Spritebeam Ltd v HMRC: debunking a few myths?

In the First-tier Tribunal (FTT),[2] there were four main issues. Regrettably for the writer, but perhaps understandably from the point of view of the parties to the case, only two of these four issues were appealed to the UT. Overall, the taxpayer lost in both the FTT and UT, but for slightly different reasons and it did not all go HMRC’s way on all points. This note looks at the FTT decision first and analyses these four issues and then considers the UT decision on the two appealed issues and offers a few comments at the end.

The FTT decision

The four main points were:
1) whether the Lender had correctly accounted for the transaction under the loan relationship rules;
2) whether the Lender was taxable under section 786(5) of the Income and Corporation Taxes Act 1988 (ICTA 1988);
3) whether the Share Recipient was taxable under Schedule D Case VI as defined in section 18 ICTA 1988; and
4) whether paragraph 13 of Schedule 9 to the Finance Act 1996 (FA 1996) (entitled “loan relationships for unallowable purposes”) applied to disallow all or part of the interest debit for the Borrower.

In the FTT HMRC argued points 1 and 2 above in the alternative and point 3 only if it failed on both points 1 and 2. Point 4 was argued whatever the outcome of points 1, 2 and 3 (so there was at least the chance that the Tribunal would tax the interest with no corresponding deduction).

Had the Lender correctly accounted for the transaction under the loan relationship rules?

As ever, the starting point for the loan relationship rules was, at that time, section 84 FA 1996. This provided that debits and credits should be made “in accordance with an authorised accounting method.” The question was whether the non-recognition of any interest credit in the accounts of the Lender was supported by an authorised method, that is, in conformity with generally accepted accounting principles (GAAP).[3] This did not mean that it had to be the only conforming method or even the best or fairest method. It was agreed that HMRC had to demonstrate that the correct and only application of GAAP in these circumstances was one which required the Lender to recognise interest income (or other profit) on the loan, notwithstanding the fact that it had never received or been entitled to receive any of that interest.

Two independent expert witnesses were used and their opinions were analysed. Since there was no UK accounting standard which specifically addressed the accounting by the Lender in these circumstances, the key reporting standard was FRS 5 (Reporting the Substance of Transactions).[4]

Put briefly,[5] HMRC’s expert focused first and foremost on the requirement in FRS 5 paragraphs 51 and 52 to consider the position of all parties to assess the overall commercial effect of the transaction, and to allow an assessment of the overall commercial logic behind the transaction. This led to the conclusion, said HMRC’s expert, that the Lender had in substance earned a return on the loan which it had gifted or contributed to the Share Recipient. The commercial benefit of the lending was not lost to the Lender on issue of the preference shares as those shares had been issued to a subsidiary of the Lender.

The taxpayer’s expert focused primarily on the requirement in FRS 5 paragraph 16 to identify whether the transaction had changed existing, or had given rise to new, assets or liabilities for the Lender. Here the Lender had entered into the loan in exchange for the right to the return of the principal and the right to insist on a transfer of value between two wholly-owned subsidiaries. Considering its net assets and liabilities position, said that taxpayer’s expert, there was no value to be attributed to the right to insist on this interest payment since: 1. the increase in net assets for one subsidiary investment on receipt of the interest was exactly offset by the decrease in net assets for the other subsidiary paying that interest; and 2. the right to insist on the payment of interest between the two subsidiaries had no intrinsic value to a third party. Accordingly, the economic benefit of the transaction for the Lender was akin to an interest-free loan to the Borrower (notwithstanding that the Borrower would not look at it this way—FRS 5 did not require symmetry) and FRS 5 did not require any recognition of income in the Lender’s accounts.

The Tribunal preferred the taxpayer’s expert’s approach—the key point being that it was correct, in the Tribunal’s opinion, to identify first the assets changed or created in order to determine the substance of the transaction rather than the other way round. Analysing this way round and considering the net position, there were no valuable assets changed or created and, testing that by reference to commercial logic and looking at the Lender’s position, this transaction equated in substance to an interest-free loan.

Was the Lender taxable under section 786 ICTA 1988?

The relevant parts of section 786 ICTA 1988 were as follows:

“Transactions associated with loans or credit”

1) This section applies as respects any transaction effected with reference to the lending of money or the giving of credit, or the varying of the terms on which money is lent or credit is given, or which is effected with a view to enabling or facilitating any such arrangement concerning the lending of money or the giving of credit.
2) Subsection (1) above has effect whether the transaction is effected between the lender or creditor and the borrower or debtor, or between either of them and a person connected with the other or between a person connected with one and a person connected with the other.
5) If under the transaction a person assigns, surrenders or otherwise agrees to waive or forgo income arising from any property (without a sale or transfer of the property) then, without prejudice to the liability of any other person, he shall be chargeable to tax under Case VI of Schedule D on a sum equal to the amount of income assigned, surrendered, waived or forgone.”[6]

HMRC’s position was that the words should be given their ordinary meaning. The issue of the preference shares to the Share Recipient was a transaction “with reference to” the lending of money between the Lender and the Borrower, and the Share Recipient was a connected person within sub-section (2) of section 786 ICTA 1988. These shares represented income arising on the Lender’s property (the loan), and the enforceable right for that income to be paid to the Share Recipient was in effect a “waiver” or “forgoing”[7] of that income by the Lender in favour of the Share Recipient.

Looking at the plain words of the section, this analysis seems to the writer to be pretty straightforward, and the FTT agreed that “it remains necessary to construe the provision according to its terms.”[8] The Tribunal agreed with HMRC that here the Lender had “forgone” interest even though it had never been entitled to it at any time, and refused to limit the scope of sub-section (5) of section 786 ICTA 1988 by reference to the sorts of transactions which it was claimed were originally targeted by section 786 ICTA 1988. But things then took an unexpected turn for HMRC. The Tribunal agreed with the taxpayer that the use of the phrase “with reference to” in subsection (1) of section 786 ICTA 1988 meant that the “transaction” needed to be something different from the loan or credit arrangement itself.[9] So the simplicity of a single loan agreement between Lender and Borrower meant that section 786 ICTA 1988 did not apply—there was no collateral transaction for section 786 to bite on.

Even though this was enough to dismiss HMRC’s arguments on the application of section 786 ICTA 1988, the Tribunal went on to consider whether section 80(5) FA 1996 meant that, in any case, section 786 ICTA 1988 was of no application. Section 80(5) FA 1996 provided:

“(5) Subject to any express provision to the contrary, the amounts which in the case of any company are brought into account in accordance with this Chapter as respects any matter shall be the only amounts brought into account for the purposes of corporation tax as respects that matter.”

This is an important provision, described earlier by Moses LJ as creating “a discrete and exclusive code” for the taxation of loan relationships.[10] The Tribunal quickly noted that noone had argued that section 786 ICTA 1988 was “an express provision to the contrary.” The taxpayer’s argument was elegantly simple: here a credit of nil had been brought into account under GAAP by the Lender in accordance with the loan relationship provisions, so there was no scope for any alternative charge outside those provisions. HMRC’s case relied on the assertion that the “matter” dealt with by section 786 ICTA 1988, being the foregoing of income, was not a matter dealt with under the loan relationships code at all, and so there was no “matter” to which section 80(5) FA 1966 could apply, leaving the door open for section 786 ICTA 1988 to fill the void. The Tribunal preferred the taxpayer’s approach here.

Was the Share Recipient taxable under Schedule D Case VI?

Schedule D Case VI taxed

“any annual profits or gains not falling under any other Case of Schedule D and not charged by virtue of Schedule A or by virtue of ITEPA 2003 as employment income, pension income or social security income.”[11]

Given that the Share Recipient was not a party to a loan relationship, the loan relationship provisions and section 80(5) FA 1996 had no application here. So we were back to basic principles—were the shares “profits or gains” of the Share Recipient under Case VI? The taxpayer focused on the need for income to have a source—a fundamental principle of tax law.[12] The Tribunal referred to several cases both ancient and modern[13] and, crucially, concluded its review by making a distinction between a purely voluntary receipt which could not have a source[14] and circumstances where, although there was no enforceable right to receive the income exercisable by the recipient of the income, there was an enforceable obligation on the payer of that income to pay it (albeit that a third party had this right to enforce its payment). Here the shares issued to the Share Recipient retained their character as “interest”, being a return at a commercial rate for the use of the money lent,[15] and the source of that interest income was the loan agreement. So the Share Recipient was taxable under Schedule D Case VI.

Did paragraph 13 of Schedule 9 FA 1996 apply to disallow all or part of the interest deduction for the Borrower?

Paragraph 13 of Schedule 9 FA 1996 applied to deny debits on a just and reasonable apportionment for loan relationships which had an “unallowable purpose.” An unallowable purpose was a purpose which was not “amongst the business or other commercial purposes of the company”,[16] and where one of those purposes was a tax avoidance purpose (a purpose which consisted in securing a tax advantage for the company or any other person), that tax avoidance purpose was a business or other commercial purpose only where it was not a “main purpose, or one of the main purposes.”[17]

Given that we have had paragraph 13 of Schedule 9 FA 1996 (or its replacement [18]) on the statute books for nearly 20 years, there have been remarkably few cases on it. In the early years it was understandable perhaps that HMRC would wish to “keep their powder dry”, relying on the deterrent effect of one of their first targeted anti-avoidance rules (TAARs). Any case on whether a tax avoidance purpose is or is not a “main purpose or one of the main purposes” remains relevant and important in a number of areas. But HMRC framed this issue in a way which the Tribunal aptly described as “a little unusual.”[19] They asked the Tribunal to reach the “inevitable conclusion”[20] that paragraph 13 of Schedule 9 FA 1996 would operate to deny some or all of the debit on the basis of three assumed facts only:

“(a) The only reason for the borrowing’s design, structure and terms was to obtain a tax advantage for the Lender and/or Share Recipient (in that the entirety of any payments made by the Borrower would escape tax altogether in the hands of the Lender and the Share Recipient).

(b) The lender, the Share Recipient and the Borrower all knew at the time of entering into the borrowing that the borrowing was designed and structured so that the Lender and/or the Share recipient would obtain the tax advantage.

(c) The Borrower had a commercial need for the borrowing.”[21]

As pointed out by the Tribunal, the question posed by HMRC was not whether paragraph 13 of Schedule 9 FA 1996 inevitably applied where these were the only potentially relevant facts, the question was whether the existence of these facts meant that paragraph 13 of Schedule 9 FA 1996 applied whatever other facts might be found in the circumstances of any particular case. There are tantalising references to IRC v Brebner,[22] Trustees of the Sema Group Pension Scheme v IRC[23] and IRC v Kleinwort Benson[24] and some odd analogies with killing and squashing flies.[25] The rather bland conclusion though was that “the fact that a tax advantage is an inevitable consequence of the entry into the loan relationship does not mean that it is a purpose of the borrower, even if he knows that will be a consequence”.[26]

Purpose could not be determined simply by reference to effect and knowledge of effect. The parties’ intentions, and the significance of the tax advantage to the taxpayer, were crucial questions to be weighed up as part of a full factual enquiry, which would also address what any “just and reasonable apportionment” might be. This meant that the three assumed facts referred to above were not always sufficient by themselves to engage paragraph 13 of Schedule 9 FA 1996, and the Tribunal decided this issue in favour of the taxpayer.

The UT decision

As mentioned above, only two of the four issues considered in the FTT were appealed. HMRC did not appeal the accounting issue (issue 1 above) or the paragraph 13 issue (issue 4 above). This approach is understandable, if a little disappointing. The accounting issue was decided following a detailed analysis of expert evidence, and perhaps it was thought likely in the circumstances that a higher Tribunal would be very reluctant to disturb the factual conclusions reached (particularly bearing in mind the high bar that had been set for HMRC to win that issue—it had to demonstrate that their approach was the only one which was GAAP compliant). The FTT had dealt with the limited facts approach by HMRC on the paragraph 13 issue thoroughly and logically and the result was probably considered not worth appealing, and it still kept some dry powder for another day.

The UT decision therefore focused on the section 786 ICTA 1988 issue and the Schedule D Case VI issue.

Was the Lender taxable under section 786 ICTA 1988?

Here the UT robustly endorsed HMRC’s uncluttered “ordinary meaning”[27] approach to the interpretation of the section and allowed HMRC’s appeal. In their view, the “plain meaning” of the section did not require any collateral or separate transaction to be engaged, concluding that any such interpretation put “form over substance.”[28] The taxpayer made another attempt to import some form of contextual or purposive tax avoidance purpose requirement, noting that the section was originally entitled and was in ICTA 1988 housed within parts of the tax code labelled “tax avoidance”, and noting that HMRC had not appealed the paragraph 13 issue. Attention was also drawn to early HMRC guidance indicating that HMRC were mainly (but not exclusively) minded to apply the section where there was income tax avoidance. In contrast to the FTT, the UT refused to import such a requirement to disturb the natural (if wide) meaning of the section.[29]

The UT did though agree with the FTT that section 80(5) FA 1996 applied to reserve all issues concerning the taxation of the Lender here exclusively to the loan relationship provisions. The UT again noted that HMRC had not argued that section 786 ICTA 1988 was an “express provision to the contrary”,[30] although one gets the impression that they might possibly have entertained this argument if it had been raised.[31] The UT otherwise endorsed the FTT’s approach here with little more to say on it.

Was the Share Recipient taxable under Schedule D Case VI?

The UT helpfully summarised the taxpayer’s primary argument on this issue into four elements:

1) the receipt must have the character of income;
2) it must be the recipient’s income;
3) it must have a source; and
4) there must be a sufficient link between the source and the recipient.

Element 1 was seemingly all but conceded by the taxpayer following the observations of Megarry J, quoted above.[32]

On element 2, the UT looked again at case law on voluntary payments and reached the same conclusion as the FTT: there did not need to be an enforceable legal right in the recipient to receive a payment before it could form part of his income. What mattered was whether there was an obligation on the payer to pay. Here, there was such an obligation on the Borrower.

The taxpayer’s position on elements 3 and 4, as interpreted by the UT, was seemingly slightly different from the way in which this issue had been argued in front of the FTT. It was now less of a question as to whether there was any possible source (since the payment did have a source—the loan agreement), it was more of a question as to whether there was a sufficient link between that source and the Share Recipient (element 4). So the focus of the debate was now on element 4.

Elements 2 and 4 were linked, but not identical. The taxpayer asserted that the case law required a sufficient degree of connection between the source and the recipient, referring to its use of words and phrases such as “possession”, “acquiring”, “existing in the hands of” and “parting with”. But the UT distilled this approach into the simple question as to whether the source of income continued to “exist” and the taxpayer continued to be connected to that source. The case law did not impose a necessary degree of connection. Here, the source was the loan agreement, the Borrower was under an obligation to pay interest, and the Share Recipient was at the relevant time the named beneficiary of that obligation. That was enough.

Comment

This case has shed some welcome light on a couple of historically slightly mysterious parts of the tax code. In the writer’s view, the UT’s approach was clear and correct on both points appealed. As a practitioner it is tempting sometimes to over-contextualise (if that is a word) parts of the tax code which seem to be aimed at particular transactions or mischief and conclude that they have no more general application, in particular the older legislation which remains on the statute books. The FTT’s decision on the application of section 786 ICTA 1988 was perhaps an example of this. This part of their decision seems to the writer to be completely at odds with the assurances given earlier by that Tribunal that the provision should be construed according to its terms without limiting it by reference to its context and the assumed mischief it targeted. Perhaps a “myth” perpetuated in the FTT was debunked here? It is a good reminder that the starting point is always to consider the plain words of the section, notwithstanding that this might on occasion lead to an anomalous or unfair result (not that it did that here).

The Tribunal decisions also provide a good and thorough summary of the doctrine of source, perhaps blowing away a few of the more archaic cobwebs that the scheduler system has allowed to be spun. The conclusion that one did not need a right to receive but only an obligation to pay neatly dealt with the rag-bag of cases on source and Schedule D Case VI referred to by the Tribunal. Another myth debunked perhaps?

The conclusion reached on paragraph 13 of Schedule 9 FA 1996 is also, in the writer’s view, an unsurprising one. Purpose is subjective and cannot be determined simply by reference to effect, even if the taxpayer was assumed to be fully aware of that effect. One might question why HMRC framed their paragraph 13 argument in such narrow terms as it seemed open to them, on the particular facts of this case, to allow a full factual enquiry into intention and significance. It is worth noting though that this was a lead case for a number of similar schemes which had been implemented. It may well be that HMRC were mindful that each scheme would have its own set of facts, so that their approach was dictated on the basis of asking the Tribunal to consider only three irreducible facts common to all of the schemes implemented.

Both Tribunals also helpfully endorsed the approach taken in previous cases that the loan relationship code was emphatically exclusive—this must be correct (however ingeniously HMRC’s Counsel argued otherwise), and this part of the decision gives a continuing degree of certainty in this difficult area.

Tim Crosley

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1 Spritebeam Ltd, Prowting Ltd, HMRC v HMRC, Versteegh Ltd [2015] UKUT 75 (TCC).
2 Versteegh Ltd, Nestron Ltd, Spritebeam Ltd, Prowting Ltd v HMRC (Spritebeam FTT) [2013] UKFTT 642 (TC)
3 FA 1996 s.85(2).
4 Financial Reporting Council, Accounting Standards Board April 1994, Financial Reporting Standard 5 Reporting the Substance of Transactions (as amended), available at: https://frc.org.uk/Our-Work/Codes-Standards/Accounting -and-Reporting-Policy/Standards-in-Issue/FRS-5-Reporting-the-Substance-of-Transactions.aspx [Accessed April 23, 2015].
5 The summary below of the expert witnesses’ reports is brief only, and may not do justice to the subtleties of some of the points made!
6 ICTA 1988 s.786(1), (2) and (5).
7 ICTA 1988 s.786(5).
8 Spritebeam FTT, above fn.2, [2013] UKFTT 642 (TC) at [82].
9 Spritebeam FTT, above fn.2, [2013] UKFTT 642 (TC) at [86].
10 DCC Holdings (UK) Ltd v HMRC [2009] EWCA Civ 1165; [2010] STC 80 at [7]. 11 ICTA s.18(3).
12 It is worth noting that HMRC did not generally concede in this case that profits or gains taxable under Sch.D Case VI needed to have a source, and they reserved the ability to argue this in other proceedings. The FTT noted this in Spritebeam FTT, above fn.2, [2013] UKFTT 642 (TC) at [105], and the UT also noted it in Spritebeam UT, above fn.1, [2015] UKUT 75 (TCC) at [55] pointing to the House of Lords decision in Brown (Surveyor of Taxes) v National Provident Institution (Brown) [1921] 2 AC 222; 8 TC 57 which had left the point open.
13 Spritebeam FTT, above fn.2, [2013] UKFTT 642 (TC) at [106]–[119]. These included Brown, above fn.12, 8 TC 57 (HL), Pumahaven Ltd v Williams [2002] EWHC 2237 (Ch); [2002] STC 1423, HMRC v Bank of Ireland Britain Holdings Ltd [2007] EWHC 941 (Ch); [2008] STC 253.
14 Relying on Stedeford v Beloe [1932] AC 388; 16 TC 505 (HL) at [126].
15 HMRC’s case was helped here by the observation of Megarry J in Re Euro Hotel (Belgravia) Ltd [1975] STC 682 (HC) at 691: “Thus I do not see why payments should not be ‘interest of money’ if A lends money to B and stipulates that the interest should be paid not to him but to X.”
16 FA 1996 Sch.9, para.13(2).
17 FA 1996 Sch.9, para.13(4).
18 CTA 2009 Ch.15.
19 Spritebeam FTT, above fn.2, [2013] UKFTT 642 (TC) at [140].
20 Spritebeam FTT, above fn.2, [2013] UKFTT 642 (TC) at [141].
21 Spritebeam FTT, above fn.2, [2013] UKFTT 642 (TC) at [141].
22 IRC v Brebner 43 TC 705 (HL).
23 Trustees of the Sema Group Pension Scheme v IRC [2002] EWCA Civ 1857; [2003] STC 95. 24 IRC v Kleinwort Benson 45 TC 369 (HC).
25 Spritebeam FTT, above fn.2, [2013] UKFTT 642 (TC) at [54].
26 Spritebeam FTT, above fn.2, [2013] UKFTT 642 (TC) at [149].
27 Spritebeam UT, above fn.1, [2015] UKUT 75 (TCC) at [12].
28 Spritebeam UT, above fn.1, [2015] UKUT 75 (TCC) at [17].
29 This is rather similar to the approach taken in the recent decision in Project Blue Ltd v HMRC [2014] UKUT 564 (TCC) on SDLT in the UT on the application of the wide-ranging FA 2003 s.75A.
30 Spritebeam UT, above fn.1, [2015] UKUT 75 (TCC) at [38].
31 Spritebeam UT, above fn.1, [2015] UKUT 75 (TCC) at [36]–[39].
32 Above fn.15.