A tax avoidance scheme failed when two LLPs were denied capital allowance claims on the cost of licensing specialist software, and so couldn’t generate the losses promised to their investors.
The two LLPs were Daarasp LLP and Betex LLP, whose cases were heard together as TC06718.
Daarasp was formed in 2004 to exploit software which purportedly offered an innovative financial trading platform. Betex was formed in 2005 to exploit online gambling software.
In both cases, the information made available to their prospective investors included the suggestion that substantial first year capital allowances would be claimed, generating initial losses which would be available to the members for sideways loss relief.
Daarasp LLP purchased a 25-year licence from a software developer for £18,188,244, granting the developer an option to repurchase for £26m. The licensing agreement warranted that the software would yield a minimum net operating income of £174,427 per quarter or £21.9m over the term of the licence.
Betex LLP purchased a 24-year software licence for £58,427,394; the vendor was granted an option to repurchase for £77.5m. This contract also included warranties of minimum net operating income.
Operation of the licences was outsourced to companies closely connected to the original software developers.
When the two LLPs submitted tax returns, HMRC made lengthy enquiries which culminated in closure notices reducing the partnership losses to nil.
The issues the tribunal judge set out to determine were:
- Whether Daarasp or Betex were carrying on a trade at the time when the qualifying expenditure was incurred, either directly or through agents.
- Whether Daarasp and Betex were “small enterprises” within the context of section 45(1)(b) of the Capital Allowances Act 2001 (CAA 2001).
- Whether the anti-avoidance rule in CAA 2001 section 215 applies.
Trading or not
On the evidence, both pieces of software had – at the relevant time – limited functionality, so that it would be a considerable stretch to say they could be exploited commercially. In the first accounting period, in which Daarasp paid out £18.1m for its prime asset, it generated income of only £3,619.
The only significant income stream was payments from the developers under the warranty agreements, since the software did not, in fact, generate the 'guaranteed' net revenues. For example, in a period when it generated fee income of only £5, Betex received warranty payments of £1,193,591!
The judge characterised the warranty arrangements as essentially a confession that the software was not capable of generating the promised commercial yields.
For both LLPs, their core activities were outsourced to other parties. There was no evidence that any of the members of either LLP exercised any supervision or oversight of the actions of their “agents” – who were, in essence, the very people who had sold them the software.
The valuation of the licence agreements was done by individuals with no experience in the area of valuing commercial software. One admitted it was “done on the back of an envelope”. The judge felt that the valuations were driven more by “the amount of investments available” than by any commercial factors.
The inclusion and operation of the warranty arrangements shows that there was little or no real risk or speculation involved.
It was fairly straightforward for the judge to conclude that neither LLP was trading at the time the money was spent.
While this question only matters if the judge’s decision on trading is overturned on appeal, she considered it anyway.
To claim first-year allowances, the entities must be “small or medium enterprises”. The statutory definition (CAA 2001, s 48) includes either “a partnership of which all the members are individuals”, or “a body corporate which is not a company but is within the charge to corporation tax”.
Betex qualifies as a small enterprise since it is a partnership and all its members are individuals. The same is not true of Daarasp: its general member was a company (Piedama Ltd).
Could Daarasp qualify through the other route? It is certainly a body corporate and not a company. Unfortunately, it is not within the charge to corporation tax. By virtue of ICTA 1988 s118ZA, its tax position is that all its activities are treated as carried on by the members – the LLP itself is not within the charge to any tax.
Daarasp could not, therefore, claim first year allowances, even if it were found to be trading.
No capital allowances may be given if “the sole or main benefit of the transactions” was the obtaining of those allowances by either a party to the relevant transactions or “any other party”.
The judge pointed out that this could only be relevant to Betex, and only if her other judgment was overturned.
Looking at Betex alone (and not its underlying members), the judge felt that the allowances were of no use whatsoever to the LLP – it had no taxable profits, present or future, against which to offset them. Weighed against the acquisition of the software licence, it would be perverse to say that the capital allowances were the sole or main benefit to Betex.
The allowances would, of course, be of considerable use and benefit to the members of the LLP. However, they were not parties to the transactions, despite HMRC’s suggestion that the wording could be taken to mean “other persons”. The LLP is a separate legal entity from its members, and the judge was “not certain that imputing the activities of the partnership to its members necessarily also involves imputing the legal contracts entered into by the LLP to its members”.
It might be argued that the benefit of the members could be seen as a perceived benefit to the LLP itself. However, the judge considered this would be taking matters too far, having regard to the LLP’s separate legal identity.
Overall, she decided that the scope of the anti-avoidance rule did not extend widely enough to catch these transactions.
This was a complex tax avoidance scheme (this article has barely scratched the surface of its complexity) to generate sideways loss relief for investors. Despite its elaborate sophistication, it failed on the fundamental point that the purported “trading” activity (if indeed there was any) was dwarfed by the funding and administration activities.
The judgment includes a valuable reminder that an LLP can only qualify as a “small enterprise” if it has no corporate members.
It also suggests that the anti-avoidance rule in CAA 2001 may not be strong enough to cope with LLPs, as the benefits to the members cannot be held against the LLP itself.