Appeal Number SC/3146/2008

[2009] UKFTT 156 (TC)

TC00122

Appeal number SC/3146/2008

CGT – Exemption and relief – Disposal of qualifying corporate bond: (“QCB”) – Taxpayer acquiring loan notes in exchange for shares – Loan notes not QCBs at time of acquisition – Loan notes containing currency conversion right exercisable by issuer – Right cancelled – Whether notes becoming QCBs following cancellation of issuer’s currency conversion right - TCGA 1992 s117(2)

CGT – Conversion of securities – Crystallisation of capital gain on securities while non-QCBs – Whether transaction required to cancel issuer’s currency conversion right amounted to conversion – Yes – TCGA 1992 s132

FIRST-TIER TRIBUNAL

TAX

M. R. KLINCKEAppellant

- and -

THE COMMISSIONERS FOR HER MAJESTY’S

REVENUE AND CUSTOMSRespondents

(Capital Gains Tax)

TRIBUNAL: SIR STEPHEN OLIVER (Chamber President)

NICHOLAS ALEKSANDER

Sitting in public in London on 6 and 7 May 2009

Julian Ghosh QC and Elizabeth Wilson, counsel, instructed by KPMG, accountants, for the Appellant

Michael Gibbon and Ruth Jordan, counsel, instructed by the General Counsel and Solicitor for HM Revenue and Customs for the Respondents

© CROWN COPYRIGHT 2009

1

DECISION

1.Mr Michael Klincke, the Appellant, appeals against an estimated assessment to capital gains tax in respect of the redemption proceeds of certain loan notes (“the Notes”). His appeal to HMRC was dated 14 November 1996, it was referred to the Surbiton General Commissioners. The General Commissioners transferred the appeal to the Special Commissioners on 24 April 2008. The tribunal hearing the appeal was the First-tier Tax Chamber.

Short summary of the issues

2.The “first issue” here is whether the gain that accrued to Mr Klincke in respect of the Notes was a chargeable gain. The issue arises in the context of Taxation of Capital Gains Act 1992 section 115. (All statutory references in this Decision are to the Taxation of Capital Gains Act 1992 unless otherwise stated.) Section 115(1) provides that a gain which accrues on the disposal of qualifying corporate bonds (“QCBs”), as defined in section 117, “shall not be a chargeable gain”. This requires us to identify the asset disposed of at the time of disposal and to determine whether it was then a QCB. There is no dispute that the assets disposed of were the Notes. Nor is there any dispute that the time of disposal was the date when the redemption proceeds of the Notes fell due for payment.

3.The “second issue” arises because the Notes had been obtained as part consideration for the sale of shares in a trading company controlled by Mr Klincke and others. The Notes had not been QCBs at the time of issue. If the transaction designed to transform the Notes into QCBs had ranked as a “conversion” of the Notes within the meaning of section 132 (as HMRC contend) any “latent” gain “rolled” into the Notes would have crystallised at the time of their later redemption when they were QCBs.

Outcome

4.We dismiss the appeal on the grounds that the transaction designed to transform the Notes into QCBs was a “conversion” within section 132 with the consequence summarised in paragraph 3 above. As to the first issue we have not been able to agree. The interpretation of the words defining QCBs in section 117(1) was the subject of the decision of the Court of Appeal in Harding v Revenue and Customs Commissioners [2008] EWCA Civ 1164 and [2008] STC 3499. We have reached different conclusions as to the application of the Harding reasoning to the present circumstances.

The Facts

5.Mr Klincke, a United Kingdom resident and domiciled individual, contracted (on 2 July 1993) together with others for the sale of the entire issued share capital of High Speed Productions (Holdings) Ltd (“HSP”) to Rubicon Group Plc (“Rubicon”). The consideration obtained by Mr Klincke from Rubicon comprised 1,109,134 10p shares in Rubicon (a small part of which were held for another shareholder) and the Notes which had a nominal value of £1,857,992. The Notes were issued to Mr Klincke on 20 August 1993.

6.The Notes were governed by a Loan Note Instrument of 20 August 1993 (“the Loan Note Instrument”) constituting 3,503,004 loan notes. The parties to this instrument were Rubicon and Lloyds Bank Plc (as guarantor). As guarantor Lloyds Bank agreed (in clause 9) to pay to the note holder any amount unpaid by Rubicon 90 days after the due date for Rubicon’s payment to such note holder. Other relevant terms provide:

(a)The Notes were not redeemable until after 1994 (condition 1.1 of Schedule 1). Thereafter the Notes were redeemable at the holder’s option on 30 days’ notice (condition 1.2 of Schedule 1);

(b)Rubicon had an option to satisfy the redemption in US Dollars on notice to the holder, such notice to be given within 15 days of receipt of the notice of repayment (clauses 4.2 and 4.3). Clause 4 is set out in its entirety in the Appendix to this Decision; and

(c)An extraordinary resolution passed at a meeting of noteholders had effect to assent to any modification of the provisions of the Loan Note Instrument which was proposed by the Company (paragraph 16(e) of Schedule 3), and such an extraordinary resolution bound all noteholders whether or not present at the meeting (paragraph 17 of Schedule 3).

7.Condition 5 in the Loan Note Instrument provided that the provisions of the Instrument and the rights of the noteholder could from time to time be modified, abrogated or compromised in any respect with the sanction of an Extraordinary Resolution of the noteholders and with the consent of Rubicon. (At the time of issue of the loan notes there were six noteholders.)

8.The transactions of July and August 1993 constituted a “reorganisation” for the purposes of section 126. The gain arising to Mr Klincke on the disposal of his HSP shares was therefore “rolled over” into his Rubicon shares and the Notes. The effect of section 135 was for his HSP shares and his Rubicon shares and the Notes to be treated as the same asset acquired as the HSP shares were acquired. By the time of the transactions to which this issue relates, ie 17 October 1995, a substantial capital gain had accrued and was potentially chargeable on disposal of the Notes.

9.On 17 October 1995 an Extraordinary Meeting of the noteholders took place. An extraordinary reslution to which Rubicon consented, was held and this approved the modification of the terms of the Loan Note Instrument (by Deed of Variation executed on 17 October by Rubicon and Lloyds Bank (“the Deed of Variation”)) whereby Rubicon’s foreign currency conversion right was cancelled.

10.Prior to the execution of the Deed of Variation and the Extraordinary Resolution, Rubicon had the right to discharge its redemption obligation in dollars. The effect of that right, if exercised by Rubicon, was that the noteholder would receive a US Dollar amount whose value in Sterling on the redemption date would lie in a narrow band extending above and below the Sterling amount, being the amount that would have been repayable had Rubicon not exercised the right.

11.The tax implication of Rubicon’s right (in Clause 4) was that the Notes were not QCBs for the purposes of section 117.

Preparation for the Extraordinary Resolution of 17 October 1995

12.In April 1995 (19 months after the date of the sale agreement), Mr Klincke (with some of the other former HSP shareholders) sought advice from KPMG (accountants) on ways in which the capital gain which would arise on a disposal of the Notes might be mitigated or avoided. No tax avoidance or mitigation had been considered by Mr Klincke before then.

13.On 25 May 1995 Mr Klincke’s advisers wrote to a Mr Allenza of Rubicon. The letter points out that as things were the Notes might, at the option of Rubicon, be redeemed in US dollars. That provision, it was noted in the letter, had been introduced to prevent the Notes being QCBs for tax purposes. The proposal would involve the removal of those parts of clause 4 covering Rubicon’s foreign currency redemption right. The writer stated that he was not aware of any disadvantages to Rubicon that might arise from the proposal “and indeed there may be some limited advantages”. Rubicon were asked if they would confirm in principle that they had no objection to the proposal. On 12 June 1995 Rubicon confirmed that it had no objection. Mr Klincke’s advisers then asked that Rubicon confirm with Lloyds Bank, the guarantor, that the latter would be prepared to undertake the change. On 10 October 1995 Lloyds Bank consented to the proposed alteration of the Loan Notes Instrument and the terms and conditions of the Notes.

The events of 17 October 1995

14.At 10.00am a meeting of noteholders attended by two representatives of Rubicon and five noteholders, including Mr Klincke, took place in Hamilton, Scotland. Mr Klincke was chairman.

15.The meeting of noteholders was held on short notice (with the consent of all the noteholders). The following resolution was proposed and passed by the noteholders as an extraordinary resolution:

“THAT the terms of an instrument dated 20th August 1993 made between the Company and Lloyds Bank plc constituting £3,503,004 Loan Notes and the rights attached to the Loan Notes constituted by the said instrument be and are hereby modified and abrogated by the deletion of Clauses 4.2 and 4.3 of the said instrument and that a proposed Deed of Amendment to be made between the Company and Lloyds Bank plc effecting such amendment, a draft of which was produced to the meeting and initialled by the Chairman for the purposes of identification, be and is hereby approved.”

16.Mr Whiteman and Mr Allenza of Rubicon were in attendance at the meeting. We note the following passage in the minutes of the meeting:

“… It was further explained that the Loan Noteholders had received advice from KPMG and Counsel that the proposed alteration should take place in advance of a possible change in legislation concerning corporate bonds for capital gains tax purposes. The proposed amendment to the terms of the Loan Note Instrument and the rights attached to the Loan Notes would convert the Loan Notes from a non-qualifying corporate bond into a qualifying corporate bond which would allow the Loan Noteholders the opportunity to redeem the Loan Notes without incurring a liability to capital gains tax.”

17.This passage in the minutes of the meeting is consistent with the evidence of Mr Klincke, who told us that the meeting and the amendments were part of a “scheme” to convert the Notes into QCBs, as QCBs were not liable to capital gains tax, and that the amendments had no other purpose. So far as this is relevant we find that the sole purpose of the amendments was to turn the Notes into QCBs with the intention of avoiding the capital gains tax that would otherwise arise on the disposal of the Notes.

18.Later on 17 October 1995, following the meeting, the Deed of Variation was executed by Rubicon and Lloyds Bank plc giving effect to the Extraordinary Resolution. The deed recited in full the terms of clauses 4.2 and 4.3 of the Loan Note Instrument and recited the Extraordinary Resolution of noteholders approving the deletion of these clauses. The operative provisions of the deed were as follows:

“Now it is agreed and declared by and between the parties as follows:

1.To modify and abrogate the wording of the Loan Note Instrument and the rights attached to the Loan Notes constituted thereby by deleting clause 4.2 and 4.3 of the Loan Note Instrument in their entirety.

2.That subject to the modification and abrogation set out in clause 1 above, all the terms and conditions of the Loan Note Instrument and the rights attached to the Loan Notes constituted thereby shall remain in full force and effect and shall be binding on all the parties.

3.That this Deed is Supplemental to the Loan Note Instrument.”

19.Following the Extraordinary Resolution Mr Klincke travelled to HSP’s offices in Wandsworth, London. From there a notice of repayment was sent to Rubicon requiring repayment in respect of £1,857,942 nominal value of his Notes

Subsequent events

20.On 27 October 1995, £1,857,992 plus £3,125.48 interest was paid into Mr Klincke’s bank account. The discrepancy between the amount specified in the redemption notice and the nominal value of Mr Klincke’s actual holding (which was the amount actually paid on redemption) was not explained. We assume that it was a typographical error, and that nothing turns on it.

21.On 24 September 1996, Mr Klincke submitted his 1995/6 tax return on the basis that his disposal of the Notes was exempt from capital gains tax. An assessment to capital gains tax was issued on 6 November 1996 in the amount of capital gains of £2,500,000 of which £1,831,323 is attributable to the redemption of the Notes.

The Legislation

22.We first set out the overall scheme of the legislation, and address the provisions in detail later.

23.Where there is a reorganisation of a company’s share capital, and as a result shares previously held by a taxpayer become reorganised into other shares and possibly debentures, the result could be that the shareholder would be treated as disposing of his original shares, and a taxable capital gain or allowable loss could arise. Section 127 avoids this result by deeming there to be no disposal and treating the new shares or debentures as acquired as and when the original shares were acquired. Thus in computing the gain or loss on the later disposal of those new shares or debentures the calculation is performed by reference to the original cost of the original shares. Any gain or loss that would otherwise have arisen at the time of the reorganisation is rolled forward into the computation of the subsequent gain or loss.

24.Section 132 applies reorganisation treatment under section 127 to a conversion of securities. So, for example, on the conversion of convertible bonds into the shares of the issuing company, there is deemed to be no disposal of the bonds and the shares acquired on conversion will be treated as having the acquisition cost of the convertible bonds for the purpose of calculating any gain or loss on the later disposal of those shares.

25.Section 135 extends reorganisation treatment to shares and debentures acquired in takeovers and like transactions: where company A issues shares or debentures to the shareholders of company B in return for their shares or debentures in company B and the exchange is (very broadly) part of a takeover, the shares and debentures in company A will be treated as having the same acquisition cost as the shares and debentures originally held in company B.

26.There are additional complexities where debentures (such as loan notes) are involved. This is because some debentures are QCBs, and gains and losses on QCBs are by section 115 outside the CGT regime. The definition of a QCB is contained in section 117. The relevant parts of section 117 read (as they applied at the time) as follows:

“(1)For the purposes of this section, a “corporate bond” is a security, as defined in section 132(3)(b) –

(a)the debt on which represents and has at all times represented a normal commercial loan; and

(b)which is expressed in sterling and in respect of which no provision is made for conversion into, or redemption in, a currency other than sterling.

And in paragraph (a) above “normal commercial loan” has the meaning which would be given by sub-paragraph (5) of paragraph 1 of Schedule 18 to the Taxes Act if for paragraph (a)(i) to (iii) of that sub-paragraph there were substituted the words “corporate bonds (within the meaning of section 117 of the 1992 Act)”

(2)For the purposes of subsection (1)(b) above –

(a)a security shall not be regarded as expressed in sterling if the amount of sterling falls to be determined by reference to the value at any time of any other currency or asset; and

(b)a provision for redemption in a currency other than sterling but at the rate of exchange prevailing at redemption shall be disregarded.”

27.As a result, without further statutory provision, if a share were exchanged for a QCB in circumstances where reorganisation treatment applied, then, although the QCB would be treated as acquired as the share was acquired, the latent gain or loss in the share at the time of the reorganisation or exchange would not be brought into the CGT regime because it would be exempted by section 115. Section 116 contains provisions to address this problem (and also the converse circumstance where a QCB is exchanged for shares). Where shares are reorganised into, converted into, or exchanged for a QCB, it provides in effect that:

(a)you calculate the gain or loss which would have arisen had the shares been sold at that time for market value;

(b)you freeze that gain or loss; and

(c)when eventually there is a disposal of the QCB, although any gain or loss from fluctuations in value of the QCB itself remains exempt, the frozen gain or loss comes into charge to CGT.

28.If Mr Klincke had sold his HSP shares in 1993 for market value, a substantial gain would have arisen. If the Notes had at all times been QCBs for the purpose of section 116, then the gain arising on the exchange of the HSP shares for the Notes would have been frozen. That frozen gain would have become taxable on the redemption of the Notes. If the Notes had at all times not been QCBs, then at the time of the issue of the Notes no gain would have become frozen. Instead reorganisation treatment would have applied – with the result that on the disposal of the Notes a chargeable gain would be calculated by reference to the (relatively modest) original acquisition cost of the shares.