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Corporation tax deductions for abortive transaction fees

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A client company has incurred expenditure on due diligence costs for a proposed acquisition by way of merger which proved to be abortive. Will these costs be allowable for corporation tax purposes?


Legal and professional fees may not be allowable for corporation tax purposes under general principles, either because they are capital in nature or because they are not incurred wholly and exclusively for the purpose of the trade, or as qualifying expenses of management of a company’s investment business.
Trading companies
CTA 2009 s 53 (1) states that in calculating the profits of a trade, no deduction is allowed for items of a capital nature. Legal and professional fees relating to a company’s structure are generally capital, and this will usually include fees relating to company mergers, demergers and share reorganisations.
CTA 2009 s 54 states that a company is prevented from deducting expenditure in computing its trading profits unless it is incurred wholly and exclusively for the purposes of the trade. It is a question of fact whether expenditure is incurred wholly and exclusively for the purposes of the trade. Legal, accounting and other professional expenses are deductible or not according to the underlying reason for which they are incurred, whether or not the expenditure may prove to be abortive.
HMRC’s Business Income Manual (at BIM35325) confirms that: ‘Expenditure that would have been capital had it been successful does not change its character merely because in the event it is abortive.’
Therefore, if any deduction is to be available, it should not be on the basis that otherwise capital expenditure on due diligence work relates to an aborted merger.
This means that, in order for due diligence costs to be allowable for corporation tax purposes, a trading company will need to be able to demonstrate that the investigation of the potential transaction formed part of the company’s trade, and that the costs were not capital in nature. In the case of a merger these tests are most unlikely to be met.
Companies carrying on investment business
The rules on whether expenses are deductible for corporation taxes are different for a company that carries on investment business (as defined at CTA 2009 s 1218B). 
For such companies, a deduction will be available against the company’s total profits in an accounting period for the management expenses that relate to that period. Expenses of management of a company’s ‘investment business’ are those costs incurred in making investments and where the investments are not held for an unallowable purpose (CTA 2009 s 1219(2)). Capital expenses are not allowable (s 1219(3)).
Case law has established that the direct costs of investment transactions, such as stamp duties and brokerage fees, do not qualify as management expenses. HMRC’s guidance (Company Taxation Manual CTM08190) explains that when considering whether other costs relating to acquisitions and disposals qualify for relief as expenses of management it is necessary to consider whether the expenditure is an expense of managing the investment business and whether the expenditure is capital in nature.
The case of Camas Plc v Atkinson [2004] EWCA Civ 541 was decided at a time when there was no exclusion from management expenses for capital costs, so the only question that arose in relation to the costs in question was whether they were expenses of management or acquisition costs of the investment. The court concluded that expenditure does not form part of the acquisition costs until, at the earliest, the date of the decision to acquire the investment. Prior to that date the expenditure is generally preparatory to a decision to acquire and is not closely enough linked to the acquisition to form part of the acquisition costs. Also, expenditure does not cease to be on management simply because a target has been identified.
CTM08190 mentions that expenditure after a decision to acquire can still qualify as an expense of management if it is decision making expenditure and not costs of implementation of a purchase already decided upon.
CTM08260 confirms that expenditure on appraising and investigating investments will in general be revenue in nature. However, the process of appraisal will eventually reach the stage where the company will decide which, if any, companies it is seeking to acquire. Expenditure up to the point at which a decision is made to acquire a particular investment will generally be non-capital. Once the decision has been made then the expenditure is capital in nature and therefore disallowed by s 1219(3). In the context of a takeover, the making of any offer to the target company would suggest that a decision to acquire that investment had been made and any expenditure incurred thereafter would be capital in nature. Effectively, therefore, it appears that in the view of HMRC the test as to whether a cost is an expense of acquisition rather than of management and the test as to whether it is capital rather than revenue are one and the same.
This section of the manuals confirms again that an abortive acquisition or disposal is no different, in terms of the nature of expenditure, from a successful acquisition or disposal. If the expenses would be capital if the asset were acquired, they would not change their nature because the attempt to acquire it was unsuccessful. Therefore, the fact that a purchase or sale does not ultimately go through has no bearing on whether expenditure is capital or revenue.
Where does this leave us?
Trading companies and companies with investment business each must consider whether expenditure is capital or revenue in nature. For trading companies, it is also necessary to consider whether the expenditure is incurred wholly and exclusively for the purposes of the company’s trade; whereas for companies with investment business, the test is whether the expense is an expense of managing the investment business. Provided the company carried on an investment business, it is likely that costs incurred at least up until the point any offer in principle or any other more specific offer is made will be deductible as management expenses. 
Issue: 1337
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