[2010] UKFTT 286 (TC)

TC00575

Appeal number TC/2009/12486

INCOME TAX — interest earned by solicitors on short-term funds in clients’ account — fee agreements with clients reflecting the solicitors’ right to retain the interest — whether interest to be taxed in accordance with s 5 or s 369 of ITTOIA — priority rules — interest properly to be regarded as trading income — appeal allowed

FIRST-TIER TRIBUNAL
TAX 

				BARNETTS (a firm)	Appellant

- and -

THE COMMISSIONERS FOR HER MAJESTY’S
				REVENUE AND CUSTOMS	Respondents

			TRIBUNAL: 	Judge Colin Bishopp

	Sitting in public in Manchester on 25 May 2010

Nigel Hutton of Grant Thornton UK LLP, chartered accountants, for the Appellant
Susan Alexander of their appeals unit for the Respondents

© CROWN COPYRIGHT 2010

DECISION
1.	The taxpayer in this appeal is a partnership, a firm of solicitors. The appeal arises from the amendment by the respondents of its partnership return for the year 2006-07. The nominated (and senior) partner is Richard Barnett, who gave the only evidence I heard. The issue is an essentially simple one: whether certain interest receivable by the partnership on its clients’ account is to be treated, for income tax purposes, as interest or as trading income. The firm’s liability for other years will also be affected by the outcome of this appeal, but I am asked to determine only the principle. The return in issue was originally submitted in a form which offset trading losses for the year against interest for the year, but was later re-submitted, claiming to offset trading losses incurred in earlier years against the interest. The respondents have rejected the revised return, and say the original return, subject to some adjustments immaterial for present purposes, was correct.
2.	Although the taxpayer undertakes other types of work, Mr Barnett’s evidence was that by far the greater part of its income is derived from volume conveyancing work, principally re-mortgage transactions. That work is carried out, as his evidence made clear, on a production-line basis by relatively unqualified staff supported by computers. The firms’ clients are lending institutions advancing money to home owners (who do not usually instruct solicitors of their own), on the security of their homes, who use the money to pay off an existing mortgage; sometimes, but not always, there is a surplus which the home owner may use for other purposes. The firm’s fees are paid by the lending institution.
3.	Mr Barnett’s evidence was that the lending institutions put their work out to tender and negotiated with the taxpayer and with other competing firms undertaking similar work, driving a hard bargain in order to secure the lowest level of fee possible. The fee alone did not cover the cost of doing the work, but the taxpayer was able to earn an additional income from the interest paid to it by its bank on the balance in its clients’ account. Typically, Mr Barnett said, the amount to be lent to a home owner was paid to the taxpayer on the day fixed for completion of the transaction, or the working day before. Although the individual amounts were relatively modest and remained in the account for a short time, the volume of the work meant that the aggregate balance in the taxpayer’s clients’ account at any one moment was a very large sum, and the interest earned on it, at least in the period with which I am concerned, correspondingly significant. The interest more than offset the loss on the fees, leaving the firm with an overall profit on its volume conveyancing business.
4.	Like any firm of solicitors, the taxpayer is bound by the Solicitors’ Accounts Rules 1998, made by the Solicitors Regulation Authority in accordance with the requirements of the Solicitors Act 1974, as amended. The Rules prescribe the circumstances in which, in the absence of an agreement with a client to the contrary, a solicitor must account to his client for the interest earned by deposit of that client’s money in a general clients’ account (that is, one in which the money of several clients is deposited rather than one operated solely for an individual client) and when, instead, he may retain that interest for his own benefit. In essence, the Rules impose a threshold, derived from a combination of amount and period, above which the solicitor must account for the interest and below which he may retain it. The aim is to strike a reasonable balance between ensuring that clients receive the benefits of their money and relieving the solicitor of the labour and expense of accounting for small sums.
5.	The brevity of the period for which the individual advances remained in the taxpayer’s clients’ account meant that rarely, if ever, was the firm required by the Rules to account for the interest to the lending institution. Mr Barnett’s evidence was that this fact was well known to the lending intuitions, who overtly took it into account in the course of negotiating the fees—it was, in other words, understood on both sides that the firm’s reward consisted of both the fee and the interest. Susan Alexander, who represented the respondents before me, at first sought to cast some doubt on Mr Barnett’s belief that its clients took the interest into account when negotiating the fees, but later accepted what Mr Barnett had told me. I think the concession was inevitable; it seems to me highly unlikely that lending institutions negotiating with firms of solicitors tendering for their work were not very well aware of the requirements of the Rules. In case there is any residual doubt, I find as a fact that it was agreed on both sides that the firm’s reward was made up of the fees and the retained interest.
6.	The taxpayer’s case, against that background, is that the retained interest is to be regarded as part of the firm’s trading income, and taxed accordingly, while the respondents contend that is to be taxed as interest. The significance of the difference between the parties lies in the restrictions on the offsetting of trading losses incurred in one year against interest gains in later years: see s 385 of the Income and Corporation Taxes Act 1988, in force in the relevant year but since replaced by various provisions of the Income Tax Act 2007. There is no dispute about the effect of that section and I shall therefore not dwell on it. It is also not necessary for the purposes of this decision to set out the figures, but sufficient to record that the parties agree that, in the year of assessment with which I am concerned, the result, if the respondents are right, is that the firm must pay tax on a much greater sum than its true net profit. In some other years it would be liable to pay a significant amount in tax despite making an overall loss. I accept, however, Mrs Alexander’s point that it is immaterial that the effect of the statute may seem unfair.
7.	The legislative provisions relevant to the dispute are to be found in the Income Tax (Trading and Other Income) Act 2005 (“ITTOIA”). Section 5 provides that “Income tax is charged on the profits of a trade, profession or vocation” while s 369(1) provides simply that “Income tax is charged on interest”. There is no dispute that the taxpayer’s fee income comes within s 5. Although the Act contains a number of provisions which specify what is or is not interest for the purposes of s 369, none of those provisions is relevant to this case, and the Act does not offer a general definition of “interest”. There can in my view, however, be no real doubt that the interest in issue in this case, taken in isolation, must be regarded as interest for the purposes of the section. The question is, rather, whether it is also to be regarded as part of “the profits of a trade, profession or vocation”, so as to bring it within s 5, for which purpose it is necessary to examine the priority rules.
8.	The rule relevant in this case is at s 366(1) of ITTOIA:
“Any income, so far as it falls within—
(a)	any Chapter of this Part, and
(b)	Chapter 2 of Part 2 (receipts of a trade, profession or vocation),
is dealt with under Part 2.”
Sections 366 and 369 are within Part 4 of the Act, while s 5 is within Chapter 2 of Part 2. The taxpayer’s case is that this provision is sufficient authority for the taxation of the interest in accordance with s 5 (which, as the respondents concede, would also result in its being able to offset past trading losses against current year interest gains) rather than in accordance with s 369 (which, as the taxpayer concedes, would have the contrary result). However, although the Act identifies the charging provisions which apply if the interest is capable of coming within Part 2, and favours the taxpayer’s case to that extent, it does not answer the question, whether it is so capable. All that can be said is that it does not exclude the possibility.
9.	Mrs Alexander’s argument in respect of the priority rules turned largely on the background to the legislation. Section 2 of the Act, entitled “Overview of priority rules” provides that
“(1)	This Act contains some rules establishing an order of priority in respect of certain amounts which would otherwise—
(a)	fall within a charge to income tax under two or more Chapters or Parts of this Act, or
(b)	fall within a charge to income tax under a Chapter or Part of this Act and ITEPA 2003.
(2)	See, in particular—
…
section 366 (provisions which must be given priority over Part 4),
…
(3)	But the rules in those sections need to be read with other rules of law (whether in this Act or otherwise) about the scope of particular provisions or the order of priority to be given to them.”
10.	ITTOIA was drafted in the course of the Tax Law Rewrite Project, and should, she said, be read together with the Explanatory Notes produced as part of the project. The note relating to s 2(3) reads “Subsection (3) recognises that it is necessary to look at the scope of the charging provisions as well as the priority rules. It is also a pointer to … case law.” In addition, the Explanatory Notes said, in relation to new material, that “In the main, such changes are intended to clarify existing provisions, make them consistent or bring the law into line with well established practice.” The predecessor legislation, s 18 of the Income and Corporation Taxes Act 1988, did not set out an order of priority but a practice of “Crown Option” grew up, by which the Commissioners were able to choose, in case of overlap, which of the various Cases of Schedule D should be applied. That practice was later enshrined in s 9D of the Taxes Management Act 1970, added by the Finance Act 2001. I should, Mrs Alexander said, respect the earlier practice, pursuant to which (as Nigel Hutton, the chartered accountant who represented the taxpayer, accepted) the interest would have been taxed as interest and not trading income.
11.	The difficulty with that argument, in my judgment, is that while it may be that the Rewrite Project did not intend to make material changes, s 366(1) is in unambiguous terms which may be overridden, by virtue of s 2(3), only by another rule of law. But the rule of law on which Mrs Alexander relied, s 9D of the 1970 Act, was repealed by ITTOIA. I do not understand how it is possible to favour a repealed provision over another provision which is, and at the material time was, in force, and which is contained in the very enactment which effected the repeal. All that preceded s 9D (and the earlier provision it replaced) was practice; but practice, however well-established, is not a rule of law. In my judgment the earlier Crown Option practice and the repealed s 9D cannot impede the taxation of the relevant income in accordance with s 5 of ITTOIA, provided of course that it is properly described as “the profits of a trade, profession or vocation”. The change, if change it is, may have been unintended but in my view the statutory rules are clear.
12.	The Act offers no guidance on the criteria by which it should be determined whether interest comes within Chapter 2 of Part 2, or is to be taxed in accordance with Part 4, but there is some relevant judicial authority. The leading case (as both Mr Hutton and Mrs Alexander agreed) is Nuclear Electric plc v Bradley [1996] STC 405, a decision of the House of Lords. The facts of that case and this were rather different: the taxpayer in that case earned interest on money set aside, though not in a designated account, in order meet its future decommissioning costs, principally of disposing of spent fuel and nuclear waste. It, too, sought to offset trading losses against interest, arguing that although it was described as investment income it was nevertheless trading income for taxation purposes. At p 409 Lord Jauncey of Tullichettle, giving the only substantial judgment, said
“When does investment income amount to a trading receipt of the taxpayer? The statute provides no guidance on the matter beyond impliedly recognising that it can sometimes do so. Such few authorities as are relevant have refused to lay down any hard and fast rule or draw any distinct line for determining the matter …. It must at the end of the day always be a question of fact.”
13.	He then proceeded to examine some of those authorities before observing, at p 412, 
“Whether income from investments held by a business is trading income must ultimately depend upon the nature of the business and the purpose for which the fund is held. At one end of the scale are insurance companies and banks part of whose business is the making and holding of investments to meet current liabilities. It has been suggested that tour operators might fall into this category but without a good deal more information I do not feel able to express an opinion on this matter. At the other end of the scale are businesses of which the making and holding of investments form no part. In between these two ends there will no doubt fall other types of businesses whose position is not so clear. However in this case it is absolutely clear that the business of NE was to produce and supply electricity. The making of investments was neither an integral nor any part of its business. Furthermore the investments which it did make were in no sense employed in the business of producing electricity during the year of assessment.”
14.	In practice, Mr Hutton said, the investment income earned by insurance companies and tour operators was treated as trading income because it was an integral part of their trade to put premiums and customers’ deposits to one side in order to meet future liabilities, and the interest earned on them was used in order to reduce what would otherwise have been the cost to the customer of the service provided. There was no material difference in this case: the common understanding of the taxpayer and its clients was that the money received in respect of advances would be used in the taxpayer’s business, and the retention by the taxpayer of the interest earned would result in a reduction in the fees charged to the client. The interest was accordingly earned on money used for the firm’s trading activities and it was the product of those trading activities. Thus it was quite unrealistic to regard it as income from savings or investments; it naturally came within s 5 of the Act.
15.	Mrs Alexander based part of her argument on what Lord Avonside had said in Liverpool and London and Globe Insurance Co v Bennett [1974] STC 342 at 366, a passage from his judgment which was quoted with evident approval by Lord Jauncey in Nuclear Electric v Bradley:
“Income becomes a trading receipt when it arises from capital activity employed and at risk in the business, capital which is employed in the business because it is required for its support or, perhaps, to attract customers looking to the credit of the business. Trading income is ‘the fruit’ of the capital employed in the business in a present and active sense.”
16.	The interest in this case could not be regarded as trading income because it was earned from money which belonged to others, the firm’s clients; it was not capital at risk in the business. Whatever the exact relationship between the solicitor and his client, I do not think there is any doubt that Mrs Alexander’s premise is right: the money is not at risk in the business since the relationship between the solicitor and his client is of trustee and beneficiary rather than debtor and creditor, and a solicitor’s clients’ account is protected from his own creditors. In another of the authorities to which I was referred, re Euro Hotel (Belgravia) Ltd [1975] STC 682 Megarry J said, at p 692,
“It seems to me that running through the cases there is the concept that as a general rule two requirements must be satisfied for a payment to amount to interest, and a fortiori to amount to ‘interest of money’ [the expression used in Case III of Schedule D]. First, there must be a sum of money by reference to which the payment which is said to be interest is to be ascertained. A payment cannot be ‘interest of money’ unless there is the requisite ‘money’ for the payment to be said to be ‘interest of’. … Second, those sums of money must be sums that are due to the person entitled to the alleged interest; and it is this latter requirement that is mainly in issue before me. I do not, of course, say that in every case these two requirements are exhaustive, or that they are inescapable. Thus I do not see why payments should not be ‘interest of money’ if A lends money to B and stipulates that the interest should be paid not to him but to X: yet for the ordinary case I think that they suffice.”
17.	I do not entirely agree with Mrs Alexander that the capital sums in this case are not “due to the person entitled to the alleged interest”, since the bank which pays interest to a solicitor on his clients’ account does not, indeed cannot, look beyond the solicitor; but I nevertheless agree with her that this is, in substance, a case falling within the last sentence of that extract: the effect of the taxpayer’s arrangements with its clients is that the clients lend the money to the taxpayer’s bank on the footing that the interest earned is paid to the taxpayer. 
18.	The last of the authorities to which I need to refer is Northend v White & Leonard and Corbin Greener [1975] STC 317, a decision of Templeman J. The taxpayer in that case was also a firm of solicitors. The issue was a little different: whether so much of the interest which accrued on its general clients’ account as was retained by the firm should be treated as earned income, then taxed at a lower rate than unearned, essentially investment, income. At p 325 the judge said
“… the question is whether the deposit interest was ‘immediately derived’ by the firm from the carrying on or exercise by them of the profession of solicitors.”
19.	Then he added
“… if the Solicitors Act 1965 had not been passed, or if the firm had not carried on the exercise of the profession of solicitors, there would have been no deposit account and no interest. But it does not follow that the interest was ‘immediately derived’ from the carrying on of the profession. To produce the interest there must be an intervening event which could not be described as the carrying on of the profession of a solicitor; namely, the loan of money by a customer to a bank on terms that interest should be paid. The fact that the money lent did not belong to the customer did not prevent the interest deriving from the intervening event; namely, the loan and the contract between the customer and the bank.”
20.	His conclusion (at p 327) was “that the earned income of a solicitor is limited to the moneys which he receives from his clients in return for his professional services, and does not include interest credited to his clients’ deposit account and received by the solicitor as consideration for the loan of the money to the bank.”
21.	In my judgment, however, there is a distinction to be drawn between that case and this. In the Northend case the interest accrued to the solicitors because of the operation of the Solicitors’ Accounts Rules without any particular understanding between them and the clients. Here, as I have found, it was understood that the interest would comprise part of the solicitors’ reward. In Northend the interest could properly be regarded as a casual bonus for the solicitor; here it is an integral part of his reward. I accept Mr Barnett’s evidence that, had the taxpayer not agreed to accept fees which fell short of the cost of doing the work, it would not have been instructed and in consequence would not have had the opportunity of earning the interest which made up the shortfall. The taxpayer could instead have agreed with its clients that it would charge fees which provided it with a profit and account to the clients for the interest earned, whether or not the Solicitors’ Accounts Rules required it do so. The overall “package” would have been much the same, but the taxpayer’s profit would unquestionably have fallen within s 5. That the taxpayer agreed, at the clients’ insistence, to structure the arrangement differently does not seem to me to affect the outcome.
22.	The reality as I see it is that the interest was earned in the course of the solicitors’ trading, and as an integral part of the trading activities. It was not interest earned on money set aside, as in Nuclear Electric, to meet future liabilities, nor interest casually earned, as in Northend. It was, to adopt Templeman J’s phrase, “moneys which [the solicitor] receives from his clients in return for his professional services”, even if it was indirectly received. It is not a case in which carrying on the profession of a solicitor gives rise to the opportunity of earning interest, but one in which the interest is properly to be regarded as part of the solicitor’s trading income, because it was understood between solicitor and client that the interest would form part of the total fee. I do not regard what Lord Avonside said in Liverpool and London and Globe Insurance Co, quoted above, as an exhaustive definition of interest; it was said in the context of a particular case and was an apt description of the interest which had been earned in that case. It is, moreover, inconsistent with the view of both Megarry J and Templeman J that the capital on which the interest is earned need not always belong to the solicitor.
23.	I am satisfied that, after applying s 2(3) of ITTOIA, the interest in this case is properly to be regarded as trading income and is to be taxed in accordance with s 5 of that Act. The appeal is, therefore, allowed.
24.	This document contains full findings of fact and reasons for the decision. Any party dissatisfied with this decision has a right to apply for permission to appeal against it pursuant to Rule 39 of the Tribunal Procedure (First-tier Tribunal) (Tax Chamber) Rules 2009. The application must be received by this Tribunal not later than 56 days after this decision is sent to that party. The parties are referred to “Guidance to accompany a Decision from the First-tier Tribunal (Tax Chamber)” which accompanies and forms part of this decision notice.

COLIN BISHOPP
Tribunal Judge
Release Date: 22 June 2010