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Loan relationships - tribunal holds no unallowable purpose once tax avoidance purpose achieved

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Summary: In a surprising decision, the First-tier tribunal held that a loan relationship did not have an allowable purpose because the tax avoidance purpose had been achieved before the accounting period in which the debit arose.

Alternatively, even if the tax avoidance purpose continued into the accounting period in which the debit arose, it only lasted for a scintilla in time. Therefore, on a just a reasonable apportionment​ none of the debit should be disallowed.

Expect HMRC to appeal this decision. 

The scheme

The scheme essentially involved exploiting a change in accounting standards to engineer a tax deductible reduction in the accounting value of bonds.

In late 2004 Fidex issued four classes of redeemable preference shares. Each class tracked an underlying class of bond held by Fidex. These bonds were originally acquired in 2000 for a commercial purpose.

Under UK GAAP the bonds were accounted for as assets on Fidex's balance sheet.

Fidex adopted IFRS from 1 January 2005. Under IFRS the preference shares were treated as liabilities and derecognised in Fidex's accounts. Because of the way that the preference shares tracked the bonds, the bonds were also derecognised as to 95% of their value. The accounting value of the bonds was, therefore, reduced by 95% because of the change in accounting policy.

Fidex claimed that this gave rise to a tax deduction under the loan relationship rules for 95% of the bonds' value. HMRC argued that the deduction should be disallowed because it was attributable to an unallowable purpose (old paragraph 13 Schedule 9 FA 1996, now s.441 & 442 CTA 2009).

HMRC also argued that only 5% of the value of the bonds should not have been recognised under UK GAAP so the accounting change did not trigger a change in accounting value. The tribunal rejected this argument so the case turned on the unallowable purpose point.

What is an unallowable purpose?

Where "in any accounting period" a loan relationship of a company has an unallowable purpose, the debits for "that period" are reduced on the basis of a just and reasonable apportionment.

A company has an unallowable purpose in an accounting period where the purposes for which, at times during that period, the company:

  • is party to the relationship; or
  • disposes of or acquires rights or liabilities under that relationship

include a non-business/commercial purpose (which includes where one of the main purposes is a tax avoidance purpose).       

Was there a disallowance?

The tribunal held that the main purpose of the issue of the preference shares (and other related transactions) was tax avoidance. However, the debit was not disallowed because Fidex's tax avoidance purpose had been achieved before the 2005 accounting period in which the debit arose.

As the debit was being claimed in the 2005 accounting period, the tribunal looked at Fidex's purposes in 2005. The purpose of anything it did in 2004 was irrelevant.

The tax deduction depended upon the accounting value of the bonds at the beginning of 2005. This depended upon the "facts existing" at the end of 2004 and the tribunal accepted that the tax deduction, therefore, crystallised at the end of 2004. The sale of the bonds in January 2005 would not have affected the accounting or tax treatment.

As Fidex's tax avoidance purpose had been achieved before the 2005 accounting period began it did not have an unallowable purpose in 2005.

No tax avoidance in 2005, not even for a scintilla?

The tribunal's decision that the tax avoidance purpose ended before 2005 seems odd. Given that the tax treatment depended upon the value of the bonds at the end of 2004, surely the bonds had to be held for at least a scintilla of time at the start of 2005?

Not according to the tribunal (although it accepted that the scheme would not have worked had the bonds been sold before 1 January 2005). However, in case it was wrong on this point it considered how paragraph 13 would have applied if Fidex had a tax avoidance purpose for a scintilla in time in early 2005.

Just and reasonable apportionment

The tribunal applied the just and reasonable apportionment test on a purely temporal basis. On any just and reasonable apportionment no part of the debit would be attributed to the scintilla in time in 2005 for which Fidex had a tax avoidance purpose. No part of the debit would, therefore, be disallowed even if Fidex's tax avoidance purpose can continued into 2005.

This is an even more surprising conclusion. The very term "just and reasonable" indicates something more than a purely time-based apportionment. And if the draftsman had intended it to be a mechanical time-based test then surely he would have drafted it as such.

For example, where two group companies have non-coinciding accounting periods, the corporation tax group relief rules generally apportion profits and losses on a time basis. However, where a time-apportionment would operate unjustly or unreasonably, either HMRC or the company can use an alternative just and reasonable basis of apportionment (see s.141(3) CTA 2010 and CTM80260).

Derecognition rules

The scheme would now be caught by the anti-avoidance rules in s.455A CTA 2009. Some commentators think this (along with Mayes) means it is not surprising that the scheme in this case worked. That does not necessarily follow.

The flaws in the tribunal's reasoning described above in themselves make the decision surprising. As for s.455A, it is undoubtedly designed to prevent more than one scheme. And the Government often changes the law to stop a scheme without necessarily accepting that the scheme worked.

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