Our pick of the five tax cases reported to date this year of most interest.
In R (on the application of Miller and another) v Secretary of State for exiting the European Union [2017] UKSC 5 (24 January 2017), the Supreme Court held (by a majority of eight lords to three) that the government cannot trigger article 50 without an Act of Parliament authorising it to do so.
Following the referendum of June 2016, the issue was whether a formal notice of withdrawal can lawfully be given by the government without prior legislation being passed in both Houses of Parliament and assented to by HM The Queen.
Their lordships observed: ‘It is a fundamental principle of the UK constitution that, unless primary legislation permits it, the royal prerogative does not enable ministers to change statute law or common law.’ They also accepted the general rule that the government’s power to make or unmake treaties is exercisable without legislative authority; however, they noted that this general principle is based on the ‘so-called dualist theory’ that international law and domestic law operate in independent spheres.
Turning to the European Communities Act 1972 art 2, their lordships pointed out that it authorises a ‘dynamic process’ by which, without further primary legislation (and, in some cases, even without any domestic legislation), EU law not only becomes a source of UK law, but actually takes precedence over all domestic sources of UK law, including statutes. The 1972 Act therefore created a new constitutional process for making UK law.
Their lordships rejected the secretary of state’s argument that the loss of EU rights has already been sanctioned by the 1972 Act; withdrawal by the UK from the EU involves a unilateral action by the relevant constitutional bodies, which effects a fundamental change in the constitutional arrangements of the UK. As such, it differs from changes in domestic law resulting from variations in EU law. It would therefore be inconsistent with longstanding and fundamental principles for such a far-reaching change to the UK constitutional arrangements to be brought about by ministerial decision.
Their lordships added that the High Court had also been right to hold that changes in domestic rights acquired through the EU treaties represented another reason for the requirement for an Act of Parliament.
Why it matters: Their lordships observed that ‘this case has nothing to do with issues such as the wisdom of the decision to withdraw from the EU, the terms of withdrawal, the timetable or arrangements for withdrawal, or the details of any future relationship with the EU.’ Their lordships thus held back from giving explicit instructions for the Brexit process.
Commenting on the decision, Michael Conlon QC observed: ‘The court’s decision is a landmark ruling on the separation of powers between the legislature, the executive and the courts. It should be a cause for celebration by both sides in the Brexit battle. Those who pilloried the Divisional Court judges for their decision would do well to reflect that a main driver in the “Leave” campaign was the demand to regain full Parliamentary sovereignty. The Supreme Court’s decision has affirmed that fundamental principle of our constitution.’ (Brexit, article 50 and the separation of powers, Tax Journal, 2 February 2017).
In Samarkand Film Partnership and others v HMRC [2017] EWCA Civ 77 (24 February 2017), the Court of Appeal found that two film partnerships had not been trading so that the scheme they had implemented failed.
Two film partnerships had acquired rights in Oliver Twist, The Queen and Irina Palm. In each case, the films were acquired as part of a single transaction which encompassed their acquisition and their associated leaseback in return for fixed, increasing, secured and guaranteed rental payments for a 15 year period.
The partnerships were marketed to wealthy individuals resident but not domiciled in the UK, who wished to generate substantial losses to set against their taxable income by taking advantage of the 100% first year allowance available on expenditure for the production and acquisition of a film (ITOIA 2005 ss 130 to 144). Under s 134, this favourable treatment is only available to taxpayers carrying on a trade. The issue was therefore whether the partnerships were carrying on a trade. Both the FTT and the UT had found that no trade was established.
The Court of Appeal observed that Eclipse [2015] EWCA Civ 95 is authority for the proposition that whether or not an activity constitutes a trade ‘depends upon an evaluation of all the facts relating to it against the background of the applicable legal principles’.
The court rejected the taxpayers’ contention that the FTT had been guilty of a recharacterisation of the transactions ‘into something else’. It found that the FTT had simply expressed ‘the ultimate inference of fact which they drew from the totality of the primary facts which they had found’. It also refused to take into account the borrowings made and the losses actually incurred by the partners in their personal capacities. The fact that the partnerships had no legal personality did not mean that the partnership business was not separate from the affairs of the partners.
Finally, the taxpayers’ application for judicial review also failed. The guidance they relied upon contained a ‘health warning’ that it did not apply in cases of suspected tax avoidance and HMRC had reasonable grounds to suggest tax avoidance.
Why it matters: The Court of Appeal reiterated the principles set out in Eclipse and refused to distinguish this case from it. In doing so, it refused to consider in isolation the purchase and leaseback of the films as ‘inherently trading activities’.
In Smith and Nephew Overseas and others v HMRC [2017] UKFTT 151 (8 February 2017), the FTT found that losses incurred as a result of a change in functional currency were allowable.
Following a change in its functional currency, from sterling to US dollars, as the result of a company reorganisation, Smith and Nephew and its two sister companies claimed foreign exchange losses totalling over $1m, arising as a result of the fall in value of the pound against the US dollar. HMRC disallowed the losses.
There were three issues. The first one was whether the appellants’ accounts complied with GAAP for the purpose of the loan relationship rules. This depended on the correct approach when accounting for a change in functional currency. The FTT was swayed by the taxpayers’ expert; and by the fact that E&Y had confirmed that the companies’ accounts gave a true and fair view.
The next issue was whether the exchange differences were ‘exchange losses’ within FA 1996 s 103. The FTT noted that an exchange loss is ‘the comparison at different times of the expression in one currency of the valuation put by the company in another currency in relation to an asset’. This is therefore an arithmetic exercise and the legislation does not require any exposure to exchange rates between two dates, just a comparison at different times, first in one currency and then in another. The exchange differences were therefore exchange losses for the purpose of s 103.
Finally, the FTT had to decide whether the exchange differences ‘fairly represented’ a loss arising to the appellants, as defined by s 84(1). The tribunal rejected HMRC’s argument that the expression required an overarching ‘sanity check’ to prevent an arithmetic difference from giving rise to a loss. The expression had been included simply for identification and/or timing purposes to identify the relevant entries. The exchange differences did therefore ‘fairly represent’ losses.
Why it matters: The FTT rejected the statement of HMRC’s witness, noting that he had sought ‘to avoid giving direct answers to questions put to him in cross examination and gave the impression, contrary to the overriding duty of an expert to help the tribunal on matters within his expertise, of seeking to argue HMRC’s case’. A seemingly biased witness can therefore prove highly detrimental. The case is also a reminder that tax legislation sometimes caters for ‘purely arithmetic’ losses.
Commenting on the decision, Jeanette Zaman and Zoe Andrews (Slaughter and May) observed: ‘Given the significant amount of exchange losses involved, it is likely that HMRC will seek to appeal this decision. It will be interesting to see if the Upper Tribunal follows the approach in GDF Suez Teesside [2015] UKFTT 413 and takes the opportunity to use s 84(1) to tackle the asymmetry between the economic reality and the accounting treatment of the exchange losses.’ (Tax and the City briefing for March 2017, Tax Journal, 16 March 2017).
In Alway Sheet Metal and others v HMRC [2017] UKFTT 198 (24 February 2017), the FTT found that payments made to employee benefit trusts by three companies were not deductible.
The three appeals raised similar issues relating to the deductibility, for corporation tax purposes, of payments made to discretionary trusts established for the benefit of employees and their families. The main question was whether the payments to the EBTs were made wholly and exclusively for the purposes of the companies’ trades.
Referring to Scotts Atlantic Management [2015] UKUT 66 and ‘the authorities referred to in it’, the FTT noted that:
(1) if any expenditure is incurred partly for a purpose other than the trade, the test is failed;
(2) in order to determine the taxpayer’s object in incurring the expense, the tribunal must look ‘into the taxpayer’s mind’;
(3) what matters is the object of the payment (rather than its effect); and
(4) where a payment is part of a wider set of arrangements, the relevant question is still the object of the payment (and not the purpose of the wider arrangements).
The tribunal observed that the mere fact that a choice is influenced by tax consequences does not mean that the payment has a dual purpose; but also that the mere fact that a payment is made to directors does not compel the conclusion that the payment is wholly and exclusively for the purpose of the trade.
The FTT found that the object of the payments to the EBTs was (at least partly) to provide the EBTs with funds that could be put at the disposal of directors in such a way as to defer (perhaps indefinitely) the PAYE and NIC costs that would arise on a payment of a cash bonus, while at the same time obtaining a corporation tax deduction for the payment, which would not have been available on a dividend payment. The tribunal pointed out that no other explanation had been put forward for the convoluted arrangements, which necessitated the creation of offshore trusts and extensive advice.
Why it matters: The FTT robustly rejected the notion that there is a presumption that sums paid to employees are deductible and that special circumstances are needed to displace this presumption. It noted that where a company makes a payment to an employee, in order to obtain a deduction for that payment, it must establish that the payment is ‘wholly and exclusively’ for the purposes of the trade. This is often, but not always, straightforward.
In MVM Magyar Villamos Művek Zrt. v Nemzeti Adó- és Vámhivatal Fellebbviteli Igazgatóság (Case C-28/16) (12 January 2017), the CJEU found that the free supply of management services by a holding company to its subsidiaries is not an economic activity giving rise to a right to deduct input tax.
MVM leased power plants and fibre optic networks. It was also responsible for the strategic management of the group and supplied legal, business management and public relations services to other group companies. It did not charge for those services but it had deducted the VAT incurred in supplying them.
The Hungarian tax authorities refused the deduction but MVM claimed that the relevant VAT had been incurred on general expenses relating to its taxable activity, since it was a taxable person and did not make any exempt supplies.
The issue was therefore whether the involvement of a holding company in the management of its subsidiaries, without any charge covering the cost of the supplies (or the corresponding VAT), can be regarded as an ‘economic activity’ giving rise to a right of deduction.
The CJEU observed (referring to Larentia + Minerva and Marenave Schiffahrt (Case C‑108/14 and Case C‑109/14)) that for VAT to be deductible, the relevant input transactions must have a direct and immediate link with taxable supplies. It added that the mere acquisition and holding of shares in a company are not economic activities, unless the holding company is involved in the management of its subsidiaries and charges a fee for its services.
MVM had not received any remuneration from its subsidiaries in exchange for its centralised management of the activities of the group, so that its involvement in the management of its subsidiaries could not be regarded as an ‘economic activity’.
Why it matters: The CJEU confirmed that a holding company’s involvement in the management of its subsidiaries will only be an economic activity if it charges for its services to them. It also made the point that the fact that MVM carried on a taxable activity (the leasing of power plants and fibre optic networks) did not help, in the absence of a direct link between the VAT at issue and those supplies.
Commenting on the decision, Peter Dylewski and Philippe Gamito (KPMG) observed: ‘HMRC, which intervened in the MVM case, has now released an update to its draft guidance on the UK VAT position of holding companies. These developments illustrate the need for taxpayers to take practical steps to ensure they mitigate potential VAT costs on acquisitions.’ (M&A input tax recovery by holding companies: an elementary issue? Tax Journal, 16 February 2017).
Our pick of the five tax cases reported to date this year of most interest.
In R (on the application of Miller and another) v Secretary of State for exiting the European Union [2017] UKSC 5 (24 January 2017), the Supreme Court held (by a majority of eight lords to three) that the government cannot trigger article 50 without an Act of Parliament authorising it to do so.
Following the referendum of June 2016, the issue was whether a formal notice of withdrawal can lawfully be given by the government without prior legislation being passed in both Houses of Parliament and assented to by HM The Queen.
Their lordships observed: ‘It is a fundamental principle of the UK constitution that, unless primary legislation permits it, the royal prerogative does not enable ministers to change statute law or common law.’ They also accepted the general rule that the government’s power to make or unmake treaties is exercisable without legislative authority; however, they noted that this general principle is based on the ‘so-called dualist theory’ that international law and domestic law operate in independent spheres.
Turning to the European Communities Act 1972 art 2, their lordships pointed out that it authorises a ‘dynamic process’ by which, without further primary legislation (and, in some cases, even without any domestic legislation), EU law not only becomes a source of UK law, but actually takes precedence over all domestic sources of UK law, including statutes. The 1972 Act therefore created a new constitutional process for making UK law.
Their lordships rejected the secretary of state’s argument that the loss of EU rights has already been sanctioned by the 1972 Act; withdrawal by the UK from the EU involves a unilateral action by the relevant constitutional bodies, which effects a fundamental change in the constitutional arrangements of the UK. As such, it differs from changes in domestic law resulting from variations in EU law. It would therefore be inconsistent with longstanding and fundamental principles for such a far-reaching change to the UK constitutional arrangements to be brought about by ministerial decision.
Their lordships added that the High Court had also been right to hold that changes in domestic rights acquired through the EU treaties represented another reason for the requirement for an Act of Parliament.
Why it matters: Their lordships observed that ‘this case has nothing to do with issues such as the wisdom of the decision to withdraw from the EU, the terms of withdrawal, the timetable or arrangements for withdrawal, or the details of any future relationship with the EU.’ Their lordships thus held back from giving explicit instructions for the Brexit process.
Commenting on the decision, Michael Conlon QC observed: ‘The court’s decision is a landmark ruling on the separation of powers between the legislature, the executive and the courts. It should be a cause for celebration by both sides in the Brexit battle. Those who pilloried the Divisional Court judges for their decision would do well to reflect that a main driver in the “Leave” campaign was the demand to regain full Parliamentary sovereignty. The Supreme Court’s decision has affirmed that fundamental principle of our constitution.’ (Brexit, article 50 and the separation of powers, Tax Journal, 2 February 2017).
In Samarkand Film Partnership and others v HMRC [2017] EWCA Civ 77 (24 February 2017), the Court of Appeal found that two film partnerships had not been trading so that the scheme they had implemented failed.
Two film partnerships had acquired rights in Oliver Twist, The Queen and Irina Palm. In each case, the films were acquired as part of a single transaction which encompassed their acquisition and their associated leaseback in return for fixed, increasing, secured and guaranteed rental payments for a 15 year period.
The partnerships were marketed to wealthy individuals resident but not domiciled in the UK, who wished to generate substantial losses to set against their taxable income by taking advantage of the 100% first year allowance available on expenditure for the production and acquisition of a film (ITOIA 2005 ss 130 to 144). Under s 134, this favourable treatment is only available to taxpayers carrying on a trade. The issue was therefore whether the partnerships were carrying on a trade. Both the FTT and the UT had found that no trade was established.
The Court of Appeal observed that Eclipse [2015] EWCA Civ 95 is authority for the proposition that whether or not an activity constitutes a trade ‘depends upon an evaluation of all the facts relating to it against the background of the applicable legal principles’.
The court rejected the taxpayers’ contention that the FTT had been guilty of a recharacterisation of the transactions ‘into something else’. It found that the FTT had simply expressed ‘the ultimate inference of fact which they drew from the totality of the primary facts which they had found’. It also refused to take into account the borrowings made and the losses actually incurred by the partners in their personal capacities. The fact that the partnerships had no legal personality did not mean that the partnership business was not separate from the affairs of the partners.
Finally, the taxpayers’ application for judicial review also failed. The guidance they relied upon contained a ‘health warning’ that it did not apply in cases of suspected tax avoidance and HMRC had reasonable grounds to suggest tax avoidance.
Why it matters: The Court of Appeal reiterated the principles set out in Eclipse and refused to distinguish this case from it. In doing so, it refused to consider in isolation the purchase and leaseback of the films as ‘inherently trading activities’.
In Smith and Nephew Overseas and others v HMRC [2017] UKFTT 151 (8 February 2017), the FTT found that losses incurred as a result of a change in functional currency were allowable.
Following a change in its functional currency, from sterling to US dollars, as the result of a company reorganisation, Smith and Nephew and its two sister companies claimed foreign exchange losses totalling over $1m, arising as a result of the fall in value of the pound against the US dollar. HMRC disallowed the losses.
There were three issues. The first one was whether the appellants’ accounts complied with GAAP for the purpose of the loan relationship rules. This depended on the correct approach when accounting for a change in functional currency. The FTT was swayed by the taxpayers’ expert; and by the fact that E&Y had confirmed that the companies’ accounts gave a true and fair view.
The next issue was whether the exchange differences were ‘exchange losses’ within FA 1996 s 103. The FTT noted that an exchange loss is ‘the comparison at different times of the expression in one currency of the valuation put by the company in another currency in relation to an asset’. This is therefore an arithmetic exercise and the legislation does not require any exposure to exchange rates between two dates, just a comparison at different times, first in one currency and then in another. The exchange differences were therefore exchange losses for the purpose of s 103.
Finally, the FTT had to decide whether the exchange differences ‘fairly represented’ a loss arising to the appellants, as defined by s 84(1). The tribunal rejected HMRC’s argument that the expression required an overarching ‘sanity check’ to prevent an arithmetic difference from giving rise to a loss. The expression had been included simply for identification and/or timing purposes to identify the relevant entries. The exchange differences did therefore ‘fairly represent’ losses.
Why it matters: The FTT rejected the statement of HMRC’s witness, noting that he had sought ‘to avoid giving direct answers to questions put to him in cross examination and gave the impression, contrary to the overriding duty of an expert to help the tribunal on matters within his expertise, of seeking to argue HMRC’s case’. A seemingly biased witness can therefore prove highly detrimental. The case is also a reminder that tax legislation sometimes caters for ‘purely arithmetic’ losses.
Commenting on the decision, Jeanette Zaman and Zoe Andrews (Slaughter and May) observed: ‘Given the significant amount of exchange losses involved, it is likely that HMRC will seek to appeal this decision. It will be interesting to see if the Upper Tribunal follows the approach in GDF Suez Teesside [2015] UKFTT 413 and takes the opportunity to use s 84(1) to tackle the asymmetry between the economic reality and the accounting treatment of the exchange losses.’ (Tax and the City briefing for March 2017, Tax Journal, 16 March 2017).
In Alway Sheet Metal and others v HMRC [2017] UKFTT 198 (24 February 2017), the FTT found that payments made to employee benefit trusts by three companies were not deductible.
The three appeals raised similar issues relating to the deductibility, for corporation tax purposes, of payments made to discretionary trusts established for the benefit of employees and their families. The main question was whether the payments to the EBTs were made wholly and exclusively for the purposes of the companies’ trades.
Referring to Scotts Atlantic Management [2015] UKUT 66 and ‘the authorities referred to in it’, the FTT noted that:
(1) if any expenditure is incurred partly for a purpose other than the trade, the test is failed;
(2) in order to determine the taxpayer’s object in incurring the expense, the tribunal must look ‘into the taxpayer’s mind’;
(3) what matters is the object of the payment (rather than its effect); and
(4) where a payment is part of a wider set of arrangements, the relevant question is still the object of the payment (and not the purpose of the wider arrangements).
The tribunal observed that the mere fact that a choice is influenced by tax consequences does not mean that the payment has a dual purpose; but also that the mere fact that a payment is made to directors does not compel the conclusion that the payment is wholly and exclusively for the purpose of the trade.
The FTT found that the object of the payments to the EBTs was (at least partly) to provide the EBTs with funds that could be put at the disposal of directors in such a way as to defer (perhaps indefinitely) the PAYE and NIC costs that would arise on a payment of a cash bonus, while at the same time obtaining a corporation tax deduction for the payment, which would not have been available on a dividend payment. The tribunal pointed out that no other explanation had been put forward for the convoluted arrangements, which necessitated the creation of offshore trusts and extensive advice.
Why it matters: The FTT robustly rejected the notion that there is a presumption that sums paid to employees are deductible and that special circumstances are needed to displace this presumption. It noted that where a company makes a payment to an employee, in order to obtain a deduction for that payment, it must establish that the payment is ‘wholly and exclusively’ for the purposes of the trade. This is often, but not always, straightforward.
In MVM Magyar Villamos Művek Zrt. v Nemzeti Adó- és Vámhivatal Fellebbviteli Igazgatóság (Case C-28/16) (12 January 2017), the CJEU found that the free supply of management services by a holding company to its subsidiaries is not an economic activity giving rise to a right to deduct input tax.
MVM leased power plants and fibre optic networks. It was also responsible for the strategic management of the group and supplied legal, business management and public relations services to other group companies. It did not charge for those services but it had deducted the VAT incurred in supplying them.
The Hungarian tax authorities refused the deduction but MVM claimed that the relevant VAT had been incurred on general expenses relating to its taxable activity, since it was a taxable person and did not make any exempt supplies.
The issue was therefore whether the involvement of a holding company in the management of its subsidiaries, without any charge covering the cost of the supplies (or the corresponding VAT), can be regarded as an ‘economic activity’ giving rise to a right of deduction.
The CJEU observed (referring to Larentia + Minerva and Marenave Schiffahrt (Case C‑108/14 and Case C‑109/14)) that for VAT to be deductible, the relevant input transactions must have a direct and immediate link with taxable supplies. It added that the mere acquisition and holding of shares in a company are not economic activities, unless the holding company is involved in the management of its subsidiaries and charges a fee for its services.
MVM had not received any remuneration from its subsidiaries in exchange for its centralised management of the activities of the group, so that its involvement in the management of its subsidiaries could not be regarded as an ‘economic activity’.
Why it matters: The CJEU confirmed that a holding company’s involvement in the management of its subsidiaries will only be an economic activity if it charges for its services to them. It also made the point that the fact that MVM carried on a taxable activity (the leasing of power plants and fibre optic networks) did not help, in the absence of a direct link between the VAT at issue and those supplies.
Commenting on the decision, Peter Dylewski and Philippe Gamito (KPMG) observed: ‘HMRC, which intervened in the MVM case, has now released an update to its draft guidance on the UK VAT position of holding companies. These developments illustrate the need for taxpayers to take practical steps to ensure they mitigate potential VAT costs on acquisitions.’ (M&A input tax recovery by holding companies: an elementary issue? Tax Journal, 16 February 2017).
