First published in Tax Journal on June 20, 2020.
Speed read: In NCL Investments, the Court of Appeal has considered the question of what it means for expenses to have been 'incurred' wholly and exclusively for the purposes of a trade. Differing with the approach taken by the Upper Tribunal in Ingenious, the court concluded that the use of 'incurred' did not introduce any requirement for there to have been any 'real' expenditure or outflow of resources. In finding that nothing more was required than that the debit was required under the relevant accounting standard, the court has confirmed that the starting point in determining a company's profits and losses is the accounting treatment. A decision in favour of HMRC might have had wide-reaching implications.
At times, cases involving the tax treatment of employee incentive arrangements may seem much removed from the world of mainstream corporate tax and therefore any case law in this area may appear of little interest. However, every now and then, a case appears which is of interest outside what could be seen as a narrow area. This is the position in relation to the Court of Appeal decision in HMRC v NCL Investments Ltd and another  EWCA Civ 663.
The facts in NCL Investments are relatively straightforward and uncontroversial. Refreshingly, it was also agreed by both HMRC and taxpayer that this was not a case involving any form of tax avoidance or motivated by tax mitigation. The taxpayer and its sister company employed individuals and, as is often the case within financial service groups, provided their services across the group. It was recognised that this was a trade for tax purposes. They arranged for the employees to benefit from share options in their parent company, the parent of the Smith and Williamson group. The share options were granted by an employee benefit trust which sourced the share options from the parent. So far, so normal.
What may seem unusual, at least to a lawyer, is the way in which the provision of the share options was dealt with in accounting terms, under the appropriate accounting standard (IFRS2). IFRS2 requires recognition of the cost of services received under a 'share-based payment transaction', the cost to the employing company in this case being the cost of the options granted to the employees. Because this cannot be easily calculated, the relevant accounting standard requires that the fair value of the option itself be used as a suitable proxy. This meant that the employing company recognised a debit in its accounts equal to the fair value of the option. The employing company also recognised a capital contribution from the parent equal to the same value. As a policy matter, it recharged the cost of the options to the other members of the group and, after recognising a suitable margin, paid the expense element to its parent company. The value of the expense was not recognised in its profit and loss account but reduced the quantum of the capital contribution. The employing company was left with a net debit, even though in cash terms it had borne no expense. It was however accepted by the courts that this was in accordance with an acceptable accounting practice.
The issue therefore for the taxpayer was whether it was entitled to any tax relief for the expense. Before looking at the arguments, it is worth noting the absence of specific statutory provision at the time allowing or denying relief in respect of the grant of options. There has been (for some considerable time) a regime for giving corporation tax relief for the exercise of share options under what is now Part 12 of the CTA 2009 and a restriction of that relief if there is not a charge to employment tax within nine months of the end of the relevant accounting period under CTA 2009 s 1290. Given the lack of any statutory framework, the courts in this case had to look at the general provisions for a taxpayer carrying on a trade to obtain tax relief for the expenses of that trade, which is why this case has a wider impact beyond the area of employment tax. In order to look at the claim for relief, the Court of Appeal had to look at provisions on which corporate taxpayers rely for tax relief for expenses generally.
The first argument (from the taxpayer) was that in accounting terms, there was a debit in the accounts and therefore, subject to any rule to the contrary, relief should be given. This seems clear. Section 46 of the CTA 2009 states clearly that in computing the profits of a trade, you start off by looking at its accounting profit (or loss). This is not a surprise and codifies what we have understood from case law for some time; the lead speech often quoted is the judgment of Lord Brightman in Southern Railway v Peru  AC 334. However, this is subject to any adjustment required by or authorised by law. The issue that concerned the court was whether any adjustment was required, with the taxpayer arguing not and HMRC taking the opposite view. The next section considered was CTA 2009 s 48 which states that one looks at the accounting debits or credits and it is not necessary for an expense to be paid (or be a receipt or received) in cash terms. The Court of Appeal passed quickly over s 48, endorsing the Upper Tribunal's conclusion that what s 48 is doing is to make it clear that there is no necessity for an item to be paid for, or for there to be a legally enforceable obligation, for the expense to be relievable. The story however does not end there; like s 46, s 48 is subject to any provision to the contrary.
This led to the real crux of the issue, which was whether CTA 2009 s 54 precluded relief. Section 54(1) is very short. Tax relief is not available for 'expenses that are not incurred wholly and exclusively for the purposes of the trade'. Section 54 itself had a long history before the 2009 Act consolidated the various corporation provisions; it was originally found in ICTA
Tax Journal, Issue 1492, 10 at 11
1988 s 74(1)(a). It is best known as the provision which denies tax relief for expenses that have a duality of purpose, that are not incurred wholly and exclusively for the purposes of the trade and most famously in what was the then House of Lords decision in Mallalieu v Drummond  2 All ER 1095, when tax relief was denied for a barrister's clothes. However, the use that HMRC sought to make of it was the reference to the use of the word 'incurred'. The argument made was that this must mean that money has to have been actually spent or to be spent by the taxpayer and that this was an adjustment required by law for the purposes of s 46. Here, there was no such money spent, there was an accounting debit.
In advancing this argument, counsel for HMRC relied heavily on the recent decision in Ingenious Games v HMRC  UKUT 226. It is not necessary for the purposes of this case to look in detail at that decision; as readers will know, it concerned the claim of the members of the LLP for tax relief in respect of film production activities. The claims failed at the Upper Tribunal on the basis that the LLPs were not trading. In addition, the tribunal considered what degree of relief would have been available had the LLPs been trading as, in the view of the tribunal, the taxpayers had only borne an outgoing of 30; this was the 'real' expenditure, quoting from the decision in Tower MCashback LLP v HMRC  UKSC 19. Bearing in mind that this was the economic burden that the taxpayers has suffered, the tribu-nal considered that if the partnerships had been trading, this would have restricted relief to that extent.
This conclusion draws primarily not on the case law relating to trading expenses, but relies instead on case law relating to capital allowances where, in order for the relief to be available, the expenditure (as opposed to the expense) has to have been incurred. The Court of Appeal's comments on this are interesting and refreshing: if this conclusion had been correct, it would have cast doubt on the overall approach previously understood to have been taken by these sections in basing the claim for tax relief for expenses on the accounting position. First, they agreed with counsel for NCL that the comments made by the tribunal in Ingenious were not part of the main decision of the tribunal and therefore not binding. In addition, the Court of Appeal referred to the 'imperfect analogy with authorities on capital allowances' which had not been advanced before then. It was concluded that in determining trading profits it was sufficient that there was an accounting debit; there was no additional test imposed by the use of the word 'incurred'.
Having lost this argument, HMRC sought to argue that the expense was not incurred wholly and exclusively for the purposes of the taxpayers' trade, in that the expense was a necessary result of IFRS2 and arose by reason of the grant of the share options by the trustee of the employee benefit trust. This was given short shrift by the court; the reason for grant of the share options was to incentivise the employees used to provide services to the group companies. Further, a recharge was made to the recipients of these services reflecting the cost (in accounting terms) of the options. This again does seem the right conclusion; if the court had adopted HMRC's argument, it would have put in place a strict causal requirement which could significantly narrow the scope for deductions.
The same is true of the next argument raised by HMRC, namely that the debits should be disallowed because they were capital in nature; the corresponding credits were the capital contributions deemed to be made by the holding company (reflecting the provision of the share options). This was dismissed by the court. The reasoning for this is similar to that used in determining the purpose of the arrangements. The underlying transactions in respect of which the debits arose were revenue. The share options were granted as part of, and linked to, a revenue transaction — the provision of the services by the service companies in the group.
The last argument raised by HMRC was that relief was restricted by CTA 2009 s 1290 which had the effect of deferring relief until the tax charge arose for the employee. In this case, no tax charge arose on the grant of the share options as any tax charge was deferred until the option is exercised. These options were never exercised because of a fall in the value of the shares to which they were linked. This was dismissed by the Court of Appeal following the reasoning of both the First-tier Tribunal and the Upper Tribunal; this depended on a technical reading of the section, rejecting the submission that the options constituted 'property' that was 'held or may be used, under an employee benefit scheme' and does not have a wider import.
The judgment of the Court of Appeal is not lengthy — a mere 81 paragraphs long. In this, it does benefit from two much longer decisions of both the Upper Tribunal and the First-tier Tribunal. The court also benefited from the facts not being in dispute; much of the earlier decisions are taken up with understanding the accounting treatment of the arrangements and the application of IFRS2. The brevity of the Court of Appeal judgment does not undermine its im-portance. What is clear from it is the court's reluctance to depart from, and the importance attached to, the principle that the starting point in determining a company's profits and losses is the accounting treatment. When this is not disputed; and the court accepted that the accounts were drawn up correctly, they should be followed unless there is clear authority to the contrary. Section 54 seemed at first sight to offer HMRC an opening to argue that there was such authority, but the court took the opportunity to shut the door on any such opening, stepping back from what could be seen to be an over-reliance on the use of the word 'incurred' divorced from the purpose of the section. If they had taken the opposite view, and followed the arguments made by HMRC, there may have been much wider implications and maybe unexpected consequences.
This case then is another case where HMRC has sought to challenge the result provided for by the accounting treatment. The issue HMRC continually faces is that while accounting treatment looks to prudently reflect the financial position (i.e. there is a preponderance to under declare profits as opposed to over declare), this runs contrary to their principal aim of taxing profits. Hence the need to resort to innovative arguments such as those in this case.
There is one final comment. The accounting periods in question were 2010, 2011 and 2012; the EBT was originally established in 2003. The hearing in front of the First-tier Tribunal took place in 2017 and it has taken another three years for the Court of Appeal decision to be handed down. There is no real delay on the part of the Court of Appeal; the hearing took place in the middle of March and the decision is only two months later. The hearing was one of the last before the Covid-19 lockdown. After we emerge from the lockdown, it is to be hoped (perhaps vainly) that we find some way to speed up the process, so that the time from start to finish is shortened.