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HMRC internal manual

Business Income Manual

Capital/revenue divide: general themes: recurrence: limited and unlimited periodical payments

There is a difference between payment of a defined lump sum by means of a series of recurrent payments and payments that go on in perpetuity. The former may represent instalments of a capital sum, the latter will not.

The case of Commissioners of Inland Revenue v Mallaby-Deeley and Another [1938] 23TC153 concerned the arrangements used to finance a literary work.

In November, 1926, Sir Harry Mallaby-Deeley, Bart undertook to pay a sum of money in five equal amounts to finance the completion of a literary work (‘The Complete Peerage, or History of the House of Lords and all its Members’). On 10 March 1930, Mallaby-Deeley entered into a deed of covenant. The deed was exchanged for the original undertaking, but the deed contained no reference to the original undertaking. Under the deed Mallaby-Deeley was to pay, in each of seven years ending 31 March 1936, sums, which after deduction of income tax, ranged from £5,600 in the first year to £700 in the last year. In aggregate the sums payable equalled the balance remaining due at 1 April 1929, under the original undertaking.

On appeal Mallaby-Deeley claimed that the respective amounts payable under the deed of 10 March 1930, with an appropriate addition for income tax, were proper deductions in computing his total income for surtax purposes.

The Special Commissioners decided:

  1. that the payments under the deed were income payments, but
  2. that the deed was not ‘a disposition made for valuable and sufficient consideration’ within the meaning of S20(1)(b) Finance Act 1922, and
  3. that, in the computation of the appellant’s liability to surtax, the deductions allowable in respect of the payments under the deed must be restricted each year to the gross amount, before deduction of income tax, corresponding to the net sum of £700, as being the only amount payable for more than six years.

In the Court of Appeal the Master of the Rolls, Sir Wilfrid Greene, explained that to distinguish between payments of an income and of a capital character it is necessary to determine the precise nature of the transaction. If parties agree that the one shall pay to the other a capital sum, the nature of that sum does not change if it is paid in instalments. Sir Wilfrid Greene summarised the position in the middle of page 166:

‘The distinction which is to be drawn for the purposes of the Income Tax Acts between payments of an income character and payments of a capital nature is sometimes a very fine and rather artificial one. It may depend upon - in fact it does depend upon - the precise character of the transaction. To take a simple case, if the true bargain is that a capital sum shall be paid, the fact that the method of payment which is adopted in the document is a payment by instalments will not have the effect of giving to those instalments the character of income. Their nature is finally determined by the circumstance that the obligation is to pay a capital sum, and instalments are merely a method of effecting that payment. On the other hand, to take another simple case, where there is no undertaking to pay a capital sum and no capital obligation in existence, and all that exists is an undertaking to pay annual sums, those may, in the absence of other considerations, be annual payments of an income nature for the purposes of the Income Tax Acts. The operation of that distinction in individual cases may present some appearance of unreality. Nevertheless, it is a distinction which is now well-founded…’

Applying this analysis to the facts, Sir Wilfrid said that the true construction of the documentation before the Commissioners showed there was a covenant to pay the balance of £28,000 by annual payments of £5,600. In other words it was a covenant to pay a capital sum by instalments and not a covenant to make annual payments in the nature of income. The instalments were simply the means of liquidating a capital obligation and so were capital.

The case of Commissioners of Inland Revenue v 36/49 Holdings Ltd (In Liquidation) [1943] 25TC173 concerned periodical payments for shares the quantum of which was linked to the sales of the company concerned. The issue being whether the periodical payments were capital or revenue.

36/49 Holdings Ltd was an investment company that was incorporated on 27 January 1937 to acquire the whole of the issued share capital of a trading company, Rudge-Whitworth Ltd (R Ltd). The consideration being the whole of 36/49 Holdings Ltd’s authorised share capital.

By an agreement of 3 March 1937 with two other companies, the Gramophone Co Ltd (G Ltd) and E.M.I. Ltd, 36/49 Holdings Ltd sold their shares in R Ltd to G Ltd. The consideration included the sums of:

  • one shilling ‘without deduction’ for each non-mechanically propelled bicycle, and
  • £1 ‘without deduction’ for each motor bicycle

sold by R Ltd, G Ltd, E.M.I. Ltd, or any subsidiary company of those companies.

Payments under the sales linked clauses were to be accounted for and made quarterly, and were to continue ‘at all times thereafter’. G Ltd had the right under the agreement to commute future payments for a sum of £50,000 at any time between December 1938 and January 1949.

36/49 Holdings Ltd estimated the total amount receivable as consideration at £150,000 and the difference of £137,950 between this sum and the assets as previously shown in the balance sheet was carried to reserve and the greater part of it capitalised by the creation of unsecured loan stock which was distributed among 36/49 Holdings Ltd’s shareholders.

36/49 Holdings Ltd treated payments under the sales linked clauses as capital. The total sum received by November 1939 amounted to £142,048. In July 1940, 36/49 Holdings Ltd went into voluntary liquidation.

Directions were made for a number of years under the tax law applicable at that time such that 36/49 Holdings Ltd’s income was apportioned among its members.

36/49 Holdings Ltd contended that the directions should be discharged, but that, if they were confirmed, in computing 36/49 Holdings Ltd’s income for the purposes of apportionment, sums received under the sales linked clause should be excluded as capital.

The Special Commissioners confirmed the directions but discharged the apportionments on the grounds that the payments under the sales linked clause were receipts of capital.

In the Court of Appeal the Master of the Rolls, Lord Greene, explained why the receipts under the sales linked clause were income. Lord Greene said that the first thing to do is to look at the contract itself and obtain from it such assistance as it affords. The contract seemed to him on the face of it to mean what it says. Lord Greene said that the contract was for a sale of assets for a purchase price with two components:

  • one quite obviously of a capital nature, and
  • the other of a periodical nature.

By itself a periodical nature does not conclude the question. There are many cases in which periodical payments have nevertheless been held to be in the nature of capital payments. Where the purchase consideration is built up of two (or more) elements, the fact that some of the elements are of a capital nature does not determine that the periodical payments must also of a capital nature.

Lord Greene then considered in detail the terms of the sales linked clause. He said that the clause had some very remarkable features. First of all it was helpful to observe that the amounts to be paid under the clause are in effect an element of the total consideration attributable to the items of property of R Ltd upon which no value had been set elsewhere in the agreement. The items in question being goodwill, patterns, drawings, trademarks, patents and designs. It seemed to Lord Greene that the sum of one shilling per bicycle or £1 per motor bicycle was in the nature of a consideration for those elements in the assets of the company.

Lord Greene then observed that unless the right to commute was exercised, the payments go on in perpetuity. He found it very difficult to classify as ‘capital’ a perpetual payment. In the lower half of page 183 Lord Greene said it is difficult to see such annual payments as instalments of a capital sum:

‘The length of time during which a payment is to endure may be a very important factor in determining its character. It is obviously much easier to treat a payment which is only going to extend over two years as really a payment of purchase price by instalments, than it is to treat a payment which it is contemplated may continue in perpetuity. That characteristic of these particular payments appears to me to be one of substantial importance.

…The next point to observe about it is that the sums payable under this sub-paragraph are not tied in any way or related in any way to any special sum whatsoever. Indeed, regarding the payment as a payment which may continue in perpetuity, it seems impossible to say that it is to be regarded as payment by instalments of a capital sum. What is the capital sum? Not merely, therefore, is there no reference to or dependence upon any capital sum, but the very nature of the payments appears to exclude the idea that any connection with any such capital sum was ever present to the mind of anybody.’

Lord Greene thought it important that the disputed payments were related to turnover and that the right to commute was unilateral. The power of commutation did not relate the periodical sums payable on turnover to a capital sum. On the contrary, the matter was expressed in such a way that the capital sum is to be paid for the purpose of terminating a payment which is in its essence periodical and which unless terminated will go on forever. He summarised the position in the upper half of page 184:

‘It seems to me that all those factors, when taken together, stamp upon these payments indubitably an income character. I can find no element present which would justify me in attributing to them a capital character. Neither from the point of view of contract, the actual contract that the parties have made, nor from the point of view of any business or accountancy consideration, can I find any justification for saying that these sums are of a capital nature.’

The payments under the sales linked clause were therefore income and not capital.