Bank of Ireland Britain Holdings Ltd v Revenue & Customs [2006] UKSPC SPC544 (06 June 2006)

                                                                                         SPC00544
Corporation tax – tripartite repo transaction with two non-resident parties – whether resident party deemed to be in receipt of interest on deemed loan – whether deemed annual payment representing deemed manufactured overseas dividends deductible – appeal allowed on both issues

THE SPECIAL COMMISSIONERS

BANK OF IRELAND BRITAIN HOLDINGS LIMITED	Appellant

- and -

THE COMMISSIONERS FOR HER MAJESTY’S
REVENUE AND CUSTOMS	Respondents

Special Commissioners: 	JOHN CLARK
MICHAEL JOHNSON

Sitting in public in London on 27 and 28 March 2006

John Gardiner QC and Philip Walford of Counsel, instructed by Slaughter and May, for the Appellant

Michael Furness QC, instructed by the Acting Solicitor for HM Revenue and Customs, for the Respondents

© CROWN COPYRIGHT 2006

DECISION

1.	There are two issues in this case, both arising in respect of the Appellant’s self-assessment return for its accounting period ending on 31 March 2001. The first is whether the Appellant (referred to in this decision as “BH”) is deemed to have received a payment of interest under s 730A of the Income and Corporation Taxes Act 1988 (“ICTA 1988”). The second is whether the payment deemed to have been made by BH under s 737A ICTA 1988 is to be treated as a charge on income for the purposes of corporation tax by virtue of ss 338(7) and 125 ICTA 1988. For convenience, we refer to the Respondents throughout this decision as “HMRC” and assume that they existed by that description at all material times. 
Background to the dispute
2.	The transactions in issue in this case constituted what is commercially known as a “repo” transaction. The simple version of such a transaction is where an owner of securities agrees to sell those securities and subsequently to repurchase them from the other party by a specified future date, the repurchase price being agreed (or fixed by formula) at the outset. Under the terms of the agreement, the original owner is entitled or required to repurchase those securities.
3.	The object of the repo is to provide funding to the original owner pending the repurchase, and to give the buyer the benefit of the securities for the same period. The transaction amounts to a form of secured lending, under which the buyer utilises surplus funds. Until the repurchase the buyer is the beneficial owner of the securities, but his rights as owner are fettered by the obligation to allow the repurchase to proceed. The original owner has the use of the sale price, but in the knowledge that when the repurchase takes place, he will have to pay the amount of the repurchase price.
4.	Repo transactions may involve more than two parties. The buyer may, by agreement with the original owner, pass the securities to a third party, who is fettered with the obligation to retransfer the securities eventually to the original owner. The result will then be that the resale obligation falls to be fulfilled by the third party rather than by the buyer.
5.	This appeal concerns a repo transaction of this tripartite kind.
The legislation
6.	As the applicable legislation is complex, we set out extracts from it in the order in which it is relevant to the issues in this appeal. (All references are to ICTA 1988, except where otherwise stated.)
7.	Section 730A provides:
“(1) Subject to subsection (8) below, this section applies where—
	(a) a person (“the original owner”) has transferred any securities to 	another person (“the interim holder”) under an agreement to sell 	them;
	(b) the original owner or a person connected with him is required to 	buy them back either—
		(i) in pursuance of an obligation to do so imposed by that 		agreement or by any related agreement, or
		(ii) in consequence of the exercise of an option acquired 			under that agreement or any related agreement;
	and
	(c) the sale price and the repurchase price are different.
(2) The difference between the sale price and the repurchase price shall be treated for the purposes of the Tax Acts—
	(a) where the repurchase price is more than the sale price, as a 	payment of interest made by the repurchaser on a deemed loan from 	the interim holder of an amount equal to the sale price; and
	(b) where the sale price is more than the repurchase price, as a 	payment of interest made by the interim holder on a deemed loan 	from the repurchaser of an amount equal to the repurchase price.
(3) Where any amount is deemed under subsection (2) above to be a payment of interest, that payment shall be deemed for the purposes of the Tax Acts to be one that becomes due at the time when the repurchase price becomes due and, accordingly, is treated as paid when that price is paid.
. . . 
(6) For the purposes of Chapter II of Part IV of the Finance Act 1996 (loan relationships)—
	(a) interest deemed by virtue of subsection (2) above to be paid or 	received by any company shall be deemed to be interest under a loan 	relationship; and
	(b) the debits and credits falling to be brought into account for the 	purposes of that Chapter so far as they relate to the deemed interest 	shall be those given by the use in relation to the deemed interest of an 	authorised accruals basis of accounting.
. . . 
(9) In this section references to the repurchase price are to be construed—
	(a) in cases where section 737A applies, and
	(b) . . .
as references to the repurchase price which is . . . applicable by virtue of section 737C( . . .) or (11)(c)”.
8.	Section 737A provides:
“(1) This section applies where on or after the appointed day a person (the transferor) agrees to sell any securities, and under the same or any related agreement the transferor or another person connected with him—
(a) is required to buy back the securities, or
(b) acquires an option, which he subsequently exercises, to buy back the securities;
but this section does not apply unless the conditions set out in subsection (2) below are fulfilled.
(2) The conditions are that—
	(a) as a result of the transaction, a dividend which becomes payable 	in respect of the securities is receivable otherwise than by the 	transferor,
	(b) . . .
	(c) there is no requirement under any agreement mentioned in 	subsection (1) above for a person to pay to the transferor on or before 	the relevant date an amount representative of the dividend, and
	(d) it is reasonable to assume that, in arriving at the repurchase price 	of the securities, account was taken of the fact that the dividend is 	receivable otherwise than by the transferor.
(3) For the purposes of subsection (2) above the relevant date is the date when the repurchase price of the securities becomes due.
(4) . . .
(5) Where this section applies, Schedule 23A and dividend manufacturing regulations shall apply as if—
	(a) the relevant person were required, under the arrangements for the 	transfer of the securities, to pay to the transferor an amount 	representative of the dividend mentioned in subsection (2)(a) above,
	(b) a payment were made by that person to the transferor in discharge 	of that requirement, and
	(c) the payment were made on the date when the repurchase price of 	the securities becomes due.
(6) In subsection (5) above “the relevant person” means—
	(a) where subsection (1)(a) above applies, the person from whom the 	transferor is required to buy back the securities;
	(b) where subsection (1)(b) above applies, the person from whom the 	transferor has the right to buy back the securities;
and in that subsection “dividend manufacturing regulations” means regulations under Schedule 23A (whenever made).”
9.	Section 737B provides:
“(1) In section 737A and this section “securities” means United Kingdom equities, United Kingdom securities or overseas securities; and—
(a) . . .
(b) where the securities mentioned in section 737A(1) are overseas securities, references in section 737A to a dividend shall be construed as references to an overseas dividend.
(2) In this section “United Kingdom equities”, “United Kingdom securities”, “overseas securities” and “overseas dividend” have the meanings given by paragraph 1(1) of Schedule 23A.
(3) For the purposes of section 737A agreements are related if each is entered into in pursuance of the same arrangement (regardless of the date on which either agreement is entered into).
(4) In section 737A “the repurchase price of the securities” means—
	(a) where subsection (1)(a) of that section applies, the amount which, 	under any agreement mentioned in section 737A(1), the transferor or 	connected person is required to pay for the securities bought back, or
	(b) where subsection (1)(b) of that section applies, the amount which 	under any such agreement the transferor or connected person is 	required, if he exercises the option, to pay for the securities bought 	back.
(5)-(9) . . . ”
10.	Section 737C provides:
“(1) This section applies where section 737A applies.
(2)-(9) . . .
(10) Subsection (11) below applies where—
	(a) the dividend mentioned in section 737A(2)(a) is an overseas 	dividend, and
	(b) by virtue of section 737A(5), paragraph 4 of Schedule 23A 	applies in relation to the payment which is treated under section 	737A(5) as having been made;
and in subsection (11) below “the deemed manufactured overseas dividend” means that payment.
(11) Where this subsection applies—
	(a) the gross amount of the deemed manufactured overseas dividend 	shall be taken to be the amount found under paragraph 4(5)(b) and (c) 	of Schedule 23A;
	(b) any deduction which, by virtue of paragraph 4 of Schedule 23A, 	is required to be made out of the gross amount of the deemed 	manufactured overseas dividend shall be deemed to have been made;
	(c) the repurchase price of the securities shall be treated, for the 	purposes of section 730A, as increased by the gross amount of the 	deemed manufactured overseas dividend.
(11A)-(12) . . . ”
11.	The relevant parts of paragraph 4 of Schedule 23A provide:
“(1) This paragraph applies in any case where, under a contract or other arrangements for the transfer of overseas securities, one of the parties (the “overseas dividend manufacturer”) is required to pay to the other (“the recipient”) an amount representative of an overseas dividend on the overseas securities; and in this Schedule the “manufactured overseas dividend” means any payment which the overseas dividend manufacturer makes in discharge of that requirement.
(2) . . . where this paragraph applies the gross amount of the manufactured overseas dividend shall be treated for all purposes of the Tax Acts as an annual payment, within section 349, but—
(a) the amount which is to be deducted from that gross amount on account of income tax shall be an amount equal to the relevant withholding tax on that gross amount; and
(b) in the application of sections 338(4)(a) and 350(4) in relation to manufactured overseas dividends the references to Schedule 16 shall be taken as references to dividend manufacturing regulations . . . ”
12.	In relation to treatment as a charge on income, the following parts of s 338 are relevant:
“(1) . . . in computing the corporation tax chargeable for any accounting period of a company any charges on income paid by the company in the accounting period, so far as paid out of the company’s profits brought into charge to corporation tax, shall be allowed as deductions against the total profits for the period as reduced by any other relief from tax, other than group relief.
(2) . . . “charges on income” means for the purposes of corporation tax— . . .
	(a) payments of any description mentioned in subsection (3) below, 	not being dividends or other distributions of the company . . .
(3) Subject to subsections (4) to (6) below, the payments referred to in subsection (2)(a) above are—
	(a) any annuity or annual payment payable otherwise than in respect 	of any of the company’s loan relationships . . .
(4) No such payment as is mentioned in subsection (3)(a) above made by a company to a person not resident in the United Kingdom shall be treated as a charge on income unless the company is so resident and either—
	(a) the company deducts income tax from the payment in accordance 	with section 349, and accounts under Schedule 16 for the tax so 	deducted . . .
(5) No such payment made by a company as is mentioned in subsection (3) above shall be treated as a charge on income if—
(a) the payment is charged to capital or the payment is not ultimately borne by the company; or
(b) the payment is not made under a liability incurred for a valuable and sufficient consideration (and, in the case of a company not resident in the United Kingdom, incurred wholly and exclusively for the purposes of a trade which is or is to be carried on by it in the United Kingdom through a branch or agency), and is not a qualifying donation (within the meaning of section 339).
. . .
(7) Any payment to which section 125(1) applies shall not be a charge on income for the purposes of corporation tax.”
13.	The relevant parts of s 125 provide:
“(1) Any payment to which this subsection applies shall be made without deduction of income tax, shall not be allowed as a deduction in computing the income or total income of the person by whom it is made and shall not be a charge on income for the purposes of corporation tax.
(2) Subject to the following provisions of this section, subsection (1) above applies to any payment which—
	(a) is an annuity or other annual payment charged with tax under 	Case III of Schedule D, not being interest; and
	(b) is made under a liability incurred for consideration in money or 	money’s worth all or any of which is not required to be brought into 	account in computing for the purposes of income tax or corporation 	tax the income of the person making the payment.” 
The facts relevant to the appeal
14.	The evidence before us was provided by way of a Statement of Agreed Facts, together with an Agreed Bundle of Documents. Accordingly, no oral evidence was given.
15.	Although the appeal was heard in public, we were requested to use alternative descriptions of certain parties to avoid identifying the overseas institution which had been involved through certain of its subsidiaries in providing the securities for the purposes of the repo transaction. As nothing turns on the identity of that institution, we accepted BH’s argument that naming the institution indirectly by referring to the full names of the companies involved might be commercially sensitive. We therefore refer to these companies as, respectively, “BCo” and “PSub”.
16.	BH is a wholly-owned subsidiary of the Governor and Company of the Bank of Ireland (“the Bank of Ireland”). BH is a private limited company incorporated and registered in England and Wales; it is resident in the UK.
17.	The Bank of Ireland is incorporated and resident in the Republic of Ireland; it entered into the relevant transactions through its head office in Dublin.
18.	BCo was a Cayman Islands incorporated and resident company. On 8 November 2000, the entire ordinary share capital of PSub, another Cayman Islands incorporated and resident company, was issued to BCo. BCo continued to own this ordinary share capital at all material times after this date.
19.	On 9 November 2000, 225,000 £1 Class A Redeemable Preference Shares in PSub (“the Securities”, subsequently the subject-matter of the repo) were issued to BCo at a price of £1,000 per share. These carried the right to receive a cumulative preference dividend accruing at a rate of 5% per annum until the end of the first dividend payment date on 14 November 2000. The directors of PSub were required to set a rate for all subsequent dividend payment dates (the 25th day of each month, or the next business day); this had to be done before 14 November 2000. They had a discretion to authorise a “special dividend” to be paid prior to a dividend payment date, in which case the amount payable would be the amount accrued up to the date of the special dividend; the amount of the dividend payable on the next normal dividend payment date would be correspondingly reduced.
20.	On 10 November 2000, various agreements comprising the repo were entered into. For the purposes of this appeal, it is only necessary for us to have regard to three of them.  These are as follows:
(1)	An agreement between BCo and the Bank of Ireland whereby BCo agreed to sell the Securities to the Bank of Ireland for a consideration of £225,000,000, the sale to be completed on 14 November 2000 and the consideration to be paid on that date.  We refer to this consideration as “the Sale Price” and to this agreement as “the Share Sale Agreement”. Under the Share Sale Agreement, the Bank of Ireland covenanted not to transfer the Securities to any person other than BH; the Share Sale Agreement referred to the option agreement described at (2) below.
(2)	An agreement entered into by the Bank of Ireland and BH whereby the Bank of Ireland granted to BH a call option on the Securities and BH granted to the Bank of Ireland a put option on the Securities.  (Thus, until the options expired, either of the parties could require that the Securities be transferred from the Bank of Ireland to BH.)  Under the terms of this agreement, either party could give notice to the other, up until 23 March 2001, that it wished to exercise its option, and, if an option was exercised, BH would have to pay the Bank of Ireland a purchase price amounting to the aggregate of £225,000,000 and an amount equal to any unpaid accrued dividends on the Securities.  We refer to this price as “the Intermediate Price” and to this agreement as “the First Option Agreement”.
(3)	An agreement between BH and BCo whereby BH granted to BCo a call option on the Securities and BCo granted to BH a put option on the Securities.  Under the terms of this agreement, either party could give notice to the other, up until 23 March 2001, that it wished to exercise its option, and, if an option was exercised, BCo would have to pay BH a determinable purchase price.  We refer to this price as “the Repurchase Price” and to this agreement as “the Second Option Agreement”.
21.	The Repurchase Price was specified as:
(1)	the aggregate of (a) £225,000,000; (b) the amount which at a rate of 8.30% per annum would have accrued on the sum of £225,000,000 in the period from 14 November 2000 until the completion date, ie the date when the sale was effected and the consideration paid; and (c) any finance breakage costs arising as a result of completion taking place earlier than 30 March 2001 (the last possible date for completion); less
(2)	the amount of any dividends paid in the period from 14 November 2000 until the completion date, divided by 0.7. (As the dividend rate was set at 5.81% per annum, the result of this division equated to a rate of 8.30% per annum.)
22.	On 14 November 2000, the cumulative preference dividend payable in respect of the securities for the first dividend period was paid by PSub to BCo, and, pursuant to the Share Sale Agreement, BCo sold the Securities to the Bank of Ireland for £225,000,000.
23.	Following its purchase of the Securities, the Bank of Ireland received dividends on the Securities in respect of the periods ending on 25 November 2000, 25 December 2000 and 25 January 2001. However, on 20 February 2001 the Bank of Ireland exercised its put option under the First Option Agreement in respect of the Securities. Pursuant to the option exercise notice, the completion date for that option was 23 February 2001. The Bank of Ireland received a special dividend on the Securities for the period to 23 February 2001. In total it received £3,617,322 in dividends on the Securities.
24.	On 23 February 2001 BH paid the Intermediate Price of £225,000,000 to the Bank of Ireland and received the Securities. It subsequently received a dividend on the Securities for the period to 25 February 2001.
25.	Pursuant to the Second Option Agreement, on 26 February 2001 BH gave notice of exercise of its put option in respect of the Securities. The completion date was specified as 5 March 2001. BH received a special dividend on the Securities for the period to 5 March 2001. The aggregate amount which it received in dividends on the Securities during its period of ownership of the Securities was £358,151.
26.	On 5 March 2001, BCo duly paid the Repurchase Price and repurchased the Securities. The result of applying the formula set out at paragraph 21 above was that the amount of the Repurchase Price was £225,000,000.
27.	BH delivered a corporation tax return for the year ended 31 March 2001 to its Inspector of Taxes on 26 March 2002. The return included a self-assessment which was calculated on the basis that BH was entitled to a deduction of £3,975,473 arising by virtue of section 737A.
28.	On 26 April 2002 the Inspector of Taxes gave notice that he intended to enquire into that return and on 5 July 2004 a closure notice in respect of that enquiry was issued. On 10 August 2004 HMRC amended BH’s return, in effect excluding the deduction of £3,975,473. By notice dated 9 September 2004, BH appealed against that amendment on the ground that it was entitled to that deduction.
Arguments for BH
29.	Mr Gardiner explained the history of the statutory provisions. Their purpose was to tax capital transactions on a deemed basis. The provisions sought to go beyond normal legal analysis. There was a very detailed statutory code and very precise statutory definitions. If the legislation had not succeeded in its intention, this was the result of the way in which it had been drafted. HMRC were asking for the provisions to be rewritten rather than construed. It was necessary to construe the words which were there, rather than what the draftsman might have included.
The deemed interest issue
30.	Both parties accepted that ss 730A and 737A applied to the repo and that by s 737A(5) BH was deemed to have paid a manufactured overseas dividend of £3,975,473 to BCo. It was also agreed that by virtue of s 737C(11)(c), the repurchase price for the purposes of s 730A was deemed to be the aggregate of £225,000,000 (the actual Repurchase Price) and £3,975,473, and that the Sale Price was £225,000,000.
31.	Both parties therefore accepted that by s 730(2)(a) £3,975,473 was deemed to be treated:
“as a payment of interest made by the repurchaser on a deemed loan from the interim holder of an amount equal to the sale price.”
32.	It was agreed that BCo was the “repurchaser” for this purpose. During the course of the hearing HMRC had confirmed its acceptance that the “interim holder” was the Bank of Ireland.
33.	It was agreed that the sum of £3,975,473 was to be treated as an amount of interest paid by BCo on a deemed loan from the Bank of Ireland. The point of contention was whose income was it? BH contended that it was the income of the Bank of Ireland (the maker of the deemed loan), whereas HMRC argued that it was the income of BH (which received the Repurchase Price). Put another way, the point in contention was whether or not, by reason of the sum of £3,975,473 being treated as paid by BCo as interest on a deemed loan from the Bank of Ireland, BH was chargeable to tax on interest of such a sum.
34.	BH’s position had been summarised in its Statement of Case, as follows. Section 730A(2) had the effect of deeming there to be a payment of interest made by BCo to the Bank of Ireland on a notional loan from Bank of Ireland, and if the Bank of Ireland had been resident in the UK it would clearly have been assessable upon such interest.  The Bank of Ireland was the only interim holder (as defined) and the purpose (and only purpose) of referring to a deemed loan was to provide the source of profits in respect of which that interest was to be taxed.  Only a person with a source of profits could be taxed.  The section made no provision for anyone other than the interim holder (the Bank of Ireland) to be taxed; it should be noted that the amount of interest was a deemed amount (the difference between the Sale Price and the Repurchase Price).  The fact that BH received the repurchase price did not deem it to receive any deemed interest, let alone to possess the source on which such interest could be taxed.  Finally it should be noted on the facts that it was the Bank of Ireland which in economic terms had provided finance to BCo for 90 per cent of the term of the repo.
35.	Section 730A(2)(a), in relation to the present facts, provided that the amount of £3,975,473 was to be treated for the purposes of the Tax Acts as a payment of interest made by BCo on a deemed loan from the Bank of Ireland of an amount equal to £225,000,000. The legislation did not in any way deem such interest to be received by BH. The interest was notional; the only basis for taxing it was that it was deemed to be interest paid by BCo on a loan from the Bank of Ireland. If the Bank of Ireland had been resident in the UK, it and not BH, would have been assessable on this notional interest. The Bank of Ireland’s non-resident status did not alter the position that it, and not BH, was deemed to have made the loan and to receive the interest.
36.	The purpose of deeming the existence of a loan was to establish the source of the deemed interest and thus to tax the annual profits and gains arising from that source.
37.	HMRC disliked the consequences of the statutory provisions in this case because the interim holder, which would otherwise have been assessable, was non-resident. This was no justification for a distorted construction of the statutory provisions, which worked perfectly well when the assessable interim holder was UK resident.
38.	The repo did not itself constitute a loan relationship. It was only the deemed interest which was taxed as if it were interest from a deemed loan relationship. The only persons which could have been parties to that loan relationship from which that interest arose were BCo and the Bank of Ireland, as a result of the deeming by section 730A(2). This was set out in HMRC’s Company Taxation Manual at paragraph CTM51770, which emphasised that the treatment of repo interest was quite separate from the treatment of the repo.
39.	Despite this, HMRC contended that BH was deemed to have received the section 730A interest. Mr Gardiner referred to HMRC’s reasoning in support of this contention, and responded with contrary arguments against each element.
40.	HMRC argued that s 737C deemed the whole of the deemed manufactured dividend to be added to the repurchase price for the purpose of s 730A; the repurchase price was ex hypothesi received by BH. That additional amount on the repurchase price was then deemed to be interest arising under a loan relationship. Therefore, prima facie it was BH which was deemed to receive the interest.
41.	Mr Gardiner commented that HMRC had confounded the statutory provisions involved and ignored the fact that s 730A(2)(a) referred to “a loan from the interim holder”. The statutory scheme was that ss 737C(11) and 730A(9) deemed the Repurchase Price of the Securities to be increased by the amount of the deemed manufactured dividend, and the difference between the Sale Price and the (deemed) repurchase price was treated as a payment of interest by BCo on a loan from the Bank of Ireland. He emphasised that the legislation did not deem a part of the repurchase price to be interest: there was nothing at all which equated receipt of the repurchase price with receipt of the interest. HMRC’s argument amounted to an invitation to construe s 730A(2)(a) without the words “from the interim holder”, to assume that BH was to be taken to be the entity which prima facie received the interest, and to consider whether those words were sufficient to rebut that presumption. However, on the actual wording of the sub-section it was clear that it was the Bank of Ireland and not BH which was deemed to receive the interest.
42.	He contended that HMRC’s further points in relation to s 730A were subsidiary to their main initial argument set out at paragraph 40 above. Nevertheless, he considered these subsidiary arguments in turn.
43.	HMRC argued that it was possible for interest on a loan to become payable to someone other than the person to whom the principal was due, and that the repo transaction which had taken place was similar in economic terms to the assignment of a loan. They also contended that the deeming under s 730A(2)(a) of a loan from the Bank of Ireland did not entail an assumption that the interest was to be treated as received by an entity different from the one which was otherwise deemed to be entitled to it.
44.	Mr Gardiner found it hard to see how the analogy with assignment could assist matters. The relevant question was not whether the receipt by BH of interest on a loan was legally consistent with the loan being made from the interim holder; it was whether the legislation deemed BH to have received the interest. There was nothing in the statutory provisions to deem some sort of assignment of the loan from the Bank of Ireland to BH; it would be surprising if, having specifically deemed there to be a loan from the interim holder, Parliament had intended an inference that the benefit of the loan or the interest on it had been “assigned” in some way by the interim holder.
45.	HMRC’s next argument was that the reference to the deemed loan from the Bank of Ireland served not only to attribute a source to the deemed interest, but also to fix the tax treatment of the repurchaser.
46.	Mr Gardiner made two comments in response. This argument showed that HMRC had failed to understand and to engage with the points in BH’s Statement of Case set out at paragraph 34 above. The identification of the loan relationship was generally as necessary for the payer of the interest as it was for the recipient. The words served no purpose other than to identify the loan relationship in respect of which the interest was notionally paid and taxed. The fact that the payer of interest might be affected as well as the recipient in no way detracted from the point that it was only from these words that the s 730A(2)(a) “amount” could be given a tax treatment at all.
47.	His second comment was that HMRC could not on their case give a meaning to all the words of the phrase in s 730A(2)(a) “ . . . payment of interest made by the repurchaser on a deemed loan from the interim holder . . . ”. In particular, HMRC appeared to be unable to give a purpose to the words “from the interim holder”.
48.	HMRC’s remaining argument on the deemed interest issue was that ss 730A, 737A and 737C were designed to operate together, and that it was perfectly obvious that the deduction in respect of the total manufactured dividends, and the corresponding amount of interest treated as payable on the resale, were intended to be attributed to the same party.
49.	Mr Gardiner argued that this amounted to a suggestion that the legislation should be rewritten and that its actual wording should be ignored. If Parliament’s intention had been as HMRC contended, why would the draftsman refer at all in s 730A(2)(a) to the interim holder? Why not refer to the person from whom the securities were repurchased?
50.	Section 730A had been inserted by s 80(1) of the Finance Act 1995. This meant that when it was drafted, ss 737A to 737C were already in existence, having been inserted by s 122 of the Finance Act 1994. It was clear from amendments made by s 80 of the Finance Act 1995 that the draftsman had closely considered ss 737A to 737C. Thus if the draftsman had wished to ensure that the person who was deemed to pay a manufactured dividend was invariably the same person as the one to whom the s 730A interest was treated as paid, he would certainly have provided for this. Mr Gardiner set out the revised versions of s 730A(2) and ss 730B(2) and (2A) which would have been needed to achieve this; they did not exist.
51.	Repos by their very nature were circular transactions; nevertheless Parliament had chosen for reasons of financial policy to recognise them despite that circularity and to lay down a tax treatment for them. The repo legislation was very detailed and precisely drafted; this was specifically because it was prescribing the tax treatment by reference to the agreements which were entered into, rather than by economic effect. Mr Gardiner regarded it as meaningless to say that a particular result was “obvious” where such a result was not apparent from the terms of the legislation.
52.	The legislation used two different terms “interim holder” and “relevant person” to label two different concepts. It was an established principle of statutory construction that in legislation different words were used to convey different meanings (Bennion on Statutory Interpretation, 4th edition, 2002, page 995; Hadley v Perks (1866) LR 1 Q.B. 444 at 457). However, here it was not merely the case that different words were used; there were different statutory definitions. There were two separate concepts. In full knowledge of the conceptual apparatus employed by s 737A, the draftsman of s 730A had employed a different one. It was the concept of interim holder which determined who was a party to the s 730A loan relationship and therefore who was deemed to receive the notional interest. 
53.	In his reply to HMRC’s Skeleton Argument, Mr Gardiner referred to HMRC’s contention that the notional s 730A(2)(a) interest was deemed to be received by BH as a result of a statutory fiction created by s 737C(11). They argued that this receipt was one of the “consequences and incidents inevitably flowing from or accompanying that deemed state of affairs” (Peter Gibson J in Marshall v Kerr 67TC 56 at 79A, [1993] STC 360 at 366). Mr Gardiner strongly disagreed with their argument. The consequences of the state of affairs deemed to be that case by s 737C(11) could not be any wider than the consequences which would follow if that state of affairs were actually true. Section 737C(11)(c) merely deemed the repurchase price in s 730A to be greater by the amount of any manufactured overseas dividend. All it did was to alter the figure for the repurchase price in s 730A; it could have no other effect on that section. The change in the amount of the repurchase price could not alter the identity of the person who was taxed on the notional interest.
54.	For the principle in Marshall v Kerr to apply, any consequence would have to be inevitable. In Polydor Ltd v Harlequin Record Shop Ltd [1980] 1 C.M.L.R. 669 at 673, Megarry V-C, in referring to making a statutory hypothesis, had said that the word “inevitably” should not be softened into “probably”. Mr Gardiner strongly resisted HMRC’s suggestion that the s 737C(11) deemed increase in the repurchase price had the inevitable consequence of making BH taxable on the interest on the loan deemed to have been made by the Bank of Ireland.
55.	HMRC were seeking to conjure up an ambiguity in s 730A(2)(a) which was not there. Their only reason for doing so was that they did not like the result which the wording of the legislation produced in the present case, as the Bank of Ireland, the interim holder, was non-resident. Fundamentally, HMRC’s sole complaint was that there was a mismatch. This was a consequence of the way in which the legislation had been drafted. Mr Gardiner considered other circumstances on the basis of BH’s construction in which the position would have been to HMRC’s advantage. Further, HMRC’s construction would not prevent mismatches from occurring as a result of these provisions.
The deductibility issue
56.	It was not disputed that the deemed manufactured overseas dividend of £3,975,473 was an annual payment, nor was it disputed that the amount of £3,975,473 was a charge on income paid by BH, and so allowable as a deduction, unless prevented from so being by either or both of s 338(5)(b) and s 125(2)(b) (and s 338(7)). In relation to s 338(5)(b) the question in contention was whether the deemed payment was made “under a liability incurred for valuable and sufficient consideration”. In relation to s 125 it was not clear whether HMRC contended that any free-standing question arose. If BH’s case was correct on s 338(5)(b), BH submitted that for the reasons set out below, it must succeed on the s 125 point. 
57.	Under s 737A(5) BH had been deemed to pay the deemed manufactured dividend to BCo “under the arrangements for the transfer of the securities”. BH had given valuable and sufficient consideration for the agreements it had entered into; this had been accepted by HMRC. The annual payment representing the dividends was deemed to be made under those arrangements and consequently had been made under a liability [incurred] for a valuable and sufficient consideration. It was an inevitable consequence of the deeming by s 737A(5) that the deemed manufactured dividend had been deemed to be made under a liability within that description. Accordingly the condition in s 338(5)(b) had been met. The purpose of s 338(5)(b) was to ensure that the transaction in question was a commercial one; it was clearly not intended to catch deemed payments which arose from entering into commercial transactions.
58.	It was the intention of Parliament, and manifest from the wording of ss 737A to 737C and paragraph 4 of Schedule 23A, that it should be possible in principle for a deemed manufactured overseas dividend to be a charge on income and hence deductible. BH believed that this was not in dispute. It must therefore be possible for a deemed manufactured payment not to fall within s 338(5)(b) and s 125(2)(b), ie to meet the condition considered in paragraph 57 above, and to be regarded as made for a taxable rather than a non-taxable consideration (see paragraph 13 above).
59.	The only consideration which BH had received was the dividends paid to it by PSub and the fee from BCo. These had both been brought into account in computing BH’s corporation tax, so that the deemed manufactured dividend did not fall within s 125(2)(b). HMRC argued that BH had received no consideration at all. Thus it seemed that on each party’s case s 125 would not apply (despite the contrary implication in the concluding paragraph of HMRC’s Statement of Case).
60.	In relation to s 338(5)(b), the prohibition from being a charge only applied if the payment was not made under a liability incurred for a valuable and sufficient consideration. It was in respect of the liability, rather than the amount of the payment, that the consideration was required to be valuable and sufficient (Ball v National and Grindlay’s Bank Ltd [1973] 1 Ch. 127 at 138 to 140, 47 TC 287).
61.	The liability (if there was one) created by s 737A(5)(a) was relevant only for the purposes of Schedule 23A and dividend manufacturing regulations. The sub-section did not apply for the purposes of s 338. For the latter purposes, the only liability under which the annual payment was made was that which was actually incurred, and it was not disputed that that was for valuable and sufficient consideration.
62.	However, HMRC contended that the annual payment fell within s 338(5)(b); their reasoning was as follows:
(1)	It was the individual deemed transaction which must be entered into for valuable and sufficient consideration.
(2)	Looking at the actual and deemed transactions individually, the deemed manufactured overseas dividend had not been incurred for any consideration at all.
(3)	Consequently, s 338(5) prevented the deemed manufactured overseas dividend from being deductible.
(4)	However, where the s 730A interest was paid to the person making the deemed manufactured overseas dividend, then that interest (and only that interest) would count as consideration for the deemed manufactured overseas dividend.
63.	For the reasons already stated, BH submitted that points (1) to (3) above did not hold, and that s 338(5)(b) was concerned with whether the actual transactions were commercial ones.
64.	In relation to point (4), HMRC had accepted that if they were wrong on the s 730A(2) issue, their contentions as to the application of ss 737A(5) and 338(5)(b) gave rise to a problem. They had referred to the party paying the deemed manufactured dividend receiving an equal and opposite interest payment by way of compensation. However, they had also acknowledged that any argument that the consideration paid to the Bank of Ireland (ie the deemed interest payment) was sufficient consideration was untenable, as the consideration had to be received by the payer of the deemed manufactured dividend.
65.	The consequence of HMRC’s construction was that in every tripartite repo transaction in overseas securities where the seller was non-resident (or even UK resident), any deemed manufactured dividend would not be a charge on income, even if both the other parties were UK resident.
66.	HMRC’s contentions were irretrievably flawed. There was absolutely nothing in the legislation to deem the s 730A(2) interest to be consideration for paying the s 737A(5) deemed manufactured dividend; these were both notional payments which arose by virtue of the legislation.  The amount of the interest did not need be equal to the deemed manufactured dividend, and could even be nil There could be notional interest under s 730A(2) without there being any deemed manufactured dividend at all, as well as the converse being true.  Further, it could be the case that both a deemed manufactured dividend and s 730A(2) interest were paid to the seller.  For example, if A sold securities in short supply to B for £100, B received a dividend of £10 on them, and B resold them to A for £80; B would make a deemed manufactured dividend payment of £10 to A and a notional interest payment of £10 to A.
67.	HMRC’s argument also gave rise to problems in a very simple case where, for example, X sold securities to Y, with X being under an obligation to buy them back from Y for £100, and during the repo Y received £10 in overseas dividends. On BH’s argument, s 338(5)(b) would be satisfied because it was an inevitable consequence of the deeming in s 737A(5) and paragraph 4 of Schedule 23A that if the real transactions were entered into for valuable and sufficient consideration, then the deemed manufactured overseas dividend was made under a liability for valuable and sufficient consideration.
68.	On the basis of their argument, HMRC would say that there was an equal and opposite interest payment by way of consideration for the deemed manufactured overseas dividend. Mr Gardiner repeated his argument that there was nothing to deem the notional interest to be consideration for the payment of the dividend, and pointed out that s 730A(2)(a) specifically deemed the interest to be paid by X on a deemed loan from Y of £100. It was inescapable from the wording of s 730A(2)(a) that the notional interest was not paid in consideration of the deemed manufactured overseas dividend: in the Parliamentary Draftsman’s fictional world it was paid because it arose under the deemed loan of £100. The notional interest was never consideration for the deemed manufactured overseas dividend. Thus if HMRC were correct that it was not sufficient to establish that the actual transactions were for valuable and sufficient consideration, it would follow that in every single repo involving a deemed manufactured overseas dividend, a deduction could not be claimed.
69.	It was clear that the only possible construction of the reference to valuable and sufficient consideration was that it must be a reference to the actual consideration received for entering into the actual transactions.
70.	In relation to s 125, sub-section (2)(b) was not satisfied, as all consideration  in money or money’s worth for which the liability under which the deemed manufactured dividend had been made  (ie the dividend receipt and fee) had been brought into account in computing BH’s income. BH had not been paid any capital sum or made any relevant chargeable gain.
71.	In his reply to HMRC’s Skeleton Argument, Mr Gardiner argued that HMRC were seeking to distort the meaning and operation of s 338 in order to rectify by another means what they perceived to be a deficiency in the repo rules. Looking at the effects of this distortion on those rules, their argument, if correct would produce the problem identified at paragraph 64 above; HMRC had not addressed this.
72.	Section 338(5)(b) was concerned purely with the commerciality of the amounts of real liabilities. The commerciality of deemed liabilities was “somewhat oxymoronic”; the section was not concerned with them. The section did not prevent the deemed manufactured overseas dividend from being deductible.
73.	If HMRC considered s 730A to be unsatisfactory, the proper course would be for them to request that the legislation should be amended. It would be a highly inappropriate course to distort the charge on income provisions to provide a “quick fix” solution, especially one which would bring with it its own problems (and hamper any redrafting of the repo legislation, if that were felt by Parliament to be necessary).
Arguments for HMRC
The deemed interest issue
74.	Mr Furness explained the purpose of the legislation. In essence a repo was a form of loan at interest. The legislation was designed to take transactions which were, as a matter of legal analysis, transactions of sale and purchase, and for tax purposes to recharacterise the profit which they yielded as interest on a loan. He considered the example of a simple repo between two parties. Income generated by the securities while they were owned by the interim holder could be dealt with by two methods. The first was for the interim holder to remit the income (by way of manufactured dividends) to the original owner as and when it arose. The second method was for the interim holder to keep the income for his own benefit, and set off the amount of income received against what would otherwise be the amount by which the repurchase price would exceed the repurchase price.
75.	Under the first method, the tax treatment was governed by Schedule 23A; the securities in the present appeal were overseas securities, so the relevant paragraph of that Schedule was 4. This provided that the gross amount of the manufactured dividend was to be an annual payment; subject to meeting general requirements, it would be deductible from the payer’s taxable income. Thus Schedule 23A would usually operate to cancel out any liability to tax on the interim holder arising from the receipt of income from the securities, and instead allocate that liability to the original owner. This followed the economic reality of the transaction.
76.	Where the second method was employed, the policy of the legislation was to recharacterise the transaction so as to tax it as if the first method had been employed instead. This was achieved in the following way. Section 737A deemed the interim holder to pay manufactured dividends in respect of all the income which he received while holding the repo securities. This cancelled out his liability to tax on that income and transferred the liability to tax on that income to the original owner (if he was UK resident). Section 737C deemed the aggregate of the deemed manufactured dividends to be added to the repurchase price, which had the result that the difference between the sale and repurchase price was increased by that amount. The amount of this increase was then deemed to be interest payable to the interim holder under s 730A when the repo was unwound and the securities were repurchased.
77.	HMRC stressed the bizarre tax results which stemmed from BH’s construction of the legislation. In their view, it was reasonable to suppose that Parliament’s intention in enacting this complex legislation was to ensure that tax liabilities and tax losses coincided with economic reality. Using simplified figures for the present case, the following had occurred:
(1)	The Bank of Ireland had paid BCo £225 million for the Securities.
(2)	The Bank of Ireland had received £3.5 million in dividends on the Securities.
(3)	BH had paid the Bank of Ireland £225 million for the Securities.
(4)	BH had received £0.35 million in dividends.
(5)	BH had sold the securities back to BCo for £225 million. Under the formula for interest in the Second Option Agreement a further £3.85 million had fallen to be added to the £225 million, but that additional amount had fallen to be reduced by the amount of the dividends actually received, ie the £3.85 million.
78.	BH had made a profit of £0.35 million, and the Bank of Ireland had made a profit of £3.5 million. However, the result of BH’s construction of the legislation was that BH had made a loss [for tax purposes] of £3.5 million. The further result was that if the Bank of Ireland had been UK resident for tax purposes, it would have made a profit [again, for tax purposes] of £7.35 million. This raised a serious question as to the construction advanced by BH, looked at from the point of view of a UK resident interim holder; was it appropriate to allow HMRC to tax such a holder on an entirely non-existent profit, on the strength of BH’s argument?
79.	There was a contest between two deeming provisions, s 730A(2)(a) and s 737C(11). The significance of the latter was consistently understated by BH. Under the transaction the entity which had been entitled to the Repurchase Price, and had actually received it, was BH. If that price was [treated as] increased then BH was clearly deemed to be entitled to, and to receive, the increased amount, as well as the Repurchase Price itself. For BH to argue that the Bank of Ireland was to be taxed on the deemed interest was to argue for a party to be taxed in respect of a sum which the legislation deemed another party to be entitled to receive.
80.	BH argued that the amount by which the Repurchase Price was [treated as] increased by virtue of s 737C(11) was not actually deemed to be interest. HMRC accepted that what was deemed to be interest was the difference between the Sale Price and the [deemed] repurchase price. However, BH was the party which was deemed to receive the sum by reference to which the interest was computed. What was happening in s 730A(2)(a) was a recharacterisation of part of a sum of money deemed to have been received by BH. The amount by which the sum BH received as the [deemed] repurchase price exceeded the Sale Price was referred to in that sub-section as “the difference”. The sub-section said that “ . . . the difference shall be treated as interest . . . ”. It did not say that interest should be deemed to be paid “in an amount which equals the difference”. The sub-section said that the difference itself was to be treated as interest. What the draftsman was doing was treating part of a sum of money which had actually been paid to BH (albeit in a larger sum than in reality due to s 737C(11)) as interest rather than the sale price of an asset.
81.	HMRC did not deny that there was a tension between s 730A(2)(a) and s 737C(11), nor did they deny that the legislation could have been better drafted. Where there was a collision between two deeming provisions, it was necessary not only to have regard to the full implications of the state of affairs which was deemed to exist, but also to ensure that the deeming provision was not pushed to the point at which injustice or absurdity resulted. Mr Furness cited the comments of Peter Gibson J in Marshall v Kerr 67 TC 56 at 79A, [1993] STC 360 at 366.
82.	Among the consequences and incidents which inevitably followed from a deemed increase in the repurchase price was that BH was treated as receiving and being entitled to that increase in the price. By contrast, it was not an inevitable consequence of the fact that the difference between the Sale Price and the [deemed] repurchase price was deemed to be interest on a loan from the interim holder that the latter was the person entitled to the interest when it arose. Various examples could be cited to illustrate why the right to receive interest did not go hand in hand with the original lending. Where it was found that pursuing the deeming provision to the point at which any interest deemed to arise on the deemed loan was received by the interim holder created injustice and absurdity, which was clearly the case here, then it became clear that pushing that deeming provision to that extent was not permissible.
83.	BH argued that HMRC’s interpretation of the legislation made it impossible to understand why the draftsman troubled at all to deem the loan on which interest arose to be a loan from the interim holder. On HMRC’s approach it would always be the reseller who was taxed on the deemed interest, so why not deem the loan to be made by him? However, it was natural for the draftsman to say that the deemed loan was “from” the interim holder because the interim holder would be the person who paid the money (the purchase price) which was deemed to constitute the capital of the deemed loan. There was no definition of reseller in the legislation; the reseller would not always be the “relevant person”, because there would not always be a relevant person, as there might not be any deemed manufactured dividends. The draftsman might have created a special definition of reseller in order to deem the loan to have been made by him, but clearly thought that an unnecessary complication given that the difference between the sale and repurchase prices, which was what was being deemed to be interest, would always be received by the reseller. In the usual commercial two-party repo, the interim holder and the reseller were one and the same. Outside that context, the reference to the interim holder gave rise to the problems of construction being faced in this appeal. The legislation should ideally have been better drafted to deal with the introduction of a third party into the repo. However, it was not necessary for the legislation to be redrafted, as suggested by BH, in order to justify HMRC’s construction.
84.	Section 737A operated with s 737C to convert for tax purposes a repo under which income from the securities was retained by the holder(s) of the securities into a repo under which the income from the securities was remitted to the original owner by way of manufactured dividends. This was done by deeming the relevant person (in effect the reseller) to make manufactured dividend payments corresponding to the income receipts and by adding an equal and opposite amount to the repurchase price, so that one cancelled out the other. It would therefore be expected that the tax treatment of these deemed transactions would be self-cancelling (otherwise why deem the sums in question to flow to and from the same people?) HMRC’s construction achieved this result.
85.	In contrast, BH’s construction placed all its weight on the reference to the interim holder in s 730A(2)(a). BH had made no attempt to explain why the draftsman should have created the mismatch between these two self-cancelling payments which its construction produced, and had neither made, nor could make, any justification for the unfair tax results (as between the reseller and the interim holder) which its result created. Instead BH submitted that the result for which it contended was the inevitable consequence of the mechanistic working out of detailed statutory provisions, which it invited the Tribunal to apply blindly without regard to whether the result was remotely sensible. For the reasons already given, BH’s result was by no means inevitable. To put it at its lowest, HMRC’s construction was a tenable alternative; HMRC maintained that it was clearly preferable on the wording. Once the Tribunal was presented with alternative constructions, especially constructions of deeming provisions, it must have regard to the likely purpose of the legislation, and take care to avoid an unjust or absurd result.
The deductibility issue
86.	If HMRC were wrong about the construction of s 730A(2), and BH was correct that the deemed interest payment should be attributed to the Bank of Ireland, the deductibility question arose for BH. The terms of the deemed transaction arising from BH’s construction had to be considered, because the deductibility of the deemed manufactured dividends had to be tested by reference in the circumstances in which they were deemed to be made. The transaction was:
(1)	The Bank of Ireland paid BCo £225 million for the Securities.
(2)	The Bank of Ireland received £3.5 million in dividends on the Securities.
(3)	BH paid the Bank of Ireland £225 million for the Securities.
(4)	BH received £0.35 million in dividends.
(5)	BH sold the securities back to BCo for £225 million.
(6)	On the same date as the resale BH paid a manufactured dividend of £3.85 million to BCo.
(7)	On the same date as the resale BCo paid £3.85 million of interest to the Bank of Ireland.
Steps (6) and (7) made this a very odd transaction, viewed commercially, but this was the transaction which was deemed to have taken place, according to HMRC’s understanding of BH’s construction.
87.	The first reason why the payment at (6) was not deductible was s 338(5)(b) (see paragraph 12 above). For this purpose valuable consideration was not enough. It had to be sufficient. In Ball v National and Grindlay’s Bank 47 TC 287 at 299, Russell LJ had said that this “connotes adequacy, an adequate quid pro the quo of the liability incurred”.
88.	The key question between the parties was whether it was enough that BH received valuable and sufficient consideration under the transaction which it entered into in reality. HMRC accepted that BH had done so, although did not accept that the transaction was a “commercial” one in the sense that it had a business purpose beyond tax avoidance. BH clearly did not receive valuable and sufficient consideration under its version of the deemed transaction, because it had ended up £3.85 million out of pocket. HMRC’s view was that the sufficiency of the consideration for the liability to pay the deemed manufactured dividend must be judged by the terms of the deemed transaction, not the real transaction. The liability only existed in the deemed transaction. It was not possible to ask whether the consideration for the payment had been sufficient in the real transaction, because the liability had not existed in that transaction.
89.	BH argued that it was enough that the real transaction had been entered into for valuable and sufficient consideration, and that the purpose of s 338(5)(b) was to ensure that the transaction in question was a commercial one. However, the section focused on liabilities, not transactions; in any case, the transaction in question must be the one under which the liability arose. That must be the deemed transaction, not the real transaction.
90.	Contrary to BH’s argument that s 737A(5)(a) did not apply for the purposes of s 338, s 737A(5)(a) imported Schedule 23A and the dividend manufacturing regulations. BH had to show that the latter provisions applied to give it a deduction. Schedule 23A characterised the manufactured dividend as an annual payment. However, it was not enough for BH to show that it had incurred a liability to make an annual payment. As BH wished to deduct it, it had to show that the annual payment was a charge on its income. This involved satisfying s 338.
91.	BH received no consideration at all for the payment of £3.85 million to BCo. The £0.35 million that it received as a dividend was received as consideration for BCo’s use of the £225 million during BH’s holding of the Securities. The £3.85 million was effectively a gift to BCo, or more accurately to the Bank of Ireland, which had received £3.85 million in interest over and above the dividends (which had already compensated it for allowing BCo to use the £225 million during the Bank of Ireland’s period of ownership of the Securities). A review of the cash flows in the deemed transaction made it impossible for BH to show that it had given valuable and sufficient consideration for the liability represented by the deemed manufactured dividend.
92.	In relation to s 125, BH was right to say that the only consideration which it received under the actual transaction had been brought into account. However, the section involved considering whether the liability under which the payment was made had been incurred for consideration which was required to be brought into account for BH’s tax purposes. That question could only be answered in terms of the deemed transaction, because the liability only existed under the deemed transaction. Under that transaction the consideration for  the deemed manufactured dividend was the deemed increase in the purchase price, which on BH’s construction of s 730A had been received by the Bank of Ireland, and thus was not brought into account in computing BH’s income for tax purposes.
93.	Mr Furness denied any acceptance by HMRC that s 125 simply did not apply. HMRC’s primary position was that there was no consideration for the deemed manufactured dividend payment. If that was correct, BH did not get beyond s 338(5). If BH showed that there was valuable and sufficient consideration, it had to satisfy s 125(1) in respect of that consideration.
Discussion and conclusions
The deemed interest issue
94.	We accept the analysis put forward by Mr Furness of the tax treatment of a simple two-party repo. However, it does not automatically follow that the same form of analysis can be applied to a tripartite repo of the type encountered in this case. There appeared to be some difference of view as between the parties on the question of how many tripartite repo transactions occurred in practice. Mr Gardiner’s view, as we understood it, was that they were reasonably frequently encountered. However, Mr Furness appeared to take the view that they were relatively rare, and that it was doubtful whether they would be entered into without tax avoidance in mind.
95.	Neither view can be taken as amounting to evidence of the true position, and there was nothing else before us constituting such evidence. We therefore have to approach the questions of construction arising in this case without full knowledge of the practical context.
96.	The legislation does not in every respect sit comfortably with repo transactions involving more than two parties. We review it in an attempt to apply it in that context.
97.	The primary question is the construction to be applied to s 730A(2)(a). The repurchaser is BCo. The interim holder is the Bank of Ireland. The difference between the Sale Price and the [deemed] repurchase price is therefore to be treated as a payment of interest made by BCo on a deemed loan of £225 million from the Bank of Ireland. This leaves the further question of identifying the person to whom the interest is treated as paid.
98.	In the simple two party repo, as Mr Furness explained, the interim holder is the other party, so it is logical for it to be treated as receiving interest for the use of its money.
99.	In the case of a “repo” involving more than two parties, the interim holder will not necessarily be the person who sells back the securities.  In a case such as the present, where the interim holder has sold the Securities to BH, the repurchase by BCo is from BH, which has paid the Intermediate Price for the Securities to the interim holder.  In such a case it is not immediately apparent why, when the repurchase is effected and the Repurchase Price is paid, there should be treated as arising a deemed loan from the interim holder giving rise to a payment of interest made by the repurchaser.
100.	The purpose of the deemed loan is to bring into charge to tax as interest the commercial result of the transaction, namely the difference between the Sale Price and the deemed repurchase price, the latter taking into account the benefit of the dividends in respect of the Securities. While this works satisfactorily in the context of a two-party repo, it creates various difficulties in relation to a tripartite repo.
101.	The first difficulty is that s 730A(2)(a) simply compares the original sale price and the ultimate repurchase price, without looking at any intermediate transactions. This means that, if HMRC’s construction of the sub-section were to be accepted, the whole of the price differential would be regarded as received by BH, even though it received only part of the dividends in respect of the Securities arising during the life of the repo.
102.	Secondly, on BH’s construction the interest is treated as received by the interim holder, ie the Bank of Ireland. If the Bank of Ireland had been UK resident, this would have resulted in it being taxable on the deemed interest as well as the actual dividends which it received in respect of the Securities. Again, the deemed interest would have been calculated on the whole of the price differential, even though the Bank of Ireland did not receive all the dividends arising on the Securities during the repo. We therefore do not agree with Mr Gardiner’s contention that the statutory provisions work perfectly well in this context where the (assessable) interim holder is UK resident. He commented that the interim holder and the other repo participants would be able in such circumstances to contract on terms which took into account the tax position, which suggests to us that in practice a UK resident interim holder would be reluctant to enter into a tripartite repo agreement unless the burden of the disadvantageous tax treatment could be passed on contractually to one of the other parties.
103.	Thirdly, section 730A(2)(a) makes no indication as to how the parties to the deemed loan relationship are to be identified where a tripartite repo is involved. Clearly one party will always be the repurchaser. For a two-party repo, there is no need to look at any party other than the interim holder. In the case of a tripartite repo, if HMRC’s construction were to be adopted, on what basis would the intermediate party (here BH) be regarded as becoming a party to that deemed loan relationship? We accept Mr Gardiner’s argument that it is necessary to establish the loan relationship as the source in order to treat the relevant party as within the charge to tax in respect of the interest.
104.	These difficulties, as well as a close examination of the rest of the legislation concerning the treatment of repo transactions, draw us to the conclusion that we do not consider the draftsman to have had in mind the concept of anything other than a two-party repo.
105.	We accept Mr Gardiner’s contention that the draftsman of s 730A would have been aware of the detailed provisions introduced by the previous year’s Finance Act. However, we doubt whether the draftsman would have been considering these in the context of tripartite (or even multi-party) repo transactions.
106.	Thus we have to apply the legislation to circumstances for which it does not seem to have been intended. Although BH received the Repurchase Price, the question is whether the legislation deems BH to have received the interest. We regard the words of s 730A(2)(a) as clear; they require the interest to be treated as arising to the interim holder, the maker of the deemed loan, which in the present case is the Bank of Ireland.
107.	We accept that, as Mr Furness argued, the result is “bizarre”. However, we can see no justification for seeking to construe s 730A (2)(a) in any other way.
108.	It follows that Mr Gardiner is correct in submitting that the £3,975,473 was not income of BH.  It was income of the Bank of Ireland, which was the interim holder.
109.	We accordingly decide that BH succeeds on the deemed interest issue. This means that the corporation tax loss created by the deduction of £3,975,473 is not eliminated by deemed interest of the same amount. We therefore proceed to the deductibility issue.
The deductibility issue
110.	Deductibility of the deemed manufactured overseas dividend depends on the application of s 338(5)(b) and s 338(7), bringing in s 125(1). The application of these provisions arises in the following way. Section 737A(5) applies Schedule 23A and dividend manufacturing regulations “as if” the position were as set out in s 737A(5)(a)-(c). Under paragraph 4(2) of Schedule 23A, the gross amount of the manufactured overseas dividend is to be treated for all the purposes of the Tax Acts as an annual payment within s 349. To deduct that annual payment as a charge on income, BH must satisfy the relevant conditions in s 338.
111.	The first condition which we need to consider, under s 338(5)(b), is that the annual payment must be “made under a liability incurred for a valuable and sufficient consideration”. From the arguments put to us, it appears that there are three possible ways of applying the test in the present case:
(1)	on the basis of the actual transactions entered into;
(2)	on the basis of a statutory assumption that the conditions are met in respect of the payment deemed to be made; or
(3)	on the basis that the conditions must be fulfilled in respect of the relevant transactions as they are deemed to have occurred.
112.	Mr Gardiner referred to the intention of Parliament as being that it should be possible in principle for a deemed manufactured overseas dividend to be a charge on income and hence deductible. We accept that it is appropriate to consider such intention in the context of a simple two-party repo; however, given our doubts whether the legislation was drafted in contemplation of tripartite or multi-party repo transactions, we are not convinced that an intention can be attributed to Parliament in relation to cases where transactions involve such additional complications. In the absence of any clear indication, we have to decide which of the above three approaches appears most consistent with the legislative scheme as we consider it to apply to tripartite repos.
113.	For a two-party repo, any of the above tests would appear to work entirely satisfactorily. The difficulty in relation to a tripartite repo arises because the deemed manufactured overseas dividend is not matched by a corresponding deemed receipt.
114.	The attraction of test (1), if it were to be the appropriate test to apply, is that there is no need to look beyond the transactions entered into in the “real world”. The deemed payment of the manufactured overseas dividend is simply regarded as overlaid on those transactions, which both parties acknowledge to have been entered into for valuable and sufficient consideration.
115.	In his argument in support of test (3), Mr Furness emphasised that s 338(5)(b) focuses on liabilities and not transactions. This prompts us to consider the reason for the liability to pay the deemed manufactured overseas dividend. The liability to pay it arises because of s 737A(5)(a). That liability is therefore one imposed by statute, not as part of a commercially negotiated transaction; a person does not give consideration for a liability imposed by statute. If s 338(5)(b) is to be applied in such circumstances, this would mean that no deemed manufactured overseas dividend under s 737A(5)(a) could ever qualify as a charge on income.
116.	We are therefore drawn to the conclusion that it is inappropriate to look at what, if any, commercial consideration is to be regarded as given in return for the liability to pay the manufactured overseas dividend. This means that tests (1) and (3) cannot be applied.
117.	Clearly, some mechanism is required to enable a deemed manufactured overseas dividend treated as an annual payment under paragraph 4(2) of Schedule 23A to be set off for corporation tax purposes against the deemed payer’s income. This is necessary in the simple reciprocal two-party case as shown by Mr Furness in his general analysis of the repo legislation. In the present case BH seeks the same deduction, even though we do not regard it as being in receipt of the deemed interest payment.
118.	Our view is that test (2) applies; on the basis that the requirement in s 338(5)(b) could never be met in relation to any form of repo (whether two-party or multi-party), as the relevant liability is imposed by s 737A(5)(a) rather than for any form of commercial consideration, the only way of applying the legislation is on the assumption that what is deemed under paragraph 4(2) of Schedule 23A to be an annual payment will automatically be deemed to meet the condition in s 338(5)(b).
119.	In relation to s 125, it follows that we do not consider the deemed annual payment to have been made under a liability incurred for consideration in money or money’s worth, so that it does not fall within s 125(2)(b). Accordingly, it is not prohibited by s 125(1) (nor by s 338(7)) from being a charge on income.
120.	We therefore decide the deductibility issue in favour of BH.
Summary
121.	 We decide both issues in favour of BH. This means that BH’s appeal against the Notice of Amendment issued on 10 August 2004 is allowed in full.
122.	We are grateful for the clear exposition by both Mr Gardiner and Mr Furness of their arguments, and for the supply after the hearing of the CD containing their respective Statements of Case, Skeleton Arguments and BH’s Replies.

JOHN CLARK

MICHAEL JOHNSON

SPECIAL COMMISSIONERS
RELEASE DATE: 6 June 2006

SC 3025/2005