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HMRC internal manual

Business Income Manual

Wholly and exclusively: expense of earning or application of profits?: technical assistance in return for a share of profits

S34 Income Tax (Trading and Other Income) Act 2005, S54 Corporation Tax Act 2009

An expense computed by reference to profits is not necessarily a distribution out of profits

Normally you should not disallow a payment simply because it is measured by profits. The method of quantification does not fix the character of the payment. You need to get to the bottom of the arrangements so as to ensure that you do not confuse form and substance. What may appear on a superficial examination to be a distribution of profit may well be a genuine expense - for example, a performance-related fee. The reverse may be equally true.

In the case of British Sugar Manufacturers Ltd v Harris [1937] 21 TC 527, the company entered into an agreement with the Skoda Works in Czechoslovakia to pay for technical advice on the use and operation of the plant required to process sugar beet. British Sugar also entered into an agreement with British & Allied Investments Corporation Ltd (Skoda’s UK financial agents) for office accommodation and staff and general financial advice. The payment to the two companies was to be 20% of the net profit before depreciation. Skoda and their agent were to apportion the sum between them by agreement.

The Special Commissioners decided that the payment was a distribution of profits and so not an allowable deduction.

The High Court, with some reluctance, agreed.

In the Court of Appeal, the Master of the Rolls, Sir Wilfred Greene, explained that the method of computing the payment to Skoda did not convert what was a trading expense into a share of profit. The payment was therefore allowable. The Master of the Rolls explained that there is difference between:

  • a contract that simply provides for payment of a share of profits, and
  • a payment of remuneration that was calculated by reference to profits and is deductible for tax purposes

The distinction in some cases may be very difficult to draw. In this particular case, the payment was a deductible expense and not a share of profits. To make the distinction it is essential that you fully of establish and understand the underlying facts.

The part of Sir Wilfred Greene’s judgment on which the above guidance is based is set out below:

`Now the matters to be observed in this case, I think, are, first of all, the nature of the work that is being done. The nature of the work that is being done is what one may succinctly describe as ordinary management work or ordinary advisory work in respect of technical matters. The next point to observe is that what is referred to as “net profits” is a figure to be arrived at upon a conventional basis, not the basis upon which the Company would ascertain its profits for commercial purposes nor the basis upon which it would ascertain its profits for Income Tax purposes, although, speaking for myself, I think that the latter consideration is not one of any importance. But it is an important factor to be considered (although I agree not necessarily in any individual case conclusive) that the fund of so called “profits”, to 20 per cent of which the companies are to be entitled for their services, is a fund ascertained by means of a conventional account between the parties.

Now, bearing all those things in mind, the question arises: on which side of the line does the case fall? I quite accept the proposition that there is a line between a contract for payment of a share of profits simpliciter and a payment of remuneration which is deductible in truth before the profits divisible are ascertained, and that line in some cases may be very difficult to draw…

Now in the present case there is nothing approaching a purchase of a share of profits in that sense. It is not cash that passes in exchange for these profits; it is services, and the badge of such a contract is remuneration for services, and, therefore, the first thing that this remuneration would certainly not be is a share of profits purchased by the employee. Again I quite accept the proposition that the mere circumstance by itself that services are rendered may not be conclusive. I can conceive of a case where a person contributes services to some sort of joint adventure, while others contribute perhaps capital, land, plant and goods, arranging between themselves (it may be something short of a partnership) that nobody shall get anything until the pool of profits is ascertained, and then they shall divide it up between them in specified proportions. That, it seems to me, would be a real agreement for division of profits, because there would be one profit fund only. There would not be two “profit” funds to be ascertained for different purposes. There would be one profit fund, and nobody would have any interest in anything until that profit fund was ascertained and fell to be divided, but, in the present case, that is not the fact. In the present case there are two funds of so-called “profits” which come into the picture. The first one is the fund which has to be ascertained for the purpose of calculating the 20 per cent. In that fund as such, the persons entitled to the profits of this Company, namely, the shareholders, have no concern. It is used for the purpose, and for the purpose only, of ascertaining what is to be paid to the Skoda Works and to the Corporation. Now when that amount has been ascertained, that fund has ceased to have any usefulness at all, and it then becomes necessary to ascertain what are the divisible profits and, for that purpose, to take another account, and the account that is taken then would be an account which not only would bring in depreciation (or, as they did here, would bring out a figure expressed to be subject to depreciation), but would also take into account the sum that had been paid out to the Skoda Works and the Corporation upon the taking of the first account. It seems to me that the circumstance that those two accounts have to be made out throws a very clear light upon the real nature of this transaction, and, looking at the clause in question as a whole, it seems to me clear beyond any reasonable doubt that the agreement is merely an agreement under which, before ascertaining the divisible profits of this Company at all, the Skoda Works and the Corporation are to receive, upon a particular conventional basis, a commission sum as remuneration for their services. When that has been said, it appears to me that it brings the case within a very familiar category.’