The perennial issue of capital versus income

The distinction between capital and income has been the subject of many decisions and much controversy between HMRC and taxpayers. Now, a new decision, Healey v R & C Commrs [2015] BTC 513, has been added to the mix.

The facts

The issue was whether the taxpayer, Mr Healey, realised a profit of an income nature when, on 12 September 2003, he sold in the market a floating-rate promissory note (“FRN”) which he had bought on 11 December 2001 from Kleinwort Benson Private Bank (“KB”). The profit which Mr Healey realised on the sale was £2.2 million. It was common ground that, if the profit was of an income nature, it was subject to income tax in Mr Healey’s hands under Case III of Schedule D, which at the material time charged tax in respect of “all discounts”. If, however, it was a profit of a capital nature, it was not liable to income tax and was also exempt from capital gains tax (“CGT”) as a gain accruing on the disposal of a qualifying corporate bond – see sections 115(1) and of the Taxation of Chargeable Gains Act 1992.

The FRN in question (“the ANZ FRN”) was a normal commercial security which had been issued at par (£30 million) by ANZ Bank. It was redeemable, also at par, on 13 September 2004, and carried interest in the meantime at a commercial floating rate linked to LIBOR, payable quarterly on 12 March, June, September and December each year until 12 September 2004, the day before redemption. ANZ Bank had a high credit rating. Because of that, and the floating commercial interest rate, it was predictable that the ANZ FRN would trade at a market value close to its par value throughout its term. It is therefore no surprise that the price which Mr Healey obtained for the ANZ FRN when he sold it (through KB) on 12 September 2003, immediately after payment of the interest coupon due on that day, was £29.997 million. This price reflected the rights which the purchaser acquired to receive the par value of the note on redemption a year later, together with the four remaining payments of interest which would fall due in the meantime.

When Mr Healey bought the ANZ FRN from KB on 11 December 2001, however,the interest coupons had been stripped from it and Mr Healey acquired the benefit of the coupon due on the next day, 12 December 2001, (coupon 1) and the four coupons due from 12 December 2003 until 12 September 2004 (coupons 9 to 12), while KB retained the benefit of the seven interest coupons falling due from 12 March 2002 until 12 September 2003 (coupons 2 to 8). Thus the price which Mr Healey paid to KB for the ANZ FRN reflected the right to receive the £30 million principal on redemption and the rights to interest conferred by coupons 1 and 9 to but not the rights to receive coupons 2 to 8 which had been retained by KB. These were described by KB as ‘Flexi-Notes.’   They were designed and marketed by KB as a means of providing wealthy individual UK-resident clients or their trusts with an after-tax return on their surplus cash significantly higher than the returns then obtainable on fixed-term deposits.

It was, of course, essential to the fiscal efficacy of the Flexi-Note scheme that the profit realised by the investor on sale of the FRN should not be liable to income tax. After a lengthy enquiry into Mr Healey’s self-assessment tax return for 2003/4, HMRC made amendments to it in September 2011 on the footing that the profits made by Mr Healey on sale of the ANZ FRN (and other Flexi-Note products supplied to him by KB) were chargeable to income tax under Case III of Schedule D. Mr Healey appealed to the FTT, which decided both issues against Mr Healey.

In the UT

The UT analysed the leading cases in this area, including Ditchfield v Sharp (1983) 57 TC 555, [1983] 3 All ER 681.

The UT said:

‘What, then, did Mr Healey buy? He bought a FRN which had been issued on standard commercial terms by a bank with a high credit rating, but which had been deliberately modified by the removal of the seven interest coupons covering the period of 21 months from 13 December 2001 to 12 September 2003. The price which Mr Healey paid to KB for the FRN was calculated by reference to the discounted value of the seven interest payments which he was not going to receive. By contrast, when Mr Healey sold the FRN on 12 September 2003, immediately after coupons 9 to 12 had been re-attached, the price which he obtained for it was only £3,000 less than its par value of £30 million. The reason for this, of course, was that the FRN now carried a commercial floating rate of interest over the remaining period of one year until its redemption at par on 13 September 2004. Mr Healey’s profit represented the difference between the discounted price which he paid on 11 December 2001 for the ANZ FRN in its modified form, and the price which he obtained for it on the market, after it had been restored to its original form, 21 months later.

It is now common ground that Mr Healey’s profit was a profit on a discount within the meaning of Case III, paragraph (b). The reason for this, as it seems to us, is as simple as it was in Ditchfield v Sharp: Mr Healey acquired the FRN, before maturity, at an amount less than its face value. That was a discount in the normal commercial sense of the term. The next question, therefore, is whether the discount was of a capital or an income nature. We emphasise that it is the character of the discount which has to be ascertained, not the character of the legal rights which Mr Healey bought and sold, although they are a relevant part of the circumstances which have to be taken into account.

Clearly, no part of the discount was intended to compensate Mr Healey for capital risk. ANZ was a “blue chip” borrower, with a high credit rating. The ANZ FRN traded on the market at around its par value both when it was bought by KB and when it was sold by Mr Healey. Equally clearly, in our view, the purpose of the discount was to compensate Mr Healey for the absence of interest on his investment over the period covered by the seven stripped coupons…..from the perspective which matters, namely that of Mr Healey, the position was in our judgment the same in all essential respects as it would have been if he had bought a non-interest bearing note issued at a discount. In cases of that nature, as the authorities show, the conclusion that the discount is of an income nature is all but irresistible, unless the taxpayer adduces evidence to establish the contrary.

Furthermore, to characterise the discount as one of an income nature would not in our judgment involve falling into either the trap of characterisation by economic equivalence, or the trap of confusing the measure of a payment with its essential nature. Rather, the conclusion would follow from a proper assessment of the reasons which led Mr Healey to pay the discounted price for the modified FRN. The only reason, on the evidence before the FTT, lay in the absence of an income return on the note for Mr Healey during the stripped period. It is wholly immaterial to this analysis that, during the same period, the interest was payable to KB.

It is a further advantage of this approach, in our view, that it accords with common sense, and with the emphasis placed by Dixon J in the Hallstroms case “on what the expenditure is calculated to effect from a practical and business point of view”.

Levy and Levy comment

The UT in this case was of the clear view that the appellant’s return was not capital in nature and that the discount on the FRN was not attributable to the acceptance by the appellant of a capital risk. The absence of risk meant that the structure was simply designed to give a return on the use of the appellant’s funds and was therefore income. The result makes it extremely hard for a taxpayer with similar circumstances to persuade HMRC that a return on such banking products can meet the criteria necessary for an exemption for capital gains tax.

 

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