Rae (Inspector of Taxes) v Lazard Investment Company Limited [1963] UKHL 7

House of Lords
Between
Rae (Inspector of Taxes)AppellantLazard Investment Company LimitedRespondent
It is Ordered and Adjudged, by the Lords Spiritual and Temporal in the Court of Parliament of Her Majesty the Queen assembled, That the said Order of Her Majesty's Court of Appeal, of the 13th day of March 1962, complained of in the said Appeal, be, and the same is hereby, Affirmed , and that the said Petition and Appeal be, and the same is hereby, dismissed this House : And it is further Ordered, That the Appellant do pay, or cause to be paid, to the said Respondents the Costs incurred by them in respect of the said Appeal, the amount thereof to be certified by the Clerk of the Parliaments.Rae (Inspector of Taxes) v. Lazard Investment Company Limited.

HOUSE OF LORDS

Lord Reid Lord Cohen Lord Jenkins Lord Guest Lord Pearce

RAE (Inspector of Taxes)

v. LAZARD INVESTMENT COMPANY LIMITED

10th April, 1963.

Lord Reid

My Lords,The Respondents were assessed to income tax for the years 1956-57 in the sum of £12,507 under Case V of Schedule D. In 1955 they had bought for £21,397 2,000 shares in Certain-teed, a corporation incorporated in the State of Maryland. That corporation was carrying on two separate businesses as manufacturers of asphalt roofing products and as manufac- turers of gypsum and paper products. It was thought to be in the interest of the latter business that it should be " hived off ". This was done by a procedure authorised by the laws of that State, a distribution in partial liquidation. A new company called Bestwall was formed and the gypsum business was sold to it with all the assets used in that business. The consideration was 715,145 shares of Bestwall and these shares were distributed to the shareholders of Certain-teed, who received one for each three Certain-teed shares. The prices on the New York Stock Exchange for Certain-teed shares cum Bestwall and then for Certain-teed shares ex Bestwall showed that the business sold to Bestwall was considerably more valuable than the business which Certain-teed retained.In this distribution the Respondents received 666 ⅔ Bestwall shares free of cost, and they allocated the original purchase price so that much the greater part was attributed to their Bestwall shares. They were assessed on the basis that these Bestwall shares were income within the meaning of Case V. The Special Commissioners discharged this assessment. Their decision was reversed by Plowman, J. but restored by the Court of Appeal.The Crown now maintain that these Bestwall shares should be held to have been received by the Respondents as income. They rely on the rule applicable to foreign companies in countries whose law is similar to the law of England. Under our law there is no doubt that every distribution of money or money's worth by an English company must be treated as income in the hands of the shareholders unless it is either a distribution in a liquidation, a repayment in respect of reduction of capital (or a payment out of a special premium account) or an issue of bonus shares (or it may be bonus debentures). But the Respondents maintain that this case depends on the law of Maryland. Partial liquidation is unknown to our law. but its effect was explained in evidence by Mr. Egerton, an eminent member of the Bar of Maryland, and in light of that evidence the Special Com- missioners have made findings of fact as to the law of Maryland which are not challenged.

The most important findings of fact are—

" (3) Certain-teed effected the ' hive-off ' by proceeding under the " said Section 70. Certain-teed did not declare a dividend. Under " Maryland law it would not have been possible to effect this ' hive-off ' " by way of a declaration of dividend. What the stock-holders received " from Certain-teed was part of Certain-teed's capital assets represented " by stock in Bestwall. Put in another way, the distribution effected " a division of capital assets formerly owned by Certain-teed and now " owned in part by Certain-teed and in part by Bestwall." (4) In the case of a distribution under the said Section 70 to a " stockholder who held Certain-teed stock as a trustee for a Maryland " trust the question as to whether the distribution is to be regarded2" as principal or income of the trust is answered by section 3 (2) of " Article 75B (Exhibit ' J '). The relevant words are ' All receipts " ... in liquidation of the assets of a corporation '. Under Article 75B " the Bestwall stock would belong to ' Remaindermen' and not to " ' Tenants ' (as defined in Section 1 of Article 75B). The said " Article 75 B was copied by the State of Maryland from one of the " model acts promulgated by the Commissioners on Uniform State " Laws; most of the States of the Union have adopted a similar " provision. The words ' in liquidation' in the said Section 3 (2) " cover a partial liquidation as well as a full liquidation." (5) The observation of Lord Normand in Commissioners of " Inland Revenue v. The Trustees of Joseph Reid (deceased), 30 TC 431 " at p. 442, viz. ' it is incorrect, both in law and in substance, though I " would prefer to draw no such distinction, to treat the shareholder as " possessing the capital assets of the company', would be a correct " statement of the law in Maryland.
" (6) As a result of the distribution by Certain-teed in partial " liquidation, under Maryland law Lico's original interest in Certain-teed " did not remain intact. Under that law the Courts of Maryland would " look for the substance of the transaction. The substance of this " transaction was that Lico's original interest was in the entirety of " Certain-teed's capital assets ; Lico's subsequent interest was comprised " in its combined holdings of stock in Certain-teed and in Bestwall " and those two holdings represented in reality the identical assets in " which it had its original interest. Without any question under the " law of Maryland, Lico did not receive a dividend from Certain-teed " but received capital."
I would first observe that Mr. Egerton's evidence and these findings relate not to the general effect of partial liquidation in Maryland but to the facts of this case. If the Courts of Maryland look for the substance of each transaction we cannot assume that the same results would follow if the facts were substantially different. It was suggested in argument for the Appellants that, if the findings in this case are given what seems to me to be their natural meaning, this procedure by way of partial liquidation could be used for tax avoidance: all that would be necessary would be to use accumulated profits to buy shares in another company and then distribute these shares by way of a partial liquidation when the shareholders would receive them as capital. But that would be quite a different case from the present case, and I am not at all prepared to assume that the Courts of Maryland, looking for the substance of the transaction, would reach the same result. It may well be that tax avoidance is not unknown in the United States, and that Courts there have appropriate means for dealing with. In the present case partial liquidation appears to me to be an apt name for what was done: it did not involve the death of the company but it did involve the amputation of one of its businesses.In deciding whether a shareholder receives a distribution as capital or income our law goes by the form in which the distribution is made rather than by the substance of the transaction. Capital in the hands of the company becomes income in the hands of the shareholders if distributed as a dividend, while accumulated income in the hands of the company becomes capital in the hands of the shareholders if distributed in a liquidation. In the present case the form of the distribution was one unknown to our law—distribution in a partial liquidation. By the law of Maryland which governs the company and which authorised this distribution the shares distributed were capital in the hands of the shareholders. Why, then, should we regard them as income? It is said that if this had been an English company and it had done what Certain-teed did these shares would have been income in the hands of the shareholders. But an English company could not do what Certain-teed did, for it could not distribute in a partial liquidation. No doubt an English company could have reached the same result by using a different method-- deciding a dividend. But it is found as a fact that it would not have been3possible in Maryland to effect this transaction by way of a declaration of dividend. So why are we to hold something to be a dividend which by the law of Maryland was not and could not be a dividend? There is no question here of the foreign law producing a result which is unreasonable or contrary to our idea of justice.The argument for the Crown was based to a large extent on what was said in this House in Inland Revenue Commissioners v. Reid's Trustees [1949] A.C.361. In that case a dividend in the form of cash was received from a South African company by a taxpayer in Scotland. It is clear from several of the speeches that this dividend was received as income. But its source was profit from appreciation of capital assets of the company. It was assumed, in the absence of evidence to the contrary, that the law of South Africa was the same as the law of England: so the dividend would be received in South Africa as income. But the taxpayer maintained that it was not taxable income, founding on the fact that a similar dividend paid by a British company would not be subject to income tax. This was held to be irrelevant: the dividend was income from a foreign possession and was therefore within Case V. The decision is, therefore, not in point, but the Appellant relied on statements which I shall quote. Lord Simonds said (at p. 373):
" I cannot imagine a safer or better [basis], the question is " as to income arising from a foreign possession, than to ask whether the " corpus of the asset remains intact in the hands of the taxpayer."
Lord Normand said (at p. 374):
"It seems to me beyond dispute that ' the "
' possessions ' are the shares ... In law capital cannot be returned to " shareholders by a mere money distribution whether called a dividend or " by some other name and there was in this instance no return of capital. " The shares of the company remained after the distribution intact and " precisely as they were before it." Lord Morton of Henryton said (at p. 379) :
" This sum must be either income arising from that possession or part of the " capital of that possession "
. And Lord MacDermott said (at p. 383) :
" No doubt the shares abated in market value after the payment of the " dividend, but they nevertheless remained intact. The ripe tree loses weight " and worth when it sheds its fruit, but the fruit remains fruit and no more " unless in its fall it has taken part of the tree with it."
Accepting that test, as I do without reservation, the question is whether " the corpus of the asset " or " the shares of the company " or " the capital " of the possession " did or did not remain intact after the Bestwall shares were distributed: or whether the Bestwall shares were merely fruit or had in their fall taken part of the tree with them.It is not disputed that the nature of a taxpayer's right to his foreign possession must be determined by the foreign law— Archer-Shee v. Garland [1931] AC 212 . So we must go to the law of Maryland to find whether the taxpayer's capital asset remained the same, and it is found as a fact " (6) As a result of the distribution by Certain-teed in partial liquidation, " under Maryland law Lico's original interest in Certain-teed did not remain " intact ", and then the reason is given, followed by the statement that the shareholder received capital. The plain meaning of that appears to me to be that after the partial liquidation the corpus of the Respondents' capital asset did not remain intact. And I do not find it surprising that the law of Maryland should so hold: I would expect that after a partial liquidation the corpus would be different. To adopt Lord MacDermott's metaphor, trees in Maryland are unlike trees in England, they can be split and both halves can live: after partial liquidation Certain-teed was only half the original tree, the other half becoming Bestwall. The Appellant says that both before and after the distribution the Respondents held 2,000 shares of Certain-teed, so their foreign possession or capital asset must be the same. But that is going by our law ; which looks to form. We are told that the law of Maryland looks to substance, and in substance the foreign possession did not remain intact. The shares after partial liquidation were not the same in substance as they had been before. So on the findings of fact as to the law of Maryland I have no difficulty in holding that this appeal should be dismissed.My Lords,my noble and learned friend, Lord Cohen, is unable to be present this morning, and he has asked me to say that he concurs.4

Lord Jenkins

My Lords,In this case I agree with the judgments delivered by my noble and learned friend Lord Evershed, M.R., and Upjohn and Diplock, LL.J. in the Court of Appeal, and would serve no useful purpose by repeating them at length. Accordingly I have very little to add.

Each, case in which it is sought to charge with income tax under Case V

of Schedule D income arising from possessions out of the United Kingdom must turn on its own facts, including as part of those facts whatever foreign law may be found to be properly applicable to such income or possessions.In the present case the proper law has been found to be that of the State of Maryland in the United States of America, and it has further been found (on the evidence of Mr. Egerton. a well known Corporation lawyer in Maryland) that under Maryland company law it is (within limits) possible and permissible to effect what is known as i partial liquidating distribution, which is a method of returning assets to members of a company in a partial liquidation, extending to part only of such assets, without winding up.It would seem that no comparable procedure exists under United Kingdom company law. Be that as it may, there is, as I understand it. no doubt that according to Maryland law a " partial liquidation distribution " was validly effected in the present case and that it resulted in the receipt by the Company, Lazard Investment Company Ltd. (incorporated and carrying on business in England), of the 666 ⅔ rds common shares in Bestwall in respect of which income tax is now claimed, in addition to the 2,000 common shares of $1 each in Certain-teed originally purchased by the Company, and still held by it.The Inspector of Taxes claims that the 666-odd shares in Bestwall were income arising from possessions outside the United Kingdom in the shape of the 2.000 shares in Certain-teed acquired by Bestwall as already men- tioned. I find it difficult to understand how any element of dividend or income could come into this transaction. It seems to me to have been essential to the scheme that the Company's interest in the capital assets made over to Bestwall should be retained as capital and not paid away as income, which, as I understand the position, would have been both incon- sistent with the scheme and indeed with Maryland company law.Mr. Egerton has described very clearly the way in which a partial liquidating distribution works with special reference to the present case. At page 11, paragraph (3), of the Case he said :
" Put in another way, the " distribution effected a division of capital assets formerly owned by Certain- " teed and now owned in part by Certain-teed and in part by Bestwall "
. At page 12, paragraph (6), of the Stated Case he said:
"Without any " question under the law of Maryland, Lico " (that is, Lazard Investment Co. Ltd.) " did not receive a dividend from Certain-teed but received " capital."
It is interesting to note that in Mr. Egerton's view (page 11, paragraph (4), of the Case) on a distribution of Bestwall stock to the Trustee for a Maryland Trust such stock would belong to the " remaindermen" and not to " Tenants " (i.e. " for life ").As regards the much-discussed case in your Lordships' House, Inland Revenue Commissioners v. Reid's Trustees [1949] A.C. 361, I need only say that I think it should be held distinguishable from the present case on the ground that it was decided without any evidence of the relevant foreign law.For these reasons I would dismiss this appeal.5

Lord Guest

My Lords,I have had the advantage of reading the speech delivered by my noble and learned friend on the Woolsack, and I agree that the appeal should be dismissed for the reasons given by him. I only propose to add a very few observations.The question as to what is the character of the payment by Certain-teed in the hands of recipient shareholders, the Respondents, falls to be determined by the law of the country in which Certain-teed is incorporated (Garland v. Archer-Shee [1929] 15 T.C.693). Certain-teed was incorporated under Maryland corporation law. Being a creature of statute the corporation's activities are entirely governed by and subject to Maryland law. The rights of shareholders in that corporation could only be exercised according to Maryland law. The character of a payment in the hands of a share- holder in this country is determined for all purposes by the legal machinery employed by the company acting under the relevant statutes (see Viscount Haldane in Commissioners of Inland Revenue v. John Blott, 8 T.C.101 at page 125). In ascertaining the character of a payment to a shareholder in this country resort must therefore be had to the machinery under English law. Similarly, if the corporation is incorporated under Maryland law resort must be made to the machinery under Maryland law. Counsel for the Appellant argued that the enquiry was whether the Bestwall distribution came within the words of Case V of Schedule D as " income arising from "possessions out of the United Kingdom" (section 123, Income Tax Act, 1952). The question depended on whether the distribution was income according to English law. But the form in which the " partial liquidating " distribution " was made under section 70 of the Maryland code is unknown to our law. To ask what would be the effect of such a distribution if made in England is to embark upon a fruitless inquiry because English law gives no guiding light. Accordingly to English law a distribution of capital profits would be income in the hands of the shareholder (Commissioners of Inland Revenue v. Trustees of Joseph Reid (Deceased), [1947] 30 T.C.431). But this is nihil ad rem in the present case, where the distribution has been made under Maryland law. In the Stated Case there are findings of fact as to the law of Maryland and they leave me in no doubt that according to the law of Maryland there was a capital distribution. In these circumstances my opinion is that the Special Commissioners arrived at a correct conclusion and the decision of the Court of Appeal was right.

Lord Pearce

My Lords,I agree with the judgments of the Court of Appeal.Certain-teed since its incorporation in Maryland in 1917 had been continuously engaged in the manufacture and sale of asphalt. Since 1926 it had also been engaged in the manufacture and sale of gypsum and paper products. For various commercial reasons in 1956 it decided to conduct the two businesses as two distinct entities and it separated them accordingly.If one could regard the commercial substance of the transaction without the necessary formalities and fictions of company law, the Respondents before 1956 owned a share in the two businesses conducted together under one management, and after 1956 they owned a like share in the two businesses conducted as separate entities. Their commercial position is therefore sub- stantially unchanged. From this informal aspect it would be surprising if the retention of their share in the gypsum and paper business were to be regarded as income. It would also be surprising if their share in that business were to go to the life tenant under a settlement or were to pay income tax before going to the remainderman.Undoubtedly, a large portion at least of the assets of Bestwall were the undivided trading and capital profits of the two businesses previously6conducted by Certain-teed. But that fact does not, even by English company and income tax law, decide whether the Bestwall shares were received by the Respondents as income or capital. The matter was put succinctly by my noble and learned friend, Lord Reid, in the cause of Reid's Trustees [1949] A.C. 361 at page 386, which dealt with income from a company in South Africa where the company law was taken to be similar to that in England. " There are many ways in which a company can deal with its " profits. If it adopts certain methods the result is the creation of new capital " assets. If it adopts other methods the result is the receipt of income by its " shareholders. In either case it is immaterial whether the profits were trading " profits or capital profits ... I can find no satisfactory alternative to the " view that, if a foreign company chooses to distribute its surplus profit as " dividend, the nature and origin of those profits does not and cannot be " made to affect the quality of the receipt by the shareholder for the purpose " of income tax."In that case the taxpayer had received a dividend out of capital profits; but there was no liquidation and no reduction of capital. The taxpayer's original capital was intact. It was therefore held that the dividend must be treated as income.In Commissioners of Inland Revenue v. Blott (1921) 8 T.C.101 at page 125, Lord Haldane said:
" The company, acting with the assent so given " of the shareholders, can decide conclusively what is to be done with " accumulated profits. It need not pay these over to the shareholders. "
It can convert them into capital as against the whole world, including, " as I think the principle plainly implies, the Crown claiming for taxing " or any other purposes." In that case it was held that fully paid bonus shares in the company credited to a shareholder, being distributed as capital, were not income in the hands of the shareholder.Thus it is not the source from which the assets are distributed but the machinery employed in their distribution which determines the question whether they are received as capital or income. They are received as capital if they are distributed as a bonus issue as in Blott's case or on an authorised reduction of capital or in a liquidation (see Commissioners of Inland Revenue v. Burrell, 9 T.C.27). If, however, they are distributed in any other way they are received and taxable as income (R. A. Hill and Others v. Permanent Trustee Company of New South Wales, Limited and Others [1930] A.C.720). But it is possible for a new statutory method of distribution to enlarge the categories of possible capital distribution set out in Hill v. Permanent Trustee. See In re Duff's Settlements. National Pro- vincial Bank Ltd. v. Gregson and Others [1951] Ch.923, where the distribu- tion of money paid out of a share premium account under the Companies Act. 1948, was held to have been received as capital. If, however, assets are distributed as shares in another company that is " merely a distribution of " money's worth instead of money " and they " simply represent a dividend " (per Rowlatt, J. in Wilkinson v. Commissioners of Inland Revenue, 16 T.C.52, and in Briggs v. Commissioners of Inland Revenue, 17 T.C.11).It is conceded that had Certain-teed been an English company controlled by English law its method of distribution could not have constituted a capital distribution and must therefore have been an income distribution, since our law does not allow the process of partial liquidation. But Certain- teed is incorporated under Maryland law which does allow a partial liquida- tion whereby part of a company's business or assets may be " hived-off " in the method adopted by Certain-teed in the present case. The stock so " hived-off " belongs to remaindermen and not to life tenants under a trust. The law of Maryland was a question of fact for the Special Commis- sioners to decide on the evidence before them. They accepted the expert evidence that Certain-teed did not distribute a dividend, and that without any question the shareholders received not a dividend but capital. The distribution was made in accordance with powers conferred by Section 70 (which related to partial liquidation) of the law relating to Corporations in the State of Maryland, and by that law the distribution could not have been made as a dividend.The question whether a receipt is " income arising from possessions out " of the United Kingdom " is a question to be decided according to the " law " of England " (see Camille and Henry Dreyfus Foundation Inc. v. Inland Revenue Commissioners [1956] A.C.39 at page 44). But it cannot be decided in vacua. The factual situation (which includes the foreign law) has to be examined in order to apply the English law. In Garland (H.M. Inspector of Taxes) v. Archer-Shee, 15 T.C.693 at page 711, Rowlatt, J. said: " The question of the American law is, what are exactly the rights " and duties of the parties under an American trust, and when you find " what those rights and duties are, you see what category they come in, " and the place they fill in the scheme of the English Income Tax Acts " which the Courts here must construe ".A corporation, being a persona ficta, owes its existence to the law under which it is created and cannot act except in accordance with it. It is, therefore, impossible to assess the behaviour of a Maryland company on the hypothesis that it has been created by and acts in accordance with English law.By the law of Maryland this Maryland Corporation has made a distribu- tion of capital. In the hands of the shareholder the distribution is received as capital and not income. It is, therefore, not liable to tax under the English Income Tax Act.In the present case that conclusion accords with the commercial substance of the transaction. It has been suggested in argument that foreign law might create colourable labels or machinery whereby it could fix upon a distribution a specious appearance of capital when in truth it should be income and that thus tax could be unfairly avoided. If such a situation arises, it may well be that the English Courts would feel entitled to look behind the labels or even, perhaps, behind the machinery itself to find the true substance of the matter. But in the present case the transaction was admittedly genuine, and I see nothing in the concept of partial liquida- tion which is wholly out of accord with the notions of English law.I would dismiss the appeal.

(P/30784) Wt 8024—149 15 7/63 St.S