UK: Defeased Leases: Some Light, If Not Certainty

The case is of great importance in resolving the tax treatment of a large number of existing defeased transactions. The case also provides the latest statement on the courts’ approach to the application of the "anti-avoidance" principles arising from WT Ramsay Limited -v- IRC ("Ramsay").

For those who are still unaware of the background to this case, the following is a brief outline of the relevant aspects of the structure of the transaction:

The case concerned the gas interconnector pipeline running between Scotland and Ireland which was constructed by Bord Gáis Éireann ("BGE"). BMBF entered into two acquisition agreements with BGE whereby BMBF agreed to purchase the interconnector for approximately £91 million. BMBF borrowed from Barclays Bank plc ("Barclays") a sum slightly in excess of this purchase price.

BMBF leased the pipeline to BGE which in turn sub-leased it to its own UK subsidiary, BGE (UK). It was agreed that BMBF would invoice BGE (UK) for the head lease rentals and thus BGE (UK) would pay to BMBF amounts in discharge of BGE’s own obligations to BMBF. Such payments would also be set against BGE (UK)’s obligations to BGE under the sub-lease. Barclays itself guaranteed BGE (UK)’s liability to BMBF.

BGE (UK) agreed to transport gas through the pipeline as required by BGE. BGE, having placed upon deposit an amount of approximately £91.5 million with Deepstream Investments Limited (a Jersey "orphan" company, "Deepstream"), assigned its interest in that deposit to BGE (UK) as security for payment obligations under the Gas Transportation Agreement. BGE (UK) in turn assigned its interest in this deposit and related accounts in favour of Barclays.

Deepstream in turn deposited a similar sum with Barclays Finance Co (Isle of Man) Limited and executed a Deed of Indemnity in Barclays’ favour supported by an assignment of its rights to this deposit. Barclays was also granted a fixed and floating charge over all of Deepstream’s assets and a charge over the deposit. The funds representing the deposit were transferred to Barclays Group Treasury in accordance with the Bank’s usual practice. If one followed the flow of money around the Barclays group of companies, it could be seen that the money used to fund the purchase of the equipment started with Barclays Group Treasury, passed through a whole series of companies and ultimately ended up back with Barclays Group Treasury.

The case itself arose from the claim by BMBF to receive capital allowances on its capital expenditure on the pipeline pursuant to Section 24(1) of the Capital Allowances Act 1990. The Inland Revenue refused the claim on the basis that, having regard to the Ramsay principle and looking at the transaction as a whole (and in particular, all of the security arrangements and the flow of money around the Barclays group of companies) no expenditure had in fact been incurred by BMBF. The Inland Revenue’s arguments succeeded both before the Special Commissioners and before Park J in the High Court. The Special Commissioners considered the arrangement as nothing more than "a complicated, convoluted tax avoidance transaction" with no commercial reality.

Park J somewhat surprisingly considered, as did the Special Commissioners, that BMBF had not in fact incurred expenditure "on plant and machinery". His Lordship considered that, to the extent BMBF had incurred expenditure, such was incurred simply on a "complex network of agreements". At the time of Park J’s judgment, the leading statement on the Ramsay principle was Lord Hoffman’s speech in the House of Lords decision in MacNiven v Westmoreland Investments ("MacNiven"). In MacNiven, Lord Hoffman had tried to explain the line of Ramsay cases by drawing a distinction between those cases where the taxing provision in issue referred to "commercial concepts" – which justified a purposive approach (where non-commercial steps could be ignored), versus those which involved a legal concept which justified a more literal interpretation. Park J referred to this dichotomy in BMBF. He considered that the relevant wording regarding incurring of capital expenditure on the provision of machinery or plant contained in Section 24(1) was a commercial concept which required him to look at the whole series of transactions together in order to establish their overall commercial effect.

The Court of Appeal (Peter Gibson, Rix and Carnwath LJJ) held however, upon BMBF’s appeal, that neither the source of funds constituting the capital expenditure nor the use to which the vendor put the purchase price were relevant considerations in looking at the provisions of Section 24(1). The important point was whether a "trader" (either an end user or a lessor) "incurred expenditure on machinery or plant" (emphasis added). This concept, the Court of Appeal considered, was a legal concept and not a commercial one.

Upon the Inland Revenue’s appeal to the House of Lords, the Appellant Committee of the House dismissed the appeal for reasons substantially similar to those of the Court of Appeal. Lord Hoffman’s legal/ commercial concept dichotomy expressed in MacNiven, had caused a great deal of uncertainty concerning the application of the Ramsay principle. Consequently, during the appeal to the House of Lords in BMBF, Mr Aaronson QC who appeared for BMBF, said that he spoke on behalf of the profession when he hoped the House would use the appeal as an opportunity to give definitive guidance. It is therefore highly notable that the House responded by delivering a short and clear committee judgment, received on behalf of the House, by Lord Nicholls. On the key issue, their Lordships held, that Section 24(1) required that the trader should have incurred capital expenditure on the provision of machinery or plant for the purposes of his trade. Importantly, their Lordships then continued:

"When the trade is finance leasing [as it was in the case of BMBF], this means that the capital expenditure should have been incurred to acquire the machinery or plant for the purpose of leasing it in the course of the trade. In such a case, it is the lessor as owner who suffers the depreciation in the value of the plant and is therefore entitled to an allowance against the profits of his trade."

Their Lordships considered that it is solely the acts and purposes of the lessor itself with which section 24(1) is concerned. What the lessee does with the purchase price or how he pays the rent or uses the plant were not relevant considerations. The fact that the bulk of the purchase price is irrevocably committed at the outset of the transaction to paying the rent owed under the lease of the equipment is of no concern to the lessor. The important point is that from the lessor’s perspective, the transaction remains the same. This focus upon the consequences of the transaction from the lessor’s perspective is to be welcomed.

In terms of the correct approach to Ramsay, the judgment of the House has clarified much of the uncertainty caused by MacNiven. The House considered that the essence of the Ramsay principle was a purposive approach to taxing statutes. The court had to give a statutory provision a purposive construction to determine the nature of the transaction to which it was intended to apply and then to decide whether the actual transaction (which might involve considering the overall effect of a number of elements intended to operate together) answered to the statutory description. The basic question is always whether the relevant provision of a statute upon its true construction applies to the relevant facts. Their Lordships were at pains to state that:

(a) a tendency to use the principles arising from Ramsay and MacNiven to disregard transactions or elements of transactions which had no commercial purpose when construing the application of any taxing statute went too far; and

(b) the apparent dichotomy between "legal" and "commercial" purposes which Lord Hoffman in MacNiven indicated was to be pursued, was merely a generalisation and not a substitute for adopting the correct purposive approach described above.

Although these comments by the House have generally helped to clarify the Ramsay principle, nevertheless, lessors and their advisors are still left with the difficulty of determining as a first step in any transaction exactly what form of transaction will, on a "purposive" construction, answer to the requirements of the statute and then to determine whether the transaction in question does or does not fall within that construction.