Special Capital arrangements and miscellaneous income

The Court of Appeal has dismissed the taxpayer's appeal in HMRC v HFFX LLP [2024] EWCA 813 against HMRC's decision to tax reallocations of Special Capital as miscellaneous income. The Court has rejected the argument that a taxpayer must have a legal right to receive the income for it to fall within this category. Furthermore, the Court did not consider that contractual arrangements providing, in principle, for complete discretion in relation to the allocation of Special Capital were not in practice unfettered. Taken together, the contractual arrangements in the Partnership Deed, together with the reallocation process, gave rise to income in the hands of the individual members.

Background

The case concerns incentivisation arrangements put in place when GSA, an investment management business, transferred its high frequency foreign currency trading team to a limited liability partnership called HFFX LLP. HFFX's business was to second members of the team to GSA Capital Partners LLP, GSA's primary trading entity.

As a result of the restructuring, members of the team who were made members of HFFX became treated for tax purposes as self-employed partners rather than as employees. Under the arrangements with GSA their overall "pay-out" from the profits they earned for GSA was also increased, but a substantial proportion of it was deferred. The deferral was achieved via a "Capital Allocation Plan" (CAP), under which 50% of the pay-out that the team would otherwise have received was allocated to a corporate member of HFFX, GSA Member Ltd (GSAM). GSAM invested those amounts in funds managed by GSA.

On the first, second and third anniversaries of the allocation GSAM sold a third of the investments that it had acquired and contributed the net proceeds back to HFFX as "Special Capital". GSAM then decided to reallocate the Special Capital to individual members, who were able to withdraw it.

The hoped-for tax analysis was that GSAM would be taxed at corporation tax rates on the amounts allocated to it (rather than the higher income tax rates to which individual members would be subject if the profits were allocated to them) and that the subsequent reallocation of Special Capital would not give rise to tax for the individual members.

HMRC argued that the individuals were nevertheless taxable on the profits based on three arguments:

(a) The allocation of profits to GSAM should be considered an allocation to the individual partners under ITTOIA 2005 s.850

(b) The individuals were taxable on the reallocation of Special Capital to them as miscellaneous income under ITTOIA 2005 s.687

(c) The individuals were taxable on the reallocation of Special Capital to them as sales of occupational income under ITA 2007 Part 13 Chapter 4.

The FTT held against HMRC on (a), but upheld HMRC's assessment on the basis of (b) and (c). This decision was upheld by the Upper Tribunal and the individuals appealed to the Court of Appeal. HMRC accepted that the Court of Appeal decision in BlueCrest determined the s.850 issue against them and did not appeal that aspect.

Miscellaneous income

The taxpayers argued that the receipt of Special Capital did not fall within the scope of taxation as miscellaneous income under s.687. In particular, they argued that:

1. In order for there to be a source of income for s.687, the taxpayer must have a legal right to receive the income, whereas the individual members at no stage had a right to receive the Special Capital.

2. Another way of expressing this is that the taxpayer must "possess" the source. That requirement is said to be apparent from case law and legislation, and to cast light on what is meant by "source".

3. If wrong on those arguments and the existence of a "fettered" discretion exercised in the recipient's favour is sufficient, then the proper interpretation of the Partnership Deed was that the discretion to reallocate Special Capital is unfettered, in contrast to the position in BlueCrest  where it was common ground that the Braganza principle applied.

In particular, the taxpayers pointed to the express terms of the agreements in this case which gave GSAM an absolute discretion over allocation of the Special Capital.  

The Court of Appeal rejected the argument that there must be a legal right to the income in order to engage s.687. In BlueCrest, what was held to amount to a source was the exercise by the corporate partner of its discretion to reallocate Special Capital in the context of a legal agreement which conferred certain rights on the individual members. The Court of Appeal considered that it was only necessary to decide that that the contractual arrangements in the Partnership Deed, together with the reallocation process, gave rise to income in the hands of the individual members, as it did under the BlueCrest. That combination was sufficient to mean that what was received was not a pure gift and was capable of amounting to a source from which the income was received. It was not necessary to go further and, for example, consider the precise limits of the requirement for a connection between the source and the income.

The Court also rejected the argument that the right to allocate Special Capital was unfettered. As with the similarly widely drawn clause in BlueCrest, that right was in practice subject to the Braganza principle (that a contractual discretion may be subject to an implied term that the discretion is exercised rationally). Given the nature of the arrangements in this case and the confirmations provided in a pro forma letter included in Schedule 7 of the Partnership Deed, it was clear that the discretion was not unfettered. "If GSAM had not played the part expected of it for some irrational reason then the individual members who had received letters in the form set out in Schedule 7, and who had continued to work for up to three years in the expectation of their deferred reward, would not only complain but would have a legitimate basis to do so."

Sales of occupational income

Having held against the taxpayers that the allocation of Special Capital amounted to miscellaneous income, it was unnecessary to consider the sales of occupational income issue.

Comment

Recent decisions on the scope of the miscellaneous income head of charge in cases such as BlueCrest and in Boston Consulting Group have consistently applied a wide interpretation to this head of charge. In particular, the fact that contractual arrangements may be drafted so that the discretion to allocate awards is, in principle, unfettered have not prevented the courts from reaching the conclusion that the provisions should be interpreted more restrictively and that such discretion is not, in practice, unlimited.