Kato Kagaku Company Ltd v R & C Commissioners
| Jurisdiction | England & Wales |
| Judgment Date | 07 March 2007 |
| Date | 07 March 2007 |
| Court | Special Commissioners |
special commissioners decision
Dr John F. Avery Jones CBE
Jonathan Schwarz, counsel, instructed by Deloitte & Touche LLP, for the Appellant
David Ewart QC, counsel, instructed by the Acting Solicitor for HM Revenue and Customs for the Respondents
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 - Income and Corporation Taxes Act 1988 section 77ICTA 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
A special commissioner decided that an indemnity payment under a loan agreement was a capital payment and in general was not deductible in computing Sch. A income. Income and Corporation Taxes Act 1988 section 77Section 77 of ICTA 1988 allowed the deduction of the indemnity payment in principle as an incidental cost of obtaining finance. Income and Corporation Taxes Act 1988 section 77 subsec-or-para 7Section 77(7)(a) disallowed part of the indemnity payment as being paid in consequence of losses resulting from changes in the rate of exchange between different currencies. On the other hand, s. 77(7)(b) did not disallow the payment as being a premium.
The taxpayer was a Japanese resident company which borrowed sterling for ten 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 taxpayer at a variable 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 taxpayer indemnified the bank against liability on termination of the swap transaction resulting in a payment of about £21m.
The taxpayer appealed against amendments made to its income tax returns for the years ending 5 April 1997 to 5 April 2003 on the ground that the indemnity payment was deductible and accordingly the losses carried forward for such periods were different from what was stated in the closure notices. The taxpayer contended that the agreement permitted prepayment of the loan without penalty. The indemnity was a separate matter so that the bank could not refuse repayment when tendered and if necessary would have to enforce the indemnity separately. The indemnity payment was not to terminate the loan; it was paid in consequence of the termination of the loan. While not representing interest, it was calculated entirely by reference to interest on notional principal sums. It was treated as a revenue expense for accounting purposes.
The taxpayer submitted that, the indemnity payment was within the definition of "the incidental costs of obtaining finance" in ICTA 1988, s. 77 as being an incident of repayment. The indemnity payment did not represent a sum "paid in consequence of … losses resulting from changes in the rate of exchange between different currencies". There was no currency loss, merely a payment calculated according to a formula. The indemnity payment was not a premium as understood in the context of loan transactions, namely a payment in excess of the amount borrowed to be made on repayment under the terms of the loan.
The Revenue contended that the loan was a capital transaction, applying the test in Beauchamp v F W Woolworth plcTAX[1989] BTC 233; 61 TC 542. The loan was for ten years, although the taxpayer could repay earlier. It was for the express purpose of purchasing a property and was clearly for a capital purpose. The indemnity giving rise to the indemnity payment was part of the consideration for the loan and was an integral part of the agreement. The fact that the indemnity payment was computed by reference to interest payments on a notional principal was not relevant; that confused how it was computed with the nature of the payment, which was capital.
On s. 77, the indemnity payment was not "expenditure on fees, commissions, advertising, printing and other incidental matters" since it was not similar to the items listed and was not incidental (meaning subordinate) to the agreement but part of it. The indemnity payment was to indemnify the bank against a loss on the termination of the swap transaction and that loss arose because of changes in the rate of exchange between different currencies within s. 77(7)(a). The indemnity payment was a premium since the terms of the loan provided for something in excess of the amount borrowed to be paid at the time of prepayment.
Whether the indemnity payment was deductible on general principles and under Income and Corporation Taxes Act 1988 section 77s. 77 of ICTA 1988.
The special commissioner (Dr John Avery Jones) (dismissing the appeal) said that the essential difference between the parties was that the taxpayer contended that the indemnity payment for termination of the swap transaction should be viewed separately from the prepayment of the loan, which was made without any penalty; while the Revenue contended that the indemnity payment should be viewed as the cost of prepayment of the loan.
The categorisation of the payment depended on the true analysis of the transaction in which the taxpayer's purpose was not determinative. It was clear that the loan could not be prepaid without terminating the swap transaction. The circumstances unconnected with prepayment of the loan in which the swap transaction could be terminated were those in which a party was entitled to designate an early termination date under the swap master agreement. Apart from some events outside the taxpayer's control or expectation, there were no circumstances in which a payment calculated in a similar way to the indemnity payment could be made for terminating the swap transaction separately from prepaying the loan. Any agreement would provide for defaults by the other party and changes in the law making the transaction unlawful or subject to unexpected tax charges. Whatever the tax treatment of a payment made on termination of the swap transaction in such events, it would not be an income payment.
The making of the indemnity payment was a necessary part of the prepayment. The making of the indemnity payment achieved the removal of the onerous loan, rather than the termination of the swap arrangements following the prepayment of the loan. The indemnity payment was not merely a consequence of the prepayment of the loan rather than a payment to terminate the loan; the prepayment could not have been achieved without it. While the agreement provided that termination of the loan could be made without penalty on an interest payment date, the agreement also provided for automatic termination of the swap transactions for which the taxpayer had to make the indemnity payment.
The question then was whether the indemnity payment was a capital payment within the definition in s. 77 of "the incidental costs of obtaining finance" which meant "expenditure on fees, commissions, advertising, printing and other incidental matters (but not including stamp duty), being expenditure wholly and exclusively incurred for the purpose of … repaying it". In all the circumstances, the indemnity payment was something that had a subordinate conjunction with the prepayment of the loan. The purpose and effect of the payment was to achieve the prepayment of the loan. The fact that it was made in accordance with the agreement did not make it cease to be incidental to the loan repayment. It thus qualified as an incidental cost of obtaining (defined to include repaying) finance.
In relation to s. 77(7)(a), an indemnity was a payment that made good a loss, here the loss that the bank would incur on termination on the swap transaction because the present value of the payments that the bank would have to make during the remainder of the life of the swap was greater than the present value of the payments that it would receive. There was therefore a loss to the bank. The issue under s. 77(7)(b) was whether "premium" was used either in a technical sense of the terms of issue of a loan requiring repayment of a loan to be of a greater sum than was borrowed, whether that amount was fixed or calculated according to a formula; or in a more general sense of anything paid in excess of that borrowed. A corporate finance expert reading the words of s. 77(7)(b) and the words of the agreement would not consider that the loan was repayable at a premium because the indemnity payment for terminating the swap transaction was required to be made in consequence of the prepayment.
Accordingly, the indemnity payment was "an incidental cost of obtaining finance", and was not a premium, but part of it was "in consequence of, or for obtaining protection against, losses resulting from changes in the rate of exchange between different currencies" and that part was not deductible (Lawson (HMIT) v Johnson Matthey Bank plcTAX[1992] BTC 324 distinguished; Beauchamp (HMIT) v FW Woolworth plcTAX[1989] BTC 233 considered).
1. 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...
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