SPC00598

SCHEDULE A – indemnity payment made by non-resident investor for termination of swap transaction in connection with the early repayment of an onerous loan – whether capital or income – capital because the payment was made to enable the repayment of the loan 
INCIDENTAL COSTS OF OBTAINING LOAN FINANCE – TA 1988 s.77 – whether indemnity payment was an incidental cost of obtaining finance – yes – whether paid in consequence of changes in the rate of exchange between currencies – yes, in part – whether a premium – no – appeal allowed in part

THE SPECIAL COMMISSIONERS

	KATO KAGAKU CO. LIMITED	Appellant

	- and -

	THE COMMISSIONERS FOR HER MAJESTY’S
	REVENUE AND CUSTOMS	Respondents

		Special Commissioner: 	DR JOHN F. AVERY JONES CBE 

Sitting in public in London on 26 and 27 February 2007

Jonathan Schwarz , counsel, instructed by Deloitte & Touche LLP, for the Appellant

David Ewart QC, counsel, instructed by the Acting Solicitor for HM Revenue and Customs for the Respondents

© CROWN COPYRIGHT 2007

DECISION

1.	This is an appeal by Kato Kagaku Co Limited, a Japanese company, against amendments made on 25 February 2005 to its income tax returns for the years ending 5 April 1997 to 5 April 2003 on the ground that the payment in issue in this appeal is deductible and accordingly the losses carried forward for such periods are different from that stated in the closure notices.  The Appellant was represented by Mr Jonathan Schwarz, and the Revenue by Mr David Ewart QC.
2.	The Appellant is a Japanese resident company which borrowed sterling for 10 years from the UK branch of a Japanese bank to finance the purchase of land in the UK.  The bank borrowed dollars in the market and entered into a swap transaction as a result of which it obtained sterling to lend to the Appellant at a formula rate of interest that depended on the rate of exchange between yen and sterling.  Following movements in the exchange rate the interest rate became higher than the rental yield from the property and the loan was repaid in accordance with the borrower’s entitlement to repay early, which caused an automatic termination of the swap transaction.  By the loan agreement the Appellant indemnified the bank against liability on termination of the swap transaction resulting in a payment of about £21m.  The issue is the deductibility of the indemnity payment on general principles and under s 77 of the Taxes Act 1988.
Facts
3.	There was an agreed statement of facts as follows: 
(1)	The Appellant is a company which is incorporated and resident in Japan and not resident in the UK for tax purposes.
(2)	In 1989 the Appellant engaged the First Boston Corporation to evaluate the possible purchase of commercial property in London, as a result of which Bush House, Aldwych, London (“Bush House”) was purchased in  December 1989 at the price of £130,000,000.
(3)	Bush House has at all material times been let on a commercial basis to third party tenants thereby generating UK source rental income chargeable to tax (for all relevant periods) under Schedule A.  The Appellant is not resident for tax purposes in the UK; accordingly, the net rental income received by it from the letting of Bush House is chargeable to income tax (and not corporation tax).
Financing of the Purchase
(4)	The Appellant financed the acquisition of Bush House in part with funds borrowed from the London branch of The Tokai Bank Limited (“the Bank”), a banking company incorporated in Japan, in the amount of £95,250,000. At all relevant times the London branch of the Bank was carrying on a bona fide banking business in the UK for the purposes of s.349 Income and Corporation Taxes Act 1988.
(5)	The sum of £95,250,000 (“the Loan”) was made available in Sterling to the Appellant by the Bank for the acquisition of Bush House under the terms of a Facility Agreement dated 7 December 1989 (“the Agreement”). Under the terms of the Agreement the Loan was repayable in Sterling in full after 10 years. The Appellant was required by the Agreement to enter into a debenture with the Bank (“the Debenture”) in the form set out in the Fourth Schedule to the Agreement under which Bush House was given as security for the Loan.
(6)	On 12 December 1989, the Bank advanced to the Appellant the principal amount of ₤95,250,000 pursuant to the Agreement and the Appellant executed the Debenture.
(7)	The Bank offered an interest rate based on a variable formula (“the Variable Formula Rate”) as follows: 
		[0.3  x  227.9/FX]  -  0.256
where “FX” refers to the number of Yen to the pound exchange rate on the fourth business day preceding the date on which interest was payable.  Under the Variable Formula Rate, as Sterling rose in value against the Yen the interest payable under the Variable Formula Rate would fall, and as Sterling fell in value against the Yen the interest payable under the Variable Formula Rate would rise. 
(8)	If interest had been payable at drawdown, the result of the Variable Formula Rate would have been interest at 4.4% per annum. 
(9)	Interest on the Loan was payable annually in arrears.  
The Swap
(10)	The ability of the Bank  entered in to an arrangement involving (i) a US$150,304,500 borrowing by the Bank in the Eurodollar market, the interest on which was based on US$ LIBOR, and (ii) the swap described below (“the Swap”).
(11)	Accordingly, making the Loan was conditional on, among other things, execution and delivery of a Swap Supplement (“the Swap Supplement”) evidencing the Swap, in form and substance satisfactory to the Bank.  The Swap is documented in the pre-existing Currency/Rate Swap Master Agreement (“the Swap Master Agreement”) between the Bank and Security Pacific National Bank (“Security Pacific”) and incorporates (except so far as modified or excluded) the terms of the International Swap Dealing Association Inc. Code of Standard Wording, Assumptions and Provisions for Swaps, 1986 Edition (the “Code”).
(12)	  In addition, the Appellant had to indemnify the Bank against any costs or expenses incurred by the Bank in a variety of circumstances: if the Swap were entered into but the Loan was not drawn down; if the Bank and the Appellant were to renegotiate or terminate the Loan where the Swap was terminated; and if the Swap were terminated early for any reason except default by the Bank under the Swap.  
(13)	On 8 December 1989 the Bank entered into the Swap Supplement thereby hedging its exposure resulting from the interest it was to receive from the Appellant under the Variable Formula Rate provided for in the Agreement and its own interest obligation on its borrowing based on US$ LIBOR.    
(14)	Under the Swap:
(a)	 The Bank paid US$150,304,500 to Security Pacific on 12 December 1989 and at the same time Security Pacific paid the Bank ₤95,250,000.
(b)	 On an annual basis, the Bank paid Security Pacific an amount in Sterling equal to interest which would accrue during the one year period on ₤95,250,000 at the Variable Formula Rate.
(c)	Every six months, Security Pacific paid the Bank an amount in US dollars equal to interest which would accrue during the six month period on US$150,304,500 at a rate  equal to 0.3% over the six month US$ LIBOR.
(d)	On 12 December 1999 when the Swap was to terminate, the Bank was required to pay Security Pacific ₤95,250,000, and Security Pacific was required to pay the Bank $150,304,500.
(15)	From the Bank’s perspective, the net result was that it was earning a 0.3% margin on a US$150,304,500 extension of credit.  From the Appellant’s perspective, it was borrowing ₤95,250,000 at the Variable Formula Rate.
Payment of Interest by the Appellant
(16)	In January 1991, the Appellant accepted the Bank’s offer of a four year arrangement for a fixed interest rate at 5.2% per annum in place of the Variable Formula Rate for the interest payments from December 1991 to December 1994.  
Yen Loan 
(17)	By contrast, in late 1996, interest on loans denominated in Yen had fallen well below the Variable Formula Rate.  Accordingly, at the Appellant’s request, the Bank and the Appellant agreed to replace the Loan with an approximately equivalent Yen denominated loan (the “Yen Loan”) in the amount of ¥17 billion with interest at  three months Euro-Yen LIBOR plus 0.5% (then totalling 1.031%) .
Payment in Respect of Swap Termination
(18)	Clause 18.4(ii) of the FA provided for compensation by the Appellant to the Bank for any payments by the Bank as a result of termination of the Swap:
18.4	The Borrower undertakes to indemnify the Bank against:
…
(ii)	any compensation payable to the Swap Counterparty [Security Pacific] as a consequence of any early termination of the Swap Transaction (save as a consequence of a default by the Bank).
(19)	The payment under Clause 18.4(ii) of the Agreement might arise in a number of circumstances, including (among others): voluntary termination of the Swap by the parties, regulatory issues in connection with the Swap, and prepayment of the Loan under Clause 8.1 of the Agreement (providing for prepayment of the Loan without penalty). 
(20)	On early termination of the Swap the Bank was required to pay compensation to Security Pacific.  If rates moved in the opposite direction, it would have been Security Pacific who would have been required to compensate the Bank. The Swap was terminated and the Bank was obligated to pay compensation to Security Pacific.  
(21)	The Bank provided to the Appellant the calculation of the compensation amounting to ₤21,100,092 the Bank would incur in connection with the termination of the Swap three years before maturity (see paragraph 9 below).
(22)	The compensation amount was based on the relevant interest amounts and was equivalent to the net present value (“NPV”) at to December 1996 of future swap payments which the Bank expected to make to Security Pacific over the remaining three-year term of the Swap, less the NPV of future receipts that Security Pacific expected to pay to the Bank over the same period. No amount was included on account of principal or currency.
(23)	This amount (the “Indemnity Payment”) became due from the Appellant to the Bank in accordance with clause 18.4(ii) of the FA.
Deduction of Interest and Payment in Respect of Swap Termination
(24)	Inland Revenue (as it then was) accepted that the interest paid by the Appellant on the Loan under the Variable Rate Formula, at the fixed 5.2%, and in Yen was deductible by the Appellant in computing its Schedule A profits.
(25)	The Appellant accounted for the Indemnity Payment in respect of swap termination in its UK branch accounts in accordance with normal UK accountancy practice and deducted the Indemnity Payment in computing its profits chargeable to income tax under Schedule A.
(26)	HM Revenue & Customs has denied the deduction for the Indemnity Payment in respect of swap termination. 
(27)	The Appellant has appealed against denial of the deduction.
4.	I head evidence (through an interpreter) by Mr Kazuo Minatani, the Appellant’s finance director who had been from 1989 to 1994 manager of the foreign trade group of the Bank, and as such was responsible for making the Loan on behalf of the Bank and responsible on behalf of the Appellant for its prepayment in 1996.  His witness statement was in English.  He explained that he understands written English for financial matters sufficiently to approve it, and that swap transactions are normally in English for which a direct translation to and from Japanese is difficult.  A witness statement by Mr Sadao Kato, the Appellant’s director in charge of international operations, was admitted unopposed. I find the following additional facts: 
(1)	The expected rental return on Bush House was about 7% per annum.  The Appellant naturally wanted to borrow in sterling to match the sterling asset but fixed 10 year sterling loans were at 12.8% interest and floating rates were between 15% and 16% interest.  The only way to obtain an interest rate of less than 7% was under the Variable Formula Rate which depended on the yen/sterling exchange rate and was risky.  Since the Bank did not have effective access to sterling it needed to borrow dollars at floating rate LIBOR in the Eurodollar market and enter into a swap with two elements: the first of the principal into sterling, and the second, an interest rate swap from six-monthly floating rate dollar LIBOR into the Variable Formula Rate.
(2)	The Variable Formula Rate set out in paragraph 3(7) above was expressed in outline in the Agreement with the figures to be filled in by a subsequent exhibit.  The exhibit is dated 8 December 1989, the same date as the swap agreement, to which the same figures are contained in a schedule.  The figure of 227.9 in the formula was the number of Yen to the pound at the date of the drawdown of the Loan.  The formula is equivalent mathematically to (30%*227.9/Ex) – 38.4% + 12.8%, which is how it was arrived at.  30% is three times the 10% yen fixed rate LIBOR for 10 years at the time; 12.8% is the sterling fixed rate LIBOR for 10 years at the time, and 38.4% is three times that rate.  The exchange rate (“Ex”) is expressed as the rate at which ¥6,512,242,500 can be acquired for sterling on each of the annual interest payment dates starting on 12 December 1990; that figure is interest at 30% on the yen equivalent of the Loan converted at ¥227.9=£1.  The interest rate was calculated at the end of each year.  If exchange rates did not move the initial Variable Formula Rate would have been 30-5.6=4.4%.  
(3)	For the first year to 12 December 1990 the formula produced an interest rate of 0.85%.  From 1991, when the exchange rate between yen and sterling had changed drastically, resulting in a much higher Variable Formula Rate, the Bank entered into a further four-year interest rate swap with Swiss Bank Corporation (but leaving the existing swap in place) providing for a fixed 5.2% interest rate from December 1991 to December 1994.  After that the Variable Formula Rate applied again and produced a rate of 18.368% due in December 1995 and 11.726% due in December 1996. At that point the Loan was prepaid and replaced by the Yen Loan.  At the date of prepayment of the Loan the exchange rate was ¥188.02 to the pound, as can be seen from the calculation in paragraph 9 below.  
(4)	The interest on the replacement Yen loan was three-month Yen LIBOR plus 0.5% (0.75% for 1999 and after) resulting in rates of 1.019% for 1997, 1.292% for 1998 and 1.039% for 1999.  
(5)	The Indemnity Payment was equal to 7.384% over these three years.
Documents
5.	The Agreement provides:
Clause 5.5: “The Borrower shall indemnify the Bank, on demand, against any loss or expense suffered or incurred by the Bank as a consequence of the Loan not being made on the date specified in the Notice of Drawdown by virtue of any condition to such drawdown not being fulfilled on or prior to such date. The Borrower hereby acknowledges that the Bank has entered into this Agreement on the basis that the Bank will obtain sterling in an amount sufficient to fund the Loan by a currency exchange under the Swap Transaction, and that accordingly any such loss or expense shall include any loss or expense (as certified by the Bank) incurred by the Bank under the Swap Transaction as a consequence of the Loan not being so made on the date specified in the Notice of Drawdown.”
Clause 6.3: “…the Borrower acknowledges that the Bank has entered into this Agreement on the basis that (a) the Bank will obtain sterling in an amount sufficient to fund the Loan by a currency exchange under the Swap Transaction and (b) the Bank will, throughout the term of the facility, pay amounts equal to the interest payments made by the Borrower pursuant to Clause 6.2 annually to the Swap Counterparty in exchange for six-monthly payments based on the prevailing US dollar LIBOR by the Swap Counterparty under the Swap Transaction.  Accordingly, if for any reason a notice of early termination of the Swap Transaction is served by the Bank or the Swap Counterparty under the Swap Agreement (save as a consequence of a default by the Bank thereunder and save for any termination of the Swap Transaction under the Swap Agreement consequential upon a prepayment of the Loan pursuant to Clause 8.1 [the consequences are set out, which are in summary that the Bank must certify the cost of a replacement swap having identical economic terms; and the Appellant can request the Bank to enter into the replacement swap, or convert the Loan into another currency, or prepay the Loan].”
Clause 8.1  “The Borrower may prepay the Loan in whole or in part, without penalty, on any Interest Payment Date, upon giving to the Bank not less than ten days notice of its intention to do so.  Prior to the giving of any such notice, the Borrower shall be entitled to request the Bank to provide the Borrower with an estimate of the amount of any loss or expense expected to be incurred by the Bank in respect of a corresponding early termination of the Swap Transaction if a prepayment were to be made by the Borrower hereunder at a time and in an account specified by the Borrower.  The Bank shall promptly consult with the Swap Counterparty and shall provide the Borrower with any such requested estimate as soon as reasonably practicable.”
Clause 8.4.  “Any prepayment made pursuant to Clause 8.1 shall be made together with interest on the amount prepaid to the date of prepayment and any other sums then due to the Bank hereunder…”
Clause 18.4(ii) is set out in paragraph 3(18) above.
6.	The Swap Supplement provides:
Clause 3.7: “In the event that all or part of the Loan is proposed to be prepaid on any date under the [Agreement], the [Bank] shall promptly notify Security Pacific thereof, specifying the amount and date of such proposed prepayment.  Each of Security Pacific and the [Bank] shall thereupon estimate (in accordance with paragraph 3.8 below) the payments which would be required to be made upon a corresponding termination of this Swap Transaction…”.
Clause 3.8: “Any notice confirming that a prepayment is to be made under the [Agreement] given pursuant to paragraph 3.7 above shall be deemed to be a notice designating an Early Termination Date in respect of all or part of this Swap transaction for the purposes of Section 4 of the [Swap Master] Agreement….”
These provisions apply notwithstanding section 4 of the Swap Master Agreement which provides that a party entitled to designate an Early Termination Date (defined in the Code) shall do so by giving 10 days notice to the other party of the Early Termination Date.  Clause 4 goes on to provide for payments to be made on designation of an Early Termination Date (i) if there is a Defaulting Party (defined in the Code), or (ii) if the Early Termination Date occurs as a result of a Termination Event.  Termination Event is defined in clause 2(xii) of the Swap Master Agreement to mean Illegality, Tax Event upon Substantial Likelihood of Gross-up, Change in Tax Law (all of which are defined in the Code), and certain substantial disposals of assets within clause 13. 
Statutory provisions
7.	The computation of income for Schedule A purposes is set out in s 21(3) of the Taxes Act 1988:
“(3) Except in so far as express provision to the contrary is made by the Income Tax Acts, the profits or gains of a Schedule A business and the amount of any loss incurred in such a business shall be computed as if Chapter V of Part IV applied in relation to the business as it applies in relation to a trade the profit or gains of which are chargeable to tax under Case I of Schedule D.”
In relation to Case I of Schedule D, s 74 provides:
“Subject to the provisions of the Tax Acts, in computing the amount of the profits or gains to be charged under Case I or Case II of Schedule D, no sum shall be deducted in respect of—
…
(f) any capital withdrawn from, or any sum employed or intended to be employed as capital in, the trade, profession or vocation, but so that this paragraph shall not be treated as disallowing the deduction of any interest.”
8.	Section 77 of the Taxes Act 1988 at the relevant time provided: 
“77 Incidental costs of obtaining loan finance
(1) Subject to subsection (5) below, in computing the profits or gains to be charged under Case I or II of Schedule D there may be deducted the incidental costs of obtaining finance by means of a qualifying loan or the issue of qualifying loan stock or a qualifying security; and the incidental costs of obtaining finance by those means shall be treated for the purposes of section 75 as expenses of management.
(2) Subject to subsections (3) and (4) below, in this section—
(a) “a qualifying loan” and “qualifying loan stock” mean a loan or loan stock the interest on which is deductible—
(i) in computing for tax purposes the profits or gains of the person by whom the incidental costs in question are incurred; or
(ii) under section 338 against his total profits; and
(b) “qualifying security” means any deep discount security, as defined by paragraph 1 of Schedule 4, in respect of which the income elements, as defined by paragraph 4 of that Schedule, are deductible under paragraph 5(1) of that Schedule in computing the total profits of the company by which the incidental costs in question are incurred.
…
(6) In this section “the incidental costs of obtaining finance” means expenditure on fees, commissions, advertising, printing and other incidental matters (but not including stamp duty), being expenditure wholly and exclusively incurred for the purpose of obtaining the finance (whether or not it is in fact obtained), or of providing security for it or of repaying it.
(7) This section shall not be construed as affording relief—
(a) for any sums paid in consequence of, or for obtaining protection against, losses resulting from changes in the rate of exchange between different currencies; or
(b) for the cost of repaying a loan or loan stock or a qualifying security so far as attributable to its being repayable at a premium or to its having been obtained or issued at a discount.
(8) This section shall not apply for the purposes of corporation tax.”
Calculation of the Indemnity Payment
9.	The calculation of the Indemnity Payment was as follows:
“1. Coupon swap unwinding
[Box 1]
Date	Principal GBP side	Disc factor	Original transaction 	 	
 	 	 	Rate	Interest	NPV	
12-Dec-97	£95,250,000	0.930475	38.40%	36,576,000	34,033,053.60	
12-Dec-98	£95,250,000	0.860410	38.40%	36,576,000	31,470,356.16	
12-Dec-99	£95,250,000	0.794725	38.40%	36,576,000	29,067,861.60	
 	 	 	 	NPV total	94,571,271.36	
[Box 2]
Date	Principal JPY side	Disc factor	Original transaction 	 	
 	 	 	Rate	Interest	NPV	
12-Dec-97	21,707,475,000	0.995524	30.00%	6,512,242,500	6,483,093,703	
12-Dec-98	21,707,475,000	0.984067	30.00%	6,512,242,500	6,408,482,940	
12-Dec-99	21,707,475,000	0.966730	30.00%	6,512,242,500	6,295,580,192	
	 	 	 	NPV total    19,187,156,835	
	GBP/JPY spot	188.02		£102,048,488.64	
				Cost (£)	7,477,217.28	
2.  GBP fixed loan unwinding
[Box 3]
Date	Principal	Disc factor	Original transaction 	 	
 	 	 	Rate	Interest	NPV	
12-Dec-97	£95,250,000	0.930475	12.80%	12,192,000.00	11,344,351.20	
12-Dec-98	£95,250,000	0.860410	12.80%	12,192,000.00	10,490,118.72	
12-Dec-99	£95,250,000	0.794725	12.80%	12,192,000.00	9,689,287.20	
 	 	 	 	NPV total	31,523,757.12	
[Box 4]
Date	Principal	Disc factor	Current market 	 	
 	 	 	Rate	Interest	NPV	
12-Jun-97	£95,250,000	0.966336	6.5229%	3,098,020.08	2,993,728.33	
12-Dec-97	£95,250,000	0.930475	6.8524%	3,272,396.47	3,044,883.11	
12-Jun-98	£95,250,000	0.895428	7.1921%	3,415,853.41	3,058,650.79	
12-Dec-98	£95,250,000	0.860410	7.3358%	3,503,246.46	3,014,228.29	
12-Jun-99	£95,250,000	0.827853	7.4007%	3,553,552.55	2,941,819.14	
12-Dec-99	£95,250,000	0.794725	7.5859%	3,583,090.75	2,847,571.80	
 	 	 	 	NPV total	17,900,881.46	
						
				Cost (£)	13,622,875.66	
						
				Total (£)	21,100,092.94	
[The references to Box 1 etc are my additions so that I can refer to each of them]”
Contentions of the parties
10.	Mr Schwarz, for the Appellant, contends in outline:
(1)	One must start with the terms of the documents read as a whole in their context: Spectros International plc v Madden [1997] STC 114, 138.
(2)	The Agreement permitted prepayment of the Loan without penalty.  The indemnity was a separate matter so that the Bank could not refuse repayment when tendered and if necessary would have to enforce the indemnity separately.  The Indemnity Payment was not to terminate the Loan; it was paid in consequence of the termination of the Loan.
(3)	The Indemnity Payment, while not representing interest was calculated entirely by reference to interest on notional principal sums.  It was treated as a revenue expense for accounting purposes.  The purpose of the Indemnity Payment must be determined at the time of payment: Vodafone Cellular Ltd v Shaw 69 TC 375, 435 “…the question whether a payment is capital or income must depend on the circumstances at the time when the payment is made.”  The purpose was to reduce the high interest rate that the formula produced.  It was a “cost of earning that income itself or performing the income-earning operations” per Viscount Radcliffe in Commissioner of Taxes v Nchanga Consolidated Copper Mines Ltd [1964] AC 948.
(4)	No capital asset was acquired, modified (as with the 40 year lease in Tucker v Granada Motorway Services Ltd (1979) 53 TC 92), or disposed of, for the Indemnity Payment.  No enduring benefit (as explained by Rowlatt J in Anglo-Persian Oil Co Ltd v Dale (1931) 16 TC 253, 262 to mean “a benefit which endures, in the way that fixed capital endures; not a benefit that endures in the sense that for a good number of years it relieves you of a revenue payment) was acquired or created by the Indemnity Payment.  It was irrelevant that the effect was to reduce the interest rate for a number of years.  Where no asset is acquired or disposed of the question whether there is an enduring benefit depends on whether the payment goes to the whole of the profit making apparatus, or whether it merely enables it to trade more profitably: IRC v Carron Co (1968) 45 TC 18.  Here the Appellant’s business was the same before and after the Indemnity Payment; it continued to derive rental income from Bush House.  The Loan was replaced by another loan from the Bank of the same value (but now denominated in yen) and subject to the same security with a far smaller interest rate; the interest rate would have been 10.76% under the formula if the Loan had continued but was now 1.031% under the replacement loan.
(5)	Nor was there a disposal of a liability.  While the Loan was a capital item the Indemnity Payment did not discharge the Loan.  It did not matter that the Indemnity Payment was made at the same time as a capital payment.  In Lawson v Johnson Matthey plc (1992) 65 TC 39 the payment of £50m to get rid of an obstacle to successful trading was a revenue payment even though it was associated with a capital asset.
(6)	The Indemnity Payment has the same nature as the sums which it represents: Ven den Berghs v Clark 19 TC 390 at 431 in which the contracts related to the whole of the taxpayer’s profit-making apparatus; and Vodafone Cellular Ltd v Shaw 69 TC 376.  Here it represents the Variable Formula Rate of interest that would be payable during the remainder of the Loan, less the payments to be made by Security Pacific.
(7)	In the loan cases, in Tubbs (Elastics) Ltd v Whitehead (1983) 57 TC 472 the payment that was held to be capital was for cancellation of a loan agreement and debenture which removed terms of the loan providing an option to subscribe and for the right to be informed about the business and released charges on all assets except for one property.  Beauchamp v F W Woolworth plc (1987) 61 TC 542 is distinguishable since here the loan was made and repaid in sterling.
(8)	On s 77 of the Taxes Act 1988, the Indemnity Payment was within the definition of “the incidental costs of obtaining finance” as being an incident of repayment.  Robson v Dixon (1972) 48 TC 527 at 534 interpreted “merely incidental” in the Schedule E rule relating to the place of performance of duties as “an activity (here the performance of duties) which does not serve any independent purpose but is carried out in order to further some other purpose.”  The Indemnity Payment did not represent a sum “paid in consequence of…losses resulting from changes in the rate of exchange between different currencies.”  There was no currency loss, merely a payment calculated according to a formula.  The Indemnity Payment was not a premium as understood in the context of loan transactions of a payment in excess of the amount borrowed required to me made on repayment in accordance with the terms of the loan.
11.	Mr Ewart QC for the Revenue contends in outline:
(1)	The Loan was a capital transaction, applying the test in Beauchamp v F W Woolworth plc (1989) 61 TC 542 in which Woolworths had borrowed Swiss francs on a five year loan, immediately converted them into sterling and had made an exchange loss when buying Swiss francs at the end of the period in order to repay the loan.  Hoffmann J expressed the principle:
“The exchange losses are allowable as deductions only if the borrowings were themselves part of he Company’s revenue transactions rather than accretions to the capital which it employed.”
He reversed the Special Commissioners in deciding that the loan was on capital account.  Lord Templeman, reversing the Court of Appeal, which had reversed Hoffmann J, agreed with Hoffmann J saying at p 581:
“Mr. Park [for the taxpayer] submitted that an asset or advantage which only endured for five years was not enduring, although a loan which endured for 10 years would be sufficiently enduring. But when a taxpayer borrows money for five years, he obtains an asset or an advantage which endures for five years and the authorities show that such a loan increases the capital of the taxpayer for that period. A loan is only a revenue transaction if it is part of the ordinary day to day incidents of carrying on the business.”
(2)	Here the Loan was for 10 years, although the Appellant could repay earlier.  It was for the express purpose of purchasing Bush House and was clearly for a capital purpose.  The indemnity giving rise to the Indemnity Payment was part of the consideration for the Loan and was an integral part of the Agreement.  The fact that the Indemnity Payment was computed by reference to interest payments on a notional principal was not relevant; that confuses how it was computed with the nature of the payment, which was capital.
(3)	On s 77, the Indemnity Payment was not “expenditure on fees, commissions, advertising, printing and other incidental matters” since it was not similar to the items listed and was not incidental (meaning subordinate) to the Agreement but part of it.
(4)	The Indemnity Payment was to indemnify the Bank against a loss on the termination of the swap transaction and that loss arose because of changes in the rate of exchange between different currencies within subs (7)(a).
(5)	The Indemnity Payment was a premium since the terms of the Loan provided by clause 18.4 of the Agreement for something in excess of the amount borrowed to be paid at the time of prepayment.
Reasons for the decision
Capital or income
12.	We are concerned with income tax as the Appellant is a non-resident company not carrying on a trade in the UK.  Schedule A income is computed on Case I principles, of which the most relevant one is that no deduction is given for capital expenditure.
13.	I start with my understanding of the calculation of the Indemnity Payment set out in paragraph 9 above.  This gives effect to the equivalent interest formula (see paragraph 4(2) above) of (30%*227.9/Ex) – 38.4% + 12.8%, in which 30% is three times the 10 year yen fixed rate LIBOR, 12.8% is the 10 year fixed sterling LIBOR and 38.4% is three times that rate.  Each of the terms of the formula are calculated separately so that the formula is represented by Box 2 (the division by the current exchange rate is done at the end but this makes no difference to the result) minus Box 1 plus Box 3 respectively.  Boxes 1 and 2 (headed coupon swap unwinding) represents the currency part of the interest rate swap, and boxes 3 and 4 (headed GBP fixed loan unwinding) represent the fixed to variable interest rate part, which I presume is why Box 3 is calculated separately rather than Box 1 being calculated at an interest rate of 25.6%.  In other words, Box 2 minus Box 1 plus Box 3 is the present value of the interest payments to be made by the Appellant (and the swap payments to be made by the Bank to Security Pacific) during the remainder of the Loan.  Box 4 estimates of the present value of the variable rate payments in dollars (but represented by sterling as a result of the currency swap of the principal) from Security Pacific to the Bank.  The Indemnity Payment is the difference between these two.
14.	The essential difference between the parties is that Mr Schwarz contends persuasively that the Indemnity Payment for termination of the swap transaction should be viewed separately from the prepayment of the Loan, which was made without any penalty in accordance with clause 8.1 of the Agreement; while Mr Ewart contends equally persuasively that the Indemnity Payment should be viewed as the cost of prepayment of the Loan.  If Mr Schwarz’s analysis is correct the Indemnity Payment represents an indemnity against a series of net income payments that the Bank would have made less the payments that it would have received if the swap had continued.  On that basis, there would be no related asset and no enduring benefit from the Appellant making the Indemnity Payment and so I agree with him that it would be an income payment.  If Mr Ewart’s analysis is correct the Indemnity Payment was made for terminating the Loan which, being a 10-year loan was clearly on capital amount as was the five year loan in Beauchamp v FW Woolworth plc; it was made pursuant to a contractual provision in the Agreement at a time when the Variable Formula Rate of interest was onerous, and so I agree with him that it would be a capital payment regardless of how it was calculated.  The key is therefore how the facts are analysed, just as it was in Lawson v Johnson Matthey.
15.	The fact that the Appellant could not prepay the Loan without also terminating the swap transaction does not of itself mean that Mr Ewart’s analysis is correct.  The same was true of the £50m loan and waiver and the transfer of the shares for £1 in Lawson v Johnson Matthey but that depended on the shares being fully paid and worthless but not a liability, and so the payment was not made to dispose of the shares.  As Lord Keith said at p.[1992] STC 466 at 468: 
“The transfer to the Bank of England of the share capital of JMB was not an end and purpose in itself, but was merely incidental to the purpose of achieving the rescue operation which was in fact achieved.  The injection of £50m into JMB was on a proper analysis not the payment of the price for getting rid of a burdensome asset, but a contribution required by the Bank of England towards its planned rescue operation, the rest of the funds needed for its being supplied by the Bank of England.”
Lord Templeman said at p 472
“In agreement with the General Commissioners and with the submissions forcefully made by Mr Park QC on behalf of the taxpayer company I have come to the conclusion that the £50m was paid, and paid solely, to enable the taxpayer company to be able to continue in business. The shares in JMB were fully paid and worthless. The shares were freely transferable and did not constitute a threat to anybody. The insolvency of JMB was a threat to the taxpayer company and £50m was paid to remove that threat. It is true that the Bank of England were not contractually bound to ensure that the creditors of JMB were satisfied but £50m was paid and accepted in the expectation, which was fulfilled, that the creditors of JMB would be satisfied and that in consequence the taxpayer company would be able to continue in business. It is true also that the Bank of England required that the taxpayer company should both contribute £50m to JMB and also transfer the shares in JMB to the Bank. But the £50m was not paid to persuade the Bank to take the shares. The £50m was paid to persuade the Bank to rescue JMB.”
Lord Goff said at p 475:
“But in these circumstances the payment cannot be described as money paid for the divestiture of the shares; it was rather a contribution to the rescue of JMB planned by the Bank, which was a prerequisite of the transfer of the shares in JMB to the Bank for a nominal consideration. As such it was, in my opinion, a revenue payment.
It is important to observe that the payment does not become a revenue payment simply because the taxpayer company paid the money with the purpose of preserving its platinum trade from collapse. That was the approach of the General Commissioners, which I do not feel able to accept. The question is rather whether, on a true analysis of the transaction, the payment is to be characterised as a payment of a capital nature. That characterisation does not depend on the motive or purpose of the taxpayer. Here it depends on the question whether the sum was paid for the disposal of a capital asset. I have come to the conclusion that, on a true analysis, the sum was not paid for the disposal of the shares. It was paid by the taxpayer company as a contribution towards the rescue of JMB, which the taxpayer company knew the Bank was going to mount immediately in the public interest. As such, it is in my opinion to be properly characterised as a revenue payment.”
Lord Jauncey said at 477:
“The question in this appeal is therefore whether the £50m was paid to dispose of the shares in JMB or whether it was paid to enable the taxpayer company to continue to trade by removing the danger of JMB’s insolvency. My Lords, I must confess that I was attracted by the argument for the Crown that the payment was made to enable the taxpayer to dispose of the shares. However, the issue is narrow and I do not feel inclined to dissent from what I understand to be the view of the majority of your Lordships. I therefore agree that the appeal should be allowed and the decision of the General Commissioners restored.”
Lord Emslie did not give a separate speech.
Thus the categorisation of the payment depends on the true analysis of the transaction in which the taxpayer’s purpose is not determinative.  The £50m payment could not have been made to be rid of the shares in JMB because the shares were not a liability.
16.	I shall therefore examine the connection between the Loan and the swap transaction.  It is clear from clauses 5.5 and 6.3 of the Agreement (see paragraph 5 above) and from Mr Minatani’s evidence that the Loan could not have been made in sterling without the swap transaction.  The Swap Supplement provides in clause 3.7 (see paragraph 6 above) that if the Loan is proposed to be prepaid under the Agreement, the Bank must notify Security Pacific which estimates the payment required to be made for a corresponding termination of the swap transaction.  It is assumed that the Bank will communicate this to the Appellant which can decide whether or not to prepay the Loan in the light of this information.  The Bank then notifies Security Pacific whether or not the prepayment will be made.  If it is to be made, clause 3.8 provides that the notice of prepayment of the Loan is treated as a notice designating an Early Termination Date in respect of the swap transaction.  (So far as I can see this is not deemed to be a Termination Event as well, in which case clause 4 of the Swap Master Agreement does not deal with the consequences but I think that the same result is achieved under the Code.)  It is clear therefore that the Loan cannot be prepaid without terminating the swap transaction. 
17.	The circumstances unconnected with prepayment of the Loan in which the swap transaction can be terminated are those in which a party is entitled to designate an Early Termination Date under clause 4 of the Swap Master Agreement summarised in paragraph 6 above.  The Code provides in section 11.1 for a right to designate an Early Termination Date (a) if there is an Event of Default (as defined in the Code) or (b) a Termination Event has occurred, this expression being defined in the Swap Master Agreement to mean Illegality, Tax Event upon Substantial Likelihood of Gross-up, Change in Tax Law (all of which are defined in the Code), and certain substantial disposals of assets by one of the parties as set out in clause 13 of the Swap Master Agreement.  (Mr Schwarz’s skeleton states that termination by notice by one party and on a Termination Event are alternatives, but my reading is that it is the Termination Event (and also Default) that gives rise to the party’s entitlement to designate an Early Termination Date, and there is no separate right to terminate by notice.)  The Agreement provides in clause 6.3 (see paragraph 5 above) that if for any reason a notice of early termination is served under the swap agreement (except as a consequence of a default by the Bank) then the Bank must inform the Appellant of the cost of such termination (for which the Appellant has indemnified the Bank under clause 18.4(ii) of the Agreement) and the cost of a replacement swap transaction.  The Appellant then has the option of requesting the Bank (1) to enter into the replacement swap transaction (for which the Appellant must indemnify the Bank), (2) to maintain the loan in sterling or convert it into another currency (for which the Appellant must enter into negotiations with the Bank with a view to agreeing an interest rate of 0.3% above LIBOR for that currency together with interest periods and payment dates), or (3) prepaying the Loan.  These options depend on the occurrence of a Termination Event which is outside the Appellant’s control and will result in one of those three alternatives, of which in (1) and (2) the swap transactions would terminate with a similarly calculated Indemnity Payment being made while the Loan continued either on the same basis in (1) or on a different basis in (2).  
18.	I should also mention clause 5.5 of the Agreement under which the Appellant indemnifies the Bank against any expense incurred by the Bank if the Loan is not made on the date specified in the Notice of Drawdown.  I read this as dealing with a delay in drawing down the Loan rather than an occasion when the swap transaction would be terminated, although if there were some reason why the Loan could never be drawn down presumably the swap transaction would be terminated, in which case the Indemnity Payment would be made under clause 18.4(ii) (or more probably clause 18.4(i) if it were caused by a default by the Appellant of its obligations under the Agreement).  Again, this deals with events outside the Appellant’s control (or at least outside the Appellant’s contemplation at the time of entering into the Agreement that it will voluntarily cause it to occur).
19.	Paragraph 3(19) above states as an agreed fact that another occasion where a payment similar to the Indemnity Payment would be made is the voluntary termination of the Swap by the parties.  The point was not argued but I find it difficult to see why, if the Bank voluntarily agreed with Security Pacific to terminate the swap otherwise than in accordance with its terms and to the detriment of the Bank, this would not be in consequence of a default by the Bank and so the Appellant would not be under any obligation to indemnify the Bank.  
20.	Apart therefore from some events outside the Appellant’s control (or at least expectation) there are no circumstances in which a payment calculated in a similar way to the Indemnity Payment could be made for terminating the swap transaction separately from prepaying the Loan.  Any agreement will provide for defaults by the other party and changes in the law making the transaction unlawful or subject to unexpected tax charges.  Whatever may be the tax treatment of a payment made on termination of the swap transaction in such events—and I can see the force of Mr Schwarz’s contention that it would be an income payment—I do not consider that they are relevant to the question of categorising the Indemnity Payment made on the voluntary prepayment of the Loan by the Appellant because the whole transaction will be the termination of the swap arrangements if they occur as a result of an involuntary termination, but here the Indemnity Payment is made as part of a larger transaction, the prepayment of the Loan.  
21.	By contrast with Lawson v Johnson Matthey, not only was the Loan onerous and its prepayment an end in itself, but the swap transaction could not voluntarily be terminated separately from the Loan and so such termination could not have been an end in itself.  The making of the Indemnity Payment was a necessary part of such prepayment.  The Appellant’s purpose was certainly to prepay the Loan but that is not determinative.  If one asks what the making of the Indemnity Payment achieved, the answer is that it achieved the removal of the onerous Loan, rather than it achieved the termination of the swap arrangements following the prepayment of the Loan.  I do not therefore accept Mr Schwarz’s contention that the Indemnity Payment was merely a consequence of the prepayment of the Loan rather than a payment to terminate the Loan; the prepayment could not have been achieved without it.  While the Agreement provided in clause 8.1 that termination of the Loan could be made without penalty on an interest payment date the Agreement also provided for automatic termination of the swap transactions for which the Appellant had to make the Indemnity Payment.  Clause 8.4 provided: “Any prepayment made pursuant to Clause 8.1 shall be made together with interest on the amount prepaid to the date of prepayment and any other sums then due to the Bank hereunder…”  The Indemnity Payment was one of the “other sums then due to the Bank hereunder…”.  It was the cost of getting rid of an onerous capital liability (a ten-year Loan undoubtedly being a capital transaction).  It is no different from a payment to terminate an onerous lease.  The payment may be calculated by reference to future rent but the nature of the payment is capital.  
22.	Mr Schwartz also contended that the Appellant’s capital was untouched by the making of the Indemnity Payment and the rental business continued as before.  This is correct if one regards the Yen Loan as part of the same loan particularly as the debenture continued with a minor variation.  But if one regards the Yen Loan as part of the same loan it seems to me that the Indemnity Payment was then paid for a variation in the onerous terms of the Loan, namely the Variable Formula Rate, and so the payment is still a capital one, being akin to the payment for the variation of the loan in Whitehead v Tubbs (Elastics) Ltd or the 40-year lease in Tucker v Granada Motorway Services Ltd.
23.	Accordingly in my view the Indemnity Payment is a capital payment and is not deductible in computing Schedule A income.
Section 77 of the Taxes Act 1988
24.	Section 77 is relevant having decided that the Indemnity Payment was a capital payment.  The first issue is whether the Indemnity Payment is within the definition of “the incidental costs of obtaining finance” which means “expenditure on fees, commissions, advertising, printing and other incidental matters (but not including stamp duty), being expenditure wholly and exclusively incurred for the purpose of …repaying it.”  The only possible head is “other incidental matters.”  The Oxford English Dictionary definition of incidental is “occurring or liable to occur in fortuitous or subordinate conjunction with something else.”  I consider that the Indemnity Payment was something that had a subordinate conjunction with the prepayment of the Loan.  For similar reasons to deciding that it was capital payment it did not, as in the quotation from Robson v Dixon, “serve any independent purpose but is carried out in order to further some other purpose.”  The purpose (and effect) of the payment was to achieve the prepayment of the Loan.  The fact that it was made in accordance with the Agreement does not make it cease to be incidental to the Loan repayment; the same would no doubt be true of other costs of repayment.  In my view it thus qualifies as an incidental cost of obtaining (defined to include repaying) finance.
25.	The next issue is whether either limb of subs (7), which I set out again, prevents the deduction of the Indemnity Payment.
“(7) This section shall not be construed as affording relief—
(a) for any sums paid in consequence of, or for obtaining protection against, losses resulting from changes in the rate of exchange between different currencies; or
(b) for the cost of repaying a loan or loan stock or a qualifying security so far as attributable to its being repayable at a premium or to its having been obtained or issued at a discount.”
26.	In relation to subs (7)(a), an indemnity is a payment that makes good a loss, here the loss that the Bank would incur on termination on the swap transaction because the present value of the payments that the Bank would have to make during the remainder of the life of the swap is greater than the present value of the payments that it would receive.  There is therefore a loss to the Bank.  Does that loss result from changes in the rate of exchange between different currencies?  One can test that by converting ¥13,187,156,835 in Box 2 of the calculation of the Indemnity Payment at the starting rate of exchange of ¥227.9=£1.  The Box 2 total then becomes £84,191,123, and the Indemnity Payment would have been £3,242,727 because the rate of exchange does not affect any of the other Boxes which are all sterling calculations.  Since the actual Indemnity Payment was £21,100,092.94 it seems to me that the difference between that and £3,242,727 is caused solely by a change in the rate of exchange between yen and sterling and so is not deductible.  In case my calculation of this figure is not correct I will give this decision in principle to allow the parties the opportunity to agree the figure.  I appreciate that as stated in paragraph 3(22) above it is an agreed fact that “No amount was included on account of principal or currency” but the currency conversion is clear on the face of the calculation in Box 2 and is inherent in the Variable Formula Rate of which Box 2 is one element and so I do not feel able to ignore the currency conversion on account of this agreed fact.
27.	On subs (7)(b), the issue is whether “premium” is used either (1) in a technical sense of the terms of issue of a loan requiring repayment of a loan to be of a greater sum than was borrowed, whether that amount is fixed or calculated according to a formula, or (2) in a more general sense of anything paid in excess of that borrowed which was applied in R v Delmayne [1969] 2 All ER 980 connection with the Protection of Depositors Act 1963, where protection of the public requires a wide meaning to be given to “premium.”  In the context of “being repayable at a premium or to its having been obtained or issued at a discount” it seems to me that “premium” is being used in the former technical sense that is customarily used in relation to loans.  Clause 8.1 of the Agreement provides that “The Borrower may prepay the Loan in whole or in part, without penalty, on any Interest Payment Date…”.  I do not consider that a corporate finance expert reading the words of subs (7)(b) and those words of the Agreement would consider that the Loan was repayable at a premium because the Indemnity Payment for terminating the swap transaction was required to be made in consequence of the prepayment.
28.	Accordingly on s 77, the Indemnity Payment was “an incidental cost of obtaining finance,” and was not a premium, but part of it was “in consequence of, or for obtaining protection against, losses resulting from changes in the rate of exchange between different currencies” and that part is not deductible.
29.	My decision is that:
(1)	The Indemnity Payment is a capital payment;
(2)	Section 77 of the Taxes Act 1988 allows the deduction of the Indemnity Payment in principle as an incidental cost of obtaining finance; 
(3)	Section 77(7)(a) disallows part of the Indemnity Payment as being paid in consequence of losses resulting from changes in the rate of exchange between different currencies;
(4)	Section 77(7)(b) does not disallow the Indemnity Payment as being a premium;
and I allow the appeal in principle to the extent of the part of the Indemnity Payment not disallowed by (3) above but otherwise dismiss the appeal.

JOHN F. AVERY JONES

SPECIAL COMMISSIONER
RELEASE DATE:  7  March  2007

SC 3090/06

Authorities referred to in skeletons and not referred to in the decision:
Dunlop Pneumatic Tyre Co Ltd v New Garage Motor Co Ltd [1915] AC 79
British Insulated and Helsby Cables Ltd v Atherton [1926] AC 205
Mallet v Staverley Coal and Iron Co Ltd (1928) 13 TC 772
Burmah Steamship Co Ltd v IRC (1930) 16 TC67
European Investment Trust v Jackson (1932) TC 1
Lomax v Peter Dixon and Son (1943) 25 TC 353
Barr, Crombie & Co Ltd v ITC (1945) 26 TC 406
London and Thames Haven Oil Wharves Ltd v Attwooll (1966) 43 TC 491
IRC v McGuckian (1997) 69 TC 1
Indofood International Finance Ltd v JP Morgan Chase Bank NA [2006] STC 1195
Wharf Properties v IRC [1997] STC 351