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The two-day hearing in this case will begin on 21 February 2011.

The Supreme Court will consider both a procedural issue (in essence, whether issues that were not referred to in a closure notice be raised by HMRC in an appeal); and a substantive issue (whether expenditure on the acquisition of a right to use software, which was funded by non-recourse loans from the owner of the software, can qualify for an allowance under section 45 of the Capital Allowances Act 2001 (the “CAA”)).

Factual background

Tower MCashback (“MCashback”) developed a software system. In order to finance it, four LLPs were set up.  The LLPs entered into licence agreements with MCashback under which each acquired rights to use an element of the software.  25% of the consideration was funded by the investor members of the LLPs, and the 75% balance was funded by non-recourse loans provided indirectly by MCashback.  The first two LLPs (“LLP1” and “LLP2”) claimed first-year allowances under section 45 of the CAA in respect of 100% of the expenditure on the software. HMRC denied the allowances by reference to section 45(4) of the CAA (expenditure on software is disqualified if “the person incurring it does so with a view to granting to another person a right to use or otherwise deal with any of the software in question“).

Round One – the Special Commissioner

HMRC abandoned their section 45(4) argument during the hearing. Instead, they, inter alia, asserted that the LLPs had not ‘incurred’ the full expenditure, but only an equivalent amount to the capital contribution (i.e. 25%). The Special Commissioner adopted his own analysis and recharacterised the transaction as a contingent instalment sale, with an up-front payment of 25%. The legal realities of the transactions could be disregarded, and the transaction taxed on this basis, i.e. the LLPs could claim allowances in respect of the 25% only.

Round Two – High Court (Henderson J)

Henderson J held that the scope of the appeal was delimited by the closure notice – i.e. whether or not section 45(4) applied.  The Special Commissioner had no jurisdiction to entertain the wider question whether the other requirements of section 45 were satisfied, because the appeal would then no longer be an appeal against the conclusions stated in the closure notice.  However, if he had to consider the expenditure issue, then he would have allowed the appeals of the LLPs on this issue.

Henderson J also said that, if he had had to decide the issue, then he would have held that LLP1 was not trading in the relevant year.  Following this, LLP1 abandoned its point as to the year in which it commenced trading during the course of the appeal to the Court of Appeal.

Round Three – the Court of Appeal (Moses, Arden and Scott-Baker LJJ)

The Court of Appeal (Arden LJ dissenting on this issue only) held that the Special Commissioners (now the First-tier Tax Tribunal) had jurisdiction to hear any legal argument relevant to the subject matter of the conclusions stated in a closure notice, and, here, the relevant subject matter was section 45, and not just subsection 45(4).

Turning to the expenditure issue, the Court of Appeal said that the approach taken by the House of Lords in Ensign Tankers (Leasing) Ltd v Stokes [1992] STC 226 was the one that should be used to determine whether LLP2 had really incurred the expenditure. It noted that the funds borrowed from MCashback belonged to LLP 2, and LLP 2 expended those funds on the purchase of the software agreement.  Also, LLP2 acquired the full economic benefit of the software in return for the expenditure.  Whilst the loans were “plainly not commercial”, potentially they could be paid off from income generated (albeit that, commercially, this was unlikely).

The Court of Appeal concluded that LLP2 had expended the borrowed funds on the purchase of the software.  It was entitled to a first year allowance in respect of the full expenditure.

The Supreme Court (Lords Hope, Rodger, Walker, Collins, Kerr, Clarke, and Dyson)

The decision of the Supreme Court is awaited with interest.  Whilst the extent to which a series of transactions can be recharacterised to give effect to the economic reality of those transactions is a question that frequently arises in a tax context, guidance from the Supreme Court (sitting as a panel of seven) will assist considerably.  On the closure notice issue, the fact that Henderson J and Arden LJ took a different view to Moses and Scott-Baker LJJ demonstrates that there is uncertainty.  The answer of the Supreme Court will end that uncertainty as regards this important procedural matter.