Kato Kagaku Co. Limited v Her Majesty's Revenue & Customs, SPC 00598
| Jurisdiction | UK Non-devolved |
| Judge | Dr John Avery Jones CBE |
| Judgment Date | 07 March 2007 |
| Respondent | Her Majesty's Revenue & Customs |
| Appellant | Kato Kagaku Co. Limited |
| Reference | SPC 00598 |
| Court | First-tier Tribunal (Tax Chamber) |
SPC00598
SCHEDULE A – indemnity payment made by non-resident investor for termination of swap transaction in connection with the early repayment of an onerous loan – whether capital or income – capital because the payment was made to enable the repayment of the loan
INCIDENTAL COSTS OF OBTAINING LOAN FINANCE – TA 1988 s.77 – whether indemnity payment was an incidental cost of obtaining finance – yes – whether paid in consequence of changes in the rate of exchange between currencies – yes, in part – whether a premium – no – appeal allowed in part
KATO KAGAKU CO. LIMITED Appellant
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Special Commissioner: DR JOHN F. AVERY JONES CBE
Sitting in public in London on 26 and 27 February 2007
Jonathan Schwarz , counsel, instructed by Deloitte & Touche LLP and Alston & Bird LLP for the Appellant
David Ewart QC, counsel, instructed by the Acting Solicitor for HM Revenue and Customs for the Respondents
© CROWN COPYRIGHT 2007
DECISION
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This is an appeal by Kato Kagaku Co Limited, a Japanese company, against amendments made on 25 February 2005 to its income tax returns for the years ending 5 April 1997 to 5 April 2003 on the ground that the payment in issue in this appeal is deductible and accordingly the losses carried forward for such periods are different from that stated in the closure notices. The Appellant was represented by Mr Jonathan Schwarz, and the Revenue by Mr David Ewart QC.
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The Appellant is a Japanese resident company which borrowed sterling for 10 years from the UK branch of a Japanese bank to finance the purchase of land in the UK. The bank borrowed dollars in the market and entered into a swap transaction as a result of which it obtained sterling to lend to the Appellant at a formula rate of interest that depended on the rate of exchange between yen and sterling. Following movements in the exchange rate the interest rate became higher than the rental yield from the property and the loan was repaid in accordance with the borrower’s entitlement to repay early, which caused an automatic termination of the swap transaction. By the loan agreement the Appellant indemnified the bank against liability on termination of the swap transaction resulting in a payment of about £21m. The issue is the deductibility of the indemnity payment on general principles and under s 77 of the Taxes Act 1988.
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There was an agreed statement of facts as follows:
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The Appellant is a company which is incorporated and resident in Japan and not resident in the UK for tax purposes.
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In 1989 the Appellant engaged the First Boston Corporation to evaluate the possible purchase of commercial property in London, as a result of which Bush House, Aldwych, London (“Bush House”) was purchased in December 1989 at the price of £130,000,000.
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Bush House has at all material times been let on a commercial basis to third party tenants thereby generating UK source rental income chargeable to tax (for all relevant periods) under Schedule A. The Appellant is not resident for tax purposes in the UK; accordingly, the net rental income received by it from the letting of Bush House is chargeable to income tax (and not corporation tax).
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The Appellant financed the acquisition of Bush House in part with funds borrowed from the London branch of The Tokai Bank Limited (“the Bank”), a banking company incorporated in Japan, in the amount of £95,250,000. At all relevant times the London branch of the Bank was carrying on a bona fide banking business in the UK for the purposes of s.349 Income and Corporation Taxes Act 1988.
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The sum of £95,250,000 (“the Loan”) was made available in Sterling to the Appellant by the Bank for the acquisition of Bush House under the terms of a Facility Agreement dated 7 December 1989 (“the Agreement”). Under the terms of the Agreement the Loan was repayable in Sterling in full after 10 years. The Appellant was required by the Agreement to enter into a debenture with the Bank (“the Debenture”) in the form set out in the Fourth Schedule to the Agreement under which Bush House was given as security for the Loan.
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On 12 December 1989, the Bank advanced to the Appellant the principal amount of ₤95,250,000 pursuant to the Agreement and the Appellant executed the Debenture.
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The Bank offered an interest rate based on a variable formula (“the Variable Formula Rate”) as follows:
[0.3 x 227.9/FX] - 0.256
where “FX” refers to the number of Yen to the pound exchange rate on the fourth business day preceding the date on which interest was payable. Under the Variable Formula Rate, as Sterling rose in value against the Yen the interest payable under the Variable Formula Rate would fall, and as Sterling fell in value against the Yen the interest payable under the Variable Formula Rate would rise.
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If interest had been payable at drawdown, the result of the Variable Formula Rate would have been interest at 4.4% per annum.
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Interest on the Loan was payable annually in arrears.
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The ability of the Bank entered in to an arrangement involving (i) a US$150,304,500 borrowing by the Bank in the Eurodollar market, the interest on which was based on US$ LIBOR, and (ii) the swap described below (“the Swap”).
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Accordingly, making the Loan was conditional on, among other things, execution and delivery of a Swap Supplement (“the Swap Supplement”) evidencing the Swap, in form and substance satisfactory to the Bank. The Swap is documented in the pre-existing Currency/Rate Swap Master Agreement (“the Swap Master Agreement”) between the Bank and Security Pacific National Bank (“Security Pacific”) and incorporates (except so far as modified or excluded) the terms of the International Swap Dealing Association Inc. Code of Standard Wording, Assumptions and Provisions for Swaps, 1986 Edition (the “Code”).
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In addition, the Appellant had to indemnify the Bank against any costs or expenses incurred by the Bank in a variety of circumstances: if the Swap were entered into but the Loan was not drawn down; if the Bank and the Appellant were to renegotiate or terminate the Loan where the Swap was terminated; and if the Swap were terminated early for any reason except default by the Bank under the Swap.
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On 8 December 1989 the Bank entered into the Swap Supplement thereby hedging its exposure resulting from the interest it was to receive from the Appellant under the Variable Formula Rate provided for in the Agreement and its own interest obligation on its borrowing based on US$ LIBOR.
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Under the Swap:
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The Bank paid US$150,304,500 to Security Pacific on 12 December 1989 and at the same time Security Pacific paid the Bank ₤95,250,000.
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On an annual basis, the Bank paid Security Pacific an amount in Sterling equal to interest which would accrue during the one year period on ₤95,250,000 at the Variable Formula Rate.
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Every six months, Security Pacific paid the Bank an amount in US dollars equal to interest which would accrue during the six month period on US$150,304,500 at a rate equal to 0.3% over the six month US$ LIBOR.
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On 12 December 1999 when the Swap was to terminate, the Bank was required to pay Security Pacific ₤95,250,000, and Security Pacific was required to pay the Bank $150,304,500.
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From the Bank’s perspective, the net result was that it was earning a 0.3% margin on a US$150,304,500 extension of credit. From the Appellant’s perspective, it was borrowing ₤95,250,000 at the Variable Formula Rate.
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In January 1991, the Appellant accepted the Bank’s offer of a four year arrangement for a fixed interest rate at 5.2% per annum in place of the Variable Formula Rate for the interest payments from December 1991 to December 1994.
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By contrast, in late...
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