‘One in the eye’ for tax avoidance in Cyclops case

HMRC is claiming victory at an Upper Tribunal in a legal challenge involving two businesses which issued loan notes as bonuses as a form of tax avoidance – Cyclops Electronics and Graceland Fixing – which it says will protect £55m, as the scheme was used by over a hundred other companies

This scheme was formulated and implemented in the 2003 to 2004 and 2004 to 2005 tax years, and was initially designed and promoted by Haines Watts.

It was devised to work around the anti-avoidance legislation introduced to the employment income share schemes legislation at part 7 ITEPA 2003 by schedule 22 FA 2003. The legislation has been amended to prevent any further attempts exploit the rules.‎

Specially created companies issued loan notes in £10 denominations that matched the bonus amount exactly. Special conditions were included to dodge the tax and National Insurance due when the loan notes were given to the director.

An Upper Tribunal gave a ruling on the scheme in January. [Cyclops Electronics Ltd and Graceland Fixing Ltd, and Her Majesty’s Commissioner’s for Revenue and Customs, [2018] UKUT 0007 (TCC)].

In essence Cyclops’ employees incorporated a new company (NewCo). Cyclops then subscribed for loan notes issued by NewCo. The loan notes were subsequently transferred to the employee, and the loan notes were redeemable and would be forfeited if the employee died within one year. In which case, the loan notes would have to be returned to Cyclops with no compensation for the estate of the deceased.

As a consequence of the forfeit provision, Cyclops sought to agree that the loan notes were restricted securities and therefore no income tax or NIC arose on the transfer to the employee. In addition, it was argued that due to the detailed provisions in Part 7 ITEPA, no income tax or NIC charge arose on redemption of the loan notes.

The Upper Tribunal rejected these arguments, finding that the principal amount of the loan notes were earnings in the hands of the employees when they received the loan notes and should have been subject to PAYE and NIC.

The tribunal found that the loan notes were not restricted securities for broadly the same reasons given by the Supreme Court in UBS/Deutsche Bank v HMRC, on the grounds that a restricted security ‘is to be construed as being limited to provisions having a business or commercial purpose, and not to commercially irrelevant conditions whose only purpose is the obtaining of the [restricted securities] exemption.’

The tribunal also held that the transfer of the loan notes to the employee was akin to a cash payment for PAYE and NIC purposes, in line with the judgment in Aberdeen Asset Management v HRMC. As such, the UT did not need to consider the final issue of whether income tax or NIC arose on the redemption of the loan notes (since the tax point occurred on receipt of the loan notes).

In its analysis of the outcome of the tribunal, KPMG noted: ‘Interestingly, HMRC did invite the Upper Tribunal to consider whether the judgment in Rangers v HMRC applied to the subscription by Cyclops for the loan notes. This, in effect, would have treated the payment to NewCo as a redirection of earnings and so PAYE and NIC would have applied at that point.

‘However, the Upper Tribunal declined to apply Rangers and, ultimately, nothing turned on this.

‘As the judge put it: “[it is] accepted that an analysis based on the Rangers decision (the payment made to NewCo was earnings) and an analysis based on the UBS decision (the transfer of the loan notes to the employee was earnings) produced the same outcome, namely that the Employee is taxable on the amount subscribed by the employer for the loan notes. In those circumstances, the point is academic and we say no more about it.”’

Penny Ciniewicz, HMRC’s director general for the customer compliance group, said: ‘We cannot allow tax avoidance schemes like these to deprive the UK of vital revenue. The money we’ve protected in this case alone would be enough to pay the annual salaries of around 2,400 newly qualified teachers.’

The win over Cyclops Electronics, a supplier of electrical components, and Graceland Fixing, a building company, was worth £350,000, with £55.2m in related cases.

Cyclops Electronics Ltd and Graceland Fixing Ltd, and Her Majesty’s Commissioner’s for Revenue and Customs, [2018] UKUT 0007 (TCC)

Report by Pat Sweet

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