HMRC’s finest hour - a bet was lost and tax advisor chastened

Background

The tale starts in 2011, when a taxpayer (Root 2 Tax Limited) was incorporated. Formed to provide tax advice to clients, it created a scheme which involved spread betting. This scheme was instigated by clients who wished to undertake “investment strategies” and was rolled out to approximately one hundred clients.

Overview of the scheme

The directors of the taxpayer entered into a spread bet contract (the “bet”) and a related call spread option (the “CSO”), the success of which depended on the growth in the value of five hedge funds (the “basket”). The scheme was administered by a registered financial bookmaker (RFB).

Where the value of the basket of five hedge funds grew by a defined amount at the end of a stated period (typically three months) (the “term”), the individual would win under the Bet and make a profit, whilst losing under the CSO (or vice versa if the funds failed to grow).

Where the growth was between certain thresholds then there was a variance between the profit and loss resulting from the bet and the CSO. However, to reduce the risk to both RFB and directors, there was a cap on the “maximum winnings” for the bet and “maximum loss” under the CSO. The maximum loss agreed between the RFB and the directors.

The directors were required to pay a stake to enter into the bet. RFB was required to pay the director premiums under the CSO (being an initial subscription premium and a final premium) regardless of outcome. The amounts initially paid by the directors was a net amount being the stake to enter the bet less an initial premium.

Position if the director retained both the CSO and the bet for the duration of the term

The court looked at the position if the director retained the CSO and the bet for the duration of the term:

•  If the director “won” the bet: They would receive the maximum winnings under the bet plus the premiums paid by the RFB. However, they would make a simultaneous loss under the CSO. Broadly, the loss under the CSO exceeded the amounts the directors stood to win.
• If the director “lost” the bet: They would lose their stake but still receive premiums under the CSO. This would again result in an overall loss for the director.

What happened in practice

As you could imagine, the directors do not want to make a guaranteed loss! Therefore, the directors did not retain the CSO and the bet. Instead, the CSO rights were acquired by the director’s employer (the taxpayer).

When the employer acquired the rights to the contract, it was agreed that:

1. The taxpayer would be responsible for making the payout to the RFB (capped to the maximum loss); and
2.  The taxpayer would receive the final premium.

The legal effect was that the rights and obligations under the original CSO were extinguished, and a new CSO created between the taxpayer and RFB (hereby known as “the novation”). At novation, the taxpayer made a payment of the margin (being the difference between the maximum loss and the final premium), which was held by the RFB.

Under the novated contract, the following would arise:

• If the director “won” the bet: The director would receive the maximum winnings from the bet plus the initial subscription fee. The taxpayer would pay RFB a fee comprising the maximum loss less the final premium.

The net result was that the amount paid to the director was equal to the amount paid by the taxpayer to the RFB (less a fee for the RFB)

• If the director “lost” the bet: The director would lose their stake but were repaid the initial premium. Conversely, the taxpayer would be paid the final premium due under the CSO.

The net result of the above was that the RFB would retain the difference between the stake and the two premiums.

As the CSO had a value in favour of the RFB (i.e. the payment of the maximum loss exceeded the potential premium payable in the event of the directors winning and the basket was geared towards the director wining), the taxpayer was advised that in taking on the onerous contract, this would generate a benefit for the directors.  

It was agreed that a ￡213 was the value of the benefit that should be reported on the director’s Form P11D. This was calculated by the Black-Scholes method of valuation for the contract less the final premium payable under CSO.

For the period considered by the tribunal, all bets were won by the directors and payouts made.

The taxpayer’s view

Summary of the taxpayer’s view

The taxpayer’s view was that a capital gains tax charge would arise on the initial premium and a minimal taxable benefit arise on the novation.  

The long version

Taxpayer view on whether the income was employment income

The taxpayer argued that the bet, the CSO and novation formed separate transactions with distinct legal and commercial consequences. These amounts are from a non-employed source and would therefore were not earnings.

This was because:

• There is precedent under Abbott v Philbin, whereby it was held that the exercise of a share option would not give rise to employment tax benefits. By virtue of this case, once a taxable benefit has been provided by grant of an asset further fruits from that asset do not constitute earnings. Therefore, when the CSO was novated, the director’s rights and obligations under the original CSO was extinguished and the risks and rewards of the new CSO taken on by the taxpayer. Whilst the novation generates a taxable benefit, the payments under the bet and CSOs are not linked with the employment.
• Highly relevant to this analysis was that the outcome of the bets and CSO was entirely uncertain. The risk of loss was real, and at a later period, these losses did materialise.
• The level of returns under bets and CSOs did not reflect any decision by the taxpayer as to the remuneration to be awarded. This is evident from the fact certain directors invested more than others. There was no decision by the taxpayer to pay remuneration to the individuals – instead, the taxpayer would judge each CSO on its own merits.
• There was no certainty that the CSO would be novated to the taxpayer. Whilst it is hoped this would arise (otherwise the taxpayer would make a loss), whether this ultimately happened depended on the taxpayer’s directors. There is evidence to this effect (e.g. each director approaching the taxpayer individually, taking bespoke advice etc.). Linked to this, whilst the directors may have been directors of the taxpayer, there was a distinction between entering into transactions in a personal capacity and when he was a director.
• The taxpayer contended that the risks of losing on the bets and winning on the CSOs were not artificially inserted into the arrangements.  
• HMRC’s view on the Rangers argument, in picking out one aspect of the transaction, is inconsistent with their stance that the overall effect of the transactions must be considered. The taxpayer’s view was that the novation simply put the directors in a position where they were exposed to the bet.
•  Finally, the payments were disassociated from the directors’ employments. In taking on the CSOs, the taxpayer simply provided the directors with the opportunity to profit from the contractual rights under the bets, which were entered independently of the taxpayer. The payments merely flowed from contractual rights thereafter.

Value of the employment benefit

The taxpayer relied on Abbot v Philbin (see above) which suggested that the benefit of the novation had to be valued as at the date of transfer. The novation then transferred all risks and rewards associated with the CSO to the taxpayer, thereafter the link with the directors’ employment ended. As such, the payments did not arise in connection with the employment.

Under s.203(1), the code treats the cash equivalent of benefits as earnings in the tax year they are provided. HMRC’s view that all contingent liabilities must be included in the calculation of the cost leads to the difficulty that the taxable benefit would be made by reference to subsequent tax years (e.g. a CSO was novated on March 2017, but the bet won in May 2017, then the reporting position for 2016/17 would depend on an event occurring during the 2017/18 tax year).

Finally, the benefit was valued under an industry standard method (Black-Scholes).   

Disguised remuneration (DR)

Similar to the arguments made above, the taxpayer contended that:

• There was only one discrete transaction – the novation of the CSO. All payments thereafter were not made under that arrangement and were not “relevant arrangements” for the purposes of DR.
• In any event, Section 554(1)(c) was not satisfied as each director approach the RFB individually, the terms of the CSO and bets were determined by each individual and not by any arrangement or plan on the part of the taxpayer to provide income to the directors.
• It is not reasonable to suppose that payments to the taxpayer and directors were made in pursuance of a relevant arrangement. The payments were made by an unrelated third party under agreed contractual terms.

HMRC’s view

Summary of HMRC’s view

Employment income  

Their view was that the maximum winnings from the stake plus the initial subscription fee constituted earnings.

Employment benefit arising from novation

In addition, HMRC contended that the benefit in respect of the novation was not confined to the ￡213 benefit calculated.

Disguised remuneration

It was argued that the income was disguised remuneration (captured by Part 7A Chapter 2 of ITEPA).

The long version

Employment income

Attention was drawn to the principles established under the Rangers case. In this case, it was established that income is not prevented from being earnings where the individual is not entitled to the payment. Helpfully, in this instance, an actual amount was paid out under the bets.  Therefore, the bet payments were employment income.

HMRC argued this because:

The tribunal should consider the intentions of the parties at the outset rather than the actual results of the bet and CSO. It was apparent, given external advice, that the directors intended to win the bets and lose the CSO. It was clear the intention from the outset was to novate the CSO (or otherwise garner a loss).

• The directors set the value of the bets and CSO by reference to the amounts which the taxpayer was able and willing to pay under the CSO to ensure novation.  
• The taxpayer accepted the novation of the CSOs in the knowledge and expectation that it would lose under them, generating remuneration to the directors.
• The potential losses which the taxpayer was willing to take out were divided equally between the three individuals. This matches the typical profit share in prior years.
• The RFB played a standard role in the transaction. Its net position was neutral – it bore no risk and took a fixed fee for the transaction. Its role was facilitating the exchange of cash.

In addition, reference was made to Scottish Provident Institution v IRC. Following the principles established under this case, the risk that the directors would “lose” the bet and the taxpayer “win” under the CSO is disregarded for the purposes of identifying the overall legal effect of the composite transactions. Whilst there was a risk of an adverse outcome, the position should be looked at in context.

It was important, therefore, to note that if the individual lost the bet, the fees would go to the taxpayer and not an unrelated party. The taxpayer could pay the winnings under the CSO back to the directors and the scheme run anew.

Value of the employment benefit

HMRC contended that it is wrong to assess the value of the benefit by reference to the market value of the CSOs at the date of novation. In reality, the “cost” of the benefit (as defined under s.204 ITEPA) was the payment from the taxpayer to the RFB under the CSO.

This is because, in order to reward the taxpayer for their services, the taxpayer agreed to take on the potential costs under the CSO. The “cost” of a benefit is not restricted to expenses incurred before or at the same time as the benefit is provided. Future and contingent expenses must also be taken into account.

Alternatively, it could be argued that the benefit was only “provided” when the CSO was activated, thereby resulting in a taxable benefit during that year.

Disguised remuneration (DR)

When taken holistically, it was argued that the all the transactions formed an “arrangement” which fell into the scope of DR. There was a relevant third party, the RFB, which took relevant steps by:

1.     Paying the initial premium and maximum winnings to the individuals under the bets;

2.     The stakes to the individual when returned to the directors winning under the bets; and

3.     The final premium to the taxpayer.

These relevant steps were taken in in pursuance of the relevant arrangement.  

The tribunal’s position

Were the transactions genuine and commercial

The tribunal considered the arrangements and took the view that the presentation of the scheme as an “investment strategy” is inherently implausible. This is because:

• An individual can hardly be described as entering into a pair of Bets and CSOs used in the scheme as an investment where, if the contracts were held to term, the individual would inevitably make a loss; and
• If the individual intended from the outset to divest himself of the CSO, as the contract he expected to “lose”, any investment strategy would be dependent on him being able to sell the contract for no or minimal cost. However, given the design of the CSO as an onerous contract, it is improbable that anyone other than a party who wished to benefit the individual, such as his employer, would be willing to accept a novation of it on that basis.

This position was further undermined by external advice sought from advisors, which based on the scope and nature of the advice provided, indicated that the intention of the scheme was to enter into Bets and CSOs as a pair of transactions to provide an alternative form of remuneration to the employee by acquiring the onerous contract.

Finally, when preparing its accounts, the taxpayer treated payments under the scheme as employees’ remuneration and claimed a deduction in its corporation tax returns to this effect.

Was the income employment income?

Tribunal considered historic case law on this matter and drew attention to the recent Rangers tax case. Rangers both established/re-affirmed the following:

• It is legitimate to view a tax planning scheme as it was intended to work without regards to the possibility of the scheme not working as planned.
• The purpose of the income tax legislation was to impose an income tax charge on money/money’s worth paid as a reward for the exertions of an employee. There was no requirement for the employee to actually receive the money for which he is entitled for the payment to be taxable.
• There must be a link between the payments made between the payments and the employee’s employment.

To this effect, tribunal ignored the various transactions and looked at the overall impact of the bets and CSOs. It took the view that the scheme was merely a device to extract funds from the taxpayer. This was because:

• If the directors lost the bet, the winnings under the CSO would be paid to the taxpayer who would then be able to remunerate the directors in the normal way. However, if the individuals won their bets, the contracts would operate to extract cash, specifically set at the level in which the appellant wished to remunerate the individuals, from the RFB to the directors. This would effectively be delivered “tax-free”.
• Whilst there was a contingent nature of outcome, tribunal determined that it was sufficiently tempered by the design of the scheme. The risk of an adverse outcome was simply the price the directors paid to generate a tax free payment under the bet.
• The scheme was also undermined by the repeat nature of transactions – given that there was standard documentation for the novation process and in each instance the taxpayer agreed to the novation, it undermined the argument that genuine commercial transactions had taken place.
• The basket was designed specifically to enable the director to win the bets but lose on the CSOs.
• The RFB was merely facilitating the transaction – it would receive a fixed fee (plus an amount to cover the betting duty cost where the bet was “won”) regardless of the outcome and whether the contract was novated.
• Given the onerous nature of the contracts (i.e. there was a high risk that the maximum loss would need to be paid out given the assets included within the basket), the only individual who would agree to novate the contract would be the taxpayer.
• There was a degree of collusion around the maximum losses.  The directors had broadly similar maximum losses (and in some cases identical), which reflected the appropriate level the taxpayer would be willing to pay them individual for their services as directors. These transactions also took place at more or less the same time. These maximum losses were set by reference to the taxpayer’s available resources.

There was also a riveting discussion about the “veil of incorporation” and whether the directors, when entering into the transactions and having communications about the levels of trades were done in their personal capacities or as directors of the business.

The tribunal also dismissed the argument made by the taxpayer that such as scheme was not the optimum vehicle to efficiently draw funds, as corporation tax would be due on winnings under the CSO following novation. It was opined that this was the price that the directors were willing to pay to achieve the payment of income without deduction of income tax or NIC.

Finally, the tribunal agreed with HMRC that the principles of Abott v Philbin were not relevant. Unlike that tax case, a clear demarcation could not be drawn between the realization an employment related benefit on the immediate award of an asset, and the subsequent increase in the value of the asset. Tribunal also considered that the tax case did not set down a definitive rule that, where an award of an asset generate a taxable benefit/earnings, any future payments are not necessarily taxable.

Value of the employment benefit

The act of relieving the directors from the onerous CSO was the benefit enjoyed by the directors. This meant that the taxable benefit arose in the year of novation. Therefore, HMRC’s contention that the benefit arose when the CSO crystalised was dismissed.

The tribunal considered the value of the benefit was the bundle of contingent contractual liabilities and rights as taken on that date.

To this effect, tribunal considered that the Black-Scholes method was not suitable for valuing the CSO. However, the correct valuation methodology was not explored further in this case.  

Disguised remuneration (DR)

Whilst in the main the tribunal agreed with HMRC’s argument that the payments made under the bet and/or the payments made to the AFB would fall within the scope of the DR legislation, they disagreed that the stakes returned to the directors would constitute such earnings.

This was because, in the economic sense, the individual did not gain from the return of the initial funds. Tribunals view was that Parliament only sought to capture transactions where an economic gain was received by the recipient.

What can one take away from this case?

Kudos to you if you have managed to get this far. Or alternatively, if you decided this was the most relevant section for you, your honesty is saluted.

So what did I learn from reading this case?

It was interesting to see how the courts disregarded the paper trail created on this scheme. As an example, board minutes were drawn up evidencing each novation was considered on its own merits. However, the tribunal looked through the documentary evidence into the reality of the situation when making its decision. As tax advisors, it once again demonstrates the frivolity of relying on contracts when doing audits/employment tax reviews – we should always seek to understand the reality of the situation.

In addition, tribunals use a purposive interpretation of the legislation – they will not merely look at the wording within the legislation, but first look at the purpose behind the legislation and interpret the wording of the legislation accordingly. This has given the courts greater flexibility in interpreting legislation and can increase the scope and breadth of legislation.

I was intrigued by the court’s interpretation on the meaning of “cost of a benefit”. In stating that the cost includes all potential contractual liabilities and rights on a particular date, it adds complexity for employers. One would have assumed the Black-Scholes method would have been enough. I look forward to this point being considered further.

Finally, this case highlights the generous ammunition parliament has given HMRC to counteract tax avoidance schemes. Twinned with a purpose interpretation of the legislation and the exceptionally wide scope of the DR legislation, tax avoidance scheme are increasingly unlikely to succeed.