All settled!

In Hexagon Properties Ltd v HMRC [2022] UKFTT 00137 (TC), the First-tier Tribunal (FTT) confirmed that the release of a debt owed to a bank as part of the settlement of litigation did not fall to be taxed as a loan relationship.

Background

Hexagon Properties Ltd (Hexagon) owned, developed, and let out residential and commercial properties.  In 2007, it entered into new banking and loan facilities with a new bank .  At about the same time, it entered into an interest rate swap (the Swap) with the same bank with a notional amount of £1m for five years, extendable at the option of the bank, at a fixed rate of 5.95% (at the time the base rate stood at 5.5%).  During and following the 2008 financial crisis, the base rate decreased substantially.

In May 2012, the Swap was terminated.  Hexagon had paid nearly £200k into the Swap.  Hexagon alleged that it had been mis-sold the Swap. The practice of mis-selling interest rate swaps at the time was sufficiently common for the Financial Conduct Authority to establish a scheme for those who had been mis-sold swaps to be offered financial redress.

Hexagon was offered a payment under this scheme, but it included only £600 in respect of Hexagon's loss that resulted from the mis-selling of the Swap which it said had led to its credit rating being affected as it had to service the payments under the Swap and it could not therefore complete the relevant developments it was engaged in.  Due to breaching of its banking covenants, the bank had appointed Law of Property Act (LPA) receivers over numerous properties owned by Hexagon.  

Hexagon therefore sought damages from the bank.  The parties settled the claim. Under the settlement agreement, Hexagon repaid around £1.5m of its debt to the bank, and its liability to pay the remaining c. £3.5m was 'released and discharged' as part of the settlement of all claims.

Hexagon included a credit in respect of the £3.5m released in its accounts for the period ended 25 April 2017 (which otherwise showed a pre-tax profit of £1.9m for the year).  It adjusted its reported profit down by the amount of the credit, noting that it constituted compensation, thereby reducing its profit to a £1.15m trading loss, with a chargeable gain of £37k, resulting in a nil corporation tax liability for the year.  

HMRC enquired into Hexagon's return, and issued a closure notice adding back the £3.5m to Hexagon's trading profits, resulting (after other adjustments) in a corporation tax liability of £265,581.55, which Hexagon appealed to the FTT.

Legislation

Part 5, Corporation Tax Act 2009 (CTA) governs the treatment of loan relationships.  

Section 296, CTA, provides that; "[p]rofits and deficits arising to a company from its loan relationships are to be calculated using the credits and debits given by [Part 5]".

Section 304, CTA, defines a "related transaction", in relation to a loan relationship, as "any disposal or acquisition (in whole or in part) of rights or liabilities under the relationship" and provides that "the cases where there is taken to be such a disposal or acquisition include those where rights or liabilities under the loan relationship are transferred or extinguished by any sale, gift, exchange, surrender, redemption or release".

Section 306A(1), CTA, provides that profits and losses of a company arising to it from its loan relationships and related transactions (excluding interest or expenses) are to be brought into account for the purposes of Part 5, CTA.

FTT decision

The appeal was allowed.

HMRC argued that Hexagon's pre-existing debts to the bank were loan relationships of Hexagon, and that their release fell within the meaning of the phrase 'related transaction' in the loan relationships code.  Since Hexagon had recognised a credit in its accounts, and in accordance with generally accepted accounting practice, Hexagon was required to bring the amount into account as a trading receipt under the loan relationships rules.

Hexagon argued that this approach was an oversimplification.  It was necessary to establish the character of the payment and that entailed looking at what the payment was for.  It argued that in the present case an arm's-length settlement of bona fide litigation had been negotiated and the amounts were substantially capital in nature.  

The FTT noted that it was clear that Hexagon had been party to one or more loan relationships with its bank until the settlement of its claim.  Further, the 'release and discharge' of the £3.5m could properly be described as the extinguishment, pro tanto, of its liabilities under the pre-existing debtor relationship.  It therefore fell to be considered as a 'related transaction' for the purposes of section 304, CTA.  It was not relevant that it might be described in economic terms as the settlement of a liability in damages.  

However, this was not the end of the matter.  As had been made clear in Union Castle Mail Steamship Co Ltd v HMRC [2020] EWCA Civ 547, it was necessary to consider whether the credit in Hexagon's accounts constituted "profits … that arise to [it] from its loan relationships and related transactions" for the purposes of section 306A, CTA.  The FTT held that any objective consideration of what the £3.5m arose from would conclude that it arose from Hexagon's damages claim, and not from any related transaction of its loan relationships.  This, in the view of the FTT, was reinforced by the very clear entry and note in Hexagon's accounts identifying the £3.5m not as a profit arising from a loan relationship, or related transaction, but as compensation from the mis-sold Swap.  

Comment 

This decision stresses the importance of the "arising from" provisions in the loan relationship code.  The scope of the "related transaction" provisions is extraordinarily broad and in practice the causation element on which this decision turns will be crucial for any corporate taxpayer that has anything other than the simplest and most straightforward relationship with its banker.

The decision can be viewed here.