The First-tier Tribunal (“FTT”) has published its decision in the case of Root 2 Tax Ltd v HMRC [2019] UKFTT 0744 (TC), very nearly 18 months after the case was heard in June 2018 (which must itself be some kind of record: it’s a 96-page decision of 341 paragraphs, but nonetheless…).
The decision is an important one and deals with the tax planning arrangements that were marketed under the name of “Alchemy”. Readers may recall that in 2017 HMRC succeeded in arguing before the FTT that the scheme should have been disclosed under the Disclosure of Tax Avoidance Scheme (“DOTAS”) rules, opening the door to Accelerated Payment Notices for participants in the scheme and weighty non-compliance penalties for the promoters. At the time HMRC suggested that the case could lead to the recovery of £110 million.
The 2017 case having been about whether the scheme should have been notified under DOTAS (yes, it should), the hearing in 2018 was about whether the scheme worked (no, it didn’t). In neither case did the Tribunal have much confidence in the evidence of the principal witness for the scheme promoter: in 2017 the Tribunal “found much of [his] evidence on these points disingenuous, if not evasive”; and in 2018 that “some of his views lacked credibility in the overall context of the evidence”.
Most strikingly, the presentation of the scheme as an “investment strategy” was “inherently implausible” – it being clear that the planning was “specifically designed to enable the parties to extract cash from the appellant, in the amounts in which it wished to remunerate the Individuals for their employment services, in a form which was intended to be virtually tax free”.
There is a lesson here: if you are going to create something that a blind man on a dark night would recognise as a tax avoidance scheme, it’s unlikely to help your case before a Tribunal to represent it as something different.
The scheme was essentially simple. The employee entered into a spread bet and, at the same time, a hedging contract (a “call spread option” or “CSO”). The two were designed to complement each other: if the spread bet resulted in a profit, the CSO would result in a loss of roughly equal size (the small difference being in effect the fee charged for the arrangement) and vice versa. Thus, if both contracts were held to maturity, a net loss was assured (hence the FTT’s demurring at the description as an “investment strategy”).
Of course, it was never intended that both contracts would be held to maturity. The expectation (which was normally fulfilled) was that the spread bet would generate a profit — purportedly tax-free, like all betting winnings — while the CSO would give rise to a loss. The CSO was therefore novated to the employer at an early stage, and a modest tax charge accepted by reference to the (negative) value of the CSO at the time of assignment computed using an industry methodology known as the Black-Scholes model (of which, more later).
HMRC argued before the FTT that, taking a purposive approach to the legislation, either (a) the payments made by the employer to the counterparty under the CSO or (b) the amounts paid by the counter-party to the employee met the description of “earnings from employment”. In particular, the fact that the CSO payments were made to someone other than the employee did not, on the authority of the Rangers FC case [2017] UKSC 45, prevent them from being “earnings”.
Alternatively, HMRC said, the “disguised remuneration” legislation applied: all that that required was that there was an “arrangement” which related to the employee; that the “arrangement” was concerned with providing rewards in connection with the employee’s employment; and that a “relevant step” (in this case, the payment of winnings under the spread bet) was, pursuant to the arrangements, taken by a third party (the counterparty).
HMRC won on both counts.
As regards the first, it was wrong on the facts to look at the spread bet, the CSO and the novation separately. It was plain that “neither the Individuals nor the appellant undertook them in order to speculate on movements in the market”: on the contrary, the transactions “as set up and implemented to operate as [a] composite whole” were designed to ensure that cash “specifically set at the level in which the appellant wished to remunerate the Individuals” would be extracted from the employer and would find its way to the employees in tax-free form. The FTT was not swayed by the fact that in some few cases the market had moved the wrong way resulting in (much more modest) amounts being in effect paid by the employee to the employer. That, the FTT said, was simply a risk that the parties were prepared to take for the chance of realising employment earnings virtually tax-free.
As regards the second argument, the FTT thought it “readily apparent” that HMRC’s contentions were well-founded (in fact, so apparent that the conclusion is stated in just one paragraph). The FTT did, however, suggest that that part of the spread bet payment that represented a return of the stake should not fall within the charging section.
There was one small consolation: HMRC did lose on their third argument.
The planning recognised that the novation of the CSO to the employer gave rise to a taxable benefit: it purported to work because the taxable value of that benefit was very small, based on the “Black-Scholes” valuation at the time of novation. HMRC did not challenge the “Black-Scholes” valuation (though they didn’t accept it either: the valuation issue was by agreement between the parties “parked” for consideration at a later date if required). Instead, they took a more subtle point: they argued that the “cost” to the employer of providing the benefit constituted by accepting the novation (and therefore the measure of the tax charge on the employee) was not limited to the valuation (by whatever means) of the CSO at the time of novation. Rather, they said, it extended to all costs that the employer incurred as a result of accepting the novation — thus including the full amount paid out to the counterparty on the maturity of the CSO.
The FTT rejected that argument: the benefit was provided at the time of novation and could be assessed only by the value at that time.
This case will doubtless go further. If you are affected by it or by other tax planning arrangements that have been challenged by HMRC, please get in touch with your usual BKL contact or use our enquiry form.