Appeal Number SC/3108/2008

[2010] UKFTT 6 (TC

TC00325

Appeal number SC/3108/2008

Income Tax - Claim by an LLP to have incurred trading losses in relation to its trade of distributing films - Whether circular payments resulted in expenditure “not having been incurred” - whether payments were deductible as trading expenses - whether part or all of any payments were capital payments - whether those payments that were deductible were deductible in the LLP’s first period of account or whether payments made in that period included pre-payments - Issues in relation to the Closure Notice - Appeal substantially dismissed

FIRST-TIER TRIBUNAL

TAX CHAMBER

ICEBREAKER 1 LLPAppellant

- and -

THE COMMISSIONERS FOR HER MAJESTY’S

REVENUE AND CUSTOMS (Income Tax)Respondents

TRIBUNAL: HOWARD M NOWLAN (Judge)

NICHOLAS DEE

Sitting in public in London on 5 to 9 October 2009

Jonathan Peacock QC and James Rivett, counsel, for the Appellant

Peter Blair QC and Jonathan Davey, counsel, for the Respondents

© CROWN COPYRIGHT 2009

1

DECISION

Introduction

1. This was an appeal in relation to whether the Appellant, Icebreaker 1 LLP (“Icebreaker 1”), succeeded or not in establishing that various payments that it made on 5 April 2004, its first day of trading, gave rise to tax-deductible losses in its trade of acquiring, licensing, exploiting and distributing rights in all forms of moving imagery, including filmed and recorded material. Icebreaker made payments on that day virtually equal to its entire capital and resources, immediately closed its accounting period and claimed that the vast majority of the payments contributed to its allowable loss, that the members could then set against their other income.

2. The appeal really raises two sets of questions. The first is whether a major element of the payments made by Icebreaker 1 had nothing to do with its trade but simply generated guaranteed receipts, basically inserted into the structure to ramp up the apparent spending on trading items in order to increase the initial tax relief available to the LLP and its members. The other questions are whether various elements of Icebreaker 1’s remaining expenditure were capital or income payments, and whether the income payments included pre-payments or not. The appeal also raises a third set of questions surrounding the Closure Notice (see paragraph 22).

3. Icebreaker 1 had been formed, initially with two corporate members, in February 2004 with a view to conducting a trade of film distribution. On 5 April 2004 six individuals joined Icebreaker 1, contributing capital of £1,520,000 between them, 70% of which (£1,064,000) had been funded by way of non-recourse loans advanced by Bank of Scotland. Also on 5 April, approximately 26 documents were executed. The most relevant effect of these documents is summarised in paragraphs 4 to12 below.

4. Icebreaker 1 paid £46,950 to a company called Screen Partners Asset Management Ltd (“SPAM”) for the near exclusive 10-year licence interests in relation to the screenplay or other rights in relation to eight films, potential films and DVDs. Only one of the eight proved material, £20,000 being allocated to the licence rights in relation to a screenplay and other rights to a work called “Young Alexander” that was about to be filmed.

5. Icebreaker 1 entered into both an Administrative and an Advisory Agreement with a company called Icebreaker Management Limited (“IML”) under which, later in the same day, it paid the aggregate of £120,000 and £50,000 for services, having been invoiced for those sums that were due under the two agreements.

6. Icebreaker 1 appointed a company called Centre Film Sales Limited (“Centre”) to be its head distributor in relation to the exploitation of the acquired licence rights. Under this agreement, the Head Distribution Agreement (the “HDA”), the basic expectation was that Icebreaker 1would pay fees, thereby meeting a proportion of the distribution costs (and the film production costs where a screenplay first had to be filmed, before it could be distributed) and under this agreement Icebreaker 1 became entitled to various payments. These payments were essentially of two categories. Some were payable without any reference to whether there were any film distribution revenues or not. Others were payable only out of such revenues.

The former category of payments consisted of

• a payment of “a Final Minimum Sum” of £1,064,000 payable at the end of year 10, guaranteed by Bank of Scotland, and
• 10 annual payments (defined as “Annual Advances”) of amounts equal to interest at Bank of Scotland’s Base Rate, on £1,064,000, the first four, but not the last six annual payments, being guaranteed by Bank of Scotland.

The latter category of payments consisted of a proportion of distribution revenues, calculated on the basis that Centre would first retain 30% of such revenues, and then in the case of the Young Alexander film, Icebreaker 1 would receive 250/1,040 of the 70% balance until a total of £1,040,000 had been paid, and thereafter it would receive the fractionally greater amount of 25% of the 70% balance.

7. At the end of year four, and on the later anniversaries of that date, the HDA contained option provisions enabling each of Icebreaker 1 and Centre to sell and respectively to acquire Icebreaker 1’s business for a formula figure, the minimum amount of which was always to be £1,064,000. In this decision we will generally refer to the former category of payments referred to in paragraph 6 above, and to the minimum amount of the option consideration, i.e. the £1,064,000 just mentioned, as “the certain payments”.

8. Icebreaker 1’s commitments under the HDA to meet a proportion of the distribution and production costs arose under a clause in the agreement which provided, rolling together a clause and a definition, that Centre was to provide Icebreaker 1 with invoices for “all costs and expenses incurred under [13 categories of expenditure described in a Schedule to the HDA], and Icebreaker 1 was to pay such invoices within 30 days”. The same clause went on to provide that Icebreaker 1 undertook “to pay an amount of £[ ] in respect of such [costs] to Centre immediately upon signature hereof”.

9. Whilst the figure in the clause of the HDA just quoted was left blank, Centre provided Icebreaker 1 with an invoice on 5 April 2004 for £1,273,866, containing just the words “Re: Head Distribution Agreement”. Icebreaker 1 paid this amount to Centre on the same day.

10. Whilst we will give more details in relation to the critical discussions as regards the payment instructions below, we should mention in this summary that before the payment, just referred to, was made to Centre, Centre modified the payment instructions to Bank of Scotland and directed that £1,064,000 be paid to one account, which was effectively a blocked deposit account with Bank of Scotland, paying annual interest equal to Bank of Scotland’s Base Rate. The residue of the total payment, in other words £209,866, was paid to a different Centre account with Bank of Scotland, on which the monies were freely available to Centre.

11. Under the HDA, Centre was required to procure and provide security from a AA- rated entity for the payment of the certain payments. This was achieved by Bank of Scotland providing an effective guarantee to Icebreaker 1, in the form of a Letter of Credit, for Centre’s payment of the certain payments. Bank of Scotland’s exposure under this Letter of Credit was itself secured by Bank of Scotland taking a charge over the blocked deposit placed by Centre with Bank of Scotland, referred to in paragraph 10 above. Bank of Scotland also took charges over all of Icebreaker 1’s assets, including the Letter of Credit, for the repayment of the members’ limited recourse borrowings of £1,064,000.

12. Icebreaker 1 also paid an amount (explained below) of £17,024 to Bank of Scotland, leaving Icebreaker 1 thus by the end of the day with £12,160 standing to the credit of its account with Bank of Scotland.

13. Although Icebreaker 1 can only have commenced its trade on 5 April 2004, it closed its first accounts on that day; claimed that virtually all of its expenditure (all the sums referred to above with the exception of that mentioned at paragraph 12) contributed to a trading loss for the period, and it was then claimed that the individual members of Icebreaker 1 could set their respective proportions of the loss against their other income for Income Tax purposes.

14. In due course, HMRC opened an enquiry into the return. At one point, Icebreaker 1 conceded that the licence payments referred to in paragraph 4 above were capital payments that did not qualify for tax relief. Over two years later, on 2 May 2007, HMRC issued a Closure Notice, containing the conclusion that Icebreaker 1’s claimed loss was to be reduced from £1,491,816 to £11,900.

15. A day or two after Icebreaker 1 filed an appeal against the conclusions and adjustments in the Closure Notice, HMRC wrote to Icebreaker 1 explaining the basis of the re-calculation of the loss to £11,900. Ignoring an irrelevant error in relation to a £1000 audit fee, the basis of the calculation was that the whole of the payment being made to Centre was being disallowed; 30% of the total sum of £170,000 paid to IML was being disallowed, and the balance of the £170,000, namely £119,000, was being allowed but 9/10ths of it treated as a pre-payment. Accordingly the only loss allowed for the period ending 5 April 2004 was the allowable 1/10th of £119,000, namely £11,900.

16. This case raises a considerable number of points. By far the most important relates to the deductibility of the £1,064,000 element of the £1,273,866 paid to Centre under the HDA. One contention advanced by HMRC in relation to this element of the payment was that because of the banking mechanics with Bank of Scotland, and the claimed elements of “circularity”, the right analysis was that the £1,064,000 element was not really paid or incurred at all. HMRC’s alternative contention in relation to the £1,064,000 element was that it was still appropriate to consider this element of the payment separately from the payment of the balance of £209,866. The former element was paid to acquire rights broadly equivalent to those of a loan of £1,064,000, such that the payment of £1,064,000 had nothing to do with either Icebreaker 1’s trade or the production and distribution of films, and only the balance of £209,866 could realistically be said to have been incurred “as fees on production or exploitation” at all.

17. These contentions in relation to the £1,064,000 element have variously been advanced, and in turn resisted, by debate as to whether they rely on contentions of “mislabelling”, whether contentions of “mislabelling” are tantamount to contentions that there were sham elements to the documentation, and finally just on the simple proposition that the reality was that the £1,064,000 element was not realistically paid for any trading purpose.

18. Without at this stage expanding on the facts relevant to the £1,064,000, and to the reasons for our decision, we confirm now that we accept the contention that the payment of £1,064,000 was not a deductible trading expense.

19. The £209,866 balance payment to Centre still raises 5 questions. One is whether it is appropriate to sub-split this payment and to consider what elements of it were paid for. We consider that it is. This creates four further questions. Were the payments for the production of the film, Young Alexander, as distinct from the distribution of the finished material, capital or income payments? If production payments were income payments, was any element of the £209,866 attributable to production costs a prepayment at 5 April 2004? Two identical questions then arise in relation to the rest of the £209,866 element expended or to be expended on distribution. Should these amounts be treated as capital or income payments, and if the latter, as prepayments or not?

20. Very considerable expert accounting evidence was given to us, generally with some conflict between the respective experts, on these prepayment issues and in relation to the proper treatment of the £1,064,000 element. We will not at this stage summarise our conclusions in relation to the £209,866 element, though we will say that in arriving at decisions, the regrettable fact that there was a total breakdown in relations between Icebreaker 1 and IML on the one hand and Centre, SPAM and the individual controlling those companies on the other hand, means that we are having to resolve complex factual and accounting questions in circumstances where no-one at the hearing actually knew what expenditure had been incurred or spent by 5 April 2004, if at least it is the spending pattern relevant to Centre that governs this issue as regards Icebreaker 1.

21. We must finally address questions relating to the payments of £120,000 and £50,000 made to IML on 5 April 2004. The issues here are first whether Icebreaker 1 was being charged a capital payment for “setting up the structure”. To the extent that it was not, the question is whether the payments were pre-payments or not.

22. There are also issues in relation to the Closure Notice, though we will deal with these last since it will emerge that the basis on which we decide this case will, we believe, make the Appellant’s contentions in relation to the Closure Notice somewhat forlorn contentions.

The facts in more detail

Background

23. The major promoter of “the Icebreaker concept”, as it was periodically termed, was Caroline Hamilton. Caroline Hamilton, who gave extensive evidence, was an impressive woman. In addition to having been a Cambridge graduate, a triple blue and having led “all women” expeditions to both the North and South Poles, she had been a banker for eight years at Samuel Montagu and Kleinworts. Her work in the banking sector had involved a broad range of lending activities, including project and tax-based financings. She had thereafter worked for over ten years in the film industry with a man called Kent Walwin, being employed during this period by Screen Partners Limited and Screen Partners London Limited, two of his companies.

24. Kent Walwin was a director, and also a major shareholder, of a number of companies in the film industry. Amongst the companies, so far as this appeal is concerned, were Young Alexander Limited (“YAL”), the assumed owner of the screenplay for, and intended producer of, “Young Alexander”, SPAM and Centre. Kent Walwin was described by several of the witnesses as an enthusiast, and someone who could impart his enthusiasm to others. He had worked in the film industry for 35 years, was said to know “everyone in the industry”, was said to be the kind of man who “got things done”, and the type of man required for any project that involved turning the basic idea for a film into reality.

25. Kent Walwin and one of Caroline Hamilton’s close colleagues, Tim Jeynes, had all been involved with sale and leaseback structures on behalf of film production companies, and they had been particularly involved with structures that used insurance to insure or guarantee certain streams of income derived from films.

26. It appears that Kent Walwin and Caroline Hamilton concluded that insurance was ceasing to be so readily available for attracting investment into film projects on account of large losses incurred by insurers, and so Caroline Hamilton and Tim Jeynes in particular began to work on “the Icebreaker concept”. Kent Walwin was also involved with the project and the three, and SPAM and Centre were referred to in the Information Memorandum for Icebreaker 1 itself as “the Icebreaker team”.

27. Reference was made in the Information Memorandum and in Caroline Hamilton’s Witness Statement to what was referred to as “the Icebreaker concept”, though it was never made quite clear what the essence of the Icebreaker concept was asserted to be. It was probably a mix of the following four attributes.

28. An intended attribute was that generally Icebreaker LLPs (and it was assumed and intended that there might be numerous LLPs) were expected to be trading in distributing films, DVDs etc, and generally exploiting completed works, rather than in actually owning or producing films. Consistently, the second expectation was that most of the expenditure of the LLPs would be revenue expenditure, as distinct from capital expenditure in buying, or producing films.

29. A third related aspect was the feature that it would not generally be necessary for the LLPs to own films or other works. Where they were interested for instance in distributing a film, it would often be sufficient just to take a reasonably long-term licence, entitling the LLP to have, say, exclusive or near-exclusive distribution rights for a 10-year period, without actually acquiring the copyright and ownership of the film itself.

30. The fourth intended attribute was the feature that investors would generally borrow to make their capital contributions to the LLPs. In order to diminish the risks of the investment, it was implicit that matters would have to be structured so that certain receipts were guaranteed to arise, rather than all receipts be dependent on the successful distribution of the film or the DVDs.

31. All LLPs were intended to operate in conjunction with a company specifically set up and owned by Caroline Hamilton, namely IML, and in conjunction also with Kent Walwin’s various companies. For taxation purposes, members of the LLPs would need to demonstrate that they were actively engaged in the LLPs’ distribution activities, but it was also always expected that advisory services in selecting films, screenplays, and other such material, and administrative services would all be furnished to the LLPs by IML. Similarly it was expected that Centre would often be involved in procuring the licences over various screenplays, generally making them available from its library of more than 400 titles, and, most important of all, Centre would act as the LLPs’ head distributor.