Victory For Commonsense

SEMA IS AN occupational pension scheme which is exempt from income tax under section 592, Taxes Act 1988. In May and June 1996, Sema (using Mercury Asset Management as a discretionary fund manager) participated in two share buy-backs by Powergen. Part of the consideration received was treated as qualifying distribution under section 209, Taxes Act 1988. Following the buy-backs, Sema claimed payment of the tax credits (equal to the advance corporation tax payable on the distribution) in respect of the buy-backs under section 231, Taxes Act 1988. These were paid.

The Inland Revenue then issued notices under section 703, Taxes Act 1988 to counter tax advantages that it claimed Sema had received as a result of the buy backs, namely the repayment of the tax credits.

Sema challenged the notices before the Special Commissioners and succeeded on the grounds that it had not received abnormal amounts by way of dividend as required by section 704A, Taxes Act 1988. The Special Commissioners also decided that tax advantages had been obtained, and that one of the main objects of the transactions was to obtain tax advantages.

The Revenue appealed to the High Court, where Mr Justice Lightman upheld the appeal on the grounds that Sema had received abnormal amounts by way of dividend. Sema appealed to the Court of Appeal. Lord Justice Jonathan Parker gave the Court's judgment; he upheld Sema's appeal concluding in particular that Sema had not received any abnormal amount by way of dividend.

Statutory references are to Taxes Act 1988 unless otherwise specified.

Issue 1: Whether Sema had received an abnormal amount by way of dividend.

Issue 2: Whether Sema had obtained a tax advantage.

Issue 3: Whether one of the main objects of the buy- backs was to obtain a tax advantage.

Mr Justice Lightman disagreed. He held that the tax credit was to be excluded. He found that section 209(2) was relevant for defining what was a 'distribution', and this did not include tax credits which were statutory rights to payment.

When considering what was an abnormal return, the 'normality' stipulated in section 704 was normality of return to be expected to be paid on securities of the type in question. He agreed with the Inland Revenue that the normal returns on the securities which were ordinary shares in a major limited company, were interim or final dividends (which had a quality of recurrence and presupposed the continued existence and ownership of the shares).

The judge decided that section 709 postulated a current yield on investment and not the extraction and return of capital to the shareholder. He found support for this in the decision of Sir John Vinelott in Commissioners of Inland Revenue v Universities Superannuation Scheme Limited [1997] STC 1. Mr Justice Lightman stated that the decision set out a methodology for calculating an average income yield and evaluating that in the light of the degree of risk attaching to the investment, and paying no attention to the fact that capital value was lost on a buy-back.

On this analysis, Mr Justice Lightman found that the dividends paid as part of the consideration on the share buy-backs could not qualify as normal. They represented a return to the investor of part of the capital value of the shares.

Mr Justice Lightman held that the Special Commissioners had correctly addressed themselves in law, and so the decision that the transactions did have as one of their main objects the obtaining of a tax advantage could not be challenged.

The Revenue argued that the anti-avoidance provisions were a wide-ranging attack on tax avoidance generally.

(John Gardiner QC and Jolyon Maugham appeared for Sema; Launcelot Henderson QC and Christopher Tidmarsh QC appeared for the Revenue.)

Also under section 709(4)(b), it was the normality of the 'return' that should be taken into account, not the normality of the 'dividend'.

The Revenue argued that what was important was the normality of the dividend in issue, not the normality of the overall return the recipient received on his investment. The only normal return on shares of the type involved was interim or final dividends. The dividend element on the buy-back was thoroughly abnormal.

Sema also argued that in the legislation, 'relief' and 'repayment' were mutually exclusive terms. 'Repayment' could only apply to a person who was entitled to repayment otherwise than in consequence of a relief. Repayment applied where tax had been deducted at source. A payment of a tax credit was not a repayment as no tax was deducted at source.

The Revenue argued that an 'exemption' is a 'relief' within the normal meaning of the word. An exemption presupposes a liability to tax which the exemption removes. Both exemptions and reliefs operate conceptually at the same stage. The only difference between them was the extent to which the underlying liability was removed. If this was wrong and relief and exemption were mutually exclusive, 'relief' should be given a wide meaning to include exemption.

The Revenue also argued that it would be irrational to hold that an income tax exempt body can obtain a tax advantage in respect of income paid under deduction of tax, but not in respect of dividends.

The Revenue argued that the finding of fact that one of the main objects of the transaction was tax avoidance was open to the Commissioners, and so was not open to challenge.

He also held that section 709(4)(b) set down an exhaustive test. As a result, the question was whether the amount received by Sema by way of qualifying distribution substantially exceeded the normal return on the consideration provided by it for the shares. In answering this, regard had to be had to how long before the receipt of the distribution Sema had held the shares and also the dividends or other distributions made on the shares during that time.

He held that the Special Commissioners had correctly directed themselves in law and their conclusion that the return was normal was one they were entitled to reach. Mr Justice Lightman had made an error by asking himself the wrong question. There was nothing in the relevant provisions that provided that amounts had to be treated as if they were dividends. It made no sense to disregard the essential nature of the transaction by disregarding the fact that part of the qualifying distribution represented part of the purchase consideration paid for redemption of the shares. The appeal would therefore be determined in Sema's favour.

The Revenue's arguments in respect of the first issue are unattractive as they adopt a strict interpretation of legislation that is already hard to construe. It must be wrong to try and compare the sums received on a share buy-back with the sums received by way of interim or final dividends. The transactions are of a completely different nature. In one, the capital asset is extinguished but not in the other.

When one looks at section 209, it is clear that this envisages a wide scope for the term 'distribution' which includes a dividend which itself includes a capital dividend. Section 14(2) envisages a distribution consisting of share capital. These fundamental sections do not support the approach proposed by the Revenue. This, coupled with the definitions in section 709, support Lord Justice Jonathan Parker's decision.

Lord Justice Jonathan Parker's approach is somewhat contradictory in that when considering the sections, he adopts a strict approach to construing sections 709(4) and 709(6). This contradicts the general approach for interpreting the legislation he approves. That said, it is hard to disagree that there is a significant difference between the sections.

Mr Justice Lightman relied on Sir John Vinelott's comments in Universities Superannuation Scheme in relation to what is an abnormal amount by way of dividend. I consider that these must be regarded as obiter. Sir John Vinelott makes the point that the only question for the appeal before him was whether the qualifying distribution included the tax credit. Whether the amount was abnormal was to be the subject of a further hearing before the tribunal. It is surely therefore inappropriate to rely on these comments as the basis for a methodology when the judge himself was not relying on them.

No doubt the Revenue regards this decision as a big defeat, particularly given the number of buy-back cases in the pipeline. It has petitioned for leave to appeal to the House of Lords.

If it is not successful, it is important to note that the Revenue did win on the main objects arguments. Sema had tried to argue that participating in the buybacks was in the ordinary course of making and managing investments, so it could not follow that the main object was obtaining tax advantages. The Special Commissioners did not agree. They accepted that there were other objects in deciding to sell the shares and that the fund manager wanted to sell them for good investment reasons. However, they decided that sales in the buy back were only made because the fund manager knew tax credits would be received.

As the Special Commissioners point out, only with the tax credit did the price paid for the buy-back together result in a benefit. The buy-backs were at values that were below the then market value of the shares, so without the tax credits they would have resulted in deficits for the fund manager.

The Revenue will doubtless argue that this decision is based on the particular facts in issue, and so other cases will be treated on an individual basis. However, as it stands, the decision may result in a number of similar cases with similar (if not the same) facts being decided against the Revenue, but when balancing that against the impact for the Revenue of losing on the main objects argument, it does not seem so bad, especially as it is likely that most of the tax credits have been paid out already, so in theory the national coffers will not be depleted by these losses.

Bearing in mind the fact that repayments of tax credits are no longer available to taxpayers like Sema, the decision of Lord Justice Jonathan Parker looks much more like a victory for the Revenue in terms of the application of section 703 in the future. The Revenue will be able to take comfort from the fact that his Lordship's decision has clearly isolated the main objects test as a separate test and that a decision in the course of making and managing investments does not preclude the application of the tax advantages test.