Tax Briefing - Watson, Farley & Williams

Tax Briefing
October 2002
The Mawson case has
become a hot topic within
the leasing industry. It has
created some uncertainty
as to which defeased
transactions are vulnerable
to Revenue attack and
which are not.
However, the case needs
to be considered in context
and perspective. It should
not be regarded as a judicial
condemnation of structured
lease transactions and all
forms of defeasement.
The Mawson case
On 22 July 2002, Mr Justice Park gave judgment in the case of
Barclays Mercantile Business Finance Ltd v Mawson. The case
concerned BMBF’s entitlement to capital allowances following a
sale and leaseback transaction under which BMBF expended capital
monies on the acquisition of a pipeline from the Irish Gas Board
(“BGE”). The Revenue denied BMBF allowances and its decision to
do so was upheld by both the Special Commissioners and, on appeal,
the High Court. It is understood that BMBF is appealing against
Park J’s decision and an application to expedite the appeal has
been made. The appeal could be heard as early as November 2002.
The case is of importance to the leasing industry, particularly so
since it was the method by which BGE’s obligations under the
leaseback were defeased which caused BMBF’s claim to capital
allowances to be denied. Defeasance of a lessee’s obligations under
a lease is a common feature of “big ticket” finance leasing and the
case has created some uncertainty as to which methods of
defeasance will be acceptable in the future and which will not.
The purpose of this Briefing is to analyse the judgment, to draw
some conclusions from it and to consider its importance in the
context of leasing as a whole.
There is another decision of the Special Commissioners, involving
the denial of capital allowances to a finance lessor in relation to a
defeased lease transaction, currently subject to appeal to the
High Court. The Special Commissioners’ decision at first instance
was reported anonymously under the name of Delta Finance Newco
v The Commissioners of Inland Revenue. The appeal hearing
commenced before Mr Justice Etherton on 15 October 2002 and is
listed under the name BMBF (No. 24) Ltd v The Commissioners
of Inland Revenue. However, this Briefing is limited to a discussion
of the Mawson case.
THE TAX BRIEFING WATSON, FARLEY & WILLIAMS TAX GROUP

FINANCE LEASING OR A “...COMPLICATED CONVOLUTED
TAX AVOIDANCE TRANSACTION...”
Facts
At material times prior to 31 December 1993, BGE was the
owner of a natural gas pipeline which runs from Scotland to
the Irish Republic. The net cost to BGE of the pipeline,
after deducting the benefit of grants from (what is now) the
European Union, was approximately £91m.
On 31 December 1993, the following transactions took place:
Barclays Bank lent approximately £91m to its leasing
subsidiary, BMBF.
BMBF purchased the pipeline from BGE for approximately
£91m and leased it back to BGE for an initial period of a little
under 33 years, plus a possible secondary period. The initial
period was divided into a pre-primary period of a little under
two years and a primary period of 31 years. A modest fixed
rent was payable during the pre-primary period. The rent
reserved during the primary period had a profile not untypical
of a tax based finance lease with escalating rentals. It was
structured to enable BMBF to recover its capital cost on the
pipeline plus a margin over that period after taking account of
funding costs and the benefit of group relief receipts arising
from the surrender of losses derived from capital allowances
to other companies in the Barclays Bank group.
BGE sub-leased the pipeline to its wholly owned UK subsidiary,
namely BGE (UK). The terms of the sub-lease were broadly
similar to those in the lease, although, unlike the lease, the
rentals were not variable as a result of a change of tax
assumption. Although the rental profile equated to that under the
lease at inception, the sub-lease rental profile would diverge from
that under the lease in the event of rental adjustments under the
lease consequent upon (inter alia) a change of tax assumption.
Deepstream applied monies deposited with it in making a
deposit with Barclays IOM, a subsidiary of Barclays Bank in the
Isle of Man.
In accordance with Barclays Bank’s group policy, Barclays IOM
applied the monies deposited with it by Deepstream in making
a deposit with Barclays Bank group treasury.
BGE entered into a Transportation Agreement with BGE (UK)
under which the latter company agreed to transport gas for BGE
for a fee. Although the fee payable was to be calculated in
accordance with a formula, it incorporated a minimum amount
which would be payable in any event and which would never
be less than the amount which BGE (UK) was required to pay
in rent under the sub-lease.
BMBF, BGE and BGE (UK) entered into an Assumption
Agreement under which BGE (UK) would pay an amount equal
to the rent due to BGE under the sublease direct to BMBF in
satisfaction (wholly or in part) of BGE’s obligations to pay rent
under the lease. The Assumption Agreement further provided
how such payments would be modified in the event that the
rentals due from BGE to BMBF under the lease altered as a
consequence of changes in assumption.
Barclays Bank guaranteed to BMBF that BGE (UK) would make
payments to it under the Assumption Agreement. Deepstream
agreed to indemnify Barclays Bank against any liabilities
incurred by it under the guarantee and charged its deposit with
Barclays IOM in favour of Barclays Bank, in support thereof.
BGE charged its deposit with Deepstream in favour of BGE
(UK) to secure its obligations to make payments to BGE (UK)
under the Transportation Agreement.
BGE deposited the proceeds of sale of the pipeline with a
Jersey company called Deepstream. Although Deepstream was
an “orphan” company owned by a charitable trust, it was
managed by Barclays Bank.
THE TAX BRIEFING WATSON, FARLEY & WILLIAMS TAX GROUP 02

THERE WAS A CASHFLOW CIRCUIT WHICH THE
SPECIAL COMMISSIONERS FOUND, AS A MATTER
OF FACT, WAS PRE-ORDAINED AND DESIGNED AS
A COMPOSITE WHOLE.
Cashflows
The effect of the foregoing is that upon the origination of the
arrangements on 31 December 1993, the £91m emanating
from Barclays Bank passed:
from Barclays Bank to BMBF by way of loan
from BMBF to BGE as purchase price for the pipeline
from BGE to Deepstream by way of deposit
from Deepstream to Barclays IOM by way of deposit
from Barclays IOM to Barclays Bank by way of deposit.
There was a cashflow circuit which the Special Commissioners
found, as a matter of fact, was pre-ordained and designed as a
composite whole.
During the primary period of the lease, the cashflows would
reverse year by year in accordance with a pre-ordained formulation.
monies would be released by Barclays Bank from the deposit
with it to Barclays IOM
Barclays IOM would release an equivalent sum from the
deposit with it to Deepstream
Deepstream would release an equivalent sum to BGE.
The releases from the Deepstream deposit comprised three
elements known as the A, B and C amounts. The A amount
was structured so as to equate to BGE (UK)’s rental liability
year by year under the sub-lease
Deepstream would, presumably at the direction of BGE, pay
the A amount to BGE (UK) in satisfaction of the minimum
fee under the Transportation Agreement. (To the extent
necessary, BGE would make top up payments to BGE (UK)
in the event that the fees payable under the Transportation
Agreement exceeded the minimum amount.) Deepstream
would pay any B and C amounts to BGE
BGE (UK) would apply its receipt in relation to the minimum
fee paid under the Transportation Agreement in satisfying its
rental obligations under the sub-lease. In this respect, in
accordance with the Assumption Agreement, it would pay
that sum direct to BMBF unless (following a change of tax
assumption in the lease) the rentals under the lease had
reduced, in which case BGE (UK) would pay a sum to BMBF
sufficient to satisfy BGE’s rental obligations under the lease
and would account to BGE for the excess. (If, following a
change of tax assumption, BGE’s rental obligations under the
lease exceeded that payable under the sub-lease, BGE
would, in turn, be obliged to pay the shortfall to BMBF, but
would have the B and C amounts released from the
Deepstream deposit with which (at least in part) to meet
that obligation)
it is assumed that BMBF would apply the amounts received
from BGE (UK) under the Assumption Agreement (and from
BGE under the lease where relevant) in repaying principal
and interest on its loan from Barclays Bank.
Revenue’s contentions
In order for BMBF to claim capital allowances it had to be able
to satisfy the requirements of (inter alia) Section 24(1) Capital
Allowances Act 1990 (now substantially re-enacted as Section
11(4) Capital Allowances Act 2001). In particular, BMBF
would have to be a trading company and would have to have:
“…incurred capital expenditure on the provision of machinery or
plant wholly and exclusively for the purposes of the trade…”.
The Revenue contended that it was entitled to deny BMBF
allowances for any of the following three reasons:
having regard to the circularity of the cashflows, BMBF had
not actually incurred any expenditure, in the sense of having
borne expenditure
if it had incurred expenditure, it was not upon the pipeline
but upon acquiring the benefit of cashflows to be derived
from the arrangements as a whole
even if it had incurred expenditure on the pipeline,
such expenditure had not been incurred for the purposes
of its leasing trade but upon an exercise of
“…financial engineering…”.
THE TAX BRIEFING WATSON, FARLEY & WILLIAMS TAX GROUP 03

THE JUDGE AGREED THAT THE MONIES EXPENDED
BY BMBF WERE NOT UPON THE PIPELINE BUT UPON
“…MONEY FLOWS…” TO BE DERIVED FROM AN
EXERCISE OF “…FINANCIAL ENGINEERING…”.
The judgment
A majority of Park J’s judgment was devoted to analysing the
second of the Revenue’s arguments since that was the principal
argument advanced. The Judge, in dismissing BMBF’s appeal:
Agreed that the monies expended by BMBF were not upon the
pipeline but upon “…money flows…” to be derived from an
exercise of “…financial engineering…”.
Agreed that, when one analysed the arrangements in their
entirety, BMBF’s involvement in the arrangements had not
been in pursuance of its normal leasing trade. Although he
accepted that a trading activity could not be denatured
purely because fiscal benefits would be derived therefrom, in
his view the transactions were “…heavily dominated by fiscal
elements…”, to such an extent that (applying Megarry J’s
test in Lupton v FA & AB Ltd) it could not be said that BMBF’s
involvement in the arrangements was in pursuance of trade.
Tended to the view that BMBF had incurred capital
expenditure, although he acknowledged that where there is a
circulation of money difficult issues can arise largely due to
the existence of apparently conflicting judicial authorities.
In reaching his conclusion the Judge:
Accepted that in analysing whether BMBF was entitled to
allowances he was required to consider all of the arrangements
as a whole and was not restricted to considering solely those
elements of the arrangements to which BMBF was a
contractual party. The fact that BMBF did not know the
precise detail of those parts of the structure to which it was
not a party would not preclude an examination of the
arrangements in their entirety, particularly so since BMBF
was aware that the arrangements involved a fully
collateralised financing.
Rejected the Special Commissioners’ assertion that in order for
the Revenue to defend BMBF’s appeal successfully it would
have to establish that the arrangements amounted to “…a
complicated, convoluted tax avoidance transaction…”. In this
respect, Park J considered that the role of the Court was to
analyse the “…real…” (a word to which he referred extensively
in his judgment) effect of the arrangements with a view to
determining whether they enabled the statutory provisions,
upon which BMBF’s claim to allowances depended, to be
satisfied, giving the words of the relevant statutory provisions
their commercial (as opposed to purely juristic) meaning, such
method of construction being consistent with the approach
prescribed by the House of Lords in MacNiven v Westmoreland
Investments Ltd.
Regarded the security arrangements as a critical issue.
In particular, he considered the method of internal defeasance
under which monies expended by BMBF had to be applied
in a comprehensive pre-ordained security “loop”, in order to
collateralise BGE’s obligations to it under the lease, led to
the conclusion that BMBF had not incurred expenditure on
the pipeline, but had embarked upon an exercise of
“…financial engineering…”.
As Park J put it:
“…I accept that finance lessors always wish to limit the credit
risk to which they are exposed. But there can be cases where
the credit risk is so comprehensively eliminated that it becomes
apparent, if one steps back and thinks about it, that the lessor
has not really laid out its money on a leasing transaction at all…”.
THE TAX BRIEFING WATSON, FARLEY & WILLIAMS TAX GROUP 04

“…FINANCE LESSORS ALWAYS WISH TO LIMIT CREDIT RISK
...BUT THERE CAN BE CASES WHERE THE CREDIT RISK IS SO
COMPREHENSIVELY ELIMINATED THAT IT BECOMES APPARENT
...THAT THE LESSOR HAS NOT REALLY LAID OUT ITS MONEY
ON A LEASING TRANSACTION AT ALL…” PARK J.
Although the security “loop” was circular and all parties thereto
were effectively controlled by Barclays Bank (albeit that
Deepstream was not a member of the Barclays corporate
group), the Judge implied that his conclusion would not have
been different had the security arrangements been “…linear…”
rather than circular. In other words, it would not have affected
his decision if the monies derived from the sale of the pipeline
had, as part of pre-ordained arrangements, been deposited with
an independent bank (rather than, indirectly, with Barclays
Bank) which, in turn, was obliged to provide both security for
BGE’s obligations under the lease and the funds to enable
rentals to be paid (wholly or substantially/directly or indirectly)
in the form of releases from the security deposit.
Placed importance on the fact that, given the transaction
between BGE and BMBF was that of sale and leaseback,
“…BGE could not get its hands on the money…” i.e. the
proceeds of sale of the pipeline. A characteristic of expenditure
being incurred on plant and machinery in the course of a
leasing trade is that the price paid by the lessor for the
relevant asset should either be available to the lessee for use
in its business, where the transaction is structured as a sale
and leaseback, or, presumably, should be applied in relieving
the lessee of expenditure it would otherwise have had to pay
in order to obtain the use of the asset, where the lessor
acquires the asset direct from a third party, such as a
manufacturer. In essence, the lessor must provide “…up
front…” finance which is either made available to the
lessee or applied for its benefit.
Concluded that the security arrangements prevented BGE from
realising monies on the sale of the pipeline which it was then
free to deal with as it wished in the course of its business.
(Clearly, since BGE already owned the pipeline at the time
of the sale and leaseback, there was no question of BMBF’s
money being applied on the purchase of the pipeline from a
third party.)
Placed some significance on the fact that no attempt was
made to attribute a true value to the pipeline for the purposes
of determining the price at which it was sold to BMBF. That
factor suggested that, apart from the ability to generate capital
allowances, the pipeline was not particularly relevant to the
arrangements as a whole, leading to the conclusion that
BMBF’s expenditure was not on the pipeline but upon the
“…cashflows…” to be derived from the “…financial engineering…”
constituted thereby.
Distinguished the arrangements under review from those in
a conventional funding by means of lease finance. The Judge
noted “…this case is exceptional and possesses unusual
features which differentiate it from the general run of BMBF’s
finance leasing…”. In a conventional finance lease, the lessee
enjoys a lower funding cost as a result of the lessor’s claim to
capital allowances being factored into the calculation of the
lease rentals. In the case under review, BGE did not enjoy a
lower funding cost since no new monies were made available
to pay off the existing banking syndicate which had financed
BGE’s acquisition of the pipeline in the first instance.
The benefit to BGE of the arrangements was the B and C
amounts released periodically from the Deepstream deposit;
such payments represented BGE’s share of the fiscal
benefits to be derived from the arrangements but, in the
absence of new funding, the payment of such monies was,
as Park J observed: “…not remotely characteristic of
finance leasing…”.
THE TAX BRIEFING WATSON, FARLEY & WILLIAMS TAX GROUP 05

...IT IS APPARENT THAT IT IS NOT THE FACT
THAT BGE’S OBLIGATIONS UNDER THE LEASE
WERE SECURED WHICH THE JUDGE FOUND
OFFENSIVE BUT THE METHOD BY WHICH THEY
WERE DEFEASED...
Comment
The Barclays case should not be regarded as a general attack
on leasing nor, as a general proposition, as an attack on
structured financial arrangements, even where those
arrangements are fiscally motivated i.e. designed to enable a
tax benefit to be derived therefrom. Indeed, there are a number
of passages in the judgment which clearly demonstrate that
Park J does not find structured leasing offensive, nor the fact
that, as he puts it: “…careful tax planning is always
involved…”. In particular, the Judge notes:
“ …As regards finance leasing the underlying purpose of
Parliament, in my view, is to enable capital allowances to be
used so as to provide to lessees at attractive rates finance for
them to use or to develop their real business activities…”.
Furthermore, the case should not be regarded as a general
attack upon defeasance in the context of lease arrangements.
Again, there are passages in the judgment in which Park J
clearly accepts that lessors wish to limit the credit risk to which
they are exposed and that they commonly require lessee’s
obligations to be secured by a bank guarantee or other method
of security. He also acknowledges that where a bank provides
security to a lessor in relation to a lessee’s obligations under a
lease, the bank usually wishes to secure its own position by
counter guarantees and indemnities or, presumably, other forms
of security.
In the Mawson case, it is apparent that it is not the fact
that BGE’s obligations under the lease were secured which
the Judge found offensive but the method by which they
were defeased.
In any event, certain types of defeasance are specifically
permitted by statute in the case of finance leases to lessees
who are in tonnage tax.
Acceptable and unacceptable
defeasance
Based upon Park J’s comments and his analysis in the Mawson
case, as a general proposition, there is no reason to believe that
there is anything objectionable to the defeasance of a lessee’s
obligations under a lease where a letter of credit (or other form
of contractual security) is provided to the lessor by a third party
bank, in circumstances in which the letter of credit is supported
by a deposit made with the third party bank emanating either
from funds freely available to the lessee (or a member of its
group) or from a source which is independent of the lessor.
That being the case, a typical security arrangement under
which a third party bank (independent of the lessor) lends
money to the lessee which is deposited with a defeasance bank
who, in turn, issues a letter of credit in favour of the lessor, to
secure the lessee’s obligations under the relevant lease, should
not cause the Revenue to deny the lessor capital allowances.
That should be the case even where, typically, the third party
bank takes a charge over the relevant asset to secure the
payment to it, by the lessee, of any rebate of hire consequent
upon a sale of the asset following a termination of the lease.
In the foregoing example, it is clear that the funds required to
support the letter of credit issued by the defeasance bank do not
emanate directly or indirectly from the lessor. This is because there
are two separate sources of cash: one provided by the lessor under
the lease and one which is provided by the third party bank.
The defeasance arrangements which are likely to result in the
greatest risk of the lessor’s allowances being denied are those in
which money emanating from the lessor is applied in providing
both the security for, and the method of financing, the lessee’s
rental obligations under the lease (i.e. circumstances akin to
those in the Mawson case); they are not to be recommended.
THE TAX BRIEFING WATSON, FARLEY & WILLIAMS TAX GROUP 06

WHILST, QUITE CLEARLY, CAUTION NEEDS TO BE
EXERCISED FOLLOWING THE MAWSON DECISION,
...THE CASE NEEDS TO BE CONSIDERED IN CONTEXT
AND PERSPECTIVE.
However, between those two extremes there are a number of
defeasance structures in respect of which the position is now
somewhat less certain than was hitherto the case, in view of
Park J’s comments in the Mawson case, some of which are less
vulnerable than others.
Would, for example, a lessor’s claim to allowances be denied if,
in the case of a sale and leaseback, the proceeds of sale of the
asset are used to provide a security deposit with a defeasance
bank which, in turn, issues a letter of credit to the lessor to
secure the lessee’s obligations under the lease
Perhaps the analysis, and the answer to the question, will
depend upon whether or not it is contemplated that the
defeasance bank will release funds from the deposit, on a
periodic basis, to enable the lessee to meet its rental
obligations under the lease. If the arrangements are so
structured then, having regard to Park J’s comment that his
decision would have been the same in the Mawson case if the
transactions and cashflows had been “…linear…” (i.e. where
money emanating from the lessor passes into the hands of a
banking group which is independent of the lessor) as opposed
to circular, a risk must exist that allowances would be denied.
However, if it is contemplated that the lease rentals will be
funded separately and will not depend upon releases from
the deposit with the defeasance bank, it may be possible to
distinguish such circumstances from those which pertained in
the Mawson case. In particular, the monies necessary to meet
the lessee’s obligations will not originate (directly or indirectly)
from the lessor except, possibly, in a default situation in which
the letter of credit is called. A further distinguishing feature is
that the lessor (or a company in its group) does not “control”
the cash deposit and is exposed, in a default situation, to the
credit risk of the defeasance bank, a situation very different
from that in the Mawson case.
Would the analysis be different if, in a sale and leaseback
scenario, monies emanating from the lessor were applied in
repaying interim finance required to fund the asset, with the
lessee then drawing down a further loan to provide the security
deposit with the defeasance bank Moreover, does it matter if
the further drawdown is from the same source which provided
the interim funding or must it be from an independent source
and/or must the further drawdown be on different terms from
that of the interim funding In his judgment, Park J recognised
that a lessor should be treated as incurring expenditure on plant
and machinery in the course of its leasing trade where “…up
front monies…” are applied in refinancing an asset; in those
circumstances, the lessee is able to use the monies so
generated in its business to relieve it of an existing liability.
It should not necessarily be concluded that all security arrangements
which result in the lessee applying cash proceeds derived from a
leasing transaction to support security which is, in turn, provided
to the lessor to secure the lessee’s obligations, will render the
lessor vulnerable to a denial of allowances. Whilst, quite clearly,
caution needs to be exercised following the Mawson decision,
and each situation needs to be considered on its merits by
reference to the specific facts pertaining, the Mawson case needs
to be considered in context and perspective. That case related to
a particular set of circumstances which, arguably, provided
greater opportunity for the Revenue to challenge than in the
majority of cases where a lessee’s obligations are defeased.
There is clearly less scope for the Revenue to challenge
defeasance arrangements where the lessor’s expenditure on
the asset is paid to a third party (e.g. a manufacturer), since in
those circumstances there is little scope for the Revenue
to argue that monies emanating from the lessor are applied in
providing security for, and the funds with which to meet, the
lessee’s obligations under the lease.
Conclusion
The Mawson case should not be regarded as a general attack
on all defeased leasing but merely upon the method adopted in
that case.
THE TAX BRIEFING WATSON, FARLEY & WILLIAMS TAX GROUP 07

If you wish to discuss this briefing, please do not hesitate to
contact us.
Christopher Preston
cpreston@wfw.com
+44 (0) 020 7814 8005
Michael L’Estrange
mestrange@wfw.com
+44 (0) 020 7814 8046
Watson, Farley & Williams
15 Appold Street
London EC2A 2HB
Tel: +44 (0) 20 7814 8000
Fax: +44 (0) 20 7814 8141/2
www.wfw.com
Chris Comyn
ccomyn@wfw.com
+44 (0) 020 7814 8025
WATSON, FARLEY & WILLIAMS LONDON ATHENS PARIS NEW YORK SINGAPORE BANGKOK ROME
This brochure is produced by Watson, Farley & Williams. It provides a summary of the legal issues, but is not intended to give specific legal advice. The situations described may not apply to your circumstances.
If you require advice or have questions or comments on its subject, please speak to your usual contact at Watson, Farley & Williams.