Capital Tax Review by Matthew Hutton, MA, CTA (Fellow), AIIT, TEP
The ‘end of the road’ has been reached in the long ‘flip flop’ saga, explains Matthew HuttonThe ‘end of the road’ has been reached in the long ‘flip flop’ saga. The House of Lords following the High Court has found unanimously for the Revenue (the Special Commissioners and the Court of Appeal having decided for the taxpayers).Trennery v West: the facts
Mr and Mrs Trennery (T) were shareholders in an unquoted UK bus company, B Ltd. There was a possibility of the sale of the company to another company. Mr and Mrs T wanted to sell their shares in B Ltd in such a way as would mitigate the CGT liability.On 1.4.95 Mr T made a life interest settlement (Trust 1) for himself. On 4.4.95 Mr T gave shares in B Ltd to Trust 1. On that day he made a second life interest settlement for himself (Trust 2). The Trust 1 trustees authorised their solicitors to hold the share certificates or proceeds of sale of the B Ltd shares to the order of the bank in consideration of a loan advance and authorised the bank to advance the funds to the solicitors. The advance was credited to a loan account in the name of the trustees of Trust 1 and transferred to the solicitors' client account at that bank. On 4.4.95 the trustees of Trust 1 transferred part of the trust fund to Trust 2. The solicitors' client account ledgers for Trust 2 were credited with the amount appointed. On 5.4.95 the trustees of Trust 1 irrevocably excluded Mr and Mrs T as beneficiaries of Trust 1 and appointed their children as substitute life interest beneficiaries.
On 13.4.95 the trustees of Trust 1 sold the B Ltd shares to C Ltd. The consideration for the share purchase was paid by C Ltd to the solicitors who credited their client account ledger for the trustees of Trust 1 with the sale proceeds. The outstanding loan to the bank was repaid and the trustees' bank account was closed.
The transactions were carried out to reduce the CGT on the share sale from the 40% applicable to Mr T (or to the Trustees of Trust 1 if he still had an interest in that settlement) to 25% which would otherwise apply to the trustees. TCGA 1992 s77 provided that a settlor should be regarded as having an interest in the settlement if any [settlement] property, or any derived property, was or would or might become payable to or applicable for the benefit of the settlor or his spouse in any circumstances whatsoever. Mr T appealed against the Revenue's assessments calculated at a 40% rate.
The decision: HL (Lords Steyn, Hoffmann, Millett, Rodger of Earlsferry and Walker of Gestingthorpe)
‘Derived property’ was not limited to property comprised in the initial settlement and so the ‘flip-flop’ scheme was bound to fail
The substantive judgments were given by Lord Millett and Lord Walker. The issues in this case had narrowed to the one point of the scope of TCGA 1992 s77(2) and specifically the meaning of ‘derived property’. The Court of Appeal had decided on 18 December 2003 that, once property left Trust 1 (while it could be derived property in relation to the trust fund of Trust 2), it ceased to be derived property in relation to Trust 1. It was this with which the HL disagreed. As Lord Millett said at para 16:‘The final question is whether the Revenue are correct in contending that the moneys comprised in the trust funds of the second settlement during the relevant year and the income therefrom which was payable to the settlor constituted derived property within the meaning of Section 77(8) in relation to the Einkorn shares. There can be only one answer to this: of course they do. The moneys comprised in the trust fund of the second settlement directly represented the proceeds of a mortgage of the Einkorn shares and the income payable to the settlor during the relevant year represented the income therefrom. If the trustees of the second settlement had invested the moneys in stocks and shares, these would have indirectly represented those proceeds. It will be observed that I have equated the proceeds of a mortgage of property with the proceeds of the property itself. But the Subsection does not refer to “the proceeds of a sale of that property”, but to “the proceeds of that property”; and this covers any process, whether sale or mortgage or otherwise howsoever, by which value is extracted from one property and transferred to another.’
Lord Millett went on to deal with the ‘reductio ad absurdum’ [my expression] raised by the taxpayers, viz that this interpretation would prevent one from ever knowing, during the settlor’s lifetime, whether assets advanced out of the first trust ceased to be ‘derived property’. On this possibility Lord Millett placed a limitation as follows:
‘The taxpayers submitted that this was an extravagant application of the statutory provisions, since whatever assets were comprised from time to time in the trust funds of the second settlement they would never cease to represent, directly or indirectly, the proceeds of the mortgage of the Einkorn shares. That is true, but once the Einkorn shares were sold the assets in the second settlement and the income therefrom would cease to constitute derived property in relation to any property for the time being comprised in the first settlement.’
Lord Millett said that the CA interpretation, that the word ‘proceeds’ in s78(1) referred only to the mortgage proceeds while comprised within Trust 1, ‘emasculates’ s77(2) and deprives the elaborate provisions relating to derived property of all effect.
Lord Walker went on to trace the legislative history of s77, examining the changes made by FA 1995. He found that the argument on the meaning of ‘derived property’ developed for the taxpayers faced an insuperable objection: ‘if correct, the whole elaborate definition of ‘derived property’ in s77(8) could have been replaced by a simple reference to any capital or income of the property comprised in the chargeable settlement’. He went on to say: ‘ … But Parliament must be taken to have intended the expression to add something to the effect of section 77, and it would occasion no great surprise if the addition were found to be a category of property which is settled property, and is derived from settled property comprised in the chargeable settlement, but is not itself still comprised in the chargeable settlement’.
Lord Walker was not impressed by Brian Green QC, for the taxpayers, putting forward various imaginary scenarios in which, on totally different facts, taxpayers might be faced with tax claims which might appear oppressive. He said: ‘In the end the taxpayers’ case is based, as it seems to me, not on the way in which the Inland Revenue seek to apply the statutory provisions in these cases, but on the anomalous and oppressive effect which they might have in other hypothetical circumstances far removed from those of the present case.’
Lord Walker went on to say: ‘Parliament has for very many years passed many enactments aimed at settlors who seek to use settlements to shelter assets from high rates of tax, and later to enjoy the benefit of the settled property themselves. The possibility of even a small benefit may have severely adverse consequences. That is well understood by those who advise settlors. As Lord Wilberforce said in Leedale v Lewis [1982] 1 WLR 1319 at 1330, “Settlors, after 1965, make their settlements with knowledge of the legislation and of its consequences”.’
In accordance with the terms on which leave was granted to the Revenue to appeal to the HL, the Revenue were ordered to pay the taxpayers’ costs in the HL, with the taxpayers liable to pay the costs below.
(Trennery v West and others 27.1.05 [2005] UKHL 5)
Comment
It is technically interesting (though depressing for those taxpayers who have indulged in flip-flop schemes) that this HL judgment has found the decisions of both the Special Commissioners and the Court of Appeal, both strongly supporting the taxpayers’ case, to be wrong. For me, Lord Walker’s judgment, based on the need to give meaning to the definition of ‘derived property’ in s77(8), was the knockout blow. Lord Millett had cut the ‘Gordian knot’ of the taxpayers’ ‘reductio ad absurdum’ argument in a fairly straightforward sort of way: it certainly provides a practical solution to the difficulty, though it is hard to see the justification for this in statute.Matthew Hutton
June 2005
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