8 July 2011

Capital allowances on software

The United Kingdom Supreme Court's judgment in Tower MCashback LLP1 v HMRC was reported in the latest Simon's Tax Cases. The nature of the case brought the Supreme Court back to analyse its judgment as the House of Lords in Barclays Mercantile Business Finance Ltd v Mawson (Inspector of Taxes) [2005] STC 1. The case involved two LLPs, where the members were individuals with large incomes who put up only 25% of the consideration paid for acquiring the rights in software. The remaining 75% was provided by interest-free loans on non-recourse terms, made to the investor members by Special Purposes Vehicles set up for the purpose.

The appellant partnerships were seeking capital allowance on the bits of MRewards technology they had purchased. As Lord Walker of Gestingthorpe put it, those familiar with the leading cases in this troublesome area of the law will not be surprised to hear that the LLPs rely strongly on the decision in Barclays Mercantile, and seek to distinguish the decision of the House of Lords in Ensign Tankers (Leasing) Ltd [1992] STC 226. Her Majesty's Revenue position was not precisely the converse in that they sought to distinguish Barclays Mercantile but did not rely particularly strongly on Ensign, while repudiating any suggestion that Ensign had been impliedly overruled by Barclays Mercantile (at paragraph 26).

The software was a system that MCashback had devised to enable manufacturers to promote their products to retail customers by offering them free airtime on their mobile phones. The manufacturers would pay MCashback a fixed fee per transaction. The software system was called "MRewards". MCashback needed funding to roll out the system. They approached Tower Group PLC, which had experience of arranging finance for similar software companies. The funding arrangement was for MCashback to sell part of its software by means of service level agreements to four newly created Tower LLPs, the members of which included Tower personnel and individual outside investors.

The LLPs acquired a right to receive part of the clearing fees derived from the exploitation of the MRewards. LLP 1 raised about £7,3 million and LLP 2 £27,5 million. Apart from the groups of participants, there were two banks involved in the transactions. The first bank held security deposits placed with it by MCashback, which it in turn deposited with the second bank Janus as security for a loan by Janus to Tower Finance Company.

The Tower Finance Company then made interest free nonrecourse loans to the individual investor members of the LLPs. It was intended that each LLP would raise 75% of the finance which it needed by way of bank borrowing, and that MCashback would be obliged to deposit approximately 82% of the consideration which it received for the grant of the licence as an indirect security for that borrowing. For those of our readers interested, Lord Walker gives a detailed discussion of the English authorities on artificial tax avoidance commencing at paragraph 41 and running through to paragraph 52. When the Special Commissioner considered the Tower MCashback scheme, he said that the scheme was not a sham but was preordained and designed as a composite whole.

For instance:

  • The market value of the software rights disposed of was materially below the price ostensibly paid for those rights.
  • There was little chance that the members loan would be repaid in full within 10 years; as much as 60% of the loans might be unpaid and waived at the end of that period.
  • There was no commercial justification for the insertion into the scheme of the two banks but the consideration paid by the LLPs was not paid partly for soft finance.

Accordingly, the critical issue which the Special Commissioner had to find on was whether it was appropriate to say that the capital expenditure had been incurred when the seller had filtered back 75% of the price to the investor members of the LLPs via the banking chain. Bearing in mind, the reality was that there was a great likelihood that a substantial proportion of the wholly un-commercial loans would eventually be waived and when, in the meantime any partial repayments of the loans was liable to be made on an entirely contingent basis. He said that looking at the transaction on a purposive basis it seemed to him that the investor members of the partnerships had incurred 25% of the total price and that they would incur further capital expenditure if and to the extent that the LLPs discharged the members loans on their behalf by the envisaged application of 50% of the clearing fees that they would receive.

Lord Walker said that the fact that the extreme unreality of selling the software rights in bits when they were parts of a closely integrated system designed for a specialised task emphasised the extreme unreality. Lord Walker criticised the judge in the Lower Court for treating the case as being essentially similar to Barclays Mercantile, and thought that it was wrong in law particularly overlooking the continuing validity of the decision in Ensign Tankers. While Her Majesty's Revenue had discarded the soft finance argument by the time the matter reached the Supreme Court, Lord Walker pointed out that an investor member did not incur expenditure of £300,000 on acquiring software rights, because only £50,000 of the money reached MCashback, and £225,000 went into a loop from which MCashback received no immediate benefit at all. If the future money were to flow back to MCashback out of the loop it would be because of its own commercial success in generating clearing fees. The crucial issue was that 75% of the capital raised, while not being simply a sham, was really being used to attempt to quadruple the investor members' capital allowances.

Lord Walker also went on to point out that one of the lessons of Barclays Mercantile is that it is not enough for Her Majesty's Revenue in attacking a scheme of this sort to point out that the money goes around in a circle. However, in Tower MCashback the borrowed money did not go to MCashback even temporarily, it passed straight to the bank where it produced no economic activity (except for a minimal spread for the two Guernsey banks) until the clearing fees would begin to flow from MCashback to the LLPs.

Lastly, Lord Walker was concerned that commentators would complain that the Court had abandoned the clarity of Barclays Mercantile and returned to the uncertainty of Ensign Tankers. He disagreed with this he said. Both are decisions of the House of Lords and both are good law. The composite transactions in this case like that in Ensign Tankers and unlike that in Barclays Mercantile, did not on a realistic appraisal of the facts meet the test laid down by the Capital Allowances Act of 2001 which requires real expenditure for the real purpose of acquiring plant for use in a trade. "Any uncertainty that there may be will arise from the unremitting ingenuity of tax consultants and investment bankers determined to test the limits of the Capital Allowances Legislation (at paragraph 80)."

Alastair Morphet

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