The First-tier Tribunal in Eclipse Film Partners No 35 LLP v HMRC [2012]
UKFTT 270 TC (Eclipse 35) has held that a film “leasing”
partnership was not trading. It is important to leasing
companies that they are trading as this enables them to surrender
losses to, and receive losses from, other members of the group.
In this context it was important for
individuals borrowing to invest in the “leasing” partnership to
establish the existence of a trade as they could only claim a
deduction for interest costs if the partnership carried on a trade
with a view to profit. Given that Eclipse 35 is the second
trading case that HMRC have recently won it is likely that the
question of trading will be raised by HMRC more frequently.
The other recent case (Samarkand [link to article]) is
being appealed and it has been reported in the press that Eclipse
35 also propose to appeal. The most controversial element of
the Eclipse 35 decision is likely to be the requirement that a
business needs to contain just the right amount of speculative
activity to be considered to be a trade.
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Facts
In Eclipse 35 individuals borrowed
sums to invest in a limited liability partnership (the
LLP) on the basis that by making an interest
prepayment they would receive large current year tax deductions for
the interest payable over the life of the loan.
Once the individuals had contributed money to
the LLP, the LLP licensed rights in respect of two films from Walt
Disney Pictures (Disney). It immediately
on-licensed the film rights to a second Disney company (the
Distributor). The Distributor agreed to pay
the LLP fixed sums over 20 years together with contingent receipts
if both films performed well. No contingent receipts were
paid.
The LLP also made a loan to the individual
partners. The partners used this loan to make a prepayment of
interest on the loans taken out to invest in the LLP, arguing that
this prepayment of interest was deductible in the tax year in which
it was paid. Individuals
borrowing to invest in a partnership may claim a deduction for
interest costs only if the partnership carries on a trade with a
view to profit.
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By GlobalDataThe decision
The Tribunal held that the LLP was not
carrying on a trade. It considered that the business of the
LLP did not contain a sufficient element of speculation (or
commercial risk) to constitute a trade; the fixed receipts payable
by the Distributor were calculated without reference to the success
of the films, and were thus de facto a fixed source of
income.
With respect to the contingent receipts, the
Tribunal held that, given the remote possibility that they would be
paid, they were not sufficiently speculative to justify the
existence of a trade. Weight was given to the fact that the
contingent payments were largely ignored in material provided to
potential investors. The Tribunal considered the risk of
non-payment, concluding that it was not actually connected with the
acquisition and exploitation of films, but instead that the risk of
non-payment derived from the creditworthiness of the lending
bank. There was no mechanic whereby a loss could have been
suffered by the LLP in the event that the films were
unsuccessful.
The Tribunal held that the transaction failed to
demonstrate that it involved the provision of services by way of a
business to an identifiable customer; it found that the LLP did not
actively supervise the marketing and release of the films as this
role was fulfilled by the largely autonomous Distributor.
The Tribunal considered that it was not
possible to treat the LLP as trading by analogy with the position
of a lessor under a sale and finance leaseback arrangement.
The two scenarios could be distinguished, as in a sale and
leaseback the lessor provides finance in the course of a financial
trade whilst the LLP in Eclipse 35 was the recipient of finance,
not the provider. Also, the LLP did not retain any residual
rights in the financed matter (the films) which is a necessary
condition of a sale and finance leaseback. The Tribunal
considered that where a single purpose lessor is a member of a
financial group, it is possible to look at the financial trading
activities of the group in order to determine whether the lessor is
carrying on a financial trade. Leasing companies, who would
typically retain an interest in the asset (via an interest in the
sales proceeds) when providing finance, will be able to seek
comfort in this element of the judgment.
Helpfully, the Tribunal considered that the
manner in which the partners financed their contribution to the LLP
was not relevant to whether or not the LLP was trading. The
Tribunal did also accept that the transactions were not tax
avoidance schemes.
Comment
Classically the courts have determined whether
a person is trading by reference to a number of factors, such as
the badges of trade. Eclipse 35 forms part of the departure
from that approach to one in which each and all of the
characteristics of the arrangements said to be a ‘trade’ will be
examined. In this instance, the Tribunal broke down the
functions of the LLP; as the LLP did not provide finance, the
Tribunal concluded that the LLP did not have a finance leasing or
financial trade. However, it was not immediately apparent
that the LLP did not have a trade of exploiting films. In
finding that the LLP was not trading the Tribunal relied on the
absence of speculation in the LLP’s revenue stream. This is a
significant departure from the previous approach taken by the
courts, which was to view a financial arrangement as a trade if it
had the character of a trade and could satisfy one of the badges of
trading.
This approach may have unseen ramifications;
the options presently available to a business seeking to minimise
its risk are numerous and comprehensive yet at a certain point a
business availing itself of these options could cease to be a
trade. Applying the Tribunal’s reasoning, one could argue that
businesses should inhabit the middle ground of risk; where an
activity is too speculative, it will not constitute a trade
(Emanuel (Lewis) & Son Ltd v White [1965] 42 TC
369).
The Tribunal relied on Ransom (Inspector
of Taxes) v Higgs 50 TC 1 to support the notion that to be
trading the LLP needed to be providing business services to a
customer. In Ransom, it was held that directing the
activities of others to enter a scheme was not sufficient to
establish that the taxpayer was trading. Although the LLP did
arrange the transactions (as in Ransom) the activities of
the LLP can be distinguished from those in Ransom as the
LLP did enter into transactions itself.
HMRC’s drive to counteract tax avoidance
schemes by arguing that an activity is or is not trading in recent
times have met with limited success. The two recent decisions
in Samarkand and Eclipse 35 have stoked the
longstanding debate; however, it will be for the courts to draw
distinctions on a case by case basis. This will be no easy
task, and a period of uncertainty for taxpayers may follow.
