Background

We previously wrote about the Court of Appeal decision, including the implications of the decision in practice. In short, Centrica Overseas Holdings Ltd (COHL) acquired the Oxxio group (Oxxio) in 2005. The investment was unsuccessful, and Centrica made an in-principle decision to dispose of Oxxio in 2009. COHL incurred professional advisory fees, including those of investment bankers, accountants and lawyers, for purposes ranging from considering how best to realise value from Oxxio to advising on the structuring and implementation of the final transaction, which completed in 2011.  

To recap, investment holding companies subject to UK corporation tax can deduct their “expenses of management”, but the relevant legislation specifically excludes deductions for expenses which are “of a capital nature”. On the one hand, it is generally accepted that fees incurred in implementing a specific transaction, for example those paid to a law firm for preparing the transaction documents on an acquisition, are not deductible as expenses of management. On the other hand, costs arising prior to a general decision to divest should not typically be treated as capital expenditure. However, there is uncertainty on the deductibility of expenses falling in the grey area between these two scenarios – which the Court in this case has gone some way to clarifying.

COHL claimed deductions for its professional advisory fees as expenses of management of its investment business, which HMRC subsequently denied. 

The Court of Appeal decision made it clear that whether an expense is an expense of management, and whether it is capital or revenue in nature, are separate questions, with the test for the latter being the same as that for determining capital expenditure of an ordinary trading business. In short, the Court of Appeal found that the professional advisory fees in question were broadly expenses of management but were capital in nature and therefore not deductible.

What did the Supreme Court say?

As anticipated, COHL appealed to the Supreme Court on the capital expenditure question, on two grounds.

Firstly, COHL argued, in short, that the Court of Appeal had erred in using the trading concept of capital expenditure in the context of special rules to accommodate expenses of a non-trading business (i.e. that the deductibility test for trading companies is different to that for investment holding companies). However, the Supreme Court dismissed this, holding that the capital/revenue test in the management expenses legislation should be interpreted in the same way as the test for trading companies.

A point worth mentioning here is that COHL had argued that all expenditure incurred by an investment holding company necessarily has a connection to a capital transaction because the activity of an investment business is the making and holding of capital assets. However the Supreme Court’s view was that it is possible to distinguish between the ongoing management of an investment business where the expenses are generally of a revenue nature (day-to-day staff costs, rent, administration costs, etc.) and the buying or selling of an investment (the expenses of which are generally capital in nature).

The second ground of appeal was that the Court of Appeal failed to identify that the relevant expenses were not “of a capital nature” (because expenditure relating to the core function of an investment management business - which includes the buying and selling of assets - cannot be treated as capital expenditure).

However, again, the Supreme Court rejected this argument, finding that the expenses in question were capital in nature. Broadly, this was because COHL had made a commercial decision to sell Oxxio (a capital asset of COHL) in 2009 and the relevant expenses were of a one-off nature and incurred with the objective purpose of achieving that sale (i.e., they did not relate to COHL’s investment business more generally). This was evidenced by language in the professional advisers’ engagement letters indicating that they were working towards the disposal of Oxxio, even though there was no certainty at the time of their engagement that the disposal would go ahead. On this basis, professional services costs incurred when a decision is still in the process of being taken as to whether or not to acquire or dispose of an asset may potentially be treated as capital in nature (and therefore non-deductible).

Practical implications

The question of whether an item of expenditure is capital or revenue in nature is a question of law – set out in case law - and is separate to the question of whether the expenditure is an “expense of management” or not. The factors relevant in determining this include:

• the true nature and purpose of the payment;
• the object or effect of the expenditure;
• whether an asset was obtained in consideration for the payment and if so, whether the asset is a capital asset or not;
• how it is to be used; and
• how it is obtained (e.g. is it a lump sum or periodic payment).

These principles cannot be applied uniformly to every set of facts, but the objective purpose for which a payment is made is likely to be an important indicator. Where a capital asset is bought or sold, the starting position is likely to be that expenditure relating to the sale or purchase of that asset will be capital in nature.

This case highlights the fact that the deductibility of deal fees incurred by a Bidco in a private equity holding stack should be treated with caution – expenses related in any way to the acquisition or disposal of target shares by a Bidco subject to UK corporation tax are unlikely to be deductible. Anyone seeking to argue that these expenses are deductible should closely review the engagement letters of their professional advisers, in case the precise scope of work specified comes under scrutiny by HMRC or the courts.

If you would like to discuss any of the points raised in this note, please get in touch.