CAPITAL GAINS TAX – qualifying corporate bond – loan note convertible into relevant discounted security which is itself convertible into ordinary shares – whether the loan note represents a normal commercial loan within paragraph 1(5) Schedule 18 TA 1988 as modified for the purpose of section 117 TCGA 1992 – no

THE SPECIAL COMMISSIONERS

	BUSINESSMAN	Appellant

	- and -

	HM INSPECTOR OF TAXES	Respondent

		Special Commissioner:	DR JOHN F AVERY JONES CBE

Sitting in private in London on 15 July 2003

Michael Sherry, counsel, instructed by David Langridge, Chartered Accountant, for the Appellant

Launcelot Henderson QC and David Ewart instructed by the Solicitor of Inland Revenue, for the Respondents

© CROWN COPYRIGHT 2003

ANONYMISED DECISION

1.	Mr Businessman appeals against an amendment to his self-assessment for 1997/98 increasing the tax due by £2,647,729.20.  The issue is whether certain loan notes are qualifying corporate bonds and accordingly exempt from capital gains tax.  The taxpayer was represented by Mr Michael Sherry, and the Inspector by Mr Launcelot Henderson QC and Mr David Ewart.
2.	The Appellant applied for a hearing in private.  Under Regulation 15(2) of the Special Commissioners (Jurisdiction and Procedure) Regulations 1994 as amended by the General Commissioners and Special Commissioners (Jurisdiction and Procedure) (Amendment) Regulations 2002 (SI 2002 No.2976), applying to proceedings commenced on or after 31 December 2002:
“A Tribunal may direct that all or part of a hearing shall be in private—
(a)	upon the application of all the parties by notice to the Clerk;
(b)	upon the application of any party by notice to the clerk;
(c)	of its own motion,
if in each case, a Tribunal is satisfied that a hearing in private is necessary—
(i)	in the interests of morals, public order, national security, juveniles or for the protection of the private life of the party; or
(ii)	it considers that publicity would prejudice the interests of justice.”
The rules also provide that in cases (2)(b) and (2)(c) the Tribunal shall give the other party or parties to the proceedings the opportunity to make representations, and also that before giving a direction that the entire hearing be in private the Tribunal shall consider whether only part of the hearing should be heard in private.
3.	The reasons given for making the application were (1) that the Appellant has committed no wrong, the case turns on a purely technical matter of construction, the facts are agreed and no witnesses are to be called, and (2) that for reasons that were mistaken, in the past the Appellant has suffered personal attacks in the national press resulting from his directorship of the principal concern involved; accordingly he is concerned and sensitive about any publicity from that perspective, and also wishes to ensure that his private financial affairs are not exposed to the curiosity of his friends and acquaintances, both business and social; and that he was concerned about the effect of a hearing in public, resulting in details of his private financial affairs and his wealth becoming public knowledge, being detrimental to both his business and social relationships.  The Inspector had no objection to the hearing in private.
4.	As this is one of the first such applications under the amended rule I am setting out my reasons for granting the application in the decision for the benefit of those reading this decision when it is published in an anonymised form.  The rules clearly state that consent of both parties is in itself not enough; I must be satisfied about the matters set out in (i) or (ii) of Rule 15(2).  There is a public interest in open hearings and a presumption that sittings will be in public unless sufficient reasons are shown that one of those matters is satisfied.  In this case given the circumstances of the previous adverse press publicity I consider that sitting in private is necessary for the protection of the private life of the Appellant to a greater extent than would ordinarily be the case.  Protecting the taxpayer’s private life could not be achieved if part of the hearing were in private.  Accordingly I agreed that the hearing would be in private.  However, I should add that I do not consider that reason (1) above is relevant, or that preventing the Appellant’s private financial affairs being exposed to the curiosity of his friends and acquaintances is sufficient in itself to require a hearing in private in order to protect the private life of the taxpayer.  Cases will be judged on their merits, and I would be receptive to omitting figures that are not necessary to the decision.  
5.	There was an agreed statement of facts as follows: 
(1)	At 28 May 1997 the Appellant owned 241,376 5p ordinary shares, 270,000 £1 cumulative preference shares and 12,861 5p deferred convertible shares in Target Limited (Target).
(2)	On 29 May 1997 the Appellant and other shareholders in Target created the Target Shareholders’ Settlement of which the Trustees were trustees.  The Settlement is a multi-settlor interest in possession trust, and the settlors are primary beneficiaries.  
(3)	On 29 May 1997 the Target Shareholders Settlement acquired 2 £1 ordinary shares, the entire issued share capital, in Shelfco Limited (Shelfco), a dormant company incorporated on 2 April 1997.
(4)	On 30 May 1997 the Target Shareholders Settlement subscribed cash at par for £194,670 of loan notes issued by Shelfco, and for 10,248 £1 ordinary shares in Shelfco.   
(5)	The relevant terms of the Shelfco loan notes were as follows:
1.	The notes carried monthly interest at 10% per annum,
2.	The notes were entitled to repayment at par after 5 years, and
3.	Between 6 months and 54 months after issue, the notes could be exchanged for Shelfco “second schedule loan notes”.  The terms of these second schedule loan notes would be that:-
i.	they would be repaid nine years after issue at a rate of £2 per £1 face value, and
ii.	between six and twelve months after issue they could be converted into £1 ordinary shares in Shelfco at par (plus any accrued discount from issue to the date of the conversion).
(6)	On 15 June 1997 the Appellant gifted his 241,376 5p ordinary shares in Target to Shelfco.
(7)	On 13th February 1998 the shareholders and loan note holders of Shelfco entered an option agreement with Purchaser Group Limited for that company to purchase the shares and loan notes of Shelfco and the shares in Target not owned by Shelfco.  The consideration for the option amounted to £500,000.
(8)	On 23 February 1998 Purchaser Group Limited exercised the option agreement and purchased the entire issued share capital of Shelfco, all the Shelfco loan notes, and the shares in Target not owned by Shelfco.
(9)	The Target Shareholders Settlement received £466,800 (net of costs) for its shares in Shelfco, and £8,865,565 (net of costs) for its holding of Shelfco loan notes.  For the purposes of tax on chargeable gains the consideration received for the option fell to be included as part of the consideration for the sale on 23 February 1998 and is included in the net proceeds noted here.  
(10)	The Appellant sold his 270,000 £1 preference shares for consideration (net of fees) of £300,111 and 12,861 5p deferred shares in Target for net consideration of £384,813.
(11)	 Under section 77 of the Taxation of Chargeable Gains Act 1992, chargeable gains arising to the Target Shareholders Settlement are assessable on the settlors.  The Appellant’s share of any such gains is 241,376/323,286 of the total gain.
(12)	The Appellant included in his 1997/98 tax return chargeable gains on the disposal of his personal holding of £1 cumulative preference shares and 5p deferred convertible shares in Target, and his share of the gain arising to the Target Shareholders Settlement on the sale of the ordinary shares in Shelfco.
(13)	No gain was included in respect of the sale of the Shelfco loan notes by the Target Shareholders Settlement.  The Appellant disclosed on his 1997/98 tax return that the loan notes had been disposed of and provided detailed supporting paperwork and analysis, which concluded that the loan notes were qualifying corporate bonds and hence, by virtue of section 115 of the Taxation of Chargeable Gains Act 1992, any gain accruing on their disposal was not chargeable. 
(14)	The Respondent Inspector of Taxes opened an enquiry into the Appellant’s return for 1997/98, and contended that the Shelfco loan notes were not qualifying corporate bonds, that a chargeable gain arose on the disposal of those loan notes by the Target Shareholders Settlement, and that 241,376/323,286 of that gain was chargeable on the Appellant by virtue of section 77 of the Taxation of Chargeable Gains Act 1992. 
(15)	As the parties were unable to agree, on 21 October 2002 the Respondent Inspector wrote to the Appellant to notify him that he was amending the Appellant’s self-assessment for 1997/98 to increase the tax due by £2,647,729.20.
(16)	On 31 October 2002 an appeal against the Inspector’s amendment of the self-assessment was lodged on behalf of the Appellant.
6.	In summary, the Appellant owned 51 per cent of the ordinary shares in Target.  He and the other shareholders in Target (other than the trustees of another trust) transferred their shares in Target to the Trustees.  This transfer can be ignored for tax purposes since the Appellant would be taxable on his share of any capital gain made by the Trustees.  The Trustees acquired the two subscribers’ shares in Shelfco which then increased its ordinary capital, and on 30 May 1997 issued 10,248 ordinary shares at par to the Trustees and £194,670 loan notes to the Trustees (and 4,750 ordinary shares and £90,330 loan notes to the trustees of the other trust holding the remaining shares in Target).  The Trustees (and the other shareholder) gave their shares in Target to Shelfco on 15 June 1997.  At that time, such a gift qualified for hold-over relief, which was granted.  On 23 February 1998 the ordinary shares and loan notes in Shelfco and the preference and deferred shares in Target were sold to an outside purchaser, Purchaser Group Limited, for a total consideration of £17.036m.  The price attributable to each ordinary share in Shelfco was virtually identical to the price attributable to each £1 of loan notes.  The result that the Appellant hoped to achieve by these transactions was freedom from capital gains tax on what was previously the gain on the shares in Target to the extent to which this was then represented by the value of the loan notes, on the basis that they were qualifying corporate bonds the gain on which was not liable to capital gains tax.
7.	The loan notes (the first loan notes) in Shelfco are created by an Instrument dated 30 May 1997 (as varied by a Deed dated 10 June 1997).  After 6 months the noteholder may on giving one month’s written notice to Shelfco convert the loan note into new loan notes (the second loan notes) of the same par value in the form set out in the Second Schedule to the Instrument creating the first loan notes.  The second loan notes are then issued and the certificate for the first loan notes is cancelled.  The terms of the second loan notes are that they do not carry interest but are redeemable after nine years at £2 for every £1 par value.  It is common ground that they are relevant discounted securities within Schedule 13 to the Finance Act 1996.  The terms of the second loan notes also provide that after six months the noteholder may on giving one month’s written notice to Shelfco convert the second loan notes into ordinary shares in Shelfco having a par value of the amount of the loan note plus the accrued discount.  It was the first loan notes that were sold to the outside purchaser before any conversion had taken place. 
Statutory provisions
8.	The relevant statutory provisions are as follows.  Section 117 TCGA 1992 as in force in 1997/98 provides:
“(A1) …for purposes other than those of corporation tax references to a qualifying corporate bond shall be construed in accordance with the following provisions of this section.
(1) For the purposes of this section, a ‘corporate bond’ is a security, as defined in section 132(3)(b)—
(a)	the debt on which represents and has at all times represented a normal commercial loan; and…
and in paragraph (a) above ‘normal commercial loan’ has the meaning which would be given by sub-paragraph (5) of paragraph 1 of Schedule 18 to the Taxes act if for paragraph (a)(i) to (iii) of that sub-paragraph there were substituted the words ‘corporate bonds (within the meaning of section 117 of the 1992 Act)’.”
…
(7) …for the purposes of this Act, a corporate bond—
(b)	is a ‘qualifying’ corporate bond if it is issued after 13 March 1984….
Subsection (2AA) also provides that the expression “corporate bond” also includes any asset not included within the definition in subsection (1) that is a relevant discounted security for the purposes of Schedule 13 to the Finance Act 1996, and subsection (8A) provides that such a corporate bond is a qualifying corporate bond whatever its date of issue.  The second loan notes are qualifying corporate bonds by virtue of this provision.
9.	Incorporating the amendment made by the closing words of subsection (1) into paragraph 1(5) of Schedule 18 to the Taxes Act 1988 results in the following definition of normal commercial loan for the purposes of section 117(1) TCGA 1992:
“…‘normal commercial loan’ means a loan of or including new consideration and—
(a) which does not carry any right either to conversion into shares or securities of any other description except corporate bonds (within the meaning of section 117 of the 1992 Act) or to the acquisition of any additional shares or securities….”
It is not necessary to set out paragraphs (b) and (c) of the definition as it is common ground that they are satisfied.
10.	It is common ground that the first loan notes are securities.  The question is whether they represent a “normal commercial loan.”  If they do, they are qualifying corporate bonds and the gain on the disposal of them is free of capital gains tax.
Contentions of the parties
11.	Mr Sherry for the Appellant contends that the first loan notes carry a right of conversion into corporate bonds, the second loan notes.  Any rights attaching to the second loan notes are inchoate and may never come into being.  They come into being only when the second loan notes are issued in which case the first loan notes will have ceased to exist.  One should look at the rights attaching to the loan note one is considering, not the security into which it might be converted.  The draftsman knows how to refer to future rights, as in section 416(4) of the Taxes act 1988: “…a person shall be treated as entitled to acquire anything which he is entitled to acquire at a future date, or will at a future date be entitled to acquire.”  He also points out that the gain on the Target shares has not disappeared; it was held over on the gift to Shelfco and is still in the purchaser’s group.  Any tax saving results from the effect of the hold-over.
12.	Mr Sherry also considers the interpretation of the words “any right” in the unmodified paragraph 1(5) of Schedule 18 (as inserted by the Finance Act 1989).  
“…‘normal commercial loan’ means a loan of or including new consideration and—
(a)	which does not carry any right either to conversion into shares or securities of any other description except 
(i)	shares to which sub-paragraph (5A) below applies,
(ii)	securities to which sub-paragraph (5B) below applies, or
(iii)	shares or securities in the company’s quoted parent company,
or to the acquisition of any additional shares or securities….”
This allows conversion into three categories, set out in paragraph 1(5A), 1(5B) and into shares or securities of the company’s quoted parent company.  If one goes to paragraph 1(5A): 
“(5A) This sub-paragraph applies to any shares which—
(a)	satisfy the requirements of sub-paragraph (3)(a), (c) and (d) above [containing parts of the definition of fixed-rate preference shares], and 
(b)	do not carry any rights either to conversion into shares or securities of any other description, except shares or securities in the company’s quoted parent company, or to the acquisition of any additional shares or securities.”
The effect is to incorporate the whole of the definition of fixed-rate preference shares in paragraph 1(3), except for the restrictions on conversion and acquisition rights which in that definition is in identical terms to paragraph 1(5)(a) set out above.  Paragraph 1(5A)(b) instead contains its own restriction on conversion, that the only conversion right permitted is a right to convert into shares or securities in the company’s quoted parent company, and a prohibition on acquisition rights.  Similarly, paragraph 1(5B) incorporates by reference the whole of the definition of normal commercial loan in paragraph 1(5) except for the restriction on conversion or acquisition in paragraph 1(5)(a).  Instead it contains its own restriction on conversion and acquisition for which it incorporates paragraph 1(5A)(b) by reference, thus also permitting only conversion into securities of the company’s quoted parent company and no rights of acquisition.  Mr Sherry contends that if “any right” to conversion at the beginning of paragraph 1(5)(a) included indirect rights of conversion then the restrictions in paragraph 1(5A) and 1(5B) would be otiose.  Since paragraphs 1(5)(a), 1(5A) and 1(5B) were all enacted at the same time by the Finance Act 1989 it must be presumed that “any rights” in paragraph 1(5A) and “any such rights” in 1(5B) have some meaning “any right” in paragraph 1(5)(a).  The opening words of paragraph 1(5)(a) therefore refer only to direct rights of conversion and not indirect rights, which are dealt with by paragraphs 1(5A) and 1(5B).  
13.	Mr Henderson QC for the Inspector contends that one needs to concentrate on the whole of the contract for the first loan notes; the fact that the second loan notes viewed in isolation are qualifying corporate bonds is not relevant.  The question is whether the first loan notes carry “any right” to conversion into shares or securities of any other description except for corporate bonds.  All the terms of the first loan notes are contained in the Instrument of 30 May 1997 and formed part of the chose in action constituting the loan notes from the moment they were issued.  The loan notes conferred two rights of conversion: first, the direct right to convert into the second loan notes (which is a right to convert into corporate bonds); and secondly, the indirect right to convert the first loan notes into Shelfco ordinary shares (which is clearly not a right to convert into corporate bonds) by first exercising the right to convert into the second loan notes and then exercising the right to convert them into ordinary shares.  The words “any right” are wide and are apt to include the indirect right of conversion.  As a matter of commercial reality the indirect right gives them their value.  He contends that the reason why relevant discounted securities are deemed to be corporate bonds and accordingly exempt from capital gains tax is that a gain on them is liable to income tax on disposal, including a disposal on conversion into other shares or securities, the gain being calculated by reference to the market value of the new shares or securities.  It was therefore appropriate that a relevant discounted security that carried conversion rights should be excluded from the capital gains tax regime.  But Parliament cannot have intended to exempt from capital gains tax securities that carried indirect rights of conversion into shares via a relevant discounted security.
14.	Mr Henderson QC’s answer to Mr Sherry’s contention based on the unmodified form of paragraph 1(5) is that it is wrong in principle to assume that the meaning of words in the context of, and as modified by, section 117 is the same as the meaning of the words in the unmodified and very different context of Schedule 18.  The draftsman had borrowed the definition and modified it.  He should not be assumed to be importing every nuance of interpretation of the definition in its unmodified form and its original context.  In any case it is paradoxical to rely on words (the references to paragraphs 1(5A) and 1(5B)) that are not included in the modified form.  Lastly, if it were the case that “any right” in paragraph 1(5) was restricted to direct conversion rights, the same must follow in paragraphs 1(5A) and 1(5B), in which case there would be no restriction on indirect conversion rights in the securities permitted by the latter two paragraphs.  The mischief aimed at by Schedule 18 in defining disguised equity holders is exactly the same for indirect rights as direct rights.  It cannot have been the intention of the draftsman to allow further unrestricted indirect conversion rights when he was expressly restricting the indirect conversion rights of the original security in those paragraphs.  
Reasons for the decision
15.	I start by setting out again paragraph 1(5) of Schedule 18 in its modified form:
“…‘normal commercial loan’ means a loan of or including new consideration and—
(a)	which does not carry any right either to conversion into shares or securities of any other description except corporate bonds (within the meaning of section 117 of the 1992 Act) 
or to the acquisition of any additional shares or securities.”
The question is whether the first loan note carries “any right” to conversion into something other than corporate bonds, namely whether it carries any right to convert into Shelfco ordinary shares.  It seems to me that on the ordinary meaning of language it plainly does.  That right is an indirect right, in that in order to obtain Shelfco ordinary shares the noteholder must (a) wait six months, (b) complete a conversion notice, (c) receive the second loan note on cancellation of the first loan note, (d) wait another six months, and (e) complete another conversion notice.  Other than effluxion of time and completing the conversion notices the holder of the first notes has an absolute right from the start to convert into the ordinary shares, which is a right granted by the terms of the first loan notes.  It is of course the case that the first loan note ceases to exist before the right to convert the second loan note becomes exercisable, but that is not relevant to the question whether the first loan note carries the right to convert.  That interpretation corresponds also to the commercial reality that on sale the loan notes had virtually the same value as the ordinary shares into which they were indirectly convertible attributed to them on the sale to the outside purchaser.
16.	Mr Sherry makes what is at first sight the powerful point that in the context of paragraph 1(5) of Schedule 18 “any right” to convert cannot include indirect rights to convert since such indirect rights are expressly dealt with by paragraphs 1(5A) and 1(5B).  The purpose of those paragraphs is to enable different restrictions to be imposed on secondary conversion rights than on primary conversion rights.  The definition of normal commercial loan permits direct conversion into three types of shares or securities: (i) paragraph 1(5A) shares, (ii) paragraph 1(5B) securities, and (iii) shares and securities in the company’s quoted parent company.  Paragraph 1(5A) shares are fixed-rate preference shares, the definition of which, if it had been incorporated in full, would itself permit the same conversion rights into (i) paragraph 1(5A) shares, (ii) paragraph 1(5B) securities, and (iii) shares and securities in the company’s quoted parent company.  Similarly paragraph 1(5B) securities are normal commercial loans, the definition of which, if it had been incorporated in full, would itself permit conversion into (i) paragraph 1(5A) shares, (ii) paragraph 1(5B) securities, and (iii) shares and securities in the company’s quoted parent company.  The draftsman wanted to restrict the conversion rights of the securities into which primary conversion was permitted, so that the only indirect (or secondary) conversion right was into shares or securities in the company’s quoted parent company (which is only one of the three permitted primary conversion rights).  In other words, in the context he made indirect conversion rights narrower than direct ones.  I agree with Mr Henderson QC that the draftsman cannot be presumed, in the course of restricting the indirect (secondary) conversion rights, to have left open the possibility of unrestricted tertiary conversion rights.  He clearly did not intend to permit a first normal commercial loan carrying conversion rights into a second normal commercial loan within paragraph 1(5B), which itself carried conversion rights into (thirdly) securities of the company’s quoted parent company, with those third securities themselves being permitted to carry conversion rights into any other shares or securities whatsoever, for example back into securities of a subsidiary carrying further conversion rights.  That possibility is prevented if one reads “any rights” to conversion or acquisition in paragraph 1(5A) as including indirect conversion rights, and the same for “any such rights” in paragraph 1(5B).  The same interpretation must apply to the same words in the singular in paragraph 1(5) in relation to permitted conversion (iii) into shares or securities of the company’s quoted parent company, which is the only case where secondary conversion rights are not dealt with expressly.  I therefore do not agree with Mr Sherry’s contention that the words “any right” in the unmodified paragraph 1(5) do not cover indirect conversion rights.  In relation to conversion into shares or securities of the company’s quoted parent company, they do.  In relation to conversion into paragraph 1(5A) shares and paragraph 1(5B) securities they do not need to cover indirect conversion rights since such rights are expressly dealt with, but the same words “any rights” are used in those paragraphs and have the same effect in relation to further conversion rights.
17.	I have reached my decision on the ordinary meaning of the words of the modified paragraph 1(5) but this view is fortified by the scheme of the legislation, that gains on relevant discounted securities are liable to income tax and so it is necessary to exclude them from capital gains tax by making them qualifying corporate bonds.  There is no reason why a right to convert into relevant discounted securities should not take into account the indirect right of those securities to be converted into shares.
18.	Accordingly I dismiss the appeal and confirm the amendment increasing the Appellant’s self-assessment for 1997/98 by the agreed figure of £2,647,729.20 to £3,382,564.90.

J F AVERY JONES

SPECIAL COMMISSIONER

SC 3003/03