A Welcome Decision - Andrew Roycroft comments on the House of Lords decision in MacNiven v Westmoreland Investments Limited

A Welcome Decision

ANDREW ROYCROFT comments on the House of Lords decision in MacNiven v Westmoreland Investments Limited.

The eagerly awaited judgment of the House of Lords in MacNiven v Westmoreland Investments Limited was handed down on 8 February 2001 (see [2001] STC 237. Doubtless, much will be said and written about their Lordships latest decision on the Ramsay/Furniss line of cases and its implications. What is clear is that their Lordships have reaffirmed the line taken in McGuckian, that the Ramsay and Furniss decisions are no more than examples of the established principle that, when searching for the meaning of any particular statute the courts will have regard to the underlying purpose that the statutory language is seeking to achieve. This is the so-called 'purposive approach' to the interpretation of statutes, which is not confined to taxation statutes.

The case is of particular note because their Lordships refused to accept that there are any bounds to the circumstances in which this principle can be applied. According to Lord Nicholls, previous cases 'cannot be understood as laying down factual pre-requisites which must exist before the court may apply the purposive, Ramsay approach to the interpretation of a taxing statute'. Instead 'The paramount question always is one of interpretation of the particular statutory provision and its application to the facts of the case... It would be wrong, therefore, to set bounds to the circumstances in which the Ramsay approach may be appropriate and helpful'.

Accordingly, the Inland Revenue can take much comfort in the decision, even though their Lordships found for the taxpayer on the facts of the case. Taxpayers can also take something from the decision, namely that 'one cannot disregard a transaction which comes within the statutory language, construed in the correct commercial sense, simply on the ground that it was entered into solely for tax reasons'. Of course, it is the italicised words which may cause future difficulties. How are the courts to construe the correct commercial sense of particular statutory provisions?

The facts

In contrast to many cases where the Inland Revenue has sought to invoke the Ramsay principle, the facts in MacNiven were fairly simple. The taxpayer company, Westmoreland Investments Limited, owed approximately £70 million to the Electricity Supply Pension Scheme (the 'Scheme'). Over £40 million of this represented accrued but unpaid interest. At the time in question, companies such as the taxpayer were unable to claim a tax deduction for interest expense until the interest in question was paid. (An exception was made for interest paid to a bank which was deductible as and when it was debited to its account in the books of the bank; see section 338(3), Taxes Act 1988.) This was something of an anomaly in that most other expenses were deductible on an accruals basis. Since the Finance Act 1996, this anomaly has been removed and most interest expense is now deductible on an accruals basis. There are, of course, exceptions. For instance where the interest is paid late to a non-United Kingdom resident related party; see paragraph 2 of Schedule 9 to the Finance Act 1996.

As the Scheme was the ultimate parent company of the taxpayer, it had an incentive to extract any value possible from the taxpayer. The taxpayer had been established as a vehicle to engage in property investment by the Scheme. That investment had proved unsuccessful, resulting in the £70 million of indebtedness. If any of the £40 million of accrued interest could be 'paid' by the taxpayer, the taxpayer could claim a tax deduction for the amount 'paid' and would, therefore, be in a position to generate significant charges on income available to carry forward. This would make the taxpayer valuable to a potential purchaser, who might acquire the taxpayer in order to access its carried forward charges on income to shelter future taxable profits (a technique which is no longer available to taxpayers, since section 768B, Taxes Act 1988 was introduced by Finance Act 1995).

Accordingly, a simple scheme was devised whereby the interest could be 'paid' by the taxpayer. This involved the taxpayer borrowing approximately £20 million of further sums from the Scheme. The taxpayer returned these borrowed funds to the Scheme as a payment of part of the accrued interest. The flow of cash was purely circular, with the accrued interest being, in effect, replaced by the further advances. The Inland Revenue refused to accept that this involved interest being 'paid' for the purposes of section 338(1), Taxes Act 1988 and denied the taxpayer its tax deduction.

The Special Commissioners accepted that the taxpayer had paid the interest within the meaning of section 338(1) and, therefore was entitled to the tax deduction. This decision was overturned on appeal to the High Court (see [1997] STC 1103). The Court of Appeal reinstated the Special Commissioners' decision (see [1998] STC 1131) and the Inland Revenue appealed to the House of Lords.

The House of Lords decision

The House of Lords unanimously rejected the Inland Revenue's appeal, deciding that the Ramsay/Furniss principle could not be invoked to deny the taxpayer the deduction which is claimed. Their Lordships held that the £20 million of interest had been 'paid' within the meaning of section 338(1), even though the funds used to pay that interest had been borrowed from the creditor for no commercial purpose other than gaining the tax advantage of generating the tax deduction.

At first sight this may seem a surprising decision, as the taxpayer appears to have generated a tax deduction merely by replacing one debt (the accrued interest) with an identical amount of indebtedness to the same creditor (the further advances). Indeed, this might seem a particularly generous result given the taxpayer's financial position and the improbability of it ever being in a position to repay the original advances, let alone the further advances which replaced the accrued interest. However, this ignores two crucial factors.

First, the taxpayer had incurred a genuine economic burden when it undertook to pay the interest expense. As Lord Hutton noted '… the obligation undertaken by Westmoreland to pay interest on the sums it had been lent by the scheme trustees was a genuine one which exists in the real world … Therefore by undertaking to pay the interest Westmoreland had incurred the economic burden which Parliament intended to give rise to the allowances given by section 338'.

Readers might like to bear in mind that in the case of most other forms of expenditure (and in the case of interest expenditure after the Finance Act 1996), merely accruing the expense would have been sufficient to trigger the entitlement to a tax deduction, even if the expense remained unpaid. It was only interest expense for which the additional hurdle, of payment, was imposed in order to trigger the right to claim a tax deduction. This hurdle was removed by the Finance Act 1996 for most interest expense incurred by companies.

Accordingly, it was not surprising that their Lordships took the view that Westmoreland was entitled to take steps to obtain a tax deduction in respect of the economic burden which it incurred.

Secondly, a 'payment' of interest had two consequences. It not only generated the tax deduction which the taxpayer sought to achieve, but in addition it triggered an obligation on the part of the payer to withhold income tax from the payment, and account to the Inland Revenue for that income tax.

As Lord Nicholls pointed out:

'The tax benefit of being able to treat the payment as a charge on income is offset by the obligation to account to the Inland Revenue for tax on the payment.'

Accordingly, in most cases granting the tax deduction would be tax neutral for the Inland Revenue. Indeed, it should generate a cash flow advantage. Of course, in this case the Scheme was an exempt body and, thus, entitled to reclaim the income tax which the taxpayer had deducted from the payment of interest. This was the feature of the transactions which the Inland Revenue found unattractive. However, as Lord Nicholls pointed out, this is a consequence of the tax exempt status of the Scheme. Accordingly, their Lordships refused to accept that this should influence the meaning to be attached to the word 'paid' in section 338(1), Taxes Act 1988.

Whilst there were, therefore, good reasons why the Inland Revenue's challenge to the taxpayer's right to claim the tax deduction should have failed, why did that challenge fail? Why was the Inland Revenue not able to disregard the further advances and the 'payment' of the accrued interest, on the basis that these transactions formed part of a pre-ordained series of transactions, with steps inserted for no commercial purpose other than tax avoidance, within Lord Diplock's classic formulation of the Ramsay principle in Commissioners of Inland Revenue v Burmah Oil [1982] STC 30?

The Ramsay principle

Lord Hoffmann neatly sidestepped the need to apply the classic formulation of the Ramsay principle. His Lordship explained that Furniss and Ramsay are no more than examples of cases in which the courts have decided that, in using a particular word or phrase used in a taxation statute, Parliament intended it to be used to convey a broader 'commercial' meaning than its recognised legal meaning. To use his Lordship's words, '... although a word may have a "recognised legal meaning", the legislative context may show that it is in fact being used to refer to a broader commercial concept'. In Furniss, the court construed the words 'disposal' and 'loss' as referring to commercial concepts which were wider than their traditional juristic categorisation. In Ramsay, the concept of a 'disposal' to a particular person was interpreted as a commercial concept, rather than a purely legal concept with no broader commercial meaning.

It seems from the decision in MacNiven that, in each case, the court's function is two-fold. According to Lord Hope's comments: 'The only relevant questions are (1) the question of law: what is the meaning of the words used in the statute? And (2) the question of fact: does the transaction, stripped of any steps that are artificial and should be ignored, fall within the meaning of these words?'. Accordingly the court must first interpret the meaning of the statutory provision which is to be applied to the transaction in question. Using a purposive construction, it must determine whether the word or phrase in question was intended by Parliament to impose tax by reference to an existing legal concept or by reference to a wider commercial concept, i.e. whether the word or phrase used was intended to bear its recognised legal meaning or a broader commercial meaning. In Lord Hoffmann's words 'One cannot elide the first and fundamental step in the process of construction, namely to identify the concept to which the statute refers. I readily accept that many expressions used in tax legislation ... can be construed as referring to commercial concepts ... But that is not always the case. Taxing statutes often refer to purely legal concepts'. Once it has been determined whether the statutory language used was intended to be given a commercial meaning capable of 'transcending the juristic individuality of its component parts', the court's function is to identify whether the transaction in question falls within the meaning of the word or phrase used in the legislation, whether that be the recognised legal meaning or some broader commercial meaning.

If the court decides that a word or phrase was intended to bear its recognised meaning and a transaction falls within that meaning, it makes no difference that the transaction has no business purpose. This was the basis upon which the House of Lords was able to reject the Inland Revenue's appeal. Their Lordships could find no reason for giving the word 'paid' in section 338(1), Taxes Act 1988 anything other than its normal legal meaning of the simple discharge of a debt. As the normal legal meaning of this term includes the discharge and replacement of one debt with another (even if the creditor in respect of both debts is the same person), replacing the accrued interest with the further advances involved the accrued interest being 'paid' within the meaning of section 338(1), Taxes Act 1988. Accordingly, the taxpayer was entitled to its tax deduction.

Open issues

The decision in MacNiven leaves at least two open issues. First, what criteria will the courts apply in determining whether Parliament intended a particular word or phrase in a taxation statute to be a reference to a legally defined concept or to a broader business or commercial concept? The nearest their Lordships came to give guidance on this issue was Lord Hoffmann's comment that:

'Taxing statutes often refer to purely legal concepts. They use expressions of which a commercial man, asked what they mean, would say, "You had better ask a lawyer".'

Clearly, His Lordship cannot have intended the courts to determine whether a word is being used in its traditional legally recognised sense or in a broader commercial sense by assessing whether a 'commercial man' would regard the word in question as having a commercial meaning or something which he would refer to a lawyer. Indeed, such a test may have caused difficulty for the taxpayer on the facts of MacNiven, as many commercial men might doubt whether the taxpayer had 'paid' anything merely by exchanging the obligation to pay the accrued interest with a debt of equally doubtful value. It is more likely that this exercise of determining whether a traditional legal meaning or a commercial meaning was intended by Parliament will have to be performed by looking at the legislative history of the statute in question, with the usual mixed results.

The second issue is how should the courts determine the limits of the meaning of a word or phrase which they determine was used by Parliament to convey a business or commercial concept, as opposed to its traditional legal meaning? In MacNiven, their Lordships recognised that where the court determines that a particular word or phrase was intended to convey a business or economic concept, the transaction must still be shown to fall within that concept for the statute to apply. As Lord Hoffmann noted 'Business concepts have their boundaries no less than legal ones'.

Accordingly, the 'commercial concept' still needs to be defined, in order to determine whether the transaction being evaluated falls within the statutory provision which is being applied to that transaction. However, if the courts have rejected the clarity of an accepted legal definition, where are they to look for a definition of the wider commercial concept? Again, the answer will probably have to be determined on a case by case basis. However, this does illustrate that the decision in MacNiven, like that in McGuckian before it, has moved away from circumscribing the situations in which the Inland Revenue can invoke the Ramsay principle to challenge tax driven transactions, towards a more broad brush approach whose application may be even more difficult to predict in practice.

Andrew Roycroft ATII is a tax lawyer with Baker & McKenzie.

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