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Julie Butler FCA, describes an equine business tax issue in respect of horse racing and affiliated activities.

Introduction

The horsey culture is a thriving UK industry.  The dream of the equine enthusiast is to extend the passion (and what might have started as a simple hobby) into a commercial activity.

Equine business clients and moreover potential equine business clients can be found in every UK accountancy practice.

Julie Butler FCA

Wholly and Exclusively

HMRC have difficulty in accepting that expenses related to horses taking part in competitions (e.g. dressage, eventing, show jumping) are incurred wholly and exclusively for the benefit of a trade.  In tax law this goes back to the concept called ‘duality of purpose’, where HMRC effectively try to argue that if someone enjoys what they are doing, any expenses associated with the activity are disallowable.  HMRC generally believe that many equine businesses are an attempt to achieve tax relief for the costs of a hobby.  HMRC try to deny expenditure on the grounds that the taxpayer obtains private enjoyment from the expenditure.

HMRC have historically been concerned about duality of purpose and personal benefit.  However, horses being competed professionally, which are either for sale or being used for breeding purposes, should not pose a significant problem provided income and commerciality can be shown as they will be able to display the “badges of trade”.

Duality

The concept of duality can be explained by Mallalieu v Drummond [1983] 57 TC 330 where black clothing needed for the appearance in court was held to be needed for the more conventional use of clothing the body as well.

The legislation that defines the allowability of expenses was contained in s74 ICTA 1988, but is now in s34 ITTOIA 2005.  Under this section, if an expense is incurred for more than one purpose then no deduction is allowed, except for any identifiable part or identifiable proportion of the expense which is incurred wholly and exclusively for the purpose of trade.

McQueen, the successful rally driver

Good news for competitors with sponsorship arrangements!  A recent tax case “McQueen” (19 March 2007) has ruled it is all about the winning – winning new clients that is.  The decision in the tax case has resulted in a helpful and favourable result for those involved in commercial sponsoring of competitors of sports activities.  In McQueen it was shown that the marketing advantage was not vague and uncertain but was clear and successful.  There was evidence to demonstrate a direct correlation between sponsorship and the gaining of new clients.

Mr McQueen was a good rally driver and he chose to publicise his coach business by sponsoring a rally car which he drove with success.  The rally car was painted in the colours of the coach business and was generally high profile – for example parked outside the business premises in Garelochhead and apparently easy to see in that part of Scotland.

The question was whether the expenditure on sponsoring the rally car was incurred wholly and exclusively for the purposes of the business or whether there was a duality of purpose.  HMRC argued that this was Mr McQueen’s way of indulging his interest and the business purpose was incidental. 

Promoting the Business

The Special Commissioner decided against HMRC by concluding that the whole of the expenditure was incurred for the purpose of the benefiting the coach business by the promotion of the name and facilities it offered.  The fact that it gave Mr McQueen satisfaction was merely a consequential and incidental effect of the expenditure.  The Commissioner stated that: ‘Mr McQueen used his skill and enthusiasm for rally driving as the best means available for promoting his coaching business’.  Accordingly the expenditure was laid out wholly and exclusively for the purposes of the coach trade and was fully deductible.

This may seem like a surprising decision because many have tried and failed in this area before.  There was evidence demonstrating a direct correlation between the sponsorship and the gaining of new clients.  It may be that in another case such a correlation would not be so clearly established but it certainly looks like a very helpful decision for the taxpayer.

Can equine businesses prove such promotion?  It would be difficult to paint the horses in the company’s colours, but what about the pictures of the horses on the side of the company’s vans?

Purpose and Effect

In McQueen, the Commissioner’s view was that the expenditure had been incurred for the purpose of promoting the business and getting names and liveries into the public awareness.  Although the taxpayer gained some personal satisfaction from competing in rallies, his preferred leisure activity was sailing rather than rallying and the private satisfaction of success on the rally circuit was an incidental benefit of expenditure, rather than its purpose.

It has been argued that it is the purpose that matters, not the effect.  In many cases although there has been a benefit for the business, the taxpayer could not demonstrate that the main purpose was anything other than for private benefit.

A sponsorship type of arrangement has to be able to prove purpose (to promote the business) and the effect which was a direct correlation to sales.  Can the trader show more sales as an effect of the sponsorship?

A view to a Profit

Moving away from the sponsorship scenario, where the equine activity is subsidised by an associated business, the other areas where HMRC are currently taking a very keen interest is that of the horse businesses which do not produce a profit.  This is especially the case where the proprietor has other income.  The relevant legislation is now contained in s64 ITA 2007 onwards.  S384 ICTA 1988 has been replaced by s66 ITA 2007.

There are therefore two tests to be proven.  One that the business is being carried on with a view to profit and two, that it is commercial.  To quote HMRC: “We are after the extreme cases in which expenditure very greatly exceeds income or any possible income which can ever be made in which, however long the period, no degree of profit can ever have been reached.”

Sideways Swipe

HMRC Brief 2 March 2007 and its “swipe” at sideways loss relief: relief is limited to the first £25,000 of losses each year, unless the claimant works for an average of 10 hours per week in the loss making business.  This is likely to be a problem for breeders – establishing a stud is a long term business – though in reality the non racing studs are likely to have less problems through this latest brief as the owners tend to invest more blood, sweat and tears than financial contribution.  Another point to watch is that the restriction only applies to loss relief by partners – sole traders are not affected.

There is still the requirement that the business should be potentially profitable. Can the non racing studs produce a business plan that shows a profit?  Can the potential sales proceeds cover not just the direct costs (nomination fees) but also the overheads?  Can these businesses contribute to the projected profits with other income streams?  Sponsorship?  Liveries?  Would the diversification from the stud core trade of breeding (which qualifies as husbandry for tax purposes) jeopardise the agricultural reliefs?

The Competitive Sports Horse

It must be noted by the practitioner that in the “sports horse world”, e.g. eventing, dressage, show jumping, showing, endurance riding and arab racing etc, etc, there are different rules of breeding to the Thoroughbred bloodstock industry.

The rules in racing prohibit using artificial insemination (AI) or embryo transfer.  In other areas of equine sport, AI is routinely used, meaning that stallions compete at the same time as being used at stud.  Even stallions used for natural covering on mares frequently compete in the “sports horse” world and have dual purpose and potentially conflicting treatment for tax.  Do the stallion rules apply or the competition horse rules?

Embryo transfers are used for good performance mares in show jumping, eventing and polo, where the mare continues to compete while her genetic offspring is developing in another mare via in vitro fertilisation.

Consistency of Treatment

This creates some interesting accounting and tax considerations and it is essential that the practitioner understands how their client operates.  One of the biggest challenges is the stock valuation, for example how to treat the stallion, how monies spent and received on AI are treated in the accounts.  The Thoroughbred racing industry has more definition through tax cases and Inspectors' Manuals.  There is greater flexibility for the sports horse but it must be consistent.

Show jumping and the joys of ownership

The basic principle of Sharkey V Wernher i.e. ownership is tax free and any profits and loss of owning horses is outside the scope of tax is something that has been enjoyed by the show jumping industry.  But the business of show jumping can be run commercially- prize money, sale proceeds from improved horses, basic dealing profits, liveries, training for pupils, sponsorship etc can all result in a business plan that will show a profit and genuine trading surpluses exist. The underlying overheads of show jumping can be less than eventing - perhaps the costs of just one discipline not three helps.

It is perhaps a total mystery to those who live outside (and inside?) the world of eventing as to why the industry cannot achieve commerciality? Most competitors have to pay to compete and it is almost impossible to achieve financial return from seeking to be a professional eventer!  Badminton Horse trials attract more spectators than almost any other European team combined with the fact that our British teams are always successful at winning team and individual medals. Why can that success not be reflected in a commercial return? Are the costs of producing the horses and the events too high in relation to the income streams? Are world TV deals missing?  Perhaps the absent ingredient of gambling income streams might be a disadvantage to the sport!

Tax free ownership and transfers

Some clever but well balanced tax planning has been achieved with horses sold to outside the business before they reach their full potential for success and profitability. “Tax free” ownership profits have been made (compared to £millions of “tax free” losses!) This system must not be abused. Any transfers or sales must be a true market value (as per Sharkey v Wernher) and convenient retrospective transfers are basically tax fraud.

Cynical transfers of prime prospects from the core commercial business to say, family members, purely to move the animal from the taxable to non-taxable environment will be subject to severe attack by HMRC. There are genuine examples where racehorses, eventers and show jumpers are transferred to family members from the “training business” to keep overheads reduced. Full records, documentation of when, how and why must always be kept, especially the basis of calculation of market value - ideally by an independent valuer.