Our
more detailed findings-in-fact emerge in our consideration of the Background
to the Scheme, Whether the options are separate transactions, and Mark to Market.
- Citibank approached
the Appellants, with whom they had an established relationship, with the scheme
on 22 June 1995 following the Appellant’s refusal to sign a confidentiality
undertaking because of that relationship. The scheme was not given to anyone
else. At that time, the scheme was called a "Negative I–generating tax
structure" (this being a reference to the I minus E method of taxing
insurance companies), about which Mr Moynihan made much play, and later it
was called a "cross options scheme." We do not find the name material;
it is admitted that it was a tax avoidance scheme. After some negotiations,
during which the collateral agreement was introduced and the strike prices
changed from 65 and 95 to 70 and 90, the scheme in its final form was put
to the Appellant’s board on 27 June 1995 since the transactions did not fall
within its normal investment guidelines; it was approved by the Board. The
options, the collateral agreement and the success fee agreement were all entered
into on 30 June 1995. The option prices were based on a price for the gilt
of 99.75 which was the price on the day the Appellant’s Board approved the
transaction. The options were entered into on commercial terms. The options
created a genuine economic risk to Citibank; they passed the risk to Citibank
NA (Frankfurt) which who managed a pool of option contracts. The fee of £60,000
built into the option prices remained with Citibank in the UK.
- The Appellant’s
investments were managed by a subsidiary, which operated in a similar manner
to an external investment adviser. This transaction was not managed by the
subsidiary and, in its investment records, the options were included with
N/A against the valuation.
- The options
were entered into on the last day for commenting on the consultative document
on gilts and bonds before the details of the legislation was known. It was
then expected that the legislation would come into force during the accounting
period to 31 December 1995 in which case it was likely that both options would
be exercised. It was announced in July 1995 that the commencement date for
companies would be deferred until 1 April 1996, the last day for exercising
the options. The options were therefore unexercised on 31 December 1995 and
were valued for the purposes of the 1995 accounts (Option A minus £34.875m,
Option B plus £14,875m with the collateral deposit being plus £20m so that
the net amount was nil). Because of an error caused by the absence of values
for the options in the investment summary, the asset of the collateral deposit
but not the net liability of the options was included in the accounts, resulting
in an overstatement of assets by £20m. This was discovered when the Department
of Trade and Industry return was made. The auditors agreed that the error
was not material.
- On 20 March
1996 Mr Paterson of the Appellant wrote [J/35] to Citibank agreeing to net
off payments and stock deliveries if both parties exercised their options.
Citibank agreed in a letter, which was countersigned by Mr Paterson on 28
March 1996 [J/36]. This agreement did not commit either party to exercise
the options, although Mr Paterson stated in his letter of 20 March that it
was the Appellant’s present intention to exercise Option B. There was no advance
agreement that both options would be exercised on 1 April 1996, although this
must have been likely by 28 March 1996. The legislation duly came into force
on 1 April 1996 and both options were exercised on that day, the last day
for exercise. Because of the agreement to net off the payments, no money or
stock changed hands.
Submissions
- Counsel for
both parties produced skeleton Notes of Argument. Mr Moynihan, for the Revenue,
produced a detailed written closing submission, which he revised in the course
of his submissions, and Mr Aaronson produced written proposed findings-in-fact.
Both counsel supplemented the written material with detailed submissions on
the law and the evidence. We are grateful to counsel for the wealth of material
presented to us and trust that we shall be forgiven for not incorporating
all of it into this decision. We have endeavoured in this part of the Decision
to distil the essential features of each side’s arguments. We consider what
seem to us to be the critical points at issue below.
Submissions
for the Appellant
- Underlying the
Appellant’s case was the acceptance that the purpose behind the transactions
under consideration was the exploitation of detailed statutory rules to produce
a statute-created loss. This could have been achieved by entering into Option
A without entering into the hedging arrangement (Option B). It was anticipated
correctly that the new rules relating to "loan relationships" (which
would include gilts) would borrow certain features from legislation dealing
with financial instruments, the effect of which would be that payments made
prior to the commencement date for the new statutory rules would be left out
of account in computing profits and losses arising from loan relationships
under the new regime (see also the Taxation of Capital Gains Act 1992 section
115 and ICTA 1988 section 128). Thus the £30m paid prior to the commencement
of the new regime was excluded from any charge to tax. On the other hand the
other elements of Option A, namely the transfer of £100m gilts for £70m was
expressly included in the new regime and created a loss of £30m. That all
this came to pass, was as a result of educated guesswork by those involved.
There were various other possibilities when the Options were entered into,
which might have had very different tax consequences. The result, submitted
Mr Aaronson, was a drafting "own goal"; the draftsman had not considered
the case where initial payments excluded from computation under the new rules
were also excluded from tax by the old regime. This appeal was likely to be
the only case where the particular own goal would lead to a win for the taxpayer.
Mr Aaronson then turned to the detail of the statutory provisions. Chapter
II of Part IV of the Finance Act 1994, as amended, has effect from 1/4/96.
Transitional provisions contained in paragraph 25 of Schedule 15 to 1996 Act
were not relevant for present purposes. He submitted that a loan relationship
included a gilt (1996 Act, section 81(1)); the relationship between the parties
constituted a debt contract or option within section 150A of the Finance Act
1994 (subsections (1) and (10)). The Appellant was a qualifying company
for the purposes of Chapter II (1994 Act section 154); the payments made were
qualifying payments (1994 Act section 153(1)(ca), 150A(5), 151). Gilts
are money’s worth therefore a transfer of a gilt is treated as a payment
(1994 Act section150A(11)). The payment of the sum of £60,000 fell within
section 150A(5)(a) or (b); it was part of the price to induce Citibank to
become a party to the transactions. Even if it does not fall with section
150A it falls within section 151. In any event it or alternatively it falls
to be regarded as small within section 152 of the 1994 Act. Each option
fell to be treated as a separate contract.
- The operative
part of the statutory scheme was section 155 of the 1994 Act. Section 155(4)
applied (mark to market basis). The sum of £30m fell to be left out of account;
it was not a qualifying payment, having been paid before 1/4/96. Accordingly,
under the new statutory rules, a loss of some £34m was made because the Appellant
had transferred £104m worth of gilts (£104 being the value of the gilts on
transfer) but received only £70m of qualifying payments. Under Option B, they
made a profit of £14m; they received £104m worth of gilts but paid only £90m.
The net loss is £20m. Without the hedging Option B, the loss under the new
statutory regime would have been greater, namely £34m. Although the Appellant
entered into the transactions on 30/6/95, it was deemed to have become entitled
to rights or subject to duties thereunder on 1/4/96 (1994 Act section 147A(2)).
As noted above, the sum of £60,000 fell to be included as part of the price
for Option B. It included an element of hedging costs. If contrary, to his
primary submission, the options fell to be treated as a single composite transaction,
the statutory provisions meant that the single transaction was a debt option
and the ultimate result was the same, namely a loss of £20m.
- Mr Aaronson
then dealt with the deeming provisions. There were two deeming provisions,
namely section 155(7) and 147A(2) of the 1994 Act. The combined effect of
section 147A(2)&(3) was that the Parliamentary draftsman failed to consider
the position of a transaction that was exempt from capital gains tax.
- As to the evidence,
Mr Aaronson began by submitting that there was a fundamental flaw in the Revenue’s
whole approach to this appeal. The flaw was that, as both Mr Mitchell and
Mr Russell stated in evidence, the scheme only worked if both options were
entered into. This, he submitted, was obviously wrong. On the evidence, there
were two legally separate contracts. They were accounted for separately by
the Appellant, and there was evidence from Mr Paterson that the Appellant
recognised that the options might not be exercised together. He relied upon
the terms of a letter dated 22/6/95 9[J/6] to Citibank from their advisers
Arthur Andersen, internal Memoranda of the Appellant dated 12/7/95 [J/28],
and 9/1/0/95 [M/11], and on the evidence of Mr Paterson and Mr Woods. This
recognition was genuine and reasonable, particularly when one considered that
there was no certainty what Citibank might do with their option (Option A).
He also drew our attention to TCGA 1992 section 144(8)(c))(iii) which recognises
that options hedging other options exist and may be taxed separately. The
relevant test was not what was expected or most likely, but whether there
was any realistic or genuine commercial possibility that the options might
not be exercised together or would be dealt with separately. An outside
chance, as Mr Grimes put it, was a genuine commercial possibility. Mr
Paterson stated that letting Option B lapse was regarded as a genuine possibility.
Here, the test was passed having regard to the foregoing considerations. Mr
Aaronson invited us to make a series of factual findings to support this contention
and other arguments. He accepted that if we held that there was no genuine
commercial possibility of the Options not being exercised together, then the
appeal failed.
- On the issue
of mark to market (section 155(4) of the 1994 Act), Mr Taylor’s view,
according to Mr Aaronson, was that one should mark to market, even where netting
off is carried out. Netting could not change the nature of the arrangements
or the operation of the tax code. Even Mr Mitchell, whose view was based upon
the proposition that the options had to be exercised together accepted the
mark to market basis as appropriate if the options were exercised separately.
The policy of the Appellant was to mark to market; and this was consistent
with commercial or normal accountancy practice.
- As to the question
of the "loan" it was a collateral contract that could not be treated
as part of the options contracts. It was described by the parties as a collateral
deposit [see J/35 letter dated 20/3/96 Appellant/ Citibank, and J/36 letter
dated 28/3/96 Citibank/ Appellant. The legislation did not contemplate such
a deposit being treated as a qualifying payment. Moreover, it required
separate accountancy treatment. In relation to the authorities, Mr Aaronson
referred us to the decision of the House of Lords in MacNiven v Westmoreland
2001 STC 237 and, in particular, paragraphs 47-49, 56, 59-62. He accepted
that there was no commercial loss but submitted that that did not matter because
we were here dealing with a series of highly technical statutory provisions.
It did not matter if the only purpose was the exploitation of a drafting blunder
and the creation of a tax loss. He next referred us to Griffin v Citibank
Investments Ltd 2000 STC 1010, especially paragraphs 33-49 and 52-53.
He submitted that paragraph 43 was no longer good law having been superseded
by MacNiven. He also informed us that the Revenue were refused leave
to appeal in Griffin. He argued that it would be wrong to say that
there was no practical likelihood that the options in the instant appeal
would not be exercised on the same date. Finally, he referred to the decision
of Special Commissioners Cornwell-Kelly and Wallace in HSBC Life (UK) Ltd
v Stubbs 6/11/01, LON/SC00295 paragraphs 54, 71, 73, 81, and 87-89
Submissions
for the Revenue
- Mr Moynihan
began by making submissions on the evidence. He submitted that (1) the transaction
(he used the singular) had no other commercial purpose than the securing of
a tax advantage; (2) given the strike prices, there was no commercial (practical
or realistic) likelihood of there being any financial consequence for either
party; this was the expectation of both the Appellant and Citibank; (3) the
relevant contract had to be identified for the purposes commercial accountancy
issues, the proper interpretation of the statutory provisions, and the Ramsay
argument; the relevant contract was a single composite transaction, or
it least it became so by the relevant date, if not before; (4) there were
five steps in the transaction, namely (i) Option A, (ii) Option B; (iii) the
Collateral Agreement; (iv) the premium payable for Option B ie £9.75m plus
the initial fee of £60,000; and (v) the Structuring Fee, which was the lesser
of (a) 10% of the tax saved less £60,000, or (b) the sum of £240,000; (5)
the transaction itself was unique; (6) steps (i) to (iii) of the transaction
were inter-linked and were the constituent parts of the tax scheme, and (iv)
and (v) were Citibank’s fee for licensing its scheme to the Appellant; (7)
what actually happened, ie both options being exercised on the same day, was
the most likely outcome and what parties expected to occur; (8) Steps (i)
to (iii) were self cancelling and there was no commercial purpose other than
an attempt at tax avoidance in exchange for a success fee, (9) there were
various inbuilt checks and balances to ensure that the options had no separate
commercial value, such as the Collateral Agreement and the reduction of the
strike price from 95 to 90; (10) by 28/3/96, if not before, the operative
parts of the scheme had become indivisible and self cancelling; an agreement
was entered into on that date whereby it was agreed that if the Appellant
exercised its option on 1/4/96 both options would be exercised on that date
and netting off would apply, (11) Option B was not simply a hedge; it was
thought that it would produce its own tax advantage, but this has now been
conceded by the Appellant.
- Mr Moynihan
then referred us to Griffin, Piggott v Staines Investments Co Ltd1995
STC 114 at 134E-H, and MacNiven, particularly paragraphs 33, 34,
40, 49, 58. He submitted that we should approach matters in a commercial manner.
He accepted the test could be expressed in terms of genuine commercial
possibilities. There was no justification for applying mark to market
separately to the two options. It had to be established that doing so
accorded with normal accountancy practice; this requires an examination
of the substance as well as the form of the transaction; the question whether
there was no genuine commercial possibility of a fall in the value of the
gilt to less than 90 or 70 was not considered by the Appellant’s management.
- In relation
to the Collateral Agreement, Mr Moynihan submitted that even if the two options
were qualifying contracts it was wrong to exclude the payment under
the Collateral Agreement from the aggregate of qualifying payments; the Collateral
amount was part of the consideration for Option A; it was part of the consideration
for the debt contract and is therefore a qualifying payment. Mr Moynihan then
submitted that the fee for the proprietory tax scheme was not a debt contract;
moreover, there has to be a debt contract as at 1/4/96 for the Appellant’s
scheme to work. Given the agreement on 28/3/96 to net off with the result
that neither stock nor money would be exchanged it would be nonsensical to
speak of any subsisting rights or duties under a debt contract or of any entitlement
or duty to become a party to a loan relationship.
- Mr Moynihan
made a number of subsidiary arguments. He submitted, in particular, that section
155(7)(a) of the 1994 Act did not apply to deemed acquisitions; deemed
acquisitions fall to be entered at their market value as at midnight on 31/3/96.
He referred us to Marshall v Kerr 67 TC 56 and Jenks v Dickinson 69 TC
458 at 487-8 for the proposition that deeming provisions may be limited
in effect if a literal application would produce unjust or absurd results.
He attached two computations to his written submissions to demonstrate his
arguments.
Whether
the options are separate transactions
- In relation
to a series of transactions, it is well recognised that the only time they
can be considered as a single transaction is when there is no practical likelihood
that the events will not take place in the order ordained. As was stated by
Patten J in Griffin v Citibank Investments [2000] STC 1010, 1038 this
does not refer to a theoretical possibility but a genuine practical likelihood.
In the words of Lord Oliver in Craven v White [1988] STC 476, 503h
the test is whether "the successive transactions are so indissolubly
linked together, both in fact and intention, as to be properly and realistically
viewed as a composite whole." We approach the question of the separate
nature of the options and the collateral agreement in this light.
- The combined
effect of the two options is that so long as the price of the gilt is above
90 neither party makes a profit or a loss when they are both exercised; the
profit on one option is always offset by the loss on the other. If the price
of the gilt was below 90, the Appellant would not exercise Option B but would
buy cheaper in the market and make a profit of the amount by which the price
was below 90 and Citibank would make a corresponding loss. The maximum profit
for the Appellant and loss for Citibank is £20m which occurs when the price
of the gilt falls to 70. The options are therefore self-cancelling if there
is no practical likelihood or no genuine commercial possibility of the price
falling below 90. Accordingly we examine this aspect first.
- On this point
there was the following evidence. At the time of grant of the options the
price of the gilt was very volatile. There had been a 4 point rise in May
1995 then a 3.5 point fall in June 1995. The price was 101.28 on 22 June 1995
and 99.06 on 29 June 1995, a fall of 2.2 points in a week. Mr Grimes showed
that a drop from 99.16, the price on 30 June 1995 when the options were granted,
to 90 represented a rise in interest rates of 2.25%. The chance of a change
of this magnitude occurring, based on the Financial Times 5 year gilt indices,
was 0.26% (based on 1990 to 2000) to 0.45% (based on 1984 to 1990) in the
2 months during which the options could not be exercised, the latter period
being in his view more relevant because of the degree of volatility in the
market in May and June 1995. During the 9 month life of the options the chance
was about 3% which he said might be an over-estimate. Mr Paterson, acknowledging
that the future was unknown, said that the chances were similar to that on
an outsider winning a horse race. In re-examination his assessment was 20-1
to 25-1 which was 5%-4%. It is interesting that in an internal note (written
on the notepaper of a subsidiary of the Appellant, Prolific Life Asset Management
Limited) on 12 July 1995 [J/27], Mr Simon Burke, then Group Tax Manager of
the Appellant, drew to the attention of his colleagues the announcement that
the legislation would come into force on 1 April 1996 and referred as a consequence
of the postponement of the expected date to the possibility of making a profit
if the price dropped below 90.
- In evaluating
this aspect of the appeal, we emphasise that the price of the gilt depends
on market forces, particularly interest rates, which are outside the control
of the parties. In asking the question (whether there was any practical likelihood
or genuine commercial possibility of the strike price of the gilt falling
below 90) we are also speculating about the future about which there can be
no certainty (it is worth recalling that we were sitting during the events
of 11 September 2001). The past occurrence of price movements during a 9 month
period is a guide to the future but only that. It is also relevant that Citibank
was willing to enter into a transaction under which it made a loss if the
price of the gilt fell below 90 but, apart from the fee built into the option
price, it could never make a profit. This suggests that they did not consider
that making a loss was particularly likely, although as a dealer in options
they would be able to offset the liability. They regarded the £60,000 as including
the cost of hedging the risk they were taking. We accept Mrs Austin’s evidence
to this effect; she was clear and firm on this point and we can find no reason
to disbelieve her; Mr Grimes was of the view that the sum of £60,000 would
have included a risk element; we therefore reject the Respondent’s attack
on her reliability. Mr Burke’s note of 12 July 1995 [J/28] showed that the
possibility of making a profit was in the minds of officers of the Appellant
shortly after entering into the options. Our decision, based on this evidence,
is that the price falling below 90 was unlikely but not so unlikely that one
could say that there was no practical likelihood of its occurring, and accordingly
that there was a genuine practical likelihood or to put it another way a genuine
commercial possibility that the Appellant would not exercise Option B. We
were attracted by Mr Paterson’s horse race analogy which gets away from seemingly
exact figures. If the chance of the price movement occurring was similar to
an outsider winning a horse race we consider that this, while it is small,
is not so small that there is no reasonable or practical likelihood of its
occurring; outsiders do sometimes win horse races. It follows that there was
a genuine practical likelihood or a genuine commercial possibility that the
Appellant would not exercise Option B. The result would be that the Appellant
would make a profit and Citibank a loss.
- We consider
that, while it is near the limit, this degree of uncertainty saves the transactions
from being ignored for tax purposes. Mr Moynihan tried to argue that nobody
would carry out the transaction for that small possibility of profit. The
Appellant admits that; they did it for tax reasons, not in any expectation
of making a profit from the price of the gilt falling below 90, but the point
is that they did something that had a sufficient degree of uncertainty attached
to it that we cannot ignore what they did. Mr Moynihan argued strongly that
(as the Appellant admits) this is nothing but a tax avoidance scheme in which
no money passed, apart from the fee of £60,000, nobody acquired any gilts,
and in the end everything cancelled out as was always expected. These are
serious considerations but they do not enable us to ignore the transactions.
They were genuine transactions under which the parties could make a profit
or loss even though the expectation was that they would not. In our assessment
of the evidence, this was clearly more than a mere theoretical possibility.
We can add to all this that it was, according to the evidence of Mrs Austin,
which we accept, as at 30/6/95 by no means a foregone conclusion that the
proposed legislation contained in the Consultative Document {J/3] would be
enacted.
- In the light
of this finding, we turn to the remaining facts. There was no agreement that
the options would not be exercised early. Each party was free to exercise
the options if it wanted. Had Citibank done so early and deprived the Appellant
of the opportunity of making a tax loss there was no obligation on it to return
the fee built into the price. Although it might appear that Citibank would
exercise Option A if the price approached 90 in order to force the Appellant
to exercise Option B and thereby prevent Citibank from making a loss, it did
not follow that the Appellant would exercise Option B if Option A was exercised.
It was possible that Citibank would exercise Option A without the Appellant
exercising Option B, even though that would leave the Appellant immediately
out of pocket because it would have to buy in the market above 90, perhaps
because the price was close to 90 when that option would have significant
time value. In any case, Option A was held in an options pool, and it would
not be looked at by Citibank in isolation. It was unlikely that the Appellant
would exercise Option B (which necessarily means that the price would be above
90) without Citibank exercising Option A. If by 1 April 1996 the price was
below 90 (but above 70) it is certain that Citibank would have exercised Option
A and the Appellant would not have exercised Option B. Accordingly, there
are various circumstances in which the options might not be exercised together.
- There was a
dispute between the parties about whether the Appellant thought that there
might be a tax benefit to Option B. If the Appellant were of that view, it
strengthens the Respondent’s argument that the two options should be considered
together because they would need to be exercised together. Citibank’s original
proposal of 22 June 1995 expected that Option B would be exercised before
the commencement date of the new legislation in which case any profit would
be exempt. However, Citibank’s later "deal structure" document faxed
to Mr Paterson on 27 June 1995 [J/10] states: "…it is conceivable that
the premium paid on [Option B] may be added to the purchase price of the bonds
when the option is exercised (since no relief has been obtained under the
capital gains tax rules)." No mention of this possibility is made in
Mr Burke’s memorandum of 23 June [J/7], revised on 26 June [J/9] or the supplementary
note of 26 June [J/11] by Mr Gillon for the Appellant’s Board meeting. All
of these were made before the 27 June deal structure document and refer to
a loss of £30m entirely from Option A. We find therefore that it was not part
of the Appellant’s plan to obtain any tax advantage from Option B and it is
therefore to be regarded as hedging the risk relating to Option A. Accordingly,
it was not part of the Appellant’s plan that both options must be exercised
at the same time. Indeed it may have been their original intention to exercise
Option B before the legislation coming into force, which, with the benefit
of hindsight, would have been the better course of action.
- We find that
the Collateral Agreement [J/20] is separate from the two options. It consisted
of a genuine loan or at least a genuine deposit. Its purpose was to provide
Citibank with security and to remove the incentive for Citibank to exercise
Option A early. There was no right to offset it against payments under the
options.
Mark
to market
- For the Appellant
to succeed under the legislation which we consider below it has to show that
the mark to market basis of accounting, that is that the options should be
valued in the accounts on each accounting date and the profit determined by
the difference, is applicable to the transactions; if the alternative accruals
basis of accounting applied there would be no loss accruing on 1 April 1996.
Section 156 of the Finance Act 1994 provides:-
(1) Where, for
the purposes of a qualifying company’s accounts, profits and losses for an
accounting period on a qualifying contract held by the company are computed
on—
(a) a mark to
market basis of accounting which satisfies the requirements of this section,
or
(b) an accruals
basis of accounting which satisfies those requirements,
profits and losses
for the period on the contract shall be computed on that basis for the purposes
of this Chapter.
…
3) A mark to
market basis of accounting satisfies the requirements of this section as regards
a qualifying contract if—
(a) computing
the profits or losses on the contract on that basis is in accordance with
normal accountancy practice;
(b) all relevant
payments under the contract are allocated to the accounting periods in which
they become due and payable; and
(c) the method
of valuation adopted is such as to secure the contract is brought into account
at a fair value.
- This requires
determining whether computing the profits or losses on these particular options
on a mark to market basis is in accordance with normal accountancy practice.
There is the obvious difficulty that the options were left out of the 1995
Accounts of the Appellant in error. However, the fact that they were valued
for the purpose of including in the accounts suggests that this is what the
Appellant intended to do.
- Paragraph 14
of FRS 5 [M/Accounting Texts, tab 3] (ie Financial Reporting Standard issued
in April 1994) provides that the substance of transactions should be reported
in the accounts. In the case of options, paragraph 19 provides that "their
commercial effect should be assessed in the context of all the aspects and
implications of the transaction in order to determine what assets and liabilities
exist." Paragraph 59 explains that normally an option should be treated
as a separate asset from the underlying asset on which it is based. Paragraph
61 provides that "in determining the substance of a transaction incorporating
options, greater weight must be given to those aspects and implications more
likely to have a commercial effect in practice. This will involve considering
the extent to which there is a genuine commercial possibility that the options
will be exercised or, alternatively that they will not be exercised."
- Taking these
together, we find that normally a life assurance company would account for
options by considering each to be a separate asset or liability. It would
be normal accounting practice to mark to market such options (unless designed
as a hedge). In relation to Options A and B in the light of our previous finding
about the possibility of the price of the gilt falling below 90, we find that
there was a genuine commercial possibility of Option B not being exercised.
Such a view must be made at the time of grant of the options and the treatment
does not vary because of later events. In particular, the agreement made on
28 March 1996 to net off the transactions if both options were exercised does
not affect this point.
- The policy of
the Appellant was to compute the profit and loss of each of the options for
the accounting period to 31 December 1995 separately on a mark to market basis.
Because of an error, the valuations that had been made of the options were
omitted from the balance sheet on that date. They were included in the returns
to the Department of Trade and Industry, which resulted in the error being
spotted. It was accordingly the view of the Appellant’s management at the
time of grant of the options that there was a commercial possibility that
one of them might not be exercised. We find that the treatment that the Appellant
intended to apply was in accordance with normal commercial accountancy that
the options should be accounted for as separate assets on a mark to market
basis.
- Finally, in
relation to the correct accounting treatment, we find that the £20m under
the collateral agreement could not be netted off against the options. This
is because there was no right to insist on a net settlement of the amount
payable under the options and the receivable under the Collateral Agreement.
Following the agreement to set-off on 28 March 1996, it was proper to net
them off. The mark to market basis still applied because that had to be determined
at the time of grant of the options. But following the agreement to net off,
it applied to the net amount.
The
approach to interpreting legislation in relation to a tax avoidance scheme
- We remind ourselves
that judicial anti-avoidance doctrines are an approach to statutory construction.
Following McNiven v Westmoreland [2001] STC 237, one must identify
the concept to which the statute refers and determine whether this is a legal
one or a commercial one. As Lord Hoffmann said at p.257a "The fact that
steps taken for the avoidance of tax are acceptable or unacceptable is the
conclusion at which one arrives by applying the statutory language to the
facts of the case. It is not a test for deciding whether it applies or not."
The statute which we consider below uses commercial concepts like normal accounting
practice and couples these with extremely detailed legislation involving formulae
for computing profit or loss. Such detailed statutory material does not generally
leave room for a commercial interpretation; the concepts are in the main legal
concepts.
Application
of the legislation
- Accordingly,
we turn to attempting to apply this complex statutory code to the transactions.
Section 154 of the Finance Act 1994 provides:-
(1) Subject to
subsections (2) and (3) below, any company is a qualifying company for the
purposes of this Chapter.
Subsections
(2) and (3) are not relevant. The Appellant is accordingly a qualifying company.
- Section 150A
provides:
(1) A contract
is a debt contract for the purposes of this Chapter if, not being an interest
rate contract or option or a currency contract or option—
(a) it is a contract
under which, whether unconditionally or subject to conditions being fulfilled,
a qualifying company has any entitlement, or is subject to any duty, to become
a party to a loan relationship; and
(b) the only
transfers of money or money’s worth for which the contract provides (apart
from those that will be made under the loan relationship) are payments falling
within subsection (5) below and payments falling within section 151 below.
…
(5) The payments
falling within this subsection are—
(a) a payment
of an amount representing the price for becoming a party to the relationship;
(b) a payment
of an amount determined by reference to the value at any time of the money
debt by reference to which the relationship subsists;
…
(11) For the
purposes of this section and, so far as it relates to a debt contract or option,
of section 151 below the transfer of money’s worth having a value of any amount
shall be treated as the payment of that amount.
Section
151(1) provides:
(1) An interest
rate contract or option, [a currency contract or option or a debt contract
or option] may include provision under which the qualifying company—
…
(b) becomes subject
to a duty to make a payment in consideration of another person’s entering
into the contract or option.
- Subsection (1)(a)
of section 151 is satisfied as the Appellant and Citibank have an entitlement
to become party to a loan relationship, namely the gilt. Subsection (1)(b)
is satisfied because the only payments are within subsection (5) of section
150A, being the price paid for the options, the price paid for the exercise
of the options, and, reading subsections (5)(b) together with subsection (11),
the transfer of the gilts pursuant to the options. The fee of £60,000 built
into the option price is part of the price for becoming party to the relationship
within subsection (5)(a). There is no entitlement to rewrite the contract
on the basis that Citibank treated it separately for their internal accounting.
The success fee is within section 151(1) as a payment that the Appellant is
under a duty to make in consideration of Citibank’s entering into the options.
- The Collateral
Agreement is clearly linked to the options but it is a separate agreement
making a loan or deposit that is not part of the options. Mr Moynihan argued
that in any practical sense the collateral amount is part of the consideration
for Option A, and legally that is so, also because it is payable when Option
A is exercised. We do not agree. It is a loan or deposit which is repaid when
the options are exercised. The only consideration is the interest foregone
which is neither "the payment of an "amount" within subsection
(5) of section 150A nor "the transfer of money’s worth" within subsection
(11) of that section. If we are wrong about this, it can be ignored under
section 152 as being small Section 152 provides:-
(1) Where—
(a) but for the
inclusion in a contract or option of provisions for one or more transfers
of money or money’s worth, the contract or option would be a qualifying contract;
and
(b) as regards
the qualifying company and the relevant time, the present value of the transfer,
or the aggregate of the present values of the transfers, is small when compared
with the aggregate of the present values of all relevant payments,
the contract
or option shall be treated for the purposes of section 149 or, as the case
may be, section 150 [or 150A] above as if those provisions were not included
in it.
(2) For the purposes
of subsection (1) above—
(a) any present
value of a relevant payment which is a negative value shall be treated as
if it were the equivalent positive value; and
(b) any relevant
payment the amount of which represents the difference between two other amounts
shall be treated as if it were a payment of an amount equal to the aggregate
of those amounts.
(3) In this section—
"relevant
payments" means—
(a) in relation
to a contract, qualifying payments under the contract; ….
The
computation of what is small depends on comparing the interest foregone on
£20m for 9 months, say £1m, with the total of the positive and negative qualifying
payments, that is (ignoring the 9 month delay and taking the value of the
gilts as it turned out to be on the day of exercise of 104) of 90+70+104+104=368m.
The amount is clearly small.
If
we are wrong about either the £60,000 fee built into the option price or the
success fee of up to £240,000 these are separately or together small in relation
to this total.
- Accordingly
the options are debt contracts within section 150A. We turn to whether they
are qualifying contracts. Section 147A provides:
(1) For the purposes
of this Chapter a debt contract or option is a qualifying contract as regards
a qualifying company if the company becomes entitled to rights, or subject
to duties, under the contract or option at any time on or after 1st April
1996.
(2) For the purposes
of this Chapter a qualifying company which is entitled to rights, or subject
to duties, under a debt contract or option both immediately before and on
1st April 1996 shall be deemed to have become entitled or subject to those
rights or duties on that date.
(3) This section
has effect subject to paragraph 25 of Schedule 15 to the Finance Act 1996
(transitional provisions).
This
must be read with section 177(2):
(2) For the purposes
of this Chapter—
(a) a company
becomes entitled to rights or subject to duties under an interest rate contract
or option,[a currency contract or option or a debt contract or option], when
it becomes party to the contract or option; and
(b) a company
holds such a contract or option at a particular time if it is then entitled
to rights or subject to duties under it;
and it is immaterial
for the purposes of paragraph (b) above when the rights or duties fall to
be exercised or performed.
It
is common ground that the transitional provisions referred to in section 147A(3)
do not apply because we are dealing with a mutual insurance company and gilts
which are not within the capital gains regime. Mr Aaronson also raised an
argument that the transitional provisions only apply to assets and not liabilities,
with which Mr Moynihan did not agree. It is not necessary for us to decide
the point. Mr Moynihan argues that because of the agreement to net-off made
on 28 March 1996 there were no subsisting rights and duties under the options.
We do not agree. The agreement to net off said merely that if both parties
exercised their options, then neither stock nor money would be exchanged;
and if the Appellant did exercise its option then Citibank should be taken
to have exercised its option. Both options continued in place and although,
by 28 March 1996, both parties expected to exercise their options, their rights
and duties under the two options continued to subsist. Since the Appellant
is entitled to rights and subject to duties under the options before and on
1 April 1996 for the purpose of section 147A(2), the Appellant is deemed to
have become entitled to rights or subject to duties on 1 April 1996. By virtue
of section 147A(1), the options are accordingly qualifying contracts.
- Section 155(7)
provides:
(7) Subject to
subsection (8) below, where a qualifying contract—
(a) becomes held
by a qualifying company at any time in an accounting period, or
(b) ceases to
be so held at any such time,
it shall be assumed
for the purposes of subsection (4) above that its value is nil immediately
after it becomes so held or, as the case may be, immediately before it ceases
to be so held.
Subsection
(8) is not relevant. Section 147A(2) deems the Appellant to have become entitled
to rights under the contracts on 1 April 1996. Mr Moynihan argued that it
did not follow that the contracts became held on 1 April 1996 so as to make
section 155(7) apply because that did not apply to deemed acquisitions. He
argued that deeming should not be allowed to produce an unjust or absurd result
following cases such as Marshall v Kerr 67 TC 56 at 79A-C, per Peter
Gibson J and 92H per Lord Browne-Wilkinson. It seems to us that since by section
177(2)(b) a company holds a contract at a particular time if it is then entitled
to rights or subject to duties under it, it follows that where a company is
deemed to have become entitled to rights under a contract on 1 April 1996,
the contract is deemed to have become held on that date so as to make section
155(7) applicable. The result is that it is to be assumed that the value of
the contract is nil immediatedly after it is deemed to have become held on
1 April 1996. At first sight the provision is odd but the reason for it seems
to be that, ignoring the transitional date, payments for entering into the
contract are taken into account and so it is not appropriate for the value
of the contract to be taken into account at the same time. It is not a case
of deeming producing an unjust or absurd result but of detailed statutory
language avoiding double counting.
- We have at last
reached the point. Section 155(4) contains the calculation to be made.
Where, as regards
a qualifying contract held by a qualifying company and an accounting period,
amount A exceeds amount B, a profit on the contract of an amount equal to
the excess accrues to the company for the period.
…
(4) Where as
regards a qualifying contract a qualifying company’s profit or loss for an
accounting period falls to be computed on a mark to market basis incorporating
a particular method of valuation—
(a) amount A
is the aggregate of—
(i) the amount
or aggregate amount of the qualifying payment or payments becoming due and
payable to the company in the period, and
(ii) any increase
for the period, or the part of the period for which the contract is held by
the company, in the value of the contract as determined by that method, and
(b) amount B
is the aggregate of—
(i) the amount
or aggregate amount of the qualifying payment or payments becoming due and
payable by the company in the period, and
(ii) any reduction
for the period, or the part of the period for which the contract is held by
the company, in the value of the contract as so determined.
We
have already found that the correct basis of accounting was to mark to market
so that subsection (4) applies. For option A and assuming that the price of
the gilt on the date of exercise is 104 (as put forward by the Appellant;
Mr Moynihan worked on the basis that the value was 101, but whatever the price
the amount will cancel out) and ignoring any increase in value during the
day, amount A is £70m and amount B is £104m, resulting in a loss of £34m.
For option B amount A is £90m and amount B is £104m, resulting in a profit
of £14m. The net effect is a loss of £20m (using the round figures we have
used throughout).
- At this point
we stand back and, like Mr Moynihan, ask whether, having accepted that a mark
to market basis of accounting is appropriate on the basis of normal accountancy
practice, a loss of £30m and a gain of £10m can occur in the course of 1 April
1996 when plainly the value of the options did not change and such a loss
and gain is not in accordance with normal accountancy practice. In particular,
it cannot have been Parliament’s intention to tax the gain on Option B which
could occur in circumstances far removed from any tax avoidance scheme. We
agree that the result is unexpected but it follows from the application of
detailed statutory provisions that do not leave room for application of a
different result. The legislation, while stating in section 156(1), that profits
and losses are computed for tax purposes on the mark to market basis, where
this is applicable, requires one to apply the formula set out in section 155
regardless of whether the result is in accordance with normal accountancy
practice. The mark to market basis of accounting in accordance with normal
accountancy practice precedes the application of the formula, and is not the
result of applying the formula. What is wrong here is that the transitional
provisions do not apply in the circumstances of this case, presumably because
the draftsman did not foresee those circumstances (hence the own goal analogy),
which is not a reason for not giving the statutory provisions anything other
than their normal meaning, particularly so in the case of detailed legislation
of this type.
- Accordingly,
the appeal is allowed in principle. We have used round figures in this decision
and we expect the parties will be able to agree the precise figures. We authorise
them to apply for further Directions etc if they cannot agree.
JOHN
F AVERY JONES C.B.E.
