Trennery v HM Inspector of Taxes

These five appeals raise a common question as to the meaning and effect of section 77(2) of the Taxation of Chargeable Gains Act 1992 (“the 1992 Act”), as amended by the Finance Act 1995 (“the 1995 Act”). The appellant taxpayers succeeded before the Special Commissioners but failed before the judge, Peter Smith J. Permission for a second appeal was granted by Carnwath LJ on the papers on 15 May 2003.

It is agreed between the appellants and the Revenue that the facts of the five appeals are for present purposes indistinguishable, and that Mr Trennery’s appeal should be treated as the lead appeal.

Unless otherwise stated, references in this judgment to sections in the 1992 Act are references to those sections as they applied in the fiscal year 1995/6.

The appellants were formerly shareholders in Einkorn Ltd, an unquoted UK bus company. They wished to sell their shares, which were pregnant with gain, to another bus company, North British Bus Ltd. After taking advice, they each entered into a scheme, sometimes called a “flip-flop” scheme, designed to reduce the liability for capital gains tax accruing on the proposed sales.

A “flip-flop” scheme involves the creation by the owner of the asset in question of two separate settlements, and the subsequent sale of the asset by the trustees of one of them (the chargeable settlement). In paragraph 2 of their Decision dated 23 May 2002 (“the Decision”), the Special Commissioners explain how such a scheme is designed to work, as follows:

Before the Special Commissioners and before the judge, the Revenue contended that the schemes entered into by the appellants failed to achieve their desired object since in each case, by virtue of the definition of ‘derived property’ in section 77(8), the appellant had an interest in the chargeable settlement in the relevant year of assessment (1995/6). The Special Commissioners rejected this contention, but the judge accepted it. I will refer to this issue hereafter as “the Derived Property issue”. The Revenue also attacked the schemes on other grounds, but those grounds were rejected by the Special Commissioners and by the judge and the Revenue does not pursue them on these appeals.

The following are agreed facts in Mr Trennery’s appeal.

On 1 April March 1995 Mr Trennery executed a settlement (“the First Settlement”). The trustees were Mr Trennery and his wife. Under the trusts of the First Settlement, Mr Trennery was entitled to a life interest in possession, with remainder to his children and remoter issue.

On 4 April 1995 Mr Trennery executed a second settlement (“the Second Settlement”). As in the case of the First Settlement, Mr and Mrs Trennery were the trustees and Mr Trennery was entitled to a life interest in possession (subject, in the case of the Second Settlement, to a power of revocation exercisable by the trustees).

Clause 7 of the First Settlement conferred on the trustees power to apply the whole or any part of the capital or income of the trust fund by paying or transferring it to the trustees of any other settlement for the benefit of any of the beneficiaries under the First Settlement. Clause 12 of the First Settlement conferred on the trustees power to exclude any beneficiary wholly or partially from future benefit under the First Settlement.

Also on 4 April 1995, Mr Trennery transferred 8,000 shares in Einkorn Ltd into the First Settlement. On the same day, the trustees of the First Settlement borrowed £770,000 from National Westminster Bank, secured by a charge over the shares, and in exercise of the power in clause 7 of the First Settlement paid that sum to the Second Settlement to be held as an addition to the trust fund subject to the Second Settlement.

On 5 April 1995 (the last day of the fiscal year 1994/5) the trustees of the First Settlement, in exercise of the power in clause 12 of the First Settlement, executed a Deed of Exclusion and Appointment irrevocably excluding Mr Trennery from benefit under the First Settlement.

On 13 April 1995 (that is to say in the fiscal year 1995/6) the trustees of the First Settlement sold the shares for £1,044,640, thereby realising a substantial capital gain.

On 18 April 1995 the trustees of the First Settlement repaid the Bank.

It is to be noted at this stage that the Revenue accepts that, as the Special Commissioners record in paragraph 20 of the Statement of Agreed Facts set out in paragraph 4 of the Decision, the sale of the shares was not “pre-ordained” in the sense in which the majority of the House of Lords used that expression in Craven v. White[1989] AC 398. Hence the various transactions do not fall within the Ramsay principle (as explained by the House of Lords in Macniven v. Westmoreland Investments Ltd [2003] 1 AC 311). Further, the Revenue accepts that the First Settlement and the Second Settlement are separate taxable entities for capital gains tax purposes (cf. Roome v. Edwards [1982] AC 279).

Section 77 provides that in certain specified circumstances chargeable gains accruing to the trustees of a settlement in any year of assessment are to be treated as accruing to the settlor in that year. Section 78 gives the settlor a right of recovery from the trustees of any tax chargeable on and paid by him in respect of gains falling within section 77. Hence although the Revenue will look to the settlor to pay the tax on a gain falling within section 77, the end result in most cases will be that the settlement will bear the tax, and will bear it at a higher rate (viz. the settlor’s marginal rate) than if the gain had not fallen within section 77. Section 79 contains provisions supplementing sections 77 and 78.

Sections 77, 78 and 79 are in the following terms (so far as material):

The Special Commissioners addressed the Derived Property issue in paragraphs 12 to 23 of the Decision, as follows:

The Special Commissioners went on to reject the further grounds on which the Revenue attacked the schemes. They accordingly allowed the appellants’ appeals in principle. The Revenue appealed.

In paragraph 24 of his judgment, the judge sets out his approach to the interpretation of section 77, as follows:

After noting that there is no authority directly in point, the judge (in paragraph 26 of the judgment) rightly identifies the question for decision as being:

In paragraphs 28 to 38 of the judgment, the judge addresses the Derived Property issue, as follows:

The judge accordingly allowed the Revenue’s appeal on the Derived Property issue. For completeness, the judge went on to consider the Revenue’s other grounds for attacking the schemes. In agreement with the Special Commissioners, he rejected those grounds. There is no Respondent’s Notice.

Mr Brian Green QC (leading Mr Ewart, for the appellants) submits that, in concluding (in paragraph 35 of the judgment) that the cash sum paid to the Second Settlement could not be said to be anything other than indirectly derived from the shares, the judge applied the wrong test. Mr Green accepts that as a matter of ordinary language the cash sum can be said to have derived from the shares, but he submits that that does not address the question whether, as the Revenue contend, the cash sum represents ‘derived property’ within the meaning of section 77(8).

In addressing that question, it is (he submits) important to have in mind that the concept of ‘derived property’ is relevant only in determining whether, at any time during the relevant year of assessment (1995/6), the settlor had an interest in the First Settlement. He points out that in the instant case Mr Trennery was excluded as a beneficiary of the First Settlement prior to the commencement of that year, and that thereafter he enjoyed no benefit (directly or indirectly) under the First Settlement.

Mr Green submits that what he describes as the ‘root concept’ of section 77 is that of the settlor having an interest in the chargeable settlement. He submits that it would be strange if, in order to determine whether the settlor had an interest in that settlement, it were necessary to examine what interest the settlor might have under an entirely different settlement in which property which was formerly trust property in the chargeable settlement happens to be for the time being vested. He submits that, in principle, the acts of an independent third party (be that third party the trustees of another settlement or an absolute beneficial owner) ought not to be determinative of the question whether the settlor has an interest in the chargeable settlement.

Mr Green submits that paragraphs (a) and (b) of section 77(2) are mutually exclusive, in the sense that there is no scope for overlap between them. He submits that paragraph (a) covers the situation in which the settlor is a beneficiary under the chargeable settlement, whereas paragraph (b) covers the situation in which the settlor, although not a beneficiary, nevertheless enjoys a benefit from the settlement. In contrast, he submits, if the Revenue’s construction of the definition of ‘derived property’ is right not only is there, on the facts of the instant case, an overlap between paragraph (a) and paragraph (b), but there is also an overlap within paragraph (b) itself in that as a beneficiary under the Second Settlement in 1995/6 Mr Trennery enjoyed benefits deriving (indirectly) from property comprised in the First Settlement and (directly) from derived property forming part of the trust fund in the Second Settlement.

Elaborating on his submission that paragraph (a) is intended to cover cases in which the settlor is an actual beneficiary under the chargeable settlement, Mr Green submits that the words ‘.... is, or will or may become, payable to ....’ are apt to cover an interest in possession (‘is’), an interest in reversion (‘will’) and a contingent or discretionary interest (‘may’). Similarly, he submits, the words ‘applicable for the benefit of’ are apt to refer to applications of trust property (other than money) made within and under the terms of the chargeable settlement. He submits that support for this construction can be found in the equivalent subsection (subsection (3)(a)) in the ‘old’ section 77 (that is to say section 77 pre-amendment by the 1995 Act). He stresses that the Revenue accepts that in determining whether, under the ‘old’ section 77, the settlor had an interest under the chargeable settlement it was not permissible to look outside that settlement. He points out that the only material difference between the ‘old’ and the ‘new’ versions of paragraph (a) is the substitution of ‘derived property’ for ‘income which may arise under the settlement’. He submits that there is nothing to suggest that section 77 was intended to carry a new meaning by reason of that substitution.

As to paragraph (b), he submits that that paragraph is intended to cover, among other things, a situation in which the settlor, although not a beneficiary, enjoys a benefit (directly or indirectly) by reason of an appointment or an advancement to a beneficiary.

Mr Green submits that in applying paragraph (b) in the instant case the relevant inquiry is not as to the source of the £770,000 but as to the source of the benefits enjoyed by the settlor. Paragraph (b) will only apply, he submits, if the source of such benefits is the First Settlement.

Turning to the definition of ‘derived property’ in section 77(8), Mr Green submits that as a matter of construction the words ‘income from ....’ govern all that follows. Thus, he submits, the definition of ‘derived property’ in section 77(8) covers (a) ‘income fromthat property’; or (b) ‘income from.... any other property directly or indirectly representing proceeds of .... that property’; or (c) ‘income from .... any other property directly or indirectly representing proceeds of income from that property’; or (d) ‘income from .... income therefrom [i.e. from (b) or (c)]. (Emphasis supplied.) He further submits that the tax treatment of the First Settlement following the transfer of capital from the First Settlement to the Second Settlement should in principle be the same, irrespective of whether the capital appointed happens to represent the proceeds of a secured borrowing in the First Settlement, and that his construction of section 77(8) achieves that result.

Turning to the Revenue’s contrary contentions, Mr Green addresses first its contention that in the relevant year of assessment (1995/6) the settlor, by virtue of his interest under the Second Settlement, enjoyed an actual benefit from ‘derived property’, on the basis that until they were sold (on 13 April 1995) the shares constituted the security for the advance which in turn funded the appointment of the £770,000 to the Second Settlement; and that paragraph (b) of section 77(2) accordingly applies.

As to that, Mr Green submits that the benefits which the settlor enjoyed in 1995/6 were benefits which arose directly and exclusively under the Second Settlement. He submits that the existence of a continuing secured borrowing in the First Settlement is wholly immaterial to the benefits enjoyed by the settlor under the Second Settlement in 1995/6. He points out that the settlor benefited in the same way and to the same extent both before and after the borrowing was repaid. He submits that the continued existence of the First Settlement in 1995/6 was wholly immaterial. Had it ceased to exist, he submits, the settlor would have continued to benefit under the Second Settlement in precisely the same way. The true analysis, he submits, is that any linkage between the First Settlement and the Second Settlement ceased in 1994/5, and with it any possibility of actual benefit to the settlor from the First Settlement in 1995/6.

As to the Revenue’s further contention that in 1995/6 ‘derived property’ (in the form of the £770,000) was potentially applicable for the settlor’s benefit, and that paragraph (a) of section 77(2) accordingly applies, Mr Green submits that the legislative history favours his construction of the definition of ‘derived property’ in section 77(8), in that the amendment of section 77 was introduced by way of a consequential amendment, in order to bring section 77 into line with section 660A of the 1988 Act.

Generally, Mr Green submits that the construction of section 77(8) for which he contends gives effect to all the words of the definition, leaving none of them redundant. By contrast, he submits, the Revenue’s construction involves writing words into the definition so as to provide expressly that ‘derived property’ will include property which is no longer comprised in the settlement (i.e. the First Settlement) if the property (or the ‘derived property’, as the case may be) from which it originated is still comprised in the settlement.

Mr Green submits, therefore, that in considering whether the settlor has an interest in the First Settlement for the purposes of section 77(2) it is neither necessary nor appropriate to look beyond the confines of the First Settlement.

Mr McCall QC (for the Revenue) submits that the judge reached the right conclusion for the right reasons. He submits firstly that it is clear that paragraph (b) of section 77(2) applies in the instant case, on the basis that the shares yielded a benefit by providing security for the advance which in turn funded the appointment into the Second Settlement. Secondly, he submits that the £770,000 in the Second Settlement was property within the definition of ‘derived property’ in section 77(8), and in 1995/6 the settlor, as a beneficiary under the Second Settlement, enjoyed benefits deriving directly therefrom. He submits that the width of the definition of ‘derived property’ in section 77(8) clearly covers the instant case.

Mr McCall accepts, indeed asserts, that on the Revenue’s construction of section 77(8) ‘derived property’ which is no longer comprised in the chargeable settlement will cease to be ‘derived property’ when the entirety of the property from which it originated (in the instant case, the shares) ceases to be comprised in the chargeable settlement. He further accepts that to make this construction clear on the face of section 77(8) additional words would need to be included. However, he submits that, desirable though the inclusion of such additional words might have been, the true construction of section 77(8) is sufficiently clear on the face of the section as it stands.

He submits that section 77(8) requires the court to look at whatever may be the property which may at any time be for the time being comprised in the chargeable settlement, and then to ask itself, in relation to such property:

He submits that the words of section 77(2) require no more and no less than that.

As to paragraph (a) of section 77(2), Mr McCall accepts that under the ‘old’ section 77 it was not permissible to bring into account potential benefits enjoyed outside the chargeable settlement, but he submits that the change of language in the ‘new’ section 77 requires this to be done. He submits that if, as the appellants contend, ‘derived property’ can only exist within the confines of the chargeable settlement, then the concept of ‘derived property’ becomes largely, if not wholly, redundant. He submits that the appellants are seeking to whittle away at that concept in a manner and to an extent which cannot be justified by the language of the definition in section 77(8). He submits that that definition focuses on property, not on whether that property happens to be comprised in a particular settlement at a particular time.

He submits that there is no inherent objection to an overlap between paragraphs (a) and (b) of section 77(2), that by using wide language the draftsman of the definition has in effect invited overlaps of that kind.

The wording of the definition of ‘derived property’ in section 77(8) is so convoluted, and its grammar and punctuation so eccentric, that the task of construing it is, to my mind, a particularly challenging one. For that reason if no other, it seems to me to be thoroughly unsafe to approach the question of construction by reference to any attempted assessment of what Parliament’s intention in introducing the concept of ‘derived property’ into section 77 might possibly have been. Accordingly I respectfully endorse the approach which the judge adopted, namely that of looking at section 77 and seeing what it means, and then applying that meaning to the facts of the instant case (see paragraph 24 of his judgment, quoted earlier).

I accordingly turn straightaway to the definition of ‘derived property’ in section 77(8). As one would expect, the definition is framed by reference to property from which the ‘derived property’ derives: hence the introductory words ‘in relation to any property ....’. For convenience, I will refer to such property as “the Source Property”.

In order to identify the Source Property, one has to go back to section 77(2). Under paragraph (a) of section 77(2) the relevant Source Property is ‘any property which may at any time be comprised in the settlement’. Under paragraph (b) of section 77(2), the relevant Source Property is ‘any property which is comprised in the settlement’.

References to ‘the settlement’ in paragraphs (a) and (b) can only be references to the chargeable settlement. Section 79(2)(a) provides that references in section 77 to ‘property .... comprised in the settlement’ are references only to ‘property originating from [the] settlor’, which in turn includes ‘property representing that property’ (see section 79(3)(b)). Thus the draftsman is focusing on particular assets forming part of the settled fund, being assets which are, or which represent, assets originating from the settlor within the meaning of section 79(3)(a).

Read in the context of section 79(1), which is concerned with settled property originating from the particular settlor, the expression ‘property representing that property’ in section 79(3)(b) can only mean, in my judgment, property representing that property as settled property. Thus, where, for example, property has been sold out of the chargeable settlement, such property thereupon ceases to be ‘property .... comprised in the settlement’ and is effectively replaced as settled property by the net proceeds of the sale. Equally, the expression ‘property representing that property’ in section 79(3)(b) cannot, in my judgment, include property which was once but is no longer comprised in the chargeable settlement.

Returning to the facts of Mr Trennery’s case, since all the property in the First Settlement originated from Mr Trennery (within the meaning of section 79(2) and (3)), the Source Property for the purposes of the definition of ‘derived property’ in section 77(8) are the assets originally settled by Mr Trennery (i.e. the shares), and any property for the time representing the shares as settled property (that is to say, the cash advance of £770,000 whilst it remained settled property in the First Settlement).

I now return to section 77(8). I begin by construing the words ‘income from that property or any other property ....’. I reject Mr Green’s submission, the effect of which is, in my view, to insert the word ‘from’ immediately before ‘any other property’, so that the definition reads ‘income from that property or from any other property directly or indirectly ....’. In my judgment not only is that not the most natural – or perhaps I should say the least unnatural – reading of the words, but if it were correct it would introduce the (to my mind) bewildering concept of ‘income from .... the proceeds of property representing .... income from [the Source Property] .... and income therefrom’. I prefer the Special Commissioners’ analysis of section 77(8) as set out in paragraph 17 of the Decision (quoted earlier): an analysis which appears at that time to have been agreed by the appellants. Thus, on its true construction the definition covers, in my judgment:

income from the Source Property (which includes property ‘originating from’ the settlor, and any property ‘representing’ that property: see paragraph 46 above);

any other property directly or indirectly ‘representingproceeds’ of the Source Property;

income from 2;

any other property directly or indirectly ‘representing proceeds’ of income from the Source Property; and

income from 4.

I turn next to the word ‘proceeds’ in section 77(8).

In my judgment the word ‘proceeds’ in section 77(8) does not include income, since income is already expressly included more than once elsewhere in the definition. The expression ‘proceeds .... of income’ will, however, plainly cover accumulated income (and any property which ‘represents’ accumulated income: see section 79(5)(b)). Generally, the word ‘proceeds’ is in my judgment wide enough to cover the proceeds of any dealing with the Source Property. I accordingly agree with the judge that the word ‘proceeds’ is apt to cover a sum of money advanced on the security of settled property. In such a case the ‘proceeds’ of the security (i.e. the sum advanced) can be said to represent a proportionate part of the property charged. Both the property (subject to the charge) and the ‘proceeds’ are settled property within the chargeable settlement. Where the dealing in question is a sale, then (as already noted) the subject-matter of the sale ceases to be settled property and is replaced as settled property by the proceeds of sale. Indeed, I find it impossible to construe ‘proceeds’ so as to include property which is not itself settled property. To my mind, giving the word ‘proceeds’ its natural meaning, the ‘proceeds’ of settled property will inevitably themselves be settled property.

It follows, in my judgment, that a particular trust asset may qualify as both Source Property and ‘derived property’; and that in referring in section 79(2)(a) to ‘any property which may at any time be comprised in the settlement, or any derived property ....’ the draftsman was not intending to contrast settled property on the one hand with ‘derived property’ (as non-settled property) on the other. In using the expression ‘any property comprised in the settlement’ in section 79(2)(a) the draftsman must, I think, have had in mind the provisions of section 79(1), (2) and (3) relating to property originating from the settlor and the consequent need to restrict ‘derived property’ to property deriving only from such property.

Returning once again to the facts of the instant case, the cash advance of £770,000, whilst it remained settled property in the First Settlement, qualified (in my judgment) both as Source Property (as being property ‘representing’ property originating from Mr Trennery as settlor) and as ‘derived property’ (as being property representing ‘proceeds’ of the shares, which had in turn originated from the settlor). In addition, income from the £770,000, whilst that sum remained settled property in the First Settlement, would have been ‘derived property’ within the definition, as being ‘income from .... other property directly or indirectly representing proceeds of’ the Source Property, i.e. the shares. Similarly, if income from the £770,000 had been accumulated in the First Settlement and the income from such accumulations paid to the settlor, that too would have been ‘derived property’ (see section 79(5)(b)).

The next, and crucial, question is whether, on the true construction of section 77(8), property which was ‘derived property’ whilst it remained settled property in the chargeable settlement retains that character when it leaves the chargeable settlement.

In my judgment, the answer to that question is No. I have already concluded (see paragraph 51 above) that the word ‘proceeds’ in section 77(8) can only refer to property which is settled property in the chargeable settlement. It follows, if that is right, and given my conclusion as to the meaning of the word ‘representing’ in section 79(3)(b) (see paragraph 47 above), that the expression ‘property representing proceeds’ in section 77(8) must be similarly restricted.

I readily acknowledge that the draftsman of section 77(8) might have achieved the result which, in my judgment, he has achieved by using fewer words and by using them more clearly; or even, perhaps, by using no words at all. However, I do not regard that as a reason for rejecting what is, in my judgment, the true construction of the subsection.

As to Mr McCall’s submission (see paragraph 37 above) that in any event paragraph (b) of section 77(2) applies in the instant case, since the benefits enjoyed by the settlor in 1995/6 under the Second Settlement were benefits ‘deriving directly or indirectly from property comprised in’ the First Settlement, I accept Mr Green’s submission (see paragraph 30 above) that the only source of such benefits was the property comprised in the Second Settlement. In my judgment, those benefits cannot be said to have derived, even indirectly, from property comprised in the First Settlement. With respect to Mr McCall, the contrary seems to me to be unarguable.

It follows that I accept the appellants’ contention that in determining whether Mr Trennery had an interest in the First Settlement in 1995/6 for the purposes of section 77(2) one does not look beyond the confines of the First Settlement. In particular, on its true construction section 77(8) does not, in my judgment, extend to property which was once but is no longer settled property in the First Settlement. Hence, in my judgment, in applying section 77 it is not legitimate to have regard to any interest which the settlor may have had under the Second Settlement, or to any benefits which he may have enjoyed under that settlement, in the relevant year.

I reach this conclusion with no sense of reluctance, for it seems to me to produce a workable mechanism for determining whether a settlor is to be chargeable to tax in respect of a capital gain realised by the trustees of the settlement, as well as one which produces a measure of consistency between the capital gains tax code and the income tax code. By contrast, if the Revenue’s contention were correct the consequences could be far-reaching and, as it seems to me, might well lead to irrational results. In particular, it is hard to see the logic of a situation in which the liability of a settlor to capital gains tax should depend on the manner in which property which was once, but is no longer, comprised in the chargeable settlement is applied by third parties into whose hands it has come and over whom the trustees of the chargeable settlement have no control whatever. However, I do not rest my conclusion in this case on any such factors. I rest it simply on what I take to be the true construction of section 77(8).

I would allow these appeals.

I agree.

I also agree.