A little over a year ago, I wrote a post called "The cautionary tale of Mr Bostan Khan". It was prompted by the Court of Appeal decision in Bostan Khan v HMRC and I wrote it because I thought it neatly illustrated the way that the tax consequences of transactions with a different form, but substantively the same effect, can differ greatly. As Lady Justice Arden put it:
“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."
I thought of these words when reading the opening paragraphs in the First-tier Tribunal's judgment in Hexagon Properties v HMRC.
"This appeal concerns the appropriate tax treatment of what was expressed to be a release of debt of some £3.5 million previously owed by the Appellant to its bank; the release was not however a simple or standalone release but took place as part of a settlement of a claim brought by the Appellant against that bank in respect of the mis-selling to the Appellant of an interest rate hedging product.
In broad terms, HMRC claim the amount so released to be taxable as income under the loan relationship rules on the straightforward basis that a “release” (or possibly an exchange or redemption) had taken place, whatever the wider context; the Appellant claims the amount so released to represent a payment to it by the bank in settlement of its action for damages against the bank and accordingly to represent wholly or in part a receipt of capital outside the scope of any charge to corporation tax under the loan relationship rules. The Appellant then claims to be entitled to the benefit of extra-statutory concession D33 in respect of the capital element, but the parties are agreed the applicability of that concession lies outside the scope of the Tribunal’s jurisdiction."
My initial reaction to that was that it sounded rather hopeless for the taxpayer. If it really is the case that a loan relationship has been released, and that has given rise to a £3.5 million profit in the taxpayer's accounts, that is surely taxable irrespective of the wider context in which the release was agreed.
Reading on, the facts were laid out in more detail, including the relevant terms of the settlement agreement, and the FTT summarised the positions as follows:
"The Appellant’s pre-existing indebtedness to the bank under the loan accounts was, I was given to understand, in the region of £5 million. By agreeing to accept a payment of £1.49 million and a waiver of all claims in settlement of that £5 million debt, the bank was therefore effectively paying approximately £3.5 million by way of damages to settle the Appellant’s claims."
Just like poor Mr Boston Khan, I thought. The parties could have structured this such that the taxpayer repaid the £5 million in full and the bank paid the taxpayer £3.51 million in damages and there would have been no question of the £3.51 million being taxable under the loan relationship rules. In my view, this would include a "cashless settlement" if the settlement agreement had provided for the taxpayer to repay the £5 million in full, the bank to pay £3.51 million in damages to the taxpayer, and for those two obligations to be settled, to the extent possible, through set-off with the effect that only a net payment of £1.49 million was made to the bank. But they did not. They chose to structure it as a partial repayment of £1.49 million and a release of the £3.51 million balance.
So, when the FTT concluded that the release of the £3.51 million was a "related transaction" for loan relationship purposes and that it "follows that any profit arising to the Appellant from the related transaction in question must be brought into account as a loan relationship credit under s. 306A CTA09", it looked to me like the writing was on the wall for the taxpayer.
However, there was one last test to be passed. Did the credit in the taxpayer's accounts "arise from" the release for the purposes of section 306A of the Corporation Tax Act 2009 (CTA09)? Here the FTT noted that the correct test, based on the Court of Appeal's judgment in Union Castle, was whether there was a "direct causal connection" between the release and the accounting credit. Counsel for HMRC said that such a connection was "self-evidently present" because, if the bank had not released the debt, there would have been no credit in the accounts. In a few short sentences the FTT rejected this on the basis that "Any objective consideration of what the £3.5 million arose from in this case would conclude that it arose "from" the Appellant's claim in damages against its bank and not "from" any related transaction of its loan relationship".
There is no real reasoning here, although the FTT drew some comfort from the way the credit was described in the taxpayer's accounts as compensation for a misselling claim. There is no attempt to explain why HMRC's argument that, without the release, there would have been no accounting credit did not establish a direct causal connection. There is no consideration of the possibility that both the related transaction and the claim in damages might have a causal connection to the credit and that the former might be considered the direct cause, due to proximity, and the latter an indirect cause, meaning only the former passes the Union Castle test. It is tantamount to HMRC having argued "it's obviously X", the FTT having countered with "it's obviously Y", and leaving it at that. When to me at least, it is not obviously Y at all (and probably was X all along).
The potential uncertainty this decision creates for a number of common commercial scenarios is then highlighted by the FTT seeking to distinguish an example HMRC's counsel gave of the owner of a company releasing a large debt owed to her by the company. They argued that any resulting credit in the company's accounts would be chargeable under the loan relationships regime as a profit arising from the release and would not fall outside the regime on the basis that it really "arose from" the bounty of the shareholder in releasing the debt. Correct, said the FTT. Whilst in that case the "cause" of the profit might be that bounty, "on any objective view" the profit would undoubtedly arise from the release and not the bounty. And that would be so irrespective of whether the accounting entry made reference to the reason for the credit (the shareholder's bounty) or not.
I for one find it very hard to distinguish between these scenarios. It seems to me pretty clear (although perhaps I am not objective?) that, in each case, there is a direct causal connection between the release and the accounting profit. The profit arises from the release. And in each case, there is a more indirect cause or reason why the release has taken place, too. In the first instance, the bank has released the debt to give the taxpayer a £3.5 million profit in order to compensate it for the misselling claims. The reason why the bank has acted does not and should not change what the profit arises from any more than the reason why the shareholder has acted does not and should not change what the profit arises from in the hypothetical scenario posed by HMRC's counsel.
This decision creates scope for uncertainty for taxpayers and HMRC alike. It used to be clear that, when a debt is released by a connected company, the resulting credit is not taxable for the debtor company (section 358 CTA09). That is a provision often relied on in group reorganisations. But groups may now have to watch out for HMRC seeking to argue that, although on the face of it, it might seem like the credit "arises from" the release, it in fact "arises from" something else instead (the reason for the release) and may in fact be taxable. The flipside is that, prior to this decision, it was also equally clear that when a debt was released by a third party - common in many restructuring scenarios - the resulting credit would be taxable unless one of the specific exclusions in section 322 CTA09 applied. But a taxpayer might now conceivably argue that, even if section 322 CTA09 does not apply, the credit is simply not taxable because it arises from something other than the release.
So whilst I have every sympathy for the particular taxpayer in this case, I rather hope HMRC appeal this point and the Upper Tribunal restores certainty and removes this blurring of the distinction between the cause of a profit arising and the reason for causing a profit to arise.