FIRST PRINCIPLES

Capital or revenue?
Cheryl Sacks addresses a question that is crucial to the tax treatment of expenses and receipts

here is no simple test for or statutory definition of capital. Guidance comes from legislation, then from case law that has evolved. Accountancy practice may be informative, but tax treatment is a question of law, determined on the facts of the case.

Legislation
ITTOIA 2005, s. 33 provides that: In

calculating the profits of a trade, no deduction is allowed for items of a capital nature. Section 34(1)(a) prohibits any deduction for expenses not incurred wholly and exclusively for the purposes of the trade. Expenses must pass both tests to be allowable tax deductions. Capital expenditure is not allowable unless specifically allowed by statute. Revenue expenditure is allowable unless specifically prohibited.

Broad distinctions
Revenue items normally include: costs and proceeds from disposal of trading stocks (or circulating capita); costs of maintaining the value of capital assets (or fixed capital). Capital items normally include: acquisition and improvement costs and proceeds from the disposal of capital assets;

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profits and losses from disposal of capital assets; depreciation to provide for loss in value of capital assets.

allowance for one owner does not imply allowance for another.

The economist Adam Smith attempted to define fixed capital as what the owner turns to profit by keeping in his own possession; the owner makes a profit from circulating capital by letting it change masters. The distinction depends on how the business uses the assets. For example, machinery may be fixed for a factory, but circulating for a machinery retailer.

Hire and sale

Gloucester Railway Carriage and Wagon Company Ltd v CIR [1925] 12 TC 720 established three important considerations: the nature of the trade; the relationship of the asset to the nature of trade; the substance of the transaction rather than the accounts presentation. The trade included manufacture, hire and sale of wagons. The company capitalised hire wagons on the balance sheet. The company ceased its hiring trade and sold the wagons previously hired. They classed the ex-hire wagons as fixed capital, and not taxable. The courts decided that the trade included hire and sale of wagons. The relationship of the wagons to the nature of the trade was that all wagons were stock. The accounts presentation was inconclusive. Therefore exhire wagons were circulating capital, and disposal profits were chargeable under Schedule D Case I. (The result would have been different if the courts had decided that hiring wagons was a separate trade.)

The company bought a ship that required substantial repairs and improvements before it could be used in the trade. The previous owners could have claimed a revenue deduction if they had undertaken the repairs. The purchasers claimed a revenue deduction for all repairs. The court held that the ship cost less because of its state, it could not be used for the trade without the repairs, and that the capital cost of the ship should include the repairs arrears. In Odeon Associated Theatres Ltd v Jones [1971] 48 TC 257 deferred repair costs of cinemas were allowed. The peculiar conditions imposed by the war meant that the dilapidated condition of cinemas had not reduced their price, and the cinemas were fit for use in the trade. Weight was given to the accountancy treatment of deducting the repairs in the profit and loss account.

Entirety
Building repairs often involve replacement or improvement. If the entity replaced is only part of an identifiable whole, then expenditure may be revenue; if the entity replaced is a whole, or an entirety, then expenditure is capital. Expenditure on a part may still be capital if it represents an improvement, ie, if brings into existence, modifies, or adds to an asset for the enduring benefit of the trade. Leading cases demonstrate the importance of the meaning of entirety. Factors have included physical, functional, and commercial separation, and relative importance of an entity. Brown v Burnley Football and Athletic Co Ltd [1980] 53 TC 357 concerned a replacement football stand; the decision depended on whether the entirety was the stand or the whole stadium in which it stood. It was held that the stand had its own distinct function and was a separate entity, and therefore an entirety, and that replacement was capital. In Conn v Robins Brothers Ltd [1966] 43 TC 266 substantial repairs were allowed; it was held that the entirety was a whole building, repairs had been carried out on a part, the premises did not change, and no new or improved asset was created.

Dutch company. These could not work normally during the First World War and disputes arose. Finally Van den Berghs Ltd received 450,000 from the Dutch company to terminate the agreements. The House of Lords held that the termination of the agreements damaged the whole structure of the trade; the compensation receipt was capital. Kelsall Parsons & Co v CIR [1938] 21 TC 608 concerned compensation for breach of one of many contracts. The court held that the breach did not affect the whole framework and structure of the business. The receipt was revenue. Capital treatment applies only in exceptional circumstances. Compensation to replace a revenue item is a revenue receipt; treatment of compensation for a capital item depends on what the compensation was for. Short Bros Ltd v CIR [1927] 12 TC 955 illustrates three questions: does compensation arise from the trade? does compensation arise from ordinary trading operations? when should income be brought into the accounts? The company entered many contracts in its ship building trade. It agreed to cancel two contracts for compensation of 100,000. The company claimed the compensation was a capital receipt; but if it was to be treated as a revenue receipt then the income should be apportioned over the period for which the work would have been completed. The Revenue claimed, and the court held, that the compensation was revenue, and taxable in the year of receipt. The court held that compensation arose from ordinary trading operations because the company entered many contracts, and cancellations would occur in the course of trade. The compensation was for ships, which were circulating assets in this trade, and therefore a revenue receipt. The compensation had not terminated a substantial part of the business, which would indicate a capital receipt. Finally, income should be brought into the accounts based on when it was actually received, rather than when it might have been received if the parties had not cancelled the contracts. Compensation arising from ancillary operations such as sale of scrap material and insurance claims are also revenue receipts. The treatment of compensation for loss of fixed capital assets depends on whether the loss is temporary or permanent. Compensation for any of the following permanent losses are capital receipts: partial loss, complete loss, permanent loss of use of asset. Compensation for temporary loss is

Enduring benefit
Atherton v British Insulated & Helsby Cables Ltd [1925] 10 TC 155 established that expenditure made with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade is capital. The company set up an employee pension fund. It acquired the enduring benefit of contented staff.

Repairs
Repairs and maintenance expenses are revenue; costs of improving, adding to or modifying fixed assets are usually capital (ICTA 1988, s. 74(1)(d)&(g)). Law Shipping Co Ltd v CIR [1923] 12 TC 621 established three principles: expenditure required to make an asset fit for use in the trade is capital; if the purchase price is substantially reduced due to dilapidated condition then reinstatement expenditure is capital;

Compensation
Van den Berghs Ltd v Clark [1935] 19 TC 390 is the leading case illustrating the principle that compensation is capital where the whole structure of the trade has been damaged. The companys trade was manufacturing and dealing in margerine. The company entered into profit-sharing agreements with a

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FIRST PRINCIPLES
revenue. The tax treatment does not depend on the method used to calculate the compensation. In Glenboig Union Fireclay Co Ltd v CIR [1922] 12 TC 427 the company received compensation for agreeing not to extract fireclay from under a railway line. The compensation was based on the profits foregone. The court held that the receipt was capital: it compensated permanent loss of a fixed capital asset, irrespective of how it was calculated. In Burmah Steam Ship Co Ltd v CIR [1930] 16 TC 67 the company claimed damages based on estimated profits lost when repairs to their ship were delayed. The court held that the receipt was revenue: loss of use was temporary, and the asset was worth the same to the taxpayer before and after the loss. As above, the calculation method was not relevant. Compensation or insurance receipts for damage to a fixed capital asset are capital. If the damage is repaired, the deduction allowed for repairs is reduced by the compensation or insurance receipt (ICTA 1988, s. 74(1)(l)). Fees connected with acquisition, alteration, enhancement or defence of the fundamental structure of a business are generally capital. This includes forming a company or changing its status (eg, to Plc), and forming or dissolving a partnership (BIM35525). Changes to a companys charter to permit more effective trade without acquisition or disposal of a capital asset are likely to be revenue (BIM35565). Franchise agreements A franchisor grants the franchisee rights to sell products in return for an initial fee and subsequent annual fees. The annual fees are revenue for both franchisor and franchisee. As no capital asset is diminished, and this type of expansion is part of the franchisors ordinary business, the initial fee is treated as revenue. The receipt is taxable in the year of receipt rather than spread over the life of the agreement. The franchisees initial payment is treated as bringing a business into existence, and therefore capital. Tax treatment need not be symmetrical; it depends on the nature of each partys trade. Computer software (BIM35810) Commercial software is usually licensed to users. Treatment depends on the form of the consideration. Regular payments resembling a rental are revenue. Treatment of a lump sum depends on whether the licence is a capital asset in the trade of the licensee. Where software is expected to have a useful economic life of less than two years, revenue treatment is accepted. Computer hardware and the licence to use software are often purchased as a package. Treatment of each portion should be separately considered. Some businesses develop their own software and own it outright. The principles mentioned for licensed software apply; treatment of expenses depends on the economic function of the software in that trade. The salaries of staff working on a major new project are likely to be capital. Expenses of staff making minor changes or updates are likely to be revenue. Borrowing Borrowing is on revenue account if it relates to ordinary day-to-day activities, eg, temporary borrowing, or to buy current assets. A loan is likely to be capital if it cannot be repaid in the short term without causing the business to collapse. The costs of obtaining finance are allowable provided that the interest on the loan itself qualifies as an allowable deduction (ITTOIA 2005, s. 58). Lease or hire purchase agreements comprise a disallowable capital element and an allowable interest element. A capital payment made by instalments is still capital. Other Unless the trade is property dealing, the cost of an interest in land is capital (BIM35560). This includes preparing the land for use in the business. Running costs are revenue. Costs incidental to capital expenditure are capital (BIM35120). Expenditure that would have been capital if successful cannot become revenue just because in the event it is abortive (BIM35325).

Areas of current commercial interest

Intangible assets Expenditure is capital if the identifiable asset is of a sufficiently substantial and enduring nature. Walker v The Joint Credit Card Company [1982] 55 TC 617 concerned the permanent removal of a potential threat to goodwill. The company paid a smaller credit card company to cease trading. The payment was capital because the removal of the competition created an asset of a more enduring nature. Costs of preserving an existing business, goodwill or assets without addition or improvement are likely to be revenue (BIM35540). In Southern v Borax Consolidated Ltd 23 TC 597 the costs of defending title to land were held to be revenue.

Summary
I quote from HMRCs summing up at BIM35910: The capital/revenue divide is an ill-defined area.

Cheryl Sacks M Eng (Oxon) ACA CTA is the director of Finansol Ltd Tax Software (www.finansol.co.uk). Cheryl may be contacted at tax@finansol.co.uk

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