Mr Justice Norris:
- A repurchase transaction (or "repo") is one under which securities are sold by their original owner to an interim owner subject to an unconditional commitment to repurchase those securities (or an identical parcel) at a fixed price unrelated to market value. The fixed repurchase price means that the benefits and risks of ownership remain throughout with the original owner. The transaction is an entirely ordinary commercial one, not one undertaken with tax avoidance in view: and there is a well-developed global market with quoted rates available "on screen" around-the-clock. Although in form it is one of sale and repurchase, in substance it is (like the classic mortgage) a secured funding arrangement. (To avoid the metaphysics and the sometimes pejorative connotations of the contrast between "substance and form" it might be more accurate to say that the same real event is described in the language of commercial men as "a loan" and in the language of lawyers as "a sale and repurchase"). The repurchase price of the securities is fixed by reference to the cost of the money constituting the sale price (i.e. the cash provided by the interim owner) for the duration of the interim ownership.
- During the period of their ownership by the interim owner the securities may yield an income by way of interest or dividend. This can be dealt with in one of two ways. Either the interim owner will account for the interest or dividend to the original owner immediately upon its receipt (sometimes referred to as "a gross paying repo"): or the interim owner will retain the interest or dividend and reduce the price payable by the original owner on the repurchase, so that in effect the income received constitutes a partial repayment of the loan and interest (sometimes referred to as "a net paying repo").
- In the instant case X Bank (an overseas company) sold gilts to DCC Holdings (UK) Ltd ("DCC") (a UK resident company) during DCC's accounting year ending the 31st March 2002 pursuant to five net paying repo transactions. By way of specific example, on the 30th August 2001 X Bank sold to DCC £149 million nominal of 10% Treasury Stock 2003 for £170 million: and on the 10th September 2001 it repurchased an identical parcel for £163 million. The repurchase price represented the original sale price plus interest thereon for 11 days at 4.65% but less a coupon received by DCC on the repo securities of £7.45 million. The coupon, of course, related to a period of 182 days even though DCC only held the gilts for 11 days.
- Overall in the five relevant transactions DCC bought gilts for £812 million from X Bank, and resold them (or substituted securities) for £785 million, in the meantime receiving total coupon payments of £28.8 million. Overall what it received in the transaction exceeded what it had paid by £1.8 million (£785 million + £28.8 million - £812 million = £1.8 million). In the argument about the tax consequences of these transactions it was assumed that the apportioned part of the coupon relating to the period of DCC's ownership of the gilts was £2.9 million.
- Reverting to the particular transaction I outlined, in economic terms DCC had lent X Bank £170 million at 4.65% for 11 days. But in legal terms it had bought and sold gilts at a loss and had received income by way of coupon during the period of ownership. This appeal, against the decision of the Special Commissioner Charles Hellier dated 8th May 2007, involves an examination of how the taxing statutes address that situation. It requires a consideration of the tax treatment of repo transactions generally, and a consideration of a particular category of such transactions (involving bond-based repos conducted between companies).
- It is instructive to begin with an examination of how (according to the conventions current in 2002) the question of substance and form is addressed in the company's books and accounts i.e how the real event is described in accounting terms. On this the Special Commissioner received unchallenged expert evidence from Mr Peter Holgate (senior accounting technical partner in the London office of PricewaterhouseCoopers LLP) who was called by DCC. He summarised the position thus:-
"In summary, the seller [X Bank] accounts for a fixed price repo as a fixed rate borrowing with a related interest cost and continues to recognise the underlying security as an asset in its balance sheet. The buyer [DCC] accounts for a fixed price repo as a loan receivable with related interest income and does not recognise the underlying security as an asset."
- This position results from an application of the following principles:-
(a) Accounting standard FRS5 paragraph 14 provides that
"A reporting entity's financial statements should report the substance of the transactions into which it has entered. In determining the substance of a transaction, all its aspects and implications should be identified and greater weight given to those more likely to have a commercial effect in practice. A group or series of transactions that achieves or is designed to achieve an overall commercial effect should be viewed as a whole."
(b) FRS 5 Application Note B19 deals in these terms with transactions the substance of which is that they are secured loans:-
"Where the substance of the transaction is that of a secured loan, the seller [X Bank] should continue to recognise the original asset and record the proceeds received from the buyer [DCC] as a liability. Interest - however designated - should be accrued…."
(c) So far as X Bank is concerned, therefore, it will according to these principles continue to recognise the gilts as an asset in its balance sheet, will treat the sale proceeds received from DCC as "cash received" and as a liability to be repaid, will accrue the interest payable at the repo rate over the term of the transaction, and (if a coupon payment is made on the gilts which it is carrying on its balance sheet) will recognise that coupon as income (even though the cash is received via DCC, either immediately upon payment (if it is "a gross-paying repo") or by a reduction in the repurchase price (if it is a "net-paying repo")).
(d) FRS 5 and FRS 4 do not directly and specifically address the position of the buyer under the repo transaction (DCC), and in particular do not contain a specific requirement to "net" the impact of the coupon received and the compensating onward payment of that coupon to X Bank: but in Mr Holgate's view
"… it is the consequence of applying the principles contained within the standards, which require the overall economic profit of the arrangement to be recognised in the profit and loss account."
(e) According to the application of these principles, DCC would not recognise the gilts as an asset (even though it had legal ownership), would recognise a "loan receivable" equivalent to the cash it had paid X Bank to purchase the gilts, would accrue the interest receivable on the loan over the term of the repo at the repo rate, and would record a cash receipt in respect of the coupon (but subject to an obligation to pass the cash to X Bank or to credit it to the loan receivable).
- The accounting approach accordingly uses the actual transactional figures simply as the raw data from which to work out the interest rate implicit in the transaction for the purpose of accruing the interest due or receivable in the relevant accounting period: and it is that interest (due or receivable) and not the transactional figures that will appear in the statutory accounts. With that description of the transaction itself and of the accounting principles applicable to it, it is possible to turn to the tax treatment of such transactions. In outline, the taxing statutes applicable at the time of the relevant repos did not adopt the accounting treatment of the real world transactions; but they tried to achieve the same result by a complex series of interlocking or cumulative hypotheses.
- The earliest provision that is relevant is s.730A of the Income and Corporation Taxes Act 1988 ("TA 1988") (which came into force in 1993). This was a very precisely targeted section the object of which was to treat the real legal event as if it was something different. Section 730A(1) describes repo transactions. Section 730A(2) then treats certain features of them "as if" they were something different, stating :-
" The difference between the sale price and the repurchase price shall be treated for the purposes of the Tax Acts (a) where the repurchase price is more than the sale price, as a payment of interest made by the repurchaser on a deemed loan from the interim holder of an amount equal to the sale price: and (b) where the sale price is more than the repurchase price, as a payment of interest made by the interim holder on a deemed loan from the repurchaser of an amount equal to the repurchase price".
So for tax purposes a price difference is treated as if it was a payment of interest. Where there is such a deemed payment of interest then section 730A(4) says that the repurchase price shall be adjusted so as to eliminate any difference from the sale price. What was an actual difference in price is thereby converted into a deemed income flow. To achieve this result the section does not directly adopt the treatment of the transaction in the participants' accounts as the basis for the charging of tax: rather, it creates a hypothetical world which seeks to achieve the same end. The hypothetical world contains deemed income ("…shall be treated….. as a payment of interest") and a deemed source for that income (" a deemed loan from the interim holder").
- The instant case is one in which in the real transaction legally analysed the actual repurchase price is lower than the actual sale price; but that is so only because of the terms of the transaction relating to the treatment of the coupon received during the period of the repo transaction. This possibility is catered for by section 737A TA 1988 by the adoption of another hypothesis.
- Section 737A applies if:-
(a) as the result of the transaction a dividend which becomes payable in respect of the securities is receivable otherwise than by the transferor [X Bank] (and here DCC receives the coupon); and
(b) there is no agreement for the payment to the transferor on or before the repurchase date of an amount representative of the dividend (and here DCC keeps the coupon); and
(c) it is reasonable to assume that in arriving at the repurchase price of the securities account was taken of the fact that the dividend is receivable otherwise than by the transferor [X Bank] (and here the price payable by X Bank on the repurchase is reduced because DCC has been allowed to keep the coupon).
Each of those conditions is satisfied in the present case. So section 737A(5) then requires that the following hypotheses shall be applied, namely, (a) that the relevant person [DCC] was required to pay to the transferor [X Bank] an amount representative of the coupon [of £28.8 million], (b) that a payment was made by DCC to X Bank to discharge that obligation, and (c) that that payment was made on the date when the repurchase price of the gilts became due. It is common ground on this appeal that this is the hypothesis on which the relevant transactions must be approached.
- When that hypothesis is applied then the "dividend manufacturing regulations" are engaged. The rules generally applicable to all repo transactions (covering, for example, situations where the underlying securities are shares or where the parties to the transactions are individuals) are set out in Schedule 23A TA 1988. The rules apply when one of the parties (who is called an "interest manufacturer") is required to pay to the other (who is called "the recipient") an amount which is representative of a periodical payment of interest on the securities (which is called the "manufactured interest"). This is the hypothesis required by section 737A(5).
- In a net-paying repo there is no actual payment of a sum representing the interest paid on the bond, so the representative sum is called "deemed manufactured interest": section 737C(7). Section 737C(9) provides that the repurchase price of the securities shall (for the purposes of section 730A) be treated as increased by the gross amount of the deemed manufactured interest. So the repurchase price would be raised from £785 million by £28.8 million, so making it £813.8 million, and it would then exceed the sale price for the purposes of s.730A, with the consequence that the difference between the sale price and the repurchase price would for tax purposes be treated as a payment of interest made by X Bank on a deemed loan by DCC.
- However, by paragraphs 3(11) and 3(12) of Schedule 23A the operation of its terms is modified in relation to particular transactions: they do not have effect for determining how any manufactured interest falls to be treated "for any purpose in relation to a company" in relation to which that interest falls to be treated under section 97 of the Finance Act 1996 for that purpose. It is common ground on this appeal that each transaction between X Bank and DCC falls within section 97: and it is a key section for the purposes of the appeal.
- Section 97 deals with one particular type of repo security ("an asset representing a loan relationship") and one particular category of party to a repo transaction (any "company"). So repo transactions relating to gilts and bonds and conducted between companies are singled out for special treatment under section 97 FA 1996. This section forms part of Chapter II of the Finance Act 1996 Part IV which deals with loan relationships generally, and this is the second tranche of legislation that requires consideration.
- The key concept here is that of the "loan relationship": it is the tool used to charge tax otherwise than by reference to the conventional categories of "capital", "income", "profits" and "gains" in relation to "assets". Section 81 provides that:-
" a company has a loan relationship…… wherever (a) the company stands (whether by reference to a security or otherwise) in the position of a creditor… as respect any money debt; and (b) that debt is one arising from a transaction for the lending of money".
The gilts that were originally owned by X Bank and came to be owned by DCC constitute just such a loan relationship.
- Section 80 FA 1996 declares that for the purposes of corporation tax all profits and gains arising to a company from its loan relationships are chargeable to tax in accordance with Chapter II, and it treats the "loan relationship" as a source of income (see s.80(4)). Income arising from that source is brought into charge either by bringing it into account in computing the profits of a trade or by making it chargeable to tax under Case III of Schedule D (and paragraph (3A) of Schedule D contains a special corporation tax charging provision within Case III in respect of profits and gains arising from loan relationships treated as chargeable under Chapter II). Importantly, section 82 explains how that is to be done
" using the credits and debits given for the accounting period in question by the following provisions of this Chapter".
- The relevant debits and credits to be brought into account are set out in section 84 FA 1996. This is another key section on this appeal. Section 84(1) provides:-
"The credits and debits to be brought into account in the case of any company in respect of its loan relationships shall be the sums which, in accordance with an authorised accounting method and when taken together, fairly represent, for the accounting period in question (a) all profits, gains and losses of the company, including those of a capital nature, which…….. arise to the company from its loan relationships and related transactions…".
The reference to "an authorised accounting method" is explained in section 85 to mean either an accruals basis or alternatively a "mark to market" (or fair value) basis. It is common ground on this appeal that the accruals basis applies. The reference to "related transactions" in relation to a loan relationship is explained by section 84(5) to mean any disposal or acquisition of rights or liabilities under the relationship.
- To these general rules for ascertaining the relevant debits and credits there are engrafted some special provisions, set out in Schedule 9 FA 1996, (which section 84(7) FA 1996 describes as containing provisions disallowing certain debits and credits for the purposes of Chapter II and making assumptions about how "an authorised accounting method" is to be applied in certain cases). The particular situation addressed in paragraph 15 of Schedule 9 is a disposal or acquisition of rights or liabilities under a loan relationship made in pursuance of a repo arrangement. The special provision made is that
"..in determining the credits and debits to be brought into account for the purposes of this Chapter in respect of any loan relationship it shall be assumed that a disposal or acquisition is not a related transaction for the purposes of section 84"
So the debits and credits that would otherwise arise are disallowed or ignored.
- Now that the context of section 97 has been explained it is possible to refer to its terms. So far as relevant to this appeal they are as follows:-
"(1) This section applies where (a) any amount ("manufactured interest") is payable by…or to any company under any contract…. relating to the transfer of an asset representing a loan relationship: and (b) that amount is…. representative of interest under that relationship ("the real interest").
(2) In relation to that company the manufactured interest shall be treated for the purposes of this Chapter (a) as if it were interest on a loan relationship to which the company is a party; and (b) where that company is the company to which the manufactured interest is payable, as if that relationship were the one under which the real interest is payable.
(3) Any question whether debits or credits falling to be brought into account in the case of any company by virtue of this section (a) are to be brought into account under section 82(2) [which deals with loans for the purposes of a trade]…; or (b) are to be treated as non-trading debits or non-trading credits, shall be determined according to the extent… to which the manufactured interest is paid for the purposes of a trade carried on by the company…
(4) Where section 737A(5) of the Taxes Act 1988 (deemed manufactured payments) has effect in relation to a transaction relating to an asset representing a loan relationship so as, for the purposes of Schedule 23A to, that Act, to deem there to have been a payment representative of interest under that relationship, this section shall apply as it would have applied if such a representative payment had in fact been made."
By this last subsection the "deemed manufactured interest" brought into being by s.737A(5) is brought within section 97. It is then provided by section 97(2)(a) that that deemed manufactured interest is for the purpose of Chapter II to be deemed to be interest under a loan relationship. This deeming treats DCC ("the interest manufacturer") as if it were a borrower under a loan relationship paying the deemed manufactured interest to X Bank (whereas the substance of the transaction, as reflected in the accounts of the participants, is the exact opposite namely that it is X Bank that has borrowed money from DCC and is paying interest to DCC). In this respect the hypothesis does not reflect the underlying economic reality.
- When section 97 was placed before Parliament as Clause 10 of the bill the Minister of State explained to the House that it
" …ensures that the tax rules for the treatment of repos reflect the underlying economic reality of the transaction. It also prevents the risk of tax being lost by repos being used to turn income into capital… The new clauses also provide for the price differential under a repo to be treated as interest for tax purposes and for consequential adjustments to be made to the capital gains tax rules".
- It is something of a disgrace that in order to work out the tax consequences of an entirely ordinary commercial transaction one must refer to about 20 closely articulated and specific statutory provisions replete with cross references: and it is a matter of no great credit that the eventual method of charging tax is to postulate a notional sum paid under a hypothetical obligation, which notional payment is then itself treated "as if" it was something else so that it can be deemed to affect the repurchase price and create a fictional income flow. Having entered into such a maze of hypothesis, notion, fiction and deeming it would be no surprise to discover that the draftsman did not find himself quite where he intended or facing the direction he thought.
- When DCC made its corporation tax return for the relevant accounting period it included as a credit the £1.8 million economic profit that it had made on the transactions (being also the notional interest arising from the adjusted repurchase price under section 730A). It is common ground on this appeal that it was correct so to do (though the parties have from time to time differed as to why it was correct). DCC then deducted as non-trading debits the £28.8 million (which was the manufactured interest payment that section 97(4) said had to be treated under section 97(1) and (2) as interest payable under a loan relationship). HMRC's original position was that DCC was correct to do so: but it subsequently modified its position, and has further modified it on this appeal. DCC did not in its return for the relevant accounting period bring in as a credit the £28.8 million coupon which it had actually received. This is the key issue on the appeal. HMRC's position is that DCC must in its tax computation bring in some credit to cancel out the debit which sections 97(1) and (2) entitle it to make (and it is because the credit must cancel out the debit that in argument HMRC has changed its position as to whether the correct debit was £28.8 million or some other figure). These are the issues that came before Mr Charles Hellier as a Special Commissioner.
- DCC and HMRC identified three issues critical to the outcome of the appeal; and in this judgement I will adopt that structure.
- The first issue was whether, having regard to the hypotheses on which DCC is to be taxed, there could ever be any question of DCC having to give credit for the £28.8 million coupon at all. DCC's position was that in the hypothetical world created by Chapter II of Part IV FA 1996 it never became a party to the "loan relationships" represented by the gilts. Just as in the accounting treatment of the real transaction (under FRS 5) DCC would not show itself as the owner of the gilts, so in the hypothetical world created in Chapter II it was not to be treated as the owner of the gilts. Thus there could be no question of DCC ever having to give credit for the coupon receivable by the owner of the gilts, because it must be assumed that it was not the owner.
- DCC's argument proceeded as follows. The key concept in Chapter II is that of "the loan relationship". Section 82 FA 1996 requires the loan relationships to be identified, and says that, for the purposes of corporation tax, profits and gains and deficits are to be identified and computed by following the provisions of Chapter II. Section 84 then says that the credits and debits to be brought into account are those which fairly represent all the profits gains and losses arising to DCC from its loan relationships and related transactions, but that this is subject to the provisions of Schedule 9 to the Act. Section 84(5) defines "a related transaction" as a disposal or acquisition of rights or liabilities under the loan relationship. Paragraph 15 of Schedule 9 requires that "in determining the debits and credits to be brought into account" for the purposes of Chapter II "it shall be assumed" that in a repo arrangement neither the disposal nor acquisition of the underlying gilts is a "related transaction". This (says DCC) means that in determining the relevant debits and credits one must make a statutory assumption that the sales of the gilts by X Bank to DCC and the sales of the gilts by DCC to X Bank are not disposals or acquisitions of rights or liabilities under the loan relationships: accordingly if there are no disposals or acquisitions the statute requires the assumption that the rights and liabilities under the gilts remain with X Bank and that DCC does not become a party to a loan relationship represented by the gilts. If it is not a party to the loan relationship represented by the gilts for the purposes of Chapter II it cannot be required to give credit for the coupon receivable by someone who is a party to the loan relationship.
- Mr John Gardiner QC submitted that this analysis and understanding was supported by the draft speaking notes prepared for the Economic Secretary to the Treasury at the time when the bill was promoted. Referring to what was then paragraph 14 of Schedule 8 to the bill the notes state
"…where a company …..repos a loan relationship which it holds it retains the economic benefit of that loan relationship. The company will therefore continue to show the loan relationship as an asset and to accrue income, such as interest, arising from that loan relationship. This paragraph ensures that the new rules follow the accounting practice in this respect"
The draft note, of course, refers to the party in the position of X Bank in the transaction: but Mr Gardiner QC submits that the policy it espouses must apply equally to the party in the position DCC. He also referred to some draft notes on the bill obtained from the Board of Inland Revenue under the Freedom of Information Act which stated (in relation to what became paragraph 15(1)) that, in computing profits and losses, disposals and acquisitions under arrangements described in that paragraph "shall not be treated as related transactions and may therefore be disregarded". Finally, he said that this understanding was also evident in the like explanatory notes prepared for the 2002 Finance Bill which amended paragraph 15, it being explained that the amendment
" makes explicit what was implicit in the paragraph as it stood before this amendment. That is, treating a repo or stock lending transaction as not involving a related transaction… also means that the seller or lender is treated as remaining a party to the loan relationship concerned. Similarly the buyer or borrower is not treated as becoming a party to the loan relationship…"
- The Special Commissioner rejected this argument. He held that paragraph 15 was precisely targeted at debits and credits which could otherwise arise on the "related transactions" involved in a repo, and that its purpose and effect was simply that no debits or credits should be brought into account in respect of such related transactions. He described it as "interference… with a defined term…. a definitional provision which, in a closely articulated manner, affects the way in which section 84 operates".
- In my judgement the Special Commissioner was correct. Mr Gardiner QC is reading paragraph 15 of Schedule 9 as if it said that "for the purposes of determining the credits and debits to be brought into account in relation to a repo arrangement it shall be assumed that there is not an acquisition or a disposal". But the only assumption actually required by paragraph 15 is that any disposal or acquisition is not "a related transaction" i.e. that the actual disposal or acquisition is not within the category of "loan relationships and related transactions" in respect of which all profits, gains and losses (including those of a capital nature) have to be brought into account under section 84(1) FA 1996 for the purpose of being brought into a charge to corporation tax under section 80(1). The assumption is that the identified transaction is not a taxable event, not that there is no transaction.
- I consider that treating DCC as having acquired the gilts but not being liable to bring into account any gain simply arising on their acquisition and disposal
(a) to be evident from the actual words used in paragraph 15(1);
(b) to be implicit in other provisions of the paragraph - in particular paragraph 15(5)( the terms of which mean that if DCC had made disposal of rights under securities by way of discharge that would have been "a related transaction" which would have to be brought into account, something that is possible only if DCC had acquired the rights);
(c) to be apparent from the structure of paragraph 15 as a whole, which would not have taken the form it does if its intended effect was simply say that a repo transaction does not create a loan relationship;
(d) to be consistent with the claim DCC itself makes to be able to debit "the deemed manufactured interest" payment under s.97(4) FA 1996 (which it can only do if it was a party to a contract relating to the transfer of an asset representing a loan relationship).
- I accept that a construction of paragraph 15 which treats DCC as having acquired the gilts (but treats the acquisition and disposal as non-chargeable events) does not mirror the accounting treatment that is given to the transaction under FRS 5 (which would treat DCC as not having acquired the gilts). But that is simply because the Taxes Acts proceed in this respect not on the footing that tax is to be charged by reference to the economic profit as apparent from a company's accounts prepared in accordance with GAPP, but on the footing that tax is to be charged on deemed income flows created by the application of a succession of hypotheses required by the Taxes Acts. The statute does not adopt accounting practice: it seeks to achieve the same result but by a wholly different means.
- The draft speaking notes prepared for the Economic Secretary to the Treasury for the 1996 bill do not help in this regard. Both DCC and HMRC were agreed that there was no evidence that they were ever read out in Parliament, and I do not regard them as a permissible aid to construction. Nor do I think that their terms actually do assist. The draft notes said only that the new rules were intended to "follow" accounting practice i.e were intended to bring about the same result.
- I further accept that the construction I favour means that paragraph 15(6) adds little to section 730A itself: Mr Gardiner QC went so far as to describe it as "wholly otiose" (though Mr Furness QC disputed this). The point is that because of the price adjustment provisions contained in section 730(A)(4), even if the disposal or acquisition of the gilts was treated as "a related transaction" there would never be a price difference which could give rise to a charge to tax. The actual charge to tax is on the deemed interest arising from the deemed loan and is achieved by eliminating the price difference. This will generally be true. But I do not regard the "redundancy" argument as of any real strength in the complex world created by the sundry hypotheses and assumptions which the taxation scheme requires to be made. The draftsman is simply not quite where he thought he was and has made provision for a difficulty which was not in fact created by his other hypotheses.
- I also accept that my construction runs counter to the Explanatory Notes to the Finance Bill 2002. Explanatory Notes may be of assistance when considering the context in which an Act is passed and the mischief at which it is aimed: R (Westminster CC) v National Asylum Support Service [2001] 1WLR 2956 at 2959E. The explanatory notes brought my attention in this case may therefore assist in the construction of the Finance Act 2002: but they cannot assist in the construction of any earlier statute.
- Mr Gardiner QC's points were well made but cannot overcome the actual words of the paragraph which require only the assumption that particular actual transactions are not "related transactions" for the purposes of section 84 FA 1996.
- I move to the next issue. Since DCC is (on this construction) a party to the "loan relationship" represented by the gilts the second question that rises is: "What "credit" is it required to bring into account (if any) in respect of that loan relationship?". Section 84 FA 1996 requires DCC to bring into account those credits and debits which, in accordance with the accruals basis of accounting, when taken together, fairly represent for the accounting period in question all profits which arise to DCC from its loan relationships. The question is whether this includes the £28.8 million coupon on the gilts (which in the accounting treatment of the transactions will be treated as accruing to X Bank as in substance continuing owner of the securities). The possible answers are : (a) nothing (because under FRS 5 and the accruals method of accounting it is X Bank not DCC that is accruing the income): (b) £28.8 million (because that is what DCC actually received, albeit in respect of a 182 day period when it only held the gilts for a much shorter time): and (c) £2.9 million (the amount of the coupon referable to the period of DCC's ownership on an accruals basis).
- The Special Commissioner decided that no credit at all needed to be given in the tax computation in respect of the coupon. He did so for reasons which impact also on the third question which arises: and it is therefore convenient to state that question at this point. The third question is "What debits should DCC bring into account? In particular is it entitled to make a debit of £28.8 million under section 97 FA 1996?". The arguments on the construction of section 84 and on the construction of section 97 are clearly intertwined.
- The reasons why the Special Commissioner decided that no credit needed to be given may be summarised in this way. His starting point was that FA 1996 had the effect of generally making profits and losses on debt taxable or allowable as income, with the accounting recognition of the profit or loss generally determining what was taxed and when it was taxed [para 18]. This suggested to him that "where possible and not specifically directed otherwise one should endeavour to construe the statute so that taxable profits and losses equate to the accounting results" [para 21]. Where the factual circumstances which give rise to the loan relationship to be brought into account under section 84 FA 1996 are taken into account in the statutory accounts then " you must interrogate the actual accounts of the company to determine what sums resulted from the application of the [authorised accounting] method used in those accounts to the loan relationship events" and unless statutory provisions specifically so require "you are neither entitled nor required to require your accountant to make counterfactual assumptions when drawing up or explaining the accounts" [para 72]. The selection of the sums which fairly represent the loan relationship events requires the application of judgement and commonsense and an eye to the recognition of profit or loss by those accounts [ibid]. Since the accountancy evidence was that no amount would have been brought into DCC's profit and loss account in respect of the £28.8 million the answer to the question "What sum fairly represents that interest?" is "Nil"[para 74]. Section 84 FA 1996 sits on the boundary between two different worlds. In one of them there are the accounting entries representing DCC's transactions, and in the other are tax concepts such as "loan relationships": section 84 requires a fair correspondence to be found between them [para 84]. This requires the determination of which of the sums recorded in the company's statutory accounts (and arising from the authorised method of accounting) represent the legal construct of a loan relationship: [para 89]. When you look at the actual accounting and Mr Holgate's evidence, judgement and commonsense tell you that the sum which fairly represents the coupon received of £28.8 million is nil: [para 94].
- Adopting essentially the same approach the Special Commissioner went on to hold that in bringing the debits and credits relating to the transaction into account a nil debit should be made under section 97 FA 1996. He said that section 84 required the interpretation or interrogation of the actual accounts to find the relevant tax debits and credits: [para 132]. By "the relevant tax debits and credits" he meant the sums which arise by virtue of the application of the accruals method to the actual accounts and which represent the price differential between sale price and repurchase price [para.133]. Even though these sums do not represent real interest on a real loan relationship the terms of section 84 require the section to be applied as if they were [para143]. Section 97(1) and (3) then requires a manufactured interest payment also to be treated as a loan relationship event to which section 84 must be applied [para146]; and s.97(4) requires a deemed manufactured interest payment to be treated in the same way [para 154]. This is so not because some payment is deemed to have been made, but because section 97(4) is to be applied "as it would have applied" if such a payment had been made: [para 152]. The effect of section 97 is simply to "switch on" section 84: and when under section 84 the accruals method of accounting is applied to the circumstances which give rise to the in the loan relationship they do not (according to Mr Holgate's evidence) result in a profit and loss account entry; so just as the credit was "nil" so also the debit is "nil".
- This summary does not do justice to the elegance of the argument (which continued over some 30 pages of the judgement): but it identifies its key features. It was not an outcome for which either party had contended before the Special Commissioner. Nor was treating the statutory provisions as simply recharacterising real events, rather than as deeming transactions to have occurred, an analysis promoted by either side. But HMRC now adopt it in the alternative to their main submission.
- In my judgement the Special Commissioner was wrong both in his analysis of these complex provisions and in the outcome his analysis produced. In general I think he was so concerned to give primacy to the actual accounting treatment of the transactions that he effectively ignored the deeming provisions of the statute. I will give my reasons and then address various arguments advanced by each party as to why particular steps in the analysis must be wrong.
- My starting point is the terms of the statutory provisions themselves, without any presupposition that they are to be read as charging the economic profit to tax. Taxing provisions are not necessarily aimed at economic profit. A company's economic profit may be struck after taking into account particular heads of expenditure: but if the Taxes Acts say that the expenditure is not allowable as a deduction from profits, then the taxable profit will differ from the economic profit, and the starting point must be to look at the words of the statute to see what is and what is not allowable. Again, the economic profit may be struck after carrying certain items to a reserve: but the Taxes Acts may say (and section 84(2) of Chapter II itself does say) that the taxable profit should include gains which under normal accountancy practice would be carried to a reserve. So you have to start with the words of the statute.
- A "loan relationship" is regarded as a source of income: s.80(4). A transaction relating to a loan relationship is charged to tax (and only charged to tax) under Chapter II: see section 80(1) (and s.80(5)). One must therefore enquire whether there are any actual loan relationships to which DCC was party. It actually owned gilts as part of a series of repo transactions. (I have held above that Chapter II does not require one to assume that DCC never acquired the gilts).Those gilts are "loan relationships" within s.81. The gains from the gilts are to be computed in accordance with s.82 using the credits and debits provided for by s.84. Under s.84 one must identify the sums which in accordance with the accruals method (and when taken together with any other credits and debits produced by the accruals method) fairly represent the gains arising to DCC from the gilts for the accounting period in question. Section 84 (and the accruals method) is concerned with the allocation of income to differing periods of account, rather than the admission or elimination of entries in the account. DCC actually received £28.8 million as a profit or gain arising from the loan relationship constituted by the gilt. What sum under the accruals method fairly represents that cash receipt for the accounting period in question? In my judgement £2.9 million, being the portion of the coupon attributable to DCC's period of ownership of the gilts (the accruals method requiring other owners to accrue income in respect of their periods of ownership). (This was in fact the evidence of Mr Holgate in paragraph 7.19 of his report). There are no actual debits which arise to DCC in respect of the loan relationship constituted by the gilts and which under the accruals method must be brought into account. So a credit of £2.9 million (with no debit) is to be entered in the computation.
- Is DCC party to any other "loan relationship" within s.81? It is. Because the gilts were the subject of a repo transaction the price differential on sale and purchase is converted into a taxable income flow under s.730A TA 1988. This taxable income flow is to be treated for the purposes of the Taxes Acts as a payment of interest made on a deemed loan: s. 730A(2). So there is a deemed loan relationship. Because the repurchase price has been arrived at taking account of the receipt by DCC of the coupon on the gilts the taxing scheme is to be operated as if DCC had been required to pay X Bank an amount representative of the coupon, and had paid it on the repurchase date: s.737A(5). These provisions do not "recharacterise" the coupon: they create a fictional sum (the deemed manufactured interest), numerically equivalent to, but different from the coupon and (quite possibly) payable at a different time. Because the repurchase price is thus adjusted by the amount of the deemed manufactured interest, the deemed loan is one by DCC to X Bank of an amount equal to the sale price of the gilts, and the differential of between sale price and the repurchase price of £1.8 million pounds is treated as interest paid by X Bank to DCC under the deemed loan relationship: s.730A(2).
- But what of the deemed manufactured interest itself? This falls under Schedule 23A TA 1988 to be treated under s.97 FA 1996. The deemed manufactured interest which DCC is taken to have paid is for the purposes of Chapter II to be treated as if it were interest under a loan relationship to which DCC was a party: s.97(2)(a). There is thus another deemed loan relationship, but one under which DCC is the borrower. This has no correspondence to any real event, and no trace of it will be found in the statutory accounts or books of DCC. The deemed manufactured interest which is treated as if it were interest under a loan relationship paid by DCC is an entirely fictional creation of the statute. (The rationale for the fiction that the deemed manufactured interest is to be treated as if it were interest under a loan relationship payable by DCC is probably that it was intended to perform in the hypothetical world the role of "the compensating onward payment" which under normal accountancy practice is entered in the books against the receipt of the coupon).
- What credits and debits have to be brought into account by DCC in respect of these deemed loan relationships?
- Under the deemed loan of the sale price by DCC the sum to be credited is £1.8 million. The sale of the gilts by X Bank (and so the deemed loan by DCC of the sale proceeds) occurred in the same accounting period as the deemed payment of the deemed interest on the repurchase date, so on the accruals method the whole will be entered in the account. DCC will be taxed as if it had received £1.8 million. This is a conclusion in which everyone agrees.
- So far as the deemed manufactured interest is concerned this is treated as an interest payment made by DCC on the repurchase date. What sums under the accruals method will, when taken together fairly represent the gains or losses under this deemed loan relationship? The answer will not be found in any accounts because the transaction is entirely fictional. The answer seems to me to be £28.8 million. This is the amount of the deemed interest and it cannot relate to any period other than the period for which the relationship between DCC and X Bank existed under which the deemed interest is deemed to be paid i.e the period of the repo transaction. This began and ended in the same accounting period, so the accruals method does not require it to be apportioned over any other period. A debit of £28.8 million must therefore be entered in the computation.
- The outcome of this analysis is the secondary position for which DCC contended before the Special Commissioner and on this appeal namely:-
Acquisition price of gilts (812.0)
Accrual of coupon 2.9
Manufactured interest (28.8)
Adjusted gilt resale price 812.0
Deemed repo interest 1.8
Loss (24.1)
- The taxable (or allowable) sum is different from the economic profit. But that is because in the welter of hypotheses by means of which the transaction is taxed (introduced in two sets of statutory provisions enacted at different times) the draftsman has overlooked that in the application of the accruals method to the coupon one is accruing interest over the payment period of the gilt, whereas in the application of the accruals method to the deemed manufactured interest payment one is accruing interest over the term of the repo.
- Having set out my analysis I will address the arguments advanced on either side against it.
- So far as the credit in respect of the coupon was concerned Mr Gardiner QC's primary position was that the accruals method did not require one to bring into account any sum. He submitted that FRS 5 was part of the accruals method and that FRS 5 did not require recognition of legal ownership by DCC of the gilts at all. I do not agree. In my judgement the reference to the authorised accounting method is a reference to the method by which particular sums are brought into account in each accounting period ("the sums which….. fairly represent, for the accounting period in question… gains and losses"): and see section 85(1), (2)(b), (3) and (4). It is not a reference to authorised accounting methods generally or to normal accountancy practice generally. If the taxing scheme proceeds on the footing that DCC is the owner of the gilts (as I have held) then the accruals method must be applied on that basis.
- So far as the credit in respect of the coupon was concerned Mr Furness QC argued (in the event that the section 97 debit was £28.8 million) that the credit for the coupon should be £28.8 million. He began with the submission that DCC's arguments produced a result which cannot sensibly have been intended by Parliament, though he acknowledged that if it was what the enacted words required then it must be accepted. He submitted that in construing tax legislation there was a presumption that neither injustice nor an absurdity was intended, citing the well known passage from speech of Lord Donovan in Mangin v IRC [1971] AC 739 at 746B-F. He elaborated this by submitting that in the application of deeming provisions the statutory fiction must be limited to the extent needed to avoid injustice or absurdity (citing Peter Gibson J in Marshall v Kerr 67 TTC 56 at 79A): though he also fairly drew attention to the passage which said that
"… because one must treat as real that which is only deemed to be so, one must treat as real the consequences and incidents inevitably flowing from or accompanying that state of affairs, unless prohibited from doing so…"
- He then argued that the credit in respect of the coupon and the debit in respect of the deemed manufactured interest must be looked at together, because section 84 requires that the debits and credits to be brought into account for loan relationship purposes must when taken together fairly represent all the gains arising on the company's loan relationships. By that he meant that because the £1.8 million price differential was charged to corporation tax as deemed interest under section 730A (and it represented the economic profit on the transaction) one must otherwise look for self-cancelling debits and credits in relation to any other loan relationships so that no other taxable gains or losses arose. So if the "section 97 debit" amounted to £28.8 million then section 84 required there to be a credit of £28.8 million in the tax computation.
- I do not agree. What section 84 requires is that the debits and credits to be brought into account in respect of the loan relationships are those which are in accordance with an authorised accounting method; and, further, that the debits and credits so identified shall (when taken together) fairly represent the gains arising from the loan relationships. The section does not say that the debits and credits must fairly represent the profits, and it does not say that you can create debits or credits (such as would not normally be made in accordance with an authorised accounting method) in order to produce such a "fair representation". I agree with Mr Gardiner QC that section 84 does not introduce some free-floating concept of "fairness" by reference to which the tax charge is made. In rejecting some theoretical basis of "fairness" I was assisted by his citation of the judgement of Sir John Pennycuik V-C in Odeon Associated Theatres v Jones [1971] 1 WLR 442 at 453-4:-
"It was not clear to me… precisely what standard the Court should adopt, apart from that of the ordinary principles of commercial accountancy, in arriving at the profit of a trade for the purpose of income tax. [Counsel for the Crown] used the word "logic". If by that he intended no more than to say that one must apply the correct principles of commercial accountancy, I agree with that…..I think, however, he intended to go beyond that, and meant that the Court must ascertain the profit of the trade on some theoretical basis divorced from the principles of commercial accountancy. If that is what is intended, I am unable to accept that contention, which I believe to be entirely novel."
The debits and credits to be brought into account in the computation of the taxable gain under section 82 must be made "in accordance with an authorised accounting method". But Mr Holgate's evidence did not disclose any authorised accounting method by which £28.8 million could be entered as a credit in respect of the receipt of the coupon. The accruals method required a credit of £2.9 million (the income accruing during the period of ownership).
- So far as the debit in respect of the deemed manufactured interest is concerned, Mr Gardiner QC's primary position was that (as I have held) the whole of it should be brought into account. But he argued that this was because section 97 had the effect of created a "freestanding" debit, to which section 84 was not relevant. He drew attention to the fact that section 97(3) speaks of "debits or credits falling to be brought into account in the case of any company by virtue of this section…"; so that it was by virtue of section 97 and not by virtue of section 84 that the relevant debit fell to be made, and any reference to the processes required under section 84 was unnecessary. I do not agree. Section 97 forms part of the overall scheme of which section 84 is part. Where it says that the deemed manufactured interest is to be treated "as if it were interest under a loan relationship" it simply invites the inquiry: "How is interest under a loan relationship treated?": and that inquiry is answered by reference to the whole of the provisions of Chapter II. This is demonstrated by a reference to the whole of the passage from which Mr Gardiner QC's quotation is taken. It says:
" Any question whether debits or credits falling to be brought into account in the case of any company by virtue of this section (a) are to be brought into account under section 82(2)……".
This demonstrates that the debits or credits which section 97 says are to be brought into account are so brought into account under other sections of Chapter II.
- So far as the debit in respect of the deemed manufactured interest is concerned, Mr Furness QC argued (in the event that the credit in respect of the coupon was limited to £2.9 million) that this debit should be limited also to £2.9 million. His argument was that whilst section 97 deems the amount of the manufactured payment to be interest under a loan relationship, it says nothing about the duration of the period by reference to which interest is payable, and nothing about the date on which DCC became party to the loan relationship. That being so he argues that it is entirely plausible that the period of the deemed loan relationship which Parliament had in mind was the same period as the coupon period. I do not agree. I see no basis (other than Mr Furness QC's presupposition that debits must match credits, so that the entire complicated machinery is always designed to produce a nil result) for thinking that Parliament intended interest to be notionally payable in respect of a period when there was no relationship between DCC and X Bank. It is salutary to remind oneself that the deemed manufactured interest under section 97 is an entirely fictional sum: it is not the coupon in some other guise (so as to make the coupon period more relevant than the repo period).
- In the result I would allow the appeal and substitute the computation set out in paragraph 49 above.
- I do not require the attendance of legal representatives when this judgement is formally handed down. I will adjourn any application for costs (in the event that costs are not agreed) and any other application of which I am notified by 2.00pm on the day preceding the handing down, in each case to a date to be fixed for further argument.
Mr Justice Norris…………………………………………………….17 October 2008
