The Upper Tribunal (UT) (Judge Newey and Judge Howard Nowlan) has upheld a decision of the First–tier Tribunal (FTT) that 25% writing-down allowances (WDA) were available to a UK lessor of ships and that the requirements of section 123 Capital Allowances Act 2001 (CAA) were satisfied in HMRC v Lloyds TSB Equipment Leasing (No 1) Limited5 (TCC). All statutory references below are to the CAA.
In 2001 an invitation by various non-UK resident oil companies, headed by Norwegian company Statoil SA (Statoil), was made for shipping companies to tender for contracts to acquire two carriers and to operate the ships for time charter for oil companies. The tender process was won by the Japanese shipping line, Kawasaki Kisen Kaisha Limited (K-Line), one of Japan’s largest shipping companies. Having been successful in the tender process, K-Line entered into contracts on 19 December 2001 with Japanese shipbuilders for the construction of the vessels, and also time charter parties of those vessels to Statoil on behalf of the selling companies.
On 19 September 2002, a leasing structure was put in place. Lloyds TSB Equipment Leasing (No 1) Limited (Lloyds Leasing) took over ownership of the two vessels by taking a novation of the shipbuilding contracts at a total cost of £198m. Progress payments that had already been made by K-Line were refunded and replacement payments were made by Lloyds Leasing. Lloyds Leasing then granted finance leases with a 30-year primary period to two specially formed Cayman Islands companies each of which took a lease of a vessel. On the same day, the two companies granted bareboat charters to K-Euro Limited (K-Euro) a UK resident company whose business comprised the operation of coastal container ships in European waters and a general agency for K-Line’s container and car carrier business in Europe. Also on 19 September 2002, K-Line novated its role under the time charters to K-Euro. During the construction period of the vessels, K-Euro’s business expanded its activity, in particular in the operation and management of vessels in its bulk and gas division. However it was realised that increases in manning costs of such vessels would lead to K-Euro suffering substantial losses once the vessels had been delivered and discussions took place about this. Subsequently, there was a major reorganisation of K-Euro’s business in 2006 shortly before delivery of the two vessels. As a result, all activities of K-Euro that were unrelated to time chartering of the two vessels were transferred to other K-Line companies. K-Euro retained the contractual obligation to supply, man and maintain the ships, but it contracted with another K-Line company for that company to deal with the manning and maintenance on K-Euro’s behalf.
The vessels were delivered and brought into service in February and July 2006 respectively.
Lloyds Leasing claimed the 25% WDA on the cost of the vessels in the years ended 30 September 2002 to 30 September 2006. HMRC challenged the claim of £33m for the year ended 30 September 2006 and sought an adjustment for the earlier years. HMRC’s grounds for denying the capital allowance claims were that the vessels were not used for a qualifying purpose within section 123 and, even if they were, the main object or one of the main objects of the arrangements was the procuring of capital allowances. The taxpayer was successful in its appeal before the FTT and HMRC appealed to the Upper Tribunal (UT).
- The UT agreed with the FTT that the qualifying use test in section 123(1) was satisfied even if the operating costs were not entirely met by the ship operator (in this case insurance costs typically representing 6 to 8% of total expenses were in effect passed through to the end lessees). In particular, it was noted that the words "substantially all" in section 123(1)(b)(ii) were there for a reason and on HMRC’s construction the word "substantially" would be otiose.
- A ship cannot be used for a "qualifying purpose" within section 123(1) unless it is "let on charter in the course of a trade which consists of or includes operating ships". The FTT had concluded that K-Euro did let the vessels on charter in the course of a trade which consisted of or included operating ships. The UT decided that the FTT was justified in reaching this decision and noted that HMRC’s complaint was not about the interpretation of the provision but about the FTT’s application of the law to the facts. Accordingly, the question was whether there was evidence to support that conclusion and whether there was a sufficient basis for the FTT’s view. Moreover, albeit the position changed in 2006 as K-Euro shed activities, outsourced manning and maintenance of vessels, and was left with one part-time employee, this was not necessarily inconsistent with continued trading. The UT observed that a company can trade notwithstanding that it has delegated the performance of its obligations to a third party. The time charters were unchanged and it continued to be in K-Euro’s interests to minimise the cost of performing its obligations under the time charters.
- The UT confirmed that the "main objects" anti-avoidance provision in section 123(4) applied albeit the claim was to obtain a 25% WDA and agreed with the FTT’s conclusion that there were "no grounds of logic or policy" to limit the application of the "main objects" anti-avoidance provision in the way that was sought by Lloyds Leasing.
- The UT criticised some of the FTT’s observations about the "main objects" test in section 123(4), which suggested that the FTT (wrongly) considered that the test focused on the sole or main benefit that might be expected to accrue from the transactions rather than on whether one of the main objects was to obtain a WDA. Nevertheless, HMRC’s appeal was dismissed. There was, however, a difference of opinion between Newey J and Nowlan J. Both agreed that the FTT had made observations on the law which were open to criticism (see paragraphs 77 to 86 of the decision). They disagreed, however, on whether the FTT had failed to apply the correct legal test when arriving at its decision. Nowlan J considered that the FTT had applied the incorrect test. Further, the FTT’s decision that obtaining capital allowances was an object but not a main object was unreasonable because the FTT had failed to evaluate the significance of the tax advice (which he considered to be structural rather than due diligence advice), the financial significance of the transactions, the true beneficiary of the allowances (in terms of reduced rentals) and the parties’ approach. Newey J, however, applying a casting vote, decided that there was no indication that the FTT had done anything other than apply the correct legal test nor did he think that the FTT’s decision was, on the facts, unreasonable.
Although this case was determined mainly on its facts and relates to a period that predates the current tax rules for leasing, the lease terms that were under consideration in this case were common in the shipping industry and a number of other companies may potentially be affected by the outcome of this case.
The decision contains a useful commentary on the "sole or main benefit" test considered in Barclays Mercantile Industrial Finance Limited v Melluish6 and "main objects or one of their main objects" test considered in IRC v Brebner7.
The decision also emphasises the difficulty facing any litigant seeking to challenge a decision of the FTT on Edwards v Bairstow8 grounds. Newey J said, at paragraphs 105 and 106:
"For this Tribunal to be entitled to disturb the FTT’s findings, it must conclude that they were unreasonable … It is also perhaps worth stressing that, to succeed in the appeal, HMRC must do more than show that one of the parties’ objects was to obtain a writing-down allowance. That much is uncontroversial, and the FTT expressly so found … HMRC has to establish, in effect, that no reasonable tribunal could have concluded that the admitted tax objective was not a main object."
More generally, it is reassuring to note that in this case it was found that, where there is a genuine commercial purpose behind a transaction, taking advice on the conditions that must be met in order to qualify for a relief does not equate to entering into arrangements with the object of obtaining the relief.