Trennery v West

This appeal concerned the construction of section 77 of the Taxation of Chargeable Gains Act 1992 (as amended by the Finance Act 1995), in particular the meaning and operation of the phrase "derived property" in section 77(8). The House held that "derived property" includes money representing proceeds extracted from settled property by any process (including a mortgage) and that such proceeds continue to be "derived property" in relation to the original settled asset even after they have been appointed out of the original settlement into a second settlement. Consequently, where trustees of a chargeable settlement dispose of settled property in a year in which the settlor is deriving benefit from property that represents proceeds of that settled property, the settlor is to be regarded as having an interest in the chargeable settlement under section 77(2) and is chargeable to tax at his highest marginal rate rather than the trustees' (lower) rate.

This case concerned a tax avoidance arrangement (the "flip-flop" or "two settlement" route) deployed to secure trustees' rate capital gains tax on the sale of shares. The taxpayers (shareholders) created a first settlement holding shares, took a highly geared loan secured on those shares, appointed the loan proceeds to a second settlement (of which the settlor was a beneficiary), excluded themselves from the first settlement before the tax year in which the shares were sold, and thereafter the first-settlement trustees sold the shares. The Inspectors of Taxes contended that section 77(2) and the definition of "derived property" in section 77(8) brought the loan proceeds and the income from them within the ambit of the first settlement, so that the settlor should be taxed at his rate; the taxpayers contended that once the proceeds left the first settlement they ceased to be "derived property" in relation to the shares.

The procedural history was: a Special Commissioners' decision in favour of the taxpayers ([2002] STC (SCD) 370); a contrary decision by Peter Smith J in the Chancery Division ([2003] STC 580); the Court of Appeal reversed Peter Smith J and restored the Special Commissioners ([2003] EWCA Civ 1792); leave was given to appeal to the House of Lords. The House considered statutory construction principles (applying the approach in IRC v McGuckian) and rejected the taxpayers' narrow reading of "derived property".

The central issues framed by the court were:

• whether the proceeds of a mortgage of settled property, and income from assets representing those proceeds after appointment into a new settlement, fall within the statutory concept of "derived property" in section 77(8); and
• whether, if they do, the settlor is to be regarded as having an interest in the original (chargeable) settlement under section 77(2), so that the settlor is chargeable at his rate under section 77(1).

The House concluded that the statutory language and structure supported a construction that "derived property" reaches proceeds extracted by mortgage and property indirectly representing those proceeds, and that such property may be "derived property" in relation to the original settled asset even after transfer to a different settlement. Applying those constructions to the facts, the Court held that the settlor was to be regarded as having an interest in the chargeable settlement and therefore liable to tax at his highest marginal rate. The House allowed the appeal and gave consequential orders as proposed.

Appeal allowed. The House held that section 77(8)'s definition of "derived property" covers money representing proceeds of the settled asset (including proceeds of a mortgage) and property or income which directly or indirectly represents those proceeds even after appointment out of the original settlement. Accordingly the settlor was to be regarded, under section 77(2), as having an interest in the chargeable settlement and chargeable at the settlor's rate under section 77(1). The Court set aside the Court of Appeal's construction and gave the orders proposed by Lord Walker (restoring Peter Smith J's approach as to construction), with costs directions recorded in the judgment.

Special Commissioners decided for the taxpayers: [2002] STC (SCD) 370. Peter Smith J (Chancery Division) decided for the revenue: [2003] STC 580. Court of Appeal reversed Peter Smith J and restored the Special Commissioners: [2003] EWCA Civ 1792. House of Lords allowed the appeal: [2005] UKHL 5.