Commissioners of Inland Revenue v Scottish Provident Institution
| Jurisdiction | UK Non-devolved |
| Judgment Date | 25 November 2004 |
| Neutral Citation | [2004] UKHL 52 |
| Docket Number | No 3 |
| Court | House of Lords |
| Date | 25 November 2004 |
[2004] UKHL 52
HOUSE OF LORDS
ORDERED TO REPORT
The Committee (Lord Nicholls of Birkenhead, Lord Steyn, Lord Hoffmann, Lord Hope of Craighead and Lord Walker of Gestingthorpe) have met and considered the cause Her Majesty's Commissioners of Inland Revenue (Appellants) v. Scottish Provident Institution (Respondents) (Scotland). We have heard counsel on behalf of the appellants and respondents.
The following is the opinion of the Committee to which all its members have contributed.
This appeal concerns an artificial scheme devised in 1995 to take advantage of a prospective change in the system of taxing gains on options to buy or sell bonds and government securities ("gilts"). Under the legislation then in force, the Scottish Provident Institution ("SPI"), as a mutual life office, was not liable to corporation tax on any gain realised on the grant or disposal of such an option. Under the system proposed in an Inland Revenue consultation document published in May 1995, all returns on such options would be treated as income and losses made on disposals would be allowable as income losses.
The scheme in outline
The central element of the scheme devised by Citibank International plc ("Citibank") to enable SPI take advantage of the change-over was extremely simple. During the old regime, SPI would grant Citibank an option ("the Citibank option") to buy short-dated gilts, at a price representing a heavy discount from market price, in return for a correspondingly large premium. The premium received on the grant of the option would not be taxable. After the new regime came into force, Citibank would exercise the option. SPI would have to sell the gilts at well below market price and would suffer an allowable loss.
If that was all there was to the transaction, there would also have been a risk that SPI or Citibank would have made a real commercial profit or loss. The premium would have been fixed by reference to the current market price, but the possibility of a rise or fall in interest rates during the currency of the option created a commercial risk for one side or the other. Neither side wanted to incur such a risk. The purpose of the transaction was to create a tax loss, not a real loss or profit. The scheme therefore provided for Citibank's option to be matched by an option to buy the same amount of gilts ("the SPI option") granted by Citibank to SPI. Premium and option price were calculated to ensure that movements of money between Citibank and SPI added up to the same amount, less a relatively small sum for Citibank to retain as a fee. In addition, SPI agreed to pay Citibank a success fee if the scheme worked, calculated as a percentage of the tax saving.
The calculation of the SPI option price obviously needed careful thought. In one sense, of course, it did not matter. Whatever price was selected would be reflected in the corresponding premium and subsequent movements in the market price would cancel each other out. But the option price for SPI had to be higher than the option price for Citibank, otherwise the "profit" realised by SPI on the exercise of its option would cancel out the "loss" which it suffered on the exercise of the Citibank option and the whole exercise would be futile. Indeed, the greater the difference between the Citibank price and the SPI price, the greater would be the net tax loss created by the scheme. The difference did give rise to a potential cash flow problem because, if Citibank paid the premium for its option, it would be out of pocket in respect of the difference between the two premiums between the date on which the options were granted and the date on which they were exercised. But this was covered by a collateral agreement under which SPI agreed to deposit the difference with Citibank, free of interest, until its option had been exercised or lapsed. This enabled the payment of both premiums to take the form of book entries.
On the other hand, the purpose of the SPI option was to reduce or eliminate the possibility that the outcome of the transaction would be affected by events in the real world such as movements in interest rates. So the SPI option price had to be sufficiently below market price as to be, for practical purposes, out of the possible range of such movements. There was also a third consideration. Plainly it was inconceivable that Citibank, having parted with a large premium for its option, would not exercise it. Equally, if the SPI price had been very low, it would have been inconceivable that SPI would not have countered by the exercise of its own option. That might have given rise to a doubt about whether in truth there was any transaction in gilts at all. It would have been inevitable that the obligations of Citibank and SPI to deliver gilts would cancel each other out and that none would change hands. So the SPI option price had to be close enough to the market price to allow for some possibility that this would not happen.
The scheme as implemented
The scheme was proposed by Ms Harrold of Citibank to Mr Burke, Group Taxation Manager of SPI, in a fax dated 22 June 1995. At that stage, it proposed option or "strike" prices of 95 and 70 (assuming market value on the trade date to be 100) respectively. The scheme as implemented used 90 and 70; a narrower spread which gave SPI a smaller tax loss but provided Citibank with greater security against a commercial loss. The way the scheme would work was explained with great clarity by Ms Harrold in a fax to Mr Paterson, Senior Corporate Manager of SPI, on 27 June 1995:
"1. The company buys a nine month in-the-money Bermudan style call option contract which gives it the right but not the obligation to purchase 5 year gilts at a strike price of 90, in return for paying an up front premium.
2. The company sells a nine month in-the-money Bermudan style call option contract which gives Citibank the right but not the obligation to purchase 5 year gilts at a strike price of 70, in return for paying an up front premium.
All options are to be settled for physical delivery. The strikes on the options are set at a level assuming that the value of the gilt is 100 on trade date. The style of the options is 'Bermudan' ie European for the first 2 months and American thereafter. Both options should be considered as qualifying 'financial options' for the purposes of taxation.
Expected taxation treatment
The premium received on the call option sold is treated as an exempt capital gain under the current tax regime. Drawing an analogy with the new financial instruments regime, it is conceivable that the premium paid on the option purchased may be added to the purchase price of the bonds when the option is exercised (since no relief has been obtained under the capital gains tax rules).
After the date of commencement of the new legislation relating to the taxation of gilts and bonds ('commencement date'), the first call option is exercised by the company and immediately afterwards, Citibank exercises the second call option. The purchase and sale of the gilts under the options are netted down within the Central Gilts Office clearing accounts and therefore neither counterparty needs to take delivery of the gilts. The net of the two strikes is paid by the company to Citibank-in the example above 20.
The loss on sale of the bonds is expected to be an income expense to the company under the new tax legislation and may be offset against other taxable income. This will be calculated as the sale proceeds of 70 less the cost of purchasing the bonds. If the premium on the option purchased is added to the cost of the bonds (see above), the net loss will be calculated as 30-ie 70 less the strike of 90 plus the option premium of 10. The amount of the loss available for offset should be at least the difference between the two strikes on the options-ie 90 less 70-in the case that the premium on the option purchased is not added to the cost of the bonds.
Collateralisation of premium paid by Citibank to the company
The cash paid to the company as the net of the two option premiums (20 in the above example) can be passed back to Citibank as collateral against the exposure to the company. If this cash collateral is interest free, this will enable the options to be priced as American style, ie with only intrinsic value and no time value. This means that no funding costs are borne by the company through the option pricing. The collateral is refundable when the option sold to Citibank is exercised, effectively neutralising the attractiveness of early exercise of the deep-in-the-money American style call option. At the same time, Citibank has cash collateral against its credit exposure to the company.
The net option premium received by the company is the net intrinsic value of the options ie the difference between the two strikes (in our example, 20) and this is also the amount of the net cash which passes back to Citibank on exercise of both the options.
Citibank NA is pleased to present to you the proposed transaction or transactions described herein. Under no circumstance is it to be considered as an offer to sell, or a solicitation to buy, any investment."
At a board meeting held in Dublin on 27 June 1995, SPI's board of directors decided to enter into the scheme as outlined in a paper prepared by the Group Actuary, Mr Gillon. The board minutes stated:
"Citibank: Cross Options Scheme. The board received a paper. We were satisfied that we were running no risks other than the cost of the fixed fees involved (£100,000). The tax loss which would be established would be set against future capital gains (which would probably arise within the next few...
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