Perennial Question

SYLVIA ELWES reviews the Court of Appeal's decision in Commissioners of Inland Revenue v John Lewis Properties plc.

WHETHER AN ITEM of expenditure or a particular receipt is capital or income by nature has been at issue in a number of decided cases. While the decision in each case depends on its own particular facts, they are useful as illustrations, as the following examples show.

Previous decisions

In Glenboig Union Fireclay Co Ltd v Commissioners of Inland Revenue 12 TC 427, compensation was paid to a company for not being able to work certain fireclay beds. The receipt was held to be a capital one. It was immaterial that the compensation was calculated by reference to loss of expected trading profit from the inability to work those fireclay beds. It was more significant that the compensation was 'the price paid for sterilising the asset from which otherwise profit might have been obtained'.

In Nethersole v Withers 28 TC 501, a dramatist received payments from an author in respect of a work she had dramatised. When the author died, his estate disposed of film rights in the book for a lump sum and the dramatist was entitled by agreement to a part of that sum. The court held that this was a capital sum unrelated to any royalty payments. It amounted to a partial realisation of her copyright in the play.

In McClure v Petre [1988] STC 749, a landowner received a lump sum payment for the grant of a licence to deposit topsoil on his land. As this was a once and for all disposal of a valuable right, the receipt was held to be capital rather than income.

The taxpayer in Paget v Commissioners of Inland Revenue 21 TC 677 held bearer bonds with interest coupons attached. She sold the interest coupons which were detachable bearer obligations, independently of the bonds, and the question was whether the proceeds were income or capital. The court unanimously held that the sale proceeds were not 'income from securities' subject to income tax. Lord Romer said:

'The only question to be decided is whether the proceeds of a right to receive income in the future can be treated as income for the purposes of the Income Taxes Acts ... The proceeds of sale for a lump sum of an annuity, for instance, are capital in the hands of the vendor and not income. And this is true even when the subject of the sale is not the annuity for its whole duration but the right to be paid the annuity for a number of years or even for one year.'

The issue in Lowe v Ashmore 46 TC 597 was whether the sale proceeds which a farmer had received for turf extracted from his land were income or capital. The judge found that by proper cultivation of the land it should be possible to produce turf again, and so the receipts were income.

Future benefits

Where premiums are payable on the grant of a lease, then even when the amount has been calculated by reference to the rent payable in the future, it has been treated as a sum paid to obtain a capital asset, the lease, and therefore a capital payment.

In Strick v Regent Oil Co Ltd 43 TC 1, because of competition between the major oil companies, each company offered financial inducements to garage owners to buy all their petrol from a particular supplier. In order to avoid taxation of lump sum payments by the oil companies to the retailers as income, premiums were payable on leases granted at nominal rents from five to 21 years to an oil company by a petrol retailer. The oil company then granted subleases back to the retailer with restrictive covenants in favour of the oil company. The House of Lords considered these to be capital payments.

Lord Reid considered that the question of whether a payment is revenue or capital 'must be answered in the light of all the circumstances which it is reasonable to take into account'. In this case, lump sum payments for 21-year ties were capital payments, whether or not a lease had been granted. A premium paid for the grant of a lease for ten or five years is always a capital receipt, but he left the position open where a premium is paid for a very short lease of two or three years.

Lord Wilberforce said that it was necessary to determine how that for which the payment was made was to be used. The payments here were to secure the emergence of an asset or advantage to be enjoyed over a period. The asset or advantage gained was to earn future profits and so it was of a fixed nature. The brevity of the life of the fixed asset was irrelevant.

Lord Pearce said that the fact that an interest in land, a lease, was being acquired pointed strongly to capital expenditure. But where a payment is made just for a tie-in arrangement, if the transaction was only to last for five years, it would be an item of revenue expense; if it were to last for 21 years, it would be capital.

Lord Upjohn considered that a premium paid on the grant of any lease, of whatever length, was a capital payment. But where a payment is made for a mere tie-in arrangement, without the grant of a lease, the amount of the payments and the length of the tie were important factors to be considered.

Nature of payments

Recently, in Commissioners of Inland Revenue v John Lewis Properties plc [2003] STC 117, the Court of Appeal considered the nature of payments received by the taxpayer for assigning the right to receive rent from certain properties. The money was used by the taxpayer's holding company to open new stores and improve existing ones. The taxpayer claimed that the capital gain on the assignment should be rolled over against the new and improved buildings, but this was challenged by the Revenue which contended that the assignment was a revenue transaction only and that no rollover relief was therefore available. It said that the receipts were income as they arose from the short-term disposal of income-producing assets which had been retained by the taxpayer. Moreover, the receipt did not arise from the outright disposal of properties, but the conversion of future income into present income.

The Court of Appeal, by a majority decision, upheld the contention of the taxpayer. It was accepted by the Court that whether an item is capital or revenue is determined from a commercial and practical point of view, and not from a 'juristic classification of the legal rights'.

Lord Justice Dyson laid down certain tests to determine whether an item is capital or revenue.

Long-lasting

Firstly, if what is sold is long-lasting, it is more likely to be a capital item and what is received for its acquisition is more likely to be a capital receipt. On the other hand, if it is appropriate on other grounds to classify an item as part of the fixed rather than circulating capital of a business, then it will be a capital item, even though it has a brief life. The context is therefore important.

Here, the assignment was of six years rent and it was not relevant that this period was short in relation to the total period of the landlord's ownership. Otherwise, as the owner of the freehold owns the property for an indefinite period, even if he assigned the future rents for 25 years, if the contrary were the case, the 25 years is insignificant to the indefinite period and so the lump sum payment for such an assignment would have to be classified as revenue. His Lordship concluded that this was clearly wrong.

Asset's value

Secondly, the value of the asset assigned is important - the higher its value, the more likely that the payment is a capital one. As £25.5 million was received as a lump payment in this case, it was capital.

Diminution in value

Thirdly, the fact that the payment causes a diminution in the value of the assignor's remaining interest is important.

The fact that the value of the property has been permanently diminished shows conclusively that the payment is capital. However, even where the value of the property has not been permanently diminished, the payment may still be capital.

Thus the premium paid on the grant of a lease is a capital payment, but the grant of the lease only diminishes the value of the landlord's reversion for the length of the lease.

The question of whether there has been a diminution of the value of the assignor's interest should be judged at the date of the assignment. Thus, if the assignor were to sell his reversion at the date of the assignment, he would receive less than if he had not disposed of the right to receive the income from the asset for a period of time.

The amount by which the value of the reversionary interest has diminished is also material. This reflects how long the asset has been assigned and its value. The longer the period for which the asset is assigned and the greater the value of the asset, the greater will be the diminution in value of the reversion.

On the facts, there was a diminution to the value of the recipient's reversionary interest. At the time of the assignment, this was significant, although it reduced over time.

Lump sum

Fourthly, where the payment is a single lump sum, it is more likely to be capital than one of a series of recurring payments made at frequent intervals.

Certainly, this is not always a decisive test. For example, in certain trades some capital assets have to be replaced regularly and only last a short time. However, a rent factoring agreement does not come into this category.

Here, a lump sum payment was received, not a series of recurring payments.

Risk

Finally, where the disposal of an asset is accompanied by the transfer of risk this suggests that it is a capital transaction.

The risk of non-payment of the rent was transferred to the transferee although the transfer of risk was theoretical, as the indemnities secured by the assignee meant that risk was only transferred on the insolvency of John Lewis Partnerships plc.

Fruit and tree

Lord Justice Dyson then considered the 'hackneyed simile' that income is the fruit of a tree, and capital is the tree itself. In his view, it merely begged the question: what is the tree and what is the fruit?

On the facts of the case, had John Lewis Properties plc granted a 15-year lease to the bank and received a premium from it, there was little doubt that this would have been classified as a capital receipt, even though it was difficult to see that this was a disposal of the 'fruit tree'. Also, it was difficult to see why it was any more a disposal of the 'fruit tree' as compared to an assignment of the right to receive rents for 15 years, rather than granted a lease for a premium. In both cases, the company retained the freehold, although the value of that freehold was temporarily reduced.

The judge also made the point that how the lump sum was calculated should not determine how it was classified. The fact that it was worked out as six-years rent discounted for early receipt did not mean that it was an income receipt.

There is a difference between the pre-payment of rent by a tenant in a lump sum which represents the discounted value of future rents payable, and the assignment of the right to rents in the future, which is a chose in action. In the former case, it is an income receipt by the landlord even though it has been converted into a lump sum. In the latter case, there is the disposal of an asset.

He rejected the argument that the source of the asset from which the payment is derived is important in deciding the issue. Thus the fact that the source of the payment was an assignment of income did not mean that it was likely that the payment was income by nature.

It was conceded in this case that, had the company granted, for example, a six-year lease for a nominal rent to the bank at a premium, that premium would be regarded as a capital payment. From a commercial point of view, there were real similarities between the grant of a lease and the receipt of a premium, and the receipt of money for the assignment of future rents for six years.

The length of time of six years was the same in both cases - the rent payable by the lessee is exchanged for a lump sum which is paid in advance, the reversion is retained by John Lewis Properties plc, and the value of the reversion is temporarily diminished for the same period and by the same amount.

In each case, John Lewis Properties plc receives a lump sum which represents the rent payable for the properties. The premium for the lease granted at a nominal rent represents the rent which would be payable had the lease not been granted at a nominal rent discounted for early payment. Also, the price payable for the assignment of the right to receive rent is equal to the value of that rent, discounted for early payment again. From a commercial point of view, there is no difference for John Lewis Properties plc. The only distinction is a juristic one, but this is not relevant when deciding if a receipt is capital or income.

The differences between the two concepts did not justify a difference in treatment for tax purposes.

Dissent

Lady Justice Arden gave a dissenting judgment.

Firstly, under Financial Reporting Standard 5, by which John Lewis Properties plc had prepared its accounts, the lump sum was treated as an advance and the assigned rents for the period as receivables. Thus the lump sum was a revenue receipt from an accounting viewpoint. This, however, had not been argued.

Where a premium is paid, a capital asset is created. This is different from the payment of a lump sum representing the accumulation of payments for which a tenant is liable.

Where a lessor receives a premium, he has realised some of the capital value of his property by granting a lease. However, here the capital value of the property had not been sold, just the income that it would produce in future.

Other factors

There were other important factors in determining the nature of the money received, as follows.

First, the profits of the recipient were higher because of the assignment than if they had been received in the usual way as they fell due. This was the commercial motive of the transaction.

Secondly, the proceeds were used on capital improvements by the group. They were not used any differently than they would have been, had they been rents received.

Thirdly, the tenant was a party to the transaction and it gave a guarantee. This meant that there was only a theoretical transfer of risk. If there was a default in any of the assigned rents, they could be recovered either from the tenant or from the assignor.

Fourthly, the proceeds were substantial, but negotiated at arm's length.

Finally, and importantly, the assignment of six rents payable over five years was a short period compared with the length of ownership of the assignor. It either owned the freehold or had a long leasehold interest in the properties. It did not dispose of anything of an enduring nature and it got the properties back intact. They continued to be profit-generating assets. Had this been a disposal of the rents for the entire period of ownership, the case might have been different.

The commercial reality of the matter was that the company received accelerated payments of rent, discounted for early payment. It received a lump sum only because it aggregated a number of payments of rent and received a single accelerated payment for them.

The assignment of the rents did not mean that the company had parted with its property and so received a capital payment. The rents will recur. There is no disposal of any income-bearing property as opposed to income. The resultant diminution of the market value of the properties was only a temporary fluctuation in value.

Just because the payment was calculated by reference to profits did not make it a revenue payment. However, the rentals were the assets realised by the transaction. The proceeds were the present value of the rents.

The commercial reality of the proceeds was that they took their nature from the rentals they represented. The company received discounted rents and these were income.

The position might have been different had John Lewis Properties been entitled to a head lease for 50 years and it had assigned the rentals for the full period of the head lease.

Accordingly, Lady Justice Arden thought that the proceeds were income and should be taxed under Schedule A as 'receipts arising to a person from or by virtue of his ownership of an estate in land'.

Important decision

This case is important because of the tests laid down by the Court of Appeal to determine whether a receipt is of a capital or revenue nature. It should be noted, however, that because of the provisions in section 110, Finance Act 2000 which inserted sections 43A, 43B and 43C into the Taxes Act 1988, the actual decision in the case would be different had the facts occurred after 21 March 2000. Where under normal accounting practice, the assignor of the rents has to account for the proceeds perceived as a liability in his accounts, then provided that the assignment of the rents is for a term under 15 years, the new statutory provisions provide that the consideration received for the assignment must be treated as income. The new provisions do not apply where the assignment is for a period of more than 15 years.

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