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WILL ALTERING THE terms of an existing loan note agreement trigger a disposal of that instrument for capital gains tax purposes? This article considers the changes which could be made, including extending the term of the loan note and revising the loan note's interest rate.
WILL ALTERING THE terms of an existing loan note agreement trigger a disposal of that instrument for capital gains tax purposes? This article considers the changes which could be made, including extending the term of the loan note and revising the loan note's interest rate.
The capital gains tax legislation does not extend the meaning of the definition of disposal of a debt. Nor does it apply differing definitions of disposal to different classifications of debt. It does, however, specifically acknowledge that 'the satisfaction of a debt or part of it (including a debt on a security as defined in section 132) shall be treated as a disposal of the debt or of that part by the creditor made at the time when the debt or that part is satisfied' – section 251(2), Taxation of Chargeable Gains Act 1992 (see also section 22).
Qualifying and non-qualifying bonds
Notwithstanding the above, while not specifically extending the definition of disposal, where the tax status of a debt changes from a qualifying corporate bond into a non-qualifying corporate bond or vice versa, either because of an alteration in the terms of the debt, or the operation of the terms of a debt, section 132 treats the change as a conversion of securities. In conjunction with section 116, this may in certain circumstances result in a deemed disposal.
Where the conversion is from qualifying corporate bond to non-qualifying corporate bond status, section 116(9) would apply so that the qualifying corporate bond would be treated as having been disposed of at the date of the conversion. Where, however:
'the conversion is from a debt which is not a qualifying corporate bond into a debt which is a qualifying corporate bond, section 116(10) applies, ... There is no disposal at the time of the conversion, but any gain (or loss) which would have arisen on a disposal of the debt at its market value at the date of conversion is computed under section 116(10)(a). This gain (or loss) is then held over until disposal of the qualifying corporate bond, section 116(10)(b). This treatment therefore ensures that any gain or loss on the original asset, such as shares, as well as on the debt itself up to the time of the conversion into the qualifying corporate bond, remains within the charge to capital gains tax.' (Inland Revenue Capital Gains Tax Manual at paragraph 55021.)
When considering the application of these rules it is important to bear in mind that qualifying corporate bond is defined differently in the case of companies compared to other taxpayers. The corporate definition is wider than that applying to other persons and includes, subject to exceptions, any asset representing a loan relationship of a company (section 117).
West v Crossland
The question as to whether changing certain terms of a loan constituted the making of a new loan was considered in West v Crossland; West v O'Neill [1999] STC 147. This case, which was heard in the Chancery Division of the High Court, involved the assessment of beneficial loans under Schedule E. Certain of the points raised in the case involve peculiarities pertaining to the relevant Schedule E legislation contained in sections 160 to 161, Taxes Act 1988. The broader arguments of general application to determining whether a disposal of the original loan note has occurred are considered in some detail below.
The facts
In April 1993 the taxpayer and his wife obtained a variable rate mortgage from his employer (a mortgage lender). In January 1994 the couple applied for and were granted a change from a variable rate of interest to a fixed rate.
In the words of Mr Justice Lindsay:
'There was no repayment of the existing loan or redemption of the existing mortgage followed by the advancing of a new loan or the making of a fresh mortgage; there was, for example, no exchange of cheques from borrower to lender and then afresh from lender to borrower. However, terms were then agreed that had not applied before.'
The issues
The taxpayer's argument that switching from a variable to a fixed rate product amounted to a new loan was accepted by the Commissioners but rejected on appeal by the High Court.
The taxpayer argued that 'where there is a new deal, there is a new loan'; in particular that the following new terms freshly agreed between the parties indicated that a new loan had been made:
- a variable interest rate was replaced, by an agreement in writing, by a fixed rate of interest for two years;
- repayments had, as a condition of the switch, to be made via direct debit throughout the fixed rate period;
- a fee was paid;
- a valuation fee was paid.
Mr Justice Lindsay, however, did not accept the contentions made by the taxpayer pointing out that it would lead to so unnatural a meaning being given to the 'making of a loan as surely to have required, if intended, to have been carefully specified (which it is not)'. He provided the following examples illustrating why the taxpayer's argument should be rejected:
- 'Suppose a building society loan on residential mortgage was made on terms that included an absolute prohibition forbidding a parting with possession of any part of the charged premises. Suppose also that the building society and the borrower later agreed in writing that the basement might nonetheless be let. On [the taxpayer's] argument he has to accept that a loan would have been "made" upon that new term being agreed.'
- 'A loan would be "made" also upon an agreed change in the property charged by the mortgage.'
- 'If an informal unsecured loan with no initially agreed terms as to interest at all was later supplemented by specific terms agreed, orally or in writing, as to interest, again, on [the taxpayer's] argument (certainly if the newly-agreed terms differed from those implied by the law) a loan would, upon that subsequent agreement, have been made.'
Clearly in the judge's view none of the above changes when considered apart would constitute the making of a new loan. He then turned to the taxpayer's alternative argument, which went as follows:
'that if it is not any change in the agreed terms that leads to there being a new loan being made at the time of the change, at least that is the case where the change is so fundamental as to represent the rescission of the former agreement and its replacement by a new one, even though the original loan is not repaid or a fresh loan advanced. However, the line between rescission and variation is notoriously difficult (see Chitty on Contracts, 27th Edition, paragraph 22–025), where it is added that:
"The change must be fundamental and the question is whether the common intention of the parties was to 'abrogate', 'rescind' or 'extinguish' the old contract by a 'substitution' of a 'completely new' or 'self-subsisting' agreement."
' .... Here, though, very little changed and there is no finding of fact that there was a change as "fundamental" as that. Nor, in my judgment, would one ordinarily speak of a change in a mortgage, an arrangement often operable for 20 or 30 years — its being a change which was to be applicable for two years and which related to the extent only of a few per cent. To the interest payable in those years — as fundamental.'
In his comments, Mr Justice Lindsay left open the question as to whether in the case of such abrogation, rescission, etc. there would be a disposal for the purposes of the relevant Schedule E provisions. He said:
'More generally, firstly, it may be that this argument and the preceding one confuses the making of a loan with the making of a contract of a loan, and, secondly, as to this argument, had Parliament had in mind that some contractual changes would, and other ones would not, amount to the making of a loan, it is, in this notorious area, unthinkable that it would not have set about specifying which changes were to be which.'
Notwithstanding the preceding comments in the judgment itself, the judge, in determining that no new loan had been made, held that 'there was nothing sufficiently powerful to displace or qualify that natural construction of the provisions'. Implicitly therefore he would appear to have accepted that where change is sufficiently powerful a disposal of the old loan may occur.
Observations
In order for the modification of a loan note to constitute the making of a new loan as a finding of fact the change must be so fundamental that it extinguishes the old contract.
It would appear unlikely that the mere alteration of an interest rate by a couple of per cent, in order to reflect the current market rate would of itself be a fundamental change. However it must be emphasised that the question is one of fact and the particular circumstances of each case would need to be carefully considered.
In similar vein, extending by five years a 20 year mortgage would appear to be unlikely to create a new loan. However, would extending a seven-month loan note with an interest rate fixed by reference to the base rate, to a 15 year term carrying a long term interest yield constitute the abrogation, rescission or extinguishment of the old contract? Looking at it from an economic perspective, the loan's nature would have changed fundamentally, i.e. from a short term to a long term commitment with a dramatic change in the economic risks attaching. Is it perhaps likely that such a change in the character of the loan would imply the disposal of the original loan?
In order to avoid a finding that a disposal has occurred, it is undoubtedly helpful that the original instrument contemplates the desired modification of the loan note by containing specific clauses governing the extension of the term of the loan note, etc. If the relevant changes are contemplated by the parties from the outset, it would be harder to establish that their subsequent occurrence constituted rescission, etc.
Notwithstanding the above, section 132, Taxation of Chargeable Gains Act 1992 provides that changes in the tax status of a qualifying corporate bond to a non-qualifying corporate bond or vice versa may in certain circumstances be treated as a conversion of securities. Therefore even very minor alterations to loan notes, for example merely adding clauses (for instance, currency clauses or clauses granting the right to subscribe for further securities) to an existing loan designed to bring a loan note from qualifying corporate bond to non-qualifying corporate bond status, would be treated as a conversion of securities for capital gains tax purposes.
Not an automatic trigger
Modifying the terms of an existing loan note does not automatically trigger a disposal of the note for capital gains tax purposes. However, where the changes are so fundamental as to rescind the original agreement and replace it with a new one, the changes may well effect a disposal.
David Hughes is a tax consultant with Moore Stephens, London.
