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HMRC internal manual

Business Income Manual

Capital/revenue divide: intangible assets: profit making structure - more recent developments

The Van den Berghs (see BIM35530) line of cases has been revisited in two Special Commissioners’ cases. In the light of these more recent decisions Van den Berghs may be seen as something of a high water mark.

In the case of The Croydon Hotel & Leisure Company Ltd v Bowen [1996] SPC101 the company was formed to obtain a lease over land in Croydon, to construct and operate a hotel. Croydon Hotel & Leisure concluded a twenty-year management agreement with Holiday Inns Inc. to mange the hotel on its behalf. Croydon Hotel & Leisure came into dispute with Holiday Inns about the quality of management and the agreement was terminated on terms that Croydon Hotel & Leisure paid Holiday Inns £2 million. A new manager was appointed.

The Special Commissioners allowed Croydon Hotel & Leisure’s claim to deduct the £2 million as a revenue expense. The Commissioners used a degree of hindsight to establish the character of the agreement. The fact of termination did not cause any hiatus in Croydon Hotel & Leisure’s trading operations; another manager was engaged and trading carried on seamlessly.

There is precedent for such use of hindsight, see for example the Lord President’s comments in Barr Crombie & Co Ltd [1945] 26TC406 (on pages 410 and 411):

‘…the Special Commissioners were much influenced by the view which they took of the construction of the fourth article of the agreement. They appear to have considered that the concluding part of that article (which provides that in the event of liquidation the remuneration to be paid…will become immediately due…) determined…the character of the payment…and made it an income payment and not a capital payment. That view of the meaning and effect of article 4 was maintained in argument by the learned Counsel who appeared for the Inland Revenue, who also maintained that, because this article appeared in the original agreement at the inception of the relationship between these two companies, it must bear this meaning and have this effect, though it might have borne a different meaning and effect in an agreement specially contracted between the two parties upon the eve and in contemplation of liquidation.

…I take a different view…and I am further of opinion that the meaning of the article must be just what its meaning would have been if it had been part of a contract specially made with reference to an imminent liquidation…it appears to me that every fact in the case favours the view that the payment…was of the nature of a capital payment and not of the nature of a payment chargeable to income tax as annual profit.’

The fact that Croydon Hotel & Leisure’s agreement with Holiday Inns provided for the management of the company’s only asset did not stamp it as capital. You have to look at the results expected to flow from losing the contract. Is the trade itself threatened?

The case of A Consultant v H M Inspector of Taxes [1998] SPC180 dealt with the receipts side of ‘profit making structure’ cases. The taxpayer had a varied and successful career in business as an entrepreneur, during which he had been a director of a company involved in film and video distribution, and had also successfully invested in films. The taxpayer was invited to become a consultant for a US corporation, ‘Megabucks’, who had previously mainly been involved in music and wished to go into the film business. The taxpayer entered into a three-year agreement with Megabucks that provided for remuneration and a ‘back end participation fee’ equal to 10% of Megabucks’ profits from motion pictures distributed during a period. Megabucks had the right to buy out the taxpayer’s rights at any time for $3 million.

The taxpayer fulfilled his commitments to Megabucks earlier than expected and there was a mutual decision to terminate their relationship. In return for surrendering his rights under the agreement Megabucks paid the taxpayer $2 million. The taxpayer no longer had a ‘power base’ in the film industry and returned to England to his farm. The taxpayer subsequently decided to invest in another group of companies, of which he became a director.

The taxpayer argued that the consultancy agreement with Megabucks was the ‘whole structure of (his) profit-making apparatus’ within the meaning of Van den Berghs (see BIM35530), such that the compensation for its cancellation was a capital receipt. The Special Commissioner rejected this. Although subject to certain restrictive covenants the termination did not of itself prevent the taxpayer from continuing as a consultant in the film industry. In addition the taxpayer had continued in the consultancy field as a director of his own consultancy business. The termination of the Megabucks’ agreement did not terminate prematurely the taxpayer’s ability to continue as an entrepreneur in many fields of enterprise although the taxpayer voluntarily decided not to continue in the film business.