Forfeitable Loan Notes – Insecure Securities

The First Tier Tribunal (“FTT”) handed down its decision in the case of Cyclops Electronics Ltd & Anor v Revenue and Customs [2016] UKFTT 487 (TC) on 12 July 2016.

The case concerned two companies who had undertaken very similar planning, involving the award of loan notes to senior members of their management teams, who also just happened to be the main shareholders in each company.

The planning involved the following steps:

* A “money box” company was established for each participant;

* The main employer entity subscribed for loan notes issued by the money-box companies;

* The loan notes were transferred to the participants.

The loan notes were immediately redeemable, but were structured as “forfeitable securities”: if the participant died within a year of the date of issue, the loan notes would revert to the employer company.

The planning was structured this way because the loan notes would be treated as “employment-related securities” and be subject to the special regime in ITEPA 2003, Part 7.

The fact that they were forfeitable securities and the forfeiture condition lasted less than five years meant that the promoters of the planning believed that ITEPA 2003, s425 would apply, which meant that there would be no charge to tax when the loan notes were awarded to the participants and instead a tax charge should arise when the forfeiture condition lifted (i.e. at the end of the year from the date of issue in this case). The intention was that the loan notes would be redeemed before the forfeiture condition lifted, the argument being either:

* that the redemption of the loan notes was not a chargeable event for the purposes of the restricted securities rules; or,

* in the alternative, the way that the formulas in ITEPA 2003, Part 7, Chapter 2 work means that any charge would have been zero.

In a decision that drew heavily on the Supreme Court judgment in UBS/DB Group Services v HMRC [2016] UKSC 13, the FTT held that there was no commercial reality behind the forfeiture clause in the loan notes – it had been inserted simply to avoid tax and there were a number of work-arounds that deprived the forfeiture provision of its operative effect.

For this reason, the FTT determined that the forfeiture condition was not of a sort that Parliament intended to grant tax relief to when it enacted ITEPA 2003, s425 and should be ignored for the purposes of working out the tax treatment of the loan notes.

This decision meant that the value of the loan notes was treated as taxable employment income on the date that they were received by the participants.

The FTT did not consider the fiscal value of the loan notes, instead focussing on the money-box companies and arguing that the participants were entitled to the cash in the money-box companies and should be taxed on the value of that cash.

The case highlights the approach that the courts are taking to the interpretation of tax legislation, looking beyond a construction of the words on the page and towards the objective that Parliament had in mind in enacting the legislation.

It also highlights the risks associated with complex tax avoidance: in each of the cases the participating employees were also shareholders in the company – it would have been possible for them to take dividends and pay tax at a far lower rate if they had not been willing to gamble all on a zero tax rate. For further information please contact the TaxDesk on 0845 4900 509 and ask for Thomas Dalby.