Case Report: BADR Denied as Non-Trading Activities “Substantial”

The FTT held that the 20% test (i.e. less than 20% non-trading activities to be considered trading) is not in statute and the correct test is a multifactorial analysis of the relevant factors – in this case, the deciding factors were that 97% of Allam Developments Ltd’s income was attributed to non-trading activities and the asset base was primarily comprised of non-trading assets.

Notes: This case deals with three issues, the appellant’s BADR claim, the appellant’s claim for business investment relief, and the appellant’s appeal against a counteraction notice under the Transactions in Securities legislation.

The BADR aspect is the point for which we wish to highlight and so is the only aspect of the case that has been discussed below.

All three issued were appealed to the Upper Tribunal (“UT”). However, given that the UT approved the FTT’s decision in relation to BADR issue, we are discussing the FTT decision in this case report.

Context

• The appellant (Dr Allam) disposed of his shares in Allam Developments Ltd (“ADL”) to Allam Marine Ltd (“AML”) on 26 July 2011 for £4.95m, paid in cash.
• The appellant claimed entrepreneurs’ relief (now BADR) in his 2011/12 tax return, reporting a gain of £4.925m.
• HMRC enquired into the appellant’s 2011/12 tax return and, on 8 April 2016, issued a closure notice denying the claim for entrepreneurs’ relief. The additional Capital Gains Tax (“CGT”) payable was £524,034.72.
• The appellant appealed the closure notice.

Legislation

• Entrepreneurs’ relief reduces the rate of CGT on “qualifying business disposals”.
• A disposal of shares (as in this case) can fall within this meaning where it is a “material disposal of business assets”.
• Broadly, this means that the following are met for two years prior to disposal (at the time of this case, the time period was one year):
  • The company is the individual’s personal company (5% ownership test).
  • The company is a trading company or the holding company of a trading group.
  • The individual is an employee or office holder of the company.
• The only dispute in this case was around whether ADL was a trading company.
• A trading company is defined as a company carrying on trading activities whose activities do not include to a substantial extent activities other than trading activities.
• The phrase “to a substantial extent” is not defined in the legislation. HMRC manuals state that 20% or more non-trading activities are sufficient to be substantial such that the company is not trading. However, the 20% test is not in statute and, in reality, a multifactorial analysis of the relevant factors should be undertaken.
• The relevant factors (per HMRC and affirmed by this decision) are:
  • Income from non-trading activities.
  • The asset base of the company.
  • Expenses incurred or time spent by officers and employees of the company.
  • The company’s history.

Facts of the Company

• ADL’s business involved holding, developing, and leasing properties in and around Hull.
• The business of ADL was considered during the relevant period (one year, now it would be two years).
• ADL had the following groups of properties:
• A factory and associated offices in Melton leased to AML for use as their offices.
  • Another factory and associated offices on Lime Street leased to AML as their secondary factory and offices. However, there had been some development, and the intention was to develop the area into flats and apartments.
  • A factory site and car park on Cannon Street leased to the previous owners while planning permission was obtained.
  • Car parks and adjacent buildings in Lime Street. Works had been completed by ADL to demolish the existing buildings and develop the car park.
  • Miscellaneous properties let to tenants. The scale was small and not considered by the FTT.

Arguments

Appellant

• The appellants argued that the vast majority of the directors’ time and expenditure was spent on the trading activities of ADL, i.e. property development.
• The appellant argued that the focus of the legislation was on “activities”, i.e. that turnover, assets, and history (the other factors above) may provide a misleading impression.
• The appellant also asserted that the 20% test was not included in the statute but, even if it was, it would meet the 20% test via the director’s time and expenditure.
• Finally, the appellant argued that the 20% is a cliff edge test, and 50% should realistically be the rest for substantially.

HMRC

• HMRC accepted that ADL was carrying on some trading activities but assert that ADL’s non-trading activities make up a substantial portion of ADL’s activities.
• HMRC conceded that the 20% test is merely guidance, and the proper test is the statutory test which should be applied by reference to all the relevant facts, including turnover, assets, and history which provide a useful indicator of the scale of trading activities (and are therefore relevant, contrary to the appellant’s assertions above).
• HMRC’s evaluation of the relevant factors was such that ADL’s non-trading activities were substantial, given that 97% of ADL’s income was derived from its rental (i.e. non-trading) income.

Decision

• The only question before the FTT was whether, in the relevant period, the activities of ADL also included “to a substantial extent” activities other than trading activities.
• The FTT held that it must consider the holding of investments when considering the activities of the company (regardless of the passive nature of certain investments) otherwise, relief could be obtained on the sale of a company with a small but active trading business which also holds a substantial investment portfolio generating significant passive income.
• The FTT rejected HMRC’s and the appellant’s gloss on “to a substantial extent” and held that it should be taken to mean “of material or real importance in the context of the activities of the company as a whole”.
• The FTT noted that the development of the Lime Street car park was trading development activity, and they accepted that demolishing properties and seeking planning permission were activities in preparation for trading, i.e. to be treated as trading activities for these purposes.
• However, most of the properties are let to produce income, which is a passive activity but, as discussed above, must be considered (and is a non-trading activity).
• If ADL and AML were in the same group, for these purposes, the leasing of property by ADL to AML could have been disregarded and the situation may have been different.
• However, taking all this in the round, the FTT stated:“In our view, although the company was clearly carrying on some trading activity or activity in preparation for trading, the proportion of the income of the company which comprises non-trading rental income and the proportion of its asset base which are devoted to properties which are let simply for their rental income demonstrate that its property investment and rental activities have real importance and cannot be ignored.”
• As such, the FTT dismissed the appeal and the taxpayer lost.

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