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Section 730A of ICTA 1988 (Treatment of price differential on sale and repurchase of securities) is the starting point in understanding the tax treatment of repos as it was in 2001-2002. Ratio |
Section 730A provided a self-sufficient code for the simple case in which either no coupon was paid during the repo period, or a coupon was paid and was receivable (the expression in section 737A(2)(a)) by the original owner (the expression used in section 730A(1) for Mr Holgates seller). Ratio |
This might occur if the gilts were throughout registered in the name of a nominee. Ratio |
That is the simple case because it did not involve any manufactured interest or deemed manufactured interest (explained in para 16 below). Ratio |
In the simple case the operative provision was section 730A(2)(a): 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 int... |
This corresponded to the economic reality, that the interim holder had made a secured loan, at interest, to the original owner. STA |
In less simple cases section 730A operated not as a self-sufficient code, but in conjunction with sections 737A and 737C. Parliament seems to have proceeded on the basis that when a coupon is paid during the repo period, there are three possible situations: (1) a gross paying repo under which the coupon goes to the ori... |
In the second of these situations the payment on by the interim holder was termed manufactured interest. Ratio |
In the third situation there was no actual payment on by the interim holder, but the interim holder was treated for tax purposes as making a payment on, termed deemed manufactured interest. Ratio |
The rationale seems to be that the original owner had made use of the accruing coupon as part of the repo bargain, since by opting for a net paying repo he could negotiate a much lower repurchase price. Ratio |
His turning it to account in this way was treated for tax purposes as equivalent to an actual receipt of it. Ratio |
The relevant statutory provisions in relation to (actual) manufactured interest were principally section 736A of, and paragraph 3 of Schedule 23A to, ICTA 1988. Ratio |
They are not directly relevant to this appeal. Ratio |
Indeed, because of paragraph 3(12) (introduced by an amendment made in the Finance Act 1997) they really do no more than explain the expression manufactured interest. Ratio |
The statutory provisions in relation to deemed manufactured interest, by contrast, are of central importance. STA |
They are section 737A (Sale and repurchase of securities: deemed manufactured payments), subsections (7) and (9) of section 737C (Deemed manufactured payments: further provisions) and section 730A(9). STA |
Most of section 737A needs to be set out in full: 737A Sale and repurchase of securities: deemed manufactured payments (1) This section applies where on or after the appointed day a person (the transferor) agrees to sell any securities, and under the same or any related agreement the transferor or another person connec... |
(2) The conditions are that (a) as a result of the transaction, a dividend which becomes payable in respect of the securities is receivable otherwise than by the transferor, (b) [repealed] (c) there is no requirement under any agreement mentioned in subsection (1) above for a person to pay to the transferor on or befor... |
(3) For the purposes of subsection (2) above the relevant date is the date when the repurchase price of the securities becomes due. STA |
(5) Where this section applies, [words repealed] Schedule 23A and dividend manufacturing regulations shall apply as if (6) (a) the relevant person were required, under the arrangements for the transfer of the securities, to pay to the transferor an amount representative of the dividend mentioned in subsection (2)(a) ab... |
In subsection (5) above the relevant person means (a) where subsection (1)(a) above applies, the person from whom the transferor is required to buy back the securities; Section 737C(7) and (9) provided that the repurchase price for a gilts repo was to be increased by the gross amount of the deemed manufactured interest... |
I have already explained the legislative purpose, as I understand it, of these provisions for deemed manufactured interest. STA |
These provisions are not easy reading (and it has to be said that they are no more than the prologue to the difficult issues that have to be decided in this appeal). Ratio |
It may be helpful to give some simple examples by way of recapitulation of the legislation as it stood before the coming into force of FA 1996. Ratio |
The examples assume a sale price of 1,000, a coupon of 35, and a repurchase price of 1,020 for a gross paying repo and 985 for a net paying repo. Ratio |
(1) No coupon during repo period interim holder taxed on differential of 20 as interest original owner taxed on coupon of 35 (received later) and has trading or non-trading debit of 20 (2) Gross paying repo, coupon direct to original owner interim holder taxed on differential of 20 as interest original owner taxed on c... |
The change to an accruals basis Ratio |
Part IV, Chapter II of FA 1996 introduced for corporation tax purposes a new statutory source of income, profits and gains from loan relationships, with concomitant changes in the computations of debits and credits, so as to put them on an authorised basis of accounting. Ratio |
These represented an important development in tax law. Ratio |
They were presented by the Revenue as a simplification that would make life easier for companies: Details of a simpler and more coherent tax regime for borrowers and lenders were announced today with the proposed repeal of a variety of complex rules for different types of bond and their replacement with a single set of... |
This is a major deregulatory initiative which will simplify decisions for companies and lead to a substantial reduction in the amount of tax legislation on debt. Ratio |
That is from the Inland Revenue Budget Day release in 1996, quoted in a note on the Finance Bill in 1996 BTR 349, 356. Ratio |
The official claims were not groundless, but may nevertheless be regarded with some scepticism by those involved in this particular appeal. Ratio |
The opening sections of Chapter II are sections 80 (Taxation of loan relationships), 81 (Meaning of loan relationship etc) and 82 (Method of bringing amounts into account). Ratio |
They are important machinery but it is not necessary to set out the text. Ratio |
Section 83 (Non-trading deficit on loan relationships) is technical and it is not necessary to set it out. Ratio |
It is however of crucial importance to DCC, which seeks to surrender a non-trading deficit (by way of relief) against profits earned by its subsidiaries of over 28m (the precise figures of the original claim appear in form CT600 (2001) in Appendix Part IV and also at [2009] STC 77, 122). Ratio |
In Section 84 (Debits and credits brought into account) subsection (1) is of crucial importance to this appeal: 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 tog... |
Subsection (5) defines related transaction as meaning, in relation to a loan relationship, any disposal or acquisition (in whole or in part) of rights or liabilities under that relationship. STA |
But paragraph 15 of Schedule 9 to FA 1996 makes it unnecessary, as is common ground, to consider the related transaction provisions in this case. STA |
Paragraph 13 of Schedule 9 contains an anti-avoidance provision (loan relationships for unallowable purposes) which the Revenue has not invoked in this case, partly it seems because of doubts (since removed by an amendment) as to its efficacy. STA |
Section 85 (Authorised accounting methods) provides as follows: (1) Subject to the following provisions of this Chapter, the alternative accounting methods that are authorised for the purposes of this Chapter are (a) an accruals basis of accounting; and (b) a mark to market basis of accounting under which any loan rela... |
(2) An accounting method applied in any case shall be treated as authorised for the purposes of this Chapter only if (a) it conforms (subject to paragraphs (b) and (c) below) to normal accountancy practice, as followed in cases where such practice allows the use of that method; (b) it contains proper provision for allo... |
Subsection (3) contains further provisions as to accruals. STA |
The accruals basis is the only permitted method for computations under section 730A of ICTA 1988, that being the effect of the new subsection (6) inserted into section 730A by section 104 of, and paragraph 37 of Schedule 14 to, FA 1996. STA |
Section 97 (Manufactured interest) must be set out (as amended by the Finance Act 1997) in full: (1) This section applies where (a) any amount (manufactured interest) is payable by or on behalf of, or to, any company under any contract or arrangements relating to the transfer of an asset representing a loan relationshi... |
In relation to that company the manufactured interest shall be (2) treated for the purposes of this Chapter (a) as if it were interest under 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 ... |
(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) above, or (b) are to be treated as non-trading debits or non- trading credits, shall be determined according to the extent (if any) to... |
(4) Where section 737A(5) of [ICTA 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... |
The resolution of this appeal depends on the correct interpretation and inter- relation of sections 730A(2) and 737A(5) of ICTA 1988 and sections 84(1) and 97(2) and (4) of FA 1996. Ratio |
Argument has focused, in particular, on whether and how far the words in section 84(1) the sums which, in accordance with an authorised accounting method and when taken together, fairly represent . . . Ratio |
can be stretched (or need to be stretched) in order to avoid the absurd result of DCCs deemed income receipt in respect of the coupon being different from its deemed interest payment as a borrower which is party to a loan relationship under section 737A(5) of ICTA 1988 and section 97(4) of FA 1996. Ratio |
The absurdity of that asymmetrical result has been recognised in the Special Commissioners decision [2009] STC 77 (paras 164-166 and numerous other passages) and in the Court of Appeal [2010] STC 80, especially by Rimer LJ at para 85 (Moses LJs reasoning . . . Ratio |
clothes the relevant legislation with a garb of commercial sanity) and Rix LJ at para 92 (a most unfortunate, uncommercial, and no doubt unintended result). Ratio |
Moses LJ referred at para 69 to the deemed income flow under section 97(4) as retaining its essential function, which is to cancel out, but not to exceed, the amount which it represents. Ratio |
Norris J, by contrast, was scathing about the statutory drafting (para 22) and unwilling to make any presupposition about its intended effect (para 42). Ratio |
In my opinion the need for a symmetrical solution lies at the heart of this appeal. Ratio |
The need for symmetry comes from the statutory purpose of the deemed income flows provided for in the provisions of sections 730A, 737A and 737C of ICTA 1988, which I have already analysed at tedious length. Ratio |
They are intended to have a cancelling effect so that DCC is taxed on the repo as if it had made a secured loan at interest, and the coupon is taxed as income of the Bank, whether it reaches the Bank directly, or in the form of a representative payment, or not at all. Ratio |
Some sort of case can be made out for each of the three pairs of symmetrical answers: (1) credit 28.8m, debit 28.8m; (2) credit 2.9m, debit 2.9m; (3) credit nil, debit nil. Ratio |
The Special Commissioner (Mr Charles Hellier), in a long and closely-reasoned decision, concluded that credit nil, debit nil was the right answer. Ratio |
Neither side has treated this conclusion with any enthusiasm, but the Revenue have adopted it as their second and final fall-back position. Ratio |
Norris J reached the asymmetrical answer of credit 2.9m, debit 28.8m. Ratio |
Rimer LJ agreed with Norris J. Rix and Moses LJJ concluded that the correct answer was the symmetrical credit 28.8m, debit 28.8m. Ratio |
Mr Holgates evidence as to the accruals basis Ratio |
I have already summarised Mr Holgates evidence about the nature of repos and the proper accounting treatment which recognises their economic substance. Ratio |
I must also give a brief account of his evidence about the accruals basis. Ratio |
This part of his written evidence is in section 6 (My understanding of the legislative assumptions), section 7 (The exercise posed by section 84 Finance Act 1996) and section 8 (Conclusions). Ratio |
In section 6 he considers section 84 at some length and concludes that the expression fairly represent is, from an accounting perspective, not significantly different from giving a true and fair view. Ratio |
He also states his assumptions as to the effects of section 737A of ICTA 1988 and section 97 of FA 1996 (paragraph 6.18) and of section 730A of ICTA 1988 (paragraph 6.20). Ratio |
Paragraph 7.11 is in the following terms: Furthermore, in order to prepare financial statements that show a true and fair view of the transactions undertaken by the entity, full knowledge of the transactions and arrangements undertaken by an entity must first be understood, both from a legal and an economic perspective... |
Accordingly, accounting standards and GAAP are based on real, economic transactions and therefore determining the most appropriate accounting treatment without the full facts or based on transactions which do not make economic sense is difficult, if not impossible. FAC |
At paragraphs 7.16 to 7.19 Mr Holgate set out his views on the issue of DCCs credit. Ratio |
On one view (paragraph 7.16) it should be nil, since in substance DCC never had beneficial ownership of the gilts. Ratio |
The alternative view (paragraphs 7.18 and 7.19) was as follows: DCC held the gilts at the coupon date and so was entitled to receive an interest payment from the government in respect of its investment. Ratio |
From an accounting perspective, applying the accruals basis (as defined in FRS 18 paragraph 27), it is appropriate to bring into account the interest accruing on the gilts only in respect of the period those gilts are held by DCC, ie the proportion of the interest received by DCC. Ratio |
This is because any other party holding the gilts before and after the term of the repo transaction would expect to be compensated by receiving the proportion of the coupon relating to their period of ownership of the gilts. Ratio |
Therefore under this assumption, in my opinion the sum which fairly represents the interest arising on the gilts held by DCC (ignoring any purchase and sale proceeds) is the accrued portion of the coupon for the period of the repo transaction. Ratio |
In accordance with an accruals basis of accounting, it could be no more; specifically, DCC could not recognise the receipt of the full interest coupon unless the gilts had been held for the full period to which the coupon relates. Ratio |
Coupons on gilts are typically paid every six months; accordingly, it would be appropriate to recognise as income the full amount of a coupon received only if the gilts in question had been held for the full six- month period. Ratio |
At paragraphs 7.22 and 7.23 Mr Holgate set out his views on the proper treatment of DCCs debit in respect of deemed manufactured interest. Ratio |
I have emphasised a passage which takes a preliminary view on a point of statutory construction: From an accounting perspective it is not possible to determine the debits and credits to be brought into account in respect of any deemed cash payment that fairly represent the loan relationship, unless one has more informa... |
For example the premium on redemption of a deeply discounted bond would be taken into account in determining the interest accruing on such a bond for an accounting period. Ratio |
However, without knowing the full terms of the transaction, it is not possible to determine whether the deemed interest does fairly represent the interest accruing under the loan relationship and related transactions (if any) for the accounting period. Ratio |
However, if there is a legislative need to determine the debits to be brought into account on an accruals basis that fairly represents the loan relationship, then I would understand the legislation may be making an assumption that the deemed interest, which is to be treated as paid by DCC under a loan relationship to w... |
If that is the case, then, from an accounting perspective, a debit for the whole amount relating to that period should be recognised in respect of that accrued interest payable. Ratio |
In paragraph 8 Mr Holgate summarised his conclusions. Ratio |
Most relevantly for present purposes, he stated that DCCs credit should be either nil or an apportioned amount of 2.9m (paragraph 8.5) and that DCCs debit should be the whole of the deemed interest payment, or could not be determined from accounting principles, on the basis of the information given (paragraph 8.9). Rat... |
The judgments below RLC |
I have already made some reference to the judgments below, and I do not think that it would be helpful to attempt to analyse them at length. Ratio |
But I would add a few more comments. Ratio |
I respectfully think that Norris J was wrong to criticise the Revenues case (as put by Mr Furness QC) as based on a presupposition. Ratio |
I would have said that it was based on a careful analysis of sections 730A, 737A and 737C, to which Norris J seems to have been at least partly receptive at para 44 of his judgment. Ratio |
It was not an unreasonable presupposition, but a reasonable expectation, that Parliament intended to preserve, rather than to destroy, the essentials of those provisions when enacting Part IV, Chapter II of FA 1996. Ratio |
As it was Norris J went along with the assumption put forward in paragraph 7.23 of the report, putting it like this (para 48): So far as the deemed manufactured interest is concerned this is treated as an interest payment made by DCC on the repurchase date. Ratio |
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. Ratio |
The answer seems to me to be 28.8m. Ratio |
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 [the Bank] existed under which the deemed interest is deemed to be paid ie the period of the repo transaction. Ratio |
Rimer LJ agreed with Norris J on this point (indeed he seems to have agreed with him on all points, but reluctantly because he was more concerned about the lack of commercial sanity: para 85). Ratio |
Moses LJ also agreed (para 51: [t]he deemed expense incurred as a result of the deemed manufactured payments could only be incurred by DCC and thus only accrued to DCC). Ratio |
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