Treatment of payments arising from warranties

The Upper Tribunal Decision in Revenue and Customs Commissioners v Sir Alexander Fraser Morrison ([2013] UKUT 0497 (TCC)) was published on 21 October 2013.

Background

In September 2000 Anglian Water plc (AWG) acquired the whole of the issued share capital of Morrison plc (MPLC) for a total consideration of approximately £263m. Sir Alexander Fraser Morrison (SFM) received consideration for his shares, in the form of shares and loan notes in AWG, with an approximate value of about £33m.

In July 2000, shortly after AWG had expressed an interest in acquiring the company, SFM authorised the sending to AWG of MPLC’s Five Year Strategic Plan, which included a profit forecast for the year to 31 March 2001.

In August 2002 – i.e almost two years after the sale – AWG took action against SFM and another director alleging that it had been induced by a number of false representations and misstatements to offer more for the company than it was worth.  They sought damages of £132m and these proceedings were defended.

In February 2006, shortly before the action was due for trial, a settlement was agreed whereby AWG and MPLC would release SFM and others from any liability, and in return, without accepting liability, SFM would pay £12m to AWG.

It is worth pausing here.  AWG had sold his shares for £33m, in relation to which – and subject, of course, to any available losses or reliefs – capital gains tax would be payable.  In the event, however, AWG had paid back £12m and incurred legal costs – and his net position was therefore somewhere south of £21m.

SFM claimed that the payment of £12m was the enforcement of a contingent liability in respect of representations made on the disposal of his shares in MPLC, and that the consideration received for his shares for capital gains purposes should be reduced by £12m under TCGA 1992, s 49.

The First-Tier Tribunal had allowed SFM’s appeal against a closure notice issued by HMRC, who appealed to the Upper Tribunal.

The Settlement Agreement and the operation of TGCA 1992, s 49

In the Upper Tribunal, Lord Glennie analysed the statutory provisions and the submissions by HMRC and SFM in detail, highlighting a number of issues in connection with the application of s 49 that are of importance to taxpayers whenever they are faced with paying contingent liabilities following the sale of shares and other assets.

Section 49 operates by reducing the consideration received for the sale of the asset, and is most commonly seen in connection with claims under a warranty or indemnity given on a sale of shares.

The fundamental point in SFM’s case was that the payment was not made by him in his capacity as the person making the disposal.

SFM had made the representations in his capacity as chairman of the company, and not as minority shareholder in the company. He would have provided the same information whether or not he had any shares in the company. His liability on that representation was not incurred as seller of his shares, but as chief executive of the company.

The liability arising in connection with the action brought by AWG had no direct relationship or nexus between the contingency and the value of the consideration receivable for his shares. In order to demonstrate this point HMRC referred to the cases of Burca v Parkinson (Inspector of Taxes) [2001] STC 1298 and Gray’s Timber Products Limited v Revenue and Customs Commissioners [2010] STC 782, both of which show that amounts paid out or received in connection with a sale of shares are not always taken into account in establishing the consideration for the shares for CGT purposes.

Lord Glennie concluded that:

what a court has to assess in the case of a contingent liability in respect of a warranty or representation made on a disposal by way of sale is whether the liability is “directly related to the value of the consideration” received by the taxpayer on the disposal of the property….The liability of SFM on representations made by him as chairman of MPLC in connection with AWG’s purchase of its whole share capital is wholly distinct from the consideration received by him for his shares in MPLC.

The treatment of costs of defending the High Court action

The second issue the Upper Tribunal considered was the treatment of legal costs incurred by SFM. As SFM failed on the first issue, his appeal on the second issue must fail. However, Lord Glennie made some comments “in case the matter should go further”.

In principle, there is no reason why the legal costs should not follow the treatment of the settlement payment, so that if SFM should succeed on the first issue, the legal costs would form part of an adjustment under s 49(2).

However, the question is whether there is sufficient link between the legal costs and the contingent liability. Lord Glennie took the view that, although there is no reference to “wholly and exclusively” in s 49, the test is relevant in the same way as it is relevant in s 38 (which looks at allowable costs for CGT purposes). SFM incurred the legal costs in relation not only to AWG’s claims against him, but also against others, including family interests, which begs the question as to whether the costs would be allowed because of a potential duality of purpose. This problem is not resolved in the decision, but demonstrates the importance of analysing the purpose of expenditure when preparing a CGT computation.

Conclusion

This decision is important for its insight into the way in which s 49 operates. In particular it shows the importance of establishing a clear link between the payment arising from the warranty or representation, and the sale of the asset. In connection with a sale of shares, directors will need to take care when making representations that they are making them as shareholder and not as director. This seems to be especially important where the individual concerned has a small shareholding in the company, but is providing information to the purchaser that is key to establishing the price to be paid for the shares.

In order to avoid a challenge on the basis of this decision it would appear to be important to ensure that the contingency is borne pro-rata to the shareholdings in the company. If only some of the shareholders bear the cost of a contingency, HMRC are likely to challenge the nexus between the payment and the sale of shares.

If you would like further information in relation to the treatment of contingencies please contact the TaxDesk on 0845 4900 509 and ask for Paul Howard.