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United Kingdom Special Commissioners of Income Tax Decisions
You are here: BAILII >> Databases >> United Kingdom Special Commissioners of Income Tax Decisions >> DCC Holdings (UK) Ltd v Revenue & Customs [2007] UKSPC SPC00611 (08 May 2007)
URL: http://www.bailii.org/uk/cases/UKSPC/2007/SPC00611.html
Cite as: [2007] UKSPC SPC611, [2007] UKSPC SPC00611, [2007] STC (SCD) 592, [2007] UKSPC 0611, [2007] STI 1649
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- In 2001 the Appellant, DCC Holdings (UK) Limited ("DCC") undertook a number of net paying repos with X Bank. As a result of those repos it made an economic and accounting profit of £1.8m. It claims that the effect of the tax legislation applying at that time is that for corporation tax purposes those repos delivered to it a loss of £27m. HMRC claim that properly construed the legislation delivered a corporation tax profit of £1.8m.
- A repo is a transaction under which shares or securities ("securities") are sold by one person (the original owner) to another (the interim holder) coupled with an agreement that they be bought back. In this case gilts were sold by X Bank to DCC and then some days later sold back by DCC to X Bank. During the period of the repo the interim holder has full ownership of the securities: it can sell them and then buy back the same or other securities to satisfy its obligation to resell securities to the original owner at the end of the repo, or it can simply hold on to the securities throughout the period; and if the interim holder receives interest or a dividend on the securities, it receives it beneficially and not as trustee for the original owner.
- Where the sale and repurchase price of the securities is fixed at the outset by the terms of the repo agreement, the economic effect of the repo can be that of secured lending by the interim holder to the original owner. Thus if DCC bought the gilts for £812m on day 1 and sold them back for £813.8m on day 11, the economic effect is similar to a transaction under which it lent X Bank £812m for 11 days and received interest of £1.8m, and under which DCC received the gilts as security for that lending.
- If, during the period the securities are held by the interim holder, interest or a dividend is paid on the securities, the repo agreement will deal with that payment in one of two ways, each of which preserve the economic effect of secured lending.
- One way is simply to provide that the interim holder will pay an amount equivalent to the interest or dividend to the original owner but otherwise to leave the term of the repo unaltered. I shall call this a "gross paying repo". Thus if the repo described above had been a gross paying repo and interest of £28.8m had been received by DCC during the period of the repo, the sale and repurchase prices (£812m and £813.8m) would remain unaltered but DCC would pay £28.8m to X Bank shortly after it received the interest on the gilts.
- The other way, when the amount of interest on the securities which will be paid during the repo term is known (or can be described) at the time of the making of the repo agreement, is to adjust the purchase or resale price to take account of the receipt. In this type of repo the agreement between DCC and X Bank would provide for no separate payment representing the £28.8m received by DCC but instead the repurchase price would be reduced by £28.8m (down to £785m). I shall call this a "net paying repo". (Of course if the interest or dividend is received early on in the repo period some further adjustment to the price may be made to reflect the fact that DCC would have had the use of the £28.8m for the remainder of the period, but the effect of such a reduction would be to reflect the fact that in essence DCC's loan to X Bank would have been £28.8m smaller for part of the period and is not material to the arguments in this appeal.)
- In this case there is no dispute as to the transactions undertaken by DCC. The details are set out in the Appendix taken from the agreed statement of facts: DCC entered into five repos in its accounting period ending on 31 March 2002 with X Bank. In each case it bought gilts from X Bank for a fixed price and resold them to X Bank several days later for a fixed price. In each case DCC received interest on the gilts while it held them. In each case the repos were net paying repos so no separate payment representing the interest was paid to X Bank but the repurchase price it received was lower reflecting the interest DCC had received.
- In this decision I use the following example figures for a single repo to represent those several repos: DCC bought gilts from X Bank for £812m, it sold them back to X Bank 11 days later for £785m and received interest of £28.8m on the gilts in the interim period in respect of which it did not make any separate payment to X Bank. I take the value of 11 days interest on the gilts as £2.9m. These example figures distort the economics of the transactions a bit because the overall period of the transactions was 98 days not 11 days but they helpfully illustrate, and are for me at least more easily memorable when considering, the arguments.
- As will be seen, central to the operation of the relevant tax provisions is the operation of proper accounting methods. I heard oral evidence from Peter Holgate, the senior accounting technical partner in the London office of PricewaterhouseCoopers relating to this issue. Mr Holgate also produced a written report and replies to written questions from the Respondents and gave written replies after the hearing to written questions from me. I shall deal with the substance of Mr Holgate's evidence and the relevant findings of fact later, but I should mention at this stage an issue relating to his evidence raised by the Respondents.
- Mr Holgate is a partner in PwC. PwC was involved in advising DCC on the tax matters. The Respondents did not object to Mr Holgate's giving evidence as an expert to the tribunal, but indicated that in other circumstances they may have objected to a witness who had some connection with the appellant giving expert evidence. Whilst the Court of Appeal had indicated in R (Factortume Ltd) v Transport Secretary (No.8) [2002] 3 WLR 1104 that disinterest of a witness in the outcome of the proceedings was not automatically a precondition to the admissibility of his evidence as an expert, there could be circumstances where it might be.
- Mr Holgate provided a clear and detailed report discussing the accounting principles applicable to repo transactions, the accounting treatment adopted by DCC and, on the basis of certain assumptions he was asked to make, his conclusions as to what sums should be brought into account as debits or credits. I accept Mr Holgate's evidence as to the effects of the transactions at issue and of the assumptions he was required to make. I set out the relevant parts of this evidence and address whether these assumptions were appropriate later in this decision.
- Although the appeal was held in public and DCC's counterparty referred to by name at the hearing, I was requested by Mr Gardiner to use an alternative description of the counterparty to avoid its identification in the decision. Mr Furness did not object to that request. In Bank of Ireland Britain Holdings Ltd v HMRC SpC 544 the Special Commissioners accepted a similar request as nothing turned on the identity of the counterparty. I accept it in this case and have referred to it as X Bank.
- I start this decision by considering generally the statutory provisions affecting the taxation of the repo transactions undertaken by DCC. I then describe the broad thrust of the parties' arguments and the detailed contentions on the three issues which were identified in the argument before me. I then set out my conclusions on the operation of the legislation relevant to those issues and apply those conclusions to the relevant facts:
- The tax treatment of DCC in relation to the repo transactions is governed by two sets of statutory provisions. The first of these are the manufactured payment provisions which are to be found in sections 730A to 730C, 737A to 737E and Schedule 23A TA 1988. The second set is the loan relationship rules in FA 1996.
- The manufactured payment provisions were originally enacted in 1991 and came into force over a period ending in 1993. Broadly their effect is to assimilate payments representative of interest and dividends which are made in transactions for the transfer of securities to the payments they represent. They therefore make provision for: the way in which receipts of some such payments manufactured are taxed, reliefs in respect of the making of some such payments, and the calculation of and accounting for withholding tax on the payment. Where the payment relates to interest however and the taxpayer is a corporation taxpayer these provisions were, after FA 96, silent as to the taxation of the manufactured payment. In the context of a gross paying repo, these provisions will affect the tax treatment of the payments representing the interest received by the interim holder. Schedule 23A deems the contractual payment representing interest or a dividend (the "manufactured payment") to be a payment with particular tax attributes depending upon the payment it represents. Section 737A extends this deeming to net paying repos: where the price differential reflects the fact that the interim holder has received a dividend or interest it deems the interim holder to have made a manufactured payment for the purposes of Schedule 23A . Thus in our example section 737A deems DCC to have made, for Schedule 23A purposes, a payment of £28.8m to X Bank.
- Section 730A, although I have included it under the heading manufactured payment provisions, has an effect specific to repos. This effect is to treat that part of the price differential on a repo which represents the economic effect of interest on the secured loan which the repo represents as if it were interest for tax purposes. Thus if DCC entered into a gross paying repo under which it bought securities for £812m and sold them back 11 days later for £813.8m and no interest or dividend was paid on the securities, section 730A treats the difference £1.8m as interest paid to DCC by X Bank.
- But with a net paying repo where interest on the repo'd securities is received in the repo period there has to be an interaction with section 737A because part of that price differential represents the interest and has already been treated as a manufactured payment. So, before 730A applies to treat the whole differential as interest, the manufactured payment has to be added back. Thus where DCC buys gilts for £812m and sells for £795m but receives £28.8m of interest on the gilts, section 737A treats DCC as making a manufactured payment of £28.8m to X Bank, the repurchase price is increased by £28.8m to £813.8m and section 730A treats the difference between £813.8m and £812m as interest of £1.8m paid to DCC. In this way equality of treatment is preserved between the gross paying and the net paying repo.
- The second set of provisions are the loan relationship rules. These were enacted after the repo rules. In broad terms their effect is to make the tax treatment of debt relationships follow that used in a company's accounts. The enactment of these provisions changed the way in which interest and debt profits were taxed: previously payment was key to taxability: receivability without receipt was nothing, and profits and gains on debt could be taxable as capital or as income depending on the circumstances; after this enactment almost all profits and losses on debt were taxed and allowed as income, and the accounting recognition of the profit or loss generally determined what was taxed and when it was taxed.
- But the earlier manufactured payment rules - which dealt not only with dividends on equities but also with interest and debts - needed in respect of their provision for interest and debt to mesh with the new loan relationship rules. Amendments were made to section 730A, and specific provisions included in FA 96 to deal with that interaction. Those provisions are at the heart of this appeal.
- The alignment of tax results with accounting results is an important feature of Chapter II Part IV FA 96. This can be seen in the colour and substance of that chapter's provisions: section 84 speaks of "debits" and "credits" calling to mind accounting entries, it requires the application of an "authorised accounting method", subsection (2) deals with amounts transferred to share premium account and reserves; section 85 prescribes which accounting methods are authorised by reference to "normal accounting practice" (I refer to this later in this decision as "proper accounting"); section 86 deals with the correspondence between the accounting method actually used in the company's statutory accounts and the methods which are authorised, and so on. The overall message is clear: the taxable profits and losses in respect of loan relationships should generally follow those in the statutory accounts.
- This highlights the importance of what actually happens in those accounts and the importance of accountancy evidence, but also suggests to me that where possible and not specifically directed otherwise one should endeavour to construe the statute so that taxable profits and losses equate to the accounting results.
- Section 80 FA 96 brings into charge "all profits and gains arising to a company from its loan relationships." Section 81 defines loan relationship. Section 82 defines those profits and gains by reference to the "credits and debits given…by…this Chapter." When the taxpayer holds a loan relationship on trading account the credits are to be treated as receipts of the trade, and the debits as expenses; where the loan relationship is not so held the net amount obtained by subtracting debits from credits is brought in to charge as a D III profit or a deductible deficit. Thus all hinges on what are the "credits and debits". That is provided for by section 84.
- I need to set out the relevant provisions of section 84:
- The next provision to which I must refer is section 97 FA 96. It plays a pivotal role in the argument so I must set it out in full:
- For the moment I need only note that the first three subsections deal inter alia with gross paying repos, and that it is subsection (4) which deals with net paying repos.
- Finally, I need to set out paragraph 15 of Schedule 9:
- The repos entered into by DCC were "repo or stock lending arrangements" within subparagraph (3). Subparagraph (1) therefore applies.
- I set out in this section some of the more general pieces of Mr Holgate's evidence which I accept as describing normal accounting practice at the relevant time. I deal in the separate sections of this decision with the particular features of his evidence relevant to the argument under those sections. The discussion below deals with the accounting for both X Bank and DCC because in argument the question as to the proper effect of the relevant sections was tested in relation to the effect of any interpretation on both parties.
- Mr Holgate notes that in a sale and repurchase agreement, where one party (the 'seller') sells securities to another party (the 'buyer') for an agreed amount of cash and simultaneously agrees to repurchase the same or an identical security at a specified future date for a fixed amount of cash (a "fixed price repo"), the cash flows and the timings of those cash flows are fixed in advance and hence the return under the arrangement for the repo buyer (DCC) is fixed. He notes that although legally a sale and subsequent repurchase of securities, the seller retains the risks and benefits of market price fluctuations of the securities, rather than passing them to the buyer. Hence, he concludes that such arrangements are economically similar to a secured loan providing a fixed rate of return, with the security acting as collateral.
- The relevant accounting standard in force for the year ended 31 March 2002 (FRS5) provided that:
- More detailed guidance was appended to FRS 5 in the form of Application Notes. Application Note B was relevant to the repos entered into by the Appellant. Application Note B required an analysis of all the features of the agreement from the perspective of both parties to the agreement to determine whether the transaction's commercial effect was that of a sale or that of a secured loan and required it to be accounted for according to that determination. This required an analysis of who had the benefits and risks of the original asset, namely the gilts: and that was X Bank.
- Mr Holgate notes that in both a gross paying repo and a net paying repo, the substance of the repo transaction was that of a secured loan from the buyer to the seller. Although the buyer had legal ownership of the security for the repo term, the seller retained all significant benefits and risks relating to the security (ie movements in market price and the benefits of any coupon or dividend payments on the security) over the term of the repo.
- Where the substance of the transaction is that of a secured loan rather than a sale of the security then, in accordance with Application Note B paragraph B19, the required accounting for the seller (X Bank) was as follows:
- The seller (X Bank) continues to recognise the security (the gilts) as an asset in its balance sheet.
- The proceeds received from the buyer are recorded as cash received and as a liability (the secured loan).
- Interest payable by the buyer on the secured loan should be accrued at the repo rate over the term of the transaction.
- The carrying amount of the security (the gilts) should be reviewed and provided against if necessary.
- If a coupon or dividend were paid by the security issuer to the buyer (DCC) during the term of the repo arrangement, then, because the seller would benefit from such a payment, the seller (X Bank) should recognise as income the coupon or dividend payment on the security as though the seller had continued to legally own the security, even though the cash was received "via the buyer".
- FRS 4 provided more detailed requirements in respect of the calculation and accounting treatment for the 'interest' arising on the loan. FRS 4 used the term 'finance cost', which was defined in paragraph 8 as follows:
- Therefore the finance cost of the secured loan inherent in a gross paying repo would be calculated by the seller as the difference between sale price and repurchase price For a net paying repo the finance cost would be the difference between the sale price and the repurchase price after adding back the amount of the coupon or dividend payment. The actual finance cost, being the economic profit of the transaction, would be unaffected by whichever of the two arrangements for any dividend or coupon had been entered into, as the two arrangements were commercially equivalent to each other.
- In accordance with FRS 4 paragraphs 28-30, the finance cost under the repo arrangement should be charged to the profit and loss account over the term of the borrowing at a constant rate on the carrying amount.
- Although Mr Holgate's analysis related to what were the required elements of the financial statements, he also provided details of the expected accounting entries which would be made by the seller, in respect of a gross paying repo:
- "The seller continues to recognise the security as an asset in its balance sheet. On entering into the repo arrangement the sale proceeds are recognised as a liability:
- The finance cost, being equivalent to the economic profit under the repo, is accrued to the profit and loss account over the term of the arrangement:
- Any cash received from the buyer during the term of the repo in lieu of the coupons or dividends paid on the securities is recorded as though it had been received directly from the issuer of the securities:
- At the end of the repo term the loan is repaid and no gain or loss arises:
- In the case of a net paying repo he explained that the last two sets of entries above would be replaced with the following journal. This grosses up the final cash payment to reflect the repayment of the secured borrowing plus finance cost and the receipt of the coupon or dividend payment in respect of the security via the buyer:
- The FRS 5 analysis of the transaction as in substance a secured borrowing and the requirement to account for it as such also applied to the buyer (DCC). In substance, the buyer had lent funds to the seller with the security as collateral. Therefore, in accordance with FRS 5, the buyer should account for the fixed price repo transaction as a secured lending. Under a gross paying repo, the buyer should account for the transaction as follows making the following bookkeeping entries:
- The buyer would not recognise the security as an asset, even though it has legal ownership, as it does not have beneficial ownership.
- The buyer would recognise a loan receivable equivalent to the cash it paid to purchase the security:
- The buyer would accrue 'interest' receivable on its loan over the term of the repo at the repo rate, crediting the profit and loss account and increasing the loan receivable balance. The interest receivable would be equivalent to the finance cost payable by the seller on the same transaction and is, in effect, the economic profit on the loan:
- The cash receipt in respect of the coupon or dividend, if any, is recognised as an obligation to pass the cash to the seller:
- This obligation is then satisfied by the subsequent payment of the coupon or dividend receipt to the seller:
- When the security is sold back to the seller, the buyer would credit the loan receivable balance with the cash proceeds, reducing it to zero. No gain or loss would arise:
- In the case of a net paying repo, then the fourth and fifth sets of journal entries above in respect of the coupon receipt would be replaced with the following:
- FRS 5 and FRS 4 do not contain a specific requirement to net the effect of the coupon receipt and the compensating onward payment of that coupon payment to the seller (either explicitly under the terms of the arrangement or through an adjustment to the repurchase price). However, it is the consequence of applying the principles contained within the standards, which require the overall economic profit of the arrangement to be recognised in the profit and loss account.
- Mr Holgate summarised the accounting treatment thus:
- Mr Holgate confirmed that the statutory accounts of DCC had been drawn up in accordance with those principles.
- Coarsely to summarise Mr Gardiner's arguments in relation to DCC's facts they are these:
- In other words DCC brings into account in respect of the gilt interest only a debit of £28.8m and therefore is to be treated as making a loan relationship loss of £28.8 - £1.8 = £27m. The essence of the Respondents' case was first to deny that paragraph 15 had the effect for which the Appellant contended and second to say that in ascertaining the amounts to be taken into account the same sum must be taken into account in respect of the coupon actually received by DCC as for the manufactured interest deemed to be paid by it: as a result these amounts would net off leaving the section 730A credit of £1.8m as the net chargeable amount - which was equivalent to the economic and accounting profit. At the hearing the issues were discussed under three headings:
- Paragraph 15(1) provides that:
- The Appellant says that the effect of this provision is that X Bank rather than DCC is to be treated as remaining the holder of the gilts throughout the repo - or more specifically remaining a party to the loan relationship for the purposes of Chapter II - and that DCC is not to be treated as a party to the loan relationship constituted by the gilts during the period it actually held them. As a result it says that the Appellant can bring in no credits in respect of the gilts under section 84 since it is not to be treated as party to any loan relationship by reference to the gilts in respect of which section 84 can bite, and that X Bank would (assuming it is a UK resident corporation) bring in credits and debits on the basis that its ownership of the gilts was uninterrupted.
- The Appellant says that such treatment reflects the substance of the repo and also its accounting treatment. It refers to Mr Holgate's evidence:
- Given the accounting treatment, Mr Gardiner says that it is not unreasonable to assume that the purpose of paragraph15 was to conform the tax treatment with that accounting treatment and thus to require X Bank rather than DCC to be treated as continuing to hold the gilts for all loan relationship purposes.
- He says that paragraph 15 Schedule 9 was enacted so as to make provision for the fact that in substance the underlying loan relationship during the currency of a repo remains with the seller (who will continue to accrue the interest); the buyer does not become a party to it. Accordingly, it provides that for the purposes of s84, the acquisition and disposal of the repo securities are assumed not to be "related transactions". Since the acquisition and disposal are not related transactions they are disregarded for the purposes of s84: thus the seller (here X Bank) is treated as retaining the loan relationship and the buyer (DCC) does not become a party to it. He says that the point was well made by the explanatory notes to the 2002 Finance Bill which introduced the following amendment to paragraph 15:
- In other words the promoter of the amendment thought that the effect of paragraph 15 was wider than simply requiring the related transaction to be ignored in applying section 84.
- Mr Gardiner admits that the above clause was subject to a subsequent Government amendment inserting the additional words (which were also enacted):
- But he says it is plain that this addition did not, and did not purport to, represent the law as it stood prior to FA 2002 i.e. at the time relevant to this appeal. If the buyer was not party to the loan relationship, it could not have brought into account credits in respect of the interest. The law prior to FA 2002 was accurately described by the formulation in the original 2002 bill, as stated in the notes to it.
- Thus, he says under the legislation, DCC only brings into account the deemed section 730A credits and the deemed section 737A/section 97 debits, which relate to separate deemed loan relationships. Subject to that, and by force of the legislation, it is not otherwise a party to a loan relationship and as such there is no statutory basis on which debits or credits can be brought into account. The answer to the question under Issue 1 is, therefore, no, i.e. there is no credit to be brought into account in respect of the interest coupons.
- I do not agree. It seems to me that paragraph 15 is precisely targeted at debits and credits which could otherwise arise on the "related transactions" involved in a repo. Its purpose and effect is that no debits or credits should be brought into account in respect of such related transactions. And that is all.
- This to my mind is clear from the words of paragraph 15: the draftsman has selected a precise term, "related transaction" which was specifically defined in section 84. The draftsman does not attempt to interfere with the reality of whether or not there is an acquisition and disposal, but instead with the scope of the defined term. The manifest intention is that, and only that, the definition of "related transaction" should for the purposes of that section only have added at the end "other than a disposal or acquisition described in paragraph 15(2) Schedule 9." Because the interference is with a defined term there are no consequences or incidents which flow from the deeming other than in relation to the use for the purposes of section 84 of the defined term "related transaction". This is to my mind not truly a deeming provision in the sense that it deems something to be the case which is not the case, but a definitional provision which, in a closely articulated manner, affects the way in which section 84 operates.
- I therefore reject the idea that paragraph 15(1) has the effect that DCC is to be treated as not acquiring the gilts, as not disposing of the gilts or as not owning the gilts. On the contrary DCC is to my mind to be treated as doing all three: it becomes through acquisition a party to the loan relationship constituted by the gilts it receives interest on them, and it disposes of them; but in applying section 84 the related transaction constituted by the acquisition and by the disposal is not to be treated as a related transaction; as a result section 84 applies only to require debits and credits to be brought into account in relation to profits and losses etc. arising from the gilts and interest charges and expenses incurred by DCC under or for the purposes of the gilts. And profits, losses, expenses and charges representing the related transaction in the gilts - their acquisition and disposal - are not items in respect of which debits and credits are to be brought into account.
- Although I note the assumptions made in the explanatory notes to the 2002 Finance Bill I do not believe they are correct and do not find them relevant to the construction of paragraph 15 as it stood before those amendments.
- The Appellant argues that if paragraph 15 does not have the effect contended for then its position is as follows:-
- In other words because of a mismatch between the credit in respect of interest received, and the debit for manufactured interest deemed to have been paid, DCC still ends up with a loss of £27m or thereabouts.
- In this section I deal with the evidence and arguments relating to the gilt coupon receipt. One of the ways in which HMRC formulated its argument was to link the proper treatment of the receipt by DCC with the deemed payment and to say that fairness required those sums to be equal. That argument I shall deal with in relation to the third issue although it is also relevant to this issue.
- Mr Holgate says this:
- On that hypothesis Mr Holgate then says that applying the accruals basis (as defined in FRS 18 paragraph 27) it would have been appropriate to bring into account the interest accruing on the gilts only in respect of the period for which they were held by DCC. Thus in his opinion the sum which fairly represented the interest arising on the gilts (ignoring any purchase and sale proceeds) is the accrued portion of the coupon for the 11 day period of the repo transaction.
- Mr Holgate concludes his analysis:
- nil, on the basis that without entering into the related transaction with X Bank, DCC has no investment in the gilts ('scenario 1') or on the basis that in substance DCC has no beneficial ownership of the gilts, even if the debits and credits relating to the acquisition and disposal of the gilts are ignored ('scenario 2'); or
- the accrued proportion of the coupon on the gilts based on the period of the repo transaction, if it is assumed that the related transaction occurred but the debits and credits arising in respect of the sale and repurchase of the gilts are ignored and the legal ownership of the gilts is accounted for - [I interpose that on the basis of the example transaction this would be £2.9m].
- recognise income on the gilts that accrues over the repo term; or
- not recognise any income in respect of the gilts for that period."
- Mr Gardiner's submission echoes Mr Holgate's evidence. He says that:-
- And, Mr Gardiner says, whatever else there is no basis for recognising under section 84 the full amount of the interest coupon received unless the gilts had been held for the full period to which the coupon relates.
- Mr Gardiner says that on any basis DCC can be treated as party to the gilts only for the period of the repo. Other persons, such as X Bank, will have been a party for the remainder of the coupon period. Such persons will have accrued interest on the gilts, and if corporation tax payers will have been taxable under FA 96 in respect of that accrual: there would be double taxation of the same interest if DCC were taxable on the full amount of the coupon.
- But apart from any presumption against double taxation Mr Gardiner says that the language of the legislation makes clear that DCC cannot be taxed on the full amount of the coupon. Section 84 requires credits and debits to be brought into account in accordance with an authorised accounting method (which in this case is an accruals basis) and Mr Holgate's clear evidence is that if anything was to be brought into account it was only the accrued position of the coupon for the period of the repo transaction; it could be no more.
- Mr Furness says that either the full coupon received of £28.8m should be taken into account by DCC as a credit, or the accrued £2.9m. A case he said can be made for either, but what is to be taken into account as a credit must, if the debits and credits are fairly to represent the loan relationship events be the same as the amount taken into account in respect of the deemed manufactured payment as a debit. The correct construction of section 84 he says must inevitably inform the correct construction of section 97 and vice versa.
- I remind myself of the key words of section 84(1):
- In my judgment, for the reasons which follow, the following propositions are relevant to the application of this section:
- I shall set out my reasoning below. But I should first explain the effect of the application of these propositions in relation to the £28.8m of gilt interest actually received by DCC. These propositions also affect the other issues in this appeal as I shall explain in later sections of this decision.
- Mr Holgate's evidence was that no amount would have been brought into DCC's profit and loss account in respect of the £28.8m coupon DCC received on the gilts. The accounting method used was an authorised accruals basis. And so, when I ask what sum fairly represents that interest, the answer is nil. There is no tax debit or tax credit to be brought into account under Chapter II. In particular:
- I now turn to my reason for the propositions set out at paragraph 72 above.
- First, the "debits" and "credits" which section 84 defines are not necessarily the same as the debits and credits in the company's day to day accounting records. In its books the company will record its transactions. In almost all cases it will use a debit and credit system for doing so. These debit and credit entries are then analysed having regard to the transactions they record and in accordance with accounting principles to produce the financial statements of the company. As can be seen from the extracts from Mr Holgate's evidence that analysis can be expressed in terms of debits and credits too. Some of these debits and credits will give rise to profit and loss account amounts, some to balance sheet amounts.(I have used the terms "tax debits" and "tax credits" to distinguish the debits and credits defined by section 84 from the accounting on bookkeeping entries which transaction give rises to)
- Section 84 requires the identification of sums which arise in accordance with an "authorised accounting method". That phrase is defined in section 84 by reference to the way the method (i.e. the accounting principles) allocates amounts to accounting periods. It is therefore primarily concerned with the determination of profit or loss for the period rather than with balance sheet amounts. The sums to be identified therefore are those which the accounting method allocates to profit and loss for the period, and, although the section speaks of debits or credits the sums so defined are not simply all the debits and credits in the accounting records.
- (Subsection 84(2) makes this emphasis on the determination of profit and loss clear: amounts which on company law principles are profits (albeit nowadays for a UK incorporated company undistributable) arising from issuing shares at a premium are expressly excluded, but amounts of profit or loss which are recorded in other reserves are included where I use "profit and loss" in the preceding paragraphs I use it with the broader meaning required by section 84.)
- Second, the application of the authorised accounting method. I consider this in more detail in paragraphs 108 to 122 below but in summary: section 86(3) provides that if a basis of accounting which is to an authorised method is used in a company's statutory accounts as respects any loan relationship, then that method is to be used for the purposes of Chapter II as respects that loan relationship. Whatever is used in preparing a company's statutory accounts will take account of all the company's activities; what is required by section 86 is that the method actually used in those accounts (which must take account of all the company's activities) be that used for Chapter II. In other words, and so long as the method used is an authorised method, the debits and credits must be determined by reference to the method actually used. I say "so long as the method used is an authorised method". The term "authorised method" is defined by section 85. On the basis of the evidence before me I find that the method adopted as respects these loan relationships was an authorised method. Accordingly, the method actually used in the accounts of DCC is the method by reference to which section 84 must be applied.
- Third, the requirement is to determine what sums "fairly represent" certain loan relationship events. That requires an application of judgment and common sense.
- Mr Holgate told me that in determining the amounts which arose from the application of proper accounting principles, he was not concerned with the concepts used by the tax legislation - in particular the concepts of "loan relationship", "related transaction" used in section 84. As far as concerns the proper accounting for the repo transactions it would have made no difference to him if section 84 had instead referred to rabbits.
- Mr Holgate's world is different from that of a lawyer. Mr Holgate may treat what is at law the lease of plant as a loan by putting a figure in the accounts as attributable to loan and not indicating a figure in respect of the ownership of the leased plant but that "loan" is not a "loan relationship" for FA 96 purposes. Mr Holgate accounts for the repo of the gilts to DCC as a loan by DCC: he shows no entry in respect of DCC's ownership of the gilts. The lawyer (absent specific instruction to the contrary) recognises no loan because there has been no loan of money and says DCC owns the gilts.
- There are other examples of different ways of describing real events where a correspondence can be found between the two. The front door is left open and your grandmother worries about the cold "coming in"; the physicist describes it as the heat energy leaving the room. Slate is "cold" when you touch it; the physicist says that slate is a good conductor of heat. The correspondence between the two approaches to the description of the world is found through the factual circumstance they describe.
- Section 84 thus sits on the boundary between two different worlds. In one of those worlds there are accounting entries representing the transactions of the company. In the other world are concepts such as "loan relationship - whether or not they would otherwise be recognised as having any legal element of indebtedness" (or specific transaction which are required to be treated as loan relationships) and events relating to them which may represent, albeit in a different manner, the transactions of the company. Section 84 requires a fair correspondence to be found between the accountant's sums and the loan relationships events. That exercise requires an element of judgment.
- Common sense is needed too: the tax debits and credits are not every debit and credit which the accountant makes in the books of the company and at the very least some common sense is needed in applying section 84.
- Consider the acquisition by a company of a loan relationship (a bond) for £100 and its subsequent sale the next day (and in the same accounting period) for £110 (no interest having been paid in the meantime). The accountant makes the following entries (ignoring as de minimis any accrual of interest for the single day the bond is held):
- Likewise consider a bond bought for £100 at the beginning of the eight month of the accounting period just after its coupon payment date and held to redemption 12 months later when principal of £100 and interest of £12 was paid. The company uses the accruals basis of accounting in FRS 18 which requires "the non-cash effects of transactions to be reflected in the financial statements… for the period in which they occur and not for example in the period in which any cash involved is received or paid". It brings into its profit and loss account £4 of profit (representing 4 months' accrual of interest) in the first period and £8 in the second. It is clear that these sums should also be the credits brought into account for the purposes of section 84 in respect of those periods. But the accounting entries will not be limited to those sums:
- Thus even in simple transactions there is a need (normally theoretical only because common sense dictates the answer in most cases) to exercise judgment in determining the debits and credits which fairly represent the loan relationship events.
- As I have already noted, "loan relationship" is not an accountancy term; it is a term defined by and for the purposes of Chapter II. It plays no part in the accounting for a company. Thus what is required is not an accountancy exercise which identifies as a matter of proper accounting principles what profits etc are actually recorded against the heading "loan relationship", but an exercise to determine which of the sums arising from the authorised method used in the proper accounting (i.e. not necessarily those which arise simply from the bookkeeping) represent the legal construct of a loan relationship or the specified events in relation to it.
- That is not to say that the help of an accountant is not needed for this stage. The accountant can explain how the amounts he has recorded have arisen, and he can indicate what amounts should properly be recorded. But whether or not a sum which has been produced in accordance with proper accounting practice represents the relevant legal construct is not solely a question for him. You can approach this exercise above in two ways. Either you describe to the accountant the real world facts that constitute the legal construct such as "related transaction", or "interest under a loan relationship", and ask what sums have been brought into account to represent those facts; or you describe to the accountant the facts and ask him what sums they give rise to, and then you make a determination as to which of those sums represent the legal constructs. The application of common sense in either approach should yield the same answer. But what in my judgement you are not entitled to do is to require the accountant to adopt some special method of accounting - to require him to produce sums which normal accounting does not produce - to help you with the process: you are not required or permitted to require the accountant to adopt "legal form accounting" or to wear a suit which does not fit him in order to please a lawyer.
- It seems to me that the principal effect of the word "fairly" in section 84 relates to the manner in which this selection of what sum represents what loan relationship event is to be conducted.
- It is said that the loan relationship legislation is prescriptive and closely articulated and so does not leave room for judgement in its application. It is true that parts of it are detailed: that can be seen in many of the paragraphs of Schedule 9. But the fact that some provisions may be so restrictively drafted as to be mechanical in their operation does not mean that all are, or that there are not parts of even seemingly prescriptive mechanical provisions which are, or incorporate, concepts or words which require proper construction and judicious application. The words "fairly represent" fall squarely into that category.
- In summary, the evidence of Mr Holgate as to what would be the accounting entries "if it was necessary to account for the legal ownership of the gilts" is irrelevant. It is not required that there should be accounting for the legal ownership of the gilts; rather what is required is the application of judgment to determine what sums which result from the application of the authorised method used in the proper accounts fairly represent the loan relationship events. And neither is such evidence relevant to what was done or what should have been done. Sections 85 and 86 make clear that where the company's accounts use an authorised method of accounting in respects a loan relationship then that is the method to be used in section 84. Mr Holgate's evidence as to the basis of accounting used by DCC leads to the conclusion that it was as respects the gilts an authorised basis of accounting, thus that actual basis is what is relevant in applying section 84. Mr Holgate dealt in his report and in his oral evidence with what became described as "legal form accounting". Legal form accounting was shorthand for a world where it was "necessary to account for the legal ownership of the gilts." He said of it "I just struggle because legal form accounting for these [transactions] is not what we do". Legal form accounting was not the "actual substance accounting that we follow". Neither should we.
- When you look at the actual accounting in Mr Holgate's evidence, judgment and common sense tell you that the sum which fairly represents the coupon receipt of £28.8m is nil.
- Mr Holgate starts by assuming that section 737A and section 97 have the effect of deeming there to be amounts of interest equal to the coupon received on the gilts (£278.8m) which are to be treated as paid by DCC under a loan relationship.
- But Mr Holgate says no more is known about the term of that loan relationship (other than that, because DCC is deemed to have paid interest, it must be a liability of DCC).
- As a result he says it is not possible to determine the debits and credits to be brought into account without further information (e.g. when the liability was incurred, what its amount was, how interest was calculated, what the redemption amount was, when it is redeemable).
- But he says:
- Mr Gardiner says that the purposes and effect of section 97 are to give DCC a free standing debit for the whole of the amount which section 737A deems to be manufactured interest. He says:-
- Mr Furness did not directly attack all of the propositions advanced by Mr Gardiner.
- HMRC say that section 84 applies to the deemed interest payments under section 97. Section 97 merely deems the manufactured payment to be interest under a loan relationship to which the company in question is a party. That brings it within section 84(1) alongside all other interest profits gains losses etc arising on such relationships. No cross-reference in section 97 is necessary for this purpose.
- He says that section 84(1) requires that the credits and debits to be brought into account for loan relationship purposes must when taken together fairly represent all the profits gains losses etc arising on the company's loan relationships and related transactions. He notes the use of the word "all" and the fact that "loan relationships" are referred to in the plural. Only credits and debits which pass this "fairly represents" test are to be taken into account. Section 84 is not satisfied merely by taking each loan relationship in isolation and asking whether the credits and debits fairly reflect the profits, gains losses etc arising on that relationship.
- He says section 84(1) places two requirements on the sums which must be taken into account in computing profits and losses on loan relationships, namely:
- The parties are agreed that the accruals basis is the appropriate basis of accounting in the present case. But in applying the accruals basis to any given receipt, the first question an accountant has to ask is whether this receipt is actually received by the recipient on its own behalf, or on behalf of another party. If the receipt is received on behalf of another party and is duly transmitted on to that party no part of the income or the onward payment will accrue to the initial recipient. This is the way that coupon receipts arising on repo'd gilts are dealt with under Application Note B to FRS5, the relevant accounting standard. Paragraph B4 requires the interim holder simply to account for the profit on the repo. On this approach the coupon and the manufactured interest are treated as self cancelling. Indeed paragraph B19 of Application Note B requires the original owner of the gilts to continue to recognise them as an asset. In its statutory accounts the Appellant adopts this approach – the only entry in the profit and loss account for the repos is the economic profit, or interest, on the repos. Of course, the Appellant's accounts are drawn up by reference to the actual repos, which did not involve manufactured interest payments. But the accounting treatment of repos would not have been different if the repos had provided for manufactured interest payments, as the statute deems them to do so for tax purposes.
- He says that the Appellant's approach is to construe para 15 and section 97 in isolation, without regard to the fact that they must have been intended to work together. Having construed them, the Appellant then asks Mr Holgate to give a view on the correct accountancy treatment of each of the deemed transactions. The Appellant then puts the results of this exercise into its loan relationship tax computation. At no point does the Appellant ask the question whether taking:
- The coupon is being taken into account in a loan relationship computation under which the profit or loss on the acquisition and disposal of the gilts is to be disregarded. HMRC contend that a case can be made under paragraph 15 for crediting the Appellant either on the basis of interest accrued during the duration of the repo, or on the basis of interest accrued over the whole coupon period of the gilts. Similarly a case can be made under section 97 either for assuming that the whole of the interest under section 97 accrued during period for which the Appellant was party to the loan relationship (this is Mr Holgate's assumption in para 7.23 of his report) or that the interest accrued over the whole of the coupon period, in which case the Appellant, being a party to the loan arrangement only for the few days of the repo would account only for interest accrued in that period. Which is the correct construction of each provision depends on an informed construction of the provisions in the context of the legislation as a whole. The correct construction to place on one of these provisions must inevitably inform the construction of the other. If a similar construction is placed on both provisions (ie both provisions take account of the whole of the coupon and the interest (£28.8m), or both take account only of the proportion of the coupon and interest (£2.9m) accrued during the period of the repo when compared with the period of the coupon) the tax result is the same and HMRC win this appeal on either basis. If dissimilar constructions are placed on the two provisions then that can operate either for the benefit of the taxpayer in the position of the Appellant or to his disadvantage, depending on which way round the construction works.
- I consider first the question of the determination of "authorised accounting method," and its application, then section 730A about which there was no dispute, then set out what to my mind is the proper approach to section 97, and finally examine the debits and credits which on this approach arise to DCC and (assuming it to be a corporation tax payer) X Bank.
- The authorisation of accounting methods is prescribed by section 85. An accounting method is authorised and therefore available for use in the section 84 mechanism only if:
- Section 86 determines which accounting method is to be used where more than one method is authorised. It provides that if a method which is, or equates to, an authorised method is used in the statutory accounts as respects a loan relationship then that method (or the one it equates to) is the one to be used for the purposes of section 84. If no method is determined by this process then an accruals basis is to be used.
- A loan relationship is anything defined to be or deemed to be one. In DCC's case the following loan relationships, or deemed loan relationships, fall to have an authorised accounting method applied to them:
- I accept Mr Holgate's evidence that the method of accounting used in DCC's statutory accounts for the repo transactions was in accordance with the then applicable accounting requirements. It was therefore a method which conformed to normal accountancy practice.
- Accordingly, if that method was applied to the three loan relationships described above and was an accruals basis or a mark to market basis, it must be used in applying section 84 to those loan relationships.
- It seems to me that that method was used as respects each of those loan relationships and that it was an accruals basis which complied with section 85.
- That method was an accruals basis because, had it been necessary to allocate payments to different accounting periods DCC would in my view have followed the requirements of FRS18 and reflected the "effects of the transactions - for the accounting period in which they occur and not for example in the period in which any cash involved is received or paid". That complies with the requirement of section 85 for proper allocation summarised at 106 above.
- The remaining requirements of section 85 as respects an accruals basis are not presently relevant; if DCC did not comply then the effect of being required to choose the basis to which its method equated leaves, as respects these loan relationships, the position unchanged. If it did comply then the method it used is the only relevant method.
- That method was used as respects each of those relationships because under it each of the factual circumstances which comprised that relationship were taken into account in computing the statutory accounts. It matters not whether or not there were separate entries in respect of each set of circumstances or that the accounts do not describe the circumstances as loan relationships.
- That would not be the case where the statute deemed something to happen which did not happen in reality so that it could not have been reflected in the proper accounts. But for the reasons set out in the sections headed "Section 730A" and "Section 97" in my judgment neither of those sections have that effect: they merely deem something which did happen to be a loan relationship event. If the statute says "X is to be treated as a loan relationship" then it is to me clear that if an accounting method is used as respects X, then it is used for the purposes of section 85 as respects the loan relationship constituted by X. The fact that the method brings no amount into profit or loss as respects X is neither here nor there. Nor does it make any difference if the loan relationship is one defined by section 81 rather than "deemed" by section 730A or section 97(2): in both cases the statute treats circumstances as being a loan relationship (or interest on one) the fact that those circumstances may or may not involve an actual lending is irrelevant.
- Accordingly the method which is authorised for the purposes of section 84 is the method used in DCC's accounts and expounded in Mr Holgate's evidence relating to the proper accounting for repos which I set out earlier in paragraphs 28 to 44.
- It is only if DCC did not use an authorised accounting method as respects any of the circumstances constituting these loan relationships that a potentially different accruals method may be required to be used (section 86(4)).
- As I explain below, section 730A treats the sale price under a repo as the amount of a deemed loan, and the price differential as interest on a deemed loan relationship. When you are asked how has that deemed interest and loan relationship been accounted for, the answer is that it has been accounted for as that element of the repo has been accounted for, not that an authorised accounting method has not been used as respects it, or that it has been ignored in the accounting.
- Section 97(1) to (3) treat a manufactured payment as interest on a loan relationship. When you are asked how has that interest been accounted for, the answer is that it has been accounted for as the actual payment was accounted for, not that it has been ignored just because the profit or loss account amount which arose was nil. For the reasons I set out below in the section headed "Section 97" in my judgment the effect of section 97(4) is the same and the same analysis applies to the circumstances treated as interest on a loan relationship under it.
- The consequence of both section 97 and section 730A is to my mind to require the circumstances which gave rise to the legal construct "loan relationship" to be treated for the purposes of section 84 as the loan relationship they are deemed to constitute (in the same way a loan may be defined in section 81 to be a loan relationship so that section 84 will apply to it). If an authorised method was used in the proper accounts as respects those facts so it must be used for section 84..
- I mentioned the effect of section 730A at paragraph 16 above. There is no dispute that it applies. It applies where under a repo transaction the sale price and the repurchase price are different. Subsection (2) provides:-
- The sale price was £812m, the repurchase price was £785m but as a result of section 737C and section 730A(9) the repurchase price falls to be increased for the purposes of section 730A by the £28.8m dividend received. It is therefore £813.8m for the purposes of section 730A, so that the excess of £1.8m falls to be dealt with as described in subsection (2)(a) above.
- Subsection (3) treats the deemed interest as paid when the repurchase price is paid. Subsection (4) deals with consequences for other presently irrelevant tax provisions of the deeming. Subsection (5) contains provisions enabling the distribution legislation to apply to the deemed interest. Subsection (6) provides for the requisite interaction with the loan relationship legislation and was inserted when that legislation was enacted in 1996. It provides:-
- I note the following features of these provisions:-
- This was Mr Holgate's evidence in relation to proper accounting for the finance element in a repo:-
- 12 Therefore the finance cost of a fixed price repo will be calculated by the seller as the difference between sale price and the repurchase price, if any coupon or dividend payment on the security is immediately passed back to the seller under the terms of the arrangement. Alternatively, if the coupon or dividend payment is retained by the buyer, but the repurchase price has been reduced to compensate for this, then the finance cost will be the difference between the sale price and the repurchase price after adding back the amount of the coupon or dividend payment. The actual finance cost, being the economic profit of the transaction, should be unaffected by whichever of the two arrangements for any dividend or coupon has been entered into, as the two arrangements are commercially equivalent to each other. "
- That finance cost in our example is £1.8m.
- 16 The FRS 5 analysis of the transaction as in substance a secured borrowing and accounting for it as such is just as relevant for the legal buyer of the security. In substance, the buyer has lent (or, in other words, deposited) funds to the seller, with the security as collateral. Therefore, in accordance with FRS 5, the buyer should account for the fixed price repo transaction as such. Where, under the repo agreement, the buyer must immediately pass on any coupon or dividend payment on the securities to the seller (ie the buyer is merely acting as agent for the seller in this regard), then the buyer would account for the transaction as follows:
- The buyer would not recognise the security as an asset, even though it has legal ownership, as it does not have beneficial ownership.
- The buyer would recognise a loan receivable equivalent to the cash it paid to purchase the security:
- The buyer would accrue 'interest' receivable on its loan over the term of the repo at the repo rate, crediting the profit and loss account and increasing the loan receivable balance. The interest receivable would be equivalent to the finance cost payable by the seller on the same transaction and is, in effect, the economic profit on the loan:
- The cash receipt in respect of the coupon or dividend, if any, is recognised as an obligation to pass the cash to the seller:
- This obligation is then satisfied by the subsequent payment of the coupon or dividend receipt to the seller:
- When the security is sold back to the seller, the buyer would credit the loan receivable balance with the cash proceeds, reducing it to zero. No gain or loss would arise:
- Accounting by the seller [X Bank]:
- The seller continues to recognise the security as an asset in its balance sheet. On entering into the repo arrangement the sale proceeds are recognised as a liability:
- The finance cost, being equivalent to the economic profit under the repo, is accrued to the profit and loss account over the term of the arrangement:
- Any cash received from the buyer during the term of the repo in lieu of the coupons or dividends paid on the securities is recorded as though it had been received directly from the issuer of the securities:
- At the end of the repo term the loan is repaid and no gain or loss arises:
- And this is what Mr Holgate said specifically about section 730A.
- 24 I assume that the effect of s730A ICTA 88 is to deem there to be amounts of interest equal to those set out in paragraph 34 of the Appellant's Statement of Case (ie equivalent in amount to the economic profit of each repo transaction) which are treated as paid by [X Bank] to DCC in respect of a loan relationship.
- 25 On this basis, DCC is deemed to have received interest in respect of a loan relationship. No more appears to be specified about the terms of such a loan relationship, and therefore from an accounting perspective without more information I cannot determine the debits and credits to be recognised that fairly represent the loan relationship and related transactions (if any).
- 26 However, if there is a legislative need to determine the credits to be brought into account on an accruals basis that fairly represent the loan relationship, then I would understand the legislation may be making an assumption that the deemed interest, which is to be treated as received by DCC under a loan relationship to which DCC is a party, was payable in respect of a period for which DCC was a party to that loan relationship. If that is the case, then, from an accounting perspective, a credit for the whole amount relating to that period should be recognised in respect of that accrued interest receivable."
- In summary he says:
- is for the whole amount of the deemed interest (i.e. an amount equivalent to the economic profit of each repo transaction), as explained in paragraph 7.26; or
- cannot be determined from accounting principles, on the basis of the information given."
- It seems to me that the correct approach to the determination of the debits and credits to be brought into account as a result of section 730A(6) is not that evidenced by the extract in the preceding two paragraphs. First, there is no such need as is referred to in para 7.26 above to determine accounting entries: the need is for interpretation or interrogation of actual accounts (because it is in those accounts that the authorised method is used) to find the tax debits and credits.
- Second, in this extract Mr Holgate is assuming that section 730A is deeming some action – the payment of interest – to happen which did not happen, and understandably he says that if that is all he is given to work on he is in difficulties, although he will do his best to help. But there is no need for Mr Holgate to make that assumption. All section 730A does is to characterise the price differential as interest; section 84 then requires you to search the accounts for the sums which arise by virtue of the application in those accounts of the authorised method which represent that price differential. Those sums emerge plain as a pikestaff from the actual accounting in the earlier extract from Mr Holgate's evidence. Mr Holgate says that "the finance cost will be the difference between the sale price and the repurchase price after adding back the coupon or dividend payment". That finance cost (an amount which bears in its description a remarkable resemblance to (or in common sense terms, equates to) the difference which section 730A(2) deems to be interest) is to be debited to P&L in the case of X Bank, or credited in the case of DCC. That debit or credit to P&L represents the difference which is deemed to be interest on a loan relationship. It is that amount which is the debit or credit produced by the application of section 84.
- The result is that the application of proper accounting and section 84 to the difference treated as interest by section 730A(2) and brought into Chapter II by section 730A(6) is a credit of £1.8m for DCC and a debit for X Bank (assuming it to be a UK corporate) of the same amount.
- There was no disagreement before me that this was the amount of the credit, but I have gone through the detail of its determination for three reasons:-
- I start my consideration of section 97 by noting that it applies in cases other than net paying repos:-
- Subsections (1) and (3) apply in both these cases, and are extended in their operation by subsection (4) to the case of a net paying repo. It seems to me therefore that an examination of the effect of section 97 should start by examining its effect in these simpler cases. Does the section create a free standing debit for the whole of the manufactured interest in those cases?
- Absent section 97 the manufactured payment by A or X would not be recognised by the loan relationship legislation: it is not interest and probably not a profit or loss which arises to a company from its loan relationships, and may therefore not fall into section 84(1) (a) or (b). There would therefore be no deduction in respect of the payment or any charge in respect of the receipt.
- Section 97(2) remedies this state of affairs (or clears up any uncertainty) by providing that the manufactured payment is to be treated as interest under a loan relationship:-
- Paragraph (a) applies both to A and B, and to X and Y: it is the provision which lets Chapter II bite on the contractual payment. Paragraph (b) by contrast applies only to B and to Y, and attaches the payment to the loan relationship held by B or Y. In relation to the payer there is, as Mr Gardiner points out, no indication of the terms of the loan relationship under which the interest is paid, no indication who was creditor or debtor or for how long, and no indication as to the period to which the interest relates.
- Mr Gardiner says that the result of this is that A and X get free standing debits for the full amount of the payment they make.
- I do not agree. Subsection (2) applies for the purposes of Chapter II: it therefore requires the manufactured payment to be treated as interest on a loan relationship for the purposes of section 84, and section 84 will determine the debit which arises. The words "by virtue of this section" in section 97(3) do not dissuade me from this approach: the fact that the debit may be calculated under section 84 does not mean that it does not arise by virtue of the deeming in section 97. "[B]y virtue of" does not mean or imply that the only source of the debit is that section.
- So then what is the effect of applying section 84 to these payments? These are actual payments which will have been reflected in the accounts of the payer and recipient. There will be accounting entries for them in the same way as there will have been for real interest on real loan relationship. You must therefore apply section 84 to these payments in the same way as you apply it to payments of interest: you seek the sums which in accordance with the authorised accounting method represent the payments. There is no need to impose extra conditions or counter factual assumptions on the accountant: he is not to be interfered with, but there must be a further interrogation to determine which are the representative sums. I shall return to that exercise below
- But if this is right why is there specified provision in relation to the recipient in paragraph (b)? Does this not suggest that something other than the normal accounts approach is indicated in paragraph (a)? I do not think so. First the specification of the loan relationship in paragraph (b) clearly points to the fact that the provisions are intended to operate through section 84: paragraph (b) cannot have that effect on its own because it needs the deeming in paragraph (a) to get started, but (b) makes no sense if it is intended to operate without regard to section 84. Thus both (a) and (b) must operate, at least in the case of the recipient, through section 84. But if in the case of the recipient (a) acts through section 84 then that is good reason for saying that it should also act through section 84 in the case of the payer. In other words what at first sight seems to be a different approach as respects the payer (in (a)) and the recipient (in (b)) is in fact the same approach: both operate through section 84.And in the general context of Chapter II an interpretation which draws its debits and credits from the proper accounting is to be preferred.
- It seems to me that the purpose of the express specification of the loan relationship in (b) is not to create a contrast with a free standing deduction to be given where (a) applies to the payer, but to cater for uncertainties or double counting in relation to the recipient. The recipient, if it uses an accruals basis of accounting, may already have made entries representing the accrual of interest on the loan relationship. In the case of a repo transaction that accrual will relate to its period of holding including the time for which the stock was repo'd out. If the manufactured payment were not expressly treated as real interest received on the loan relationship, there would be a possible argument that both the accrual credit, and a credit in respect of the receipt should be brought into account. There is no such complexity in the payer's case because there is no other relationship to which the payment could relate.
- Thus it seem to me that the effect of section 97 in the case of A, B, X and Y is to require the manufactured payment to be treated as a loan relationship event to which section 84 must be applied. The payment is simply clothed in apparel which enables it to be seen by the operator of section 84. And it imposes no additional factual assumption in the determination by the accountant of the sums which arise from the company's transactions. This achieves in the case of the cum div sale and the gross paying repo taxable debits and credits which follow the accounting.
- In these cases it provides for no free standing debit for the payer.
- Thus section 97(1) to (3) applies in relation to a gross paying repo to clothe the contractual manufactured payment with the attribute "interest on a loan relationship" so as to characterise that payment as something on which section 84 can bite. It seems to me that section 97(3) is for the avoidance of doubt and does not suggest a contrary analysis.
- The reader will recall that section 97(4) provides that:
- Section 97(4) applies to a net paying repo. It comes into action when section 737A deems there to have been a manufactured payment for the purposes of Schedule 23A (which it does for the purposes of Schedule 23A alone - that is why section 97(4) is needed). The subsection provides that section 97 shall apply as it would have applied if such a payment had in fact been made. But how would section 97 have applied? The answer is that it would have clothed that payment with the features on which section 84 can bite.
- It seems to me that section 97(4) does not deem a payment to have been made, it does not say that a payment shall be treated as made for the purposes of Chapter II .
- It simply requires section 97(1) to (3) to be applied "as it would have applied" if such a payment had in fact been made. The italicised words are crucial: the section is not applied "as if" such a payment had been made, but as it would have applied if such a payment had been made. The language focuses on the effect of section 97, and that effect is to treat something as a loan relationship event which would not otherwise be one; it does not deem for the purpose of Chapter II there to have been a payment which was not in fact made.
- In this context I note the language of section 737A(5) which states that Schedule 23A "shall apply as if… the relevant person were required to pay… an amount representative of the dividend..."; not "as it would have applied as if such a…. payment had in fact been made".
- Whereas in section 97(1) to (3) a contractual payment is clothed as a loan relationship event, it seems to me that the proper construction of section 97(4) is that it clothes the circumstances which trigger section 737A(5) as a loan relationship event. Just as its effect in relation to a gross paying repo was not to deem something to have happened which did not, its effect in relation to a net paying repo is the same: it merely characterises the factual circumstances in such a way as requires section 84 to apply to them.
- The consequence of such characterisation is to switch on section 84. One is required as a result to determine what sums arise as a result of the application of the authorised accounting method (which it will be remembered is that actually used by DCC) to the circumstances which give rise to this deemed loan relationship. What sums arise? The answer is none. Mr Holgate's evidence was clear: neither the receipt of the actual coupon, nor its onward payment in the case of a gross paying repo, nor its economic application in the purchase price differential for the benefit of the original holder result in any Profit and Loss account entry. The application of the applicable authorised accounting method to the circumstances results in the case of DCC in sums which are nil, and the amount of the debit and credit representing those circumstances is thus in my judgment also nil.
- In written submissions on this question of the interpretation of section 97(4) Mr Furness said that "section 97(4) can… be said to deem an interest payment to be made which was not actually made, but it does so only for the limited purposes of section 97 (and not for the purposes of Chapter II generally)". It seems to me that this both overstates and understates the effect of section 97(4). It overstates it because the language is more subtle: the payment is not deemed to be made, but the section is required to apply as it would have applied if it had been made. It understates it because the effect of such applications extends to section 84 and requires that section to apply to some circumstances which are not a loan relationship event (as that phrase is normally defined by section 81 and 84) but is to be treated as one.
- In its written submissions, the Appellant says that where section 737A(5) applies, it is section 97(4) which causes there to be a payment within section 97(1); and that it does this so that a debit may be brought into account for the purposes of Chapter II. It seems to me that this does not do full justice to the nicety of the wording in section 97(4).
- They say that the purpose of section 97(4) is to enable the other subsections of section 97 to deem the payment to be a payment of interest under a loan relationship for the purposes of this Chapter. The Appellant accepts that section 97(4) does not deem there to have been a manufactured payment for all the purposes of Chapter II because its language is restricted to "this section". But they say that it does not need to: the existence of a contractual payment is irrelevant to how section 84 and the other loan relationship provisions operate once section 97 has done its work. In each case they say the payment is deemed by section 97 to be interest under a loan relationship and after such deeming its need is spent.
- It seems to me that the difficulties encountered by Mr Holgate in determining the proper accounting for such a deemed payment illustrate the problems with this approach. Without more information about the payment and the loan relationship Mr Holgate is stuck and has to make more and more assumptions. If the Appellants are right then section 97 has done its work very shoddily for, other than in the case of the recipient, it has provided no help on how section 84 should apply. That seems to me a reason for supposing it should not apply as Mr Gardiner suggested.
- Lest it be said that that is a reason for treating section 97(4) as delivering a free standing debit without the mechanism of section 84, I should add that in the case of the cum div sale and the net paying repo there seems, for the reasons given, above no reason to treat it as so applying and every reason to the contrary.
- I set out above paragraph 7.23 of Mr Holgate's report. Mr Holgate started by saying that absent further information he could not determine the proper accounting entries for a free standing deemed interest payment so he made a number of assumptions. It seems to me that he should not have been forced to wear such a tight pair of shoes and that the assumptions he makes are not necessary because there is no new payment deemed to have been made which was not made, rather the circumstances (which caused section 737A to apply) are treated as a loan relationship event. He has no difficulties with the proper accounting for those circumstances: no assumptions to be made and no uncertainties.
- There is another way of looking at Mr Holgate's problem. If a payment were deemed to have been made what would be the natural consequences of that? The commercial deal would surely have been different, the sale or repurchase price would have been altered (there is no requirement in section 97(4) that all other events remain unchanged). The problem with treating section 97(4) as providing simply for a deemed payment is that it leaves such questions unanswered. It is an interpretation which gives rise to conceptual uncertainty and is unsatisfactory.
- It seems to me that if section 97(4) were simply to require a manufactured payment to be treated as made then there would be a strong argument that you should treat that payment as being part of the sale price. Were that the case the question would be how section 84 should apply to that part of the sale price representing the deemed interest. And the answer would be that no debit or credit would arise.
- Mr Gardiner's approach to section 97(4) seems to me to create an anomalous result. That is not because the end result for DCC for which he contends is anomalous, but because it involves construing section 97(4) as creating a free standing debit which is not reflected in the actual accounts of the company, and that result is anomalous in the context of Chapter II. It would also create an absurdity in the difference between the treatment of gross paying repos where section 97(5) makes no adjustment to reality and net paying repos where it would be construed to do so where the two forms of repo are economically and for accounting purposes the same.
- This tribunal has to do its best to make sense of the legislation, not only making grammatical sense of the text but also finding a rational scheme in the legislation. Although it should not shrink from saying that a tax statute has missed fire, if there is a choice between two interpretations, one of which would fail to achieve the purpose of the legislation, or reduce the legislation to futility or anomaly, it should accept a bolder construction based on the view that Parliament could legislate only for the purpose of an effective result. If one interpretation produces an undoubted anomaly which is contradictory to the evident purpose of the statutory provision viewed as a whole, "principle common sense, and authority show that the court is "entitled and indeed bound to adopt some other possible meaning" if it exists" (to quote Newberger J in Jenks v Dickinson [1997] STC 853 at page 874).
- It seems to me that for the reasons I have set out that the interpretation of section 97 that I favour does achieve the purpose of parliament whereas that of Mr Gardiner manifestly does not.
- Although I was not referred to Luke v IRC [1963] AC 557, we did discuss O'Rouke v Binks [1992] STC 703 in which it was considered. In Luke Lord Reid considered that in the particular circumstances of the case to achieve the obvious intention of the statute and to produce a reasonable result some violence had to be done to the words. He said that in order to avoid imputing to Parliament an intention to produce an unreasonable result "we are entitled, and indeed bound, to discard the ordinary meaning and adopt some possible meaning which will produce a reasonable result. He thought that his interpretation was possible and produced a reasonable result: so he adopted it.
- It seems to me that I am far from Luke. I need to do no violence to the words of section 97 to construe them so that they produce a "reasonable result"; indeed it seems to me that all I need to do is to look at them carefully. If I am wrong and I am doing violence to them, then I have no doubt that Lord Reid would have forgiven me.
- To summarise: section 97 is characterising some part of this transaction as the payment of interest, thus the debits and credits to be brought into account in respect of this transaction are those accounting sums which together fairly represent:
- Those sums, on the basis of Mr Holgate's evidence are respectively:
- As a result the only credit to be brought into account is £1.8m.
- On the assumption that X Bank is UK resident, the provisions we have been discussing also effect the calculation of its taxable profit. The only relevant difference in the applicable words is that in section 97(2) where, as noted above, it is spelt out that the manufactured interest is to be taken to be interest on the loan relationship on which the real interest was payable (in this case the gilts).
- Applying the process developed above it seems to me that the correct approach is the following:
- Thus the debits and credits given by and for the purposes of Chapter II are a debit of £1.8m and a credit of £2.9m. This is consistent with the economic and accounting effects of the transactions. It seems to me to be consistent with the object of the legislation and a fitting converse to the position of DCC.
- During the course of the hearing Mr Gardiner expressed his sorrow that parliament had been persuaded to enact paragraph 15 and section 97. He said that if they had not been enacted and section 84 left to its own devices simply picking up the accounting entries the (potential for an) excessive deduction for DCC would not have arisen. I note that the effect of the interpretation which I have set out above might be said to be the same as if those sections had not been enacted. That is:
- It does not seem to me that this consideration weighs against the approach I have adopted. That is for the following reasons. First the potential redundancy of a provision is well recognised as being a sorry aid to the construction of tax statutes.
- Second, with the exception of the treatment of interest on the gilts in the hands of DCC, the statutory provisions give the impression of attempting to mimic the proper accounting practice: they create a notional (secured) loan on which interest is paid, they ignore profits and losses on sale and disposal of the securities, and they treat the original holder as continuing to receive the interest on the repo'd securities. That all strongly suggests that those provisions are for the avoidance of doubt rather than provisions expected to be put to regular use (save in the case of section 730A which is needed for the mechanics of section 84 and section 97 where it applies to cum divi sales and gross paying repos).
- So far as the treatment of interest on the gilts in the hands of DCC is concerned, the provisions are silent: the debit or credit is that reflected in the accounts. Section 97(2)(a) (with 97(4)) creates the possibility of a debit in respect of the manufactured payment (or its equivalent in the price differential). Mr Holgate noted (see paragraph 42 above) that FRS 4 and 5 contain no specific requirement to net the effect of the coupon receipt and the compensating onward payment (whether explicit or via the purchase price). The draftsmen in my judgment may be taken to have understood this and to have foreseen three possibilities which arose as a result.
- The first was that the proper accounts applying an authorised method to the real transactions would recognise as income the receipt of the £28.8m but would also recognise a cost of £28.8m; for that case he provided for the cost to be capable of recognition as a loan relationship debit of the same amount; the second was that the accounts would recognise accrued income of £2.9m and an equivalent cost: for that case the accrued cost is also permitted recognition; and the third was that nothing would be brought in on either the profit or the loss side. The last required no specific provision, but the earlier possibilities did. But what was not contemplated was that the two accounts amounts would be different and there has been no evidence that they would in proper accounts. The draftsman's caution may not have been needed. But it is explicable as caution rather than as an attempt to create a divergence from the accounts.
- Thus although the attempt to avoid doubt may in fact have created it, it seems to me that, at least on the accounting evidence relevant in this case, properly construed these provisions do not create an anomalous result. It may well be that in other circumstances the proper accounts would have brought in some profit in relation to the receipt of the coupon and some expense in relation to its transmission. There might even be circumstances where the terms of the repo or of the securities meant that an economic and accounting profit in respect of the gilts when held by DCC should be recognised. If so these provisions properly construed enable both the credit and the debit to be recognised. If Mr Holgate had said that in the proper accounts £2.9m should have been brought in as a profit and £2.9m as a loss then those sums would be recognised as a debit and a credit for Chapter II, but (i) on DCC's facts it is impossible that the accounting sums would be different from each other, and (ii) if bringing into the P & L account both items had been the proper accounting, the net tax result would have been the same as that given by the actual accounting and the results of its application in this case: namely, nil.
- Mr Furness' argument about fairness arises only if I am wrong about the determination of the correct credits and debits: although I find that both gilt interest credits and debits are nil rather than both either £2.9m or £28.8m (as Mr Furness argued), I do not believe that he would object that my determination is unfair.
- A different answer arises, or could arise, on one of the following bases:
- If (ii) is the case Mr Furness cannot appeal to fairness since that appears only in section 84. But as I have already explained it is clear to me that section 97 does not produce a free standing debit.
- It is clear that the company's accounting method has been applied to the receipt of the gilt interest. That method was normal accounting practice, was an accruals method satisfying the relevant conditions, and was used in the accounts. There is no other method that is authorised. And under it the credit/debit is nil. I cannot see how fairness could compel a selection of any other sum when there is only one sum - nil - produced by the authorised method.
- Thus fairness rears it head only if I am wrong that the company's accounting method has been applied to the section 97 interest and only in respect of that interest in circumstances where an authorised accruals method has been applied to it separately which produces a different result from "nil". If it were possible to overcome Mr Holgate's misgivings and to accept his assumptions then a debit of £28.8m or £2.9m might arise in respect of that section 97 interest. If so Mr Furness can then complain that taken together with the "nil" recorded for the receipt, the sums do not when taken together fairly represent the loan relationship events.
- Mr Furness said that the words "taken together, fairly represent" have a particularly important role to play when dealing with deemed loan relationships where the possibility of adopting inconsistent premises was a very real one. In this context it seems to me that a "deemed loan relationship" must mean one which is defined by facts which are deemed to happen rather than simply a provision which defines real facts as a loan relationship even though they have nothing to do with the legal concept of debt. The latter is qualitatively no different from a section 81 loan relationship so far as concerns the application of section 84.
- Those words, he said, prevented a series of loan relationships being looked at seriatim in isolation, and accounting methods applied which gave rise to results which were based on inconsistent premises and which, when put together, were (therefore) unfair. The words said Mr Furness had two effects: first they permitted any necessary assumptions which had to be put to the accountant to be those assumptions which would give a fair result, and second they would influence the accounting method which should be adopted.
- Assumptions: Mr Furness says that when Mr Holgate had been asked to give the accounting results which would arise if section 97 deemed there to be a payment of interest on a loan relationship which was in addition to anything real (and which was not to be taken to reflect anything real) he could not do it unless he made assumptions. On the assumptions Mr Holgate made he came up with a cost (and so a tax debit arose) of £28.8m. But if he was asked to make other assumptions he might come up with a figure equal to whatever was the reverse of the figure for the income recognised from DCC's holding of the gilts (so if that were £2.9m, the debit would be £2.9m).
- And in relation to accounting method Mr Furness put it this way: you say to the accountant, "here are three loan relationships, this is the legal basis on which you are required to account for them, these are the deeming provisions, this is what you have to assume, please put on each of these loan relationships figures which when taken together fairly represent the losses, gains, profits etc of those relationships."
- So far as the assumptions went Mr Furness said it would be perfectly possible to make the assumption that the section 97 "interest" payable by DCC accrued over the same period as the actual interest receivable by it on the gilts. In that case it was clear that an authorised accountancy method would produce equal and opposite debits and credits for the same amounts. It was perfectly possible to make such assumptions because of the slack in section 97(2)(a) as to the terms of the relationship under which DCC was deemed to pay.
- Mr Gardiner says that the loan relationship legislation requires one to bring in certain matters itemised by the legislation, and thus find the sums to be brought into account in accordance with an authorised accounting method which when taken together fairly represent those matters. He says it is the loan relationship events which must be fairly represented not all the profits, gains or losses of the company. He says you cannot find the amounts from the commercial accounting because there were none (although, of course, in my view, that may mean that the tax debit or credit is nil if nil represents the facts which are to be treated as a loan relationship event). So far as any necessary assumptions go Mr Gardiner says that the assumptions Mr Holgate made were those which flowed from legislation: section 97 specifically deems a loan relationship to exist to which DCC only was a party as debtor: so it follows that the interest treated as paid must represent the accrual for the whole period of that relationship. There is no choice, the words "fairly" in section 84 cannot affect that. Mr Holgate's accepted evidence was that normal commercial accounting on an accruals basis would bring in £28.8m as an expense. Thus that must be the debit. There was no other possibility.
- For my part, the doubt and confusion created by construing section 97 as deeming a payment made which was never actually made on a loan (relationship) which never existed is a strong pointer to the construction of section 97 that I have adopted: namely that this provision creates nothing new but merely characterises something old and so permits us to access the actual accounts and the method used in them and thus the figures reflected in them to represent the events which are deemed to be loan relationship events. But since the point was argued I shall venture a view.
- If section 97 deems a payment to be made which was not actually made and deems that payment to be on a loan which did not actually exist but which is treated as a loan relationship, then section 84 requires debits and credits to be ascertained. In so doing, the first step is to find the authorised accounting method. Since no method is actually used as respects this loan relationship in the statutory accounts section 86(4) requires that "an" authorised accruals basis of accounting shall be used.
- The word "an" suggests that there may be more than one such basis. Section 85 requires the basis to conform to normal accounting practice and to contain proper provision for allocating payments, but that does not seem to me to mean that there is only one method. At a detailed level one company might accrue interest on one loan on a straight line basis, and interest on another on a basis reflecting daily compounding. Each of them to my mind comply with section 85(3) but they are different. So long as the normal accounting practice condition is satisfied (as I strongly suspect it would be) each would be an authorised accrual method.
- So there is some scope for different possible authorised accruals method which could be applied to this section 97 payment. It is also the case that surrounding circumstances may affect the way in which an authorised method operates: for example the existence of the repo arrangements meant that the authorised accruals basis which Mr Holgate advocated for DCC brought in a credit of nil in respect of its interest receipt on the gilts, whereas had they be held in different circumstances - as an investment perhaps - a time accrued element of interest income would have been brought into account.
- As I have noted earlier, it seems to me that "fairly" is about the selection of the sums from those produced by the prescribed accounting method rather than about the assumptions necessary for the operation of any deeming provision. The context in which it is situated suggests that is relevant to selection - to representation - rather than to the properly construed effects of other sections. Therefore I reject the proposition that the word can affect the setting of assumptions.
- It does however seem to me possible that "fairly represents" could affect the choice between two or more available authorised methods. Thus if, in circumstances where section 86(4) applied (where the method was not determined by the proper accounts), straight line accrual was sought to be applied to a debt of £100 which financed an interest on a debenture of £100 to which compound interest accrual was sought to be applied, then the sums when taken together from those methods would not fairly represent the two loan relationship events. But this requires some form of real world connection between the two sets of facts to which the words are to be applied. If the section 97 deemed interest is sui generis and nothing to do with the repo or the gilts, then the existence of the gilt coupon receipt cannot affect the authorised method applicable to the computation of the relevant amounts. And, once those amounts have been determined it does not seem to me that the words "taken together fairly" permit a post extraction, post calculation adjustment by reference to an overall transaction (the repo) which is not linked to the other sums. Only if the section 97 deemed interest is to be treated as arising from the circumstances which gave rise to its deeming could "taken together fairly" permit a choice to be made between say the standard straight line accrual and the method which may recognise the existence of the other transactions.
- The latter approach is perilously close to the approach which I am in this section obliged to eschew, namely that the section 97 deeming is merely a characterisation of the circumstances which give rise to these loan relationship events. I conclude therefore that in pursuing this analysis I should treat, for the purposes of this discussion, the section 97 interest as sui generis. Accordingly there is nothing in the circumstances surrounding its birth which should influence the calculation of the relevant sum. If the section 97 interest is sui generis then fairness does not help Mr Furness.
- But the problem with treating this deemed interest as real and as an addition to the real world means presenting the accountant with a situation which is different from reality and with economically different facts: he has the repo and the interest on this new loan. How can he offer a proper accounting method which gives sums which fairly represent reality and which also fairly represent this new world when the two are different. It does not seem to me that "taken together fairly" are strong enough words to force a choice determined by the actual world on the results of the deemed world.
- I therefore dismiss the appeal.
- The Appellant ("DCC") is a UK-resident company, incorporated in England and Wales and is an indirect subsidiary of DCC plc, a publicly-quoted company.
- On 13 August 2001, DCC's board of directors approved a proposal to enter into repo transactions with X Bank Limited ("X Bank"), a company incorporated in the Republic of Ireland..
- On or around 27 August 2001, DCC entered into an agreement ("the Master Repurchase Agreement") with X Bank under which it was agreed that, inter alia:
- On or around 27 August 2001, DCC entered into an agreement ("the Master Custody Agreement") with The Northern Trust Company ("Northern Trust") under which it was agreed that Northern Trust would act as custodian for cash, securities and other property delivered by DCC to Northern Trust from time to time. Annexed to the Master Custody Agreement were pro-formâ instructions to Northern Trust for the transfer of securities from X Bank into the custody account held by Northern Trust in DCC's name, and for the transfer of securities from that account to X Bank.
- Further to entering into the Master Repurchase Agreement, and by way of supplementing and forming part of it, DCC and X Bank entered into in 2001 five repo transactions in gilts ("the Gilt Repos"); in the case of each repo it was agreed that DCC would not be required to pay to X Bank any coupon payments received from the securities during the repo term. The Gilt Repos were as follows:
- Pursuant to each of the Gilt Repo agreements (and the Master Repurchase Agreement and the Master Custody Agreement), on the relevant purchase day (i.e. on the day DCC was to buy the relevant gilts from X Bank), the relevant gilts were transferred by X Bank to DCC's Custody Account with Northern Trust and the relevant purchase price was paid to X Bank. [2]
- During the term of each of the Gilt Repos, the following payments (being the semi-annual coupons payable) on the relevant gilts were paid to DCC:
- Pursuant to each of the Gilt Repo agreements (and the Master Repurchase Agreement and the Master Custody Agreement), on the relevant repurchase day (i.e. on the day X Bank was to repurchase the relevant gilts from DCC), the relevant gilts were transferred by Northern Trust, from DCC's Custody Account to X Bank and the relevant repurchase price was paid to DCC.
- The Gilt Repos were investment transactions and were not entered into for the purposes of a trade carried on by DCC.
- The Gilt Repos were transactions such as would be entered into by persons dealing with each other at arm's length. Furthermore, as each of the Gilt Repos was a fixed-price repo (with the repurchase price and date determined at the outset), none of the benefits or risks arising from fluctuations in the market price of the Gilts accrued to, or fell on, DCC. Section 730A ICTA 1988 applies to each of the Gilt Repos and, for the purposes of that section, X Bank is the original owner and repurchaser and DCC is the interim holder in relation to each repo.
- As stated in paragraph 5 above, it was agreed that DCC would not be required to pay to X Bank any coupon payments received from the securities. There was no requirement under any agreement for a person to pay to X Bank (or any person connected thereto) an amount representative of the dividend. Furthermore, from the terms of the transactions it is reasonable to assume that, in arriving at the repurchase price of the securities, account was taken of the fact that the coupon payments were receivable otherwise than by X Bank (and any person connected thereto). Section 737A ICTA 1988 applies to each of the Gilt Repos and, for the purposes of that section, X Bank is the transferor and DCC is the relevant person in relation to each Gilt Repo.
- Gilts held by companies represent loan relationships within the meaning of FA 1996.
- The Appellant used at all material times the accruals basis of accounting as defined in FRS 18 paragraph 27. This was an authorised method of accounting within the meaning of FA 1996 (thus, it conformed to normal accountancy practice and contained proper provision for allocating payments). For the purposes of this Appeal, it is an authorised accruals basis of accounting which is to be used as the authorised accounting method.
- In accordance with UK and Irish accounting standards (and in particular FRS 5, Application Note B, which was an authorised accruals basis of accounting), the Gilt Repos were accounted for by DCC as a secured loan from them to X Bank and only the economic profit from these purchase and resale transactions was recognised in DCC's profit and loss account (being determined by reference to all the relevant cashflows). The economic profit was also the amount which was included in its Return as non-trading credits from "Interest on repo" (see Statement P4 of its Corporation Tax Computation for the period 1 April 2001 to 31 March 2002).
- If X Bank (the original owner) had been following UK and Irish accounting standards, then, in accordance with FRS 5, Application Note B, it would have continued to recognise the gilts in its balance sheet and the interest thereon would continue to be accrued in its profit and loss account. In addition it would, in respect of the Gilt Repos, record on its balance sheet a deposit from DCC and record in its profit and loss account the cost of interest payable to DCC on that deposit.
- On 11 March 2004, the Inspector, Mr Williams, wrote to inform DCC that he intended to enquire into its Return for the period 1 April 2001 to 31 March 2002. Correspondence then ensued between the parties.
- In a letter dated 6 July 2005, Mr Hards of HMRC wrote to the representatives of DCC and stated that he was requesting the Inspector to issue a closure notice. The Inspector then wrote to close the enquiry on 14 July 2005 and issued a formal closure notice on 18 July 2005. On the 11 August 2005, DCC refused to amend its return to reduce its non-trade deficits by £27,012,751 (i.e. by £28,800,125 less £1,787,374). By letter dated 18 August 2005 and notice dated 23 August 2005, HMRC made that amendment to DCC's Return which DCC then appealed on 9 September 2005.
Spc00611
Gilt repo - purchase and resale of gilts - interest paid to interim holder not required to be paid to original holder but recognised in repurchase price - application of paragraph 15 Schedule 9 FA 96 - related transaction - effect of section 737A to 737C and 730A TA 88 - effect of section 97 FA 96 - approach to section84 FA 96 - section 86 FA 96 determining which authorised accounting method to use.
THE SPECIAL COMMISSIONERS
DCC HOLDINGS (UK) LIMITED Appellant
- and -
THE COMMISSIONERS FOR HER MAJESTY'S
REVENUE AND CUSTOMS Respondents
Special Commissioner: CHARLES HELLIER
Sitting in public in London on 23, 24, 25 and 26 January 2007.
John Gardiner QC and Philip Walford instructed by Reynolds Porter Chamberlain LLP for the Appellant
Michael Furness QC and Michael Gibbon instructed by the Acting Solicitor for HM Revenue and Customs for the Respondents
© CROWN COPYRIGHT 2007
DECISION
| The statutory provisions - commentary | Paras 14 to 27 |
| The Proper Accounting Treatment of repos | Paras 28 to 44 |
| The Identified Issues: | Paras 45 to 46 |
| Issue 1 : para 15 Sch 9 | Paras 47 to 59 |
| (argument, evidence discussion) | |
| Issue 2: section 84 and the interest receipt | Paras 60 to 94 |
| (argument evidence discussion) | |
| Issue 3: section 97 | Paras 95 to 171 |
| (argument evidence discussion) | |
| The Position of X Bank | Paras 172 to 175 |
| Are the Provisions redundant | Paras 175 to 180 |
| Fairness | Paras 181 to 199 |
| Summary and Conclusion | Paras 200 to 201 |
The relevant statutory provisions
The manufactured payment provisions
The Loan Relationship Rules: FA 96
"(1) The credits and debits to be brought into account in the case of any company in respect of its loan relationships shall be the sums which, in accordance with an authorised accounting method and when taken together, fairly represent, for the accounting period in question:
(a) all profits, gains and losses of the company, including those of a capital nature, which (disregarding interest and any charges or expenses) arise to the company from its loan relationships and related transactions; and
(b) all interest under the company's loan relationships and all charges and expenses incurred by the company under or for the purposes of its loan relationships and related transactions."
I shall refer to things within paragraphs (a) and (b) as "loan relationship events" in the rest of this decision. For the present I note that these events include a mix of legal constructs and other terms: "loan relationships" and "related transaction" are specifically defined - the first in section 81 and the second in section 84(5); "interest" has a well known legal meaning; but "profits", "gains", "losses", "charges", and "expenses" are less clearly terms of art.
"(2) The reference in subsection (1) above to the profits, gains and losses arising to a company:
(a) does not include a reference to any amounts required to be transferred to the company's share premium account; but
(b) does include a reference to any profits, gains or losses which, in accordance with normal accountancy practice, are carried to or sustained by any other reserve maintained by the company."
Subsections (3) and (4) refer to various charges and expenses and are not of direct relevance to this appeal save to that they relate to charges and expenses related to "loan relationships" and "related transactions" - both of which are defined terms.
"(5) In this section "related transaction", in relation to a loan relationship, means any disposal or acquisition (in whole or in part) of rights or liabilities under that relationship.
(6) The cases where there shall be taken for the purposes of this section to be a disposal and acquisition of rights or liabilities under a loan relationship shall include those where such rights or liabilities are transferred or extinguished by any sale, gift, exchange, surrender, redemption or release.
(7) This section has effect subject to Schedule 9 to this Act (which contains provision disallowing certain debits and credits for the purposes of this Chapter and making assumptions about how an authorised accounting method is to be applied in certain cases).
Section 84 refers to the use of an authorised accounting method. What may be authorised is prescribed by section 85 which authorises any method which conforms to normal accounting practice and is either an accruals or a mark to market method and section 86 has effect for the determination of which of the available methods authorised by section 85 is to be used. Section 86(3) and (4) provide:
"(3) If a basis of accounting which is or equates with an authorised accounting method is used as respects any loan relationship of a company in a company's statutory accounts, then the method which is to be used for the purposes of this Chapter as respects that relationship for the accounting period, or part of a period, for which that basis is used in those accounts shall be:
(a) where the basis used in those accounts is an authorised accounting method, that method; and
(b) where it is not, the authorised accounting method with which it equates.
(4) For any period or part of a period for which the authorised accounting method to be used as respects a loan relationship of a company is not determined under subsection (3) above, an authorised accruals basis of accounting shall be used for the purposes of this Chapter as respects that loan relationship."
These provisions are I believe crucial to this appeal.
"Manufactured interest
(1) This section applies where—
(a) any amount ("manufactured interest") is payable by or on behalf of, or to, any company under any contract or arrangements relating to the transfer of an asset representing a loan relationship; and
(b)that amount is, or (when paid) will fall to be treated as, representative of interest under that loan relationship ("the real interest");
(2) In relation to that company the manufactured interest shall be treated for the purposes of this Chapter -
(a) as if it were interest under a loan relationship to which the company is a party; and
(b) where that company is the company to which the manufactured interest is payable, as if that relationship were the one under which the real interest is payable.
(3) Any question whether debits or credits falling to be brought into account in the case of any company by virtue of this section:
(a) are to be brought into account under section 82(2) above, or
(b) are to be treated as non-trading debits or non-trading credits,
shall be determined according to the extent (if any) to which the manufactured interest is paid for the purposes of a trade carried on by the company or is received in the course of activities forming an integral part of such a trade.
(4) Where section 737A(5) of the Taxes Act 1988 (deemed manufactured payments) has effect in relation to a transaction relating to an asset representing a loan relationship so as, for the purposes of . . . Schedule 23A to, that Act, to deem there to have been a payment representative of interest under that relationship, this section shall apply as it would have applied if such a representative payment had in fact been made.
(5) [had been repealed by 2001]
"(1) In determining the debits and credits to be brought into account for the purposes of this Chapter in respect of any loan relationship, it shall be assumed that a disposal or acquisition to which this paragraph applies is not a related transaction for the purposes of section 84 of this Act.
(2) This paragraph applies to any such disposal or acquisition of rights or liabilities under the relationship as is made in pursuance of any repo or stock-lending arrangements.
(3) In this paragraph "repo or stock-lending arrangements" means any arrangements consisting in or involving an agreement or series of agreements under which provision is made:
(a) for the transfer from one person to another of any rights under that relationship; and
(b) for the transferor, or a person connected with him, subsequently to be or become entitled, or required:
(i) to have the same or equivalent rights transferred to him; or
(ii) to have rights in respect of benefits accruing in respect of that relationship on redemption.
(4) For the purposes of sub-paragraph (3) above rights under a loan relationship are equivalent to rights under another such relationship of they entitle the holder of an asset representing the relationship:
(a) to the same rights against the same persons as to capital, interest and dividends; and
(b) to the same remedies for the enforcement of those rights,
notwithstanding any difference in the total nominal amounts of the assets, in the form in which they are held or in the manner in which they can be transferred.
(5) Nothing in this paragraph shall prevent any redemption or discharge of rights or liabilities under a loan relationship to which any repo or stock-lending arrangements relate from being treated for the purposes of this Chapter as a related transaction (within the meaning of section 84 of this Act).
(6) This paragraph is without prejudice to section 730A(2) and (6) of the Taxes Act 1988 (deemed payments of loan interest in the case of the sale and repurchase of securities).
(7) Section 839 of the Taxes Act 1988 (connected persons) applies for the purposes of this paragraph."
The Proper Accounting Treatment of repo transactions
The Accounting Evidence
"A reporting entity's financial statements should report the substance of the transactions into which it has entered. In determining the substance of a transaction, all its aspects and implications should be identified and greater weight given to those more likely to have a commercial effect in practice. A group or series of transactions that achieves or is designed to achieve an overall commercial effect should be viewed as a whole."
"The difference between the net proceeds of an instrument and the total amount of the payments (or other transfers of economic benefits) that the issuer may be required to make in respect of the instrument".
Dr Cash
Cr Secured loan
Dr Profit and loss account – interest payable
Cr Secured loan
Dr Cash
Cr Coupon or dividend accrual in respect of the security
Dr Secured loan
Cr Cash"
Dr Secured loan
Cr Coupon or dividend accrual in respect of the security
Cr Cash
Dr Loan receivable
Cr Cash
Dr Loan receivable
Cr Profit and loss account – interest receivable
Dr Cash
Cr Amount owing to seller
Dr Amount owing to seller
Cr Cash
Dr Cash
Cr Loan receivable"
"Dr Cash
Cr Loan receivable"
"In summary, the seller accounts for a fixed price repo as a fixed rate borrowing with a related interest cost and continues to recognise the underlying security as an asset in its balance sheet. The buyer accounts for a fixed price repo as a loan receivable with related interest income and does not recognise the underlying security as an asset."
The Identified Issues
(1) the effect of paragraph 15 is to treat DCC as never being party to the gilts. As a result it should bring no credit into account in respect of the £28.8m received (but if this is wrong Mr Gardiner has a fall back argument);
(2) because DCC entered into a net paying repo section 737A deems for Schedule 23A purposes it to have paid £28.8m; section 97(5) treats that payment as interest under a loan relationship giving rise to a debit (on one of two alternative bases) of £28.8m;
(3) section 730A deems DCC to have received a loan relationship credit of £1.8m.
Issue (1) Did DCC become a party to the loan relationships represented by the gilts for the purposes of s84 FA 1996? This is the issue as to the effect of paragraph 15 Schedule 9 FA 96;
Issue (2) If it is to be treated as a party to the gilts, what credits should DCC bring into account in respect of those loan relationships?
Issue (3) What debits should DCC bring into account by virtue of s737A ICTA 1988 and s97 FA 1996?
Issue 1: Paragraph 15 Schedule 9 FA 96
"In determining the debits and credits to be brought into account for the purposes of this Chapter in respect of any loan relationship, it shall be assumed that a disposal or acquisition [made in pursuance of a repo transaction] is not a related transaction for the purposes of section 84 of this Act."
"[F]rom an accounting perspective even though DCC legally owns the gilts, as in substance it does not have beneficial ownership of the gilts DCC does not recognise the gilts as an asset and does not recognise any profits, gains, losses or interest in the accounting period in respect of its legal ownership of the gilts."
Schedule 25, Paragraph 32: Repo transactions and stock lending
"(1) Paragraph 15 is amended as follows.
(2) After sub-paragraph (4) (equivalent rights) insert—
"(4A) In consequence of sub-paragraph (1) above—
(a) the person transferring the rights mentioned in subparagraph (3)(a) above does not, as a result of the transfer, fall to be regarded for the purposes of this Chapter as ceasing to be party to the loan relationship; and
(b) the person to whom those rights are transferred does not, as a result of the transfer, fall to be regarded for the purposes of this Chapter as being party to the loan relationship."
The explanatory notes stated:
Paragraph 32 modifies paragraph 15 Schedule 9 FA 1996 (repos and stock lending). Paragraph 32(2) inserts a new paragraph 15(4A). It makes explicit what was implicit in the paragraph as it stood before this amendment. That is, treating a repo or stock lending transaction as not involving a related transaction (sale etc) also means that the seller or lender is treated as remaining a party to the loan relationship concerned. Similarly the buyer or borrower is not treated as becoming a party to the loan relationship. Accordingly credits and debits relating to such matters as accruing discount and exchange gains and losses will continue to be brought into account by the seller/lender. [Emphasis added]
"but nothing in sub-paragraph (1) or paragraph (b) above shall prevent any credit in respect of interest from being brought into account for the purposes of this Chapter by the person described in that paragraph."
Issue 2: if DCC is to be treated for the purposes of s84 as having become a party to the gilts, what credit should it bring in respect of the interest received?
(i) of the £28.8m coupon received by DCC on the gilts the correct credit required by section 84 is either nil or very small (because that is the accounting evidence);
(ii) as before section 737A deems for the purpose of schedule 23A manufactured interest to have been paid by DCC of £28.8m;
(iii) again as before, section 97(5) treats that payment as giving rise to a loan relationship debit of £28.8m; and
(iv) as before section 730A deems a receipt of £1.8m.
The Evidence of Mr Holgate
"7.16 As described in sections 4 and 5 of my report, the accounting treatment follows the substance of the repo arrangement, rather than its legal form. Therefore, from an accounting perspective, even though DCC legally owns the gilts, as in substance it does not have beneficial ownership of the gilts DCC does not recognise the gilts as its asset and does not recognise any income in respect of those gilts. On this basis, DCC would not recognise any profits, gains, losses or interest in the accounting period in respect of its legal ownership of the gilts.
"7.17 Alternatively, if one assumes that we ignore the debits and credits arising on the acquisition and disposal of the gilts with X Bank, but that it is still necessary to account for the legal ownership of the gilts, being the 'loan relationship', then the position is as follows."
"8.4 I understand, from reading the Appellant's and Respondents' Statements of Case, that the primary issue is the amount of the credit to be taken into account by DCC in its tax return in respect of the actual repo transactions under the application of s84 FA 96 and paragraph 15 Sch 9 FA 96, and this turns on the appropriate credits to be taken into account in accordance with an accruals basis of accounting.
"8.5 Based on the assumptions I have used in this report, as summarised below, in my opinion, such a credit is either:
"8.7 If similar assumptions are made from the perspective of X Bank, then under both scenarios X Bank would continue to recognise income in respect of its holding of the gilts other than in the repo term. For the period of the repo arrangement, for the purposes of s84, subject to the effect of paragraph 15 Sch 9 FA 96, X Bank could either:
The Parties' arguments
(1) since for accounting purposes DCC did not have beneficial ownership of the gilts and accordingly does not recognise any income in respect of these in its accounts, it should bring in neither credit nor debit under section 84; or
(2) if it is still necessary to recognise the interest on account of the legal ownership of the gilts, then the interest has to be determined on an authorised accruals basis and that, for the relevant period, is the amount of £2.9m.
Discussion
"[t]he debits and credits… shall be the sums which, in accordance with an authorised accounting method and when taken together, fairly represent, for the accounting period [the loan relationship events]".
(i) it defines debits and credits for tax purposes (or Chapter II) purposes and those tax debits and credits are not necessarily the same as the debits and credits which appear in the bookkeeping entries in the books of the company (I refer to these defined debits and credits hereafter as "tax debits and credits);
(ii) as I explain in paragraphs 108 to 122 below, because of section 85 and 86 FA 96, where the factual circumstances which give rise to that loan relationship are taken into account in statutory accounts which are proper accounts and those accounts use an authorised method to account for those circumstances then you must apply the method used in those accounts to determine those debits and credits; you do not simply apply any authorised accounting method to an isolated loan relationship event; instead you must interrogate the actual accounts of the company to determine what sums resulted from the application of the method used in those accounts to the loan relationship events.
Unless other statutory provisions specifically require you to do so you are neither entitled nor required to require your accountant to make any counter-factual assumptions when drawing up or explaining the accounts nor to adopt any authorised accounting method which is different from that used in the proper accounts.
(iii) the selection of the sums which fairly represent the loan relationship events requires the application of judgment and common sense and an eye to the recognition of profit or loss by those accounts.
(i) the bookkeeping entries being a credit and a debit of £28.8m on receipt of the interest are irrelevant;
(ii) I am not required to look at this loan relationship in isolation and to ask what accrued of interest (11 days' worth) should be brought in. Nothing is in the proper accounts: nothing is required by section 84;
(iii) I reject the approach that one is required to ask the accountant to adopt some special form of "legal" accounting to determine the answer; and
(iv) I reject the proposition that, because you cannot find any amount representing the interest on the gilts from the company's commercial accounting because no such amounts were ever brought in, it must be the case that the only way you can do what you are required to do is to identify such interest and separately to apply the principles of normal accounting practice arrive at the result. In my view, where the accounts are proper accounts and use an authorised method, the result - the determination of the sum - does not derive from a separate application of accounting principles but from the application of the authorised method actually applied in those accounts i.e. from an interrogation of accounts drawn up on those principles;
(v) the application of judgment and common sense to the accounting described by Mr Holgate shows that there is no amount to be brought into account by section 84 in respect of this coupon receipt: it is not properly to be regarded as a profit of the company.
Acquisition
Dr. bond account 100
Cr cash 100
Sale Cr bond account 100
Dr cash 110
Cr P&L 10
Which sums when taken together fairly represent the profit on the related transaction/loan relationship? The credit of 10 to P&L clearly does. But what of the two cash account entries 100 Cr and 110 Dr? They too are sums which when taken together represent the profit on those transactions. But it would be nonsense to bring all three into account: the result - a net credit of 20 would not fairly represent the profit. So a choice is made and only a net 10 credit is selected for the purpose of section 84. That credit is the sum representing the profit; it is not necessarily to be identified with any of the accounting entries to the exclusion of others.
(i) in the first year there will be a sum credited to P&L of £4 and a debit to a debtor account of £4, representing the accrued interest. Clearly it is a credit of £4 which should be selected for the purposes of section 84;
(ii) in the second year the £12 of interest is received: £12 will be debited to the cash account, and there will be credits of: (i) £4 set against the accrued interest debit and (ii) £8 to P&L.
In that second year section 84 requires the determination of the sums which in accordance with an approved accounting method fairly represent for the accounting period the "interest under the company's loan relationship". Common sense (and fairness) dictates that it is the credit of £8 to P&L which is to be brought into account under section 84: but that common sense requires a decision that neither the debit of the £12 of cash coupon received, nor the credit of £4 fairly represents the interest for the period.
Issue 3: the effect of section 97: should DCC bring into account as a debit the full amount of the deemed interest payment?
Mr Holgate's evidence
"7.23 However, if there is a legislative need to determine the debits to be brought into account on an accruals basis that fairly represents the loan relationship, then I would understand the legislation may be making an assumption that the deemed interest, which is to be treated as paid by DCC under a loan relationship to which DCC is a party, was payable in respect of a period for which DCC was a party to that loan relationship. If that is the case, then, from an accounting perspective, a debit for the whole amount relating to that period should be recognised in respect of that accrued interest payable."
DCC's Argument
(i) section 737A deems a manufactured payment to have been made;
(ii) section 737A produces a manufactured payment of the total gross amount of the interest received by DCC;
(iii) section 97 recognises the full amount of that payment;
(iv) the obvious purpose of Section 97 is to give a debit in respect of that payment;
(v) it achieves its purpose in section 97(2) where the debit is given by reference to a notional loan relationship. He contrasts paragraphs(a) and (b) of section 97(2): the latter deals with the recipient only and deems the payment to be the interest on the actual loan relationship which was the subject of the repo; in contrast subsection (a) deliberately specifies no terms for the loan relationship and no duration for its holding. The only person specified as a party to this loan is the taxpayer. Paragraph (a) creates a loan relationship source for the deduction. Because that is a notional relationship the payer gets a deduction for the whole of it. There is no mechanism for disregarding any part of the interest debit;
(vi) the debit is given by section 97 and is not affected by section 84: you never get into section 84. Section 97(3) makes clear that the debit fails to be bought into account "by virtue of this section". There is no reference to section 84 and there is no need for any recourse to section 84;
(vii) even if the debit had to be fed through section 84 the same result obtained: a debit for the full amount of the interest would fall to be brought into account. That is because if one applies an accruals basis of accounting to the notional loan relationship invented by section 97 the evidence of Mr Holgate shows that the only debit which arises is a debit for the full amount of the interest.
HMRC's Argument
(a) they must be computed in accordance with an authorised accounting method and (in addition to (a))
(b) they must when taken together fairly represent all profits gains losses interest charges and expenses detailed in paragraphs (a) and (b) of section 84(1).
(a) a credit for the coupon on the accruals basis, and
(b) debit for the whole of the interest payment on the loan relationship created under section 97 (the interest under which is computed by an amount which is representative of the coupon)
produces sum which when taken together fairly represent the profits losses etc on those two loan relationships.
Discussion
The Authorised Accounting Method
(a) it is an accruals basis or a mark to market basis;
(b) it conforms (subject to (c) and (d) to normal accountancy practice;
(c) it contains proper provision for allocating payments under a loan relationship to accounting periods. For an accruals basis this means that it must allocate payments to the period to which they relate apportioned as just and reasonable rather than just to the period in which they become due and payable; and
(d) satisfies certain other presently irrelevant requirements for bad debts.
It seems to me that section 85 does not suppose or require that there is as respects any circumstances only one possible accruals method of accounting or only one possible mark to market method.
(i) its holding of the gilts for 11 days and the interest thereon;
(ii) the notional loan created by section 730A and the interest thereon;
(iii) the notional loan for which debits and credits are required to be brought into account by section 97.
Section 730A
"(2) The difference between the sale price and the repurchase price shall be treated for all purposes if the Tax Acts –
(a) when the repurchase price is more than the sale price as a payment of interest made by the repurchaser on a deemed loan from the interim holder of an amount equal to the sale price…."
"(6) For the purposes of Chapter II of Part IV of the Finance Act 1996 (loan relationships)-
(a) interest deemed by virtue of subsection (2) to be paid or received by any company shall be deemed to be interest under a loan relationship; and
(b) the debits and credits falling to be brought into account for the purposes of that Chapter so far as they relate to the deemed interest shall be then given in relation to the deemed interest of an authorised accruals basis of accounting." [my emphasis].
(i) that they do not deem there to have been any action in the real world; instead the excess of one payment (the "difference") over another is given the characteristics of interest;
(ii) that they require Chapter II to apply to that difference by deeming it to be paid on a loan relationship; and
(iii) that they anticipate that section 84 will apply to determine the debits and credits but limit the choice of authorised accounting methods upon which it applies to an accruals basis. If such a basis is used in the proper accounts then I read section 86 as requiring it to be used for section 84. If a mark to market basis were used in those accounts then for section 84 it would have to be replaced by an accruals method. The latter is not the case for DCC: its accounts used an accruals basis.
"Fixed price repos and their accountancy treatment
"Accounting by the buyer [DCC]
Dr Loan receivable
Cr Cash
Dr Loan receivable
Cr Profit and loss account – interest receivable
Dr Cash
Cr Amount owing to seller
Dr Amount owing to seller
Cr Cash
Dr Cash
Cr Loan receivable"
And it will be seen that the only sum which represents profit or loss is the £1.8m finance cost earned on the "secured loan".
"4.14 Summary, therefore, the expected accounting entries made by the seller, in respect of a fixed price repo, where the proceeds from any coupon or dividend are passed immediately to the seller by the buyer are as follows.
Dr Cash
Cr Secured loan
Dr Profit and loss account – interest payable
Cr Secured loan
Dr Cash
Cr Coupon or dividend accrual in respect of the security
Dr Secured loan
Cr Cash"
And again the only entry which reflects profit or loss is the finance cost of £1.8m.
"Section 730A and s737C ICTA 88
"8.10 I understand that the debits and credits arising under FA 96 in respect of the application of s730A and s737C ICTA 88 are not under dispute. However for completeness my conclusions are summarised below. Based on the assumptions used in this report, in my view, the credit DCC would recognise in its profit and loss account in respect of the deemed interest receivable under s730A and s737C ICTA 88 either:
(i) first because it is dealt with tangentially in Mr Holgate's evidence;
(ii) because it illustrates the proper approach to the determination of any tax debit or credit arising in respect of interest on the gilts;
(iii) importantly because it also illustrates what seems to me to be the proper approach also to the provisions of section 97, in circumstances where the arguments are less complex; and
(iv) because it illustrates the fallacy of assuming that because the legislation deems something to be interest or interest on a loan relationship, that such deeming is qualitatively different from a provision which defines a loan relationship. If the statute said "rabbits are loan relationships" we should have to search for the accounting entries for rabbits. Section 730A does no more than that.
The effect of section 97
(i) it applies if B buys stock from A after the record date for payment of interest on the stock but before the date of payment and on terms that A will account to B for the interest when received. The payment A makes to B will be manufactured interest falling within section 97(1)(a), and A's debit and B's credit will be created through the operation of section 97;
(ii) it also applies to a gross paying repo when the interim holder (X) actually pays the original owner (Y) of the stock the interest X receives.
"… the manufactured payment shall be treated for the purpose of this chapter:
(a) as if it were interest under a loan relationship to which the company is a party; and
(b) where the company is the recipient of the payment as if that loan relationship were the one under which the real interest is payable."
"Where section 737A(5) of the Taxes Act 1988 (deemed manufactured payments) has effect in relation to a transaction relating to an asset representing a loan relationship so as, for the purposes of . . . Schedule 23A to, that Act, to deem there to have been a payment representative of interest under that relationship, this section shall apply as it would have applied if such a representative payment had in fact been made."
(i) circumstances which give rise to the section 737A manufactured interest of £28.8m (the section 97(4) circumstance);
(ii) the actual coupon received of £28.8m;
(iii) the section 730A deemed interest of £1.8m on the transaction.
(i) nil (because there is no amount representing this payment);
(ii) nil (because there is no amount representing this interest benefit); and
(iii) £1.8m (because it is represented by the finance cost).
The Position of X Bank
(i) the relevant transactions are identified - namely the repo;
(ii) there are no counter factual assumptions to make;
(iii) the accounting evidence is that X Bank will recognise in proper accounts:
(a) a finance cost of £1.8m on the economic loan represented by the repo;
(b) interest on the gilts throughout the term for which they are treated as held. For present purposes I take this to be the term of the repo so that the accrual will be £2.9m;
(c) no profit or loss in respect of the disposal and acquisition of the gilts.
(iv) the relevant loan relationship events for the purposes of section 84 are:
(a) the receipt of a loan on which interest of £1.8m is paid (as a result of the deeming in section 730A);
(b) the receipt of £28.8m interest on the gilts (as a result of section 97(2)(b) and more generally section 84).
(v) the authorised accounting method as respects these events is the actual method used in the proper accounts as respects each of those loan relationship events. That method has been applied in reaching the amounts in (iii) above;
(vi) the identification of the sums:
(a) the finance cost of £1.8m represents the interest on the section 730A loan. It is a cost and therefore a debit;
(b) the interest accrued in the accounts of £2.9m represents the interest on the gilts. It is a profit and therefore a credit.
Although £28.8m has been received, the accrual for the period of the repo (which I am assuming for the present purposes is the period for which the gilts are economically held by X Bank) is only £2.9m. That is the profit recognised for that period in the accounts in respect of the gilts: it is therefore the "sum" which represents the interest on the gilts. £28.8m is the interest received for the purposes of Chapter II but not the sum which represents the interest for the period; that is £2.9m.
(vii) there are no variations required to these amounts by the legislation.
Does this analysis make the provisions of paragraph 15 and section 97 redundant?
(i) because no gains or losses were recognised in the proper accounts in respect of the acquisition and disposal treating the injunction in paragraph 15 as merely requiring any gains and losses to be ignored makes it otiose;
(ii) because interest of £2.9m is treated as accrued by X Bank in its accounts on the gilts, treating section 97(2)(b) as simply requiring that actual recognition to be translated into Chapter II makes section 97(2)(b) otiose; and
(iii) because no amount is brought into its accounts by DCC as a profit or a loss in respect of either its actual receipt of the £28.8m or its transmission of the benefit of that amount to X Bank in the pricing of the repo, the requirements in section 97(2)(a) and 97(4) are otiose.
Fairness
(i) I am wrong in finding that the company's actual accounting method has been applied to either the gilts or the section 737A/section97 interest so that instead a free standing accruals method has to be applied (under section 85(4)); or
(ii) if section 97(4) produces a free standing debit which is not subject to the section 84 machinery.
Summary and Conclusion
(1) Neither paragraph 15, section 730A nor section 97 requires reality to be adjusted. No payments are deemed to be made which are not made, and no transaction is deemed to take place which does not take place and no transaction is deemed not to take place which does take place.
(2) DCC's accounting method was (or sufficiently equated to) an authorised accruals method and was used as respects:
(i) the gilt interest it received;
(ii) the circumstances giving rise to the section 730A loan;
(iii) the circumstances giving rise to the section 97 interest.
(3) The use of an accounting method as respects the circumstances giving rise to a deemed loan relationship event is the use of the accounting method as respects that event for the purposes of section 85. Therefore the actual accounts of DCC need to be interrogated to determine what sums arise in respect of those events.
(4) The sums which arise and which fairly represent those events are:
(i) nil in respect of the gilt interest received;
(ii) £1.8m credit in respect of the section 730A loan;
(iii) nil in respect of the section 737A deemed interest.
(5) Therefore the net credit arising to DCC is £1.8m.
CHARLES HELLIER
SPECIAL COMMISSIONER
RELEASE DATE: 8 May 2007
SC 3041/2006
Appendix
The Agreed Facts
All references herein to statutory provisions are references to the Income and Corporation Taxes Act 1988 ("ICTA 1988") or to the Finance Act 1996 ("FA 1996"), as amended. References to "TB" are to the Agreed Trial Bundle of Documents. "FRS" stands for Financial Reporting Standard.
The Master Agreements
(1) DCC and X Bank may, from time to time, enter into repurchase transactions ("repos") in UK Treasury stock ("gilts"). (Paragraph 1 of the Master Repurchase Agreement; Paragraph 1 of Annex I, Part 1; and Paragraph 2 of Annex I, Part II);
(2) Each such transaction being an agreement whereby one party, "the Seller", agrees to sell gilts to the other party, "the Buyer", for a specified purchase price with a simultaneous agreement by the Buyer to sell on a specified "repurchase date" (or, alternatively – if so specified – on demand) gilts of an identical type to the Seller for a predetermined, or predeterminable, repurchase price. (Paragraphs 1 and 3 of the Master Repurchase Agreement);
(3) Such transactions may be entered into either orally or in writing, but with a written confirmation to be delivered promptly by X Bank to DCC (and also by DCC, if DCC so opts). (Paragraph 3 of the Master Repurchase Agreement; and Paragraph 1 of Annex I, Part 1);
(4) Such confirmations, together with the terms of the Global Master Repurchase Agreement, shall constitute primâ facie evidence of the terms of any such transactions (unless objection to the confirmation is promptly made); and, in relation to each transaction the terms of the confirmation shall, in the case of any conflict, prevail over the terms of the Master Repurchase Agreement. (Paragraph 3 of the Master Repurchase Agreement); and
(5) One party can require the payment of margin (in the form of cash) by the other party, where there are outstanding repos and where the market value of the repo-ed gilts has altered, so that neither party is left with a significant financial exposure. (Paragraph 4 of the Master Repurchase Agreement; and Paragraphs 1 and 2 of Annex I, Part 1).
The Gilt Repos
(1) An agreement ("Repo 1") made on 28 August 2001 (and evidenced by a confirmation from X Bank dated 29 August 2001 that
(a) DCC buy from X Bank, on 30 August 2001, £149,000,000 (nominal)[1] of 10 % Treasury Stock 2003 for a purchase price of £170,240,597.83, and
(b) X Bank repurchase from DCC, on 10 September 2001, £149,000,000 (nominal) of 10 % Treasury Stock 2003 for a repurchase price of £163,029,167.87; the repurchase price being equal to the aggregate of the purchase price (£170,240,597.83) and interest thereon (for 11 days) at a rate of 4.65 per cent (£238,570.04), less the coupon receivable by DCC on the repo securities (£7,450,000).
(2) An agreement ("Repo 2") made on 5 September 2001 (and evidenced by a confirmation from X Bank dated 5 September 2001) that
(a) DCC buy from X Bank, on 10 September 2001, £131,300,000 (nominal) of 8 % Treasury Stock 2013 for a purchase price of £170,467,360.87, and
(b) X Bank repurchase from DCC, on 27 September 2001, £131,300,000 (nominal) of 8 % Treasury Stock 2013 for a repurchase price of £165,572,641.78; the repurchase price being equal to the aggregate of the purchase price (£170,467,360.87) and interest thereon (for 17 days) at a rate of 4.50 per cent (£ 357,280.91), less the coupon receivable by DCC on the repo securities (£5,252,000).
(3) An agreement ("Repo 3") made on 25 September 2001 (and evidenced by a confirmation from X Bank dated 25 September 2001) that
(a) DCC buy from X Bank, on 27 September 2001, £133,500,000 (nominal) of 9 % Treasury Stock 2008 for a purchase price of £170,822,004.10, and
(b) X Bank repurchase from DCC, on 15 October 2001, £133,500,000 (nominal) of 9 % Treasury Stock 2008 for a repurchase price of £165,180,952.40; the repurchase price being equal to the aggregate of the purchase price (£170,822,004.10) and interest thereon (for 18 days) at a rate of 4.35 per cent (£366,448.30), less the coupon receivable by DCC on the repo securities (£6,007,500).
(4) An agreement ("Repo 4") made on 11 October 2001 (and evidenced by a confirmation from X Bank dated 11 October 2001) that
(a) DCC buy from X Bank, on 15 October 2001, £138,300,000 (nominal) of 6¾ % Treasury Stock 2004 for a purchase price of £150,000,068.76, and
(b) X Bank repurchase from DCC, on 26 November 2001, £138,300,000 (nominal) of 6¾ % Treasury Stock 2004 for a repurchase price of £146,000,416.67; the repurchase price being equal to the aggregate of the purchase price (£150,000,068.76) and interest thereon (for 42 days) at a rate of 3.87 per cent (£667,972.91), less the coupon receivable by DCC on the repo securities (£4,667,625).
(5) An agreement ("Repo 5") made on 23 November 2001 (and evidenced by a confirmation from X Bank dated 26 November 2001) that
(a) DCC buy from X Bank, on 26 November 2001, £127,600,000 (nominal) of 8½ % Treasury Stock 2005 for a purchase price of £150,663,107.00, and
(b) X Bank repurchase from DCC, on 7 December 2001, £127,600,000 (nominal) of 8½ % Treasury Stock 2005 for a repurchase price of £145,397,209.41; the repurchase price being equal to the aggregate of the purchase price (£150,663,107.00) and interest thereon (for 11 days) at a rate of 3.46 per cent (£157,102.41), less the coupon receivable by DCC on the repo securities (£5,423,000).
(1) In respect of Repo 1, £7,450,000 on 10 September 2001
(2) In respect of Repo 2, £5,252,000 on 27 September 2001
(3) In respect of Repo 3, £6,007,500 on 15 October 2001
(4) In respect of Repo 4, £4,667,625 on 26 November 2001
(5) In respect of Repo5, £5,423,000 on 7 December 2001
Accounting treatment
The Assessment and the Appeal
Note 1 “£[X] (nominal)” is used here to denote that the nominal (i.e. face) value of the relevant Treasury Stock was £[X]. [Back] Note 2 In relation to Repo 2, Repo 3, Repo 4 and Repo 5, the relevant purchase price was paid, in whole or in part, by way of being set off against other amounts due to the Appellant from X Bank on the relevant purchase day. [Back]