The Supreme Court has defeated profit sharing arrangements (known as the Capital Allocation Plan (CAP)) implemented by a foreign exchange trading firm (HFFX) to minimise the tax payable by individual members of the firm on profits received by them.
Background
Following the end of each financial year, a proportion of the profits that would potentially otherwise have been allocated to each participating individual member of HFFX for that financial year (the Pre-Retention Amount) were instead allocated to a corporate member, GSA Member Limited (GSAM). From this allocation, GSAM would invest the net amount (after tax and other costs) into GSA fund shares. A letter of recommendation would then be sent by the managing member of HFFX to GSAM recommending what percentage of the allocation made to it was to be held for potential later payments to individual members of HFFX participating in the CAP. GSAM could however ignore these recommendations and deal with the said profits at its complete discretion. GSAM would then sell the GSA fund shares it held for each member's deferred award in three equal annual tranches and contribute the net sale proceeds to HFFX as “Special Capital”. At GSAM’s discretion, HFFX would then reallocate that Special Capital to individual members of HFFX, who could then withdraw it.
The intended tax effect of the CAP (the terms of which were set out HFFX's limited liability partnership deed (the LLP Deed)) was that the profits allocated to GSAM would be subject to corporation tax (rather than income tax) in GSAM’s hands and there would be no tax charge on the amounts of Special Capital subsequently re-allocated to the individual members.
First appeal
This was an appeal by HMRC concerning the correct allocation of partnership profits (under section 850 of the Income Tax (Trading and Other Income) Act 2005 (ITTOIA)) for income tax purposes between the members. HMRC sought to tax the individual members of HFFX in relation to the indicative allocations of Special Capital under the CAP arrangements.
Section 850 provides –
"(1) For any period of account a partner’s share of a profit or loss of a trade carried on by a firm is determined for income tax purposes in accordance with the firm’s profit-sharing arrangements during that period. This is subject to sections 850A and 850B.
(2) In this section and sections 850A and 850B ‘profit-sharing arrangements’ means the rights of the partners to share in the profits of the trade and the liabilities of the partners to share in the losses of the trade.”
HFFX argued that section 850 had no application to the indicative allocations of Special Capital. It said that individual members had no right existing in each relevant period to share in the profits of HFFX allocated to GSAM; instead, they only had a right to be considered for a distribution under the CAP arrangements. The interposition of a discretionary decision by GSAM regarding the amount to be received meant that shares of profits for individual members were not a matter of contractual entitlement and so were not “determined … in accordance with the firm’s profit-sharing arrangements” within the meaning of section 850.
HMRC's disagreed. They considered the amounts received by individual members (by way of both immediate and deferred payments) were rewards for the work they did for HFFX and they were taxable on them even though they had consented to their redirection to GSAM in the first instance.
The Supreme Court confirmed that section 850 should take its ordinary and natural meaning and that the amount of each individual member's income should be a specific amount in respect of the relevant period which is knowable because it is determined by contractual rights subsisting in that period. Section 850 did not have the effect of converting deferred remuneration received by an individual member under the CAP into their income during the relevant period. This is because the individual member had no contractual right subsisting in the relevant period to receive that sum of money as part of the ordinary profit allocation process.
HMRC's appeal on this point failed and consequently, the profit shares that were allocated to GSAM were not to be regarded as individual members’ profit shares in accordance with HFFX’s profit-sharing arrangements.
Second appeal
This was an appeal by the individual members concerning whether they were liable (under section 687 ITTOIA) to income tax on receipts under the deferred remuneration mechanism.
Section 687 is headed – 'Charge to tax on income not otherwise charged' and sub-section (1) provides -
"Income tax is charged under this Chapter on income from any source that is not charged to income tax under or as a result of any other provision of this Act or any other Act.”
By the time the proceedings reached the Supreme Court, despite it having been conceded by the individual members that the deferred sums paid under the CAP constituted "income", they still disputed that section 687 applied to these payments. Their position was that for section 687 to apply, the income had to be “from [a] source” and on the basis that the payments to individual members were purely voluntary, because GSAM was not under any legal obligation to reallocate its Special Capital, or even to consider whether to do so, because it had an absolute discretion in that regard, the payments could not constitute a “source”. The individual members also tried to argue that in order for there to be a relevant source, it had to be something which is possessed by the recipient of the income; and in this case, there was nothing in the possession of the individual members which led to their receipt of the income which was sought to be taxed.
HMRC took the view that the deferred sums paid under the CAP were not purely voluntary or in the nature of a gift. They were paid by reason of the individual members’ rights under the CAP, which in combination with the exercise of the discretion under the provisions of the LLP Deed, amounted to a source from which the receipt of the Special Capital was derived.
The Supreme Court confirmed that the word “source” should be given its natural meaning and it agreed with HMRCs view on this point. The Supreme Court also confirmed that the fact that there was a possibility of a decision in respect of the Special Capital allocation to be altered before it was implemented, did not affect the analysis. The Supreme Court held that such a reallocation that is actually made, still had its source in the decision to make it.
The Supreme Court determined that section 687 did not contain any concept of "possession" of a source. It only refers to there being a source of the income, not a source that is possessed by the recipient of the income. A source of income may exist so long as there is some relevant and sufficient factor connecting the income and the recipient.
This appeal was dismissed and consequently, income tax was payable by the individual members on receipts of the Special Capital.
In the Supreme Court, counsel for the individual members sought to raise a new point based on section 575 of ITTOIA. Section 575 is headed “Provisions which must be given priority over Part 5 [of ITTOIA]” and sets out a priority rule for the application of different parts of ITTOIA. Subsection (1) provides that “Any income, so far as it falls within—(a) any Chapter of this Part [i.e. Part 5], and (b) Chapter 2 of Part 2 (receipts of a trade, profession or vocation), is dealt with under Part 2”. Section 687 is in Part 5 of ITTOIA. Counsel said that HMRC was seeking to tax the income from a trade, within Part 2 of ITTOIA, and it is the trade of HFFX which is the source of the income; therefore it is Part 2 which applies, excluding the operation of section 687.
The Supreme Court rejected this and said that there was no overlap between the taxation of the profits of the underlying trading activity of HFFX and the taxation of the deferred remuneration element received by the individual members pursuant to the LLP Deed and the CAP arrangement. Although the deferred remuneration element was paid by GSAM out of money which derives from the profits of HFFX which had been taxed as profits in GSAM’s hands, this was deemed irrelevant to the question of the application of section 575 on the basis the payments of deferred remuneration were payments out of GSAM’s funds, not out of funds of HFFX.
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