Eclipse Film Partners No 35 – To trade or not to trade, that is the question!

The First-tier Tribunal (Tax Chamber) ('FTT') has recently held in Eclipse Film Partners No 35 LLP v HMRC [2012] UKFTT 270 (TC),...

...that a film partnership engaged in a film license and sub-licence arrangement, was not trading and that its partners were not entitled to tax relief on interest payments on funds borrowed to invest in the partnership – section 362, Income and Corporation Taxes Act 1988 (now rewritten as section 398, Income Tax Act 2007).  From 6 April 2013, the type of relief sought by the partners will be caught by the proposed new income tax relief capping provisions. However, the case is of wider significance to those taxpayers who may need to demonstrate to HMRC that they are engaged in a trade.

Facts

The facts are complex.  In brief, Eclipse Film Partners No 35 LLP ('Eclipse') was established to carry on the business of production, distribution, financing and exploitation of films.  On 3 April 2007 it acquired from the Walt Disney group a licence to exploit and distribute two films, Enchanted and Underdog, for 20 years.  Twenty years of annual licence fees, £503 million, were payable up front on completion.  In addition, a variable royalty was payable.

Although the licence granted Eclipse the exclusive right to distribute and exploit the films, Eclipse had to enter into a distribution agreement on the same day with a Disney distribution company ('the Distributor').  The agreement with the Distributor essentially mirrored those in the licensing agreement.  The Distributor agreed to perform all of Eclipse's obligations under the licensing agreement other than the payment of the licence fee.  The Distributor agreed to pay Eclipse fixed annual amounts and a variable royalty.

Funding

The Eclipse members funded their capital contributions as to 94% from loans advanced by a Barclays group company, Eagle Financial and Leasing Services (UK) Limited  ('Eagle') and 6% out of their own resources.  The loans were for 20 years, at a fixed rate of interest and investors were required to make a prepayment of 10 years’ worth of interest to Eagle.  The reason for this followed a change in the tax rules that restricted sideways loss relief and the intention was to enable members to claim tax relief on the prepaid interest.

Cash flows

The overall effect of the arrangements, in terms of cash flow, was as follows.  Barclays Bank Plc ('Barclays') lent £790 million to Eagle.  Eagle lent this amount to the investors.  The investors paid £790 million, together with £50 million of their own monies, to Eclipse.  Eclipse paid £503 million to Disney and £293 million to the investors which they used to make the prepayments of interest to Eagle.

The £293 million went back, via Eagle, to Barclays.  The £503 million was deposited with Barclays, less a fee of £6 million payable to Disney,

Marketing arrangements

Eclipse engaged a member of the Disney Group, WDMSP Limited ('WDMSP') to act as its agent with respect to the marketing and release of the film.

The decision

The FTT (Edward Saddler and John Walters QC) dismissed the taxpayer's appeal on the basis that Eclipse was not carrying on a trade.  The members were not, therefore, entitled to claim relief for interest payments on their loans from Eagle.  In the FTT's view, the acquisition and sub-licence of the rights were not sufficient to lead to the conclusion that Eclipse was trading.  Eclipse was not at sufficient commercial risk and the fixed and variable annual distribution under the licences and the structuring of the arrangements as a whole meant that Eclipse would make a profit each year without any reference to the success or otherwise of the films.  The FTT also considered that the possibility of receiving contingent receipts was too remote to justify the conclusion that Eclipse had embarked on a trading venture on a genuine commercial level.  This was because both films would have to perform very well financially in order that any such receipts would become payable as they had been cross-collateralised, which meant that a poor performance by one film would reduce or remove altogether the possibility of receiving contingent receipts.  This was despite the fact that a report prepared by an independent firm specialising in valuing film rights had confirmed that a payment of contingent receipts was possible even with the cross-collateralisation.

The FTT also concluded that Eclipse had no meaningful role in actually directing or influencing the marketing and release of the films.

The good news

In the view of the FTT, the manner in which Eclipse's members had financed their capital contribution and the related banking of security arrangements were not relevant to the question of whether Eclipse was conducting a trade, although they were 'part of the context' and could be taken into account when considering the motivation for the transactions entered into.  In particular, the FTT found that the borrowing arrangements were on full recourse terms, because that was what the loan agreement expressly and unequivocally provided.  In this respect, the FTT rejected HMRC's argument that the arrangement was on non-recourse terms because none of the parties took any commercial risk.  HMRC attempted to re-characterise the legal rights and obligations created by the agreements (so that the agreements had a legal effect that did not accord with the actual transaction agreed between the parties). The FTT does not appear to have been impressed by this attempted re-characterisation describing it as 'scarcely a step away from asserting that the agreements were a sham'.

Comment

Given HMRC's current campaign to challenge any arrangements that they consider constitute 'unacceptable' tax avoidance, it is perhaps not surprising that this case found itself before the FTT.

The transactions were structured in such a way as, effectively, to deprive Eclipse of the 'badges of trade' necessary to establish that a trade had been conducted.  Things might have been different had the transactions been implemented in a different manner, for example, a more meaningful contingent receipts system being negotiated and agreed upon by the parties, or the taxpayer being able to demonstrate that it had enjoyed greater influence over the subsequent marketing and release of the films.  As always, each case will be determined on its own facts and careful implementation is therefore key to the success or otherwise of any fiscal arrangements.

It is understood that Eclipse is likely to appeal the decision of the FTT and the controversy will, no doubt, rumble on for some considerable time to come.