Capital loss scheme with "matching" derivatives fails, says Upper Tribunal

The Tribunal also decided in the case involving Explainaway that even if it was wrong on this point, applying the Ramsay principle, the profits and losses could be ignored as no "real" gain or loss arose,

"HMRC have scored another success in the Explainaway case, with the Upper Tribunal having little difficulty deciding that the losses on a complex series of options were not 'real' losses," said Heather Self, a tax expert at Pinsent Masons, the law firm behind Out-Law.com. "By contrast, the Mayes and UBS cases have shown that where the legislation is detailed and prescriptive, the taxpayer has more chance of winning."

Paul Rackham Limited (PRL) had purchased a scheme from its accountants with a view to sheltering the corporation tax on chargeable gains which would be triggered on the disposal of subsidiary company, Waste Recycling Group (WRG).

PRL purchased a new company off the shelf, Explainaway. PRL sold shares in WRG to Explainaway with the consideration left outstanding on intra-group loan account. Explainaway sold WRG and repaid its debt before buying two derivative contracts. One of the two contracts was to generate a loss which would be set against the gain on the WRG shares; the other contract would generate a gain. Explainaway was then to be sold to a third party with capital losses, which would shelter the gain on the second derivative contract.

The sale of Explainaway did not take place and instead further transactions had to be entered into involving subsidiaries of Explainaway and further derivative contracts, in order to shelter the remaining gain.

HMRC argued that the derivative transactions did not give rise to any gains, profits or losses for the purposes of the relevant statutory provisions. It relied on the decisions in cases involving FA & AB Ltd and Lupton in 1972  and WT Ramsay Ltd and the Inland Revenue Commissioners in 1982.

The derivative transactions could only be taken into account for capital gains tax purposes if, but for Section 128 ICTA, they would have fallen within Case VI of Schedule D. In order to qualify, the gains and losses must therefore be "income profits and losses".

The Lupton case concerned whether or not a transaction was a trading transaction. It decided that “some transactions may be so affected or inspired by fiscal considerations that the shape and character of the transaction is no longer that of a trading transaction”. HMRC argued that by analogy the derivative transactions in this case should be viewed as “tax planning machinery” which did not generate income profits or losses.

The Upper Tribunal found that the derivative contracts had not produced "income profits and losses" because they were one-offs; their objective was to achieve a loss; they had a fiscal motivation; and taken together, it was plain that they had not been entered for commercial purposes. The Tribunal said "we do not think Lupton requires the Court to consider each of the July contracts only individually, without regard to the matching contract entered into on the same day and between the same parties. If the contracts are looked at together, it becomes, as we have said, perfectly plain that they have not been entered into for ordinary commercial purposes".

Although their finding on the Lupton case was sufficient to prevent the taxpayer succeeding, the Tribunal went on to express a view on the Ramsay argument.

Disagreeing with the First Tier Tribunal, the Upper Tribunal found that the Ramsay principle applied as "the transactions were essentially self-cancelling. The aim was to achieve fiscal consequences." The loss and gain produced by the derivative contracts were not "a real loss or a real gain".

The Upper Tribunal summarily dismissed any arguments that the existence of the unfulfilled plan that Explainaway would be sold to a capital loss company and that certain elements of the transaction were outside the control of the parties (they were linked to the FTSE index) changed the analysis.

The principle expressed by the House of Lords in the Ramsay case, and refined and commented upon in subsequent cases, is that in determining the fiscal nature of a pre-ordained series of transactions, any steps inserted merely to avoid tax can be disregarded.

In April 2011, the Court of Appeal dismissed HMRC's appeal in the Mayes case, which involved a highly artificial tax avoidance scheme marketed as "SHIPS 2". UBS were successful in the Upper Tribunal in September this year, where an employee incentive scheme was upheld, despite attempts by HMRC to counteract it using the Ramsay principle.