The Supreme Court has distinguished Mawson in its decision in HMRC v Tower MCashback LLP1. The Court held that first-year allowances were only available on part of the expenditure incurred by two LLPs to acquire software for significantly more than its market value. The remaining expenditure, which was financed by way of limited recourse loans from the seller, was not paid to acquire the software and so was not allowable. The importance of this case is two-fold. It illustrates the robust approach adopted by the Supreme Court to tax avoidance schemes and it emphasises the importance of having a commercial rationale when entering into tax-motivated transactions.
MCashback developed some complex software which it wished to exploit. In order to do this, it needed to raise finance which it sought to do by way of a structure devised by Tower Group plc.
The directors of Tower established four limited liability partnerships (LLPs). Wealthy individuals invested in two of the LLPs and each LLP used the individuals’ investment to acquire a licence over part of the software which it planned to exploit in conjunction with MCashback.
The individuals financed one quarter of their investment out of their own resources and borrowed three quarters under non-recourse loans. The way in which the loans were provided was an important feature in the judgment.
Expenditure issue
This form of financing is familiar in many contexts. The economic reality is that the individuals were at risk for only the 25% of the capital contributed from their own resources.
However, the partners claimed tax relief on the full 100% of the purchase price. The value of this relief, when set against income from other sources, would be sufficient to recoup their personal investment and provide a satisfactory return even if the business of the LLP was a total failure.
As a result, the individuals were not interested in the value of the software or its future returns. The seller (MCashback) was required to commit most of the sale price to securing the limited recourse loans but would obtain a cash injection (in this case around 17%) of the purchase price of the software.
The question before the courts was whether the individuals were entitled to first-year allowances on the 100% or 25% of the purchase price for the software licence. This boiled down to how much expenditure the LLPs had incurred on the software.
HMRC argued that even if the LLPs had spent 100% of the expenditure, only a quarter of this could be described as having been incurred on the software since the remaining 75% went round in a circle. The LLPs argued that they had spent the entire purchase price on the software, as evidenced by the fact that they owned the software.
The Special Commissioner considered that the individuals were only entitled to allowances on 25% of the purchase price. The High Court and the Court of Appeal disagreed and held that the individuals were entitled to first-year allowances on the full amount of the expenditure.
The question of whether the economic reality of the legal transaction undertaken must be taken into account for tax purposes has troubled the courts for 30 years since the decision in W T Ramsay Ltd v IRC [1981] STC 174.
The courts approach this question by purposively construing the legislation in question and applying it to the facts construed realistically.
The Ramsay line of cases includes two House of Lords decisions covering similar ground to Tower – Ensign Tankers (Leasing) Ltd v Stokes [1992] STC 226 and Barclays Mercantile Business Finance Ltd v Mawson [2005] STC 1.
In Ensign a partnership acquired the right to make and exploit a film. The partnership funded this purchase by borrowing approximately $11 million from the seller of the film under a non-recourse loan and by using approximately $3 million of its own money.
The loan was structured so that the seller made payments to a bank account in the name of the partnership and on the same day those payments were paid back to the seller ostensibly as payment of the production cost incurred by the seller. The partnership could not operate the bank account without the consent of the seller.
The House of Lords refused to accept that the partnership had incurred $14 million of expenditure. They considered that the loan was not in reality a loan; this was particularly since the seller was being repaid out of the profits of the transaction.
It followed that the payment back was not expenditure incurred on the film, and, as a result, the taxpayer had only incurred $3 million of expenditure on the film. Viewed realistically the partnership and the seller were investing jointly in the film.
Ensign differed from Tower, in that the Supreme Court refused to treat the loan to the individuals as anything other than a real loan.
The question in Tower was whether there was real expenditure on the acquisition of software rights. This is very similar to the issues raised by Mawson.
Mawson involved the sale and leaseback of a gas pipeline between BMBF and the Irish Gas Board (BGE). BGE’s obligations to BMBF were secured by a deposit placed at its parent, Barclays Bank plc. The source of the deposit was indirectly the sale price for the pipeline received by BGE.
HMRC argued that BMBF had not incurred expenditure on the pipeline as the seller could not get its hands on the purchase price. The House of Lords disagreed. Applying the tax rules in a purposive way, they considered that the relevant rule required consideration only of what BMBF had paid to acquire. The source of BMBF’s funds and the circular flow of funds was irrelevant.
Perhaps surprisingly, the Supreme Court managed to distinguish the facts in Tower from those in Mawson. Lord Walker considered that there were two key differences:
As a result, the Supreme Court held that the part of the purchase price which had been funded by way of a limited recourse loan was not expenditure incurred on the provision of software.
However, the 25% of the purchase price which was funded by the individuals was incurred on the provision of software, and as such, allowances were available on this amount.
Closure notice issue
The taxpayer also argued that the terms of the closure notices issued by HMRC restrict HMRC to raising a single issue (which HMRC had abandoned prior to the Supreme Court hearing). This argument did not succeed and is discussed in more detail in the article by Hartley Foster on page 23 of this issue of Tax Journal.
Why it matters
As a result of Tower being heard by seven Supreme Court justices, it appears that the Supreme Court did consider whether to overrule Mawson.
Supreme Court cases are only heard by such a large bench in limited circumstances. The only one which appears to apply to Tower is that the Supreme Court considered it may overrule a decision of the House of Lords (which is the predecessor to the Supreme Court). In fact, the Supreme Court affirmed that Mawson is the leading case in this area, but distinguished Tower on its facts.
The importance of Tower arises from what it tells us about the approach of the Supreme Court to tax avoidance. Tower is now the second tax mitigation case to be heard by the Supreme Court and HMRC has won both. What is striking is the robust approach adopted by the court.
For example, in DCC Holdings (UK) Ltd v HMRC [2011] STC 326, Lord Walker started his analysis by saying that the intention of the legislation was to give a symmetrical answer and then worked back to find the route which gave that result.
In Tower, the Court used Ensign as support for the denial of the claim for allowances without getting tied down in seeking to rationalise how it should distinguish Mawson.
The element of commercial unreality in Tower is however unusual. The other difference between Tower and Mawson is that in Tower, MCashback did not physically receive the purchase price whereas in Mawson the seller did receive the purchase price – albeit that it was under an obligation to immediately on-pay it. It is surprising if Tower should turn on such a small point.
So where does this leave those taxpayers who wish to mitigate their tax liabilities? While the Ramsay line of cases is not a broad spectrum antibiotic to combat tax planning, they do make such planning more difficult.
It is important for taxpayers to remember that the fact that they enter into planning which involves money moving round in a circle or steps being inserted for no commercial purpose is not fatal to the planning.
It all depends upon the nature of the underlying legislation. What this seems to mean is that tax motivated transactions which fall within the remit of the legislation can in principle succeed.
This view was supported by the Court of Appeal in HMRC v Mayes [2011] EWCA Civ 407; although HMRC have asked for leave to appeal this decision to the Supreme Court.
In most cases however, it will be vital to show that each step of the underlying transaction has a proper commercial rationale.
This is really where the taxpayer went wrong in Tower. The individuals were looking to make money from the transaction solely as a result of obtaining a tax benefit.
Had the individuals in Tower planned to get a return from the software, it appears that they may have been successful. Why the LLPs failed was the total disinterest in the assets they were buying, the value of those assets and the likely return which those assets would generate.
Chris Bates, Tax Partner, Norton Rose LLP
Judy Harrison, Senior Associate, Norton Rose LLP
Is a GAAR necessary?
Giles Goodfellow QC, Barrister, Pump Court Tax Chambers
The Court’s decision emphasises the importance of having credible valuation evidence to show that the expenditure is being incurred on the plant rather than the finance package. The use of limited recourse/vendor assisted loans to finance the purchase price has not been ruled out but there will be greater uncertainty as to what additional factors are required to prevent the expenditure being attributed to something other than the plant which is purchased. More broadly, the case illustrates the difficulty of distinguishing on objective grounds between tax avoidance and ordinary tax planning. One might also question the need for a GAAR, when no use is made of the statutory anti-avoidance provisions already available.
Consistent with Astall
Rupert Shiers, Partner, Herbert Smith
Tower MCashback is, on its face, consistent with the Court of Appeal decision in Astall that nonarm’s-length transactions without commercial importance may well be ignored or rewritten for tax purposes. Advisers suggesting that it increases uncertainty have taken an over-optimistic view of the meaning of BMBF. But it probably pushes the GAAR one step further away: as so often, the courts have not needed a GAAR to reach their chosen result.
A return to reality
Bill Dodwell, Partner, Deloitte
Tower MCashback started its judicial life before a judge with lots of commercial experience; Special Commissioner Howard Nowlan knew that capital allowances should not be awarded on non-recourse loans which funded a price well in excess of market value. The High Court and Court of Appeal judges found themselves hung up on a legalistic interpretation. Fortunately the Supreme Court returned to reality. Lord Walker said that the LLPs ‘… did not pay the borrowed money to MCashback to acquire software rights. Instead they put it into a loop as part of a tax-avoidance scheme.’ Ensign Tankers and BMBF both remain good law; we need to analyse the reality of the transactions.
The impact on avoidance
Jason Collins, Partner, McGrigors
Planning around prescriptive legislation or legislation which creates statutory ‘fictions’ will tend to succeed and it is HMRC’s responsibility to make sure its legislation does not contain loopholes. Where the legislation applies a broader approach, most artificial tax planning will fail. As the Supreme Court noted, all tax legislation will be pored over by ‘unremitting’ and ingenious tax advisers to see if it creates loopholes and this practice will continue to a lesser or larger degree whatever the outcome of any given tax avoidance case.
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