when the property was held as an investment and the benefit of indexation on selling an investment property, were factors likely to induce the taxpayer to classify the property as an investment property rather than as trading stock.

The appeal also involved a subsidiary issue relating to a penalty of £1million which HMRC had imposed on the basis that in reporting the sale as a disposal of an investment, the taxpayer had been negligent.

Both parties accepted that the fundamental issue for the FTT to determine was the factual one of whether, when the taxpayer acquired the property, it intended to retain it as an investment, subject to the reality that if circumstances changed radically, the property might have to be sold. Thus, was the property acquired with a view to its retention or was it intended to be sold immediately for the best possible price?

The FTT’s decision

The starting point was considered to be that the presumption is that a developer would hold development sites as trading stock. They accepted that the claimed strategy of seeking to retain developments where rental growth looked highly promising in order to diminish fluctuating results seemed entirely cogent. They therefore found that it was the change in circumstances which led to the change of plan, and confirmed that the property was rightly treated as an investment property, allowing the appeal.

The facts were long and complicated but the essential elements which persuaded the Tribunal that the acquisition was an investment and not trading were as follows:

1. The accounting treatment of the property was as a capital asset – and not as trading stock;
2. A claim for capital allowances had been made which could only have been possible it if was an investment;
3. The evidence before the Tribunal was that at the point of acquisition the property was intended to be an investment;
4. The documentation was (mainly) consistent with an investment;
5. The sale was motivated by a disappointing rental performance combined with an extremely attractive offer to sell.

The FTT accepted the Chairman’s evidence that he pursued a strategy of seeking to retain developments where rental growth looked highly promising so as to maximise net rental income and reduce delays in the realisation of profits. The FTT attached some weight to the fact that the Chairman was an accountant and that as such he was familiar with the factors that governed whether a property was rightly treated as an investment. It was significant that the property was always treated as a capital asset for accounting purposes.

It was also significant that whenever minutes referred to the views of the Chairman, they consistently supported his evidence that he wished to retain what he hoped was going to be a very attractive Mayfair office development as an investment. The FTT also accepted that in being the Chairman and the person responsible for advancing the fortunes of family trusts which owned the Group, it was his objectives that governed the strategy adopted by the Group.

The impressive nature of the evidence given on behalf of the taxpayer coupled with the credible strategy which it was claimed was being pursued and the entirely understandable manner in which changed circumstances led to a change of plan, led the FTT to conclude that the property was held as an investment and was rightly accounted for throughout in that manner.

The penalty dropped away in the light of the conclusion reached, but the FTT did record (in case the primary decision was overturned on appeal) that there was no neglect by the taxpayer in the filing of its corporation tax return. In the view of the FTT, the taxpayer honestly believed that its case was correct and that its return was also therefore correct.

The full judgement of the case is available from http://www.financeandtaxtribunals.gov.uk/judgmentfiles/j8260/TC04282.pdf