SPC00560

Enterprise Investment Relief – Income Tax – Capital gains tax – Qualifying trade – Trade of leasing – Use of money – Purpose of raising money – Receipt of value

THE SPECIAL COMMISSIONERS

	OPTOS PLC	Appellants

-	and –

	THE COMMISSIONERS FOR HER MAJESTY’S REVENUE & CUSTOMS 	 Respondents

				Special Commissioner:	I J GHOSH

Sitting in public in Edinburgh on 27 March 2006 

Andrew Thornhill QC for the Appellants 

Andrew Young, counsel for the Respondents

© CROWN COPYRIGHT 2006

DECISION

1.	This is an appeal by Optos plc (‘Optos’) against a refusal by the inspector of taxes, Mr M G Weir, to allow Optos to issue a certificate under section 306(2) of the Income and Corporation Taxes Act 1988 (‘TA 1988’) for the purposes of the Enterprise Investment Scheme (‘EIS’) regime.  The refusal to issue a certificate has both income tax and capital gains tax consequences, as I explain below.  The refusal was made on three alternative grounds in relation to both income tax relief and capital gains tax (“CGT”) relief and separately on the ground that the subscribing individuals had received a “return of value” for the purposes of the Taxation of Chargeable Gains Act 1992 (“TCGA 1992”), Schedule 5B, paragraph 13 although I understand the Crown to contend that the individuals also received in return of value for the purposes of TA 1988, section 300(1A).  The parties agreed that this case be a representative case for a number of other appeals.  As I make clear in my below however, this case raises four separate issues and the parties will have to agree as to how my decision on each of these four issues applies to each of the appeals which stand behind this representative case.  

2.	This Decision is long.  I set it out as follows:

Paragraph(s)
1.	THE FACTS							3 to 49
2.	THE WITNESSES						50 to 81
3.	THE LAW:	The scheme of EIS Income Tax and
Capital Gains Tax Relief;			82 to 90
The Statutory Provisions			91 to 103
4.	THE RELEVANT ISSUES IN THIS APPEAL		111 to 113
5.	THE APPELLANT’S CONTENTIONS			114 to 119
6.	THE RESPONDENTS’ CONTENTIONS			120 to 128
7.	DECISION							129 to 157
8.	CONCLUSION						158

1.	THE FACTS

3.	The documents in this appeal are extensive.  And both parties rely on their terms to support their respective contentions.  So I have set out the terms of each relevant document at some length.  Also, since the Statement of Facts and documents before me are supplemented by the oral evidence of four witnesses, it is convenient to summarise my findings of fact at this stage.  I make clear below where my findings arise either from oral evidence or by inference.
(i)	Optos manufactures P200 units and exploits some of these units itself and sells others to Inc at cost, which Inc then exploits.  No issue arises in this appeal in relation to the sale of the units by Optos to Optos’ 100% subsidiary, Optos Inc; Optos Inc is incorporated and tax resident in the United States
(ii)	Each of Optos and Inc exploit their respective units, once manufactured by Optos, by charging a periodic fee (to use a neutral word) to opticians under an “ATN agreement” (see below).  The opticians do not take title to the P200 units.  Thus the ATN agreements generate an income stream payable to the owner of the P200 units.
(iii)	The fee is for a combination of the use of the units, training, education and support for optician staff and for software support and upgrades.
(iv)	Optos and Inc each also raised finance by means of “finance agreements” (see below) in the form of sale and sale back agreements (Optos with a finance company I refer to as BA/CA as from December 2002 and Inc with one finance company I refer to as Copelco as from July 1999 and a second finance company I refer to as DLL as from June 2002).  The finance company in each case acquired title to the units (by paying a Purchase Price to Optos/Inc) and a right to the income stream from the opticians under the ATN agreement (whether current or prospective).  To the extent that the income stream exceeded the return due to the finance company, it was paid to Optos/Inc.  The intention was that title to the units and the income stream would revert to Optos/Inc once the finance company received repayment of the Purchase Price and a stipulated return.  Optos/Inc sold and reacquired the units from the finance company at a Purchase Price which was well below the market value of the units at the material time.  No issue in this appeal arises by reason of these undervalue sales and reacquisitions.
(v)	Optos also raised further finance by means of an issue of convertible debentures (“the Loan Notes”) on 25 May 2001 which Loan Notes were converted into ordinary shares of Optos (in two tranches) on 1 June 2001 and 26 September 2001.
(vi)	Finally a sum of money (£1,053,385.39) raised on the issue of the Loan Notes was transferred by Optos to Inc on 3 September 2001 to escape a potential arrestment.  I do not find there to have been any retransfer of this sum by Inc to Optos on or before 26 September 2002 or 26 September 2003.

4.	The parties agreed a Joint Statement of Agreed Facts.  The Appellant also led the evidence of Mr Anderson, Mr Sealey, Mr Stevens and Mr Watson, to which I refer below.

The Optos Group

5.	The Appellant, is a company registered and resident in the United Kingdom. It was incorporated on 26 August 1992 as Zenoplan Limited. It subsequently changed its name to Besca Limited and then, on becoming a public limited company in 1997, to Optos plc.  I refer to the Appellant as “Optos”.

6.	Optos has a wholly-owned, United States subsidiary, Optos Inc (‘Inc’), which was incorporated in July 1999 as a sales and sales support company. I refer to Optos and Inc collectively as ‘the Group’.

The Nature of the Business Carried on by Optos

7.	Optos was originally founded for the purposes of addressing a specific gap in the diagnostic tools available to detect eye diseases. It has developed a scanning laser ophthalmoscope for use in hospitals and opticians’ surgeries (the Panoramic 200 or ‘P200’). For convenience, the term ‘optician’ has been used for the purposes of this appeal to include both optometrists and ophthalmologists, whether operating from hospitals or from private practices. The P200 ophthalmoscope allows a detailed digital image of the patient’s retina to be prepared and stored. The image is of a high quality and shows a wide field. It is produced without any pain and can be used to make accurate diagnoses. The digital image produced is referred to as an Optomap. It took the company seven years (until 1999) and around £20 million to develop the necessary equipment and software to produce an ‘Optomap’. During this development state, no income was generated and the company did not start to generate income from opticians until September 1999.

8.	The principal activities of Optos have been:
(i)	to research and develop new, high-technology products within the ophthalmic field; 
(ii)	to manufacture or arrange for the manufacturing of the P200 units (‘units’); 
(iii)	to supply the units and associated support services to opticians in the UK; and 
(iv)	to supply the units (and any spare parts required for the units) to Inc: Optos (or, in the USA, Inc) installs units at opticians’ practices and provides training and marketing support to opticians; it also provides (or, in the USA, sells to Inc for the purposes of providing) spare parts to replace parts that fail in the opticians’ units.

9.	The Group has at various times manufactured the ophthalmic equipment itself but at other times the assembly has been subcontracted. There has been no manufacture or assembly of units in the USA. 

10.	Apart from functions described above, Optos owns all intellectual property rights, organises group finance, and carries out IT and administrative functions.

The ATN Agreements

11.	The original business plan had been to sell the units to opticians outright. However, by the time that the technology had been developed to the point that it could be exploited commercially, the units had such a high capital cost that a different route to market was considered necessary.  Opticians generally could not afford to acquire these units outright.  To exploit the units, each of Optos and Inc entered into Access Technology Now (‘ATN’) agreements with opticians.

12.	Under the ATN agreements, Optos (or, in the USA, Inc) retained ownership of the units supplied to the optician, who paid a fixed fee for each successful Optomap examination. The fixed fee included the cost of any staff training, repairs, servicing, sales support and software upgrades. The optician was connected to Optos’ mainframe computer via an internet connection, which allowed for support and monitoring by the staff of Optos.  The Appellant and the Crown agree that the ATN agreement encompasses both the use of the P200 units by the optician and the provision of the ancillary services by Optos to the optician.

13.	Under the original ATN agreements, if the usage fell below a given level the unit could be removed at the discretion of the Group. There were control requirements placed on the use of the equipment, such as compulsory training in the operation of the unit. Under the same original agreements the Group retained the right to upgrade the machine to improve quality of product and patient comfort. The terms were later modified so that customers entered into a three-year minimum term contract and were obliged to make minimum monthly payments regardless of usage.

14.	The majority of the Group’s income therefore was generated from the fixed fees paid by the opticians under the ATN agreements. The remaining Group income consisted of the outright sale of units. A different charging structure exists for opticians who purchase the units outright. Such opticians pay monthly fees for access to the various support services.

The Finance Agreements

15.	Despite the income generated by the ATN agreements, the Group was not in a position financially to continue funding the units that were to be installed on a pay per patient basis.  The group needed further funds, beyond that obtained under the ATN agreements.  As a result, the Group companies decided to enter into three finance agreements. Inc entered into an agreement with a US bank, Copelco Capital Inc (which later became Citibank but which I shall refer to for convenience throughout as ‘Copelco’). This agreement (‘the Copelco Agreement’) was signed on 2 June 2000, but Mr Barry Sealey, who gave evidence on behalf of Optos (see below) stated, and I so find, that the arrangement with Copelco in fact began in July 1999. Inc entered into a similar arrangement with a second US bank, De Lage Landen Financial Services Inc (‘DLL’) in June 2003 (‘the DLL Agreement’). Optos entered into a similar arrangement with BA/CA Asset Finance Limited in December 2002 (‘the BA/CA Agreement’) in respect of placements of units with opticians in the UK.

16.	Notwithstanding the three finance agreements, I note that in some cases where Optos and the customer entered into an ATN agreement whereby the customer agreed to pay for the use of the P200 unit on a per patient use basis, no third party was involved. For example, in some of the early transactions in the UK there was no finance company agreement.  However both parties agreed that such examples were small in number.  I will ignore these transactions in ascertaining the essence of the trade of Optos and Inc and what constitutes the “substantial part” of these trades.

17.	Since signed versions of the finance agreements between Inc and Copelco and Inc and DLL were produced and only an unsigned document to which the parties were Optos and BA/CA was put before me, I shall deal with the Copelco and DLL agreements first and then with the BA/CA agreements. 

The Copelco Agreement

18.	The Copelco Agreement was, in substance, a finance agreement in the form of a sale agreement.  The bank provided finance to Inc in the form of a “Purchase Price” (which Mr Sealey said in evidence, and I so find, was well below the market value of the units) and acquired title to the units.  As generally with finance agreements, the intention, according to Mr Sealey and Mr Watson (and I so find) was that title to the units would only remain with Copelco until the financing (the Purchase Price together with a return to Copelco)was repaid by the income stream on the units (from the ATN agreements) placed in practices in the USA.  From the time of such repayment both Mr Sealey and Mr Watson said that the intention was that title revert to Inc.  However, there was no express provision in the Copelco agreement to that effect.  Nevertheless this is how the parties to the Copelco agreement treated their respective rights and obligations according to Mr Sealey and Mr Watson (and I so find).

19.	The master agreement, which governed the financing relationship between Copelco and Inc, was signed on 2 June 2000. It worked as follows:
(i)	Inc identified an optician and entered into an ATN agreement with that optician;
(ii)	Copelco reviewed the optician to determine whether it presented an acceptable credit risk;
(iii)	Copelco could elect to purchase the rights, title and interest in the ATN agreement between Inc and the optician from Inc for a specified sum, and Copelco would then also acquire title to the unit;
(iv)	the optician’s payments per Optomap were made initially to Copelco based on a statement issued by the Group from its unit-usage monitoring;
(v)	Copelco retained a fixed amount per month from each optician’s remittances and paid the balance received under the ATN agreements to Inc; and
(vi)	once a certain income had been returned to Copelco, expected to be after three years, the rights in the ATN agreement and title to the unit reverted (or ought to revert) to Inc. Ongoing revenue streams then accrued entirely to the Group. No units had reverted to Inc before 30 September 2004.

20.	As noted above, the arrangement was later modified so that new optician customers entered into ATN agreements that guaranteed a minimum term – usually three years – and a minimum level of income.

21.	According to recital B of the Copelco Agreement:

Subject to the terms and conditions set forth in this Agreement, Vendor [Inc] agrees to sell and Copelco agrees to evaluate and, in its sole discretion, purchase, from time to time, from Vendor all of Vendor’s rights, title and interest in and to certain lease or rental agreements that Vendor has entered into and will in the future enter into with customers of the Vendor (‘Lessees’) for the lease of certain equipment (the ‘Equipment’) under the program(s) agreed from time to time by the Vendor and Copelco by written Amendment and Addendum to this Agreement (the ‘Program’).

22.	Clause 1(a) of the Copelco Agreement provides that Copelco has a right of first refusal to:

…acquire such leases entered into or which it is proposed to enter into, by Vendor, that it considers are appropriate for the purposes of this Agreement in respect of equipment manufactured by it (which leases are hereinafter referred to as ‘the Offered Leases’) and related Equipment.

Clause 1(a) refers to Exhibit 1 to the Copelco Agreement, which ‘shall be the form of lease agreement approved by Copelco’. It is called ‘the Lease Agreement’.  Clause 1(a) also provides that Inc has the right to offer to Copelco ‘Offered Leases’ prior to their being entered into by the customers. 

23.	Clause 2(a) provides that if Copelco accepts an Offered Lease, Copelco has the right to pay the ‘Purchase Price’, which will give it the rights not only to the Lease but also (inter alia) to the Equipment, and proceeds of both the Lease and the Equipment. Clause 2(a) also provides that the parties enter into a ‘Master Assignment and Bill of Sale’, which is in the form attached to the Agreement as Exhibit 2. The ‘Purchase Price’ is to be agreed between the parties from time to time.

24.	The Master Assignment and Bill of Sale attached to the Copelco Agreement as Exhibit 2 provides at clause 1 that:

For good and valuable consideration, the receipt and adequacy of which are hereby acknowledged, upon payment of the Purchase Price and delivery to Copelco of the original counterpart copy of each Assigned Lease, Assignor will and does hereby sell, assign and transfer, and by these presents has sold, assigned and transferred to Copelco each such Assigned Lease, together with all of the Assignor’s right, title and interest in and to the Equipment described in each such Assigned Lease, the Equipment and Assets related thereto, and all sums due under each such Assigned Lease (including without limitation all sums payable by reason of damage, destruction or loss to the Equipment), all claims for damages arising out of the breach thereof and all rights of Assignor including, without limitation, the right to terminate the Assigned Lease, to perform thereunder and to compel performance of the terms thereof.

25.	Clause 8(a) of the Copelco Agreement provides that Copelco has ‘the sole right to do all billing and make all collections on all Leases and to exercise any and all of Vendor’s rights, powers and remedies thereunder’, such as commencing litigation against defaulting lessees.

26.	Clause 10 provides that the intellectual property rights in relation to the P200 units remain the property of Inc.

27.	Clause 16 provides that Copelco has the right to assign the Leases.

28.	Clause 17 provides that the law governing the Copelco Agreement is the law of the State of New Jersey.

29.	By an Amendment and Addendum to the Copelco Agreement dated 2 June 2000, the parties agreed to include in the sale to Copelco the ‘Access Technology Now Program’ (‘the ATN Program’) (that is, the ATN agreement with the opticians).  In other words the sale to Copelco included Inc’s rights under the ATN agreements Inc concluded with opticians.  The form of an ATN agreement is exhibited to the Addendum. It provides that each use of the P200 unit (a ‘Billable Patient Encounter’) be aggregated and paid for on a monthly basis. It also exhibited a standard Customer Letter of Agreement, which provides, under ‘Terms and Conditions’, that:

2.	EDUCATION AND TRAINING: All operators of the Panoramic 200 must be certified by Optos. Training will consist in dedicated classroom time and hands-on time. Optos will provide ongoing clinical support, educational seminars and help desk assistance.
3.	SERVICE COMMITMENT: Optos will respond to all service calls within one hour. Our goal is to provide onsite service support within an average of 24 hours and to have the system operational again within an average of 48 hours.

30.	To summarise, therefore, the effect of the Copelco Agreement and the accompanying documents is that title to the P200 units was transferred from Inc to Copelco as well as the rights under, according to clause 1(a), a ‘Lease agreement’ (the ATN agreement) entered into between Inc and the optician customer.  Inc and Copelco intended that the title to the units revert to Inc once the Purchase Price and a return was paid to Copelco and this (I find) was how the Copelco Agreement was applied by the parties despite the absence of any express provision of a reverter of title.  Copelco received its return from the fees paid by the opticians under the ATN agreements.  As explained by Mr Stevens in evidence, the balance of the fees under the ATN agreements which were not paid to Copelco as a return to Copelco was paid to Inc.  The nature of this transaction was clearly a finance agreement.  The sale and sale back was in the nature of a security arrangement, despite the absence of an express provision requiring a sale back of the units once the financing agreements had come to an end.  This is clearly demonstrated by the Purchase Price paid by Copelco to Inc being lower than the market value of the P200 units and also by the intention that the title to the P200 units revert to Inc once Copelco was paid a satisfactory return on the Purchase Price (together with a repayment of the Purchase Price as the price paid by Inc to Copelco for the reacquisition of the P200 units). 

The DLL Agreement

31.	The DLL Agreement was substantially the same as the Copelco Agreement and replaced the Copelco Agreement as the relevant finance agreement for Inc.  A copy of the DLL Agreement, headed ‘Master Contract Financing Program Agreement’ and dated 2003, was produced. The recitals stated that the agreement was entered into in reference of the following facts:

a.	[Inc] is engaged in the sale of medical equipment and, in connection therewith, desires to offer its customers the opportunity to lease, rent and/or use such equipment (‘Equipment’)…for commercial or business purposes. DLL and [Inc] desire to establish a quasi-private label lease program whereby [Inc] will offer DLL the opportunity to enter into rental agreements (‘Rental Agreements’) and cost per optomap agreements (‘CPO Agreements’) with such customers (the ‘Customers’) for the Equipment (the Rental Agreements and CPO Agreements may hereafter collectively be referred to as ‘Contracts’) together with such guarantys [sic] (‘Guaranty’) and other documentation as required by DLL;
b.	DLL agrees, at its sole discretion, to enter into the Contracts (which Contracts shall include [Inc’s] and DLL’s logo but shall identify DLL as the owner on all such Contracts) and purchase the Equipment from [Inc], upon the terms and conditions contained herein.

32.	The DLL Agreement made express provision (at clause 5.7) for the reassignment of DLL’s interest in the Equipment to Inc upon the expiration in due course of a Contract with a Customer.  As I observe above, there was no such express clause in the Copelco agreement.  The sale price of the units by Inc to DLL was well below their market value again according to Mr Sealey’s evidence (and I so find).  I cannot easily make out from clause 5.7 whether the Purchase Price was (being in substance the principal effectively advance by DLL to Inc in the form of a Purchase Price for the P200 units) repaid out of the income stream from the ATN Agreements or by Inc paying a Purchase Price for the reacquisition of the units.  This is neither here nor there for present purposes however.

33.	Clause 10.5 of the DLL Agreement provides that the law governing the agreement is the law of the Commonwealth of Pennsylvania.

34.	Thus the DLL Agreement was a finance arrangement of the same type as the Copelco Agreement (even more clearly so since the reverter of title at clause 5.7 was expressly catered for).

The BA/CA Agreement

35.	The BA/CA Agreement was a finance agreement which performed broadly the same commercial function for Optos as did the Copelco Agreement and the DLL Agreement for Inc.  The parties were Optos and BA/CA Asset Finance Limited (“BA/CA”).  An unsigned copy of the BA/CA Agreement, dated 2002, was produced.  Counsel for the Crown expressed some dissatisfaction that a signed document was not made available.  However I do not understand Counsel for the Crown to object to the lodging of this unsigned document as a production in the hearing.  Nor do I understand Counsel for the Crown to submit that the terms of the BA/CA Agreement, once signed, were materially different to the draft before me.

36.	The recitals provide that BA/CA Asset Finance has agreed with Optos ‘to enter into certain ATN Agreements in respect of Goods with Users introduced to it by’ Optos. In order to facilitate this, Optos agreed to:

…act as Agent of the Principal [BA/CA Asset Finance] for the purpose of acquiring the Goods [defined as ‘the equipment which is the subject matter of any ATN Agreement’], entering into the ATN Agreements and administering the same and receiving payments thereunder and certain other matters, all as subject to the terms herein contained. 

‘ATN Agreement’ is defined with reference to Part 1 of the Schedule ‘or in such alternative form or forms as may be agreed in writing from time to time between the parties’. Part 1 of the Schedule is blank.

37.	Under clause 2 of the agreement, Optos is obliged:

…to approach prospective Users with a view to soliciting business under this Agreement; to act upon an Approved Request [defined in clause 1.1 as a notification from Optos to BA/CA Asset Finance under clause 3.2] to enter, in the Agent’s name but on the Principal’s behalf, into ATN Agreements in respect of Goods to be purchased in accordance with clause 4 and to purchase such Goods in accordance with clause 4; and to manage such ATN Agreements in accordance with the provisions of this Agreement

‘Ancillary Services’ are defined in clause 1.1 as:

the provision of repairs, maintenance, substitute goods, supplies for use in or with the Goods and other ancillary operational services provided by the Agent either itself or under contract from a third party approved by the Principal, all in relation to any ATN Agreement, and generally any obligation arising under or in respect of any ATN Agreement other than the provision of finance to enable Goods to be made available to the User under that ATN Agreement.

Clause 3.7 provides for the avoidance of doubt that:

…all Ancillary Services provided under or in relation to any ATN Agreement are provided by the Agent as principal contractor to the User and not as agent of the Principal and if the same are provided by any other person, such other person shall be a sub-contractor of the Agent as principal.

38.	Clause 4 provides, in slightly obscure terms, for the sale of the units by Optos to BA/CA and for Optos to enter into ATN agreements with opticians as agent for BA/CA.  Again, it is difficult to ascertain the price at which the P200 units were sold by Optos to BA/CA but Mr Sealey’s evidence was that the price was commercially equivalent to the amount which Optos would wish to borrow from BA/CA (and, like the finance agreements entered into by Inc, below the market value of the P200 units).  Clause 11 of the BA/CA Agreement provides for the reacquisition of the units by Optos from BA/CA on the expiry of this finance agreement.

39.	Clause 7 of the agreement provides:

7.1	In respect of each ATN Agreement the Agent will act as the Principal’s agent to issue to the User the appropriate VAT invoices in the Agent’s name for and to collect the User Rentals.
7.2	In respect of each ATN Agreement the Agent shall collect punctually as the Principal’s agent all sums due and, except as otherwise permitted by clause 7.3, it shall:-
7.2.1	remit to the Principal all sums collected; and
7.2.2	pay to the Principal, to assist cash flow, the amounts of all sums due from the User on or before the Default Date and unpaid;
in each case inclusive of any applicable VAT. Such sums will be paid to the Principal by the Agent by direct debit. Pending payment, all sums received by the Agent from the User will be held by the Agent on trust for the Principal.

40.	Clause 20 of the agreement provides that it shall be governed by Scots law.

41.	Thus the BA/CA Agreement was a finance arrangement between Optos and BA/CA of the same type as the Copelco Agreement and the DLL Agreement.

42.	The essence of the business of Optos and Inc can, on the basis of the Statement of Agreed Facts and the evidence be described as follows:
(i)	each of Optos and Inc maintains the P200 units;
(ii)	each of Optos and Inc exploited the P200 units by
(a)	generating income from opticians under the ATN agreements.  The ATN agreements charged regular payments from the opticians for not only the use of the units but also the education, training and support for the optician’s staff and software support and upgrade (see above);
(b)	generating further finance from BA/CA (for Optos) and Copelco and DLL (for Inc) under the finance agreements. The finance agreements were in form sale and sale back agreements.  In each case the price for which the units were sold to the relevant finance company was well below the market price of the units.

The Loan Notes

43.	Quite separately from the ATN agreements with opticians and the finance agreements which sought to exploit the units, once developed and maintained, Optos required finance for the very development of these units themselves.  In order to raise capital for the development of the units, Optos turned predominantly to a number of business angel and venture capital investors. The early funding was entirely from the issue of shares and from shareholder loans as the revenue flows were too uncertain to support loan borrowings from banks. Optos first raised capital under the Business Expansion Scheme by means of a share issue on 6 October 1992. It then raised further funding via various share issues, to which I have already referred above. A major placing of shares was planned for late 2000 but proved unsuccessful.

44.	In May 2001, to meet an urgent funding requirement, a number of the existing shareholders provided cash to Optos in the form of Convertible Unsecured Zero-Coupon Loan Stock (‘the Loan Notes’), with the intention that these would convert into shares on the next equity-raising round. The Loan Notes were dated 25 May 2001. The Loan Notes were governed by Scots Law (clause 20.1).  The cash raised by the issue of the Loan Notes was £4,729,816. All the Loan Notes were subsequently converted into ordinary shares in Optos in two tranches, on 1 June 2001 and 26 September 2001. The conversion was effected under the terms of Part 4 of the Loan Notes (see below).  Critically, the shares, as were required by the terms of the Loan Notes, were issued as fully paid up (clause 15.1 and part 4, paragraph 3 of the Schedule to the Loan Notes).  I shall refer to these shares as “conversion shares”.

45.	Clause 9 (see clause 9.1 and 9.2) of the Loan Notes provides that each stockholder is entitled, upon a ‘Further Financing’ (defined in clause 1.1 as ‘the raising by the Company of new funds of £2,500,000 or more by way of subscriptions for shares and/or debentures or loan stock of the Company’), to either to demand repayment of the debt or alternatively ‘exercise their Stock Conversion Rights’ (defined in clause 1.1 as ‘the rights to convert Stock into Ordinary Shares pursuant to this Instrument’). Thus the Loan Notes expressly distinguishes between a repayment of the debt and a conversion of that debt into shares.  The ‘Stock Conversion Procedure’ is set out in Part 4 of the Schedule to the Loan Note, which provides that:

The Stockholder may, where Stock Conversion Rights are exercisable, exercise them by giving written notice (a ‘Stock Conversion Notice’) to the Company to require the Company to allot fully paid Ordinary Shares in accordance with Clause 10…in exchange for all his holding of Stock at the rate implied by the Stock Conversion Price.

The ‘Stock Conversion Price’ is defined at clause 1.1 as 

the price per Ordinary Share at which Stock may be converted by the Stockholders into Ordinary Shares in the event of a Further Financing, being:- (a) If the Further Financing Price is more than £0.8667, 75% of the Further Financing Price; (b) If the Further Financing Price is more than £0.65 but not more than £0.8667, £0.65; and (c) If the Further Financing Price is not more than £0.65, the Further Financing Price

The ‘Further Financing Price’ is defined in clause 1.1 as ‘the price per share at which the investors subscribe for new equity shares in the capital of the Company under a Further Financing, including for this purpose the price of preference shares, long-term debentures and long-term loan stock’.  

46.	Paragraph 3 of Part 4 of the Schedule to the Loan Notes provides that on receipt of a Stock Conversion Notice the company will:

…allot and issue…to the Stockholder…the nominal amount of Ordinary Shares credited as fully paid to which he…shall be entitled by virtue of the exercise of his Stock Conversion Rights and such allotment and issue shall be in full satisfaction and discharge of the principal moneys in respect of the Stock so converted

The Transfer of Funds to Inc in September 2001

47.	Optos received money in respect of the 25 May 2001 Loan Note issue during August 2001 and kept it in a separate bank account (Bank of Scotland account no. 00711374). On 3 September 2001, two amounts of £1 million and £466,000 respectively were transferred from this separate bank account to the main Optos current account (Bank of Scotland account no. 00148547). On 3 September 2001, a sum of £1,053,385.79 was transferred to a US current account of Inc from the main Optos current account. The reason for this transfer became apparent during the course of the hearing (see below).

The Reliefs and Credits Claimed

48.	A number of investors invested in equity during the development or pre-trading stages, i.e. before September 1999. The EIS applications for these investors were submitted with the company’s “qualifying business activity” for the purposes of the Income and Corporation Taxes Act 1988 (TA 1988) section 289(2) given as ‘research and development, intended to lead to a trade of selling ophthalmic imaging systems’. EIS relief was granted on these share issues. The qualifying activity of Optos for EIS purposes changed in September 1999 when it started to generate income through entering into ATN agreements with opticians. This change was noted on the forms EIS1 submitted in respect of the share issues that took place on 5 April 2001, 1 June 2001, 26 September 2001 and 31 October 2001, in which the qualifying activity was described as ‘sale of ophthalmic imaging systems’.

49.	Optos also sought venture capital trust (‘VCT’) funding and, in a letter dated 14 October 1999, the inspector confirmed that, on the basis of the information supplied, Optos was a qualifying company for VCT purposes. The company has also been entitled to, and claimed, research and development tax credits in the years ended 30 September 2000 onwards.

2.	THE WITNESSES

50.	The following witnesses gave evidence: Mr Douglas Crombie Anderson, co-founder and Executive Vice-Chairman of Optos; Mr Barry Edward Sealey CBE, former Chairman of Optos; Mr Ian Herbert Stevens, former Chief Financial Officer of Optos and present General Manager of Optos North America; and Mr Allan Mark Watson, Chief Financial Officer of Optos.  All four witnesses gave evidence in chief and were cross-examined by Counsel for the Crown.  I find all four witnesses to be reliable witnesses in that all of the witnesses endeavoured to give accurate evidence to the Tribunal. 

Mr Anderson’s Evidence

51.	Mr Anderson is a design engineer who has been specialising in the design of health-related technology since 1980, when he founded Crombie Anderson Associates Limited. In 1992, his five-year-old son Leif Anderson, suffered a retinal detachment that went undetected until all vision in his left eye was lost. As a result of this experience, and of the years which followed in which his child had follow-up exams, Mr Anderson decided to improve upon the technology then available to make it more likely that asymptomatic eye conditions could be detected and treated earlier and more effectively, particularly in difficult patients such as children.

52.	It was Mr Anderson’s evidence that after three years of research, the research team of Optos succeeded in patenting a technology that fulfilled its aim, described in Mr Anderson’s witness statement at paragraph 7 as a ‘non-mydriatic, ultra-widefield, scanning laser ophthalmoscope’. In layman’s terms, this is a scanning laser ophthalmoscope that allows a digital image of the patient’s retina to be prepared and stored.

53.	Mr Anderson explained that over this three-year period and indeed the ensuing six years, the highly speculative nature of the work, involving many technical failures and setbacks, put off institutional investors. The first challenge for Optos was to demonstrate that the technology was safe, and to have it approved by various regulatory bodies, such as the US Food and Drug Administration. The next was to build a commercial infrastructure that would enable opticians to access the P200s. Most primary-care optometrists are small, independent businesses without the reserves to purchase high-technology imagining systems. This was, according to Mr Anderson, whose evidence I accept, the basis for charging opticians on a pay per use basis that enabled the opticians to use the equipment free of capital cost.

54.	Mr Anderson also said that Optos recognised from the start that the adoption of new healthcare technology in the UK is typically very late and shallow. This was the reason that Optos, a company with very little resources, took the very high-risk decision of opening its market in the US. So far, Optos had managed to export over two thousand P200 units to the US. To date, over six million Optomaps have been executed worldwide.

55.	Mr Anderson said, and I find as a fact, that for the first six years of Optos’ existence, 90% of its employees were research engineers. The balance changed as Optos added manufacturing, regulatory and customer focus teams.  However neither Optos nor Inc employed any persons who dealt with the management of leasing activities, in contrast to BA/CA, Copelco and DLL.

Mr Sealey’s Evidence

56.	Mr Sealey was a founder investor of Optos in 1992 and Chairman until December 2005. He has had a distinguished career in science and engineering and was awarded the CBE for his services to industry in 1990, when he retired. Since then he has been an active business angel, investing in and supporting young companies. Since 1990, he has been involved in a hundred companies and is still involved in a portfolio of some fifty.

57.	Mr Sealey saw the commercial potential for Mr Anderson’s idea at an early stage and led a group of friends to back the concept. They invested £80,000 to finance an initial design. A prototype of the P200 was available and put into use in 1999. However, it was Mr Sealey’s evidence, which I find as fact, that the cost and complexity of each machine meant that if sold outright they would cost at least £100,000. Since most small opticians’ practices could not afford this, it was decided to opt for a pay per view model, under which the payment would pay for a range of services in addition to the provision of an Optomap. It was Mr Sealey’s evidence, which I accept, that opticians who used the P200s would have the services of a team of professional experts in account management, clinical operations and technical support, and that these professional have years of experience of integrating the Optomap into many different practice settings. These professionals would train the opticians using the P200 units. Optos would also provide promotional materials such as brochures, posters, videos, public relations support and advertising templates to help educate patients and the community about the value of the Optomap. The service charge also covers repairs or maintenance to be carried out when necessary on the machines by Optos personnel. Optos also provides as part of its service a helpline and advisory services provided by specialist consultants including diagnostic second opinions. Counsel for the Crown challenged the depth and vigour of these second opinions which were generally carried out by a single individual.  Mr Sealey maintained (and I accept) that the second opinions were indeed conducted on a sound professional basis.  The advisory service enables any clinician who sees something unusual in the Optomap to obtain a second opinion by sending the image electronically to a very experienced optometrist whose services are retained by Optos.  In response to a question from me Mr Sealey said that in no case was a P200 unit placed with an optician for a lease for use of the unit alone without the sort of support and ancillary service I describe here.

58.	It was Mr Sealey’s evidence that the Group was not in a position to fund the machines that were installed in opticians’ practices on a pay per patient model. As a result, Inc entered into the agreement with Copelco. Mr Sealey said, and I accept, as I have already observed, that the agreement began in July 1999 but was only signed on 2 June 2000. He also explained, as has already been noted, that Optos entered into a similar agreement in the UK with BA/CA Asset Finance for P200 units sold in the UK, which was signed on 2 December 2002.

59.	It was Mr Sealey’s evidence that the Copelco Agreement worked thus. Under the terms of the Copelco Agreement, Optos and Inc would identify a customer and agree the terms for an integrated service with that customer. Copelco assessed the credit risk in relation to each customer. Copelco would then purchase the rights, title and interest in the agreement between Optos/Inc and the customer for a specified sum.  This sum was below the market value of the units sold to Copelco which reflected the financing nature of the transaction (that is the P200 units were sold for the amount which Copelco effectively advanced to Inc).  The customer would pay a fixed sum per Optomap, and this would be paid to Copelco. Copelco would retain a fixed amount per month from those remittances and pay the balance to Optos /Inc. He stated that once the principal and interest had been returned to Copelco, the rights in the agreement would revert to Optos/Inc.  Mr Sealey said that DLL Agreements and the BA/CA Agreements worked in the same way.

60.	From September 2002 onwards, Copelco entered directly into agreements with customers for a minimum period, usually three years, and a minimum level of income. Mr Sealey also stated that at this time the agreement was extended to cover units placed in the UK by Optos.

61.	In order to secure future security and growth, an attempt was made in late 2000 to raise $25 million by means of private equity placing with US and UK institutions through the merchant bank ING Baring. This, and a subsequent effort by the stockbroker Bell Lawrie White early in 2001, failed to find investors. During the period, Optos was financed by a modest fundraising in October 2000 and thereafter by regular injections of cash from a small number of shareholders (including non-executive directors) on a loan basis. As I have already observed, a number of investors subscribed for a total of £4,729.816 inconsideration of the issue of the Loan Notes with a face value of that sum.

62.	The Loan Notes issued on 25 May 2001 were converted entirely into ordinary shares in two tranches on 1 June 2001 and 26 September 2001.  It was Mr Sealey’s evidence, which I find as a fact, that the intention behind the Loan Notes issue and the subsequent conversion of the principal debt on the Loan Notes into shares (rather than repayment of the debt in cash) was to ensure that the company was adequately funded and to meet the company’s perceived needs in the following year. It was Mr Sealey’s and Mr Watson’s evidence (see below), which I accept, that the intention was that the money raised by the Loan Notes issue was used to pay salary costs and the cost of further development and manufacture of the P200 units.  In response to a question from me, Mr Sealey’s evidence was that although the Loan Note subscribers appreciated that they had a right to enforce a money debt upon subscription for the Loan Notes, none of the Loan Note subscribers expected to be repaid in cash.  Mr Sealey also said that the conversion shares on the Loan Notes were given a par value which anticipated that all or almost all of the Loan Notes would indeed be converted into shares.  I accept Mr Sealey’s evidence on these two points and find them as facts.

63.	Mr Sealey said that during 2002 sales income did not grow as fast as hoped and that a further £2.5 million was raised from existing and new shareholders by mid-2002. In July 2002, Optos secured a further £3.5 million cash injection from an existing institutional investor, coupled with a commitment to invest a further £5 million subject to Optos achieving certain commercial targets.

64.	In relation to £1,053,385.79 transferred by Optos to Inc, Mr Sealey said that this cash must have been re-transferred by Inc to Optos as Optos required funds.  Counsel for the Crown did not accept this part of Mr Sealey’s evidence.  Mr Sealey also said that Inc used some (but not all) of the funds transferred to settle Optos’ liabilities.  I did not understand Counsel for the Crown to challenge this last part of the evidence.  However I do not find as a fact that Optos has established in this appeal that Inc spent a proportion of those transferred funds in this way (see below).

65.	Mr Sealey said that the company had benefited from the availability first of the Business Expansion Scheme and then of EIS relief in encouraging small investors to invest in Optos. It had never occurred to him that the fact that the P200 units were sold on a pay per patient basis would affect the availability of EIS relief. Indeed, he said that the practice of pay per patient is common in the medical world.

Mr Stevens’ Evidence

66.	Mr Stevens was the Chief Financial Officer of Optos from September 1998 until September 2003 and has been the General Manager of Optos North America since March 2003. 

67.	In relation to the funds transferred by Optos to Inc on 3 September 2001, in his witness statement, Mr Stevens said at paragraph 7 that:

The fund raising on 26 September 2001 was to raise cash for the ongoing UK trade. Cash was, at that time, transferred between Optos plc and Optos Inc to ensure that any bank fees or interest was minimised. However the cash raised by the share issue was raised in order to fund the UK trade of Optos and was actually used for that purpose.

However, during the course of the hearing Mr Stevens changed his explanation as to the use of the money raised. Mr Stevens accepted when cross examined that the reason he gave in his witness statement for the transfer of funds by Optos to Inc was incorrect.  Mr Thornhill recalled Mr Stevens to give further evidence.  In the course of his further evidence, Mr Stevens explained that the reason that the sum of £1,053,385.79 was transferred from the Optos bank account to the US bank current account of Inc was in order to protect its assets, as a result of possible litigation in the UK. A copy of an e-mail dated 3 September 2001 was produced, which was sent by a Paul McEwan to a Kelly Blackwood. The e-mail reads:

Kelly,
We’ve paid Transamerica.
Also, there’s $1.5M on its way across to you – don’t spent it yet. We can coordinate the release of funds over the next few days. You’re getting the $1.5M for safe keeping as MBM are suing us.
Paul.

Another e-mail of the same date was produced, from a Russell Thomson to Mr Stevens, in which the following passage appears:

On MBM, I’ll fax you a copy summons early this afternoon and fax or deliver a copy to Mike too. Fiona Cumming in our Litigation Department will join us at the meeting. As you will recall, I consulted Fiona about the arrestment risk when the litigation was first threatened and I think that her input on the merits of the dispute and tactics will be useful too.

68.	I find as a fact that the reason that the sum of £1,053,385.79 was transferred from Optos to Inc was the potential litigation that Optos was facing at that time, and the perceived risk that its assets were to be subject to an arrestment.  I also find that Optos did not intend that the transfer to Inc be final but merely for the purpose of ‘safe keeping’ as the e-mail states.  However I do not find as a fact that this money was in fact transferred back from Inc to Optos (see below).  Mr Stevens did not give evidence as to if and when this cash was transferred back from Inc to Optos except that he considered that it must have been so retransferred.  

69.	Mr Stevens explained that the reason for Inc entering into the Copelco Agreement was that it provided Inc with a one-off injection of cash. Furthermore, the bank carries the risk associated with this type of arrangement. For example, if a doctor fails to pay the monthly instalment on time, it is the bank’s job to chase payment. Similarly, if the doctor’s business were to cease, then it is the bank that would have the task of recovering the equipment and which would bear the loss. In return for this service, the bank earns a return of 7-8% on the funds made available to Optos every time a new contract is commenced. Mr Stevens said that Optos recognises the monthly payment as revenue in its accounts and leaves the P200 unit on its balance sheet to comply with prudent accounting regulations. He also stated that if an optician uses its P200 to perform more monthly Optomaps than the monthly payment allows then that revenue is also recognised by Optos. Therefore, he said, Optos’ total revenue is much greater than the 7-8% earned by the bank and is consistent with the high risk, high return nature of the project.

70.	Mr Stevens gave the following example at paragraph 13 of his witness statement to illustrate his point:

•	Doctor enters 3 year contract paying $20 per Optomap, subject to a minimum usage of $2,000 or 100 Optomaps per month;
•	Bank forwards 36 x $2,000, discounted at c7% (approximately $66,000)
•	Doctor performs 200 Optomaps per month
•	For the life of the contract the Doctor pays $2,000 to the bank for the first 100 Optomaps per month, and $2,000 to Inc for the remaining 100 Optomaps per month
•	Inc recognises $4,000 per month revenue for 36 months – $144,000
•	Bank earns 7% return on the $66,000 (the leasing return) on the funds lent to Optos – approximately $6,000

Mr Stevens said this was a fair and representative example, which showed that it was Copelco, and not Inc, that carried out the leasing service. He stated that at the end of the contract, the equipment is returned to the ownership of Inc, which has the continuing opportunity to benefit from its use at the doctor’s location.  In response to a question from me Mr Stevens said the DLL agreement and the BA/CA agreement worked in the same way.

Mr Watson’s Evidence

71.	Mr Watson has been Chief Financial Office of Optos since December 2003. He stated that the principal activity of the company is the development and provision of retinal examination to the eye care sectors.

72.	His witness statement at paragraph 5 contained the following information as to the spread of employees of the Group in different departments:

At the End of the 
Year 
Ended	
Sales & Marketing	
Research & Manufacturing	Customer Support & Clinical Consultation	
Admin.
	
Total
	
Sep 2000	13	22	5	13	53	
Sep 2001	10	17	15	11	53	
Sep 2002	18	33	22	13	86	
Sep 2003	28	35	47	19	129	
Sep 2004	33	42	64	22	161	

73.	At paragraph 8 of his witness statement, Mr Watson gave the following analysis of the destination of the P200 units to illustrate that over 98% of units are not sold but are placed with opticians:

12 Months Ended	UK Placements	US Placements	Total Placements	Capital Sales	Total 
Units	
Sep 1999	2	0	2	0	2	
Sep 2000	3	19	22	1	23	
Sep 2001	9	48	57	0	57	
Sep 2002	41	158	199	5	204	
Sep 2003	5	374	379	8	387	
Sep 2004	9	701	710	4	714	

74.	At paragraph 10 of his witness statement, Mr Watson said that after entering into the finance agreement with Copelco in 2000, Inc entered into a new finance agreement with DDL in June 2003. He also noted that Optos entered into an agreement with BA/CA Asset Finance in December 2002 for placements in the UK.  At paragraph 9, he explained that prior to September 2002 the contract would have been between Optos or Inc and the optician, whereas from that date onwards the initial agreement would be between the financier and the optician.

75.	Mr Watson said, and I accept, that Inc would purchase P200 units from Optos at cost which was well below market value. Optos would then charge Inc a fixed fee per month ($833 per machine per month) for every unit that Inc placed in the US market, equivalent to a charge of the intellectual property. Inc then entered into the agreements with the opticians. The vast majority of the units placed by Inc are the subject of agreements with one of the financiers.

76.	Mr Watson also said (at paragraph 12 of his witness statement) that under the terms of the Copelco Agreement, the optician’s payment per month is made entirely to Copelco based on usage information provided by Optos and Inc from unit usage monitoring. Copelco would retain a fixed amount per month from each optician’s remittances and pay the balance received under the terms of the agreement to Inc. Once a specified sum had been returned to Copelco, expected to be after three years, the rights in the agreement revert to Inc. Inc entered into a contract with an optician and then immediately assigned the agreement to Copelco. Inc would then issue Copelco with a bill of sale and transfer title to the unit and the benefit of the lease to Copelco. Copelco thereafter performed all billing and cash collection activities. He stated that once a specified sum had been returned to Copelco, the rights in the agreement would revert to Inc.

77.	Mr Watson explained that the effect of the pre-September 2002 Copelco Agreement (i.e. before the revision referred to below) was that:
(i)	Optos sells P200 units at cost (say, $40,000) to Inc.
(ii)	Inc signs an agreement with the customer, and then immediately assigns all rights to that agreement to Copelco and issues Copelco with a sale invoice for $66,000, which Copelco pays.
(iii)	Over the term of the agreement, Inc informs Copelco of the monthly use of the P200; Copelco then invoices the customer for, on average, $2,500 per month.
(iv)	The customer pays the monthly $2,500 to Copelco.
(v)	Copelco withholds $2,000 per customer and repays Inc the surplus each month.
(vi)	To the extent that usage falls below $2,000 per month, Copelco withholds the shortfall from surpluses made on machines lent to other customers.
I accept this as a summary of the effect of the Copelco agreement, as it existed pre-September 2002.

78.	Mr Watson explained that in September 2002, Copelco terminated the agreement with Inc and replaced it with a revised agreement. Under the revised agreement, Copelco is offered contracts, which they can choose to enter into directly with the customer. Customers are obliged to make minimum monthly payments regardless of usage, which is then supplemented by an additional charge payable to Inc based on actual usage measurements. The fixed minimum monthly payment is then used to calculate the payment made for the sale of the machine by Inc to Copelco, reflecting the cash flows due over the course of the agreement discounted at an agreed interest rate. Copelco bills the customer and collects the minimum monthly payment directly from the optician, with Inc responsible for measuring, billing and collecting any additional usage fees. He stated, and I accept, that Inc entered into a side agreement with each optician, known as the Program Guidelines, through which it promised to maintain the units in an operational condition and offer various support services.

79.	Mr Watson said that with both pre- and post-September 2002 Copelco agreements, over a 36-month contract Optos receives on average $84,000 in cash, split between an initial payment of $66,000 from the bank in respect of the sale of assets, supplemented by $18,000 over that period from the optician by way of service charges. The bank makes $6,000 in lease fees, which reflects a 4-5% spread over base rate.

80.	Mr Watson said at paragraph 18 of his witness statement that the employees engaged by Optos and Inc are not employed in managing lease finance roles. The finance employees comprise classic accounts receivables, accounts payables, management accounts functions. He said that he had no banking or lease finance experience. By contrast, Copelco is staffed by seasoned professionals who do nothing other than lease finance deals.

81.	Mr Watson confirmed that the sales effected by all of the finance agreements (the Copelco Agreement, the DLL Agreement and the BA/CA Agreement) were finance transactions which worked in the same way.  Mr Watson also confirmed that the sale price of the P200 units to the respective finance companies were well below market value of the P200 units.

3.	THE LAW

The scheme of EIS Income and CGT Tax Relief

82.	Under the EIS regime, an individual is eligible for relief against income tax and capital gains tax (‘CGT’) if eligible shares in a qualifying company for which he has subscribed are issued to him.  The EIS regime gives relief in two forms (income tax and CGT).  TA 1988, Part VII, Chapter III (sections 289 to 312) gives relief for income tax purposes.  An investor who subscribes for shares in a "qualifying company", within section 293, has his income tax liability reduced, potentially to nil, under section 289A.  EIS relief is also available for CGT Purposes.  TCGA 1992, section 150C and Schedule 5B give EIS relief by setting off the subscription price for shares in a qualifying company within ICTA 1988, section 293 (imported into Schedule 5B by paragraph 1(2)(b), paragraph 19(1)) against other chargeable gains: Schedule 5B, paragraph 2.  An investor must make a claim for EIS relief (both against income tax and CGT) before the relief is available: ICTA 1988, section 289(1); Taxation of Chargeable Gains Act 1992 (‘TCGA 1992’), Schedule 5B, paragraph 2(1)). A claim cannot be made unless the company that issues the shares subscribed for has issued a certificate, which certifies that the conditions for relief relating to the company and the shares subscribed for (but not the investor) are satisfied: TA 1988, section 306(2). No certificate can be issued without the authority of the inspector of taxes: section 306(4). A right of appeal for income tax purposes lies with the issuing company against a refusal of authority to issue a certificate: section 306(10). These provisions are applied for the purposes of CGT by TCGA 1992, Schedule 5B, paragraph 6.  Thus the issuing company has a substantive right of appeal against the issue of a certificate for CGT purposes as well as income tax purposes.

83.	Optos made twenty-five separate applications to the Inland Revenue for authorisation to issue a certificate in relation to shares issued on twenty-four different dates between 29 September 1994 and 31 October 2001. Two separate applications were made for shares issued on 26 September 2001. The Inland Revenue refused to authorise an EIS certificate in relation to four Optos share issues, dated 1 April 2001, 1 June 2001, 26 September 2001 and 31 October 2001 respectively. It also withdrew the authorisation it had previously given in respect of sixteen further shares issues on dates between 5 April 1996 and 26 September 2001. The authorisation given in respect of the first five share issues (on dates between 29 September 1994 and 15 April 1996) has not been withdrawn. The parties have agreed to take as a representative appeal the appeal against a Notice of Decision dated 24 March 2005 given in respect of the issue of shares on 26 September 2001, in relation to which Optos had sought authority to issue an EIS certificate by a form EIS1 dated 7 May 2002.  Although the parties have treated this case as a representative case, it seems to me that different issues arise as regards the availability of EIS relief for both income tax and CGT in respect of the conversion shares on the one hand and shares issued prior to the issue of the conversion shares on the other.  I shall deal with the issues argued before me in principle and leave it to the parties to apply my decision to these two categories of shares. 

84.	The legislation concerning EIS relief for both income tax and capital gains tax is long, turgid and complicated.  I have set out the relevant provisions at some length as they have, moreover, been amended several times over the years (often to little discernible effect) and it is as well to have to hand the relevant provisions in the form in which they applied at the material times.  
  
85.	However it is convenient to distil the terms of the relevant provisions into an intelligible structure which puts the issues which arise in this appeal into context, before I set out their terms verbatim.

86.	So far as EIS relief from income tax is concerned the regime is, as I observed above,  contained in TA 1988, section 289 to section 312.  The regime has four main categories of requirements.  Firstly, the regime makes certain stipulations as to conditions which a subscribing individual must satisfy.  In particular that a subscribing individual must subscribe for shares on his own behalf (TA 1988, section 297(1), (2)) and not be connected to the issuing company (section 297(1)(b), (2), section 291A, section 291B).  Both parties agree that all such conditions are satisfied in the circumstances of this appeal.

87.	Secondly, the shares for which an individual subscribes must be “eligible shares” that is, broadly, ordinary shares which have no preferential rights to dividends, on redemption or on a winding up (section 289(7)).  Both parties agree that the conversion shares on the Loan Notes satisfy the conditions in section 289(7).  However the shares must inter alia:-
(i)	be subscribed for wholly in cash (section 289(1)(a));
(ii)	be issued in order to raise money for the “qualifying business activity” (section 289(1)(b)).  
The Crown does not accept that these conditions are met in relation to the conversion shares.

88.	Thirdly, the company which issues the shares must:
(i)	be a “qualifying company” that is, be carrying on a “qualifying trade” (see below) or be the holding company of a trading group (section 293(1), (1A), (1B), (2)(a), (aa));
(ii)	carry on a “qualifying business activity” (section 289(1)(b)), which is broadly a “qualifying trade” (section 289(2)(a)(i)), which must not have as a “substantial part”, any of the activities specified in section 297(1).  The relevant potential offending activity in this appeal is that of “leasing”: section 297(1)(e).  
(iii)	employ 80% of the cash raised by the share income wholly for the purpose of the “qualifying activity” within 12 months of the date of issue of the shares and 100% of the cash for those purposes within 12 months thereafter, i.e. two years after the date of issue of the eligible shares, (section 289(1)(c), (d), (3)).

The Crown does not accept that these conditions have been met in relation to the money raised by the Loan Notes issue and the subsequent issue of the conversion shares.  Further, the Crown does not accept that conditions (i) and (ii) are satisfied in relation to any of the shares issued by Optos because Optos, says the Crown, has a trade a substantial part of which comprises “leasing” within TA 1988, section 297(1)(e).    

89.	In relation to EIS relief for capital gains tax the regime is, again as I have observed above, contained in TCGA 1992, section 150C and Schedule 5B.  The conditions for relief are very broadly the same as for income tax.  In particular the conditions that the eligible shares be issued for the purposes of “raising money” which corresponds to TA 1988, section 289(1)(b) is specified in TCGA 1992, Schedule 5B, paragraph 1(2)(f) and the condition that the money so raised be employed for the purpose of the “qualifying trade” of the issuing company within specified time limits which corresponds to TA 1988, section 289(1)(c) and (d) is contained in TCGA 1992, Schedule 5B paragraph 1(2)(g) and (h).

90.	Fourthly, there are anti-avoidance provisions which have the effect of either withdrawing or prohibiting relief which would otherwise be available.  The relevant anti-avoidance provision in this appeal relates to EIS relief for capital gains tax.  If a subscribing shareholder receives a “relevant receipt”, being a “return of value”, where that return of value is made “on” the subscription for shares, the shares are treated as never becoming “eligible shares” for EIS relief purposes (“eligible shares” has the same meaning as for income tax purposes: Schedule 5B, paragraph 19(1)).  For income tax purposes, a “return of value” either reduces or entirely claws back EIS relief: TA 1988, section 300(1A)(b).  There are other anti-avoidance provisions (relating to a return of value after the subscription for shares and otherwise) which are not relevant to this appeal.  The Crown considers, for the reasons given below, that the issue of the conversion shares amounted to a prohibited return of value, so as to disqualify the conversion shares from relief..

The Statutory Provisions

91.	The conditions for eligibility for relief under EIS regime as it applies for the purposes of income tax relief is contained in TA 1988, Part VII, Chapter III. Section 289 (before amendment by the Finance Act 2004 for the purposes of shares issued after 16 March 2004) contains the basic conditions for eligibility:

(1)	For the purposes of this Chapter, an individual is eligible for relief, subject to the following provisions of this Chapter, if—
(a)	eligible shares in a qualifying company for which he has subscribed wholly in cash are issued to him and, under section 291, he qualifies for relief in respect of those shares,
(aa)	at the time when they are issued the shares are fully paid up (disregarding for this purpose any undertaking to pay cash to the company at a future date),
(b)	the shares and all other shares comprised in the same issue are issued in order to raise money for the purpose of a qualifying business activity,
(ba)	the requirements of subsection (1A) below are satisfied in relation to the company,
(c)	at least 80 per cent. of the money raised by the issue mentioned in paragraph (b) above is employed wholly for the purpose of the activity mentioned in that paragraph not later than the time mentioned in subsection (3) below, and
(d)	all of the money so raised is employed wholly for that purpose not later than 12 months after that time.
(1A)	The requirements of this subsection are satisfied in relation to a qualifying company if throughout the relevant period the active company—
(a)	is a company which—
(i)	is such a company as is mentioned in section 293(2)(a), and 
(ii)	if it is a subsidiary of the qualifying company, is a 90 per cent subsidiary of that company, or
(b)	would be a company falling within paragraph (a) above if its purposes were disregarded to the extent that they consist in the carrying on of activities such as are mentioned in section 293(3D)(a) and (b) and (3E)(a), or
(c)	is a 90 per cent subsidiary of the qualifying company and falls within subsection (1B) below.
(1B)	A subsidiary of the qualifying company falls within this subsection if—
(a)	apart from purposes capable of having no significant effect (other than in relation to incidental matters) on the extent of its activities, it exists wholly for the purpose of carrying on activities such as are mentioned in section 293(3D)(b); or
(b)	it has no profits for the purposes of corporation tax and no part of its business consists in the making of investments.
(1C)	In subsection (1A) above ‘the active company’ means the qualifying company or, where the qualifying business activity mentioned in subsection (1) above consists in a subsidiary of that company carrying on or preparing to carry on a qualifying trade or research and development, that subsidiary.
(1D)	Subsections (4A) and (6) of section 293 shall apply in relation to the requirements of subsection (1A) above as they apply in relation to subsection (2) of that section.

92.	The terms ‘qualifying company’ and ‘qualifying trade’ are defined in ICTA 1988, sections 293 and 297 respectively (see further below).

93.	‘Qualifying business activity’ is defined in subsection (2) of section 289:

In this Chapter ‘qualifying business activity’, in relation to a company, means— 
(a)	the company or any subsidiary—
(i)	carrying on a qualifying trade which, on the date the shares are issued, it is carrying on, or
(ii)	preparing to carry on a qualifying trade which, on that date, it intends to carry on wholly or mainly in the United Kingdom and which it begins to carry on within two years after that date,
but only if, at any time in the relevant period when the qualifying trade is carried on, it is carried on wholly or mainly in the United Kingdom, or 
(b)	the company or any subsidiary carrying on research and development—
(i)	which, on the date the shares are issued, it is carrying on or which it begins to carry on immediately afterwards, and 
(ii)	from which it is intended that a qualifying trade which the company or any subsidiary will carry on wholly or mainly in the United Kingdom will be derived,
but only if, at any time in the relevant period when the research and development or the qualifying trade derived from it is carried on, it is carried on wholly or mainly in the United Kingdom.

94.	Subsection (3) of section 289 lays down, for the purpose of section 289(1)(c), the conditions for the time within which the money raised must be spent by the company:

The time referred to in subsection (1)(c) above is— 
(a)	the end of the period of twelve months beginning with the issue of the eligible shares,
(b)	in the case of money raised only for the purpose referred to in subsection (2)(a) above, the end of that period or, if later, the end of the period of twelve months beginning when the company or subsidiary concerned begins to carry on the qualifying trade,
and for the purposes of this Chapter, conditions in subsection (1)(c) and (d) above do not fail to be satisfied by reason only of the fact that an amount of money which is not significant is employed for another purpose.

95.	Subsection (6) of section 289 is an anti-avoidance provision:

An individual is not eligible for relief in respect of any shares unless the shares are subscribed for, and issued, for bona fide commercial purposes and not as part of a scheme or arrangement the main purpose or one of the main purposes of which is the avoidance of tax.

96.	Subsection (7) of section 289 defines the term ‘eligible shares’ (as used in section 289(1)(a)):

In this Chapter ‘eligible shares’ means new ordinary shares which, throughout the period— 
(a)	beginning with the issue of the shares, and
(b)	ending immediately before the termination date relating to those shares,
carry no present or future preferential right to dividends or to a company’s assets on its winding up and no present or future right to be redeemed.

97.	Section 289A of ICTA 1988 contains provisions relating to the form of relief. Subsections (1) and (2) set out the amount for which an individual investor can claim EIS relief:

(1)	Where an individual eligible for relief in respect of any amount subscribed for eligible shares makes a claim, then, subject to the following provisions of this Chapter, the amount of his liability for the year of assessment in which the shares were issued (‘the current year’) to income tax on his total income shall be the following amount.
(2)	That amount is the amount to which he would be so liable apart from this section less whichever is the smaller of— 
(a)	an amount equal to tax at the lower rate for the current year on the amount or, as the case may be, the aggregate of the amounts subscribed for eligible shares issued in that year in respect of which he is eligible for relief, and
(b)	the amount which reduces his liability to nil.

Subsections (3) and (4) of section 289A give the investor the ability to spread relief over more than one tax year. Subsection (5) is a computational provision:

In determining for the purposes of subsection (2) above the amount of income tax to which a person would be liable apart from this section, no account shall be taken of— 
(a)	any income tax reduction under Chapter I of Part VII of this Act or under section 347B,
(b)	any income tax reduction under section 353(1A),
(c)	any income tax reduction under section 54(3A) of the Finance Act 1989 
(ca)	any income tax reduction under paragraph 19(2) of Schedule 16 to the Finance Act 2002 (community investment tax relief),
(d)	any relief by way of a reduction of liability to tax which is given in accordance with any arrangements having effect by virtue of section 788 or by way of a credit under section 790(1), or
(e)	any tax at the basic rate on so much of that person’s income as is income the income tax on which he is entitled to charge against any other person or to deduct, retain or satisfy out of any payment.

Subsection (6) and (7) provide as follow:

(6)	A claim for relief shall not be allowed unless subsection (7) below is complied with but, where it is complied with, the relief may be given at any time when it appears that the conditions for the relief may be satisfied.
(7)	This subsection is complied with if— 
(a)	in the case of shares issued for the purpose of a qualifying business activity falling within paragraph (a) of section 289(2), the company or subsidiary concerned has carried on the trade for four months, and
(b)	in the case of shares issued for the purpose of a qualifying business activity falling within paragraph (b) of that subsection or within both paragraph (a) and paragraph (b) of that subsection, the company or subsidiary concerned has carried on the research and development for four months.

98.	Section 289B of ICTA 1988 provides a mechanism for attributing shares issued by the company to the investor. This is not in issue in this appeal. Section 290 provides for minimum and maximum levels of subscriptions eligible for relief, which, again, are not in issue in this appeal. 

99.	Section 291 of ICTA 1988 contains further conditions that the individual claiming EIS relief must fulfil. Subsections (1) and (2) provide as follows:

(1)	An individual qualifies for relief in respect of eligible shares in a company (referred to in this section and sections 291A and 291B as the ‘issuing company’) if— 
(a)	he subscribes for the shares on his own behalf; and
(b)	subject to section 291A(4), he is not at any time in the period—
(i)	beginning two years before the issue of the shares, and
(ii)	ending immediately before the termination date relating to those shares
connected with the company (whether before or after its incorporation).
(2)	For the purposes of this section, an individual is connected with the issuing company if he, or an associate of his, is— 
(a)	an employee of, or of a partner of, the issuing company or any subsidiary,
(b)	a partner of the issuing company or any subsidiary, or
(c)	subject to section 291A, a director of, or of a company which is a partner of, the issuing company or any subsidiary
or if he, or an associate of his, is so connected by virtue of section 291B.

In this appeal, it is common ground that if the investors can be said to have ‘subscribed for shares’, they did so on their own behalf. It is also common ground that for the purposes of the legislation the investors were not ‘connected’ to Optos. Whilst some of the investors were directors of Optos, section 291A provides that directors are not connected to the company if the payments they receive from that company are on arm’s-length terms.

100.	Section 293 of ICTA 1988 defines what constitutes a ‘qualifying company’. In particular, subsections (1A) and (1B) provide that it must be an unquoted company and there must be no arrangements in existence for it to cease to be unquoted or to become a subsidiary of a quoted company. Subsection (2) provides:

The company must, throughout the relevant period, be— 
(a)	a company which exists wholly for the purpose of carrying on one or more qualifying trades or which so exists apart from purposes capable of having no significant effect (other than in relation to incidental matters) on the extent of the company’s activities, or
(aa)	the parent company of a trading group.

101.	For these purposes, the ‘relevant period’ is defined by section 312(1A):

In any provision of this Chapter ‘relevant period’, in relation to any eligible shares issued by a company, means whichever of the following periods is applied for the purposes of that provision—
(a)	the period beginning either—
(i)	with the incorporation of the company, or
(ii)	if the company was incorporated more than two years before the date on which the shares were issued, two years before that date,
and ending immediately before the termination date relating to the shares, and
(b)	the period beginning with the issue of the shares and ending immediately before the termination date relating to them.

The ‘termination date’ is, essentially, the third anniversary of the date of issue: ICTA 1988, section 312(1).

102.	The term ‘qualifying trade’ is defined in section 297:

(1)	A trade is a qualifying trade if it complies with the requirements of this section.
(2)	Subject to subsection (9) below, the trade must not at any time in the relevant period consist of one or more of the following activities if that activity amounts, or those activities when taken together amount, to a substantial part of the trade— 
(a)	dealing in land, in commodities or futures or in shares, securities or other financial instruments;
(b)	dealing in goods otherwise than in the course of an ordinary trade of wholesale or retail distribution;
(c)	banking, insurance, money-lending, debt-factoring, hire-purchase financing or other financial activities;
(d)	…
(e)	leasing (including letting ships on charter or other assets on hire) or receiving royalties or licence fees;
(f)	providing legal or accountancy services;
(fa)	property development;
(fb)	farming or market gardening;
(fc)	holding, managing or occupying woodlands, any other forestry activities or timber production;
(fd)	operating or managing hotels or comparable establishments or managing property used as an hotel or comparable establishment;
(fe)	operating or managing nursing homes or residential care homes, or managing property used as a nursing home or residential care home;
(g)	providing services or facilities for any trade carried on by another person (other than a company of which the company providing the services or facilities is the subsidiary) which consists to any substantial extent of activities within any of paragraphs (a) to (fe) above and in which a controlling interest is held by a person who also has a controlling interest in the trade carried on by the company

Subsections (4) to (5C) of section 297 provide that if a company receives a licence fee attributable to ‘relevant intangible assets’ its trade shall not for that reason be excluded from the definition of ‘qualifying trade’.

(4)	A trade shall not be treated as failing to comply with this section by reason only that at some time in the relevant period it consists to a substantial extent in the receiving of royalties or licence fees if the royalties and licence fees (or all but for a part that is not a substantial part in terms of value) are attributable to the exploitation of relevant intangible assets.
(5)	For this purpose an intangible asset is a ‘relevant intangible asset’ if the whole or greater part (in terms of value) of it has been created— 
(a)	by the company carrying on the trade, or
(b)	by a company which at all times during which it created the intangible asset was—
(i)	the parent company of the company carrying on the trade, or
(ii)	a qualifying subsidiary of that parent company.
(5A)	For the purposes of subsection (5) above— 
(a)	in the case of an intangible asset that is intellectual property, references to the creation of the asset by a company are to its creation in circumstances in which the right to exploit it vests in the company (whether alone or jointly with others);
(b)	‘parent company’ means a company that—
(i)	has one or more 51% subsidiaries, but
(ii) 	is not itself a 51% subsidiary of another company; and 
(c)	(c)	a subsidiary of the parent company referred to in subsection (5)(b) above is a ‘qualifying subsidiary’ of that company if it is a subsidiary of a kind which the parent company may hold by virtue of section 308.
For the purposes of paragraph (c) above, section 308 shall have effect as if the references in that section to the qualifying company were to that parent company. 
(5B)	For the purposes of subsections (4) to (5A) above ‘intangible asset’ means any asset which falls to be treated as an intangible asset in accordance with generally accepted accounting practice.
(5C)	In subsection (5A)(a) above ‘intellectual property’ means— 
(a)	any patent, trade mark, registered design, copyright, design right, performer’s right or plant breeder’s right; and
(b)	any rights under the law of a country or territory outside the United Kingdom which correspond or are similar to those falling within paragraph (a) above.

103.	Subsections (1) and (1A) of section 300 of ICTA 1988 provide that EIS relief is withdrawn from an investor where the investor ‘receives any value’ from the company:

(1)	Subsection (1A) below applies where an individual who subscribes for eligible shares in a company receives any value (other than insignificant value) from the company at any time in the period of restriction. 
(1A)	Where any relief is attributable to those shares, then (unless the amount of the relief has already been reduced on account of the value received)— 
(a)	if it is greater than the amount mentioned in subsection (1B) below, it shall be reduced by that amount, and
(b)	if paragraph (a) above does not apply, the relief shall be withdrawn.

In this case, it is common ground that if there is a receipt of value, it leads to a total withdrawal of the relief for income tax purposes under section 300(1A)(b) and not its reduction under section 300(1A)(a).  I was however not addressed as to whether it is common ground as to how any withdrawal of relief would be properly effected by the Crown in relation to shares issued by Optos other than the conversion shares. if the Crown succeeds in its argument that there has been a receipt of value in relation to the conversion shares  I will therefore deal with the receipt of value issue in principle only.

EIS Capital Gains Tax Relief

104.	As I observe above, EIS relief is also made available for CGT purposes by virtue of section 150C of, and Schedule 5B to, TCGA 1992. Under paragraph 1(1) of Schedule 5B, the Schedule applies where:

(a)	there would (apart from paragraph 2(2)(a) below) be a chargeable gain (‘the original gain’) accruing to an individual (‘the investor’) at any time (‘the accrual time’) on or after 29th November 1994;
(b)	the gain is one accruing either on the disposal by the investor of any asset or in accordance with section 164F or 164FA, paragraphs 4 and 5 below or paragraphs 4 and 5 of Schedule 5C; 
(c)	the investor makes a qualifying investment; and
(d)	the investor is resident or ordinarily resident in the United Kingdom at the accrual time and the time when he makes the qualifying investment and is not, in relation to the qualifying investment, a person to whom sub-paragraph (4) below applies.

Sub-paragraph (4) is not in issue in this case. Paragraph 1(2) defines ‘qualifying investment’ thus:

The investor makes a qualifying investment for the purposes of this Schedule if— 
(a)	eligible shares in a company for which he has subscribed wholly in cash are issued to him at a qualifying time and, where that time is before the accrual time, the shares are still held by the investor at the accrual time
(b)	the company is a qualifying company in relation to the shares,
(c)	at the time when they are issued the shares are fully paid up (disregarding for this purpose any undertaking to pay cash to the company at a future date),
(d)	the shares are subscribed for, and issued, for bona fide commercial purposes and not as part of arrangements the main purpose or one of the main purposes of which is the avoidance of tax,
(e)	the requirements of section 289(1A) of the Taxes Act are satisfied in relation to the company, 
(f)	all the shares comprised in the issue are issued in order to raise money for the purpose of a qualifying business activity,
(g)	at least 80% of the money raised by the issue is employed wholly for the purpose of that activity not later than the time mentioned in section 289(3) of the Taxes Act, and
(h)	all of the money so raised is employed wholly for that purpose not later than 12 months after that time,
and for the purposes of this Schedule, conditions in paragraphs (g) and (h) above do not fail to be satisfied by reason only of the fact that an amount of money which is not significant is employed for another purpose.

105.	‘Eligible shares’ are defined as having the meaning given by ICTA 1988, section 289(7) and ‘qualifying company’ is defined as a company which is a qualifying company for the purposes of Chapter III of Part VII of ICTA: TCGA 1992, Schedule 5B, paragraph 19(1). The ‘qualifying time’ referred to in paragraph 1(2) is defined in paragraph 1(3) in the following terms:

In sub-paragraph (2) above ‘a qualifying time’, in relation to any shares subscribed for by the investor, means— 
(a)	any time in the period beginning one year before and ending three years after the accrual time, or
(b)	any such time before the beginning of that period or after it ends as the Board may by notice allow.

106.	Paragraph 2 makes provision for the relief from CGT on a ‘chargeable event’ (defined in paragraph 3 but not relevant to this appeal):

(1)	On the making of a claim by the investor for the purposes of this Schedule, so much of the investor’s unused qualifying expenditure on the relevant shares as— 
(a)	is specified in the claim, and
(b)	does not exceed so much of the original gain as is unmatched,
 shall be set against a corresponding amount of the original gain. 
(2)	Where an amount of qualifying expenditure on the relevant shares is set under this Schedule against the whole or part of the original gain— 
(a)	so much of that gain as is equal to that amount shall be treated as not having accrued at the accrual time; but
(b)	paragraphs 4 and 5 below shall apply for determining the gain that is to be treated as accruing on the occurrence of any chargeable event in relation to any of the relevant shares.
(3)	For the purposes of this Schedule— 
(a)	the investor’s qualifying expenditure on the relevant shares is the amount subscribed by him for the shares; and
(b)	that expenditure is unused to the extent that it has not already been set under this Schedule against the whole or any part of a chargeable gain.
(4)	For the purposes of this paragraph the original gain is unmatched, in relation to any qualifying expenditure on the relevant shares, to the extent that it has not had any other expenditure set against it under this Schedule or Schedule 5C.

107.	Paragraph 13 provides that where an individual who subscribes for eligible shares, and that individual receives a ‘relevant receipt’ from the company, the eligible shares are deemed not be eligible shares. Sub-paragraph (1) provides:

Where an individual who subscribes for eligible shares (‘the shares’) in a company receives any value (other than insignificant value) from the company at any time in the period of restriction, the shares shall be treated as follows for the purposes of this Schedule— 
(a)	if the individual receives the value on or before the date of the issue of the shares, as never having been eligible shares; and
(b)	if the individual receives the value after that date, as ceasing to be eligible shares on the date when the value is received.

The ‘period of restriction’ in relation to any shares is defined in paragraph 19(1) as the period beginning one year before the shares are issued and ending immediately before the termination date relating to the share. For these purposes, the termination date is defined by reference to its meaning for the purposes of ICTA 1988.

108.	Paragraph 13(1B) provides that:

Where— 
(a)	the individual who subscribes for the shares receives value (‘the relevant receipt’) from the company during the period of restriction,
(b)	the individual has received from the company one or more receipts of insignificant value at a time or times—
(i)	during that period, but
(ii)	not later than the time of the relevant receipt, and
(c)	the aggregate amount of the value of the receipts within paragraphs (a) and (b) above is not an amount of insignificant value, 
the individual shall be treated for the purposes of this Schedule as if the relevant receipt had been a receipt of an amount of value equal to the aggregate amount.
For this purpose a receipt does not fall within paragraph (b) above if it has previously been aggregated under this sub-paragraph.

109.	Paragraph 13(2) defines the circumstances in which an individual ‘receives value’ from a company:

For the purposes of this paragraph an individual receives value from the company if the company— 
(a)	repays, redeems or repurchases any of its share capital or securities which belong to the individual or makes any payment to him for giving up his right to any of the company’s share capital or any security on its cancellation or extinguishment;
(b)	repays, in pursuance of any arrangements for or in connection with the acquisition of the shares, any debt owed to the individual other than a debt which was incurred by the company—
(i)	on or after the date on which he subscribed for the shares; and
(ii)	otherwise than in consideration of the extinguishment of a debt incurred before that date;
(c)	makes to the individual any payment for giving up his right to any debt on its extinguishment;
(d)	releases or waives any liability of the individual to the company or discharges, or undertakes to discharge, any liability of his to a third person;
(e)	makes a loan or advance to the individual which has not been repaid in full before the issue of the shares;
(f)	provides a benefit or facility for the individual;
(g)	disposes of an asset to the individual for no consideration or for a consideration which is or the value of which is less than the market value of the asset;
(h)	acquires an asset from the individual for a consideration which is or the value of which is more than the market value of the asset; or
(i)	makes any payment to the individual other than a qualifying payment.

110.	Paragraph 13(7) defines ‘qualifying payment’:

In this paragraph ‘qualifying payment’ means— 
(a)	the payment by any company of such remuneration for service as an officer or employee of that company as may be reasonable in relation to the duties of that office or employment;
(b)	any payment or reimbursement by any company of travelling or other expenses wholly, exclusively and necessarily incurred by the individual to whom the payment is made in the performance of duties as an officer or employee of that company;
(c)	the payment by any company of any interest which represents no more than a reasonable commercial return on money lent to that company;
(d)	the payment by any company of any dividend or other distribution which does not exceed a normal return on any investment in shares in or other securities of that company;
(e)	any payment for the supply of goods which does not exceed their market value;
(f)	any payment for the acquisition of an asset which does not exceed its market value;
(g)	the payment by any company, as rent for any property occupied by the company, of an amount not exceeding a reasonable and commercial rent for the property;
(h)	any reasonable and necessary remuneration which—
(i)	is paid by any company for services rendered to that company in the course of a trade or profession; and
(ii)	is taken into account in computing the profits of the trade or profession under Case I or II of Schedule D or would be so taken into account if it fell in a period on the basis of which those profits are assessed under that Schedule;
(j)	a payment in discharge of an ordinary trade debt.

4.	THE ISSUES RELEVANT IN THIS APPEAL	

111.	The parties to this appeal made a joint application, which I allowed in a preliminary decision handed down on 25 October 2005, that substantive hearing should address the following four issues:
(i)	Whether or not Optos carried on a ‘qualifying trade’ at the relevant times, within ICTA 1988, section 297, or whether it carried on the trade of ‘leasing’ within section 297(2)(e) (“the leasing issue”).  This is relevant for all of the shares issued by Optos (the conversion shares and any other shares) for which EIS relief is claimed for income tax and CGT.
(ii)	Whether or not conversion shares were issued by Optos in order to ‘raise money’ within ICTA 1988, section 289(1)(b) and TCGA 1992, Schedule 5B, paragraph 1(2)(f) (“the raising money issue”).  This issue relates of course to the conversion shares alone.  This issue also relates only to the conversion shares.
(iii)	Whether or not Optos issued shares in order to raise money which was ‘employed wholly’ for the purpose of a qualifying trade, within ICTA 1988, section 289(1)(c) and (d) and TCGA 1992, Schedule 5B, paragraph 1(2)(g) and (h) or whether the transfer of funds by Optos to Inc prevented Optos from satisfying this condition (“the use of money issue”).
(iv)	Whether there was a receipt of ‘value’ (on or before the date of issue of the shares in question) to investors in Optos within the meaning of TCGA 1992, Schedule 5B, paragraph 13(1)(b) by reason of the issue of the conversion shares on the conversion of the Loan Notes (“the receipt of value issue”).

112.	These issues are raised in a slightly different order to how I would address them if I followed the structure of the scheme of the EIS provisions I set out above.  I will address the issues in the order in which they were argued.

113.	The Appellant must succeed on all four issues to win its appeal in respect of the conversion shares.  This is common ground.  In so far as EIS relief for income tax and CGT depends on the leasing issue alone, Optos need only succeed on this issue.  The parties have not precisely indicated which share subscriptions in Optos depend on the leasing issue alone for EIS relief for income tax and CGT purposes so I will deal with each issue in principle. 

5.	THE APPELLANT’S CONTENTIONS

114.	With regard to the four areas of dispute, the Appellant’s contentions were, in summary:
(i)	that Optos’ services are not adequately characterised as ‘leasing’; 
(ii)	that the 26 September 2001 share issue was made ‘in order to raise money’ and thus falls under TA 1988, section 289(1)(b) and TCGA 1992, Schedule 5B, paragraph 1(2)(f); 
(iii)	that the money raised by the share issue was ‘employed wholly’ for the purpose of a qualifying trade, within TA 1988, section 289(1)(c) and (d) and TCGA 1992, Schedule 5B, paragraph 1(2)(g) and (h); and 
(iv)	that there was no a receipt of ‘value’ to investors in Optos within the meaning of TCGA 1992, Schedule 5B, paragraph 13(1)(a), which, if there were such a receipt, would deny the availability of the EIS relief.

The Leasing Issue

115.	With regard to whether or not the trade of Optos has consisted wholly or substantially of leasing since August 1999, as HMRC contends, Mr Thornhill QC who appeared for Optos, submitted that leasing consisted in the owner of tangible or intangible property making the use of that property available to a third party (the lessee), and that leasing was excluded from the EIS regime because it is essentially a passive activity consisting of the receipt of income from investment. However, although Optos (and, in the USA, Inc) made the P200 units available to customers, they provided an integrated service including expert diagnostic services, which entailed that the service was not properly characterised as leasing. Secondly, by virtue of the financing transactions, as at September 2001 title to over 80% of the machines in use passed to Copelco and remained with it until the bank recovered its acquisition costs and interest. Mr Thornhill accepted that Copelco became a lessor of the P200 units to the customers, as the remaining services continued to be supplied by Optos. However, says Mr Thornhill, this means that Optos could not therefore be a “lessor” in relation to the units.

The Raising Money Issue

116.	This issue concerns the issue of the conversion shares on the conversion of the Loan Notes on 1 June 2001 and 26 September 2001.  With regard to whether the share issue was made ‘in order to raise money’, Mr Thornhill conceded that if it was the case that the statutory test was that new cash had to pass to the company, on the issue of the conversion shares, then TA 1988, section 289(1)(b) (and indeed TCGA 1992, Schedule 5B, paragraph 1(2)(f)) would not be satisfied and Optos would lose the appeal.  He initially submitted that the Crown’s interpretation of the test was too narrow, and that money was “raised” by the company on the issue of the conversion shares in the sense that, had the conversion of the Loan Notes into ordinary shares not taken place, the company would have been obliged to repay the convertible loan in cash. It was not, he submitted, a misuse of words to say that the cash not so repaid was ‘raised’. In other words, the issue of the conversion shares on the agreement by the Loan Note subscribers to take fully paid up shares rather than a cash repayment of the money debt owed to them was properly described as the raising of cash by Optos since to have repaid cash would have been commercially impossible for Optos.  However, Mr Thornhill, over the course of his submissions, abandoned this contention which he conceded was inconsistent with the condition in section 289(1)(a) (and indeed in TCGA 1992, Schedule 5B, paragraph 1(2)(a)) that the conversion shares be subscribed for “wholly in cash” in order to obtain EIS relief for income tax and CGT.  Mr Thornhill instead contended that the subscription for the Loan Notes for cash and the conversion of the money debt they represented into ordinary shares, issued as fully paid up, should be viewed as a single process.  This process, says Mr Thornhill, culminated in an issue of shares which could be said to have been subscribed wholly for cash and issued to “raise money” since the subscription for the Loan Notes and the issue of the conversion shares were effectively part of the same single commercial process.  The subscription for Loan Notes was effectively an interim step which in the circumstances of this case should be ignored in construing TA 1988, section 289(1)(a) and (b) and TCGA 1992, Schedule 5B, paragraph 1(2)(a) and (f).  This was right, said Mr Thornhill, if the subscription for Loan Notes and their conversion was looked at as a matter of commercial common sense especially given Mr Sealey’s evidence (which I accept) that there was no expectation on the part of any subscriber for the Loan Notes that there would be a cash repayment. 

The Use of Money Issue

117.	This issue assumes that the issue of the conversion shares was indeed in order to “raise money”.  If so, this issue raises the question of whether or not the conversion share issue could be said to have raised money ‘employed wholly’ for the purpose of a qualifying trade within section 289(1)(c), (d) and TCGA 1992, Schedule 5B, paragraphs 1(2)(g) and (h).  Mr Thornhill submitted that the legislation did not require a tracing exercise and that the fact that a large part of the money raised was used by Inc as opposed to Optos was neither here nor there. The important point, according to Mr Thornhill, was that the money was raised in order to defray expenditure in the UK and that it did defray such expenditure.  I agree with Mr Thornhill on this point of principle.

118.	With regard to the transfer of the £1,053,385.79 from Optos to Inc, Mr Thornhill accepts that these funds represent part of what he contends were funds subscribed for “eligible shares”.  So Mr Thornhill accepts if these transferred funds were not used by Optos for the purposes of its UK trade within the relevant time limits, the appeal fails.  However Mr Thornhill submitted that this transfer was only a short-term measure resulting from litigation in which Optos was involved at the time.  It was clearly not the intention behind either the Loan Notes or the 26 September 2001 share issue that the money be sent to Inc.  Mr Thornhill invited me to accept the evidence of Mr Sealey in particular that the cash was returned entirely to Optos by Inc within the time limits specified by TA 1988, section 289(1)(c), (d) and TCGA 1992, Schedule 5B, paragraph 1(g) and (h).

The Receipt of Value Issue

119.	Mr Thornhill contended on behalf of Optos that there was no receipt of value by the investors in Optos on or before the issue of the 1 June 2001 and the 26 September 2001 shares. Mr Thornhill initially contended that the mechanics of the conversion of the Loan Notes into shares under Part 4 of the Schedule to the Loan Notes involves a cancellation of the Loan Notes and an issue of shares. There was, therefore, no repayment of the loan, either by actual repayment or by set-off.  On Mr Thornhill’s alternative contention, that the subscription for the Loan Notes was, in truth, a subscription for the conversion shares, there was no return of value at all.

6.	THE RESPONDENTS’ CONTENTIONS

120.	Mr Young appeared for the Crown.  With regard to the four areas of dispute, Mr Young’s contentions were, in summary:
(i)	that Optos’ services come under the heading of ‘leasing’ and are thus not a ‘qualifying business activity’;
(ii)	that the 26 September 2001 share issue was not made ‘in order to raise money’ as the money had already been raised by the Loan Notes, and thus fails the test under TA 1988, section 289(1)(b) and TCGA 1992, Schedule 5B, paragraph 1(2)(f); 
(iii)	that in any event, the money which Optos did raise was not ‘employed wholly’ for the purpose of a qualifying trade, within the meaning of TA 1988, section 289(1)(c) and (d) and TCGA 1992, Schedule 5B, paragraph 1(g) and (h), but rather sent in large part to Inc; and 
(iv)	that there was a receipt of ‘value’ to investors in Optos within the meaning of TCGA 1992, Schedule 5B, paragraph 13(1)(a), as a result of which the EIS relief for CGT (or indeed for income tax by reason of TA 1988, section 300(1A)was not available.

The Leasing Issue

121.	Mr Young’s contention that the Appellant’s supplies to customers were in the nature of leasing took as its starting point the ATN agreements, which were central to the relationship between customers and the Appellant. In particular, Mr Young relied on the following terms of the ATN agreements:
(i)	the stipulation in the ATN agreement that the customer may not ‘sublease the equipment’; 
(ii)	the fact that the ATN agreement does not contain terms obliging Optos to provide wider services to the opticians beyond making the P200 units available to them, and that it is impossible to specify an integrated service from the terms of the ATN agreement; 
(iii)	the fact that the ATN agreement expressly provided that it represents the whole agreement between Optos and the optician; 
(iv)	the fact that the Copelco agreement refers to the ATN agreement as a ‘lease’;
(v)	the fact that in its audited accounts to 2001, Optos described its turnover as based on ‘hire and sale of ophthalmic equipment’; and
(vi)	the fact that in its 2000/2001 tax return, Optos described its business activity as being the ‘rental’ of ‘medical equipment’.

122.	Mr Young submitted that the true analysis of the Copelco Agreement is that Optos enters into a three-year lease with the opticians and then uses Copelco to capitalise some of the rental payments to aid cash flow. Title to the equipment eventually reverts to Optos once its agreement with Copelco terminates after three years. Optos is then entitled to continue to lease the equipment.   

The Raising Money Issue

123.	Mr Young submitted that in order for EIS relief for income tax and CGT to be available to an individual, he must have ‘subscribed wholly in cash’ for shares (TA 1988 section 289(1)(a), TCGA 1992, Schedule 5B, paragraph 1(2)(a)) which ‘are issued in order to raise money’ for the qualifying activity of the company, but that this test had not been met in the present case, as the conversion of the Loan Notes did not ‘raise money’ for the company.  The money says Mr Young, had been raised when the Loan Notes were issued in May 2001. No new funds became available to Optos as a result of the conversion. Rather, the conversion was a re-organisation of the company’s finances. Since the test was that the shares (and not the Loan Notes) must be issued in order to raise money, the test was failed.  Mr Young did not accept that the subscription for the Loan Notes was effectively a subscription for the conversion shares.

The Use of Money Issue

124.	Mr Young submitted that the transfer of the transfer of £1,053,385.79 from Optos to Inc indicated that the money raised by the share issue was not employed for the purpose of a qualifying trade. My Young accepted that in some cases payments made to overseas subsidiary companies could be considered to be made for the purpose of a qualifying trade: see 4Cast Limited v. Mitchell (HM Inspector of Taxes) [2005] STC (SCD) 287. However, Mr Young distinguished that case on the basis that the payments were made in consideration for services rendered to the UK company by its overseas subsidiaries, whereas Inc did not perform any services for Optos. Indeed, it was Optos that performed services for Inc.  In any event Mr Young submitted that the evidence did not establish that the funds transferred by Optos to Inc were used by Optos for the UK trade within the relevant time limits.

The Receipt of Value Issue

125.	I have already recorded that Mr Young did not accept that the subscription for the Loan Notes was for EIS relief purposes, or subscription for the conversion shares.  Mr Young submitted that there was a receipt of value in the ‘period of restriction’ (TA 1988, section 300(1)). The ‘period of restriction’ is defined in section 312(1) as the period beginning one year before the [eligible] shares are issued and ending immediately before the ‘termination date’, itself defined, for these purposes, as three years from the date of the share issue (section 312(1)). Mr Young relied on the definition of ‘receipt of value’ as including a repayment by the company of ‘any debt owed to the individual other than a debt incurred by the company (i) on or after the date on which he subscribed for the shares in respect of which the relief is claimed; and (ii) otherwise than in consideration of the extinguishment of a debt incurred before that date’ (section 300(2)(b)). Mr Young noted that there are (immaterial) differences between the income tax and CGT definitions of ‘receipt of value’. Paragraph 13(2)(b) of Schedule 5B, TCGA 1992 provides that:

(2)	For the purposes of this paragraph an individual receives value from the company if the company—…
(b)	repays, in pursuance of any arrangements for or in connection with the acquisition of the shares, any debt owed to the individual other than a debt which was incurred by the company— 
(i)	on or after the date of issue of the shares; and
(ii)	otherwise than in consideration of the extinguishment of a debt incurred before that date.

126.	The debt owed by the company to the investors by virtue of the Loan Notes was, according to Mr Young, repaid by the company through the issue of the shares on 26 September 2001. Mr Young emphasised the strictness of the test with reference to case law on similar provisions to section 300(2), ICTA 1988 in section 164L(3), TCGA 1992 (now repealed). Section 164L(3) provided that a number of specified transactions ‘shall be treated as’ being a return of value, and section 300(2) simply provides a list of transactions which are considered receipts of value ‘for the purposes of this section’.  

127.	In Wakefield v. Inspector of Taxes [2005] STC (SCD) 439 the Special Commissioners held that the principle of the ‘potency of the term defined’, as defined in section 199 of Bennion, Statutory Interpretation: a Code, 4th edn (London, 2002), did not apply with regard to section 164L. The principle was that:

Where a term is defined by a definition which specifies examples of the intended meaning; none the less the actual meaning of the term being defined influences the meaning to be attached to the term as extended [paragraph 71].  

However, they did not hold that the principle of potency applied with regard to section 164L:

The words ‘shall be treated as’ in sub-s (3) make it clear that what is intended is that transactions falling within the words used in sub-s (3) are a return of value for the purposes of s 164L whether or not they could otherwise have carried that meaning. The breadth and apparent artificiality of some of the items included in sub-s (3) remove any real force in a suggestion that they can be read as limited to actual returns of value. We therefore hold that sub-s (3) does require the fictitious returns of value to be treated as disqualifying the investments of both sums of £500,000 from the relief [paragraph 72].  

128.	Similarly, Mr Young contended, the fact that section 300(2) provides that certain transactions are receipts of value ‘for the purposes of this section’ shows that they include transactions that would not ordinarily be considered returns of value. The Special Commissioners accepted that:

…the main intention of s 164L is that the re-investor must have truly increased his investment in the eligible company and must not have it returned, either directly or indirectly, whether to the investor or to any associate of his [paragraph 50]. 

However, they held that the legislation had been drawn so widely partly so as to avoid the need to investigate the intentions of parties to the transactions. They accepted therefore that it caught innocent transactions (paragraphs 74, 75).  

7.	DECISION

129.	I take the four issues in turn in order in which they were argued by the parties.

The Leasing Issue

130.	It is important to note that TA 1988, section 297(1)(e) does not impose a test of whether a putative “qualifying company” is a “lessor”.  Nor does section 297(1)(e) ask whether a putative “qualifying trade” has “any” part of that trade which can properly be described as “leasing”.  Rather section 297(1)(e) asks whether a “substantial” part of a putative “qualifying trade” is “leasing”.  Thus, for Optos’ trade to fail the requirement imposed by section 297(1)(e), Optos must have a trade comprised at least partly of “leasing” and that part must be “substantial”.  

131.	The term “leasing” is not further defined.  “Leasing” covers a multitude of commercial activities.  “Leasing” covers, for example, finance leasing which is a passive activity the essence of which is to exploit rights of ownership.  The term “leasing” also covers operating leasing where a lessor not only grants the use of an asset to a lessee for consideration but often provides other services, such as technical support.  

132.	In the context of the EIS regime and section 297(1)(e) (whether for income tax purposes or for CGT purposes), I consider Mr Thornhill’s construction of the term “leasing” to connote essentially a passive activity where consideration is charged for the use of an asset, as opposed to other services, to be correct.  There is some assistance to be gained from the provisions of TA 1988, section 297(4) to (5C), which provide expressly that where a developer has developed intangible assets by itself and then exploits them by charging fees for their use and exploitation (that is to say, leasing), that is nevertheless a “qualifying trade”.  It was no part of Mr Thornhill’s argument that Section 297(4) to (5C) applied to Optos’ trade, or that any part of the fees payable under the ATN agreements were payable for the use of intangible assets developed by Optos.  Nevertheless, section 297(4) to (5C) does reveal the underlying policy of the EIS provisions, which is to preserve relief for what is essentially a productive activity (the development of intangible assets and intellectual property), albeit that those intangible assets are exploited by, essentially, “leasing”.  It is unsurprising that there is no analogous provision for preserving relief for the manufacture of tangible assets which are then exploited by leasing, since this is relatively rare.  On the other hand, this method of exploitation is orthodox for intangible assets.  

133.	Optos does not, I consider, have “leasing” as a “substantial” part of its trade.  Firstly, on any view, Optos has a trade of developing and manufacturing the P200 units.  And I accept that Optos’ method of exploiting these P200 units is, in the vast majority of cases, by means of the ATN agreements.  I further accept that to the extent that the fees charged to the opticians under the ATN agreements are for the use of the P200 units, Optos is a “lessor”.  I should say that I accept Mr Young’s contention that the finance agreements are, in essence, security arrangements so that to the extent that Optos is entitled to any proportion of the fees payable under the ATN agreements during the life of the finance agreements, Optos is a “lessor” in the context of section 297(1)(e), notwithstanding that (in form) title to the P200 units is with the relevant finance company during the life of the finance agreement (in the case of Optos, BA/CA).  The same holds true for Inc and the finance agreements concluded by it.  However, looking first at what Optos does, it is clearly the very essence and heart of Optos’ trade that it develops and manufactures the P200 units.  I have already observed that I accept Mr Anderson’s evidence that I find as a fact that for the first six years of Optos’ existence, 90% of its employees were research engineers.  Although the balance changed as Optos added manufacturing regulatory and customer focus teams, I have also already observed that I accept Mr Anderson’s evidence that none of the employees engaged by either Optos or Inc are employed in managing lease finance roles (in stark contrast to the finance company counterparties to the Copelco, TLL and BA/CA finance agreements).  So in terms of what Optos’ (and Inc’s) employees do and how they spend their time and their expertise, it cannot be said that “leasing” is a “substantial” part of what they do.

134.	But of course Optos overwhelmingly exploits the P200 units, once developed and manufactured, by means of the ATN agreements.  But here the fee paid by the opticians is not only for the use of the P200 units.  Indeed, the fee encompassed the training of the opticians to use the P200 units, repairs and maintenance to be carried out when necessary by Optos personnel and a helpline and advisory service provided by specialist consultants including diagnostic second opinions.  I repeat that I find as a fact that the second opinions were delivered (albeit by a single individual) on a sound professional basis.  Thus the fee paid by the opticians covered far more than a fee paid for the use of the P200 units.  Although no evidence was submitted by Optos as to how the regular fees paid by the opticians were broken down among the several elements which they represented payment for, Mr Sealey’s evidence (which I accept) was that the ATN Agreements universally charged the opticians for a combination of use and the ancillary services.  I infer that the P200 units could not have been placed with opticians under the ATN Agreements without the ancillary services and that the use of the P200 units on the one hand and the need for and utilisation of these ancillary services on the part of the opticians on the other were inextricably linked.  I find that no optician could (or did) realistically use the P200 units without also paying for and using the ancillary services.  This reinforces my conclusion that Optos was not simply exploiting proprietorial rights in the P200 units but rather exploiting its particular expertise, having developed these units in the first place.  So it cannot be said, either qualitatively or quantatively that a “substantial” proportion of the fee was for the use of the P200 machine alone.  Rather the fee was for the use and (inextricably) other services provided by Optos.  It is impossible on the facts as I find them in this case to bifurcate this fee into an element for use of the unit and an element for the services so as to find a “substantial” part of the fee to be paid for use alone of the unit.  Neither Optos nor Inc can be described as having a “substantial” part of their respective trades as “leasing” any more than a hotelier who charges for the use of a room but also (inextricably) for other services.

135.	It follows that I find in favour of Mr Thornhill on this first point as to whether Optos as a trade a “substantial” part of which constitutes “leasing”.  The same is true of Inc.

The Raising Money Issue

136.	This issue relates to the issue of the conversion share on the Loan Notes on 1 June 2001 and 26 September 2001.  In the circumstances of this appeal, I find (for the reasons I give below) that it cannot be said that the “shares … [were] issued in order to raise money for the purpose of [Optos’] qualifying activity” for the purposes of section 289(1)(b).  Mr Thornhill accepted, as he must, that in order to qualify for EIS relief, the shares issued on the conversion of the Loan Note must be subscribed wholly for cash.  Thus  Mr Thornhill abandoned his initial contention that the conversion shares were issued as fully paid up because their subscription price was paid by way of a cancellation (i.e. a waiver) of the money debt owed by Optos on the Loan Notes.

137.	But I do not find Mr Thornhill’s alternative argument, namely that the issue of the Loan Notes and the subsequent conversion and issue of the shares was a single process, to be convincing.  This was precisely the argument put to the Special Commissioners by Counsel for the taxpayer in Inwards v Williamson [2003] STC (SCD) 355 (see paragraph 26 of the Decision).  In that case Counsel for the taxpayer suggested that the Special Commissioners construe the term “acquisition” [of shares] as a “process of acquisition” for the purposes of TCGA 1992, section 164L(3)(b) [reinvestment relief which was a statutory predecessor of EIS relief for CGT].  The Special Commissioners in Inwards rejected that argument as inconsistent with the scheme and purpose of section 164L and one which did impermissible violence to its language (paragraphs 39-41).  Mr Thornhill’s contention in this case seeks to construe the term “shares” in TA 1988, section 289(1)(a) and (b) and TCGA 1992, Schedule 5B, paragraph 1(2)(a) and (f) as encompassing “shares [issued on conversion of a security where there was no intention that the security be repaid in cash]”.  This approach is open to the same criticism as was made of the taxpayer’s argument in Inwards, namely that the scheme and purpose of the EIS regime does not permit one to ignore the subscription for one instrument (the Loan Notes) and apply it as if there had been a subscription for another instrument (the conversion shares).  And certainly it does impermissible violence to the language of TA 1988, section 289(1)(b) (and TCGA 1992, Schedule 5B, paragraph 1(2)(f)) if the term “shares”, where it appears in those provisions, was construed so as to interpolate the words I mention above.  The Loan Notes are not a deferred share subscription agreement.  Put shortly, the Loan Notes and the shares are separate instruments.  The Loan Notes and the conversion shares give entirely separate rights and obligations to the subscribers on the one hand and the issuing company on the other.  The Loan Notes comprise a liability which rank ahead of liabilities owed to shareholders.  Thus Loan Note subscribers take a lesser risk than subscribers for shares.  This explains why Parliament (at the material time) did not give relief under the EIS regime for the subscription of loan notes, albeit convertible loan notes, but did give relief for subscription for ordinary shares.

138.	Neither do I find it convincing that the subscription of Loan Notes should, in the commercial circumstances of this appeal and the relevant facts, simply be ignored as commercially meaningless, so that a subscription for the Loan Notes (for cash) should, in the round, as it were, be seen as a subscription (for cash) for the conversion shares.  Mr Sealey’s evidence was particularly relevant here.  As I observed above, in response to a question from me, Mr Sealey said that the pricing of the par value of the conversion shares was set at a price which anticipated conversion because none of the Loan Note subscribers anticipated repayment in cash.  This shows (and I find) that the subscribers for Loan Notes recognised that they were indeed subscribing for Loan Notes rather than shares when the Loan Notes were issued on 25 May 2001 and that the subscribers for the Loan Notes recognised that they had a legal right to call for the repayment of the debt in cash, albeit that they did not expect to be repaid in cash on the Loan Notes but anticipated that they would take conversion shares instead.  The fact remains that Mr Sealey’s evidence demonstrates peradventure that all of the subscribers for the Loan Notes recognised that they were subscribing for debentures in the form of the Loan Notes and not for shares, albeit that they expected to receive shares ultimately on conversion.  The Loan Notes were exactly that.  I repeat that the Loan Notes cannot be recategorised as a deferred share subscription agreement (which would have prohibited any repayment of subscription funds in cash and would have obliged the subscribers to take shares).  And although the first tranche of conversion shares was issued on 1 June 2001 about a week after the subscription for the Loan Notes, the second transfer of conversion shares was issued on 26 September 2001, some four months after that time.  The Loan Notes cannot be dismissed as transitory instruments which should be ignored in applying the EIS regime.  Contrast Inwards, where the subscriber for shares merely subscribed cash for shares before the shares were issued, so that a debt arose between the issuing company and the subscriber as a mere incidence of the cash injection prior to the share issue.  (paragraphs 49 to 51 of the Decision).  Here, as I have observed already, the Loan Notes clearly created express debtor obligations on the part of Optos, which were separate to the issue of the conversion shares (which issue was itself contingent on the subscribers for the Loan Notes taking shares rather than a repayment of the debt). 

139.	Since the subscription for the Loan Notes cannot be seen to be a deferred subscription for the conversion shares and no fresh money was raised on the issue of the conversion shares, the conversion shares cannot be said to have been issued in “order to raise” money.  The conversion shares were issued because Optos could not afford to repay the debt in cash and the Loan Notes subscribers recognised this and opted to take the conversion shares instead of cash.  That is the evidence.  The conversion shares were not issued “in order to raise money”.  The conversion shares were issued “in order” to save Optos from having to find cash it did not have.  In other words the conversion shares were issued to prevent Optos from having to pass over money in repayment of the debt on the Loan Notes.  That is not the same thing as “raising” money, that is, securing additional funds.  My conclusion is consistent with the purpose of the EIS regime (both for income tax and CGT) which is to give relief for additional investment into qualifying companies (see Inwards (paragraph 44)).  The issue of the conversion shares was not the making of any additional investment by the Loan Note subscribers.  

140.	It follows that I reject Mr Thornhill’s contention that the conversion shares were issued in order to raise money.  I accept Mr Young’s argument to the contrary.  This means that TA 1988 section 289(1)(b) and TCGA 1992, Schedule 5B, paragraph 1(2)(f) were not satisfied in relation to the conversion shares.

The Use of Money Issue

141.	Put shortly, I find as a fact that the £1,053,385.79 was transferred by Optos to Inc on 3 September 2001 (that is before the conversion of the shares in the second tranche of the conversion on 26 September 2001).  I also accept Mr Stevens’ and Mr Sealey’s evidence that the reason for the transfer to Inc was to escape a potential arrestment of these funds in Optos’ hands and so it was a temporary arrangement under which it was expected and intended that Inc would return the funds to Optos.  As I have observed above, the provisions of section 289(1)(c) and (d) [and TCGA 1992, Schedule 5B paragraph 1(2)(g) and (h)] require that the funds be used by Optos as part of its trade in the United Kingdom within 12 months of the date of issue of the conversion shares (as to 80%) and within 2 years (as to any balance as yet unused for this purpose).  There is, quite simply, no evidence as to if and when these funds were returned by Inc to Optos.  I cannot place any confidence in Mr Stevens’ evidence in relation to these transferred funds, since Mr Stevens’ recollection altered dramatically over the course of the hearing.  That is not to say that I find Mr Stevens an unreliable witness.  I have already said that I find him generally a reliable and attractive witness.  However I do record that I placed no reliance on Mr Stevens’ evidence in relation to these transferred funds in relation to any retransfer since his recollections here are clearly clouded.  Mr Sealey’s evidence was that the funds must have been retransferred by Inc to Optos since Optos needed the money.  Mr Sealey’s evidence was also that some of the funds were used while Inc held the funds to satisfy Optos’ liabilities because Optos had liabilities that could not be satisfied in any other way.  However, Mr Sealey accepted, when cross-examined by Mr Young for the Crown, that Mr Sealey had responsibilities for the group at a strategic level only.  Mr Sealey did not have day to day involvement with either Optos or Inc.  Mr Sealey accepted that he could not speak to the precise mechanics of the day to day running of either Optos or Inc.  This means that Mr Sealey’s supposition that Inc must have retransferred the funds within the time limits relevant for EIS relief and that Inc used part of the relevant funds to satisfy Opto’s liabilities while Inc held these funds are both vulnerable to Mr Sealey’s acceptance, under cross examination, that Mr Sealey had strategic rather than day to day involvement with the Group.  I have recorded above that Counsel for the Crown quarrelled with Mr Sealey’s proposition that Inc must have retransferred these funds to Optos on the basis that Mr Sealey himself accepted that he had no day to day involvement with the running of the group.  I also record that Counsel for the Crown did not, as I understand it, quarrel with Mr Sealey’s proposition that Inc spent some of these funds on meeting Optos’ liabilities.  So far as any purported retransfer of funds is concerned I do not find there to have been any such retransfer within the time limits relevant for EIS relief which has been established by Optos.  Other than Mr Sealey’s evidence on which I place little weight for the reasons put to me by Mr Young (that it, Mr Sealey had little involvement in the running of the group), there is no other evidence which Optos can found on at all in relation to a purported retransfer of these funds by Inc to Optos.

142.	As for Inc’s expenditure on meeting Optos’ liabilities out of these funds I have already acknowledged that the Crown seems to accept this.  But it is for me to make a finding of fact and I find that Mr Sealey’s lack of day to day involvement with the Group means that Mr Sealey cannot have a sufficiently precise recollection of how Inc spent part of the funds transferred to it.  If this case goes further the parties can proceed on the basis that it is common ground that Inc so used part of the funds Optos transferred to it.  But I do not find this as a fact.  No invoices were produced.  No other evidence was produced to support this proposition of fact.  Neither was this proposition in the Agreed Statement of Facts.  In any event I record that the Crown does not accept that Inc spent a sufficient proportion of the funds on Optos’ behalf within the time limits specified in TA 1988, section 289(1)(c) and (d), TCGA 1992, Schedule 5B, paragraph 1(2)(g), (h) and that it was no part of Optos’ case that Inc had done so.  

143.	Neither can I make any inference as to any retransfer or expenditure from the accounts, for the accounting periods ended 30 September 2001, 2002, and 2003, which were put before me.  They simply do not reveal any retransfer of funds by Inc to Optos within the times specified in TA 1988, section 289(1)(c), (d) [and TCGA 1992, Schedule 5B paragraph 1(2)(g) and (h)].  In each case a loan by Optos to Inc of £768,100 is recorded in the accounts (see respectively note 9 to the 2001 accounts and note 10 to the 2002 and 2003 accounts).  Loans owned by Group companies to Optos have increased over the years (see note 12 to each of the 2001 accounts, the 2002 accounts and 2003 accounts) which does not (put at its lowest) support any contention of a retransfer of funds by Inc to Optos.  And nothing appears in the accounts for “related party transactions” (see note 26 for the 2001 accounts, 2002 accounts and the 2003 accounts).

144.	Indeed, the reason given for the initial transfer of funds by Optos to Inc (the potential arrestment of funds in the hands of Optos) makes it surprising that there is no record of any retransfer of these funds by Inc to Optos.  Given the terms of the e-mail from Optos to Inc (see above) which made it plain that the reason for the (temporary) transfer of funds by Optos to Inc meant that Inc should not spend these funds (except presumably as directed by Optos), I would have expected some communication between Optos and Inc on a retransfer.  The absence of any evidence of the retransfer makes it even more difficult for Mr Thornhill to demonstrate, on the balance of probabilities, that the funds were indeed retransferred from Inc to Optos by 26 September 2002 (as to 80%) and 26 September 2003 (as to the balance of 20%) and used by Optos for its qualifying activities in the meantime.  This is especially so given that the burden of proof to make good propositions of fact is on Optos (Taxes Management Act 1970, section 50(6)).  I record that is was no part of Mr Thornhill’s case that Inc held the relevant funds as Optos’ nominee (and in any event Optos would have had to demonstrate that Optos had used the money for the purposes of  its qualifying trade even if Inc had been a nominee).

145.	I should also add that I find it conceptually difficult to conceive of the conversion shares being subscribed wholly for cash within TA 1988, section 289(1)(a) and TCGA 1992, Schedule 5B, paragraph 1(2)(a) when, prior to the issue of the second tranche of conversion shares on 26 September 2001, over £1 million of the cash subscribed for by the Loan Note subscribers had already been transferred to another person (Inc).  It seems to me to demonstrate even more clearly that it cannot be said that the cash subscribed for the Loan Notes was in truth subscribed for the conversion shares in relation to the raising money issue.

The Receipt of Value Issue

146.	I consider that the issue of the conversion shares represented a return of value within TCGA 1992, Schedule 5B, paragraph 13(2).  Paragraph 13(2)(b) applies if there is a repayment of a debt “in pursuance of arrangements for on in connection with the acquisition of shares” where the debt was incurred The terms of the Loan Notes themselves comprise “arrangements” whereby Optos incurred a debt to the Loan Note subscribers and the conversion shares would be issued if the debt was not repaid in cash.  If Mr Thornhill was correct in his contention that the subscription for the Loan Notes was properly viewed as a subscription for the conversion shares, there could be no return of value.  But I have rejected this contention for the reasons I give above in relation to the raising of money issue.  And I repeat that this case is in stark contrast to Inwards, where the “arrangements” could not be said to have any repayment of a debt as a feature separate to the subscription for shares.  Here I repeat that the Loan Notes created express debtor obligations which were separate to the issue of the conversion shares.  So I must address whether the issue of the conversion shares was indeed on receipt of value for the Loan Note subscribers.

147.	The conversion shares were issued as fully paid up.  Thus the full subscription price for the conversion shares must have been paid.  The short point is whether part 4, paragraph 3 of the Schedule to the Loan Notes which simply obliged Optos to issue the conversion shares as “fully paid up” if the Loan Note subscribers elected to take these conversion shares, means that the par value of conversion shares was paid by a setting of the money debt on the Loan Notes against the amount which must be paid by the holders of the conversion shares to allow them to be issued as fully paid up, or (alternatively) whether the subscription price on the conversion shares was paid by the Loan Note subscribers cancelling that money debt, that is, waiving their rights to ask for repayment in cash, which waiver had a monetary value equal to the subscription price otherwise due on the issue of the conversion shares.  Frankly this issue is academic.  If there was a set off amounting to a repayment of the debt, there is a return of value within TCGA 1992, Schedule 5B, paragraph 13(2)(b).  If, on the other hand the consideration for the conversion shares was the waiver of the debt on the Loan Notes, the conversion shares cannot be said to be issued wholly for cash within TA 1988, section 289(1)(a), TCGA 1992, Schedule 5B, paragraph 1(2)(a) and EIS relief is again denied.  But since I have had the benefit of submissions I will decide the point, which may be of assistance if this point becomes relevant on any appeal.

148.	The Loan Notes are governed by Scots Law.  I should therefore say something about the notion of “set off” in Scots Law.  The traditional Scots term is “compensation”.  The phrase “set off” derives from England (Bell Commentaries II, 119) although it is now in common use in Scotland.  The phrase “set off” covers both compensation and the balancing of accounts in bankruptcy: Laing v LA 1973 SLT (Notes) 81: (see McBryde “Law of Contract in Scotland (second edition) paragraph 25-32).  Compensation is governed by the Compensation Act 1592.  Compensation is not identical to English law notions of set off.  In English law, set off can apply to closely linked cross debts as a matter of equity.  Such equitable set off operates ipso jure and independent of any pleadings: Hanak v Green [1958] 2 QB 9.  The cross debts may be liquid or illiquid: Federal Commerce and Navigation Co Ltd v Modena Alpha Inc [1978] 1 QB 972, 982.  English equitable set off amounts to payment of both cross-debts: Mellham Limited v Burton [2006] STC 908.  Where cross-debts are not sufficiently closely linked, English law, in the absence of consent, permits “legal set-off” (as opposed to equitable set off) of the cross-debts by one party against the other but only if the two cross-debts are subject to the same jurisdiction.  So legal set off in England in the absence of consent cannot operate where one debt is enforceable before one arbitration tribunal and the other debt is enforceable before another arbitration tribunal: Aectra Refining and Manufacturing Inc v Exmar NV [1994] 1 WLR 1634, [1995] 1 WLR 526.

149.	Scots compensation is closer (but not identical) to English legal set off than to equitable set off.  Compensation does not operate ipso jure.  In the absence of pleading there must be an agreement that compensation will operate: Cowan v Gowans (1878) 5 R 581.  The cross debts must be of the same nature (Bell Commentaries II 122) but need not be due at the same time (Smith v LA 1980 SC 227 at 231).  The debts must be liquid  (in contrast to English equitable set off where the debts may be illiquid): Bell Commentaries II 122.  And since if compensation is sustained it has retrospective effect (so that, for example, interest is no longer due: Inch v Lee (1903) 11 SLT 374), compensation amounts to payment of the respective cross debts.  

150.	In this case the Loan Notes are indeed an instrument which provides that the parties agree to the operation of compensation.  I consider that the proper construction of the mechanism by which the conversion shares were raised (in particular Part 4 of the Schedule to the Loan Notes) is that the money debt on the Loan Notes was set against the subscription price on the conversion shares so that compensation (set off) applied on the issue of the conversion shares (which in turn led to a repayment of the debt on the Loan Notes, so that there was a return of value to the subscribers within TCGA 1992, Schedule 5B, paragraph 13(2)(b)).  The money debts on the Loan Notes on the one hand and the subscription price for the conversion shares are money debts giving rise to a debtor-creditor relationship.  They are of the same nature.  The issue of the conversion shares means the cross debts are due at the same time.  Both debts are self evidently liquid.

151.	The questions in this appeal is whether the Loan Notes and in particular Part 4, paragraph 3 of the Schedule operates as an agreement between the Loan Notes subscribers and Optos that compensation will operate to set the subscription price of the conversion shares against the debt owed to the subscribers on the Loan Notes.  I consider that it does.  I do not consider it plausible that the subscription price for the conversion shares, issued as fully paid up, was paid in consideration of the cancellation (waiver) of the money debt on the Loan Notes.  Nothing in the terms of the Loan Notes mention anything at all about the subscribers waiving the money debt due before the issue of the conversion shares.  The Loan Notes simply oblige the issuer (Optos) to issue fully paid up conversion shares if the subscribers so elect.  Thus the terms of the Loan Notes are more consistent with the conversion shares being issued in consideration of the setting of the money debt due on the Loan Notes against subscription price on the conversion shares than with the subscription price having been paid by the way of a waiver of that money debt.

152.	I consider that the distinction made in the terms of the Loan Note between repayment and conversion in clause 9.1 and clause 9.2 irrelevant.  This distinction in clause 9 envisages a repayment of the principal amount due on the Loan Notes in cash, (or money’s worth) without conversion or conversion into ordinary shares.  They say nothing at all about how the conversion is to be effected, and in particular whether or not the subscription price for the shares is to be satisfied by set-off against the liability owed by Optos on the Loan Notes.  I accept Mr Sealey’s evidence that on subscription for the Loan Notes none of the Loan Note subscribers expected to be repaid in cash at all.  They all expected to convert the money debt owed by Optos to the Loan Note subscribers into the conversion shares.  Indeed this is what happened.  No Loan Note subscriber was repaid in cash or any other form of money’s worth.  All of the Loan Note subscribers converted their money debts owed to them by Optos into shares.  But again this evidence says nothing at all about whether or not a convertible Loan Note where conversion is anticipated, effects the issue of the conversion shares by way of set-off of the debt due on the Loan Note against the subscription price on the conversion shares, or, alternatively, that conversion is effected by the Loan Note subscribers forbearing to take the money debt (that is, waiving the money debt) in consideration of the conversion shares being issued to them, as fully paid up.

153.	Quite apart from the notion of compensation, it seems to me that the Loan Note subscribers and Optos intended that the debt on the Loan Note be set against the subscription price on the conversion shares, rather than have that subscription price be paid out of profits arising to Optos on a waiver of that debt (by the subscribers electing not to take a cash repayment).  It seems to me that a Loan Note which is drafted expressly as a convertible Loan Note, on its terms, effects the issue of the conversion shares by way of set-off of the debt against the subscription price, unless there are clear words to the contrary.  The issuing company has assumed an unconditional obligation to issue shares as fully paid up on an election by the subscribers for the Loan Notes.  Set off of the subscription price against the debt owed on the Loan Notes is the most obvious mechanism to allow the issuing company to issue the conversion shares.  And it is strained and commercially unrealistic to treat the election to take fully paid up shares rather than have a debt repaid in cash as an implied waiver of the debt, in the absence of any words indicating such a waiver  After all, the issue of shares otherwise than for cash attracts, in certain circumstances, company law obligations which are simply not referred to in the Loan Notes here and which I would expect to be referred to if, on a conversion of a money debt in to shares, the shares were issued as paid up by reason of a waiver of the money debt.  

154.	I find that the terms of Part 4, paragraph 3 of the Schedule to the Loan Notes, properly construed, effects a set-off (by compensation) of the money debts owed by Optos to the Loan Note subscribers on the issue of the conversion shares, which, in turn, means that there was a return of value within Schedule 5B, paragraph 13(2)(b) on the issue of the conversion shares.  As it happens, I should record, for completeness, that this does not mean that the conversion shares were issued wholly for cash.  The debt was repaid by way of set-off.  It was not repaid in cash.  Set-off by way of compensation avoids the need to circulate cash.  “Repayment” does not equate to “repayment [in cash]”.

155.	As it happens, if I had accepted Mr Thornhill’s contention that the true construction of Part 4, paragraph 3 of the Schedule to the Loan Notes was that the Loan Note subscribers decided not to enforce their money debts, so that there was no repayment of those money debts but rather the subscribers took the conversion shares issued as fully paid up as consideration for that waiver, there would still have been a return of value within paragraph 13(2)(c) [return of value on the “giving up” of a right to “any debt” where the debtor company makes a “payment”].  The issue of the conversion shares required payment by the Loan Note subscribers of an amount equal to the par value of the conversion shares.  The Loan Note subscribers clearly did not pay any money to Optos whatsoever for the issue of the conversion shares other than agreeing not to enforce Optos’ liability to them under the Loan Notes, if Mr Thornhill’s construction of Part 4, paragraph 3 of the Schedule to the Loan Notes had been correct (which I repeat I do not consider to be the case).  But that means that the Loan Note subscribers “gave up” their rights to the money debts owed to them by Optos and received fully paid up shares in consideration for “giving up” that right.  The issue of shares, fully paid up, where no further subscription price has been paid other than the “giving up” of a right against the issuing company in relation to a debt owed by the issuing company to the recipient of the conversion shares is, to my mind, a “payment” within paragraph 13(2)(c).  “Payment” is a term of wide import: Charter Reinsurance Co Ltd v Fagan [1997] AC 313, 391.  And it does not assist the Loan Note subscribers to say that the issue of the conversion shares as fully paid up does not constitute a “payment” since they gave full consideration for the shares in the form of agreeing not to enforce the money debt comprised in the Loan Notes against Optos.  “Payment” can (and usually is) made for full consideration.  As soon as the Loan Note subscribers accept that they agree not to enforce the money debt against Optos they have “given up” their right to the debt owed by Optos to them within paragraph 13(2)(c) and the issue of conversion shares issued as fully paid up in consideration for such “giving up” is a “payment” which is “for” the “giving up” of such rights.  And Schedule 5B, paragraph 13(2)(b)(ii) [no receipt of value if a debt is repaid in consideration of the extinguishment of a debt] does not assist, since paragraph 13(2)(b)(ii) is referring to the repayment of one debt, it seems to me, in consideration of the extinguishment of another separate debt.  But even if I am wrong about this, my conclusion on the point concerning set off means that there is a receipt of value in this appeal.

156.	However, I repeat that the most obvious construction of the conversion mechanism in the Loan Note is that the money debt owed by Optos to the Loan Note subscribers was set off by compensation against the subscription price for the conversion shares.

157.	Finally, I should say, for completeness only, that I do not consider that TCGA 1992, Schedule 5B, paragraph 13(2)(a) [return of value where the issuing company “repays, redeems or repurchases any of its … securities …”] is relevant.  Paragraph 13(2)(a) made a brief appearance in the Crown’s submissions.  Paragraph 13(2)(a) is specifying different types of alienation which amount to a realisation by an individual of shares or securities in the issuing company.  This is clear from the composite phrase “repays, redeems or repurchases …” and indeed the second limb of paragraph 13(2)(a) which refers to the “… giving up [a] right to any of the company’s share capital or any security on its cancellation or extinguishment”.  Paragraph 13(2)(a) is thus contemplating a realisation of a share or a security or a realisation of an entitlement to hold a share or a security (“right to” a share or security), both of which amount to a return of value.  A conversion of a debt owed on a Loan Note into shares does not amount to any such realisation.  The Loan Notes are not “securities” within TCGA 1992, section 132(3).  For example, they are interest free (clause 3).  But I should also say that I accept that the term “security” in paragraph 13(2)(a) is simply a synonym for a debenture, that is, it takes the wide meaning of “security” used in cases such as Williams –v- Singer 7 TC 387.  I see no reason whatsoever, in the context of provisions which seek to deny relief where there is a return of value to construe the term “security” in a narrow manner, such as, for example, in the context of TCGA 1992, Section 132(3) [debt on a security], where the term “security” is a synonym for an investment capable of giving rise to a gain (so that allowable capital losses may only be realised on such debts on a security, since Parliament could not have intended to give allowable capital losses in respect of securities which were incapable of giving rise to chargeable gains).  The context of the return of value provisions in paragraph 13(2)(a) is very different.  Parliament here wishes to deny CGT relief in circumstances where an individual who subscribes for eligible shares in an issuing company does not in truth make an additional investment at all, because he has effectively retrieved his investment by realising shares or securities (or an entitlement to acquire such shares or securities).  Thus “securities” should not be given a restricted meaning.

8.	CONCLUSION

158.	This appeal is, as I have said, a representative appeal.  But I have also observed that whereas the leasing issue necessarily applies to all of the shares issued by Optos for which EIS relief for income tax and CGT had been claimed, the raising of money issue, the use of money issue and the receipt of value issue relate to the conversion shares alone.  I was not addressed as to the parties’ views on the effect on EIS relief for income tax and CGT purposes in relation to shares issued by Optos other than the conversion shares if the Crown succeeded on the raising of money, the use of money and receipt of value issues.  So I record that I consider Mr Thornhill to be correct and I find for Optos in relation to the leasing issue in principle.  I would allow the appeals which are governed by this representative case to the extent that EIS relief for income tax and CGT purposes is dictated by the leasing issue alone.  And I record that I consider Mr Young to be correct and I find for the Crown in relation to the raising of money issue, the use of money issue and the receipt of value issue in principle.  I would therefore dismiss the appeals which are governed by this representative case (including, of course, this representative case) to the extent that EIS relief for income tax and CGT purposes is dictated by these issues.  I leave it to the parties to apply my decision to each of the appeals which stands behind this representative case.  I should record that I find my conclusion unattractive, in relation to the raising of money issue and the receipt of value issue.  This is not a tax avoidance case.  The Group undertakes activities which are worthwhile and not discouraged by statute.  And it is not as if the subscribers sought to disguise the subscription for Loan Notes as a subscription for the conversion shares.  But the way in which the financing of Optos took place in relation to the Loan Notes issue was misconceived so far as attracting EIS relief was concerned and means that Optos has had to rely on arguments which I find to be unconvincing.  

I J GHOSH
SPECIAL COMMISSIONER

RELEASED: 18 August 2006

SC 3026/2005