FTT rules on Icebreaker arrangements
Stepping Sideways
The First-Tier Tribunal (FTT) has recently rejected appeals concerning arrangements entered into for the acquisition and exploitation of intellectual property rights.
The FTT concluded that although each of the partnerships was trading on the exploitation of intellectual property rights, their purpose, to secure sideways loss relief, ultimately failed for partnerships’ members. This was because their objective was to increase the amount of lloss relief by unnecessary borrowing. The FTT further found that the individual members of the partnerships also did not satisfy the conditions enabling them to become eligible for sideways loss relief.
The Facts
This case followed on from the Upper Tribunal decision in the Icebreaker 1 LLP V R & C Commrs [2011] BTC 1579. Five limited liability partnerships’ (‘the appellant partnerships’) and their members were scrutinised. These five appeals were agreed with HMRC as test cases and consisted of the appellant partnerships and seven other individuals (‘the individual referrers’). In all, there were 46 partnerships and approximately 1,000 members affected by the test cases. (All the 51 partnerships were collectively referred to by the FTT as the ‘Icebreaker partnerships’).
The case focused on arrangements in the tax years 2005-6 to 2009-10, during which each of the partnerships acquired, for relatively modest sums, certain intellectual property rights, mainly in the music or publishing industry. Large payments were agreed with an exploitation company that it would exploit the rights on the partnerships’ behalf.
Guarantee
From the exploitation, the revenue was to be shared between the partnerships and the exploitation company. The requirement was to pay certain guaranteed sums to the partnerships as part of the arrangements with Icebreaker Management Limited, (‘IML’). IML was to provide various services to the partnerships in return for large payments.
The members’ capital injections would be financed by IML, partly from members’ own resources, typically 20–25 percent, and partly from secured bank borrowings, usually 75 – 80 per cent. This expenditure was incurred in the first accounting period of the partnerships, giving members guaranteed returns, thus enabling them to service and repay their secured borrowings.
Argument
The appellant partnerships claimed that the incurred expenditure, in the first year of trading, gave rise to allowable losses. They claimed their members were entitled to a set off, by way of sideways loss relief, against income or capital gains tax arising outside the trade of the partnership.
HMRC acknowledged that the appellant partnerships were trading with a view to profit and that none of the arrangements were a sham, but argued that artificial losses had been created, with the purpose of generating tax relief as part of a tax avoidance scheme. The earning of trading profits was incidental to this purpose.
At the FTT HMRC ran two main lines of argument. Firstly, HMRC submitted that the expenditure which gave rise to the supposed losses was not incurred wholly and exclusively for the purposes of the partnerships’ trade. They pointed out that their accounts were not prepared in accordance with Generally Accepted Accounting Practice (GAAP) and that the expenditure was of a capital rather than revenue nature (referred to by the FTT as ‘the ineffective argument).’
Secondly, HMRC argued that, even if the schemes were successful in generating a tax advantage, the fiscal effect should be disregarded under the Ramsay principle.
Response from the FTT
The FTT focused on five key questions (the first four relate to the ineffective argument).
Firstly, what were the payments for?
The FTT determined that payments to the exploitation company were, when they matched the amounts borrowed, paid for the purchase of a guaranteed income stream, with the remainder of the payments being for exploitation services. Other payments were for the purchase of a ready–made package of projects, advisory services rendered in the relevant year and a pre–payment for future services.
Secondly, were the payments were of a revenue or capital nature?
The FTT concluded that the payments which represented the acquisition of a guaranteed income stream were capital, whilst the remainder were of an income nature. The advisory fees paid by all bar one of the appellant partnerships were capital, but the fee paid by the partnership which comprised the purchase of a ready-made package of projects, advisory services rendered in the relevant year and a pre–payment for future service had to be divided up. The two parts compromised the purchase price of the package, which was capital in nature, whilst the other was of revenue nature. The administration service fee paid on closure of the partnership was also of a revenue nature.
Thirdly, did the partnership accounts properly reflect the true nature of the expenditure?
The FTT found that the accounts were not GAAP compliant because substantial amounts had been taken to the profit and loss account as income rather than being disregarded as capital.
Fourthly, what were the tax consequences of the arrangements?
The FTT decided that each partnership was entitled to treat as an allowable expense in the relevant year, only so much of the payments it made as was of revenue nature and which did not represent a pre–payment. If so, the FTT accepted that, considering they were of a revenue nature and attributable to the relevant year, the payments were indeed made for the purposes of the partnerships’ trades.
The FTT acknowledged they were not excluded from relief by virtue of being expenses not incurred wholly and exclusively for the purposes of trade (ITTOIA 2005, s.34(1); however the true loss for the relevant year was far less than the amount claimed, although more than HMRC accepted.
The FTT was unable to determine the actual loss in each case as the relevant information was not available to them, so they were unable to decide just how the closure notices were to be amended.
Fifthly, could the tax consequences be disregarded on Ramsay grounds?
HMRC argued that the arrangements were put in place in such a way that the Ramsay principle would apply. This is because the members were guaranteed to be returned to their starting position, with no money at risk, apart from their own capital. However, convincing the FTT was another matter. The FTT said:-
“We too are not altogether persuaded that the Ramsay line of authority can have any application to these cases, though perhaps for slightly different reasons. If we are right in our conclusions about the ineffective argument, the tax treatment of the transactions, as we have found them to be, conforms with the purpose of the legislation: once the appellant partnerships’ accounts have been redrawn to comply with GAAP, only those payments which were of a revenue nature and made in respect of expenses incurred for the purpose of the trade in the relevant year would be brought into the profit and loss account for that year. If, instead, we are wrong and the entirety of the exploitation fee was, as the appellant partnerships argue, paid for exploitation services then, again, we do not see anything in the arrangement which offends the relevant taxing provisions…..(para 330).”
Other points
In terms of other conditions that would have been required to have been satisfied in for the partnerships to make a successful claim for sideways loss relief, the FTT decided as follows.
Trade on a commercial basis
The FTT decided that only a small number of projects could have been expected to generate significant profits and that it was far likelier that losses would be generated than profits.
Active partners
The FTT accepted that members typically spent approximately two hours a week on management activities such as attending partnership meetings and considering reports and other documents. The FTT was also willing to assume that a typical member spent a further eight hours a week on research activities connected to the partnership, such as listening to music and attending sports events and concerts. However, these activities did not advance the trade of the partnership; the individuals spent the time because they had been advised that they had to.
Partnership (Restrictions on Contributions to a Trade) Regulations 2005 (SI 2005/2017)
The FTT found that these Regulations did not apply as it could not be said that the borrower did not truly have any liability to repay the loan, although the loans were wholly unnecessary and taken out only as part of the arrangements in issue.
Arrangements entered into on or after 21 October 2009
The FTT held that one referrer was caught by the provisions of ITA 2007 S.74ZA as he had entered into the arrangements in question as part of tax avoidance arrangements the main purpose of which was to secure sideways loss relief and avoid paying tax.
Levy and Levy comment
The decision of the Tribunal illustrates the difficulties faced by those who have entered into complex arrangements such as the ones in issue here. The key argument, that sideways loss relief should be granted to the taxpayers, was lost because the FTT determined that payments to the exploitation company were, when they matched the amounts borrowed, paid for the purchase of a guaranteed income stream. The commerciality of the partnerships was also not upheld by the FTT. The result, therefore, is a blow to those arrangements which depend on ‘gearing’ and genuine trading to produce allowable losses. Such arrangements have, historically, been very popular with taxpayers. On a brighter note for taxpayers, the FTT had no difficulty in disposing of HMRC’s Ramsay point. The battle will no doubt continue in the Higher Courts.
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