The Durham Case and Local Authority In-House projects

Subsidy Control law regulates the transfer of State resources towards economic activities. Economic activities are typically carried out by businesses and include activities for which there is a commercial market. Often the giver of the subsidy is a local authority and the recipient is a business which is a separate legal entity from that local authority.

However a local authority may conduct a "business" itself, like an in-house regeneration project. An in-house project is one that is carried out within a division of the local authority, rather than a separate legal entity, like a wholly owned subsidiary.

A regeneration project by definition is designed to jump start demand in a flagging economy and compete within a commercial market. Common examples of these are where a local authority owns, develops and operates commercial property, such as retail, leisure, transport facilities, office spaces or industrial parks.

In other subsidy jurisdictions like that in the EU, a functional approach is taken. The regeneration project is treated as a separate enterprise from the local authority, even if it is carried out in-house. This means that when the local authority formally allocates part of its general budget to that particular project, there can be a subsidy to the project, even though it all happens within the same legal entity.

The question is whether this is also the position in the UK, following the Durham case judgment. We answer this using the case study of a typical regeneration project as a start.

Case Study – typical local authority regeneration project

A local authority seeks to increase footfall in a deprived inner city town centre by refurbishing a derelict building it owns and converting it into a series of modern spaces for a mixture of uses such as retail, hospitality and offices. These spaces will be for commercial lets to operators and will generate revenues for the local authority which will cover its costs but not generate a return significant enough to interest a private sector developer. Hence the local authority will fund these works using its own general budget.

The local authority project team will identify the amount of funding through a viability gap assessed through development appraisal and the amount so determined will be formally and unequivocally allocated from the general budget of the local authority by cabinet decision. When ready to start works the funds will be transferred into a separate account dedicated to transactions for the project.

The project is regarded as a separate division from the rest of the Council in management accounting terms and funding towards it may well be paid into a new bank account or escrow. This will allow for maximum transparency, particularly in monitoring performance as value for money on an on-going basis, and at the year end the project's results are included within a single set of financial statements of the local authority as an entity. Recognised transfer pricing techniques are used to assess the terms of the dealings between the local authority and the project, as if the project were a separate entity.

Can a local authority subsidise itself?

The question is whether at the point of the cabinet decision, the local authority provides a subsidy to itself, or rather its division carrying out the project. So does the cabinet decision create a transfer of State resources to an economic activity.

A transfer of State resources occurs when there is a physical transfer of funds, such as an unconditional commitment to pay a grant to a business. It can also arise where the general State budget is allocated (ring fenced) to a specific activity, meaning that it is no longer available for other spending. This is commonly referred to as a "charge to government expenditure". If the cabinet decision does constitute a charge, then it would potentially involve a subsidy to the project.

The answer is important as local authorities are encouraged to engage themselves more and more in commercial activities in competition with the private sector and are now an intrinsic and fundamental part of any commercial supply chain.

Local authorities therefore need legal certainty in the form of a well-tailored framework within which to conduct economic activities, given the risk they run of displacing private sector investment in an area. This is precisely the objective of Subsidy Control, which recognises the need for private sector investment, with public funding only directed to areas where there are gaps.

It is reasonable that the regeneration project in the case study should be brought within Subsidy Control, regardless of whether it is in-house or carried out by a separate legal entity. It follows that for an in-house project, a local authority should be capable of subsidising itself, as functionally it is in fact a charge on government expenditure.

The logical answer to the question is therefore that the cabinet decision in the case study is a charge on government expenditure, as the fund allocated to the project is now taken out of the general budget of the local authority, and ring fenced into a particular division of it carrying out the project. On this basis an in-house project like that in the case study could potentially involve a subsidy by the local authority to the project.

However this is not the approach taken in the Durham case.

Durham case

The functional approach above was flatly rejected in the Durham case. The case rules that an in-house project does not involve a subsidy to it, as there is no charge to government expenditure. The reasoning is that an internal allocation of public funds within the same legal entity would not involve a transfer of State resources. It would only do so if the project was hived down to a separate legal entity and then funded on sub-commercial terms.

In the case study scenario therefore, the local authority would not need to follow Subsidy Control law at all if it keeps the project in-house and does not demerge it into a subsidiary which is then funded on sub-commercial terms (for instance through a grant or sub-commercial loan, or transfer of asset at undervalue to it).

The Statutory Guidance notes that in certain circumstances local authorities in any event have a statutory obligation to conduct commercial activities through a separate legal entity like a subsidiary company. For operational reasons also it is often recommended that such projects are demerged into subsidiary legal entities as it makes financing them more flexible and transparent, while still retaining control over deliverables.

Nevertheless there are occasions where a local authority is not obliged to do so, and would often prefer not to so as to avoid the additional administration and governance responsibilities this would entail. In such circumstances the reasoning in the Durham case would suggest that Subsidy Control law would not apply to it. This would bring unwelcome legal uncertainty to the local authority as it would now be subject to general public law controls, rather than the more specific Subsidy Control regime.

Observations on the Durham case

The Durham judgment follows the legal and financial accounting approach which looks outward at the local authority as a whole and its relationship with other entities, rather than looking inward at the relationships between its own various divisions.

The latter approach is the functional approach exemplified by management accounting principles and procedures such as transfer pricing between these divisions. Inter-divisional functional or management accounting typically refers to such projects as cost profit or investment centres, often with distinct accounting sub-routines for recording transactions, meaning functionally these are separate entities from the local authority. Subsidy Control law follows this functional approach as a rule, such as for example:

• the definition of enterprise is based on its activity rather than legal form. So for example in the Statutory Guidance it is recognised that a single legal entity can pursue both economic and non-economic activities, and it is only an enterprise in terms the former. The logical extension of this principle would be to regard the regeneration project in the case study as an enterprise, even though the local authority is not; and

• A charge to government expenditure, and hence a transfer of State resource, can occur without a physical transfer of funds between separate legal entities. The giving of a State guarantee for example is a recognised subsidy even though it may never be called upon.

The Durham case appears to ignore the above, and rejects the functional view. It acknowledges however that were the local authority to hive the project into a separate legal entity and then fund that entity on sub-commercial terms, there would be a potential subsidy to it.

This is an odd distinction to make, as that separate legal entity would typically be a subsidiary of the local authority meaning that the financial results of both would be eventually consolidated. The gist of consolidation in financial accounting is to treat the whole group as a single enterprise, meaning that intra-group transactions are anyway treated as similar to intra-divisional dealings. So it is unclear why a subsidy does not arise in an in-house project, but may arise if the same project is hived down into a subsidiary whose results would in any event be consolidated within the local authority group.

The reasoning also does not match operational reality. A supplier or customer of the development is in substance dealing with that shop, hotel or office manager, and not with the wider local authority. These facilities will typically be managed by an operator using its own branding with which it will interface with third party customers, tenants and suppliers. The functional independence of the project from the passive role of the local authority is therefore evident and it is therefore logical for them to be considered separate entities.

This approach is also at odds with the treatment of in-house projects in other subsidy control regimes.

Does the Durham case breach UK's international obligations?

The Durham case signifies a material divergence from State aid law followed by the EU which is the counterparty to the UK-EU Trade and Cooperation Agreement. State aid follows an entirely functional approach, in that an in-house project like the case study may give rise to a subsidy to it.

Under State aid, the local authority would be deemed to be potentially subsidising its own division as if it were an enterprise carrying out the project. In practical terms the subsidy arises when a formal and unequivocal internal allocation of funding from the local authority's general budget to its division undertaking the project is made, for instance through an internal decree like the cabinet decision. At this point there is taken to be a charge on State budget which is sufficient to demonstrate a transfer of State resources to an economic activity (the project) and hence a potential State aid to it.

Any other interpretation would mean that commercial activity carried out in-house by a local authority would not fall within State aid control and this would be an unhealthy position to take given the increasing involvement of local and regional authorities in almost all day to day commercial supply chains. Therefore a large number of projects would be taken out of State aid control simply because they are public sector in-house projects, leading to an incomplete subsidy regulation and considerable legal uncertainty (in terms of general public law obligations) for the local authorities involved.

While there is nothing to suggest in the treaty that UK Subsidy Law should mimic State aid, such a significant divergence from it may affect the UK's ability to renegotiate the treaty on more favourable terms in the future.

What happens to Central Government Funding?

The Durham judgment is relevant to a local authority allocating part of its general budget to a specific project. Its general budget will be made up of revenues from several sources and of course include funds from Central Government. In the case study the general budget of the local authority may constitute Central Government funding as well, and the Durham case applies to it equally.

There may be instances where Central Government provides the local authority with funds to carry out a specific project, as opposed to its general budget. Examples would be grants which are directed towards specific project applications submitted by local authorities to Central Government as part of a grant competition. In such cases it could be argued that this is no longer an in-house project, as the donor is a separate legal entity from the local authority delivering the project. The reasoning in the Durham case may therefore no longer apply meaning that the donor Central Government department would indeed need to satisfy itself of the reasonableness of its decision to support the local authority under Subsidy Control law.

Conclusion

The Durham case approach of course applies until it is distinguished or overruled. Until then its effect is that local authorities may be outside the reach of Subsidy Control law altogether for in-house regeneration (and other commercial) projects, despite their undeniable involvement in commercial markets. This approach is at odds with the otherwise functional nature of Subsidy Control in general and also its international counterpart of EU State aid.

As local authorities involve themselves more and more in commercial supply chains, they are rightly accorded the relative legal certainty of Subsidy Control in doing so. However by taking a large number of such projects out of Subsidy Control just because they are conducted in-house exposes local authorities to the greater uncertainty in following general public and judicial review law. Hence the Durham case may be a poisoned chalice for local authorities, and they are therefore encouraged to use separate legal entities to deliver their commercial activities. While this may entail additional administrative burden it has the advantage of bringing the project within the relatively more legally certain regulation of Subsidy Control, and also allows greater flexibility in transfer pricing its financing.

This article covers an area which is complex and hence not a substitute for detailed legal and accountancy advice. For further information or guidance please contact Jay Mehta.