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HMRC internal manual

Business Income Manual

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Capital/revenue divide: intangible assets: payment to bind employee with a restrictive covenant

The cost of securing a lasting business advantage by buying out a competitor was found to be capital in the case of Walker v The Joint Credit Card Co Ltd [1982] 55TC617 (see BIM35510).

A payment to bind an employee under a restrictive covenant not to compete in the same line of business in various geographical locations was held to be capital in Associated Portland Cement Manufacturers Ltd v Kerr [1945] 27TC103. At the end of 1939 the (69-year old) managing director and another (60-year old) director were due to retire. Both had extensive knowledge of and contacts in the cement industry. Both would be free to set up in competition with the company. The company entered into agreements with directors where in exchange for payments of £20,000 to one and £10,000 to the other the retiring directors agreed not to compete with the company anywhere in the world. The £30,000 was included in the company’s profit and loss account under the heading ‘sundry special reserves’. At page 116 the Master of the Rolls, Lord Greene, discusses the role of accountancy evidence and the means used to finance a purchase in determining the nature of the expenditure. Accountancy is not determinative and how the purchase was funded is immaterial. What matters is whether the expenditure results in the acquisition (modification or disposal) of a capital asset:

‘On the question of whether an item of expenditure is of a capital or a revenue nature, it is no doubt helpful to consider the circumstances from the accountancy point of view. But one must be careful to define one’s terms. Whether or not an item of expenditure is to be regarded as of a revenue or capital nature must in many, and indeed in the majority of cases I should have thought, depend upon the nature of the asset or the right acquired by means of that expenditure. If it is an asset which properly appears as a capital asset in the balance sheet, then that is an end of the matter. But it must never be forgotten that, an asset which may properly and quite correctly appear and only appear in the balance sheet as an asset, may be acquired out of revenue. There is nothing in the world to force a company or a trader who buys a capital asset to debit the cost of it to capital. Conservatively managed companies every day pay for capital assets out of revenue if they are fortunate enough to have the revenue available. It is, therefore, no sufficient test to say that an asset has been paid for out of revenue, because the consequence does not by any means necessarily follow that it is an asset of a revenue nature as distinct from a capital nature. Similarly, there is nothing to prevent a company or a trader who has acquired a capital asset from refraining from placing any value on that asset in his balance sheet … I venture to think, therefore, when one is considering the nature of an asset acquired by a piece of expenditure, it is by no means conclusive to find that the asset does not have any definite value set upon it in the balance sheet.’

Lord Greene went on at page 117 and page 120 of 27TC to consider the nature of the asset acquired by the company:

‘What is the true nature of the asset which the company has acquired? It has acquired two choices in action, the benefit of two restrictive covenants against competition…for which it has paid a total sum of £30,000. The danger against which these covenants protected the company was serious and imminent. It would be quite wrong to allow oneself to think for a moment that the company was not getting its money’s worth. When these gentlemen left the board they were free to compete, not merely in Great Britain, but in Mexico, and indeed in the South Sea Islands. Against that danger the company has protected itself. What is the true business result of all that? When these gentlemen left the company the goodwill of the company would immediately have become extremely vulnerable. When the company had the monopoly of their services it was in a very advantageous position. As soon as they became potential competitors there was ground for thinking that the goodwill of the company would receive a serious shock. The risk of competition and damaging competition was great. The company succeeded in protecting itself against that risk. In effect the company was buying off two potential competitors. It seems to me that the effect of buying off potential competitors must of its very nature affect the value of the company’s goodwill…

As I have said, these benefits acquired by the company were solid; they were permanent; and they were world-wide. They protected the company against certain risks, and the value to be set on that protection was shown by the company itself in deciding to pay these amounts. No doubt it will be a disappointment to the company that they cannot crown their success in acquiring these solid advantages by passing on to the general taxpayer the privilege of paying for a large part of the expense so incurred.’

In deciding if the cost of obtaining a restrictive covenant is capital or revenue you need to look to the period during which the potential competitor is precluded from competing. You may accept that the cost of any restrictive covenant that secures a non-competition period of less than five years is not capital. The cost of securing a non-competition agreement for a period of less than five years will likely be less than the cost of a longer lasting arrangement. You need to satisfy yourself that the costs of any short-term agreement were incurred wholly and exclusively for the purposes of the trade. Where significant amounts are claimed in respect of short-term agreements there may be significant non-trading purposes in making such payments.