Harding v Revenue & Customs

This is an appeal from a decision of Briggs J [2008] STC 1865. The judge dismissed an appeal from a decision of the Special Commissioner (Mr Charles Hellier) dated March 15, 2007, whereby he dismissed an appeal by Mr Nicholas Harding (“Mr Harding”) from an assessment to capital gains tax for the year ended April 5, 1996 in respect of a gain which the Commissioners for Inland Revenue (“the Revenue”) decided had arisen on his redemption of certain loan notes (“the Loan Notes”) on July 1, 1995.

Mr Harding helped build up a highly successful company in the computing industry, Frontline Distribution Ltd (“Frontline”), in which he was a substantial shareholder.

By a Subscription Agreement of April 5, 1990, a German company, Computer 2000 AG agreed to provide capital to Frontline for new A and C ordinary shares. The Subscription Agreement also contained call options whereby Computer 2000 AG could buy, and put options whereby the holders could sell, all the B ordinary shares in Frontline. As from December 1994 Mr Harding held 33,120 B ordinary shares in Frontline. Two other shareholders held the bulk of the remaining B shares.

The Loan Notes were to be denominated in sterling but contained an option for the holder of each Loan Note exercisable during the ten day period following the giving of a Redemption Notice, to have the Loan Note redeemed in US dollars, Canadian dollars or German deutschmarks, at a defined exchange rate, close but not identical to the exchange rate prevailing at redemption. The earliest redemption date was July 1, 1995.

The currency conversion provision was Condition 4.7, which provided:

“The Holder may by notice in writing to the Company given no more than 10 days after a Redemption Notice given in accordance with Condition 4.2 elect that the Note should be redeemed on the Redemption Date in US dollars, Canadian dollars or German deutschmarks at the Holder’s option … In the event that the Holders fail to notify the Company in accordance with the provisions of this Condition 4.7, that payment should be made in a currency other than Sterling, this Condition 4.7 shall lapse and cease to have any effect.”

On January 13, 1995 the options to sell the Frontline shares to Computer 2000 AG were exercised, and Mr Harding was issued the Loan Notes by Computer 2000 AG in exchange for his Frontline shares. On the same day he gave notice to redeem the Loan Notes on July 1, 1995. He (unlike the other shareholders) did not exercise his currency conversion option, and accordingly it lapsed on January 23, 1995.

Mr Harding received £2,240,000 on redemption.

Upon issue to Mr Harding, the Loan Notes had rolled-over into them a very substantial capital gain which had accrued by reason of the large increase in the value of the shares for which the Loan Notes were exchanged. If he is liable for capital gains tax it has been agreed that the chargeable gain was £1,920,000, on which the tax payable would be £765,600.

The only question is whether the Loan Notes were, or were not, qualifying corporate bonds (“QCBs”) at that time, within the meaning of section 117 of the Taxation of Chargeable Gains Act 1992 (“the 1992 Act”), and related provisions, in the form then in force.

The question of construction which is raised by this appeal is whether a security in which a currency conversion option has lapsed, becomes (as Mr Harding contends) for the purposes of section 117(1), at the moment of lapse, “a security … in respect of which no provision is made for conversion into, or redemption in, a currency other than sterling.”

If Mr Harding’s case on construction is correct, then the rolled-over gain simply disappeared from tax altogether when his currency conversion option lapsed on January 23, with the consequence (for him) that it will never be taxable at all. It was common ground that it could not have been intended that the language of section 117(1)(b) should have the effect that a rolled-over gain should disappear altogether from tax, and that if he was right on the point of construction, Mr Harding would obtain a windfall benefit as the unintended result of a drafting anomaly. If the Revenue’s case on construction is correct (as the Special Commissioner and the judge decided), then that rolled-over gain, together with any additional gain between the issue and redemption of the Loan Notes, became chargeable to tax on July 1, 1995.

Capital gains tax is charged on disposals of chargeable assets: 1992 Act, section 1(1). Debts are property for the purposes of the Act (section 21(1)(a)), and “Debts on a security” are chargeable assets: section 251(1). But qualifying corporate bonds (“QCBs”) are exempt assets by virtue of section 115(1), which provides: “A gain which accrues on the disposal by any person of (a) …qualifying corporate bonds … shall not be a chargeable gain.”

So far as material section 117(1) of the 1992 Act provides as follows:

“(1)

For the purposes of this section a ‘corporate bond’ is a security as defined in section 132(3)(b) –

(a)

the debt on which represents and has at all times represented a normal commercial loan; and

(b)

which is expressed in sterling and in respect of which no provision is made for conversion into, or redemption in, a currency other than sterling

and in paragraph (a) above ‘normal commercial loan’ has the meaning which would be given by sub-paragraph (5) of paragraph 1 of Schedule 18 to the Taxes Act if for paragraph (a)(i) to (iii) of that sub-paragraph there were substituted the words ‘corporate bonds (within the meaning of section 117 of the 1992 Act)’.

(2)

For the purposes of subsection (1) (b) above –

(a)

a security shall not be regarded as expressed in sterling if the amount of sterling falls to be determined by reference to the value at any time of any other currency or asset; and

(b)

a provision for redemption in a currency other than sterling but at the rate of exchange prevailing at redemption shall be disregarded.

…”

Section 117 provides that if an asset is to qualify as a QCB it must be a “security” as defined in section 132(3)(b), which provides as follows:

“(b)

‘security’ includes any loan stock or similar security whether of the Government of the United Kingdom or of any other government, or of any public or local authority in the United Kingdom or elsewhere, or of any company and whether secured or unsecured.”

It must also represent and at all times have represented “a normal commercial loan” within the meaning of the Income and Corporation Taxes Act 1988 (“the Taxes Act”), Sched. 18, para 1(5), which provides, broadly, that a “normal commercial loan” is a loan which does not carry any right to conversion into shares or securities.

Consequently a person who acquires, either by original issue or by purchase, a QCB is exempt from chargeable gains on it, and is not entitled to credit for losses incurred, in each case between his acquisition and his disposal of it, whether by redemption, sale or gift. By contrast, the holder of a security which is not a QCB (“a non-QCB”) is not so exempt.

The identification of QCBs as a class of asset qualifying for special capital gains tax treatment was originally enacted by the Finance Act 1984, section 64 and Schedule 13, Part I. Section 64(1) provided as follows:

“Part 1 of Schedule 13 to this Act shall have effect for the purpose of−

(a)

providing, in relation to qualifying corporate bonds, an exemption from capital gains tax and corporation tax on chargeable gains similar to that provided in relation to gilt-edged securities by Part 4 of the Capital Gains Tax Act 1979…”

At that time there was a narrower definition of a QCB than was in force by 1995, in that the relevant security had to be quoted on a recognised stock exchange in the United Kingdom, or dealt with on the Unlisted Securities Market, or was issued by a body which at that time had some other quoted share, stock or security. The exemption from capital gains tax of “corporate bonds” was introduced in order to stimulate the British bond market, and the conditions (especially the condition relating to “normal commercial loan”) were designed to ensure that the exemption only extended to bonds that were genuinely traded in that market; and more generally to ensure that the exemption could not be used as a vehicle for avoidance: Weston v. Garnett [2005] STC 1134, at [41]-[42], per Buxton LJ.

As the judge pointed out, by 1995 the requirement that, to qualify as a QCB, a security had to be listed, or issued by a company with other listed shares or securities, had been removed. It follows that the original purpose, identified by Buxton LJ, of stimulating the British bond market, and limiting the special treatment by way of exception to bonds genuinely traded in that market had been outgrown.

Special provision is made for the consequences which follow from the acquisition or the disposal of QCBs and non-QCBs by way of exchange in the context of corporate reconstructions and take-overs, such as (as in this case) a takeover in which a chargeable asset in the target company (such as an ordinary share) is exchanged for a security (QCB or non-QCB) in the acquiring company.

Where a share is exchanged for a non-QCB, the accrued gain in the old asset (the share) is “rolled-over” into the new asset (the non-QCB). The exchange is not treated as involving any disposal of the old asset or any acquisition of the new asset, and the new asset is treated as if it had been acquired at the same time, and for the same price, as the old asset: sections 126,127, 135(3). The effect of such a roll-over is that the person exchanging his old asset is temporarily relieved from paying tax on the latent capital gain at the time of its exchange for the new asset. That rolled-over gain becomes taxable, together with any gain in the value of the new asset, upon a chargeable disposal of the new asset, such as a sale or redemption of it for cash.

Because an essential feature of a QCB is that a disposal of it for cash is not chargeable to tax, it was necessary to make special provision for an exchange of an old chargeable asset (such as a share) for a QCB, in the context of a take-over. The relevant special provision is contained in section 116, which provides:

“ (1) This section shall have effect in any case where a transaction occurs of such a description that, apart from the provisions of this section –

(a)

sections 127 to 130 would apply …and

(b)

either the original shares would consist of or include a qualifying corporate bond and the new holding would not, or the original shares would not and the new holding would consist of or include such a bond;

and in paragraph (b) above ‘the original shares’ and ‘the new holding’ have the same meaning as they have for the purposes of sections 127 to 130.

(2)

In this section ‘relevant transaction’ means a reorganisation, conversion of securities or other transaction such as is mentioned in subsection (1) above …”

By section 116(5), section 127 is disapplied, so that there is no roll-over. By section 116(10) such an exchange gives rise to no immediately chargeable disposal of the share but the chargeable gain or allowable loss which would then have arisen is calculated as if there had then been a disposition, and then charged to tax or (if a loss) allowed, at the time of the disposal of the QCB, and at the rate then in force. This is described by the Special Commissioner as a “frozen gain” mechanism.

In relation to the latent gain inherent in the old asset immediately prior to exchange, the frozen gain regime achieves in relation to an exchange for QCBs substantially the same result as the roll-over arrangement achieves in relation to an exchange for non-QCBs. In both cases the latent gain in the old asset is taxed upon the disposal of the new asset. Gains or losses attributable purely to the new asset are, if it is a QCB, left out of account. The key to the successful operation of the frozen gain regime is that it displaces the ordinary rule that no chargeable gain or allowable loss occurs on the disposal of the QCB.

A feature of the frozen gain regime as it stood in 1995 was that it depended upon the occurrence of “a transaction” of such a description that, apart from section 116, the roll-over provisions of sections 127 to 130 would have applied: see section 116(1)(a).

This requirement creates no difficulty where the new asset qualifies, both upon its acquisition and upon its disposal, as a QCB. It can only be acquired by means of a transaction. Indeed, the whole of the roll-over scheme and the frozen gain regime substituted for use in connection with QCBs works without anomaly, provided that there is no change in the status of the new asset between acquisition and disposal (whether it is a QCB or a non-QCB).

There were amendments to the QCB statutory regime in the Finance Act 1997 with effect from November 1996, and therefore only after the dates relevant for present purposes. There are two relevant amendments. The first, to section 132 of the 1992 Act, widened the definition of “conversion of securities”, so that the relevant part of it now reads (with square brackets round the sections inserted by amendment):

“(a)

‘Conversion of securities’ includes [any of the following, whether effected by a transaction or occurring in consequence of the operation of the terms of any security or of any debenture which is not a security, that is to say]

(i)

…

[(ia) a conversion of a security which is not a qualifying corporate bond into a security of the same company which is such a bond, …].”

The second amendment (by section 88(4)) was to insert into section 116(2) the following phrase:

“references to a transaction include references to any conversion of securities (whether or not affected by a transaction) within the meaning of section 132 …”

The effect of those amendments, from November 1996, is to ensure that if a non-QCB is capable of changing its status without a transaction (such as the lapsing of a foreign currency option) into a QCB, that will trigger the frozen gain regime, such that any gain which would have been chargeable if on the same date the non-QCB had been disposed of, will be frozen and taxed upon the subsequent disposal of the QCB at the rates then in force. A Revenue press release seeking to explain those amendments stated by way of example that:

“If a security held by an individual has an option to convert into a non-sterling currency it will not be a QCB. If, however, the option lapses after a given time, the security may become a QCB. It has been argued that in such cases, there would be no chargeable claim on the disposal of the security, nor would there be any disposal when the conversion right lapses.

To ensure that tax is not lost in these circumstances, provisions will be introduced so that the change of status of the security from a non-QCB to QCB (and also a QCB into a non-QCB) is treated as a conversion of securities. This will ensure that the liability on any existing gain is preserved. Any capital gain resulting from the treatment of the change in status as a conversion of the security may still be deferred by the taxpayer, where existing rules allow for this, until the security is disposed of.”

The principal point on this appeal arises from Mr Harding’s contention that the Loan Notes, which it is common ground were non-QCBs upon acquisition, changed their status upon the lapse of the currency conversion option on January 23, 1995, ten days after acquisition and about five months before redemption.

If that change in status occurred, then two consequences would flow. The first consequence is that the roll-over regime would not apply because there is no statutory provision for a charge to tax upon the disposal constituted by the redemption of what would by then be a QCB. The second consequence would be that the frozen gain regime would not apply because the Loan Notes were not QCBs upon acquisition, and did not change their status so as to become QCBs by virtue of any transaction for the purposes of section 116.

The substantial capital gain would fall out of tax because the disposal of the QCBs (as Mr Harding says they were) in 1995 would give rise to no chargeable gain, and because the exchange of the shares for the Loan Notes in January (when they were on any view non-QCBs) would not give rise to a charge to tax either: see section 127, as applied by section 135, which together require the new asset to be classified as at the time of the take-over, rather than (if different) at the time of its subsequent disposal.

Mr Harding’s argument is, in essence, as follows. Section 117(1)(b) looks to the time when the test is to be applied and therefore to rights which may be exercised at that time and in the future. This is said to appear from the use of the present tense in the words “is expressed in sterling and in respect of which no provision is made for conversion …” Consequently, if the right to convert has lapsed, the Loan Note is not only still expressed in sterling but also there is no subsisting provision for conversion, and the Loan Notes have become QCBs without any “transaction” for the purposes of section 116. The interpretation is said to be clear and unambiguous, and also supported by the contrasting use of the words “represents and has at all times represented” a normal commercial loan in section 117(1(a).

The essence of the Special Commissioner’s decision dismissing Mr Harding’s appeal was that “the test in [section 117(1)](b) must be conducted by reference to the formal terms of the security rather than by reference to those that are effective or operative at the time of disposal.”

He supported this conclusion by reference to the distinction between “security” and “debt” in the two conditions in section 117(1). Section 117(1)(a) referred to the “security … the debt on which” represented a normal commercial loan, whereas section 117(1)(b) referred to a “security .. which” is expressed in sterling and in respect of which no provision is made for conversion. That distinction in his view showed that section 117(1)(b) was looking more to the formal terms of an instrument rather than to rights attaching to the debt.

The second distinction was the use of the words “at all times” in section 117(1)(a), which did not appear in section 117(1)(b). The Special Commissioner did not consider that that distinction assisted Mr Harding, because the words fulfilled a function in section 117(1)(a) which was not needed for section 117(1)(b), because the provisions for the definition of commercial loan in the Taxes Act, Sched. 18, did not contain any time constraint.

The judge came to the same conclusion, but on somewhat different grounds. He said that in section 117 the word “security” identified an asset in the nature of an investment. It was used as meaning something distinct from the debt on it referred to in section 117(1)(a), but it was not simply a reference to the document which evidenced the debt: W T Ramsay Limited v. IRC [1982] AC 300; [1981] STC 174. Consequently, the condition in section 117(1)(b) called for an analysis of the underlying chose in action or asset, rather than the security document itself: at [31], [63].

In the judge’s view, a cardinal feature of the task of construction was the anomaly arising from Mr Harding’s construction which, by permitting a security to change after acquisition from a non-QCB to a QCB before disposal but without any transaction, thereby enabled substantial accrued gains to fall altogether out of tax. The mischief which caused the anomaly was simply the propensity of a security which is a non-QCB only because it falls foul of the condition in section 117(1)(b) to acquire that desirable status when any relevant currency conversion option lapsed. Nothing else in section 117 gave rise to that anomaly, and it was therefore to be questioned whether Parliament can possibly have intended that the condition in section 117(1)(b) should do so.

Literally construed, and in particular by reference to the differences in time-language by comparison with the (a) condition, the (b) condition did appear to have the consequences for which Mr Harding contended. There was nothing linguistically inappropriate in treating the (b) condition as requiring the analysis as at the disposal date to take account of a currency conversion condition which has yet to become exercisable in the future.

The judge concluded (at [64])

“ …the alternative construction, by which an otherwise relevant currency conversion option does not fall out of view merely because it has lapsed by the date of disposal, is both an available construction, and the construction which ought to be preferred. My reasons follow. First, it plainly avoids the glaring anomaly, and no counter-mischief has been suggested. Secondly it does so by bringing the (b) condition into conformity with the rest of section 117, by preventing the lapse of a relevant currency conversion option from causing a non-transactional change of status. Thirdly I find it impossible to believe that the draftsman who framed the (b) condition, or Parliament when it passed it, consciously intended to introduce a propensity for non-transactional change of status, simply by using the phrases ‘is expressed’ and ‘in respect of which no provision is made’, and by leaving out the phrase ‘at all times’. No conceivable purpose can have existed for introducing by a side wind a propensity for non-transactional changes of status, merely by requiring the chose in action to be examined on every relevant occasion to see what are its terms. At the moment of redemption, the Loan Notes in the present case contained a lapsed currency conversion provision. In my judgment the language of the (b) condition contains no deliberate pointer to the relevance or otherwise of its lapse, and may perfectly reasonably be construed as applying as much to a lapsed provision as to a currently exercisable provision or (which Mr Southern concedes) to a provision which has yet to become exercisable at the relevant date. The answer to the question which of those three different types of provision fall foul of the (b) condition is to be arrived at by consideration of the underlying consequences. The only answer which is free of anomaly is that all three types, including for present purposes a provision that has lapsed, do so.”

The consequence was that the Loan Notes in the present case were not, either when issued or when redeemed, securities “in respect of which no provision is made for conversion into, or redemption in, a currency other than sterling” within the meaning of section 117(1)(b) of the 1992 Act.

The arguments presented by Mr David Southern on behalf of Mr Harding were these. The natural and ordinary sense of the words used in section 117(1)(b) bears only one meaning, and the judge imposed on the words a meaning which the words used were not capable of bearing. Purposive construction cannot be used for judicial law-making, where the ordinary and natural meaning of the words, considered in context, allowed only one interpretation.

It is not possible to read into section 117(1)(b) the same temporal requirements as in section 117(1)(a) when the two paragraphs differ significantly in wording and are dealing with different types of gain and risk. The test in section 117(1)(a) looks to the past, present and future. It has to be satisfied “at all times” during the life of the instrument. Condition (b) does not use an expression equivalent to “at all times”, and uses the present tense alone. The second test looks at the present and the future. It has to be applied separately on each relevant occasion.

If the security is to be regarded as a chose in action, a bundle of rights, then rights which were in the bundle, but have lapsed, are not relevant to the section 117(1)(b) test (though such rights are taken into account in the section 117(1)(a) test).

The judge’s construction removes the distinctions between section 117(1)(a) and section 117(1)(b), and treats the same conditions as applying to section 117(1)(b) as to section 117(1)(a).

The “anomaly” which led to the judge’s conclusion is a consequence of this scheme. It is an error to proceed on the basis that there is a single intelligible principle which underlies the scheme of the legislation. Like any other legislation, it is the product of a series of compromises.

For the Revenue, Mr Michael Furness QC accepted that on a literal interpretation of the words of condition (b) either construction is possible.

The key to the application of the (b) condition is that it applies to the security. The security is a wider expression than merely the debt which is payable under it. “The security” refers to the whole range of contractual provisions which govern matters such as assignability, priority, redemption, default provisions and the currency in which the debt is to be expressed or paid. The security is the package of rights and obligations which makes the debt marketable by the creditor (the ability to market the debt being a key feature of a debt on a security).

The Revenue now accepts that the judge was correct to reject the argument that the security is the written document setting out the terms on which the debt is held, on the ground that following W T Ramsay Limited v. IRC [1982] AC 300 it is clear that a debt on a security does not have to be in writing. But whether the terms of the security are oral or written, it is always possible to ask the question posed by condition (b), namely is this a security which is expressed in sterling and in respect of which there is no provision for currency conversion? The Loan Notes did at all times contain a provision allowing for redemption in a foreign currency; and the fact that Mr Harding did not himself elect to invoke that provision does not alter this.

The absence of the expression “has at all times” in condition (b) is explained by the fact that condition (a) and condition (b) are looking at two different concepts – the debt, and the security itself. Condition (b) is looking at the terms on which the debt has been issued. The question of what the terms are can be asked and answered once and for all when the security is issued.

There was no real dispute on the basic principles of interpretation. The question is always whether the relevant provision of the statute, upon its true construction, applies to the facts as found, and the statutory provision should be given a purposive construction in order to determine the nature of the transaction to which it was intended to apply and then to decide whether the actual transaction answers to the statutory description: Barclays Mercantile Business Finance Ltd v Mawson [2005] STC 1, at [32], [36]. In particular, if a literal construction would lead to injustice or absurdity, and the language admits of an interpretation which would avoid it, then such an interpretation may be adopted: e.g. Luke v IRC [1963] AC 557, at 577; Mangin v. Commissioner ofInland Revenue [1971] AC 739 at 746; Jenks v.Dickinson [1997] STC 853. But there may be cases in which the anomaly cannot be avoided by any legitimate process of interpretation: e.g. HMRC v Bank of Ireland Britain Holding Ltd [2007] EWCA Civ 58, at [44].

In my judgment the appeal can be disposed of on a very simple ground, which is not dependent on any distinction between “security” and “debt,” and which does not require any departure from the plain meaning of the words in section 117(1)(b).

Neither side (but for different reasons) argues that the distinction is crucial. Section 117(1)(a) applies to the “debt on [the security],” and section 117(1)(b) refers to the “security.” The words “the debt on a security” can refer to an obligation to pay or repay embodied in the Loan Note, which is evidence of the right to receive payment: Taylor Clark InternationalLimited v Lewis [1997] STC 499, at 513. But a debt, to qualify as a debt on a security, need not necessarily be constituted or evidenced by a document: W T Ramsay Limited v. IRC [1982] AC 300, at 329. In Weston v. Garnett [2005] STC 1134 the assets in issue were two successive loan notes and the terms of the first gave the holder a right to exchange them for the second. The second notes (but not the first) contained a share conversion option, and the question was whether the debt on the security constituted by the first loan notes at all times represented a normal commercial loan within the meaning of section 117(1)(a). The existence of the share conversion option in the second loan note was fatal to the “normal commercial loan” test if, and only if, it was a term of the debt on the security constituted by the first loan notes. The taxpayer’s submission was that the right to convert into shares was conferred only by the second loan notes, and therefore did not affect the question whether the first loan notes were QCBs. It was held that the first loan notes did not represent “a normal commercial loan” for the purposes of section 117(1)(a) because (at [28]-[31]) the loan note was the security and the underlying loan, which the loan note secured, was the debt; it was the underlying loan which had to satisfy the condition that it “represents and has at all times represented a normal commercial loan”; the loan was made on terms that the debt could be converted into shares, and the right of conversion was an essential part of the bargain.

I agree with the judge that there is nothing in this decision to require this court to regard the distinction between “debt on the security” and “security” in section 117(1)(a) and (b) as controlling in this appeal, particularly because section 117(1)(b) uses the expression “in respect of which”. I agree therefore that the question cannot be answered simply by a conclusion that the security document contains a right of conversion.

In my judgment the key to the interpretation of section 117(1)(b) is the word “provision”. If one were to ask whether, on the date of issue, provision is made “in respect of” the security (meaning for this purpose the agreement represented by the Loan Notes and the terms embodied in them) there would, of course, be no doubt on any possible view.

But if the same question were to be asked at the date when the currency conversion right lapsed or when the Loan Notes were redeemed there would, in my view, be the same answer, namely that “provision” is made for conversion, even though the right can no longer be exercised. In my judgment the word “provision” is a reference to the terms of the agreement, and not simply to subsisting rights. There was no need for section 117(1)(b) to have the phrase “at all times” because it was looking to the terms of the agreement and not to rights which may have existed under it from time to time.

Consequently, there is no contrast here between a literal construction and the purpose of the legislation, nor any need for a special construction to avoid anomalies. There is no anomaly, and Mr Harding’s argument is misconceived.

For completeness I should mention (although the point was not pressed on the appeal) that I agree with the judge that the 1997 amendments do not assist in the construction of the legislation as it was in 1995. Even if the amendments were enacted on a precautionary basis, it does not follow that they were introduced because a construction along the lines propounded on behalf of Mr Harding was considered to be correct, still less that the amendments would affect the true construction of the legislation in its form before the amendments.

I would therefore dismiss the appeal.

I agree.

I also agree.