The following tale is not only cautionary, it is an alarming illustration of how a strict interpretation of tax law and the legal form of transactions can result in taxable income out of all proportion to their economic substance.

As Lady Justice Andrews stated in the opening comments from the judgement in Khan v Revenue and Customs (Rev 1) [2021] EWCA Civ 624: “This is a cautionary tale, which illustrates all too graphically the importance of seeking specialist tax advice before entering into commercial arrangements that might have adverse tax consequences, however remote that risk might appear.”

What happened?

In Khan, the shareholders of a company (CAD) approached Mr Khan to see if he would be interested in buying the company with a view to winding it up, as they believed there was no prospect of finding a buyer and did not want the burden of closing CAD.

Mr Khan could not afford to pay for the shares personally, so the transaction was funded by the company’s resources. A share sale and purchase agreement was executed whereby Mr Khan bought the entire issued share capital of CAD (ie, 99 shares) for £1.95m plus net asset value of £18,771 (ie, a total of £1.968m). Less than 40 minutes later, CAD bought back from Mr Khan 98 of CAD’s shares for £1.95m, which was subsequently paid to the vendor shareholders (Mr Khan paid the £18,771 balance of the purchase price later).

Following an enquiry into Mr Khan’s self assessment return for the relevant tax year (ie, 2013/14), HMRC considered that the proceeds received from CAD for the share buy-back represented a distribution to him.

Valiant attempts

Mr Khan fought valiantly through several appeals, raising some attractive (albeit unsuccessful) arguments.

• At the First-tier Tribunal (FTT), he contended that the shares were trading stock and that trading transactions took precedence over a distribution for income tax purposes (s366, Income Tax (Trading and Other Income) Act 2005 (ITTOIA 2005)). Alternatively, Mr Khan argued that what happened should be viewed as a single composite transaction, the effect of which was to make him the owner of one share in the company for a small net cost.
• Mr Khan argued before the Upper Tribunal (UT) that the FTT had erred in failing to recognise the true substance of the transaction, (ie, a composite transaction whereby Mr Khan received the remaining share in the company devoid of £1.95m distributable reserves).
• Finally, at the Court of Appeal, Mr Khan submitted that the UT erred in law in refusing to consider the sale and buy-back of the shares as a single composite transaction and consider its overall effect; ‘entitlement’ to the distribution (in s385(1)(b), ITTOIA 2005) should be given a wide practical meaning, such that the former shareholders were liable to tax on the distribution (as he had assumed).

The court decided that the transactions could not be recharacterised as a buy-back arrangement made directly between the vendor shareholders and CAD. The vendor shareholders were entitled to the proceeds from the sale of their shares to Mr Khan, not to the distribution of £1.95m in respect of the shares, which CAD bought from him.

Purposive construction

Counsel for Mr Khan submitted that the transactions had a commercial unity and should be taxed accordingly. Reference was made to WT Ramsay v Inland Revenue Commissioners [1982] AC 300, where the ultimate question was: “whether the relevant statutory provisions, construed purposively, were intended to apply to the transaction, viewed realistically.”

However, in UBS and Ors v HMRC [2016] 1 WLR 1005, Lord Reed stated: “…but if the legislation requires the Court to focus on a specific transaction, then other transactions, although related, are unlikely to have any bearing on its application.” The court in Khan considered this passage to be particularly pertinent, and stated: “…even if one were to look at the transactions taken as a whole, they do not produce the end result contended for by [counsel for Mr Khan], namely, a distribution by the company in respect of its shares to the vendor shareholders.”

The bigger picture

Pausing there, the net effect of the events in Khan was:

• the CAD shareholders sold their shares for £1.968m;
• Mr Khan held one share in CAD, at a cost to him of £18,771;
• CAD’s assets reduced by £1.95m; and
• CAD’s issued share capital reduced from 99 shares to one share.

From a tax perspective, the vendor shareholders were liable to capital gains tax on their share disposal, and Mr Khan was liable to income tax of £594,815 on the distribution of £1.95m.

Going to court

HMRC is normally the party seeking to invoke Ramsay, when challenging artificial anti-avoidance schemes (of course, Khan did not involve artificial tax avoidance). The Court of Appeal found that the principles in Ramsay are of “general application”, whereas in Khan the focus was on the specific transaction under which the taxable distribution arose.

Case law has developed the Ramsay principle over the years. Is there any scope for the courts to develop a ‘reverse Ramsay’ principle capable of producing a fairer tax outcome than suffered by Mr Khan? Some encouragement may be derived from Reeves v HMRC [2018] UKUT 293 (TCC), where the UT was prepared to look at Parliament’s intention rather than merely a strict interpretation of the holdover relief legislation.

If a ‘reverse Ramsay’ principle is not on the agenda, is there another way to achieve equitable tax outcomes?

If a mistake is made about the tax consequences of a transaction, the courts may consider it appropriate in some instances to accept an application for rectification, or for a transaction to be set aside (for example see Pitt & Ors v Holt [2013] UKSC 26). However, court applications can be costly and the outcome by no means certain.  

Exercising HMRC’s functions

In s9, Commissioners for Revenue and Customs Act 2005, the Commissioners are empowered to “…do anything which they think:

1. necessary or expedient in connection with the exercise of their functions; or
2. incidental or conducive to the exercise of their functions.”

HMRC’s mantra is to collect the ‘right’ amount of tax, but would many taxpayers or agents criticise HMRC for exercising its functions in a sensible and reasonable way? Nevertheless, it seems unlikely that taxpayers would be content to rely on HMRC’s discretion.

Change the law

The obvious way to achieve certainty would be to change the law. For example, following Lobler v HMRC [2015] UKUT 152 (TCC) – in which the taxpayer was treated as realising taxable income of some $1.3m and was liable to tax of around $560,000, despite making only a small economic gain – legislation was introduced allowing taxpayers to apply to HMRC for a review of tax calculations on the basis that the gain arising is wholly disproportionate (s507A, ITTOIA 2005). However, it would be highly impractical to draft targeted legislation dealing with every potentially disproportionate tax outcome.

The general anti-abuse rule (GAAR) is aimed at counteracting tax advantages arising from arrangements that are abusive by specifically targeting ‘loopholes’ in the law. A ‘reverse GAAR’ to prevent disproportionate tax outcomes is surely not unreasonable. A purposive construction of legislation and the ability to consider composite transactions should work both ways.

About the author

Mark McLaughlin, CTA (Fellow), ATT (Fellow), TEP is a consultant editor to Bloomsbury Professional and a freelance tax author