Revenue & Customs v Bank of Ireland Britain Holdings Ltd [2007] EWHC 941 (Ch)

[2007] EWHC 941 (Ch)Case No CH/2006/APP/0555 & 0593
IN THE HIGH COURT OF JUSTICE
CHANCERY DIVISION
Venue Royal Courts of Justice, Strand, London, WC2A 2LLDate 30/04/2007
Before
THE HONOURABLE MR JUSTICE HENDERSON
Between
COMMISSIONERS FOR HER MAJESTY'S REVENUE & CUSTOMSAppellantsBANK OF IRELAND BRITAIN HOLDINGS LTDRespondent
Mr Michael Furness QC (instructed by Solicitor for HM Revenue & Customs) for the AppellantsMr John Gardiner QC and Mr Philip Walford (instructed by Slaughter and May) for RespondentHearing Hearing date: 28 March 2007
Judgment

Introduction

[1]The question that I have to decide on this appeal is whether a tax avoidance scheme succeeded in its object of generating a loss for tax purposes in a situation where the taxpayer suffered no corresponding commercial loss. The taxpayer company is Bank of Ireland Britain Holdings Ltd (“BH”), a private limited company incorporated and registered in England and Wales and resident for tax purposes in the UK. BH is a wholly-owned subsidiary of the Bank of Ireland, which is incorporated and resident in the Republic of Ireland and entered into the relevant transactions through its head office in Dublin. The relevant events took place between November 2000 and March 2001.[2]The scheme involved a transaction for the sale and repurchase of securities, generally known to tax specialists as a “repo”. This particular “repo” involved three parties, and dividends were paid on the securities during the period of some four months for which it operated. The amount of the loss, if the scheme worked, was equivalent to the dividends actually paid to Bank of Ireland during its period of ownership of the relevant securities, a sum of approximately £3.6 million. This sum also comprised most of a so-called “manufactured overseas dividend” which is deemed to have been paid by BH, and which is prima facie deductible by BH as a charge on income in computing its taxable profits. The scheme sought to take advantage of a perceived mismatch between two related, but independent, groups of sections in Part XVII (Tax Avoidance) of the Income and Corporation Taxes Act 1988 (“ICTA 1988”), each of which is replete with deeming provisions. The purpose of each group of sections, in the broadest terms, is to replace transactions which would otherwise be taxable, if at all, under the capital gains tax regime (or its equivalent for companies) with deemed flows of taxable income.[3]A further consequence of the perceived mismatch, if the scheme worked, is that Bank of Ireland would be deemed to have received a payment of interest equal in amount to the dividends paid during the currency of the scheme. If Bank of Ireland were itself resident for tax purposes in the UK, or if it had entered into the relevant transactions through a UK branch, it would then have been subject to economic double taxation on the dividends which it actually received as well as on the interest which it was deemed to receive. However, as Bank of Ireland is not within the charge to UK corporation tax in respect of the relevant transactions (see section 11(1) and (2) of ICTA 1988) this is a matter of indifference to it.[4]Counsel for BH (Mr John Gardiner QC and Mr Philip Walford) do not claim that there is any fiscal or economic merit in the result for which they contend. They simply submit that the relevant legislation admits of only one construction, and if the result is not to the Revenue’s liking, they say that the Revenue has only itself to blame for procuring the enactment of such complex deeming provisions without giving enough thought to the consequences.[5]Counsel for the Revenue, Mr Michael Furness QC, readily acknowledges that the legislation could and should have been better drafted to deal with the problems posed by tripartite repos, but submits that it nevertheless can, and therefore should, be construed in a way which produces an economically and fiscally sensible result in the present case. That result is one which would not give BH a commercially unreal tax loss, because the deduction for the deemed manufactured overseas dividend would be matched by a deemed receipt of taxable interest, thereby producing a situation of basic fiscal neutrality for BH and leaving it taxable only on the comparatively small amount of dividends (some £338,000) which it actually received during its period of ownership of the securities. The result for which the Revenue contends would also not subject a UK-resident counterparty in the position of Bank Ireland to economic double taxation, because it would no longer be deemed to receive a payment of interest in addition to its actual receipt of dividends. In other words, the Revenue’s construction would avoid the perceived mismatch which the scheme evidently sought to exploit.[6]The Revenue also has an alternative argument, which raises the question whether BH was in fact entitled to a deduction in computing its taxable profits for the manufactured overseas dividend which it is deemed to have paid. This argument involves consideration of the conditions for allowance of charges on income in section 338 of ICTA 1988, and turns mainly on the question whether the deemed payment should be regarded as “not made under a liability incurred for a valuable and sufficient consideration” within the meaning of section 338(5)(b).[7]The matter comes before me by way of an appeal by the Revenue from a decision (“the Decision”) of the Special Commissioners (Mr John Clark and Mr Michael Johnson) released on 6 June 2006. The Special Commissioners decided both issues (i.e. who is the deemed recipient of the payment of interest, and the question of deductibility) in favour of BH, although they agreed with the Revenue that the result of their decision on the first issue was “bizarre”: see paragraph 107 of the Decision.

The Facts

[8]The relevant facts are not in dispute. There was a statement of agreed facts before the Special Commissioners, and an agreed bundle of documents. There was no oral evidence.[9]The agreed facts say nothing about the background to the scheme, or the circumstances in which BH was introduced to it. However, there is no suggestion that the transactions had any independent commercial purpose, and the inference that this was a carefully designed tax avoidance scheme is in my judgment irresistible. That said, however, this is not a case where the Revenue seeks to apply any special approach to the construction or application of tax legislation. The question, as always, is simply whether or not the scheme works; and that has to be ascertained by applying the legislation, purposively construed, to the facts.[10]The scheme was evidently provided to BH by the Morgan Stanley Dean Witter group (“Morgan Stanley”). On the Morgan Stanley side, it involved two group companies both of which were incorporated and resident in the Cayman Islands, MSDW Birkdale Ltd (“Birkdale”) and MSDW Portrush Ltd (“Portrush”).[11]On 8 November 2000, the entire ordinary share capital of Portrush was issued to Birkdale. At all material times thereafter Portrush continued to be a wholly-owned subsidiary of Birkdale.[12]On 9 November 2000, 225,000 £1 Class A Redeemable Preference Shares in Portrush (“the Securities”) were issued to Birkdale at a price of £1,000 per share. The Securities carried the right to receive a cumulative preference dividend accruing at a rate of 5% per annum until the end of the first dividend payment date on 14 November 2000, and at a rate to be set prior to 14 November 2000 by the directors of Portrush for all subsequent dividend payment dates (being the 25th day of each month, or the next business day thereafter, commencing with 25 November 2000). The dividends were payable to those holders registered in the Register of Members two business days prior to the relevant dividend payment date.[13]Under its articles, the directors of Portrush had a discretion to authorise a “special dividend” to be paid prior to a dividend payment date in which case the amount payable would be the amount accrued up until the date of the special dividend. The amount of the dividend payable on the next normal dividend payment date would then be correspondingly reduced. This power was used to ensure that dividends were paid up to each of the dates on which the Securities were transferred, with the result that they were never transferred with an accrued right to dividend.[14]On 10 November 2000, various agreements were entered into of which the three most important for present purposes were the following:(1) A share sale agreement (“the Share Sale Agreement”) whereby Birkdale agreed to sell the Securities to Bank of Ireland on 14 November 2000 for a price of £225 million payable on that date;(2) An option agreement (“the First Option Agreement”) whereby Bank of Ireland granted BH a call option and BH granted Bank of Ireland a put option on the Securities, the options being exercisable until 23 March 2001 at a purchase price of £225 million plus any unpaid accrued dividend on the Securities; and(3) A further option agreement (“the Second Option Agreement”) whereby BH granted Birkdale a call option and Birkdale granted BH a put option on the Securities, the options being exercisable until 23 March 2001 with a completion date (“the Completion Date”) no later than 30 March 2001. The purchase price, if either option was exercised, was fixed by a formula the effect of which is summarised in the statement of agreed facts as being “the aggregate of £225 million, plus an amount accruing on that sum at a rate of 8.3% per annum from 14 November 2000 to the Completion Date, less any dividends paid on [the Securities] divided by 0.7, together with any finance breakage costs if completion took place before 30 March 2001.”[15]On the same day, the directors of Portrush set the rate at which the cumulative preference dividend on the Securities would accrue at 5.81% in respect of all dividend periods subsequent to the dividend period ending on 14 November 2000. It will be observed that 5.81 divided by 0.7 is 8.3, so the effect of setting the dividend at this level was that the interest and dividend elements of the purchase price for the Securities payable under the Second Option Agreement would automatically cancel each other out, and unless there were any finance breakage costs, which in the event there were not, the formula, for all its apparent complexity, would again yield a purchase price of £225 million.[16]The events which then followed are conveniently summarised in paragraphs 10 to 14 in the statement of agreed facts, which I shall reproduce (but omitting the cross-references to the bundle of documents, and substituting references to BH and the Securities for references to the Appellant and the Class A Shares):
“10. On 14 November 2000, the cumulative preference dividend payable in respect of the first dividend period was paid to Birkdale and, pursuant to the Share Sale Agreement, Birkdale sold the Securities to Bank of Ireland for £225 million. 11. Following its purchase of the Securities, Bank of Ireland received dividends on the Securities in respect of periods ending on 25 November 2000, 25 December 2000 and 25 January 2001. However, on 20 February 2001, Bank of Ireland exercised its put option on the Securities; pursuant to the option exercise notice, the completion date for that option was 23 February 2001. Bank of Ireland received a special dividend on the Securities for the period to 23 February 2001. In total it received £3,617, 322 in dividends on the Securities. 12. On 23 February 2001 BH paid the purchase price of £225 million to Bank of Ireland and received the Securities. It subsequently received a dividend on the Securities for the period to 25 February 2001 and also a special dividend on those shares for the period to 5 March 2001. The aggregate amount it received in dividends on the Securities was £358,151. 13. Pursuant to the Second Option Agreement, on 26 February 2001, BH exercised its put option on the Securities; the completion date for that option was 5 March 2001. 14. On 5 March 2001, Birkdale duly paid BH the repurchase price of £225 million and repurchased the Securities.”
[17]It can be seen from the above summary that the Securities were transferred from Birkdale to Bank of Ireland on 14 November 2000, from Bank of Ireland to BH on 23 February 2001, and from BH back to Birkdale on 5 March 2001. The purchase price on each occasion was £225 million. Both Bank of Ireland and BH received dividends on the Securities at the fixed rate of 8.3% for their respective periods of ownership, amounting to £3,617,321 for Bank of Ireland and £358,151 for BH. The total dividends paid for the period from 14 November 2000 to 5 March 2001 were therefore £3,975,473. That is also the amount of the deemed manufactured overseas dividend for which BH claims to be entitled to a deduction by virtue of section 737A of ICTA 1988.

The Issues

[18]As I shall explain, there is no dispute that BH is prima facie entitled to a deduction for the full amount of £3,975,473 in computing its profits for its accounting period ending on 31 March 2001. The issues are:(1) Whether BH is also deemed to have received a matching payment of interest of the same amount pursuant to section 730A of ICTA 1988; and(2) Whether the payment of the manufactured overseas dividend deemed to have been made by BH under section 737A is deductible as a charge on income.

Issue (1): The deemed interest

[19]I shall begin by setting out the relevant legislation, as amended and in force in 2000/01. As I have already said, two groups of sections in Part XVII of ICTA 1988 are involved. The first group comprises sections 730A and 730B; the second group comprises sections 737A, 737B and 737C. Section 737A in its turn applies by reference, with appropriate modifications, the provisions relating to manufactured dividends and interest in Schedule 23A to ICTA 1988.[20]Sections 730A and 730B provide as follows: “730ATreatment of price differential on sale and repurchase of Securities.(1) Subject to subsection (8) below, this section applies where – (a) a person (“the original owner”) has transferred any securities to another person (“the interim holder”) under an agreement to sell them; (b) the original owner or a person connected with him is required to buy them back either – (i) in pursuance of an obligation to do so imposed by that agreement or by any related agreement, or (ii) in consequence of the exercise of an option acquired under that agreement or any related agreement; and (c) the sale price and the repurchase price are different.(2) 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.(3) Where any amount is deemed under subsection (2) above to be a payment of interest, that payment shall be deemed for the purposes of the Tax Acts to be one that becomes due at the time when the repurchase price becomes due and, accordingly, is treated as paid when that price is paid.(4) Where any amount is deemed under subsection (2) above to be a payment of interest, the repurchase price shall be treated for the purposes of the Tax Acts (other than this section and sections 737A and 737C) and … for the purposes of [the Taxation of ChargeableGains Act 1992] – (a) in a case falling within paragraph (a) of that subsection, as reduced by the amount of the deemed payment; ….(5) For the purposes of section 209(2)(d) and (da) any amount which is deemed under subsection (2)(a) above to be a payment of interest shall be deemed to be interest in respect of securities issued by the repurchaser and held by the interim holder.(6) For the purposes of Chapter II of Part IV of the Finance Act 1996 (loan relationships) – (a) interest deemed by virtue of subsection (2) above to be paid or received by any company shall be deemed to be interest under a loan relationship; and (b) the debits and credits falling to be brought into account for the purposes of that Chapter so far as they relate to the deemed interest shall be those given by the use in relation to the deemed interest of an authorised accruals basis of accounting. …. (9) In this section references to the repurchase price are to be construed – (a) in cases where section 737A applies … as references to the repurchase price which is … applicable by virtue of section 737C … (11)(c). 730B Interpretation of Section730A (1) For the purposes of section 730A agreements are related if they are entered into in pursuance of the same arrangement (regardless of the date on which either agreement is entered into). … (3) In section 730A and this section “securities” has the same meaning as in section 737A. …” (a) a person (“the original owner”) has transferred any securities to another person (“the interim holder”) under an agreement to sell them; (b) the original owner or a person connected with him is required to buy them back either – (i) in pursuance of an obligation to do so imposed by that agreement or by any related agreement, or (ii) in consequence of the exercise of an option acquired under that agreement or any related agreement; and (c) the sale price and the repurchase price are different. (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. (a) in a case falling within paragraph (a) of that subsection, as reduced by the amount of the deemed payment; …. (a) interest deemed by virtue of subsection (2) above to be paid or received by any company shall be deemed to be interest under a loan relationship; and (b) the debits and credits falling to be brought into account for the purposes of that Chapter so far as they relate to the deemed interest shall be those given by the use in relation to the deemed interest of an authorised accruals basis of accounting. (a) in cases where section 737A applies … as references to the repurchase price which is … applicable by virtue of section 737C … (11)(c).[21]Sections 737A to 737C provide as follows:
“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 connected with him – (a) is required to buy back the securities, or (b) acquires an option, which he subsequently exercises, to buy back the securities; but this section does not apply unless the conditions set out in subsection (2) below are fulfilled. (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) … (c) there is no requirement under any agreement mentioned in subsection (1) above for a person to pay to the transferor on or before the relevant date an amount representative of the dividend, and (d) 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. (3) For the purposes of subsection (2) above the relevant date is the date when the repurchase price of the securities becomes due. … (5) Where this section applies … Schedule 23A and dividend manufacturing regulations shall apply as if – (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) above, (b) a payment were made by that person to the transferor in discharge of that requirement, and (c) the payment was made on the date when the repurchase price of the securities becomes due. (6) 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; (b) where subsection (1)(b) above applies, the person from whom the transferor has the right to buy back the securities; and in that subsection “dividend manufacturing regulations” means regulations under Schedule 23A (whenever made). 737B Interpretation of Section 737A (1) In section 737A and this section “securities” means United Kingdom equities, United Kingdom securities or overseas securities; and (a) is required to buy back the securities, or (b) acquires an option, which he subsequently exercises, to buy back the securities; but this section does not apply unless the conditions set out in subsection (2) below are fulfilled. (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) … (c) there is no requirement under any agreement mentioned in subsection (1) above for a person to pay to the transferor on or before the relevant date an amount representative of the dividend, and (d) 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. (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) above, (b) a payment were made by that person to the transferor in discharge of that requirement, and (c) the payment was made on the date when the repurchase price of the securities becomes due. (a) where subsection (1)(a) above applies, the person from whom the transferor is required to buy back the securities; (b) where subsection (1)(b) above applies, the person from whom the transferor has the right to buy back the securities; and in that subsection “dividend manufacturing regulations” means regulations under Schedule 23A (whenever made). (a). … (b) where the securities mentioned in section 737A(1) are overseas securities, references in section 737A to a dividend shall be construed as references to an overseas dividend. (2) In this section … “overseas securities” and “overseas dividend” have the meanings given by paragraph 1(1) of Schedule 23A. (3) For the purposes of section 737A agreements are related if each is entered into in pursuance of the same arrangement (regardless of the date on which either agreement is entered into). (4) In section 737A “the repurchase price of the securities” means – (a) … (b) where subsection (1)(b) of that section applies, the amount which under any such agreement the transferor or connected person is required, if he exercises the option, to pay for the securities bought back. … 737C Deemed manufactured payments: further provisions (1) This section applies where section 737A applies. … (10) Subsection (11) below applies where – (a) the dividend mentioned in section 737A(2)(a) is an overseas dividend, and (b) by virtue of section 737A(5), paragraph 4 of Schedule 23A applies in relation to the payment which is treated under section 737A(5) as having been made; and in subsection (11) below “the deemed manufactured overseas dividend” means that payment. (11) Where this subsection applies – (a) … (b) where subsection (1)(b) of that section applies, the amount which under any such agreement the transferor or connected person is required, if he exercises the option, to pay for the securities bought back. … (a) the dividend mentioned in section 737A(2)(a) is an overseas dividend, and (b) by virtue of section 737A(5), paragraph 4 of Schedule 23A applies in relation to the payment which is treated under section 737A(5) as having been made; and in subsection (11) below “the deemed manufactured overseas dividend” means that payment. (c). the repurchase price of the securities shall be treated, for the purposes of section 730A as increased by the gross amount of the deemed manufactured overseas dividend. … ”
[22]The relevant parts of paragraph 4 of Schedule 23A provide as follows:
“(1) This paragraph applies in any case where, under a contract or other arrangements for the transfer of overseas securities, one of the parties (“the overseas dividend manufacturer”) is required to pay to the other (“the recipient”) an amount representative of an overseas dividend on the overseas securities; and in this Schedule the “manufactured overseas dividend” means any payment which the overseas dividend manufacturer makes in discharge of that requirement. (2) … where this paragraph applies the gross amount of the manufactured overseas dividend shall be treated for all purposes of the Tax Acts as an annual payment, within section 349, but – (a) the amount which is to be deducted from that gross amount on account of income tax shall be an amount equal to the relevant withholding tax on that gross amount; and (b) in the application of sections 338(4)(a) and 350 (4) in relation to manufactured overseas dividends the references to Schedule 16 shall be taken as references to dividend manufacturing regulations …” (a) the amount which is to be deducted from that gross amount on account of income tax shall be an amount equal to the relevant withholding tax on that gross amount; and (b) in the application of sections 338(4)(a) and 350 (4) in relation to manufactured overseas dividends the references to Schedule 16 shall be taken as references to dividend manufacturing regulations …”
[23]It is common ground that section 730A is engaged in the present case, on the basis that the securities were transferred by Birkdale as the “original owner” to Bank of Ireland (the transferee under the Share Sale Agreement) as the “interim owner”, and that Birkdale was required to buy them back in consequence of the exercise of an option acquired under a related agreement, namely the Second Option Agreement. At first sight it might appear that the condition in section 730A(1)(c) was not satisfied, because the sale price and the repurchase price were in the event the same (£225 million); but as I shall explain the repurchase price was deemed to be increased by the amount of the deemed manufactured overseas dividend, and by virtue of section 730A(9) this increased amount is to be taken as the repurchase price for the purposes of section 730A, so by this indirect route the condition was satisfied.[24]The amount of the deemed manufactured overseas dividend, and hence the amount of the difference between the sale price and the repurchase price of the Securities, was £3,975,473. Accordingly, by virtue of section 730A(2)(a), that amount is to be treated for the purposes of the Tax Acts as a payment of interest made by the repurchaser (Birkdale) on a deemed loan from the interim holder (Bank of Ireland) of an amount equal to the sale price (£225 million). Thus far there is no disagreement between BH and the Revenue. The point of contention is whether the deemed recipient of this deemed payment of interest is (as BH argues) the interim holder, i.e. Bank of Ireland, or (as the Revenue argues) the recipient of the repurchase price, BH.[25]Before I come on to consider this question, I must first describe how section 737A operates. I can do so briefly, because there is no dispute about it. It is common ground that section 737A(1) applies, on the basis that Birkdale (the transferor) agreed to sell the Securities under the Share Sale Agreement, and under a related agreement (the Second Option Agreement) Birkdale was required to buy them back following exercise of the put option by BH. It is equally common ground that the conditions in subsection (2) are satisfied, as a result of the payment of the dividends on the Securities to Bank of Ireland and BH, the absence of any requirement for an amount representing those dividends to be paid to Birkdale, and the fact that the repurchase price of the Securities under the Second Option Agreement was evidently calculated on the basis that the dividends would not be received by Birkdale.[26]Because these threshold conditions were satisfied, section 737A(5) then applies the dividend manufacturing regime in Schedule 23A of ICTA 1988 as if the “relevant person” were required to pay to Birkdale an amount representative of the dividends paid during the life of the repo. That amount is agreed to be £3,975,473. The “relevant person” is BH, i.e. the person from whom Birkdale had the right to buy back the Securities: see section 737A (6)(b). The Securities were “overseas securities”, as defined, with the consequence that paragraph 4 of Schedule 23A applied so as to deem the gross amount of the dividends to be an annual payment within section 349 of ICTA 1988. Furthermore, the repurchase price of the Securities is treated for the purposes of section 730A as increased by that amount: see section 737C (11)(c) and section 730A(9).[27]I can now return to focus more closely on the point in issue, that is to say who is to be treated as the recipient of the deemed payment of interest under section 730A(2)(a).[28]I begin by observing that if the repo involved only two parties there would be no problem. The interim holder, and the person from whom the original owner (Birkdale) was required to buy back the Securities, would be one and the same, and the deemed interest would clearly be taxable in the hands of the single counterparty who received the repurchase price. The purpose of section 730A, at the simplest level, must be to replace the CGT treatment which would otherwise apply (assuming the original owner not to be a financial trader) with a deemed payment of interest reflecting the economic return to the counterparty on the purchase price which he has made available to the original owner during the life of the repo. A repo is typically used to provide funding in a way that is commercially similar to a secured loan, with the purchased securities providing the counterparty with his “security” for the “loan” represented by the purchase price. Thus it is intelligible that Parliament should have decided to tax repos in accordance with what is usually their underlying economic substance, and the inclusion of section 730A in Part XVII of ICTA 1988 (Tax Avoidance) no doubt reflects a perception that repos were widely used as a means of providing finance without the usual income tax consequences of making a loan. Consistently with that approach, and in order to avoid double taxation, the repurchase price is treated for CGT purposes as reduced by the amount of the deemed interest: see section 730A (4)(a).[29]Precisely because the deemed interest represents the return on a notional loan, one would naturally expect to find that it will be taxable in the hands of the deemed lender; and that is indeed what section 730A (2)(a) appears to provide. The difference between the sale price and the repurchase price is to be treated “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”. The deemed lender is the interim holder, who is defined in subsection (1)(a) as the person to whom the original owner has transferred the securities under an agreement to sell them.[30]The problem arises when a third party is introduced into the arrangements, here BH, and the notional lender (i.e. the interim holder, here Bank of Ireland) is no longer the person who receives the repurchase price. Is it possible, in these circumstances, to construe the legislation in a way which makes the interest taxable in the hands of the reseller who receives the repurchase price, as the Revenue submits, instead of in the hands of the interim holder, who does not receive the repurchase price?[31]In agreement with the Special Commissioners, I have come to the conclusion that this question must be answered in the negative. It seems to me that the wording of subsection (2)(a) is clear and unambiguous. The deemed loan is still from the interim holder, notwithstanding the tripartite nature of the arrangements, and that deemed loan is the only source (albeit a deemed source) from which taxable interest can arise. The interest must therefore be taxable in the hands of the owner of that source (the interim holder), whether or not the interim holder also receives the repurchase price. The legislative scheme, for better or for worse, is to treat the interim holder as the deemed lender of the original sale price for the life of the repo, and it is therefore in the hands of the interim holder that the deemed interest is taxable.[32]If the draftsman had intended the result for which the Revenue contends, it seems to me that he would have had to do at least two things. First, he would have had to deem part of the repurchase price itself to constitute a payment of interest; and secondly, he would have had to deem the loan to be made by the person to whom the repurchase price is paid, i.e. the reseller, whether or not that person is also the interim holder. In fact, however, the draftsman has in my judgment done neither of those things. As to the first point, the payment of interest is a purely notional payment. True, it is quantified as the difference between the sale price and the repurchase price, but as subsection (3) makes clear it is not itself part of the repurchase price. It is merely a deemed amount which becomes due at the time when the repurchase price becomes due, and is treated as paid when that price is paid. In short, it is a wholly notional payment, divorced from the actual payment of the repurchase price, although quantified by reference to it. As to the second point, the words “on a deemed loan from the interim holder” are clear and unqualified. It is not suggested that there can be sequential interim holders within the meaning of the definition of interim holder in subsection (1)(a), that is to say the person to whom the original owner has transferred the securities. I can find no basis for implying into subsection (2)(a) a deemed loan from anybody other than the interim holder in circumstances where (for whatever reason) the interim holder is not the reseller.[33]Indeed, Mr Furness QC did not go so far as to submit that the loan itself should be deemed to be made by anybody other than the interim holder. However, he submitted that the draftsman has deemed so much of the repurchase price as exceeds the sale price to be interest, and although he has deemed the interim holder to be the lender he has not in terms identified the deemed recipient of the interest. Mr Furness submits that it is commonplace for a person other than the lender to become entitled to the interest on a loan, for example if the loan is assigned, or if there is an assignment of the right to receive the interest.[34]I am unable to accept these submissions, although they were advanced by Mr Furness with his customary skill and lucidity. As I have already said, I do not agree that section 730A deems any part of the repurchase price itself to be interest. Nor do I agree that a person other than the original lender can be taxable on the interest from a loan, unless the taxable source itself has been transferred. A mere direction to pay the interest to a third party, for example, or a mere assignment of the right to receive the interest without an assignment of the underlying loan agreement itself, would not, as I understand it, suffice to make the third party taxable on the interest in place of the original lender.[35]For these reasons there is in my judgment no real force in Mr Furness’ point, true as far as it goes, that section 730A(2)(a) nowhere states expressly that the interim holder is deemed to receive the notional interest. Since the only relevant source is the deemed loan by the interim holder, and since I can find no basis for deeming that loan to be assigned to anybody else, the deemed payment of interest must in my view be taxable in the hands of the interim holder and nobody else.[36]The importance of identifying the source of the deemed interest was in my judgment rightly emphasised by Mr Gardiner QC in his submissions. The source doctrine is fundamental to the UK law of income tax (see for example Brown v National Provident Institution [1921] 2AC 222), as is the need to identify a charging provision before any charge to tax can be imposed. Section 730A is not in itself a charging provision. The function of section 730A is, first, to deem potentially chargeable income to exist, in the form of the deemed interest, and secondly, to deem a source of that income to exist, in the form of a deemed loan from the interim holder. It is that deemed loan which provides the necessary link between the notional interest and the relevant charging provisions which are to be found elsewhere in the tax legislation. The deemed loan is therefore of fundamental importance in bringing the notional interest into the charge to tax.[37]In the case of an interim holder who is an individual, the relevant charge to tax is imposed under Case III of Schedule D in section 18 of ICTA 1988, and the relevant source is the deemed loan itself. In the case of a corporate lender, the position since 1996 has been governed by the special regime dealing with loan relationships introduced by the Finance Act 1996, and the wording of Case III has been modified accordingly: see section 18(3A). The main charging provision in the loan relationship regime is to be found in section 80 of the Finance Act 1996, which provides by subsection (1) that for the purposes of corporation tax all profits and gains arising to a company from its loan relationships shall be chargeable to tax as income in accordance with Chapter II of Part IV of the Act, and by subsection (3) that profits and gains arising from a loan relationship of a company that are not brought into account under subsection (2) (which applies where the company is a party to a loan relationship for the purposes of a trade carried on by it) shall be brought into account as profits and gains chargeable to tax under Case III of Schedule D. In the present case, BH is not a trading company, so it is Case III of Schedule D (in the modified form in which it applies to corporate loan relationships) which imposes the relevant charge to tax by virtue of section 80(3).[38]Reverting now to section 730A, it will be seen that, where the notional interest is deemed to be paid by a company, the interest is deemed to be interest under a loan relationship for the purposes of Chapter II of Part IV of the Finance Act 1996: see subsection (6), as substituted by the Finance Act 1996 with effect for accounting periods ending after 31 March 1996. In this way the necessary machinery is again provided in order to bring the notional interest into charge to tax. However, section 730A(6) does not itself deem anybody to be a party to the deemed loan relationship. As subsection (6)(a) makes clear, it is necessary to go back to subsection (2) in order to find out who is deemed to pay the notional interest, and who is deemed to receive it. And for the reasons which I have already given, it seems to me inescapable that section 730A(2) identifies the deemed payer of the interest as the repurchaser (here Birkdale) and the deemed recipient of the interest as the interim holder (here Bank of Ireland).[39]It is true, as the present case well illustrates, that this conclusion can lead to strange results where dividends have been paid during the life of the repo and received by the interim holder. Those dividends may give rise to deemed manufactured dividends under section 737A, which will in turn lead to a deemed increase in the repurchase price of the securities, which will then trigger a deemed payment of interest under section 730A. So the interim holder may end up potentially liable to tax not only on the dividends which it has actually received, but also on the interest which it is deemed to have received. This does not appear to be a fiscally sensible end result, and if I could see my way to a construction of the legislation that avoided it, and did not give rise to further anomalies, I would be disposed to adopt it. However, I can see no answer to Mr Gardiner’s simple argument that the language of section 730A(2)(a) is clear and unambiguous, and in those circumstances consideration of possible anomalies takes the matter no further.[40]It is also fair to add that economic double taxation of the interim holder is unlikely to be a problem in practice, because a repo under section 730A must consist either of a single agreement or of related agreements entered into pursuant to the same arrangement; so in either case the parties may be expected to have thought through the tax consequences, and to have provided for them in a way they find satisfactory.[41]It is also worth noting that, from the Revenue’s point of view, the real vice in the present case is not that section 730A fails in its object of replacing what would otherwise be a capital gain with a flow of taxable income, but rather that the arrangements have been framed in such a way that the income accrues to a non-resident company outside the charge to corporation tax.[42]I have not rehearsed in full all of the arguments which were presented by each side on this issue, because they are very fully set out in the Decision. The point is ultimately a short one, and for the reasons I have given I consider that the Special Commissioners came to the right conclusion. It follows that the deemed interest of £3,975,473 was not income of BH. It was income of the interim holder, Bank of Ireland.

Issue (2): Deductibility

[43]This issue concerns the deductibility of the deemed manufactured overseas dividend of £3,975,473 paid by BH as the “relevant person” under section 737A. It is not disputed that this deemed manufactured overseas dividend is an annual payment within section 349 of ICTA 1988, by virtue of paragraph 4 (2) of Schedule 23A as applied by section 737A(5). It is also not disputed that it is a charge on income paid by BH within section 338, and therefore allowable as a deduction, unless it is prevented from being a charge on income either by section 338(5)(b) or by section 338(7) read with section 125(1) and (2)(b). As with the first issue, I shall begin by setting out the relevant legislation.[44]The relevant provisions in section 338 are as follows:
“(5) No such payment made by a company as is mentioned in subsection (3) above [which includes annual payments otherwise than in respect of the company’s loan relationships] shall be treated as a charge on income if – (a). … (b) the payment is not made under a liability incurred for a valuable and sufficient consideration … … (7) Any payment to which section 125(1) applies shall not be a charge on income for the purposes of corporation tax.” (7) Any payment to which section 125(1) applies shall not be a charge on income for the purposes of corporation tax.”
[45]Section 125 is headed “Annual payments for non-taxable consideration” and provides as follows:
“(1) Any payment to which this subsection applies shall be made without deduction of income tax, shall not be allowed as a deduction in computing the income or total income of the person by whom it is made and shall not be a charge on income for the purposes of corporation tax. (2) Subject to the following provisions of this section, subsection (1) above applies to any payment which – (a) … (b) is made under a liability incurred for consideration in money or money’s worth all of any of which is not required to be brought into account in computing for the purposes of income tax or corporation tax the income of the person making the payment.” (b) is made under a liability incurred for consideration in money or money’s worth all of any of which is not required to be brought into account in computing for the purposes of income tax or corporation tax the income of the person making the payment.”
[46]I shall begin by considering section 338(5)(b). The question posed by the subsection is whether or not the deemed payment by BH was made “under a liability incurred for valuable and sufficient consideration”. It is common ground that BH received valuable and sufficient consideration for the transactions which it entered into in reality.[47]Mr Furness submits, however, that in order to answer this question it is necessary to enter the deemed world, and if one does so it becomes apparent that BH received no consideration for the deemed manufactured overseas dividend which it paid to Birkdale. The result of BH’s success on the first issue is that the deemed payment of interest by Birkdale on 5 March 2001 was made, not to BH which paid the manufactured dividend, but to Bank of Ireland. Accordingly, says Mr Furness, in the deemed world brought about by operation of sections 737A and 730A BH ended up some £3.6 million out of pocket, and it therefore cannot be said to have made the payment under a liability incurred for a valuable or sufficient consideration. The question must be tested, he submits, by the terms of the deemed transaction, not the real transaction, because the liability only exists in the deemed transaction. It is not possible to ask whether the consideration for the payment is sufficient in the real transaction, because the liability does not exist in that transaction.[48]The argument is an ingenious one, but I am unpersuaded by it. Section 338 (5)(b) is a general provision relating to charges on income, and in my judgment its language only makes sense in relation to transactions in the real world. Since it is conceded that BH received full and valuable consideration for the transactions which it entered into in reality, that is in my view the end of the matter. Parliament cannot sensibly have contemplated an investigation of the value and sufficiency of the consideration for a transaction which is only deemed to have occurred. There is no indication of how such an unreal exercise is supposed to be performed, or of the assumptions that would have to be made for the purpose. It is certainly not enough, in my view, merely to point out that Birkdale is deemed to have paid the interest to Bank of Ireland rather than to BH. The implication is that if the Revenue had succeeded on the first issue, and Birkdale were deemed to have paid the interest to BH, there would then have been the necessary (deemed) valuable and sufficient consideration matching BH’s liability to pay the (deemed) manufactured overseas dividend to Birkdale. But as Mr Gardiner pointed out, even in terms of the deemed world this argument breaks down, because the deemed interest is still payable on a deemed loan from the interim holder, Bank of Ireland. If it is to be treated as consideration for anything, it must be deemed consideration for that deemed loan. It cannot also be treated as deemed consideration for a wholly separate deemed obligation on the part of BH to pay the manufactured dividend.[49]In my judgment a further clue that section 338(5)(b) must remain firmly anchored to the real world, even in the context of a deemed manufactured dividend, is provided by section 737A(5)(a) which provides that Schedule 23A and dividend manufacturing regulations are to apply “as if … 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) above. ” The arrangements for the transfer of the securities here referred to are clearly the real world arrangements, and what the subsection does is to deem the existence of an obligation on the part of the relevant person (here BH) to pay a manufactured dividend to the transferor (Birkdale) as part and parcel of those real world arrangements. That being so, it seems reasonably clear to me that Parliament must have intended the question of the value and sufficiency of the consideration for that deemed obligation to be tested by reference to the value and sufficiency of the consideration for the actual obligations undertaken by the relevant person under the arrangements.[50]The Special Commissioners took the view that, because the relevant obligation is imposed by statute in the form of section 737A(5)(a), it could never form part of a commercially negotiated transaction. As they said in paragraph 115 of the Decision, “a person does not give consideration for a liability imposed by statute”. They went on to say that if section 338(5)(b) were to be applied in such circumstances, this would mean that no deemed manufactured overseas dividend under section 737A(5)(a) could ever qualify as a charge on income. Since Parliament could not have intended such an extreme result, which would effectively nullify the operation of the latter section, they concluded that the only way of applying the legislation was on the assumption that the deemed annual payment would automatically be deemed to meet the condition in section 338(5)(b). While I accept that this is a possible view, I myself prefer the alternative advanced by Mr Gardiner that the question should be answered by an examination of the real world transaction. This would leave scope for Section 338(5)(b) to operate in cases where there is no valuable and sufficient consideration for the obligations actually undertaken by the relevant person. I acknowledge the force of the point that a person cannot sensibly be regarded as giving consideration for a liability or obligation to make a purely notional payment imposed on him by statute, but as I have said the wording of section 737A(5)(a) seems to me to provide a clue as to Parliament’s intention, and I prefer to adopt a construction which leaves section 338(5)(b) with work to do in some circumstances rather than one which treats it as automatically satisfied. However, in the circumstances of the present case the result is of course the same whichever route to it is adopted.[51]It remains to consider section 125(1) and (2)(b), which I can do very briefly. If, as I have held, BH is correct on section 338(5)(b), then it must follow that section 125(2)(b) is not engaged because it is common ground that all the consideration in money or money’s worth for which BH’s actual obligations were undertaken has been brought into account in computing BH’s income. The Revenue’s case on section 125 again requires one to enter the deemed world, but for the reasons I have given I do not consider that to be appropriate. I would only add that it is hard to see how section 125 could apply even if the Revenue were correct on section 338, because the logic of their argument is that in the deemed world BH received no consideration for the deemed manufactured overseas dividend. If that is right, the payment cannot be regarded as having been made under a liability incurred for consideration in money or money’s worth, so the requirement in the opening words of section 125(2)(b) would not be satisfied and the section could not apply.

Conclusion

[52]For the reasons which I have given this appeal must in my judgment be dismissed.

Cited in 1 later judgment