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Cite as: [2003] UKSC SPC383, [2003] UKSC SPC00383

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Forthwright (Wales) Ltd v HM Inspector of Taxes [2003] UKSC SPC00383 (29 September 2003)

ENTERPRISE INVESTMENT SCHEME – part of the money raised used to pay dividends including dividends paid to employees – whether shares issued to raise money for the purpose of a qualifying business activity – no – whether necessary for there to be a closure notice for certificate to be refused – no

THE SPECIAL COMMISSIONERS

FORTHRIGHT (WALES) LIMITED Appellant

- and -

HM INSPECTOR OF TAXES Respondent

Special Commissioner: DR JOHN F AVERY JONES CBE

Sitting in public in London on 23 September 2003

Louise Rippon instructed by Hayvenhursts Limited, chartered Accountants, for the Appellant

Colin Williams, HM Inspector of Taxes, Appeals Unit Wales, for the Respondents

© CROWN COPYRIGHT 2003

DECISION

This is an appeal by Forthright (Wales) Limited against the refusal by the Inspector to issue certificates to investors in the Appellant entitling them to claim enterprise investment relief pursuant to section 306 of the Taxes Act 1988. The Appellant was represented by Ms Louise Rippon and the Inspector by Mr Colin Williams.

The issues in this appeal are first whether it is necessary for there to be an enquiry followed by a closure notice for the certificate to be refused, and secondly whether the issue of shares in the Appellant qualifies under the enterprise investment scheme, in particular whether the money raised was used for a qualifying business activity. The Inspector had considered that the appellant company was not carrying on a qualifying business activity on two grounds: that part of the funds were used to pay liabilities taken over when it acquired the trade, and part had been used to pay dividends. During the hearing the first point was conceded, leaving only the dividend point to be decided.

There was a statement of agreed facts and issues as follows:

(1) The Appellant Company was incorporated on 23 February 1998.

(2) The Appellant Company acquired the trade and assets of Forthright Management Services Limited.

(3) The Appellant Company commenced trading in the United Kingdom on 3 April 1998 supplying management services to Bartons, Chartered Accountants, which is a qualifying trade for the purposes of the EIS relief provisions, on the same terms as previously used by Forthright Management services Limited.

(4) The liabilities taken over by the Appellant Company from Forthright Management Services Limited were:

Loan from P T Felman Management Services Ltd £69,446

Loan from Bartons Ltd £87,500

Bank overdraft £4,100

(5) On 3 April 1998 the Appellant Company made a share issue raising £299,998.

(6) These funds were used to pay or repay:

Trade expenses £81,350

Liabilities taken over from Forthright

Management Services Ltd £161,046

Dividends and advance corporation tax £57,602

(7) On 10 November 1998 the Appellant Company submitted Form EIS 1 tot eh Inland Revenue, requesting authority to issue certificates to the investors under the provisions of section 306 of the Taxes Act 1988.

(8) On 28 march 2000 Mr A L Davies, HM Inspector of taxes, issued a formal notice of decision refusing to give the required authority, on the grounds that the funds raised by the share issue were not used for the purposes of a qualifying business activity.

(9) On 29 March 2000 the Appellant Company appealed against that decision, claiming that it was bad in law.

Whether a closure notice is required

On the first issue, section 306(10) provides:

"For the purposes of the provisions of the Management Act [i.e. the Taxes Management act 1970] relating to appeals against decisions of claims, the refusal of the inspector to authorise the issue of a certificate under subsection (2) above shall be taken to be a decision refusing a claim made by the company."

Miss Rippon contends that this provision incorporates the procedure in Schedule 1A of the Taxes Management Act 1970 under which a closure notice must either allow a claim or disallow it wholly or to such extent as appears to the officer appropriate (paragraph 7(3)), and an appeal is against the conclusion stated in the closure notice (paragraph 9). Here there had been no enquiry started under paragraph 5 (and the inspector is now out of time for starting one) and so there cannot be any closure notice, and so she contends that the claim must be admitted.

Mr Williams contends that the refusal to give the certificate is not a claim and is not deemed to be a claim. All the section says is that for the purposes of the appeal provisions there shall be taken to be a decision refusing a claim, which is a means of allowing the taxpayer to appeal.

Reasons for decision

There is now no appeal against refusal of a claim as such, but paragraph 9 of Schedule 1A provides:

"An appeal may be brought against—

…

(b) any decision contained in a closure notice under paragraph 7(3) above."

It therefore assumes that a decision to refuse a claim will be contained in a closure notice. The time limit for appealing is given in subsection (1A) by reference to the date of the closure notice. I was not taken to the legislation in force at the time section 306(10) was first enacted but it appears that until the Finance Act 1994 an appeal lay against the decision on a claim (see the original section 42 of the Taxes Management Act 1970). Section 306(10) may not have kept up with the changes resulting from self-assessment. Miss Rippon's point therefore has some force on a strict reading of the legislation. I am not sure however that if she is right it would follow that the certificate must be issued as the Inspector can no longer start an enquiry that could lead to a closure notice; it might equally be that the taxpayer has no right of appeal. The purpose of the provision is stated: it is "for the purposes of the provisions of the Management Act relating to appeals against decisions of claims." It seems to me that I should give effect to the purpose of the legislature that there should be a right of appeal against the refusal to give the certificate. Section 306(1) provides that the decision not to issue the certificate shall be taken to be a decision refusing a claim. If there had been such a refusal of a claim today it would necessarily have been contained in a closure notice and so I consider that I am justified in assuming that the decision refusing the claim was given in the form that would give rise to a right of appeal, namely one contained in a closure notice. Accordingly on this point I find in favour of the Inspector that an actual closure notice is not necessary.

Qualifying business activity

Section 289 of the Taxes Act 1988 provides:

"(1) For the purposes of this Chapter, an individual is eligible for relief, subject to the provisions of this Chapter, if—

(a) eligible shares in a qualifying company [an unquoted company which exists wholly for the purpose of carrying on one or more qualifying trades] for which he has subscribed are issued to him and, under section 291, he qualifies for relief in respect of those shares,

(b) the shares are issued in order to raise money for the purpose of a qualifying business activity,

(ba) the requirements of subsection (1A) below are satisfied in relation to the company [meaning that it exists wholly for the purpose of carrying on one or more qualifying trades etc], and

(c) the money raised by the issue is employed not later than the time mentioned in subsection (3) below [normally 12 months from the date of issue] wholly for the purpose of that activity [subsection (3) also provides that this does not fail to be satisfied by reason only of the fact that an amount of money which is not significant is employed for another purpose].

(2) In this Chapter 'qualifying business activity', in relation to a company, means—

(a) the company or any subsidiary—

(i) carrying on a qualifying trade which, on the date the shares are issued, it is carrying on, or

(ii) preparing to carry on a qualifying trade which, on that date, it intends to carry on wholly or mainly in the United Kingdom and which it begins to carry on within two years after that date,

but only if, at any time in the relevant period when the qualifying trade is carried on, it is carried on wholly or mainly in the United Kingdom."

I heard evidence from Mr Philip Felman, chartered accountant. The Appellant continued an arrangement of Forthright Management Services Limited whereby staff were paid a nominal salary plus dividends, which had the advantage that the dividends did not attract National Insurance contributions. This arrangement started when following a take-over of another accountancy practice which turned out to be unsuccessful the practice was in financial difficulties and the staff agreed to work for dividends. The Appellant has two classes of shares, A ordinary shares which are held by investors and B-Z ordinary shares which are held by employees. The articles state that "all shares shall rank pari passu as if they constitute one class of share." Presumably the intended effect is that different dividends can be paid on each class. This seems to have occurred. In the Appellant's accounts to 31 July 1999 dividends totalling £37,500 were paid on 300,000 A shares of £1, and £85,260 on 258 B shares of £1.

Miss Rippon contends that the effect of reading subsection (2) into subsection (1)(b) was that the shares must be issued in order to raise money for the purpose of a company carrying on a qualifying trade, which is different from for the purposes of the trade itself. The drafting was unusual and must be assumed to be intended to be different from the frequently-used formula "for the purposes of the trade." It was sufficient if the money was raised for the purpose of a company carrying on a qualifying trade even if there is an element of duality present. In relation to the dividends it was the Appellant Company's practice to remunerate its employees by way of dividends. Such dividends were essential to the Appellant's trade.

Mr Williams contends that the words "for the purpose of [a company carrying on a qualifying trade]"were synonymous with "for the purposes of a qualifying trade." The effect was similar to the test for deductibility in section 74 of the Taxes Act 1988 as interpreted in Strong and Company of Romsey v Woodifield 5 TC 215 by Lord Davy at page 220:

"These words…appear to me to mean for the purpose of enabling a person to carry on and earn profits in the trade…. It is not enough that the disbursement is made in the course of, or arises out of, or is connected with, the trade or is made out of the profits of the trade. It must be made for the purpose of earning the profits"

The dividends were distributions of profit, not sums paid out in earning the profits of the trade. Under section 263(3) of the Companies Act 1985 dividends could be paid only out of realised profits; it is not enough, as Lord Davy said, that they are made out of the profits.

Miss Rippon contended in reply that there was nothing to prevent a payment being both a dividend and a payment of remuneration; it was merely that Schedule F took precedence, see section 20 of the Taxes Act 1988. She cited O'Leary v McKinlay [1991] STC 42 in which the employer as a condition of a footballer's service made a loan to a non-resident trust under which the income was payable to a footballer, and the trust deposited the money and paid the interest to the footballer. The interest was held to be taxable under Schedule E not Case V of Schedule D.

Reasons for decision

Section 289(1) quoted above requires that a company existing wholly for the purpose of carrying on one or more qualifying trades, issues shares in order to raise money for the purpose of a qualifying business activity (meaning the company carrying on the qualifying trade, or preparing to carry on a qualifying trade), and the money raised must be employed wholly for the purpose of the qualifying business activity. The wording of the definition of qualifying business activity is odd in meaning the company carrying on (or preparing to carry on) a qualifying trade, whereas one might have expected it to say that it meant the qualifying trade that the company was carrying on (or preparing to carry on). However, the effect seems to be the same: the company must exist for the purpose of carrying on a qualifying trade, and the shares must be issued in order to raise money for, and the money raised must be employed wholly for, the purpose of a qualifying trade that it actually carries it on at the time the shares are issued, or which it is preparing to carry it on (and actually does so within a time limit). I therefore agree with Mr Williams that the test is the same as for the purpose of the qualifying trade. The reason for the different wording seems to be that the draftsman needed to make a distinction between a trade then being carried on and a trade that the company was preparing to carry on.

The question is therefore: was the money raised for the purpose of paying the dividends paid for the purpose of the trade, and was the money employed wholly for the purpose of the trade? Normally one would not say that a dividend was paid for the purpose of the trade as interpreted by Lord Davy in Strong v Woodifield; it is payment out of the profits, not for the purpose of earning the profits. Does it make any difference that there is a special class of shares and the employees contract to work partly for dividends? I did not have any evidence about the precise terms of the arrangement but I accept that the employees agreed to work for remuneration partly in the form of dividends (and therefore on the basis that there were profits out of which to pay them). In this sense I agree that in the unusual circumstances of this case the dividends were paid for the purpose of the trade even though it gives that expression a different meaning from the deductibility provision. However, it seems to me that the Appellant still cannot succeed because dividends were also paid on the A shares which were not held by employees. In the period to 31 July 1999 dividends of £122,760 were paid, £37,500 on the investors' A shares (30.5 per cent of the total) and £85,260 on the employees' shares. There is no evidence that the dividends were paid to the employees first. Of the amount raised by the share issue £57,602 was paid in dividends, which I take to be a balancing figure after taking into account the liabilities taken over and trade expenses paid. Not all of this was paid to employees, 30.5 per cent (£17,596) would have been paid to investors. The Appellant cannot show that the money raised was employed wholly for the purpose of the trade even if dividends paid to employees in these circumstances are for the purposes of the trade. The dividend paid to the investors clearly cannot be ignored as not significant.

Accordingly the Appellant does not satisfy the tests in section 289(1) and the appeal is dismissed.

J F AVERY JONES

SPECIAL COMMISSIONER

SC 3032/03