England and Wales High Court (Chancery Division) Decisions

IN THE HIGH COURT OF JUSTICE
CHANCERY DIVISION

		Royal Courts of Justice Strand, London, WC2A 2LL
		12/04/2006

Mr Justice Lightman:

INTRODUCTION

1. This is an appeal by the Commissioners of Revenue and Customs ("the Commissioners") against a decision released on the 25^th July 2005 ("the Decision") of the VAT & Duties Tribunal ("the Tribunal") by which the Tribunal allowed an appeal by Enron Europe Limited ("the Taxpayer") against an assessment for VAT dated the 8^th September 2003 in the sum of £6,608,250 ("the Assessment"). The Taxpayer was the representative member of the VAT group of which Enron Capital Trade & Resources Limited ("Enron") was a member.
2. The issue before the Tribunal and the issue before me is as to the timing of supplies of gas and electricity made by Enron to Morgan Stanley Capital Group Inc. ("Morgan Stanley"). The timing of such supplies is determined by the date on which those supplies are paid for. The timing of the supplies (and accordingly of payment) determines the accounting period for VAT in respect of those supplies and accordingly the accounting period in respect of which the Commissioners can make an assessment for VAT. The Assessment related to Enron's VAT accounting period 09/02 which ran from the 1^st July 2002 to the 30^th September 2002. I have to decide whether the date of payment was: (a) the 1^st December 2001; (b) the 21^st February 2002; or (c) the 6^th August 2002. Only if the date of payment was the third of these alternatives, namely the 6^th August 2002, was the Assessment valid.
3. The Commissioners have at all times contended that the date of payment was the 6^th August 2002 and the Assessment was made on this basis. The Taxpayer, whilst challenging the Assessment, at no time disclosed that it challenged that this was the date of payment or that it maintained that the correct date was some other date until the eve of the hearing before the Tribunal. On the eve of the hearing before the Tribunal the Taxpayer for the first time maintained that the correct date was, at the latest, the 21^st February 2002. This remained the Taxpayer's contention until in the course of the hearing before me and in response to a direct question from me the Taxpayer identified the actual date of payment as the 29^th November 2001. After I had reserved judgment when in response to a query from me the Taxpayer contended that the date of payment was the 1^st December 2001. At a later date it occurred to me that the date of payment might be the 21^st February 2002 and I invited counsel to make submissions in writing in this regard and they did so.
4. It is and has at all times been common ground (as is clear as a matter of law) that: (1) the sum assessed ("the Debt") became due on one of the above dates. (The holding to the contrary by the Tribunal without reference to the parties is by common consent clearly wrong and unsupportable); and (2) the choice between the alternative dates turns on the construction of the provisions of an 'industry' netting agreement dated the 26^th October 2001 made between Morgan Stanley and Enron ("the Netting Agreement").
5. The question immediately arises why there had to be this litigation over the issue as to the date of payment when the existence and quantum of the liability are common ground. The answer is that after the Taxpayer had disclosed the alternative date of supply for which it was contending, the Commissioners issued a protective assessment for the period 03/02. Though this assessment is in time the Taxpayer is challenging the assessment before the Tribunal on the ground that it was issued too late, is out of time and is accordingly invalid. The Taxpayer apparently was not required to disclose earlier the date of supply for which it contended though if he discovered an error in relation to his VAT return he was required to correct that error by making voluntary disclosure to the Commissioners. I shall say a word later on this aspect of the case. The Commissioners quite reasonably have not issued a protective assessment on the basis that the supply was made on the 1^st December 2001 because that was not an alternative in the contemplation of the Commissioners or the Taxpayer until I suggested it.

FACTUAL HISTORY

6. There was prepared by the parties in advance of the hearing before the Tribunal a Statement of Agreed Facts. A brief summary of the facts and an extensive quotation of the relevant provisions of the Netting Agreement are all that are required in this judgment.
7. On the 26^th October 2001 Morgan Stanley and Enron entered into a Netting Agreement. The Netting Agreement (in which Morgan Stanley is referred to as "MSCG" and Enron as "the Counterparty") so far as material provided as follows:

"Whereas MSCG and the Counterparty (together the 'parties' and each a 'party') have entered into and intend entering into (i) cash settled derivative transactions, (ii) spot and forward transactions to purchase and sell gas and electricity in the United Kingdom and Europe, and (iii) transactions, whether spot or forward transactions, with a right to purchase or sell gas and electricity in the United Kingdom and Europe (each a 'Transaction');

Whereas MSCG and the Counterparty wish to provide for close out netting in respect of the Transactions in certain circumstances.

Now Therefore in consideration of the mutual undertakings herein the parties agree as follows:

1. Close-out Netting.

(a) If a party … (vi) seeks or becomes subject to the appointment of an administrator ….

…. an 'Event of Default', the party which has suffered, … an Event of Default, shall be the 'Defaulting Party' and the other party shall be the 'Non-Defaulting Party'. Upon the occurrence of an Event of Default the Non-Defaulting Party may by not more than 20 days' notice in writing to the Defaulting Party specifying the relevant Event of Default and designating a day, not earlier than the day of such notice, as the date of termination (the 'Early Termination Date'), terminate all, but not some only, of the Transactions then outstanding.

(b) Upon the service of a notice in accordance with clause 1(a), no further payments or deliveries in respect of the terminated Transactions shall be made.

(c) On termination of all Transactions in accordance with clause 1(a) the amount due from one party to the other shall be an amount equal to the net Market Value (as defined below) of all Transactions on the Early Termination Date. If such amount is a positive number, the Defaulting Party will pay it to the Non-Defaulting Party, if it is a negative number, the Non-Defaulting Party shall pay the absolute value of such amount to the Defaulting Party. For the purposes of this clause 1(c), the 'Market Value' of a Transaction on the Early Termination Date means the sum in pounds sterling of: (i) the amount determined reasonably and in good faith (such determination to be based as far as possible on published indices generally relied on by participants in the relevant market) by the Non-Defaulting Party as the likely cost (expressed as a positive number) or gain (expressed as a negative number) to the Non-Defaulting Party if it were required to replace the Transaction on the Early Termination Date with a Transaction to be entered into with an independent counterparty in the market which would have the effect of preserving for the Non-Defaulting Party the economic equivalent of any payment or delivery which would have accrued to the Non-Defaulting Party under the original Transaction had it not been terminated; and (ii) the aggregate amounts due and remaining unpaid to the Non-Defaulting Party (expressed as a positive number) or by the Non-Defaulting Party (expressed as a negative number) in respect of each Transaction.

(d) On or as soon as reasonably practicable following service of a notice in accordance with clause 1(a), the Non-Defaulting Party shall make the calculations referred to in clause 1(c) and shall provide to the Defaulting Party a statement showing in reasonable detail such calculations and specifying any amount payable.

(e) The party due to receive the amount calculated in accordance with clause 1(d) shall invoice the other party for the same. The amount set out in such invoice shall be due and payable on the date that is (5) five working days after the day of receipt of the invoice by the paying party (the 'Due Date'). Interest shall be payable on such amount (before as well as after judgment) in pounds sterling from (and including) the Due Date to (but excluding) the date such amount is paid at the rate set out in clause 3.

(f) The parties agree that the amount recoverable under clause 1(c) is a reasonable pre-estimate of loss and not a penalty. Such amount is payable for the loss of bargain and the loss of protection against future risks and, except as otherwise specifically provided under the terms of any Transaction, neither party will be entitled to recover any additional damages as a consequence of such losses.

…

4. General

…

(b) The parties agree that the valuation provisions for terminated Transaction set out in clause 1(c) shall override any provisions governing payments to be made on termination of a Transaction contained in the terms of the individual Transactions. The parties further agree that each of the other terms of the Transactions shall remain unchanged…."

8. In October 2001 and thereafter Morgan Stanley and Enron entered into a series of forward Transactions (as defined in the Netting Agreement) with each other and accordingly were mutual counterparties to physical gas and electricity trades.
9. On 29^th November 2001 Enron went into administration. By a letter of the same date ("the Notice") Morgan Stanley gave notice to Enron that, by reason of the appointment of an administrator, an Event of Default had occurred under Clause 1(a)(vi) of the Netting Agreement and designated the 1^st December 2001 as the "Early Termination Date", that is to say the date on which all outstanding Transactions would be terminated. There were no further payments or deliveries in respect of the terminated Transactions after that date. Thereafter, Morgan Stanley was required to make the calculations referred to in Clause 1(c) of the Netting Agreement in respect of the terminated Transactions. Morgan Stanley duly did so and, under cover of a letter dated 21^st February 2002, provided Enron with the statement setting out the calculations referred to in Clause 1(d) ("the Calculation Statement") specifying the net amount payable to Enron under the Netting Agreement as £655,858.
10. The Calculation Statement and underlying exhibits show, amongst other things, that Enron supplied Morgan Stanley with electricity and natural gas (UK – Forward Physicals) totalling £38,319,606 in value which was unpaid; Morgan Stanley supplied Enron with electricity and natural gas (UK Forward Physicals) totalling £27,341,033 in value which was unpaid; and the unpaid output tax relating to the aforesaid supplies of electricity and natural gas made by Enron to Morgan Stanley amounted to £6,705,931 (£264,574 for electricity and £6,441,356 for natural gas). On 19^th July 2002 Enron prepared an invoice (although it is common ground that this was not a VAT invoice) pursuant to the terms of the Netting Agreement seeking payment from Morgan Stanley of a net total of £655,858 "per Calculation Statement dated 21^st February 2002".
11. On the 6^th August 2002 Morgan Stanley duly paid Enron the net total demanded of £655,858
12. On the 8^th September 2003 the Commissioners made an assessment in respect of the total supply of £38,319,606 in respect of the VAT period 09/02 on the basis that the unpaid purchase price was paid and discharged on the 6^th August 2002 when Morgan Stanley paid the sum of £655,858 to Enron.

THE RELEVANT LEGISLATION

13. VAT is charged on the supply of goods or services made in the United Kingdom where it is a taxable supply made by a taxable person in the course or furtherance of any business carried on by him: section 4(1) of the Value Added Tax Act 1994 ("the 1994 Act"). It is charged by reference to the value of the supply: sections 2(1) and 19 of the 1994 Act. VAT due on the supply of goods and services becomes due at the time of supply: section 1(2) of the 1994 Act. The supply of gas and electricity is a supply of goods: section 5(1) of the 1994 Act and paragraph 3 of Schedule 4 to the 1994 Act. The rules for determining the time when a supply of gas or electricity is treated as taking place for the purpose of charging tax are contained in Regulation 86(1) of the Value Added Tax Regulations 1995 ("Regulation 86(1)"), which is a regulation made under section 6(14) of the 1994 Act: see De Voil Volume 1 at paragraph V3.140 (pages 3224-3225). Regulation 86(1), so far as material, provides:

"86(1) Except in relation to a supply to which subsections (7) and (8) of section 6 of the Act apply, and subject to paragraphs (2) and (3) below, a supply of –

…..

(b) coal gas, water gas, producer gases or similar gases, or

(c) petroleum gases, or other gaseous hydrocarbons, in a gaseous state, or

(d) any form of power, heat, refrigeration or ventilation,

shall be treated as taking place each time that a payment in respect of the supply is received by the supplier, or a VAT invoice relating to the supply is issued by the supplier, whichever is the earlier."

14. Where the amount of consideration payable under a transaction is affected by a set-off arrangement, for example where goods are taken in part exchange, there are usually two separate supplies involved by way of barter and it is therefore necessary to identify these mutual supplies so that VAT is charged and accounted for in each direction (De Voil at paragraph 3.108).
15. Further, in barter transactions the supply by one party is also the consideration for the supply by the other party. Each party must therefore determine the monetary value of the supply it makes and account for VAT accordingly. At the same time each will be able to recover as input tax the VAT it has been charged, subject to the normal rules (De Voil at paragraph 3.108).
16. There was no dispute between the parties before the Tribunal that:

i) this principle applied to the value of the mutual supplies in this case. The Netting Agreement makes it quite clear that there were mutual supplies between Enron and Morgan Stanley; and

ii) payment for the mutual supplies in this case was effected by following the procedures provided for in Clause 1 of the Netting Agreement and this was payment for the purposes of Regulation 86(1).

THE ISSUE

17. The issue is whether, in respect of VAT period 09/02, the Taxpayer is liable to account to the Commissioners for output tax:

i) on the total value of supplies of natural gas and electricity made by Enron to Morgan Stanley of £38,319,606, as the Commissioners contend. On this basis Enron is liable to account for £6,608,250 (i.e. 7/47 x £38,319,606) which is the Sum Assessed; or

ii) on the sum of £655,858 actually paid on the 6^th August 2002 as the Taxpayer contends. On this basis Enron is only liable to account for £97,680.98 (i.e. 7/47 x £655,858) output tax, which is the amount declared in the 09/02 return.

18. It is common ground that at the date that Enron went into administration (for VAT purposes) no supplies of gas or electricity had been made as neither of the triggering events prescribed by Regulation 86(1) (i.e. payment or service of a VAT invoice) had occurred. Accordingly the issue turns on the question: (1) whether (as contended by the Commissioners) the debt of £38,319,606 remained due as the unpaid purchase price for the supplies made by Enron to Morgan Stanley until it was discharged on the 6^th August 2002 by contractual set off of the unpaid purchase price for supplies made by Morgan Stanley to Enron and the payment to Enron of the balancing figure of £655,858; or (2) whether (as contended by the Taxpayer) the debt in respect of the sum of £38,319,606 was discharged earlier and in particular on the Early Termination Date (the 1^st December 2001) by the Notice on the 29^th November 2001 or (as I have suggested) by the provision of the Calculation Statement on the 21^st February 2002 and replacement of the debt by the different obligation, namely to pay the balancing figure under the provisions of the Netting Agreement. If the Taxpayer or my suggestion is correct an assessment should have been issued in respect of the earlier period 12/01 or 03/02 and the Assessment is invalid.

FORMS OF NETTING

19. Argument has figured large before me (as it did before the Tribunal) on the processes known as "close-out netting", "novation netting" and "settlement netting" and I should therefore say a word about them.
20. The recital to the Netting Agreement states that the parties wish to provide for close-out netting in respect of the transactions in the circumstances specified and Clause 1 is headed "Close-out Netting". Close-out netting is a process intended to reduce exposures on open contracts if one party should become insolvent or a like event occurs before the settlement date. As in this case, the agreement typically provides that, on an event of default in relation to one party, the other party can terminate all outstanding contracts between the parties, calculate the losses and gains on each contract and then set them off so that only a balance is owing. These losses and gains are usually the difference between the agreed price of each transaction concerned and the market price at termination - essentially compensation for the termination calculated on damages principles. It is often agreed that the parties will account to each other for losses and gains, as here. These contracts are routine in financial markets and elsewhere.
21. Novation netting is an agreement whereby the parties agree that all contracts between them shall be consolidated into a single contract as soon as each new contract is entered into. Each new contract in a series is amalgamated with any existing contract. The object is to endeavour to treat all the several contracts as one contract on the theory that the insolvency administrator of the party in default might otherwise, if there were several contracts, selectively choose to perform a contract profitable to the estate and terminate the unprofitable contracts and thereby defeat the netting of all contracts together in those jurisdictions where the estate would be entitled to selective performance. The hope is to strengthen close-out netting in those jurisdictions where otherwise there are problems. There is no provision in the Netting Agreement whereby each new contract is to be consolidated by novation with an existing contract when they are entered into and so this type of arrangement is not relevant here and I do not need to comment on it. Close-out netting is not a novation of the type described - it is simply a termination and set-off of compensation amounts owing either way.
22. Settlement or payment netting is an agreement to net payments or deliveries of the same currency or asset which fall due on the same date. It applies only to amounts or deliveries due on the same date and only if the payments are in the same currency or are the same asset. Settlement or payment netting is additional to close-out netting and deals with a different risk. The intention is to reduce the risk that one party pays a gross amount and the other party fails before it has paid its gross amount on that day. Instead only the net amount is at risk. In this case there was no clause providing for this type of netting.
23. These matters are discussed by Professor Goode in Principles of Corporate Insolvency Law (2005) 3rd ed. p.217 and Phillip R Wood in Chapter 10 of Title Finance, Derivatives, Securitisations Set-Off and Netting (1995).

THE TRIBUNAL'S DECISION

24. The Tribunal accepted the Taxpayer's arguments and held that Clause 1 of the Netting Agreement provided for a novation (and not payment) netting and the replacement of the liability on the part of Morgan Stanley to pay the outstanding purchase price of £38,319,606 with the different obligation to pay the sum calculated under Clause 1(c); that the payment of £655,858 was the payment, not of the balance due in respect of the outstanding purchase price, but of the sum due under the replacement obligation under Clause 1; and that no tax point arose in respect of any sum other than the £655,858 in the period 09/02. The appeal accordingly succeeded. The Tribunal added that, even if it were a case of payment netting, the result would be the same "given the terms of Regulation 86". This (as I have already said) is clearly wrong.

DECISION

25. The decision in this case turns on a careful analysis of the terms of the Netting Agreement informed as to the forms of netting to which I have referred. The distinctive features of the Netting Agreement are as follows:

i) Clause 1(a) provides that on service by the Non-Defaulting Party after an Event of Default of the required notice of default all outstanding Transactions shall terminate on the Early Termination Date;

ii) Clause 1(b) provides that upon service of such notice (and accordingly ahead of the Early Termination Date) no further payment or delivery in respect of the terminated Transactions shall be made;

iii) Clause 1(c) provides that in lieu of such payments or deliveries there shall be due from one party to the other an amount equal to the net Market Value (as there defined) of all Transactions on the Early Termination Date. The Market Value of each Transaction is the sum of two figures. The first is (in substance) the assessment by the Non-Defaulting Party of the replacement cost with an independent third party of each Discharged Transaction so as to arrive at the loss or gain compared to the agreed price for that Transaction. The second is the aggregate of the amounts remaining due and unpaid between the Defaulting and Non-Defaulting Parties;

iv) Clause 1(d) provides that the Non-Defaulting Party shall make the calculations provided for in Clause 1(c) and provide to the Defaulting Party the Calculation Statement showing in reasonable detail such calculations and specifying any amount payable;

v) Clause 1(e) provides that the party due to receive the sum calculated in accordance with Clause 1(d) shall invoice the other party for the same, and the amount set out in the invoice shall become due five working days after receipt of the invoice by the paying party and shall bear interest as there provided.

26. Clause 1 accordingly provides that on service of the Notice a six part process should be undertaken in respect of outstanding transactions and indebtedness: (1) cancellation of executory contracts; (2) the process of the calculation of the sums due between the parties (the taking of the "account"); (3) in the course of such process the set off of the sums calculated as due between the parties; (4) the provision of the Calculation Statement; (5) the invoicing by the party entitled to payment to the other party of the sum due which becomes payable five days later; and (6) payment of the sum invoiced.
27. The issue before me is at which of these stages is the prior entitlement and indebtedness of the parties to each other discharged and cancelled out and replaced by the obligation of one party to pay the balance due.
28. Notwithstanding the valuable assistance which I have received from both Counsel I do not find this question easy. But after anxious consideration I have concluded that the pre-existing indebtedness survives the Notice and the Early Termination Date and the cancellation of executory contracts. The provision of Clause 1(b) to the effect that no further payment shall be made does not discharge the indebtedness: it imposes a moratorium prior to its subsequent discharge. The subsequent calculation exercise is designed to take account of the sums which continue to be due (though not payable) and carry out an exercise in set off. It gives effect to a contractual set-off. The calculation exercise is completed and the set off is effective to discharge the pre-existing indebtedness when (but not before) the Calculation Statement is provided. When it is so provided, the accounting exercise is completed, the exercise in set off is effective and pre-existing liabilities are discharged. The Calculation Statement is binding on the parties as soon as it is provided. There is no deferment of its binding effect pending verification or agreement. The balance so calculated alone is due and this only becomes due and payable five working days after receipt of the invoice.
29. In this case the balance became "due", reflecting the completion of the netting process and the discharge by way of set off of the pre-existing liabilities, on the 21^st February 2002 when the Calculation Statement was provided by Morgan Stanley to Enron. The payment of unpaid purchase price of £38,319.606 was accordingly paid and discharged on that date. The payment of the balance of £655,858 on the 6^th August 2002 had no effect on this (previously discharged) liability: the payment discharged the new liability to pay this sum which arose from the provision of the Calculation Statement. The Assessment is accordingly invalid.

CONCLUSION

30. I accordingly dismiss this appeal. I should however add that it appears to me to be highly unsatisfactory that recovery of VAT turns upon the Commissioners determining correctly and within a limited period of time the date on which a supply (or payment) is made. The taxpayer (who is possessed of the relevant information) may not be forthcoming in disclosing his hand (as the Taxpayer was not forthcoming until a late date in this case); and even when and where the facts are clear, a difficult and contentious issue of law may arise (as it does in this case). Fairness to other taxpayers who pay their tax may require steps to be taken to remove (at any rate in cases such as the present) serious (and on occasion insurmountable) hurdles to the recovery of VAT which is unquestionably due and should be paid.