The House of Lords have upheld the decision of the Court of Appeal in Garner v Pounds Shipowners & Shipbreakers Limited. The case provides a reminder of some basic CGT principles that apply in the context of the grant of an option (in this case to buy land). In the Garner case, the taxpayer granted an option to M to purchase freehold land. The option price was GBP 400k. The taxpayer undertook to use its best endeavours to procure the release of certain restrictive covenants affecting the land. The taxpayer duly obtained the release from the restrictive covenants for a payment of GBP 90k. M did not in fact exercise the option and in accordance with the agreement the taxpayer received GBP 400k (which had been held in a stakeholder account). The taxpayers argued that the GBP 90k should either be treated as a reduction from the GBP 400k received or be treated as deductible expenditure under what is now Section 38 Taxation of Chargeable Gains Act 1992, but the House of Lords disagreed.
At first blush this might seem harsh on the taxpayer but when one considers the capital gains tax rules relating to the grant of an option and the rules relating to allowable expenditure the decision is not surprising. The grant of an option over land owned by the taxpayer is not a disposal or part disposal of the underlying asset. The option itself is treated as a separate asset and the grant of that option is the disposal of the seperate asset. However, under the CGT rules the exercise of an option by the grantee is not treated as the disposal of the option; instead the grant of the option and the transfer of the asset (in this case land) pursuant to the option are treated as a single transaction which occurs at the time of the later transaction. This is an important point in understanding the Garner case.
The CGT legislation contains specific rules identifying the extent to which "enhancement" expenditure can be deducted from the proceeds of the disposal of the asset in computing any taxable gain. For the expenditure to be allowed it must be on the asset and have been incurred for the purpose of enhancing the value of the asset and be reflected in the state or nature of the asset at the date of disposal.
If in the Garner case the taxpayer incurred expenditure in removing the restrictive covenants in order to increase the value of the land and therefore the price the land would fetch and then sold the land, there would seem to be little doubt that the expenditure incurred would be allowable expenditure and would be taken into account in computing the gain. Similarly, if the purchaser had exercised the option and acquired the land, then the taxpayer would have been entitled to treat the consideration given for the removal of the restrictive covenants as allowable expenditure. Because the option was not exercised the relevant disposal was the grant of the option itself and the House of Lords held that the expenditure incurred in removing the restrictive covenants was incurred after the grant of the option and therefore could not possibly be treated as allowable expenditure in computing the gain on that disposal. If the option had been exercised the only disposal would be the disposal of the land.
The House of Lords also dismissed an argument by the taxpayer that the amount to be brought in as received by the taxpayer should be reduced by the amount paid to release the restrictive covenants on the basis that the reduced amount represented the true consideration received by the taxpayer.. The House of Lords held that the option price could not be reduced by reference to a sum of money paid to a third party.
This would seem to be a fair result as well as being correct as a matter of law. There would seem to be no reason why the taxpayer should not obtain a deduction for the expenditure incurred when the taxpayer ultimately sells the land.
It should be noted however, that not all enhancement expenditure will be allowable because of the restrictive nature of the test. In particular expenditure not reflected in the asset at the date of disposal will not be allowable. So, for example, if a landlord makes a payment to a tenant to procure the surrender of a lease, that payment will not qualify as allowable expenditure if at the date of disposal of the reversionary interest, the taxpayer had granted a new lease on essentially the same terms. Clearly, a payment to procure the surrender of a lease in order to give vacant possession to a purchaser would qualify as allowable expenditure.
For further information on this topic contact Mike Boutell at mqn@cms-cmck.com or on +44 (0)20 7367 3000.
