The Upper Tribunal (UT) has granted the taxpayer’s appeal in W Reeves v HMRC [2018] UKUT 293. The taxpayer undertook a paradigm ‘enveloping’ transaction, and sought to rely on holdover relief for gifts to defer (or avoid) CGT. The First-tier Tribunal (FTT) denied the relief, albeit based on the arbitrary and seemingly irrelevant fact that Mr Reeves’ wife was non-resident. The UT found a way to disregard that feature, adopting an expansive approach to construction that may have implications well beyond the particular statutory context. Strikingly, the UT also held that (if he needs to) Mr Reeves can rely on his human rights to make the planning effective.
As predicted in my discussion of the First-tier Tribunal’s decision (see Tax Journal, 30 June 2017), this case on the anti-avoidance provisions relating to capital gains tax (CGT) holdover relief continues to cause real difficulties. On the literal wording of the legislation, Mr Reeves seemingly sailed through a strange-looking gap in the anti-enveloping provision (it did not apply because he held the envelope himself), only to be caught because of an obviously irrelevant personal detail (to do with his wife, who never even saw the envelope). Both HMRC and the taxpayer have good cause to find this state of affairs objectionable. The FTT found for HMRC, but the UT granted Mr Reeves’ appeal. Straying (in my view) into legislative rather than judicial territory, it felt able to construe the relevant provisions in such a way as to disregard the irrelevant personal details. More than that, it held that the arbitrary way in which, if read literally, the legislation would apply to Mr Reeves was unjustifiably discriminatory and thus breached his rights under the European Convention on Human Rights (ECHR). Consequently, if necessary, an appropriate restriction could be ‘read down’ into the provisions pursuant to s 3 of the Human Rights Act 1998, thereby reaching the same end result as its preferred ‘domestic’ construction.
At the time of the relevant transactions in 2010, Mr Reeves was neither resident nor ordinarily resident in the UK (‘non-resident’ for short). He was a 7% partner in an LLP called BlueCrest, which carried on a hedge fund business in the UK. As such, Mr Reeves was within the charge to CGT in respect of (his share of) those UK business assets, pursuant to TCGA 1992 s 10.
A plan was afoot to move the business to Guernsey. Without more, this would remove the assets from the territorial scope of CGT. If that happened, then the emigration charge in TCGA 1992 s 25 would deem a market value disposal, thereby capturing any latent gain at the point of the business’s migration.
Ahead of the move, Mr Reeves gifted his partnership interest to a new UK resident company called WHR, of which he was the sole shareholder. A claim was made for holdover relief under TCGA 1992 s 165. Because WHR was UK resident, migrating the business would now no longer remove (the 7% share of) the assets from the territorial scope of CGT, and so no emigration charge would arise. Meanwhile Mr Reeves could – and did, in 2011 – sell the shares in WHR without triggering any CGT: he was non-resident, and the shares were not a UK business asset. (Interestingly, the UT decision records that Mr Reeves paid US tax on ‘the gain’. The decision is not entirely clear on this, but it would seem that ‘the gain’ for US purposes may have reflected Mr Reeves’ full economic gain on the partnership interest, and not only any increase in the value of the WHR shares between 2010 and 2011. We might wonder, therefore, whether if Mr Reeves ultimately loses his battle in the UK, he could look to credit the UK tax against his US tax liability.)
It is not clear whether the subsequent disposal was in contemplation when Mr Reeves made his gift. In their effect, though, these steps amounted to a paradigm ‘enveloping’ transaction, as illustrated in the diagram below.
The provision in dispute in the case, TCGA 1992 s 167, was introduced by FA 1989 alongside a significant curtailing of the scope of holdover relief on gifts. Having been introduced for business assets only in 1978, the relief was significantly extended in the early 1980s. But in 1989, supposedly to reflect the changes to inheritance taxation in the meantime, the relief was cut back again so as to apply only to transfers of business assets.
Care was taken all along to deny the relief in cases where the transferee was non-resident (and this requirement remains in TCGA 1992 s 166, modified somewhat to cater for the extension of CGT to catch certain disposals by non-residents of residential property). This requirement ensures that the held-over gain remains within the territorial scope of CGT. (Indeed, as noted in our previous article, it goes further than is needed to achieve that, bearing in mind TCGA 1992 s 10.)
TCGA 1992 s 167 was a new anti-avoidance measure introduced (as CGTA 1979 s 126B) by FA 1989. It denies relief in circumstances where the transferee is a UK resident company (implicitly: if it was non-resident, then s 166 would already deny relief), but is controlled by one or more non-residents who are connected with the transferor. Both FTT and UT were content to adopt the taxpayer’s characterisation of s 167 as an ‘anti-enveloping’ measure. In general terms, this is no doubt correct; but it is worth considering precisely what kind of enveloping transaction the draftsman might have had in mind. Any gift to a company would ‘envelope’ the business assets. (And because the company would have to be UK resident, the latent gain would remain at the level of the company itself.) The particular concern seems to have been to prevent a relief for gifts being used to position matters for a subsequent arm’s length disposal to be made outside the territorial scope of CGT (by way of a sale at the level of the shares in the company) – which of course is exactly what happened in Mr Reeves’ case.
If that was the concern, you might ask, then why does s 167(2) only capture cases where the transferee company is controlled by connected persons, and not by the transferor himself? Both FTT and UT seem to have thought that this was explicable by reference to the purpose of s 167(2), which they took to be concerned with UK resident transferors only. But I think it may well simply have been an oversight: a UK resident transferor could not engineer the CGT-free disposal of shares in the transferee herself (because she would not obtain base cost for the gift element of the transfer, and s 165(7) would cap the holdover relief at the amount of the gift element), and so would need the transferee company to be in a connected person’s hands; and the draftsman seems to have forgotten that he also had to cater for a non-resident transferor such as Mr Reeves, who might be within the charge to CGT in respect of UK business assets by virtue of TCGA 1992 s 10.
HMRC (represented before the UT by David Ewart QC) argued that this was a mere drafting glitch, which it was open to the tribunal to correct, applying principles set out in the House of Lords judgment in Inco Europe Ltd v First Choice Distribution [2000] 1 WLR 586. The bar set here is a high one, and (as before the FTT) HMRC failed to clear it. Whilst the UT perhaps did not do full justice to the point, that outcome does not seem surprising. It certainly does not help HMRC’s case here that, as Kevin Prosser QC pointed out for the taxpayer, Parliament has seemingly made the same ‘glitch’ in permitting non-residents to access rollover relief under the nearby provisions in TCGA 1992 s 162. (I might also point out that at the same time as introducing TCGA 1992 s 167, Parliament also enacted what is now TCGA 1992 s 159 – which specifically deals with precisely the same point for business assets rollover relief.)
As explained above, TCGA 1992 s 167(2) asks whether the transferee company is ‘controlled’ by a non-resident connected person; and TCGA 1992 s 288 tells us that ‘unless the context otherwise requires’, control is to have its ICTA 1988, s 416 meaning. If s 167 was supposed to target situations where holdover relief might be used to envelope assets in such a way as to permit an arm’s length disposal, then it is immediately obvious that s 416 is far too broad a concept for the purpose. In Mr Reeves’ case, it meant that holdover relief was denied because his wife was non-resident: even though she had no interest in the shares in WHR (and so could not possibly realise a CGT-free gain in respect of them), she nevertheless controlled it, because s 416(6) attributed to her the rights over WHR held by her husband (an ‘associate’ of hers). Any number of examples can be adduced to show just how arbitrary this makes the rules.
The taxpayer turned first to TCGA 1992 s 167(3) to try to resist the unadulterated application of the s 416 ‘control’ definition. In catering for the case of the connected person who is UK resident as a domestic law matter, but nevertheless able to rely on non-resident status under a double tax treaty, s 167(3) refers to a person who controls the transferee ‘by virtue of holding assets relating to that or any other company’. The taxpayer argued that those words should also be implied in s 167(2). It is certainly hard to see any reason why the two subsections differ in this way, but the UT was not persuaded – or at least, as we shall see, it preferred to reach the same end point by a different route.
It is easy to see that the ‘full’ ICTA 1988 s 416 definition of ‘control’ is inapt for the task it is given in TCGA 1992 s 167. The difficulty is what to do about it. The UT’s reasoning here proceeded in two steps, both of them (in my view) quite ambitious.
The first step was to accept that the TCGA 1992 s 288 caveat, ‘unless the context otherwise requires’, permits the s 416 definition to be imported in part only. One might think that s 288 tells us to use the s 416 meaning of ‘control’, unless it is apparent from the way in which the term is used that the draftsman intends a different meaning – in which case, that meaning ought to be reasonably clear on the face of the legislation. (One obvious possibility would be that the term should simply take its natural meaning, rather than the defined one. But given the purpose of s 167(2), it is hard to see why a general notion of control – as opposed to ownership – would be what the draftsman needed.) However, there is nothing about the context of s 167(2) that suggests a departure from the default instruction to use the s 416 meaning. If anything, the deliberate use of modified references to control elsewhere (a point we will return to below) suggests the reverse. I suspect that the UT was swayed to use a different meaning not by the context, but rather by the inappropriate effect of using the unadulterated definition.
The danger in taking the first step becomes apparent when we come to the second one. The UT focused its attention on the attribution rules in s 416(6) (although, as noted in my analysis of the FTT decision, s 416(4) also contains attribution rules that could treat a person with no present economic interest in the company as controlling it). It was accepted in argument that disregarding s 416(6) altogether would go too far, because (for example) it would not capture the case where a connected non-resident owns the transferee through another company. So the ‘controlled company’ attribution rule remained. As regards the ‘associate’ attribution rule, the UT settled on a reading that would permit the attribution of an associate’s rights, but only if the person in question herself was a participator in the company. On this basis, Mr Reeves’ case was not caught by s 167(2); but it would have been, had his wife held a single share in WHR.
Can ‘the context otherwise requires’ in TCGA 1992 s 288 really justify such an intricate modification to the way in which the s 416 definition is applied for s 167(2) purposes? This smacks of judicial legislation – an impression that is reinforced by the fact that Parliament has elsewhere specifically included wording to achieve precisely this modification, in TCGA 1992 s 96(10). It seems to have been agreed that the limiting wording actually included in s 167(3) would have the same effect as the s 96(10) modification, and so the UT held that the context effectively required s 167(2) to be read as referring to control ‘by virtue of holding assets relating to that or any other company’. (Perhaps it disguises the expansiveness of the tribunal’s approach to put it that way. But it is not even clear that those words do have the same effect as s 96(10): if Mrs Reeves held a single share in WHR, would that really mean that she had control ‘by virtue of’ holding the share, as opposed to by virtue of being attributed the shareholding of her husband?)
The taxpayer argued that the literal reading of TCGA 1992 s 167(2) would breach his right to the protection of property under ECHR article 1 protocol 1 (A1P1), as read with the article 14 prohibition on discrimination. A1P1 specifically mentions states’ rights to secure payment of taxes, and a wide ‘margin of appreciation’ is afforded to them in that regard, making this a high bar for the taxpayer to clear.
Mr Reeves needed first to show that there was discriminatory treatment, in as much as the rules fastened upon an identifiable personal characteristic, and consequently treated him less favourably than they did others in relevantly similar situations. Unsurprisingly perhaps (although the FTT had taken a different view), the UT found that the rules discriminated against Mr Reeves as an individual with a non-resident spouse.
But that was not enough. Mr Reeves also needed to show that the discriminatory treatment had no objective and reasonable justification – either that it did not pursue a legitimate aim, or that it was disproportionate in the means by which it sought to achieve that aim. The UT accepted that s 167(2) pursued a legitimate anti-avoidance aim, but found that, if applied literally, it failed the requirement of proportionality. To deny relief according to the residence status of Mr Reeves’ wife was both ‘entirely unexpected’ and ‘entirely arbitrary’. The UT also suspected that, because its application in this way was so unexpected, HMRC might not have been even-handed in its treatment of taxpayers: put another way, HMRC stood accused of using the arbitrary way in which s 167(2) could be applied to Mr Reeves by reference to his wife’s residence status in order to plug the gap that arose because s 167(2) was not engaged by Mr Reeves’ own control of WHR. (HMRC tried to turn this around, arguing that any irrationality in the way that s 167(2) applied should be tolerated in Mr Reeves’ case. The UT gave this short shrift.)
The UT’s reasoning on the ECHR is surprisingly convincing (and more so than its efforts to reach the same conclusion as a matter of ‘domestic’ construction): the taxpayer who plays with fire may get his fingers burned – but not by an anti-avoidance rule that is entirely arbitrary in its application.
It remains to be seen whether HMRC will appeal the decision, though it surely will not want to let the matter lie there. In addition, we might all welcome a higher court’s opinion on how much interpretive creativity is given by the deceptively straightforward phrase, ‘unless the context otherwise requires’.
