GDF Suez Teesside and the ‘fairly represent’ rule

The case of GDF Suez Teesside Ltd (formerly Teesside Power Ltd) v HMRC [2015] UKFTT 0413 (TC) (reported in Tax Journal, 4 September 2015) considered HMRC’s longstanding contention that FA 1996 s 84(1) permits a company’s accounting treatment to be overridden for corporation tax purposes in certain circumstances. The taxpayer Suez Teesside (TPL) argued that this was to change the amounts actually brought into account for tax purposes, rather than to perform an allocation role on the amounts recognised in the accounts. 

 

The case was heard by the First-tier Tribunal (FTT) on 13–15 April at the Royal Courts of Justice in the Strand before Judge Rachel Short and Mr Nigel Collard (sitting as a member of the FTT); and their decision was released on 11 August. TPL’s appeal related to taxable profits amounting to approximately £200m. HMRC contended that these should be brought into account by the company, for the purposes of the corporation tax regime for loan relationships in FA 1996 Part IV Chapter II (the loan relationships rules), in its accounting periods ended 5 December 2006 and 30 September 2007. This was said to be the consequence of the transfer of certain loan relationships to a wholly owned Jersey -resident subsidiary, Teesside Recoveries and Investments Ltd (TRAIL), in exchange for ordinary shares. The loan relationships arose from TPL’s claims against various Enron group companies in respect of Enron’s failure, following its collapse, to perform obligations under long-term agreements to purchase electricity from TPL. HMRC and TPL agreed that the claims fell to be treated as creditor relationships for corporation tax purposes. 

 

Pursuant to a scheme disclosed under the disclosure of tax avoidance scheme (DOTAS) rules between 1 December 2006 and 2 March 2007, TPL assigned the claims to TRAIL in exchange for ordinary shares. This constituted a ‘related transaction’ (an acquisition or disposal of rights under a loan relationship) under the loan relationships rules. As the loan relationships constituted contingent assets under UK GAAP, they were not recognised for accounting purposes in TPL’s balance sheet prior to the assignment to TRAIL, while no profit or loss was recognised for accounting and corporation tax purposes by TPL on the transfer to TRAIL. This resulted, overall, in the value of the assets at the time of transfer escaping the charge to corporation tax. 

 

It is unclear how TRAIL was regarded under the CFC rules: the DOTAS disclosure apparently referred to ‘a step-up’. The claims were subsequently monetised for £243m by TRAIL, which was subsequently liquidated by its shareholder. HMRC issued closure notices in August 2013 to include profits of £200m in respect of the transfer. TPL appealed the matter to the FTT. 

 

The FTT was asked to consider four questions:

 

 

TPL’s accounts for the period ended 5 December 2006 were subject to independent audit, and the auditors confirmed that the financial statements gave a true and fair view in accordance with UK GAAP of the state of the company’s affairs as at 5 December 2006 and its profits for the period. TPL did not recognise a value for the loan relationships prior to their transfer, because they constituted contingent assets. The applicable accounting rules did not permit the company to recognise value for the assets in the company’s balance sheet. HMRC agreed with this treatment. 

 

TPL did not recognise value in respect of the shares of TRAIL because, on the basis of the substance of the transactions in accordance with FRS 5, TPL’s economic position was unaffected by the transfer. The future economic benefits arising from the TRAIL shares flowed exclusively from future realisation of the self-same contingent assets – the shares were a ‘wrapper’ for the contingent assets (TRAIL was a wholly owned subsidiary under the control of TPL with no other assets). 

 

HMRC contended that TPL’s accounts were not GAAP compliant; and that an alternative accounting method existed, by which an unrealised gain could have been recognised in the company’s statement of total recognised gains and losses (STRGL). 

 

The FTT concluded that the evidence of TPL’s expert witness, former Deloitte partner Ken Wild, should be accepted, and that the relevant accounting principles had been correctly applied by TPL to produce GAAP compliant accounts for the disputed accounting periods. 

 

The FTT did not consider that HMRC had made out its case that an alternative UK GAAP compliant treatment existed (consisting of recognising a gain in the company’s STRGL). Quoting from Mann J’s decision in Greene King Plc v HMRC [2014] UKUT 0178 (TCC), the FTT also did not agree that s 84(1) permitted any such alternative to be substituted for the GAAP compliant method actually used. This determined the first three questions in the company’s favour.

 

 

Under the loan relationships rules, profits and gains arising from a company’s loan relationships are computed using the credits and debits given by the regime’s various computational provisions. The first of these is s 84(1): 

 

 

The ‘sums’ are given by FA 1996 s 85A (computation in accordance with GAAP), which refers in sub-s (1) to the amounts recognised in accordance with GAAP in determining the company’s profit or loss for the period. This is itself determined in accordance with FA 1996 s 85B by directly including amounts recognised in a company’s profit and loss account or income statement, the STRGL or certain other performance statements for a period of account. Per s 85A(1), the included amounts are subject to the computational provisions of the Chapter and, in particular, the ‘fairly represent’ rule. 

 

The ‘fairly represent’ rule operates to bring ‘sums’ – the starting point for which is amounts recognised in accordance with GAAP per s 85A – into account as debits and credits. The sums are those that, when taken together, fairly represent ‘for the accounting period in question’ (as distinct from the financial statements’ period of account) profits, gains and losses arising from ‘loan relationships’ and ‘related transactions’. It must be borne in mind that the accounts-derived data relate to accounting concepts of assets, liabilities, and profits and losses of a period of account, and these might correspond only imperfectly with the tax correlatives of accounting periods, loan relationships and related transactions. 

 

Counsel for the taxpayer argued that the ‘fairly represent’ wording in s 84 could only be used to allocate amounts recognised in accordance with GAAP between accounting periods, or to deal with a situation in which accounting profits had to be allocated partly to the loan relationship code and partly elsewhere. Counsel asserted that the rule did not permit the creation of a freestanding credit, particularly in circumstances such as those of the present case. 

 

Counsel did not consider that the decision in DCC Holdings (UK) Ltd [2010] UKSC 58 was authority for creating profits beyond those produced by an ‘authorised accounting method’ (this referred to an earlier computational methodology, where amounts were not directly included from the accounts). Neither did counsel consider that any statutory basis existed for HMRC to depart from a company’s GAAP compliant accounts. If that was the intended effect of s 84(1), legislative guidance would be necessary to clarify when the override should apply and how amounts should be determined. 

 

On behalf of HMRC, Mr David Milne QC accepted that the starting point was the company’s GAAP accounts. However, he said, the ‘fairly represent’ rule was an understandable ‘long stop’ to ensure that profits arising from loan relationships did not fall out of tax, merely because they were not reflected in the company’s accounts. 

 

Counsel said that this was in accordance with the approach in DCC Holdings, and that this was the effect of the insertion in 2006 of the statutory language expressly making s 85A subject to the ‘fairly represent’ rule. If it was accepted that the ‘fairly represent’ rule operated to allocate part of accounting amounts to loan relationship profits and gains for an accounting period, it should likewise apply in circumstances where none of the accounting profits fairly represent the company’s profits, gains and losses.

 

The FTT criticised the approach of counsel for the taxpayer for producing a hermetically sealed version of s 84 into which only accounting profits were allowed. The FTT said that there was nothing in the legislation to suggest that the requisite ‘fairness’ was referable only to the allocation or attribution of profits. The FTT accepted that no profits arose from the transaction under GAAP; however, it did not agree that this was sufficient when a transaction had been structured to ensure that profits were eliminated or deferred for tax purposes by relying on accounting rules. 

 

The FTT said that on any realistic commercial approach to the transaction, the loan relationships were monetised by TPL when exchanged for shares in TRAIL. The FTT noted that the loan relationships were valued at approximately £200m and said that this was non-contingent. The FTT concluded that £200m of profit should be recognised for the purposes of the loan relationships, applying the ‘fairly represent’ rule to bring in the associated credits in respect of TPL’s related transaction. 

 

The FTT referred to Stanton v Drayton Commercial Investment Co Ltd [1982] STC 585) to support the conclusion that the value of the shares issued should be taken as consideration for tax purposes. Responding to TPL’s suggestion that it was not possible to generate a credit which was not derived from the company’s accounting profits, the FTT said that it could be viewed as accelerating credits, which would otherwise be recognised in a later accounting period (when ultimately, profits were realised from the investment in TRAIL). However, the FTT decided that the ‘fairly represent’ rule could go further than allocation to accounting periods and look at a wider picture in determining a fair representation of profits.

 

The FTT noted concerns with allowing the application of a subjective accounting principle to be relied upon in the context of a DOTAS reported transaction. The FTT viewed FRS 5 as leading to a recharacterisation which ignored the separate legal identity of the companies. The FTT stated that this was its starting point in concluding that the GAAP compliant accounts of TPL did not give a fair representation of the profit arising to TPL from the disposal of the loan relationships. 

 

Objections were raised that the approach was contrary to the accounts-driven approach of the loan relationship rules, and to the significance accorded to commercial accountancy evidence in questions of profit determination. The FTT responded that the current case was abnormal, in that it was a structured transaction in which the accounting rules had been used in order both to defer and potentially remove profits from the UK tax net. The authorities contained caveats that the profits must not be ‘inconsistent with the true facts or otherwise inapt to determine the true profits or losses of the business’ (Gallagher v Jones [1993] STC 537, Bingham MR at p 556). 

 

The FTT acknowledged that its decision applied the ‘fairly represent’ rule as an anti-avoidance provision; and noted that this was in line with the proposed Finance Bill 2015 changes to the loan relationships regime.

 

 

Strictly, the loan relationships were monetised only in the hands of TRAIL after the transfer: they were not ‘monetised’ by the transfer for shares. It is not clear why the valuation of the creditor relationships on transfer should be regarded as fairly representing the profit arising from the related transaction, in the face of accountancy evidence that was accepted by the tribunal. The reference to Stanton v Drayton would appear more relevant in a capital gains context. It may also be noted that specific provision (FA 1996 Sch 9 para 11B) was made in 2008 to address the avoidance potential of transactions of this kind. 

 

The result would not seem to constitute acceleration of the profits arising from TPL’s related transaction, as such. The profits recognised when the loan relationships were monetised were in different amounts, in respect of different related transactions, and obtained by a different company (TRAIL). TPL’s profits from the ultimate disposal of the shares of TRAIL, or any dividends, would not have arisen as loan relationship profits from TPL’s related transaction. 

 

It does not appear that the legal form of the transaction was ignored by the accounting treatment, or that the assets of TRAIL were treated as assets of TPL. The accounting treatment involved the derecognition of the loan relationships by TPL; and the recognition (at nil cost) of the shares of TRAIL. FRS 5 was relevant in that it governed the amount – nil – at which the loan relationships were derecognised and the shares of TRAIL recognised. 

 

The FTT’s hostility to using the accounting approach for tax purposes stems from the fact that the transactions implemented a DOTAS scheme that depended upon the (GAAP compliant) accounting treatment. The tribunal acknowledged it was using the ‘fairly represent’ rule as such an anti-avoidance provision, but the rule is not drafted as such. On the contrary, it is the regime’s fundamental computational rule – the linchpin between the accounting and tax treatment. The FTT’s decision (if upheld) inevitably creates uncertainty regarding the tax treatment of loan relationship transactions.

 

The Finance Bill 2015 reshapes the fundamental computational rules and dispenses with the ‘fairly represent’ rule – essentially to eliminate uncertainty regarding the scope of the rule. Various anti-avoidance rules are repealed and replaced by a wide ranging but purpose driven regime anti-avoidance rule. It is not the case that the latter specifically replaces the ‘fairly represent’ rule. The computational rules are primarily focused on amounts recognised in profit and loss in GAAP compliant accounts. Interestingly, specific provision is made for cases where loan relationships are ‘wrapped’ within non-loan relationship instruments. However, it is unclear how any of this aids interpretation of the historic ‘fairly represent’ rule. 

 

 

If enacted, the reformed loan relationships rules will not include the ‘fairly represent’ rule. Thus the proposed reform may mean that the FTT’s decision only materially impacts future litigation of similar cases involving the ‘fairly represent’ rule. In this respect, there are a number of areas where the FTT’s decision could usefully be reviewed by the higher courts, if it is subject to appeal in due course.