BANK of IRELAND BRITAIN HOLDINGS Limitedappellant

SPC00544

Corporation tax – tripartite repo transaction with two non-resident parties – whether resident party deemed to be in receipt of interest on deemed loan – whether deemed annual payment representing deemed manufactured overseas dividends deductible – appeal allowed on both issues

THE SPECIAL COMMISSIONERS

BANK OF IRELAND BRITAIN HOLDINGS LIMITEDAppellant

- and -

THE COMMISSIONERS FOR HER MAJESTY’S

REVENUE AND CUSTOMSRespondents

Special Commissioners: JOHN CLARK

MICHAEL JOHNSON

Sitting in public in London on 27 and 28 March 2006

John Gardiner QC and Philip Walford of Counsel, instructed by Slaughter and May, for the Appellant

Michael Furness QC, instructed by the Acting Solicitor for HM Revenue and Customs, for the Respondents

© CROWN COPYRIGHT 2006

1

DECISION

1. There are two issues in this case, both arising in respect of the Appellant’s self-assessment return for its accounting period ending on 31 March 2001. The first is whether the Appellant (referred to in this decision as “BH”) is deemed to have received a payment of interest under s 730A of the Income and Corporation Taxes Act 1988 (“ICTA 1988”). The second is whether the payment deemed to have been made by BH under s 737A ICTA 1988 is to be treated as a charge on income for the purposes of corporation tax by virtue of ss 338(7) and 125 ICTA 1988. For convenience, we refer to the Respondents throughout this decision as “HMRC” and assume that they existed by that description at all material times.

Background to the dispute

1. The transactions in issue in this case constituted what is commercially known as a “repo” transaction. The simple version of such a transaction is where an owner of securities agrees to sell those securities and subsequently to repurchase them from the other party by a specified future date, the repurchase price being agreed (or fixed by formula) at the outset. Under the terms of the agreement, the original owner is entitled or required to repurchase those securities.
2. The object of the repo is to provide funding to the original owner pending the repurchase, and to give the buyer the benefit of the securities for the same period. The transaction amounts to a form of secured lending, under which the buyer utilises surplus funds. Until the repurchase the buyer is the beneficial owner of the securities, but his rights as owner are fettered by the obligation to allow the repurchase to proceed. The original owner has the use of the sale price, but in the knowledge that when the repurchase takes place, he will have to pay the amount of the repurchase price.
3. Repo transactions may involve more than two parties. The buyer may, by agreement with the original owner, pass the securities to a third party, who is fettered with the obligation to retransfer the securities eventually to the original owner. The result will then be that the resale obligation falls to be fulfilled by the third party rather than by the buyer.
4. This appeal concerns a repo transaction of this tripartite kind.

The legislation

1. As the applicable legislation is complex, we set out extracts from it in the order in which it is relevant to the issues in this appeal. (All references are to ICTA 1988, except where otherwise stated.)
2. Section 730A provides:

“(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.

. . .

(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, and

(b) . . .

as references to the repurchase price which is . . . applicable by virtue of section 737C( . . .) or (11)(c)”.

1. Section 737A provides:

“(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.

(4) . . .

(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 were 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).”

1. Section 737B provides:

“(1) In section 737A and this section “securities” means United Kingdom equities, United Kingdom securities or overseas securities; and—

(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 “United Kingdom equities”, “United Kingdom securities”, “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) where subsection (1)(a) of that section applies, the amount which, under any agreement mentioned in section 737A(1), the transferor or connected person is required to pay for the securities bought back, or

(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.

(5)-(9) . . . ”

1. Section 737C provides:

“(1) This section applies where section 737A applies.

(2)-(9) . . .

(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) the gross amount of the deemed manufactured overseas dividend shall be taken to be the amount found under paragraph 4(5)(b) and (c) of Schedule 23A;

(b) any deduction which, by virtue of paragraph 4 of Schedule 23A, is required to be made out of the gross amount of the deemed manufactured overseas dividend shall be deemed to have been made;

(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.

(11A)-(12) . . . ”

1. The relevant parts of paragraph 4 of Schedule 23A provide:

“(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 . . . ”

1. In relation to treatment as a charge on income, the following parts of s 338 are relevant:

“(1) . . . in computing the corporation tax chargeable for any accounting period of a company any charges on income paid by the company in the accounting period, so far as paid out of the company’s profits brought into charge to corporation tax, shall be allowed as deductions against the total profits for the period as reduced by any other relief from tax, other than group relief.

(2) . . . “charges on income” means for the purposes of corporation tax— . . .

(a) payments of any description mentioned in subsection (3) below, not being dividends or other distributions of the company . . .

(3) Subject to subsections (4) to (6) below, the payments referred to in subsection (2)(a) above are—

(a) any annuity or annual payment payable otherwise than in respect of any of the company’s loan relationships . . .

(4) No such payment as is mentioned in subsection (3)(a) above made by a company to a person not resident in the United Kingdom shall be treated as a charge on income unless the company is so resident and either—

(a) the company deducts income tax from the payment in accordance with section 349, and accounts under Schedule 16 for the tax so deducted . . .

(5) No such payment made by a company as is mentioned in subsection (3) above shall be treated as a charge on income if—

(a) the paymentis charged to capital or the payment is not ultimately borne by the company; or

(b) the payment is not made under a liability incurred for a valuable and sufficient consideration (and, in the case of a company not resident in the United Kingdom, incurred wholly and exclusively for the purposes of a trade which is or is to becarried on by it in the United Kingdom through a branch or agency), and is not a qualifying donation (within the meaning of section 339).

. . .

(7) Any payment to which section 125(1) applies shall not be a charge on income for the purposes of corporation tax.”

1. The relevant parts of s 125 provide:

“(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) is an annuity or other annual payment charged with tax under Case III of Schedule D, not being interest; and

(b) is made under a liability incurred for consideration in money or money’s worth all or 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.”

The facts relevant to the appeal

1. The evidence before us was provided by way of a Statement of Agreed Facts, together with an Agreed Bundle of Documents. Accordingly, no oral evidence was given.
2. Although the appeal was heard in public, we were requested to use alternative descriptions of certain parties to avoid identifying the overseas institution which had been involved through certain of its subsidiaries in providing the securities for the purposes of the repo transaction. As nothing turns on the identity of that institution, we accepted BH’s argument that naming the institution indirectly by referring to the full names of the companies involved might be commercially sensitive. We therefore refer to these companies as, respectively, “BCo” and “PSub”.
3. BH is a wholly-owned subsidiary of the Governor and Company of the Bank of Ireland (“the Bank of Ireland”). BH is a private limited company incorporated and registered in England and Wales; it is resident in the UK.
4. The Bank of Ireland is incorporated and resident in the Republic of Ireland; it entered into the relevant transactions through its head office in Dublin.
5. BCo was a Cayman Islands incorporated and resident company. On 8 November 2000, the entire ordinary share capital of PSub, another Cayman Islands incorporated and resident company, was issued to BCo. BCo continued to own this ordinary share capital at all material times after this date.
6. On 9 November 2000, 225,000 £1 Class A Redeemable Preference Shares in PSub (“the Securities”, subsequently the subject-matter of the repo) were issued to BCo at a price of £1,000 per share. These 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. The directors of PSub were required to set a rate for all subsequent dividend payment dates (the 25th day of each month, or the next business day); this had to be done before 14 November 2000. They 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 to the date of the special dividend; the amount of the dividend payable on the next normal dividend payment date would be correspondingly reduced.
7. On 10 November 2000, various agreements comprising the repo were entered into. For the purposes of this appeal, it is only necessary for us to have regard to three of them. These are as follows:

(1)An agreement between BCo and the Bank of Ireland whereby BCo agreed to sell the Securities to the Bank of Ireland for a consideration of £225,000,000, the sale to be completed on 14 November 2000 and the consideration to be paid on that date. We refer to this consideration as “the Sale Price” and to this agreement as “the Share Sale Agreement”. Under the Share Sale Agreement, the Bank of Ireland covenanted not to transfer the Securities to any person other than BH; the Share Sale Agreement referred to the option agreement described at (2) below.

(2)An agreement entered into by the Bank of Ireland and BH whereby the Bank of Ireland granted to BH a call option on the Securities and BH granted to the Bank of Ireland a put option on the Securities. (Thus, until the options expired, either of the parties could require that the Securities be transferred from the Bank of Ireland to BH.) Under the terms of this agreement, either party could give notice to the other, up until 23 March 2001, that it wished to exercise its option, and, if an option was exercised, BH would have to pay the Bank of Ireland a purchase price amounting to the aggregate of £225,000,000 and an amount equal to any unpaid accrued dividends on the Securities. We refer to this price as “the Intermediate Price” and to this agreement as “the First Option Agreement”.

(3)An agreement between BH and BCo whereby BH granted to BCo a call option on the Securities and BCo granted to BH a put option on the Securities. Under the terms of this agreement, either party could give notice to the other, up until 23 March 2001, that it wished to exercise its option, and, if an option was exercised, BCo would have to pay BH a determinable purchase price. We refer to this price as “the Repurchase Price” and to this agreement as “the Second Option Agreement”.

1. The Repurchase Price was specified as:

(1)the aggregate of (a) £225,000,000; (b) the amount which at a rate of 8.30% per annum would have accrued on the sum of £225,000,000 in the period from 14 November 2000 until the completion date, ie the date when the sale was effected and the consideration paid; and (c) any finance breakage costs arising as a result of completion taking place earlier than 30 March 2001 (the last possible date for completion); less

(2)the amount of any dividends paid in the period from 14 November 2000 until the completion date, divided by 0.7. (As the dividend rate was set at 5.81% per annum, the result of this division equated to a rate of 8.30% per annum.)

1. On 14 November 2000, the cumulative preference dividend payable in respect of the securities for the first dividend period was paid by PSub to BCo, and, pursuant to the Share Sale Agreement, BCo sold the Securities to the Bank of Ireland for £225,000,000.
2. Following its purchase of the Securities, the Bank of Ireland received dividends on the Securities in respect of the periods ending on 25 November 2000, 25 December 2000 and 25 January 2001. However, on 20 February 2001 the Bank of Ireland exercised its put option under the First Option Agreement in respect of the Securities. Pursuant to the option exercise notice, the completion date for that option was 23 February 2001. The 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.
3. On 23 February 2001 BH paid the Intermediate Price of £225,000,000 to the Bank of Ireland and received the Securities. It subsequently received a dividend on the Securities for the period to 25 February 2001.
4. Pursuant to the Second Option Agreement, on 26 February 2001 BH gave notice of exercise of its put option in respect of the Securities. The completion date was specified as 5 March 2001. BH received a special dividend on the Securities for the period to 5 March 2001. The aggregate amount which it received in dividends on the Securities during its period of ownership of the Securities was £358,151.
5. On 5 March 2001, BCo duly paid the Repurchase Price and repurchased the Securities. The result of applying the formula set out at paragraph 21 above was that the amount of the Repurchase Price was £225,000,000.
6. BH delivered a corporation tax return for the year ended 31 March 2001 to its Inspector of Taxes on 26 March 2002. The return included a self-assessment which was calculated on the basis that BH was entitled to a deduction of £3,975,473 arising by virtue of section 737A.
7. On 26 April 2002 the Inspector of Taxes gave notice that he intended to enquire into that return and on 5 July 2004 a closure notice in respect of that enquiry was issued. On 10 August 2004 HMRC amended BH’s return, in effect excluding the deduction of £3,975,473. By notice dated 9 September 2004, BH appealed against that amendment on the ground that it was entitled to that deduction.

Arguments for BH

1. Mr Gardiner explained the history of the statutory provisions. Their purpose was to tax capital transactions on a deemed basis. The provisions sought to go beyond normal legal analysis. There was a very detailed statutory code and very precise statutory definitions. If the legislation had not succeeded in its intention, this was the result of the way in which it had been drafted. HMRC were asking for the provisions to be rewritten rather than construed. It was necessary to construe the words which were there, rather than what the draftsman might have included.

The deemed interest issue

1. Both parties accepted that ss 730A and 737A applied to the repo and that by s 737A(5) BH was deemed to have paid a manufactured overseas dividend of £3,975,473 to BCo. It was also agreed that by virtue of s 737C(11)(c), the repurchase price for the purposes of s 730A was deemed to be the aggregate of £225,000,000 (the actual Repurchase Price) and £3,975,473, and that the Sale Price was £225,000,000.
2. Both parties therefore accepted that by s 730(2)(a) £3,975,473 was deemed 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.”