The Upper Tribunal (UT) has found for HMRC in a lead case concerning a disclosed tax arrangement where a deduction was claimed for a debit arising from the partial derecognition of financial assets relating to derivative contracts. Although the facts are quite specific, the implications apply more widely and provide some insight on areas where there have been differing approaches taken by the First-tier Tribunal. The key issues considered, included whether the derecognition debit represents a loss, if there is a loss, whether this ‘arises from’ a derivative contract, does the debit ‘fairly represent’ a loss and, importantly, whether the issue of shares is within the scope of the transfer pricing rules.
The Union Castle Steamship Company Ltd (Union Castle) claimed a deduction under the derivative contracts regime for a £39 million debit in respect of the partial derecognition of derivative contracts which were carried as assets on its balance sheet (the Options). The accounting derecognition was required following a bonus issue of shares by Union Castle to its parent company Caledonia Investments plc (Caledonia) under the terms of which 95 percent of the cash from the Options was to be distributed to Caledonia.
The key points in the UT decision are as follows:
- The transactions did give rise to a loss, the existence of which should be determined by focussing on the net worth of the company as shown in GAAP compliant accounts;
- The claimed loss did not ‘arise from’ the Options which are derivative contracts, rather it arose from the bonus issue of shares, albeit that the quantum of the loss depended on the valuation of the Options. In coming to this conclusion, the UT said that the concept of ‘arising from’ derivative contracts has a different (narrower) meaning to being ‘in respect of’ or ‘under’ derivative contracts and implies a direct causal connection. In this case, however, the loss arose from the share issue and the value of the derivative contracts was unchanged;
- The UT found that if, contrary to the above, there is a loss which arises from a derivative contract that it would meet the requirement (repealed for accounting periods beginning on or after 1 January 2016) to ‘fairly represent’ a loss. The UT said that case law has shown that the ‘fairly represents’ requirement is wider than the attribution or timing of recognition of profits and losses but fell short of a freestanding criterion of fairness by which the accounting treatment of profits and losses can be reopened. Rather, ‘fairly represents’ enables HMRC to prevent a mismatch in the accounting treatment and, in this case, there was no such mismatch. The Court of Appeal decision in the GDF Suez case is awaited and this is expected to further clarify the ‘fairly represents’ requirement;
- The UT determined that the bonus issue of shares is capable of being a ‘provision’ for the purposes of the transfer pricing rules, applying a test (derived from the OECD Guidelines) of whether this was an activity which provided economic or commercial value to the parent or enhanced its financial position such that an independent enterprise would be willing to pay for the share issue. Acknowledging that the transfer pricing rules do not affect the calculation of chargeable gains, the UT criticised the view that they should therefore be construed as excluding capital transactions in general, noting that in this case any adjustment would have been made under the derivative contracts regime. The UT did not go on to consider whether the share issue by Union did in fact differ from the arm’s length provision issue as Union’s appeal had already failed on other grounds; and
- If the derecognition debit is recognised directly in equity (relevant for one of the follower cases which applied UK GAAP rather than IFRS), such a debit is required to satisfy the same requirements as if it was recognised in the profit and loss account, including in particular that it ‘arise from’ a derivative contract.
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