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Our client has sold their shares in a trading company to an unconnected third party. There is a clause in the sale agreement which provides for any legal and professional fees (up to a limit) to be invoiced to the shareholders personally but paid by the company.
The company will pay the fees directly to the advisers and we are aware that there will be a benefit in kind to be reported on form P11D and class 1 NIC to be paid through the payroll on the payment of these pecuniary liabilities.
For capital gains tax purposes, these fees do not appear to be allowable as incidental costs in calculating the gain arising on the disposal of their shares because TCGA 1992, s 38(2) states the expenditure must be ‘incurred by him …’ (unlike s 38(1)(b) which allows expenditure incurred ‘… on his behalf …’). Alternatively, can it be argued that the shareholder has ‘incurred’ the cost because it is being taxed on him as a benefit in kind?
I look forward to receiving clarification from readers.
Query 19,880 – MM.
The client could disclose grounds for the deduction.
The client made a contract to sell their shares in a trading company to an unconnected third party. Under the contract the client had a duty to pay the fees of their legal and professional advisers relating to the sale. That duty was, however, discharged by the client’s employer which paid the fees directly to the advisers thereby giving rise to a receipt of earnings by the client (ITEPA 2003, s 62(2)(b)). It appears that the earnings are from the client’s employment (it being assumed that the employment alone explains the employer’s payment) (ITEPA 2003, s 9(6)). Alternatively, the payment is a residual benefit in kind (ITEPA 2003, s 201). So, as is correctly stated, the earnings or benefit must be reported on the client’s P11D and Class I NICs are due through the payroll.
The disposal of the shares requires the client to calculate a capital gain. The amounts deductible in computing that gain are exhaustively set out in TCGA 1992, s 38 and include the incidental costs to them of making the disposal (TCGA 1992, s 38(1)(c)). Those incidental costs of disposal are exhaustively set out in TCGA 1992, s 38(2). The sub-section provides that they ‘shall consist of expenditure wholly and exclusively incurred by [the disponor] for the purposes of the disposal’ if they come within one of the categories of expenditure set out in the sub-section. Fees for certain professional services (including legal advisers) are so included.
Although the client’s legal professional fees fall within one of the qualifying categories of expenditure, the question that arises is whether they have been incurred by the client (the disponor) wholly and exclusively for the purposes of the disposal. The prima facie answer is that the fees have been so incurred as the client is by virtue of the sale contract under a duty to pay them (ie they are committed to the expenditure) and so the fees are deductible in the computation of their gain. On the face of it, the legislation does not require the client actually to pay the fees. The conclusion seems to be enforced by considering TCGA 1992, s 38(1)(a) where, in order to acquire an asset an amount of consideration has to be ‘given’ by the disponor, suggesting that the disponor has to part with the consideration.
However, one must keep in mind the words of Lord Wilberforce in Aberdeen Construction Group Ltd v IRC [1978] STC 127 that capital gains tax operates in the real world; it’s a tax on gains, not a tax on arithmetical differences. Results that are contrary to business sense are to be avoided. This suggests that the disponor, in addition to incurring the expenditure, must actually expend it (so that economically speaking they are that much the poorer). This suggests therefore that if the expenditure is met by another, then the disponor cannot be said to have incurred the expenditure, and in the light of authority may be the better conclusion.
On the face of it therefore, the client cannot be said to have expended the legal fees as they have been paid by their employer and the client has saved the money that it would otherwise have paid out (ie they are better off). However, the point is arguable. First, although on the one hand the client is better off by the money saved, they are worse off in that an amount equal to the amount saved is a taxable receipt, which receipt isn’t represented by an actual amount of money in their hands (although they are indemnified against any demand for payment and so in receipt of money’s worth). If the fees incurred are £100, the client saves £100 if their employer pays the fees. However, as they also pay tax at 40% (say) on £100 of deemed earnings, they are worse off but only by £40. It would be a matter of negotiation with HMRC whether the client would be entitled to a deduction of £40 in computing their capital gains. Alternatively, it may be argued that in a general and business sense the fees have been expended as they are balanced out by the receipt of a taxable amount.
Secondly, TCGA 1992, s 50 disallows a deduction for expenditure met by public grants. This seems to suggest that without this provision, money provided by a third party does not deprive a disponor of a deduction for expenditure incurred by them when calculating a capital gain. However, against this is the argument that the provision exists only for the avoidance of doubt to make it clear that a deduction is denied where funds derive from the public purse (which deduction would have been disallowed anyway on the basis of the economic argument set out above).
As the answer to the question is far from clear, it may be a case for the client to deduct the legal fees in computing their gain, but to disclose to HMRC the grounds on which they are relying for the deduction and then to argue the point as best they can. – KS.
Reply by –Nick Wright @ Jerroms.
As MM has already concluded, the professional fees have been invoiced to the shareholders personally and are therefore the shareholders’ liability. As the pecuniary liability has been settled by the company, this falls within ITEPA 2003, s 62(3)(a) and should therefore be treated as ‘money’s worth’. As the payment is reportable on form P11d, it will be subject to income tax at the shareholders’ marginal rate.
For National Insurance purposes the settlement of an employee’s pecuniary liability differs from the income tax treatment in that it is treated as earnings and therefore both employees and employers Class 1 National Insurance are due but not Class 1A.
The payment must therefore be included on the payroll for the National Insurance Contributions to be collected as ‘earnings subject to National Insurance’ however, as stated above, income tax is not collected via the payroll and is included on a P11d and collected via self-assessment.
As stated by MM, to allow the incidental costs of either an acquisition or disposal, said costs must be ‘incurred’ by the individual.
Whilst the word ‘incurred’ may be considered important in this case, the reading of ITEPA 2003 s.38(2) would suggest the main intention of this provision is to ensure that the expenses ‘wholly and exclusively’ relate to the disposal i.e. they must directly relate to the disposal itself, which they do in this case.
The word ‘incurred’ is not defined within the legislation and we must therefore take the ordinary business dictionary meaning, defined as ‘to be made to lose money or have to pay a charge’.
The fact income tax and National Insurance has been paid on the fees by the shareholders personally would certainly fit this definition. In direct application to MM’s scenario, we can see the client has borne the tax on these costs in full, and as such should be deductible entirely in calculating the gain.
ITEPA 2003, s 38(1)(b), is not relevant in this case as it relates to incurring enhancement expenditure on the asset and the phrasing ‘on behalf of’ is to cover circumstances such as an agent arranging the expenditure.
In this scenario, s 38(2) applies as it relates to the incidental costs of acquisition or disposal. As such, from the intent of the legislation, I would personally have little concern in advising the client that these costs should be allowable in calculating their chargeable gain on the basis that he has ‘incurred’ the costs, both because they are legally invoiced to him and he has personally borne the tax consequences of the fees being paid by the company. – Nick Wright @ Jerroms.
