United Kingdom Special Commissioners of Income Tax Decisions

 


SPC00477

CORPORATION TAX – Promotional expenses, whether disallowed in whole or in part as expenses incurred in providing business entertainment – s.577 ICTA 1988 – Held they were in part – Appeal allowed in part

CORPORATION TAX – Relief for trading losses carried forward – s.393(1) ICTA 1988 – whether the trade in the accounting periods in which the losses were incurred was the same trade as that carried on in the accounting period when relief was claimed – Held it was not – Appeal dismissed

THE SPECIAL COMMISSIONERS

NETLOGIC CONSULTING LIMITED Appellant

- and -

HER MAJESTY'S REVENUE AND CUSTOMS Respondent

KAWTHAR CONSULTING LIMITED Appellant

- and -

HER MAJESTY'S REVENUE AND CUSTOMS Respondent

SPECIAL COMMISSIONERS: JOHN WALTERS QC

STEPHEN OLIVER QC

Sitting in public in London on 16 and 17 February 2005

Dr. Fahmy, Director of both Appellants, appeared for both Appellants

Craig Breed, HM Inspector of Taxes, appeared for the Respondents in both appeals.

© CROWN COPYRIGHT XXXX DECISION
1. The Special Commissioners heard two appeals, by Netlogic Consulting Limited ("Netlogic") and Kawthar Consulting Limited ("Kawthar"), respectively, at one hearing on 16 and 17 February 2005.
2. Both Netlogic and Kawthar are companies under the control of Dr. Fahmy, who appeared on behalf of both companies before us at the hearing.
3. Netlogic's appeal is against an assessment made under section 29 Taxes Management Act 1970 ("TMA") for the accounting period ended 31 December 1998.
4. Kawthar's appeal is against:

(1) an assessment made under section 29 TMA for the accounting period ended 31 December 1998;

(2) an amendment to its self-assessment made under paragraph 34(2), Schedule 18, Finance Act 1998 ("FA 1998") for the accounting period ended 31 December 1999; and

(3) an amendment to its self-assessment made under that paragraph for the accounting period ended 31 December 2000.

5. We deal with Netlogic's appeal and Kawthar's appeal in turn.

Netlogic's appeal

6. We take the following relevant facts from the "Statement of Facts Not in Dispute" with our papers. They are that the tax computation produced by Netlogic showed that its profit chargeable to corporation tax for the accounting period ended 31 December 1998 was £6,564. In arriving at this figure the following had been claimed as trading deductions:

(a) £2,481 in respect of "entertaining, relating to a function for 250 potential customers" of Netlogic;

(b) £194,000 in respect of contractor fees, professional management fees and consultancy fees payable to Kawthar.

7. Although in his Skeleton argument Mr. Breed (who appears for the Revenue) claims that the £194,000 payable to Kawthar is not deductible as a trading expense by Netlogic, he goes on to say that the relevant fees represent taxable income of Kawthar and because the Revenue seeks tax in relation to that income and "does not wish to seek tax twice in respect of the same amount", he asks us to find that "as well as giving rise to a charge to tax on Kawthar … these fees do indeed give rise to an allowable deduction for Netlogic". We interpret this submission as one whereby the Revenue raises no objection to the deduction. We have seen nothing to indicate that the fees were not deductible. We therefore say no more about this deduction.
8. Therefore, the only remaining issue in Netlogic's appeal is whether the £2,481 deducted in respect of the function for 250 potential customers of Netlogic is an allowable trading deduction. Mr. Breed contends that it is not, citing section 577 Income and Corporation taxes Act 1988 ("ICTA").
9. Section 577 ICTA relevantly provides:

"(1) Subject to the provisions of this section

(a) no deduction shall be made in computing profits chargeable to tax under Schedule D for any expenses incurred in providing business entertainment …

(5) For the purposes of this section 'business entertainment' means entertainment (including hospitality of any kind) provided by a person … in connection with a trade carried on by that person …

(7) In this section

(a) any reference to expenses incurred in providing entertainment includes a reference to expenses incurred in providing anything incidental thereto;"

10. The expense of £2,481 is the total, net of VAT, of two invoices. £1,800 represents the charge made by Oasis Cuisine for "food and service and set-up for party of 250 people", while £681 was charged for room hire.
11. Dr. Fahmy told us (and we accept) that the function took place on 27 December 1998 and was a general promotional function where the guests were persons who had registered in advance, in response to prior advertisement, as persons interested in learning more about training courses offered by Netlogic. Thus the persons attending the function were potential clients or customers of Netlogic.
12. The Inspector submitted that the £1,800 charged to Netlogic by Oasis Cuisine a charge for hospitality, and therefore, in this context, business entertainment within section 577(5) ICTA, and that the £681 charged for room hire was and expense incurred in providing something incidental to the provision of the business entertainment.
13. Dr. Fahmy argued that both amounts were expenses on advertising or promotion rather than hospitality or entertainment.
14. In the context of VAT the Court of Appeal has held that "to give people free meals … is … to entertain them within the ordinary meaning of the word" (per Lord Brandon in Customs and Excise Commissioners v Shaklee [1981] STC 776 at page 782e). We consider that this is guidance of general application, and we therefore accept Mr. Breed's submission that the £1,800 charged by Oasis Cuisine is an expense incurred in providing business entertainment and is therefore disallowed as a trading deduction by section 577(1) ICTA.
15. The £681 charged for room hire was a charge for the provision of the room so that the meeting of potential clients or customers of Netlogic could take place. The purpose of this meeting was to attract business to Netlogic and not entertainment. We find that the entertainment was incidental to the promotional purpose of the meeting, rather than the hire of the room being incidental to the provision of the entertainment. In argument Mr. Breed (as we understood him) was eventually prepared to accept this. Therefore the £681 is not an expense within section 577(7) ICTA and is not precluded from being deductible by section 577(1). To that extent, therefore, we allow Netlogic's appeal.

Kawthar's appeal

16. Dr. Fahmy, for Kawthar, submits that Kawthar's profits for the accounting periods ended 31 December 1998 to 2000 (inclusive) ("the 1998 to 2000 accounting periods") fall to be reduced by brought forward trading losses sustained in earlier accounting periods before 1995. He relies on section 393(1) ICTA, which relevantly provides as follows:

"Where in any accounting period a company carrying on a trade incurs a loss in the trade, the loss shall be set off for the purposes of corporation tax against any trading income from the trade in succeeding accounting periods; and (so long as the company continues to carry on the trade) its trading income from the trade in any succeeding accounting period shall then be treated as reduced by the amount of the loss, or by so much of that amount as cannot, under this subsection … be relieved against income or profits of an earlier accounting period."

17. Mr Breed, for the Revenue, contends that relief cannot be given in the 1998 to 2000 accounting periods under section 393(1) ICTA because either:

(a) Kawthar's trade in which the losses were incurred ceased in 1995, or

(b) If Kawthar's trade in which the losses were incurred continued beyond 1995, it changed its nature with the result that the trade carried on in the 1998 to 2000 accounting periods was not the same trade as the trade in which the losses were incurred.

18. Mr. Breed further contends that if we accept that the trade carried on in the 1998 to 2000 accounting periods is (contrary to his earlier submissions) the same trade as the trade in which the losses were incurred, then it is for Kawthar to prove that there were accumulated trading losses at 31 December 1997 (immediately before the 1998 accounting period) of an amount more than £217,511 – that amount being the amount of accumulated trading losses as at that date which is agreed by the Revenue.
19. There was no debate before us as to the meaning of the relevant legislation (section 393 ICTA 1988), which is clear on its terms. The main issue for our determination is whether, on the facts, the trade which Kawthar carried on before 1995 was being carried on by Kawthar in the 1998 to 2000 accounting periods. As we have stated, Mr. Breed submitted it was not. Dr. Fahmy submitted it was.

Facts

20. Dr. Fahmy himself was the only witness. He gave evidence both orally and in the form of a Witness Statement. We find the following facts.
21. Dr. Fahmy is the founder of Kawthar. He is a leading information technology ("IT") consultant. He was born in Egypt. He has been a member of the Institute of Directors in the UK for almost 17 years. He has been involved in the IT industry in the UK for many years. He has worked in academic institutions. Dr. Fahmy is a member of several associations in the IT sector. He started his own IT consultancy in 1982 under the name "Applied Technology". In 1984 this consultancy was incorporated as "Applied Microsytems Technology Ltd.". The shareholders at the outset were Dr. Fahmy and his wife. The name of Applied Microsystems Technology Ltd. was changed to Kawthar Consulting Ltd. on 17 April 1998. For convenience, we refer to the company as Kawthar throughout the rest of this Decision.
22. The company now named Kawthar "was formed in 1984 to enable Dr. Fahmy's expertise in the forefront of the field of computer technology to bear fruit" as it was put in Dr. Fahmy's Witness Statement. The Objects of Kawthar, taken from its Memorandum of Association are very general objects in the field of IT.
23. The accounts of Kawthar for the years ended 31 December 1985 to 1987 describe the company's principal activity as "manufacturers, designers, importers, exporters and dealers in computers". This description changed slightly in the accounts for the years between 1988 and 1997 (inclusive). In those accounts the reference to "computers" was replaced by "computers and computer software". In the accounts for the years from 1998 to 2001 (inclusive) the company's principal activity was described as "computer consultancy and the provision of management services". An advertisement from 1988, in the extensive documentation before us, records that Kawthar "has been a constantly growing force in the UK microcomputer industry since 1983" and that "that growth took on a new dimension nearly three years ago [in 1985] when [Kawthar, then Applied Microsystems Technology Ltd.] extended its sphere of activity from research and development, software and consultancy work to producing out own range of state-of-the-art microcomputers".
24. An important assignment in which Kawthar was engaged for approximately 2½ years from 1987 to 1990 was the design of a complete plant in Egypt for the production of computers and monitors. Dr. Fahmy referred to this as "the Big Project". It was a "turnkey" project, in that Kawthar provided everything needed to establish the client's IT systems. Kawthar's work involved design, implementation, training and the supply of the factory and of the electronic components required for the manufacturing processes. This one project accounted for nearly all the stock and work-in-progress recorded in the 1988 and 1989 accounts. Kawthar's client went into administration in 1990 and Kawthar incurred heavy losses on the project. The losses recorded in the 1988 and 1989 accounts represent much of the amount which Kawthar seeks to carry forward under section 393(1) ICTA in this appeal.
25. We give below agreed figures extracted from Kawthar's accounts as follows:

Year Turnover Net Profit Stock Work-in-Progress Expenses

1988 1,481,413 (969,160) 150,550 602,317 942,600

1989 983,072 (373,117) 50,550 684,810 679,960

1990 1,504,962 (9,434) 20,000 0 303,064

1991 489,407 (43,356) 14,333 0 145,066

1992 71,611 (58,472) 4,070 0 73,420

1993 65,986 (54,810) 3,460 0 77,557

1994 70,066 (17,877) 85 0 37,118

1995 4,200 4,182 0 0 18

1996 0 (168) 0 0 168

1997 0 (158) 0 0 158

1998 194,000 180,863 0 0 7,870

1999 36,225 19,385 0 0 11,015

2000 111,825 40,764 0 0 21,025

The figures listed under the heading "Expenses" represent the aggregate of figures given for administrative expenses and distribution expenses respectively.

26. Dr. Fahmy explained, and we accept, that the failure of the Big Project led to the decline in turnover in 1991 and 1992 and succeeding years, and that in 1995 Kawthar had exhausted all sources of cash available to it. Dr. Fahmy himself funded the search on Kawthar's behalf for new projects in 1996 and 1997. In those years Dr. Fahmy went through further training in Microsoft technology, and he himself (not Kawthar or Netlogic) obtained certification as an expert in that technology. This certification stood him and Kawthar in good stead because the contract with Reuters (see: below, at paragraph 30) would not have been obtained without it.
27. The agreed figures extracted from the accounts of Kawthar (for years up to and including 1997) show total numbers of employees, including directors as follows:

1988: 32; 1989: 25; 1990: 7; 1991: 4; 1992: 3; 1993: 3; 1994: 4; 1995: 2; 1996: 2; 1997: 2.

We infer that the 2 employees including directors in 1995 to 1997 inclusive were Dr. Fahmy and his wife.

28. The agreed figures extracted from annual forms P35 submitted by Kawthar to the Revenue for tax years 1997-98 to 2000-01 inclusive (which, of course, excluded directors, such as Dr. Fahmy and his wife) showed no employees in 1997-98, 3 employees in each of 1998-99 and 1999-2000 and 4 employees in 2000-01.
29. In the years before 1992, Kawthar marketed computer hardware items, and advertised such items for sale extensively. The advertisements were discontinued in 1992 when Kawthar stopped selling computer hardware items.
30. Kawthar's fortunes revived in 1997 when a major contract with Reuters was obtained. This contract was to undertake a project known as "Reuters 1998 Euro and Millennium Compliance". It was tied to the introduction of the euro on 1 January 1999 and the implementation of Year-2000 compliance software. Dr. Fahmy described the project as a "roll-out" project, to "roll-out" the introduction of the euro currency and implement Year-2000 compliance software in over 200 foreign banks in the City of London.
31. In order that Kawthar should be protected from legal liability in relation to this project, for which Reuters would not itself provide insurance cover, the project was run through Netlogic. Netlogic paid a fee to Kawthar in respect of its involvement, which included the provision of software for the project. (Reuters had their own suppliers of computer hardware, so the project was not the complete, or "turnkey", provision of an installation, as had been the case with the Big Project.) There were other operators involved in the Reuters project, besides Kawthar, and they also put their participation through Netlogic and received fees from Netlogic. Netlogic invoiced Reuters. Kawthar's turnover of £194,000 noted above for the year 1998 was the total of the fees which Netlogic paid to Kawthar in respect of Kawthar's involvement in the Reuters project. This involvement was the provision of Dr. Fahmy's services as project director, software designer and technical consultant, together with the provision of the services of two more engineers and a project office coordinator, and training services.
32. In 1999, Kawthar obtained a further contract, this time from the Foreign Office, for work on the computers in embassies. This work was not routed through Netlogic.

Kawthar's submissions

33. Dr. Fahmy's main submission is that Kawthar has, from before 1988 and to date, been carrying on a trade which could be described as IT consultancy. He submits that the Revenue's view of what is the nature and extent of the trade which Kawthar has been carrying on is too narrow and does not have regard to the reality of the IT industry. In particular, he contends that IT consultancy includes the provision of everything both in the nature of services and goods to fulfil a customer's requirement for IT systems. IT consultancy can, he submits, mean the provision of services only, or it can mean the provision of services and hardware, or the provision of services, and the implementation and management of systems. He submits that this nature of the extent of IT consultancy is recognised in the IT industry. Thus, for example, the different ways in which Kawthar's principal activities are described in the accounts for the years 1985 to 1987, 1988 to 1997 and 1998 to 2001 respectively (see: paragraph 23 above), although different, are merely descriptions of different aspects of the trade of IT consultancy which Kawthar was at all times carrying on. The IT industry is subject to rapid and continuing change, for example from the provision of computer architecture, to applications, networking, internet and computer languages, and this fluidity should be recognised by the recognition of a widely-drawn concept of an IT consultancy trade for tax purposes.
34. On this basis Kawthar has never ceased trading, nor changed from carrying on one trade to carrying on another and its losses from years before 1995 are available for carry-forward to years after 1996.
35. Of the period 1996 to 1997 (which we refer to below as the "hiatus period"), in which Dr. Fahmy sought external finance and new projects and went through further training in Microsoft technology, and he himself (not Kawthar or Netlogic) obtained certification as an expert in that technology, because there were no projects on hand, he submits that this was a period of hiatus in Kawthar's trading activities, during which Kawthar, through Dr. Fahmy and his wife, the directors, intended to resume trading when new projects could be found, and did so, on securing the Reuters project.

The Revenue's submissions

36. The Revenue point to the decline in activity in 1995, as evidenced by the fall in turnover, stock and work-in-progress and expenses figures, and the number of employees (only the two directors remained from 1995 to 1997), as showing a cessation of trade by Kawthar at that point. Mr. Breed submits that there is not sufficient evidence to enable us to conclude that Kawthar was engaged in persistent attempts to seek new business in 1996 and 1997 so that the trade continued during that period and was revived in 1998. He cited Goff v Osbourne & Co (Sheffield) Ltd. 34 TC 441, submitting that we should follow that decision and not Kirk v Randall Ltd. v Dunn 8 TC 633.
37. Apart from the evidence of the hiatus, he contends that the activities carried out by Kawthar before 1995 and the activities carried out after 1997 were sufficiently different to constitute the commencement of a new trade in 1997 in any event. He submitted that the evidence was that Kawthar's activities before 1995 were predominantly the provision of goods and that Kawthar's activities after 1997 were predominantly the provision of services. He points out that the provision of Dr. Fahmy's services by Kawthar to Netlogic (to enable Netlogic to provide services to Reuters) accounts for the entire turnover of Kawthar in 1998. Mr. Breed also argues that the arrangement with Netlogic in relation to the Reuters project shows a different customer base for Kawthar's activities from the time before 1995 when Kawthar advertised the sale of goods to independent customers. He relies on Seaman v Tucketts 41 TC 625 to show that the change in activities and customer base were sufficiently significant to compel the conclusion that after 1997 Kawthar carried on a different trade.
38. Mr. Breed also cites Marriott v Lane 68 TC 157 as authority for the proposition that even if a cessation of activities can be shown to have been intended to be temporary, evidence to show that the intention to resume operation of the same trade was not fulfilled compels a conclusion that the intended temporary cessation has turned out to be permanent.
39. The Revenue contend alternatively that if there was cessation of trade at the commencement of the hiatus in the activities of Kawthar, there was, from 1998 a sufficient change in those activities to justify a similar conclusion, namely that there was a cessation of the trade carried on before 1998 and the commencement of a new trade at that time. Mr. Breed submits that the change in 1998 when the Reuter's project was taken on and the arrangement with Netlogic put in place was so sudden and dramatic as (on its own) to bring about a commencement of a new trade. He relied on Rolls Royce Motors Ltd v Bamford 51 TC 319.

Our Decision

40. Entitlement to loss relief under section 393(1) ICTA requires that the trade carried on by a company in the loss-making accounting period must be the same trade as the trade carried on by the company in a succeeding accounting period when trading income arises from the trade. Thus we are concerned to see whether the trade carried on by Kawthar in the accounting periods up to the end of 1995 is the same as the trade carried on by Kawthar in the 1998 to 2000 accounting periods.
41. The Revenue raise essentially two arguments as to why it is not the same trade. The first is that the activities carried on by Kawthar up to the end of 1995, on the one hand, and in the 1998 to 2000 accounting periods, on the other, were not the same activities. The second is that the hiatus which occurred in 1996 and 1997 was such as to break any continuity between the activities carried on before it and after it, respectively, so that we should conclude that the trade carried on before 1996 had ceased (either before or after the hiatus) and a new trade had been commenced in 1998.
42. In order to decide this issue, we must consider what amounts to a trade for tax purposes. This has been considered as a general question in some of the cases which have been cited to us. We find most useful the citation by Walton J. in Rolls-Royce Motors Ltd. v Bramford of a passage from the judgment of Lord Donovan in the Court of Appeal in J.G. Ingram & Sons Ltd. v Callaghan 45 TC 151, on which he relied. Lord Donovan said (ibid. at pp.166):

"I doubt if one can as a rule segregate the various activities involved in carrying on a trade, select one of them as being of the essence, and then designate the one selected as being the real trade. There is, I think, an organic unity about a trade which invalidates this sort of dissection, and I think that Rowlatt J. was saying much the same thing, though more incisively, when he remarked in Graham v Green [9 TC 309 at 312] that a trade differs from the individual acts which go to make it up, just as a bundle differs from odd sticks."

43. In this passage of his judgment, Lord Donovan was rejecting the taxpayer company's submission that, throughout, the essence of its trade had been selling, and that it was immaterial that in one period the goods sold were manufactured by the company and in another they were purchased ready-made from somebody else.
44. It seems to us that Dr. Fahmy's principal argument displays the same fallacy. He submits that the trade of Kawthar has throughout been IT consultancy. He has selected the aspect of all Kawthar's activities from time to time, that they have been connected with IT, and he has designated that aspect as being the real trade – IT consultancy.
45. This approach ignores the fact that, as Lord Donovan put it, there is an organic unity about a trade, which invalidates this sort of dissection. It comes very close to an assertion that because Kawthar has been involved in IT-related activities throughout its existence, therefore it has been carrying on a single trade of IT consultancy. However, it is clearly not the case that everything a company, or any person, does by way of trading activities connected to a subject-matter which comes under the same general description (such as IT) must therefore be regarded as a single trade – see, for example: Seaman v Tucketts.
46. The correct approach is to examine the whole range of the activities undertaken by Kawthar from time to time to see whether they display that "organic unity about a trade", of which Lord Donovan spoke in the passage we have cited above.
47. The facts we have found are that in the period before 1996, Kawthar dealt in computers and computer software. Kawthar provided connected services as well, particularly when it was fulfilling "turnkey" projects, such as the Big Project, but the core of its activities was dealing in computers and computer software. There were changes over time in the nature of these activities, for example, the computers themselves changed, computer software, rather than computers, assumed more importance, and in 1992 Kawthar stopped selling computer hardware items. We regard these changes as organic developments of Kawthar's trade.
48. In the period after 1997, however, Kawthar's activities were indeed properly described as IT consultancy activities. We recognise that Kawthar supplied software in connection with the Reuters project, but we find that that project, and the later Foreign Office project, were chiefly contracts for the provision of IT consultancy services, including (in the case of the Reuters project) the implementation of computer schemes to cater for the introduction of the euro currency and the implementation of Year-2000 compliance software. This change in the nature of Kawthar's trading activities was, we consider, correctly recognised by the change in the description of Kawthar's principal activity in its accounts for the 1998 to 2000 accounting periods (see: paragraph 23 above). The change was also underlined by the involvement of Netlogic, to deal with Kawthar's fulfilment of its obligations in the Reuters project. Netlogic was clearly not simply Kawthar's agent in the carrying out the Reuters project. Netlogic was interposed, as principal, to deflect possible liabilities in connection with the project away from Kawthar. Thus the involvement of Netlogic itself was a major change in the way Kawthar carried on its trading activities, and this, coupled with the change in emphasis of Kawthar's activities towards the provision of consultancy services strongly suggests that from 1998 onwards Kawthar has been carrying on a different trade from that carried on by it before 1996.
49. The additional factor of the hiatus in 1996 and 1997 makes it impossible, in our judgment, to conclude that Kawthar carried on the same trade after 1997 as it had done before 1996. There was no turnover and there were virtually no expenses incurred in the hiatus period. Although we accept Dr. Fahmy's evidence that he was looking for new projects in the hiatus period (and eventually secured the Reuters project), we find that this did not constitute an intention, on Kawthar's part, to continue the trade it had carried on before 1996. Kawthar, through Dr. Fahmy, was exploring the possibility of securing IT consultancy contracts, rather than the continuation of its trade of dealing in computers and computer software. During the hiatus period, Dr. Fahmy received training and certification from Microsoft, which, as he told us, enabled him to secure the Reuters project. This demonstrates that the basis of what Kawthar was able to offer Reuters was the IT expertise of Dr. Fahmy, in other words IT consultancy services, and that it was something different from what Kawthar offered its clients in the accounting periods before the hiatus period.
50. Therefore we hold that Kawthar's trade of dealing in computers and computer software – the trade in which its losses were incurred – ceased at the end of 1995, and that a new trade of providing IT consultancy services and associated computer software began when the contract for the Reuters project was secured in 1998. On this basis we dismiss Kawthar's appeal.
51. In view of our decision that the trade carried on by Kawthar in 1998 and thereafter was not the same trade as Kawthar's trade in which the trading losses were incurred, it is not necessary for us to decide the amount of the tax losses incurred. The Revenue agree a figure of £207,639 for trading losses incurred up to the end of 1995. Dr. Fahmy, for Kawthar, claims that the true figure is greater. However he did not at the hearing establish a greater figure and was content in his submissions to accept that were we to decide in his favour on the main issue, then the quantum of losses would have to be agreed. Accordingly we say no more about this issue.

JOHN WALTERS QC

STEPHEN OLIVER QC

SPECIAL COMMISSIONERS

RELEASE DATE: 24 May 2005

SC 3158 04