BIM35600 - Capital/revenue divide: intangible assets: compensation for sterilising an asset

The treatment of sums paid (or received) for refraining from carrying on trade operations depends on the circumstances of the payment, the nature of the asset and of the trade. If the compensation derives from a capital asset then it will be capital; if from a revenue matter, then the compensation will be on revenue account.

In the case of The Glenboig Union Fireclay Co Ltd v CIR [1922] 12TC427 a railway company took legal action to prevent the extraction of fireclay from beds under its track. The action was unsuccessful and the railway company paid the fireclay company a sum of money to refrain from working under the track to ‘sterilise’ that particular asset.

The Special Commissioners determined that the sum received by the fireclay company was a capital receipt and not taxable as a receipt of the company’s trade. The courts agreed.

Lord Wrenbury explained the decision at page 465:

Was that compensation profit? The answer may be supplied, I think, by the answer to the following question: Is a sum profit which is paid to an owner of property on the terms that he shall not use his property so as to make a profit? The answer must be in the negative. The whole point is that he is not to make a profit and is paid for abstaining from seeking to make a profit…It was the price paid for sterilising the asset from which otherwise profit might have been obtained.

You should recognise that the asset in Glenboig was a capital asset, the fireclay bed. Glenboig did not trade in fireclay beds.

Where the asset in question is a trading asset the outcome is different. This again emphasises the importance of establishing the taxpayer’s trade (see BIM35428). In Johnson v W S Try Ltd [1946] 27TC167 the company, which operated a trade of building and development, received compensation under legislation designed to curtail so-called ribbon development. The sum was held to be a trading receipt. There was a subsidiary point as to the year in which the receipt was to be taxed; was it the year when the planning authority first refused permission to develop the land or was it the year when the company received the compensation. Macnaghten J at pages 172 and 173 explained why the compensation was taxable:

Although in most cases land belonging to a trading company forms part of its capital assets, in the case of a company engaged in ribbon development the land which is acquired for the purposes of such development is not part of its capital. In such a case the land forms part of its stock-in-trade, just as much as the materials which it buys for the purpose of erecting the buildings on it. The cost of the land must come into its trading account as a trading expense. If it sells the land the price must come into its trading account as a trading receipt. And, likewise, compensation for injurious affection must also, in my opinion, be regarded as a trading receipt.

In Shadbolt v Salmon Estate (Kingsbury) Ltd [1943] 25TC52 a building company was compensated for the withdrawal of planning permission for building plots that it held as stock in trade. The compensation was held to be a trading receipt. At page 57 Macnaghten J explained why the compensation was taxable:

The question at issue is: Was the right to build on these 87 plots a trading asset? Was it part of their stock in trade? If the land had been actually bought by the company and then they had sold part of it for £5,000, it is admitted that the £5,000 received for the bit so sold would have been a trading receipt, and, as it seems to me, the right to build on the plots was likewise a trading asset.

In Short Brothers Ltd v CIR [1927] 12TC955 a shipbuilder received compensation for the cancellation of a contract to build two ships. The ships would have been trading assets. The compensation was taxable. Rowlatt J at page 968 distinguished the case from Glenboig: 

The sum of £100,000 which they received was not in any material sense received as compensation for not being allowed to make their profits; that is to say, it was not received in respect of the termination of any part of their business; nor was it received in respect of any capital asset, as was the sum in the Glenboig case that was received in respect of the obligation not to work the seam of fireclay; it was the same thing really, to all intents and purposes, as selling the seam of fireclay.

In London & Thames Haven Oil Wharves Ltd v Attwooll [1966] 43TC491 the company’s jetty was damaged by an oil tanker. The company received payment from the tanker owner and from its own insurers, which exceeded the cost of repairing the jetty. The insurance was for physical damage only but it was agreed with the insurers that the recovery from the tanker owner should be taken to include a sum for the loss of use of the jetty whilst undergoing repair. The compensation for the loss of use of the jetty was to make up a hole in the profits and was taxable. Lord Diplock first of all set out the general rule governing compensation cases: the compensation is to be treated for income tax purposes in the same way as the sum of money would have been treated if it had been received instead of the compensation. Lord Diplock explained his decision at page 515:

I start by formulating what I believe to be the relevant rule. Where, pursuant to a legal right, a trader receives from another person compensation for the trader's failure to receive a sum of money which, if it had been received, would have been credited to the amount of profits (if any) arising in any year from the trade carried on by him at the time when the compensation is so received, the compensation is to be treated for income tax purposes in the same way as that sum of money would have been treated if it had been received instead of the compensation. The rule is applicable whatever the source of the legal right of the trader to recover the compensation.

In the case of Deeny & others v Gooda Walker Ltd & others [1996] 68TC458 Lord Hoffmann offered commentary on Lord Diplock’s test from London & Thames Haven Oil Wharves. Underwriters successfully sued their former managing agents for failure to exercise reasonable skill and care in conducting the business of underwriting on their behalf. They were awarded such damages as would place them in the same position as if the underwriting carried out on their behalf by the syndicates of which they were members had been competently performed. The judge gave detailed directions in relation to the assessment of those damages.

The managing agents contended that the damages should be reduced on the grounds that the damages would not be taxable in the underwriters' hands and, whether or not that was so, a reduction by the amount of any tax saving should be made under the rule in British Transport Commission v Gourley [1956] AC185. For the purposes of arguing the taxability issue (but not the Gourley issue) the Commissioners of Inland Revenue joined the proceedings and supported the underwriters’ contentions.

The courts decided that the receipt of damages was a receipt of the individuals’ underwriting business as a member of Lloyds.

In what is strictly not part of his reasoning, in his judgment on this case, Lord Hoffmann commented on Lord Diplock’s approach to compensation payments in London & Thames Haven Oil Wharves (68 TC pages 509G to 510F):

Mr Eder QC (Counsel for the defendants) says that it cannot be of general application because there is no special rule in the Act of 1993 for compensatory payments. There is only one test for all payments, namely whether they are receipts arising out of the trade. The rule propounded by Diplock LJ might be a useful test for deciding whether a payment which undoubtedly arose out of the trade was capital or income but cannot take the place of the statutory language. The context, says Mr Eder, was a case in which the only question was whether the payment was capital or income: a tortfeasor had negligently damaged the plaintiff's jetty, an asset of their trade, and the compensatory payment in dispute was for their inability to use it while it was being repaired.

I think that Diplock LJ can safely be credited with having known that the duty of the court is to apply the language of the statute and not to add its own glosses or agenda. He described his proposition as one of logic rather than law, by which I think he meant that it did no more than express what was logically entailed by the proposition that a trader was entitled to receive a payment in compensation for what would have been a receipt of his trade. It meant, in his view, that the compensatory payment was likewise a receipt of the trade.

I respectfully think that this is right and that it is consistent with the cases. Of course, like all such reformulations, it restates the question rather than providing an answer. It is still necessary to decide what the compensation was for. Was it for a revenue receipt or expense? Or was it for the partial or total loss of a capital asset employed in the trade? Or was it for something which does not form part of the trade at all? These questions sometimes give rise to very fine distinctions. The fact that damages are computed by reference to income which would have been earned does not mean that they are compensation for the loss of that income. The income which might have been expected to be received may be merely an element in the valuation of a different asset or interest... As Diplock LJ said in Attwooll (at page 816):

'The method by which the compensation is assessed in the particular case does not identify what it was paid for; it is no more than a factor which may assist in the solution of the problem of identification.'

... It seems to me that the Attwooll proposition is about which compensatory payments can be said to arise from the trade. It identifies them as payments in compensation for what would have been revenue items in the trade. If they are not compensation for such revenue items, the question of what else they are compensation for is irrelevant. So I do not accept Mr Eder's submission that one first asks whether a receipt arises out of the trade and then whether it is capital or income. There is nothing special about compensation for a capital asset. It is no more than one kind of compensation which does not for income tax purposes arise out of the trade.

In two cases concerning the EEC Dairy Herd Conversion Scheme, White v G & M Davies [1979] 52TC597 and CIR v Biggar [1982] 56TC254, compensation was found to be taxable on the basis that it was paid to make good a notional loss of income during the period when the farmers had undertaken to convert from dairy activities into beef production.

At page 604 in G & M Davies, Browne-Wilkinson J applied Lord Diplock’s test from the London & Thames Haven Oil Wharves case:

Mr Sumption for the taxpayers suggested that Diplock L.J.'s test was limited to a compensation payment in the strict sense and did not apply to this case. I cannot accept that. It seems to me that the principle as stated applies to all cases where somebody, whether under ordinary contract, or under a contract of insurance, or by way of damages, receives a sum of money intended to make good, or to help in making good, a deficiency of some sort in receipts he would otherwise have had. Therefore, the question to be answered is this: Is the premium received under the EEC scheme to be treated as a premium paid to make good income losses which would otherwise have been suffered by the taxpayers, or is it to make good, or to help to make good, a capital loss?

Browne-Wilkinson J considered that the payment was to make good an income loss and was in consequence taxable.

At page 266 of Biggar the Lord President (Lord Emslie) again followed Lord Diplock and distinguished Glenboig:

What one must do therefore is to ask what the sum was paid for. If what it was paid for or what it represented would have been treated as income of the taxpayer the payment falls to be treated in the same way. What is received to fill a hole in profits is of a revenue character (see Burmah Steam Ship Co Ltd v Commissioners of Inland Revenue, [1931] 16TC67 SC 156 [BIM35427]. What is received in compensation for loss of a capital asset is not (see for example, Glenboig Union Fireclay Co Ltd v Commissioners of Inland Revenue, [1922] 12TC427 SC (HL) 112 Van den Berghs Ltd v Clark, [1935]19TC390 AC431 [BIM35530]; and Barr, Crombie & Co Ltd v Commissioners of Inland Revenue, [1945] 26TC406 SC 271 [BIM35530].

In Higgs v Olivier [1952] 33TC136 an actor, Sir Laurence Olivier, received £15,000 in return for agreeing not to take part in any films for a period following the release of the film Henry V. Olivier was not precluded from carrying on any other business such as acting on the stage or in radio. The decision very much depended on the particular facts of the case and in the light of more recent cases (see for example A Consultant v H M Inspector of Taxes at BIM35535) may be considered doubtful. At page 149 Singleton LJ explained why he considered that the Commissioners had come to the correct conclusion:

Whether it be, as one side contended, a question of fact or whether it be, as I think, rather a question of mixed fact and law, I am of the opinion that the conclusion at which the Commissioners arrived was correct. I do not feel it was shown that the £15,000 was “profits or gains” from the vocation of the actor. Indeed it was a payment for abstaining from following his vocation.