[2009] UKFTT 261 (TC)
TC00208
Reference No: SC/3054/2008
Corporation Tax - Joint referral of four disputed issues in relation to treatment of derivatives and to capital gains treatment of the sale of a company - scheme for the avoidance of income recognition on a re-couponing of an "in the money" fixed/floating swap - paras 15 and 28 of Schedule 26 to FA 2002 - capital gains value shifting - Section 30 TCGAct 1992- one issue determined in favour of the taxpayer company and three issues determined in favour of HMRC
FIRST-TIER TRIBUNAL
TAX
HBOS TREASURY SERVICES PLC
(now HBOS TREASURY SERVICES LIMITED)
The First Referrer
(Corporation Tax)
-and-
THE COMMISSIONERS FOR HER MAJESTY'S REVENUE AND CUSTOMS
The Second Referrer
(Corporation Tax)
TRIBUNAL JUDGE: HOWARD M. NOWLAN
Sitting in public in London on 28 – 30 April and 22 July 2009
Malcolm Gammie Q.C. on behalf of the taxpayer
Kevin Prosser Q.C. and James Rivett, counsel, on behalf of HMRC
©CROWN COPYRIGHT 2009
DETERMINATIONS
Introduction
1. This case was not strictly an appeal but a joint reference, made under paragraph 31A of Schedule 18 to FA 1998, by HBOS Treasury Services Limited ("Treasury Services") and HMRC for me to determine four disputed questions that had arisen in relation to the consideration of Treasury Services' return for its accounting period ended 31st December 2003.
2. All four issues arose in connection with a scheme implemented by Treasury Services, designed to monetise and re-coupon some highly valuable fixed/floating interest rate swap contracts with Banque AIG ("AIG"), and to achieve that basic aim in a manner designed to avoid the normal incidence of tax on such a transaction.
3. These Determinations are ordered in the following way. In paragraphs 4 to 10, I will summarise the basic facts that have occasioned the dispute between the parties. In paragraphs 11 to 15, I will indicate the four issues in dispute, and my determinations. In paragraphs 16 to 42 I will then record the facts in more detail. I will then take each issue in turn, adding information relevant only to that particular issue, the contentions of the respective parties, my decision on that issue and the reasons for it. Thus paragraphs 43 to 87 contain those subjects in relation to the first, and the most important, issue. Paragraphs 88 to 120, 121 to 138, and 139 and 140 deal similarly with the second, third and fourth issues.
The facts and the points in dispute in outline
4. By the time of the transactions that occasioned the dispute in this case, Treasury Services held various swaps with AIG that had a positive value of approximately £180 million. These were swaps under which Treasury Services was entitled to receive payments equivalent to fixed-interest payments at the rates of 11% and 9.375% on total notional principal amounts of £400 million until 2014 and 2021, whereas it was only liable to make floating-rate payments, involving in 2003 payments of roughly 5%. The more detailed facts will make it clear that the fixed receipts were hedging a large proportion of the fixed-rate exposure of other group companies in relation to bonds that had been issued when the higher interest rates had prevailed, such that the HBOS plc group as a whole effectively had a floating rate exposure for accounts and tax purposes in relation to that proportion of the bonds, the high fixed interest cost of which had been swapped into a floating rate exposure by the swaps.
5. The valuable swaps held by Treasury Services were unusual in that they did not require the party that currently had the greater liability (i.e. AIG) to provide cash collateral to secure its obligation to pay the excess payments. Since the HBOS plc group also had substantial other credit exposure to AIG, Treasury Services wished to reduce its credit exposure to AIG under these swaps. The conventional way of achieving this, whilst still preserving the benefit of the swaps, was to monetise and re-coupon the swaps. This would generally involve AIG in paying the present discounted value of the excess payments that it currently owed (approximately £180 million) for the termination of the present swaps, followed by the agreement of two replacement swaps. Under these, a new fixed/floating swap would be entered into by reference to a fixed interest rate of 5% (the then current market rate of interest) on the full principal amount, and a second amortising swap would be entered into in respect of the reducing balance of the £180 million. Under this amortising swap, Treasury Services would be receiving 5% fixed payments in return for floating rate payments on the reducing balance of the £180 million, the assumption being that the group’s ultimate fixed interest exposure would be met out of the fixed receipts under the first replacement swap, by progressive applications of the £180 million cash received, and by the reducing fixed interest receipts under the amortising swap.
6. One further important detail in relation to any re-couponing transaction is that the counter-party (i.e. AIG) would never make an outright payment exactly equal to the then discounted value of its future excess payments. Having regard to the liquidity cost of actually having to make a payment for which it otherwise had only a deferred liability, it would conventionally negotiate to pay only a lesser sum, say of £177.8 million, if the discounted value of its excess payment liability was £180 million. Whilst this reduction in payment would usually be dealt with simply by negotiating to make the slightly reduced payment of £177.8 million, an alternative was possible, and this alternative was actually adopted in this case. Thus Treasury Services agreed to make a payment of £2.2 million in return for AIG agreeing to monetise the swaps at mid-market rates (i.e. for £180 million if the swaps had been re-couponed immediately).
7. For tax purposes it was common ground that, had the swap been re-couponed in the manner suggested above, the £180 million received would have ranked as income, but that since it was hedging a long-term liability to pay 9.375% and 11% fixed interest on internal swaps held by Treasury Services with the group company that had issued the high interest bearing bonds, the income in respect of the £180 million would only be brought into account on an accruals basis as the fixed-interest payments themselves were being deducted. Equally if the payment received was the lower £177.8 million, such that in overall terms the transaction with AIG (when matched with the high interest liability on the internal swaps) occasioned a loss of £2.2 million, that loss would also only be recognised over the period of the remaining life of the bonds. Under the alternative arrangement, if a fee of £2.2 million was paid to monetise at mid-market rates, such that the loss was represented by the fee, rather than the lesser amount received, the fee would occasion the loss. The loss would similarly only be recognised over the life of the hedged liabilities, and would almost certainly have been a tax-deductible loss, if the fee had been paid for a direct re-couponing transaction effected by Treasury Services itself.
8. HBOS's dominant motive in wishing to effect any sort of re-couponing transaction was the desire to reduce its credit exposure to AIG. It was however reluctant to recognise a £2.2 million loss, and so was very attracted by a proposal put to it by Lehman Brothers, and later by Swiss Re, which it was suggested would enable it to re-coupon the swap without recognising a loss at all, since the proposal would eliminate the liability to Corporation Tax on the large payment received on the re-couponing transaction.
9. Ignoring the detail, the scheme that I will describe from now on as the Swiss Re scheme was simple. Treasury Services formed a new subsidiary called Dorus Investments Limited (“Dorus”), subscribed various shares in Dorus for £181 million cash, and novated the swaps into Dorus for £180 million in the expectation that that “group” transaction would pass all the latent tax liabilities in relation to the swaps down into Dorus, with its own £180 million receipt being tax free. It then sold Dorus to a Swiss Re company for approximately £150 million. The expectation was that within the Swiss Re group, it would be possible to monetise the swaps without the then holder being taxed on the receipt of the £180 million because otherwise, Dorus would only have been worth approximately £126 million, i.e. £180 million, minus the Corporation Tax liability of 30% of £180 million.
10. Ignoring, for present purposes, the way in which Treasury Services entered into the replacement swaps to achieve the basic purpose mentioned in paragraph 5 above, the above transactions were all that directly concerned Treasury Services, and indeed Treasury Services almost certainly did not know how it was that the Swiss Re group would manage to eliminate the potential Corporation Tax liability on the net £180 million excess payments within Dorus. It was perfectly plain that Swiss Re did expect to achieve this result however, because it would not otherwise have paid £150 million for a company with an assumed value of approximately £126 million, and it was equally obvious that the avoidance was somehow associated with a further assignment within the Swiss Re group, since various modifications to the swaps made in anticipation of the novation to Dorus and the other steps in the scheme, contemplated a further proposed novation of the swaps from Dorus to a Swiss Re company called Ampersand Investments (UK) Limited (“Ampersand”). Nothing in this case hinges on the following point, but I was told by Mr. Prosser for HMRC towards the end of the hearing that the explanation for the evaporation of Dorus’s potential liability to Corporation Tax on the £180 million was that, in the final novation, Dorus would be covered by the requirement to disregard the transaction because it was between group companies within the charge to Corporation Tax, whereas Ampersand would not be so treated because it would not, at the point of the novation, be covered by the new derivative rules.
The four points in dispute
11. The first point in dispute is whether Treasury Services was right in its expectation that the novation of its swaps in favour of Dorus was covered by paragraph 28 of Schedule 26 to FA 2002, such that by virtue of the novation being between group companies, both of which were within the charge to Corporation Tax, the novation would be disregarded, Treasury Services would avoid tax on its £180 million receipt and Dorus would potentially inherit Treasury Services’ Corporation Tax liabilities in relation to the swaps, and in particular the net liability in respect of the excess fixed receipts over the much lower floating amounts payable. This issue depended on whether the novation was covered by the wording of paragraph 28(1), either on its own or coupled with paragraph 28(4).
12. HMRC contended that the novation was not covered by paragraph 28(1) because that paragraph required the successor to “replace” the original party to the derivative, as the “party to the derivative contract”, and HMRC contended that this wording applied only to assignments, and not to novations. Paragraph 28(4) extended the application of paragraph 28(1) to apply to novations, but HMRC contended that the combined application of paragraph 28(1) and (4) did not cover the novation in this case because the rights and liabilities of the novatee after the novation had to be “equivalent to” the rights and liabilities of the predecessor immediately before the novation, and HMRC contended that certain technical features meant that the “equivalence” requirement was not satisfied in this case. My determination on these points is that paragraph 28 did not apply in this case, though I have the found the point to be very difficult, and finely balanced.
13. The second point in dispute was also difficult. It was the question of whether under paragraph 15 of Schedule 26, Treasury Services was entitled to a deduction for the fee that it paid of £2.2 million, or rather the lesser fee that was eventually paid because the provisions for variation of the fee resulted in the fee ultimately being paid in a lesser sum. HMRC’s initial contentions in relation to this issue were directed to establishing that a tax deduction should be denied if Treasury Services had succeeded on the first question and avoided tax on the £180 million, though the contentions changed during the course of the hearing. During the hearing it was contended that the fee should not be deductible because it was never the purpose of Treasury Services that it itself should monetise the swaps. My determination on this point is that the fee was deductible. This might seem natural in the light of my determination on the first issue, namely that Treasury Services was indeed chargeable to tax on the £180 million received from Dorus, but the basis of my decision on the second issue would in fact have been the same, had I determined that Treasury Services avoided the tax, as it expected to do, on the novation to Dorus, and my decision is not based on my conclusion that Treasury Services was indeed taxable on its receipt of £180 million.
14. The third and fourth questions were very inter-linked, and as they were argued before me they effectively pre-supposed that the determination on the first issue had been in favour of Treasury Services, such that it would have avoided tax on the £180 million received on the novation of the swaps. Having subscribed the shares in Dorus for £180 or £181 million, and having sold them for approximately £150 million, Treasury Services claimed that it was entitled to a capital loss of £30 million. HMRC contended that the capital gains “value shifting” provisions of section 30 TCGAct 1992 would apply if the determination on the first issue had been in favour of Treasury Services, since Treasury Services would then have received a “tax-free benefit” within the meaning of that section, and the value of the shares in Dorus would have been materially reduced in value. The third question was whether HMRC’s “value-shifting” contention was fundamentally correct, and, if it was, the fourth question was by how much the consideration for the disposal of the Dorus shares should be adjusted to conform with the provision of section 30 that required the consideration to be adjusted by “such amount as is just and reasonable having regard to the scheme or arrangements and the tax-free benefit in question.” HMRC’s contentions were that the section was in point, and that the claimed loss should simply be eliminated. Both of these questions drop away in view of my determination on the first issue, since Treasury Services has not received the “tax-free benefit” that it assumed that it would receive. Indeed the shares of Dorus had not been reduced in value either since the feature that I consider that Treasury Services was taxable on its receipt of £180 million means that Dorus was correspondingly entitled to a deduction for that payment, such that it had no material inherited tax liability, and was thus worth something close to £180 million rather than either £150 million or £126 million.
15. Since my determination on the first issue may be reversed on appeal, I will now decide the third and fourth questions on the alternative basis that Treasury Services’ £180 million receipt on the novation was tax free. On that basis, my determinations on these two points are that the section would have been in point, and that the loss should be entirely disallowed. Indeed there are only two reasons why an element of a chargeable gain ought not to be substituted for the claimed loss, one of which is that HMRC merely asserted that the loss should be disallowed. That would accordingly have been my determination on the third and fourth issues, had they not been rendered irrelevant by my determination on the first issue.
The facts in more detail and the evidence
16. The facts and the evidence given to me took three forms. I was given an agreed Statement of Facts; evidence was given on behalf of Treasury Services by Mr. Martin Cooper who had been head of trading in the Treasury Division of the HBOS banking Group, and who had been the lead negotiator in relation to all of the negotiations with AIG, Lehman Brothers and Swiss Re, and, finally, written expert evidence was given to me in relation to accounting treatment by Guy Bainbridge, ACA, a partner in KPMG LLP.
17. I will summarise the further facts that were given to me in the Agreed Statement of Facts, though some are not particularly relevant to the determination of the tax issues. I will then record the important points emerging from Martin Cooper’s evidence, though I will defer mentioning some points until dealing with the specific issues, where points are only relevant to one issue. I will finally make little reference to the accounting evidence, other than to describe the basic points that it was asserted that the accounting evidence established, and to explain why I consider that the accounting evidence was not particularly relevant.