Expenditure in film financing arrangement not deductible trading expense

Practical Law UK Legal Update 5-504-7405 (Approx. 8 pages)

Expenditure in film financing arrangement not deductible trading expense

by PLC Tax

Background

Trading profits for tax purposes

The current categories of income subject to income tax include trading income (formerly, Case I of Schedule D).

Trading profits are calculated by deducting certain trading expenses from gross trading receipts for the relevant period. Subject to any specific rules to the contrary, you must calculate trading profits (and losses) in accordance with generally accepted accounting practice (GAAP). While the starting point is to calculate trading profits on the basis of accounting profits calculated using GAAP (subject to any statutory exceptions), the accounting profit must be adjusted for tax purposes (both for receipts and deductions).

When calculating your taxable profits, you cannot claim deductions for expenditure that is capital rather than revenue (section 33, Income Tax (Trading and Other Income) Act 2005 (ITTOIA 2005)). For expenditure to be deductible, you must incur it "wholly and exclusively" for the purposes of your trade (section 34, ITTOIA 2005).

For further information on the calculation of income profits for the purposes of income tax, see Practice note, Income tax: calculation of income profits.

Section 74 of ICTA 1988

For the relevant period, section 74 of the Income and Corporation Taxes Act 1988 (ICTA 1988) (section 74) applied to the calculation of the profits of a trade. It provided that in computing the amount of the profits or gains to be charged under Cases I or II of Schedule D, no sum was deductible in respect of:

Any disbursements or expenses, not being money wholly and exclusively laid out or expended for the purposes of the trade (section 74(1)(a)).
Any capital withdrawn from, or any sum employed or intended to be employed as capital in the trade (section 74(1)(f)).

The Ramsay principle

Over the last 30 years or so, the courts have explored existing legal principles to see how they could be employed to undo aggressive tax planning schemes. The first authoritative expression of principle was by the House of Lords in WT Ramsay v Inland Revenue Commissioners (1982) 54 TC 101, where it was held that, in determining the fiscal nature of a pre-ordained series of transactions, any steps inserted merely to avoid tax could be disregarded.

The House of Lords in MacNiven (Inspector of Taxes) v Westmoreland Investments Ltd (2001) 73 TC 1, introduced the notion that concepts included in statutory language could be classified as either "legal" or "commercial". However, in Barclays Mercantile Business Finance v Mawson (Inspector of Taxes) [2004] UKHL 51 (BMBF), the House of Lords stated that this was not intended to provide a substitute for a close analysis of what the statute means.

In BMBF and Inland Revenue Commissioners v Scottish Provident Institution [2004] UKHL 52, the House of Lords made it plain that, contrary to accepted thinking, there is no separate Ramsay principle at all. There is merely the rule that the provisions of a statute should be interpreted in a purposive manner "in order to determine the nature of the transaction to which [the statute] was intended to apply and then to decide whether the actual transaction (which might involve considering the overall effect of a number of elements intended to operate together) answered to the statutory description" (BMBF). In other words, Ramsay is authority only for the proposition that tax law is no different to all other areas of law: its statutes are to be construed by reference to all prevailing rules of construction, and not just formalistic rules.

For further information on the development of anti-avoidance case law from Ramsay to date, see Practice note, Anti-avoidance case law and tax: Direct taxes and stamp duties.

Facts

Icebreaker 1 LLP (Icebreaker) was established to conduct a film distribution trade. At issue was whether payments made by Icebreaker, which virtually equalled its entire capital, were deductible in computing the losses of its trade. The payments were made on 5 April 2004, which was its first day of trading and also the date that its accounting period ended.

On 5 April 2004:

Six individuals became members of Icebreaker, contributing capital totalling £1,520,000 of which £1,064,000 was funded by non-recourse loans from the Bank of Scotland (BOS).
Icebreaker licensed from Screen Partners Asset Management Limited (SPAM) rights relating to eight film and television projects (SPAM rights) for £46,950.
Icebreaker appointed Centre Film Sales Limited (Centre) as its head distributor in relation to the SPAM rights under a head distribution agreement (HDA). Icebreaker was required to meet a proportion of distribution and production costs and had the right to receive guaranteed annual payments, referred to as "certain payments" (see The principal terms of the HDA).
BOS issued an irrevocable standby letter of credit in favour of Icebreaker. This secured Icebreaker’s right to the first four certain payments under the HDA.
Icebreaker paid £1,273,866 to Centre pursuant to the HDA. £1,064,000 of this was paid into a blocked deposit account at BOS. This was charged to BOS to secure its obligations to Icebreaker under the letter of credit.
Icebreaker Management Limited (IML) agreed to provide advice and administrative services to Icebreaker under separate agreements (IML agreements). Icebreaker paid IML £120,000 for administration services and £50,000 for advice (IML fees).

On 16 August 2004, Icebreaker submitted its tax return for the year ended 5 April 2004, claiming a loss of £1,491,816. This represented the payments made by Icebreaker on 5 April 2004 (the £1,000 difference relating to a minor error concerning an audit fee). On 2 January 2005, the Inland Revenue (now HMRC) opened an enquiry into the tax return. On 2 May 2007, HMRC issued a closure notice reducing the loss relief claim to £11,900. Icebreaker appealed against the amendment.

The principal terms of the HDA

The HDA included the following provisions:

Icebreaker appointed Centre as its sole and exclusive distributor in relation to the SPAM rights for a term of ten years.
Icebreaker was required to pay specified costs relating to pre-production, post-production and exploitation of films met by Centre, which were defined as "exploitation costs". None of the specified costs related to the investment or deposit of monies for any purpose. Specifically, clause 2.4 required Centre to provide Icebreaker with copies of invoices for all exploitation costs, which Icebreaker should pay, and that "[Icebreaker] undertakes to pay an amount of £[ ] in respect of such Exploitation Costs to Centre immediately" on signing the HDA. The figure was blank in the HDA, but Icebreaker paid the invoiced sum of £1,273,866.
Centre was obliged to distribute and exploit Icebreaker’s distribution and exploitation rights (defined in the HDA) and pay receipts into a collection account.
Under clause 4.1, it was agreed that: "[i]n consideration of the rights and benefits obtained by Centre under [the HDA], Centre hereby undertakes and agrees to pay the Annual Advances and Final Minimum Sum to [Icebreaker] on" specified dates. The Final Minimum Sum was £1,064,000 payable at the end of the ten-year term (guaranteed by BOS). The Annual Advances were ten annual guaranteed payments equal to interest, at the BOS base rate, on £1,064,000. These payments are referred to as the "certain payments".
Put and call options, exercisable after four years, under which Icebreaker might sell its trade for an amount not less than £1,064,000.
Centre undertook to obtain bank security for its obligations relating to the payments required to be made under the HDA.
Centre would pay gross revenues from the distribution and exploitation rights into a collection account from which payments would be made to Icebreaker in satisfaction of its proportionate entitlement, calculated by reference to a formula.

First-tier Tribunal decision

On 5 January 2010, the First-tier Tribunal (FTT) ruled that:

£1,064,000 paid under the HDA was not a deductible expense as it was not incurred for the purposes of Icebreaker’s trade; it was incurred to obtain and secure the right to the certain payments. The FTT rejected Icebreaker’s argument that the effect of clause 4.1 was that the right to the certain payments was in return for the rights and benefits obtained by Centre (which, in the FTT, was assumed not to include any part of the payment of £1,273,866). Instead, the FTT focused on the right to the certain payments and the security arrangements that were put in place to ensure the payments were made. This rested on the FTT’s conclusion that all the parties knew that £1,064,000 had to be credited to the BOS blocked account and, therefore, was not available to be spent on film production or distribution. The FTT viewed it as “realistic” to match the payment with the rights that its application produced.
£174,866 paid under the HDA was capital expenditure incurred by Icebreaker on the production of the master negative of a film. Section 40A of the Finance (No. 2) Act 1992 treated this as revenue expenditure, but allowable only in subsequent accounting periods (by section 40B of that Act).
£35,000 was a prepayment made for film distribution purposes and only deductible in subsequent accounting periods.
£51,000 of the IML fees was for the acquisition of the Icebreaker structure and not deductible, either because it was a capital expense or because it was not incurred for the purposes of Icebreaker’s trade.
£90,000 of the IML fees was for past services and, therefore, deductible for the year ended 5 April 2004.
£29,000 of the IML fees was a prepayment for IML’s services and only deductible in subsequent accounting periods.

Upper Tribunal decision

The Upper Tribunal (tribunal) held that:

The £1,064,000 was not a trading expense within section 74(1)(a) of ICTA 1988 as it was not expended wholly and exclusively for the purposes of Icebreaker’s trade. However, the tribunal’s reasons differed from the reasons given by the FTT (see £1,064,000 not deductible trading expense).
The £174,866 and £35,000 were deductible as trading expenses under section 74(1)(a) (see £209,866 was deductible trading expense).
The entire payment made to IML for administration services was deductible. In particular, no part was disallowable as capital expenditure for the acquisition of the Icebreaker structure (see IML fees).
The entire payment to IML for advice was disallowed as a prepayment, but would be deductible in subsequent accounting periods (see IML fees).

Preliminary legal issues

Application of the proper construction of section 74 to the facts

The tribunal reviewed several decisions including Ramsay, Westmoreland and BMBF concluding that:

Section 74 must be construed purposively.
Section 74 must be applied to the facts, viewing those facts realistically.
Regard should be had to whether section 74 is concerned with commercial concepts (in which case elements of a transaction without any commercial purpose can be disregarded) or legal concepts.
In considering the purpose of a transaction, the terms of section 74 must be construed so as to determine from whose point of view the purpose is to be determined.

The tribunal ruled that section 74(1)(a) allowed a deduction for revenue expenses incurred by Icebreaker for the purposes of its trade. The focus was on Icebreaker’s trade and the ultimate use of the monies by the recipient was not relevant to determining the purpose for which the expenditure was made. The same was also true of section 74(1)(f). It was concerned with whether a sum is employed as capital in Icebreaker’s trade and not on the use made of the money by the recipient. This conclusion accepted Icebreaker's argument that section 74 required a determination of Icebreaker's purpose in making the payment, which had also been accepted by the FTT.

However, in determining whether the expenditure was deductible, it was necessary to apply that construction of section 74 to the facts "viewed realistically". This required a proper construction of all the agreements made on 5 April 2004.

Construction of the HDA

The tribunal ruled that there was clear evidence that the omission of the agreed figure was an oversight. The agreed figure was specifically referred to in a proposal sent to Icebreaker members on 4 April 2004. It was clear that the parties knew and intended that clause 2.4 was to contain the figure of £1,273,866. This kind of error did not require a rectification claim to remedy it.

Clause 4.1 expressly provided that the certain payments were paid in consideration of the rights and benefits obtained by Centre under the HDA. One of the rights and benefits was the payment it received under clause 2.4. Clause 4.1 overrode clause 2.4 (which provided that the payment was for exploitation costs), as "all the rights and benefits" included the right to receive the £1,273,866. Icebreaker had argued that, in return for the certain payments, Icebreaker granted to Centre the right to receive a proportion of gross revenues (based on a formula), a license over rights acquired from time to time by Icebreaker and an option to acquire Icebreaker’s business. However, while these rights and benefits were within clause 4.1, it did not follow that no part of the £1,273,866 payment was paid for the certain payments.

There was an inherent conflict between clauses 2.4 and 4.1. Clause 2.4 was expressed to be for exploitation costs (but did not say "only" exploitation costs) while clause 4.1 implied that the payment was for something more than exploitation costs. However, a proper construction of the HDA could not resolve the purpose of the entire payment.

Whether appropriate to apply the Ramsay principle

It was accepted that whether the expenditure was wholly and exclusively for the purposes of Icebreaker’s trade was a commercial, rather than a legal, question. Therefore, it was permissible to have regard to the commercial realities in deciding whether the payment was made wholly and exclusively for the purposes of Icebreaker’s trade. The tribunal held that the FTT's central finding of fact, that Icebreaker knew that £1,064,000 of Icebreaker's initial payment was to be paid into a blocked account at BOS to secure the certain payments, could only be challenged if it was a finding that no person acting judicially and properly instructed as to the relevant law could have come to. Not only did this not fall within that category, but the tribunal would have reached the same conclusion.

Specific issues

£1,064,000 not deductible trading expense

The tribunal agreed with the FTT's analysis of the transaction and conclusion that the payment was paid to secure the certain payments. The FTT reached this conclusion by looking at what Icebreaker paid the money for and not what Centre did with the money. The FTT was entitled to conclude, from the evidence, that Icebreaker never intended that the payment would be used for a film production or distribution trading purpose. Icebreaker knew that the sum would be deposited in the BOS blocked account in order to ensure that the certain payments would be made.

The tribunal agreed that the FTT was right not to rely on section 74(1)(f) in concluding that the payment was not a deductible expense. Without elaborating, the tribunal ruled that Icebreaker never intended to employ the payment as capital in its own trade, even though it intended Centre to employ the capital in its trade.

£209,866 was deductible trading expense

This sum was the balance of the £1,273,866 payment. The tribunal held that the FTT was wrong in concluding that £174,866 of the balance was capital expenditure and the remaining £35,000 was a pre-payment for film distribution. The FTT reached its decision by looking at what Centre did with the money, which as the FTT had accepted in relation to the application of section 74 to the £1,064,000, was the wrong approach.

There was no reason to suppose that, from Icebreaker's view point, the £209,866 was anything other than a payment for exploitation costs. The implication from clause 2.4 was that payment was for past exploitation costs. It was not appropriate to enquire as to whether the consideration for the payment was adequate or how Centre applied it.

IML fees

The tribunal held that the FTT had failed to take proper account of the provisions of the IML agreements and had instead, without evidence, substituted its own view of what the IML fees were for.

The IML administrative services agreement listed the services some of which had already been carried out while other services would be carried out after the date of the payment. There was no evidence that any part of the fees under this agreement was for establishing the Icebreaker structure.

However, the IML advice agreement expressly related to providing advice during the ten-year term of the agreement. Therefore, although a revenue expense, it was not deductible in the accounting period ended on 5 April 2004.

Accounting treatment

It was argued that section 42(1) of the Finance Act 1998 required Icebreaker's accounts to be drawn up in accordance with GAAP, and that the certain payments that Icebreaker would receive should have been reflected in the accounts, reducing the loss by £1,064,000. However, the issue was not determinative so it was not fully argued or considered.

Comment

The approach of the courts to applying Ramsay has changed in recent years. BMBF requires tax legislation to be construed purposively and applied to the facts viewed realistically. In some cases there might be only one way in which to look at the facts and the issue is how the statutory provisions apply to the facts. In other cases, the statutory provisions may be clear but the facts are open to different interpretations. Due to the flexibility that this approach gives to the courts (and the uncertainty this creates for the taxpayer), cases that concern the Ramsay principle will continue to be of interest, even if they do not create new law.

The tribunal had no difficulty in concluding that section 74 required it to consider what Icebreaker paid the money for and that what Centre did with the money was irrelevant. This was consistent with BMBF. In BMBF, the issue was whether the lessor bank was entitled to capital allowances under section 24(1) of the Capital Allowances Act 1990 (now section 11(4), Capital Allowances Act 2001) for expenditure incurred for the provision of an item of machinery or plant for the purposes of its trade. The House of Lords concluded that it was so entitled and that, since the statutory requirements were concerned entirely with the acts and purposes of the lessor, it did not matter what the lessee did.

The tribunal's approach to applying section 74 to the facts differed from that of the FTT. It is interesting because the tribunal's ruling that £1,064,000 was not deductible focused on construing the HDA, in particular, its conflicting provisions. This contrasted with the FTT's approach, which focused on the surrounding arrangements. One lesson to learn from this is that careful attention to the drafting of transaction documents remains of crucial importance.

Case

Icebreaker 1 LLP v Revenue and Customs [2010] UKUT 477 (TCC).

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Expenditure in film financing arrangement not deductible trading expense | Practical Law