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HMRC internal manual

Business Income Manual

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HM Revenue & Customs
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Capital/revenue divide: intangible assets: building society demutualisation

What was the practical and business effect of the expenditure?

Why you should critically examine any claim that significant amounts of fees incurred on the structure or status of a company are revenue in character is explained at BIM35525. The Special Commissioners allowed the costs incurred by building societies in converting from entities within the regulatory regime imposed by the Building Societies Acts (BSA) and implemented by the then Building Societies Commission (BSC), now the Financial Services Authority (FSA), into banks under the Companies Acts and regulated by the Bank of England, now the FSA, in the following four cases:

  • Halifax plc v Davidson (SPC239).
  • Woolwich plc v Davidson (SPC240).
  • Northern plc v Davidson (SPC241).
  • Alliance & Leicester plc v Hamer (SPC242).

The decisions in each case were the same; the costs incurred were allowable deductions.

Each of the building societies concerned could trace their origins back to the nineteenth century. Traditionally building societies raised funds from their investing members, which were then lent to borrowing members to purchase their homes, so that the majority of customers were members of the society. In more recent times societies began to offer products and services that did not confer membership of the society, for example current accounts and non-secured personal loans. The societies had grown, merged and developed over the years into substantial institutions offering a wide range of financial products to their members and customers, extending well beyond the scope of their progenitors.

The BSC was created in 1986. Counsel for the societies described the BSA as firmly prescriptive in nature. Building societies are only able to do those things laid down in the Act and subsequent statutory instruments. In particular societies were subject to so-called ‘nature limits’ that restricted the source of funding and how it might be applied. The BSA and the BSC restricted the range of activities that societies could undertake and the speed with which they could react to their non-society competitors in the market place. From the early 1980s onwards the distinctions and boundaries between the building societies, banks and life assurance companies became less distinct. The diversification of activities imposed competitive pressures on the building societies to obtain the benefits of economies of scale and to reduce costs. The societies needed to broaden their access to cheaper forms of ‘wholesale’ funding. The tight constraints imposed by the BSA and the BSC limited the societies’ freedom to adapt to meet competitive pressures.

Each of the societies decided to meet the competition by converting from a building society into a plc. The conversion process required satisfactory completion of three separate stages:

  1. Approval by the BSC.
  2. Authorisation by the Bank of England.
  3. Stock Exchange listing.

The disputed expenditure arose from meeting the various requirements of these three bodies. The expenditure fell into the following broad categories:

  • staff and related costs,
  • literature/stationery/postage and mail,
  • communications and advertising,
  • legal and advisory,
  • share reorganisation/distribution, and
  • statutory cash bonus.

With the exception of the statutory cash bonus the sums were charged to the profit and loss account and accountancy evidence was adduced that this treatment was correct.

Counsel for the societies advanced a simple analysis that the proper approach involved two stages:

  1. first, take the figure of profits for the relevant year from the accounts (having satisfied yourself that the accounts have been drawn up in accordance with the ordinary principles of commercial accountancy practice), and
  2. second, make such adjustments to that figure as are required by any relevant statutory provision (in the societies’ contention the only relevant statutory provision was what is now S53 Corporation Tax Act 2009 (CTA 2009) (see BIM35002), which counsel said did not bite on this occasion).

The Revenue argued that the decision as to whether expenditure was capital or revenue was a matter of law and not a matter of commercial accounting practice. That in drawing a balance of profit or loss a comparison had to be made between incomings of a revenue nature with outgoings of a revenue nature, and that capital items should be excluded. The Revenue also argued that for expenditure to be capital there was no requirement to show that it resulted in an asset that appeared on the balance sheet.

The Special Commissioners accepted the Revenue’s arguments on the law but differed on the application to the facts. The Special Commissioners said that this was a borderline case (paragraph 176 of SPC 239) and so following Hallstroms (see BIM35045) the ultimate answer was to be found by ascertaining what the expenditure was calculated to effect from a business and economic point of view. The Special Commissioners decided (paragraph 184 of SPC239) that from a practical and business point of view, the expenditure on the conversion costs was calculated to effect a transfer from a restrictive regulatory regime to a more flexible regulatory regime. This was undertaken for the purpose of the societies’ trades. The new regulatory regime was not an asset owned by any of the societies because it was available to all companies incorporated in the same way as the societies. The business was carried on in the same way, and by the same people, before and after conversion. The advantage obtained by conversion was not a new asset but the ability to continue to trade in the same way but with fewer restrictions.

The Special Commissioners held that the statutory cash bonus (broadly speaking, a statutory sum paid to those members who had a share in the societies’ reserves but who did not receive shares as a result of the demutualisation process) was capital. The sum was treated in the societies’ accounts as a deduction from reserves, not operating profits. Accountancy evidence was given that this was proper treatment. The Special Commissioners found that relief was denied by what is now S53 CTA 2009, representing capital withdrawn from the trade.