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The Actuary The magazine of the Institute & Faculty of Actuaries

Heads, they win; tails you lose!

In June 2001 the special commissioners, who hear tax appeals in the first instance, considered an important tax case where the Inland Revenue challenged tax computations filed by HSBC Life (UK) Limited and four other life offices. Their decision was issued on 6 November 2001. It concerns the tax treatment of structured derivatives entered into by life offices to back certain life assurance policies, typically high-income and guaranteed equity bonds. The Revenue argued that the contracts should be taxed as loan relationships. The special commissioners disagreed and upheld the taxpayer’s appeal so that the derivatives continued to be taxed under the regime for taxing chargeable gains.
The appeal period lasted until 31 December 2001 but the Inland Revenue decided not to appeal. There was some suggestion that an ancillary decision on section 128 might leave the Revenue with an opportunity to deny treatment as chargeable gains because the profits and gains arose as part of a trade, but it did not pursue this line either.
The Revenue has, however, responded by changing the rules, and warned in a press release, dated 27 November 2001, that such derivatives would be included in the financial instruments regime for accounting periods beginning on or after 1 October 2002. The draft legislation was published for comment on 19 December and will be included in the Finance Bill 2002. The consequence will be that all derivatives backing income bonds and those backing capital growth bonds with a guaranteed return of 80% or more of capital invested will be taxed annually on an accounts basis. There would be a deemed disposal for the purpose of tax on chargeable gains at the point of change (the next company period end after 30 September 2002), with any gain or loss recognised later in what would otherwise have been the period of realisation. Given the way in which markets have moved in 2000 and 2001, some companies are concerned that they could be left with capital losses at the point of change and subsequent taxable income profits against which the losses could not be relieved. Actuaries will wish to monitor the position here carefully.

Background facts of the case
Life offices have sought for many years to mitigate tax on assets matching single premium products. The broad aim has been to increase the return offered to the policyholder by minimising the tax liability and deferring payment for as long as possible. From 1 April 1996, a number of bespoke derivatives were used to secure treatment of the investment return as capital gains rather than income with the resultant benefits of indexation allowance and the time-value of taxation only upon realisation.
The bespoke derivatives offered a minimum guarantee with an equity upside benefit sufficient to match policy benefits and the life office’s expected tax liability. Counterparty risk was controlled for the purposes of regulatory solvency by way of margining loans from the counterparties to the taxpayers or by way of collateralisation of assets.
These derivatives took multiple forms:
– cash settled;
– cash settled with share alternative;
– share settled with cash alternative; and
– share settled.

A loan relationship is defined in the Finance Act 1996. In the present context the key parts of the definition are that a loan relationship should be a ‘money debt’ which is a debt which ‘falls to be settled by the payment of money’, and which arises from a transaction for the ‘lending of money’. A loan also includes ‘any advance of money’.
In trying to persuade the special commissioners that the derivatives were loan relationships, the Revenue put considerable effort into arguments based on motive. It was agreed between the parties that the use of the derivatives was intended to achieve the perceived fiscal advantages of the availability of indexation allowance and the realisation basis. What the Revenue needed here was a creative approach to statutory construction, looking to what they said was the commercial substance of the transactions and not the legal form. It was also agreed between the parties that the margining loans were loan relationships.

Expert evidence was given that the derivatives were governed in each case by master agreements in the standard terms drawn up by ISDA (International Swap and Derivatives Association). Although this was not itself conclusive that the derivatives were not loan relationships, since the margining loans were also so governed, they had key characteristics relating to unwinding in the event of a variety of defaults, and strict provisions for the netting and offset of obligations to preserve the integrity of the derivative markets. These clearly distinguished them from mere lending where default related principally to repayment obligations and where recovery was a matter of securing the loan in the event of receivership. What all this meant was that the taxpayers had bought and the counterparties had sold something, albeit a complex ‘something’, and had not lent or borrowed money.

The commissioners found for the taxpayers, to whom they gave liberty to apply for specific determinations of assessments, which would close the relevant years and prevent the Revenue from raising other issues. As regards the question of motive, they followed Lord Hoffman’s judgment in Westmoreland Investments Limited v MacNiven.
‘The fact that steps taken for the avoidance of tax are acceptable or unacceptable is the conclusion at which one arrives by applying the statutory language to the facts of the case. It is not a test for deciding whether it [the statutory language” applies or not’
Looking therefore at the Finance Act 1996, they found that:
– the cash settled derivatives were ‘money debts’; but
– there was no ‘lending of money’ there was a purchase of an asset, so there was commercially no loan;
– the essential terms in the loan relationships legislation ‘falls to be settled’ and ‘money debt’ were juristic so that they did not need to consider commerciality except to the extent that the particular statute made provision for it;
– even if the transactions were not covered by juristic definitions and they needed to consider whether they were commercial, having found there to be no loan, they could not find that the derivatives were loan relationships, and motive was therefore not relevant.
They also gave two ancillary decisions:
– Letters from the Revenue to advisers and the text of the Life Assurance Manual provided no evidence of the intention of the legislation and could not be used as aids to statutory construction recourse on such documents had to be by way of judicial review; and
– The provisions of section 128 of the Income and Corporation Taxes Act 1988 did not apply since the profits and gains from the derivatives did arise as part of a trade.

This is an important victory for the industry, given the massive volume of business involved. It should be expected that there should be no need to restate prior years’ tax computations which took the same approach as HSBC, and so the tax treatment envisaged on such derivatives should be retained.
However, because of the proposed new legislation, from accounting periods commencing on or after 1 October 2002 any future increase in value of such derivatives will be taxed in the period of the increase and there will be no benefit from indexation allowance nor from the deferral of tax until the derivatives are realised. Companies may wish to look at policy wording and to consider policyholders’ reasonable expectations to see if such a change in external circumstances permits any additional tax liabilities to be reflected in reducing policy values and benefits.
Hence, despite their defeat before the special commissioners, the Revenue’s intention to introduce new legislation should secure the tax treatment that they sought for all future similar derivatives, and also for existing derivatives, but only in respect of future periods.