UK: The First-Tier Tax Tribunal Has Decided That A Scheme To Avoid Tax By Temporarily Devaluing Consideration Loan Notes Did Not Work

Last Updated: 13 September 2012
Article by Ashley Greenbank

In Blumenthal v HMRC [2012] UKFTT 497, the FTT has decided that a scheme to avoid capital gains tax on the redemption of certain consideration loan notes (originally in the form of non-QCBs) by artificially devaluing them shortly before redemption and then varying them so as to make them QCBs was not effective. The conversion of the non-QCBs into QCBs was held to be effective but, as a result of the application of the Ramsay principle and a drafting error in the deed of variation, the attempt to devalue the loan notes (without affecting the redemption price payable to the taxpayer) did not succeed. Furthermore, the FTT held that, although the taxpayer drew HMRC's attention to the scheme in the white space of his tax return, this disclosure was not adequate to prevent HMRC from counteracting the scheme by issuing a discovery assessment.

The facts of the case (somewhat simplified) are as follows. In 1999, the taxpayer and 5 other vendors sold their shares in a trading company to O2 in exchange for loan notes in O2. These loan notes were non-QCBs, because they contained an option for redemption in US$ at the rate prevailing three days before redemption. The taxpayer's loan notes had a nominal value of about £329,000 and he rolled over a gain of about £294,000 into the notes.

Redemption of the loan notes was due to occur on 25 March 2004, at which time the rolled-over gain would be treated as arising for CGT purposes. The taxpayer sought advice from Brian White of Deloitte about his imminent liability to CGT and, in February 2004, he implemented a scheme designed to avoid that liability. It appears from the mechanics of the scheme and from other comments by the FTT in its decision that some or all of the other five vendors must have implemented the same scheme.

Contingent provision for the loan notes to convert into QCBs

On 13 February 2004, the taxpayer and O2 entered into a Deed of Variation of the loan notes. It provided that, if on any day between 16 February and 17 March 2004 the US$/£ exchange rate had moved by at least 1.5 per cent from the rate on the first day of that period, the provision for redemption in US$ at the rate three days before redemption would, on the first day on which such rate movement occurred, be deleted and replaced by a provision for redemption in US$ at the rate on redemption. A loan note is not prevented from being a QCB by reason only of a provision for redemption in a foreign currency at the rate (against sterling) prevailing at redemption (TCGA 1992 s.117). The requirement for the exchange rate to move by at least 1.5 per cent was intended to ensure that the conversion of the loan notes into QCBs was outside the control of the parties and, therefore, not pre-ordained. However, the requirement was highly likely to be met and, in early 2004, was in fact being met on about four out of every five days. The FTT held that it was an anti-Ramsay device which could be disregarded in any application of the Ramsay principle (IRC v Scottish Provident Institution [2004] UKHL 52).

Devaluation of the loan notes

The Deed of Variation further provided that, if between 16 February and 21 March any loan notes were held by a non-current loan noteholder, the redemption price was to be 3 per cent of nominal value. The reason for this provision was that:

  • when non-QCBs are converted into QCBs, there is no disposal but the chargeable gain or allowable loss that would have arisen if the loan notes had been sold for a consideration equal to their market value is calculated (such gain or loss being frozen until a subsequent disposal of the loan notes without the benefit of the exemption for gains on QCBs) (TCGA 1992 s.116); and
  • "market value" is the price which the loan notes might reasonably be expected to fetch on a sale in the open market (TCGA 1992 s.272).

Accordingly, the idea was that, if the loan notes had been offered for sale on the date between 16 February and 17 March 2004 on which conversion occurred, no purchaser in the open market who was not a current loan noteholder would have offered more than 3 per cent of the nominal value of the loan notes to acquire them.

The Deed of Variation also provided that, if between 16 February and 21 March any loan notes were held by a current loan noteholder and four or more of them had died, the redemption price was to be 3 per cent of nominal value. This means that, if the loan notes had been offered for sale on the conversion date, no purchaser in the open market who was a current loan noteholder was likely to offer the full nominal value of the loan notes to acquire them, because, if four of the six current loan noteholders died in the period, he would make a substantial loss on redemption. However, given the unlikelihood of the "four dead men" clause coming into effect, it is debatable how great a devaluation was brought about by this provision and the FTT regarded it as minimal.

The final instrument of devaluation was a deed of covenant entered into by the six loan noteholders in favour of a charity of which Mr White was a trustee. It provided that, if the covenantor acquired loan notes for less than par, he would pay double the difference to the charity. This effectively removed all possibility of the current loan noteholders making a profit from an acquisition of loan notes (after taking the payment to charity into account) and was intended to remove them from the potential field of purchasers of loan notes when assessing their market value under TCGA 1992 s.116.

Effectively, therefore, in determining the price which the loan notes might fetch in a hypothetical sale in the open market, no purchaser who was not a current loan noteholder would offer more than 3 per cent of par and no current loan noteholder would bid at all. Of course, none of this altered the taxpayer's ability to redeem (or his expectation that he would redeem) his loan notes for £329,000 on 25 March 2004 (unless 4 of the 6 died).

Redemption of the loan notes and tax claim

In the event, nobody died and redemption occurred on 25 March 2004 at £329,000. The taxpayer claimed a loss of £25,000 in his tax return for 2003-04 on the basis that the market value of the loan notes on the date of conversion was just under £10,000 (about 3 per cent of par).

Was there an effective conversion of the loan notes into QCBs?

Based on Harding v HMRC 79 TC 885, HMRC argued that the loan notes remained non-QCBs, even after the contingent provision in the Deed of Variation for the loan notes to convert into QCBs came into effect, because they still "made provision" (admittedly of no further effect) for redemption in a foreign currency at a rate prevailing other than at redemption. This argument was rejected by the FTT on the basis of the distinction, drawn in Klinke v HMRC [2010] STC 2032, between a provision (such as in Harding) under which the currency option lapses (without the loan note ceasing to "make provision" for the option) and a variation of the loan notes which deletes the option to redeem in a foreign currency at a rate prevailing other than at redemption (with the result that the loan note no longer "makes provision" for the option).

Nor did the Ramsay principle prevent the loan notes from being successfully converted into QCBs. There was a composite transaction (despite the anti-Ramsay device) but the true effect of that transaction was to change the exchange rate under the currency option from that prevailing three days before redemption to that prevailing at redemption. That made the loan notes QCBs. In any case, the provisions of TCGA 1992 s.117 relating to redemption in a foreign currency were highly prescriptive and did not, therefore, easily lend themselves to a "purposive" Ramsay approach. This justified HMRC's normal practice of accepting that currency redemption clauses in consideration loan notes are effective to make them non-QCBs, even though they are inserted purely for tax reasons and there is no intention actually to redeem the notes in any currency other than sterling.

Was there an effective devaluation of the loan notes?

Apart from the Ramsay principle and a drafting error, the amendments made to the loan notes by the Deed of Variation were effective to devalue the loan notes, at least for the purposes of the statutory hypothetical sale in the open market. HMRC argued, on the basis of AG for Ireland v Jameson (1905) 2 IR 218, that the statutory test required an evaluation of the amount which a purchaser would pay to stand in the vendor's shoes (ie £329,000 or thereabouts). This argument was tried and failed in Grays Timber Products Ltd v HMRC [2010] UKSC 4. It did not fare any better in Blumenthal. The statutory test requires an evaluation of the price which a hypothetical purchaser would pay to acquire the asset (taking account of the rights and liabilities which would apply to him, not those which applied to the vendor if different).

The Ramsay principle

The FTT held that, under the Ramsay principle, the proper construction of the valuation provisions of TCGA 1992 s.116 and s.272 required a purposive approach. On that basis, it was necessary to take a realistic view of the facts. Parliament intended that the concept of market value should capture the true economic value of the asset being valued. Accordingly, in this case, "market value" was a reference to the real worth of the loan notes, not a value which had been artificially manipulated for tax purposes to produce a temporarily depressed value during a short period in which an actual sale of the loan notes was a wholly unrealistic possibility. This manipulated value was not what the statutory provisions, purposively construed, envisaged as the "market value" of the notes. A month later the taxpayer received £329,000 on redemption of the notes - as intended all along.

This is an interesting application of the Ramsay principle, as it was not a normal case of applying a tax provision to the real rights acquired, and liabilities entered into, by the taxpayer stripped of those elements which were wholly artificial or unrealistic. It was a case of applying those real rights and liabilities to a hypothetical transaction (a notional sale in the open market). It is, therefore, a modest development of the Ramsay principle. It will be interesting to see if it is challenged on appeal.

The drafting error

By mistake, the provisions reducing the redemption proceeds to 3 per cent of par were only given effect during the period between 16 February 2004 and 21 March 2004. However, to be effective in reducing the price which a purchaser would pay for the loan notes, those provisions should have been made to last until at least 25 March 2004 when actual redemption was due to occur.

The FTT considered the various authorities on the correct approach to the construction of contracts and the circumstances in which, to give effect to the apparent intention of the parties, a mistake could effectively be disregarded in construing the contract. In this case, the FTT held that the wording of the Deed of Variation was unambiguous and could not be re-written so as to give effect to the apparent intention of the parties. That would be to correct the contract, not construe it. Correction of a contract requires an action for rectification.

Discovery assessment

The final point considered by the FTT was whether HMRC were precluded, by the disclosure made by the taxpayer in the white space of his tax return, from raising a discovery assessment to recover the CGT due on the redemption of the loan notes. Materially identical white space disclosures had been made by two other vendors which had been "picked up" by their inspector during the enquiry window.

The white space disclosure mentioned the redemption of the taxpayer's £329,000 loan notes, their previous conversion into QCBs and the fact that their value at that time was only about £10,000. The FTT held that, in the absence of a more detailed explanation of how the scheme worked, the disclosure might have alerted an officer of HMRC to make enquiries but it would not have made him aware of the fact that insufficient tax had been paid. There was, however, no need for an effective white space disclosure to label the transaction a "tax avoidance scheme". Accordingly, HMRC were not precluded from raising a discovery assessment.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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