HM Revenue & Customs v Smallwood

For capital gains tax, a unit trust scheme is treated as a company and unit holders’ rights as shares. The computation is asset-specific: the relevant asset for a unit holder is the notional shareholding, and the subscription is the consideration for its acquisition. Under the Taxation of Chargeable Gains Act 1992, sections 39(1) and 41(2) exclude only expenditure otherwise allowable under section 38. Expenditure incurred by the trustee in acquiring qualifying property, although it generated capital allowances for unit holders under the income-tax regime, is not part of the base cost of the notional shares. Section 41(2) therefore does not restrict a loss on disposal of the units.

Mr Smallwood invested £10,000 in an enterprise zone property unit trust and obtained capital allowances of £9,678. The trustee later realised the property without triggering balancing charges. Capital distributions to Mr Smallwood were treated as deemed part disposals of his units, producing claimed capital losses.

The inspector disallowed the losses. The Special Commissioner allowed Mr Smallwood’s appeal, and Warren J dismissed HMRC’s appeal on 6 July 2006. HMRC appealed to the Court of Appeal. The central issue was whether section 41(2) of the Taxation of Chargeable Gains Act 1992 restricted the losses by reference to expenditure incurred by the trustee on property qualifying for capital allowances.

1. Appeal dismissed. The Court of Appeal affirmed Warren J’s decision, which had affirmed the Special Commissioner’s decision.
2. Section 99 of the Taxation of Chargeable Gains Act 1992 creates two levels of capital gains tax treatment. The unit trust scheme is treated as a company, and the rights of unit holders as shares. For a disposal by a unit holder, the relevant asset is therefore the notional shareholding. Section 38(1)(a) identifies the subscription as the consideration given for acquiring that asset.
3. Section 39(1) operates by excluding expenditure from sums otherwise allowable under section 38. The expenditure must therefore be expenditure by or on behalf of the person making the disposal and otherwise forming part of the relevant base cost. It cannot reach expenditure incurred by a third party on another asset. Section 41(1) disapplies section 39 for gains where capital-allowance expenditure forms part of an otherwise allowable deduction. Section 41(2) reintroduces the exclusion when computing a loss, but only for expenditure falling within that statutory scheme.
4. The deeming principle stated in Marshall v Kerr requires the consequences inevitably flowing from a statutory fiction to be treated as real. Applying that principle, the trustee’s expenditure on acquiring and constructing the property was, for capital gains tax purposes, expenditure of the notional company on its property. It was not expenditure included in the unit holder’s base cost of the notional shares. Although the unit trust was transparent for income tax and capital allowance purposes, that did not alter the capital gains tax fiction. The Revenue’s argument focused on the wrong expenditure and the wrong asset.
5. The fact that the result might confer an unusually generous or potentially double relief did not justify a different construction. Whether any capital loss at trust level was eliminated, and whether the taxpayer consequently received double relief, was not before the court and was unnecessary to decide.

• Court of Appeal (Civil Division): Appeal dismissed on 17 May 2007.
• High Court (Chancery Division): Warren J dismissed HMRC’s appeal from the Special Commissioner’s decision on 6 July 2006.
• Special Commissioner: HH Stephen Oliver QC allowed Mr Smallwood’s appeal against the inspector’s decision on 3 November 2005.