Revenue & Customs v First Nationwide

Lord Justice Moses:

1. First Nationwide, a UK resident unlimited company, is a wholly-owned investment company subsidiary of the Nationwide Building Society. It sought, in the second half of 2003, to raise funds from Anglo Irish Bank for the use of the Nationwide Building Society. The structured finance transaction by which it sought to raise those funds was a combination of a stock loan agreement and what HMRC (the Revenue) contended to be a sale of the loaned securities by First Nationwide to Anglo Irish Bank and a re-purchase of similar securities by way of subscription (a repo).

2. Blueborder Cayman Ltd (Blueborder) raised £51.1m by issuing two classes of shares, Ordinary and First Issued Preference Shares, to be used for the purposes of the financing transaction. Blauwzoom (Netherlands Antilles), Blueborder’s parent, subscribed for, and Blueborder issued, 1,050 Ordinary Shares with a nominal value of £1 each at a premium of £999 per Ordinary Share and 50,050 non-voting redeemable First Issued Preference Shares with a nominal value of £1 each at a premium of £999 per Preference Share. Thus Blueborder raised £51,048,900 on share premium account. The First Issued Preference Shares were then, for the purposes of the financing transaction, lent under a stock loan agreement to ABN AMRO (London branch) and, under a further stock loan agreement, ABN AMRO (London branch) subsequently lent them to First Nationwide. Those 50,050 First Issued Preference Shares were, it is agreed, overseas securities within the meaning of paragraph 1(1) Schedule 23A, Income and Corporation Taxes Act 1988 (“ICTA”). First Nationwide then sold the 50,050 First Issued Preference Shares to Anglo Irish Bank for the sum of £50,314,975. Anglo Irish Bank was to obtain reimbursement through the payment of two dividends by virtue of dividend rights attaching to the First Issued Preference Shares under Blueborder’s Articles of Association. The First Issued Preference Shares carried a right to a dividend on 29 December 2003 of £25,500,000, but, it is important to record, this was a right to payment of dividends exclusively out of share premium. The Second Preference Dividend was payable, similarly, exclusively out of share premium in the sum of £25,500,000 in total on 29 March 2004. By that means, Anglo Irish Bank obtained a repayment to which was added the right to redeem the First Issued Preference Shares, exercisable by both Anglo Irish Bank and Blueborder for the sum of £1m.

3. First Nationwide then had to satisfy its obligation in relation to the First Issued Preference Shares, the subject of the stock loan agreement with ABN AMRO. It satisfied that obligation by subscribing, pursuant to an agreement between First Nationwide and Blueborder, for 50,050 Second Issued Preference Shares.

4. Pursuant to the stock loan agreement First Nationwide was obliged to pay to ABN AMRO, in respect of each dividend paid on the First Issued and Second Issued Preference Shares, a manufactured dividend equal to the amount of the First Preference Dividend and the Second Preference Dividend. In its self-assessment to corporation tax for the accounting period ending 31 March 2004, First Nationwide deducted the £51m, paid as manufactured dividends to ABN AMRO pursuant to the stock lending agreement, as expenses of management. Such a deduction was only permissible if the dividends were payments of an income nature, charged to tax under Case V of Schedule D, being “income arising from possessions out of the United Kingdom”. If those manufactured dividends were of an income nature they were deductible by virtue of Regulation 4(1)(c) of the Income Tax (Manufactured Overseas Dividends) Regulations 1993. The definition of a manufactured overseas dividend is contained within paragraph 4(1) Schedule 23A ICTA 1988 : an overseas dividend is defined as “any interest dividend or other annual payment payable in respect of any overseas securities” (paragraph 1 of Schedule 23A). Regulation 2(1) of the 1993 Regulations adopts the definitions within Schedule 23A.

5. The efficiency of the structured finance transaction into which First Nationwide entered depends upon the deductibility of those dividends: such a deduction produces an income rather than a capital loss. It is in that context that the first issue in this appeal arises: were the payments of an income nature? The Revenue contends that since the dividends were paid out of the share premium account of Blueborder they constituted capital payments and were, accordingly, not deductible.

6. The second issue relates to the subscription by First Nationwide of the Second Issued Preference Shares for £1m. The Revenue contends that the subscription constitutes the buying of similar securities for the purposes of the repo legislation (s.737A and 730A ICTA). If the Revenue is correct then the effect of those statutory provisions is to deem an income payment (a deemed manufactured dividend representative of the preference dividends of £51m) to First Nationwide. That deemed manufactured payment would be taxable income of First Nationwide, offsetting the claimed deduction of the manufactured dividends paid by First Nationwide to ABN AMRO. Judge Berner, as he then was, in the First-Tier Tribunal (Tax) [2010] SFTD 408, upheld First Nationwide’s appeal against the Revenue’s amendment of its self-assessment on both issues. The Upper Tribunal [2011] STC 1540 dismissed the Revenue’s appeals. The Revenue, by way of appeal, now seeks to overturn the conclusions of both Tribunals. Both the Tribunals set out the facts in detail. Most of the facts were agreed save for a dispute between experts on Cayman Islands law. The facts have now been set out twice in both decisions and I incorporate them into this judgment by way of Annex I. Dividends: Capital or Income?

7. The essential question, in relation to the first issue, is whether the Preference Dividends, payable as they were exclusively out of share premium, were income payments or were, as the Revenue contended, payments of capital. There was no dispute between the experts that, for the purposes of Cayman Islands company law, the Preference Dividends constituted dividends (First-Tier Tribunal [8]). But that is not determinative of the answer, as a matter of United Kingdom tax law, (see Upjohn LJ in Rae v Lazard Investment Co Ltd [1963] 41 TC 1 , 20). The taxpayer contended that the distinction between capital and income turned on the legal machinery employed to make the two distributions of £25,500,000. The Revenue argued that Blueborder’s Articles of Association engrafted the share premium onto the corpus of the shares and that corpus was diminished on payment of the First and Second Preference Dividends. The distributions, in short, amounted to return of the share premium as capital forming the body of the foreign possession.

8. The starting point must be the legal mechanism by which the First and Second Issues Preference Dividends were paid. They were dividends paid out of the share premium account. That, contends First Nationwide, is not merely the starting point; it is the finishing point. The mechanism by which the payments of £51m were made, namely the payment of dividends, determines the character of the payments. They were, as dividends, necessarily income payments.

9. This simple and clear proposition rests on two foundations: the treatment of share premium in United Kingdom jurisprudence and its treatment under Cayman Islands’ Companies Law.

10. The jurisprudence is well-established. Payments made by a company in respect of shares are either income payments, or, if the company is not in liquidation, by way of an authorised reduction of capital. The courts have recognised no more than that dichotomy. The distinction has depended upon the mechanics of distribution. If the payments are made by deploying the mechanisms appropriate for reduction of capital, then they are payments of capital. Such mechanisms can be readily identified as designed to protect the capital of a company. If the payments are not made by such mechanisms but are made by way of dividend, they are income payments. In R.A. Hill v Permanent Trustee Co of New South Wales Ltd [1930] AC 720 , trustees sought a ruling whether a payment of a dividend out of the proceeds of the sale of breeding stock was income belonging to those beneficially entitled to the income of the trust estate. The Board’s opinion, expressed by Lord Russell, is authority for the proposition that the form which the distribution takes determines whether it is a capital or income distribution: - “ …moneys paid in respect of shares in a limited company may be income or corpus of a settled share according to the procedure adopted, i.e. according as the moneys are paid by way of dividend before liquidation or are paid by way of surplus assets in a winding-up”. (page 729)… “(2) A limited company not in liquidation can make no payment by way of return of capital to its shareholders except as a step in an authorized reduction of capital. Any other payment made by it by means of which it parts with moneys to its shareholders must and can only be made by dividing profits. Whether the payment is called “dividend” or “bonus”, or any other name, it still must remain a payment on division of profits”. (page 731)

11. In the United Kingdom, prior to 1948, share premium was freely distributable as ‘profits’. It was not assimilated to paid-up share capital. It did not fall within the scope of rules designed to protect against reduction of capital. In Drown v Gaumont-British Picture Corporation Limited [1937] 2 All ER 609 a shareholder failed to prevent a company from paying a dividend out of share premium; the premium was additional to and was not part of the capital subscribed on the shares. Subject to any inhibition in the articles of association, there was nothing to prevent a company dividing amongst its shareholders the premium obtained on the issue of the shares (617 A-B). It should be noted that, in that case, the premium was carried to a reserve account, to which the premiums made the major contribution (614H and 616H).

12. By s.56 Companies Act 1948 share premium was assimilated to a company’s subscribed capital and protected as if it were the paid-up capital of the company. The contrasting effect on the categorisation of payments out of share premium, before and after 1948, was clearly identified by both Harman J and the Court of Appeal in Re Duff’s Settlement [1951] Ch 721 and 923. The importance of that decision, which concerned the question whether payments out of share premium account should be treated as income or capital, lies in the emphasis the courts placed upon the mechanism of payment in order to draw the distinction between capital and income. By virtue of s.56 of the Companies Act 1948 , the repayment of share premium, in that case, was made by order of the court on a petition under that section. It followed, the courts agreed, that in contrast to the position before the 1948 Act , as explained in Drown, the payments out of share premium account were payments of capital and not income .

13. In giving the judgment of the court, Jenkins LJ described s.56 as the essential provision on which the distinction between share capital and divisible profit depends (928). “…..“the mechanics” are, in our judgment, an essential factor in determining the character as between capital and income of the sum distributed. A company, having ( sic ) an artificial person, can (as it has been laid down) make a distribution amongst its members (otherwise than in a winding-up) in one of two ways - but only in one of two ways: that is by a distribution of divisible profit, that is, by way of dividend; and by way of a return of capital pursuant to an order of the court upon a petition for reduction of capital in accordance with the Act .” (930).

14. The court continued by reflecting upon the nature of share premium. It recognised that it was essentially capital profit and not income (931). But, “if distributed in cash before s.56 came into operation (it) would…have been income in the hands of the shareholders, notwithstanding its capital character when considered as a receipt of the company ” (932).

15. Harman J’s judgment is to like effect. It is of note that he “ranked” the share premium as profits available for distribution (724) because it represented a profit in the sense that the company got more for its shares than the nominal value (727).

16. The principle that the form of the distribution dictates its character is expressed in two speeches of Lord Reid, 14 years apart. In Reid’s Trustee v IRC [1949] AC 361 , the capital profits realized on the sale of properties were distributed to shareholders by way of dividend; this was crucial to the identification of the payments as income. Lord Reid said: “…if a foreign company chooses to distribute its surplus profits as dividend, the nature and origin of those profits does not and cannot be made to affect the quality of the receipt for the purposes of income tax” (386). All depended upon the method adopted by the company for dealing with its surplus assets; it could create new capital assets or distribute those assets as income (386).

17. Lord Reid adhered to that view in Rae v Lazard Investment Co Ltd [1963] 1 WLR 555 and (1963) 41 TC 1 . A Maryland company had hived off part of its business by a process, unknown to English company law, of partial liquidation; shares in a new company to which the hived off business was sold were distributed to an English investment company which held shares in the Maryland company. The Court of Appeal and the House of Lords concluded that shares which the English company shareholders received on the partial liquidation were capital and not, as the Revenue contended, income. That conclusion was dictated by the machinery by which the shares were distributed. Lord Reid said: “In deciding whether a shareholder receives a distribution as capital or income our law goes by the form in which the distribution is made rather than by the substance of the transaction. Capital in the hands of the company becomes income in the hands of the shareholders if distributed as a dividend, while accumulated income in the hands of the company becomes capital in the hands of the shareholders if distributed in a liquidation ” (567). By the law of Maryland, which recognised the transaction as a partial liquidation, the shares distributed were capital. Both Lord Guest (570) and Lord Pearce (572) reiterated that it was the machinery by which assets were distributed which determined the question whether the assets were received as capital or income.

18. The principle that it is the machinery by which the assets are distributed which determines whether they are capital or income finds expression, yet again, in Courtaulds Investments Ltd. v Fleming [1969] 1 WLR 1683 , (1969) 46 TC 111 . Italian law identified the distribution from a share premium reserve as a distribution of capital. It brought share premium within the scope of the rules for protection of capital in a manner similar to s.56 Companies Act 1948 . Share premium could not be distributed while the legal reserve fell below 20% of the company’s capital. Italian law introduced a new tax on the payment of dividends. To avoid that tax, the Italian company transferred profits of the year, which would have been distributed as dividends, to the legal reserve and thereby freed the share premium for distribution to shareholders. Such a distribution was, under Italian law, a distribution of capital free from the new imposta cedolare . (The Weekly Law Report’s head note incorrectly describes the distribution as a dividend (1684 B), the description in the Tax Cases head note, a withdrawal from share premium reserve, is correct.) Buckley J rejected the Revenue’s contention that once the share premium was freely distributable it was, as in the United Kingdom before 1948, income. Italian law regarded the distribution as capital, and grafted the share premium onto the paid-up capital of the company (126H), (127B-C).

19. Cayman Island Companies Law has followed the reverse route to that adopted under United Kingdom company law. Prior to 1989, the law protected share premium as if it were paid-up share capital, in the same way as it was protected after s.56 of the Companies Act 1948 was introduced in the United Kingdom. But by amendment in 1989, share premium was distributable by dividend. The relevant provisions of s.34 of the Cayman Islands Companies Law (2003) read:- “34(1) Where a company issues shares at a premium, whether for cash or otherwise, a sum equal to the aggregate amount of the value of the premiums on those shares shall be transferred to an account called ‘the share premium account’. Where a company issues shares without nominal or par value, the consideration shall be paid up share capital of the company. (2) The share premium account may be applied by the company subject to the provisions, if any, of its memorandum or articles of association in such manner as the company may, from time to time, determine including, but without limitation – (a) paying distributions or dividends to members … Provided that no distribution or dividend may be paid to members out of the share premium account unless, immediately following the date on which the distribution or dividend is proposed to be paid, the company shall be able to pay its debts as they fall due in the ordinary course of business; and the company and any director or manager thereof who knowingly and wilfully authorises or permits any distribution or dividend to be paid in contravention of the foregoing provision is guilty of an offence and liable on summary conviction to a fine of fifteen thousand dollars and to imprisonment for five years.”

20. If, as is clear, prior to 1948 share premium was distributable by way of dividend as income in the United Kingdom, it seems equally plain that it was distributable as income in the Cayman Islands following the freedom from restriction in 1989.

21. Not so, says Mr Gammie QC, for the Revenue. There were two important features of the share premium account which, so he contends, demonstrate that the share premium was assimilated to the paid-up capital in Blueborder. The first and most important feature is to be found in the detail of the Articles of Association and their characterisation of the capital rights attached to the First and Second Issued Preference shares. Under the Articles, dividends in respect of preference shares could only be paid out of the share premium account and any other dividend or distribution in respect of any other class of share could not be paid out of share premium account (Art 128). The only substantive rights attached to the preference shares were rights to the amount which had been contributed to the company on issue of its shares. Those rights are described as “Capital” (Article 5.2 (b)). On “a return of capital on a winding-up or otherwise”, the owners of the preference shares are entitled to what is described as the “Preference Share Return Amount”, an amount defined by reference to a formula which has the effect that where, as occurred, the dividends were paid (whether early or late), the amount payable on a subsequent return of capital was abated pro tanto . Accordingly, the value of the capital rights attached to the preference shares depended entirely on the extent to which the share premium contributed on issue had been returned by the payment of First and Second Preference Dividends. As it turned out, since the dividends were paid on the due dates, the capital rights were almost altogether abated.

22. The Articles, accordingly, demonstrate that the share premium was part of the capital corpus of the company; that corpus was not left intact, the value of the capital rights were reduced, after the Second Preference Dividend had been paid by the full amount of the First and Second Preference dividends, £51.1m.

23. The second feature relates to the legislative treatment of share premium account under Cayman Islands Companies Law. By s.34 (1) of that law, a company is required to transfer the value of the premiums to a “share premium account”. Moreover, the proviso to s.34 (2) (cited [19]) prohibits a distribution in circumstances where debts cannot be paid, on pain of criminal sanctions, affording greater protection to the separate share premium account than that afforded by ordinary duties imposed on directors before distributing the profits of a company by way of dividend.

24. Both those features, in combination, submits the Revenue, demonstrate that the corpus of the company was not left intact on payment of the dividends out of the share premium account. Share premium is, they suggest, not part of the profits as they would ordinarily be understood but sui generis . It should be recognised as a third category, neither income nor capital, but distributable as dividend subject to satisfying a statutory cash flow solvency test. It is not comparable to share premium prior to 1948 in the United Kingdom.

25. I am unable to recognise such a third category. The character of the payment in the hands of First Nationwide is a matter for United Kingdom law, the law of the Cayman Islands being relevant, not determinative, (Upjohn LJ in Rae, (q.v. supra [7]). United Kingdom law recognises only two species of payment in respect of shares: capital or income payments. Further, the jurisprudence establishes that it is the form by which the payments are made which determines their character. It is true that, under Blueborder’s Articles of Association (Art.5.2(b)), had the First and Second Preference Dividends not been paid, the share premium would have been returned as capital on a winding-up or on a redemption. It is also true that, since those dividends were paid, the value of the capital rights which remained, on a winding-up or otherwise, was drastically diminished to £1m. But those features tell one nothing other than, had the mechanism or machinery adopted for distribution of the share premium account been a return of capital on a winding-up or otherwise, the payments would have been capital. Since the payments were made adopting the mechanism of distribution by way of dividend, (Art.5.2(a)), that mechanism dictates the conclusion that the payments were income and not capital. Under the Articles, the owner of the Preference Shares has rights to income, if the premium is distributed as dividends and, if the premium is not distributed as dividends, equivalent capital rights on a winding-up.

26. It is correct that, as Mr Gammie emphasised, judges have, from time to time, said that dividends are prima facie income, suggesting circumstances in which they will not be income (see e.g. Lord Normand (374,375) and Lord Morton (380) Reid’s Trustees ) . There are cases, where, on a true analysis of the facts, it is possible to identify a declaration of a dividend as being other than a payment of income. In Sinclair v Lee [1993] Ch 497 , the declaration of a dividend by ICI by the allotment of fully paid-up shares in the new company Zeneca was no more than part of a company reconstruction by way of de-merger, whereby a single company was replaced by two head companies and the trading entity divided into two smaller trading entities (513D).

27. But no such analysis is possible on the facts of the instant case. Nothing can be discerned by invoking examples of cases where capital has been returned (as in Courtaulds, under the Italian view of share premium, or in Lazard, a partial liquidation under Maryland law). Nor does the possibility of tearing away a “colourable label” to see the reality assist the Revenue (see the obiter dicta of Lord Pearce in Lazard (p.573)). The reality was the distribution of share premium as dividends, as Blueborder was free to do under Cayman Islands Companies Law. That mechanism establishes that the payments were income. The correct identification of the dividends as income, notwithstanding that they were paid out of share premium account, mirrors the situation in United Kingdom company law prior to 1948, as explained in Drown . For that reason, which is no more than an echo of the decisions of the First-Tier and the Upper Tribunals, I would dismiss the appeal on this point. The Repo Issue

28. The Revenue seeks to apply the provisions of Section 737 A and 730A ICTA 1988 so as to create deemed manufactured dividends which will increase the re-purchase price of £1m by £51m. The effect is to deem First Nationwide to pay interest of £1.7m on a deemed loan from Anglo Irish bank of £50.3m (subscription price of £1m + Preference Dividends of £51m – sale price of £50.3 = £1.7m). This effect accords, so the Revenue assert, with the economic reality that First Nationwide borrowed £50.3m from Anglo Irish for 6 months at an interest cost of £1.7m.

29. But the legislation cannot be applied unless First Nationwide’s subscription for and Blueborder’s issue of the Second Issued Preference Shares constituted a “buying back” within the meaning of sections 737 A and 730A. (The provisions are set out in full in Annex 2.) “737A. Sale and repurchase of securities: deemed manufactured payments. (1) This section applies where on or after the appointed day a person (the transferor) [ scilicet First Nationwide] agrees to sell any securities, and the transferor or a person connected with him-- ( a ) is required to buy them back in pursuance of an obligation imposed by, or in consequence of the exercise of an option acquired under, that agreement or any related agreement, or ( b ) acquires an option to buy them back under that agreement or any related agreement which he subsequently exercises; but this section does not apply unless either the conditions set out in subsection (2) below or the conditions set out in subsection (2A) below are fulfilled. 737B. Interpretation of section 737 A (5) In section 737 A and subsection (4) above references to buying back securities include references to buying similar securities. 730A. Treatment of price differential on sale and repurchase of securities (1) Subject to subsection (8) below, this section applies where-- ( a ) a person ('the original owner') has transferred any securities to another person ('the interim holder') [ scilicet Anglo Irish Bank] under an agreement to sell them; ( b ) the original owner or a person connected with him-- (i) is required to buy them back in pursuance of an obligation imposed by, or in consequence of the exercise of an option acquired under, that agreement or any related agreement, or (ii) acquires an option to buy them back under that agreement or any related agreement which he subsequently exercises; and ( c ) the sale price and the repurchase price are different.' 730B. Interpretation of section 730A (1) For the purposes of section 730A agreements are related if they are entered into in pursuance of the same arrangement (regardless of the date on which either agreement is entered into). (2) References in section 730A to buying back securities-- ( a ) shall include references to buying similar securities; and ( b ) in relation to a person connected with the original owner, shall include references to buying securities sold by the original owner or similar securities, notwithstanding (in each case) that the securities bought have not previously been held by the purchaser; and references in that section to repurchase or to a repurchaser shall be construed accordingly.” (My underlining)

30. These carefully articulated provisions do not admit of a construction which elides the buying of similar securities (the Second Issued Preference Shares in Blueborder) with the subscription and issue of those shares. The provisions relate to the purchase of shares, the transfer of a chose in action and not to the creation of a chose in action which is not in issue at the time of subscription and which only comes into existence following subscription on the issue of the shares by Blueborder. If Parliament had meant to include within the scope of the provisions a subscription for shares it would have said so.

31. There was ample statutory and jurisprudential precedent to deploy if there had been any intention to include a subscription for shares. The draftsman knew how to draw the distinction between acquisition (by subscription) and purchase. Section 12 Finance Act 1937 became s.729 ICTA 1988 , in force until ss.730 A and 737A were introduced. It drew a clear distinction between buying and acquiring and buying back and re-acquiring. The relevant part reads: “12. (1) Where the owner of any securities….agrees to sell or transfer those securities, and by the same or a collateral agreement- (a) agrees to buy back or re-acquire the securities…. (2) The references in the last forgoing subsection to buying back or re-acquiring similar securities shall be deemed to include references to buying or acquiring similar securities….”

32. Nor could the draftsman have been unaware of the judgment of Lord Greene MR in Re VGM Holdings [1942] 1 Ch 235 , 241 “It seems to me that the word "purchase" cannot with propriety be applied to the legal transaction under which a person, by the machinery of application and allotment, becomes a shareholder in the company. He does not purchase anything when he does that. Mr Wynn Parry endeavoured heroically to establish the proposition that a share before issue was an existing article of property, that it was an existing bundle of rights which a shareholder could properly be said to be purchasing when he acquired it by subscription in the usual way. I am unable to accept that view. A share is a chose in action. A chose in action implies the existence of some person entitled to the rights which are rights in action as distinct from rights in possession, and, until the share is issued, no such person exists. Putting it in a nutshell, the difference between the issue of a share to a subscriber and the purchase of a share from an existing shareholder is the difference between the creation and the transfer of a chose in action. The two legal transactions of the creation of a chose in action and the purchase of a chose in action are quite different in conception and in result.”

33. Both the First-Tier and Upper Tribunals said the same thing. First Nationwide did not buy similar securities. I would dismiss the Revenue’s appeal also on this ground. Mr Justice Briggs:

34. I agree. Lord Justice Rix:

35. I also agree.