UK: Capital Gains Consideration - Yet Again

Corporate Tax Bulletin January 2000
Last Updated: 15 February 2000

(or the Revenue gets its pound of flesh)

Nigel Doran considers the capital gains tax implications from the case Garner v Pounds Shipowners & Shipbreakers Ltd.

In Garner v Pounds Shipowners & Shipbreakers Ltd, the question arises whether expenditure which the vendor of a chargeable asset agrees with the purchaser to incur on, or in connection with, the asset should be taken into account in ascertaining and valuing the consideration for the sale. The High Court held that it could be but its decision has now been reversed by the Court of Appeal.

Facts of the case

The essential facts were as follows. The taxpayer company granted an option to buy certain land in Portsmouth for a sum in excess of £4 million. The option price was £399,750 to be held by the taxpayer company's solicitors as stakeholders until such time as the taxpayer company had procured the release of various restrictive covenants over the land. However, although the taxpayer company was to use its best endeavours to procure the releases, it was not required to pay more than a stated sum to procure them. The intending purchaser was entitled to pay any excess over the stated sum. If the taxpayer company was not able during the option period to procure the releases and the option was not exercised, the £399,750 was to be refunded to the intending purchaser. In the event, the taxpayer company succeeded in obtaining the releases at a cost of £90,000. This sum was paid from the stakeholder's account to the covenantees and the balance was released to the taxpayer company. However, planning permission for the intended development was not granted and the option was not exercised.

As the option was not exercised, the disposal in this case was the grant of the option (an asset distinct from the underlying land) (TCGA 1992 s.144(1)). The question was what was the consideration for that disposal for the purposes of corporation tax on chargeable gains. The inspector of taxes argued that the consideration for the option was the £399,750 stated in the option agreement and that none of the provisions of what is now the TCGA 1992 which allow a deduction or discount for the purposes of corporation tax on chargeable gains was applicable. The taxpayer company argued that its obligation to use its best endeavours to procure the releases of the restrictive covenants (and thereby incur expenditure) should be taken into account in identifying and valuing the consideration for the disposal (ie a discount should be applied to the £399,750). The taxpayer company estimated that discount at £90,000 (ie the expenditure actually incurred in procuring the releases). Alternatively, it argued that that expenditure was deductible under what is now TCGA 1992 s.38.

Relevant law

Various aspects of the law relating to the correct identification for capital gains tax purposes of the consideration for the sale of an asset are relevant to this case.

Multiple supplies by the vendor: apportionment of consideration

The vendor may agree not only to sell a chargeable asset to the purchaser but also to supply some other service stipulated by the purchaser. The sale agreement may state expressly how much of the aggregate consideration payable by the purchaser is attributable to the chargeable asset and how much to any other supply by the vendor. If it does and the apportionment is bona fide, that apportionment will generally be respected in ascertaining, for capital gains tax purposes, the consideration for the sale of the chargeable asset (Neely v Rourke [1988] STC 216). If, however, the sale agreement is silent, the aggregate consideration must be apportioned between the chargeable asset and any other supply by the vendor on a just and reasonable basis (TCGA 1992 s.52(4)).

The question whether, on its true construction, the sale agreement has made an express apportionment of the aggregate consideration or whether a just and reasonable apportionment of the consideration falls to be made under TCGA 1992 s.52(4) has given rise to some controversy in decided cases.

In Aberdeen Construction Group Ltd v IRC [1978] STC 127, the taxpayer company agreed to sell its shares in R Ltd for £250,000 subject to various conditions, one of which was that the taxpayer company should waive its £500,000 loan to R Ltd. It was held by a majority in the House of Lords that, on the true construction of the sale agreement, the £250,000 was paid not only for the shares but also for the waiver of the loan and that, accordingly, an apportionment under what is now TCGA 1992 s.52(4) was necessary. Lord Fraser said that the negotiations for the sale were conducted at arm's length and there was, therefore, no question of either of the taxpayer company's obligations (to transfer the shares and to waive the loan) having been undertaken gratuitously. He did not agree that the agreement provided for the £250,000 to be paid for the sale of a debt-free company. Dissenting, Viscount Dilhorne said that a man may offer to buy a house for a certain sum on condition that certain repairs or alterations are carried out without agreeing to pay any sum for those repairs or alterations.

By contrast, in E V Booth (Holdings) Ltd v Buckwell [1980] STC 578, the taxpayer company agreed to sell its shares in P Ltd for £35,000 and, "in addition to the said purchase price and in part consideration", the taxpayer company was entitled to withdraw in full and final settlement a part of the balance due to it under a loan to P Ltd. It was held that, as the sale agreement had specifically allocated the £35,000 payable by the purchaser to the sale of the shares and the partial payment by P Ltd to the redemption of the loan (and, by implication, nothing to the waiver), no apportionment of the £35,000 under what is now TCGA 1992 s.52(4) was necessary.

In Spectros International plc v Madden [1997] STC 114, the agreement for the sale of shares in a company provided that the price for the shares was $1,000 payable to the vendor and $20 million payable to the company's bank (in satisfaction of its indebtedness of that amount to the bank). In addition, the vendor assumed responsibility for discharging the company's indebtedness of $20 million to the bank at no cost to the purchaser. It was held that, on its true construction, the agreement was one for the sale of the company for $20,001,000 on condition that the vendor made it a debt-free company. It was not an agreement for the purchaser to pay the vendor $1,000 for the company and $20 million to ensure that the bank was repaid.

Deferred consideration (whether or not contingent)

Where any part of the consideration for the sale of a chargeable asset is deferred (whether or not it is also contingent), it is brought into account in the computation of the gain or loss arising on the sale without any discount for postponement of the right to receive it and, in the first instance, without regard to the risk of its being irrecoverable or to the right to receive it being contingent (TCGA 1992 s.48). If any part of the consideration so brought into account subsequently proves to be irrecoverable, the vendor can claim the requisite adjustment, whether by way of discharge or repayment of tax or otherwise.

If any part of the consideration for the sale of a chargeable asset is payable in instalments over a period exceeding 18 months, the tax on any chargeable gain accruing on the sale may, at the vendor's option, be paid in such instalments as the Inland Revenue may allow over a period not exceeding 8 years and ending not later than the time at which the last of the instalments of the consideration is payable (TCGA 1992 s.280).

Earn-out rights

An earn-out right is immediate (ie not deferred) consideration for the sale of a chargeable asset, being consideration which consists of a right to receive at the time of some future event an amount of money or money's worth to be ascertained by reference to some performance criterion relating to the chargeable asset (eg the price at which the purchaser is able to re-sell the asset or, in the case of land, its development value if and when planning permission is granted).

The earn-out right, being immediate consideration in kind, will need to be valued for capital gains tax purposes at the date of disposal of the chargeable asset, unless the parties have bona fide ascribed a value to it (Stanton v Drayton Commercial Investment Co Ltd [1982] STC 585). Subsequently, the vendor is treated as having disposed of the earn-out right when he receives the performance-related consideration (Marren v Ingles [1980] STC 500; Marson v Marriage [1980] STC 177).

However, where the earn-out right falls within TCGA 1992 s.138A, the vendor may be able to elect for the "rollover" provisions of that section to apply.

Immediate consideration contingently forfeitable or refundable

Where any part of the consideration for the sale of a chargeable asset has been received by the vendor but is forfeitable or refundable to the purchaser upon the occurrence of some future event, the risk of forfeiture or of having to make a refund is an incident of the consideration and must, accordingly, be taken into account in valuing the consideration for capital gains tax purposes. The consideration, properly identified, is not just the sum of money actually received by the vendor but rather that sum with the incident that it may fall to be repaid. If the nature of the contingency is such that it is impossible to value the consideration, the chargeable asset would usually be treated as having been sold for a consideration equal to its market value (TCGA 1992 s.17(1)(b)). Thus, in Randall v Plumb [1975] STC 191, it was held that, where the consideration for the grant of an option to acquire land was repayable to the grantee if the grantee did not obtain planning permission within a stated period, the risk of forfeiting the consideration was an incident of the consideration and, accordingly, had to be taken into account in establishing its amount or value for capital gains tax purposes.

This does not, however, apply to the contingent liabilities provided for in TCGA 1992 s.49 (ie contingent liabilities in connection with lease assignments, covenants for quiet enjoyment or other obligations assumed as vendor or lessor of land and warranties or representations made on a sale or lease of any property other than land). In the first instance, no allowance is made for any such contingent liability assumed by the vendor in the computation of the gain accruing to him on the disposal of a chargeable asset but, if the contingent liability is subsequently enforced, the vendor can claim the requisite adjustment, whether by way of discharge or repayment of tax or otherwise.

The High Court decision

In Garner, the High Court agreed with the inspector of taxes that, as the consideration for the grant of the option was to be held by the taxpayer company's solicitors as stakeholders until such time as the taxpayer company had procured the release of the restrictive covenants, the consideration was deferred (and contingent) consideration falling within TCGA 1992 s.48. Accordingly, it had to be brought into account without any discount for postponement of the right to receive it and, in the first instance, without regard to the contingent risk that it might never become payable to the taxpayer company if it proved impossible to procure the releases.

However, following Randall v Plumb, the High Court held that it was contrary to business reality to have regard only to the nominal consideration stated in the option agreement (£399,750), without regard to the other incidents of the transaction (in particular, the taxpayer company's obligation to use its best endeavours to procure the releases) which materially affected the value of that consideration to the taxpayer company. The need to procure the releases was an essential incident of the right to receive the £399,750. The Court, therefore, held that the consideration for the grant of the option was £399,750 less whatever was necessary to secure the release of the covenants.

The Court of Appeal decision

The Court of Appeal agreed with the High Court that, as the consideration for the grant of the option was to be held in a stakeholder account and might never become payable if the releases were not forthcoming, it was deferred and contingent consideration falling within TCGA 1992 s.48. Accordingly, the consideration (properly identified) had to be brought into account without any discount for postponement of the right to receive it and, in the first instance, without regard to the contingent risk that it might never become payable.

The Court of Appeal did not, however, agree with the High Court that, having regard to the obligation of the taxpayer company to use its best endeavours to procure the release of the restrictive covenants, the proper identification of the consideration for the grant of the option was governed by Randall v Plumb. That case decided that a contingency (not falling within TCGA 1992 s.49) upon the happening of which some or all of the consideration already received by the vendor would fall to be repaid to the purchaser is an incident of the consideration (properly identified) and must, accordingly, be taken into account in ascertaining its amount or value for capital gains tax purposes. However, the obligation of the taxpayer company in Garner to use its best endeavours to procure the release of the covenants was not a contingency which might result in consideration already received being forfeited. It was an immediate binding obligation on the taxpayer company and it had to be performed before the taxpayer became entitled to the consideration.

The Court of Appeal then turned to the question whether the proper identification of the consideration for the grant of the option was governed by Aberdeen Construction Group Ltd v IRC. If it was, the £399,750 would have to be apportioned between the grant of the option and the taxpayer company's obligation to use its best endeavours to procure the release of the covenants. In the absence of an express apportionment, this would presumably have had to be done on a just and reasonable basis under what is now TCGA 1992 s.52(4). However, the Court distinguished Aberdeen Construction on the basis that the £399,750 was expressed by the option agreement to be paid only for the grant of the option and not for both the grant of the option and the taxpayer company's obligation to use its best endeavours to procure the release of the covenants.

With respect, this is not quite right. The option was expressed to be granted to the intending purchaser in consideration of the sum of £399,750 subject to certain terms and conditions, one of which was the taxpayer company's obligation to use its best endeavours to procure the release of the covenants (and, thereby, incur expenditure). This is precisely the formulation used in the sale agreement in Aberdeen Construction. Some force would seem to be given to this point by the surprising fact that the Court of Appeal considered that, for present purposes, the most pertinent observations were those of Viscount Dilhorne (one of the dissenting minority):

"It is not open to us to re-write the bargain made between the parties, and I do not think it is right to hold that part of the £250,000 was paid for the waiver when the letter states that that price was to be paid for the issued share capital and does not state that it was to be paid for anything else."

Can it be either that Aberdeen Construction was wrongly decided or that there are grounds for appeal in Garner?

Finally, the Court of Appeal turned to the question whether the £90,000 actually expended in procuring the releases was deductible under what is now TCGA 1992 s.38. It held that that expenditure was not expenditure incurred in "providing" (ie granting) the option (s.38(1)(a)). In the case of an option, the expenditure contemplated by s.38(1)(a) appears to be restricted to the grantor's legal expenses of entering into the option agreement and the like.

This article appears in The Tax Journal, published by Butterworths

This note is intended to provide general information about some recent and anticipated developments which may be of interest. It is not intended to be comprehensive nor to provide any specific legal advice and should not be acted or relied upon as doing so. Professional advice appropriate to the specific situation should always be obtained.

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