FC Shipping Limited & Anor v The Commissioners for HMRC

We recognise the following description of the basis for capital allowances:

“The object of granting the allowance is… to provide a tax equivalent to the normal accounting deduction from profits for the depreciation of machinery and plant used for the purposes of a trade… When the trade is finance leasing, this means that the capital expenditure should have been incurred to acquire the machinery or plant [in this case, the ships] for the purpose of leasing it in the course of the trade. In such a case, it is the lessor as owner who suffers the depreciation in the value of the plant and is therefore entitled to an allowance against the profits of his trade”: Barclays Mercantile Business Finance Ltd v Mawson [2004] UKHL 51, [2005] 1 AC 684 at [39].”

While companies within the tonnage tax regime are generally not entitled to claim capital allowances (para 68 Schedule 22), the ability of lessors of ships to tonnage tax companies to access capital allowances is expressly contemplated in Schedule 22 (in stating that leases are not an abuse of the regime in allowing a lessor leasing to a tonnage tax company to access capital allowances). Provisions are then included in paragraphs 89-91 to deal with lease financing, which, by its nature, accesses and shares the benefits of capital allowances available to the provider of the finance. The history of this statutory result is informative for us to determine the purpose, and in turn the interpretation, of the legislation.

In 1999 Lord Alexander of Weedon QC led an independent enquiry into a potential tonnage tax. It was recognised that leasing was “by far the most difficult issue in the design of the tonnage tax”. The availability of capital allowances to finance lessors for ships leased to companies within the tonnage tax regime potentially increased the cost of the regime very significantly and made that cost more uncertain. However, there was concern regarding the competitiveness of the regime compared to those offered by countries such as the Netherlands if there was no possibility to access the benefit of capital allowances through finance leasing at all. The industry viewed complete abolition of capital allowances for vessels leased in the tonnage regime was too draconian. Instead, HMRC and the industry agreed the rules could be devised which would limit the allowances given to lessors on ships leased to tonnage tax companies.

The original provisions in paragraph 89 applied to a “finance lease” as defined, with paragraph 89 reading (so far as relevant):

“89(1) “In the case of a finance lease of a qualifying ship provided, directly or indirectly, to accompany within tonnage tax the provisions of Part II of the Capital Allowances Act 1990 have effect subject to and in accordance with the provisions of – paragraphs 90 and 91”

Paragraph 90 was written in the same terms as the legislation considered in this appeal save for the reference to a lessor under “the finance lease” rather than under the “lease”.

Finance lease, lessor and lessee were given the same meanings as that used in section 82A Capital Allowances Act 1990 (“s82A”) which dealt with finance leases and capital allowances generally. A finance lease in s82A is defined by reference to “normal accountancy practice” as arrangements which are to be treated in the accounts of one or more of the companies involved as a finance lease or as a loan.

In producing the balance between the exposure to tonnage tax companies accessing capital allowances and the recognition of commercial pressures for them to be able to do so to some extent through finance leasing, provisions were introduced in paragraph 91 for what are described as “excepted forms of security”. The reductions in risk as a result of those excepted securities are excluded from the application of paragraph 90 such that, in essence, what Mr Ghosh described as “normal commercial reductions in risk” for finance leasing were identified as acceptable. As he submitted, this chimes with the conclusions reached in Barclays Mercantile.

Then, in 2003, reference to finance leases was removed and the provisions in paragraph 89 instead referred to a “lease” which was defined to mean any arrangements that provide for a ship to be leased or otherwise made available by a lessor to a lessee. Furthermore, the definition of “lease” in paragraph 89 picked up the concept of “arrangements” for plant and machinery to be leased or made available to a lessee which had been found in the s82A definition of finance lease.

Consistent with those changes the non-abuse provision in paragraph 41 Schedule 22 was amended so that it was not just a finance lease which was not to be taken as an abuse of the tonnage tax regime, but a “lease” as defined in paragraph 89.

Changing the wording of paragraph 89 to refer to a “lease” rather than a “finance lease” means that the accounting limitation of the s82A CAA definition no longer applies and consequently a wider category of leasing arrangements in included.

The Explanatory Notes for Clause 168 stated that the amendments extended the restrictions on the amount of capital allowances that can be claimed by a lessor for expenditure on a ship that is used for activities within the tonnage tax to a wider range of leases. The Notes went on to explain that some lessors had begun to offer long-term leases for ships that had many of the characteristics of finance leases without being finance leases in form. Such leases could be used to allow lessors to claim significantly more in capital allowances than had been intended in the tonnage tax was introduced. The new provisions therefore extended the types of leases to which the restrictions applied. (We note that the Explanatory Notes provided in the bundle were incorrect as the original Finance Bill clause was Clause 168, not 169 to which the bundle Notes referred.)

Consequently, when considering the history and background to the legislation we conclude that the provisions in paragraphs 89-91 were introduced as a way of limiting the exposure to the Exchequer for tonnage companies within their preferential tax regime accessing capital allowances. While it was recognised that some financing arrangements should be permitted in order to remain competitive with other countries’ regimes, a line was drawn by reference to the extent of compliance risk remaining with the lessor. The restrictions were initially defined by reference to finance leases, but that category was expanded to a wider concept of “lease” as defined, due to the concern that the finance lease definition had been circumvented.

Before we move onto the detailed application of the Schedule 22 rules we address one point which arose in submissions.

In this case there was a preordained series of transactions, but this is entirely consistent with this type of financing. A series of transactions was put in place as a package in order to finance the acquisition of the Ships.

As we have explained, the tax benefit of the Appellants buying the Ships used by companies within the tonnage tax regime, where the Appellants could claim capital allowances, is not by itself something which Parliament has sought to prevent.

Furthermore, this case is not one in which HMRC are seeking to invoke the anti-abuse provisions contained in paragraph 41-42. Those provisions enable HMRC to issue a notice excluding a company or group from the tonnage tax regime where a tonnage tax company has entered into an abuse of transaction or arrangement under paragraph 41 with the result that the companies or groups tonnage tax election ceases to be in force. Instead, HMRC are seeking to rely upon provisions contained in paragraphs 89 and 90 which provide that the lessor is not entitled to capital allowances.

We therefore agree with Mr Ghosh that the issue is not that a series of preordained transactions has been entered into for a lease financing – instead, the issue is whether the provisions of paragraph 90 are triggered to deny capital allowances in relation to the Ships to the Appellants.

However, that does not mean that the findings regarding the interrelationship of the transactions are irrelevant as Mr Ghosh sought to argue. They show the context of the financing which is important in applying the purposive approach to the legislation. They also show the interactions between elements and how they elements were viewed by the parties as security, both of which are relevant to the detailed application of the legislation.

Mr Ghosh submits that it is common ground that the “lessor” under the paragraph 89 lease is the Appellants. However, the Appellants are only party to the Head Leases and therefore the paragraph 89 lease should be limited thereto. In seeking to include the Sub-Leases in the paragraph 89 lease HMRC are rewriting the transactions. Reference is made to “its terms” by the draftsman and therefore that must mean reference to actual terms. The language of paragraphs 90 and 91 already expressly tells the reader when provisions other than those in the lease may be relevant – where the provision is made in “any transaction or series of transaction of which the lease forms a part” (para 90(1)(b)). There is simply no need to stretch the definition of “lease” to try and catch other provisions. The reference to arrangements in paragraph 89(2) is intended to capture where a ship is made available by means other than a lease (for example, a licence). Where there is a lease, there is no need to look any further.

Mr Bremner submits that given the width of the provisions, including the phrase “any arrangements” and the background scheme of the legislation it is clear that the term “lease” is an intentionally broad definition which is not confined to/by the legal meaning of the term “lease”.

With the purpose of the statutory scheme and paragraph 89 (as amended) in mind we are clear that a wide definition of “lease” has been provided in the legislation in para 89(2). It is not only something which is in the form of a lease but also “any arrangements that provide for a ship to be made available by a person (“the lessor”) to another person (“the lessee”)”. That in itself is coloured by the words in paragraph 89(1) which state that the provisions apply to a “lease” (as defined in para 89(2)) of a qualifying ship provided, directly or indirectly to a company within tonnage tax.

Mr Ghosh submitted that if there is a lease there is no need to look further to identify the “lease” for the definition in paragraph 89. On that basis the Head Lease is the paragraph 89 lease. However, we do not agree with this submission because that lease would not provide a ship directly or indirectly to a company within tonnage tax. Indeed, it is fundamental to the statutory scheme with which are concerned that there is a company claiming capital allowances on the cost of the Ships and provision of those Ships directly or indirectly to the tonnage tax companies. That is the very concept which the legislation was introduced to address as we have explained. Its purpose was to address the extent to which lessors retain risk in transactions in relation to a ship which is operated by a company within the tonnage tax regime.

We agree with Mr Bremner that the use of the word “any” to describe “arrangements” emphasises the broad scope of the term and there is no implicit restriction that seeks to limit the term “lease” to just one transaction or contract. The legislation very clearly extends the meaning of the term “lease” beyond the ordinary meaning of the word. We also agree that the reference in the legislation to the ship being provided “directly or indirectly” to a company within the tonnage tax regime implies that the legislation envisages multiple steps between the lessor and lessee.

Given the width of the definition in para 89(2) and the requirement that the ship should be provided directly or indirectly to a company within tonnage tax we therefore consider that the paragraph 89 lease comprises the Head Leases and the Sub-Leases with the result that the paragraph 89 lessor is each of the Appellants and the paragraph 89 lessee is each of the Sub-Lessees.

One of the submissions made by Mr Ghosh in the context of submitting that the lease as defined was only the Head Lease is that in arguing that the paragraph 89 lease included the Head lease and the Sub-lease HMRC ignored the fact that the terms of the Head lease and Sublease did not mirror each other, require payments at different times and in different currencies and therefore cannot be collapsed together into one direct lease. However, we consider that the provisions in Schedule 22 do not require that. They are very widely drawn and can encompass a set of arrangements such as those involved in this case whereby a head lease/sublease structure was used and that forms the paragraph 89 lease for the application of the provisions without in any sense collapsing those arrangements. We recognise that there are some potentially difficult issues as to what the amount of rental is when reference to that concept is made in the legislation. We address this in context later. However, we do not consider that such difficulties can displace the need for the ship to be provided directly or indirectly to the tonnage tax company.

The assessment of whether the deal has been de-risked under paragraph 90 requires us to consider the paragraph 89 lease”– i.e. the Head lease and Sub-lease – or any transaction or series of transactions of which that paragraph 89 lease forms a part.

Given the findings set out above, including those which show that all the transactions for entered into in contemplation of each other, we are satisfied that the entire package of transactions should be taken into account subject then to the exclusion of any excepted security under paragraph 91. Indeed, Mr Ghosh did not seek to argue otherwise in the context of a finding that the paragraph 89 lease comprises both the Head Lease and Sublease.

We therefore now turn to consider what elements should be left out of the assessment under paragraph 90 as excepted securities pursuant to paragraph 91.

The parties have disputed whether the following elements of the transactions fall within the category of excepted forms of security:

However, it was conceded by HMRC in Mr Bremner’s skeleton argument, and confirmed by him during the hearing, that while it was maintained that the Vroon Guarantee is not an excepted security, it does not add anything to the analysis under paragraph 90 on its own or when added to the other provisions which HMRC say cause paragraph 90 to be applied. The experts had agreed that the Vroon Guarantee made little difference to the non-compliance risk.

We therefore do not need to consider the Vroon Guarantee further in this context.

Turning to the Fortis Bank Guarantee, one potential issue is whether a guarantee is a “security” as paragraph 91 applies to transactions which are the “provision of security” meeting specified criteria. Mr Ghosh recognised in his skeleton argument that as a matter of strict law a guarantee is not security because it is a personal obligation rather than a proprietary right. However, he maintains that interpreted purposefully, the phrase “provision of security” in paragraph 91 is sufficiently broad to capture a guarantee as a guarantee has a similar economic effect to the provision of security by related or third party. We have not needed to engage in this issue as Mr Bremner confirmed in the hearing that HMRC did not seek to argue that a guarantee was not a security (this view also according with the HMRC view set out in the tonnage tax manual). HMRC was content to follow the analysis put forward by Mr Ghosh such that a contractual right, making arrangements more secure, would suffice as a “security” for these purposes.

Mr Ghosh submits that the Fortis Bank Guarantee is an excepted security within paragraph 91 because either:

Mr Bremner submits that this is wrong because:

Addressing paragraph 91(3) first, we have identified that the paragraph 89 lessors were the Appellants and the paragraph 89 “lessees” were the Vroon Group subsidiaries, i.e. the Sub-lessees.

On that basis paragraph 91(3) does not apply to the Fortis Bank Guarantee as Fortis Bank is not the paragraph 89 lessee and is not connected to the paragraph 89 lessee.

That then leaves the question as to whether the third party provisions in paragraph 91(5) apply, regarding which we need to address the application of sub-paragraphs (a) and (d).

The “lessor” is each of the Appellants. The Fortis Bank Guarantee is provided by a third party. The issue is then whether the Prepayments were obtained by the Appellants or any third party by way of security.

At the hearing Mr Bremner and Mr Ghosh made submissions regarding the extent to which the Prepayments were made “by way of security”. Mr Bremner submitted that the Prepayments functioned to make the ability of each Appellant to recover monies from Fortis Finance (or Fortis Bank) more certain. He acknowledged that there is no charge over the monies, but they had in essence been ring-fenced within Fortis Finance, a company with no other activities. Just as a guarantee is treated as security under paragraph 91 given the function which it is performing, so the Prepayments should also be viewed in reality as performing the function of security. It would be inconsistent to apply a more formalistic need for actual security in the form of a charge in the context of the Prepayments and not to a guarantee.

Mr Ghosh submitted that the condition is met because there is no security interest created in the Prepayments and the purpose of them was not to secure the guarantee from Fortis Bank. The Fortis Bank Guarantee did not refer to, or rely upon, the Prepayments. Instead, the purpose of the Prepayments was to de-risk the Sub-Leases between Fortis Finance and the Vroon Group subsidiaries. Within the overall transaction structure there are deposits of money for the benefit of Fortis Finance, the security trustee and export credit financiers, but they have nothing to do with the Fortis Bank Guarantee. It would be absurd if a lessee placing money on deposit in a way unrelated to the lease had this effect or else lessees would effectively be debarred from having bank accounts.

Mr Bremner relied upon a difference in drafting between paragraph 91(5)(a) and the remaining subparagraphs of paragraph 91(5). In 91(5)(a) the draftsman does not require the deposit to be made under the terms of the security being considered.

We agree with Mr Bremner that the reference to a deposit by way of security should not be limited to amounts over which there is a charge. The draftsman has chosen to refer to the deposit “by way of security” which we interpret to mean that it is necessary to ask whether the deposit is carrying out the function of security.

Interpreting the provision in this way addresses Mr Ghosh’s concern that any lessee deposit would otherwise breach the condition. Deposits which do not operate “by way of security” would not breach the condition.

The participants themselves viewed numerous elements of the transactions as “security” as shown by the evidence in an email describing the transaction as “underpinned with a robust security structure, which provides multiple layers of security”. Beyond the core transactions of the Head Leases and Sub-Leases of the Ships the other numerous elements are either providing the monies needed by way of loan or are providing security for one or more of the transactions. Those layers of security did not include actual charges over assets beyond mortgages over the Ships provided under the terms of the Parallel Debt. We are therefore clear that the parties viewed the structure as involving more security than simply the mortgages of the Ships.

Mr Ghosh also relied upon the fact that the Prepayments were required under the terms of the Parallel Debt. We have found above that service of notice of the Prepayments was a condition of the provision of funds under the Parallel Debt and the Sub-Lessees undertook to use the funds received for the Prepayments and a deposit to be held with ABN Amro. The fact that the funds made available under the Parallel Debt were to be used for the Prepayments tells us little about whether those Prepayments were made by way of security.

The Prepayments were made under the terms of the Sub-leases. They were not required by the Guarantee, but we agree with Mr Bremner that the drafting of paragraph 91(5)(a) does not require the deposit to be under the terms of the security being considered. In contrast, in each of the other subparagraphs of paragraph 91(5) there is an express link to the security being considered – i.e. in (b) and (c) the draughtsman states: “the security does not…” and in (d) the draftsman refers to payments made “under the security”. If the deposit was to be limited to deposits made or required under the security being considered that would be easily achieved with different drafting.

Mr Ghosh recognised that the Prepayments were “de-risking” the Subleases and we see little basis to conclude that, consistent with this, the Prepayments were anything other than one of the layers of security in the transactions as a whole. More particularly, the Prepayments were by way of security for the Sub-lease rentals which were not received by the paragraph 89 lessor but by a third party – i.e. the Intermediate Lessor, Fortis Finance. They clearly provided security to that third party. On that basis paragraph 91(5)(a) is breached.

We would also note that there are other deposits in the transactions such as that placed with the security trustee, albeit that Mr Bremner placed less reliance on them. Consistently however, and for the same reasons we conclude that they are also layers of security in the overall transaction.

Although we do not consider this to be necessary for our decision, we also address the issue as to whether the Prepayments had the function of being paid by way of security from the Appellants’ perspective given the extent of submissions on this issue.

We also consider that the Appellants knew that the amount represented by the Prepayments had been received by the special purpose vehicle, Fortis Finance, the subsidiary set up for this financing by a credit worthy bank, Fortis Bank (rated AA). Therefore, this provided some further security in a broad functional sense for the Appellants. We recognise that the Appellants also had the benefit of the Fortis Bank Guarantee such that even if Fortis Finance did not receive payments under the sublease, the Appellants were protected. However, the transaction, in common with many large financings, had multiple layers of security as the email described. The fact that there were other elements of security does not detract from the conclusion that the Prepayments and deposit were also by way of security.

The conclusion that the Prepayments were seen to have a security function for the Appellants as well as Fortis Finance reinforces our conclusions about the application of the provisions of paragraph 91(5)(a).

We recognise that later in this decision we conclude that the Prepayments did not reduce the non-compliance risk because there was no charge or pledge applicable to them in favour of the Appellants. That is not inconsistent with the conclusion we have reached here. We are considering two very different concepts. In the case of the application of the excepted security rule in paragraph 91 we are looking at a functional test when considering “by way of security” which is considering not only the position of the lessor but also the position of third parties. In the case of the non-compliance risk we are considering a more precisely defined concept addressing the impact for the Appellants alone under paragraph 90 as we explain later. Our view therefore is that the correct place to address Mr Ghosh’s arguments regarding the legal effect of the Prepayments is the application of the non-compliance rule in paragraph 90 itself.

We are satisfied that our interpretation of the rules fits within the statutory framework we have described earlier. The concerns raised by Mr Ghosh about too wide an interpretation of “by way of security” under paragraph 91 are appropriately addressed by considering whether a provision breaches the boundary drawn between acceptable and unacceptable derisking of the transactions for the Appellants themselves under paragraph 90.

Accordingly, for all the reasons we have set out the Fortis Bank Guarantee does not meet the requirement of paragraph 91(5)(a) to be an excepted form of security.

Given the extent of submissions and the lack of authority in this area we consider it is also appropriate to consider the alternative condition which is in dispute between the parties even though the conclusion regarding paragraph 91(5)(a) excludes the Fortis Bank Guarantee from being an excepted security.

Mr Ghosh submits that:

Mr Bremner submitted:

We consider that the wording of paragraph 91(5)(d) specifically identifies that the payments under this security must be limited to the amount of the rental payments in default. We see no basis on which the plain words of “the amount of the rental payments” should be interpreted to include amounts treated as rental payments by the parties, or even amounts calculated by reference to rental payments. Mr Ghosh, unsurprisingly, did not seek to submit that payments other than actual rental payments had that nature by virtue of the clause stating that they would be treated as such by the parties.

It is not disputed that there is no express limitation in the Fortis Bank Guarantee limiting the amount payable thereunder to the amount of rental payments in default. Instead, the parties have been in dispute as to whether in practice such a limitation exists.

We recognise that if the lessee is in default in relation to payment of rental the Basic Termination Sum is payable under the Head Lease. As that is the discounted value of the future rentals it is less than the total amount of future rentals. We would note that at the time of calculating the Basic Termination Sum there is some argument that not all future rental payments are in default. However, even if the total rentals are treated as being in default we are not satisfied that it has been shown that payments under the Fortis Bank Guarantee are limited to that total amount, even recognising that the Basic Termination Sum will be less than the total outstanding rentals. Payments can cover various other circumstances as we have found in our findings of fact including payments in respect of breach of warranties. We therefore conclude that the amounts payable under the Guarantee can exceed the amount of rental in default.

We note that implicit in the arguments regarding the amount of rental in default is an assumption that the rental to which reference is made is that paid by Fortis Finance. While this does not alter the conclusion reached, we consider that the combination of paragraph 91(5)(c) and (d) means that the reference is to the rental paid by the “lessee” which is the paragraph 89 “lessee” and therefore the Sub-Lessees. (The same conclusion is reached under paragraph 91(3)(b) directly.) The “lessee” being the Sub-Lessees makes no difference to the conclusion however, because we have not been shown that the payments under the Fortis Bank Guarantee would be limited to the amounts of rent payable by the Sub-lessees for which they are in default.

Mr Ghosh submitted that the Fortis Bank Guarantee can be considered to be an excepted security insofar as it applies to rental payments or insofar as it applies to payments not in excess of the amount of rental payments. We see no basis to interpret the provision in this way. The draftsman does not use a term such as “to the extent that”.

We also do not accept that the obligations under the Fortis Bank Guarantee should be treated as individual separate obligations for the purposes of paragraph 91(5)(d). As Mr Bremner submitted, we are required by the legislation to consider the “provision of security by a third party”. The security provided by the third party, Fortis Bank is the security provided in totality by it whether as multiple obligations in one document or multiple separate documents. We see no basis to treat each obligation separately. (If the Fortis Bank Guarantee were split into multiple separate guarantees, as Mr Ghosh postulated, we would expect to aggregate them to consider the total “provision of security” by the third party.)

Accordingly, we conclude that the condition in paragraph 91(5)(d) it is not satisfied in relation to the Fortis Bank Guarantee.

We would note that our conclusions in relation to paragraph 91(5)(d) apply equally to paragraph 91(3)(b) so that the Fortis Bank Guarantee is not an excepted security whether or not the “lease” under paragraph 89 is the Head Lease and Sublease or the Head Lease alone.

HMRC submit that there are three relevant provisions (together referred to in this decision hereafter as “the Provisions”) to consider for the purposes of paragraph 90:

The Appellants submit that Provision 1 is not a “provision” on first principles and we must therefore address this issue first.

The Appellants say that the identity of the lessee under the Head Leases is a characteristic of the lessee, but is not a provision of the lease/Head Lease. The mere fact that a lessee is wealthy or creditworthy cannot be relevant as otherwise that would always have the effect of de-risking a lease compared to a hypothetical lease to a lessee who was not wealthy or creditworthy. It was not Parliament’s intention to encourage lessors to engage preferentially with poor credit risk. A critical determinant of the risk profile of the lease is the lessee’s creditworthiness. A lease to a different lessee may have a completely different risk profile. As a matter of private law the substitution of one obligor for another can take place only by novation. In this case the lessee under the Head Lease was always Fortis Finance. HMRC does not contend that the Head Lease and Sublease can be looked through in circumstances where the Head Lease and Sublease were not back-to-back, their terms did not mirror each other, and they sometimes require payments at different times and in different currencies.

Furthermore, Mr Ghosh submitted that the non-compliance risk can only be located in the Head Lease. The actual transactions entered into need to be respected. It was never contemplated that the Vroon subsidiaries would be lessees under the Head Leases rather than Sub- lessees.

Mr Bremner submitted that it is necessary to compare the actual transactions to the paragraph 89 lease and the transactions referred to in paragraph 90. By having the Head Lease/Sub-lease structure the Appellants improved their risk position by having Fortis Finance as the counterparty (which was then further improved by the Fortis Bank Guarantee and the Prepayments). There is no reason why the existence of, and identity of, the Head Lessee cannot be a relevant “provision” in the context of paragraph 90. Mr Ghosh’s submission regarding the implication that HMRC’s interpretation would mean all leases to more creditworthy counterparties breach paragraph 90 is misplaced because the comparison is only made in the context of the facts of the actual case and in the light of the particular arrangements. It would be different if you had entirely unconnectedly a lease from the Appellants to a particular charterer and then unrelated to that commercial arrangement, the charterer decided that to sub-charter. There would be no link in terms of the parties’ commercial arrangements between the two things, but that is very different to what has happened here where the very purpose of the arrangements was for the Appellants to exchange shipping risk for the much lower bank risk.

We agree with Mr Bremner that paragraph 90 is not limited to the provisions of the paragraph 89 lease using the term “provisions” to mean the legally recognised provisions of a document. Instead, the paragraph applies if the paragraph 89 lease or any transaction or series of transactions of which that lease forms a part makes provision which has the prohibited effect on risk. We are not required to identify the provisions of particular documents, whether a lease or any other document. That limits the meaning of the word “provision” beyond its natural meaning to a narrower concept of a provision of a document. We see no basis to do so. Instead, we need to identify what provision is made by the paragraph 89 lease or transactions of which that defined lease is a part.

With that in mind we agree with Mr Bremner that the paragraph 89 lease (in which, as we have already concluded, the “lessor” is the Appellants and the “lessee” is each Sub-Lessee), or the transactions of which that lease formed a part, made provision for Fortis Finance to be an intermediate lessee/sub-lessor.

We do not agree with Mr Ghosh that this means that paragraph 90 is causing comparison to be made to a hypothetical lease to a lessee who was not wealthy or creditworthy. The exercise required by paragraph 90 is entirely restricted to the context of the actual transactions – does this paragraph 89 lease, or any transactions of which it forms a part, make provision which breaches the non-compliance risk requirements of the legislation? That is consistent with the overall purpose of the legislation described by us earlier.

Therefore we need to consider, in essence, whether the provision for Fortis Finance to be the lessee under the Head Lease leasing the ships from the Appellants and sub-leasing to the Appellants removes all or part of the non-compliance risk which apart from it being lessee under the Head Lease would fall on the Appellants under the paragraph 89 lease to the Sub-Lessees.

This leads us on to consider the concept of non-compliance risk in more detail in the context of the Provisions.

The question is whether any of the Provisions alone or in combination have the effect of removing the whole, or the greater part of, any non-compliance risk which, apart from that provision, would fall directly or indirectly on the lessor.

Non-compliance risk is defined as “a risk that a loss will be sustained by any person if payments under the lease are not made in accordance with its terms.”

We note that:

So, this means that in this case we:

Mr Ghosh submitted that in this case the result is that the non-compliance risk being assessed is the risk of loss arising from the fact that the Appellants do not receive payment under the Head Lease. Provisions may de-risk Fortis Finance under the Sub-Lease except insofar as that itself de- risks the Appellants under the Head Lease. That conclusion is firstly based on his interpretation of “payments under the lease” referring to the actual lease to which the Appellants are party (i.e. the Head Lease). However, we have decided that the “lease” for the purposes of paragraph 90 is not just the Head Lease, but the entire arrangements including the Sublease. In that case, Mr Ghosh submits that it remains the case that the Appellants only receive rental payments under the arrangement from Fortis Finance under the Head Lease, so the risk again comes back to a risk of Fortis Finance not making those payments. (The concession made in the statement of agreed facts and issues was made on the basis of the rental payments under the “lease” as defined being found to be the payments made by the Sub-lessees to Fortis Finance, not the payments made by Fortis Finance to the Appellants.)

This issue is most clearly relevant in the context of the Prepayments to which we turn later in the decision and where we make clear that we agree that the non-compliance risk for the Appellants resides in the Head Lease.

The experts have provided opinions as to the measurement of the non-compliance risk and the impact of the Provisions. Both experts are well qualified, albeit with different experience. Neither party sought to challenge the credibility of either expert, although Mr Bremner submitted that Mr Bencard’s experience was less on point and somewhat outdated. Mr Ghosh submitted the fundamental issue is that the experts have measured different things and we agree.

The variety of assumptions in the expert opinions highlights quite how difficult applying this provision can be in real world circumstances. We have decided that as both parties recognised, we must first identify the correct method of assessment as a matter of law.

Mr Bencard has put forward two different assessments with very different conclusions. We therefore address the differences between them.

Mr Bencard describes the differences between his two assessments as follows:

“whereas the First Assessment involves assessing the risk of payments under the Head Lease not being made and expressing that risk is a probability weighted loss, both with and in the absence of the Provisions, the Second Assessment by contrast requires me to postulate that payments under the Head Lease are not made and then assess the risk of the relevant Appellant thereby sustaining a loss, both with and in the absence of the Provisions. The Second Assessment does not take into account the probability that a counterparty will default on payment under the Head Lease.”

In making his First Assessment Mr Bencard says that he was instructed to assess the effect, if any, on the risk of payments not being made to the relevant Appellant under the head lease by virtue of the various Provisions. He explains that he understands that the “risk” of payments not being made means the chance or probability, in relation to each payment due under the Head Lease, that the payment will not be made thereby giving rise to a loss equal to the unpaid amount, measured as a probability-weighted loss. This was calculated on the basis, in particular, of the probability of default by a counterparty given their creditworthiness and the “loss given default” which is the loss that experience showed would arise from particular types of receivable.

In making his Second Assessment Mr Bencard says that he makes the following assumptions:

The differences between Mr Bencard’s First and Second Assessments can be illustrated by his conclusion regarding the impact of Fortis Finance being lessee taken together with the Fortis Bank guarantee. He acknowledges that those provisions taken together do indeed reduce the likelihood of loss falling on the Appellants, but he maintains that they do not reduce the amount of loss which is the thing being measured under the Second Assessment because of the insolvency assumptions he has made.

We consider that Mr Bencard’s Second Assessment makes assumptions beyond the requirements of paragraph 90 with insufficient basis to do so for the following reasons:

We therefore conclude that reliance should not be placed upon Mr Bencard’s Second Assessment.

Mr Sutton has measured the risk as the probability of non-payment regardless of how much (if any) loss is expected.

One difference between Mr Sutton’s assessment and Mr Bencard’s First Assessment is that Mr Sutton has simply addressed the probability of loss whereas Mr Bencard has produced figures reached from applying probabilities of loss to the amount of the loss.

To illustrate the difference Mr Ghosh described the example of the toss of a coin. There is a 50% chance of it being heads or tails. That is the figure used by Mr Sutton. Mr Bencard goes on to consider the amount at stake so that he factors in whether one risks losing £1 or £1million.

We explored with Mr Ghosh at the hearing whether it in fact made a difference to the outcomes if one considered a percentage for the non-compliance risk including or excluding the expected loss. To take a simple example, if the probability of loss £x without a provision is 70% and the probability of loss £x with the provision is 20% the answer to whether the provision has removed the greater part of the 70% risk is the same whether you compare 70% and 20% or 70% of £x and 20% of £x. This of course assumes that £x remains the same. To the extent that £x changes then the answers produced by the two experts will change. Similarly, if £x is itself replaced with a percentage (as Mr Bencard has done) again the outcome is the same so long as that percentage is constant.

Indeed, we question how £x (or indeed the expected default rate) can change in the circumstances prescribed by the legislation? We interpret paragraph 90 as requiring an assessment of the risk of a loss £x being sustained by the Appellants under the paragraph 89 lease without the Provision(s) as compared to the risk of that loss £x being sustained by the Appellants under the paragraph 89 lease or the transactions prescribed by paragraph 90 with that Provision(s).

In practice in this case we do not need to address this point further though because the difference in outcomes resulting from the experts’ opinions do not turn upon whether one considers a risk percentage in isolation, or a risk percentage applied to another percentage (or amount). In essence, both experts have concluded that Provisions 1 and 2 together (i.e. the fact that the payment obligations under each Head Lease are borne by Fortis Finance, rather than the Sub-Lessee and the Fortis Bank Guarantee) cause the greater part of the non-compliance risk to be removed, subject to one further issue which we will shortly address.

In relation to Provision 3 (the Prepayments), their opinions differ for more fundamentally different reasons which we address later.

The figures produced by Mr Sutton and Mr Bencard (under his First Assessment) for the Provisions are as follows:

The table shows that the experts agree that if Fortis Finance is not lessee and there is no Fortis Bank Guarantee there is a significant difference in the non-compliance risk: 15.2% as opposed to 0.52% or 26.5% to 0.6%.

However, Mr Ghosh submits that whether these figures breached the rule in paragraph 90 depends upon the method of calculation. He submits that:

On either such approach Mr Ghosh submits that the greater part of the non-compliance risk has not been reduced whichever expert’s assessment is adopted. He submitted that this properly reflected the fact that it should only be in relatively rare circumstances of abuse that it is appropriate to apply the draconian consequence of taking away a lessor’s entire capital allowances.

It was recognised in the hearing that this debate over subtraction or division is essentially a question of the starting point for the calculations. Mr Ghosh submits that the starting point must take into account the permitted reductions in risk already present in the transactions including any excepted securities.

However, we agree with Mr Bremner that this does not reflect the legislation as that is not carrying out what is required under paragraph 90 for the following reasons.

Paragraph 90 asks us to identify the non-compliance risk of the paragraph 89 lease and consider whether one of more provisions contained in that lease or transactions removes the greater part of that risk. The starting point is not a hypothetical situation with 100% risk of default. As Mr Bremner submitted, the joint expert report shows that a shipping company has a risk of default that is less than 50% whichever expert’s opinion is relied upon. Consequently, the simplest finance lease between a bank and a shipping company would have a risk of default below 50%. Applying Mr Ghosh’s approach would mean that there could never be provisions which would remove the greater part of the non-compliance risk as more than 50% has been removed from the start.

Mr Ghosh also says that allowance must be made for the excepted securities. Although we have decided that none of the Provisions is an excepted security, we consider it to be important to address this issue given that it is a matter on which he relies to adopt a different starting point under the legislation.

Mr Ghosh maintains that any excepted securities must be given full recognition. Therefore if excepted securities reduce the risk in a set of transactions to less than 50%, other non-excepted securities should not breach the rule in paragraph 90 and that should not be objectionable because Parliament has approved de-risking via excepted securities.

Mr Bremner provided examples to illustrate the issue. One such example was the following:

Applying Mr Ghosh’s approach the excepted security’s reduction in the non-compliance risk by more than 50% means that non-excepted securities cannot cause paragraph 90 to be applied to remove the lessor’s capital allowances. HMRC, in contrast, say that the fact that the non-excepted security causes more than 50% of the non-compliance risk to be removed is itself sufficient to cause paragraph 90 to be applied. The effect of the excepted security is not factored into the paragraph 90 calculation.

Although we can see that there is a good argument for the approach to excepted securities advocated by Mr Ghosh, we do not consider that it is supported by the wording of the legislation.

As explained the starting point under paragraph 90 is the non-compliance risk of the paragraph 89 lease. There is nothing to extend that starting point to encompass the paragraph 91 excepted securities. It is then necessary to consider provisions of the lease or transactions other than those excepted under paragraph 91. This is achieved by paragraph 91 referring to the provisions by way of security which are excluded and removing those from the consideration of “provisions” removing non-compliance risk under paragraph 90. But the starting point against which the removal is measured is not extended to include the effect of the excepted securities.

The evidence from both experts therefore shows that the greater part of the non-compliance risk is removed for the Appellants as a result of Provisions 1 and 2.

Given the difficulties with the interpretation of this legislation we have considered this conclusion in the context of the purpose of the legislation identified by us earlier. We consider that, in effect, replacing the risk of a deal with a shipping company within the tonnage tax regime with the risk of a deal with a bank clearly reduces the non-compliance risk to which the Appellants were exposed. Indeed, that was the basis of entering into the transactions as shown by our findings earlier. Given the boundary drawn by Parliament in the legislation and the history of that legislation which we have addressed earlier, we are clear that this is a prime example of something which falls within the purpose of the rules in paragraphs 89-91. The Appellants entered into a transaction where the risk was less than that of leasing to the shipping companies. It has then been a matter of expert evidence to identify whether that reduction fell within the “greater part” test of paragraph 90.

Our conclusion as to the effect of Provisions 1 and 2 for all the reasons we have set out means that the appeals must be dismissed.

Given our conclusions regarding the application of the excepted securities rules in paragraph 91 to the Fortis Bank Guarantee in the context of the Prepayments, it is incumbent on us to set out how we consider the rules in paragraphs 89-90 go on to address the extent of security provided by the Prepayments.

The core of the dispute regarding the Prepayments is whether they should be taken into account in de-risking the transactions for the Appellants where the Appellants have no recourse to the Prepayments or security in the form of a charge over them. Mr Sutton has worked on the basis that each £1 of prepayment has reduced the Appellants’ non-compliance risk by £1, despite the lack of recourse or security and then, to put it simply, as that amount is more than 50% of the amount payable to the Appellants it follows that their non-compliance risk was reduced by more than 50%. Mr Ghosh submits that this is wrong and fundamentally the function of the Prepayments was simply to de-risk the Sub-Lease with no effect on the non-compliance risk for the Appellants. Indeed, in cross-examination Mr Sutton conceded that his £ for £ approach to calculating the effect failed to take into account any default rate on that element.

Mr Bremner submits that it does not matter that the Prepayments were not subject to a charge or recourse because when you look at how the arrangements were intended to work the money was ring fenced. It was placed with Fortis Finance and then deposited with Fortis Bank so that Fortis Finance was in the position that it would be able to pay more than 50% of the sums due under the Head Lease.

This issue brings into focus another difference between the experts. Mr Bencard has approached his assessment by looking at the transactions overall and removing one or more Provisions. Mr Sutton started with a lease between the Appellants and the Sub-lessees and added the Provisions. Mr Bremner submitted that it should, as a matter of logic, make no difference and the assessments should meet in the middle.

Our view is that we must start by identifying the non-compliance risk arising from non-payment under the paragraph 89 “lease”. That “lease” is the arrangements for a ship to be made available by the Appellants to the Sub-lessees, i.e. the Head lease and Sublease.

If all the transactions are taken into account as the starting point, then simply taking away the effect of the one Provision can be seen to have little effect where the existence of other Provisions (in particular, the Fortis Bank Guarantee) remains in place. Mr Bencard recognised that carrying out the assessments in such a way by starting with everything and removing one provision at a time could lead to the effect of different provisions being “masked”. When pressed in cross-examination about his opinion that the Prepayments had no impact on the non-compliance risk because of the lack of security, it became clear that Mr Bencard was also relying upon the fact that the recipient of the Prepayments was a subsidiary of a bank which would be supported by its parent and there was in place the Fortis Bank Guarantee. The “masking” of the other Provisions was apparent which causes us to place less weight on his assessment regarding the Prepayments alone, given our conclusion to what is required by the statutory test.

Mr Sutton’s approach of starting of adding in Provisions to a lease avoids the masking effect and on that basis is preferable. However, as Mr Ghosh submitted, Mr Sutton was wrong to start with the assumption of a lease simply between the Appellants and the Sub-lessees.

As said, the starting point is a Head-lease/Sub-lease structure. Although it is clear from Mr Sutton’s report that in the context of the Prepayments he recognised the existence of the Head-lease/Sub-lease structure (in other words he did not assume the Prepayments were made to the Appellants), his starting point was incorrect. We are unable to identify whether that made any material difference to the conclusion.

More importantly though, in the context of considering the Prepayments, in cross-examination the reliability of Mr Sutton’s assessment was called into question and he conceded that in the context of his methodology elsewhere it was incorrect to simply use a pound for pound approach rather than take into account a default rate. Given that as we have already identified, the non-compliance risk involves the concept of a loss as a result of non-payment we would expect a default rate to be applied in this context as well as that of the other Provisions.

We are therefore left with a potentially unsatisfactory conclusion that neither of the opinions is sufficiently reliable. However, in this case we are satisfied that the matter can be resolved without need to refer to an opinion regarding the amount of the non-compliance risk.

Stepping back from the experts’ opinions, we agree with Mr Ghosh that the Intermediate Lessor in the paragraph 89 lease has received more than 50% of the funds needed to pay the rentals due under the Head-lease, but in circumstances where the Appellants have no security, pledge, commitment or other recourse to those funds. The Intermediate Lessor could, as Mr Ghosh suggested, have made an investment which failed. There is nothing in the documents to limit the Intermediate Lessor’s use of the money. As noted earlier, the Appellants’ risk of loss from non-payment rests in the Head Lease.

Therefore the Prepayments alone would not be a provision of the transactions which under paragraph 90 causes the Appellants to cease to be entitled to capital allowances.

The Appellants’ appeals are dismissed for the reasons we have set out.

This document contains full findings of fact and reasons for the decision. Any party dissatisfied with this decision has a right to apply for permission to appeal against it pursuant to Rule 39 of the Tribunal Procedure (First-tier Tribunal) (Tax Chamber) Rules 2009. The application must be received by this Tribunal not later than 56 days after this decision is sent to that party. The parties are referred to “Guidance to accompany a Decision from the First-tier Tribunal (Tax Chamber)” which accompanies and forms part of this decision notice.