BIM35315 - Capital/revenue divide: general themes: recurrence: payment for a partner’s share in firm
As explained in BIM35305 - BIM35310, a capital sum remains capital expenditure notwithstanding that it is paid in instalments. In Commissioners of Inland Revenue v Mallaby-Deeley and Another [1938] 23TC153 and in CIR v Adam [1928] 14TC34 (see BIM35305) the amount of the lump sum was known in advance. In the cases discussed below the amounts to be paid were fixed by future events. In one case (Commissioners of Inland Revenue v Ledgard [1937] 21TC129) the sums paid were held to be capital and in the other (Commissioners of Inland Revenue v Hogarth [1940] 23TC491) they were not.
Ledgard and Hogarth were concerned with whether partners were entitled to extend their basic rate bands for surtax purposes for the payments they were making to former partners. The issue was determined by whether those payments were capital or revenue. Neither case concerned the question whether the partnerships were entitled to a deduction for such payments in computing the amount of their trade profits, but they are useful for the insight that they give to the importance of the facts in cases that appear on the face of things to be very similar.
In the Ledgard case the surviving partners claimed to deduct from their total income the cost of buying out a deceased partner’s share.
The taxpayers were members of a firm of architects consisting of four partners. The partnership deed provided (inter alia) that the purchase money for the share of a deceased partner should be such a sum as his personal representatives and the surviving partners might agree upon and, failing agreement:
‘a sum equal to one half of the share of profits for three years commencing from the first day of the month immediately following the death of such partner which would have been payable to such deceased partner had he continued to be a partner during those three years.’
The decision of the firm’s auditors for the time being as to the amount of the purchase money payable was to be final and binding on all interested parties, and no payment on account of such purchase money was to be required until it had been actually ascertained unless the remaining partners were willing to make payments on account.
One of the partners in the firm died in June 1933, and the others, who were his executors, arranged that the purchase money for his share should be a sum equal to one half of the share of profits for three years from 1 July 1933, which would have been payable to him if he had continued to be a partner. Sums calculated on this basis for the periods ended 31 December 1933 and 1934, were paid (under deduction of income tax) to the personal representatives of the deceased partner.
The surviving partners contended:
- that in computing their total income for surtax purposes for the years in question they were entitled to deduct their respective shares of the sums so paid, and
- that the said sums were annual payments and not instalments of a (fixed) capital sum.
The surviving partners said that the amounts paid were not capital because there was no previously quantified or fixed sum. The sums which had to be paid for the deceased partner’s share were to be fixed by reference to the profits of the partnership for the three years following the death of the deceased partner and could not be known in advance.
In the High Court, Lawrence J held, that the sum payable in respect of the deceased partner’s share in the business, though calculated on an income basis, was a single capital sum to be paid at the end of the three years when ascertained, and that the surviving partners were, accordingly, not entitled to the deductions claimed.
Lawrence J dismissed the argument that the sum could not be capital because it was not known in advance saying at page 135:
‘…it is erroneous to say in this case that this is not a capital payment because the purchase money for the deceased partner’s share is to be dependent upon what the profits of the business are for the three years succeeding the death of the deceased partner. It is, I think, a fairly common method of arriving at the value of a share in a business, a large part of which share is dependent upon goodwill, to ascertain the value of that share by reference to the profits of the business over a certain term of years. In my judgment that is what was done in this case.
… I hold upon the construction of this partnership agreement that it was not a lump sum to be paid by instalments, but was a lump sum to be paid at the end of the three years, when it had been ascertained by the auditors.’
By way of contrast to Ledgard, the Court of Sessions in Hogarth found that the payment of a proportion of net profits over a three-year period to a retiring partner was not capital.
In 1934 one of the partners of the firm of which Hogarth was a member became seriously ill and was unable to attend to the business. In the absence of a provision for retirement in the partnership deed, an agreement was concluded in January 1937, under which the partner retired as at 31 December 1936, and
‘in full settlement of his whole share … in the capital, assets and profits of the business’
he was to be paid, inter alia
‘a sum equal to one-fourteenth part of the net profits of the business for the three years ending 31 December 1937, 1938 and 1939, under deduction of income tax’.
The retiring partner died on 12 February 1937. Certain payments were made to his representatives under the agreement, including an item paid in May 1938 of £2,389 representing, after deduction of income tax, 1/14th of the net profits of the business for the year to 31 December 1937.
Hogarth claimed his share of the gross sum corresponding to this net payment as a deduction in the computation of his income for surtax purposes for 1938-39.
It was contended on behalf of the Revenue that under the head of the agreement providing for the payment in question one sum only was payable and that this sum was a capital sum in respect of which no deduction was due.
The Court of Session held, that the payment was an admissible deduction for purposes of surtax, as claimed by Hogarth.
The Lord president, Normand, distinguished Ledgard. The Lord President said that in Ledgard the partnership agreement stipulated that a deceased partner was to be paid such amount as the remaining partners and the personal representatives might agree. Only failing agreement was there provision for payment of half the profits for the three years following death. In Hogarth the agreement specified a share of profits for each of the three subsequent years. In Hogarth the agreement specified that each of the three payments was to be paid under deduction of tax. In Ledgard the agreement was silent as to the deduction of tax from the single payment envisaged. In summary the payment in Ledgard was for the acquisition of an asset but in Hogarth it was simply an annual payment. Lord Normand explained at page 501:
‘It resembles the present case in this respect, that it was a transaction between an outgoing partner and the remaining partners in a firm. But although it has that resemblance, yet the whole matter was dealt with on a different footing from the footing on which the partners proceeded in the present case; for there the partnership deed contained a provision that when a partner was going out of the firm the purchase money for the share of a deceased partner should be such sum as his personal representatives and surviving partners might agree upon and failing agreement a sum equal to one-half of the share of profits for three years commencing from the first day of the month immediately following the death of such partner which would have been payable to such deceased partner had he continued to be a partner during these three years. Accordingly there again it was typically a vendor and purchaser agreement for an asset and although the sum to be paid was to be measured by the fluctuating profits of three years it was nevertheless the price for that asset. I think that that is an important difference when the circumstances of the present case are compared. Again, in Ledgard’s case, there was no express stipulation for the deduction of income tax though in fact it appears that income tax was, rightly or wrongly, deducted. And, lastly, in Ledgard’s case, the learned Judge who decided it held on the construction of the agreement that the sum payable was a single sum payable at the end of the three years though in fact the parties had made annual payments.’
Lord Moncrieff having examined the documentary evidence concluded, although the partnership agreement was not clearly worded, that the balance of evidence pointed to the payments being revenue. The retiring partner had departed on grounds of ill health and the departure terms were something of a compromise. On balance Lord Moncrieff inclined to the view that the instalments represented a share of profits and not instalments of a capital sum, saying at the end of his judgment on page 504:
‘This seems to me much more like a continuing income right calculated upon the income right of the past, although limited for a period of years, than like a single capital payment measured by similar income instalments over the first three years following on his retiral.’