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Tax case - Unacceptable Tax Advantage

15 May 2002 / Allison Plager
Issue: 3857 / Categories:

The High Court overturned the Special Commissioners' decision and allowed the Revenue's appeal in Commissioners of Inland Revenue v Trustees of the Sema Group Pension Scheme.

The High Court overturned the Special Commissioners' decision and allowed the Revenue's appeal in Commissioners of Inland Revenue v Trustees of the Sema Group Pension Scheme.

THE INVESTMENT MANAGER of Sema Group Pension Scheme took advantage of a buy-back scheme in respect of shares bought originally on the basis that a proposed company merger would greatly enhance their value. The merger did not proceed, so the company offered to buy back a number of the issued share capital. The High Court held that while the obtaining of the resultant tax credits was not the only reason for selling back the shares, it gave rise to a tax advantage and fell to be assessed to tax.


Sema Group Pension Scheme was an exempt approved occupational pension scheme entitled to exemption from tax under section 592(2), Taxes Act 1988 in respect of money derived from investments held for the purposes of the scheme. The trustees delegated responsibility for the investment of the scheme to Mercury Asset Management.

In September 1995, Powergen made an offer to acquire Midlands Electricity plc. In the expectation that the offer would proceed, on 26 February 1996 Mercury bought on behalf of the trustees, 100,000 50p ordinary shares in Powergen for £5.39 a share, and on 7 March 1996 bought a further 20,000 ordinary shares at £5.35 a share. However, on 14 May 1996, Powergen announced that it was not proceeding with the Midlands bid, and the next day said that it intended to buy back ten per cent of its fully paid issued capital. The next day it offered to buy back a further 4.8 per cent of its capital. Powergen advised that it had not applied for clearance under section 703, Taxes Act 1988, since this depended upon the individual circumstances of the shareholder selling back shares.

Mercury, on behalf of the Sema Pension Scheme trustees, sold back 45,000 shares to Powergen for £5.25 a share.

On 5 June 1996, Powergen offered to buy back a further ten per cent of its fully paid up capital, and Mercury therefore sold back another 40,162 shares for £4.83 a share.

Under section 209(2)(b), Taxes Act 1988, the whole of the purchase price for the Powergen holding received by the trustees in excess of the paid-up capital of 50 pence a share constituted a distribution, in respect of which the trustees were entitled to a tax credit under section 231(1). The credit in respect of the first buy-back amounted to £53,437 and for the second buy-back £43,475.

The trustees claimed payment of the tax credits under section 231(3) on 3 July 1996, and this was paid on 12 August. However, to counteract the perceived advantage obtained by the pension scheme from the sale of the shares to Powergen, the Revenue invoked its powers under Part XVII (tax avoidance) of the Taxes Act 1988, and assessed the trustees under Schedule F accordingly.

The Special Commissioners allowed the trustees' appeal, so the Revenue appealed to the High Court.

(Launcelot Henderson QC and Christopher Tidmarsh for the Revenue; John Gardiner QC for the trustees.)

Decision in the High Court, Chancery Division

Mr Justice Lightman said that the first issue was whether on the sale of the shares to Powergen, the trustees received an abnormal dividend within the meaning of section 704A. This had to be divided into two elements; firstly, whether the dividend included the tax credit and, secondly, depending on the answer to the first element, whether the dividend was abnormal.

In the judge's view, the language of section 209 makes it clear that the tax credit should not be included, because account was to be taken of only the receipts from Powergen, not tax credits which are statutory rights to payment from the Revenue. The judge referred to Sir John Vinelott's opinion, based on section 20, Taxes Act 1988, in Commissioners of Inland Revenue v Universities Superannuation Scheme Ltd [1997] STC 1, that tax credits should be taken into account, but chose to rely on section 209.

He then looked at the statutory guidance relating to the size of the dividend. Section 709(4) provided that the amount received by the trustees by way of dividend be compared to the consideration provided by the trustees for the shares in respect of which the distribution was received. Section 709(6) stated that to determine whether an amount received was abnormal, the length of time that the shares had been held prior to receipt of the dividend should be considered.

Mr Justice Lightman gave the matter careful consideration. He said that the criterion of normality was the normality of return expected to be paid on the securities in question, i.e., ordinary shares in a major limited company. Thus a shareholder would normally expect to receive an interim and a final dividend at regular intervals. A dividend paid as part of the consideration on a buy-back could not therefore qualify as normal. It was rather the return to the investor of part of the capital value of his shares; it was a one-off payment, ending the taxpayer's ownership of the shares. The Special Commissioners had applied a different test, and the judge concluded that they had applied the wrong one. The dividends were abnormal.

The judge then had to consider whether the trustees had received a tax advantage. As there was conflicting case law relating to whether the section 592 exemption from income tax on exempt funds was a tax relief within the meaning of section 709(1), the judge said that he was bound by a general rule that he should follow the latest decision as an authority. This was in Universities Superannuation Scheme. He felt that it was not necessary to expand on the issue other than to say that following that decision, the trustees' exemption was a relief within the section, and 'its exploitation by the trustees brings into play the anti-avoidance provisions'.

The Special Commissioners had correctly stated that there was no inconsistency between holding that a taxpayer had carried out transactions for bona fide commercial reasons and in the ordinary course of managing investments, and holding that a main object of the transactions was to obtain a tax advantage. The Commissioners had applied the principle established by Lord Upjohn in Commissioners of Inland Revenue v Brebner 43 TC 705. Lord Upjohn had said that there were two ways of carrying out a genuine commercial transaction: one by paying the maximum amount of tax, and the other by paying no or less tax. It would be wrong to infer that in adopting to pay the least tax possible, one of the main objects of the transaction was tax avoidance.

The Commissioners concluded that the investment manager had initially bought the Powergen shares, because they would be a good investment for the pension scheme and out-perform the index. A possible buy-back was not a main reason for their purchase. However, the purchase was not in point, it was the buy-backs, and in this respect the associated tax credits were crucial. The tax credits turned the sale of the shares from a potential loss to a profit. They had accepted that there were other important reasons for the buy-backs, but decided that one of the main objects was to obtain the tax advantage afforded by the tax credits.

Mr Justice Lightman said that the only way that he could challenge the Commissioners' conclusion was if they had misdirected themselves in law. However, this was not the case, and they had reached a reasonable conclusion.

The Revenue's appeal was allowed.

Decision for the Revenue

(Reported at [2002] STC 276.)

Commentary by Allison Plager

This is another setback for pension schemes insofar as section 19, Finance (No 2) Act 1997 disentitled pension funds to payment of tax credits from 6 April 1999 regardless. So while the outcome has no practical effect for current actions, it does affect other cases in the pipeline. The outcome seems to be that while a pension scheme quite legitimately organises its investments in order to achieve the best returns, it can still run foul of the anti-avoidance provisions in Part XVII of the Taxes Act 1988.

Mr Justice Lightman indicated that, were it not for the Universities Superannuation Scheme decision, he may well have decided the case the other way. So although the Revenue has, at present, the tactical advantage of the key High Court decision in that case in its favour, it is still very much an open question as to whether an exemption from tax can be a tax advantage within section 703. The tactical advantage will, in due course, be consigned to history as the Sema case is proceeding to the Court of Appeal.

Whichever way the Court of Appeal decides this point, other cases will still stand or fall on their specific facts and on whether or not the escape clause applies in the circumstances.

Issue: 3857 / Categories:
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