Helping Hand

CLARE McMATH and MARK PENNEY consider the Court of Appeal's decision in Barclays Mercantile Finance Ltd v Mawson.

THE COURT OF Appeal has assisted the leasing industry by finding for the taxpayer in Barclays Mercantile Business Finance Ltd v Mawson after a hearing expedited to reflect the importance of the case to finance lessors.

The analysis of the Ramsay approach (W T Ramsay Ltd v Commissioners of Inland Revenue [1981] STC 174) after MacNiven v Westmoreland Investments Ltd [2001] STC 237 will be of even wider interest.

The transaction

Bord Gáis éireann had built a pipeline carrying gas between Scotland and Ireland. It entered into a leasing transaction with Barclays Mercantile Business Finance under which Barclays Mercantile purchased part of the gas pipeline and leased it back to Bord Gáis éireann. Barclays Mercantile borrowed the purchase price, £91 million, from Barclays Bank Treasury.

Bord Gáis éireann subleased the pipeline to one of its wholly owned subsidiaries, BGE (UK) Ltd, and rent was paid directly from BGE (UK), sub-lessee, to Barclays Mercantile, head-lessor. Barclays Mercantile had the option to sell the pipeline to a Bord Gáis éireann subsidiary, Sudanor Ltd.

The security and cash collateral arrangements were complex. Barclays Bank Treasury guaranteed the payments by BGE (UK) to Barclays Mercantile. Bord Gáis éireann made a 31-year deposit of £91.5 million with a Jersey company, Deepstream Investments Ltd, in exchange for three streams of annual payments, A, B and C payments. Bord Gáis éireann assigned its interest in the deposit to BGE (UK) which then assigned it to Barclays Bank Treasury by way of security. BGE (UK) executed a deed of indemnity in favour of the bank.

Deepstream deposited £91.5 million with Barclays Bank Finance Company (Isle of Man) Ltd, assigned its rights to the sum to Barclays Bank Treasury, charged the account to the bank and agreed to indemnify it in respect of the guarantee. Barclays Bank (Isle of Man) returned the £91.5 million to Barclays Bank Treasury. The arrangements are illustrated in the Diagram.

Special Commissioners

The Special Commissioners held that Barclays Mercantile was not entitled to capital allowances. The purpose of its expenditure was to obtain capital allowances rather than to fund the purchase of the pipeline. Expenditure was therefore not incurred 'on the provision of machinery or plant' as required by section 24(1), Capital Allowances Act 1990.

The Special Commissioners looked at the transaction as a whole, and saw it as tax avoidance. Bord Gáis éireann could not 'get its hand on' the purchase price because this was deposited with Deepstream for 31 years. Instead, BGE (UK) was entitled to annual A, B and C payments. The A payments matched the rental payments that BGE (UK) expected to pay; the B and C payments totalled £12.6 million. The Special Commissioners considered that these B and C payments were the only benefit that the BGE group retained from the transaction. If capital allowances were not available, then the rental payments would increase and may exceed the total of the A, B and C payments. The Bord Gáis éireann group would then have no benefit from the transaction. In this way, the benefit to the group, the B and C payments, could be seen as funded by the United Kingdom taxpayers.

High Court decision

Mr Justice Park in the High Court upheld the Special Commissioners' decision to deny capital allowances. He accepted that the commercial margin from finance lease transactions comes from capital allowances and that this is not generally considered to be tax avoidance. Barclays Mercantile did not regard the transaction as abnormal.

The judge said that Parliament intended that capital allowances would enable lessees to obtain efficient finance for them to use and develop their business activities. It was important in this case that the purchase price would not be available to Bord Gáis éireann. The Bord Gáis éireann group was not provided with a new asset, funds for its business or funds with which to repay other borrowings.

For the purposes of applying the Ramsay principle post MacNiven, 'has incurred capital expenditure on the provision of machinery or plant' was a commercial concept. Commercially, Barclays Mercantile's expenditure was on a network of agreements giving rise to secured money flows and not on the provision of machinery or plant. Additionally, the fiscal element of the transaction was so great that the purchase of the pipeline was not a trading transaction for it.

The benefit

In the Court of Appeal, the evidence was reconsidered. The documents did not specify that the B and C payments were funded by capital allowances and Lord Justice Peter Gibson considered that the Special Commissioners could not properly conclude that they were so funded. This removed a crucial factor in the Special Commissioners' decision that the transaction was one of tax avoidance.

The Court of Appeal discounted Mr Justice Park's view of the intentions of Parliament concerning capital allowances in finance leasing transactions on the basis that such a position could not be substantiated from the legislation itself. Unlike Mr Justice Park, the Court of Appeal considered that the Bord Gáis éireann group did benefit from the purchase price. The A, B and C annuities benefited Bord Gáis éireann and arose from its application of the purchase price. The intended use of the A payments to fund rental liabilities did not change their benefit to the BGE group.

Barclays Mercantile's purpose

The 'purpose' referred to in section 24 is that of the person incurring the expenditure. The Court of Appeal concluded that the evidence gave no reasonable grounds for treating Barclays Mercantile's purpose as anything other than obtaining a commercial margin on a normal finance lease. The source of funds for Barclays Mercantile and the use of proceeds by Bord Gáis éireann were irrelevant. The Court of Appeal also considered it irrelevant that Barclays Mercantile, as is usual for a finance lessor, had the additional object of obtaining capital allowances.

MacNiven

Along with most tax professionals, Lord Justices Peter Gibson and Carnwath both admitted to having difficulty with the concept of dividing terms between 'legal' and 'commercial' as required after MacNiven. Unlike Mr Justice Park, each considered that the concept of incurring expenditure was a legal one.

Section 24(1), Capital Allowances Act 1990 does not specify that the source of funds incurred should be considered. Such factors were not brought into account in interpreting section 338, Taxes Act 1988 in MacNiven and, similarly, should not be considered in interpreting section 24(1), Capital Allowances Act 1990. Circular cash flows cannot be relevant to the interpretation of a legal concept.

Lord Justices Peter Gibson and Carnwath each used examples to illustrate the difficulty of applying the MacNiven dichotomy. The question in Commissioners of Inland Revenue v McGuckian [1997] STC 908 was whether an assignment had changed income into capital. Lord Hoffmann considered this to be a commercial question even though the courts have generally regarded the capital and revenue question as one of law. In Furniss v Dawson [1984] STC 153, the question was whether statute deemed a disposal not to be a disposal for tax purposes. It is difficult to see why the application of such a deeming provision should be a commercial question.

Lord Justice Carnwath concluded on the point that:

'For the time being, it would be wrong in my view to see MacNiven as making a significant change of direction, whether by way of narrowing or expansion of the Ramsay principle.'

Ramsay

After MacNiven, opinion has differed as to whether, if a commercial term could be found, the application of Ramsay should be wider and more dramatic than before. Lord Justice Carnwath provided a much needed judicial pronouncement on the point. He emphasised that the interpretation of a commercial concept after MacNiven remains constrained by the limitations set out by Lord Brightman in Furniss v Dawson. The interdependence of transactions and lack of commercial motive for an inserted step highlighted by Lord Oliver in Craven v White [1988] STC 476 must still be found before the Ramsay principle can be applied.

Tax advisers will be happy with the clarity of Lord Justice Carnwath's colourful comment that the Ramsay principle:

'recognises the underlying characteristic of all taxing statutes, as parasitic in nature. They draw their lifeblood from real world economic effects, to which the Revenue is not a party. To allow tax treatment to be governed by transactions which have no real world purpose of any kind is inconsistent with that fundamental characteristic.'

The Court of Appeal found little scope for the application of Ramsay to the facts of Barclays Mercantile and to section 24(1), Capital Allowances Act 1990. The transfer of ownership was a real transition, the expenditure necessary to obtain it and the price financed in the normal way. The circularity arising from Barclays Bank's requirement for cash collateral was not under the control of Barclays Mercantile, and therefore could not affect its purpose.

The tax advantage obtained from the entitlement to capital allowances is 'normal and accepted' in finance leasing. It is not confined to investment in new plant and does not require the lessee to benefit from the proceeds. The Court of Appeal accepted that this was an ordinary finance leasing transaction under which the benefit of capital allowances was passed to the lessee in the form of lower rentals. Although the purchase price was taken from Barclays' treasury by Barclays Bank and returned to the treasury by Barclays Bank (Isle of Man), the group treasurer did not consider this as a return of the funds to their original position. He saw them as distinct companies. The transaction could be distinguished from Ensign because there were no non-recourse or, despite the 31 year deposit, uncommercial loans.

Barclays Bank showed its loan to Barclays Mercantile at a zero weighting for regulatory purposes. Tax advisers may have feared that the low level of risk implied by a zero weighting was an indicator that the loan had no impact on Barclays Bank's commercial position. In the judgment of Lord Justice Peter Gibson, however, it was a banking consideration driving and underlying the commerciality of the security arrangements. To him, Barclays Bank's desire to regulatory weightings as far as possible provided a commercial reason for circular cash collateral. Fully defeased finance lease transactions are now generally problematic after the introduction of section 76A(6), Capital Allowances Act 1990 (now section 225, Capital Allowances Act 2001), but the commerciality of zero weighted funding remains an important question.

The application of Ramsay requires an inserted step with no commercial purpose. None could be found. The payment of £91.2 million was not an inserted step. The price had to be paid to acquire the pipeline as the source of a rental stream. The purchase had real legal and economic effects. In certain circumstances, Barclays Mercantile was at risk as to the value of the pipeline. It could be liable on termination for £25 million in excess of the amount guaranteed by Barclays Bank. Such amount would need to be recovered by sale of the pipeline to Sudanor or otherwise.

Conclusions

In overturning the High Court decision, the Court of Appeal has poured oil onto some very turbulent waters within the leasing industry. It is understood, however, that the Inland Revenue is seeking leave to appeal to the House of Lords so this is liable to raise another storm.

On a broader front, the case illustrates the difficulty of applying the MacNiven decision and deciding whether a concept is legal or commercial. Assuming that leave to appeal is granted, further clarification from the House of Lords will be awaited with interest.

Clare McMath, senior consultant, and Mark Penney, partner, are both tax advisers in Ernst & Young's structured finance group in London.

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