The recent First-Tier Tribunal decision in the case of William Blumenthal throws light on a number of issues, in the context of a capital gains avoidance scheme. Economically, the taxpayer made a gain overall but for tax purposes sought to recognise a loss only.
Essentially, the taxpayer sold shares in return for loan notes issued by a member of the O2 group. Those loan notes were chargeable to capital gains tax, they were non-qualifying corporate bonds (“NQCBs”). The sale of the shares did not trigger a gain. Instead, the gain on the shares was rolled over into the NQCBs, it would only be crystallised upon a subsequent disposal of those NQCBs. The loan notes were treated as NQCBs by reason of a foreign currency redemption option, calculated at an exchange date shortly before redemption. All of this happened in 1998/99. All very standard.
Almost five years later the taxpayer, advised by Deloitte LLP, embarked on some tax planning. This involved changing the terms of the loans notes so that they would become qualifying corporate bonds (“QCBs”) at a time when their value was depressed. The change in status was to be achieved by amending the foreign currency redemption option, the resulting gain deemed to arise on change of status would then be frozen within the QCB. But by depressing the value of the loan notes at the time of status change it was anticipated that no gain would arise. The decrease in value was achieved by amending the loan note to allow the issuer to redeem at a fraction of the par value (3%) if the loan note was in the ownership of someone other than the taxpayer. In other words, a third party purchaser of the loan notes would not be willing to pay more than 3% of par value as this was the maximum that could be achieved on repayment, to ensure that the taxpayer himself could be discounted as a hypothetical purchaser he entered into a covenant arrangement with a charity such that he would be worse off if he were to acquire the loan notes.
This change in status was reported by the taxpayer to HMRC in his 2003/04 return, which included a “white space” disclosure outlining the arrangements. A loss was claimed on the change in status.
HMRC opened an enquiry into the return in January 2006 – but not in relation to the capital gains planning, instead the enquiry related to an unrelated claim for relief for gifts of shares to charity. That enquiry was closed after an adjustment to the tax return. At this point the taxpayer must have reached for the champagne, thinking that the arrangements had been successful. However, HMRC obtained various pieces of information from sources other than the taxpayer and in September 2009 requested further information, followed by formal notices in December of that year.
The appeal was concerned with two issues. Was the planning successful? If it was not, was HMRC entitled to make a discovery assessment outside of the usual time limits?
In relation to the substantive point it is worth noting three interesting aspects:
1. The taxpayer successfully argued that the legislative provisions dealing with a change in status from NQCBs to QCBs were prescriptive and left little room for purposive interpretation. They operated in a mechanical fashion and HMRC failed to persuade the Tribunal to accept that the arrangements, designed solely to avoid tax, were ineffective to change the status of the notes for tax purposes. The approach of the court in Mayes was specifically mentioned.
2. However, the Tribunal did not agree that the artificially manipulated value of the loan notes should be taken into account. The “Ramsay” principle applied, the depressed value obtained from manipulation of the rights was not effective. Market value was seen as a commercial concept ideally suited to the purposive approach to statutory construction embodied in the Ramsay principle.
3. In addition an error in the drafting of the variation was identified. Read literally the drafting did not work. The Tribunal was not willing to construe the contractual terms as to give effect to the desired change; there was no business or commercial common sense effect to be given to the amendment, which only had an uncommercial and artificial tax-driven purpose.
The end result was that the taxpayer lost, both on a Ramsay approach (even though the provisions in question governing the change in status did not allow for a purposive approach) and on the facts of the case due to defective drafting.
The Tribunal also found for HMRC on the discovery issue. The Tribunal accepted that if disclosure (both factual and technical) is adequate in the circumstances of the case then a hypothetical officer can reasonably be expected to be aware of an insufficiency in tax payable, even in a complex case or one involving specialist technical knowledge. But this was not considered to be the case here; the disclosure must alert the officer to an objective awareness of an actual insufficiency and it was considered that the disclosure did not do so.
Disclosure is a difficult hurdle for the taxpayer to overcome. The self-assessment includes a statement to the effect that it is to the best of the taxpayer’s knowledge correct and complete, but to protect against discovery a taxpayer needs at the same time to alert a hypothetical officer to an actual insufficiency of tax. A difficult balancing act.