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LOAN RELATIONSHIP – RELEASE – PARAGRAPH 5(3), SCHEDULE 9, FINANCE ACT 1996 – EFFECT OF COVENANTS IN LOAN AGREEMENT – DOES LENDER CONTROL BORROWER FOR PURPOSES OF SECTION 87A FINANCE ACT 1996 – NO – AMOUNT RELEASED BROUGHT INTO CHARGE

THE SPECIAL COMMISSIONERS

	FENLO LIMITED	Appellant

	- and -

	THE COMMISSIONERS FOR HER MAJESTY’S
	REVENUE AND CUSTOMS	Respondents

		Special Commissioner: 	Nicholas Aleksander

Sitting in public in London on 14 October 2008

Oliver Conolly of counsel for the Appellant

Mark Harrison, HM Revenue & Customs Appeals Unit for the Respondents

© CROWN COPYRIGHT 2008

DECISION

1.	The point at issue in this matter is the treatment of the release of part of a loan which had been made to the Appellant, Fenlo Limited (“Fenlo”).  It is common ground that the loan falls within the loan relationships legislation in Finance Act 1996, and that the amount released is to be brought into account in computing Fenlo’s profits, unless one of the exceptions in the legislation applies.  Fenlo contends that it was connected with the lender, and the release is therefore not to be brought into account by virtue of paragraph 5(3), schedule 9, Finance Act 1996.  The Revenue contend that Fenlo and the lender were not connected and that no other exemption applies.
2.	I heard evidence from Mr Sidney Taylor, company secretary of Fenlo.  In addition a statement of facts not in dispute and a bundle of documents were submitted at the hearing by the Revenue.
Background facts
3.	In 1981 Mr Taylor bought 198 Hagley Road, Birmingham.  This was a large semi-detached house, which Mr Taylor converted into a small hotel/guesthouse.  It was also his family’s home.  In 1986 the opportunity arose to purchase the adjoining property, 200 Hagley Road, which was done with the aid of a loan from Mr Teddy Yip, a long standing business associate of Mr Taylor.  For reasons which are not wholly clear, Mr Yip was not prepared to lend the money to either Mr Taylor or any company which he controlled.  Fenlo was therefore incorporated with Mrs Naomi Taylor (Mr Taylor’s wife) and Ms Tracey Mary Taylor (Mr Taylor’s daughter) as the only shareholders and directors.  Mr Taylor was the company secretary.  Fenlo’s articles of association incorporated Table A with some modifications.  Article 70 of Table A was incorporated without amendment, this provides that the business of the company shall be managed by the directors, who may exercise all the powers of the company.
4.	Fenlo purchased 200 Hagley Road at a price of £500,000, using a loan of £500,000 from Mr Yip.  Fenlo also purchased 198 Hagley Road from Mr Taylor for £200,000, which was paid to Mr Taylor in instalments over a number of years.  Building work was undertaken to join 198 and 200 Hagley Road and convert them into a hotel; a link building was subsequently added at the rear.  Approximately £100,000 was spent on joining the buildings and converting them into a hotel, and approximately £450,000 to £500,000 was spent on the link building.  All these works were financed by loans from Mr Yip.
5.	It was only in 1992 that the loans were formally documented.  The documentation took the form of a facility letter dated 19 October 1992 from Brinkley Investments Inc (“Brinkley”) to Fenlo, and a debenture of the same date charging the undertaking and assets of Fenlo by way of security for the loan.  Brinkley was a company incorporated in the Bahamas, but which was managed by Coutts in Guernsey.  It would appear from Mr Taylor’s evidence that Brinkley was a company under the ultimate control of Mr Yip.  
6.	On 19 October 1992, Fenlo drew down £1,200,000 under the facility letter, and – I assume (although there is no clear evidence on the point) – used these funds to repay the loans owing to Mr Yip.  Mr Taylor was of the view that in October 1992 the hotel was worth approximately £1,200,000.  The loan-to-value ratio in October 1992 was therefore approximately 100%.
7.	The principal terms of the loan were as follows:
(1)	Interest was charged at 10% per annum (of this, half was compounded and was only due on the repayment of the loan, the other half was payable half-yearly)
(2)	The lender was entitled to a “promote” on the repayment of the loan, based on the value of the hotel property at that time
(3)	The loan was repayable, at the latest, after 10 years on 19 October 2002
(4)	The loan was subject to a number of covenants which I describe in more detail below.
8.	The hotel was not a financial success.  Initially Fenlo paid interest at 10% per annum, but in August 1995 Fenlo reduced the interest actually paid to 5% per annum, with the balance of 5% being rolled-up and compounded.  From March 2000 onwards no interest was paid at all.
9.	In March 2002, Brinkley gave notice of default to Fenlo and demanded immediate repayment of the loan.  Attempts were made by Fenlo to sell the hotel in order to raise money to repay the loan. However it proved impossible to sell the hotel, as the planning consent required the properties to be converted back into two private residences if they ceased to be owned by Fenlo.  By an undated deed, in July 2003, Brinkley accepted payment of £650,000 in full and final settlement of all amounts owing by Fenlo to Brinkley under the October 1992 facility letter.  This amount was paid by electronic transfer out of Fenlo’s bank account to Brinkley’s solicitors on 4 July 2003.  Fenlo’s financial statements for the year ended 31 March 2004 show an exceptional item of profit of £1,072,333 being the balance of the loan that had been released by Brinkley.
Loan Relationships
10.	The statutory provisions governing the taxation status of the loan by Brinkley to Fenlo are contained in Finance Act 1996.  It is common ground that corporation tax is chargeable on the profit recognised in Fenlo’s accounts in respect of that part of the Brinkley loan that was released, unless a relevant exception applies.  The exception on which Fenlo seeks to rely is contained in paragraph 5(3), schedule 9, Finance Act 1996.  This applies if the release took place in an accounting period in which Brinkley controlled Fenlo for the purposes of section 87A, Finance Act 1996.
11.	The relevant parts of section 87A(1) read as follows:
… “control”, in relation to a company, means the power of a person to secure:
(a)	by means of the holding of shares or the possession of voting power in or in relation to the company or any other company, or
(b)	by virtue of any powers conferred by the articles of association or other document regulating the affairs of the company or any other company,
that the affairs of the company are conducted in accordance with his wishes.
12.	Brinkley did not hold any shares or possess any voting power in Fenlo.  For Brinkley to control Fenlo, Brinkley must therefore have the power to secure that the affairs of Fenlo are conducted in accordance with Brinkley’s wishes by virtue of powers conferred by some document which regulates Fenlo’s affairs.  It is Fenlo’s case that the facility letter of 19 October 1992 was such a document, and that the covenants in the facility letter enabled Brinkley to secure that Fenlo’s affairs were conducted in accordance with Brinkley’s wishes.
13.	The covenants are in clause 13 of the facility letter as follows:
(1)	[Fenlo] shall procure that [Brinkley] shall be furnished with such financial and other information as it may reasonably require relating to [Fenlo], and copies of the Accounts shall be forwarded to [Brinkley] by [Fenlo] when they are circulated to the members of [Fenlo] and monthly management accounts within one month of the end of the period to which they relate.
(2)	[Fenlo] shall not without the prior written consent of [Brinkley]:
(a)	Create or permit to subsist any charge, mortgage or lien upon its or their undertaking, property or assets or any part thereof except:
(i)	any charge, mortgage or lien in favour of [Brinkley];
(ii)	any lien arising by operation of law in the ordinary course of trading
(b)	Carry on any business other than the operation of the Property as a hotel
(c)	Sell, transfer, lend or otherwise dispose of whether by a single transaction or a number of transactions related or not the whole or part of its undertaking, business or (except in the ordinary course of trading) assets
(d)	declare make or pay any dividend or other distribution on or in respect of the issued share capital of [Fenlo] or any part thereof
(e)	incorporate or acquire any Subsidiary or acquire securities of any company or corporation
(f)	purchase, lease or hire any assets otherwise than in the normal course of business
(g)	pay remuneration (inclusive of the value attributable to any benefits provided) to any one of its directors, officers or employees in excess of £25,000 per annum
(h)	change the external auditors or the Accounting Reference Date or any member of the Company
(i)	enter into any transaction with Mr Sidney Taylor or a company or firm in which he or any member of his family has an interest of any kind
(j)	enter into any transaction involving:
(i)	the borrowing of money
(ii)	the extending of credit save in the normal course of business
(iii)	giving guarantees or indemnities or undertaking any such liability to any person
(iv)	the adoption of any scheme for the sharing of its profits
(k)	enter into any transaction otherwise than on arm’s length terms
14.	In practice, some of the covenants were breached:  Fenlo did not always produce management accounts on a monthly basis and Fenlo’s bookkeeping was undertaken for a fee by Leisure Nights Limited (a company in which Mr Taylor had an interest).  However Mr Yip was aware of these breaches, and never raised any concern about them.  Mr Yip was a regular guest at the hotel and continued to be a close business associate of Mr Taylor.
The contentions of the parties
15.	Both Fenlo and the Revenue agree that in construing the phrase “other document [i.e. other than the articles of association] regulating the company” (section 87A(1)(b) Finance Act 1996), “other document” must take its flavour from and be akin to the articles of association of a company.  Fenlo submit that the facility letter regulated (amongst other things), the objects of the company, the payment of dividends and the remuneration of officers and employees, and that therefore the facility letter was capable of being an “other document” for the purposes of section 87A(1)(b).
16.	Fenlo goes on to contend that the type and number of constraints imposed upon it by the facility letter were such as to ensure that Fenlo’s affairs were conducted in accordance with Brinkley’s wishes.  By entering into the facility letter, Fenlo accepted a straightjacket such that it could not make any meaningful decision about its affairs without having first obtained the consent of Brinkley.  It therefore follows that the affairs of Fenlo were conducted in accordance with Brinkley’s wishes.
17.	In Irving v Tesco Stores (Holdings) Ltd [1982] STC 881, Walton J said at 910 that control for the purposes of section 530 Taxes Act 1970 (which is very similar in drafting to section 87A(1)) meant control at board meeting level, as opposed to general meeting level (at least for companies whose articles incorporate a provision similar to that in Article 70 of Table A – such as Fenlo).  Although the facility letter did not give Brinkley the right to appoint a majority of Fenlo’s directors,  Fenlo submit that the covenants in clause 13 give Brinkley equivalent powers.  Although Brinkley did not have power to veto decisions made by Fenlo which were outside the scope of the restrictions in clause 13, this does not matter, as Brinkley’s wishes were directed only to the matters within the scope of clause 13.  
18.	Mr Taylor acknowledged in his evidence that an aim of the covenants was to ensure that none of the financial value injected into the company by the loan could leak out, through excessive remuneration, dividends, non-arms length transactions or through an unapproved change in the nature of the business.  Nonetheless, Fenlo argues that this does not prevent the covenants from having the effect of handing control of Fenlo’s affairs to Brinkley for the duration of the loan.
19.	The Revenue submit that the covcnants in clause 13 do not have the effect of giving Brinkley control over Fenlo’s affairs.  The restrictions in clauses 13(2)(a), (c), (d), (e), (g) and (j) are financial in nature and do nothing other than control the flow of money through Fenlo and prevent it from disposing of or tying assets into third party agreements.  The other restrictions do not dictate how the business is to be run in any way – although they may prevent the company from changing certain things, this is not the same as making the company do what the person wants – there is no positive control over Fenlo and its business.
20.	I was referred by the Revenue to CIR v Lithgows Ltd (1960) 39 TC 270.  This concerned the definition of “control” in section 333, Income Tax Act 1952.  This provision was the forerunner to section 530 Taxes Act 1970.   In his judgement, Lord Guthrie at 278 says:
“In order that a person may have ‘control’ he must be in a position to secure that the affairs of the company are conducted according to his wishes.  That phrase means that the ability to achieve an isolated result, the power to carry a particular resolution, is insufficient to establish control in the statutory sense; and that what is required is the power to secure the continuing conduct of the company’s affairs in accordance with the will of the person.  Secondly the definition does not state that control is the power of a person to secure that the affairs of the company are conducted according to his votes.  The use of the word ‘wishes’ suggests that the Statute requires that he shall be able to achieve his personal aims.”
21.	Lord President Clyde at 274 puts the matter succinctly:
“In my opinion, what the subsection is referring to is real control by one person, so that the company is really his creature.”
Conclusions
22.	I have no hesitation in deciding that at no time was Fenlo under the control of Brinkley for the purposes of section 87A.  The provisions of clause 13 of the facility letter are restricted in their scope and negative in their nature. They are typical of those found in agreements governing highly geared secured loans, such as this.  Their purpose is to protect the financial interests of the lender: to ensure that the lender’s security package is protected, that value is not leached out of the borrower and that the lender is provided with reliable financial information so that it can monitor the loan.
23.	I do not consider that the facility letter has the flavour of, or is akin to, articles of association of a company.  Even if it was, the covenants in clause 13 are not sufficient to give Brinkley control over Fenlo.  The cases indicate that control should be read as the ability to order the affairs of a company according to the “controller’s” wishes on a continuing basis.  Fenlo contend that as Brinkley’s wishes were restricted to the matters set out in clause 13 of the facility letter, the company was managed in accordance with those wishes.  No evidence was submitted as to Brinkley’s wishes or desires, and I cannot therefore accept that this is the case.  Even if at the date of the facility letter, Brinkley’s wishes were minimal and were reflected in clause 13, Brinkley would not have the ability to secure changes to Fenlo’s business in the event that its wishes changed (for example in the light of changes to the circumstances of Fenlo’s business).   Finally, accepting Fenlo’s argument would lead to the absurd result that banks and other lenders would be treated as controlling their borrowers in very many cases, as the covenants in clause 13 of the facility letter are typical of those found in many secured commercial loan agreements.
Decision
24.	It therefore follows that the amount of the Brinkley debt that was released in July 2003 is liable to be brought into account for the purposes of computing the taxable profits of Fenlo.
25.	I therefore confirm the assessment of 18 June 2007 in the amount of £311,852.10

Nicholas Aleksander

SPECIAL COMMISSIONER
RELEASE DATE: 6 November 2008

SC/3047/2008 

Authorities referred to in skeletons and not referred to in the decision: