HM Revenue & Customs v Bank of Ireland Britain Holdings Ltd

This is an appeal from a judgment of Henderson J dated April 30, 2007 by which he dismissed the Revenue’s appeal from a decision of the Special Commissioners released on June 6, 2006. The taxpayer is Bank of Ireland Britain Holdings Ltd (“BH”), which is incorporated and registered in England and resident for tax purposes in the UK. BH is a wholly-owned subsidiary of the Bank of Ireland, which is incorporated and resident in the Republic of Ireland and entered into the relevant transactions through its head office in Dublin. The relevant events took place between November 2000 and March 2001.

The scheme in this case involved a transaction for the sale and repurchase of securities, a “repo” transaction. Repo transactions are widely used by institutions operating in the financial markets. The transaction is commercially equivalent to a form of secured lending. The mechanics of a normal two-party repo transaction are that an owner of securities (“the original owner”) sells securities and subsequently repurchases the same (or equivalent) securities from another party (“the interim holder”) by a specified date. The repurchase price is agreed at the outset. The difference between the (higher) repurchase price and the original sale price is the interim holder’s return for “lending” the money.

If there were no specific legislation taxing repo transactions, then for persons other than financial traders the profit realised by the interim holder on the acquisition and disposal of shares would simply be a capital gain. The object of the repo legislation is to tax these transactions in accordance with their economic substance and their accounting treatment as loans at interest.

This appeal concerns a tripartite repo transaction, where the interim holder transferred the securities to another legal entity, and the original owner repurchased them from that entity.

The point on which this appeal turns is relevant only for certain past transactions. The relevant legislation, as amended and in force in 2000/01, involved two groups of sections in Part XVII of the Income and Corporation Taxes Act 1988 (“ICTA 1988”), but the Finance Act 2007 introduced a new accounts-based régime to replace the existing legislation.

The first group of sections comprises sections 730A and 730B. The second group comprises sections 737A, 737B and 737C. Section 737A applies by reference, with appropriate modifications, the provisions relating to manufactured dividends and interest in Schedule 23A to ICTA 1988.

Sections 730A and 730B provide:

730ATreatment of price differential on sale and repurchase of Securities.

(1)

Subject to subsection (8) below, this section applies where –

(a)

a person (“the original owner”) has transferred any securities to another person (“the interim holder”) under an agreement to sell them;

(b)

the original owner or a person connected with him is required to buy them back either –

(i)

in pursuance of an obligation to do so imposed by that agreement or by any related agreement, or

(ii)

in consequence of the exercise of an option acquired under that agreement or any related agreement; and

(c)

the sale price and the repurchase price are different.

(2)

The difference between the sale price and the repurchase price shall be treated for the purposes of the Tax Acts –

(a)

where the repurchase price is more than the sale price, as a payment of interest made by the repurchaser on a deemed loan from the interim holder of an amount equal to the sale price; and

(b)

where the sale price is more than the repurchase price, as a payment of interest made by the interim holder on a deemed loan from the repurchaser of an amount equal to the repurchase price.

(3)

Where any amount is deemed under subsection (2) above to be a payment of interest, that payment shall be deemed for the purposes of the Tax Acts to be one that becomes due at the time when the repurchase price becomes due and, accordingly, is treated as paid when that price is paid.

(4)

Where any amount is deemed under subsection (2) above to be a payment of interest, the repurchase price shall be treated for the purposes of the Tax Acts (other than this section and sections 737A and 737C) and … for the purposes of [the Taxation of Chargeable Gains Act 1992] –

(a)

in a case falling within paragraph (a) of that subsection, as reduced by the amount of the deemed payment; ….

(5)

For the purposes of section 209(2)(d) and (da) any amount which is deemed under subsection (2)(a) above to be a payment of interest shall be deemed to be interest in respect of securities issued by the repurchaser and held by the interim holder.

(6)

For the purposes of Chapter II of Part IV of the Finance Act 1996 (loan relationships) –

(a)

interest deemed by virtue of subsection (2) above to be paid or received by any company shall be deemed to be interest under a loan relationship; and

(b)

the debits and credits falling to be brought into account for the purposes of that Chapter so far as they relate to the deemed interest shall be those given by the use in relation to the deemed interest of an authorised accruals basis of accounting.

….

(9)

In this section references to the repurchase price are to be construed –

(a)

in cases where section 737A applies … as references to the repurchase price which is … applicable by virtue of section 737C … (11)(c).

730B Interpretation of Section730A

(1)

For the purposes of section 730A agreements are related if they are entered into in pursuance of the same arrangement (regardless of the date on which either agreement is entered into).

…

(3)

In section 730A and this section “securities” has the same meaning as in section 737A.

…

Sections 737A to 737C provide:

737A Sale and repurchase of securities: deemed manufactured payments.

(1)

This section applies where on or after the appointed day a person (the transferor) agrees to sell any securities, and under the same or any related agreement the transferor or another person connected with him –

(a)

is required to buy back the securities, or

(b)

acquires an option, which he subsequently exercises, to buy back the securities;

but this section does not apply unless the conditions set out in subsection (2) below are fulfilled.

(2)

The conditions are that –

(a)

as a result of the transaction, a dividend which becomes payable in respect of the securities is receivable otherwise than by the transferor,

(b)

…

(c)

there is no requirement under any agreement mentioned in subsection (1) above for a person to pay to the transferor on or before the relevant date an amount representative of the dividend, and

(d)

it is reasonable to assume that, in arriving at the repurchase price of the securities, account was taken of the fact that the dividend is receivable otherwise than by the transferor.

(3)

For the purposes of subsection (2) above the relevant date is the date when the repurchase price of the securities becomes due.

…

(5)

Where this section applies … Schedule 23A and dividend manufacturing regulations shall apply as if –

(a)

the relevant person were required, under the arrangements for the transfer of the securities, to pay to the transferor an amount representative of the dividend mentioned in subsection (2)(a) above,

(b)

a payment were made by that person to the transferor in discharge of that requirement, and

(c)

the payment was made on the date when the repurchase price of the securities becomes due.

(6)

In subsection (5) above “the relevant person” means –

(a)

where subsection (1)(a) above applies, the person from whom the transferor is required to buy back the securities;

(b)

where subsection (1)(b) above applies, the person from whom the transferor has the right to buy back the securities;

and in that subsection “dividend manufacturing regulations” means regulations under Schedule 23A (whenever made).

737B Interpretation of Section 737A

(1)

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

The relevant parts of paragraph 4 of Schedule 23A provide as follows:

(1)

This paragraph applies in any case where, under a contract or other arrangements for the transfer of overseas securities, one of the parties (“the overseas dividend manufacturer”) is required to pay to the other (“the recipient”) an amount representative of an overseas dividend on the overseas securities; and in this Schedule the “manufactured overseas dividend” means any payment which the overseas dividend manufacturer makes in discharge of that requirement.

(2)

...where this paragraph applies the gross amount of the manufactured overseas dividend shall be treated for all purposes of the Tax Acts as an annual payment, within section 349, but –

(b)

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

(c)

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 …

By virtue of paragraph 4(2), the payment can qualify as a charge on income paid by the overseas dividend manufacturer under section 338. Paragraph 4(4) provides that, in relation to the recipient, the manufactured overseas dividend is treated as if it were an overseas dividend of an amount equal to the gross amount of the manufactured overseas dividend.

The scheme was provided to BH by the Morgan Stanley Dean Witter group (“Morgan Stanley”). On the Morgan Stanley side, it involved two group companies both of which were incorporated and resident in the Cayman Islands, MSDW Birkdale Ltd (“Birkdale”) and MSDW Portrush Ltd (“Portrush”).

On November 8, 2000, the entire ordinary share capital of Portrush was issued to Birkdale. At all material times thereafter Portrush was a wholly-owned subsidiary of Birkdale.

On November 9, 2000, 225,000 £1 Class A Redeemable Preference Shares in Portrush (“the Securities”) were issued to Birkdale at a price of £1,000 per share. The Securities carried the right to receive a cumulative preference dividend accruing at a rate of 5% per annum until the end of the first dividend payment date on November 14, 2000, and at a rate to be set prior to November 14, 2000 by the directors of Portrush for all subsequent dividend payment dates (being the 25^th day of each month, or the next business day thereafter, commencing November 25, 2000). The dividends were payable to those holders registered in the Register of Members two business days prior to the relevant dividend payment date.

Under its articles, the directors of Portrush had a discretion to authorise a “special dividend” to be paid prior to a dividend payment date in which case the amount payable would be the amount accrued up until the date of the special dividend. The amount of the dividend payable on the next normal dividend payment date would then be correspondingly reduced. This power was used to ensure that dividends were paid up to each of the dates on which the Securities were transferred, with the result that they were never transferred with an accrued right to dividend.

On November 10, 2000, these agreements (among others) were entered into:

On the same day, the directors of Portrush set the rate at which the cumulative preference dividend on the Securities would accrue at 5.81% in respect of all dividend periods subsequent to the dividend period ending on November 14, 2000. The effect of setting the dividend at this level was that the interest and dividend elements of the purchase price for the Securities payable under the Second Option Agreement would automatically cancel each other out, and the formula would again yield a purchase price of £225 million.

On November 14, 2000, the cumulative preference dividend payable in respect of the first dividend period was paid to Birkdale and, pursuant to the Share Sale Agreement, Birkdale sold the Securities to Bank of Ireland for £225 million.

Following its purchase of the Securities, Bank of Ireland received dividends on the Securities in respect of periods ending on November 25, 2000, December 25, 2000 and January 25, 2001.

On February 20, 2001, Bank of Ireland exercised its put option on the Securities; pursuant to the option exercise notice, the completion date for that option was February 23, 2001. Bank of Ireland received a special dividend on the Securities for the period to February 23, 2001. In total it received £3,617,322 in dividends on the Securities.

On February 23, 2001 BH paid the purchase price of £225 million to Bank of Ireland and received the Securities. It subsequently received a dividend on the Securities for the period to February 25, 2001 and also a special dividend on those shares for the period to March 5, 2001. The aggregate amount it received in dividends on the Securities was £358,151.

Pursuant to the Second Option Agreement, on February 26, 2001, BH exercised its put option on the Securities; the completion date for that option was March 5, 2001.

On March 5, 2001 Birkdale paid BH the repurchase price of £225 million and repurchased the Securities.

The effect was that both Bank of Ireland and BH received dividends on the Securities at the fixed rate of 8.3% for their respective periods of ownership, amounting to £3,617,321 for Bank of Ireland and £358,151 for BH. The total dividends paid for the period from November 14, 2000 to March 5, 2001 were therefore £3,975,473.

In summary, therefore:

The effect of section 737A was to deem the “relevant person” to pay to the transferor an amount representative of the dividend receivable by a person other than the transferor, where the “relevant person” is “the person from whom the transferor is required to buy back the securities” (section 737A(6)(a)). That person was BH.

BH’s position was that it could deduct the whole of the £3.95 million deemed manufactured dividend, but its only taxable receipt was the £350,000 dividend it actually received. Conversely Bank of Ireland was deemed to receive the deemed interest payment of £3.95 million because section 730A(2)(a) treated the deemed interest as interest on “a deemed loan from the interim holder” (Bank of Ireland), to be added to its actual receipt of the £3.6 million dividend, but it was not taxable because it is in the Republic of Ireland.

The Revenue’s case was that the legislation should be construed as providing that the deemed interest payment from Birkdale was receivable by BH. On that interpretation the tax position would be in line with the commercial position, namely that Bank of Ireland made a profit of about £3.6 million and BH made a profit of about £350,000.

The issues before the Special Commissioners and the judge were:

Both points were decided in favour of BH by the Special Commissioners and the judge, and there is no appeal to this court on the second point.

The question on the first point was whether the “payment of interest made by the repurchaser on a deemed loan from the interim holder of an amount equal to the sale price” for the purposes of section 730A(2)(a) was to be treated as paid to BH (as the Revenue contended) or to Bank of Ireland (as BH contended). The judge decided that the section properly construed led to only one conclusion, namely that the payment of interest was deemed to be made to the interim holder, namely Bank of Ireland.

The judge’s reasoning was as follows:

Despite the apparent complexity of the legislation and of the scheme, it is accepted that this appeal involves a short point of construction, namely whether, when section 730A(2)(a) treats the difference between the sale price and the repurchase 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,” the payment of interest is to be treated as paid to BH, the reseller, or to Bank of Ireland, as interim holder.

Three principal points are made by the Revenue in support of the construction that the payment of interest is to be treated as paid to the reseller.

The first point is that the legislation makes it clear that the deemed interest forms part of the repurchase price, and the repurchase price is received by the end seller and not (in a three-party repo) by the interim holder. Section 730A(2)(a) recharacterises as interest part of the sum of money which is actually received by the person who sells the securities back to the original owner. The amount by which the sum he receives exceeds the sale price is referred to in section 730A(2) as “the difference”. What the draftsman is doing is treating part of the sum of money which has actually been paid to BH as interest rather than as part of the sale price of an asset. Section 730A(3) supports the Revenue’s case, because even though part of the repurchase price is deemed to be interest it is still treated as due and payable when the repurchase price is due and payable.

The second point is that the justification for deeming there to be a loan is the payment by the interim holder of the purchase price and the obligation of the original owner to make repayment of the purchase price. Where the interim holder assigns the benefit of the right to repayment it is reasonable to treat the loan as having been assigned as well. The economic substance of a repo is that the purchaser of the securities (the interim holder) lends the purchase price to the seller (the original owner) in return for a payment for the use of the money which is factored into the repurchase price. The economic substance is therefore that the obligation to repay the purchase price is in essence an obligation to repay a loan, and the amount by which the repurchase price exceeds the purchase price is a payment for the use of money, i.e. interest.

In seeking to tax the economic substance of the transaction, it is unsurprising that the draftsman treats the difference between the purchase and repurchase price as interest on a loan from the interim holder of an amount equal to the purchase price. The interim holder (Bank of Ireland) has assigned the right to receive the whole of the repurchase price (i.e. including that part of it which represents the difference between it and the purchase price) to BH. It therefore must have been the draftsman’s intention that the recipient of the repurchase price should be taxable as if the benefit of the loan had been assigned in a manner which corresponds to the assignment of the right to receive the repurchase price.

The third point is that a construction of the sub-section which treats the interest as payable to the party who receives the repurchase price is clearly preferable to one which divorces the interest payment from receipt of the repurchase price because the former produces a rational basis for the taxation of three-party repos and the other an irrational one. BH’s construction inevitably results in the interim holder being charged on profits which it never realises, while the person who resells the securities back to the original owner makes a loss which has no economic reality.

In construing section 730A(2)(a) the court should have regard to the bizarre consequences of accepting BH’s construction, because of the need to apply a purposive construction to the legislation. It is not sufficient, as the judge thought, simply to say that where the interim holder is UK resident it can be assumed that the parties will be able to provide for the tax consequences in a way they find satisfactory. Even if that were true, it remains the case that a construction which does not require taxpayers to foresee and provide for absurd tax consequences is clearly preferable to one that does: Kammins Ballrooms Co v Zenith Investments [1971] AC 850, at 859.

If the court is presented with two alternative constructions, the construction which gives a result which is in line with the policy of the Act should be preferred to a construction which gives a result so bizarre that it could not possibly have been intended. If necessary the court will place a strained construction on the words of an Act to avoid unfairness or absurdity: Luke v IRC [1963] AC 557, at 577.

The wording of section 730A(2)(a) is in fact silent on who receives the interest. The conclusion that it is receivable by the interim holder is merely an inference from the fact that the interest is expressed to be payable on a deemed loan from the interim holder. Particular care must be taken in drawing inferences from deeming provisions: Marshall v Kerr [1993] STC 360, at 366, per Peter Gibson J, approved [1995] 1 AC 148, 164, per Lord Browne-Wilkinson.

Extending the statutory fiction in section 730A(2)(a) to the extent of deeming the interim holder to be entitled to the interest creates injustice and absurdity. The statutory fiction in section 730A(2)(a) should be limited to deeming the difference to be interest on a loan from the interim holder, while remaining silent on who is entitled to the interest at the point at which it is deemed to be paid. The correct inference as to who is entitled to the interest, construing the legislation as a whole, is whoever is entitled to the repurchase price. In a conventional two-party repo this will be the interim holder, but in a multi-party repo it will not be.

Section 737A operates with section 737C to convert, for tax purposes, a repo under which income from the securities is retained by the holder(s) of the securities into the more usual type of repo under which the income from the securities is remitted to the original owner by way of manufactured dividends and the repurchase price is not reduced to reflect the fact that the interim holder has retained the benefit of the income. This is done by deeming the relevant person (in effect the reseller, the recipient of the repurchase price) to make manufactured dividend payments corresponding to the income receipts and by adding an equal and opposite amount to the repurchase price, so that one cancels out the other. The increase in the repurchase price will then feed through into the difference between the purchase price and the repurchase price, which is in turn deemed to be interest under section 730A(2). On the facts of this case the amount of the deemed manufactured dividend is the same as the difference between the purchase and repurchase prices, although this will not always be the case. One would expect the deemed increase in the repurchase price and the amount of the deemed interest to be deemed to be received and paid by the same person The Revenue’s construction achieves this result. For BH to argue that Bank of Ireland is to be taxed on the deemed interest is to argue for a party to be taxed in respect of a sum which the legislation deems another party (i.e. BH, as a result of the deemed increase in the repurchase price) to be entitled to receive.

I come to my conclusion, which is that I am satisfied that there is no basis for this challenge to the judge’s decision.

The starting point is that the ordinary meaning of the words plainly points to the payment of interest being treated as paid to the interim holder. What is treated as a payment of interest is the difference between the sale price and the repurchase price “on a deemed loan from the interim holder.” The “interim holder” is the person to whom the “original owner” has transferred the securities: section 730A(1)(a). The section does not contemplate, or deal with, the case where there has been an assignment.

It is true that in this case a tripartite scheme has been devised which takes advantage of a mismatch between the two sets of sections. The mismatch is that section 730A refers to the interim holder as such, i.e. the person to whom the securities are originally transferred, and section 737A refers to the relevant person, namely the person from whom the transferor is required, or has the right, to buy back the securities. But I do not consider that there is any legitimate process of interpretation which will solve the Revenue’s problem.

In argument Mr Michael Furness QC accepted that he was in effect arguing that the words “to the reseller” or “to the relevant person” (as defined in section 737A(6)(a)) should be inserted in section 730A(2)(a) so that it would read that the difference was to be treated as a payment of interest to the reseller (or relevant person). I see no legitimate basis for reading any such words into the sub-section. It would amount to an unprincipled process of legislative gloss.

This conclusion is also supported by, but is not dependant upon, BH’s argument that the law has required that a source of income be identified before the income itself can be taxed: National Provident Institution v Brown [1921] 2 AC 222.

Receipt, of itself, is not a determinant of any possible tax liability. An assignee of the right to receive interest (without assignment of the loan relationship) would not be taxable on the amount of that interest under the loan relationship provisions because he has no relevant loan relationship.

The charge to tax in the present case is under Case III of Schedule D. Interest is chargeable by virtue of section 80 of the Finance Act 1996. Section 80(1)) provides: “For the purposes of corporation tax all profits and gains arising to a company from its loan relationships shall be chargeable to tax as income in accordance with this Chapter.” Where the loan relationship is not for the purposes of a trade: “Profits and gains arising from a loan relationship of a company …. shall be brought into account as profits and gains chargeable to tax under Case III of Schedule D” (section 80(3)).

On the introduction of the loan relationships rules by the Finance Act 1996, section 730A(6) was added, and provides that for the purposes of Chapter II of Part IV of the Finance Act 1996 (loan relationships), interest deemed by virtue of section 730A(2) to be paid or received by any company shall be deemed to be interest under a loan relationship.

Although section 730A(6) is not determinative of the issue of construction, it seems to me to be highly relevant that the interest which it deems to be interest under a loan relationship is the “interest deemed by virtue of subsection (2) above to be paid or received by any company ...” and the only loan relationship expressly referred to in section 730A(2)(a) is the “deemed loan from the interim holder.”

I would therefore dismiss the appeal.

I agree.

I also agree.