In Explainaway Ltd v HMRC [2012] UKUT 362, the Upper Tribunal has reversed the FTT’s decisions that the principle in FA & AB Ltd v Lupton [1972] AC 634 did not apply to transactions in derivatives undertaken as part of a tax avoidance scheme and that a loss, although cancelled out by a gain as required by that scheme, was an allowable loss, because the scheme unexpectedly failed to eliminate the gain. However, it confirmed the FTT’s decision that there were no commercial uncertainties in the extended part of the scheme of the kind which would preclude a finding that it was a composite transaction.
The essential (and somewhat simplified) facts of Explainaway are: Paul Rackham Ltd (PRL) held shares in Waste Recycling Group PLC (WRG), which it wished to sell for £9.7m during its accounting period ending on 31 December 2001, thereby realising a gain of about £9m. PRL sought tax advice from Deloitte on this disposal and agreed to implement their CGT mitigation scheme called the ‘company derivative plan’. The following steps took place under the scheme.
Plan A: In March 2001, PRL sold the WRG shares to its wholly owned subsidiary, Explainaway, for £9.7m and, in April 2001, Explainaway sold the WRG shares in the open market for £9.4m. As it had inherited PRL’s base cost on the intra-group transfer, Explainaway realised a gain of £8.6m.
On 17 July 2001, Explainaway entered into two FTSE 100 LIFFE futures contracts (one long and one short), each with a notional value of £174m, an eight-month term and an early termination option. If the FTSE 100 rose, Explainaway would make a gain on the long contract and, if it fell, a loss, in either case based on the percentage rise or fall. The converse applied to the short contract.
The notional value of £174m was set such that a rise or fall of 3% in the FTSE 100 would produce a loss of £8.7m on the loss contract. The plan was to close out the loss contract before 31 December 2001 at a loss of as near to £8.7m as the market would allow.
On 6 September 2001, Explainaway closed out the July long contract at a loss of £8.7m (the FTSE 100 having fallen). It claimed to set that loss against its gain on the WRG shares. It did not close out the short contract (which stood at a gain of £8.7m) but ‘locked in’ that gain by acquiring a matching long contract.
The plan was for PRL to sell Explainaway to a capital loss company which could shelter its gain on the July short contract. However, it proved impossible to find such a buyer on acceptable terms. Accordingly, PRL accepted an alternative planning arrangement proposed by Deloitte.
Plan B: Explainaway acquired two new subsidiaries, Quoform Ltd and Quartfed Ltd.
On 26 February 2002, Explainaway closed out the July short contract and its matching September long contract, thereby realising the ‘locked in’ gain of £8.7m.
On 26 February 2002, Quoform acquired a long FTSE 100 contract with a notional value of £174m and a four-month term.
On 26 February 2002, Quartfed sold a short FTSE 100 contract with a notional value of £174m and a four-month term.
On 7 June 2002, the Quoform long contract was novated to Quartfed. Quartfed closed it out at a loss of £8.6m. Quartfed also closed out its short contract at a gain of £8.6m. This appears to have enabled Quartfed to eliminate tax on the gain on its short contract by offsetting the loss on the novated long contract.
On 20 June 2002, Quartfed paid a dividend of £8.5m to Explainaway. This eliminated Explainaway’s unrealised gain on its Quartfed shares. Explainaway sold its shares in Quoform to an unconnected third party for £10, thereby realising a loss of £8.8m. Explainaway claimed to set this loss against the ‘locked in’ gain of £8.7m which it had made on its Plan A short contract.
For the gains and losses on the derivatives to constitute chargeable gains and allowable losses for CGT purposes, the gains had to be, apart from TA 1988 s 128, chargeable to tax under Sch D otherwise than as the profits of a trade (TCGA 1992 s 143). This meant that they had to fall within Sch D Case VI (following Cooper v Stubbs 10 TC 29). HMRC argued, by analogy with Lupton, that the gains on the derivatives did not fall within Case VI and, accordingly, s 143 did not have the effect of bringing them within the charge to CGT.
Lupton was concerned with whether a transaction was carried out in the course of trade. Trading generally involves the provision of goods or services on a commercial basis with a view of profit. Lupton held that, where the only purpose of a transaction which has the trappings of trade is to establish a claim against the Revenue and the transaction is denatured by its overriding fiscal objectives, it is not a trading transaction. Rather, it is ‘tax planning machinery’. HMRC argued that, unlike the transactions in Cooper v Stubbs, the Plan A derivatives were not entered into for ordinary commercial purposes and with a view of profit, as they were deliberately matched to cancel each other out. The only ‘view’ was fiscal. They were stripped of their ordinary commercial character as speculative or risk-hedging transactions. Accordingly, their gains and losses did not have the character of income and did not fall within Case VI. The Upper Tribunal agreed.
Has HMRC scored an own goal? Does this decision have wider ramifications beyond speculative derivative transactions? Case VI (now ITTOIA 2005 s 687), which is a ‘sweeping-up’ provision, applies in particular to casual profits arising, not from trade, but from services provided for reward under a contract. Explainaway arguably decides that, if tax considerations crowd out any view of reward, Case VI will not apply. Has it, therefore, narrowed the sweep of the Case VI broom? It is an intriguing question which the Upper Tribunal does not answer. Only time will tell.
The decision on Lupton was sufficient to dispose of the appeal but the Upper Tribunal went on to consider these aspects of the Ramsay principle: (i) self-cancelling transactions, and (ii) the effect of contingencies and uncertainties on composite transactions.
Self-cancelling transactions: Ramsay had decided that, for a loss to be an allowable loss for CGT purposes, it had to be a ‘real’ loss and that a loss which was intended to be cancelled out by a profit as part of an indivisible process with no commercial purpose was not such a loss. Nevertheless, the FTT held that the profit and loss on the plan A derivatives should be respected. It would have been different if the gain on the plan A short contract had been eliminated, leaving the loss on the plan A long contract as a tax loss but not a commercial loss. The Upper Tribunal disagreed. The gain on the short contract was cancelled out by the loss on the long contract and neither had any commercial reality. Explainaway was never exposed to any real financial loss. This conclusion was not affected by the fact that the planned sale of Explainaway under plan A did not come to fruition. Accordingly, the loss on the long contract could not be set against the gain on the WRG shares.
Composite transactions: The FTT held that there was no practical likelihood that the shares in either Quoform or Quartfed would not be devalued under plan B and/or that the devalued shares (in, as it turned out, Quoform) would not be sold. Not effecting that sale would leave Explainaway’s ‘locked in’ gain on the Plan A short contract unsheltered and there was a market for such companies. The loss on the Quoform disposal was not, therefore, a ‘real’ loss, as it was cancelled out by the gain on the Quartfed shares as part of the same indivisible process, and, accordingly, it could not be set against the ‘locked in’ gain.
Explainaway objected that the treatment of Plan B as a composite transaction was precluded by commercial uncertainties (see Craven v White [1989] AC 398). It was not known at the outset: (i) whether the market would rise or fall enough to generate a loss sufficient to fully offset the ‘locked in’ gain, or (ii) whether a buyer for Quoform or Quartfed would or could be found.
The Upper Tribunal disagreed. The nominal value of the contracts had been carefully chosen to produce a loss of the order of £8.7m and it was a practical certainty that a buyer would be found for Quoform or Quartfed. This was a very different case from Craven v White.
Effectively, Explainaway follows Schofield v HMRC [2012] EWCA Civ 927 in holding that a scheme with a pre-ordained outcome is not prevented from being a composite transaction by the fact that parts of the process (e.g. which of two derivatives would be closed at a loss) depended on unpredictable, external factors. This is no more than an application of the decision in SPI.
It seems that, as regards the need for the identity of the purchaser of an asset to be known at the outset (not a point pressed by Explainaway), a distinction must be drawn between a disposal which must form part of a composite transaction and a disposal from A to C through an intermediary B. Ramsay shows that, for two disposals to be self-cancelling, they must both be pre-ordained to occur as part of the same indivisible process. It is, however, irrelevant who the purchaser is. Not seeking a buyer at the outset is an anti-Ramsay device which can be disregarded. This approach has been followed in Eyretel and Astall, and now in Explainaway. By contrast, Craven v White shows that, for a tripartite disposal to be treated as having been made directly from A to C (disregarding B), it is likely to be essential for C to have been identified at the time of the intermediate transfer from A to B. It may be intellectually impossible to analyse a transaction as a single disposal from A to C if A transfers an asset to B and B then goes into the market looking for a purchaser, however certain it may be that he will find one (per Lord Oliver, at 508).
Explainaway is an important case which has imported Lupton into Case VI (creating uncertainty as to how far it goes), has decided that a loss which, being cancelled out by a gain, has no commercial reality is not transformed into a ‘real’ loss by the unexpected failure of the scheme to eliminate the gain and has reinforced the existing case law on the extent to which commercial uncertainties preclude a finding of a composite transaction.
