STICS - discounts go to Hades

The First Tier Tribunal (FTT) has recently held in the case of Savva & Others -v- HMRC that a product marketed by UBS Wealth Management which was designed to deliver a tax-free return to UK individual investors failed to do so and in fact delivered a return which was fully subject to income tax.

STICS

The product was known as STICS, or "Sterling Investment in Capital Security". Under the arrangements, UBS acquired some fixed rate bonds issued by Abbey National. The bonds were held in Euroclear. The bonds were stripped of their right to interest, which was retained by UBS, and the right to receive the principal amount repayable upon maturity of the bonds was (beneficially) sold to the individuals. The bonds had a term of approximately 15 months. The individuals acquired the right to the repayment of the principal amount at maturity of the bonds at a discount, reflecting the absence of interest and the period to maturity. In the case of one individual, the principal amount repayable on maturity was £2,029,000 and the individual acquired the right to that principal amount from UBS for £1,923,068.20. The individuals hoped that the profit they made would be subject neither to income tax, on the basis that the profit was not income, nor capital gains tax, on the basis that the bonds were qualifying corporate bonds. HMRC disagreed with the income tax analysis and the principal questions for the Tribunal were therefore whether the profit realised on redemption was:

• a discount taxable under section 381 of the Income Tax (Trading and Other Income) Act 2005 (ITTOIA); or
• a profit on the disposal of a deeply discounted security within the meaning of section 428 of ITTOIA.

Section 381

Section 381 of ITTOIA provides that:

"All discounts, other than discounts in deeply discounted securities, are treated as interest for the purposes of this Act."

Discount is not defined for these purposes but has been considered in a number of cases relating to the legislative predecessors of section 381. The most important of those is Brown -v- National Provident Institution, a decision of the House of Lords from 1921, in which a number of interesting observations were made on these provisions:

• the language is very wide - "the rule … relates to 'profits' on all discounts from whomsoever made";
• "the words are not happily chosen, but must, I think, be taken to mean, 'all profits arising from a discount'";
• "the expression 'profit on a discount' … is probably elliptical for 'profit on a security bought at (or a transaction involving) a discount'"; and
• the legislation invited no investigation on what accretion was capital and what income - the whole profit was to be treated as an income profit.

The case did not, however, refer explicitly to the view long held by practitioners that, as Norfolk puts it at paragraph 2.68 of Taxation of Interest and Loan Relationships (Issue 22):

"the effect of s.381 is not to abrogate the capital/income distinction in relation to discounts. This is clear from the legislative history of the clause. It is also implicit in the statute that whenever reference is made to 'all discounts', what is in fact meant is all income discounts. The effect of ITTOIA 2005, s.381 is therefore to deem only all income discounts to be interest for the purposes of the Act. A capital discount is thus not subject to income tax except when it arises in respect of a deeply discounted security."

The FTT also referred to the later case of Ditchfield -v- Sharp in which it was held that the acquisition of an interest-free promissory note at a discount gave rise to an income profit on redemption at par. It was also made clear in that case that the normal presumption will be that any discount gives rise to an income profit and it is for the taxpayer to show that the return is truly capital and outwith those provisions.

Against this background, the FTT had no difficulty in deciding that the taxpayers had acquired the right to the repayment of principal for an amount discounted to maturity and that the profit obtained by the taxpayer was within the scope of section 381 of ITTOIA and therefore subject to income tax. The FTT also attached some significance to the fact that there was an absence of interest for the individuals under the STICS arrangements but that the product was designed to beat the after-tax returns on a normal deposit.

Deeply discounted security

While the taxpayer lost on section 381, the FTT also considered whether or not the rights which the taxpayers had against UBS under the STICS arrangements could be regarded as a deeply discounted security. Slightly surprisingly, given that UBS was effectively holding the right to the repayment of principal on trust for the taxpayers, the FTT held that the "something" which must have been done by UBS both to declare the beneficial interests of the individuals in their STICS and to evidence the nature and extent of those interests amounted to the issue of a security and, given the difference between the amount paid by the taxpayer for those rights and the amount received on redemption, the STICS itself was a deeply discounted security. Accordingly, even if section 381 did not apply, the profit would be subject to tax under the deeply discounted securities legislation.

The decision is important for two reasons:

• it highlights the very wide scope of section 381 in relation to discounts. Ditchfield -v- Sharp provides some comfort to taxpayers, in comparison with the rather bleaker message from the House of Lords in National Provident, that if the profit on a discounted acquisition is truly capital in nature section 381 should not bite but it is for the taxpayer to prove and the dividing line is a difficult one; and
• it suggests that a "security" may exist in more nebulous circumstances than might previously have been thought. It will be interesting to see whether the FTT's decision on this point is upheld if appealed.

Finally, it is worth noting that all such stripping arrangements are now specifically caught under sections 452A to 452G of ITTOIA and so such schemes have truly passed away to the underworld.

Please click on the links below for the other articles in the June 2013 tax newsletter.

• Partnership taxation - HMRC consultation on avoidance involving partnerships
• Bristol & West plc
• Fidex Ltd -v- HMRC
• General anti-abuse rule (GAAR)
• WHA Limited -v- HMRC
• Colaingrove: composite supplies for VAT purposes
• Middle Temple -v- HMRC
• The Royal College of Paediatricians -v- HMRC
• PPG Holdings BV - AG's opinion on VAT on management advice to pension fund
• Special Italian tax regime applicable to medium-long term loans: abuse of law?
• HMRC brief on SDLT overpayment relief for TOGCs following Robinson case