In a recent case in the Upper Tier Tribunal (“UTT”) (HMRC v Blackwell [2015] UKUT 0418 (TCC)), HMRC was successful in arguing that a payment made by a taxpayer to remove restrictions on his right to sell shares could not be deducted from his gains on selling those shares.
When can losses be deducted?
As a general principle, when you sell an asset, you can deduct expenditure you have incurred “on” it in enhancing its value when calculating the gain you have made. This reduces your capital gains tax liability. To be deductible, this expenditure must, broadly speaking, be “wholly and exclusively” incurred to enhance the asset’s value and must be reflected in the “state or nature” of the asset when it is disposed of.
A common example of this is deducting the cost of renovating a property from the gain made when it is sold. Renovations affect the 'state or nature' of a property by physically altering or adding to it. However, the question of whether the 'state or nature' of an asset is affected can be more complex where the relevant asset is intangible (for example, in the case of shares or legal rights under a contract) or where the expenditure relates to intangible rights over an asset.
The facts
The facts of the HMRC v Blackwell case were, in brief, as follows. Mr Blackwell owned shares in a company, BP Holdings. Another company was attempting to take over BP Holdings and therefore paid Blackwell £1m in exchange for his agreement that he would not use his shares to prevent the takeover nor sell them to anyone else. The takeover did not proceed but Blackwell remained bound by the agreement.
When another company made a higher bid for BP Holdings several years later Blackwell naturally wished to sell his shares to the higher bidder but was prevented from doing so by the restrictions in the agreement he had entered into. He ultimately had to pay £17.5m to be released from his obligations under the agreement so that he was free to sell the shares.
Blackwell thought that the £17.5m could be deducted from the consideration he received on selling the shares when calculating his gain. Assuming that Mr Blackwell paid capital gains tax at the higher rate of 28%, making this deduction could have saved him almost £5m in tax. However, HMRC refused to allow this approach. Mr Blackwell successfully argued against HMRC's refusal at the first tier tax tribunal (FTT). HMRC then appealed to the UTT.
Why wasn't the deduction allowed?
The argument in the UTT was technical and involved detailed consideration of the relevant legislation.
The UTT first considered whether the asset disposed of for capital gains tax purposes is:
- the asset as it is in the hands of the seller, bound by any rights and restrictions which affect the seller personally;
- the asset as it is in the hands of the purchaser, unaffected by any personal restrictions on the seller’s ability to deal with the asset.
The UTT decided in favour of the latter. Following this reasoning, they concluded that a payment made to remove restrictions which are personal to the seller is not deductible when calculating the gain on disposal of the asset.
The restrictions on the shares were personal to Blackwell and would not have applied to a purchaser even if they had still been in place when the shares were sold (although Blackwell could have been found liable for damages for breach of the restrictions if he had sold the shares while they were restricted). The UTT therefore decided that the £17.5m was not expenditure “on' the shares and had not altered their intrinsic “state or nature”, so could not be deducted from the gain made.
If you know your capital gains tax legislation, you might be wondering whether the £17.5m should have been an allowable deduction on the basis that it was incurred in “establishing, preserving or defending title to, or to a right over, the asset'. The UTT briefly considered this point but dismissed it on the basis that “establishing” in this case refers to proving that you have a right. When Blackwell paid to remove the restrictions he was paying to exercise rights that he already had and not to prove that he had them.
Conclusion
The UTT did have some sympathy for Blackwell and acknowledged that the result may appear unfair because the business reality was, arguably, that Blackwell had made a loss. However, this will be little comfort to a taxpayer in a similar situation as the UTT nevertheless considered that the legislation precluded it from allowing the loss.
The effect of this decision is that the taxpayer may be required to make (sometimes subtle) distinctions between expenditure which alters the intrinsic nature of an asset, which will generally be deductible, and expenditure which affects the asset extrinsically only, which will not. The test for whether an asset is “intrinsically” affected is whether the results of the expenditure pass to a purchaser or are of personal benefit to the seller only.
While some cases will be relatively clear-cut (for example, rights contained in the articles of association of a company would usually be considered intrinsic to that company’s shares) in other cases whether rights would bind a purchaser will be a complex question of law. The taxpayer may find that he has made or needs to make expenditure in order to sell an asset for the best price but which is not deductible from his gains on its disposal.
Careful advice should be taken well in advance of any sale to ensure that all expenditure is allowable for tax purposes. It can often be possible, by sequencing transactions in the right way, to turn an unallowable expense into an allowable one.
For further information, please contact John Barnett.