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You are here: BAILII >> Databases >> United Kingdom Special Commissioners of Income Tax Decisions >> Triage Services Ltd v Revenue and Customs [2006] UKSPC SPC00519 (12 January 2006)
URL: http://www.bailii.org/uk/cases/UKSPC/2006/SPC00519.html
Cite as: [2006] UKSPC SPC00519, [2006] UKSPC SPC519

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Triage Services Ltd v Her Majesty's Revenue and Customs [2006] UKSPC SPC00519 (12 January 2006)

SPC00519

Corporation tax – Profits – Capital or income expenditure – Acquisition of taxpayer company's first business – Whether lump sum payment to the vendor of business assets to secure right that minimum amounts of business be offered by vendor annually over seven year period was deductible as revenue expense or disallowed as capital payment – Appeal dismissed

THE SPECIAL COMMISSIONERS

TRIAGE SERVICES LIMITED Appellant

and –

THE COMMISSIONERS FOR HER MAJESTY'S REVENUE & CUSTOMS Respondents

Special Commissioners: THEODORE WALLACE

HOWARD M NOWLAN

Sitting in public in London on 9 and 10 November 2005

Jonathan Peacock QC, instructed by Hammonds, for the Appellant

Philip Jones, instructed by the Acting Solicitor for the Respondents

© CROWN COPYRIGHT 2005


 


DECISION

Introduction

1. This was a case on the familiar topic of whether a lump sum payment was a non-deductible capital payment or a deductible revenue payment. It arose, as is commonly the case with such disputes, in relation to a set of facts that had not been dealt with precisely by any of the authorities. The disputed payment was part of £8 million paid by the Appellant company to ICL Sorbus UK Ltd ("Sorbus"), a subsidiary of International Computers Limited ("ICL"), on a management buy-out of the UK repair activity of Sorbus.
2. Triage Services Limited ("Triage"), the Appellant company, made the payment on entering into a linked package of four contracts with Sorbus on 31 December 1997. Under one of those contracts, the Sale and Purchase Agreement, Triage, a company formed for the purpose, acquired the assets and leases involved in a distinct part of the activities of Sorbus and took over the employees of Sorbus who had been involved in that part of the activities. Triage did not however take over any customer contracts or the right to trade in the name of ICL Sorbus. Under one of the other contracts, the Repair Services Agreement, Sorbus was required to offer Triage service work commanding gross fee payments of £63 million over the next seven years, with various amounts needing to be offered in each of those years. Under the first of those two agreements Triage paid £8 million to Sorbus. The £8 million was expressed as consideration for the business and was not divided amongst the tangible and intangible assets acquired nor was it specified in either contract whether the payment was said to be paid for the assets acquired under the first contract or in return for the rights acquired under the second contract.
3. The Appellant contended that most of the £8 million was attributable to the rights acquired under the Repair Services Agreement and in particular that the evidence indicated that the payment had been calculated by reference to the number of years for which business was committed and the amount of that business, and that the payment was a revenue payment. The essential question for us was whether these features distanced the payment from the more common capital payments paid for goodwill on taking over the totality of a trade as a going concern.

The form of the dispute

4. Nothing hinged on the form of the dispute but we should nevertheless mention that in its tax returns for its first two accounting periods, ending on 31 December 1998 and 1999, the Appellant did not claim a deduction for corporation tax purposes for the yearly depreciation charge in the accounts for the greater part of the £8 million, which had been treated for accounting purposes as a payment for goodwill and capitalised. In 2002 the Appellant decided that its failure to claim a deduction for the relevant charges was erroneous and made an error or mistake claim which was rejected. In subsequent years the Appellant claimed equivalent deductions and the Revenue amended those returns disallowing the deductions.
5. The appeal was against the rejection of the error or mistake claims and against the amendments made to the Appellant's tax returns for the two later periods in contention. Naturally a similar point would in due course arise in relation to the following three remaining periods of the seven year period over which the payment for the goodwill or the contract was being amortised.

Evidence

6. There was a statement of agreed facts. Evidence was given by Mr Norman Elliott, the managing director of Triage. An expert Accountant's Report was furnished by Mr Paul Tombleson, a director of KPMG LLP, and Mr Tombleson also explained and commented on his report orally during the hearing. The bundle of documents included a business plan prepared by Coopers & Lybrand in December 1997 for the management buy-out.

Background

7. Prior to 31 December 1997, the date of the four contracts, the method of trading undertaken by ICL and Sorbus had been along the following lines.
8. ICL both manufactured and sold computers. When selling total packages of computers and IT equipment, it often sold both its own products and products manufactured by third parties. The function of Sorbus was that of maintaining and repairing computers and IT equipment. When ICL sold products and gave warranties, ICL engaged Sorbus to discharge its vendor warranty liabilities and paid Sorbus for this function. When manufacturer's or vendor's warranties had expired, Sorbus very often then entered into maintenance and repair contracts with the customers who had bought products from ICL, with ICL Sorbus then directly creating and maintaining contracts with those users of equipments and charging the customers appropriately. Doubtless Sorbus may have also undertaken other repair and maintenance obligations in relation to products that had not been supplied by ICL in the first place; however this was not clarified, and it is not particularly significant. Although Sorbus's repair activity was started to support ICL's proprietary mainframe base, by December 1997 50 per cent of the work came from repairing products of other manufacturers supplied by ICL.
9. Prior to 31 December 1997 Sorbus's trade had included two district activities. One was referred to as the diagnostic function; the other as the repair function.
10. When a customer encountered a problem with IT equipment that was either covered by an ICL warranty or covered by a repair and maintenance contract with Sorbus, the customer would initially contact the diagnostic section of Sorbus and an engineer would then deal in the appropriate way with the customer. This might be a simple matter that could be attended to without visiting the customer's premises, by the provision of a Helpline type function. In other cases, an engineer would go to the customer's premises and endeavour to solve or at least identify precisely the nature of the problem or fault. Where an item of computer equipment was faulty and could not be repaired on the customer's premises, the normal procedure would be for the engineer to detach the faulty equipment, replace it with either a new or reconditioned piece of equipment, and then remove the faulty item for repair.
11. Within Sorbus a small team allocated repairs. Sorbus itself conducted some repairs, this being the second of the two distinct strands to the company's overall activities. If the people allocating repairs considered that ICL Sorbus's internal repair division could repair the equipment competitively, then the faulty equipment would normally be sent to one of Sorbus's three fixed repair sites. Where, for any reason, it was thought that the repair could be dealt with better or more cheaply by a third party repairer, the equipment would be sent to the relevant third party repairer. Following the completion of a satisfactory repair, either by the internal repair division or by a third party repairer, the repaired product would be held in inventory by ICL Sorbus, as a reconditioned part.
12. Sorbus held a stock of parts in order to have immediate access to those parts most likely to need replacement so that customers' equipment could be put back in service with the minimum of delay. Where a customer's faulty product was exchanged for a new or reconditioned one the returned product became the property of Sorbus. The third party sub-contractors never acquired ownership of any of the equipment sent to them for repair. As just indicated, following a satisfactory repair, if the part was not to be returned to the customer, Sorbus would hold it in its inventory of spare parts which could be provided at short notice to customers.
13. The in-house repair division operated in an essentially similar manner. Albeit that Sorbus might actually own and retain a repaired part in inventory, as a matter of internal management accounting, the holding of an inventory of spare parts was no part of the repair division's responsibility. As a matter of internal accounting the repair division was simply treated as rendering services.
14. The in-house repair activity involved no contact at all with ICL Sorbus's customers. All the interface with customers was dealt with by the people operating in the diagnostic section including the engineers. It was those people who visited the customers, and either repaired equipment on the premises or installed replacement parts. The customers would be totally unconcerned with what Sorbus did with the faulty equipment and whether it engaged a third party to repair the equipment or allocated the equipment to the in-house repair division for repair.
15. The repair activity was regarded by Sorbus as a "cost centre". Sorbus's overall profitability depended on the fees received either from ICL or directly from customers for the provision of the entire maintenance function, and no customer would specifically pay for repair work done either in-house or by third party repairers. Within ICL Sorbus itself however management accounts attributed a notional fee for the performance of the repair activity to the relevant separate division in order to assess the performance of such division.
16. The repair division was staffed by approximately 130 staff, of whom the majority were full-time employees and the remainder independent contractors or "agency staff". The fixed assets of the division included leases of premises in Edinburgh, Birmingham and Manchester, together with the equipment required to perform the repairs at each of those repair centres. It appeared that the leases were all at a rack rental or at least none was said to have any capital value. The equipment was carried in the books of Sorbus at a written down value reflecting the fact that most of the original cost of the equipment had been written off.
17. The repair division of Sorbus had no marketing employees because the marketing function was performed at the level of ICL itself, when selling equipment, or by Sorbus when soliciting customers for its overall service of repair and maintenance. The division also had no, or only very few, administrative staff since all head office, accounting, personnel and other administrative functions were conducted for the company as a whole.

The disposal of the repair activity

18. Towards the end of 1997 ICL Sorbus decided to dispose of its in-house repair division, whilst retaining the diagnostic function and all the related customer contacts.
19. Efforts were made to sell the divisional activity to third parties but these came to nothing and towards the end of 1997 the idea was evolved of selling the activity to a management buy-out vehicle. Initially, at the time when non-binding Heads of Agreement were signed on 8 December 1997, the buy-out team was headed by a Mr Brooks, with Mr Elliott, acting in his capacity as a director of Sorbus, trying to dispose of the divisional activity. Very shortly after 8 December however Mr Brooks dropped out of the picture and Mr Elliott joined and effectively headed the buy-out team.
20. Sorbus wished to effect and complete the sale within the extraordinarily tight time frame of all material agreements being signed by 31 December. In this very short period it appears that the buy-out team performed the considerable feat of securing finance for the buy-out vehicle from 3i and certain 3i investors who provided all the loan finance and subscribed 70 per cent of the relatively small share capital of Triage. The other 30 per cent of the share capital was acquired by Mr Elliott and Mr Stephen Holmes or was reserved for issue to the finance and sales/marketing directors who were to be appointed.
21. Also in the period before all parties were finally committed to the deal, Coopers & Lybrand was commissioned by 3i to assist Mr Elliott and Mr Holmes in preparing a Business Plan covering the viability of the acquisition, and the growth prospects envisaged by virtue of the intention from the start of attracting third party repair work alongside the repair work initially committed by Sorbus.

Initial negotiations and the Heads of Agreement

22. The Heads of Agreement set out the key terms agreed "for the sale and purchase of the United Kingdom repair business presently carried out by ICL Sorbus." It provided under paragraph 2,

"The business to be sold will consist of all of the assets used in the ICL Sorbus repair business together with all liabilities incurred in that business".

By the time the Heads were signed, the parties had settled on the price of £8 million. This price had increased from £7 million which had been proposed at a time when Sorbus was only committed to offering business for a shorter period of time. It is clear that the calculation of the price was influenced by the amount of business that Sorbus was to be committed to offer and over what period those commitments had to subsist. Paragraph 5 provided,

"ICL Sorbus will appoint the Purchaser as its preferred supplier and will commit to placing not less than £63m of business (plus VAT) with the Purchaser over the next 7 years. The pricing of work done by the Purchaser as ICL Sorbus's preferred supplier will be at a price per part equivalent to that presently charged by the business to ICL Sorbus. However, across the next 7 years the pricing will be driven downwards in a manner to be agreed. Prices are to be benchmarked but not submitted to competitive tender".

The Heads provided for the transfer of employees and for sub-leases of the properties at Edinburgh and Manchester. In the event all three repair centres were included in the Sale and Purchase Agreement (see paragraph 27 below).

The four Agreements

23. The Agreements executed on 31 December 1997 were:

(i) the Sale and Purchase Agreement ("SPA")

(ii) the Repair Services Agreement ("RSA")

(iii) an Agreement relating to the supply of certain equipment, and for the provision of telephone, pay-roll, car fleet management, health-care and other head office type central services for a relatively short period; and

(iv) an Agreement giving Triage a right of first refusal over certain of Sorbus's European repair businesses.

The parties to all four agreement were ICL, Sorbus and the Appellant company, then called Instantsuccess Ltd.

24. For present purposes the first two agreements are the more important. The third covered the type of provisions which one would expect in a "shared services" agreement so that a new company could trade efficiently prior to putting its own equivalent internal services into operation. The fourth agreement was of no significance in relation to the present dispute.
25. The execution of all four agreements, and particularly the first two, was commercially and contractually inter-dependent. Recital (B) of the SPA provided,

"[Triage] has agreed to purchase the business carried on by ICL Sorbus from the repair centres on the terms and conditions of this Agreement and particularly upon the basis that ICL Sorbus enter into a repair service agreement."

26. Clause 2.1 of the SPA provided,

"2.1 Sale and Purchase of the Business

ICL Sorbus and ICL shall together sell or procure the sale ... and [Triage] … shall purchase … the whole of the Business as a going concern including, without limitation:

1.1 the Stock;

1.2 the Goodwill;

1.3 the Plant and Machinery;

1.4 all other property, right and assets used, enjoyed and exercised exclusively in connection with the Business …; and

1.5 … the Properties.

"Business" was defined as

"the business of repairers of general IT and telecommunication equipment carried on by the repair centres of ICL Sorbus … and also includes the Assets and the Assumed Liabilities subsisting at Completion"

The definition of Stock included the stock of components and work in progress of the Business.

"Goodwill" was defined as

"the goodwill of ICL Sorbus in connection with the Business but does not include the right for [Triage] to carry on the Business under the name ICL Sorbus."

The "Properties" were the three repair centres.

27. Clause 3.1 provided that "the consideration for the purchase of the Business" would be £8 million and the assumption of the Assumed Liabilities. Clause 3.3 provided that the parties intended "that the Business shall be sold as a going concern" for VAT purposes. Clause 4.3 provided that on completion the parties should enter into each of the ICL Contracts, which included the RSA. Clause 8.1 provided that the agreement was governed by the Transfer of Undertakings (Protection of Employment) Regulations 1981 as amended; Schedule 1 listed 105 employees. Under clause 13.1 ICL as principal obligor guaranteed the performance by Sorbus of the obligations of the agreement and each of the ICL Contracts.
28. The main omissions from a conventional transfer of business agreement were that there was no assignment of customer contracts and that Triage was precluded from using the transferor's name.
29. Under the Repair Services Agreement ("the RSA"), Sorbus agreed by clause 6 to offer Triage repair work that would generate gross fee income of £63 million over the next 7 years, with work in each of those years generating gross income of between £7.2 million and £10.8 million. The explanation of the lower of those two annual figures was that Triage was entitled to receive offers of repair work which would at least match or equal that amount, so assuring it of adequate offers of work in each year. The upper limit, of £10.8 million, was inserted to ensure that Sorbus could not discharge its commitment to offer a greater proportion of the ultimate figure of £63 million by swamping Triage with offers of work in a particular year which Triage would have to decline through having insufficient capacity to perform the additional work.
30. Insofar as Sorbus failed to offer the required amount of repair work, it was required to make compensation payments to Triage in amounts which were pre-agreed and laid down in the RSA. Under clause 6.6.1 the amounts of compensation varied according to the degree of shortfall from the minimum guaranteed figure, and according to the year in which the shortfall occurred. Thus in the first year, if the offered work had fallen short of £7.2 million by £100 the required amount of compensation was set at £40. Somewhat oddly the level of compensation declined as the quantum of annual shortfall increased, and as one might expect, the level of compensation also fell as the years passed. Doubtless it was envisaged that Triage might by the later years be generating other business so that the shortfall in Sorbus guaranteed business would be less of a concern.
31. The criterion for determining whether the business had been duly offered was that, if business was offered, then it would count towards both the annual and the ultimate figures, whether Triage undertook the work and received the relevant fees, declined the work because it did not wish to do it or declined the work because it contended that it was not capable of performing the relevant work, provided at least in that last case that some other repairer did take on the work.
32. The basis of charging for work was initially the pricing which had prevailed for management accounts purposes when the repair function had been an in-house function of Sorbus. It was then provided that Sorbus could seek to reduce the prices by 5 per cent and Triage could seek to increase them by 5 per cent if either considered that such a change was in line with current third party pricing. If the lower or higher suggested figure was accepted by the other party that became the governing figure. If a suggested change was not acceptable to the other party the dispute would be resolved by reference to a benchmark formula. Three independent quotes would be obtained for the relevant work; the cheapest would be disregarded; the price fixed would be the average of the other two prices quoted.
33. A final key feature of the RSA was that in order to fund cashflow in Triage's first year of operation, Sorbus undertook in clause 5.13 to pay £750,000 monthly, regardless of work offered. £750,000 monthly of course amounted to £9 million in the first year, £9 million being both one-seventh of £63 million and also the mid-point between the low and the high commitments of annual work. These payments, which were designed to provide assured working capital for Sorbus in its first year of operation, were not strictly loans; they are most easily understood by regarding them as loans to be repaid out of the basic fee entitlement or the compensation, so that the advance payments would almost certainly have been off-set against fees and compensation owing by the end of the second year. The cashflow advance payments did not thus ultimately affect the level of Triage's remuneration but simply eased what might otherwise have been "start-up cashflow problems" by fee income falling short of expectations in year 1, or by more of the work being offered in the latter part of the year.

Triage's business intentions

34. It was always the intention of the management team backing Triage that Triage would not simply undertake the work derived from Sorbus, but would use its workforce and its assured supply of work from Sorbus as a platform from which to attract new third party repair work. Triage's mission statement was "to be the UK's first choice provider of multi-vendor repair services in its chosen markets and products and to be recognised as the number one for quality, cost and service" (see Coopers & Lybrand report, para 111).
35. In order to achieve this objective, Triage had to set about building up a marketing team that would seek out and win new business, because within Sorbus, the in-house repair division had been unconcerned with building up any independent business in this way. Triage also had, as a stand-alone company, to engage the services of a finance director, and gradually to take on the activities, (personnel, telephone, e-mail etc,) for which it was envisaged that it would rely on services rendered by Sorbus under the third of the agreements mentioned at paragraph 24 above for just a short transitional phase.
36. It was undisputed that the above activities were ones that were not acquired from Sorbus, and were ones which it was always visualised that Triage would perform as soon as it had acquired the capacity to do so.

Later events

37. We will mention a number of later events which occurred, albeit that we consider, for reasons that will emerge, that they are not significant to the outcome of the present dispute.
38. We were first shown a coloured chart which broke down the gross turnover of Triage from 1998 to a forecast figure for 2005. The first thing that this chart demonstrated was that in 1998, all except £50,000 of Triage's gross turnover of £7,575,000 derived from work provided by Sorbus. In 1999, the picture changed marginally in that the work from Sorbus fell below the minimum target level since the work offered would only command fees of £6,480,000, on the assumption that all offered work was undertaken. Third party work had risen to £1,627,000 (marginally ahead of the forecast third party work assumed by the Coopers & Lybrand report) and compensation from Sorbus amounted to £206,000.
39. In the years 2000, 2001 and 2002 the picture appeared to change dramatically because Sorbus work fell away and third party work appeared to dwarf the Sorbus derived work, and to far out-strip the Coopers & Lybrand predictions for third party work. Thus in 2000, the Sorbus offered work was put at a figure of £3,887,000; third party work at £5,159,000 (against an estimate of £3.3 million) and the Sorbus compensation was £963,000. The picture for 2001 appeared even more dramatic because only £172,000 work was offered by Sorbus, third party work shot up to £11,745,000, and Sorbus compensation was the substantial sum of £2,021,000.
40. All of these figures must be understood however in the light of the very significant fact that in April 2000 Sorbus (or possibly ICL itself following an earlier intra-group transfer of trade) sold much of its remaining diagnostic business to an independent company called Logicom. For the period between April and July 2000, there was an agency arrangement under which Logicom placed its work, through an ICL company as agent, with Triage, so that substantial work continued to be counted as Sorbus work. From July onwards however Triage entered into new contracts with Logicom and contended that the Logicom work did not count towards the Sorbus target figures even though the Logicom business effectively involved work which would have been Sorbus work but for the sale of the business to Logicom. Triage succeeded in subsequent litigation in establishing that work undertaken for Logicom under the new contract did not count towards the fulfilment of the Sorbus targets, which is why Sorbus had to pay compensation of nearly £1 million in 2000, and over £2 million in 2001.
41. We were told by Mr Elliott that if the sale to Logicom had not taken place, then approximately £3 million and £5 million work recorded in the charts as third party work in 2000 and 2001 respectively would have ranked as Sorbus work, and the third party work figures would have declined correspondingly.
42. We should finally record that we were told that Triage did take on (as was apparent from the charts just referred to) a number of new clients. In just one case, a contract with Siemens, an up-front payment of £100,000 was paid by Triage to Siemens and there was a fairly similar arrangement under which certain amounts of work were to be provided by Siemens to Triage as preferred supplier over a 5 year period. We were told that there were no equivalent arrangements with other repair contracts entered into with the fairly numerous other new clients. We should also clarify that when new work was taken on it was all of the same nature as the work taken over from Sorbus. In other words it involved repairing equipment at Triage's three bases, and it did not involve performing the diagnostic function which had been Sorbus's other activity.

Accounting and tax treatment

43. The consideration of £8 million for the purchase of the Business under the SPA was not split by the contract between the amount paid for fixed tangible assets and other assets, nor was it expressed contractually to be paid for assets acquired under the SPA or to be the consideration effectively to be attributed to the rights acquired under the RSA.
44. The treatment in the accounts of Triage was as follows. There was first added to the £8 million the total acquisition costs incurred by Triage of £220,000. There was then deducted from the total the figure of £349,000, being the figure to which the tangible fixed assets taken over from Sorbus had been written down in the books of Sorbus. The resultant balance of £7,871,000 was treated as a payment for goodwill, and capitalised. It was then decided that because the benefit of the RSA would span over a seven year period, one-seventh of that goodwill figure, namely £1,124,429, should be amortised in each of the first seven years of operation, and thus deducted in calculating the profits for accounting purposes.
45. The depreciation figures were initially added back in calculating taxable profits for the first two years of operation, but the revised contended treatment was that revenue deductions should be available for tax purposes for the figure of £1,124,429 in each of the first seven years.
46. At one time it was contended that compensation payments received from ICL Sorbus were capital for tax purposes, but this contention was withdrawn and they were admitted to rank as ordinary income.
47. The expert evidence given in his report and supplemented by Mr Tombleson orally indicated that, whatever the correct tax treatment, the treatment of the balance payment as a payment for goodwill, capitalising it, and amortising it over an appropriate period was the only correct accounting treatment which was possible at the time in question.
48. We should also mention that reference was made to the treatment of the disposal in the books of Sorbus where no reference was made (contrary to the wording of the Heads of Agreement and the actual Agreements themselves) to the transaction amounting to a sale of a trade or business. Instead reference was made to a sale of assets which would not change the feature that the vendor company's core trade would continue unchanged.

Appellant's submissions

49. Mr Peacock submitted that the £8 million payment under the Business Purchase Agreement was calculated largely by reference to the terms of the RSA and was paid for entering into the RSA : contractually the RSA was a fundamental term of the Business Purchase Agreement.
50. Although the payment was a lump sum, this was not determinative see Millett LJ in Vodaphone Cellular Ltd v Shaw [1997] STC 734 at 739a. There it was held that a sum paid to get rid of a recurring revenue liability was revenue unless it modified an identifiable capital asset. A payment to secure an ordinary commercial contract that will generate trading income is itself revenue in nature, see Millett LJ at page 741b-e.
51. He said that the RSA was an ordinary trading agreement quite unlike that in Van Den Berghs v Clark (1935) 19 TC 390 where Lord Macmillan described the agreements as affecting "the whole conduct of their business" and "the fixed framework within which circulating capital operated." Here the RSA was simply a trading contract and the payment was only treated as goodwill in the accounts by default. The fact that a payment is for a fixed asset in accountancy terms does not make it capital, see Halifax plc v Davidson [2000] STC (SCD) 251.
52. Mr Peacock said the classification of the expenditure "depends on what the expenditure is designed to effect from a practical and business point of view," see Lord Nolan in Commissioners of Inland Revenue v Wattie [1998] STC 1160 at 1167, citing Dixon J in Hallstroms Pty Ltd v Federal Commissioner of Taxation(1946) 72 CLR 634.
53. He distinguished City of London Contract Corporation v Styles (1887) 2 TC 239 and John Smith & Son v Moore (1921) 12 TC 266 both of which involved pre-existing contracts as did Van Den Berghs. In Barr Crombie & Co Ltd v Inland Revenue Commissioners (1945) 26 TC 406, the company lost a contract to manage what was 98 per cent of its business. That was nowhere near the present case : it is not authority for the proposition that a payment for a first contract is necessarily capital.
54. He said that the Appellant did not take over a full business from Sorbus in that Sorbus referred in its accounts to a sale of activities, no customer contracts were transferred and the Appellant was prevented from trading under the name of Sorbus. It was not analogous to the type of case where a company took over the whole of a vendor's trade and paid a sum for goodwill.

Respondents' submissions

55. Mr Jones said that the issue was whether any part of the payment was anything other than capital. Ultimately the treatment of the payment must depend on whether the assets acquired were fixed or current assets. In order to succeed the Appellant had to show that the rights under the RSA agreement were separate from the fixed assets and had to go onto current account. Mr Tombleson's evidence however was that the accountancy treatment as capital was correct.
56. He submitted that it was clear that the actual value of the tangible assets was greater than their written down value in the accounts of Sorbus. He submitted that the skilled workforce operating from customised premises clearly had a value, however the Appellant attributed no value to this. Triage would not have acquired the business for £8 million without the RSA; however the RSA was valueless without the business acquired to service it.
57. He said that the Appellant acquired a business and the RSA was not just a trading agreement. He cited Lord Sands in Inland Revenue Commissioners v The Granite City Steamship Co Ltd (1927) 13 TC 1at page 14 where he said that an outlay made for the initiation of a business is broadly speaking capital. In Vodaphone Millett LJ at page 739g cited Lawrence LJ in Anglo-Persian Oil Co v Dale [1932] 1 KB 124 at page 141 where he referred to embarking upon a new enterprise. Here the £8 million payment was to acquire a viable business. The reality was that the purchase price was ascertained by working out the likely earnings of the business going forward with a guarantee of an income stream. The documents contained repeated references to acquiring a business.
58. He said that it was not an ordinary trading contract : the guaranteed cashflow was not ordinary nor were the non-competition clauses. The payment was for the whole package. Whilst a payment made in ordinary trading to secure an increase in income might be deductible on revenue account, this was not so when it related to a fixed asset of the payer or was intrinsically tied up with the acquisition of a business.
59. Mr Jones said that in City of London Contract Corporation Ltd v Styles (1887) 2 TC 239 Lord Esher MR said at page 243 that the capital embarked in the business was not deductible. In John Smith & Son v Moore (1921) 12 TC 266 it was held that a sum paid for un-expired contracts was not deductible because it was "not paid as outlay in a business already acquired", see Lord Sumner at page 296.
60. He said that, even if almost all the payment could be attributed to the RSA, it would still be capital because it was fundamental to the business. He relied on Barr Crombie & Co Ltd v Inland Revenue Commissioners (1945) 26 TC 406 per Lord Normand at page 411, citing Lord Cave in British Insulated and Helsby Cables Ltd v Atherton [1920] AC 205 at 213.

Our decision

61. The characterisation of payments as capital or income on given facts is a matter of law. Whilst there is considerable judicial authority on whether particular payments or receipts are of a capital or income nature, none of them concerned a new contract entered into as part of the acquisition of a business.
62. We start by analysing the transactions that were entered into on 31 December 1997. The nature of the payment depends on the circumstances at the time when it was made, see per Millett LJ in Vodaphone at page 741b.

The analysis of the December 1997 transactions

63. We consider that the correct analysis of the December 1997 transaction is very simple.
64. From the perspective of the vendor, the vendor did not of course dispose of its whole trade, because its trade had earlier involved both the "client facing" diagnostic and servicing work and the "back-room" activity of repairing a considerable proportion of the defective parts to support the servicing work. Sorbus retained what it appears from its accounts to have regarded as the core element of that business, namely all the diagnostic work and all the activities that directly involved contact with, and service to, its repair and maintenance customers. Sorbus could either have described the transactions of 31 December 1997 as the sale of assets or the sale of the whole of a distinct part of its business activity which was capable of independent operation.
65. From the perspective of Triage, it seems to us to be indisputable that Triage acquired what for it was a complete business, operating as a going concern. We entirely accept that Triage intended to develop the business and engage a marketing team to win non-Sorbus business, but what Triage acquired in December 1997 was a complete business, and indeed in the calendar and accounting year to 31 December 1998, virtually the entire gross turnover derived from the business acquired from Sorbus.
66. Mr Peacock relied on the facts that Triage did not acquire customer contracts and that Triage was precluded from trading under the ICL Sorbus name. Having regard to the fact that the business that Triage acquired was the repair business for Sorbus and that the client engagements of Sorbus were intrinsically related to that part of Sorbus' business which Triage did not acquire, it was perfectly obvious that Triage could not acquire customer contracts related to an activity which it was not taking over. Equally it is obvious that Triage could not trade under the name which Sorbus was still going to be using in all relations with its customers in the retained part of its business.
67. In our view Triage acquired the whole of that distinct part of Sorbus' business, described as "the repair business", as a going concern. Inherently Sorbus was the only customer for that business at the outset, albeit that the intention was to win more customers in due course. Self evidently there was no pre-existing contract to be assigned in relation to this one customer relationship. However the RSA was the agreement that created the relationship of customer and service provider between Sorbus and Triage. Indeed it went further in that whilst some purchasers of the goodwill of a business might have no assurance that all, or in the final analysis, any of the customers would continue to use the services of the old business under its new ownership, in this case Sorbus was contractually bound to offer work to Triage over a long period and in substantial amounts. In addition it gave further support to the reality that a business was being transferred as a going concern by providing the year 1 cashflow facility, so as to minimise cashflow problems for Triage in its start-up period.
68. The reality of the points just made is reinforced by considering three aspects of the changeover that occurred on 31 December 1997.

The transferred employees

69. So far first as employees in the repair division of Sorbus were concerned, they would inevitably have regarded themselves as being involved in precisely the same activity after as before 31 December, doing exactly the same work, for essentially the same one customer (i.e. Sorbus) save that their limb of the Sorbus business was now owned, as a distinct stand-alone business, by Triage. Instead of their activity being classified as a distinct activity within the one company simply for management accounts purposes, it became the activity of a trade carried on by a distinct company. However so far as the employees were concerned they were doing exactly the same work after, as before, 31 December 1997.

The continuing customers of Sorbus

70. The customers of Sorbus would quite possibly have been totally unaware of the change because their interest was in having Sorbus maintain their equipment which Sorbus continued to do. They were doubtless quite indifferent to whether Sorbus arranged for parts (which would usually be put back into Sorbus's inventory) to be repaired by third party repairers, by an in-house Sorbus team or by Triage. They were remote from what had been a distinct part of Sorbus's single business, and from what became on 1 January 1998 Triage's business.

The commencement of trade

71. The third feature to note is that even though Triage might have had ambitions from the outset to develop and expand its trade, it is nevertheless indisputable that from 1 January 1998 Triage was trading in every sense of the word with work in progress and that all assets of its trade and virtually the whole of its work-flow as at that date was acquired from Sorbus.

What was the £8 million actually paid for, and is this significant?

72. We note first that the £8 million was actually paid under the SPA and not under the RSA and that the payment was not split between the tangible assets and goodwill.
73. We do not consider that anything hinges on the fact that the payment was actually made under the terms of the first agreement, and not under the RSA at all. We accept that all the agreements were inter-dependent, and we also accept that the quantification of the £8 million was significantly influenced by the duration of the rights under the RSA, and the quantum of business to be offered.
74. Having said that, however, we note that the tangible fixed assets were taken over at a written down book price which was possibly below their value (although no evidence was given on this) and we also note that all of the acquisition expenses have been rolled into the calculation of the "balance price", and thus treated on Triage's contention as being a payment to secure future income, all of which it is alleged should be deductible. We also note, and again nothing was made of this in argument, that the amounts that Triage contends should be tax deductible are the annual depreciation charges for what has been treated for accounts purposes as a capital payment, in circumstances where we are told that no other treatment would have been possible. One would more often expect a revenue deductible payment to be deductible when incurred, albeit that we can see that in terms of realistically calculating each year's profit it would indeed be appropriate to spread the payment as it has indeed been spread. Nevertheless the mechanism for spreading the payment here has been to capitalise it and then to depreciate the capital over the seven year period, and that does appear to pose Triage with a further difficult issue. In the light of our actual decision, however, nothing in the event turns on any of these points.
75. We think that it is difficult, and in the event unnecessary, to say whether the balance payment was paid for goodwill in a wide sense under the SPA or as the consideration for the RSA.
76. Whilst we accept the evidence that the terms of the RSA strongly influenced the calculation of the £8 million, we also accept two arguments which we consider are more significant, advanced on behalf of the Respondents.
77. The first of these arguments was that just as Triage would not have acquired the assets and liabilities and employees of the repair activity without acquiring the rights under the RSA, so too it would not have entered or been able to enter into the RSA if it had not simultaneously acquired the going concern business with which to perform the services contemplated under the RSA. We accept the proposition that both were totally inter-related.
78. The second argument that we accept is that there was considerable value in taking over what seems to have been a very good workforce, premises, and equipment, so as to be able on 1 January 1998 to operate the repair activity smoothly, exactly as it had been run by Sorbus. Thus we consider that it is far-fetched to say that the whole of the balance of the price can be attributed just to the acquisition of the rights under the RSA. In our view the RSA was the medium by which most of the goodwill of the activity was passed to Triage, but the goodwill was not just confined to the rights acquired. Obviously Triage was able to represent itself as having the full equivalent competence in the IT equipment repair activity that Sorbus had previously had and in this sense the acquired goodwill included the potential profitability under the RSA, but other features as well.
79. It was only by having the whole of the workforce, premises and equipment in place from the outset, that Triage was able immediately to set about building up a marketing team and winning new business. And this, if anything, would seem to reinforce the difficulty of attributing the payment of the £7,871,000 solely to the RSA, as opposed to the overall benefit of taking over the going concern of a smoothly running repair activity.
80. It is our overall view however that the payment of £7,871,000 was a capital payment regardless of whether it can or should be allocated in some way between the assets and the contractual rights acquired, or whether it should be attributed exclusively to the acquisition of rights under the RSA. In that latter eventuality it is still the case that the RSA delivered to Triage valuable long term rights that were intrinsically tied up with its simultaneous acquisition of all the assets of the repair activity, and therefore the payment is rightly classified for tax purposes, exactly as it was classified for accounting purposes, as a capital payment.
81. It is clear that the part of the payment which did not represent the tangible assets was also correctly treated as fixed capital in the accounts. While the accountancy treatment is not determinative, Mr Peacock did not cite any case where expenditure was correctly treated as capital for accountancy purposes, but was nevertheless a revenue expense for tax purposes.
82. In our judgment the expenditure referable to the RSA was made "once and for all … with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade", see Lord Cave LC in British Insulated and Helsby Cables Ltd. The fact that the RSA was a new contract whereas the contracts in John Smith & Son were existing contracts is not in our view a reason to distinguish that case from the present. We do not consider the RSA agreement to be an ordinary commercial contract such as the fee agreement in Vodaphone; it was part of the disposal of part of Sorbus's business and it was fundamental to the initial viability of Triage.

Conclusion

83. It is accordingly our decision that the payment of the £7,831,000 was a capital payment, and whether it was a payment for rights to secure the only meaningful initial customer of the business and a stream of future business or for goodwill in the abstract is almost impossible to say, and irrelevant because both are inextricably linked with the acquisition of Triage's first business. The RSA was the only way of ensuring that Triage actually acquired the business, the level of turnover that was envisaged between the parties and the level of profit that had previously been made in the repair division by Sorbus. The features of not taking over customer contracts which were actually in a different line of business and of not being able to trade under a name that the vendor would continue to use in its continuing activities are both irrelevant. The RSA was the contract that cemented the acquisition of the goodwill of the acquired business, and the payment cannot be divorced from that reality.
84. This of course accords precisely with the accounting treatment in relation to which evidence indicated that the only correct accounting treatment was to capitalise the payment of £7,871,000, being a payment for goodwill, and amortise it over a realistic period.
85. We accordingly dismiss the appeal.

THEODORE WALLACE

HOWARD M NOWLAN

SPECIAL COMMISSIONERS

RELEASED: 12 January 2006

SC/ 3022/05