[2009] UKFTT366 (TC)

TC00304
Capital gains tax -   relief under Enterprise Investment Scheme -   whether 80% of the share capital subscribed had been "employed" in the qualifying company's trade within the twelve month period from the subscription  -   monies on instant access deposit account  -  consideration of different business requirements  -  appeal dismissed

FIRST-TIER TRIBUNAL		                    Reference no’s: TC/2009/12154 & 12155
TAX										 
  SKYE INNS LIMITED
and
    				     MR.CHRIS O. RICHARDS           	         Appellants

-and-

THE COMMISSIONERS FOR HER MAJESTY'S 
REVENUE AND CUSTOMS		       Respondents

Tribunal:  	Howard M. Nowlan (Judge)
Elizabeth Bridge (Member)

Sitting in public in London on 16 November 2009
Anthony Connelly of PriceWaterhouseCoopers, on behalf of the Appellants
Chris McMeeken and Kathryn Robertson, both of HMRC on behalf of the Respondents

©CROWN COPYRIGHT 2009 

DECISION
Introduction
1.     These appeals both depended on the one seemingly simple question of whether the Appellants could demonstrate that Skye Inns Limited ("Skye") had "employed" 80% of the cash contributed to it, when Mr. Chris Richards ("Mr. Richards") subscribed share capital in the company on 18 December 2001, in Skye's qualifying trade within the twelve-month period from the date of subscription, in other words by 17 December 2002.    
2.     Although Skye and Mr. Richards were both technically Appellants, nothing actually depended, so far as Skye itself was concerned, on the outcome of the appeal.    The only financial consequence of the appeal was that if the appeal was dismissed, on the ground that Skye had failed to meet the last of the conditions for Mr. Richards' claim for Enterprise Investment Scheme ("EIS") relief, Mr. Richards would be liable for the capital gains tax of £614,673.60 that he had sought to eliminate by subscribing the shares in Skye.
3.     Whilst we acknowledge that there are some very unfortunate aspects to this case, our decision is that 80% of the funds subscribed for shares in Skye had not been employed in the company's qualifying trade within the required time period, and therefore the appeals are dismissed. 
The facts
4.     Mr. Richards had subscribed shares in Skye on two earlier occasions, and as a result of those subscriptions Skye had purchased two pub/restaurants from which it was trading.    On account of the fact that customers are often lost when a pub or a restaurant changes hands, Skye was incurring net losses at these two restaurants after taking into account all its administrative expenses.    Mr. Richards and the other directors nevertheless had fairly major plans for expansion and we were shown projections that contemplated the acquisition of a considerable number of further outlets.     Mr. Richards had been a chef himself some years ago and more recently had been involved with a company in the supply chain for restaurants, so that he had considerable experience of the relevant trade. 
5.     On 18 December 2001, Mr. Richards subscribed further shares in the company for £1,536,684, his and the company's intention being that Skye would purchase a particular pub and restaurant that they found highly attractive, namely The Old School House, in Ockley in Surrey.     They hoped that following the purchase of this restaurant, the profits made at the Old School House would fund the losses at the two existing restaurants, and were thus very keen to make the purchase.    Whilst the acquisition was negotiated successfully, and Skye also engaged new staff to run the Old School House, in February 2002 the existing owner backed out of the sale 48 hours before the date that had been set for simultaneous contract and completion.      Had the purchase been completed, it seems highly likely that the application of the purchase price of approximately £820,000, along with the cash drain of funding the losses at the first two restaurants and the costs of undertaking numerous repairs and improvements at all three properties, would have ensured that 80% of the moneys subscribed on 18 December 2001 would have been employed in Skye's business within the required 12 month period. 
6.     Following the failed acquisition of The Old School House, there is no doubt that the directors continued with their search for appropriate further acquisitions, and we were shown an extensive list of pubs and restaurants, the purchase of which had been considered.    They were unable to find a suitable new acquisition however, and at some time they reached the conclusion that the company's better option was probably to undertake major improvements at the two existing properties.     In addition to redecoration and new carpeting, we were told that a function room was built at one of the two, and that considerable money was eventually spent in this way. 
7.     It was not entirely clear when the company abandoned its plan of buying a third pub or restaurant.   For a period after the purchase of The Old School House, the principal aim was certainly to find a replacement third outlet, though possibly a somewhat smaller one than The Old School House, because the directors began to appreciate that the cash requirement of running and improving the first two outlets restricted the amount of cash that Skye had available at the time for its third acquisition.     It was indeed not until November 2003 that there was a formal Board Minute, confirming the conclusion that by then it was appropriate to concentrate only on the improvements at the first two outlets, rather than to continue the search for a third, but Mike Hammond, one of the directors who also gave evidence, confirmed that this conclusion had in reality been reached well before the conclusion was formally recorded in the Board Minutes.
8.     On 4 May 2004, HMRC wrote to Skye's accountants, indicating that their review of the company's accounts for the year ended 31 March 2003 revealed that the company cannot have "employed" 80% of the funds raised in the 18 December 2001 share subscription in its business, because those accounts showed that on the Balance Sheet date, Skye still had £1,229,071 on deposit with its bankers, and thus not "employed in the trade". 
9.     There was then considerable correspondence, conducted by three firms of accountants, first Venthams, then BDO Stoy Hayward LLP, and finally PriceWaterhouseCoopers.     By the time PWC became involved it appeared to have been agreed that by the end of the 12-month period, 50% of the moneys had indeed been "employed in the trade" and that by the end of the 24-month period, the further condition that 100% of the moneys should have been "employed in the trade" had also been satisfied.      Whilst our conclusion is that both of those assumed conclusions were demonstrably wrong, the result of those two conclusions was that the hearing before us commenced on the basis that all that the Appellants had to do was to demonstrate that the need to retain a further 30% of the December 2001 subscription moneys (i.e. the difference between 50% and 80%) to meet anticipated losses and revenue improvements at the two existing properties, justified the conclusion that that additional 30% element had been "employed in the trade". 

Our decision
10.     A considerable number of points had been in contention in correspondence, and during the hearing, and rather than list the contentions of the parties on all of the points before giving our decision, it will be clearer to deal with each contested issue in turn, indicating the contentions of the parties and our decision in relation to each issue. 
The purchase of a third outlet
11.     It was contended on behalf of the Appellants that Skye had been about to make a major acquisition in February 2002 that would have ensured compliance with the requirements of the EIS legislation, and it was only because the vendor of the property backed out at the last minute that the acquisition fell through.  Notwithstanding this, the directors maintained their search for new acquisitions, and they certainly never decided to apply the cash fund elsewhere, in other words in some form of non-qualifying investment.     Accordingly, it was argued either that the 80% test was met at the very point when the Old School House acquisition was about to be made, or that the continued intention to find a replacement property meant that the requirement was met for that reason.    It was also argued that when the directors retained that intention, it would be ridiculous for the tax requirements to force the directors to make an unattractive purchase, and that in view of this the tax test ought at least to be applied in a fairly flexible manner.
12.     It was contended on behalf of HMRC that where a new acquisition was contemplated, it could not be said that cash, reserved and ear-marked for the new purchase, was "employed" in the business even where the company had actually entered into a contract to make the purchase.  The acquisition actually had to be made.      In response to this the Appellants suggested, somewhat curiously, that their position was different and more favourable, because no contract had actually been entered into.    
13.     Our decision makes it unnecessary to consider the position where a company has actually entered into a contract to make an acquisition.      It seems conceivable to us that if a contract was due to be completed within the 12-month period, and was completed shortly after the expiry of the period, and the delay involved a breach of contract by the counter-party, that there may be a possibility that on such extreme facts the decision will be that cash ear-marked for that acquisition can be said to be "employed in the business" once the contract binds the company to make the purchase.   Where however, as in this case, there was actually no contract, we agree with HMRC that the Appellant's case is plainly weaker, and that it cannot be said that moneys that the company merely means to employ in the business were yet "employed" in the business.     This means that the relevant test cannot be shown to have been satisfied in the few days before the counter-party backed out of the proposed sale of The Old School House, and it certainly cannot be satisfied because of the general point that it remained the directors' intention after February 2002 that some other pub or restaurant acquisition would be made. 

The invidious choice faced by the directors
14.     We accept the Appellants' evidence that it remained the directors’ intention to employ the funds in the trade, and they certainly never appropriated any of the cash for any non-trade purpose.    We also obviously note that it was highly unfortunate that the directors were faced with the unenviable choice of making an acquisition in order to satisfy the tax tests, when they were not content that the acquisition was a prudent one, or else they had to fail the tax tests because  they could not find a suitable replacement property.     The particular officers of HMRC cannot however be blamed for imposing this invidious choice on the directors and the company.    The tax test imposes a definite time period within which different percentages of the cash raised by a share issue must be employed in the trade, and they admit of no exception for the situation where the directors wanted to meet the test but were unable to do so. 
Working capital requirements
15.     Further and different arguments were advanced along the lines that, by December 2002, the directors had abandoned the intention of acquiring a third property and that the test of employing the moneys in the trade was satisfied because the directors were holding the funds to meet anticipated losses, and revenue and some capital improvements to the two existing properties.    There is obviously some conflict between this argument, and one based on the continued policy decision of trying to find a third property to purchase, and we are not convinced that the plan for the third acquisition was in fact dropped until some time after December 2002.     This, however, is not particularly critical because we conclude that the Appellants also fail the test, even if we accept the proposition that by December 2002 the decision had been reached simply to hold the relevant moneys to meet losses, and fund the various changes to the two existing properties.  
16.     The response of  HMRC to the argument mentioned in the previous paragraph was that while moneys held in current account to meet the immediate current requirements of the business could be said to be employed in the trade, this could not be demonstrated in this case for several reasons.    It was firstly suggested that if the moneys were placed on a deposit account, that would preclude satisfying the test about holding moneys on current account.    We certainly disagree with that suggestion, and in fairness HMRC had dropped this particular contention in the hearing before us.    The deposit account in the present case was an Instant Access deposit account, and since no company would leave a substantial amount of money on a non-interest-bearing current account, it must follow that placing the moneys, required for current requirements of the business, in an Instant Access deposit account must enable the tax test to be satisfied provided that the required "current requirements of the business" can be demonstrated. 
17.     HMRC then suggested that cash held on current or Instant Access deposit accounts could only be said to be employed in the business if it could be shown that it was required to meet business requirements in the next month, or at least in the very immediate future.     It seems to us that once HMRC concede (rightly in our view) that cash does not actually have to have been "spent" to justify the conclusion that it is "employed in the business", and once it is accepted that the same conclusion can be reached where the directors hold the cash because they believe that it is required to meet the current requirements of the business, any "one month" or equivalent short term test is unrealistic.   Everything must revolve around the facts relevant to the particular business.    The business in this case was making considerable losses, and whilst the directors believed that they could turn the business round by making a number of improvements to the existing properties, they still expected to be having to finance the losses for a very much longer period than either one month or, say, three months.    It seems to us that it would be appropriate to conclude that cash was employed in the business when it was held to meet losses for at least a 12-month period, and indeed possibly until the directors projected that they would have turned the business round from loss to profit. 
18.     Whilst we, and certainly it seemed the Appellants and the Respondents, were still labouring under the misapprehension that at least 50% of the cash had been "employed" in the business by December 2002, we then faced the difficult question of whether, in considering future business requirements that could lead to the satisfaction of the tax test, we could pay regard not just to the projected cash requirement in financing expected losses, but also the cash requirements for making revenue and some capital improvements to the existing properties.     We do not now strictly need to consider that question but we will say that if we could have been persuaded that the spending requirements on the existing properties were all required in order to turn the business round from loss to profit, we would have been inclined to conclude that the cash fund genuinely thought to be required to meet that objective could be said to be required to satisfy the relevant test. 
19.     The Appellants contended that, having already demonstrated that 50% of the cash raised in the relevant share issue had been employed in the business by December 2002, they could bridge the remaining gap and demonstrate that 80% had been so employed if they could pay regard to financing the losses, and paying for the revenue and capital improvements just mentioned.    This seemed a reasonable contention until we sought to reconcile it with the facts that the moneys shown in the Balance Sheets to be "deposited at bank" were £1,229,071 at 31 March 2003, and still even £560,863 at 31 March 2004.    Moreover the 2003 accounts indicated that between March 2002 and March 2003 the cash at bank had been reduced from £1,516,169 to £1,229,071 largely by the 2003 net operating loss of £161,771, and a considerable increase in debtors, there being virtually no change in turnover and stock levels.   Working capital requirements had not, in other words, resulted in either 50% or 80% of the cash being employed in the business.
20.     Since the hearing, we have reviewed the earlier exchanges of correspondence in order to ascertain how it was shown, and seemingly accepted, that 50% of the cash had, on any test, been employed in the business by December 2002.     The origin of this acceptance appears to us to derive from the following two paragraphs, which we quote, from the 11 April 2006 letter to HMRC from BDO Stoy Hayward LLP:
"In this case the EIS funds raised were not held in a separate bank account.    The approximate amounts the Company spent in the twelve-month period in question were, cost of sales £209,000, administration expenses £453,000 and, as already noted, repairs and capital improvements of approximately £106,000.     The Company therefore spent a total of £768,000 on qualifying expenditure in the twelve-month period since the funds were raised and the requirement is that £1.2 m (i.e. 80%) must be employed in that period.     As you can see of the £1.2m which must be employed £768,000 was actually spent and we believe the balance of £461,000 was employed in the business in the period in question. 
We accept that the Company had significant funds on hand at the end of the period in question but a large amount of these funds arose from the Company's sales and as already noted these funds were not held as an investment but were required for the Company's trade and in particular the anticipated acquisition of a new business." 
21.      This argument was one that was repeated before us in the hearing, in that in calculating the funds required to meet losses and the projected amounts of revenue and minor capital expenditure, we were again given a list of gross costs, with no regard to the reality that the business was generating income of significant amounts, albeit marginally below the amount of the gross costs.    Accordingly the extraordinary argument was advanced, just as it was advanced in the two paragraphs just quoted, that the test of "employing" the cash raised by a share issue in the business could be satisfied by suggesting that the whole of the cash would have been "spent" and so employed if there were sufficient gross costs and expenses, all of which were to be treated as met out of the subscription moneys, with the corresponding gross income being altogether disregarded. 
22.      We reject the argument referred to in paragraph 20 and the similar argument that was advanced in the hearing.    Quite regardless of whether or not the cash funds raised by the share issue were amalgamated in a single deposit account with the ever fluctuating receipts and payments of the current trading, we reject any argument along the lines that the share subscription moneys should be treated as having been "spent" and so "employed in the business" by treating every gross cost of the business as having been met out of the share subscription moneys, with all gross income remaining "unspent" on the deposit account.     The only realistic approach is to treat funds raised in the share issue as having been "employed in the business" only when actually spent on realistic net increases to the net trading assets or when reserved to supplement the current receipts of the trade, either in funding losses or meeting expenses that can be ranked as "current business requirements".    
23.     It thus seems to us that the basis on which it was assumed by both the Appellants and Respondents that 50% of the cash funds raised had been employed in the business within the 12-month period, and 100% employed in the business in the 24-month period were both wrong, and that it certainly follows that 80% of the funds raised had not been employed in the business in the 12-month period.     
24.     This appeal is accordingly dismissed. 

HOWARD M. NOWLAN
TRIBUNAL JUDGE
Release date:  15 December 2009