The recent case of Klincke v HMRC (TC 122) provided a surprise regarding the meaning of qualifying corporate bonds for capital gains tax purposes.
Mr Klincke sold his company for a mixture of shares and loan notes in 1993. The loan notes contained an option for redemption in a currency other than Sterling and it was accepted by all concerned that this meant that the loan notes were not qualifying corporate bonds. Accordingly, the gain on his original shares was rolled into the replacement shares and the non-qualifying corporate bonds; the gain would be charged to tax when they were eventually realised. All quite conventional so far. However, the holders of the loan notes subsequently varied the terms of the loan notes to remove the foreign currency redemption option. The loan notes thereupon became qualifying corporate bonds (QCBs). This was enormously important because QCBs are effectively exempt from capital gains tax. Magic.
HMRC claimed that the cancellation of the foreign currency redemption option represented a “conversion of securities” within the meaning of section 132(3) of the Taxation of Chargeable Gains Act (TCGA) 1992 and, therefore, a charge to capital gains tax would immediately have arisen on that occasion.
A conversion of securities is defined as including:
- A conversion of securities of the company into shares in the company;
- A conversion of the option of the holder of the securities converted as an alternative to the redemption of those securities for cash; and
- An exchange of securities arising from compulsory acquisition and the issue of other securities instead.
Mr Klincke argued that the variation of the loan notes did not represent a conversion of securities within this definition because none of these circumstances applied. The definition was obviously not exhaustive but it did indicate that to be a “conversion”, there needed to be a replacement of one asset by another. All that happened was that one term in the loan notes was varied.
This looked like a pretty good argument to me. The variation was minor to say the least. It had very few practical or financial consequences. A loan note which can be redeemed in Sterling or in US dollars is not really any different from a loan note which can be redeemed only in Sterling. The figures would be the same, apart from the costs of conversion which are hardly material. However, although the variation was insignificant in reality, it was hugely important for tax purposes because of the artificial distinction provided by the legislation between QCBs and non-QCBs.
What if the terms of the loan note were varied so as to require redemption to be in cash (I mean real cash – £50 notes) instead of bank transfer and for this to take place at a particular location in (say) Manchester? This would arguably be of more practical and financial significance than redemption in US dollars but it would not have been relevant for the definition of a QCB. Why would that not represent a “conversion”? The significance of the term to the definition of a QCB surely cannot be relevant to whether or not the loan note after the variation really represents a new security.
However, the Tax Chamber decided otherwise. They considered that the cancellation of the foreign currency redemption right amounted to a conversion of Mr Klincke’s loan notes with a result that the latent chargeable gains crystallised at that moment.
They considered that the right to repay and to receive repayment in Sterling was a change in the rights and obligations of issuer and note holder and that was a conversion in the ordinary sense of the word. The three limbs of the definition in section 132(3) were not exhaustive and a conversion of securities into other securities in the manner suggested was covered by the definition.
This interpretation is bound to have serious implications to the reorganisation rules for capital gains tax (and other) purposes. On this argument, any change in the terms of a loan note or other security (no matter how small) will obviously create different rights and obligations and represent the conversion of one security into another. This is likely to have a very wide ranging application and I will watch the future passage of this case with interest.