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HMRC internal manual

Business Income Manual

Capital/revenue divide: intangible assets: release from an onerous agreement

The cost of entering, modifying or exiting a trade contract (for example for the supply of raw materials) is on revenue account. Where the contract is such as to come within the Van den Berghs decision (see BIM35530) then the cost is capital. Whether the contract is a revenue or a capital matter is determined by the facts at the date of payment.

In the case of Vodafone Cellular Ltd & Others v Shaw [1997] 69TC376 Racal entered into arrangements with an American company, Millicom Inc, to supply what was seen at the time as vital technological know-how to enable the company to set up and run a cellular mobile telephone network. The arrangements included a so-called ‘fee agreement’ under which the company agreed to pay Millicom 10% of its profits for a period of 15 years. To comply with the then Department of Trade and Industry’s requirements that no one company run a network and sell telephones to subscribers Racal formed two subsidiaries; the one to set up and run the system and the other to sell the telephones.

In the event Millicom’s technology was not required; alternative technology was acquired more cheaply elsewhere. The fee agreement became onerous. The company bought out the fee agreement for the sum of $30 million. The company sought a deduction on the basis that this was a trading expense.

Millett LJ at page 433A of 69TC listed the leading cases on the issues of whether a payment is capital or revenue and gave an up to date distillation of the factors you should take into account when considering capital/revenue issues:

‘Whether a payment is a capital or a revenue payment is a question of law; see Strick v. Regent Oil Co Ltd 43TC1; (1966) AC 295 per Lord Reid at 313 [see BIM35560]; Commissioners of Inland Revenue v. Carron Co. 1968 SC 47; (1968) 45TC18 per Lord Wilberforce at page 73 [see BIM35565]; Tucker v. Granada Motorway Services Ltd 53TC92; (1979) 1 WLR 683 per Lord Wilberforce at page 688 [see BIM35320]; Beauchamp v. F.W. Woolworth plc 61TC542; (1990) 1 AC 478 per Lord Templeman at page 492.There is no single test or infallible criterion for distinguishing between capital and revenue payments: see Van den Berghs Ltd v Clark 19TC390; (1935) AC 431 per Lord Macmillan at pages 438-439 [see BIM35530]; Commissioner of Taxes v Nchanga Consolidated Copper Mines Ltd (1964) AC 948 per Lord Radcliffe, at page 959 [see BIM35635]; Strick v. Regent Oil Co Ltd (supra) per Lord Reid at (1966) AC 295, at page 313. On the contrary, there are many factors which tend in one direction or the other, some of which are more relevant in some situations and some in others. Some factors are particularly relevant when the question arises on an acquisition and others are of particular relevance when the question arises on a disposal, as it does in the present case.

Two matters are of particular importance: the nature of the payment; and the nature of the advantage obtained by the payment. The fact that the payment is a lump sum payment is relevant but not determinative. In a case such as the present, where the payment is made in order to get rid of a liability, a useful starting point is to inquire into the nature of the liability which is brought to an end by the payment. Where a lump sum payment is made in order to commute or extinguish a contractual obligation to make recurring revenue payments then the payment is prima facie a revenue payment.’

At page 433I of 69TC Millett LJ drew attention to an important exception; stressing that where the payment secured the modification or disposal of an identifiable capital asset then it was a capital payment:

‘But the principle that a payment made in order to commute or discharge a liability to make recurring revenue payments is itself a revenue payment is subject to an important qualification. If the liability to make recurring revenue payments is reduced or brought to an end by the modification or disposal of an identifiable capital asset, then any payment made for the modification or disposal is itself a capital payment.’

At page 434E of 69TC Millett LJ rejected the Crown submission that the fee agreement was itself a capital asset:

‘The Crown submits that the fee agreement was a capital asset. I do not accept this submission. The fee agreement was certainly not a balance sheet item, and in my opinion it was no more a capital asset than was the agency agreement in Anglo-Persian Oil Co Ltd v Dale (see BIM35505).

It is obvious that not every contract under which a liability to make revenue payments arises is a capital asset for this purpose, or the general principle that payments to get rid of revenue liabilities are revenue payments would be entirely subsumed in the exception. It is only where such a contract is one the cancellation of which would effectively destroy or cripple the whole structure of the taxpayer’s profit-making apparatus that it falls to be treated exceptionally as a capital asset. This was the case in Van den Berghs Ltd v Clark (see BIM35530) where the taxpayer received a capital sum for the cancellation of the contracts which comprised the whole or virtually the whole of the taxpayer’s business.

The Crown submits that the fee agreement was (or at least was originally thought to be) fundamental to the taxpayer’s business. It formed an integral and essential part of the arrangements made to establish the business of the taxpayer and its subsidiaries in 1983. Without the know-how to be supplied by Millicom the telephone network could not be operated successfully. The business was in the forefront of high technology, and technological know-how is central to such a business.

In my judgment the submission fails on two grounds. In the first place, the question whether a payment is capital or income must depend on the circumstances at the time when the payment is made. In the present case this requires the fee agreement to be considered in the light of the circumstances in 1986. By then it was certainly not regarded as central to the business, but as a liability. In the second place, while it was admittedly not a contract for the disposal of the taxpayer’s products, the fee agreement was in my opinion an ordinary commercial contract made in the course of trade for the acquisition of future intangible material believed to be necessary for the carrying on of the trade…

High technology, particularly in modern times, is quickly obsolete. Expenditure to acquire future know-how is paid to obtain a service; it is not made to acquire an enduring asset, but a commodity which is turned over or exploited in the course of trade at a comparatively early date. It appears to me to have the characteristics of circulating rather than fixed capital and to represent an ordinary operating cost.

The principles derived from the foregoing survey of the authorities are sufficient to satisfy me that the fee agreement was not a capital asset, that it was a liability but only because it was likely to entail a heavy drain on the annual income of the taxpayer, and that by cancelling it the taxpayer did not obtain “an enduring benefit” for its trade in the sense of which that expression is used in this context. It obtained a reduction of its annual revenue expenditure but nothing more. It follows in my opinion that the payment of $30m by which it obtained that reduction was a revenue payment.’

You should note Millett’s emphasis on considering the facts at the time when the payment was made. You should also note that in a high technology context Millett saw the acquiring of know-how as more akin to the obtaining of a service than the acquisition of an enduring advantage. It remains a question of fact to be decided from examination of the evidence in particular cases whether what has been acquired is an enduring advantage or a service.