Revenue and Customs v D'Arcy

This is an appeal by the Commissioners for Her Majesty’s Revenue and Customs (“the Revenue”) against the Decision of a Special Commissioner, Dr John Avery Jones CBE, dated 14^th June 2006 (“the Decision”) allowing in principle the appeal of the taxpayer Mrs Philippa D’Arcy against the conclusion in a closure notice dated 15^th February 2005 and the amendments to her tax return for 2001/02 to give effect to that conclusion. The Decision is reported at [2006] STC (SCD) 543.

At the hearing before the Special Commissioner there was a procedural issue in addition to the substantive issue with which I am now concerned. The Special Commissioner decided the procedural issue in favour of the Revenue: see paragraphs 4 to 15 of the Decision. There was no appeal by the taxpayer against that part of the Decision. The Special Commissioner decided the substantive issue in favour of the taxpayer, and it is against that part of the Decision that the Revenue now appeal to the High Court.

Both before the Special Commissioner and before me the Revenue have been represented by Mr Michael Furness QC, and the taxpayer by Mr Kevin Prosser QC and Mr James Henderson.

The substantive issue turns ultimately on a short question of construction of an excepting provision in Chapter II of Part XVII of the Income and Corporation Taxes Act 1988 (“ICTA”) as it applied in the tax year 2001/02 to a series of transactions in gilt-edged securities undertaken by Mrs D’Arcy with the avowed object of obtaining an allowable deduction against her taxable income for a so-called manufactured interest payment of approximately £1,511,000. It is no longer in dispute that she is entitled to such a deduction as a result of the transactions she entered into. The question that I have to decide, in outline, is whether the benefit of that deduction is largely cancelled out by a charge to income tax under the provisions relating to the transfer of securities with accrued interest (“the accrued interest scheme”) in Chapter II of Part XVII. It is common ground that such a charge arises unless it is excluded by the exception in section 715(1)(b), which applies:

At first blush it may seem surprising that there could be any question of this exception applying to Mrs D’Arcy, as the transactions which she undertook involved two acquisitions and disposals of gilts with a nominal value of £31,000,000 over a period of seven days in February 2002. However, as I shall explain the exception has to be read in the light of certain interpretative provisions in section 710, including in particular section 710(7)(b) which provides that a person holds securities on a day:

The short point on which the appeal turns is whether Mrs D’Arcy, who admittedly became entitled to £31,000,000 nominal of gilts on 20^th February 2002, also ceased to be entitled to them on that day within the meaning of section 710(7)(b), in which case she did not hold them on that day and they do not count for the purposes of the £5,000 threshold in section 715(1)(b); or whether, as the Revenue contend, she did not cease to be entitled to them on 20^th February within the meaning of section 710(7)(b) because she is already conclusively deemed to have transferred them on 13^th February by virtue of further deeming provisions in section 710(6). If the Revenue’s construction is correct, the conclusion follows that Mrs D’Arcy did indeed hold the relevant gilts on 20^th February 2002 and the exception in section 715(1)(b) is clearly inapplicable.

The facts were agreed and are set out in full in paragraph 3 of the Decision. Since the Decision is reported I will not reproduce paragraph 3, but will instead give a brief summary of the main steps in the transactions. I have rounded the figures for convenience, as nothing turns on the precise amounts involved.

Mrs D’Arcy is the founder and chief executive officer of a company called The Rose Partnership which carries on specialist executive search business in the City of London. She was introduced to the scheme by Mr Philip Shirley, a tax adviser, who wrote to her on 10^th January 2002 giving details of how it was intended to operate, the margin money (approximately £360,000) that she would need to provide in advance, and the fees (20% of any net tax saving) which she would have to pay if the scheme succeeded. The letter, and a projection which accompanied it, referred to proposed transactions with a nominal value of £33.5m, but in the event the actual transactions which took place had a nominal value of £31m.

On 13^th February 2002 the following transactions took place:

On 14^th February, RBS duly transferred £31m nominal gilts to Mrs D’Arcy under the first leg of the repo contract, and she duly transferred an equivalent amount of gilts to JPMS under the sale contract.

On 20^th February the transactions of 13^th February were unwound, as follows:

Finally, on 22^nd February 2002 the coupon on the gilts became payable. Mrs D’Arcy was not, of course, entitled to receive it herself, because she did not own the gilts when they went ex-dividend on 18^th February. However, she was obliged under the repo agreement with RBS to make an equivalent “manufactured interest” payment of £1.511m on the date when the coupon was paid, and this she duly did. She was not left out of pocket, however, because she had already made a profit of a similar (although not identical) amount on the repurchase of the £31m nominal gilts, now ex-dividend, from JPMS on 20^th February.

Mrs D’Arcy’s payments and receipts are conveniently summarised in a table in Mr Furness’ skeleton argument, which I reproduce:

As Mr Furness points out, the payments and receipts do not quite balance because, first, the transactions with JPMS are stated net of commission, and, secondly, the interest rate inherent in the repo was slightly different to the rate at which interest was accruing on the gilts.

There is no disagreement between the parties as to how the repo transaction should be taxed. In economic terms, a repo is a form of secured borrowing, and accordingly s.730A of ICTA (which was enacted in 1995) provides that the difference between the sale price and the repurchase price is to be treated as a payment of interest. In the present case, the difference between the price paid for the gilts by Mrs D’Arcy to RBS on 14^th February and the sum which she received from RBS following the repurchase on 20^th February is to be taxed as interest receivable by Mrs D’Arcy by virtue of s.730A(2)(a). The repurchase price is then reduced by the amount of the deemed interest (see s.730A(4)), thereby producing a no-gain, no-loss end result on the purchase and resale.

There is also no dispute about the taxation of the manufactured interest payment. This is dealt with by paragraph 3 of Schedule 23A to ICTA, which applies where, under a contract or other arrangement for the transfer of United Kingdom securities, one of the parties (defined as an “interest manufacturer”) is required to pay to the other (“the recipient”) an amount (“the manufactured interest”) which is representative of a periodical payment of interest on the securities. Where those conditions are satisfied, and in the present case there is no dispute that they were, paragraph 3(2) goes on to provide that the manufactured interest shall be treated as if it were an annual payment to the recipient, and an amount equal to the gross amount of that deemed annual payment is allowable as a deduction against the total income of the interest manufacturer. Accordingly Mrs D’Arcy is entitled to a deduction against her total income for the full amount of the manufactured interest.

The issue between the parties is focused on the treatment of the price obtained by Mrs D’Arcy for the gilts sold by her to JPMS on 14^th February 2002, and the availability or otherwise of the exception in s.715(1)(b) which I have already quoted in paragraph 4 above.

It is convenient to begin by considering what the position would be on the assumption that the exception does not apply. I should add that none of this is controversial.

In the absence of legislation to the contrary, the whole of the purchase price received by Mrs D’Arcy, including the part of it which represented accrued interest, would on general principles be treated as a capital receipt; but it would escape taxation under the capital gains tax legislation because there is (and always has been) a specific exemption for gains accruing on disposals of gilt-edged securities which is now contained in s.115(1) of the Taxation of Chargeable Gains Act 1992. However, since 1985 legislation has been in place, generally known as “the accrued income scheme”, which was enacted to counter “bond washing” transactions whereby the owner of a security carrying interest could avoid tax on the interest by selling the security just before the interest payment date cum dividend, with the consequence that the proceeds of sale would all be capital, including the part attributable to the right to the interest, and would escape taxation by virtue of the exemption to which I have already referred.

The essence of the accrued income scheme is to treat the interest as accruing from day to day between interest payment dates and to apportion it between the transferor and transferee according to the length of their respective periods of ownership.

The main operative provisions of the accrued income scheme are set out in ICTA s.713 and s.714. S.713 reads, so far as material, as follows:

S.714 then provides for the treatment of the deemed sums and rebates which arise under s.713. Rather than quote the section I will summarise how it operates. The sums and reliefs to which a person is treated as entitled in an interest period are first of all aggregated, with the latter being deducted from the former. If the resulting balance is positive, the person is treated as receiving a corresponding amount of annual profits or gains which are chargeable to tax under case VI of Schedule D: see s.714(2). If the balance is negative, he is given a corresponding allowance under s.714(4) which he is then entitled to set off against any interest falling due on the securities to which he may be entitled. The allowance is not available against any other income.

The basic way in which these provisions operate is clearly and helpfully set out by Mr Prosser and Mr Henderson in their skeleton argument, from which I quote the following extracts:

Application of these legislative provisions to Mrs D’Arcy’s transactions has the following consequences:

It only remains to add that section 713(2) and (3) do not apply to the repo transactions, because they are excluded by section 727A(1) which provides that:

It follows from the above analysis that Mrs D’Arcy is liable to income tax under section 714(2) on the accrued amount of interest attributable to the sale by her of the gilts to JPMS on 14^th February 2002, plus the rebate amount which she is deemed to have received on 20^th February, unless she can bring herself within the exception in section 715(1)(b). So far as material, the exception is in the following terms:

Section 715(1)(b) has to be construed and applied in the light of the interpretation provisions in section 710, of which the following are material:

It is also common ground that the only day on which she might arguably have held any gilts within the meaning of section 710(7)(b) is 20^th February 2002. The effect of section 710(6) is that she did not hold any gilts on either 13^th or 14^th February 2002. She did not hold any gilts on 14^th February, although that was the settlement date for the transactions which she entered into on 13^th February and was the date on which the actual transfers of gilts from RBS to Mrs D’Arcy and from Mrs D’Arcy to JPMS took place, because section 710(6) treats the transfers as having taken place on the date when the agreements were made, and not when the transfers were actually made pursuant to the agreements. Nor can she have held any gilts on the 13^th, because, although she became entitled to, and therefore acquired, on that day the gilts which she agreed to buy from RBS under the first leg of the repo, she clearly ceased to be entitled on the same day to the equivalent number of gilts which she agreed to sell to JPMS. Accordingly neither of the conditions in section 710(7)(b) is satisfied.

It is important to note at this point that section 710(6) also deems a third transfer of gilts to have taken place on 13^th February, namely the transfer which Mrs D’Arcy contracted to make to RBS under the return leg of the repo on 20^th February. That, too, was a transfer which she had agreed to make on 13^th February, and it follows that RBS became entitled to, and therefore acquired, those gilts on that day.

Moving on now to the position on 20^th February, it cannot be doubted that on that day Mrs D’Arcy became entitled to, and therefore acquired, a further holding of £31.1m nominal gilts, namely the gilts which she purchased from JPMS under the purchase agreement of that date. She will therefore have “held” those gilts on 20^th February within the meaning of section 710(7)(b) if either:

For Mrs D’Arcy, Mr Prosser QC submitted that the foregoing question should be answered in the affirmative, with the consequence that neither condition in section 710(7)(b) is satisfied and she did not hold any securities on that day.

Mr Prosser supported his submission with a combination of technical and purposive arguments. He began by pointing out that the statutory concepts of “transfer” and “entitlement”, while closely related, are not identical. For example, a person becomes entitled to securities when they are issued to him, even though there is no transfer on that occasion; and a person ceases to be entitled to securities when they are redeemed, even though again there is no transfer. It is therefore possible under the accrued income scheme for a person to become or cease to be entitled to securities without a transfer to or by him of those securities. Similarly, it is possible for a person to transfer securities without thereby and at that time ceasing to be entitled to them. Although section 710(6) says that securities are deemed to be transferred when the agreement to transfer them is made, it does not follow that the transferor is deemed in every case to cease to be entitled to them at that time. No doubt this will be the case if the transferor is already entitled to the securities; but if he is not entitled to any securities at the relevant time, he does not cease to be entitled to them at that time merely because they are transferred at that time.

Mr Prosser’s next point is that it is impossible, and an abuse of language, to “cease” to be entitled to something before one has first become entitled to it. It is only after one has first become entitled to something that one can then cease to be entitled to it. Not only is this a matter of ordinary English usage, but it is recognised by the draftsman himself, because in section 710(7)(b) he uses the phrase “becomes and does not cease to be entitled”, indicating, as one would expect, that becoming entitled comes before, because it is a pre-condition for, ceasing to be entitled.

If authority is needed for the proposition that you have to become entitled to something before you can cease to be entitled to it, Mr Prosser referred me to cases in which judges have held that a director cannot be said to have ceased to hold a minimum shareholding qualification if he never held the requisite number of qualifying shares in the first place. So, for example, in Salton v New Beeston Cycle Co [1899] 1 Ch 775 Cozens-Hardy J. said at 779:

It follows, submitted Mr Prosser, that a person does not “cease to be entitled” to securities on a day merely because he agrees on that day, by a “short” sale, to sell them. He first has to become entitled to securities before he can cease to be entitled to them. This commonsense conclusion, he goes on to say, is supported by the natural meaning of the term being defined, that is, to “hold” securities. A person does not “hold” securities if, when they are transferred to him and he becomes entitled to them, he has already transferred them to someone else and he ceases, or has already ceased, to be entitled to them. Similarly, a person does not “hold” securities “on a day” if he is not entitled to them at the end of the day.

Mr Prosser’s next point is perhaps best expressed as a rhetorical question: since Mrs D’Arcy admittedly became entitled to the gilts on 20^th February, and since she admittedly was not entitled to any gilts on the following day, how can it be said that she nevertheless did not “cease to be entitled” to the gilts on 20^th February?

Moving on to more purposive considerations, Mr Prosser submitted that his interpretation made sense in terms of the underlying purpose of the accrued income scheme, because the reason why an individual is excepted from the charge under the accrued income scheme by section 715(1)(b) if he is not entitled to any securities (above the de minimis £5,000 limit) as at the end of a particular day, even though he may have dealt in securities above that limit during the day, is because no income accrues on them during his period of ownership in the course of the day. So, in the case of an individual who agrees to buy £31m nominal gilts on a day and then agrees to sell them later on the same day, he is clearly excepted from the charge by section 715(1)(b), even though the value of the gilts dealt in greatly exceeds the £5,000 limit. The reason why he is excepted is because he is not entitled to any of the gilts at the end of the day, and therefore no income accrues to him on them.

Mr Prosser goes on to submit that the result is no different if by a short sale the individual agrees to sell £31m of gilts on a day and then later the same day agrees to buy the same quantity of gilts, because again he is not entitled to any of the gilts at the end of the day and no income accrues to him. Similarly, the position should not be any different if the agreement to sell is made on day 1 and the purchase of gilts to enable the sale to be completed takes place on day 2. As before, the individual is not entitled to any of the gilts at the end of day 2, so no income accrues to him.

For the Revenue, Mr Furness QC concentrates in particular on the deeming effect of section 710(6) and submits that since Mrs D’Arcy is deemed by that subsection to have transferred the gilts which she sold to RBS under the second leg of the repo on 13^th February (the date when the contract was made), and not on 20^th February (the date of the actual transfer), and since RBS is also deemed to have acquired those gilts on 13^th February, it must follow that she ceased to be entitled to the gilts within the meaning of section 710(7)(b) on 13^th February, with the consequence that it cannot be said that she ceased to be entitled to them on 20^th February. If this result appears strange, and at odds with the normal meaning of the verb “to cease”, it is nevertheless the logical consequence of the deeming that Parliament has seen fit to enact in section 710(6), and the natural use of language must, if necessary, be strained to accommodate it. It would be wrong, submits Mr Furness, to read the phrase “becomes and does not cease to be entitled to them” as a single composite expression, but rather the deeming in section 710(6) should be applied in turn to each of the two limbs, and it should be asked first whether Mrs D’Arcy became entitled to the gilts on 20^th February (to which the answer is “yes”) and then whether she ceased to be entitled to them on that day (to which the answer is “no”, because she had already ceased to be entitled to them on 13^th February).

Mr Furness went on to say that the test under section 710(7)(b) is not whether the person in question remains entitled to the securities at the end of the day, but whether he ceases to be entitled to them on the same day upon which he also became entitled to them. In the present case that test is not satisfied, because Mrs D’Arcy ceased by force of the statutory deeming in section 710(6) to be entitled to the gilts on 13^th February.

Mr Furness also reminded me of the well-known guidance on the construction of deeming provisions given by Peter Gibson J., sitting as a judge of the Court of Appeal, in Marshall v Kerr (1993) 67 TC 56 at 79A, and submitted that no injustice or absurdity results from the Revenue’s construction of the deeming provisions. On the contrary, it is Mrs D’Arcy’s construction which produces an absurd result, which Parliament can never have contemplated, because she ends up with an allowable deduction for the manufactured interest of £1.511m, and no corresponding amount of taxable income, even though in economic terms the overall effect of the transactions was virtually neutral.

I shall say at once that in my judgment the submissions of Mr Prosser QC are to be preferred.

In the first place, I am impressed by the simple linguistic point that a person cannot cease to be entitled to securities before he has become entitled to them. There is no special definition of the concept of ceasing to be entitled in section 710, so the word “cease” must in my judgment be given its ordinary and natural meaning; and more particularly so because the draftsman himself has used the expression “becomes and does not cease to be entitled”, which both in its word order and in its use of language seems to me to pre-suppose that the becoming entitled must precede the ceasing to be entitled. In the context of a “short” sale – which I suspect the draftsman did not have at the forefront of his mind – the result is in my judgment as Mr Prosser submits, namely that the vendor ceases to be entitled to the securities which he has agreed to sell at the moment when he first becomes entitled to them, but not before.

It is true that this conclusion does not sit altogether easily with the deeming in section 710(6), under which (as I have explained) Mrs D’Arcy is treated as having transferred on 13^th February 2002 the gilts which she actually acquired on 20^th February, and RBS is likewise treated as having become entitled to, and therefore having acquired, those gilts on 13^th February. However, the focus of section 710(6) is different from that of subsection (7). Section 710(6) is a general rule which deals with all cases where securities are transferred pursuant to an agreement. Such a rule is clearly needed to deal with the uncertainties to which two-stage transactions, with a contract followed by completion, would otherwise give rise: compare the analogous capital gains tax rule in section 28(1) of the Taxation of Chargeable Gains Act 1992. By contrast, section 710(7) is a much more closely focused provision which applies only for the purposes of ascertaining whether a person holds securities either at a particular time, or on a given day. In so far as section 710(7) uses the concepts of entitlement and becoming entitled, those concepts must of course be understood in accordance with the general rule laid down in subsection (6). But the tests for the holding of securities are specific and self-contained, and I agree with Mr Prosser that it is important not to lose sight either of the concept being defined (holding securities) or of the general nature of the tests and the language in which they are formulated.

It is a striking feature of the tests for holding securities “on a day” in section 710(7)(b) that they will not be satisfied if entitlement to the securities ceases during the day, whereas they will be satisfied if entitlement to the securities continues throughout the day, or if entitlement begins during the day and then continues for the rest of the day. If one asks why the position at the end of the day is so important, I would answer (again in agreement with Mr Prosser) that it is because there will then be an accrual of interest, and therefore something for the accrued interest scheme to bite on. If, however, a person both becomes and ceases to be entitled to securities during the course of a single day, no income on the securities will accrue during his period of ownership and there will accordingly be no reason why the accrued income scheme should apply to him.

I find further support for my conclusion in the terms of section 710(7)(a), and the apparent conflict with section 710(7)(b) which would arise if the Revenue’s construction is correct. If one takes any particular time on 20^th February 2002 after Mrs D’Arcy had sold the gilts back to RBS, and asks in terms of subsection (7)(a) whether Mrs D’Arcy was entitled to, and therefore held, the gilts at that time, the answer must obviously be “No”. Yet if the Revenue’s construction of subsection (7)(b) is correct, Mrs D’Arcy nevertheless held the gilts on the self same day, and moreover held them at all the particular times when application of subsection (7)(a) would lead to the conclusion that she did not hold them. The Special Commissioner evidently found this a powerful point: see paragraph 24 of the Decision. I respectfully agree.

I am also unable to accept Mr Furness’ submission that there is any absurdity in the result in the present case, if by that is meant an absurdity which should influence me to prefer the Revenue’s construction of section 710(7)(b). I can readily accept that Parliament could never deliberately have intended taxpayers to be able to take advantage of the scheme entered into by Mrs D’Arcy; but the construction of section 710(7)(b), and the availability or otherwise of the exception in section 715(1)(b), cannot in my judgment depend on whether the taxpayer happened to have a tax-avoidance motive. The Revenue’s real complaint, as it seems to me, is that the accrued income scheme does not throw up a charge to counterbalance the deduction admittedly available to Mrs D’Arcy for her manufactured interest payment. But the accrued income scheme and the provisions relating to manufactured interest were enacted at different times and with different statutory purposes. They do not form part of a single unified code, and their separation is indeed emphasised by section 727A. In short, this is in my view one of those cases, which will inevitably occur from time to time in a tax system as complicated as ours, where a well-advised taxpayer has been able to take advantage of an unintended gap left by the interaction between two different sets of statutory provisions.

For all these reasons I think that the Special Commissioner came to the correct conclusion, for essentially the right reasons, and I will dismiss the appeal.