Spc00636

QUALIFYING CONTRACTS – Profits and losses – Front end payments under currency contracts – Whether qualifying payments – No – Whether to be allocated such that payments are included as “amounts B” – No – Whether currency contracts were entered into for unallowable purposes – Yes – Appeal dismissed – FA 1994 ss 151, 155 and 168A
THE SPECIAL COMMISSIONERS

	PRUDENTIAL PLC	Appellant

-	and –

	THE COMMISSIONERS FOR HER MAJESTY’S REVENUE & CUSTOMS 	 Respondents

		

				Special Commissioners:  SIR STEPHEN OLIVER QC
							      THEODORE WALLACE						 	

Sitting in public in London on 2-5 July 2007

Jonathan Peacock QC and Jolyon Maugham, counsel, for the Appellant 

Julian Ghosh QC and Elizabeth Wilson, counsel, instructed by the general counsel and solicitor to HM Revenue and Customs, for the Respondents

© CROWN COPYRIGHT 2007

DECISION

1.	Prudential Plc appeals against the amendment to its return for its accounting period ending 31 December 2002.

2.	Prudential claimed a non-trading loan relationship debit in its corporation tax return for that accounting period in respect of £105 million, being the sum of two payments made at the inception of two swap transactions which had taken place in that period.  We refer to those two payments as “the front end payments”.  Prudential entered into the first swap (referred to as “the RBS short-term swap”) with The Royal Bank of Scotland Plc.  The second swap (referred to as “the GSI swap”) was entered into with Goldman Sachs International.  

3.	On 26 September 2006, following an enquiry into Prudential’s return for the 2002 period, Her Majesty’s Revenue and Customs (“the Revenue”) issued a closure notice stating their conclusion that the amount of the front end payments was not allowable as a deduction and consequently amended Prudential’s return for the accounting period.  On 2 October 2006 Prudential appealed against the amendment.

Summary of the Issues

4.	The overriding issue is whether Prudential is entitled to corporation tax relief in the accounting period ended 31 December 2002 for the front end payments on the basis that each of them was a deductible “amount B” within Finance Act 1994 section 153.  The outcome of the overriding issue depends on the answers to three specific issues.

5.	The overriding issue and the specific issues in this appeal arise in the context of Chapter II of Part IV of Finance Act 1994 (and all statutory references in this Decision are, unless otherwise stated, to that Act).  The legislation has since been superseded by the Finance Act 2002.  The provisions of Chapter II were the then statutory code for the taxation of  “qualifying contracts” such as interest rate and currency contracts.  The code prescribed the means of ascertaining the difference between “qualifying payments”, payable and receivable, of the relevant accounting period in respect of such contracts.  That statutory difference was then treated as a profit or loss for corporation tax purposes.  Section 155 provided, in essence, that qualifying payments received or receivable were comprised in “amount A”; qualifying payments made or falling to be made were comprised in “amount B”.  A “profit on the contract” arose where amount A exceeded amount B and a loss arose where amount B exceeded amount A.

6.	The first specific issue is whether the front end payment in question ranked as a “qualifying payment” at all.  The critical question is whether, in terms of section 151(1), Prudential had become, as regards those payments:

	“….. subject to a duty to make a payment in consideration of another person’s 	entering into the contract ….”

We refer to that as “The Qualifying Payment issue”.

7.	The second specific issue is whether the front end payments fell within the definition of  “amount B” in section 155(5) which provided:

“Where as regards a qualifying contract a qualifying company’s profit or loss for an accounting period falls to be computed on a particular accruals basis … amount B is so much of the qualifying payment or payments made as falling to be made by the company as is allocated.”

such that the front end payments were to be taken into account in the accounting period: see section 155(2).  We refer to this as “the Allocation issue”.

8.	The third specific issue is whether the front end payments, assuming they were qualifying payments and assuming that they were prima facie comprised in amount B for the relevant period, were excluded from amount B on the basis that the relevant currency contracts were entered into for an “unallowable purpose” as defined in section 168A (5)-(9).  We refer to that as the “Unallowable Purpose issue”.

Prudential

9.	Prudential is a UK incorporated and resident company which carries on the business of holding company to a multi-national retail financial services group.  With a few exceptions it holds shares in a number of wholly owned subsidiaries (collectively the “Group”) including 100 per cent of the shares of Prudential Finance (UK) Plc (“PFUK”).  PFUK performs a variety of treasury functions for the Group (such as entering into derivative contracts on behalf of other companies in the Group) and it acts as a profit centre by investing Group funds.

10.	The role of Prudential’s Balance Sheet Management Committee (“BSMC”) is to review and approve Group policies for treasury and balance sheet management.  The BSMC has scheduled monthly meetings and meets ad hoc, as required.  

Mr John Foley

11.	John Foley was the managing director of PFUK and Group Treasurer of Prudential.  At the material time he was responsible on behalf of Prudential for managing hedges of risks, including currency risks, borne by the Group.  He was also responsible for managing any surplus cash, almost always sterling which arose within the Group.  He has around thirty years experience of capital markets.  

The RBS contracts

12.	The RBS contracts comprised two swap contracts the details of which were contained in Confirmations both dated 8 March 2002.  

The RBS contracts: the Euro-debt 

13.	On 19 December 2001 Prudential raised Є500 million of fixed-interest debt (“the Euro-debt”) in the ordinary course of its business.  This euro-issue (together with the “issue” of a further £435 million of debt which is not material to this appeal) was agreed with counterparties on 4 December 2001.  The maturity date of the Euro-debt was 19 December 2021; but it could be called in by Prudential on its ten year anniversary.  Following the issuance of those debts PFUK, again in the ordinary course of its business, effected a number of interest rates swaps, the net result of which was to exchange Prudential’s fixed interest rate obligation under the Euro-debt for a floating rate.  

The RBS contracts: the decision to hedge the Euro-debt

14.	At a meeting of the BSMC on 18 January 2002 consideration was given to hedging the Euro-debt.  The meeting recognised that no significant euro-receipts and euro-expenditure would take place in the then foreseeable future.  The consensus was that in the short term the euro would weaken.  The Group’s attitude was, however, essentially cautious and, while its policy was not to enter into “naked” swaps unrelated to Group exposure, it nonetheless decided to go ahead and swap the Euro-debt for sterling.  Mr Foley waited in the expectation of benefiting from the short-term weakening of the euro against sterling.

The RBS contracts: Ernst & Young present an opportunity to make hedging tax efficient

15.	On 18 February 2002, Nikki Maynard, Director of Group Financial Reporting and Tax at Prudential, who gave evidence before us and who had been at the BSMC meeting, attended a presentation given by Ernst & Young LLP to members of Prudential’s tax “team”.  The presentation included details of a tax-efficient method of hedging exchange rate risks.  We were shown the slides that explained “the transaction” involved.  The first slide stated “The Transaction provides significant savings relative to traditional currency transactions” and began with these words:

“The transaction provides a tax enhanced method for a UK company to hedge a foreign currency exposure
The transaction provides a UK company with a tax deduction for, in economic terms, the prepayment of part of the final principal exchange under a swap
The tax deduction does not reverse on the settlement of a swap
UK Co has, for example, foreign currency denominated borrowings
UK Co enters into a currency swap with a UK Bank to hedge the borrowings into sterling
The notional principal exchange under the swap is set at an off-market rate in favour of UK Co
In consideration for entering into the swap, UK Co will pay an arm’s length premium to Bank to put the swap onto arm’s length terms
Periodic payments representative of interest on the notional principals will be paid during the term of the swap
The final principal exchange will be gross settled

The transaction is appropriate for a UK corporate or UK Group with a foreign exchange exposure on assets or monetary liabilities 
UK Co must have tax capacity”

Under “Anticipated Tax Treatment” it stated

“The transaction is a ‘one-off’ as it relies on an asymmetry between the foreign exchange and financial instruments regimes which will be corrected for accounting periods commencing on or after 1 October 2002”.

RBS contracts: Prudential’s reaction to Ernst & Young’s terms for advice on the Opportunity

16.	After the presentation the content was communicated to John Foley, either by Nikki Maynard or by a Mr Jonathan Daniels who was a member of Prudential’s Finance Team, Mr Foley’s team, as Director of Portfolio and Markets.

17.	Sometime within the next seven days a meeting between Prudential and Ernst & Young took place.  A letter dated 25 February 2002 from Ernst & Young to Nikki Maynard (headed “Project TOMS”) contains these words:

“Following our recent meeting, I have pleasure in confirming our engagement to advise Prudential Plc (‘the Company’) in respect of the tax planning opportunity (the ‘Opportunity’) using the hedging method described at our meeting.

…

1.	Scope of our work

1.1	We will provide the following advice and assistance in respect of the Opportunity:

(a)	provide a copy of the instructions to Counsel … to analyse the tax effects of the Opportunity; 
(b)	provide a copy of the note of our consultation with Counsel as settled by Counsel;
( c)	review of the tax effect of the swap confirmations used to implement the Opportunity;
…
(f)	discussion with those at the Company responsible for pricing the swap premium to be paid; the responsibility for setting the price and the commercial effects of the swap will remain with the Company.

…

3.	Estimated savings and recoveries

3.1	The Opportunity has been planned and will be implemented in order to save tax.

…

4.	Fees

4.1	In consideration of the advice and assistance that we are to provide in connection with the Opportunity, you have agreed to pay us the following fees.

A.  	Initial fee

4.2	If you sign and return this letter we will be entitled to render an invoice to you for the amount of £200,000 (plus VAT) upon completion of the implementation of the Opportunity.  

…

B.	Second fee

4.4	In addition to the fee set out above, in the event that the Company receives a reduction in profits chargeable to corporation tax following implementation of the Opportunity we shall be entitled to render an invoice for £300,000 (plus VAT).  This fee (the ‘Second Fee’) will be invoiced in stages on the due dates of the Company’s instalment payments of corporation tax for the year ended 31 December 2002.  These staged payments will be calculated prior to implementation and allocated to the tax payment dates.

4.5	For the avoidance of doubt this fee shall belong to us immediately on payment.

…

6.	Post-implementation fees

6.1	Fees for assistance with tax computations, accounting presentation and subsequent correspondence with the Inland Revenue prior to the commencement of any preparation work for an appeal before either the General or Special Commissioners will be charged on a time basis in accordance with section 2 of the terms of business.

6.2	If, following implementation of the Opportunity no tax saving is achieved, we will not be responsible for any costs that may have been incurred, directly or indirectly, by the Company in implementing the Opportunity.

…”

On the same day Nikki Maynard signed the agreement on behalf of Prudential.  

RBS contracts: the short-term and the full-term swap contracts of 8 March 2002

18.	On 8 March 2002 Prudential entered into two separate swap contracts with RBS.  Both had 7 March 2002 as their “trade date”.  Particulars of each contract were set out in the Confirmation document relating to that contract.  One of the contracts (“the short-term swap contract”) had 19 December 2001 as its “effective date” and 19 June 2002 as its “termination date”; the other (the “long-term swap contract”) had 19 June 2002 as its “effective date” and 19 December 2011 as its “termination date”.  Both agreements were said to supplement and form part of the ISDA Master Agreement.

19.	The parties to the present appeal have agreed the following summaries of both contracts.

20.	The short-term swap contract has the following effect:

(i)	Its trade date was 7 March 2002 and it matured on 19 June 2002;
(ii)	The periodics payable were made effective from 19 December 2001 to allow the cashflows under the RBS Swap to match those on the Є Debt;
(iii)	Prudential agreed to pay £244,406,000 (the “final exchange amount”) to RBS in exchange for RBS paying Є500 million to Prudential on 19 June 2002;
(iv)	Prudential agreed to pay an amount based on a fixed rate of 5.08813 per cent (calculated by reference to six month LIBOR plus 103 basis points) in relation to £244,406,000 and RBS paid Prudential an amount based on a fixed rate of 4.2925 per cent (six month EURIBOR plus 102.25 basis points) in relation to Є500 million;
(v)	The contract required each counter party to make gross payments of all periodics and the final exchange or principals;
(vi)	The “Terms and Conditions” stated: “Prudential Plc shall pay GBP £65,000,000 to The Royal Bank of Scotland Plc on 12 March 2002 in consideration of The Royal Bank of Scotland Plc entering into this Transaction”; and 
(vii)	Payment of that sum (the “RBS Premium”) was made by Prudential.

21.	The long-term swap contract has the following effect:

(i)	Its trade date was 7 March 2002, its effective date 19 June 2002 and it matured on 19 December 2011;
(ii)	PFUK agreed to pay on 19 June 2002 Є500,000,000 to RBS and RBS agreed to pay on the same day £309,406,000 to PFUK;
(iii)	PFUK and RBS agreed that on 19 June and 19 December each year, PFUK would pay to RBS an amount based on LIBOR plus 103 basis points on £309,406,000 to RBS and RBS would pay to PFUK an amount based on six month EURIBOR plus 102.25 basis points; 
(iv)	PFUK and RBS agreed that on 19 December 2011 PFUK would pay to RBS £309,406,000 and RBS would pay to PFUK Є500,000,000; and,
(v)	The sterling figure of £309,406,000 was calculated by reference to the spot rate prevailing on 7 March 2002.

The RBS contracts: the Internal Swap

22.	PFUK and Prudential had entered into an exchange rate swap on 7 March 2007.  This (“the Internal Swap”) provided that on 19 June 2002 PFUK was to pay to Prudential £309,406,000 and receive Є500,000,000; Prudential was to pay Є500,000,000 to PFUK and receive £309,406,000.

The RBS contracts: Ernst & Young’s tax analysis

23.	On 12 March 2002 Ernst & Young wrote to Prudential setting out the UK tax analysis of the RBS contracts.  

The RBS contracts: Prudential’s accounting entries in 2002 accounts

24.	Prudential’s balance sheet entries show that:

(i)	On 7 March 2002 Є500,000,000 was due from RBS and £309,406,000 was due to RBS;
(ii)	On 12 March 2002 a cash payment of £65,000,000 was made to RBS;
(iii)	On 19 June 2002 Є500,000,000 was received from RBS and a cash payment of £244,406,000 was made to RBS.

The RBS contracts: funding the front end payments: why £65,000,000 as the front end payment?

25.	It will be recalled from the words of the Ernst & Young slide (see paragraph 15 above) that the “principal exchange” under the swap had to be “set at an off-market rate” in favour of Prudential; and the Ernst & Young letter of 25 February 2002 (paragraph 17 above) stated that “the responsibility for setting the price and the commercial effects of the swap” lay with Prudential.  Mr Foley accepted that the amount of the front end payment reflected the spare cash that Prudential had at the time.  It had a cash balance of some £74,000,000 at the end of February 2002.  Mr Foley described this as money “lying idle”.  Mr Foley explained that that was money that would otherwise have been deposited with another institution had it not been used to make the front end payment under the short-term swap contract.  The monetary obligations assumed by RBS in relation to the £65,000,000 front end payment were not covered by collateral arrangements of the sort contained in the ISDA Master Agreement.  Asked if the front end payment might have been of a larger amount, Mr Foley explained that, subject to “limits on the bank and so on, it might not have been £65,000,000”.  It would not have been as much as £309,000,000 because, he explained, there would then have been no point in issuing the Є500,000,000 debt in the first place.

RBS contracts: Prudential’s need for euros

26.	Between the date of issue of the Є500,000,000 debt by Prudential in December 2001 and 2011 when redemption was possible, Prudential anticipated (so Mr Foley explained) no need for euros.  

RBS contracts: Prudential’s expected profit on the use of £65,000,000 to make the £65,000,000 front end payment

27.	Mr Foley said it had not been possible to determine what “commercial” profit there would have been on the use of £65,000,000 as front end payment under the short-term swap contract.  He had been hoping for a rate of return on the £65,000,000 that was no worse than the deposit rate offered by the “cash desk in the bank”.  He had understood there was a tax advantage in adopting the structure of the two RBS contracts and the making of a front end payment in respect of the short-term swap contract.  Mr Foley did not know the actual quantum of the tax advantage.  He accepted however that the value of the return he had “hoped for” on the £65,000,000 front end payment was much smaller than the value of the potential tax advantage.

28.	Regarding the Ernst & Young fees Mr Foley said that he had not known of these; he would not, he said, have expected the tax department’s engagements with external advisers to have been known by his department.  He had not taken the Ernst & Young fees into account in assessing the return to Prudential on the £65,000,000 front end payment.

RBS contracts: what factors determined the length of the short-term swap contract?

29.	Mr Foley explained that he had been happy to tie-up the £65,000,000 until June 2002.  He would not have agreed to tie that amount up for ten years.

Mr Foley’s perception of the two RBS contracts

30.	Mr Foley saw the two contracts “as a holistic transaction”, not as two separate transactions.  “It was one swap for one effect which was to hedge Prudential’s balance sheet from my perspective”.  The short-term swap contract had not impaired the hedge and it “had the effect of putting the £65,000,000 on deposit, which was positive”.  He accepted that in order to incorporate the tax planning “Opportunity” into the hedging objective there would have to be two swaps concluded on the same day rather than one; otherwise the £65,000,000 would be tied up for too long.  The £65,000,000 front end payment under the short-term swap contract could, he agreed, be regarded as a pre-payment of the principal of £309,000,000 due to RBS under that contract.

31.	Mr Foley accepted that, even though he had not known the detail of the tax benefit offered by the tax planning Opportunity, he “would have thought that the quantum of the premium determined the quantum of the tax benefit.”

32.	Mr Foley had seen no reason not to structure the arrangements in the manner of the Ernst & Young tax planning Opportunity.  This was because the Ernst & Young Opportunity and the interposition of the short-term swap contract would not have changed the fundamental nature of the swap.  It would still have achieved what he referred to as his “commercial objective” of executing a hedge in a commercial manner, by hedging Prudential’s exposure to the strengthening of the euro against sterling as agreed by the BSMC on 18 January 2002.  

33.	Mr Foley said that had Prudential “been ready to implement a swap, in the form in which we in fact entered into it, and there had been an announcement that altered the tax treatment in relation to the premium, I would still have gone ahead with the swap in this form”.  (In parenthesis, we wonder, however, if this would really have been the case.  Bearing in mind that Mr Foley was not au fait with the details of the scheme implemented through the use of the short-term swap contract and by means of the front end payment, surely the tax department would have told him not to waste the Ernst & Young fees of £200,000 plus VAT which was mainly irrecoverable.  We infer that he would have taken the £65,000,000 down to the cash desk and placed it on deposit there and then.)

The GSI contract: Prudential obtains $250,000,000 for £163,420,055 to finance PFUK’s  $250,000,000 loan to BPT&T

34.	In April 2002 PFUK had been invited to make a dollar loan to BP Plc’s Trinidad & Tobago subsidiary (“BPT&T”) for a year with the loan being fully guaranteed by BP Plc.  Following a meeting with BP’s representatives and an internal Prudential report on the proposal, Prudential’s BSMC met on 22 May 2002 and approved the transaction.

35	PFUK required US dollar funding for the loan of $250,000,000.  The following transactions took place on 23 August 2002:

(i)	Prudential therefore exchanged the sterling equivalent of $250,000,000 into US dollars.  It did this by means of a spot foreign exchange transaction with GSI.  This resulted in Prudential exchanging £163,420,055 for $250,000,000.  Prudential’s accounting entries show this recorded as having happened on 23 August 2002.  

(ii)	Prudential agreed to lend PFUK $250,000,000 for three months (“the Intra Group Loan”).  The effective date of that loan was 23 August 2002; its maturity date was 25 November 2002 and it carried US dollar interest at 1.71 per cent.

(iii)	PFUK entered into an agreement with BPT&T to lend $250,000,000 for a period of one year under an interest-bearing loan that matured on 21 August 2003 (“the T&T Loan”).

The GSI contract: hedging arrangements

36.	Prudential approached GSI to execute a hedge of the foreign exchange exposure on the $250,000,000 Loan.  Prudential agreed the terms of this in advance of entering into the Agreement with GSI.  Its “trade date” was 21 August 2002.  The Confirmation had 23 August as the effective date and 25 November 2002 as the maturity date.  The agreed terms of the hedging arrangements are contained in the “Revised Confirmation” from GSI to Prudential dated 24 September 2002.  We now reproduce the parties’ agreed summary of those terms:

(i)	Prudential entered into the GSI swap on 21 August 2002.  It had an effective date of 23 August 2002 and matured on 25 November 2002; 

(ii)	Prudential and GSI agreed that on 25 November 2002, Prudential would pay to GSI the sum of  $250,000,000 and GSI would pay to Prudential the sum of £203,420,055;

(iii)	Prudential and GSI further agreed that on 25 November 2002, Prudential would pay to GSI an amount based on a fixed rate of 1.71 per cent in relation to $250,000,000 and GSI would pay to Prudential Plc an amount based on a fixed rate 3.845 per cent in relation to £203,420,055;

(iv)	the contract required each counterparty to make gross payments of all periodics and final exchange of principals; 

(v)	the “Revised Confirmation” stated: “Counterparty shall pay GBP £40,000,000 to GSI on the Effective Date in consideration of GSI entering into this Transaction”; and

(vi)	payment of that sum (the “GSI Premium”) was made by Prudential.  

A cash payment of £40,000,000 was, according to an extract from Prudential’s accounting entries, made by Prudential to GSI on 23 August 2002.  

37.	Prudential’s accounting entries show that on 25 November 2002 Prudential received £205,434,359 from GSI and Prudential paid $251,116,250 (which included $1,116,250 of interest) to GSI.  

The steps leading to the GSI swap

38.	Mr Foley in his Witness Statement explained the position this way:

“I took the decision that we should hedge this risk.  The decision was a purely commercial one to reduce Plc’s US dollar exposure.  It was just good housekeeping to ensure that we were not left with an unhedged foreign currency asset.  The decision was simply one of many continuous commercial decisions made in the normal course of the company’s business.  Because the transactions were relatively straightforward there was no need for a specific meeting with the BSMC to discuss this further.

The idea for the structure of a swap on the same lines as the RBS swap had originated from Anthony Robson (in 2002 Associated Director, Risk Management at Prudential).  On 13 August 2002 he consulted Nikki Maynard who had advised that ‘it would be more tax efficient for Prudential’, which then had surplus £ sterling funds, ‘to swap these into US dollars and then lend the US dollars to PFUK rather than for PFUK to borrow the £ sterling and execute the swap itself’.”

39.	On 20 and 21 August internal messages between RBS personnel indicate that a “Pru trade” had been presented “on the basis that the up front cashflow is entirely tax driven”.  It appears from e-mails of 21 August that RBS declined the “tax trade”, the risk to RBS being “reputational and not financial”.  

40.	GSI, as noted, agreed on 21 August 2002 to enter into the GSI swap with 21 August as the trade date.

Why the £40,000,000 “premium”?

41.	Mr Foley accepted that the structuring of the GSI swap which involved Prudential paying £40,000,000 to GSI on the effective date and getting back on the termination date (25 November 2002) £40,000,000 more than the £163,420,055 (i.e. spot rate for $250,000,000 at 23 August) had not been Ernst & Young’s doing.  The instigation of that had come from his own team.  He agreed that he had been aware, though not in detail, that the quantum of the so-called premium would determine the quantum of the tax benefit.  The quantum of the premium had, he said, been determined by the spare cash available.  Mr Foley had seen the deployment of the £40,000,000 in the way it had been as “commercially neutral when compared to placing spare sterling cash on deposit (which is what we would otherwise have done with it).  … we evaluated the pricing of the swap quoted by GSI to ensure it did not commercially disadvantage Plc”.  This statement was not challenged.  The 25 November 2002 termination date was fixed because Mr Foley envisaged the making of an issue of “commercial paper” to cover the $250,000.000 exposure.

The expression “premium”

42.	The word “premium” was used by the witnesses to connote the £65,000,000 payment made on 12 March 2002 by Prudential to RBS as the “Additional Payment” due under the short-term swap contract of 8 March 2002 and the £40,000,000 payment made by Prudential to GSI on the “effective date” of the GSI swap, i.e. 23 August 2002. Those payments were not described as premiums, either in the Confirmation documents or in Prudential’s accounting entries.  Nor does the word “premium” occur in any of the statutory provisions relevant to this appeal.

43.	Mr Foley explained his understanding that premiums might be paid to compensate one counterparty for an interest disparity that might otherwise operate to his disadvantage.  But that does not explain why, where the purpose of the swap is simply to protect the principal value of the hedged amount, a premium should be payable.  There presumably the value of the principal amount will be known in advance.  Why not make an adjustment to the amounts that are the subject of the swap agreement?  Or, if the so-called premium payable by one party simply abates his liability at maturity of the swap agreement, is it not really a payment on account or an instalment payment?

44.	For those reasons we are not satisfied that Prudential’s £65,000,000 and £40,000,000 payments were in the nature of premiums.  Hence we have used instead the expression “front end payments”.

The Qualifying Payment Issue

45.	Section 155, now replaced, was the main provision of Chapter II of Part IV which enacted the code for the taxation of “qualifying contracts”.  It specified the circumstances where profits and losses accrued to qualifying companies.  (It is not in dispute that Prudential was a qualifying company within section 154.)

46.	So far as relevant to this issue, section 155 read as follows:

“(1)	Where, as regards a qualifying contract held by a qualifying company and an accounting period, amount A exceeds amount B, a profit on the contract of an amount equal to the excess accrues to the company for the period.

(2)	Where, as regards a qualifying contract held by a qualifying company and an accounting period, amount B exceeds amount A, a loss on the contract of an amount equal to the excess accrues to the company for the period.

(5)	Where as regards a qualifying contract a qualifying company’s profit or loss for an accounting period falls to be computed on a particular accruals basis –

(a)	amount A is so much of the qualifying payment or payments received or falling to be received by the company as is allocated to the period on that basis, and 
(b)	amount B is so much of the qualifying payment or payments made or falling to be made by the company as is so allocated.”

47.	Section 147(1) provided that a currency contract “is a qualifying contract as regards a qualifying company if the company becomes entitled to rights or subject to duties under the contract … on or after its commencement day”.  A company’s commencement day was, by section 147(4), the first day of its first accounting period to begin after the day preceding the appointed day, which was 23 March 1995.

48.	So far as is relevant section 150 provided:

(1)	A contract is a currency contract for the purposes of this Chapter if – 

(a)	the condition mentioned below is fulfilled, and
(b)	the only transfers of money or money’s worth for which the contract provides are payments falling within subsection (2), (3), (4) or (9) or section 151 below.”

The condition referred to in subsection (1)(a) was fulfilled: this is not in dispute.

Subsection (2) covered exchanges of currencies at maturity of the currency contract.  Subsection (3) covered periodic payments made during the lifetime of the currency contract.  Subsection (4) was the reverse of subsection (2).  It covered, in effect, an initial payment.  Subsection (9) declared that it was immaterial whether the settlement was gross or net.

49.	The expression “… transfers of money … for which the contract provides”, referred to in section 150(1)(b) being “payments falling within … section 151 below” leads to the following words of section 151(1):

“(1)	An interest rate contract or option, a currency contract or option or a debt contract or option may include provision under which the qualifying company – 

(a)	becomes entitled to a right to receive a payment in consideration of its entering into the contract or option, or 
(b)	becomes subject to a duty to make a payment in consideration of another person’s entering into the contract or option.”

50.	Those provisions bring us to section 153 which provided that a “qualifying payment” meant by subsection (1)(d):

“(d) in relation to any qualifying contract, a payment falling within section 151 …”

Section 151(2) included as qualifying payments:

“(a) a payment of a reasonable fee for arranging the contract or option;
  (b) a payment of reasonable costs incurred in respect of the contract or option;”

Hence the first specific issue is whether the front end payments were payments under provisions in the RBS short-term swap contract and in the GSI contract imposing on Prudential a duty to make each of them in consideration of RBS and GSI entering into the contract in question; see section 151(1)(b).

51.	The wording of both Confirmations contain “provisions” that the payments in question are in consideration of the counterparty entering into the contract.  The RBS short-term swap contract (dated 8 March 2002) defined Additional Payment as:

“Prudential Plc shall pay GBP 65,000,000 to the Royal Bank of Scotland Plc on 12 March 2002 in consideration of The Royal Bank of Scotland Plc entering into this Transaction.”

The GSI contract (whose trade date was 21 August 2002 and whose effective date was 23 August) provided, in relation to Additional Payment that:

“Counterparty shall pay GBP 40,000,000 to GSI on the effective date in consideration of GSI entering into this Transaction”.

Arguments on the Qualifying Payments issue

52.	It was argued for Prudential that both front end payments fell squarely within the wording of section 151(1).  The wording of both Confirmations made this clear; and there were no other situations to which section 151(1)(b) could apply.  On this basis, they were both qualifying payments and thus fell to be taken into account in calculating Prudential’s profits and losses for the accounting period for purposes of section 155(5)(b).  

53.	The response of the Revenue was that neither of the front end payments was a qualifying payment.  The front end payment made under the RBS short-term swap contract had been mislabelled.  While the words of the swap contract purported to express it as a payment to induce RBS to sell Є500,000,000 for £244,460,000 rather than to sell the Є500,000,000 for an arm’s length amount, in reality the £65,000,000 front end payment was part-payment for the Є500,000,000.  It was not an inducement to get RBS to sell the Є500,000,000 cheap.  The front end payment under the GSI swap agreement also has been mislabelled.  The £40,000,000 front end payment was not in reality made to induce GSI to buy $250,000,000 for £203,420,055 rather than for an arm’s length amount (which by reference to the exchange rate prevailing on 21 August 2002 would have been £163,420,055).  It was more in the nature of a three months deposit returnable on the termination date.  Responding to the argument for Prudential that no payments (other than front-end payments of the sort in issue here) came within the scope of section 151(1)(b), the Revenue put forward two examples of payments that they said did fall within it.  One example related to a “cap” contract; the other related to a “forex” contract.  Prudential disputed whether either example  fell within section 151(1)(b).  

Conclusions on the Qualifying Payment issue

54.	The words of section 151(1)(b) “a payment in consideration of another person’s entering into the contract …” are, as we read them, directed at payments which have the function of securing the making of the contract; they are to be distinguished from payments made in fulfilment of the contract itself.  Payments of the kind listed in section 151(2) are within section 151(1); an example might be an inducement payment.  Payments of the kind referred to in section 150(2)-(4) are examples of payments relating to the principal amounts covered by the contract which are outside the scope of section 151.

55.	The RBS contracts were entered into to cover Prudential’s exposure to increases in value of its liability in respect of the Є500,000,000 indebtedness.  Prudential’s liability in respect of the Є500,000,000 debt had a sterling value of £309,000,000.  £309,000,000 was the amount required by RBS in return for its undertaking to transfer Є500,000,000 to Prudential on 19 June 2002.  The reason for the £65,000,000 paid on 12 March is found in two features of the evidence.  First, the Ernst & Young Opportunity depended for its success on, to use the words of the presentation slide, “in economic terms the prepayment of part of the principal exchange under [the] swap”.  Second, Mr Foley admitted that the quantum of “the premium” (or front end payment) would determine the quantum of the tax benefit.  Mr Foley’s evidence simply recited how under the terms of the swap Prudential was required to pay a premium of £65,000,000 as consideration for RBS entering into the swap on the terms agreed; he went on to say that the amount represented the Group’s available cash.  The description of the front end payment in the RBS short-term swap contract as paid “in consideration of The Royal Bank of Scotland Plc entering into this Transaction” seems to us to have been chosen to suit the Ernst & Young Opportunity.  But as a statement of what really happened it was a misnomer, a deliberate mislabelling.  It was part of the consideration under the contract.  It cannot have been the intention of Parliament that any consideration under a currency contract was within section 151(1).

56.	The £40,000,000 front end payment under the GSI contract was even less consideration “for entering into the contract”.  The idea behind it was to reproduce the tax savings sought from the RBS short-term swap.  The up-front payment of the £40,000,000 which was to be returned later makes no sense save in the context of the tax scheme.  The amount of the tax benefit was determined by the funds of idle cash at Mr Foley’s disposal.  There is, as with the RBS short-term swap, no evidence that GSI required a £40,000,000 inducement to enter into the swap which had been structured on arm’s length terms and by reference to the prevailing exchange rates.  

57.	Properly understood both front end payments were, we think, payments on account or part pre-payments made by Prudential relating to its principal liabilities under the two contracts.  Despite the wording of the Confirmation documentation, they were not, in the circumstances and on the plain wording of section 151(1)(b), payments “in consideration of another person’s,” i.e. RBS’s and GSI’s as the case might be, “entering into the contract”.  We do not need examples of other types of payments that may or may not fall within the scope of section 151(1)(b) to assist us in reaching that conclusion.

58.	For those reasons we are against Prudential on the qualifying payment issue.  That determines the appeal.  But in case the matters should become relevant, we now deal with the remaining issues.

The Allocation Issues

59.	Did the front end payments under the RBS short-term swap contract and the GSI contract (assuming they were qualifying payments) fall within the definition of “amount B” in section 155(5) in that those payments are to be taken into account in Prudential’s accounting period to 31 December 2002? 

60.	We repeat the terms of section 155(5):

“(5)	Where as regards a qualifying contract the qualifying company’s profit or loss for an accounting period falls to be computed on a particular accruals basis – 

(a)	amount A is so much of the qualifying payment or payments received or falling to be received by the company as is allocated to the period on that basis, and
(b)	amount B is so much of the qualifying payment or payments made or falling to be made by the company as is so allocated.”

61.	Prudential argue that section 155 is dealing with the question of when credits or debits are to be allocated.  Here the qualifying payment (i.e. the two front end payments) were recognised in accordance with Generally Accepted Accountancy Practice (“GAAP”) and consistently with Prudential’s normal accounting practice, in its accounts for the 2002 accounting period.  That is the period to which they are properly allocated.  

62.	The Revenue say, in the first place, that the two front end payments were not “allocated” to a specific accounting period (as defined in section 156); consequently they did not fall within section 155(5)(b) and could not each be relieved as an amount B.  There was no debit to Prudential’s profit and loss accounts for either period because in both cases the accounting treatment treated the payment in question as a part-payment of principal; and in the case of the GSI front end payment, this could be regarded as a deposit that was duly repaid.  Prudential’s accounts do not therefore “allocate” the payments to any period.  

63.	Second, say the Revenue, neither payment was “computed” on a prescribed accruals basis.  This is because accountancy practice treats them both as pre-payments of principal with no separate recognition, for accounts purposes, of those payments.  

Conclusions on Allocation Issue

64.	Section 155(5) applies where profits and losses are to be computed on a particular accruals basis.  The payment in question has to be allocated to a period on the basis of an accruals accounting method, as defined in section 156, if a company is to obtain relief in that period.  In this connection section 155(5) applied to the profit and loss account (or, we take it, to the statement of recognised gains and losses) of the qualifying company in question: the balance sheet, in its record of assets and liabilities, may reflect the fact that the payment was made, but that is not relevant to this issue.

65.	At the material time Prudential accounted for both the RBS short-term swap contract and the GSI contract, and payments made in respect of those, on an accruals basis within section 156(1)(b), i.e. “an accruals basis of accounting that satisfies” the requirements of the section.  The requirements were in section 156(4) which required, in subparagraph (a), the computation of its profits and losses on the contract on an accruals basis in accordance with GAAP and, in subparagraph (b), that all relevant payments (i.e. qualifying payments) under the contract “be allocated to the accounting periods to which they relate without regard to the accounting periods in which they are made or received or become due and payable”.  Those words show that section 155(5) is concerned with the parts of the qualifying company’s accounts which contains the computations of profits and losses and which allocated payments made and payments received in computing those profits and losses.

66.	Here, Mr Foley accepted that the £65,000,000 front end payment under the RBS short-term swap contract and the £244,406,000 paid on delivery of the Є500,000,000 were together the true rate to pay for the euros.  Under the GSI contract, Prudential’s front end payment of £40,000,000 was returned to it on the maturity date (25 November 2002).  Neither front end payment was debited to Prudential’s profit and loss account because in both cases the accounting treatment for both was as part-payments of principal and there never was any diminution of Prudential’s profit.  Consequently neither front end payment was allocated in Prudential’s accounts to any period.  There was nothing to allocate because there was no expenditure.

67.	This result is, we think, consistent with the scheme of the code for interest rate and currency contracts in Chapter II of Part IV.  A payment which is not reflected in a qualifying company’s profit and loss account (being a payment which is not allocated to a particular period) is not relievable.

68.	Section 155(5)(b) provides that amount B is to be so much of the qualifying payment as is allocated to the period following computation of the qualifying company’s profit on a prescribed accruals basis.  It calls for the computation of the qualifying profit on a prescribed accruals basis to ascertain the aggregate profit or loss.  

69.	Here, as we have already noted, accountancy practice treats both the front end payments as pre-payments of principal with no separate recognition, for accounting purposes, of those payments.  The accounting treatment is to regard the £65,000,000 front end payment and the £244,406,000 final exchange payment (under the RBS short-term Swap contract) as a single payment of £309,000,000.  There has therefore been no “computation” of any payment under the RBS contract for section 155(5) purposes.  Similarly, in relation to the GSI £40,000,000 front end payment (made under the GSI contract), that payment is simply treated as a part pre-payment of the sterling amount paid to Prudential by GSI.  The accounts have neither recognised nor computed any payment.

70.	For those reasons we are against Prudential on the “Allocation issue”.  

The application of section 168A

71.	Section 168A is headed “Qualifying contracts for unallowable purposes”.  It was inserted by Finance Act 2002 section 69 with effect for accounting periods ending after 25 July 2001 in relation to any qualifying contract to which a company is party.  Its scope is defined by the opening words of subsection (1):

“Where in any accounting period a qualifying contract to which a company is party has an unallowable purpose …”

Its effect is to exclude from amounts brought into account for purposes of section 155 as part of amount B (i.e. qualifying payments made by the company):

“… so much of the amounts given by the accounting method used as respects the contract as, on a just and reasonable apportionment, is referable to the unallowable purpose.”

By subsection (5) a contract is taken to have an unallowable purpose where:

“… the purposes for which, at times during that period, the company is party to the contract include a purpose (“the unallowable purpose”) which is not amongst the business or other commercial purposes of the company.”

Subsection (7) focuses on tax avoidance.  It provides that:

“… where one of the purposes for which a company is party to a qualifying contract at any time is a tax avoidance purpose, that purpose shall be taken to be a business or other commercial purpose only where it is not the main purpose, or one of the main purposes, for which the company is party to the contract at that time.”

Subsection (8) explains the term “tax avoidance purpose” as referring to:

“… any purpose that consists in securing a tax advantage (whether for the company or any other person).

“Tax advantage” meant “a relief or increased relief from … tax”: see subsection (9) which used the definition in Income and Corporation Taxes Act 1988 section 709(1).  

72.	The central questions are these.  Did the RBS short-term swap contract and the GSI contract each have an unallowable purpose?  If so, what part (if any) of the amounts brought into account as part of amount B was, as regards each contract, referable to that unallowable purpose?

73.	The first question requires us to address the two issues, which expressed in terms found in subsection (7) are – 

•	whether one of the purposes for which Prudential was party to either or both of those contracts was a tax avoidance purpose and, if so, 
•	whether tax avoidance was not the main purpose or one of the main purposes for which Prudential was party to that contract at the relevant time.

It is not in dispute that bringing the front end payments into account for purposes of section 155 as parts of amount B would come within the expression “tax advantage”.

74.	Regarding the second question, it was common ground that if we were to conclude that the two contracts had unallowable purposes, the full amount of each front end payment would be referable to those unallowable purposes.

75.	The case for Prudential was that its main purpose for entering into the RBS swap was to hedge an increase in the Euro debts; and in so doing it sought, in a tax efficient manner, to utilise the presence on its books of idle sterling such that the return was no worse than depositing the amount of the premiums with banks for interests.  The amount of the front end payments represented what Mr Foley regarded as the Prudential group’s available cash.  The duration of each swap reflected the fact that Mr Foley was happy to tie up the amount of the front end payment in relation to the RBS swap until June 2002 but no longer.  It was stressed for Prudential that although the decision to enter into the RBS swap had been Mr Foley’s, the decisions had been taken before tax advice had been obtained and that Mr Foley had neither seen the presentation nor been told the amount of the tax saving it could achieve; nor had Mr Foley been aware of what fees Ernst & Young were charging.  From his point of view, it was emphasised, the actual form of the swaps was unimportant so long as they achieved the necessary hedging.  Seen in its proper context the only purpose of the particular swap was a commercial one and the tax treatment was merely “the icing on the cake”.  In this respect Prudential relied on the observations of Lightman J in IRC v Trustees of the SEMA Group Pension Scheme [2002] STC 276.  Commenting on the dicta of Cross J in IRC v Kleinwort Benson Ltd [1969] 2 Ch 221, Lightman J said (at paragraph 53): 

“The tax advantage may not be a relevant factor in the decision to purchase or sell or in the decision to purchase or sell at a particular price.  Obviously if the tax advantage is mere ‘icing on the cake’ it will not constitute a main object.”

76.	The Revenue say that the purposes for which Prudential was party to both the RBS short-term swap contract and the GSI swap contract were tax avoidance and tax avoidance was the main purpose, or at least one of the main purposes, for which Prudential was party to both the contracts.  

Conclusions on the RBS short-term swap agreement

77.	The decision to hedge the Є500,000,000 issue, made before the Ernst & Young Opportunity presented itself, was taken by the BSMC on 18 January 2002 leaving responsibility for its implementation to Mr Foley.  Hedging cover was needed until 2011.  Mr Foley decided to wait and benefit from the expected short-term weakening of the euro as against sterling.

78.	On 8 March 2002 two swap agreements with RBS were entered into.  The short-term swap contract provided Prudential with Є500,000,000 on 19 June 2002: Prudential was to make the front end payment of £65,000,000 on 12 March and the final payment of £244,406,000 on 19 June.  PFUK and RBS entered into the long-term swap contract by which RBS agreed to provide PFUK with Є500,000,000 on 19 December 2011: PFUK was required to provide RBS with £309,406,000 on the same date.  The long-term swap contract involved no front end payment.  PFUK’s euro-liability had arisen as the result of the Internal Swap with Prudential dated 7 March 2002.  

79.	It follows that the question posed by section 168A, namely whether the qualifying contract in question had an unallowable purpose, falls to be answered by concentrating on the short-term swap contract.  It was no part of the Revenue’s case that the long-term swap contract had such a purpose.  Moreover, while it may be possible for Prudential to contend that its main purpose in entering into the RBS swap was to hedge an increase in the Euro-debt, that will not be sustainable in the present circumstances where there have been two distinct qualifying contracts, i.e. the short-term and the long-term swap of contracts.  The initial enquiry, in the words of section 168(7), will therefore be whether one of the purposes for which Prudential was party to the short-term swap contract was a tax avoidance purpose.  

80.	This enquiry leads to the question of why a simple full-term swap (covering the period to December 2011) on the lines of the long-term swap contract would not have served the purposes of BSMC and Mr Foley.  It could have been between Prudential and RBS or, more likely, following the Internal Swap, between PFUK and RBS.  What was the point of setting things up with the Internal Swap of 7 March and then going for a short-term swap with RBS that covered only three months of the 120 months exposure and landed the Prudential Group with Є500,000,000 on 19 June 2002?  Asked whether Prudential had any need for euro cash between 2001 and 2011, Mr Foley said that “on the projections of the business at that time when we raised money, we did not”.  

81.	The enquiry leads us on to ask – what was the point of having the three agreements in place on, or in the case of the Internal Swap of 7 March by, 8 March 2002?  The explanation must be that the Internal Swap and the long-term swap contract were required to provide the Prudential Group with hedging demanded by the BSMC.  What then was the purpose for which Prudential was party to the short-term swap agreement when the Prudential Group did not actually need Euros on 19 June 2002?  As a matter of fact Prudential would not have entered into any such short-term swap agreement had Ernst & Young not presented Prudential with their tax planning “Opportunity”.  Mr Foley would have had to find some other use for his “idle” money, and no doubt he would.  The Ernst & Young Opportunity was however adopted and the front end payment was a feature of the Opportunity.  We accept that Mr Foley, with whom responsibility for the swap arrangements lay, did not know the quantum of the potential tax saving and he may not have known how the tax code operated in relation to the swap contracts.  But one thing he did know was that there was a potential tax benefit, the quantum of which was determined by the size of the front end payment.

82.	For those reasons we are satisfied that at least one of the purposes for which Prudential was party to the short-term swap agreement was a tax advantage purpose.  Was that the main purpose or one of the main purposes?  Hedging was not a main purpose of the short-term swap agreement.  We have already observed that the Prudential Group had no need of Є500,000,000 on 19 June 2002; and a full-term swap agreement of the same date as the short-term swap agreement could, we infer, have been given the same effective date as the short-term swap agreement.  The remaining candidate as a “main purpose” was the investment opportunity presented by the front end payment.  Mr Foley had £65,000,000 of what he called “idle” cash which, again to use his words, could be invested “on commercially acceptable arm’s length terms”.  

83.	Did the Prudential’s decision to deploy the £65,000,000 of idle cash as the front end payment under the admittedly tax driven Ernst &Young Opportunity rank as a main purpose for which it entered into the RBS short-term swap contract?  Prudential argue that it did.  We find the evidence in support to be unconvincing.  There is no evidence that Mr Foley or his team actually evaluated the return likely to be achieved from investing the £65,000,000 as a front end payment.  Nor is there any evidence that Mr Foley compared the possible return on the £65,000,000 as a front end payment (which had the effect of pro tanto abating Prudential’s initial liability of 5.088 per cent over a short-term swap contract calculation) with other possible returns over a 3½ month period.  Moreover, any real comparison would surely have taken into account the fact that Prudential was bound, regardless of the success of the Ernst & Young Opportunity, to have to pay £200,000 plus largely irrecoverable VAT on the Ernst & Young fees.

84.	For those reasons we are not satisfied that finding a better use for the £65,000,000 of idle currency was the main purpose for which Prudential was party to the RBS short-term swap contract.  Prudential was implementing the scheme in the manner prescribed by Ernst & Young (see paragraph 25 above) and using as much cash as was available for the purpose.  It follows, we think, that the tax advantage of securing that £65,000,000 was brought into account as part of amount B was, to use the expression of Lightman J in SEMA (see above), more than “mere icing on the cake”.  It was the main purpose.

Conclusions on the GSI swap contract

85.	The GSI arrangement differed from the RBS short-terms swap contract in two respects.  First the GSI agreement provided cover from April until November 2002.  From November onwards Mr Foley envisaged that an issue of  “commercial paper” was to be made.  Second, the front end payment of £40,000,000 paid by Prudential to RBS on 23 August 2002 was to come back to Prudential on 25 November 2002.  The 23 August exchange had been expressed as Prudential making a front end payment of £40,000,000 as consideration for GSI agreeing to buy $250,000,000 for £203,420,055 in circumstances where the arm’s length exchange rate for $250,000,000 was £163,420,055.  

86.	We accept that a swap was needed to protect the sterling value of the BPT&T loan denominated in dollars.  We accept also that Prudential had cash reserves of at least £40,000,000 available at the time for short-term investment.  There was no evidence that the benefit of investing in that manner had been evaluated.  Nor was there any evidence that using the £40,000,000 to make a returnable front end payment was as good or better than any other investment.  

87.	We are not persuaded that the main purpose or indeed one of the main purposes of the GSI swap arrangements was to provide Prudential with the opportunity of investing the £40,000,000 of idle money.  The purposes for structuring the GSI agreement such that a £40,000,000 front end payment was to be made and for Prudential’s entering into it were, we think, together a tax avoidance purpose which was a main purpose if not the main purpose.  

General conclusions on application of Section 168A

87.	For all those reasons the front end payments of £65,000,000 under the RBS short-term swap agreement and the £40,000,000 under the GSI swap agreement were both, in our view, to be left out of the amount B computation.

Decision

88.	We dismiss the appeal.

SIR STEPHEN OLIVER QC

THEODORE WALLACE
SPECIAL COMMISSIONERS

RELEASED: 11 September 2007

SC 3002/2007