In seeking to alter behaviour, HMRC have found the perfect case, as participants in Eclipse not only failed to reduce their tax bill but now face catastrophically larger tax liabilities than if they had never participated in the scheme.
The court of appeal yesterday ruled that the Eclipse Film Partners No.35 LLP was not trading. No doubt HMRC will quickly publicise their success and the dire consequences of pursuing such litigation.
For those involved in other Eclipse LLPs, the future looks bleak. The court reaffirmed the decision that whether or not a trade exists is a question and decision for the tribunal of fact, namely the first tier tax tribunal. The court, in a carefully considered judgement, saw no reason to overturn this finding. In doing so it directed a strong message to cases currently under appeal regarding the availability and chances of success of any final appeal to the supreme court.
Participants in the other Eclipse LLPs, therefore, now face the realisation that, unless they can differentiate the activities and contracts entered into by their specific LLPs from those of Eclipse 35, they are likely to face a similar fate. Suddenly, HMRC’s original settlement opportunity of receiving income tax relief on the cash contribution seems like an offer that should have been taken.
However, the decision has far wider implications. One of the main challenges facing many of the marketed tax schemes either awaiting litigation or appeal is whether or not they are carrying out a trade, and as such, rely on obtaining income tax relief from losses generated from such a trade.
For those involved in other Eclipse LLPs, the future looks bleak
Many of those awaiting appeal have lost at the first tier tax tribunal because they were found to be not trading. Therefore, for those cases awaiting their first hearing, where little or no productive trading activity was undertaken by the LLP, the decision of whether litigation rather than settlement should be pursued ought to be objectively re-evaluated.
A common thread in many of the ‘trading’ tax avoidance structures identified by HMRC is that the partnership, LLP, individual or company undertook minimal activity other than a supervisory role with little or no actual control. As identified by the courts in the case of Eclipse 35, if this is linked by only a remote prospect of generating a profit then the most likely outcome on the finding of fact is that there was not a trade.
No doubt HMRC will now see the trading argument as a magic bullet, and will focus on this in all ongoing litigation and enquiries. However, as Eclipse 35 demonstrates, each case must be decided on its own facts. Therefore, cases may still be brought in the hope that based upon factual evidence the court may be persuaded that a trade was carried on.
However, as HMRC has publicised, it has won 80% of all tax avoidance cases over the past few years. In the past advisers have been quick to point out that many of these successes have been in the lower courts and the hope was that subsequent appeals to the higher courts would see a more favourable outcome for the taxpayer. The court of appeal has now made it clear that, on the question of trading where the original decision went in favour of HMRC, there is little hope of this being overturned.
The well-publicised tax litigation relating to the Ingenious business models is ongoing and investors will be anxiously awaiting the outcome of the current hearing. Like Eclipse, the tax relief relied upon the basis that the LLPs were trading and many of the films invested in were ‘studio’ movies. There must now be concern that if the court finds that the LLPs were not trading any subsequent appeals on this point may not be successful.
A precedent may have already been set as it is understood that the decision in the Working Wheels case, where the participants were found not to be trading, has not been appealed.
The decision in the appeal heard by the upper tax tribunal in respect of Degorce, a sole trader, is also awaited where again the issue of the existence of a trade was central. If this reaffirms the view stated by the Court of Appeal in respect of decisions relating to the existence of a trade then this may be the final nail in the coffin for similar appeals.
A simple lesson can be learnt. The devil is in the detail and the most complex and carefully engineered tax structures can be undone by overlooking the simple requirement to undertake a trade. The seed of its ultimate failure was buried deep in the detail of long and complex contracts and it is unlikely that investors or their advisers would ever have had access to these documents. As with many tax avoidance structures, both the investor and their adviser need to rely on those implementing the structure to get things right.
In their unrelenting campaign to challenge and change behaviour, HMRC are now likely to use their new powers to issue follower notices to members of other Eclipse LLPs. There may be grounds to challenge their validity but decisions will need to be made as to whether or not the risk of penalties warrants the risk of further litigation.
Michael Avient is a partner at UHY Hacker Young