HMRC is set to lose out on £1.2bn in tax after the High Court agreed with PwC, the administrators of Lehman Brothers, that creditors did not have to pay income tax on interest earned while their money was tied up in the collapsed bank, with the judge highly critical of HMRC’s handling of the issue
The judge accused HMRC of issuing ‘inconsistent or confusing statements’ and said it had failed to involve a relevant specialist team and/or make proper internal checks when giving formal confirmations of their position which they must expect to be relied on.
The case concerned Lehman Brothers International (Europe) (LBIE) which went into administration in September 2008. There is a substantial surplus in the administration, estimated at between £6.6bn to £7.8bn, which is to be used, amongst other things, to pay statutory interest to creditors under the provisions of paragraph (7) of Rule 2.88 of the Insolvency Rules 1986.
The judge reported that ‘this unusual situation has given rise to a variety of novel legal issues’, one of which is whether or not these interest payments should be counted as ‘yearly interest’ and therefore be taxable.
Up until late 2015 HMRC's stated (and twice confirmed) position was that the payments did not, and so no income tax was due to be deducted at source. However, the matter was then referred to the specialist HMRC team known as the CTIS financial products team, which reversed this option. HMRC subsequently argued that the regulations applied only to payments of statutory interest to HMRC, and not to payments to other creditors.
The judge pointed out that the sums involved are considerable, with the joint administrators estimating the value of statutory interest calculated from the date of administration to the date of the final dividend to be in the region of £5bn.
PwC sought a legal ruling on the issue. The High Court heard that HMRC stated that the ‘risk to the Exchequer potentially runs up to £1.2bn’, while many of the creditors are non-resident, meaning that if tax is not deducted at source they are not liable to UK income tax. [Anthony Lomas, Steven Pearson, Paul Copley, Russell Downs, Julian Parr and Her Majesty’s Commissioners for Revenue and Customs,  EWHC 2492 (Ch)].
At court, HMRC's argument was that all that needs to be asked in determining whether the statutory right to interest satisfies the test of 'yearly interest' is whether the amount of interest ultimately required to be distributed to a creditor out of surplus is, when distributed, calculated by reference to a period of a year or more.
Its alternative argument was that the matter should be determined by looking at the position at the time the administration was commenced and whether the debts were likely to be repaid within a year: if not, then the interest payable will satisfy the criteria for qualification as 'yearly interest'.
The judge rejected both of these views, and found in favour of the administrators, saying that HMRC’s proposed approach to paying out dividends to meet its definition of yearly interest was ‘wholly unprincipled and without merit’. He also called on HMRC to improve its handling of similar points of dispute.
‘It is not only that it is inherently unsatisfactory and regrettable when government departments give materially inconsistent formal statements or guidance. It is also that, in a case such as this, debt is traded; and a change in the stance of HMRC may confound the commercial assumptions and expectations of the traders and the market.
‘It is of real importance, both in terms of good governance and a fair market that HMRC should make every effort to ensure that this sort of thing does not happen again,’ the judge said.
An HMRC spokesperson said: ‘We do not shy away from difficult legal challenges and it is right that we pursue every penny that may be due to the Exchequer. We are carefully considering the ruling and may appeal.’
Russell Downs, joint administrator for Lehman Brothers International Europe and PwC partner, said: ‘We appreciate given the size of the issue HMRC's wish to seek an appeal, which has now been granted.
‘We would hope and expect to work constructively with HMRC to develop an appropriate interim arrangement so that creditors do not face any unnecessary delays from the appeal as the joint administrators' plan for a distribution of interest next year takes shape.’