Explainaway Ltd, Quartfed Ltd Parastream Limited v HMRC FTC/72 & 79/2011

Factual and Procedural Background

This case concerns a tax planning scheme designed to avoid corporation tax on chargeable gains arising from the disposal of shares. The First-tier Tribunal (FTT) found that the scheme did not eliminate tax liability but deferred it by one year. Both the Appellants and HM Revenue and Customs (HMRC) appealed the FTT's decision. The Appellants argued there was no tax liability, while HMRC contended that the tax charge was not deferred but immediate.

Prior to the disputed transactions, Company A was the beneficial owner of four million shares in Company B. Company A sought advice on mitigating capital gains tax on a sale of some shares and received a presentation from an accounting firm outlining a scheme ("Plan A") involving intra-group transfers, derivative contracts, and sales structured to produce allowable losses to offset gains.

Company A acquired Explainaway Limited (an Appellant) and transferred two million shares to it, which Explainaway then sold, realizing a substantial chargeable gain. Explainaway entered into derivative contracts with financial institutions structured to produce offsetting gains and losses, aiming to shelter gains through losses realized on derivatives and subsequent sales within the group.

When the initial plan did not fully materialize, an "extended scheme" ("Plan B") was implemented involving newly formed subsidiaries (including two Appellants) entering into further derivative contracts designed to create corresponding gains and losses. These subsidiaries' shares were then sold to third parties for nominal consideration, with claims made for allowable losses to offset gains.

The case involves the interpretation and application of provisions in the Income and Corporation Taxes Act 1988 (ICTA) and the Taxation of Chargeable Gains Act 1992 (TCGA), particularly sections addressing derivatives and allowable losses, and the application of the Ramsay principle concerning tax avoidance schemes.

Legal Issues Presented

1. Whether the derivative transactions undertaken by Explainaway and its subsidiaries gave rise to chargeable gains and allowable losses as claimed by the Appellants.
2. Whether, as HMRC contended, the relevant derivative transactions fall outside the scope of the TCGA so that no chargeable gains or allowable losses arise.
3. Whether, applying the Ramsay principle, the loss arising on the disposal of shares in a group company was an allowable loss within the meaning of the TCGA.

Arguments of the Parties

HMRC's Arguments

• The 2001 derivative transactions did not give rise to gains, profits, or losses for tax purposes under the relevant statutory provisions.
• The House of Lords decision in Lupton and the Ramsay principle support the view that the tax liability arose on the sale of shares, not on the derivative transactions.
• Explainaway is liable to tax on the gain realized on the sale of shares in Company B in April 2001.
• The losses and gains claimed on the derivatives lack commercial reality and are part of a tax avoidance scheme.

Appellants' Arguments

• The FTT was correct in treating the 2001 derivative transactions as giving rise to allowable losses and chargeable gains.
• The Ramsay principle is not relevant to the sale of the subsidiary shares, and the loss on disposal of those shares should be allowable.
• The derivatives were genuine market transactions producing income profits and losses despite a fiscal objective.
• There was uncertainty at the time of the Plan B transactions regarding whether losses would arise or whether a purchaser could be found, so the Ramsay principle should not apply.

Table of Precedents Cited

Court's Reasoning and Analysis

The court carefully examined the nature of the derivative transactions and their tax consequences under the relevant statutory provisions. It distinguished the 2001 derivative transactions from ordinary income-producing trades, finding that these transactions were one-off and entered into solely to create a tax loss balanced by a corresponding gain, with no commercial risk or realistic prospect of profit. This fiscal purpose and lack of commercial reality meant the gains and losses did not have the character of income profits or losses and thus fell outside the scope of Case VI of Schedule D but for section 128 of ICTA.

The court applied the Ramsay principle, which mandates a purposive and realistic construction of tax statutes, disregarding artificial steps in composite tax avoidance schemes. It concluded that the 2001 derivative transactions formed a self-cancelling, indivisible process lacking commercial reality, so the losses and gains claimed were not "real" for tax purposes.

Regarding the 2002 derivative transactions and the disposal of shares in the subsidiaries, the court accepted the FTT's findings that these transactions gave rise to gains and losses. However, it agreed that the loss on disposal of the shares was not an allowable loss because the transactions were part of a pre-ordained scheme designed to avoid tax, with no genuine commercial risk or contingency. The court rejected the Appellants' argument that there was a real risk of no sale or loss, finding the FTT's factual findings on these points were reasonable and supported by evidence.

The court also analyzed relevant authorities, including Lupton, and concluded that the 2001 derivative transactions were not income-producing trades but tax planning machinery, consistent with the reasoning in Lupton. It dismissed the Appellants' contention that motive is irrelevant, emphasizing the importance of the transaction's purpose and commercial reality.

Ultimately, the court held that only the gain on the sale of shares in Company B was chargeable, and the derivative transactions did not produce allowable losses or gains for corporation tax purposes.

Holding and Implications

The court's final decision was to allow HMRC's appeal and dismiss the Appellants' appeal.

Holding: The derivative transactions in 2001 and 2002 did not give rise to allowable losses or chargeable gains as claimed, except for the gain on the sale of shares in Company B. The losses claimed on the disposal of shares in the group company were not allowable losses under the TCGA due to their artificial and pre-ordained nature under the Ramsay principle.

Implications: This decision confirms the application of the Ramsay principle to complex tax avoidance schemes involving derivatives and intra-group transactions. It emphasizes that only transactions with commercial reality and genuine economic effect will produce allowable losses or chargeable gains for tax purposes. The ruling directly affects the parties by negating the claimed tax benefits but does not establish new precedent beyond the application of established principles.