SPC00441

TRANSFERS OF SECURITIES – loan notes provided for a fixed rate of interest of 7.43375% from issue to redemption but also provided for interest to be paid on irregular days and in irregular amounts - whether loan notes carried interest at a rate which was a fixed rate which was the same throughout the period from issue to redemption – no – whether inspector made a just and reasonable determination – yes - appeal dismissed – ICTA 1988 S717(2)(a) and (9)

THE SPECIAL COMMISSIONERS

CADBURY SCHWEPPES PLC (1)

CADBURY SCHWEPPES OVERSEAS LIMITED (2)

Appellants

- and -

ALAN WILLIAMS

(H M INSPECTOR OF TAXES)

Respondent

Special Commissioners : DR A N BRICE

MALCOLM J F PALMER

Sitting in public in London on 13 and 14 September 2004

Julian Ghosh of counsel, instructed by Gordon Slater, Group Tax Adviser for Cadbury Schweppes, for the Appellants

Ingrid Simler of counsel, instructed by the Solicitor of Inland Revenue, for the Respondent

© CROWN COPYRIGHT 2004

1

DECISION

The appeal

  1. Cadbury Schweppes Plc (the First Appellant) appeals against a notice of determination under section 41A of the Taxes Management Act 1970. The notice of determination was issued on 13 July 2001 and related to the accounting period ending on 31 December 1995. Cadbury Schweppes Overseas Limited (the Second Appellant) appeals against a notice of assessment to corporation tax dated 21 November 2001; the assessment was also in respect of the year ending on 31 December 1995.

2.Parts of each of the notice of determination and the assessment were issued because the Inland Revenue were of the view that the receipts from the transfers of certain securities should be taxed as income and not partly as capital. The Appellants appealed because they were of the view that most of the relevant receipts should be taxed as capital (against which they had capital losses to set).

The legislation

3.Part XVII (sections 703 to 787) of the Income and Corporation Taxes Act (the 1988 Act) contains provisions about tax avoidance. Chapter II of Part XVII (sections 710 to 738) contains provisions about the transfer of securities. Sections 710 to 712 contain some definitions and sections 713 and 714 contain the provisions of what is known as the accrued income scheme. The aim of this legislation is to ensure that, where a person sells the right to receive interest that has already accrued on securities, the interest element (the accrued amount) is taxed as income and not as capital. The accrued amount is taxed on the transferor but section 713(2)(b) gives the transferee the right to relief of a similar amount. The calculations assume a constant rate of interest.

4.Section 717 is intended to prevent the accrued income scheme being circumvented by the use of securities which carry a variable rate of interest. Accordingly, section 717(9) provides that, if section 717 applies, then income tax is, instead of being paid on the accrued amount, paid instead on “such amount (if any) as … is just and reasonable”. Also, by providing that section 713(2)(b) does not apply, section 717(9) also provides that in such cases the transferee is not entitled to any relief.

  1. At the relevant time the relevant parts of section 717 provided:

“717 Variable interest rate

(1)This section applies to securities other than securities falling within subsection (2) … below.

(2)Securities fall within this subsection if their terms of issue provide that throughout the period from issue to redemption (whenever redemption might occur) they are to carry interest at a rate which falls into one, and one only, of the following categories-

(a)a fixed rate which is the same throughout the period;

(b)a rate which bears to a standard published base rate the same fixed relationship throughout the period;

(c)a rate which bears to a published index of prices the same fixed relationship throughout the period. …

(6)Subsections (7) to (11) below apply if securities to which this section applies are transferred at any time between the time they are issued and the time they are redeemed. …

(9)Where there is a transfer as mentioned in subsection (6) above … section 713 shall have effect with the omission of subsection (2)(b) and with the substitution for subsections (3) to (6) of the following subsection-

“(3) In subsection (2) above “the accrued amount” means such amount (if any) as an inspector decides is just and reasonable; and the jurisdiction of … the Special Commissioners on any appeal shall include jurisdiction to review such a decision of the inspector.”

The issues

6.An associated company of the First Appellant issued loan notes to the First Appellant. The nominal value of each note was £25M and each note was redeemable on 15 December 1995. The advance was expressed to bear interest at 7.43375% per annum. However, each note provided that interest was payable by irregular amounts on irregular dates, namely: £152,748.29 on 15 June 1995; £1,705,689.21 on 15 September 1995; and £463,336.47 on 15 December 1995. On 30 May 1995 the First Appellant transferred the loan notes to the Second Appellant for £157,913,679. On 31 May 1995 the Second Appellant transferred the loan notes to Lloyds Bank for £158,138,679.

  1. The parties agreed that, if section 717 did not apply, then following the transfers of the loan notes, each of the First Appellant and the Second Appellant should pay income tax under the accrued income scheme. The dispute concerned the tax treatment of the balance of the gain. The Appellants argued that the balance of the gain was taxable as a chargeable gain because section 717 did not apply; they relied upon section 717(2)(a) and argued that the loan notes carried interest at a fixed rate which was the same throughout the period, namely 7.43375%. The Inland Revenue argued that the balance of the gain was taxable as income because section 717 did apply. They argued that the exemption in section 717(2)(a) was not applicable because, although the loan notes provided for a notional fixed rate of interest, that was not the rate at which interest was to be paid and received and so the loan notes did not carry interest at a fixed rate which was the same throughout the period from issue to redemption.
  1. Thus the main issue for determination in the appeal was whether the loan notes carried interest at a fixed rate which was the same throughout the period from issue to redemption within the meaning of section 717(2)(a).
  2. There was also a second issue, namely, whether, if section 717 did apply, the Inspector had made a just and reasonable determination pursuant to section 717(9).

The facts

10.We find the following facts which were not in dispute.

11.Prior to the transactions the subject of the appeal the Appellants received a prospectus from a merchant bank about what was called an “accrued income scheme”. The prospectus stated that the merchant bank had developed a proprietary inter-company loan instrument which had an unusual payment profile. If the First Appellant were to invest £100M in a bond, and then to dispose of it after eleven months, it would realise a capital gain of £5.5M which the First Appellant could shelter by using capital losses within the group. The new structure involved the issue of a bond with an uneven payment profile. The optimum after-tax return would be derived if the bond were sold just before the first interest payment date. The scheme was stated to be designed to defeat the provisions of sections 713 and 714 of the 1988 Act under which, where a security is purchased with accrued interest, and money is paid for that interest, that money is deemed to be income and not capital. The Appellants adopted the principles of the scheme.

12.Accordingly, on 15 September 1994, in consideration of an advance from the First Appellant to an associated company called Cadbury Schweppes Finance Limited (Finance), Finance issued six loan notes to the First Appellant. The nominal value of each note was £25M and each note was redeemable on 15 December 1995. Paragraph 2 of the loan notes provided, in so far as relevant:

“2Interest

(A)The principal amount of the Note shall carry interest at the fixed rate of 7.43375 per cent. per annum for the period from (and including) the Issue Date … to (but excluding) the Maturity Date or the date on which it is earlier redeemed in accordance with the terms of paragraph 4 (the “Early Redemption Date”) which shall be calculated on the basis of actual days elapsed (but without any compounding) and a year of 365 days and shall be paid as described in paragraph 2(B).

(B)The interest on this Note (calculated in accordance with paragraph 2(A)) shall be paid as follows:

Payment DateAmount of interest to be paid

(I)On 15 June 1995 … £152,748.29

(II)On 15 September 1995 …£1,705,689.21

(iii)On the Maturity Date£463,336.47

or

On the Early Redemption Date:

An amount equal to interest for the period from (and including) the Issue Date to (but excluding) the Early Redemption Date less, if the early Redemption Date falls after the First Interest Payment Date, an amount equal to the interest payable on the First Interest Payment Date and, if the Early Redemption Date falls after the Second Interest Payment Date, an amount equal to the interest payable on the Second Interest Payment Date.”

13.Thus each note provided that interest was payable by irregular amounts on three specified dates. These dates, together with the months which elapsed from the issue date, the amount of payment due, and the equivalent months of interest which the amount of each payment represented, were:

Date interest payableMonths after issueAmount of interest Months of interest

15 June 1995nine£152,748.29one

15 September 1995twelve£1,705,689.21eleven

15 December 1995fifteen£463,336.47three

14.Thus it will be seen that no interest at all was payable for nine months after which approximately one month’s interest became payable. No further interest was payable until the anniversary of the loan notes (15 September 1995) when approximately all the outstanding interest was payable. When the loan notes were redeemed on 15 December 1995 the remaining three months’ interest was payable.

  1. On 30 May 1995 (that is, before the first interest date) the First Appellant assigned the loan notes to the Second Appellant for £157,913,679. On 31 May 1995 the Second Appellant assigned the loan notes to Lloyds Bank for £158,138,679

16.On 9 July 1998 the Inspector of Taxes wrote to the Appellants saying that it was his view that the loan notes were variable rate securities within section 717 of the 1998 Act. The consequence of the loan notes falling within section 717 was that the accrued amount of interest on the transfer was such amount as the Inspector decided was just and reasonable. The Inspector considered that the just and reasonable amounts to be included as Case VI income for the year ending on 31 December 1995 were:

The First Appellant257

----

365x £11,150,625 = £7,851,261

The Second Appellant1

---

365x £11,150,625 = £30,549.

17.The just and reasonable amounts calculated by the Inspector, of £7,851,261 for the First Appellant and £30,549 for the Second Appellant, made a total of £7,811,810. These sums represented the amount that accrued on a straight line basis on the loan notes in the hands of the respective holders prior to the respective settlement dates.

Reasons for decision

18Before turning to consider the issues in the appeal we first summarise the relevant legislative context and the areas of agreement between the parties.

The legislative context

19.As mentioned above, section 717 appears in Part XVII of the 1988 Act which contains provisions about tax avoidance. Chapter II of Part XVII contains provisions about the transfer of securities and the aim of this legislation is to ensure that, where a person sells the right to receive interest that has already accrued on securities, the accrued interest is taxed as income and not as capital.

20.Accordingly, where securities within the scope of these sections are transferred the sections seek to tax as income that part of the consideration attributable to interest. Tax is charged on the amount received by a transferor of a security which represents (calculated on a daily basis) the amount of interest to which the transferor was entitled to for that part of the interest period in which the sale takes place up to the date of sale. Thus section 713(2) provides that, where securities are transferred with accrued interest, the transferor shall be treated as entitled to an amount equal to the “accrued amount” and the transferee shall be treated as entitled to relief of the same amount. Section 714(4)(b) provides that the accrued amount is an amount equal to the accrued proportion of the interest applicable to the securities for the period. In order to calculate the “accrued amount” in this appeal the following steps would be followed:

First one would ascertain the “interest period” in which the loan notes were transferred (section 711(3)). In respect of both assignments this was the period beginning with the day following that on which the loan notes were issued (16 September 1994) and ending with the first interest payment day (15 June 1995).

Next one would ascertain the “interest applicable” to the securities for that interest period (section 711(7)) This is defined as “the interest payable on them on the interest payment day with which the period ends” It was agreed that, for each loan note in this appeal, this amount was £152,748.29 for both the First Appellant and the Second Appellant as that was the amount of interest payable on 15 June 1995 which was the interest payment day with which the period ended.

Thirdly, one would ascertain the “accrued proportion” of the interest applicable to the securities for the relevant interest period, being the number of days in the interest period up to (and including) the settlement day, divided by the number of days in the interest period (section 713(6)) and one would apply that fraction to the interest applicable to the securities for the relevant interest period.

21.Under section 714 a person who is treated under section 713 as entitled to an amount equal to the accrued interest is treated as having received annual profits of that amount and that part of the consideration attributable to interest is taxed under Case VI of Schedule D in the hands of the transferor. The transferee, of course, receives the interest he has acquired and would normally be taxed on it. However, in order to avoid the double taxing of the interest element (which has already been taxed in the hands of the transferor) relief for the same amount is given to the transferee.

22.Section 717 is an anti-avoidance provision which prevents the accrued income scheme being circumvented by the use of securities which carry a variable rate of interest. The reason is that in such cases the normal operation of the accrued income scheme, which makes calculations by reference to numbers of days, does not adequately reflect the real value of the interest which has accrued up to the date of the sale. Neither does it adequately reflect the real value of the interest effectively capitalised in the sale price. Accordingly, securities which carry a variable rate of interest could still be used to convert income into capital. The purpose of section 717, therefore, is to provide that where variable rate securities are transferred there is an income tax charge on the real commercial value of the interest transferred and not on an artificially deflated value. It does this by providing in section 717(9) that, if section 717 applies, then instead of tax being paid on the “accrued amount” under section 713, it is paid on “such amount (if any) as … is just and reasonable”. Section 719(9) also provides that section 713 has effect with the omission of section 713(2)(b) which means that, if section 717 applies, the transferee is not entitled to any relief.

The areas of agreement

23.The parties agreed that each of the assignments of the loan notes (1) by the First Appellant to the Second Appellant and (2) by the Second Appellant to Lloyds Bank was a transfer of securities with accrued interest and therefore subject to the provisions of the accrued income scheme if section 717 did not apply. It was also agreed that, if section 717 did apply, then the application of the accrued income scheme would be modified. Relief under section 713(2)(b) would be denied to the transferee (section 717(9)); and the accrued amount would be such amount (if any) as was just and reasonable (section 717(9)). Accordingly, if section 717 applied to both assignments of the loan notes (1) by the First Appellant to the Second Appellant and (2) by the Second Appellant to Lloyds’ Bank, then both the First and Second Appellants would be taxed under Case VI of Schedule D not on the accrued proportion of £152,748.29 for each loan note as mentioned in paragraph 20 above, but on a just and reasonable amount which had been calculated by the Inspector as a total of £7,811,810, although this figure was not agreed by the Appellants.

24.These areas of agreement place the arguments of the parties into context and illustrate why the Appellants sought to argue that section 717 did not apply because the transactions came within the exception in section 717(2)(a).

25.We now consider separately each of the issues for determination in the appeal.

Issue (1) – Did the loan notes carry interest at a fixed rate?