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Replies to Queries - 4 - A tax 'nothing'?

21 August 2002
Issue: 3871 / Categories:

We act for a client who had a leased premises from where it operated. Due to a downturn in the economic conditions, it was decided to vacate these premises and agreement was reached with the landlord to pay him a lump sum in settlement of its ongoing liability to him.

We act for a client who had a leased premises from where it operated. Due to a downturn in the economic conditions, it was decided to vacate these premises and agreement was reached with the landlord to pay him a lump sum in settlement of its ongoing liability to him.

The Inspector initially claimed this was capital, quoting Tucker v Granada Motorway Services Limited [1979] STC 393 and subsequently Bullrun v H M Inspector of Taxes (SpC 248). He then went on to argue that there had been no enhancement to the asset and thus it was not even allowable to be carried forward as a capital loss. Therefore, he was saying there was no income or capital loss allowable in respect of this payment.

We have argued that if the company had not in fact reached agreement with the landlord, but merely vacated the property, an amount in respect of the future liability would have been accrued in the profit and loss account and would have been allowed for tax purposes. This would have been allowable both under Financial Reporting Standard 12 and the Herbert Smith case. The Inspector has accepted this point, but seems to think that there is a difference where the payment is actually made rather than accrued.

I should be obliged to have comments from readers.

(Query T16,063) - Jacky.

It is surprising that our tax system permits a deduction for keeping surplus premises but not for exiting them, but this comes down to the fundamental distinction between capital and revenue expenditure. Regular payments to maintain or service a capital asset are revenue and allowable; payments to acquire or dispose of a capital asset are capital and not allowable.

Unfortunately the Inspector is correct. The lease in question is a capital asset. Payments in connection with the disposal of a capital asset are capital in nature and cannot be deducted for corporation tax purposes. This is made clear by a long list of cases, starting with the Tucker v Granada Motorway Services case quoted.

It is difficult to see how a capital loss could arise. I assume 'Jacky' is trying to claim a deduction under section 38(1)(b), Taxation of Chargeable Gains Act 1992. It could be argued that the payment did enhance the value of the lease to the company (i.e. from a negative value to zero), but the legislation talks about incurring expenditure 'on' the asset and the expenditure being reflected in the asset at the time of disposal, which implies two different stages. In this case the asset does not change as a result of the payment - it vanishes altogether.

'Jacky' is correct to say that a provision for future lease payments would be allowable following Herbert Smith, but this is comparing two completely different legal and economic transactions. The Revenue cannot be asked to treat the company as if it had kept a lease when in fact it terminated it.

There is probably very little that 'Jacky' can do in respect of a historic transaction, although it may be worth reviewing the legal documentation to see if there is any scope for re-negotiation.

In future the problem could be averted in the following ways.

* Instead of paying, say, £1 million to terminate, pay £999,000 to reduce the term of the lease to, say, 1 week and £1,000 to terminate. The £999,000 payment to vary the terms of the lease would be treated as rent under section 34, Taxes Act 1988 and be deductible under section 87, Taxes Act 1988.

* Assuming that the landlord will look for a new tenant when the property is empty, enter into a sub-lease of the property directly to the tenant. The landlord could be appointed as agent to find a new tenant and to manage the new tenancy. Any loss on letting (i.e. between the rent received and the rent paid to the landlord) would be tax deductible.

It is understood that the Revenue is examining 'tax nothings' and some high level lobbying may well be appropriate to ensure that such discrepancies are eliminated in future. - ANA.

 

It is unfortunate, but one has to be taxed on what has actually happened, rather than on what the alternative available was. If the landlord has released the tenant from future compliance with his rental and repairing obligations, it was presumably in return for a discounted fixed sum which would have been different both as to certainty and as to quantum and timing from the series of payments which would have fallen due had the lease been allowed to run on. It follows that this constituted a capital transaction.

The form of the arrangement with the landlord has not been stated, but presumably resulted in a surrender of the lease. Within that general end result, the transaction could have been structured in a number of ways:

(1) a surrender under contract with the lump sum being paid as a pre-condition to completion;

(2) an assignment under a similar contract;

(3) an assignment for 'reverse' consideration; or

(4) a surrender by means of exchanging lease and counterpart coupled with a deed of release of the tenant's covenants in consideration of the payment of the lump sum to the landlord.

For capital gains tax purposes, each of these would involve a 'disposal' of the lease, but arguably only the second and third would involve the acquisition of the leasehold estate as such by the landlord, as opposed to the enhancement of the freehold reversion as a result of the 'extinction' of the leasehold. Thus while the method used might have different fiscal consequences for the landlord, as far as the tenant is concerned, there has still been a 'disposal' of the lease.

The question then arises as to whether section 38(1)(b), Taxation of Chargeable Gains Act 1992 permits the lump sum paid to create a loss of that disposal. Unless the transaction was in the third format, when the opening words of section 38(1) would be in point instead, the fact that the resulting entity would have had negative capital value without this payment cannot preclude the application of this statutory provision.

Five aspects of section 38(1)(b) then need to be considered.

* First, 'for the purpose of enhancing the value of the asset' - the critical issue here is that the disposal would not have taken place unless the landlord had been paid a lump sum for, in effect, releasing the tenant from the onerous covenants. Accordingly, the payment did enhance the value of the asset, albeit from a negative value to a 'nil' one.

* Second, 'expenditure' can, in the event of some formula having been used to calculate the total sum due, include a future payment or instalment not quantified by the date of disposal (see Clarke v United Real (Moorgate) Limited [1988] STC 273).

* Third, 'being expenditure reflected in the state or nature of the asset' - the elimination of the negative value by reason of the release of covenants (however achieved) changed the 'nature' of the asset. The speech of Lord Jauncey in Garner v Pounds Shipowners and Shipbreakers Limited [2000] STC 420 is also in point here.

* Fourth, 'at the time of disposal' - although the tax point will be the date of contract (if any), (subsequent) completion is a pre-requisite for there being a disposal to backdate: see Mr Justice Park in Jerome v Kelly [2002] STC 609.

* Fifth, 'incurred on the asset' - although no physical change in the asset resulted from the payment of the lump sum, the expenditure achieved a change in the tenant's obligations to the landlord, in the same way as takes place where a home owner pays a neighbour for the release of a restrictive covenant. The fact that the recipient of the payment was the acquirer of the asset (a proposition which is, in any event, technically open to question if the transaction has taken the form of a surrender) is neither here nor there.

In consequence, this seems an open and shut case, other than in the unlikely event of the third method having been used. Nonetheless, at head office level the Revenue is likely to be predisposed to treating the other three in the same way, and contend that the application of section 38(1)(b) should be subordinated to that fact that the opening words of section 38(1) do not encompass a situation in which there is a 'minus' price, even though this is not stated in terms. The problem that they would have to overcome (and might not be willing to concede without litigation) is that, at the end of the day, there is an estate duty authority which has been accepted for inheritance tax for the proposition that minus probate values can exist - see Re Brand [1945] N Ir 1 - and therefore leak into the capital gains tax system through section 274, Taxation of Chargeable Gains Act 1992. - JdeS.

Extract from reply by 'Man of Kent':

The lessee is thrall to the lessor to a degree that is incongruous in today's climate of tenant protection. He must perform covenants, pay money, guarantee rent due from any assignee, buy the landlord's permission for doing the least thing to the property, and either give it back repaired as new or fund the work needed - even if all concerned know it is to be demolished at once. The occupancy right emerges as a mere incidental.

Accordingly, the 'ongoing liability' should be analysed, and its nature agreed in writing between the client and the landlord. There can be few exchanges of property where the surveyor's report did not include some maintenance shortfall and, unless the client has done marvels of redecoration and upkeep (unlikely if trade was falling), most or all of the 'ongoing' could emerge as dilapidations (overdue repairs). In so far as it does, the payment relates to catching up on past wear and tear, i.e. the expense was incurred in the past, making it unarguably revenue. What little remains after identifying repairs would, presumably, be rent. The smaller this balance is, the smaller is the amount at stake and, thus, the effort the Inspector is prepared to devote to its pursuit, so the client should seek to agree the largest possible proportion as dilapidations.

Issue: 3871 / Categories:
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