Spc00664

 INSURANCE – Life Assurance Business –  Finance Act 1989 section 83(2)&(3) –  enquiry into Company’s tax returns referral under paragraph 31A of Schedule 18 to the Finance Act 1989 – computation of Case 1 profits and losses –  Insurance Companies Act 1982 section 18 –- Insurance Companies Regulations 1994 –- interim Prudential Sourcebook (Insurance) –  Forms 14 and 40 – whether amounts described as “transfers from Capital Reserve” included as part of the entries at line 15 of Form 40 fall to be taken into account as receipts in computing profits or losses – yes, under s 83(3)

THE SPECIAL COMMISSIONERS

	SCOTTISH WIDOWS P LC	First Referrer

	- and -

	THE COMMISSIONERS FOR HER MAJESTY’S
	REVENUE AND CUSTOMS	Second Referrer

		Special Commissioners: 	 J GORDON REID QC
						DR JOHN F. AVERY JONES CBE

Sitting in public in Edinburgh on 3 to 7 December 2007

John Gardiner QC (of the English bar), David Johnston QC and Philip Walford, counsel, instructed by Maclay Murray & Spens, solicitors, for the Appellant

Colin Tyre QC and Jane Patterson, Advocate, instructed by the General Counsel and Solicitor to HM Revenue and Customs for the Respondents

© CROWN COPYRIGHT 2008

DECISION
Introduction
1.	This is a joint referral by Scottish Widows plc, the First Referrer (“the Company”) and the Commissioners for Her Majesty’s Revenue and Customs, the Second Referrer (“HMRC”) under paragraph 31A of Schedule 18 to the Finance Act 1998 of a question which arose in connection with an enquiry into the Company’s tax returns for the accounting periods ending 31st December 2000, 2001 and 2002.  The agreed question for determination is
“Whether in computing the Case 1 profit or loss of [the Company] for the accounting periods ending in 2000, 2001 and 2002, amounts described by the company as “transfers from Capital Reserve” and included as part of the entries at line 15 of Form 40 for each period fall to be taken into account [as receipts] in computing the profit or loss as the case may be”.
If the agreed question is answered in the negative as the Company contends it will have Case 1 losses of over One Billion Pounds (£1,000,000,000).
2.	In broad terms, the issues in this Referral flow from the demutualisation of the Scottish Widows’ Fund and Life Assurance Society (the “Society”) in 2000 and the acquisition of its business by the Lloyds TSB group of companies.  In summary the business, assets and liabilities of the Society were transferred to the Company and to another company (Scottish Widows Annuities Limited [the “Subsidiary Company”]).  These were “off the shelf” companies acquired by Lloyds in 1999.  The Company and the Subsidiary Company are wholly owned subsidiaries of Scottish Widows Financial Services Holdings Limited (the “Parent Company”); that company, too, was acquired by Lloyds off-the-shelf in 1999.
3.	The Referral was presented to the Office of the Special Commissioners on 11 October 2006.  Various Directions have been issued.  A Procedural Hearing took place at Edinburgh on 21st November 2007 before Special Commissioner Reid following which further Directions were issued.  The substantive Hearing took place at Edinburgh on 3rd to 7th December 2007.  John Gardiner Q.C. (of the English Bar) David Johnston QC, and Philip Ward, barrister, appeared on behalf of the Company, instructed by Messrs Maclay Murray & Spens, solicitors, Edinburgh.  They led the evidence of Michael Ross, former Chief Executive of Scottish Widows, Adrian Eastwood, Actuarial Director of Scottish Widows, Derek McKay , Head of Financial Control, Scottish Widows, Craig Clarke, Head of Taxation at Scottish Widows and (the expert evidence of) Andrew Chamberlain FIA of Watson Wyatt Limited.  Colin Tyre Q.C. and Jane Paterson, advocate, appeared on behalf of HMRC, instructed by Eric Brown of the HMRC, Solicitors Office, Edinburgh, and led the evidence of Richard Thomas, an assistant director in the CT and VAT Directorate of HMRC, and (the expert evidence of) Graham Allan, an actuarial consultant.  
4.	In relation to the facts we should record that each witness produced a written statement which was, by earlier agreed Directions, to be treated as the evidence in chief of that witness.  It was agreed at the Procedural Hearing on 21st November, that parties need not adhere strictly to that Direction and that a few supplementary questions may be asked in chief before cross-examination began.  Both parties availed themselves of that opportunity to a commendably limited extent. 
5.	HMRC had also proposed to lead the evidence of Robert Peel, a former assistant director in the CT and VAT Directorate of HMRC.  He retired from that position on 31st July 2005.  A witness statement had been produced at an earlier stage in accordance with those agreed Directions.  In the course of the proceedings before us, Mr Tyre indicated that he had no supplementary questions for Mr Peel and Mr Gardiner indicated that he did not propose to cross examine him although he objected generally to the admissibility of his evidence on the ground that he was giving evidence of law.  Accordingly, subject to the question of admissibility, Mr Peel’s witness statement stood as evidence-in-chief, in accordance with the agreed Directions.  An identical objection to the evidence of Mr Thomas was also advanced.  We consider these objections at paragraph 31 below.
6.	The parties each produced a Statement of Case and Skeleton Argument.  The company also produced a Reply to the HMRC Statement of Case.  A joint Statement of Agreed Facts was also lodged along with a joint bundle of documents comprising six arch lever files.  We have drawn heavily on these documents in setting out the basic framework and background within which the various points in issue fall to be determined.  We are grateful to the solicitors involved for their careful preparation of such a comprehensive bundle of documents.
7.	The sums at stake in this referral are very large.  If the Company is correct in its contentions then some £1,072,535,060 will fall to be treated as Case 1 losses which the Company will be able to surrender to another group company for the purposes of group relief.  We are not asked to determine the precise amount.  We consider that the resolution of the issue specified in the Referral falls to be determined by the proper interpretation of sections 83(2) & (3) of the Finance Act 1989 correctly applied to the facts.  In the main the facts, although apparently complex because they are concerned with the world of life insurance companies and its special accounting procedures, the financial regulatory regime pertaining to that industry and the taxation of such companies (areas of fact, practice and law with which few of us are familiar), were not seriously in dispute except around the “margins”.
8.	The Company arranged for the proceedings to be recorded and transcribed by stenographers (Merrill Legal Solutions, WordWave International Ltd, Fleet Street. London).  A transcript was available to all each day in electronic format within about an hour of the close of proceedings, and hard copy was available shortly thereafter.  For that service we are extremely grateful.  These transcripts, and the comprehensive witness statements and Skeleton Arguments minimised our note-taking duties and enabled the Hearing, set down for ten days, to be completed in four and a half days.
9.	We shall begin by setting out the insurance background, the modern regulatory framework within which the insurance industry operates, and the taxation regime applicable to the profits and losses arising from the activities of insurance companies.  We shall then set out the facts and discuss those few areas where there was dispute as to what findings of fact should properly be made. We shall then set out in summary the arguments for each side and state our conclusions.  
10.	Finally, we record that a number of additional documents were produced during the course of the Hearing all without objection.  In particular, Special Commissioner Avery Jones produced a document (the “JAJ Summary”) which summarised a variety of financial information relating to the transactions and accounting treatment of the various sums involved, gleaned initially from the documents produced but updated from time to time to take account of the evidence as the case proceeded; Mr Eastwood, for example, was recalled twice to comment on an updated version of the JAJ Summary.  All this proceeded with the parties’ consent and was generally regarded by all as a helpful, albeit unconventional, exercise.  Extracts from this document are included later in our decision.
Life Assurance Business
11.	Life policies are contracts of variable endurance.  The premiums paid may or may not be annual payments.  The contract may subsist for the life of the policyholder or for some specified shorter period.  On expiry of the specified period, the life insurance company may be obliged to pay out a lump sum or an annuity.  Annual premiums cannot therefore represent the profits or gains of the life insurance company for they carry corresponding obligations of a postponed and contingent nature.  Likewise, the number of claims in any one year cannot be applied directly to ascertain profits and losses for a given period.  Since at least the nineteenth century actuarial investigation has been deployed to determine the annual profits and losses of a life insurance company.  Happily, this case is not concerned with the detail of such actuarial techniques.
12.	Insurance companies usually aim to invest in assets that provide a good match for their liabilities under non-participating policies.  In contrast, they are often exposed to significant market risks in relation to with-profits business.  This is because these policies tend to be sold on the basis of significant exposure to equity shares, which can and often do fluctuate significantly in value, while the policies themselves provide a guaranteed benefit.  If the assets fall relative to the value of the guaranteed benefits, a loss arises.  Insurance companies writing with-profits policies need substantial amounts of working capital to absorb any such losses.  Capital is also needed to cover other risks such as operational losses or the risk of having to make more payments on annuities than anticipated because of increased life expectancy.
13.	From the late nineteenth century the assets of a life insurance company were usually accounted for on a book value basis.  On disposal, gains were transferred to an investment reserve account, to avoid these gains being treated as profits (which profits might well be transitory).  Life insurance companies are generally cautious about distributing surplus funds.  This caution is necessary because of the uncertainties with which they deal, such as interest rates and mortality experience.  The investment reserve came to be known over the years as the general reserve.  From time to time, funds from the general reserve would be “released” i.e. brought into or transferred to the profit and loss account to balance losses or to fund the distribution of surpluses.  The Society held its assets to cover its liabilities in a single fund (the fund maintained in respect of its long-term business pursuant to section 28 of the Insurance Companies Act 1982) (“the Fund”).  These assets were sufficient to cover its liabilities and to provide the additional working capital that enabled it to bear the risks associated with policies already written and to write new policies.
14.	The Society wrote both non-participating policies (i.e. non-profit policies) and with-profits policies.  The former usually provided either fixed monetary benefits (such as a specified lump sum paid in the event of death or a fixed regular annuity paid throughout life); or benefits directly linked to the performance of a particular set of assets, which usually involved an identifiable fund where each policyholder’s share is represented by a holding of units in the fund.  The performance of the fund is then reflected in the price assigned to those units, which usually changes daily.
15.	With-profits policies can take different forms.  However, they usually provide a minimum guaranteed payment for example on death or on a day certain.  Bonuses may be added to increase the guaranteed payment and a final bonus may be added when a claim is made; that final bonus is discretionary and can be varied to reflect prevailing financial conditions.
Financial Regulation of Life Insurance
16.	In carrying out actuarial investigations for the purposes of the preparation of accounts, the life insurance industry traditionally used values which were lower than the market values of its assets.  These values were known as Book Value.  Statutory recognition of this practice was given in an amendment to regulation 3 of the Insurance Companies (Valuation of Assets) Regulations 1976.  
17.	It is unnecessary to review the whole history of the regulation of the life insurance industry which stems from the Life Assurance Act 1870 which introduced a requirement to submit a periodic return to the Board of Trade which incorporated inter alia an actuarial investigation.  In more recent times, Sections 17 and 18 and 28 (among others) of the Insurance Companies Act 1982 laid down various statutory requirements in relation to the annual accounts and balance sheets of insurance companies.  Section 18 required an insurance company to cause an annual investigation to be carried out into its financial condition in respect of its long term business by its statutory actuary (appointed under section 19).  This includes a valuation of its liabilities attributable to its long term business and a determination of the excess over these liabilities of the assets maintained for its “with profits” business.  The valuation is to be in accordance with regulations.  Accounting rules regulations and procedures changed in 1994.  Following upon the EC Insurance Accounts Directive in 1994, statutory regulation of the accounts of insurance companies differed from other trading companies.  The amended 1976 regulation became Regulation 45(6) of the Insurance Companies Regulations 1994.  The primary focus has throughout been to monitor the solvency of insurance companies.
18.	Regulatory provisions are to be found in the Insurance Companies (Accounts and Statements) Regulations 1996, regulations 4-8, and 23 and Schedule.  Various forms of statutory returns including forms 40 and 58 (discussed in detail below) can be found in these Regulations. 
19.	For the Company’s accounting periods ending 31st December 2001 and 2002 section 18 of the 1982 Act and Part VII of the Insurance Companies Regulations 1994 were replaced by the rules and guidance contained in Chapter 9 of the Interim Prudential Sourcebook: Insurers 21st June 2001 (IPRU:INS) which continued to authorise book value for the purposes of an actuarial investigation  That document was issued by the Financial Services Authority under powers granted by the Financial Services and Markets Act 2000.  Reference may be made to sections 138 and 156-7 of that Act.  These provisions were not discussed before us.  More recently, the Sourcebook has been amended with effect from 31st December 2005.
20.	It was common ground that, although the rules and regulations relating to accounting requirements are somewhat diffuse, and it is not a straightforward exercise to trace the paper trail of amendments, the basic requirements and form of the annual returns required to be submitted by insurance companies to the Financial Services Authority remained largely unchanged by the more recent legislation.  In particular, no distinction falls to be made in our examination of the facts and the law between the accounting periods ending on or after 31st December 2001 and the accounting period ending on 31st December 2000.  No such distinction was advanced by either party and we have not detected any.
21.	In summary, the authority and requirement for and the reporting of:-
I.	The actuarial investigation is section 18 and 42 and the 1982 Act; and subsequently Rule 9.4 and 9.31 of IPRU:INS; and regulation 25 of and Schedule 4 to the 1996 Regulations; this includes form 58 (an abstract of the Actuary’s Report on annual Investigation)
II.	The revenue account, balance sheet and profit and loss account is section 17(1) of the 1982 Act; and subsequently Rule 9.3 and 9.14 of IPRU:INS; and Regulations 6-8 of and Schedule 1 and 3 of the 1996 Regulations; this includes forms 13, 14  (Balance Sheet) and 40 (Revenue Account).
22.	In contrast to the actuarial investigation which is concerned with surplus for distribution, regulation of insurance companies is primarily concerned with solvency, that is the excess of the value of its assets over its liabilities.  For this purpose market (admissible ie a value at or approaching market) values are used for assets.  This includes forms 9 (statement of solvency), 13 (analysis of admissible assets, which is effectively a balance sheet with assets shown at admissible values), and 14 (long term insurance business liabilities and margins).
Taxation of Life Insurance Activities
23.	The authorities establish that the insurance business is a trade within the meaning of Case 1 of Schedule D.  An insurer’s profits include its investment income (other than that which has already borne deduction at source), and its gains arising on disposal of investments.  HMRC have long been entitled to elect to assess the investment income of a life insurer rather than its trading profit and they invariably do so.  This basis of assessment led to the introduction of the I minus E basis of assessment in the Finance Act 1915.  
24.	It was also established long ago that in ascertaining the Case 1 profits of a life insurer a deduction fell to be made for its liabilities to policyholders computed on an actuarial basis.
25.	Statutory recognition was given to the accounting practices of life insurance companies.  Section 16 of the Finance Act 1923, provided that where part of its profits are reserved for policyholders or annuitants, such part of the profits were excluded from the Schedule D Case 1 computation; but when they ceased to be so reserved and were not allocated to or expended on behalf of policyholders or annuitants, they were to be treated as profits of the company for the year in which they ceased to be so reserved.  This timing provision thus enabled income and gains to be taxed when they were brought into account i.e. they ceased to be part of the reserve fund and had been transferred into the profit and loss account for whatever purpose.  Section 23 eventually became section 433 of the Taxes Act 1988.  Section 433 was repealed in 1989 and was replaced by sections 82 and 83 of the Finance Act 1989.  The reason for that repeal and the enactment of sections 82 and 83 appears to have been some disagreement between the Inland Revenue (as it then was) and the life insurance industry as to the circumstances in which profits fell to be treated as “reserved” and thus outwith the charge to tax (at least as long as they were so “reserved”).  These sections provide as follows:-
83 Receipts to be brought into account
(1) The following provisions of this section have effect where the profits of an insurance company in respect of its life assurance business are, for the purposes of the Taxes Act 1988, computed in accordance with the provisions of that Act applicable to Case I of Schedule D.
(2) So far as referable to that business, the following items, as brought into account for a period of account (and not otherwise), shall be taken into account as receipts of the period—
 (a) the company's investment income from the assets of its long term business fund, and
 (b) any increase in value (whether realised or not) of those assets.
If for any period of account there is a reduction in the value referred to in paragraph (b) above (as brought into account for the period), that reduction shall be taken into account as an expense of that period.
(3) In ascertaining whether or to what extent a company has incurred a loss in respect of that business in a case where an amount is added to the company's long term business fund as part of or in connection with—
(a) a transfer of business to the company, or
(b) a demutualisation of the company not involving a transfer of business,
that amount shall (subject to subsection (4) below) be taken into account, for the period for which it is brought into account, as an increase in value of the assets of that fund within subsection (2)(b) above.
(4) Subsection (3) above does not apply where, or to the extent that, the amount concerned—
(a) would fall to be taken into account as a receipt apart from this section,
(b) is taken into account under subsection (2) above otherwise than by virtue of subsection (3) above, or
(c) is specifically exempted from tax.
…
(6) In subsection (3) above “transfer of business” means—
 (a) a transfer of the whole or part of the long term business of an insurance company in accordance with a scheme sanctioned by a court under Part I of Schedule 2C to the Insurance Companies Act 1982;…
…
(8) In this section—
 “add”, in relation to an amount and a company's long term business fund, includes transfer (whether from other assets of the company or otherwise);
 “demutualisation” means the conversion, under the law of any territory, of a company which has been carrying on insurance business without having a share capital into a company with a share capital, without any change of legal personality;….
83A Meaning of “brought into account”
(1) In sections 83 to 83AB “brought into account” means brought into account in an account which is recognised for the purposes of those sections.
(2) Subject to the following provisions of this section and to any regulations made by the Treasury, the accounts recognised for the purposes of those sections are—
(a) a revenue account prepared for the purposes of the Insurance Companies Act 1982 in respect of the whole of the company’s long term business;….
This is a reference to Form 40.
26.	The words long-term insurance were substituted for the words long term business for periods of account ending on or after 1st December 2001.  Section 83A(2) was also amended so as to read:-
“(2)	Subject to the following provisions of this section and to any regulation made by the Treasury, the accounts recognised for the purposes of those sections are:-
(a)	a revenue account prepared for the purposes of Chapter 9 of the Prudential Sourcebook (Insurers) in respect of the whole of the company’s long-term business;
(b)	any separate revenue account required to be prepared under that Chapter in respect of a part of that business.
In paragraph (a) “the Prudential Sourcebook (Insurers)” means the Interim Prudential Sourcebook for Insurers made by the Financial Services Authority under the Financial Services and Markets Act 2000“
27.	It will be noted that the statutory phrase reserved for in the 1923 Act and in section 433 of the Taxes Act has become brought into account in section 83 of the 1989 Act.  Section 83A defines brought into account by reference to a revenue account prepared for the purposes of the Insurance Companies Act 1982.  This provides the link between the fiscal legislation on the one hand and the statutory provisions established by or under the 1982 Act and the regulatory controls in or under the Financial Services Act 2000 in relation to accounting treatment and standards in connection with the regulation of the insurance industry.  The link is even more explicit in the amended section 83A(2).  We also note in passing that section 83(2) was replaced by section 170 of and Schedule 33 to the Finance Act 2003 with effect for periods of account beginning on or after 1st January 2003. 
28.	In 1995, following upon the EC Insurance Accounts Directive and its transposition into domestic law the Revenue issued a Statement of Practice in relation to the computation of the trading profit of companies carrying on long term insurance business where insurers draw up their accounts in accordance with the Insurance Accounts Directive.  The Revenue thereby intimated that it would continue to base the computation of Case 1 profits from life assurance business or Case VI profits of inter alia pension business and overseas life assurance business on the FSA returns.
29.	The foregoing fiscal and regulatory framework was not in dispute.  The real issue between the parties as already noted was the proper statutory interpretation of certain key components of that framework and their application to the facts of this case properly analysed. 
Objection to Evidence 
30.	At the Procedural Hearing on 21st November 2007, Mr Johnston QC for the Company sought to have the evidence of Richard Thomas and Robert Peel (who had produced witness statements) excluded on the ground that their evidence was inadmissible because it was essentially evidence of matters of law.  That application was refused in hoc statu.  Immediately before Mr Thomas gave evidence, Mr Gardiner Q.C. renewed the objection.  After some discussion, he, in effect, withdrew the objection, meantime, on the basis that the evidence would be allowed subject to argument at the end of the day on its competency.  In his closing submissions, Mr Gardiner again renewed his objection and adopted it in relation to the witness statement of Mr Peel.  The argument was that these witnesses were not experts and were expressing views on the law.  In response, Mr Tyre, accepted, in effect, that part 4 of Mr Thomas’s Statement was inadmissible.  As for the rest, the submission was that it was evidence of industry practice with incidental references to the underlying law, and that Mr Thomas was sufficiently qualified to give such evidence.  Mr Tyre, with the exception of paragraphs 3.5 and 3.10, accepted that the evidence of Mr Peel was inadmissible.  However, he adopted the content of the statement as part of his submissions and invited us to accept the factual evidence given in paragraphs 3.5 and 3.10.
31.	In our view, nothing turns on the decision on the objection to the evidence of Mr Thomas or Mr Peel.  We sustain the objection in relation to Mr Peel with the exception of paragraphs 3.5 and 3.10.  These two paragraphs may properly be described as evidence of industry practice. Insofar as their evidence is admissible, we considered it to be valuable   as they both have experience of the whole life insurance industry including tax problems relating to many insurance companies, whereas the other expert witnesses may have experience of only one company (Zurich Life for Mr Allan, and two companies for Mr Chamberlain, although his experience was wider through the Government Actuary’s Department with responsibility for life insurance companies and later as a consulting actuary).  
32.	We would not have sustained the objection on the ground that Mr Peel was not an expert.  In Scotland, the question is whether the court or tribunal considers that the witness is sufficiently skilled on matters outwith judicial knowledge to enable the court to place reliance upon the factual findings  (if any) of the witness, and/or the reasoned opinion of the witness.  The court, or any decision maker, is not bound to accept the view of any witness.  The weight to be given to such evidence will normally depend upon the thoroughness of the investigation carried out by the witness and/or the strength of his reasoning which has led to the opinion and conclusions put before the decision maker.   
33.	However, as predicted at the Procedural Hearing and as discussed with Mr Gardiner the contents of much of the witness statement fall to be considered by us as part of Mr Tyre’s submissions on the law.
34.	As for the evidence of Mr Thomas, we accept that he is a skilled witness even although he has no formal qualifications as a lawyer or an actuary.  We hold that paragraphs 1.3, 2.3, 2.4, 2.5, and 2.7, are all inadmissible because they express opinion on the law.  These statements of opinion are not necessary for the purposes of the evidence of practice.  Part 4 of his witness statement is also inadmissible; that has already been conceded.  
35.	Our decision on the question of admissibility has an air of artificiality about it because the whole of the statement would have been admissible had it been framed along the lines that it proceeds on the assumption or hypothesis that the law is X and whether the law is X is a matter for legal argument at the end of the day.  It is well established that a witness (commonly but not necessarily a skilled or expert witness) may be asked a question on the basis of a hypothesis or assumption, at least where there is a prospect of that hypothesis or assumption ultimately being established.  We recognise that expert evidence increasingly trespasses on questions of law or expresses a view on the precise issue the decision maker has to determine.  There is a grey area in which the line between the admissible and inadmissible is difficult to define; professional negligence claims are an example.  Ultimately, the test may be whether the expert is expressing an opinion within his expertise and outwith judicial knowledge, and whether the evidence is likely to be helpful to the decision maker.  This formulation plainly excludes expert evidence as to what the law is, unless the law is foreign law, which raises a question of fact.
Facts 
36.	The Statement of Agreed Facts is in the following terms:-
The Society
(1)	In 1814 the Scottish Widows’ Fund and Life Assurance Society (“the Society”) was formed at Edinburgh “upon the Principle of mutual Assurance”.  Subsequently, the Society was incorporated under the Scottish Widows Fund and Life Assurance Society’s Incorporation Act 1861.
(2)	At all times material to this referral, the Society was governed by the Scottish Widows’ Fund and Life Assurance Society Act 1980, which provided its constitution and regulations.
(3)	At all material times, the Society was a company without share capital owned by its members.
(4)	As permitted by its regulations, the Society wrote both ‘with profits’ policies (or ‘participating’ policies), which entitled a member holding such a policy to participate in the Society’s distributed profits, and also ‘without profits’ policies (or ‘non-participating’ policies).
(5)	By section 17 of the Scottish Widows’ Fund and Life Assurance Society Act 1980, it was provided that, on a dissolution, surplus assets were to be distributed among its members.
(6)	The Society was authorized under section 4 of the Insurance Companies Act 1982 to transact long-term insurance business in the UK in the following classes (as specified in Schedule 1 to that Act): Class I (Life and annuity); Class II (Marriage and birth); Class III (Linked long term); Class IV (Permanent health); Class VI (Capital redemption); and Class VII (Pension fund management).  
(7)	The Society maintained a single long-term fund in respect of its long-term business pursuant to section 28 of the Insurance Companies Act 1982.
The Company and the  Scheme of Transfer 
(8)	Early in 1999, the Lloyds TSB group (of which Lloyds TSB Group plc is the ultimate parent) approached the Society with a view to acquiring the latter’s business and, on 23 June 1999, the Society and Lloyds TSB Group plc, entered into an agreement for the transfer of the Society’s business to subsidiaries of the Lloyds TSB group.
(9)	That transfer was conditional on, inter alia: an order by the Court, pursuant to section 49 and Part 1 of Schedule 2C to the Insurance Companies Act 1982, sanctioning a scheme of transfer; requisite regulatory approvals (including approval by the Financial Services Authority (“the FSA”)); and approval by the Society’s members.
(10)	The acquisition of the business was proposed entirely for bona fide commercial reasons and neither party had any tax-avoidance or tax-mitigation motive for it.
(11)	Scottish Widows plc (“the Company”), Scottish Widows Financial Services Holdings Limited (“the Parent Co”), and Scottish Widows Annuities Limited (“the Subsidiary Co”) were each incorporated in 1999 and were acquired ‘off-the-shelf’ by and ultimately owned by the Lloyds TSB group.
(12)	The Company is a UK-resident company, incorporated in Scotland and is a wholly-owned subsidiary of the Parent Co.  The Subsidiary Co is a wholly-owned subsidiary of the Company.
(13)	On 28 February 2000, the Court of Session sanctioned, pursuant to section 49 and Part 1 of Schedule 2C to the Insurance Companies Act 1982, a scheme for the demutualization of the Society and the transfer of its business to the Company (and to the Subsidiary Co) (“the Scheme”).  
(14)	At all material times prior to the implementation of the Scheme, the Society carried on mutual insurance business, consisting mainly of mutual life assurance business. 
(15)	At all material times prior to the implementation of the Scheme, the value of the Society’s assets was substantially in excess of its liabilities (see paragraphs (37) and (38) below) and, had there been a dissolution of the Society, a substantial surplus would have been distributable among its members. At 31 December 1999, the excess of the Society’s admissible assets over its liabilities shown in its FSA return was £5,804 million (see lines 13 and 51 of Form 14 of the Society’s return for year ended 31 December 1999).
(16)	The Scheme came into effect on 3 March 2000.
(17)	The terms of the Scheme provided for the transfer of the Society’s business to the Company (with the exception of certain without-profits pension business to be transferred to the Subsidiary Co).  
(18)	The Scheme provided for the membership rights of the Society’s members to cease and for the Company to become the Society’s sole member (paragraph 38); and, in consequence, for the Society’s members to receive compensation from the Lloyds TSB group (paragraph 12 of the Scheme).  
(19)	It was provided that UK members would receive, as membership compensation, redeemable shares issued by the Parent Co and that overseas members would receive cash.  The redeemable shares would then be exchanged for cash; alternatively, there was an option for UK members to receive compensation in the form of loan notes which would be subsequently repaid (this option is described in the Policyholder Circular at pp. 3, 17-18 and 60-61).
(20)	Application for clearance for the Scheme was made under sections 211, 138 and 139 of the Taxation of Chargeable Gains Act 1992 and section 444A of the Income and Corporation Taxes Act 1988 and such clearance was given on the basis that H.M. Revenue and Customs were satisfied that the transactions would be “effected for bona fide commercial reasons and [did] not form part of a scheme or arrangements of which the main purpose, or one of the main purposes, is avoidance of liability to capital gains tax or corporation tax”.
(21)	The Scheme also provided, among other things, for the establishment of a “Long Term Fund” of the Company (the fund maintained for its long-term insurance business for the purposes of section 28 of the Insurance Companies Act 1982) and provided for the Company to establish and maintain, for management and accounting purposes, two separate sub-funds of the Long Term Fund: a “With Profits Fund” and a “Non Participating Fund”.
(22)	The liability to provide benefits under policies transferred to the Company was allocated between those two sub-funds, principally by reference to whether or not the benefits were with-profits (paragraph 14 of the Scheme).
(23)	The Company’s assets and other liabilities were also allocated between the two sub-funds, with provision for the allocation of goodwill, intellectual property rights and shares in subsidiaries to a separate “Shareholders’ Fund”, outside the long-term fund (paragraphs 15 and 16 of the Scheme).
(24)	The With Profits Fund was, amongst other assets, allocated a contingent asset representing the future cashflows on business in-force at the time of demutualization (“the Right to Future Surplus”).  As a result of the contingent nature of that asset, its value was not admissible for satisfying the regulatory solvency requirements; it was provided that the Non Participating Fund would make a non-interest-bearing loan to the With Profits Fund of admissible assets with repayment contingent on surplus emerging (paragraph 22A of the Scheme); the loan is repayable as the future profits on the relevant in-force business arise (paragraphs 21 and 22A of the Scheme).
(25)	The With Profits Fund is a so-called “90/10” fund and the surplus must be applied for the benefit of the with-profits policyholders, save for one ninth of any surplus allocated to conventional with-profits policies (subject to certain restrictions) to which the Non Participating Fund or the Shareholders’ Fund is entitled (paragraph 18 of the Scheme).  
(26)	In contrast, the Non Participating Fund is a “0/100” fund: amounts from it may be transferred to the Shareholders’ Fund, subject to requirements to retain minimum amounts of capital to support the with-profits and without-profits business.
(27)	The effect of the Scheme was to procure the transfer of the business to the Company in consideration of the Lloyds TSB group procuring the payment of the compensation to the members.  The mechanics of the Scheme, to achieve that objective, can be summarized as follows.
o	Lloyds TSB Group plc and the Society entered into the transfer agreement referred to in paragraph (8) above.
o	That agreement provided that the Society’s business would be transferred to two subsidiaries of the Lloyds TSB group.
o	The agreement further provided that Lloyds TSB Group plc would pay or procure the payment of the membership compensation (the amount of the same was subsequently calculated as being £5,846 million: see paragraph (37) below).
o	Consequently, Lloyds TSB Group plc had the right to procure that two of its subsidiaries would acquire the Society’s business, without consideration payable by those subsidiaries other than the assumption of liabilities; but Lloyds TSB Group plc had the obligation to pay or procure payment of consideration for any such transfer of business (£5,846 million).
o	Lloyds TSB Group plc procured the issue of redeemable shares (and payment of cash) by the Parent Co.  The benefit received by the Parent Co for the issue was the increase in value of its subsidiary (the Company).
o	The Lloyds TSB group provided the funds for the redemption of the redeemable shares and loan notes and the cash required for the purchase (£5,846 million) by a contribution of capital in exchange for the issue of ordinary shares in the Parent Co.
o	The amount of the funds required for the payment of the membership compensation of £5,846 million by the Parent Co to the Society’s members is included in the entry for “Investments in Group undertakings” in the balance sheet of the Parent Co’s statutory accounts.
o	The provision of the membership compensation (of £5,846 million) enabled the Company and the Subsidiary Co to acquire the Society’s business.
The Capital Reserve and the Membership Compensation
(28)	Paragraph 22 of the Scheme provided for the establishment of a memorandum account within the Company’s “Long Term Fund” called “the Capital Reserve” which, it stated, would, on 3 March 2000, “represent the amount of the shareholders’ capital held within the Long Term Fund”.  The Capital Reserve could only be reduced in accordance with the terms of the Scheme by bringing an amount thereof into account in the revenue account of the regulatory return (see paragraphs (45) to (54) below) of either the With Profits Fund or the Non Participating Fund (paragraph 22.3 of the Scheme).  No amounts could be credited to the Capital Reserve subsequent to 3 March 2000.
(29)	The initial amount of the Capital Reserve was determined by the formula in paragraph 22.2 of the Scheme and was the excess of the market value at 3 March 2000 of the assets, over that of the liabilities, which were transferred from the Society to the Company’s Long Term Fund; i.e. surplus assets which built up in the Society while it was a mutual company and, if the Society had been dissolved, would have been distributable to its members (see paragraphs (5) and (15) above).  Under the Scheme, the members gave up their rights to participate in this excess, were compensated by the Lloyds TSB group for so doing, and those assets were then transferred to a new entity, viz. the Company, owned by the Lloyds TSB group.  Thus, the initial amount of the Capital Reserve is equal to the value of the excess transferred to the Company’s Long Term Fund to the ultimate benefit of the Lloyds TSB group.
(30)	Upon the Scheme coming into effect, this initial amount was determined to be equal to £4,455 million.
(31)	The initial value of the Capital Reserve and the value of the membership compensation both ultimately derived from the market value of the Society’s assets which, as at 3 March 2000, was £24,923 million.
(32)	The total amount of surplus capital of the business acquired by the Lloyds TSB group from the Society was £4,769 million (see Table A in the Appendix hereto).  Of that figure £314 million was allocated to the Company’s Shareholders’ Fund and the Subsidiary Co, and the remaining £4,455 million (the initial value of the Capital Reserve in the Company) was allocated to the Company’s Long Term Fund (see Table B in the Appendix hereto).  The Capital Reserve is a memorandum account which is not shown in either the statutory accounts or in the main body of the FSA returns (it is, however, referred to in the notes to the latter).
(33)	Paragraph 22.3 of the Scheme provides that no additional amounts can be credited to the Capital Reserve; that the Capital Reserve shall be reduced in the event that an amount of the Capital Reserve is brought into account in the Company’s revenue account; and that the Capital Reserve may not be reduced to an amount below zero.
(34)	By paragraph 22.4 and 22.5 of the Scheme, part of the Capital Reserve was allocated to the With Profits Fund and part to the Non Participating Fund.
(35)	The part of it allocated to the Non Participating Fund, £2,560 million, was that part of the Society’s total capital allocated to the Company (£4,455 million) that remained in the Non-Participating Fund, after the contingent loan had been made to the With Profits Fund.
(36)	The part of the Capital Reserve allocated to the With Profits Fund was the balance (£1,895 million).
(37)	Pursuant to the Scheme, the members’ compensation was subsequently determined as £5,846 million, based on valuations as at 3 March 2000.  
(38)	The amount of the membership compensation may be arrived at by aggregating: the total amount of surplus capital of £4,769 million (adjusted upwards by £47 million as a result of different assumptions about future mortality); goodwill of £1,826 million; the net present value of future cashflows on the in-force business equal to £1,299 million; less £1,895 million, which was the amount of capital held in the With Profits Fund immediately after all the opening transactions, and a deduction of £200 million for loss of capital liquidity.  See Table C in the Appendix hereto.
(39)	The total membership compensation of £5,846 million was paid, initially, by way of cash and redeemable shares.  The latter were then exchanged, within a few days, for cash or loan notes in accordance with any elections made by the relevant members.
(40)	Compensation payable to UK members in respect of permanent health insurance policies was chargeable to tax as income within section 209 of the Income and Corporation Taxes Act 1988.
(41)	The other compensation payable to UK members constituted chargeable gains for the purposes of capital gains tax.  But for section 490(2) of the Income and Corporation Taxes Act 1988, the provisions of the Tax Acts relating to distributions would have applied to the payments of this other compensation to UK members.
Post-demutualization events
(42)	In each of the relevant accounting periods, the market value of the Company’s assets from the inception of the Long Term Fund had decreased. For the accounting periods ending in 2000, 2001, and 2002 the market value of admissible assets less liabilities in the Company’s Long Term Fund decreased by £(1,659) million, £(1,260) million, and £(386) million, respectively (as derived from comparison of the start and end year sum of lines 13 and 51 of the Company’s Form 14 and equivalent records).  These decreases arose principally because of falls in the value of the stock market. In relation to the Non Participating Fund, the respective amounts were £(304) million, £(158) million and £(297) million.
(43)	The Company’s retained profits or losses in its statutory accounts were £(226) million, £(101) million and £15 million, for the accounting periods ending in 2000, 2001 and 2002, respectively.
(44)	The Company has calculated that the components of those statutory results which related to the post-demutualization events of the Non Participating Fund were respectively: £(231) million, £(211) million and £(253) million.  The Company has calculated these as its commercial losses on the Non Participating Fund for these periods.  None of these figures is shown in the Company’s statutory accounts or FSA annual returns; however, these figures are derived, directly or indirectly, from other figures shown in each of these documents.
FSA annual returns
(45)	Insurance companies are under an obligation to submit annual returns to the FSA, which regulates them.  These returns demonstrate that the insurer meets the regulatory standard of solvency and show the results of a required actuarial investigation which calculates the value of the insurer’s liabilities and identifies the amount of surplus in excess of those liabilities (demonstrating that there was a surplus and a sufficient surplus to cover any declared bonus).  
(46)	At the time of the demutualization, for the Company’s accounting period ending on 31 December 2000, the main regulations were found in the Insurance Companies Act 1982, the Insurance Companies Regulations 1994 and the Insurance Companies (Accounts and Statements) Regulations 1996.
(47)	For the accounting periods ending on 31 December 2001 and 2002, they were replaced with rules and guidance “the Interim Prudential Sourcebook for Insurers” made by the FSA under powers granted by the Financial Services and Markets Act 2000.
(48)	Relevantly, at all times material to this reference, the Company’s annual return included a series of numbered forms.  In particular:
o	Form 13 sets out the admissible, market value of all of a company’s assets; the aggregate figures are reconciled to the figures used in the statutory accounts.
o	Form 14 gives the amount by which the value of the admissible assets in the fund exceed the liabilities (either shown in the “excess of the value of net admissible assets” (line 51) – which is often known as the “investment reserve” – or within the “balance of surplus” (Line 13)).
o	Form 40 “Revenue Account” shows revenue flows and records the fund amount which is carried forward to Form 58.  For the Company, the form is completed for each of the total Long Term Fund, With Profits Fund and Non Participating Fund.  The form is the revenue account for each fund in question, and consists of premiums, claims, investment return, expenses, tax, etc. To the extent that those items also appear in the statutory accounts, the Form 40 is reconcilable to those accounts. 
o	Form 58 “Valuation result and distribution of surplus” determines the actuarial surplus by comparing the value of the insurer’s liabilities from the policies it has issued with the fund shown on Form 40.
(49)	The FSA annual returns and the Company’s statutory accounts are produced from the same underlying accounting data.  In drawing up the Company's annual returns the liabilities were valued and the value of the fund reported in the returns was set having regard to the regulatory admissible value of the Long Term Fund’s assets, in accordance with the relevant regulations.
(50)	What the company has calculated as its commercial losses of its Non Participating Fund (see paragraph (44) above) is derived from the decreases in the market value of admissible assets less liabilities in the Company’s Non Participating Fund which were referred to in paragraph (42) above.
Inclusion of amounts from the Capital Reserve in line 15 of Form 40
(51)	In 2000, an amount of £33,410,000 shown in the notes as “Transfer from Capital Reserve” was included within line 15 of the Company’s (With Profits Fund) Form 40 for the purpose of funding the shareholders’ one ninth entitlement to the bonuses allocated to conventional with-profits policies.
(52)	In 2001, an amount of £30,724,000 shown in the notes as “Transfer from Capital Reserve” was included within line 15 of the Company’s (With Profits Fund) Form 40 for the purpose of funding the shareholders’ one ninth entitlement to the bonuses allocated to conventional with-profits policies; and an amount of £442,000,000 was included within line 15 of the Company’s (Non Participating Fund) Form 40 and is described as “Transfer from Capital Reserve” in the notes.
(53)	In 2002, an amount of £17,000,000 shown in the notes as “Transfer from Capital Reserve” was included within line 15 of the Company’s (With Profits Fund) Form 40 for the purpose of funding the shareholders’ one ninth entitlement to the bonuses allocated to conventional with-profits policies; an amount of £353,000,000 was included within line 15 of the Company’s (Non Participating Fund) Form 40 and is described as “Transfer from Capital Reserve” in the notes.
(54)	The above amounts are the amounts referred to in the agreed question which is subject of this referral and their being brought into account in line 15 of the relevant Form 40 reduced the overall amount of the Capital Reserve by equivalent amounts.  I.e. for the relevant accounting periods the amounts in aggregate are:
£33,410,000 for the period ending 31 December 2000;
£472,724,000 for the period ending 31 December 2001;
£370,000,000 for the period ending 31 December 2002.
(55)	In each of the relevant accounting periods, by way of partial repayment of contingent loan, part of the Capital Reserve allocated to the With Profits Fund was reallocated to the Non Participating Fund: £127.6 million in the period ending 31 December 2000; £123.8 million in the period ending 31 December 2001; and £64.0 million in the period ending 31 December 2002.
Taxation of the Company
(56)	At all material times during which it has carried on life assurance business, the Company has been taxed on the I minus E basis of assessment.  
(57)	Notwithstanding the above, the Company is a proprietary company and so the profits and loss arising from its insurance trade still need to be calculated on a Case I basis.
(58)	In its tax returns and current computations for the periods ending in 2000, 2001 and 2002, the Company has included Case I tax losses equal to £(28,689,437), £(612,583,866) and £(431,261,757), respectively.  For the purposes of this referral it is agreed that, if the agreed question for determination is answered in the negative (as is contended for by the Company, but which is contrary to the contention of H M Revenue and Customs), the Company would have Case I losses of these amounts.

The Appendix hereto forms part of this Agreed Statement of Facts
Appendix

reconciliation of opening capital and membership compensation
Table A: Derivation of total opening capital of the Company and the Subsidiary Co	notes				£m	
Total market value of assets held in the Society	A1				24,923	
Actuarial liabilities allocated to the With Profits Fund of the Company	A2				(16,488)	
Provisions for other liabilities of the With Profits Fund	A3				(901)	
Actuarial liabilities allocated to the Subsidiary Co and the Non Participating Fund of the Company	A4				(2,765)	
Total opening capital 					4,769	

Table B: Derivation of opening capital allocated to the Long Term Fund of the Company	notes				£m	
Total opening capital	B1				4,769	
Opening capital allocated to Shareholders’ Fund of the Company and the Subsidiary Co	B2				(314)	
Opening capital allocated to the Long Term Fund of the Company = Opening Capital Reserve	B3				4,455	
						
Table C: Reconciliation of opening capital to membership compensation	notes				£m	
Total opening capital	C1				4,769	
Difference in reserving for annuities	C2				47	
Goodwill	C3				1,826	
Value of in-force business	C4				1,299	
Capital allocated to the With Profits Fund	C5				(1,895)	
Discount for “lock in”	C6				(200)	
Total membership compensation					5,846	

Explanatory Notes:
	
A1	The total market value of assets held in the Society was based on the final statutory accounts for that entity as at 3 March 2000.	
A2	The amount needed to pay benefits on with-profits policies and on non-profit policies allocated to the With Profits Fund. This amount  is the sum of items (i) to (iii) of 2(c) of the Membership Compensation statement.	
A3	The amount to provide for other liabilities of the With Profits Fund must also be deducted (items (vii) and (viii) of 2(c) of the Membership Compensation Statement).	
A4	The amount needed to cover liabilities for non-profit policies allocated to the Non Participating Fund or the Subsidiary Co.	
		
B1	See the last entry in Table A, above.	
B2	Assets allocated to the Company’s Shareholders’ Fund or to the Subsidiary Co.	
B3	Represents the amount of excess assets over liabilities allocated to the Long Term Fund of the Company. This equates to the total amount of the opening Capital Reserve.	
		
C1	See the last entry in Table A, above.	
C2	The Scheme allowed for a difference in reserving for annuities between that required for determining membership compensation and that required for calculation of the opening Capital Reserve.	
C3	Goodwill reflects amounts payable for other intangible assets acquired, primarily the Scottish Widows brand.	
C4	The value of in-force business represents the net present value of the future cashflows expected to emerge to the benefit of the shareholder from the book of business acquired.	
C5	See paragraphs (35) and (36) above.	
C6	A deduction was made to reflect the fact that the capital held in the Non Participating Fund would be exposed to some risks not reflected in the calculation of the value of in-force business and would not be available for immediate distribution (paragraph 12.7 of the Scheme).	
Further facts illustrated with figures from the JAJ summary
37.	From the evidence we heard and the documents considered, we find the following additional facts admitted or proved:-
38.	We are grateful to the witnesses for modifying the figures that Dr Avery Jones had extracted from the papers to try to show those that were material to the dispute out of a mass of material existing for a company of this size and complexity.  The following section is mainly explanatory but any statements in it are further findings in fact, and any statements attributed to witnesses are statements which we accept, except where it is clear from the context that we are discussing a disagreement between witnesses.  
The acquisition of the Fund under the Scheme
39.	The Scheme provided:
“4.1 On and with effect from the Effective Date [11.59 pm on 3 March 2000] the Transferred Non-Pension Assets [this is all the long-term business assets except annuity business which was transferred to a subsidiary] shall, by the Order and without any further act or instrument, be transferred by [the Society] to and vest in [the Company]…
..
5.1  On and with effect from the Effective Date the Transferred Non-Pension Liabilities shall, by the Order and without any further act or instrument (but subject to the terms of the Order and save as otherwise provided by this Scheme), be transferred by [the Society] to [the Company] and become liabilities of [the Company] and [the Society] shall be released from any liability in respect of such transferred Non-Pension Liabilities.
…
13  As a result of the transfer of the Business, the long Term Fund…shall be established.  From the Effective Date it shall be a requirement of this Scheme being implemented in accordance with the [Insurance Companies Act 1982] that [the Company] shall establish and maintain, for management and accounting purposes, two separate sub-funds within the Long Term Fund: the With Profits Fund and the Non-Participating Fund….”
We shall refer to the With Profits Fund below as “WP” and to the Non-Participating Fund as “NPF.”
40.	From Table A to the agreed statement of facts above we can summarise a simplified opening balance sheet of the Company as follows (all figures in these tables are in £m):
Opening balance sheet						
	Total	WP	NPF			
Shareholders’ funds	314		 	Assets at market value	24,923	
Capital reserve	4,455	1,895	2,560	Actuarial liabilities	(19,253)	
			 	Other adjustments	(901)	
	4,769		 		4,769	
41.	We can summarise Table C to the agreed statement of facts to show how the consideration paid to the members of the Society by the parent company of the Company (“the Parent Company”), a Lloyds TSB group company, relates to the above, as follows:
Paid to members of the Society		
Opening capital as above	4,769	
Goodwill	1,826	
Other adjustments	(749)	
Total	5,846	
The Capital Reserve
42.	The Capital Reserve is accordingly the excess of the net assets over funds designated as shareholders’ funds at the start of the Company.  The Scheme provides:
“23.1  On and after the Effective Date, [the Company] shall maintain a memorandum account within the Long Term Fund designated as the Capital Reserve (“the Capital Reserve”).  At the Effective Date the Capital reserve shall represent the amount of the shareholders’ capital held within the Long Term Fund.
22.2 [deals with the calculation of the opening value of the Capital Reserve]
23.3  After the Effective Date no amounts shall be credited to the Capital Reserve and the amount of the Capital Reserve shall be reduced only in the event that an amount of the Capital reserve is brought into account in the revenue account of:
(a) the With Profits Fund (in which case the WP Part shall be reduced by an amount equal to the amount brought into account up to a maximum aggregate amount equal to [references to the method of calculation are given]
(b) the Non Participating Fund (in which case the NP Part shall be reduced by an amount equal to the amount brought into account).”
(The meaning of bringing a figure into account in the revenue account has been explained in paragraph 27 above and is dealt with in paragraph 50 below)
43.	Because the Parent Company paid the members of the Society £5,846, being the opening capital of the Company of £4,769m plus goodwill of £1,826m (subject to other adjustments), the Company became entitled under the Scheme to have the Fund with a net value of £4,769m transferred to it for no consideration.  Effectively therefore the Parent Company received value for its paying the members of the Society in the form of value being created in the Company equal to the net value of the Fund.  The net value of the Fund is represented by shareholders’ capital of £314m and the Capital Reserve of £4,455m which, the Scheme states, represents the amount of the shareholders’ capital held within the Fund.  Mr Tyre objected to describing it as an injection of capital by the Parent Company, saying that it arose from the transfer of the business under the Scheme carrying with it an unrecognised excess from the Society.  We would analyse it as capital indirectly put into the Company by the Parent Company.  If this had not been a transfer under a Scheme the Company would by subrogation owe the Parent Company the amount that the Parent Company had paid in order to obtain the free transfer of the business.  If the Parent Company waived the debt the amount would appear as a reserve.  Because the transfer is under a Scheme this debt does not arise but the Capital Reserve is the equivalent of it.  In tax terms it seems to us the equivalent to a capital payment by the Company to acquire the Fund made out of a capital investment by the Parent Company.  
44.	Mr Allan regarded the Capital Reserve as merely an item of information recording the Company’s position at the beginning and not having any meaning or relevance either to the Company’s statutory report and accounts or to its regulatory returns.  If the Capital Reserve had not existed the transfer of the business would have been exactly the same.  He agreed with Mr Chamberlain, who paid more attention to the Capital Reserve since it was required by the Scheme, that it was appropriate to refer to it as additional information in the regulatory returns since the Scheme required its existence.  We do not believe that there is any substantial disagreement between the two experts over the nature of the Capital Reserve.
45.	The purpose of the Capital Reserve was to keep a record of this initial value created by the Parent Company and to distinguish it from subsequent profits.  It was not initially envisaged that it would be written down to reflect investment losses caused by the significant fall in the stock market occurring immediately after the demutualization and continuing in the years in issue.  No doubt it was also hoped to have tax benefits but its primary purpose was to show the amount of initial shareholders’ funds.
The two different values of the Fund
46.	In the following tables we shall illustrate the picture with figures taken from the 2001 accounts and Financial Services Authority (“FSA”) returns in order to avoid complications arising from 2000 being the opening year of the Company.  We have included certain figures in bold to show how they follow through various items into the tax computation, where they are in dispute.  
47.	We have explained in paragraphs 16 to 22 above that the two different values of the Fund are (1) market value (technically admissible value, which is market value with some restrictions on the values that can be counted), which is used for determining the solvency of the Company; and (2) what we shall call the Form 40 value, which is used in the actuarial investigation for the purpose of determining the amount of any surplus to be distributed either as bonuses to policyholders or dividends to shareholders.  The following table illustrates the use of market (or admissible) value of the Fund for the calculation of the regulatory capital:
Regulatory	WP	NPF	
Assets at admissible value	19,134	3,544	
Liabilities to policyholders	(18,935)	(872)	
Other liabilities	(110)	(526)	
Regulatory capital	89	2,146	
48.	The actuarial investigation is used to determine the amount of the surplus that the Company determines to distribute as bonuses to policyholders or as dividends to shareholders.  The value of the Fund used for this purpose, authorised by regulation 45(6) of the Insurance Companies (Accounts and Statements) Regulations 1996 (see paragraph 17 above) and from 2002 by IPRU:INS (see paragraph 19 above), we call the Form 40 value of the Fund (Form 40 is the FSA revenue account in which the value is used).  The Form 40 value is traditionally achieved (and was so achieved by the Company) by bringing the value of assets into account either by showing the value as market (admissible) value or nil as is required to achieve the desired total figure.  The use of this value is shown in the following table which we have over-simplified by excluding the actuarial investigation of business that has arisen since demutualisation so as not to complicate the picture: 
Actuarial investigation	Total	WP	NPF	
Value of assets in books ("Form 40 value of the Fund")		19,731	544	
Liabilities to policyholders ("mathematical reserves")		(18,816)	(420)	
Total surplus before distribution		915	124	
Surplus brought forward	33	0	0	
Transfer from other funds/parts of Fund	0	124	(124)	
Surplus arising (excluding transfers)	915	791	124	
Bonuses (in year and allocation)		(884)		
Shareholders' share of bonus		(31)		
Surplus carried forward		0	0	
The Form 40 value of the Fund differs from the amount shown in form 40 by the amount of payments of bonuses, and transfers to other funds, made in the year (the reconciliation can be seen in the third box in the table in paragraph 50 below).  The mathematical reserves are in principle the same as the liability to policyholders in the previous table except that in the former it is required to be stated after reversionary bonuses (£119m).
49.	The Form 40 value of the Fund is accordingly the value that produces the required nil figures at the end of the above table.  
50.	The method by which an insurance company normally achieves the required Form 40 value of the Fund in order to show a nil surplus in the actuarial investigation after distributions is through an entry in the revenue account, being FSA Form 40.  We set out below a simplified Form 40 with an analysis (shown within a box which totals the figure in the line below the box) of the two lines used by the Company as balancing items: line 13 (the normal line for the balancing figure) which is used to bring in value from the Line 51 Amount, and line 15 used for other income.  The third box is not part of the form but shows how these figures are reconciled to the Fund figure in the actuarial investigation table. 
Simplified Form 40	Line No.	Total	WP	NPF	
Premiums, investment income, decrease in value of linked assets	11,12,14	3,296	2579	426	
Investment losses		(2,268)	(1,815)	(453)	
From Line 51 Amount		1,108	1,233	(125)	
Other		(7)		(7)	
Decrease in value of assets brought into account	13	(1,167)	(582)	(585)	
Profits transferred to WP from NPF			124		
Transfer from capital reserve		473	31	442	
Shareholders' share of bonus				31	
Management fees		29		100	
Other			8		
Other income	15	502	163	573	
Total income (lines 11 to 15)	19	2,631	(419)	(12)	
Total expenditure	29	1,921	107	424	
Increase in Fund during year	39	710	429	279	
Fund brought forward	49	19,161	18,505	656	
Fund carried forward	59	19,871	18,935	935	
Adjustment for bonus payments made in year and transfer to other funds			796	(391)	
Form 40 Fund value as in actuarial investigation table			19,731	544	
51.	The effect of the two adjustments is that in line 13 £1,108m has been brought in from the Line 51 Amount to counteract in part the fall in value of investments of £2,268m, leaving a decrease in income of £1,167m.  The line 15 adjustment brings into income £473m (£442m + £31m) from the Capital Reserve (and also the Line 51 Amount).  Mr Chamberlain preferred the Company’s inclusion of this item in line 15, which means that the details have to be shown in a note to the form, but conceded that including it in line 13 would not have been wrong.  Mr Allan would have preferred the use of line 13 possibly with an additional note, but he did not disagree with Mr Chamberlain’s view.  Since both lines are totalled in line 19 it seems to us that there is no difference in principle involved here.  Mr Chamberlain pointed out that since the Capital Reserve was created on the transfer of business to the Company it could not represent any past investment income or capital profits made by the Company.  Mr Allan considered that the statutory reference was not restricted to income or gains made by the Company itself but could extend to income or gains made by the Society.  This is a disagreement between the experts about the meaning of the legislation, which is a matter for us to decide.  
52.	The corresponding changes in the capital reserve and the Line 51 Amount are:
Movement of Capital Reserve	Total	WP	NPF	
Opening capital reserve	4,422	1,734	2,688	
Contingent loan repayment	0	(124)	124	
Amount to fund shareholders' proportion of bonus	(31)	(31)		
Transfer to line 15	(442)		(442)	
Closing value	3,949	1,579	2,370	
				
Movement of the Line 51 Amount				
Opening value	3,462	1,191	2,271	
Contingent loan repayment	0	(124)	124	
Amount to fund shareholders' proportion of bonus	(31)	(31)		
Transfer to line 15	(442)		(442)	
Transfer (to)/from line 13	(1,108)	(1,233)	125	
Other	290	286	4	
Closing value	2,171	89	2,082	
53.	It will be seen that the £442m and £31m figures appear as deductions from both the Capital Reserve and the Line 51 Amount, and the figure of minus £1,108m which went to line 13 of Form 40 appears in the Line 51 Amount only.  The £442m represents the commercial losses of the Company in the years 2000 and 2001, which after adjustments, is found in the statutory accounts as losses of £226m and £101m for those years respectively.  It represents the amount by which the net assets of the Company were reduced subject to two adjustments, one relating to the “retained account” transfer required by the Scheme, and the other to the revaluation of a subsidiary, neither of which were considered to be trading items.
54.	 The difference between the admissible value of the Fund (used in the regulatory table) and the Form 40 value of the Fund (leaving aside the slightly different methodology and timing differences) was traditionally (see paragraph 13 above) called the investment reserve, although this is today considered to be a misnomer since it is not a reserve in the FSA sense of a liability to policyholders, or in the Companies Act sense as it is not available to shareholders; it is set aside for either policyholders or shareholders without allocation to either (we were referred to an article by Brian Drummond “Making sense of the FSA return in life company tax computations” 2006 FITAR 6 which makes this point).  While some witnesses referred to this difference as the investment reserve, Mr Chamberlain regarded  it as not a strictly accurate description and Mr Tyre expressed reservations about it.  It is better to regard it as purely the difference between the two valuation figures, and we shall refer to it as “the Line 51 Amount” (since it appears in line 51 of Form 14), as it is now called in the legislation.  With a continuing company, as Mr Chamberlain said, the vast majority of the Line 51 Amount will arise from investment causes, such as gains on investments that have not been brought into account in Form 40 (see below) but the Company is an example of where this is not the case as any investment gains contained in the Fund will have been made in the predecessor Society and not by the Company, which made losses in its investments in the years in question, so that the more neutral description of the Line 51 Amount is preferable.  The Line 51 Amount can also arise from other causes such as differences in mathematical reserves unrelated to investment values, or as an example given by Mr Chamberlain of writing business such that the premiums received exceed the liability under the policy.
55.	The opening Line 51 Amount is closely related to the amount of the Capital Reserve in this case, presumably because both arise from the excess value of the Fund over its liabilities, and the Form 40 value being the value of the Fund that will match those liabilities.  The following table shows the connection:
Relationship between opening Capital Reserve and the Line 51 Amount	
	Total	WP	NPF	
Capital reserve	4,455	1,895	2,560	
Difference in valuation method	664	664		
Other adjustments	35	(13)	48	
Line 51 Amount	5,154	2,546	2,608	
56.	The difference in valuation method arises because the capital reserve is valued on the “asset shares” basis and the Line 51 Amount on the FSA basis.  The former is considered to give the more realistic result.  The difference between the two methods indicates that £664m is “policyholder capital.”  Although closely related the Capital Reserve is not the same as the Line 51 Amount, particularly as the amount of the Capital Reserve cannot be increased.
The derivation of the Case I computation
57.	Next, we show again the result of the actuarial investigation, this time including the post-demutualisation part of the NPF and also a breakdown of the total surplus before distribution within the box as this will be relevant for the tax computation:
Actuarial investigation	Total	WP	NPF transferred	NPF post-demutualization	
Value of assets in books ("the Fund") grossed up		19,731	544	516	
Liabilities to policyholders ("mathematical reserves")		(18,816)	(420)	(452)	
Total surplus before distribution		915	124	64	
Surplus Brought Forward	33	0	0	33	
Transfer from other funds/parts of Fund	0	124	0	31	
Surplus arising (excluding transfers)	915	791	124	0	
Bonuses (in year and allocation)		(884)			
Transfer to WPF			(124)		
Shareholders' share of bonus		(31)			
Surplus carried forward		0	0	0	
58.	Finally, the tax computation starts from the surplus arising (excluding transfers) figure and proceeds as follows:
Case I computation		
Surplus arising (excluding transfers) from the actuarial investigation 	915	
Allocated to policyholders	(884)	
Tax adjustments	(185)	
Capital reserve (442+31)	(473)	
Other computational adjustments	15	
Case I loss	(612)	
Group relief surrender	(612)	
It is the deduction of £473m that is in dispute in this reference.
Summary of Parties’ Submissions
59.	Mr Gardiner contends in outline:
Section 83(2)
(1)	Subsection (2)(b) refers to the actual increase in value of assets of the Fund, not, as HMRC contend, increases in the Form 40 value of the Fund.  Paragraph (a) refers to actual income from assets of the Fund and para (b) to actual increases in value of the same assets.  The words “whether realised or not” also indicate that para (b) refers to actual increases.  Both such items are capable of falling in a Case I computation.  
(2)	The subs refers to the value of the assets of the Fund.  Such assets have a value, whereas the Form 40 value is a value of the Fund, not of individual assets.
(3)	It refers to the items in paras (a) and (b) being Case I receipts to the extent to which they are brought into account (meaning in Form 40).  HMRC’s interpretation that the value referred to in para (b) is the Form 40 value makes these words otiose.
(4)	The reality is that there are losses in the value of the investments, which should create Case I losses not, as HMRC’s interpretation does, notional profits.
(5)	HMRC’s interpretation results in reg 45(6) of the Insurance Companies (Accounts and Statements) Regulations 1996, and its successor IPRU(INS) made by the FSA, creating a tax liability, which cannot have been intended.
(6)	The correct reading of subs (2) is to identify the income from the assets of the Fund and any increases in their value referred to in paras (a) and (b) and then to the extent only that such items are brought into account in Form 40 to treat them as Case I receipts.
(7)	It makes no difference that the Capital Reserve figure was brought into line 15 of Form 40 rather than the normal balancing item in line 13.  Both are income items and the use of line 15 enables it to be specified that the figure comes from the Capital Reserve.
Section 83(3)
(8)	Subsection (3) is an anti-avoidance provision to prevent the creation of artificial losses.  The mischief aimed at is the injection of capital (a capital receipt) to match liabilities transferred (deductible, see Northern Assurance v Russell 2 TC 551).  Alternatively on a demutualisation when a special bonus is paid to the departing members out of a non-taxable injection of capital, thereby creating a loss.  Both deal with the creation of an artificial loss at the time of the transfer.
(9)	On a purposive interpretation a genuine loss resulting from investment losses should not be caught.
(10)	The subs is concerned with the ascertainment of a loss; there must be a causal connection between the loss and the amount added as part of (or in connection with) the transfer of business.
(11)	There must be an amount, not just assets, added to the long-term business fund.  Coupled with the subsequent reference to the amount being brought into account, the amount must be an amount brought into account other than in line 13, such as line 26.  Here nothing has been added to a long-term business fund because the fund did not exist before the transfer and was formed by the transfer.
(12)	Subsequent additions from the Capital Reserve were not added in connection with the transfer but in connection with the subsequent trading losses.
(13)	The mischief aimed at is therefore bringing in an amount and excluding it as a Case I receipt by bringing it into account in line 26 but at the same time including the corresponding liability in the mathematical reserves, thus creating a loss.  This can arise only on a transfer because with a new fund there will be no corresponding mathematical reserves that can create a loss.
(14)	The opening reference in subs (3) to ascertaining whether there is a loss (or the extent of it) cannot mean that a loss already ascertained is excluded from relief.  
(15)	Subsection (3) is disapplied by subs (4).  Here £16.8bn was added (assuming that one can add something to nothing) and matched by opening liabilities.  Both are on trading account and ignored by subs (4).
60.	Mr Tyre contends in outline:
Section 83(2)
(1)	Section 83(2) should be construed in its context of the practice of insurance companies over many years.  The statutory provisions follow the industry practice, rather than the other way round.  There is an interdependence between form 58 (the regulatory capital figures) and Form 40 (the revenue account).  Section 83(2) closely follows Form 40 as is demonstrated by s 83A which defines brought into account as meaning brought into an account which is recognised for the purposes of s 83, which is effectively defined to mean Form 40.  It is a timing provision.
(2)	If something other than an increase in value of assets is brought into account by bringing it in as a receipt in Form 40, such as an injection of capital put into line 26, that is not a Case I receipt.
(3)	The real issue in the reference is whether the description of the Capital Reserve as shareholder capital is correct in tax terms.
(4)	When the Company brings into account part of the capital reserve by showing it as a receipt in Form 40 it is bringing into account an increase in value of the assets of the Fund because that value has not been included as a receipt in Form 40 before.
Section 83(3)
(5)	Subsection (3) applies where there has been a transfer of business under the Insurance Companies Act and an amount is added to the long-term business fund of the transferee in connection with the transfer.  The words “in connection with” are wide in scope, for which he cited Vaughan-Neil v IRC [1979]  1 WLR 1283, 1288B per Oliver J that the same phrase “involves no more that that there should be a connection” between the two items; Bank of Scotland v Dunedin Property Investment Co Ltd 1998 SC 657 per The Lord President that “The phrase ‘having to do with’ perhaps gives as good a suggestion of the meaning as could be had”; and   the Special Commissioner’s decision in Kent Foods v HMRC (2007) SpC 643 per J Gordon Reid Q.C. that “The statutory phrase in connection with is wide in scope.”  There is no requirement for any causal connection with the loss.
(6)	It makes no difference that the long-term business fund did not exist before the transfer.
(7)	Subsection (3) is not disapplied by subs (4) because the Company brought the opening figure of £16.8bn into form 40 at line 15 matched by opening liabilities but did not bring in the excess value.  When further amounts are added later out of the capital reserve those amounts are still added in connection with the transfer.  Such amounts are not brought in in connection with the losses rather than the transfer because it was not the Company’s original intention to use the Capital Reserve to support investment losses, and not all transfers from the Capital Reserve were in connection with losses; there was a transfer of £100m in 2002 in anticipation of a change in legislation.
(8)	The mischief at which the subs is aimed identified by Mr Gardiner is not exhaustive.
Conclusions
Section 83 as a whole
61.	We start by looking at the section as a whole.  Section 83(1) starts by providing that the following provisions of the section apply where the profits of an insurance company in respect of its life assurance business are computed in accordance with Case I.  This implies that Case I rules apply normally, except as provided.  Subsection (2) on its natural reading is a timing provision, stating that (a) investment income from, and (b) increases in value of, the assets of the Fund (we shall continue to use the expression “the Fund” to include also the long-term business fund of insurance companies in general) are taken into account as income (and reductions in (b) are treated as expenses) for Case I for the period of account in which they are brought into account through Form 40.  Both items (a) and (b) would, but for subs (2), be taken into account on an accruals basis.  Since the section refers (via s 83A) to Form 40 and the practice of life insurance companies we agree with Mr Tyre that we should construe subs (2) in that light.  The relevant parts of Form 40 are line 13 “increase (or decrease) in the value of non-linked assets brought into account” and line 15 “other income.” 
62.	The difference between the parties on subs (2) is to which of the two values of the Fund the legislation is referring in subs (2)(b) in the expression “any increase in value (whether realised or not) of those assets” ie the assets of its Fund.  Mr Gardiner contends that it is the market value (or admissible value), and Mr Tyre that it is the Form 40 value, and he objected to Mr Gardiner’s references to “gains” as changing the meaning of the subsection.  We shall use the expression “actual increase in value” to indicate the former, and “increase in Form 40 value” for the latter.
63.	Subsection (3) relates to the situation arising in this reference where there has been a transfer of business (as defined in subs (6): subsequent references to the transfer of business are to such a transfer as defined).  It provides, on its natural meaning, that solely for determining a loss the amount added to the Fund as part of (or in connection with) the transfer of business is to be taken into account in computing the loss for the period for which it is brought into account as an increase in value of the assets of the Fund in subs (2) (except, by subs (4), where the amount added is a receipt anyway, or a receipt within subs (2), or is exempt). 
64.	One would expect from the existence of subs (3) that on a transfer of business  there was scope for claiming an artificial loss because the addition to the Fund does not represent an increase in value of the assets of the Fund (meaning either an actual increase in value of the Fund, or in the Form 40 value of the Fund, depending on the interpretation of subs (2)), which would be corrected if the addition were to be treated as such an increase.  Mr Gardiner identified two circumstances where this could arise, both involving an injection of capital, but, as Mr Tyre pointed out, those are not necessarily the only cases Parliament had in mind.  The interpretation of the two subsections is thus closely related.
65.	We make two further points on the wording of subs (3).  First, since subs (3) deals with a demutualisation not involving a transfer of business (which cannot in fact occur under the law of any part of the UK, except presumably one effected by Act of Parliament), demutualisation must have been in the mind of the draftsman and so the transfer of business in subs (3)(a) must include the transfer from a mutual to a proprietary company even though a mutual can never have a Case I profit or loss.  Secondly, it should be mentioned that s 444A of the Taxes Act 1988 provides for a number of tax consequences to be carried over to the transferee company on a transfer of business under the Insurance Companies Act, such as expenses of management, Case VI losses and the difference between two methods of allocating liabilities between parts of the Fund that HMRC can choose and the taxpayer can carry forward the difference, and the same applies to capital gains.  But the section is silent on the point in issue here of whether the Line 51 Amount is carried over, from which one can deduce that it is not, because it is an obvious item that might potentially be carried over which Parliament would no doubt have included if that were intended.  We conclude that the reference in subs (2) to an increase in value of assets is restricted to an increase in value (either an actual increase in value or an increase in the Form 40 value, depending on the interpretation of subs (2)) in the hands of the transferee.  But the effect of subs (3) applying is rather similar to saying that the transferor’s Line 51 Amount is carried over because the effect is that the whole of that amount is treated as being an increase in value of assets within subs (2).
66.	The difference in approach of the parties on subs (2) is brought out starkly in the following example produced by Mr Gardiner to which we have made changes shown in square brackets for clarification (and to the extent that they change the facts we do not believe that they do so in a way that affects the point made by the example):
Suppose a life assurance company is newly established with capital of £100m representing its long-term fund.  It writes business whereby it has liabilities of £80m in consideration of premiums of £80m, and has a Form 40 fund [valued at] £80m, and therefore £100m shown at line 51 of Form 14.  [It brought the capital of the fund in as a transfer from non-technical account in line 26.]  It has not managed to make any other income in that period [and has not incurred any expenses].
During its next accounting period, the company [has no investment income or expenses, and the premiums remain at £80m and the mathematical reserves remain at £80m.]  However, the company has also made losses: with the market value of its assets declining by £10m.  The company decides it business is not viable and brings into account in [line 13 of] Form 40 an additional £90m (resulting in a £90m surplus in form 58) which it proposes to distribute to its parent, who will then utilise it in some other way.
The essence of the example is that the company has no actual increase in value of the assets of its Fund in year 1 and an actual decrease in such value in year 2.  Mr Gardiner accordingly contends that the £90m brought into account in line 13 of Form 40 as a balancing figure in year 2 is not taxable income; Mr Tyre contends that it is because it is an increase in the Form 40 value of the Fund, although he accepts that the initial value of the Fund brought into line 26 of Form 40 in year 1 is a capital receipt.
67.	We can illustrate the effect of the difference between the parties in relation to this example in figures in the following table in which it is assumed that the lines on Form 40 not shown in the table are all blank.  We should point out that, unlike the earlier tables in this decision, this table has not been approved by the parties and we hope that it correctly represents their views but, if it does not do so, it should not be taken to contradict our reasons.
Simplified Form 40		HMRC	                    Taxpayer	
	Line	Year 1	Year 2	Year 1	Year 2	
Premiums	11	80	80	80	80	
Increase (decrease) in value of assets brought into account	13	(100)	90	(100)	90	
Transfer to (from) non-technical account	26	100	0	100	0	
Increase (decrease) in Fund in year	39	80	170	80	170	
Fund brought forward	49	0	80	0	80	
Fund carried forward	59	80	250	80	250	
Simplified Form 58						
Mathematical reserves	21	(80)	(80)	(80)	(80)	
Surplus	29	0	90	0	90	
Simplified tax computation						
Surplus as above		0	90	0	90	
Non-taxable receipt		(100)	0	0	(90)	
Case I profit (loss)		(100)	90	0	0	
68.	The difference is that in year 1 HMRC accept that the line 26 amount is a capital receipt but allow a deduction for it in line 13, whereas the taxpayer neither includes the line 26 amount nor allows the line 13 deduction for tax purposes.  In year 2 HMRC bring the line 13 receipt into the computation, while the taxpayer does not on the basis that it does not represent an actual increase in value of the Fund.  The result for HMRC’s columns corresponds to the figures given by Mr Tyre in oral argument and we hope therefore represents his position.  As he pointed out the result does not seem unreasonable since over the two years there is an allowable loss of £10m which corresponds to the investment loss.
69.	Continuing the example in order to consider the effect of subs (3), Mr Tyre’s interpretation of subs (2) creates a loss in year 1, which Mr Gardiner’s does not.  Leaving aside for the moment that the example does not concern the transfer of a business, it is clear that bringing the addition in as a receipt, ie not excluding it from the Case I computation, will remove the loss in year 1 on Mr Tyre’s interpretation, and in year 2 will remove the non-taxable receipt on Mr Gardiner’s interpretation thereby potentially creating a profit (except that subs (3) applies only in determining whether (or to what extent) a company has incurred a loss).  If this is right, it suggests that subs (3) was intended to correct a problem arising on Mr Tyre’s interpretation of subs (2) which, being HMRC’s interpretation, would have been the basis on which Parliament enacted subs (3).  
70.	So far we have kept to Mr Gardiner’s example but we now vary it to assume that the £100m addition arose on a transfer of a Fund from another company with an admissible value of £1,000m and mathematical reserves of £900m, leaving the same net £100m addition to the actual value of the transferee’s Fund as in Mr Gardiner’s example.  We attempt to show the effect of subs (3) applying to this variation on the example both on Mr Tyre’s interpretation of subs (2) and Mr Gardiner’s.  In doing this we assume that £900m of the Fund that is matched with £900m of mathematical reserves is excluded from the effect of subs (3) by subs (4).
		HMRC	Taxpayer	
Simplified Form 40		No s 83(3)	With s 83(3)	No s 83(3)	With s 83(3)	
	Line	Y 1	Y 2	Y 1	Y 2	Y 1	Y 2	Y 1	Y 2	
Premiums	11	80	80							
Increase (decrease) in value of assets brought into account	13	(100)	90							
Other income	15	1,000	0							
Increase (decrease) in Fund in year	39	980	170							
Fund brought forward	49	0	980							
Fund carried forward	59	980	1,150							
Simplified Form 58										
Mathematical reserves	21	(980)	(980)							
Surplus	29	0	170							
Simplified Tax computation							
Surplus as above		0	170	0	170	0	170	0	170	
Non-taxable receipt		(100)	0	0	0	0	(90)	0	0	
Case I profit (loss)		(100)	170	0	170	0	80	0	[170]	
The first part of the table comprising Forms 40 and 58 is set out only once as it remains the same.  The effect on the tax computation of subs (3) applying on Mr Tyre’s interpretation of subs (2) is, as before, to remove the loss in year 1 but to leave the profit in year 2 unchanged.  On Mr Gardiner’s interpretation of subs (2) the effect of subs (3) applying would not affect year 1, but would potentially increase the profit in year 2, except that the subs applies only in determining whether (or to what extent) a company has incurred a loss and so year 2 would be unchanged as well (which is why the £170m figure is in square brackets).  This shows a similar effect to the previous table.
71.	Next suppose that the line 13 deduction were minus £200m (an unrealistic figure chosen to result in a loss on Mr Gardiner’s interpretation) instead of minus £100m, which would not have been possible in Mr Gardiner’s original example because £100m was the value of the Fund, the result would be as follows: 
		HMRC	Taxpayer	
Simplified Form 40		No s 83(3)	With s 83(3)	No s 83(3)	With s 83(3)	
	Line	Y 1	Y 2	Y 1	Y 2	Y 1	Y 2	Y 1	Y 2	
Premiums	11	80	80							
Increase (decrease) in value of assets brought into account	13	(200)	90							
Other income	15	1,000	0							
Increase (decrease) in fund in year	39	880	170							
Fund brought forward	49	0	880							
Fund carried forward	59	880	1050							
Simplified Form 58										
Mathematical reserves	21	(980)	(980)							
Surplus (loss)	29	(100)	70							
Simplified Tax computation							
Surplus (loss) as above		(100)	70	(100)	70	(100)	70	(100)	70	
Non-taxable receipt		(100)	0	0	0	0	(90)	0	0	
Case I profit (loss)		(200)	70	(100)	70	(100)	(20)	(100)	70	
72.	The interesting point that emerges from this last table is that where the figures result in a loss on both interpretations of subs (2), the effect of subs (3) applying is to reduce the year 1 loss on Mr Tyre’s interpretation of subs (2) to the amount of the loss on Mr Gardiner’s interpretation of subs (2).  In year 2 Mr Tyre’s interpretation of subs (2) does not affect the result, but Mr Gardiner’s does by reducing it to the same figure as Mr Tyre’s if subs (3) applies.  Mr Gardiner’s year 2 approach shows a similar result to the actual dispute between the parties over the deduction of what was by origin a capital amount.  This clearly brings out the interrelationship between the two subsections.  Indeed whichever interpretation of subs (2) is correct does not affect the result so long as subs (3) applies.  The loss in the last table was created by the line 13 figure of minus £300m but the same result would have arisen if there had been no such deduction but the mathematical reserves had been greater by £300m, so that the effect of the capital addition was to increase an existing loss.
73.	The reason for this result is that while the £100m net value of the transferred Fund is capital in tax terms, Mr Tyre’s interpretation of subs (2) allows the amount of it to be reversed in line 13, thus causing an income deduction for a capital receipt, which is an odd result looked at purely by applying ordinary tax principles.  The reversal of the capital receipt in year 1 is partly reversed again by bringing in £90m as income.  On Mr Gardiner’s interpretation all three items (the addition to the Fund, its reversal in year 1 and the bringing back of most of it into account in year 2) are all capital, which they are in terms of tax principles.  If subs (3) applies it changes the treatment of all three items from capital to income, which gives consistency, but is wrong for all three in terms of tax principles.  Purely looked at in terms of tax principles in this way the best result is Mr Gardiner’s interpretation of subs (2) so long as subs (3) does not apply. If both subsections apply, we are therefore faced with the choice between two results both of which are wrong in terms of tax principle.  We next turn to the wording of subs (2).
Section 83(2)
74.	We have no doubt that an amount brought into account in line 13 will generally be a Case I receipt.  Subsection (2) normally operates as a relieving provision so that normally a company will not bring in all its investment income and actual increases in value of the Fund in the year into account and so there will be a deduction in line 13, thus building up a Line 51 Amount in Form 14, the majority of which, as Mr Chamberlain said, was from investment causes.  There is no difficulty in ascertaining the actual increase in value figure since the Fund is valued at market value (particularly as the increases in value specifically include unrealised increases) at the end of each year on Form 13.  When the reverse happens (for example, when there are no actual increases in value of the assets of the fund in the year), it will reverse the process and bring a positive figure into line 13 of Form 40, which will be likely to represent past income or actual increases in value by reducing the Line 51 Amount.  There is in practice no need to analyse what these represent since it will be clear that what is deducted in the former case will be out of the current year’s income or actual increases in value of the Fund; and in the latter case it will come out of past income or actual increases in value of the Fund.  
75.	Mr Tyre’s case is that what is generally the case applies to all situations including those where demonstrably there is no actual increase in value.  If we insert his interpretation into the subs it reads:
(2) So far as referable to that business, the following items, as brought into account [in Form 40] for a period of account (and not otherwise), shall be taken into account as receipts of the period—
(a) the company's investment income from the assets of its long term business fund, and
(b) any increase in value (whether realised or not) of those assets [included in Form 40].
If for any period of account there is a reduction in the value referred to in paragraph (b) above (as brought into account for the period), that reduction shall be taken into account as an expense of that period.
One can paraphrase this as saying that the increase (or decrease) in the Form 40 value of the Fund as brought into account in Form 40 (and not otherwise) is a Case I receipt (or expenditure).  This seems circular because we know that any increase (or decrease) in the Form 40 value of the Fund must arise from something being brought into account in Form 40.  As Mr Gardiner contended, there is no point in the words “and not otherwise” because there is no possible “otherwise.”
76.	Mr Tyre does not go that far.  He agrees that not all items in Form 40 increasing the Form 40 value of the Fund are included.  Suppose, as in the example given to us by Mr Chamberlain, with which Mr Allan agreed, and so we assume is a situation that can arise in real life, the Company had written new business such that the amount of the premiums exceeded the new liabilities assumed but all other values stayed the same (and we assume that the investment income is removed by an equal deduction in line 13).  If the Company did not want to show the excess as a surplus and therefore deducted it in line 13, that is clearly not within subs (2)(a) or (b) and would not be deductible for Case I.  Accordingly not all increases (or decreases) in the Form 40 value of the Fund are to be taken into account in the Case I computation; one must know what they represent.
77.	Alternatively, assume that the shareholders put more capital into the Fund which are included in line 26 as “transfers to (from) non-technical [meaning shareholders’] account” (the “to and (from)” are that way round because line 26 is an expenditure figure, so that a capital injection from the shareholders is shown as negative expenditure).  Although that increases the Form 40 value of the Fund Mr Tyre agrees that this is a capital receipt not to be included as a Case I receipt.  It follows that one cannot claim a Case I deduction for reversing the effect of this capital injection by including a negative figure in line 13.
78.	Mr Tyre’s contention started by looking circular but in our view these two exceptions clearly demonstrate the fallacy of it.  His contention becomes something on the lines that all increases (or decreases) in the Form 40 value of the Fund are Case I receipts (or expenditure) unless they are capital receipts or are included in the Form under some other heading, so that whatever put through line 13 (or 15) is a taxable receipt or allowable expenditure unless it reverses an item under another heading.  We consider that if Parliament meant to say that it would have used other words to indicate it.  
79.	We started with a preference for Mr Gardiner’s interpretation on the basis of tax principles and consider that this is strongly supported by the wording.  We agree with all his contentions: first, that it would also be odd if subs (2)(a) referred to actual income from the assets of the Fund, and (b) to artificial (Form 40 value) increases in the value of the same assets.  Secondly, that Mr Tyre’s interpretation makes the words “and not otherwise” otiose (see paragraph 75 above).  Thirdly, we consider that the reference in para (b) to assets of its long term business fund is significant; it is not a reference to the Fund.  The Fund has a Form 40 value but this value is arbitrarily attributed to particular assets by in practice including them at either admissible value or nil.  
80.	Accordingly we prefer Mr Gardiner’s interpretation that the increase in value referred to in subs (2) means an actual increase in value.  In his example there is a loss in value and so nothing on account of it can be deducted in year 1 or brought back into account in year 2.  The question in this reference is whether the receipt from the Capital Reserve (and also the Line 51 Amount) shown in line 15 is in fact a Case I receipt.  We consider that according to subs (2) it is not.  There are no actual increases in value of the Fund, and so what is brought into account in line 15 represents something else, namely a capital receipt.
Section 83(3)
81.	Our view of subs (3) in terms of tax principle suggests that if Mr Gardiner’s interpretation of subs (2) is correct, as we have decided it to be, subs (3) ought not to apply because it violates those principles by changing all the receipts, which are capital in terms of principle into income.  But had we decided that Mr Tyre’s interpretation of subs (2) was correct, in terms of principle subs (3) ought to apply because it removes the mismatch between the addition to the fund being capital and its reversal in line 13 being an income deduction.  This is not surprising because one presumes that Parliament enacted subs (3) on the basis that Mr Tyre’s interpretation was correct and, as we have seen, the two subsections are closely related.  We therefore look first for the purpose of subs (3) on the basis that Mr Tyre’s interpretation of subs (2) is correct.  Subsection (3) would have the same effect whether the addition to the Fund arises on a capital injection or on the transfer of business but in the former case Parliament did not do anything to prevent the mismatch.  Subsection (3) applies only where there is both the transfer of business and the result is a loss.  We therefore look for a mischief that arises where there is a transfer but which does not arise on a capital injection as in Mr Gardiner’s example, and which will result in a loss.  The apparent answer is that on a transfer the value of the net addition to the Fund will normally have represented a Line 51 Amount in the transferor company that had never been brought into account in the hands of the transferor and was not brought into account on the transfer (as we presume on the basis that there is no requirement for the sale to be brought into account in the transferor’s Form 40, although Mr Gardiner suggested that it would have been).  We concluded in paragraph 65 above that a Line 51 Amount is not carried over to the transferee company on a transfer of business, and subs (3) works on that assumption.  Subsection (3) preserves the position that the addition represents a Line 51 Amount in the transferee company without asking how much of it was caused by an increase in Form 40 value, which would be difficult for the transferee to establish as it would depend on the historical records of the transferor perhaps going back many years.  It merely assumes that the net addition represents a Line 51 Amount for the transferor company and provides that the whole of such amount represents an increase in the Form 40 value of the Fund.  That logic applies even more strongly if the transferor is a mutual because there is a certainty that a Line 51 Amount can never have been taxed because a Case I profit is not taxable.  We presume Parliament limited the effect of subs (3) to losses because the transferee company could choose to bring in a capital addition to balance an existing deficiency of the Form 40 value of the Fund over the mathematical reserves, thus using capital to make up an income loss.  Also if there was a profit it is unlikely that the company would be taxed under Case I on the profit because the I minus E basis would be likely to give a give rise to a greater amount of tax.  Accordingly we see a purpose for subs (3) if Mr Tyre’s interpretation had been correct.
82.	That purpose is equally applicable to Mr Gardiner’s interpretation of subs (2) which we have found to be correct.  While subs (3) would not be correcting a mismatch between the three items (the capital addition, its deduction in line 13 in year 1 and the bringing most of it back into account in line 13 in year 2), all of which are capital items, if one assumes that the net addition represented a line 51 Amount of the transferor company, for the reasons given when we were considering the purpose if Mr Tyre’s interpretation had been correct, the initial capital addition should be an income receipt rather than capital, it would be correct to treat all three as income items, which is what subs (3) does.  The reason we presumed that Parliament limited the application of subs (3) to losses, that the transferee company could bring in a capital addition to balance an existing deficiency of the Form 40 value of the Fund, applies equally on Mr Gardiner’s interpretation.  It is the Form 40 value that is relevant to the Case I computation.
83.	We turn next to the wording of subs (3). As we have already said, on its natural meaning, but solely for determining a loss, the amount added to the long term business fund as part of (or in connection with) the transfer of business is to be taken into account in computing the loss for the period for which it is brought into account as (as we have decided) an actual increase in value of the assets of the fund in subs (2) (except, by subs (4), where the amount added is a receipt anyway, or a receipt within subs (2), or is exempt).  Its ordinary meaning seems on its face to apply exactly to the situation in this reference.  An amount has been added to the Company’s Fund (in fact the whole of the Fund is represented by the addition), that addition was as part of the transfer of business to the Company, with the result that the added amount is to be treated as an actual increase in value of the Fund for the period for which it is brought into account.  That period is 2000 as to the opening Form 40 value of the Fund of £16.8bn (corresponding to the £900m in our example) and that year and later years (including the £442m and £31m in 2001) for the amounts brought into Form 40 from the Line 51 Amount (and the Capital Reserve).  Those subsequent amounts were brought into account in connection with the transfer because the Line 51 Amount and the Capital Reserve were created on the transfer.  It was the Company’s choice to bring in £16.8bn immediately; it could equally well have brought in the whole £24.9bn and then taken the excess over the opening mathematical reserves out again through line 13.  The amount brought in on the transfer of business is clearly brought in “as part of” the transfer; the subsequent amounts are brought in “in connection with” the transfer.  It should make no difference to the application of subs (3) when the Company chooses to bring them in.  
84.	Mr Gardiner raises a number of objections to this interpretation, none of which we find convincing.  First, we agree with Mr Tyre that the causal connection must be between the addition and the transfer of business, not between the addition and the loss.  Here there is a causal connection between the transfer of business and the subsequent additions out of the Capital Reserve because the Capital Reserve is the excess of the value of the Fund over its liabilities at the date of transfer.  We regard the connection as obvious and we are not assisted on this by the authorities cited.  Secondly, he contends that one cannot add something to a Fund that does not exist before the addition.  If correct this would mean that subs (3) could apply only to the transfer to a company with an existing Fund, but the purpose we have identified is exactly the same whether or not there is an existing fund.  In the context of Form 40 as an accounting form, we do not consider that there is any problem in saying that 0 + 1 = 1.  In this connection he contends that the reference to the amount added is to the Form 40 value of the Fund, suggesting that it is implied that the amount has been brought into account in line 26, which is in line with the reference to the amount being brought into account in the final part of subs (3).  We do not consider that the final reference to bringing into account assists with his interpretation of “amount.”  Suppose that initially part only of the market value of the transferred fund is brought into account in Form 40, say at line 26 (which is what actually happened here except that it was brought into line 15), subs (3) provides that that amount is to be treated as a line 13 receipt in computing any loss.  If in a future year the same occurs in relation to a further amount (again as happened here), the second added amount will still be added in connection with the transfer. He also contends that the mischief is not present with a transfer into a company without an existing fund because the regulator will not allow the creation of an insolvent Fund by bringing in the liabilities but no assets.  We do not consider that this is the case.  Mr Chamberlain told us (and we accept) that there was no legal impediment at the time to the Form 40 value resulting in a negative surplus in the actuarial investigation of the non-participating Fund; it is just that nothing can be distributed.  On that basis, the purpose of subs (3) exists equally in relation to the transfer into a new company without an existing Fund.  The regulator is concerned with form 58 and the actual value of the fund; Form 40 is concerned only with the existence of a surplus for distribution.  Thirdly, he contends that the opening reference in subs (3) to ascertaining whether there is a loss (or the extent of it) cannot mean that a loss already ascertained is excluded from relief.  We see nothing in this point; if there is an existing loss the subs says nothing about it, but it provides that such loss cannot be increased.  Fourthly, he contends that subs (4) disapplies subs (3) in the circumstances of this reference.  We agree with Mr Tyre that there has been no disapplication in respect of the amounts brought in from the Capital Reserve, but only of the initial value of £16.8bn that matched the opening liabilities.  On his general contention that subs (3) should not apply to genuine investment losses we consider that the Company has accepted the principle of this in bringing in £1,108m from the Line 51 Amount into line 13 of Form 40 to set against investment losses of £2,268m, and we do not think the amounts brought into account in line 15 are any different in principle.  Indeed, we consider that where there are genuine (income) losses it is not surprising that Parliament considered that they should not be balanced by a capital receipt out of the Line 51 Amount (or Capital Reserve) which represents amounts that would have been an income receipt if the transferor company had continued (and on the assumption that the transferor was not a mutual).
85.	Although Mr Tyre would have had a stronger case on subs (3) if we had found in favour of his interpretation of subs (2) we consider that the purpose of subs (3) we have identified applies equally to Mr Gardiner’s interpretation.  Furthermore the wording fits the circumstances of this reference exactly.   We therefore prefer Mr Tyre’s contentions in relation to subs (3) and disagree with Mr Gardiner’s for the reasons set out above.
86.	Applying this interpretation of subs (3) to the facts of this reference, the Company brought into account in Form 40 from the Line 51 Amount (using 2001 for illustration as before) £1,108m in line 13 and £442m and £31m in line 15.  If it had not been for these amounts there would have been a loss shown on Form 40 in the year caused by a fall in the value of the Fund, which was an income item.  It treated the line 15 items as capital and deducted them in the Case I computation, thus increasing the loss.  It could be equally well argued that the line 13 amount was also capital but it was treated differently and was not deducted from the Capital Reserve as well as the Line 51 Amount.  We consider that all these amounts (and the corresponding amounts in the other years) should be treated as an amount brought into account in Form 40 and accordingly as a Case I receipt by virtue of subs (3).  The fact of deducting the line 15 amounts from the Capital Account in our view makes no difference.  As we have demonstrated, the Line 51 Amount and the Capital Reserve were closely related at the start, being essentially the same figure except for a difference in valuation method that gave a higher figure for the former reflecting that the difference was policyholders’ rather than shareholders’ capital.  But both were capital.  The fact that the Company chose to reduce the Capital Reserve as well as the Line 51 Amount for the line 15 figures indicates that they considered that the shareholders had lost this amount permanently, rather than that there was any tax difference.  The £442m figure in fact went to make the post-demutualization NPF surplus into the nil figure shown in the box in the table in paragraph 57 above, without which there would have been a deficit.  While it would have been technically possible to have shown a deficit, this was not possible in practice, as Mr Chamberlain said.  In our view both the line 13 and line 15 figures should be treated as Case I receipts by virtue of subs (3).
Summary and disposal
87.	Accordingly the result is that while we find in favour of Mr Gardiner’s interpretation of subs (2), we find in favour of Mr Tyre’s on subs (3), with the consequence that we answer the question in the reference to the effect that, to the extent that they create or increase a loss, the transfers from Capital Reserve included in line 15 of Form 40 in the relevant periods do fall to be taken into account as receipts in computing the loss.  To that extent the agreed question in the reference is answered in the affirmative in favour of HMRC

J GORDON REID QC

JOHN F. AVERY JONES
SPECIAL COMMISSIONERS
RELEASE DATE: 24 January 2008

SC 3191/06