Trennery (Respondent) v. West (Her Majesty's Inspector of Taxes (Appellant) and four other actions

Under section 77 of the Taxation of Chargeable Gains Act 1992, property may remain “derived property” after it has left the settlement containing the original property. The expression includes capital or income directly or indirectly representing proceeds of that original property.

Proceeds include value extracted by a mortgage. Accordingly, a settlor who benefits from mortgage proceeds transferred into another settlement may be treated as interested in the first settlement while the mortgaged property remains there. A chargeable gain realised by its trustees is then taxed at the settlor’s rate. Hypothetical hardship cannot displace the natural construction supported by the statutory scheme.

Five linked appeals concerned a tax-avoidance arrangement known as the “flip-flop” or “two settlement” scheme. Shareholders transferred shares to a first settlement. Its trustees borrowed against the shares and appointed the borrowed money to a second settlement in which the settlor remained a beneficiary. After excluding the settlor from the first settlement, its trustees sold the shares.

The Special Commissioners found for the taxpayers: [2002] STC (SCD) 370. Peter Smith J allowed the Revenue’s appeal: [2003] STC 580. The Court of Appeal reversed him: [2003] EWCA Civ 1792.

The issue was whether the money in the second settlement remained “derived property” in relation to the shares retained by the first settlement for section 77 of the Taxation of Chargeable Gains Act 1992. The answer determined whether the gains were taxable at the trustees’ rate of 25% or the settlor’s rate of 40%.

Appeal allowed unanimously. Lord Millett and Lord Walker of Gestingthorpe delivered the substantive speeches. Lord Steyn and Lord Hoffmann agreed with both. Lord Rodger of Earlsferry also agreed with their reasoning.

1. Per Lord Millett and Lord Walker, section 77(8) of the Taxation of Chargeable Gains Act 1992 was not confined to income. “Derived property” encompassed income from the original property, other property directly or indirectly representing its proceeds, income from that other property, property representing proceeds of income from the original property, and income from that further property. The taxpayers’ construction would have caught income extraction but left capital extraction untouched, depriving the definition of effective content.

2. Derived property need not remain within the settlement containing the original property. Section 77(2) already addressed property comprised in that settlement. The additional reference to derived property therefore extended to property outside it which derived from property still comprised in it. Transfer into a second settlement did not alter that character.

3. Per Lord Millett, “proceeds” were not confined to proceeds of sale. They covered value extracted by sale, mortgage or another process. The borrowed money directly represented proceeds of the mortgaged shares, while its income represented income from those proceeds.

4. The shares remained in the first settlement during the relevant year. The borrowed money remained in the second settlement, where the settlor enjoyed its income. The settlor was consequently to be regarded under section 77(2) as interested in the first settlement. The gain on sale of the shares was taxable at his highest marginal rate.

5. Per Lord Walker, hypothetical hardship could not justify the taxpayers’ construction where decisive legal reasons favoured the Revenue. Nor could the description of the 1995 alteration as a consequential amendment change the meaning of the enacted words.

The House set aside the Court of Appeal’s order and restored the order of Peter Smith J. The Revenue was ordered to pay the taxpayers’ costs in the House under the terms governing leave, while the taxpayers were ordered to pay the Court of Appeal costs.

1. House of Lords: Allowed the Revenue’s appeal unanimously, set aside the Court of Appeal’s order and restored Peter Smith J’s order: [2005] UKHL 5.
2. Court of Appeal: Allowed the taxpayers’ appeal, reversed Peter Smith J and restored the Special Commissioners’ decision: [2003] EWCA Civ 1792.
3. High Court, Chancery Division: Peter Smith J allowed the Inspectors’ appeal and held for the Revenue: [2003] STC 580.
4. Special Commissioners: Decided the statutory-construction issue for the taxpayers: [2002] STC (SCD) 370.