The Commissioners for HMRC v Zyrieda Denning & Ors.

The issue on this appeal relates to the valuation of two leasehold interests in care homes for the purposes of capital gains tax and stamp duty land tax, where the valuations were carried out in accordance with the guidance given by the Royal Institution of Chartered Surveyors in VPGA 4. VPGA 4 gives guidance about valuing trade related properties. Where that valuation method is applied, is the resulting figure the value of the leasehold interest, or the value of both the leasehold interest and “transferable goodwill”?

An appeal from the UT to this court lies only on a point of law: Tribunals, Courts and Enforcement Act 2007 s. 13 (1).

With the permission of Asplin LJ HMRC appeal on the ground that the UT were wrong to have attributed the agreed capital values to a distinct asset of transferable goodwill as opposed to the value of the leasehold interests themselves.

Dr Denning acquired the freehold interest in Manor Place Nursing Home together with the business operating from it in April 2000 for £499,000. She acquired a leasehold interest and the business operating from Maple House Nursing Home in March 2001 and subsequently bought the freehold interest in the property in June 2006 for £1m. Dr Denning operated both care homes as a sole trader.

On 3 February 2010 Dr Denning incorporated three companies: Jasmine Care Holdings Limited (“JCHL”); MH Hants Limited (“MHL”); and MP Hants Limited (“MPL”). MHL and MPL were wholly owned subsidiaries of JCHL and Dr Denning was the sole shareholder in JCHL.

On 22 March 2011 Dr Denning, as vendor, entered into three agreements with each of MHL and MPL to transfer one care home to each company. In summary the agreements provided for:

the sale and purchase of the businesses as going concerns in consideration for “the appropriate book amounts” and including “the goodwill of the Vendor in connection with the Business”. The agreements also provided that Dr Denning would grant leases over the properties from which the businesses were operated for a term of 5 years at an annual rent (without review) of £225,000 for Manor Place and £175,000 for Maple House;

the grant of the leases on the terms set out in (i) above with no premium payable (“the leases”). Dr Denning retained the freehold interest in both Manor Place and Maple House;

deeds of assignment of the goodwill of the businesses from Dr Denning to MPL and MHL for consideration of £1,125,000 and £675,000 respectively, i.e. a total of £1.8m.

HMRC challenged the figures for goodwill and asserted that part of what had been described as consideration for goodwill was, in reality, part of the open market value of the leases. The appeal therefore concerns the open market value of the leasehold interests granted by Dr Denning to MPL and MHL under the leases.

The valuations of the leasehold interests are required for the purposes of the Taxation of Chargeable Gains Act 1992. Section 272(1) of that Act states:

There was no dispute about the nature of open market value. The question, then, is how much each of the leases would fetch if sold on the open market.

There are a number of different methods by which property can be valued. The most common is by the comparable method. In essence, the valuer looks for an analogue which is as close as possible to that which they have to value, and which has been the subject matter of a real transaction. They then work on the premise that if the subject matter of their valuation were to be the subject of a similar transaction, it would command the same value as the analogue. Since the analogue will never be identical to the subject matter of the valuation, the valuer will have to make adjustments to the value revealed by the analogue in order to reflect the differences between the analogue and the subject matter of his own valuation. In the case of a property valuation the analogues are usually called “comparables”.

Second, there is the investment method. This is appropriate where property is tenanted, and the valuer is asked to value the reversion. The valuer will have to estimate the level of risk that a buyer would be prepared to take in order to acquire the income stream. It will be necessary to determine the yield which an investor would require and then convert that into a multiple of years’ purchase.

Third, there is the residual method, which is sometimes used to value sites with development potential. This operates by calculating the value of the completed development and then deducting the costs of achieving the completed development (including financing costs and developer’s profit). The residual method requires the input of a large amount of data, which is rarely absolute or precise, coupled with making a large number of assumptions. Small changes in any of the inputs can cumulatively lead to a large change in the land value. Some of these inputs can be assessed with reasonable objectivity, but others present great difficulty. For example, the profit margin, or return required, varies dependent upon whether the client is a developer, a contractor, an owner occupier, an investor or a lender, as well as with the passage of time and the risks associated with the development. For this reason the residual method is generally regarded as unreliable and should only be adopted in the absence of some other more reliable method.

Fourth, there is the depreciated replacement cost (DRC) method. This involves assessing the cost of replacing the land and the building with a modern equivalent, including all associated costs and then making appropriate deductions for depreciation and obsolescence of the actual buildings. It is used only in cases of specialised property; and it, too is regarded as a method of last resort.

Fifth, there is the profits method, which is used in valuing trade related property; and is the relevant method used in this case.

The overarching purpose of all these methods of valuation is to arrive at the value of property.

VPGA 4 sets out the current guidance given by the RICS for the valuation of trade related property (in the quotations that follow emphasis is in the original). The hearing before the UT focussed on that guidance, and the UT considered at [96] that it was appropriate to do so. It is thus common ground on this appeal that the guidance in VPGA 4 applies to the valuation. We must therefore examine VPGA 4 in order to decide whether, as HMRC assert, the UT made an error of law.

The rubric at the start of the guidance states that it is advisory rather than mandatory. It also states that it does not cover every circumstance and that valuers must always have regard to individual facts and circumstances.

It continues by setting out its scope:

The guidance then goes on to define certain terms that are used in the valuation process.

Having defined its terms, VPGA 4 goes on to describe the method:

Section 6 of VGPA 4 deals with the assessment of trading potential. It says:

Section 7 of VPGA 4 explains that the same method of valuation applies to a non-trading property, although different assumptions may have to be made.

Section 8 explains that the valuer may be asked to give an indicative apportionment of valuation for various purposes. Paragraph 8.2 says:

Both Dr Denning and HMRC called expert evidence: Mr Ellis FRICS for Dr Denning and Ms Rodrigues MRICS for HMRC. Both experts produced written reports and were cross-examined. In addition, the two experts agreed a statement of common ground summarised by the UT at [10], as follows:

the valuation date is 22 March 2011, the date on which the relevant transactions occurred;

the care homes to be valued are trade related properties (“TRP”) for the purposes of the applicable RICS guidance and the leasehold interests are to be valued on the profits method of valuation;

the profits method of valuation requires the assessment of the fair maintainable trade (“FMT”) and fair maintainable operating profit (“FMOP”) assuming the care homes were operated by a reasonably efficient operator (“REO”);

the FMT of Manor Place was £1.84m and the FMOP was £630,000;

the FMT of Maple House was £1.51m and the FMOP was £485,000;

the FMOP figures should be adjusted by deducting the market rental value. The experts agreed that the passing rent under each of the leases was at the lower end of the range that could have been expected at the valuation date; but was nevertheless within valuation tolerances. It was reasonable to adopt those rents for valuation purposes. The adjusted FMOPs were therefore:

Manor Place: £405,000 (£630,000 less rent of £225,000 pa);

Maple House: £310,000 (£485,000 less rent of £175,000 pa).

the profits method of valuation requires the rent adjusted FMOP to be capitalised using a year's purchase multiplier. The experts (in effect) agreed a compromise year's purchase of 2.125 which gave what they described as a mid-point capital value for the leasehold interest in Manor Place of £860,000 and of £660,000 for the leasehold interest in Manor House, giving a combined value of £1.52m.

The value of the trade inventory was then deducted from these capital values. The experts agreed the following values for trade inventory:

Manor Place: £130,000;

Maple House: £117,500.

The capital values for the leasehold interests less the trade inventory were:

Manor Place: £730,000 (£860,000 less £130,000);

Maple House: £542,500 (£660,000 less £117,500).

The freehold interests were to be valued on the investment basis and were agreed at: (a) Manor Place: £2.725m; (b) Maple House: £2.06m.

Both experts followed the guidance given by the RICS. Mr Ellis used previous guidance explained in GN1 and Ms Rodrigues used the current guidance explained in VGPA 4; although Mr Ellis said that his valuation would have been the same if he had followed VGPA 4.

It is to be particularly noted that the figures agreed by the experts as FMT and FMOP were higher than the figures achieved by the actual businesses themselves.

The case for HMRC was that the agreed capital values for the leasehold interests were their open market values reflecting trading potential. The case for Dr Denning was that included in the agreed values was both the value of the leasehold interest itself and also “transferable goodwill” or “business goodwill”. The value of the leasehold interest was simply the market rent. The agreed capital value of the leasehold interest related solely to the value of the business goodwill. The transferable or business goodwill was an asset separate from the leasehold interest. She argued that the experts agreed that the rents passing under the leases were market rents, and it was obvious that a leasehold interest in property let at a market rent does not have a capital value.

As the UT (A J Trott FRICS and Diane Martin MRICS FAAV) said at [91]:

At [95] the UT held that it was wrong to value the properties as if they had been empty. As they put it:

There is no appeal against that conclusion. At [96] they held that the valuation ought to reflect VPGA 4, which was the guidance in force at the time of the hearing, rather than GN 1, the previous guidance which it had replaced.

The UT set out its understanding of the issue at [99]:

At [106] the UT observed:

There is an obscurity about the concluding words of this paragraph, which might be taken to suggest that the UT was looking at the actual business conducted at the property, rather than the market’s perception of the profit-earning capacity of the property. But in its decision refusing permission to appeal, the UT clarified that it was not considering the actual business but that of a hypothetical REO. Mr Brinsmead-Stockham, for HMRC, accepted that clarification.

The UT then focussed on step 4 c of VGPA 4, which is concerned with the establishment of a market rent on a new letting. They said that the market rent was determined by taking a percentage of the FMOP and as such it reflected the trading potential of the property. They would have expected the tenant's proportion of the FMOP to represent the amount it would require from the business to induce it to take a lease at the market rent and make sufficient return on its risk and for profit (interest on capital having already been allowed for). But, they said, the tenant had paid a premium; and they posed the question: What was that for?

Their answer was:

At [117] they concluded that the trading potential of Manor Place and Maple House that was reflected in the agreed valuations could not reasonably be attributed solely to the leasehold interests; and that Dr Denning was correct to say that those valuations must also include transferable goodwill. They therefore decided that the value of the leasehold interests in Manor Place and Maple House was nil.

In Mohammed v Newcastle City Council [2016] UKUT 415 (LC) Mr Trott himself considered the nature of a profits valuation. The claim in that case was a claim for compensation on the compulsory acquisition of a fish and chip shop. At [75] Mr Trott said:

He then recorded a submission that the value of a freehold reflects the opportunity of establishing a going concern (the “possibility” of the land being used as a fish and chip shop) rather than the established going concern as it exists in the hands of the vendor (a “realised possibility”). Mr Trott rejected that submission. At [77] he said:

Thus Mr Trott accepted that the open market value does reflect the trading potential to a reasonably efficient operator. He went on to say at [79] that the profits method of valuation combines the value of the business with the value of the property from which it is conducted. But that, as it seems to me, was an observation about the actual business carried on. Mr Trott went on to say:

In my judgment Mr Trott in this passage distinguishes between the open market value based on the trading potential to a reasonably efficient operator on the one hand, and the value to the owner if his actual profits exceed those which would be achieved by a reasonably efficient operator. This is the same distinction as that drawn by para 6.1 of VGPA 4 between market value and worth. I should also emphasise the point that Mr Trott made that the profits method does not produce distinct figures for the property value and the value of the business use which is conducted from the property: they are “inextricably linked”.

I agree with Mr Brinsmead-Stockham that both the fair maintainable trade and the fair maintainable operating profit are hypothetical figures, which reflect the view that the market would take. As Hoffmann J put it in Electricity Supply Nominees Ltd v London Clubs Ltd [1988] 2 EGLR 152:

The classic description of goodwill is found in the decision of the House of Lords in IRC v Muller’s Margarine Ltd [1901] AC 217. The issue in that case was whether goodwill attaching to a German manufacturing business was situated outside the UK. The House of Lords held that it was. In a passage that has been frequently quoted, Lord MacNaghten said:

He went on to say:

Lord Brampton endorsed the view of Pollock CB in an earlier case that:

Lord Lindley said:

As these passages demonstrate, goodwill attaches to an actual business. I find it difficult to see how goodwill can be attached to a hypothetical business. In that sense goodwill (which attaches to an actual business) must be distinguished from trading potential which is part of the value of the property itself. That is reflected in the way in which Mr Trott described a profits valuation in Mohammed, distinguishing between open market value on the one hand and value to the owner on the other.

Where one is dealing with goodwill attaching to an actual business, it is now generally accepted that the subdivision of goodwill is unhelpful; although it may be necessary to do so for certain purposes: Whiteman Smith Motor Co Ltd v Chaplin [1934] 2 KB 35; Wadlow on Passing Off (6^th ed) para 3-43. The UT said at [118]:

But that is not necessarily the case where one is not dealing with actual goodwill but with a case of valuation by the profits method, as I will try to explain.

VGPA 4 is, in my judgment, clear that (like other methods of valuation) what it is aiming at is a valuation of property (i.e. a freehold or leasehold interest). The profits method of valuation is guidance on how to value property of a particular type. VGPA is replete with references to the valuation of property (emphasis added in the following quotations):

“Certain trade related properties are valued using the profits method (also known as the income approach) of valuation.” (para 1.1) What is valued is the property; how to value it is the method.

“This VPGA relates only to the valuation of an individual property that is valued on the basis of trading potential.” (para 1.2) What is valued is the individual property; how you value it is on the basis of trading potential.

“the value of the property interest is intrinsically linked to the returns that an owner can generate from that use. The value therefore reflects the trading potential of the property.” (paras 1.3) The value of the property and the potential returns are intrinsically linked. It must therefore be impermissible to separate them.

The profits method “involves estimating the trading potential rather than adopting the actual level of trade under the existing ownership, and it excludes personal goodwill.” (para 2.10). Thus, whereas in the case of goodwill attaching to an actual business it is unhelpful to subdivide it, VGPA 4 specifically requires the exclusion of personal goodwill. This is reinforced by para 2.9.

Trading potential is “the future profit, in the context of a valuation of the property that an REO would expect to be able to realise from occupation of the property. This could be above or below the recent trading history of the property. It reflects a range of factors (such as the location, design and character, level of adaptation and trading history of the property within the market conditions prevailing) that are inherent to the property asset.” (para 2.13)

“To assess the market value of the property the FMOP is capitalised at an appropriate rate of return reflecting the risk and rewards of the property and its trading potential”. (para 3.1 Step 4 a).

All these passages stress that what is being valued is the property asset, how to value it is by the profits method, and the inclusion of trading potential as part of that property valuation reflects value that is inherent in the property asset itself. Trading potential refers to future profits, rather than actual profits. That potential is available to any reasonably efficient operator who acquires the property. On the basis that goodwill is what brings in custom, it will be reflected in the turnover and the profit of the actual business. Yet it was common ground that the valuation by the profits method was based on the market’s perception of fair maintainable trade and fair maintainable operating profit; and that that method of valuation applied both to freehold and leasehold property. Even if no business is being conducted on the property, the profits method is still the appropriate way to value it, as section 7 of VGPA 4 explains.

Put shortly, VPGA 4 does not recognise the concept of “transferable goodwill” as an asset separate from the property interest. It does, however, recognise “personal goodwill” which is excluded from the valuation under para 2.10. Apart from that personal goodwill, VPGA 4 does not refer to goodwill at all.

Moreover, as the decision in Muller illustrates, in a very broad sense goodwill attached to an actual business can include the gravitational pull exerted by the location of the property which is an intrinsic feature of the property itself. The location and physical features of the property, whether or not they exert gravitational pull, are part of the value of the property itself.

Mr Firth, for the taxpayers, placed some reliance on the decision of Mr Michael Tildesley, sitting as a Special Commissioner, in Balloon Promotions Ltd v Wilson [2006] STC (SCD) 167. That, however, was a very different case. A number of franchisees of Pizza Express occupied leasehold property from which they operated Pizza Express restaurants. They entered into agreements to sell the leases and the business to Pizza Express which wished to run the restaurants “in-house”. The overall consideration paid by Pizza Express was apportioned. The various leasehold interests were ascribed values from nil to £245,000. Part of the overall consideration was described as “goodwill not adherent in the property” and part as “personal goodwill”. The franchise agreements were also terminated and the franchisees entered into restrictive covenants. HRMC did not challenge the leasehold valuations. The issue between the parties was whether, as the taxpayers said, the part of the consideration described as goodwill was indeed a payment for goodwill; or whether, as HMRC asserted, it was in reality compensation for the termination of the franchise agreements. If the former, then the payment was made for an asset and attracted roll-over relief; if the latter, then it did not.

Because the valuation of the leasehold interests was not in issue, the question, was whether the payment was made for an asset at all; not for which asset it was made. The Special Commissioner decided that the payments were indeed payments for goodwill rather than for the termination of the franchise agreements. The Special Commissioner examined a number of authorities about the meaning of goodwill, and also expressed some reservations about the then current guidance issued by the RICS on the valuation of restaurants, bars, public houses and nightclubs. But his reservations were expressed in the context of his approach to goodwill, not in relation to the valuation of property. In this case, by contrast, it was common ground on this appeal that VPGA 4 was the correct way to value the leases.

What clearly troubled the UT was its perception of the apparent mismatch between the experts’ agreement that the passing rents were market rents on the one hand, and the experts’ agreement that the leasehold interests had substantial capital value even at those rents, on the other.

Mr Firth submitted that the correct way to value was to apply step 4 c in the case of a leasehold interest; and that step 4 a was restricted to freeholds. Once the valuer had assessed market rent in accordance with step 4 c, that was the end of the exercise. VPGA 4 had no further part to play. It made no reference to the capital value of leasehold interests. The hypothetical tenant would pay the market rent in order to acquire the leasehold interest; and that was all that he needed to pay. If and in so far as he paid more, it must have been for something else. Whether you called that “transferable goodwill” or something else did not matter. The point was that it was not paid for the lease. He relied on a passage in the cross-examination of Mr Rodrigues which, he said, showed that she agreed that value of a lease at the market would be nil:

I do not consider that that is a complete or correct reading of VPGA 4. Step 4 c is directed towards the assessment of market rent. But what is in issue in this case is not the market rent, but the capital value of the leasehold interests. Step 4 a is not explicitly restricted to freehold interests; and there is no reason why it should be. On the contrary, the definition of market value in para 2.7 of VPGA 4 deals in very general terms with an “asset or liability”. If, for example, the passing rent were less than the market rent the value of the leasehold interest would be valued in accordance with step 4 a. An adjustment would need to be made to the definition of fair maintainable operating profit, because that is defined as “level of profit, stated prior to depreciation and finance costs relating to the asset itself (and rent if leasehold)”. That is the adjustment that both experts agreed was the appropriate adjustment to make.

In addition, when one is concerned with an open market capital value, the market consists of all those who are willing to buy. The market rent, on the other hand, is concerned only with a transaction between landlord and the tenant. The fact (if it be the fact) that the landlord could not have extracted a higher rent from the tenant does not entail the further proposition that an assignee of the lease would pay nothing for the lease; especially where, as the experts agreed in this case, the passing rent was at the lower end of the range that could have been expected at the valuation date, and the agreed figures for fair maintainable trade and fair maintainable operating profit were higher than the figures actually achieved by the taxpayers.

Quite apart from that, the rubric at the head of VPGA 4 says in terms that it does not cover every circumstance; and although it does not specifically deal with the capital value of leasehold interests, there is no reason to suppose that a modified version of step 4 a is inappropriate. On the contrary, the experts agreed that it was the right way to value. Both valuers assessed fair maintainable operating profit after the deduction of rent as recorded in their agreed report; and Mr Firth did not suggest that they were in error in doing so. That was no more than the adaptation of VPGA 4 to the specific facts of the case.

Mr Firth also attempted to show, by reference to further passages in the cross-examination of Ms Rodrigues, that she had made the valuation assumption that the hypothetical purchaser of the leasehold interest would also acquire the businesses being carried on at the leasehold properties. In my judgment, however, she did no such thing. She clearly rejected the suggestion that she had valued anything other than trading potential (which she regarded as another name for what others called “transferable goodwill”). She also said that she had valued on the basis that there was a business in existence on the valuation date, which accords with what the UT itself decided at [95] and also accords with VPGA 4. But she plainly rejected the suggestion that she was trying to value the business and the property together. In so far as she considered the question whether the existing staff structure had any value, what she did was to evaluate the perception of the hypothetical purchaser rather than make any assumption about transfer of staff. That perception was no more than that it was likely that staff would “go across.” As she put it:

Mr Firth also submitted that even an average business could generate goodwill, and that Ms Rodrigues had wrongly taken that goodwill into account. But at the same time, he accepted that Mr Rodrigues had made no error in assessing the fair maintainable trade or the fair maintainable operating profit. Indeed, since those figures were agreed, it is difficult to see how Ms Rodrigues could have been wrong.

As I have said “transferable goodwill” is not a concept that features in VPGA 4. It is, however, a term used in the previous guidance issued by the RICS, namely GN 1. But as the UT correctly decided, by the time of the UT hearing, GN 1 had been superseded by VPGA 4. At [113] the UT said:

But, in my judgment, an examination of GN 1 shows that the expression “transferable goodwill” does not denote an asset separate from the property interest itself. GN 1 defines “transferable goodwill” as follows:

There are a number of points to be made about this definition. First, it is property-specific, not business specific. Second, the goodwill referred to is inherent in the property; in other words it forms part of its value. Third, it “will” transfer to a new owner on sale. It is not “transferable” in the sense that it is merely capable of transfer; it automatically transfers with the property itself.

The error of law which, in my judgment, the UT made was to disaggregate property value on the one hand, and “transferable goodwill” on the other. VPGA 4 is aimed at the valuation of property interests. That they are valued by reference to trading potential does not mean that two separate assets are being valued. As Mr Trott said in Mohammed the profits method of valuation does not produce a separate property value distinct from the value of the business use which is conducted from the property. The two are “inextricably linked” as, indeed VGPA 4 itself states in paragraph 1.3. The error that the UT made was in attempting to extricate the value of the business use from the property value.

In so far as there is a concept of transferable goodwill of a hypothetical business, it is simply part of the inherent qualities of the property itself and its trading potential, as stated in VGPA 4 para 2.13. There is only one asset, namely the property, and the profits method of valuation is, as its description implies, no more than a method of arriving at the value of the property.

I would allow the appeal. It was common ground that if we found that the UT did make an error of law in ascribing value to “transferable goodwill” (as I have held that they did), we should re-make the decision ourselves. On that basis, I would determine the open market value of the leasehold interests in the sums agreed by the experts:

Manor Place: £730,000;

Maple House: £542,500.

I agree.

I also agree.