On 25 January 2012, the UK First Tier Tax Tribunal (the “UKFTT”) released its decision in the appeal of Lloyds TSB Equipment Leasing (No1) Ltd (“Lloyds”) against the HM Revenue & Customs Commissioners.
Given the length of the full judgment (56 pages), our intention below is to summarise the key issues rather than review every point in detail.
In simple terms, a consortium lead by Statoil wished to have the use of newbuild LNG carriers for employment in North Sea natural gas fields. Kawasaki Kisen Kaisha Limited (“K-Line”), a Japanese shipping company, agreed to acquire, operate and lease the vessels to the consortium, obtaining finance from Lloyds TSB Banking Group using a tax based finance lease structure through K-Line Europe (which had an established shipping trade in Europe, albeit in containers, not in LNG carriers). Before the vessels were delivered, crewing costs for LNG vessels increased substantially. This had not been properly anticipated in the pricing offered by K-Line to the consortium rendering the contract unprofitable. As the consortium required the vessels, the K-Line business was restructured to separate out all the business apart from the LNG vessels and the consortium took an interest in the LNG business and the operation of the vessels was largely subcontracted out to another group member (“K-LNG”).
The points in question
In order for Lloyds to be able to claim the capital allowances (the tax part of the tax based leasing), Lloyds had to be leasing the vessels to a UK resident company that operated the vessels and was responsible for defraying all or substantially all of the expenses in connection with the vessels. In addition, the overseas leasing rules (which have subsequently been withdrawn) must not have applied. Under the overseas leasing rules, capital allowances would not be given to Lloyds if:
- the vessels were leased by K-Line out of the UK; and
- the main or one of the main purposes of the structure was to obtain UK capital allowances.
HMRC denied allowances and Lloyds appealed to the UKFTT. Four questions arose:
- Was K-Line responsible for defraying all or substantially all of the expenses in connection with the vessels?
HMRC’s case was that the sub-lessee consortium reimbursed costs as part of the rent and so K-Line could not be said to be responsible for doing so.
The UKFTT decided that, just because the hire charge was based on an estimate of costs (and, in some cases but not all, passed on costs), this did not stop the charges from being “hire”. Therefore, it was K-Line who defrayed the costs. The UKFTT was influenced by the fact that there was no automatic right to on-charge all costs – as was shown by the fact that, when crewing costs escalated, the structure became unprofitable and had to be changed.
- Did K-Line let the vessels on charter in the course of a trade which consisted of or includes operating ships?
HMRC claimed that, looking at the overall arrangements, K-Line’s hiring and operation of the vessels lacked commerciality and so was not in the course of a trade – especially as the management of the vessels was contracted out to K-LNG.
The UKFTT accepted Lloyds’ arguments that the management and operation of the vessels involved significant resources and personnel. The tribunal considered that K-Line remained responsible for the management and operation of the vessels after the reorganisation, albeit that it contracted these out to K-LNG, and so was involved in a continuing trade with not insignificant turnover.
- A technical issue on the interpretation of the overseas leasing rules.
HMRC won a consolation victory in respect of a point of interpretation of the overseas leasing rules but this did not affect the outcome of the case.
- Was the main object or one of the main objects of the arrangements to obtain UK capital allowances?
HMRC claimed that, even if K-Line Europe was carrying out a genuine commercial trade in the UK, one of the main objects of the leasing arrangements was to obtain UK capital allowances and so the overseas leasing rules applied.
The UKFTT noted that, where there was an incentive (such as capital allowances), this could influence behaviour. However, being influenced to enter into a structure by an incentive did not, on its own, necessarily mean that obtaining the incentive was one of the main purposes of entering into the structure. In this case, the UKFTT accepted that there were other purposes of entering into the structure such as to obtain 100% finance (with no deposit) under a finance lease and to ensure that the operator of the vessels would also own them (one of the requirements of the tender for the contract). Whilst the availability of capital allowances may have been an influencing factor, as it reduced the cost of finance, it was not one of the main factors. The UKFTT also considered that it was necessary to view the position at the time of entering into the structure and not to be influenced by later events.
The case shows that the UKFTT will not always bow to HMRC’s opposition of tax leasing structures and accept HMRC’s interpretation of the law to give HMRC’s desired result, even given the current climate against tax avoidance. However, Lloyds did not win on all points. The UKFTT took a non-literal interpretation of the law (in respect of the technical issue 3) where it considered that the interpretation claimed by Lloyds did not fit in with the intentions of the legislation.
It is also helpful that the UKFTT was prepared to accept that being influenced by a tax incentive when entering into a transaction did not necessarily mean that taking the incentive was a main purpose of entering into that transaction. This supports the position that taxpayers are generally entitled to arrange their affairs in a tax efficient manner.
It is slightly ironic that K-Line’s underestimate of the costs of crewing, which resulted in the restructuring, helped support Lloyds’ case as it showed that K-Line had a genuine commercial interest in the arrangements.
It is not all over yet
The UKFTT’s decision, while of interest, is not the final time we will hear of this case as HMRC has lodged an appeal against the decision. We eagerly await the outcome.