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Cite as: 2003 SCLR 867, [2003] STC 1035, [2003] ScotCS 188

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Inland Revenue v. Scottish Provident Institution [2003] ScotCS 188 (03 July 2003)

FIRST DIVISION, INNER HOUSE, COURT OF SESSION

Lord President

Lady Cosgrove

Lord Eassie

 

 

 

 

 

XA73/02

OPINION OF THE COURT

delivered by THE LORD PRESIDENT

in

APPEAL TO THE COURT OF SESSION AS THE COURT OF EXCHEQUER IN SCOTLAND

under

section 56A(1) of the Taxes Management Act 1970

from

a decision of the Special Commissioners of Income Tax dated 4 April 2002 and communicated to the appellants on 4 April 2002

by

COMMISIONERS OF INLAND REVENUE

Appellants;

against

THE SCOTTISH PROVIDENT INSTITUTION

Respondents;

_______

 

Act: Moynihan, Q.C., Paterson; Solicitor of Inland Revenue (Appellants)

Alt: Tyre, Q.C.; Maclay Murray & Spens (Respondents)

3 July 2003

[1]      This appeal is against a decision of the Special Commissioners in which they allowed, in principle, an appeal by the respondents against an assessment for the period ended 31 December 1996. The only matter with which the Special Commissioners were concerned was whether a sum of approximately 20m was allowable as a loss for the purposes of tax. The appellants maintain that in a number of respects the Special Commissioners erred in law and accordingly that their decision should be reversed.

[2]     
The circumstances out of which the appeal arises are briefly as follows. In May 1995 the Inland Revenue published a consultative document which proposed a major simplification of the current tax rules applicable to gilts and bonds, including derivatives such as options, by treating profits as of an income nature with losses being relievable against income. The rules for corporate holders were to parallel the rules for new financial instruments which had been made by the Finance Act 1994 ("the 1994 Act").

[3]     
On or about 20 June 1995 Citibank NA ("Citibank"), which is an American bank with a branch registered in the United Kingdom, proposed to the respondents, with whom they had an established relationship, a scheme which had as its object the creation of expenses within the new proposed tax regime. Following discussion between the respondents and Citibank, four documents comprising the scheme were executed on or about 30 June 1995. As at that date the details of the proposed legislation were not yet known. The four documents are briefly described in what follows.

[4]     
First, the respondents granted a call option to Citibank (referred to as Transaction A), in respect of 100m of nominal amount of 8% United Kingdom gilts

due 7 December 2000 at an option price of 70% of the par value of the bonds plus accrued interest. The option was exercisable by Citibank at any time between 30 August 1995 and 1 April 1996. The premium for the option was 29,750,000 payable to the respondents on 5 July 1995. Provision was made for notice of the exercise of the option to be given. In that event the bonds were to be delivered in exchange for payment.

[5]     
Secondly, Citibank granted a call option to the respondents (referred to as Transaction B) in respect of 100m of nominal amount of 8% United Kingdom gilts due 7 December 2000 at an option price of 90% of the par value of the bonds plus accrued interest. The option was exercisable by the respondents at any time between 30 August 1995 and 1 April 1996. The premium for the option was 9,810,000 payable to Citibank on 5 July 1995. Provision was made for notice of the exercise of the option to be given. In that event the bonds were to be delivered in exchange for payment.

[6]     
Thirdly, the respondents entered into a Collateral Agreement in respect of Transaction A, under which they were required to pay Citibank on 5 July 1995 the Collateral Amount, which was defined as

"an amount of pounds sterling equal to the bond entitlement of Transaction A multiplied by the difference between the option strike price of Transaction A and the option strike price of Transaction B".

This amounted, in broad terms, to 20m. Under the agreement it fell to be repaid by Citibank, without interest, on the earlier of the day on which the option under Transaction A was exercised and 1 April 1996.

[7]     
Fourthly, the parties also entered into a further agreement which entitled Citibank to a structuring fee calculated by reference to the respondents' long-term business funds, less an initial fee of 60,000 and subject to a maximum of 240,000. This agreement provided for payment on 1 September 1996. It may be noted that the total of 60,000 and 240,000, namely 300,000, represented 10% of 15% (the assumed tax rate) on 20m.

[8]     
On 5 July 1995 the sum of 60,000 was paid by the respondents to Citibank. This was the difference between the sums payable by the respondents to Citibank (9,810,000 and 20m) and the sum payable by Citibank (29,790,000).

[9]     
On or about 12 July 1995 the Inland Revenue announced that the commencement of the new rules for the taxation of gilts and capital bonds would be deferred until 1 April 1996.

[10]     
By letter to Citibank dated 20 March 1996 the respondents intimated that, in the absence of further instructions, if Citibank exercised its option under Transaction A on 1 April 1996, the letter was to be treated as constituting notice by the respondents of the exercise of their option under Transaction B on the same date. By letter in reply, on or about 28 March 1996, Citibank confirmed that if both options were to be exercised on 1 April 1996, stock deliveries and all sums due (including the 20m Collateral Amount) under Transaction A would be netted off for settlement purposes, with the result that neither stock nor money would be exchanged. The letter further provided that, in the absence of further instructions, if the respondents exercised their option under Transaction B on 1 April 1996, the letter was to constitute notice by Citibank of the exercise of their option under Transaction A on the same date. The terms of that letter were agreed by the respondents on or about 28 March 1996. Neither party provided further instructions.

[11]     
On 1 April 1996 the options under both transactions were exercised. No bonds were delivered or payment made by either party to the other.

[12]     
It is not in dispute that the scheme which was devised by Citibank was based on the expectation that the premium which was paid for the option under Transaction A before the legislation came into force would fall out of account for taxation purposes. It was not taxable under the pre-existing law, in respect that options over gilts had not previously been liable to tax on capital gains. Further, it was intended that the respondents would obtain the benefit of a loss for taxation purposes arising from the exercise by Citibank of the option under Transaction A when the new legislation was in force. It was not part of the scheme that the respondents would obtain any tax advantage from the exercise of their option under Transaction B. The respondents and Citibank proceeded on the basis that Transaction B hedged the risk to the respondents arising from the exercise by Citibank of their option under Transaction A.

[13]     
We turn next to the legislation with which the present appeal is concerned.

[14]     
Chapter II of the 1994 Act made provision for the tax treatment of profits and losses in respect of interest rate and currency contracts. Section 155 states in its first two subsections:

"(1) Where, as regards a qualifying contract held by a qualifying company and an accounting period, amount A exceeds amount B, a profit on the contract of an amount equal to the excess accrues to the company for the period.

(2) Where, as regards a qualifying contract held by a qualifying company and an accounting period, amount B exceeds amount A, a loss on the contract of an amount equal to the excess accrues to the company for the period".

Section 154(1) provides that, subject to certain exceptions, with which we are not concerned, any company is a "qualifying company" for the purposes of chapter II.

[15]     
Section 155 goes on to make provision as to how amounts A and B are to be arrived at, depending on whether profit or loss falls to be computed on a mark to market basis (subsection (4)) or on a particular accruals basis (subsection (5)). In the present case we are concerned only with the application of the mark to market basis, which involves in general the revaluation of the contract at the beginning and at the end of the accounting period.

[16]     
Subsection (4) provides:

"Where as regards a qualifying contract a qualifying company's profit or loss for an accounting period falls to be computed on a mark to market basis incorporating a particular method of valuation -

(a) amount A is the aggregate of -

(i) the amount or aggregate amount of the qualifying payment or

payments becoming due and payable to the company in the period, and

(ii) any increase for the period, or the part of the period for which

the contract is held by the company, in the value of the contract as determined by that method, and

(b) amount B is the aggregate of -

(i) the amount or aggregate amount of the qualifying payment or

payments becoming due and payable by the company in the period, and

(ii) any reduction for the period, or the part of the period for which

the contract is held by the company, in the value of the contract as so determined".

[17]     
Section 156(1) provides that profits and losses are to be computed on a mark to market basis where they are computed on that basis for the purposes of the accounts of the qualifying company if that basis satisfies the requirements of subsection (3). These requirements are:

"(a) computing the profits or losses on the contract on that basis is in

accordance with normal accountancy practice;

(b) all relevant payments under the contract are allocated to the accounting

periods in which they become due and payable; and

(c) the method of valuation adopted is such as to secure the contract is

brought into account at a fair value".

[18]     
The original scope of the expression "qualifying contract" was extended by the addition of section 147A to the 1994 Act by the Finance Act 1996 ("the 1996 Act"). The first two subsections of that section provide:

"(1) For the purposes of this Chapter a debt contract or option is a qualifying contract as regards a qualifying company if the company becomes entitled to rights, or subject to duties, under the contract or option at any time on or after 1st April 1996.

(2) For the purposes of this Chapter a qualifying company which is entitled to rights, or subject to duties, under a debt contract or option both immediately before and on 1 April 1996 shall be deemed to have become entitled or subject to those rights or duties on that date".

Subsection (3) states that the section has effect subject to the transitional provisions contained in paragraph 25 of Schedule 15 to the 1996 Act.

[19]     
The 1996 Act also added to the 1994 Act section 150A which defined the scope of "a debt contract or option". It is not in dispute that Transaction A and Transaction B fell within the scope of "a debt contract or option". It may also be noted that a "qualifying payment" for the purposes of section 155(4) was extended to include, in terms of section 150A(5):

"(a) a payment of an amount representing the price for becoming a party to

the [loan] relationship;

(b) a payment of an amount determined by reference to the value at any

time of the money debt by reference to which the relationship subsists;

(c) a settlement payment of an amount determined by reference to the

difference at specified times between -

(i) the price for becoming a party to the relationship; and

(ii) the value of the money debt by reference to which the

relationship subsists, or (if the relationship were in existence) would subsist".

[20]     
Lastly, we return to section 155 in which it is provided by subsection (7), subject to an exception with which we are not concerned, that

"where a qualifying contract -

(a) becomes held by a qualifying company at any time in an accounting

period, or

(c) ceases to be so held at any such time,

it shall be assumed for the purposes of subsection (4) above that its value is nil immediately after it becomes so held or, as the case may be, immediately before it ceases to be so held".

It appears that the general purpose of this provision is to avoid the duplication between payments and changes in value in the accounting which is required by subsection (4). In this connection, as we will explain later in this Opinion, reference was made to section 177(2) of the 1994 Act, as amended by the 1996 Act, which provides:

"For the purposes of this Chapter -

(a) a company becomes entitled to rights or subject to duties under an

interest rate contract or option, a currency contract or option or a debt contract or option when it becomes party to the contract or option; and

(b) a company holds such a contract or option at a particular time if it is

then entitled to rights or subject to duties under it;

and it is immaterial for the purposes of paragraph (b) above when the rights or duties fall to be exercised or performed".

[21]     
The Special Commissioners held that each of Transaction A and Transaction B was a "qualifying contract" for the purposes of Part II of the 1994 Act as amended; and that profits and losses in respect of each transaction fell to be computed on a mark to market basis in accordance with section 155(4). They further held that, for the purposes of that computation, in the case of Transaction A, amount A was 70m and amount B was 104m (under section 155(4), paragraphs (a)(i) and (b)(i) respectively). In the case of Transaction B, amount A was 104m and amount B 90m (under paragraphs (a)(i) and (b)(i) respectively). This yielded a loss in the case of Transaction A of 34m and a profit in the case of Transaction B of 14m, and thus an overall loss of 20m. It may be noted that it is evident that the Special Commissioners entered no amount against paragraphs (a)(ii) or (b)(ii) in respect of either transaction, upon the view that the combined effect of sections 147A(2) and 155(7) was that it was to be assumed that the value of each of these contracts was nil immediately after it was deemed to have become held on 1 April 1996 as well as immediately before it ceased to be held on that same date.

[22]     
The issues which were debated in this appeal, and in the order in which they were presented, were as follows:

"(1) was it appropriate to compute profit and loss on each of

Transaction A and Transaction B on a mark to market basis?

(2) was each of Transaction A and Transaction B a qualifying contract?

(3) was it appropriate when applying a mark to market basis to attach a nil

value to each of these transactions on the morning of 1 April 1996? and

(4) was it appropriate to exclude from the computation the Collateral

Amount of 20m?".

(1) Was it appropriate to compute profit and loss on each of Transaction A and Transaction B on a mark to market basis?

[23]     
For the appellants Mr. Moynihan invoked the line of authority beginning with the decision of the House of Lords in W.T. Ramsay Limited v. I.R.C. [1982] AC 300 and considered most recently in MacNiven v. Westmoreland Investments Limited [2003] 1 AC 311. In MacNiven it was held that the first step in the process of ascertaining the meaning of a statutory provision was the identification of the concept to which the statute referred. If the statutory language was construed as referring to a commercial concept, and steps which had no commercial purpose had been artificially inserted for tax purposes into a composite transaction they would be disregarded for the purposes of applying the relevant concept. On the other hand, as Lord Hoffmann observed at paragraph 62:

"The fact that steps taken for the avoidance of tax are acceptable or unacceptable is the conclusion at which one arrives by applying the statutory language to the facts of the case. It is not a test for deciding whether it applies or not".

Mr. Moynihan criticised the Special Commissioners for taking an unduly restrictive view. It was wrong for them to conclude, as they indicated in paragraph 35 of their decision, that a commercial approach was inappropriate simply because the legislation was complex.

[24]      Mr. Moynihan referred to the comments which the members of the House had made in MacNiven on the observation of Lord Brightman in Furniss v. Dawson [1984] AC 474 at page 527 as to the "limitations of the Ramsay principle". Lord Brightman said, in short, that there must be a pre-ordained series of transactions, or a single composite transaction, containing steps inserted which had no business purpose apart form the avoidance of a liability to tax. Where those two ingredients existed, the inserted steps were to be disregarded for fiscal purposes. At paragraph 49 Lord Hoffman emphasised that this formulation was not a principle of construction.

"It is a statement of the consequences of giving a commercial construction to a fiscal concept. Before one can apply Lord Brightman's words, it is first necessary to construe the statutory language and decide that it refers to a concept which Parliament intended to be given a commercial meaning capable of transcending the juristic individuality of its component parts".

Further, Lord Nicholls of Birkenhead remarked, at paragraph 7, that observations such as those of Lord Brightman should be read in the context of the particular statutory provisions and sets of facts under consideration:

"In particular, they cannot be understood as laying down factual pre-requisites which must exist before the court may apply the purposive, Ramsay approach to the interpretation of a taxing statute".

He went on to state in paragraph 8 that:

" ... the Ramsay approach is no more than a useful aid. This is not an area for absolutes. The paramount question always is one of interpretation of the particular statutory provision and its application to the facts of the case".

[25]      Accordingly, Mr. Moynihan submitted, the relevant question was whether the particular provision under interpretation employed a commercial concept in which case it might be possible to apply a commercial approach to it. In the present case section 156(3) required the application of a commercial concept by stating that the computation should be "in accordance with normal accounting practice". In these circumstances, as Lord Hoffmann stated in MacNiven at paragraph 34, "It is thus the statute itself which applies the tests of ordinary business". It was therefore, he submitted, permissible to use a commercial approach. That meant that where a series of legally separate, genuine transactions were nonetheless designed, intended and in fact operated as one composite transaction, one could assess the fiscal consequences by reference to the end result. This did not involve "laying down factual pre-requisites". It did not permit the retrospective reconstruction as a composite of what had been prospectively uncertain in the sense that the end result was not known in advance and only came about as a result of the juxtaposition of later events (cf. Craven v. White [1989] A.C. 398). On the other hand one should not deconstruct what prospectively was designed and intended as a composite and was in fact executed as a composite. What was designed, intended and operated as a composite was not deprived of that status merely because there might have been some intermediate variation in the plan. That was particularly so if the parties built into the plan checks and balances to guard against that variation, even more so if those checks and balances successfully prevented the variation from arising. Mr. Moynihan criticised the Special Commissioners for having relied on the approach which had been taken by Patten J. in Griffin v. City Bank Investments [2002] S.T.C. 110, at paragraph 38, where he applied the test of whether there was no practical likelihood that the pre-planned events would not take place in the order ordained. That test was derived from the passage in the speech of Lord Oliver of Aylmerton in Craven v. White at page 514, and in turn from the speech of Lord Brightman in Furniss v. Dawson. That did not square, he argued, with the application of "normal accountancy practice" in accordance with section 156(3).

[26]     
Mr. Moynihan submitted that the Special Commissioners had erred in their approach to commerciality and the prospects of the options being exercised separately. The Special Commissioners had found that the option contracts created a genuine economic risk for Citibank (paragraph 5/12), and that when Transactions A and B were entered into along with the Collateral Agreement

"there was a genuine commercial possibility of movement of interest rates and gilt prices such that it would be in Citibank's commercial interests to either refrain from exercising option A or exercising or attempting to exercising (sic) it on a date different from the exercise by the [respondents] of option B. There was a genuine commercial possibility and a real practical likelihood that the two options would be dealt with separately. Likewise, there was a genuine commercial possibility and a real practical likelihood that option B would not be exercised by the [respondents]". (Paragraph 5/18 cf. paragraph 24).

In paragraph 25 they stated with reference to the options:

"They were genuine transactions under which the parties could make a profit or loss even though the expectation was that they would not".

Mr. Moynihan submitted, however, that the Special Commissioners had failed to consider the substance of the scheme as opposed to its form. They had applied too much weight to the options and not paid attention to the other parts of the scheme which were designed to achieve a nil result.

[27]     
Mr. Moynihan drew attention in particular to two respects in which the scheme had checks and balances which were designed to avoid a profitable outcome. There would not have been these handicaps unless the parties had been engaged in a tax avoidance scheme rather than a commercial transaction. The Special Commissioners had failed to address these matters. The first was the reduction of the strike price of Transaction B from 95 to 90 during the course of negotiations (paragraph 6). This increased the prospect of the option under Transaction B being exercised. It was, of course, obvious that with a strike price of 70 Citibank were even more likely to exercise the option under Transaction A.

[28]     
The second was the provision of an interest-free loan or deposit of 20m. It made sense only as part of a tax avoidance scheme. It meant that if Citibank exercised the option under Transaction A they were penalised by having to repay that sum immediately. In paragraph 28 the Special Commissioners had made contradictory findings. They had said, on the one hand, that the Collateral Agreement was separate from the two options and, on the other hand, that its purpose was "to provide Citibank with security and to remove the incentive for Citibank to exercise option A early". It was significant, he said, that the Special Commissioners' endorsement of the commerciality of the arrangements was confined to the two options. The question was not whether this arrangement was "genuine", as the Special Commissioners had stated in paragraph 28, but whether it made any commercial sense. The conclusion of the Special Commissioners was also in conflict with the documents which demonstrated that the terms of the Collateral Agreement reflected the premiums for the two options.

[29]     
Mr. Moynihan also argued, as he had done before the Special Commissioners, that no one would have carried out these transactions for such a small possibility of profit. In paragraph 25 the Commissioners stated that the respondents had admitted that, adding:

"they did it for tax reasons, not in any expectation of making a profit from the price of gilt falling below 90, but the point is that they did something that had a sufficient degree of uncertainty attached to it that we cannot ignore what they did".

Mr. Moynihan submitted that it was entirely incorrect to say that Citibank were holding out a profit in return for the fee which they received. The fee was simply a premium for the scheme, including any hedging cost (paragraphs 4, 6 and 24), and it made sense only if it was so considered. It bore no relationship to the possible measure of profit. It was not reasonable for the Special Commissioners to regard it as a fee for the options. It was a part of a wider whole. The Special Commissioners had wrongly attributed to the transactions the appearance of a genuine speculative venture which could lead to profit or loss. It was wrong to categorise the possibility of profit or loss as commercial, since it gave the scheme no more than the semblance of commerciality. Mr. Moynihan also maintained that it was inaccurate for the Special Commissioners to state, as they did in paragraph 5/18, that the premiums were negotiated at market rates, since the fee of 60,000 had been added to the premium for Transaction B.

[30]     
As regards the mark to market basis of accounting, Mr. Moynihan submitted that the Special Commissioners had failed to apply the correct test in relation to the existence of a composite transaction for the purposes of accountancy practice. He referred to the guidance provided by the Financial Reporting Standard issued in April 1994 (FRS5). A number of passages in FRS5 showed that, according to normal accounting practice, regard should be had to the substance of a transaction, including the existence of a scheme which was designed to achieve an overall effect; the implications of the transaction should be examined, with greater weight attached to those matters which were more likely to have commercial effect in practice; in determining the substance, the logic of the transaction should be considered. If it lacked logic this might be due to some element which had been incorrectly assessed; and particular care should be taken in the assessment of options which were written in terms which made it highly likely that they would be exercised. While the Special Commissioners had referred to FRS5, they failed to give effect to its guidance and in particular did not ask themselves what was more likely to happen, although they came close (in paragraph 25) to acknowledging the practical likelihood that, subject to the contingency that the legislation would be as had been anticipated, the transactions would be carried out in the way which had been anticipated from the outset. Although it was said that the respondents might have exercised the option in Transaction B on 27 or 28 March 1996, with the result that the profit which they would have taken on the exercise of that option would not have been caught by the new legislation, the fact was that they did not do so. On 1 April 1996 the two options were exercised and the Collateral Amount settled in a single operation. There was no question of an ex post facto juxtaposition of events. What occurred was intended, and was always likely, to happen. To rely on the possibility of the separate exercise of Transaction B was to give way to a reconstruction of events. Accordingly, even on the basis of the test of "no practical likelihood", that test was met. It made no sense to attribute separate values to components of the scheme which were intended to cancel out each other.

[31]     
Mr. Moynihan also criticised the decision of the Special Commissioners in two other distinct respects. First, they failed to explain why, despite their remark in paragraph 32 that "it would be normal accounting practice to mark to market such options (unless designed as a hedge)", they thought that this basis was appropriate, standing their finding in paragraphs 3 and 27 that the option under Transaction B should be regarded as hedging the risk relating to the other option. Secondly, assuming that the correct date as at which the transaction should be considered was 30 June 1995 (which was disputed), they had wrongly relied on the effect of the announcement by the Inland Revenue on or about 12 July 1995. According to paragraph 5/14 this "introduced a potential investment risk for Citibank", the risk being the possibility that gilts would fall below 90% of their nominal value, that being the strike price of Transaction B. The measure of that risk could be seen from the figures in paragraph 23. Yet the Special Commissioners in paragraph 32 considered that the possibility of the option under Transaction B not being exercised should be viewed as at the time of the grant of the options.

[32]     
For the respondents Mr. Tyre submitted that the appellants' approach was not in accordance with the law as it had been developed in the House of Lords. He drew attention to the observations of Lord Oliver of Aylmerton in Craven v. White pages 503-504. Lord Oliver pointed out at page 503 that the essence of the decision in Ramsay

"lay not in the fact that the object of the exercise was to save tax but in the approach of the court as a matter of construction to a devised combination of events designed to produce an actual result quite different from that which, for fiscal purposes, it was intended to display."

The argument for the appellants in the present case resembled the submission on behalf of the Revenue which had been rejected in MacNiven (see Lord Hoffmann at paragraphs 27-29), and the approach taken by Lord Templeman in his dissenting speech in Craven v. White at page 492 where he said:

"First, the taxpayer must decide to carry out, if he can, a scheme to avoid an assessment of tax on an intended taxable transaction by combining with a prior tax avoidance transaction. Secondly, the tax avoidance transaction must have no business purpose apart from the avoidance of tax on the intended taxable transaction. Thirdly, after the tax avoidance transaction has taken place, the taxpayer must retain power to carry out his part of the intended taxable transaction. Fourthly, the intended taxable transaction must in fact take place".

Accordingly expressions such as "a commercial approach", "commercial validity", and "failure to address the scheme as a whole" indicated an attempt to apply the wrong test (cf. Carnwath L.J. in Barclays Mercantile Business Finance Ltd. v. Mawson [2003] S.T.C.66 at paragraphs 60 et seq).

[33]     
In the light of the speech of Lord Hoffmann in MacNiven Mr. Tyre submitted that the appellants required to demonstrate two matters. First, it was necessary for them to identify a concept in the tax legislation which in its context fell to be given a commercial and not a legal (i.e. statutorily defined) meaning (Lord Hoffmann at paragraph 58). If they could not do so, there was no room for the Ramsay approach, because in that event a business purpose was not a part of the relevant concept. Secondly, if, and only if, the appellants could identify such a concept, they must also be able to establish that there was a single composite transaction into which steps had been inserted artificially for tax purposes. Those steps might then be disregarded (Lord Hoffmann at paragraphs 48-49). For this purpose the question was not whether those steps would be separately marked to market. In determining whether there was a single composite transaction the statement of the law by Lord Oliver of Aylmerton in Craven v. White at page 514, which had been consistently applied, still held good. Thus the critical question was whether, at the time when the transactions were entered into, there was

"no practical likelihood that the pre-planned events would not take place in the order ordained, so that the intermediate transaction was not even contemplated practically as having an independent life".

The Special Commissioners had been correct in applying this test, which was the basis for the decision in Griffin v. City Bank Investments. The observations of Lord Brightman in Furness v. Dawson remained authoritative in regard to the question whether there was a composite transaction. It was plain that the question of practical likelihood required to be considered as at the time when the transactions were entered into and not, as was suggested by the appellants at one stage of their argument, by reference to the end result.

[34]     
As regards the first test which was propounded by him, Mr. Tyre submitted that section 155(2) was the critical provision. The word "loss" in the present context was a statutory construct, being the difference between amount A and amount B, if A was less than B. It followed that "loss" in the present context was a legal concept, being one which had a specific statutory meaning. Accordingly there was no justification for treating the amount which resulted from the difference between amount A and amount B as anything other than a loss for taxation purposes, on the ground that it was not a loss in commercial terms. As Lord Hoffmann observed in MacNiven at paragraph 58:

"If a transaction falls within the legal description, it makes no difference that it has no business purpose. Having a business purpose is not part of the relevant concept".

[35]     
As regards the second test, the answer was determined largely by the Special Commissioners' findings of primary fact, and in particular paragraph 5/18 of their decision to which we have referred earlier in this Opinion. He reminded the court that an appeal lay from the Special Commissioners only on an error of law, and that it was not the function of the court to re-examine the evidence and to disturb their findings of primary fact. He relied on the well-known decision of Edwards v Bairstow & Harrison 36 TC 207, and to the speeches of Viscount Simmonds at pages 225-226 and Lord Radcliffe at page 229. In any event, in the present case the court did not have before it a transcript of the oral evidence and accordingly was unable to know what the witnesses had said on a number of matters such as, for example, the significance, if any, of the reduction of the strike price to 90 and of the descriptions of the scheme which had preceded the entering into of the transactions on 30 June 1995. It was for the Special Commissioners to decide whether to accept or reject evidence as to what was or was not anticipated at that time. They had not been prepared to accept that they should infer from the evidence that there was a single composite transaction. Mr. Tyre pointed out that Lord Brightman observed in Furniss v. Dawson at page 528 that, while an appellate court could and should interfere with an inference of fact which could not be justified by the primary facts, he did not consider that, if the primary facts justified alternative inferences of fact, an appellate court could substitute its own preferred inference for the inference drawn by the fact-finding tribunal. Having decided that there remained the possibility of the non-exercise or separate exercise of an option, it was but a short step for the Special Commissioners to reach the conclusion that Transactions A and B were separate and did not fall to be treated as parts of a single composite transaction.

[36]      Mr. Tyre then turned to a number of the criticisms which had been advanced by Mr. Moynihan in regard to "commerciality". It followed from his main submissions that it would have been wrong for the Special Commissioners to ask themselves whether the scheme was not commercial because it had checks and balances written into it. As regards the strike price, what mattered was whether, given that it was 90, there was a genuine commercial possibility that the option under Transaction B would not be exercised. Their decision, based on the evidence, was that the price falling below 90 was

"unlikely but not so unlikely that one could say that there was no practical likelihood of its occurring, and accordingly that there was a genuine practical likelihood or to put it another way a genuine commercial possibility that the [respondents] would not exercise option B". (Paragraph 24)

As regards the Collateral Amount, while it acted as a disincentive to Citibank's exercise of their option, it did not remove the possibility that Citibank would exercise that option at an early stage.

[37]     
Mr. Tyre submitted that the Special Commissioners' reference to "a hedge" in paragraph 32 should be understood in the accountancy sense of a hedge which exactly matched the risk, such as two assets which exactly cancelled out one another. It was not used in same sense in paragraph 27, because the point was that the two options were not identical. The consistent position of the respondents had been that the option in Transaction B had no tax avoidance purpose but provided a hedge against risk in regard to option A, that is to say the risk of the price of gilts rising above 100. It was for this reason that the respondents would not have entered into option A on its own. Yet it was only because option B had been granted to remove some of the commercial risk that the appellants maintained that the transactions should be treated as a single composite transaction.

[38]     
As regards the complaint that the Special Commissioners had failed to address the scheme as a whole, this was not the correct test. The standard contained in FRS5 was irrelevant to this part of the argument. It became relevant only when the conditions for the application of section 155 had been met. If FRS5 was relevant to this part of the argument, what mattered was the possibility of non-exercise or separate exercise, and not the likelihood that the options would be exercised together. In any event, there had been no evidence to support a conclusion as to what was more likely.

[39]     
Mr. Tyre submitted that there was no question of the Special Commissioners having considered likelihood as at the wrong date. The likelihood of non-exercise depended not on the statutory regime but on the life of the option, which was nine months. There was nothing to indicate that the options would be exercised immediately after the statutory scheme came into force. In the event, the fact that the scheme came into force as late as 1 April 1996 almost prevented the options from being exercised. There was no finding that the timing of the coming into operation of the new statutory scheme was not in the mind of the parties as at 30 June 1995. There was nothing to back up the assertion that there was an increase from two to nine months in regard to the likely timing of the exercise of the options.

[40]     
Finally, Mr. Tyre submitted, the question whether there was a composite transaction was a tax and not an accountancy question. The Special Commissioners had applied the test enunciated in Craven v. White. So far as accountancy practice was concerned, in the context of sections 155 and 156 the question was different and more specific, namely whether the options should be separately marked to market. The answer to the question was, as the Special Commissioners had stated in paragraph 32 of their decision, that having regard to "substance" meant, in the present context, considering the possibility of non-exercise or of separate exercise of the options.

[41]     
As we have narrated, the submissions on behalf of both parties sought to harness what was said by the members of the House of Lords in MacNiven, namely that it is necessary in the first place to ascertain whether the particular enactment with which this case is concerned embodies a legal or a commercial concept.

[42]     
It is clear from section 155 of the 1994 Act that the ascertaining of profit or loss is to be carried out by reference to the particular qualifying contract and particular accounting period. The section does not address the setting off of a profit on one such contract against a loss on the other, or visa versa. Next, it is clear that whether there is a profit or loss on a particular qualifying contract for a particular accounting period does not depend on the application of a concept of profit which is independent of what is provided in the section. Subsections (1) and (2) stipulate what is to be regarded as profit or loss, and require that amount A and amount B are to be ascertained on one or other of two bases; and in the case of the mark to market basis, each of these amounts, and hence the difference between them, depend on changes in value, if any, over the accounting period and payments, if any, due and payable to or by the company in that period.

[43]     
In these circumstances we consider that Mr. Tyre was well-founded in submitting that section 155(2) employs a legal concept, being a construct which has a specific statutory meaning. In our opinion the artificial framework for which the section provides does not indicate that a commercial meaning falls to be given to "loss", let alone that the relationship between one qualifying contract and another has be considered from a commercial viewpoint, in order to determine whether there was any true "loss".

[44]     
It follows that we reject Mr. Moynihan's approach, which involved ascertaining whether there was a commercial or business purpose rather than tax avoidance for the separate treatment of the transactions which were the components of the scheme. The reference in section 156(3) to "normal accountancy practice" does not entail that the concept of "loss" for the purpose of section 155 is to be interpreted in accordance with that practice.

[45]     
Even if the concept of "loss" in section 155(2) falls to be treated as a commercial concept, we are not persuaded that Mr. Moynihan was well-founded in submitting that the Special Commissioners were in error in treating Transactions A and B as separate. This flew in the face of the findings made by the Special Commissioners as to the risks created for Citibank (paragraph 5.12), and in particular the genuine commercial possibility that due to movements of interest rates and gilt prices, it would be in the interests of Citibank to refrain from exercising Option A or exercising or attempting to exercise it on a date different from the exercise by the respondents of Option B; and that there was a genuine commercial possibility and a real practical likelihood that the two options would be dealt with separately, and that Option B would not be exercised by the respondents (paragraph 5/18). These passages are backed up in greater detail by what the Special Commissioners say in paragraphs 24 and 25.

[46]     
Faced with these findings it is not surprising that Mr. Moynihan took the course of criticising the way in which the Special Commissioners had gone about their task, in particular, as he submitted, by failing to consider the scheme as a whole and weigh the implications of its parts, and by creating a false picture of commerciality.

[47]     
We do not consider that the Special Commissioners are to be faulted for applying the test of genuine commercial possibility or practical likelihood, following what was said by Lord Oliver of Aylmerton in Craven v. White. While there is no doubt that the scheme was intended to avoid tax, it is of some importance to place it in the context of the change in the law which was brought about by the introduction of debt contracts into the category of "qualifying contracts". The essence of the Citibank scheme was to secure the treatment as a loss for tax purposes of the difference between the value of the gilts transferred by the respondents to Citibank and the price payable by Citibank for those bonds. Because it was not subject to tax either before or after the introduction of the new legislation, the premium which the respondents received for the granting of Option A could not be brought into account so as to eliminate or reduce that loss. That was a situation created by the drafting of the legislation, which far-sighted observers of the scene decided to turn to their advantage. Option B on the other hand, was not conceived as having any tax advantage to the respondents. It was not arranged in such a way as to enable them to avoid the taxation of profit or to secure relief against loss. According to the finding of the Special Commissioners it was hedging the risk relating to Option A (paragraph 27). It follows that it was not an essential part of the scheme that Option B should be exercised at the same time as the exercise by Citibank of Option A.

[48]     
We are not persuaded that Mr. Moynihan's submissions relating to the strike price and the Collateral Amount carry weight. As to the first, all that can be taken from the findings of the Special Commissioners is that it was reduced from 95 to 90. Mr. Tyre informed us that in the hearing before the Special Commissioners Mr. Moynihan sought - in vain - to elicit evidence that the reason for the reduction was to ensure that the transactions between the parties were self-cancelling. The Special Commissioners make no finding as to the reasons for the reduction; and there is, in our view, no basis for asking this court to infer one. As regards the Collateral Amount, it is true that the fact that it was payable entailed that no net sum was paid as at 5 July 1995, apart from the fee of 60,000. However, it is important to bear in mind that the Special Commissioners found that its purpose was to serve as a disincentive to Citibank making an early exercise of Option A. The fact that it was part of the scheme and balanced the interests of the parties during the life of the options does not show that each of the options lacked independent commercial significance. Lastly, we are not impressed with the castigation of the Special Commissioners for having suggested a commercial purpose of profit-making. It is clear that the Special Commissioners treated the possibility of taking of a profit as merely incidental or a windfall advantage. The essential purpose of the scheme was and remained to take advantage in the tax position of the premium and the "loss" incurred in the exercise of Option A.

[49]     
For these reasons we reject Mr. Moynihan's submissions and hold that the Special Commissioners were correct in treating Transactions A and B separately for tax purposes.

(2) Was each of Transaction A and Transaction B a "qualifying contract" as at 1 April 1996?

[50]     
In addition to the submissions based on the Ramsay approach which we have already discussed, Mr. Moynihan submitted that in any event neither of these transactions came within the scope of section 147A(2). Hence neither fell to be regarded as a "qualifying contract". For that subsection to apply it had to be the case that the respondents were entitled to rights, or, as the case might be, subject to duties under the transaction immediately before 1 April 1996. This was not the case.

[51]     
Mr. Moynihan submitted that by 31 March 1996 the transactions had been varied by an agreement constituted by the letters dated 20 and 28 March 1996, to which we referred in paragraph [10]. The effect of that agreement was that (i) if one option was to be exercised on 1 April 1996, both would be exercised; and (ii) in any event gilts and payments (including the Collateral Amount) would be netted off, so that neither gilts nor money would be delivered by one party to the other. In the result neither transaction gave rise to rights and duties in any meaningful sense: the provisions were self-cancelling, like the charges in the gas chamber, the image which Lord Wilberforce used in Ramsay at page 322. The exercise of neither option resulted in the transfer of gilts or money cf. H.S.B.C. v. Stubbs [2002] S.T.C. 9 at paragraph 25.

[52]     
For the respondents Mr. Tyre submitted that the letter dated 20 March 1996 changed nothing as a matter of law. It did not constitute the exercise of the option of Transaction B and made no contractual commitment. It merely expressed an intention in revocable terms. It did not constitute a variation of the contract. The netting off for purposes of settlement was an administrative arrangement in accordance with standard practice under the ISDA agreement which had been referred to in the documents relating to each of the transactions (see the decision of the Special Commissioners at paragraph 9). After midnight on the morning of 1 April 1996 it was open to either party to change its mind, although in practical terms it was highly unlikely that both options would be exercised. The value of gilts was nowhere near 90, let alone 70.

[53]     
We are not satisfied that to any extent the exchange of letters had the effect of varying the agreement contained in Transactions A and B and, accordingly, we reject the view that as at 1 April 1996 it was no longer the case that either party held rights or was subject to duties under either of these transactions.

(3) Was it appropriate, when applying a mark to market basis to attach a nil value to each option on the morning of 1 April 1996?

[54]     
By virtue of section 147A(2) the respondents were deemed to have become entitled to rights and subject to duties under each of the options on 1 April 1996. The Special Commissioners accepted the submission by the respondents as to the consequence of reading this provision along with sections 155(7) and 177(2)(b). Under the former, where a qualifying contract "becomes held" by a qualifying company at any time in an accounting period, it is to be assumed for the purposes of section 155(4) that its value is nil immediately after it becomes so held. Under the latter, a company holds such a contract at a particular time if it is then entitled to rights or subject to duties under it. Putting those provisions together the Special Commissioners held at paragraph 41:

"It seems to us that since by section 177(2)(b) a company holds a contract at a particular time if it is then entitled to rights or subject to duties under it, it follows that where a company is deemed to have become entitled to rights under a contract on 1 April 1996, the contract is deemed to have become held on that date so as to make section 155(7) applicable".

[55]     
In attacking this conclusion Mr. Moynihan presented two alternative submissions. The first was that in interpreting section 147A(2) the Special Commissioners had erred in law by failing to carry this deeming provision to its logical conclusion. They had not asked, in the context of section 156(3), how one should account for options which were deemed to have "become held" in April 1996. They had acted inconsistently by applying section 147A(2) to section 155(7) but not to section 156(3). Since each option was deemed to have "become held" on 1 April 1996, the natural consequence was that that date should be deemed to be the date of grant. He founded on section 177(2)(a) under which a company becomes entitled to rights or subject to duties under a debt contract when it becomes a party to the contract. The correct approach to section 156(3) was to ask what was the correct accountancy treatment of the option as it stood at the deemed date of grant. The significance of this was that as at 1 April 1996 "everything was a foregone conclusion", since on that date the strict interpretation of the test set out by Lord Oliver of Aylmerton in Craven v. White would have been satisfied.

[56]     
As Mr. Tyre pointed out, there are two significant difficulties created by this submission. The first is that it does not appear to be justifiable to give this extended effect to section 147A(2). So far as section 156(3) is concerned, the value of a contract is dependent upon the application of normal accountancy practice, which the statute does not require to be modified. Secondly, the implication of the argument presented by Mr. Moynihan is that the transitional provisions in paragraph 25 of Schedule 15 to the 1996 Act would have been unnecessary. That paragraph applies to a debt contract or option held immediately before and on 1 April 1996 if the disposal of it on 31 March 1996 would have produced a chargeable gain or a gain which would have been brought into account in the computation of the profits of the trade or business carried on by the company which made the disposal. The paragraphs provide for substitution for 1 April 1996 of the commencing day of the first accounting period to end after 31 March 1996.

[57]     
In his alternative submission Mr. Moynihan contended that it was a corollary of the proposition that there was a statute-created loss that it was equally possible for the legislation to have applied to a net profit, for example, if Transaction B had stood alone.

[58]     
Mr. Moynihan reminded the court that it could discard an interpretation where the ordinary meaning of words would conflict with the legislative intention, and prefer an alternative interpretation which was consistent with that intention (Inland Revenue v. Luke 1963 S.C. (H.L.) 65; and Chevron U.K. Limited v. Inland Revenue Commissioners [1995] S.T.C. 712). A deeming provision could more readily be subject to a purposive interpretation (Jenks v. Dickinson (1997) 69 T.C. 458 at pages 487-488). Section 147A(2) should be applied in the context of a legislative scheme which was intended to tax by reference to changes in value and payments. There was something odd about an interpretation which resulted in tax treatment solely by reference to payments. To have taxed pre-1 April 1996 gains would have represented retrospective taxation.

[59]     
It was possible, he said, to construe section 147A(2) in a manner which avoided that. First, section 155(7) when it was read naturally, applied to a qualifying contract which was newly acquired, i.e. "it became held", at any time in an accounting period. It was plain that Transactions A and B did not "become held" during the accounting period to 31 December 1996. Secondly, section 147A(2) provided - as did section 147A(1) - when a contract became a "qualifying contract". It could go no further than that. Thirdly, section 177(2)(b) provided that a contract was held over a period during which rights and duties subsisted. There was no need to conflate these three provisions. It was not necessary to leap from paragraph (a) to (b) in section 177(2), and hence to the decision that the two transactions "became held" on 1 April 1996. It was possible to determine that they were held since 30 June 1995 but became qualifying contracts as at 1 April 1996. Section 155(4) thus applied to the contract as a qualifying contract. The increase or decrease in the value over the period when it was held as a qualified contract, as determined on a mark to market basis, required account to be taken of its opening market value. There was no need to apply section 155(7) to the acquisition value, since there was no double-counting of acquisition cost. On this basis Mr. Moynihan submitted that in regard to Transaction A the Special Commissioners should have found that there was an increase in value of 34m for the purposes of section 154(4)(a)(ii), thus reducing the loss to nil; and, in the case of Transaction B, should have found a reduction in value of 14m for the purposes of section 154(4)(b)(ii), so reducing the profit to nil.

[60]     
In reply Mr. Tyre submitted that section 177(2) provided the link not only to section 155(7) but to the charging provisions of section 155. Section 155(1) used the word "held", and section 155(7) used the words "becomes held". Section 147A did not use the word "held". It referred instead to "becoming entitled to rights or subject to duties". This was to tie in with the definition of "contract" in section 150A. Thus far there was a mismatch in terminology. In order to enable the legislation to work, it was necessary to read section 177(2) along with section 147A(2). The appellants' contention, which would allow the link to operate wholly selectively, should be rejected.

[61]     
In our view Mr. Tyre's arguments are compelling and we accept them. In addition they gain support from the existence of the transitional provisions. These include the making of adjustments to Amounts A and/or B in respect of debt contracts held as at the beginning of the account period which "straddled" 1 April 1996. However, there is no provision for debt contracts which are not covered by paragraph 25 in respect that they were exempt from capital gains tax and were held by corporate investors other than traders in gilts and bonds. The argument presented by the appellants has the remarkable effect of extending transitional provisions beyond the specific scope of paragraph 25 of Schedule 15. Accordingly, we accordingly reject Mr. Moynihan's submissions under this head of the argument.

(4) Was it appropriate to exclude from the computation the Collateral Amount of 20m?

[62]     
Mr. Moynihan submitted that the Special Commissioners had erred in law in reaching the conclusion in relation to the scheme that the Collateral Amount was not part of the price of the option under Transaction A. The Special Commissioners found, however, that it consisted of a genuine loan or at least a genuine deposit; that its purpose was to provide Citibank with security and to remove the incentive for Citibank to exercise Option A early; and that there was no right to offset against payments under the options. They rejected the proposition that it formed part of the consideration for Option A, stating that the only consideration was the interest foregone which was neither the payment of an amount within section 150A(5), nor "the transfer of monies worth" within section 150A(11). Standing these findings we do not consider that there is any proper basis for Mr. Moynihan's submissions.

[63]     
Having regard to the conclusions which we have reached in the course of this opinion we consider that the appeal is not well-founded and should be refused. We will remit to the Special Commissioners to proceed as accords in regard to any detailed matters which remain to be determined.


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