Special Commissioners - Flip-Flop Succeeds

LISA SPEARMAN considers the recent Special Commissioners' decision in Mr Tee.

IN THE FIRST case of its kind, an old-style 'flip-flop' arrangement has been successfully defended. The Special Commissioners, Dr Avery Jones and Malcolm Gammie found for the taxpayer on all arguments.

This is an important case in relation to tax planning undertaken under the rules prior to the Finance Act 2000, which exploited the provisions then current to enable the sheltering of unrealised gains. The strategy was to settle assets into trust, Trust 1, (holding over the gain where relevant). The trustees would then borrow funds equal to the value of those assets and transfer the funds to a new trust, Trust 2. The settlor and other relevant beneficiaries would then be excluded from benefiting from the second trust. In the subsequent tax year, the assets in Trust 1 could be realised and the borrowing repaid without incurring the additional tax charges suffered by settlor-interested trusts. It raises some other interesting points and issues relevant for some of the more recent Schedule 4B to the Taxation of Chargeable Gains Act 1992 tax planning that forms the basis of new-style flip-flops.

The facts

The detailed facts in the Special Commissioners' decision, although quite complex, are not dissimilar to many other similar arrangements that were put in place before the rules were changed.

In summary, in this anonymised case, Mr Tee was a shareholder in Buses Ltd. At the time, following deregulation there was substantial takeover activity. The company was being considered for purchase by a number of bidders thus inflating its value. On advice, he undertook a flip-flop or dual trust strategy prior to realisation of the gain, thus hoping to reduce the rate of tax from 40 per cent to 25 per cent, which was the then basic rate applicable to United Kingdom life interest trusts.

On 31 March 1995, the appellant and his spouse executed a life interest settlement, the First Settlement, over the shares in Buses Ltd and as trustees arranged a borrowing with a high street bank equivalent to the value of the shares in Buses Ltd. The solicitor concerned held the share certificates as security for the loan or the sale proceeds of the shares. On 4 April, they executed a second trust, the Second Settlement, also on life interest trusts, for themselves. The loans were drawn down by the First Settlement trustees, and by deed of appointment that same day the funds were transferred to the trustees of the second trust. The money remained in the solicitor's client account with only a change of designation.

On 5 April, the appellants and their wives were excluded from all benefit from the First Settlement and replaced by their children. In the middle of April, the shares in Buses Ltd were sold to Bigger Buses Ltd. On 18 April, the solicitor's client account was credited with the sale proceeds and the high street bank was repaid.

The Commissioners record that the creation of the First and Second Settlements and the borrowing and transfer of funds were preordained in a manner found in the decision in Craven v White [1988] STC 476. However, the sale of the shares was not preordained in this fashion. The Revenue did not focus on preordainment, but the Inspector of Taxes raised four key arguments.

The Revenue's arguments

• Under the wording of section 77, Taxation of Chargeable Gains Act 1992, the settlor retained a benefit in the Second Settlement as a result of property derived from the First Settlement and was therefore taxable on the gains in the First Settlement.
• The settlor's indemnity to the bank had resulted in a benefit to him from the First Settlement in the year of sale because he made the borrowing personally, and he had a right of indemnity from the trust for the costs, interest and any loss on capital.
• As in Commissioners of Inland Revenue v Botnar [1999] STC 711, the settlor could benefit from the First Settlement since appointments could be made from it to another trust under which he could be, or could be appointed as, a beneficiary.
• The use of the cash in the Second Settlement was fettered until the sale of the shares in the First Settlement. The shares in the First Settlement therefore conferred a benefit on the settlor by the removal of the fetter.

In a 16-page judgment, the Commissioners considered all four arguments in detail. The Revenue was represented by Christopher McCall and the taxpayer by David Ewart.

The decision

On the first argument, the Revenue noted that section 77(2) treats a settlor as having an interest in a trust if any property or any 'derived property' is applicable for his benefit. Mr McCall argued that this is anti-avoidance legislation and should be given a wide interpretation. He also contended that the property of the Second Settlement 'derived' from the First Settlement. Therefore, as the settlor remained a beneficiary of the Second Settlement, section 77 would continue to apply to tax gains in the First Settlement as his own.

The Commissioners were not persuaded by his arguments. They preferred Mr Ewart's argument that the wording of section 77 could not apply to property outside the settlement but only within it, and the wording was intended to catch replacement property or additions, not assets appointed outside the trust. The Commissioners decided this to be a more natural use of language.

On the second argument, the Commissioners agreed that an indemnity was a benefit if one considered the decision in Jenkins v Commissioners of Inland Revenue 26 TC 265. However, in that case the indemnity was between the trustees and the settlor.

In the present case, the indemnity was simply an operation of law, since the trust could not contract with the bank as it was not a legal entity; it could only do so via its trustees. Mr McCall's argument, if it were right, would effectively prohibit settlors from being trustees in any case where there was some contractual relationship. Mr McCall argued further that the indemnity had a personal benefit in this case, since the borrowing was imprudent as being uncommercial. The Commissioners did not find the borrowing to be uncommercial, but if it was they did not accept the analysis.

The third and fourth arguments were described as 'fall back' positions of the Inspector. The Botnar case was analysed at some length, but the Commissioners decided that the drafting was very different and, in this case, the exclusion followed closely the wording of section 77. They found that Mr McCall's argument was contradictory and, if there were a benefit, it was incidental and not within the intention of section 77.

As a matter of fact, the Commissioners decided that the cash in the Second Settlement was not fettered until the sale of shares. Rather the client account was a convenient vehicle in view of the short time-scale of the transaction, and helpful in that the trustees were very involved in the sale and could not devote time to developing the investment strategy for the Second Settlement. The argument relating to the fetter was not therefore considered any further.

Commentary

Although this decision was heard in April 2002, it only recently became publicly available. Old-style flip-flops were outlawed by the Finance Act 2000, but it is enlightening to see the type of arguments used, and to consider to what extent such arguments could be used against the presently fashionable Schedule 4B tax planning (the so-called new-style flip-flops).

The consensus of professional opinion on old-style flip-flops was that the schemes worked unless they could be challenged under Roome v Edwards 54 TC 359, or on preordainment grounds. The various counsel consulted by the author when such strategies were being implemented were keen to ensure that the trust powers in the original settlement were wide enough. This was so that Lord Wilberforce's judgment could not be used by the Revenue to argue that there was in reality only one trust from which the settlor could still benefit. Roome v Edwards was an important decision and takes up several sections in the Capital Gains Tax Manuals. Clearly, if there was only one trust, the entire strategy would fail. Additionally, it was always crucial to ensure that the advance or appointment to the new trust could not be set aside under the Ramsay-type arguments of the day.

It is somewhat surprising that these arguments were not used, as they would have been expected lines for the Revenue to pursue. Roome v Edwards was perhaps not used as the settlements appear to be new and presumably carefully drafted for the purpose. In a case with older settlements and less precise drafting, such arguments may be more relevant.

The detailed arguments, particularly on the Botnar point and the section 77 point, bear close reading as these may have wider application than simply flip-flop schemes. Typically Botnar has effect in gift with reservation cases but, if the Revenue reasoning is correct, it seems that it would be extended to capital gains tax and thus make it virtually impossible to remove assets from Trust 1 unless the recipient trust had the same exclusions, etc. within it. It appears that this case may have been decided in part on the exact wording of the relevant deeds.

If this is so then in other instances where the drafting is less careful, the taxpayer could be more at risk of a successful Revenue challenge. On the section 77 point, the question depends on the meaning of the words 'property derived from'. Section 86 and its schedules use rather different wording for offshore trusts, but since the recent Schedule 4B planning can apply equally to section 77 onshore trusts as section 86 offshore ones, the point will have continuing significance.

It is understood that the Revenue is examining a number of similar cases relating to the old style flip-flop arrangements, and the questions it is asking would suggest that it continues to look for 'fetters' or derived property as well as any other weaknesses in the taxpayer's position.

The post-Finance Act 2000 legislation, which has led to new style flip-flop arrangements, operates in a different way from the Mr Tee case. Whether the decision in Mr Tee will assist the taxpayer if new style flip-flop arrangements are challenged remains to be seen, but one could see that the Botnar and section 77 points could be of use to the Revenue.

What happens next?

A significant number of these strategies was undertaken before Finance Act 2000 for offshore trusts as well as the United Kingdom structure in this case. This decision is therefore good news for a lot of people. However, the Revenue has appealed to the High Court and we await the outcome with interest. Advisers with cases currently being reviewed may wish to defer reaching an agreement until the High Court decision is known. If the Revenue were to win, it will be unclear whether cases which have long since passed the deadlines for enquiry will be re- opened. Advisers undertaking present planning will no doubt also want to keep this decision in mind.

Lisa Spearman is a tax partner at Smith & Williamson; telephone 020 7637 5377, e-mail: ljs@smith.williamson.co.uk

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