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On 6 July 2011, the UKSC delivered its judgment in Scottish Widows plc v Commissioners for Her Majesty’s Revenue and Customs (Scotland); Scottish Widows plc No 2 v Commissioners for Her Majesty’s Revenue and Customs (Scotland); Scottish Widows plc v Commissioners for Her Majesty’s Revenue and Customs (Scotland) [2011] UKSC 32.

The Court, consisting of Lord Hope, Lord Walker, Lady Hale, Lord Neuberger and Lord Clarke, unanimously allowed the cross-appeal by Her Majesty’s Revenue and Customs and held that amounts that were recorded in three consecutive annual regulatory returns (specifically the prescribed form within the returns dealing with the long term business fund (“LTBF“)) of Scottish Windows Plc fell within the scope of the Finance Act 1989 (“FA 1989“), s 83(2)(b).  Accordingly, such amounts constituted an increase in value of the LTBF for tax purposes, notwithstanding that the market value of the assets of the LTBF during this period had actually dropped.

Facts

In 2000, Scottish Widows, a new company within the Lloyds TSB banking group, acquired the principal assets and liabilities of the life assurance business of the Scottish Widows’ Fund and Life Assurance Society (the “Society”).  The Society had been incorporated in 1861 as a mutual life company and remained as such until the acquisition in 2000, which constituted a ‘demutualisation’.  This process of demutualisation was achieved by a scheme of transfer approved by the Court of Session under the Insurance Companies Act 1982 (“ICA 1982”) (the “Scheme“).

Pursuant to the Scheme, Scottish Widows acquired approximately £25bn worth of assets and approximately £19bn worth of actuarial liabilities.  Certain qualifying members of the Society received compensation of approximately £5bn, representing the difference (with various adjustments and enhancements) between the assets and the liabilities.  Such compensation was paid by Scottish Widows’ holding company in return for the relevant members giving up their right to participate in the surplus of the assets over liabilities.

As part of the Scheme, Scottish Widows was to establish and maintain an LTBF to fund its long-term insurance business and was to provide for a “memorandum account” within the LTBF called the “Capital Reserve”, which was said to represent the value of shareholder’s capital within the LTBF.

As a life assurance company, in addition to its statutory returns, Scottish Widows is obliged to complete annual regulatory returns under the ICA 1982, s 18, in particular to demonstrate its solvency.  One of the forms prescribed for the regulatory returns is Form 40, which is a revenue account in respect of the LTBF.

In the first few years of Scottish Widows’ business the market value of the assets in the LTBF was substantially reduced, largely due to a fall in the stock markets.  So as to cover those losses and to allow for a distribution to be made its policyholders, Scottish Widows brought into account certain amounts into its Form 40 for the accounting periods covering those years, which were described as “transfers from the Capital Reserves”.  This led to a dispute between Scottish Widows and HMRC as to the tax consequences of such transfer.

In 2006 Scottish Widows and HMRC jointly referred the following question to the Special Commissioners:

“Whether in computing the Case 1 profit or loss of Scottish Widows plc for the accounting periods ending in 2000, 2001 and 2002, amounts described by the company as ‘transfers from Capital Reserve’ and included as part of the entries at line 15 of Form 40 for each period fall to be taken into account [as receipts] in computing the profit or loss as the case may be.”

The answer to the above question depended on:

1. the interpretation and application of the FA 1989, s 83(2) (read with sub-s (1) of the same section) (the “First Issue“); and

2. the interpretation and application of the FA 1989, s 83(3) (read with sub-s (4) of the same section) (the “Second Issue“).

Scottish Widows had to win on both issues (by successfully arguing that neither ss.83(2) nor 83(3) applied) in order to succeed.  If the Form 40 entry fell into the scope of either subsection then the sum concerned would be treated as a chargeable receipt for the purposes of Case 1 of Schedule D of the Income and Corporation Taxes Act 1988 (“ICTA 1988“), s 18 in ascertaining whether and to what extent Scottish Widows made a loss during those years.

The amounts to be taken into account in computing the profits of an insurance business include its investment income from its LTBF and any increase in the value of its assets during the accounting period.  Those profits may be computed for tax purposes in one of two ways: (i) on the Schedule D, Case 1 basis (insurance business being a trade for this basis) or (ii) on the basis of the income which the insurer receives on its investments less management expenses, known as the “I – E” basis.  HMRC are entitled to elect to charge tax on the investment income, however, a Case 1 computation would still be required.

Scottish Widows contended that the LTBF assets had actually decreased by about £4bn and that the amounts included in line 15 of Form 40 were there for regulatory purposes only, i.e. that they were book entries with no commercial validity.

FA 1989, s 83

Pre-1989, the tax system allowed life assurance companies to defer taxation, especially on unrealised capital gains.  In order to prevent this, the FA 1989, s 83 introduced special rules governing the calculation of the profits of life assurance companies in respect of their life insurance business for corporation tax purposes.  At the time of Scottish Widows’ relevant accounting periods, s.83 FA 1989 read as follows (bold formatting added):

“(1) The following provisions of this section have effect where the profits of an insurance company in respect of its life assurance business are, for the purposes of the Taxes Act 1988, computed in accordance with the provisions of that Act applicable to Case 1 of Schedule D.

(2) So far as referable to that business, the following items, as brought into account for a period of account (and not otherwise), shall be taken into account as receipts of the period –

(a) the company’s investment income from the assets of its long term business fund, and

(b) any increase in value (whether realised or not) of those assets.

If for any period of account there is a reduction in the value referred to in paragraph (b) above (as brought into account for the period), that reduction shall be taken into account as an expense of that period.

(3) In ascertaining whether or to what extent a company has incurred a loss in respect of that business in a case where an amount is added to the company’s long term business fund as part of or in connection with –

(a) a transfer of business to the company, or

(b) a demutualisation of the company not involving a transfer of business,

that amount shall (subject to subsection (4) below) be taken into account for the period for which it is brought into account, as an increase in value of the assets of that fund within subsection (2)(b) above.

(4) Subsection (3) above does not apply where, or to the extent that, the amount concerned –

(a) would fall to be taken into account as a receipt apart from this section,

(b) is taken into account under subsection (2) above otherwise than by virtue of subsection (3) above, or

(c) is specifically exempted from tax.”

Decisions Below

The Special Commissioners (Mr J Gordon Reid QC and Dr John F Avery Jones CBE) decided the First Issue in favour of Scottish Widows and the Second Issue in favour of HMRC so that HMRC were successful overall.  Scottish Widows appealed and HMRC cross-appealed.

In its judgment, the First Division of the Inner House of the Court of Session (the Lord President (Hamilton), Lord Reed and Lord Emslie) reached the same conclusion as the Special Commissioners on both issues; unanimously on the First Issue and with Lord Emslie dissenting on the Second Issue.

In relation to the First Issue, both Scottish Widows and HMRC accepted that the FA 1989, s 83(2)(a), which deals with the bringing into account of investment income from a LTBF, applies to actual investment income only.  Scottish Widows argued that it followed that any increase in value in the LTBF, covered by the FA 1989, s 83(2)(b), should also be actual.  The Inner House considered that the FA 1989, s 83(2) was indeed entirely concerned with real gains, i.e. market value, rather than a change in notional values since statutory provisions bringing profits and gains into the charge to tax were directed to profits and gains in their natural and proper sense.

UKSC Judgment

The Court held that the proper approach was to consider the wording of the FA 1989, ss 83(2) and (3) as they were at the relevant accounting periods since self-contained statutes should be interpreted without recourse to the legislative history unless there is a real and substantial difficulty of ambiguity which classical methods of construction cannot solve.  Similarly, subsequent statutes should only be considered if the language of a provision in an existing statute is ambiguous.

First Issue

In relation to Scottish Widows’ argument that the FA 1989, s 83(2) should only be applied to actual increases in value, the Court held that s 83(2) provides a special rule for the computation of profits of an insurance company in respect of its life assurance business.  The general rules for the computation of profits and gains (as set out in Gresham Life Assurance Society v Styles [1892] AC 309) are consequently modified and disapplied to the extent provided for in s 83(2).

Regulation 45(6) of the Insurance Company Regulations 1994 allows insurance companies to use their book values in their regulatory accounts. This codified what was already standard practice in the insurance industry, i.e. using book values to demonstrate solvency to the regulatory authority.  The Court considered that the FA 1989, s 83(2) was drafted in consideration of this fact.

The Court gave particular significance to the word “as” in the phrase “as bought into account for a period of account” in the FA 1989, s 83(2) and concluded that indicated that the computation referred to in the FA 1989, s 83(1) must be carried out according to the way items are entered on the prescribed forms.  Furthermore, the FA 1989, s 83A provides that “brought into account” for the purposes of s 83 of the 1989 Act includes amounts shown in regulatory accounts completed pursuant to ICA 1982.  The Court dismissed Scottish Widows’ contention that the word “as” in this section was concerned with when the increase was brought into account rather than the extent of the increase.

The “Capital Reserve”

The demutualisation of the Society had involved a choice between ring-fencing and monetising the excess of assets over liabilities.  Monetisation was opted for, which involved the aforementioned payment of compensation to the Society’s members.  The benefit of this was a comfortable investment reserve for Scottish Widows at the inception of its business, which was earmarked as shareholder-owned capital within the LTBF.

However, it was held by the Court that the Capital Reserve was a device created for internal accounting purposes only with “no real life” of its own separate from the LTBF.

Lord Emslie in the Inner House had said that since capital reserve was shareholders’ capital, its ordinary recognition to cover actual trading receipts should not be deemed a chargeable receipt.  However, the UKSC held that, since the Capital Reserve was not separate from the LTBF, transfers from the Capital Reserve should be treated in same way as other assets comprised within LTBF for regulatory purposes.  Therefore, the FA 1989, s 83(2) would apply to such a transfer.

Second Issue

The Court considered that the question of whether the FA 1989, s 83(3) applied to the Form 40 amounts was moot since s 83(4) provides that s 83(3) does not apply where the amount falls under the scope of s 83(2).  However, Lord Hope considered that, if it had been necessary to do so, he would have affirmed the decision of the majority of the Inner House on the Second Issue and dismissed Scottish Widows’ appeal.

Comment

This decision is mostly of limited relevance as it focuses on the interpretation of legislation governing the taxation of life assurance companies.

However, one interesting point of general relevance is the approach the Court takes to the interpretation of a legislative code which has a detailed legislative history.

The Court decided that recourse should only be made to how a piece of legislation has been amended over time when there is difficulty in interpreting the legislation as currently enacted. The Court accepted that a general principle in interpreting tax statutes was that tax should only levied where the wording of the statute was sufficiently clear, but the Court was satisfied that this was the case here.

This is particularly relevant to the interpretation of tax statutes, which are constantly being revised and updated.