BIM35655 - Capital/revenue divide: intangible assets: liabilities assumed as part of the consideration for purchase of a business
Expenditure on the acquisition (and, by implication, disposal) of a business, with the exception of whatever relates to trading stock, is incurred on capital account. The factors taken into account in computing the consideration given for a business do not change what is capital expenditure into revenue expenditure. Business acquisition includes entering into franchise agreements - see BIM57620 for the treatment to adopt.
The City of London Contract Corporation Ltd v Styles [1887] 2TC239 is an early example of a line of cases where the courts have considered the issue. In common with a number of early cases the report is abbreviated.
The Contract Corporation agreed to buy the business of Philips and Company for £180,000. The company sought to deduct £80,000 as the purchase price of Philips’ trade contracts.
The Master of the Rolls, Esher, rejected the Corporation’s case, that part of the cost of the business acquired should be deducted. The Master of the Rolls explained that the constituent elements that result in the cost of the business are not what matters; the cost is capital notwithstanding how it may have been computed. At page 243 and 244 of 2TC the Master of the Rolls distinguished the capital cost of the business from the day to day running expenses:
The £180,000, as a figure, was the figure which they agreed to pay for the business. Now nothing can be more plain, if that be so, than that £180,000 was the capital which they embarked in that business, the money they paid for it.…Now if that was the capital which they embarked in that business, they then proceeded to carry on the business. How can you carry on a business after you have embarked your capital in the purchase of it? You must find new money in order to pay the expenses year by year, but then you do find money to pay the expenses year by year, and you get the receipts year by year, and the difference between the expenses necessary to earn the receipts of the year, and the receipts of the year are the profits of the business for the purpose of the income tax ... it is as plain as plain can be that you cannot deduct from those net profits so arrived at any part of the capital which you so invested, whether you paid it or not for the purchase of the business which you were obliged to purchase before you could begin the difference between expenditure and income year by year.
Royal Insurance v Watson [1896] 3TC500 is another early example of this approach. The Royal Insurance Company acquired the business of the Queen Insurance Company. The acquisition agreement provided that the manager of the Queen Insurance Company should be taken on by Royal Insurance, at a salary of £4,000 a year. The agreement further provided that the Royal Insurance Company could dispense with the manager’s services and commute his salary. This was to be done on the basis of the company's annuity tables, and on condition that the manager should not at any time accept office under any other, fire or life insurance company.
Shortly after the acquisition, Royal Insurance exercised the option and paid nearly £56,000, in commutation of the manager’s annual salary. Royal Insurance claimed to deduct this sum from their profits for the year in which the payment was made.
The House of Lords decided that the payment was a capital sum, being part of the consideration for the business acquired.
Lord Hershell explained at page 505 of 3TC that the effect of the agreement is that the costs of the business acquired are capital. One of those costs was the payment to the manager and being part of the cost of the business, it was capital and not deductible:
The payment was not made merely as the result of a contract of service with the former manager of the Queen Insurance Company. The payment was made in pursuance of a bargain entered into between the Royal Insurance Company and the Queen Insurance Company, which bargain contained the terms on which the Royal Insurance Company was to become possessed of the business of the Queen Insurance Company. Of course it could not be disputed for a moment that the price paid to a company whose concern was bought by another company, would not be expenditure which could be set against the gains of the year in which the payment was made. It would obviously be capital expenditure.
Lord Shand distinguished the payment to the manager from the compensation that a wrongfully dismissed employee might receive. The judge emphasised that the payment to the manager was part of the bargain struck between Royal Insurance and Queen Insurance. The judge said that we do not know why Queen Insurance made this stipulation but in the end it does not matter what the reason may have been. What is important is that Royal Insurance as part of the consideration that they gave to acquire Queen’s business undertook the obligation to pay Queen’s manager. The cost of that undertaking was part of the capital cost of the business acquired. Lord Shand explained at page 506 of 3TC:
I agree with your Lordships in thinking that in this question as to income tax the sum which is proposed to be deducted in striking the balance of the profits and gains was a payment of capital and must be debited to capital and not deducted from the income of the year. The Queen Insurance Company, in parting with their business, stipulated that they should have allocated amongst their shareholders a certain amount of new stock to be created. But they further stipulated that the company purchasing their business should undertake a responsibility which, in the end, has resulted in the payment of £55,846 8s. 5d. We do not see what the motive was which induced them to make this stipulation. It may be that they were themselves bound to their manager under an agreement lasting for a period of time, and that they desired to get rid of that obligation, and have it transferred to the purchasing company. It may be that they were so satisfied with his services that they desired to reward the manager who was leaving their employment. But however that may be, they did stipulate that there was to be a money advantage given to their manager on leaving their employment. That was, as it seems to me, clearly an obligation undertaken by the Royal Insurance Company to make a payment in consideration of acquiring the business of the Queen Insurance Company. That, my Lords, I think was a payment of capital, and, therefore, not a proper deduction from profits.
In John Smith and Son v Moore [1921] (12TC266) the sole proprietor of a coal merchant's business died on 7 March 1915 and, under the terms of his trust disposition and settlement, his son took over the business at a valuation, in which nothing was charged for goodwill. The price paid for the business included a sum of £30,000, representing the value of certain unexpired contracts with colliery owners for the supply of coal at fixed prices, all of which contracts expired on or before the 31 December 1915. The taxpayer sought to deduct the £30,000.
The House of Lords (Viscount Finlay dissenting) held that the sum of £30,000 was not an admissible deduction in computing the profits of the business for the purposes of Excess Profits Duty; Viscount Haldane and Lord Sumner, on the ground that the £30,000 was capital expenditure; Viscount Cave, on the ground that the Excess Profits Duty was a tax on a continuing business, and that for the purposes of the question at issue the change of ownership should be disregarded.
Viscount Haldane described how profits may be produced in two different ways, by:
- purchase and sale on income account, or
- realisation of assets.
Debiting the costs incurred under the latter category does not give rise to an allowable deduction. Haldane went on to describe Adam Smith’s distinction between fixed and circulating capital (see BIM35010) and applied that to the facts of the case. It was not by selling the contracts that he had acquired from his father that the taxpayer made profits; it was by retaining those contracts - they were part of his fixed capital, not the circulating capital. Haldane explained at pages 282 and 283 of 12TC why the costs of the coal contracts was capital expenditure:
My Lords, in the case before us the Appellant, of course, made profit with circulating capital, by buying coal under the contracts he had acquired from his father's estate at the stipulated price of fourteen shillings and reselling it for more, but he was able to do this simply because he had acquired among other assets of his business, including the goodwill, the contracts in question. It was not by selling these contracts, of limited duration though they were, it was not by parting with them to other masters, but by retaining them, that he was able to employ his circulating capital in buying under them. I am accordingly of opinion that, although they may have been of short duration, they were none the less part of his fixed capital. That he had paid a price for them makes no difference. Indeed the description of their value by the accountants, in the words I have earlier referred to, as of doubtful validity in the hands of outsiders, emphasises this conclusion. The £30,000 paid for the contracts, therefore, become part of the Appellant's fixed capital and could not properly appear in his revenue account. If that be so, then it was a sum employed as capital in his trade, and has to be excluded as a deduction from the profits on which he is assessed.
Viscount Cave at the head of page 294 emphasised that the £30,000 was not expended to purchase coal, it was expended to acquire the business:
The £30,000 was not paid by the firm for coal, nor was it paid by the trading firm as such for coal contracts; it was paid by John Ross Smith out of his private pocket as part of an overhead transaction under which the business with its assets and future profits passed into his hands, and it left the trading profits of the firm unaltered.
The Privy Council made exactly the same point in the case of CIR v New Zealand Forest Research Institute (NZFRI) [2000] (72TC628). NZFRI was specially incorporated under legislation that provided for the disposal to such bodies of assets and liabilities previously undertaken by government departments. NZFRI took over forestry related research previously performed by a division of the Ministry of Forestry, acquiring specific assets and liabilities from previous Crown entities.
The legislation provided that where any employee of a government department transferred to NZFRI and did substantially the same work as before, the employment by NZFRI was to be on the same terms as by the government department (you may consider the legislation to be broadly equivalent to our TUPE regulations). The periods of employment with a government department and with NZFRI were deemed to be a single unbroken period of service.
The consideration paid by NZFRI was calculated by deducting from the value of assets transferred, inter alia, an estimated sum in respect of the assumption by NZFRI of the Crown’s liabilities to its staff at the transfer date which included their vested or contingent entitlement to paid leave. NZFRI subsequently paid those sums to the transferred employees and sought to deduct them for the purpose of calculating its profits chargeable to tax.
The case came before the Privy Council in May and June 2000. As explained in BIM24235, Privy Council decisions are only of ‘persuasive’ authority in the UK. Given that the Privy Council included senior UK Law Lords, there is no reason to believe that the decision in a UK case would differ. Lord Hoffmann found that the payment was capital. He said that it did not matter that the estimated sum for accrued staff liabilities taken into the cash consideration was not necessarily the same as the amount expended; saying at page 631C:
…the position was that the Institute, pursuant to the transfer agreement and as part of the consideration for the purchase of the assets, accepted a liability under its employment agreements with former Crown employees not merely to remunerate them for services to the Institute but also to discharge obligations, either vested or contingent upon some future event, which were attributable to their previous service with the Crown. It seems to their Lordships plain that, viewed in this light, the payments were capital expenditure, being part of what was paid for the acquisition of the assets. There can be no doubt that the discharge of the vendor’s liability to a third party, whether vested or contingent, can be part of the purchase price. It does not matter that the payment is not made at once but pursuant to an arrangement whereby the purchaser agrees to be substituted as debtor to the third party.
The Privy Council decision gives unequivocal support for the principle that payments made to acquire a business are on capital account. The case also underlines that there is nothing inherently revenue about certain kinds of expenditure, such as wages.
The accountancy treatment on the acquisition of a business is described at BIM33700 onwards and in this context Royal Insurance v Watson [1896] 3TC500 and CIR v New Zealand Forest Research Institute [2000] 72TC628 are discussed at BIM33710.