First-tier Tribunal (Tax)

[2010] UKFTT 579 (TC)

TC00829

            Appeal number:  TC/2010/02297

TC/2010/02298

TC/2010/02299

FIRST-TIER TRIBUNAL

TAX

-and-

Sitting in public in Birmingham on 11 November 2010

Peter Kavanagh FCA of Kavanagh Limited for the Appellant

Cheryl Payne-Dwyer, Senior Officer of HMRC, for the Respondents

© CROWN COPYRIGHT 2010

DECISION

Introduction

1.     This is an appeal against an amendment made by HMRC to each of the three Appellants’ self-assessment tax returns for 2005-06.  The amendments were made as a result of HMRC denying relief to the Appellants under the Enterprise Investment Scheme (“EIS”) set out in Chapter III, Part VII of Income & Corporation Taxes Act 1988 (“TA 88”) for issues of shares made to them during that year.

2.     The basis on which HMRC sought to deny the relief was that they maintained the Appellants were “connected” with the issuing company and were unable to satisfy the condition contained in section 291A(5)(b)(ii) TA 88 which would, if satisfied, afford relief in spite of the connection.  This was due to the fact that the Appellants had, HMRC said, been involved as employees in carrying on some or all of the issuing company’s trade whilst that trade was owned by a predecessor company.

3.     HMRC maintain that as a general proposition, “management buyouts” cannot qualify for EIS relief due to this prior involvement of the acquiring managers in the trade whose ownership is transferred in the buyout.

Background

4.     The three Appellants were, up to 25 October 2004, employed as line managers within the business of Tufnol Limited (“Oldco”), a manufacturer and distributor of high pressure laminates, filament wound tube, poltruded profiles and water lubricated bearings for marine and pump equipment.  They were not directors or shareholders of Oldco. 

5.     Oldco went into administrative receivership on 13 September 2004 after making losses.

6.     The Appellants acquired a newly incorporated company, Tufnol Composites Limited (“Newco”), becoming directors of it and each acquiring two ordinary shares of £1 in it on 15 October 2004.  There was no direct evidence before us as to the order in which the director appointments and share issues took place.  On the same day (and, we infer, at the same time), one Peter Jackson (an unrelated party) acquired 6 ordinary shares of £1 in Newco.

7.     It was intended that Newco would purchase most of the assets (subject to assuming responsibility for some liabilities) of Oldco.  In preparation for that purchase, Newco applied to be registered for VAT by submitting a form VAT 1 to HMRC with a letter dated 21 October 2004.  In the form VAT 1, Newco gave the expected date of Newco’s first taxable supply as 25 October 2004, and in response to the question “Have you taken over a VAT registered business from someone else as a going concern, or changed the legal entity that owns the business...?” it was stated “will do shortly”; the date of transfer was identified as “25.10.2004 or shortly thereafter”; and Oldco’s name and VAT number was quoted as “the previous owner”.

8.     On 25 October 2004, an agreement (“the SPA”) was signed under which Oldco, at the direction of its administrative receiver, sold various assets to Newco.

9.     Clause 2 of the SPA listed the assets being sold, which included the bulk of the assets of the business of Oldco (including its fixed and loose equipment, its stock, work in progress, intellectual property, goodwill (including “the exclusive rights of the Buyer to represent itself as carrying on the Business in succession to the Seller...so far as such rights are vested in it”), its rights to occupy its premises and the benefit of all its environmental and similar licences); and after the list of assets the following phrase was included: “to the intent that the Buyer [i.e. Newco] shall from the Transfer Date [i.e. 11.50 pm on 25 October 2004] carry on the Business as a going concern.” 

10.  The debtors of Oldco were not included in the assets sold, nor was any cash balance held by it.  There were certain other less significant exclusions set out in clause 2.2 of the SPA.

11.  Newco did not assume responsibility for the existing creditors of Oldco.

12.  Clause 14 of the SPA expressed both parties’ belief that the transaction effected by the SPA was outside the scope of VAT by virtue of Article 5 of the VAT (Special Provisions) Order 1995 – i.e. the parties both believed the transaction was a “transfer of a going concern” for VAT purposes.

13.  Clause 16.1 of the SPA set out the parties’ agreement that it constituted “the sale of a business as a going concern” for employment protection law purposes, with the consequent automatic transfer of all employees to Newco.

14.  In summary, the SPA was a fairly typical receivership asset sale agreement, whereby the bulk (but not all) of the assets of Oldco were sold to Newco, Newco effectively took on the business and various exceptions and reservations were made to ensure that Oldco did not purport to sell any assets over which third party rights clearly existed. 

15.  It was pointed out that the customer contracts were not transferred under the SPA (indeed, it would probably not have been possible to do so without the consent of the relevant customers) and one result of the sale was that a major customer of Oldco (representing about 10% of its turnover) did not agree to the transfer of its contract to Newco so that business was lost to Newco.

16.  On 25 October 2005, a year after Newco’s acquisition of the assets from Oldco, Newco issued further ordinary £1 shares to the Appellants and Mr Jackson – 14,998 shares to each of the Appellants and 44,994 to Mr Jackson.

17.  Both the original and the later share issues were carried out at par.

18.  The Appellants claimed EIS relief in respect of the first small issue of shares to each of them in their 2004-05 tax returns.  HMRC have not challenged this, whilst observing that the share issues were strictly too small to qualify for relief (in light of the £500 minimum set out in s 290(1) TA 88).

19.  The Appellants also claimed EIS relief in respect of the subsequent issues of shares to them on 25 October 2005 (in their 2005-06 tax returns).  There was some confusion about whether Mr Godwin had made such a claim but HMRC confirmed they would take no point on this and if he were found to be eligible to make such a claim, they would allow it.

20.  Due to some kind of error or duplication, all three Appellants had also claimed EIS relief on the October 2005 issues of shares in their 2006-07 tax returns.  At the hearing, it was confirmed that this was an error and the Appellants accepted HMRC’s contention that no relief was available for the 2006-07 tax year.

HMRC’s disallowance of EIS relief

21.  HMRC disputed the availability of EIS relief at all in connection with the 25 October 2005 issues of shares to the Appellants.  After some discussion at the appeal, it was clarified that the only basis they sought to rely on for this purpose was the Appellants’ failure to satisfy the condition set out in s 291A(5)(b) TA 88, by reason of the existence of an “involvement” falling within s 291A(5)(b)(ii).  HMRC accepted that all other requirements for the relief were satisfied.

22.  The Tribunal therefore focused solely on this point.  To put it in context, the trail starts with s 291(1) TA 88, which provides:

“(1)       An individual qualifies for relief in respect of eligible shares in a company (referred to in this section and sections 291A and 291B as the “issuing company”) if -

(a)        he subscribes for the shares on his own behalf; and

(b)        subject to section 291A(4), he is not at any time in the period –

(i)         beginning two years before the issue of the shares, and

(ii)        ending immediately before the termination date relating to those shares,

connected with the company (whether before or after its incorporation).”

23.  The “termination date” is effectively the third anniversary of the date of issue of the relevant shares – s 312(1) TA 88.

24.  S 291(2) then goes on to explain what is meant by “connected” for this purpose:

“(2)       For the purposes of this section, an individual is connected with the issuing company if he, or an associate of his, is –

(a)        an employee of, or of a partner of, the issuing company or any subsidiary,

(b)        a partner of the issuing company or any subsidiary, or

(c)        subject to section 291A, a director of, or of a company which is a partner of, the issuing company or any subsidiary,

or if he, or an associate of his, is so connected by virtue of section 291B.”

25.  HMRC did not argue that any “connection” arose by virtue of s 291B TA 88 (equity holdings).

26.  S 291(4) TA 88 makes it clear that if a person is both a director and an employee of a company, then in s 291 (and s 291A), references to any person in his capacity as a director are to be read as including him in his capacity as an employee, but apart from that he is not to be treated as an employee.

27.  The parties agreed that if one considered only s 291 TA 88, the Appellants would be regarded as “connected” with Newco,  but only pursuant to s 291(2)(c) TA 88, by reason of their directorships of it. 

28.  S 291(2)(c) TA 88 is however made expressly subject to s 291A TA 88 which, in turn,  sets out (in subsections (1) to (3) – see below) some circumstances in which a director of the issuing company is not to be regarded as “connected” with it (i.e. it overrides the prima facie connection established by s 291(2)(c)).  Essentially, the director (or his “associate” – not relevant here) is only to be regarded as “connected” if he (or certain other persons – not relevant here) receives a payment from the issuing company (or a person related to it) and that payment falls outside the list of payments which may be disregarded under s 291A(3) TA 88.

29.  S 291A (1) to (3), in full, provides as follows:

(1)        An individual is not connected with the issuing company by reason only that he, or an associate of his, is a director of that or another company unless he or his associate (or a partnership of which he or his associate is a member) –

(a)        receives a payment from the issuing company or a related person during the period mentioned in section 291(1)(b), or

(b)        is entitled to receive such a payment in respect of that period or any part of it.

(2)        In this section –

(a)        “related person”, in relation to the issuing company, means –

(i)         any company of which the individual or his associate is a director and which is a subsidiary or a partner of the issuing company or of a subsidiary, and

(ii)        any person connected with the issuing company or with a company falling within sub-paragraph (i) above, and

(b)        any reference to a payment to an individual includes a payment made to him indirectly or to his order or for his benefit.

(3)        For the purposes of subsection (1) above there shall be disregarded –

(a)        any payment or reimbursement of travelling or other expenses wholly, exclusively and necessarily incurred by him or his associate in the performance of his duties as a director,

(b)        any interest which represents no more than a reasonable commercial return on  money lent to the issuing company or a related person,

(c)        any dividend or other distribution which does not exceed a normal return on the investment,

(d)        any payment for the supply of goods which does not exceed their market value,

(e)        any payment of rent for any property occupied by the issuing company or a related person which does not exceed a reasonable and commercial rent for the property, and

(f)        any reasonable and necessary remuneration which –

(i)         is paid for services rendered to the issuing company or related person in the course of a trade or profession carried on wholly or partly in the United Kingdom (not being secretarial or managerial services or services of a kind provided by the person to whom they are rendered), and

(ii)        is taken into account in calculating for tax purposes the profits of that trade or profession.”

30.  These provisions make up what is sometimes called the “business angel” exemption – in that they allow for an outside investor to be appointed as a director and to receive various payments in that capacity, without losing his EIS relief.

31.  Normal directors’ emoluments however fall outside the “white list” in s 291A(3) and, as is shown by Newco’s accounts for the year ended 31 October 2005, the Appellants received substantial emoluments from Newco in that year.  No Appellant has denied that he received such emoluments.  It follows that s 291A(1) does not take effect in this case to negate the prima facie “connection” established between the Appellants and Newco under s 291(2) TA 88.

32.  There is however a further potential escape route for the Appellants contained in s 291A(4) and (5) TA 88.  In broad terms, these provisions allow the relief to be granted in spite of the existence of a “connection”, as long as the connection only arises as a result of payment of (or entitlement to receive) certain remuneration as a director.

33.  There are however some conditions which must be satisfied under s 291A(5) before this escape route applies. 

34.  First, the remuneration in question must consist only of “reasonable remuneration for services rendered to the company of which he is a director in his capacity as such”.  HMRC accept that the remuneration paid in this case to each Appellant satisfies this condition.

35.  Second, and most crucial in the context of this appeal, is the condition set out in s 291A(5)(b), that:

“(b)       the subscriber was issued with eligible shares (whether the relevant shares or a previous issue of eligible shares) at a time when he had never been –

(i)         connected with the issuing company, or

(ii)        involved in carrying on (whether on his own account or as a partner, director or employee) the whole or any part of the trade carried on by the issuing company or a subsidiary”

Is the condition in s 291A(5)(b) satisfied?

36.  It is agreed that each Appellant has received two issues of “eligible shares” – the initial issue of two shares to each of them on 15 October 2004 and the subsequent issue of 14,998 shares to each of them on 25 October 2005.  It is clear that at the time of the second issue of shares, all the Appellants were involved in carrying on (as directors) the whole or some part of the trade carried on by Newco.  This condition cannot therefore be satisfied by reference to that second issue of shares. 

37.  The question is whether it can be satisfied by reference to the first issue of shares on 15 October 2004.

38.  HMRC point out that, at that time, the Appellants were involved in carrying on all or part of the trade of Oldco in their then capacity as employees of Oldco.  That much is not disputed by the Appellants.  However, HMRC go on to say that the trade of Oldco in which the Appellants were employed is the same trade as the trade carried on after 25 October 2004 by Newco, and therefore the Appellants had, at the time of the original issue of shares to them on 15 October 2004, previously been involved in carrying on, as employees, the whole or some part of the trade which was, subsequently, carried on by Newco.  Thus, HMRC say, this condition is not satisfied by reference to the 15 October 2004 issue of shares and the Appellants’ claim for relief must fail.

39.  We cannot agree with this argument.  There are two aspects to it, the first of which was argued at some length before us and the second of which received only the briefest of mentions.

Aspect 1

40.  The first aspect is the question of whether “the trade carried on” by Newco could be regarded as having a separate and continuous existence in its own right, so that the Appellants’ involvement in that trade (or some part of it) as employees of Oldco before Newco was even formed could be taken into account for the purposes of s 291A(5)(b)(ii). 

41.  HMRC maintained that the concept of “a trade” was quite distinct from the identity of the legal entity which happened to be carrying on that trade at any particular time, and the Appellants did not dispute this principle.  However where they disagreed was whether, as a matter of fact, there could be said to be a continuous single trade in this case, carried on successively by Oldco and then Newco.

42.  Mr Kavanagh on behalf of the Appellants sought to persuade us that the sale of assets from Oldco to Newco was just that – a sale of certain specified assets and nothing more.  He maintained that it was a reflection of the failure of the trade carried on by Oldco, and Newco effectively started up a new trade using (amongst other things) the assets acquired from Oldco.  He said that the SPA was so qualified in the rights which it passed to Newco that the existence and transferability of those rights was open to doubt: he referred particularly to clause 8.1 of the SPA, which read:

“The Buyer acknowledges that the Intellectual Property may be subject to restrictions or deficiencies and that it may not be sufficiently transferable to the Buyer to enable the Business to be carried on efficiently or at all....”

43.  He asserted that there had been some difficulties in this area after the sale, as other companies had started to use the “Tufnol” name and Newco had experienced problems in trying to stop them.

44.  He also argued that in order to make the business prosper as it had (in contrast to its previous failure), Newco had needed to bring in new finance, a new board, new structures, new discipline (especially financial), new processes and a new business plan.  It had been necessary to drop two lines of business previously carried on by Oldco and to generate new lines of business.  The workforce had been radically slimmed down (by approximately 50%) immediately prior to Newco’s acquisition of the business.  It was true that many of the products sold by Newco were the same as the previous products, but in Mr Kavanagh’s argument, sale of substantially the same products did not equate to the carrying on of the same trade.

45.     However, after considering all the available evidence as to the nature of the transaction in October 2004 and the surrounding circumstances, we are satisfied that there was indeed a transfer of a trade – albeit a lossmaking one – from Oldco to Newco on 25 October 2004.

Aspect 2

46.  However, there was a second aspect to HMRC’s argument, which (although only briefly and sketchily argued by Mr Kavanagh) we find more difficult.  This arises from the way s 291A(5)(b) TA 88 is worded.  To construe it as HMRC ask us to, the language of that section must be strained, by effectively inserting the words “then or at any relevant time subsequently” (or words to a similar practical effect) before the words “carried on by the issuing company”. 

47.  The natural meaning of the subsection as it stands is that the question of whether there was a “connection” or a previous “involvement” (s 291A(5)(b)(i) and (b)(ii) respectively) should be tested at the time of the issue of eligible shares which is being considered.  As mentioned above, we are here considering the first issue of eligible shares on 15 October 2004.  At that time, could it be said that any of the Appellants had ever been involved in carrying on the whole or any part of the trade carried on by Newco?  The answer must be no, because up to that time, Newco had never carried on any trade. 

48.  We see no obvious absurdity in this conclusion which would lead us to accept the conflicting interpretation argued for by HMRC: it is easy to envisage other situations in which the new owners of an issuing company’s shares could have been previously involved in carrying on its trade and would therefore fall foul of the condition in s 291A(5)(b)(ii).

Final points

49.  HMRC based their case solely on the Appellants failing, in their contention, to satisfy sub-paragraph (ii) of s 291A(5)(b) by reason of their prior involvement in the trade.  They did not argue that any “connection” had existed for the purposes of sub-paragraph (i).  As the point was not raised, we do not have to decide it, but we infer that HMRC were satisfied no such connection existed, presumably either by reason of the share issues taking place before the Appellants became directors or by reason of the Appellants not having received any payment from Newco at the time of the 15 October 2004 share issue to them.

50.  If the Appellants are (as we hold) able to satisfy the condition in s 291A(5)(b) by reference to the first issue of shares to them on 15 October 2004, then the further condition in s 291A(5)(c) must be considered, as the October 2005 issue of shares does not itself satisfy the condition in s 291A(5)(b).  This is simply a question of timing – and the 25 October 2005 issue of shares clearly took place in time to satisfy paragraph (c), which effectively provides a “shelter” for any issues of eligible shares carried out within three years after the initial issue of eligible shares which satisfies the condition in s 291A(5)(b).

Decision

51.  We therefore find that although the trade of Oldco was effectively transferred to Newco and the Appellants had previously been involved in carrying on that trade (or some part of it) in their capacity as employees of Oldco, the objections which have been raised by HMRC to the availability of EIS relief for the issues of shares made to the Appellants on 25 October 2005 cannot be sustained and the appeal must therefore be allowed.

52.            This document contains full findings of fact and reasons for the decision. Any party dissatisfied with this decision has a right to apply for permission to appeal against it pursuant to Rule 39 of the Tribunal Procedure (First-tier Tribunal) (Tax Chamber) Rules 2009.   The application must be received by this Tribunal not later than 56 days after this decision is sent to that party.  The parties are referred to “Guidance to accompany a Decision from the First-tier Tribunal (Tax Chamber)” which accompanies and forms part of this decision notice.

KEVIN POOLE

TRIBUNAL JUDGE

RELEASE DATE:  17 November 2010