Management! What's Management?

Management! What's Management?

PETE MILLER of Ernst & Young reviews and comments on the decision of the Court of Appeal in Camas plc v Atkinson .

CAMAS WAS THE holding company of a listed trading group, whose activities included quarrying, manufacture of asphalts and concrete products for the construction industry and road surfacing and associated activities. Camas was an investment company within the definition at section 130, Taxes Act 1988, its main business being the holding of investments to produce income and capital growth, and was therefore entitled to claim expenses of management under section 75, Taxes Act 1988. Its income for the accounting period concerned, the year to 31 December 1995, was interest and dividends only.

The company's board decided that earnings growth could best be enhanced by acquisitions of companies operating in a similar market and had identified Bardon Group plc, another listed company, as a potential target. Bardon's market capitalisation was slightly less than that of Camas (£209 million against £232 million) so the acquisition would have almost doubled the size of the merged group.

During 1995, there were a number of meetings between officers of Camas and its advisers, followed by meetings of officers of both companies to discuss a merger. Both agreed that there was sound 'industrial logic' for such a merger and agreed to consider it further.

By late October, Bardon's share price had dropped and the Camas board came to the view that a takeover by recommended offer was preferable to a merger. External advisers were commissioned to carry out appropriate technical work and in December the board of Camas agreed to make a bid for Bardon. The terms were intended to be settled by a mixture of Camas shares and cash, described in the case report as '40 pence per Bardon share with a partial cash alternative'. The offer was conditional, subject to due diligence and investigation of potential synergies.

The companies had remained in touch throughout the process and the offer was made in the expectation that Bardon's board would recommend acceptance to its shareholders. However, in the event, the board rejected the offer as inadequate in value, noting that they were not convinced that the hoped for synergies would be achieved. The Camas board met and decided that they would not make an increased offer and making an unrecommended, hostile bid would be too uncertain. Therefore, the proposed acquisition was aborted.

Per curiam , in 1997 the two companies did get together to form Aggregate Industries.

Between March 1995, when Bardon was first considered as a potential target, and 21 December 1995, when the bid was aborted, Camas incurred professional fees of £583,495 in connection with this project. £73,800 was accepted as being tax deductible as the incidental costs of obtaining loan finance (then section 77, Taxes Act 1988). The remaining £509,695 was claimed by the company as expenses of management under section 75, but the claim was rejected by the Revenue and was, therefore, the subject of the instant case.

Expenses of management

Section 75, Taxes Act 1988 referred then to 'expenses of management', with no expansion as to the meaning of the individual words or of the phrase as a whole. Section 75 has been substantially rewritten in Finance Bill 2004 (see, for example, 'A Brave New World', Taxation , 17 June 2004 at page 298) but the essential core of it remains unchanged, referring to 'expenses of management' with no definition of the phrase.

Before the Special Commissioners, both Camas and the Revenue agreed that the primary question was whether the expenses concerned were an integral part of the cost of acquisition of Bardon or were severable from that acquisition. If the expenses were an integral part of the cost of acquisition, then they could not rank as expenses of management of the company, following Sun Life Assurance Society v Davidson (37 TC 330). Following the principles established in that case, however, if the expenses were severable from the proposed acquisition, they would be allowable as expenses of management.

The arguments for Camas were that the fact that the proposed acquisition was aborted demonstrated that the expenses were necessarily and self-evidently severable from the costs of acquisition. Furthermore, all the expenses had been incurred before a decision to acquire Bardon had been made. Therefore, the fees for financial and legal due diligence were incurred 'to enable the company's Board to carry out its management function of taking decisions' on such issues.

The Revenue argued, in contrast, that the costs of deciding whether to make an offer are integral to the proposed acquisition and that all the disputed expenditure, therefore, related wholly to the costs of acquiring (or rather seeking to acquire) Bardon.

The Revenue also argued that the costs were, in any case, precluded from being allowed by virtue of being capital in nature (also following an obiter in Sun Life Assurance ). The company's riposte was that there was no such exclusion in section 75.

Before the Commissioners

The Special Commissioners referred initially to Sun Life . In the House of Lords, Lord Reid had said that the expression 'expenses of management' involved ordinary words of the English language whose 'application in a particular case can only be determined on a broad view of all relevant matters'. The Special Commissioners therefore decided to review the facts, then see what light the decided cases could throw on the correct treatment of the expenditure.

The Special Commissioners found, as facts, that the expenditure was all incurred for what was referred to throughout as 'Project Bardon' and that the expenses were incurred, at least partly, to help the board to come to a decision as to whether to make an offer. They also found that those expenses were largely costs of the kind that any bidder would have to incur, as the shareholders considering an offer would need much the same information as the board of a company deciding whether to make an offer. Finally, they found (not that there was any dispute on the point) that the company had decided not to proceed with a bid for Bardon and so not to acquire it.

The Special Commissioners then considered the question raised by the Revenue of whether the expenditure by Camas should be disallowed on the basis that it was capital in nature and therefore not allowable as a tax deduction. In Sun Life , Lord Somervell had described expenses of management as 'apt to cover the expenses which would normally be deductible in respect of its life assurance business if an assurance company carrying on life assurance business was assessed as a trader'. But this did not establish some non-statutory principle that capital expenditure cannot qualify as expenses of management. Furthermore, the Special Commissioners in Holdings Ltd v Commissioners of Inland Revenue [1997] STC (SCD) 144, cited by the Crown in support of its position, had not decided that the capital/revenue test was a proper test of management expenses (although they had decided that the expenditure was not capital in nature). In fact, the ratio decidendi was that the expenditure concerned had been positively shown to be expenses of management.

In summary, the Special Commissioners found that there was no exclusion of capital expenditure from the scope of expenses of management, either in statute or decided cases. There is a specific rule only applicable to trades, professions and vocations, at section 74(1) (f) , Taxes Act 1988, and there is no parallel to that provision for expenses of management.

The Special Commissioners then turned to the related point as to why, if there was no barrier to capital expenditure being expenses of management, the costs of the investments themselves should not be allowable for tax purposes. They decided that such an approach would be 'inconsistent with the statutory scheme for imposing the tax charge on an investment company's income'. They cited the explanation of Lord Justice Romer in Simpson v Grange Trust Ltd (19 TC 231) that section 75 was intended to 'remedy the disadvantage of an investment company as compared with a trading company'. Thus, in the absence of a relief for expenses of management, an investment company would be taxed on its gross investment income without any relief for the costs of managing those investments. But to allow relief against the investment income for the investments themselves would be to deduct amounts not incurred in the production of the income.

Having disposed of capital expenditure questions, the Special Commissioners reverted to the main question. In Sun Life the expenses in dispute were stamp duty and brokerage charges. The Court of Appeal had held that these items were not expenses of management, but were part of the costs of acquiring the investments concerned. Lord Reid, for example, distinguished between the 'cost of acquisition' and costs 'severable from the acquisition which can be properly regarded as an expense of management'. This principle was not disputed and was the test agreed between Camas and the Revenue to be relevant to the instant case.

Counsel for Camas argued that there is a fundamental distinction between the 'mere mechanical transaction' of buying shares through a stock exchange, whereby stamp duty and brokerage fees are necessarily incurred, and the merger with or takeover of a quoted company, which has 'to be planned and implemented with great skill'. The Special Commissioners agreed with the distinction, but said that this did not necessarily sever the fees of accountants and other advisers from the costs of acquiring or seeking to acquire Bardon.

The company had given the Special Commissioners detailed information as to how the process of merger or acquisition worked and also as to the decision-making process required at board level. In particular, they accepted that the working on a potential offer is part of the decision-making process and must be carried out before an offer can properly and responsibly be made. On that basis, the Special Commissioners found that the costs of this work could not, therefore, be severed from the cost of making the acquisition and must be disallowed as expense of management on the basis of the Sun Life test.

On the company's final argument, that the costs must be severable from acquisition as the acquisition never took place, the Special Commissioners found that the character of the expenditure was the same and unaffected by the success or failure of the acquisition.

In the High Court

In the High Court, Mr Justice Patten considered first the Revenue's contention that section 75, as then formulated, did not permit deductions for capital expenditure. He found against the Revenue on this issue on a number of grounds.

• None of the decided cases in this area had been decided on any basis that capital expenditure could not be an expense of management. Indeed, referring to, inter alia , the stamp duty and brokerage fees in Sun Life , he noted that the cases would have been settled very swiftly if capital expenditure had been excluded, as such items were clearly capital in nature.

• The interaction of capital gains tax and section 75, particularly the closing words that exclude as expense of management anything deductible for the period against chargeable gains, made it clear to the judge that expenses of management can potentially include capital expenditure, in contrast to the contrary argument put forward by counsel for the Revenue.

Mr Justice Patten then reviewed the question of whether the expenditure constituted expenses of management, as severable from the costs of the (proposed) acquisition. He found that the Special Commissioners had misdirected themselves; they had found, as a matter of fact, that the expenditure had been incurred 'so as to enable the board of Camas to decide upon and prepare for the bid'. The judge found that the expenditure was therefore 'rendered to enable Camas to reach a decision as to whether or not to make an acquisition, and was therefore necessary and payable regardless of whether the purchase took place'. Hence, as expenses clearly severable from the acquisition itself, they should be allowed as expenses of management.

The Court of Appeal judgment

In the Court of Appeal, the leading judgment was given by Lord Justice Carnwath. He briefly reviewed the authorities and upheld the view of Mr Justice Patten, that the activities of the professional advisers in this case 'were all part of the process of managerial decision-making'. Counsel for the Revenue had argued that the costs in reaching a decision as to the type of acquisition to make would be allowable, whereas costs incurred with a view to making a specific acquisition would not. His Lordship could see no ground in the legislation or the authorities, or even in the ordinary meaning of the word 'management', for such a distinction.

His Lordship suggested that the Revenue's case might have been stronger if the proposed acquisition had 'moved out of the zone of contemplation — out of the sphere of the tentative, the provisional and the exploratory — into the valley of decision'. However, even then His Lordship said that the expenses of a less provisional (or more decisive) acquisition might have qualified as expenses of management. As he so ably put it, 'How one should categorise particular expenses in any such case must depend on the particular facts'.

On the question of whether capital expenditure can be an expense of management, His Lordship agreed with both the Special Commissioners and Mr Justice Patten, saying 'I see no reason to read words in the statute which are not there'.

He also noted that the Revenue's final argument, that to allow capital expenditure as an expense of management would be to grant investment companies a more favourable régime than trading companies, was 'beside the point'.

Decision for the taxpayer

(Reported at [2004] STC 860)

Camas succeeded in its contention that the expenditure incurred on an abortive acquisition were expenses of management, confirming the decision of the High Court.

I understand that the time limit for the Revenue to seek leave to appeal to the House of Lords has passed, so this case may well be final in the Court of Appeal.

Comment

The Revenue was evidently very concerned at the unanimous (so far) view that capital expenses are not excluded from being expenses of management. So much so, in fact, that that presumed exclusion is included in the new section 75, Taxes Act 1988, which now provides that 'expenses of a capital nature are not expenses of management…'.

The Revenue has published on its website specific guidance notes on this issue: 'Guidance for management expenses — Exclusion of capital expenditure: rules from 1 April 2004'. The initial guidance was quite robust in defence of the Revenue's stance on expenses of management but, since it has decided not to appeal this decision, revised guidance was published and the old version removed from the website. I have been asked by the Revenue if I would like to update my comments on the previous version of this guidance ( Taxation , 17 June 2004, page 298) and I am delighted to do so.

In the guidance, the Revenue sets out its view that 'Expenditure on appraising and investigating investments will in general be revenue in nature', but that 'the process of appraisal will eventually reach the stage where the company will decide which, if any, companies it is seeking to acquire'. It is this 'decision-point' that the Revenue now considers triggers the change from revenue to capital expenditure. This is an important amendment to the previous version, which said that capital expenditure starts, 'Once a target is identified and the company moves to the planning/negotiation stage'.

More importantly, the revised view makes it clear that the decision point differs on a case-by-case basis: 'Deals do not always progress in exactly the same way'. This less prescriptive approach is much more in line with the Camas judgments than the first version of the guidance. The point was made by Lord Justice Carnwath in the Court of Appeal when he said that, 'Neither the commissioners nor the judge thought that section 75 was so limited [ i.e. to non-capital payments only]. This made it unnecessary to consider whether any of the payments should be regarded as capital in nature'. In other words, neither the instant case nor any of the earlier cases were decided on the basis of the capital versus revenue position, so in none of them had it been necessary to consider whether the expenditure was capital or not.

The new approach recognises both the difference between different transactions and, by implication at least, between the modus operandi of different investors.

The Revenue's view on abortive investment expenditure also follows the same approach, as does its view on the costs of disposal. I read the new guidance as being much more in line with the decision in the case of Sun Life Assurance Society v Davidson 37 TC 330, where it was found that the primary question was whether the expenses concerned were an integral part of the cost of acquisition of the investment or were severable from that acquisition. If the expenses were an integral part of the cost of acquisition, then they could not rank as expenses of management of the company. While there may still be room for robust debate as to when expenditure becomes capital, rather than revenue, the revised guidance is helpful and far more commercial than the earlier version.

The Revenue has also amended its guidance in the area of unallowable purposes, to clarify the meaning of a 'business or other commercial purpose'. Previously, the guidance referred to investments held for a 'social or recreational purpose' as not qualifying. This is now expanded to point out that such expenditure would be allowable as expenses of management where the investment is made for the benefit of the employees of the business.

So, what about the expenditure in Camas ? The Revenue guidance says that 'It is necessary to look at the commercial effects of the expenditure rather than looking at its more distant purpose' (paragraph 7). On that basis, the commercial effect was to permit Camas to evaluate whether to bid for Bardon, with the 'more distant purpose' being the acquisition or merger. Indeed, one might even argue that the distant purpose was no more than the evaluation of the potential acquisition or merger.

More sensibly, the question under the new rules, following the guidance notes, will be; when was a decision made to acquire Bardon? Arguably, no decision to do so was ever made, but I suspect the Revenue would argue that the decision point was when the board of Camas decided to make a bid. After all, if the bid had been accepted, they would have been pretty much committed to the acquisition, subject, as always, to due diligence.

Overall, I think the new rules and the Revenue's sensible commercial stance in the revised guidance notes will go a long way to reducing the number of disputes with inspectors about expenses of management. That said, I would never be so foolish as to assume that there will be no such disputes in the future!

Other matters

The Special Commissioners raised a point, not raised by the Revenue, that the scale of the proposed acquisition of Bardon was such an 'extensive restructuring project' as to be, in the Special Commissioners' view, 'far removed from the company's existing business of holding one block of shares and three loans'. This point was, however, specifically not taken by the Crown in the courts.

Finally, the Special Commissioners and the courts were all referred to the Irish case of Hibernian Insurance Co Ltd v Macuimis ([2000] 2 IR 263). The decision in this case was that, for the purposes of the Irish equivalent of section 75, expenses of management could not include capital expenditure and, in any case, expenditure similar to that incurred by Camas was not expenses of management. The Special Commissioners noted that the decision in this case was in line with their reasoning and decision on Camas , while emphasising that their decision had been based wholly on United Kingdom law and authorities. In the High Court, Mr Justice Patten said that the reasoning in that case did not persuade him. And in the Court of Appeal, his lordship merely noted that he disagreed with that decision.

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