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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.
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.
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;
TAXADVISER – August 2007 43
that the compensation was revenue. In Odeon Associated Theatres Ltd v Jones  48 TC 257 deferred repair costs of cinemas were allowed. ● the substance of the transaction rather than the accounts presentation. depreciation to provide for loss in value of capital assets. Finally Van den Berghs Ltd received £450. ie. Compensation for temporary loss is Enduring benefit Atherton v British Insulated & Helsby Cables Ltd  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. and the cinemas were fit for use in the trade. costs of improving. Entirety Building ‘repairs’ often involve replacement or improvement. Capital treatment applies only in exceptional circumstances. The Revenue claimed. It was held that the stand had its own distinct function and was a separate entity. but ‘circulating’ for a machinery retailer.000. and cancellations would occur in the course of trade. complete loss.) The company bought a ship that required substantial repairs and improvements before it could be used in the trade. and therefore an entirety. Compensation Van den Berghs Ltd v Clark  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 relationship of the wagons to the nature of the trade was that all wagons were stock. The courts decided that the trade included hire and sale of wagons. and relative importance of an entity. ● the relationship of the asset to the nature of trade. Compensation for any of the following permanent losses are capital receipts: partial loss. In Conn v Robins Brothers Ltd  43 TC 266 substantial repairs were allowed. The previous owners could have claimed a revenue deduction if they had undertaken the repairs. Short Bros Ltd v CIR  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. The accounts presentation was inconclusive. Factors have included physical.000 from the Dutch company to terminate the agreements. If the entity replaced is only part of an identifiable whole. Leading cases demonstrate the importance of the meaning of entirety. and no new or improved asset was created. s. and that the capital cost of the ship should include the repairs arrears. For example. The court held that compensation arose from ordinary trading operations because the company entered many contracts. The treatment of compensation for loss of fixed capital assets depends on whether the loss is temporary or permanent. Kelsall Parsons & Co v CIR  21 TC 608 concerned compensation for breach of one of many contracts. which were circulating assets in this trade. The company’s trade was manufacturing and dealing in margerine. They classed the ex-hire wagons as fixed capital. The company ceased its hiring trade and sold the wagons previously hired. Compensation arising from ancillary operations such as sale of scrap material and insurance claims are also revenue receipts. and that replacement was capital. Law Shipping Co Ltd v CIR  12 TC 621 established three principles: ● expenditure required to make an asset fit for use in the trade is capital. It acquired the enduring benefit of contented staff. repairs had been carried out on a part. The ‘peculiar conditions imposed by the war’ meant that the dilapidated condition of cinemas had not reduced their price. rather than when it might have been received if the parties had not cancelled the contracts. The company set up an employee pension fund. The receipt was revenue. then expenditure is capital. Therefore exhire wagons were circulating capital. modifies. which would indicate a capital receipt. Finally. treatment of compensation for a capital item depends on what the compensation was for. Compensation to replace a revenue item is a revenue receipt. hire and sale of wagons. and therefore a revenue receipt. The House of Lords held that the termination of the agreements damaged the whole structure of the trade. and taxable in the year of receipt. ● allowance for one owner does not imply allowance for another. The company claimed the compensation was a capital receipt. it could not be used for the trade without the repairs. The distinction depends on how the business uses the assets. 74(1)(d)&(g)). (The result would have been different if the courts had decided that hiring wagons was a separate trade. The court held that the ship cost less because of its state. if the entity replaced is a whole. and commercial separation. 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. Repairs Repairs and maintenance expenses are revenue. Brown v Burnley Football and Athletic Co Ltd  53 TC 357 concerned a replacement football stand. the compensation receipt was capital. and the court held. it was held that the entirety was a whole building. or adds to an asset for the enduring benefit of the trade. and not taxable. ● if the purchase price is substantially reduced due to dilapidated condition then reinstatement expenditure is capital. permanent loss of use of asset. It agreed to cancel two contracts for compensation of £100. Expenditure on a part may still be capital if it represents an improvement. The compensation had not terminated a substantial part of the business. the decision depended on whether the entirety was the stand or the whole stadium in which it stood. income should be brought into the accounts based on when it was actually received. the owner makes a profit from ‘circulating capital’ ‘by letting it change masters’. Dutch company. or an ‘entirety’. Weight was given to the accountancy treatment of deducting the repairs in the profit and loss account. adding to or modifying fixed assets are usually capital (ICTA 1988. machinery may be ‘fixed’ for a factory. if brings into existence. The court held that the breach did not affect the whole framework and structure of the business. These could not work normally during the First World War and disputes arose. The compensation was for ships. the premises did not change. then expenditure may be revenue. functional. The economist Adam Smith attempted to define ‘fixed capital’ as what the owner ‘turns to profit by keeping in his own possession’. The trade included manufacture. The purchasers claimed a revenue deduction for all repairs.FIRST PRINCIPLES ● ● profits and losses from disposal of capital assets. Hire and sale Gloucester Railway Carriage and Wagon Company Ltd v CIR  12 TC 720 established three important considerations: ● the nature of the trade. and disposal profits were chargeable under Schedule D Case I. The company entered into profit-sharing agreements with a 44 TAXADVISER – August 2007 . The company capitalised hire wagons on the balance sheet.
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. In Glenboig Union Fireclay Co Ltd v CIR  12 TC 427 the company received compensation for agreeing not to extract fireclay from under a railway line. Fees connected with acquisition. The court held that the receipt was capital: it compensated permanent loss of a fixed capital asset. Cheryl may be contacted at tax@finansol. Regular payments resembling a rental are revenue. goodwill or assets without addition or improvement are likely to be revenue (BIM35540).FIRST PRINCIPLES revenue. the calculation method was not relevant. The principles mentioned for licensed software apply. The tax treatment does not depend on the method used to calculate the compensation.uk). enhancement or defence of the fundamental structure of a business are generally capital. Treatment of each portion should be separately considered. The company paid a smaller credit card company to cease trading. it depends on the nature of each party’s trade. Some businesses develop their own software and own it outright. Walker v The Joint Credit Card Company  55 TC 617 concerned the permanent removal of a potential threat to goodwill.finansol. Computer software (BIM35810) Commercial software is usually licensed to users.’ Cheryl Sacks M Eng (Oxon) ACA CTA is the director of Finansol Ltd Tax Software (www. This includes forming a company or changing its status (eg. Summary I quote from HMRC’s summing up at BIM35910: ‘The capital/revenue divide is an ill-defined area. Borrowing Borrowing is on revenue account if it relates to ordinary day-to-day activities. In Southern v Borax Consolidated Ltd 23 TC 597 the costs of defending title to land were held to be revenue. Lease or hire purchase agreements comprise a disallowable capital element and an allowable interest element. alteration. the initial fee is treated as revenue. Other Unless the trade is property dealing. and the asset was worth the same to the taxpayer before and after the loss. Changes to a company’s charter to permit more effective trade without acquisition or disposal of a capital asset are likely to be revenue (BIM35565). Where software is expected to have a useful economic life of less than two years.uk Tax Adviser offers advertisers 100% coverage of CIOT and ATT members and has an average monthly circulation of 19. and forming or dissolving a partnership (BIM35525). Costs of preserving an existing business. revenue treatment is accepted. A capital payment made by instalments is still capital.call the sales team on 020 8247 1350 *ABC audited average net circulation for the period July 2005 . Franchise agreements A franchisor grants the franchisee rights to sell products in return for an initial fee and subsequent annual fees. s. eg. 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. Computer hardware and the licence to use software are often purchased as a package. Treatment of a lump sum depends on whether the licence is a capital asset in the trade of the licensee. In Burmah Steam Ship Co Ltd v CIR  16 TC 67 the company claimed damages based on estimated profits lost when repairs to their ship were delayed. irrespective of how it was calculated. The compensation was based on the profits foregone. s. Areas of current commercial interest Intangible assets Expenditure is capital if the identifiable asset is of a sufficiently substantial and enduring nature. The payment was capital because the removal of the competition created an asset of a more enduring nature. the deduction allowed for repairs is reduced by the compensation or insurance receipt (ICTA 1988.852* To advertise. Running costs are revenue. Tax treatment need not be symmetrical. This includes preparing the land for use in the business. Expenditure that would have been capital if successful cannot become revenue just because in the event it is abortive (BIM35325).co.co. temporary borrowing. As above. Compensation or insurance receipts for damage to a fixed capital asset are capital. and this type of expansion is part of the franchisor’s ordinary business. The costs of obtaining finance are allowable provided that the interest on the loan itself qualifies as an allowable deduction (ITTOIA 2005. The annual fees are revenue for both franchisor and franchisee. 58). The receipt is taxable in the year of receipt rather than spread over the life of the agreement. and therefore capital. treatment of expenses depends on the economic function of the software in that trade. Treatment depends on the form of the consideration. to Plc). the cost of an interest in land is capital (BIM35560).30 June 2006 TAXADVISER – August 2007 45 . The court held that the receipt was revenue: loss of use was temporary. 74(1)(l)). As no capital asset is diminished. The franchisee’s initial payment is treated as bringing a business into existence. If the damage is repaired. Costs incidental to capital expenditure are capital (BIM35120).
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