An interesting judgement was handed down in the United Kingdom’s (UK) First-tier Tribunal (Tax Chamber) recently in the case of Bluesparkle Limited v The Commissioner for Her Majesty’s Revenue and Customs [2012] UKFTT 45 (TC).

Largeflag Limited (Largeflag) was a wholly-owned subsidiary of Bluesparkle Limited (Bluesparkle). Largeflag owned a piece of land and had contracted a third party to build a hospital on the land. Bluesparkle contracted with Largeflag to purchase the land, with the hospital built thereon, on the day the hospital was completed.

Initially the parties agreed that the sale price would be payable in instalments over a few years. An initial amount would be payable followed by the instalments, each instalment having a fixed component and a component expressed as a percentage of a determined purchase price.

Subsequently the parties varied the agreement to the effect that the purchase price would be payable earlier and that the total amount would include an initial payment, followed by a determined purchase price together with a premium and interest.

Bluesparkle paid the total amount, inclusive of the premium, and claimed the premium as a deduction for tax purposes. However, the revenue authorities denied the deduction.

The legal questions that the court had to consider was whether the premium was capital or revenue in nature, and if revenue in nature, whether it was deductible. It was common cause that the amount was not interest.

On the evidence, the witnesses had different views on the nature of the premium, some were uncertain while others said it was an early settlement premium intended to compensate for interest that would have been payable had the purchase price been payable over a longer period as initially agreed. They all agreed, however, that the premium was not intended to be part of the purchase price.

The documentary evidence, however, indicated that the premium (as well as the fixed components to the instalments in respect of the initial agreement) was to ensure that Largeflag would make a profit out of the sale. Apparently the initial agreement whereby the purchase price would be payable in instalments was inspired by a scheme for the avoidance of Value-Added Tax. A premium would therefore give commercial credence to the transaction should it ever be attacked as an avoidance scheme.

It was also stated that the reason for the variation of the agreement (ie to accelerate payment of the purchase price) was to place the shareholders of Bluesparkle in a more favourable position to sell their shares.  

Nevertheless, it was submitted on behalf of Bluesparkle that the premium was additional to the purchase consideration and it was to induce Largeflag to agree to early settlement. It did not bring any enduring asset into existence and it did not divest Bluesparkle of any capital asset. The premium was therefore revenue in nature.

Also, the premium was deductible because it was wholly and exclusively expended for the purpose of Bluesparkle’s trade. Similar to what is provided in s23(g) of the Income Tax Act No 58 of 1962, the tax laws of the UK disallow the deduction of expenditure not incurred for the purposes of trade, with the added qualification that it will only be allowed if wholly and exclusively incurred for the purposes of trade.

However, the court found that the premium payable in terms of the subsequent agreement could not have been an additional sum because the purpose of the variation was simply to reconfigure the payment timetable (that is, allow for earlier payment) and not to change the character of the payments. The premium was really nothing more than the “rolling up” of the fixed components attaching to the instalments in the initial agreement.

The court remarked that: “On the face of it, any payment under a sale agreement must in the hands of the payer be presumed to be in the nature of capital, unless it is clearly otherwise.” The premium may have been intended to reflect an amount of profit in addition to the base price of the asset, but this did not change the fact that it was clearly consideration for the disposal of the asset.

The question was “what was the premium paid for?”. Undoubtedly the land with the hospital thereon was a capital asset for Bluesparkle and the premium formed part of what was given in return.

The court also found that, even if it was wrong in characterising the premium as a capital amount, it would not have been deductible because the premium had a dual purpose. The transaction was beneficial to Bluesparkle’s financial position, but the premium (in the sense that it reflected the fixed components of the instalments in the initial agreement) was also to “enhance the commerciality” of the transaction if it was ever attacked as an avoidance scheme. The expenditure could therefore not have been wholly and exclusively incurred for the purposes of trade.