21 January 2023
Companies with investment business, such as holding companies in corporate groups, may incur expenses from activities relating to the making, holding and disposing of investments, including investments in subsidiaries and joint ventures. These are not trading activities, so the tax rules for trading companies do not apply, but a special regime provides for tax relief in respect of ‘expenses of management’. Such relief can be valuable because, although holding companies frequently do not generate taxable income themselves, they can surrender excess management expenses as group relief to shelter tax liabilities of profitable operating companies.
Costs of acquiring or disposing of investments are not expenses of management. Case law dating back almost two decades appeared to have established a clear dividing line as to when an expense is a cost of acquisition or disposal, rather than a deductible cost of managing investments – until a recent Court of Appeal (CoA) decision.
What we thought we knew
In 2004, the CoA decided that costs incurred by Camas plc, after it had identified a business to acquire but before it had made a firm decision to proceed with the acquisition, were expenses of management, and therefore deductible. HMRC accepted this decision and published guidance stating that, until an offer has been made to acquire a target company, ‘expenses are generally all on decision making and are not sufficiently direct costs of the acquisition’ to be disallowed.
This provided a clear line in the sand – costs incurred before an offer is made may qualify for relief, costs incurred after that date will not. Unfortunately, the CoA’s recent decision to deny relief in respect of certain sell-side costs incurred by a Centrica group company has washed away that certainty.
The Centrica case
Centrica decided to sell a Netherlands-based sub-group during 2009, but it took until February 2011 to accept an offer. Over this period, the UK company that held the investment incurred corporate finance advisory, vendor due diligence and Netherlands legal costs related to the intended disposal. Some of the corporate finance fees were contingent on a successful sale.
HMRC challenged the deductibility of these costs and was initially successful at the First-tier Tribunal, which found that although the costs were management expenses, the company incurring them did not itself undertake the required investment management activities. The Upper Tribunal (UT) overturned that decision, accepting that the expenses were properly incurred by the company in carrying out such activities and arose from those activities.
The Court of Appeal decision
The CoA agreed with the UT in most respects but disagreed on one critical issue. The Camas case highlighted that the legislation in force at the time did not deny relief for management expenses that are capital in nature. Consequently, Parliament subsequently amended the legislation with this effect. It follows that expenditure incurred by Centrica that met all the criteria for deductibility established in Camas could still be disallowed if it was capital in nature.
The vexed question of what is capital and what is revenue for tax purposes has been debated in the courts for centuries. Reviewing this body of case law, the CoA decided unanimously that the expenses in Centrica’s case were capital in nature, as their purpose was to achieve the disposal of a capital asset.
Why it matters
The CoA’s judgment will make it more challenging for holding companies to claim relief for costs associated with the acquisition or disposal of investments under the management expenses regime. Although the Centrica case concerned sell-side expenses, the principle now established appears equally relevant to costs related to acquisitions.
It is notable that HMRC’s guidance currently suggests that expenditure that passes the tests set out in the Camas decision ought not to be regarded as capital in nature. This position is at odds with the CoA’s more recent judgment.
Relief for expenditure that is capital in nature can, in certain circumstances, be deducted in the chargeable gain calculation when the asset concerned is disposed. However, the timing of relief will generally be unfavourable and, in practice, it will disappear entirely if the capital expenditure relates to an aborted transaction or the substantial shareholding exemption applies to the disposal.
What holding companies should do now
Holding companies with costs relating to the acquisition or disposal of investments should think carefully about the tax treatment of those costs. The Camas principle still holds for costs incurred after a firm decision to proceed with a transaction has been made – these costs will not qualify as management expenses. However, costs incurred before that time will need to be analysed to determine whether they are revenue or capital in nature. This analysis can be challenging and there will often be arguments both ways.
Centrica may appeal to the Supreme Court, but if the CoA’s decision stands it will provide HMRC with a formidable new weapon to challenge the deductibility of management expenses. Those adopting a relatively more aggressive position towards claiming tax relief for such costs could find themselves on much shakier ground.