On 30 April 2021 the Court of Appeal handed down its unanimous judgment in Bostan Khan v HMRC. As tax cases go, it is neither the biggest in terms of amounts of tax at stake (except, one assumes, from the perspective of poor Mr Khan) nor the most complex. But in terms of why it is noteworthy, I can put it no better than Lady Justice Andrews did in her opening two sentences:
“This is a cautionary tale, which illustrates all too graphically the importance of seeking specialist tax advice before entering into commercial arrangements that might have adverse tax consequences, however remote that risk might appear.
It is impossible not to feel some sympathy, for the appellant, Mr Khan, who was held liable to pay income tax of almost £600,000 on £1.95 million that was paid into his bank account and then paid out again almost immediately in respect of connected share sale and buy-back transactions. Yet he found himself in that situation because he relied upon an assumption that the consequence of his having to expend the £1.95m as soon as it was received, was that the persons to whom he paid it would be liable to pay tax on it instead of him.”
In short, Mr Kahn was an accountant who had prepared the management accounts of a company called Computer Aided Design Ltd (CAD) since the mid-1990s. In June 2013, the three shareholders of CAD wanted out and, having failed to negotiate a sale, wanted to extract the remaining funds from CAD and move on. They approached Mr Kahn on the basis that they would take the cash and Mr Kahn would oversee the orderly wind up of the company, benefitting from any surplus.
The original plan was for CAD to buy back 96 of its 99 shares for £1.8m and for Mr Kahn then to buy the remaining 3 shares for c. £200k. However, the three shareholders took some tax advice (seemingly unlike Mr Kahn) and the transaction was flipped to Mr Kahn buying all 99 shares, in the end for c. £1.968m, and then the company buying back 98 of those shares for £1.95m (the sum total of its distributable reserves). So the net effect for Mr Kahn was the same in that he ended up owning the entire issued share capital of CAD (represented by one share rather than three) for a cost equal to the net asset value of CAD (then c. £18k). It appears the change of structure was to ensure that the selling shareholders could benefit from entrepreneur’s relief.
Sadly for Mr Kahn, although the net effect of the two transactions was more or less identical, the tax consequences are very different. When a company buys back shares from a shareholder, any excess above the amount originally subscribed for those shares is treated as a distribution, meaning that is taxed in the same way as a dividend in the hands of the shareholder. So Mr Kahn was not treated as having paid £18k for CAD, which is how he saw the transaction. Rather he was taxed on the basis of the transactions actually undertaken, namely that he paid £1.968m for CAD, largely funded out of the receipt of a taxable dividend of £1.95m.
Before the FTT, Mr Kahn had run two arguments. First, that he should be treated as carrying on a trade, and so entitled to a revenue deduction for the purchase price which he could deduct from the dividend income. Secondly, that he should be taxed on the basis of the single composite transaction and that he should not be taxed on the distribution as he was not the one “entitled” to it. Only the second of these made it to the Court of Appeal where it was noted that it was “unusual” for the taxpayer, rather than HMRC, to be seeking to rely on the Ramsay approach. That of itself was not an issue – the Ramsay principles, being principles of statutory interpretation, are of general application. The issue was that the relevant charging provision was not “concerned with the overall economic outcome of a series of commercially interlinked transactions”. It only cared about who was entitled to the distribution or who actually received it. And the answer to that was Mr Khan as he had a contractual entitlement to be paid the price for the shares sold back and had not created a charge or trust over the price in favour of someone else nor assigned away the right to it.
That is good news for publicly traded companies with share buyback programmes. Such programmes are often effected through the company giving a bank a mandate to go out and buy shares in the market for immediate on-sale to the company. The general expectation is that the tax consequences for a shareholder selling to the bank should be the same as for any other sale they might make and that the bank, which unlike Mr Khan will demonstrably be carrying on a financial trade, will be entitled to deduct the cost of purchasing the shares in the market from the proceeds of selling them back to the company, leaving it simply taxable on its net profit. If Mr Khan’s single composite transaction argument had succeeded, that would have raised the question as to whether the purchase price paid by the bank to a selling shareholder could similarly be recharacterised as a taxable dividend.
But it’s also a good reminder that whilst it is tempting to assume tax should always follow the economics, it often doesn’t, and different legal or commercial ways of producing effectively the same outcome can have very different tax consequences. Often there is no substitute for working through payment flows considering the deductibility/non-deductibility or taxability/non-taxability of each payment or receipt to check that the likely tax outcome is the expected one. Or at least won't come as a very unwelcome surprise...