In this month’s Chartered Accountants Tax Case Digest we look at a case which examined whether, for capital gains tax purposes, £17.5 million expenditure incurred was reflected in the state or nature of an asset at the time of disposal or whether the expenditure was incurred in establishing, preserving or defending title to, or to a right over, the asset.

Background

This case involved an appeal by HMRC against the First-Tier Tribunal (FTT) decision to allow a deduction for a payment of £17.5m in computing a capital gain.

The taxpayer had disposed of his shares in Blackwell Publishing (Holdings) Limited (“BP Holdings”).

In 2003, following an unsuccessful takeover attempt, the taxpayer entered into an agreement to promote the offer in return for a payment of £1 million from the acquiring company.

In 2006, following a much more attractive offer from another company, the taxpayer paid £17.5 million to the first interested acquiring company to be released from some of the obligations he had undertaken in 2003 in relation to his BP Holdings shares. The new offer also included a payment of £7.5 million to the first interested company. This was done in order to avoid any potential litigation and to enable the new more attractive deal to proceed. Just after making that payment, the taxpayer disposed of his shares in BP Holdings to the new acquiring company.

The FTT decision

HMRC argued that the £25 million claimed by the taxpayer as a deduction from the consideration received on the disposal of his shares in BP Holdings was not allowable under section 38(1)(b) TCGA 1992. However, the FTT considered that the £25m had been incurred on the shares for the purpose of enhancing their value. One of the arguments cited by the taxpayer was that the payment enhanced the value of his shares because it enabled the higher bid to be accepted.

The FTT also held that although the expenditure had not changed the nature of the shares (because the rights attaching to them remained the same), it was reflected in the state of the shares. Therefore the conditions of section 38 TCGA 1992 were satisfied.

The FTT drew an interesting analogy in its decision: if a car was unfit to be driven: it would still be a car, and so any expenditure incurred to make it fit for the road would not change its nature but would change its state.

The threat of litigation, whether in the form of an attempt to obtain an injunction or otherwise, could well have had a detrimental effect on the prospect of a successful acceptance of the take-over or at least have delayed it. The FTT also considered that it was easy to see that the price of the shares could have been affected or even that the deal could have failed altogether.

The appeal was allowed only in part in relation to the £17.5 million paid by the taxpayer, the remaining £7.5 million paid by the acquiring company could not be deducted.

Decision

The relevant legislation was in section 38(1)(b) TCGA 1992 which provides as follows:

“(1) Except as otherwise expressly provided, the sums allowable as a deduction from the consideration in the computation of the gain accruing to a person on the disposal of assets shall be restricted to–

1. acquisition costs
2. the amount of any expenditure wholly and exclusively incurred on the asset by him or on his behalf for the purpose of enhancing the value of the asset, being expenditure reflected in the state or nature of the asset at the time of the disposal, and any expenditure wholly and exclusively incurred by him in establishing, preserving or defending his title to, or to a right over, the asset, and
3. incidental costs”

Therefore the argument was whether the £17.5 million payment was allowable for capital gains tax purposes and it focused on breaking down section 38(1)(b) TCGA 1992 into “two limbs”.

The first limb relates to expenditure being reflected in the state or nature of the asset. The second limb relates to the establishment, preservation or defence of title to, or to a right over the asset.

The first limb

HMRC argued that the asset disposed of by the taxpayer was his shares and that the rights and obligations comprising that asset were unaffected by the 2003 and 2006 agreements. According to HMRC, the expenditure of £17.5 million was neither “on” the asset nor reflected in the state or nature of that asset at disposal.

Counsel for the taxpayer argued that the obligations undertaken in the 2003 agreement affected the rights which were available to the taxpayer and that the £17.5 million payment was therefore on, or concerned with, those rights and made a change for the better in the state or nature of the rights in the taxpayer’s hands.

The Upper Tribunal considered that when taking into account the “first limb” of the legislation, that at the time of the disposal, the state or nature of the shares did not reflect the money paid under the 2006 agreement. Since the shares were not changed by the 2006 agreement, its state or nature could not have altered.

The second limb

The taxpayer’s counsel accepted that the right need not be intrinsic to the asset since the section refers to a right “over” the asset. As a result of the 2003 agreement, tax taxpayer did not have the right to vote his shares as he wished or to dispose of them as he pleased. He acquired such rights by virtue of the 2006 agreement. They were rights “over” the asset.

HMRC argued that the taxpayer had absolute legal title to the shares and was in no need of establishing, preserving or defending it. The dictum of Goff J in Alison v Murray [1975] STC 524 was adopted. In that case Mrs Murray paid an insurance premium as a condition for the making of a variation to a trust as a result of which she would acquire an absolute interest in part of a trust fund in place of her contingent interest. One issue was whether the expenditure on the premium qualified as expenditure under what is now the second limb of section 38(1)(b). Goff J said:

“The word ‘establishing’ must be read in the context of [section 38(1)(b)] as a whole, and in particular the juxtaposition of the words ‘establishing, preserving or defending his title to, or to a right over, the asset’. In paying the premium Mrs Murray was not ‘establishing, preserving or defending’ her title. She had her title to a contingent share, which was not challenged and was in no need of establishment, preservation or defence. What she was doing was not ‘establishing, preserving or defending’ her title to something greater, but acquiring that greater thing….”

In this case the Upper Tribunal concluded that the taxpayer did not establish, preserve or defend any right over the shares. The 2006 agreement enabled the taxpayer to exercise rights relating to his shares but it did not create or establish such rights and as such, the asset i.e. his shares, remained the same.

HMRC’s appeal was therefore allowed in full, and the expenditure incurred by the taxpayer was not deductible for capital gains tax purposes.

The full judgment in this case is available from: http://www.tribunals.gov.uk