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HMRC internal manual

Business Income Manual

HM Revenue & Customs
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Capital/revenue divide: intangible assets: profit making structure

Expenditure on the acquisition or cancellation of trade agreements is normally of a revenue nature. See for example Vodafone Cellular & Others v Shaw [1997] 69TC376 (BIM35585) where a lump sum payment made by a company to relieve it of an obligation to pay annual sums for a period under the terms of an agreement for the supply of know-how was held to be revenue. Similarly a receipt arising on the cancellation or variation of a trade agreement is normally of a revenue nature.

But where the contract is so fundamental that its loss would cripple or destroy the business it may transcend the status of an ordinary commercial contract. Income or expenditure arising on entering or leaving such a contract may be capital. As ever it is a question of fact and degree. The guidance below describes a number of cases that have come before the courts.

If the agreement is one the loss of which would cripple the trade, such expenditure may be capital. In Van den Berghs Ltd v Clark [1935] 19TC390 the company received a lump sum for the cancellation of a number of agreements that it had with a Dutch competitor, so-called pooling agreements. The payments and receipts under the agreements that the company had made or received over the years had been treated as trading deductions or receipts as the case may be. After the First World War long and costly arbitration as to the amounts arising during the period of hostilities were brought to an end by the Dutch company paying a lump sum as ‘damages’. Lord Macmillan drew attention to the fact that the payment was in consideration of the consent of termination of agreements and not in respect of a balance of profits (albeit the company had set the minimum price for consent at the amount that it claimed was due under the agreements). Lord Macmillan at page 431 said that the pooling agreements were not ordinary commercial contracts:

‘Now what were the appellants giving up? They gave up their whole rights under the agreements for thirteen years ahead. These agreements are called in the stated case “pooling agreements”, but that is a very inadequate description of them, for they did much more than merely embody a system of pooling and sharing profits. If the appellants were merely receiving in one sum down the aggregate of profits which they would otherwise have received over a series of years, the lump sum might be regarded as of the same nature as the ingredients of which it was composed. But even if a payment is measured by annual receipts, it is not necessarily in itself an item of income…

The three agreements which the appellants consented to cancel were not ordinary commercial contracts made in the course of carrying on their trade; they were not contracts for the disposal of their products or for the engagement of agents or other employees necessary for the conduct of their business; nor were they merely agreements as to how their trading profits when earned should be distributed as between the contracting parties. On the contrary, the cancelled agreements related to the whole structure of the appellants’ profit-making apparatus. They regulated the appellants’ activities, defined what they might and what they might not do, and affected the whole conduct of their business. I have difficulty in seeing how money laid out to secure, or money received for the cancellation of, so fundamental an organisation of a trader’s activities can be regarded as an income disbursement or an income receipt.’

In Kelsall Parsons & Co v CIR [1938] 21TC608, the company traded as manufacturers’ agents. The business began in 1914 with two agencies. One of which was for George Ellison Ltd. Over the years the Ellison’s agreement was renewed from time to time and on occasion the terms and conditions were modified. Other agencies were also acquired. Between 1930 and 1934 the company held between 9 and 11 agencies. The Ellison’s agency was the single most lucrative and at times yielded as much as half the company’s gross commission. The company received £1,500 compensation for the termination at the end of the second of a three-year agreement. The compensation was held to be a trading receipt.

At page 619 the Lord President, Normand, drew an important contrast between the contracts in Kelsall Parsons from the agreements in Van den Berghs:

‘That was a contract incidental to the normal course of the Appellant’s business. Their business, indeed, was to obtain as many contracts of this kind as they could, and their profits were gained by rendering services in fulfilment of such contracts.’

In Barr Crombie & Co Ltd v CIR, [1945] 26TC406 a ship manager received compensation for the early termination of a ship-managing contract. The Barr Shipping Co Ltd was formed in 1924 and owned a fleet of ships. Barr Crombie had an agreement with Barr Shipping to manage the latter’s ships. In 1942 and when the agreement still had some eight years to run, Barr Shipping cancelled it and went into liquidation. The agreement provided that in the event of the shipping company going into liquidation or ceasing to carry on business, the ‘remuneration’ to be paid in respect of the period from the date of liquidation until the date of expiry of the agreement was to become immediately due. The shipping company went into liquidation in November 1942 and some £16,000 was paid to Barr Crombie in respect of the 8-year period that the agreement still had to run.

During the period from 1924 to 1942 Barr Crombie’s income was derived as follows:

Managing Barr Shipping’s ships 88.23%
Managing other owner’s ships 1.78%
Sundry sources (for example interest) 9.99%

Barr Crombie lost almost its entire business apart from some temporary wartime ship management. Barr Crombie was forced to effect reductions in staff and salaries, to move to smaller premises.

The Special Commissioners held that the sum was remuneration under a service agreement and was a trading receipt. The Court of Session disagreed, finding that the compensation was a capital receipt. Lord President Normand, dealt first with the point that the sum paid was calculated by reference to remuneration that would have been earned (page 410):

‘That is not an agreement that a certain sum shall be payable as remuneration, but that a sum which would have been payable as remuneration, if the contract had taken its expected course, should become payable at the date of liquidation, although no services could thereafter be rendered…In short the remuneration contemplated by the agreement is used as a measure of the sum which would be payable as compensation if the carrying out of the agreement…became impossible by reason of liquidation…annual payments in the nature of profits may be used as a measure by which to calculate the sum to be paid, the resultant sum is not thereby made itself an annual payment or a profit.’

Yet again the method used to compute a sum did not establish the nature of that sum.

Normand goes on to consider the use of hindsight in determining the effect of the compensation for early termination provision in the agreement. He said that the meaning of the provision was just what it would have been if it had been part of a contract specially made with reference to an imminent liquidation; explaining at page 411:

‘The parties here were far-sighted and they foresaw the possibility of liquidation and made just such arrangements as might have been made later by other parties less far-sighted but willing to deal on a reasonable basis when liquidation became inevitable.’

Normand said that the payment was a capital receipt following the Van den Berghs decision and in contrast to Kelsall Parsons (at page 411):

‘It is, therefore, an entirely different case from Kelsall Parsons & Co…I regard the payment here as a payment made, in the sense of Lord Cave’s observations, “once and for all”, and received by the appellant company as the price of surrender of its only important capital asset. In Kelsall Parsons & Co, on the other hand, the payment was in return for the loss of a single agency out of about a dozen agencies carried on by the company, and the fact that the payment in that case did not represent the whole capital assets of the company is easily shown by the fact that in the year after the surrender of the single agency profits were no less than they had been the year before the surrender.’

And later (at page 412):

‘…where you have a payment for the loss of the contract upon which the whole trade of the company has been built, where the expected profits of the contract are used to measure the loss of them for a period of future years, and where in consequence of the loss the company’s structure and character are greatly affected, the payment seems to me to be beyond doubt a capital payment.’

Commercial agents regulations

The Commercial Agents (Council Directive) Regulations 1993 (SI 1993 No 3053) give effect to EC Council Directive 86/653/EEC. The Regulations extend agents’ rights, in particular they provide for a measure of ‘compensation’ on the termination of an agency. The regulations apply both to individuals and to companies.

‘Commercial agent’ for these purposes means an independent party, which has the authority to negotiate sales and purchases on behalf of or in the name of another.

Regulation 17 gives agents the right to payment when the agency is terminated. There are only limited circumstances where payment will not be due.

The Regulations set out two methods of calculating the termination payment:

  • the compensation method, and
  • the indemnity method.

These are simply methods of calculating the payment and do not determine its nature.

A receipt under Regulation 17 is for the cancellation of a trade agreement. Receipts for the cancellation or variation of trade agreements are receipts of the trade except in the class of cases within the Van den Berghs decision.