Anthony and Tracy Hancock v HMRC is a recent First-tier Tribunal decision in which the taxpayers managed to avoid CGT on most of the proceeds of selling their company. They were able to exploit a defect in the entry conditions of TCGA 1992 s 116, converting a mixed holding of qualifying and non-qualifying corporate bonds into qualifying corporate bonds which were exempt from capital gains tax on redemption. The case illustrates the limits of both the Ramsay doctrine and the purposive construction of legislation. It remains to be seen whether HMRC will appeal and/or change the law.
In Anthony and Tracy Lee Hancock v HMRC (TC 03816), the First-tier Tribunal decided in favour of the taxpayers on a planning scheme involving the conversion of non-qualifying corporate bonds (non-QCBs) into QCBs following a reorganisation. (All statutory references in this article are to TCGA 1992.)
Mr and Mrs Hancock sold their company in August 2000 for £9.27m and an earn-out. Mr and Mrs Hancock received £4.1m and £4.6m B loan notes, respectively. It was agreed that the loan notes were non-qualifying corporate bonds.
The exchange of shares for non-QCBs is treated as not involving a disposal (ss 135 and 127), so that the loan notes stood in the shoes of the original shareholdings. Capital gains tax accrues only when the loan notes are redeemed or otherwise disposed of. This treatment depends on a bona fide commercial purpose for the transactions, which would have been the sale of the business, and not an intention to avoid capital gains tax or corporation tax. It seems that this treatment was accepted by HMRC and nothing in the report suggests that any planning was in contemplation at that time.
Mr and Mrs Hancock received a further £477,000 B loan notes, each from the earn-out on 22 March 2001. The earn-out is also treated as not involving a disposal, so that the new B loan notes stood in the shoes of the original shareholdings (TCGA 1992 s 138A treats the earn-out as a non-QCB and the pay-out in non-QCBs is treated as a conversion into new non-QCBs, by s 132). By March 2001, Mr and Mrs Hancock held c £9.7m B loan notes. Substantial capital gains would have arisen on the redemption of the loan notes at face value.
The B loan notes were redeemable in 2004, with the right to early redemption. The Hancocks decided, in 2002, that they wanted to redeem them early and their accountants, Haines Watts, suggested that tax planning might be available, with the cooperation of the issuers of the loan notes. It appears that PricewaterhouseCoopers was also involved.
The planning required that the £477,000 B loan notes that Mr and Mrs Hancock had each received in March 2001 should be converted to qualifying corporate bonds by a deed of variation, which was executed on 9 October 2002. This is a conversion of a security, so that the ‘Revised B loan notes’ would be treated as if they were the same loan notes that they had been previously (ss 132 and 127). However, since QCBs are exempt from CGT (s 115), s 116 provides that where a non-QCB (i.e. shares or loan notes) is treated by s 127 as being reorganised into a QCB, the capital gain arising on disposal of the non-QCB is computed and held over until the QCBs are redeemed or disposed of. This means that the gain has crystallised and the capital gains tax becomes payable, even if the QCBs become worthless and no redemption proceeds are received.
Therefore, the analysis of the conversion of the newer B loan notes into the Revised B loan notes is that the gain that would have accrued, on a disposal of the £477,000 B loan notes that Mr and Mrs Hancock each held, was computed and held over until the Revised B loan notes were redeemed or otherwise disposed of. This step was clearly part of the tax avoidance scheme. Crucially, though, s 132 does not require a bona fide commercial purpose and does not have a tax avoidance motive test like that for s 135.
Mr and Mrs Hancock now had a mixed holding of non-QCB original B loan notes and Revised B loan notes that were QCBs. On 7 May 2003, all of these were exchanged for Secured Discounted Loan Notes (SDLNs), which were also QCBs. These were redeemed on 30 June 2003, with the associated redemption premium.
The Hancocks’ argument was based on the wording of s 116(1)(b), which says that s 116 applies if ‘the original shares would consist of or include a qualifying corporate bond and the new holding would not’ (emphasis added). For these purposes, the ‘original shares’ is the portfolio of B and Revised B loan notes held originally, and the ‘new holding’ is the SDLNs. Since the original shares included QCBs and non-QCBs but the new holding was wholly non-QCBs, the Hancocks argued s 116(1)(b) did not apply and that s 116(10) could not apply to the conversion into SDLNs.
The result of this argument is that the exchange of the mixed B loan notes into SDLNs is a tax-free conversion within s 132, and the disposal of the SDLNs is exempt from capital gains tax under s 115, as they are QCBs.
HMRC argued that the QCBs and non-QCBs must be treated separately, so that tax arose in respect of both sets of B loan notes, as follows:
Alternatively, HMRC argued that the Ramsay doctrine applied to ignore the conversion of the mixed B loan note holding into SDLNs, so that the B loan notes and Revised B loan notes were treated as being disposed of directly. Gains would accrue on the non-QCB B loan notes as a normal disposal. The gain previously computed under s 116(10)(a) would come into charge on the Revised B loan notes under s 116(10)(b).
HMRC highlighted that the scheme of CGT largely deals with assets individually, before aggregating gains and losses in a period. The tribunal said that the legislation on reorganisations and conversions of capital clearly contemplate the rules being applied to mixed holdings: s 126 refers to holdings of shares of more than one class; s 127 refers to shares and debentures being treated as a single asset; s 130 refers to mixed holdings of shares or debentures of more than one class or, indeed, more than one company; and s 116 itself refers, as we have already seen, to mixed holdings including QCBs.
The tribunal disagreed with HMRC’s arguments that the loan notes should be treated separately for tax purposes, as the words of s 116(1)(b) were clearly ‘couched in terms that recognise the possibility of the “original shares” not being wholly comprised of a QCB or a non-QCB’. HMRC suggested that this wording had been put in place to cover the transitional arrangements when the legislation was introduced in 1984. This was dismissed, on the basis that if that had been Parliament’s intention, it would have been ‘straightforward’ to draft the legislation accordingly.
The tribunal could not ‘ignore the clear words, and seek to rewrite legislation based on what might be discerned as the true result intended by Parliament’ and it did ‘not consider that s 116(1)(b) can be construed otherwise than on its own terms’. In other words, although the tribunal considered it unlikely that Parliament intended the result argued for by the Hancocks, it was not possible to construe the clear words of the legislation in any other way. It also said that ‘no purposive construction can fill the gap created by the fact that certain circumstances that might be thought to have been intended to be within s 116 fall outside it according to the clear words of s 116(1)(b)’, as it did not see ‘that the language of s 116(1)(b) admits of an interpretation that can avoid what may be perceived as an injustice or absurdity’. This was a case ‘where an anomaly cannot be avoided by any legitimate process of interpretation’.
On the Ramsay argument, HMRC submitted that, construing the legislation purposively and viewing the facts realistically, the conversion of securities on 5 May 2003, followed by the redemption on 30 June, should be treated as a single transaction. While the tribunal accepted the inevitability of the redemption of the SDLNs, they did genuinely exist and they were always going to be redeemed eventually. Viewed realistically, the conversion and the redemption could not be conflated and the transaction could not be viewed realistically as the direct redemption of the B and Revised B loan notes.
The tribunal then looked the legislation purposively. It said that these provisions provide a rational system of taxation, delaying the payment of tax until securities are eventually sold or redeemed. Section 116 was part of that system, ensuring that where the instruments concerned were tax exempt QCBs, a tax liability could not be avoided. The tribunal also noted that the conversion of securities rules (s 132) did not require a commercial reason for the transactions and had no tax avoidance test. It decided that it did ‘not consider that a purposive construction of the reorganisation provisions, including s 132, can produce any different result merely on the basis that the transactions that have been entered into were intended, for tax avoidance purposes reasons, to exploit an anomaly in the application of those rules’.
The tribunal also noted that HMRC’s approach was more akin to the old-style Ramsay doctrine, whereby steps could be ignored or conflated in tax avoidance cases. This approach, however, was overturned in BMBF v Mawson [2005] STC 1, decided by the House of Lords.
The tribunal’s decision could be summarised by their comment that ‘the gap in the legislation ... is not capable of being plugged by a process of purposive construction, nor by applying a broad spectrum antibiotic by means of disregarding any element of those transactions’.
It seems likely that HMRC will seek leave to appeal this decision, as there are probably more cases involving this planning. I think the purpose of the words in s 116(1)(b) is clear and my guess is that the technical decision will not be overturned. But the approach of construing purposively and viewing realistically is possibly open to a wider range of interpretation, so another court might decide that the inevitability of these steps, the short life of the SDLNs, and the intention to avoid tax are sufficient to allow a different decision.
HMRC may also seek to change the law, perhaps changing the threshold provisions of s 116(1)(b). Another simpler possibility would be to apply the same tests to a conversion of securities in s 132 as to a share exchange in s 135, to ensure that a conversion of securities is only within the reorganisation rules if it is carried out for bona fide commercial reasons and is not part of a scheme or arrangements to avoid capital gains tax or corporation tax. Had there been such a test in place already, this planning would have failed that test and the planning would have failed ab initio.
