Wholly and exclusively: duality of, or non-trade, purpose: non-travel topics: building society demutualisation
S54 Corporation Tax Act 2009 (CTA 2009)
Identify the purpose
In any case where the question of whether an expense claimed as a trading deduction satisfies the rules in S34 Income Tax (Trading and Other Income) Act 2005 for unincorporated businesses and S54 CTA 2009 for companies, it is important to establish the purpose which the taxpayer had in making the payment. For general guidance on establishing the purpose, see BIM37050.
The Special Commissioners considered this point when allowing the costs incurred by building societies in converting into banks in the following four cases:
- Halifax plc v Davidson (SpC239)
- Woolwich plc v Davidson (SpC240)
- Northern Rock plc v Davidson (SpC241)
- Alliance & Leicester plc v Hamer (SpC242)
The decisions in each case were the same: the costs incurred were allowable deductions. The guidance below focuses on the decision in Halifax but the essential facts and findings were the same in the other three cases.
The Halifax Building Society, whose core business consisted of making mortgage loans and accepting deposits under the regulatory regime imposed by the Building Societies Act 1986, converted to a bank, regulated by the Bank of England. On that day, the bank succeeded to all the properties, rights and liabilities of the building society’s core business including shares in various operating subsidiaries.
The conversion was achieved by the distribution by the building society of shares in the bank, which were listed on the London Stock Exchange, to members of the building society who were entitled to vote on the transfer (essentially its mortgage borrowers and depositors) and staff. Non-voting members received statutory cash bonuses in accordance with the Building Societies Act 1986 which required that the terms of a transfer of the whole of the business of a building society to a commercial company conferred on non-voting members a right to a distribution by way of bonus from the reserves of the building society equal to their share of the reserves. Such bonuses were liable to Capital Gains Tax in the hands of the recipients.
In its accounts for the period ending 31 December 1996, the building society made a provision for the advisory and other costs of conversion as an exceptional item of administrative expenses in the calculation of operating profit. The consolidated profit and loss account for the period ending 31 December 1997 showed an additional sum for conversion costs, again as an exceptional item of administrative expenses. The statutory cash bonuses were deducted from the bank’s carried forward reserve in the profit and loss account. The latter reserve comprised one of three items included in the liabilities shown in the consolidated balance sheet for the year ending 31 December 1997 under the sub-heading ‘equity shareholders’ funds’. The other two items were called-up share capital and share premium account.
Halifax sought to deduct the conversion costs and the statutory cash bonuses in computing its profits for tax purposes for the relevant periods.
The Revenue sought to disallow the full amount as a deduction on the grounds that:
- the costs and bonuses were not incurred wholly and exclusively for the purposes of its trade and were thereby precluded from deduction by what is now S54 CTA 2009 or
- they were capital expenditure and thereby precluded from deduction by what is now S53 CTA 2009
The Revenue contended that the expenditure was not incurred exclusively for the purposes of Halifax’s trade because it was incurred for other non-trade purposes, which included:
- benefiting the trades of Halifax’s subsidiaries and Halifax’s non-trading ‘holding company’ function
- securing a merger with another building society
- resolving a perceived conflict between the interests of customers who were members and customers who were not, and
- releasing value to members
Halifax contended, amongst other things, that the sole purpose of the conversion and consequently the expenditure was to benefit the trade of the Halifax and not to benefit any other companies in the group or the owners of the building society.
As regards the conversion costs, both Halifax’s accountancy witness and the Revenue’s accountancy witness agreed that, according to generally accepted accountancy practice (GAAP), such costs should be deducted from operating profit in the profit and loss account in reliance on the fact that no asset appeared on the balance sheet.
As regards the statutory cash bonuses, Halifax’s witness did not disagree with their treatment in Halifax’s accounts as a deduction from the profit and loss reserve but took the view that the alternative treatment of including those costs with the other conversion expenditure in the profit and loss account was acceptable since the recipients were not owners of the building society in commercial substance given that they did not enjoy a right to vote or an entitlement to free shares. The Revenue’s witness was of the view that the factor which determined ownership for the purpose of determining the correctness of the treatment was the right to participate in a dissolution.
The Commissioners found that the expenditure was incurred wholly and exclusively for the Halifax’s trade. What is now S54 CTA 2009 precludes the deduction of expenses not wholly and exclusively expended to serve the purposes of the relevant trade. To ascertain whether the payment had been expended to serve the purposes of the taxpayer’s trade it was necessary to discover the taxpayer’s object in making the payment.
The object of the taxpayer in making the payment fell to be distinguished from the effect of the payment, although the taxpayer’s subjective intentions were not limited to its conscious motives at the time of the payment. Consequences that were inevitably and inextricably involved in the payment would be taken to be a purpose for which the payment was made unless they were merely incidental.
In this case, the evidence as a whole demonstrated that the purpose of the expenditure was the wholly business purpose of obtaining a release from the constraints of the BSA regime. The benefits to Halifax’s subsidiaries and its holding company operation were effects or consequences of the decision to convert. Such benefits were neither real nor subconscious purposes of Halifax in incurring the disputed expenditure. Moreover, to the extent that the disputed expenditure had been incurred for the purpose of resolving the perceived tension between members who were customers and customers who were not members, that was a wholly trade purpose.
Furthermore, on the evidence, release of value to members was not a reason for the decision to convert. At most it was a factor that was taken into account by those who had to decide whether to recommend conversion. Nor was the expenditure incurred wholly or partly to secure the merger. Moreover, the payments of the cash bonuses in accordance with the Building Societies Act 1986 had also been made as part of the expenditure incurred for the purposes of conversion and consequently for the purpose of enabling the building society’s business to be conducted more effectively and were not to be disallowed on the grounds that they were not laid out wholly and exclusively for the purposes of the trade. Accordingly, the expenditure was allowable provided it was not of a capital nature.
The capital/revenue issue in building society cases is described at BIM35645.