Special Commissioners' Decision - Financial Engineering

RICHARD CURTIS reports Delta Finance Newco Ltd (SpC 316).

Background

An appeal before the Special Commissioners in July 2001 concerned a claim to capital allowances in a finance leasing transaction. The decision published this year runs to 52 pages.

Alpha, a company in the United States of America, used movable plant and machinery (the equipment) in its factories there. On 18 December 1995, the following transactions took place.

• Alpha Newco (a United Kingdom subsidiary of Alpha) acquired the equipment from Alpha.
• Delta Finance Newco purchased the equipment from Alpha Newco for £165.8 million.
• Delta Finance Newco leased the equipment back to Alpha Newco for a term of 30 years and 19 days at an escalating rent (the headlease). The rent was to increase by 2.5 per cent every six months and was designed to amortise Delta Finance Newco's investment over the term taking account of capital allowances. If no capital allowances were due, the rent would be increased.
• Alpha Newco (with the consent of Delta Finance Newco written in a side letter) leased the equipment to Alpha for eleven years at a fixed rent (the sublease). It was specified that (as a lease between a United Kingdom resident company and a non-resident) the terms of this sublease must satisfy section 42(3), Capital Allowances Act 1990, so that Delta Finance Newco could claim 10 per cent capital allowances.
• An associated company of Alpha Newco deposited £146.7 million with Delta Finance Newco's associated bank as security for Alpha Newco's obligations under the headlease. The deposit was to be adjusted every six months to reflect the rent payments received from Alpha Newco and the interest due to the associate on the deposit. The deposit also meant that the risk rating of the lease was reduced (reflected in the rent payable, which was adjusted with the London Inter-Bank Lending Rate), improving Delta Finance Newco's ability to lend money in other transactions.
• The obligations of Alpha Newco and its associate were guaranteed by Alpha.

Analysis

A whole raft of issues arose in relation to the claim to capital allowances, which was refused by the Revenue.

Section 24(a) and (b), Capital Allowances Act 1990 states that allowances will be due if 'a person carrying on a trade has incurred capital expenditure on the provision of machinery or plant … and … the machinery or plant belongs or has belonged to him'.

Section 42, Capital Allowances Act 1990 deals with assets leased outside of the United Kingdom and states that allowances will not be due if any of the following factors come into play.

(i) If 'the lease is expressed to be for a period which exceeds 13 years or there is, in the lease or in a separate agreement, provision for extending or renewing the lease or for the grant of a new lease so that, by virtue of that provision, the machinery or plant could be leased for a period which exceeds 13 years' (section 42(3)(d)).

(ii) If 'the lessor or a person connected with him will, or may in certain circumstances, become entitled to receive from the [appellant] a payment … of an amount determined before the expiry of the lease and which is referable to a value of the machinery or plant at or after that expiry' (section 42(3)(e)).

(iii) If 'any payments other than periodical payments are due under the lease or under any agreement which might reasonably be construed as being collateral to the lease' (section 42(3)(b)).

Contentions put forward

The arguments by the Revenue and the appellants centred on the following points.

The Revenue argued that the 'lease' that had to meet the terms of section 42(3) was the 30-year headlease between Delta Finance Newco and Alpha Newco. The appellants argued that as section 42 referred to assets leased outside the United Kingdom, it must refer to a lease to a non-resident, which was not the case for the lease to which Delta Finance Newco was a party.

Alternatively, argued the Revenue, the above 'lease' was the conjoined headlease and sublease (between Alpha Newco and Alpha). This was based on the argument that, because, in a technical legal sense 'lease' applied to an estate in land, in the case of chattels, lease and leasing should be construed in a commercial sense following MacNiven v Westmoreland Investments Ltd [2001] STC 237. Delta Newco argued that even if the lease was a commercial concept (which was not accepted), section 42(3) clearly set out the agreements that it applied to and the court could not rewrite statute by applying it to different agreements.

If 'lease' did mean only the sublease, the Revenue argued that it failed to comply with section 42(3)(c), (d) or (e). The appellant argued that, reading section 42 as a whole, section 42(3)(e) (which bars allowances if there is the possibility of the lessor 'or a person connected with him' receiving payment from the lessee) must refer to the sublease and therefore section 42(3)(e) could not apply to a payment that was not under that lease. Furthermore, the side letter was not an agreement to renew the lease, it only dealt with the possibility of a new sublease and the consent required.

The Revenue argued that 'incurred' in section 24(1) should be construed as a commercial concept (the phrase 'had resonance for a businessman') and, in this case, meant the net difference between the acquisition price and the cash deposit, i.e. £19 million (per Ensign Tankers (Leasing) Limited v Stokes [1992] STC 226). The appellant relied on MacNiven and section 159(3), Capital Allowances Act 1990 to argue that 'incurs', 'capital' and 'expenditure' have legal meanings.

The Revenue argued that Delta Finance Newco could not prove that the equipment 'belonged' to it in accordance with section 24(1)(b). Although there was a bill of sale, it had not been stamped and therefore, in accordance with section 14(4), Stamp Act 1891, it could not be produced as evidence in court. The appellant would have to show that the contract was specifically enforceable and, in the case of a sale of chattels, this would only be done if damages would not be an adequate remedy. Delta Finance Newco argued that there was no challenge to its ownership, there was other evidence of ownership and, being a contract to acquire goods, it was specifically enforceable.

Judgment

The Commissioners considered the following points.

The relevant lease for section 42(3)

The Commissioners considered that the drafting of section 42 'is not wholly clear'. It might, for example, be that an initial headlease fell within the circumstances of section 42(3), but was not within section 42 because it was between United Kingdom residents. It would be surprising if a later sublease to a non-resident deprived the headlessor of its allowances. The Commissioners concluded that, in this case, section 42(3) must be applied to the lease to the non-resident, Alpha.

Section 42(3)(e)

The Commissioners found that if the headlease terminated, Alpha Newco would be entitled to a payment. This would contravene section 42(3)(e) and allowances would not be due. Furthermore, the wide wording of this subsection meant that payment did not have to be under the sublease.

Section 42(3)(d)

The side letter of 18 December 1995 conferred legal rights allowing Alpha Newco to enter into further subleases, the total periods of which could exceed 13 years, in contravention of section 42(3)(d).

Section 42(3)(c)

The Commissioners found that the headlease and sublease did not have to be between the same parties for them to be treated as 'collateral' within section 42(3)(c).

The expenditure incurred

The Commissioners held that 'where there are a series of interdependent transactions, their legal effect must be considered as a whole when determining whether a taxpayer has 'incurred capital expenditure for capital allowances purposes and how much'. However, they then noted that the transactions between the Alpha and Delta groups were at arm's length and Delta's internal documents (which they would not have expected to be scrutinised by outside parties) did not indicate that the transactions were being undertaken for tax benefit purposes. The Commissioners were also of the opinion that the width of section 42 (the purpose of which was to deny favourable capital allowances in cases of overseas leasing) argued against a wide construction of section 24. Basically, the Revenue's arguments based on the Ramsay decision were rejected by the Commissioners. In the event, however, the Commissioners felt that further argument on this subject was academic in view of their conclusions on the stamp duty issue below.

The stamp duty point

As there was not a stamped document relating to the sale of the equipment, Delta Finance Newco was unable to rely on a bill of sale (section 14, Stamp Act 1891). The Commissioners considered the appellant's possible remedies of damages or specific performance if Alpha Newco defaulted on the agreement. On balance, the Commissioners concluded that without a valid bill of sale, Delta Finance Newco did not obtain beneficial title to the equipment.

Revenue successful

Without a bill of sale, Delta Finance Newco had not established that the equipment belonged to it and the provisions of section 42(3)(d) and (e), Capital Allowances Act 1990 applied to prevent the availability of capital allowances. Thus the company's appeal failed.

Commentary

The facts of the case are particular to it, but there are some similarities with the recent decision of the Commissioners in ABC Ltd v M reported in Taxation, 7 February 2002. A major difference is that in this case (unlike in ABC Ltd v M), the Commissioners rejected the Revenue's arguments based on the Ramsay decision. They agreed that Alpha Newco had been inserted into the transactions for financial reasons, that Alpha had entered into the sale and leaseback scheme to raise finance and that its success would rest on the availability of United Kingdom capital allowances, which would benefit Alpha which would be charged a reduced rent. That said, the transactions between the Alpha and Delta groups were at arm's length and the Revenue was not justified in recharacterising the transactions as having been between different parties with different results.

However, the Commissioners decided that the side letter between Delta Finance Newco and Alpha Newco was a legal document and effectively part of the lease agreement, so breaching the section 42 conditions. This and the stamp duty point appear to have been the 'nails in the coffin' here. The case raises points regarding the interpretation of the legislation and it will be interesting to see how this develops in the future. The linking of the leases can be compared to the Revenue's view (expressed in Revenue Interpretation RI 203) that, where there is a 'chain' of leases, section 42 should apply where any lessee in the chain falls within it. Before April 1999, the Revenue took the view that section 42 applied to the end lessee only.

It is understood that no appeal has been lodged in this case, but one has recently been heard in the High Court in respect of the ABC Limited case (now Barclays Mercantile Business Finance Limited v Inspector of Taxes [2002] STC 1068). The fact that the taxpayer's appeal was dismissed would not appear favourable to Delta Finance Newco.

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