HM Revenue and Customs v DCC Holdings (UK) Ltd
| Jurisdiction | England & Wales |
| Judge | Mr Justice Norris |
| Judgment Date | 17 October 2008 |
| Neutral Citation | [2008] EWHC 2429 (Ch) |
| Docket Number | Case No: CH/2007/APP/0386 & 0464 |
| Court | Chancery Division |
| Date | 17 October 2008 |
[2008] EWHC (Ch) 2429
IN THE HIGH COURT OF JUSTICE
CHANCERY DIVISION
Royal Courts of Justice
Strand,
London, WC2A 2LL
Mr Justice Norris
Case No: CH/2007/APP/0386 & 0464
John Gardiner QC and Philip Walford (instructed by Reynolds Porter Chamberlain LLP) for the Appellant
Michael Furness QC and Michael Gibbon (instructed by the Solicitor for Her Majesty's Revenue and Customs) for the Respondent
Hearing dates: 12–14 February 2008.
Approved Judgment
I direct that pursuant to CPR PD 39A para 6.1 no official shorthand note shall be taken of this Judgment and that copies of this version as handed down may be treated as authentic.
Dated Mr Justice Norris.
A repurchase transaction (or “repo”) is one under which securities are sold by their original owner to an interim owner subject to an unconditional commitment to repurchase those securities (or an identical parcel) at a fixed price unrelated to market value. The fixed repurchase price means that the benefits and risks of ownership remain throughout with the original owner. The transaction is an entirely ordinary commercial one, not one undertaken with tax avoidance in view: and there is a well-developed global market with quoted rates available “on screen” around-the-clock. Although in form it is one of sale and repurchase, in substance it is (like the classic mortgage) a secured funding arrangement. (To avoid the metaphysics and the sometimes pejorative connotations of the contrast between “substance and form” it might be more accurate to say that the same real event is described in the language of commercial men as “a loan” and in the language of lawyers as “a sale and repurchase”). The repurchase price of the securities is fixed by reference to the cost of the money constituting the sale price (i.e. the cash provided by the interim owner) for the duration of the interim ownership.
During the period of their ownership by the interim owner the securities may yield an income by way of interest or dividend. This can be dealt with in one of two ways. Either the interim owner will account for the interest or dividend to the original owner immediately upon its receipt (sometimes referred to as “a gross paying repo”): or the interim owner will retain the interest or dividend and reduce the price payable by the original owner on the repurchase, so that in effect the income received constitutes a partial repayment of the loan and interest (sometimes referred to as “a net paying repo”).
In the instant case X Bank (an overseas company) sold gilts to DCC Holdings (UK) Ltd (“DCC”) (a UK resident company) during DCC's accounting year ending the 31st March 2002 pursuant to five net paying repo transactions. By way of specific example, on the 30th August 2001 X Bank sold to DCC £149 million nominal of 10% Treasury Stock 2003 for £170 million: and on the 10th September 2001 it repurchased an identical parcel for £163 million. The repurchase price represented the original sale price plus interest thereon for 11 days at 4.65% but less a coupon received by DCC on the repo securities of £7.45 million. The coupon, of course, related to a period of 182 days even though DCC only held the gilts for 11 days.
Overall in the five relevant transactions DCC bought gilts for £812 million from X Bank, and resold them (or substituted securities) for £785 million, in the meantime receiving total coupon payments of £28.8 million. Overall what it received in the transaction exceeded what it had paid by £1.8 million (£785 million + £28.8 million —£812 million = £1.8 million). In the argument about the tax consequences of these transactions it was assumed that the apportioned part of the coupon relating to the period of DCC's ownership of the gilts was £2.9 million.
Reverting to the particular transaction I outlined, in economic terms DCC had lent X Bank £170 million at 4.65% for 11 days. But in legal terms it had bought and sold gilts at a loss and had received income by way of coupon during the period of ownership. This appeal, against the decision of the Special Commissioner Charles Hellier dated 8 th May 2007, involves an examination of how the taxing statutes address that situation. It requires a consideration of the tax treatment of repo transactions generally, and a consideration of a particular category of such transactions (involving bond-based repos conducted between companies).
It is instructive to begin with an examination of how (according to the conventions current in 2002) the question of substance and form is addressed in the company's books and accounts i.e how the real event is described in accounting terms. On this the Special Commissioner received unchallenged expert evidence from Mr Peter Holgate (senior accounting technical partner in the London office of PricewaterhouseCoopers LLP) who was called by DCC. He summarised the position thus:-
“In summary, the seller [X Bank] accounts for a fixed price repo as a fixed rate borrowing with a related interest cost and continues to recognise the underlying security as an asset in its balance sheet. The buyer [DCC] accounts for a fixed price repo as a loan receivable with related interest income and does not recognise the underlying security as an asset.”
This position results from an application of the following principles:-
(a) Accounting standard FRS5 paragraph 14 provides that
“A reporting entity's financial statements should report the substance of the transactions into which it has entered. In determining the substance of a transaction, all its aspects and implications should be identified and greater weight given to those more likely to have a commercial effect in practice. A group or series of transactions that achieves or is designed to achieve an overall commercial effect should be viewed as a whole.”
(b) FRS 5 Application Note B19 deals in these terms with transactions the substance of which is that they are secured loans:-
“Where the substance of the transaction is that of a secured loan, the seller [X Bank] should continue to recognise the original asset and record the proceeds received from the buyer [DCC] as a liability. Interest —however designated —should be accrued….”
(c) So far as X Bank is concerned, therefore, it will according to these principles continue to recognise the gilts as an asset in its balance sheet, will treat the sale proceeds received from DCC as “cash received” and as a liability to be repaid, will accrue the interest payable at the repo rate over the term of the transaction, and (if a coupon payment is made on the gilts which it is carrying on its balance sheet) will recognise that coupon as income (even though the cash is received via DCC, either immediately upon payment (if it is “a gross-paying repo”) or by a reduction in the repurchase price (if it is a “net-paying repo”)).
(d) FRS 5 and FRS 4 do not directly and specifically address the position of the buyer under the repo transaction (DCC), and in particular do not contain a specific requirement to “net” the impact of the coupon received and the compensating onward payment of that coupon to X Bank: but in Mr Holgate's view
“… it is the consequence of applying the principles contained within the standards, which require the overall economic profit of the arrangement to be recognised in the profit and loss account.”
(e) According to the application of these principles, DCC would not recognise the gilts as an asset (even though it had legal ownership), would recognise a “loan receivable” equivalent to the cash it had paid X Bank to purchase the gilts, would accrue the interest receivable on the loan over the term of the repo at the repo rate, and would record a cash receipt in respect of the coupon (but subject to an obligation to pass the cash to X Bank or to credit it to the loan receivable).
The accounting approach accordingly uses the actual transactional figures simply as the raw data from which to work out the interest rate implicit in the transaction for the purpose of accruing the interest due or receivable in the relevant accounting period: and it is that interest (due or receivable) and not the transactional figures that will appear in the statutory accounts. With that description of the transaction itself and of the accounting principles applicable to it, it is possible to turn to the tax treatment of such transactions. In outline, the taxing statutes applicable at the time of the relevant repos did not adopt the accounting treatment of the real world transactions; but they tried to achieve the same result by a complex series of interlocking or cumulative hypotheses.
The earliest provision that is relevant is s.730A of the Income and Corporation Taxes Act 1988 (“TA 1988”) (which came into force in 1993). This was a very precisely targeted section the object of which was to treat the real legal event as if it was something different. Section 730A(1) describes repo transactions. Section 730A(2) then treats certain features of them “as if” they were something different, stating :-
“The difference between the sale price and the repurchase price shall be treated for the purposes of the Tax Acts (a) where the repurchase price is more than the sale price, as a payment of interest made by the repurchaser on a deemed loan from the interim holder of an amount equal to the sale price: and (b) where the sale price is more than the repurchase price, as a payment of interest made by the interim holder on a deemed loan from the repurchaser of an amount equal to the repurchase price”.
So for tax purposes a price difference is treated as if it was a payment of interest. Where there is such a deemed payment of interest then section 730A(4) says that the repurchase price shall be...
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