QCB conversion scheme fails for the Hancocks at the Upper Tribunal (UT)

QCB conversion scheme fails for the Hancocks at the Upper Tribunal (UT)

Fri 04 Mar 2016

HMRC have won their appeal against the decision of the First-tier Tribunal that a scheme contrived to turn CGT-taxable non-QCBs into non-taxable QCBs was effective in Hancock v HMRC [2014] UKFTT 695 (TC)

Mr. and Mrs. Hancock exchanged shares in their company for non-QCB loan notes (the ‘Sale non-QCBs’) plus an entitlement to further non-QCB loan notes through an earn-out (the ‘Earn-out non-QCBs’).

The Earn-out non-QCBs were then converted to QCBs (the ‘converted Earn-out QCBs’) by the removal of a currency conversion clause.

Subsequently, the resulting holding of a mixture of QCBs (i.e. the converted Earn-out QCBs) and non-QCBs (i.e. the Sale non-QCBs) was exchanged for a single holding of QCBs (the ‘New QCBs’). The taxpayers claimed that this exchange constituted a single transaction, the effect of which was that:

  • the conversion of the Earn-out QCBs crystallised a gain (which was deliberately contrived to be small);
  • no gain was realised when the Sale non-QCBs and converted Earn-out QCBs were exchanged for the New QCBs; and
  • when the New QCBs were encashed they carried no held-over gains that then became chargeable.

Therefore CGT of £830k on the very substantial gains rolled over into the Sale non-QCBs on the original disposal was avoided.

This analysis relied on treating the final conversion of the mixture of Earn-out QCBs and Sale non-QCBs into a single holding of QCBs as a single transaction, rather than two separate conversions (i.e. one of QCBs to QCBs and the other of non-QCBs to QCBs).

HMRC disputed this analysis and the case came before the FTT who found in favour of the taxpayer.

Background (taken from TTH 1 August 2014).

Where ss 125 to 132 apply to an exchange of securities there is neither gain nor loss, with any gain that would have arisen on disposal of the old security remaining inherent in the replacement, new security. Where the replacement is a QCB, the gain is held over until disposal of the QCB (s 116 (10)).

Section 115 generally exempts QCBs from capital gains tax (CGT). S 116 generally renders it impossible to exchange or reclassify non-QCBs for/into QCBs and so avoid CGT on any gains accrued, including gains previously held over on an exchange of shares for non-QCBs. S 116 provides that:

  • when a non-QCB is exchanged for, or converted into a QCB, any gain on the non-QCB is held over, not rolled over, and will be brought into charge when the QCB is disposed of; and
  • where a QCB is exchanged for a non-QCB, that is a disposal and any gain previously held over onto the QCB (on exchange for shares or a non-QCB) becomes chargeable.

It does not explicitly cover exchanges where the holding being exchanged is a mixture of QCB and non-QCB.  This lacuna was the point at issue in Hancock.

Mr. and Mrs. Hancock (H&H) had sold their company in exchange for non-QCBs with a right to further earn-out consideration. Under professional advice they embarked on the following series of transactions to mitigate the eventual liability on disposal of their non-QCBs, which required the cooperation of the company that had taken over their original company (i.e. the issuer of the non-QCBs).

The sequence of events

1.         24 August 2000           receive ‘B Loan’                      (non-QCBs)   

2.         22 March 2001             receive ‘B loan’ earn-out        (non-QCBs) 

3.         9 October 2002            earn-out shares reclassified as ‘Revised B Loan’ (QCBs) 

4.         7 May 2003                  exchange ‘B Loan’ and ‘Revised B Loan’ for Secured Discounted Loan (QCBs) 

5.         30 June 2003  redeem Secured Discounted Loan for cash

The crucial step was step 4, the 7 May 2003 exchange of the mixed holding of QCBs and non-QCBs for a new holding of only QCBs. This is also the step that HMRC challenged.

The Hancocks argued that:

  • this step was not covered by s 116 because s 116 only applies if “either the original shares would consist of or include a qualifying corporate bond and the new holding would not, or the original shares would not and the new holding would consist of or include such a bond” (s 116 (1)(b)), i.e. there was a single transaction with the original holding being both QCBs and non-QCBs all of which were exchanged for QCBs alone;
  • therefore as s 116 did not apply ss 126-132 applied with the result that the gain rolled over into the non-QCBs was rolled over into the new QCBs and thereby became exempt under s 115, rather than being held over under s 116 to become chargeable on subsequent disposal.  The gain disappeared.

HMRC argued that:

  • the exchange was to be treated as two separate transactions;
  • exchange of non-QCBs (‘B Loan’) for new QCBs, with any gain held over at that point but becoming chargeable when the new QCBs were redeemed; and
  • exchange of QCBs (‘Revised B Loan’) for new QCBs, triggering a gain on the old QCBs at the point of exchange.

HMRC also offered the alternative argument that steps 4 and 5 amounted to a single composite transaction, i.e. under Ramsay principles and taking a purposive view of s 116, the conversion from ‘B Loan’/ ‘Revised B Loan’ to Secured Discounted Loan was a single composite transaction. This would have meant that the intermediate conversion to Secured Discounted Loan was an artificially interposed step without commercial purpose, so that the transaction should be seen as simply encashment which triggered:

  • a gain on disposal of the ‘B Loan’, calculated on the basis of actual cash received less inherited base cost of the company shares disposed of at step 1; and
  • held-over gains on the ‘Revised B Loan).

The FTT ruled that the purpose of the restructuring into the Secured Discounted Loan was to enable H&H to obtain earlier redemption than they otherwise could have done because the ‘B Loans’ would not have been redeemable before September 2003, whereas they were able to redeem the Secured Discounted Loan on 30 June 2003. It was acknowledged that the Secured Discounted Loan was structured entirely for tax mitigation purposes but that did not detract from the fact that the exchange was a genuine transaction with a genuine commercial purpose.

As regards the purpose of s 116 the Judge made the point that (Para. 82) “We do not consider that a purposive construction of the reorganisation provisions, including s 132, can produce any different result merely on the basis that the transactions that have been entered into were intended, for tax avoidance reasons, to exploit an anomaly in the application of those rules. The result of the transaction was (Para. 86) “. . . the consequence of the legislation that Parliament has chosen to enact, and no purposive or other construction can give rise to a different result.”

The UT judgment

The UT decided that the plain words of the statute allowed for each individual transaction to be considered individually and there was no need to consider whether it was necessary to take an overall, purposive view of the relevant parts of TCGA.

The Judges ruled that the FTT had erred in focussing on s 116 when the true issue was how the conversion of the Earn-out non-QCBs into QCBs was effected. S 116 required the identification of the transaction to which s 127 – 130 would apply in the absence of s 116.

The UT found that in this case, it was s 132 that brought the transaction within s 127 – 130, and therefore potentially within s 116. The initial focus should therefore be on s 132 which defines a ‘conversion of securities’ at s 132(3)(a) which includes as examples cases where exchanges were like for like but did not include transactions involving mixed bundles of securities, as in the Hancocks’ case.

On this basis, the  UT concluded that on the proper construction of s 132 and s 116, each separate original asset or security should be considered in isolation, and that this was the only way in which the provisions could sensibly operate. As such, the appeal by HMRC was upheld.

The taxpayers claimed that as the final conversions were executed by one contract, they were one transaction and therefore should be considered as a single conversion – the UT rejected the claim that a taxpayer can determine how statutory provisions apply simply by the number of documents drafted and referred back to their finding on s 132.

In s 132 the word “transaction” is not used except in subs. (3)(a): “ “conversion of securities” includes any of the following, whether effected by a transaction or occurring in consequence of the operation of the terms of any security or of any debenture which is not a security . . .”. so what matters is the fact of conversion and no transaction is required. This is reinforced by s 116 (2) which refers to “any conversion of securities (whether or not effected by a transaction)”.

The UT acknowledged that s 116 and the whole of the reorganisations rules in TCGA are capable of more than one interpretation but said “(57) The interpretation of section 116 whereby the ‘transaction’ referred to is the conversion under section 132 and whereby that conversion is a single event relating to a particular class of security is, in our view, clearly an available construction and the one to be preferred.”

HMRC’s other argument- Ramsay

As an alternative HMRC argued that the Ramsay principle should be applied and so the whole arrangement should be considered as if it were a single transaction with any unnecessary steps disregarded, in this instance the conversion of the Earn-out non-QCBs into QCBs. Whilst it was not necessary to consider this argument in order to uphold HMRC’s appeal, the UT opined that in view of the time scale, in particular the seven week existence of the Earn-out non-QCBs it would have been difficult to ignore them and regard them as not having genuine commercial existence. Therefore the UT agreed with the FTT’s decision on this point.

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