Commissioners for His Majesty's Revenue and Customs v HFFX LLP

Factual and Procedural Background

These appeals arise from incentivisation arrangements established in October 2010 when an investment management business ("Company A") transferred its high frequency foreign currency trading team to a limited liability partnership ("Company B"). Company B's business involved seconding members of the team to Company A's primary trading entity ("Company C"). Following this restructuring, team members became self-employed partners for tax purposes rather than employees, and their pay-out from profits was increased but substantially deferred via a "Capital Allocation Plan" ("CAP"). Under the CAP, 50% of the pay-out was allocated to a corporate member of Company B ("Company D"), which invested these amounts in funds managed by Company A. On the first three anniversaries of the allocation, Company D sold a third of these investments and contributed the net proceeds back to Company B as "Special Capital," which was then reallocated to individual members who could withdraw it.

The tax strategy anticipated that Company D would be taxed at corporation tax rates on the allocated amounts, rather than the higher individual income tax rates, and that the subsequent reallocation of Special Capital would not trigger tax for individual members.

The key tax disputes concern whether:

• The allocation of profits to Company D should be treated as allocations to individual members under s.850 of the Income Tax (Trading and Other Income) Act 2005 ("ITTOIA") ("the s.850 issue").
• If not, whether individual members are taxable on the reallocation of Special Capital either as miscellaneous income under Chapter 8 of Part 5 ITTOIA ("the miscellaneous income issue") or as sales of occupation income under Chapter 4 of Part 13 of the Income Tax Act 2007 ("the sales of occupation income issue").

Both the First-tier Tribunal and the Upper Tribunal found against the tax authority on the s.850 issue. The tax authority obtained permission to appeal that issue but accepted that a recent Court of Appeal decision ("BlueCrest CA") is determinative in favour of Company B, so the s.850 issue was not further considered. The Upper Tribunal accepted the tax authority's position on the miscellaneous income and sales of occupation income issues, but permission to appeal was granted on these issues. The individual members maintain their appeal on these two issues, while the tax authority contends that BlueCrest CA disposes of the miscellaneous income issue in its favour.

The court heard submissions from counsel representing Company B and the individual members, and from counsel for the tax authority.

Legal Issues Presented

1. Whether the allocation of profits to the corporate member (Company D) constitutes an allocation to individual members under s.850 ITTOIA (the s.850 issue).
2. If not, whether the individual members are taxable on the reallocation of Special Capital as miscellaneous income under s.687 ITTOIA (the miscellaneous income issue).
3. Alternatively, whether the individual members are taxable on the reallocation of Special Capital as sales of occupation income under the Income Tax Act 2007 (the sales of occupation income issue).

Arguments of the Parties

Appellant's Arguments (Individual Members and Company B)

• The individual members argue that the reallocation of Special Capital does not give rise to taxable income under s.687 ITTOIA because they do not have a legal right to receive the Special Capital at any stage; thus, no source of income exists.
• They contend that the discretion to reallocate Special Capital is unfettered, contrasting with the position in BlueCrest CA where the Braganza principle applied, and so no source arises from the exercise of discretion.
• They assert that activities alone cannot give rise to a source of income without a legal right to payment.

Respondent's Arguments (Tax Authority)

• The tax authority submits that BlueCrest CA is dispositive of the miscellaneous income issue in their favour, as the reallocation of Special Capital constitutes income arising from a source.
• They argue that the combination of the Partnership Deed and decisions to reallocate Special Capital creates a source of income for the individual members, sufficient to trigger taxation under s.687 ITTOIA.
• The tax authority contends that the discretion exercised by the corporate member (Company D) is subject to the Braganza principle, requiring rational exercise of discretion, thereby creating a source.

Table of Precedents Cited

Precedent	Rule or Principle Cited For	Application by the Court
HMRC v BlueCrest Capital Management LP; Dodd v HMRC [2023] EWCA Civ 1481, [2024] STC 92 ("BlueCrest CA")	Determination of s.850 ITTOIA issue and interpretation of s.687 ITTOIA concerning source of income from discretionary awards.	Found determinative in favour of Company B on s.850 issue and applied to hold that the reallocation of Special Capital gives rise to income from a source under s.687.
Spritebeam Ltd v Revenue and Customs Comrs [2015] UKUT 75 (TCC), [2015] STC 1222	Taxation of interest income under Schedule D Case VI without legal rights under the loan agreement.	Supported that income can arise from a source without direct legal entitlement, relevant to the discussion of source under s.687.
Cunard's Trustees v IRC, McPheeters v IRC (1945) 27 TC 122, [1946] 1 All ER 159	Discretionary payments from capital can be taxable income when discretion is exercised under a legal framework.	Used to analogize the exercise of discretion creating a new source of income for tax purposes.
Braganza v BP Shipping Ltd [2015] UKSC 17, [2015] 4 All ER 639	Implied contractual term requiring rational exercise of discretion.	Applied to conclude that discretion exercised by Company D is subject to a rationality requirement, creating a source of income.
Horkulak v Cantor Fitzgerald International [2004] EWCA Civ 1287, [2005] ICR 402	Discretionary bonus decisions subject to bona fide and rational exercise of discretion.	Analogized to incentivisation arrangements in the Partnership Deed supporting rationality in discretion.
Reinhard v Ondra LLP [2015] EWHC 26 (Ch), [2016] 2 BCLC 571	Application of Braganza principle to profit sharing decisions in LLP context.	Supported application of rationality in discretion for LLP members.
Drummond v Collins [1915] AC 1011	Discretionary payments under a will are income when discretion is exercised in beneficiary's favour.	Used to illustrate that the combination of legal framework and discretion creates taxable income.
Stedeford (Inspector of Taxes) v Beloe [1932] AC 388	Voluntary payments without legal entitlement are not taxable income.	Distinguished to show that absence of legal framework and rights negates source of income.
Brocklesby v Merricks (1934) 18 TC 576	Payments under contract for services are taxable income even if services are minimal.	Supported that enforceable rights under contract bring payments within income tax charge.
Manduca v HMRC [2015] UKUT 262 (TCC), [2015] STC 2002	Settlement payments for failure to pay agreed bonuses treated as income under contract.	Reinforced that binding contracts for services give rise to taxable income.
Essex Hospital Services NHS Trust v Compass Group UK and Ireland Ltd [2013] EWCA Civ 200, [2013] BLR 265	Limits on implied terms fettering contractual discretion.	Clarified that rationality obligations on discretion are difficult to exclude.
Bray (Inspector of Taxes) v Best [1989] 1 WLR 167	Requirement of possessing a source of income for annual tax charge.	Discussed but found not decisive for the case facts.

Court's Reasoning and Analysis

The court began by acknowledging that the s.850 issue was resolved by BlueCrest CA in favour of Company B and thus did not require further consideration. The focus was on whether the reallocation of Special Capital to individual members constituted taxable income under s.687 ITTOIA.

The court analyzed the concept of "source" of income, drawing heavily on the reasoning in BlueCrest CA and earlier authorities such as Cunard and Drummond v Collins. It emphasized that the combination of a legal framework (here, the Partnership Deed) and the exercise of discretion by the corporate member (Company D) to reallocate Special Capital can create a source of income even if the individual members do not have an enforceable legal right to payment at all times.

The court rejected the argument that a legal right to receive income is a prerequisite for a source under s.687. Instead, it held that the exercise of discretion within a binding legal framework, which confers rights and expectations on individual members, suffices to create a source. The court found that the discretion exercised by Company D was not unfettered but subject to an implied rationality obligation under the Braganza principle, given the incentivisation context and the nature of the partnership arrangement.

The court also considered and rejected the submission that the power of the Corporate Member to restrict reallocations under clause 11.9(B) meant the discretion was unfettered or that this affected the existence of a source. The court found this power analogous to trustees' powers in discretionary trusts and did not negate the source arising from the exercise of discretion.

The court noted the warnings in the pro forma letters to members, which indicated that awards would only be reduced or withheld in limited and specified circumstances, reinforcing the expectation of entitlement.

The court declined to address the sales of occupation income issue, following the approach taken in BlueCrest CA, as it was unnecessary to dispose of the appeal.

Holding and Implications

The court DISMISSED both the tax authority's appeal on the s.850 issue and the individual members' appeal on the miscellaneous income issue.

The direct effect is that the individual members remain taxable on the reallocation of Special Capital under s.687 ITTOIA, consistent with the reasoning in BlueCrest CA. No new precedent was established beyond confirming the application of existing principles to the facts of this case.