Inland Revenue Commissioners v Oswald

[1945] A.C. 360

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(Judgment by: Lord Thankerton (including background))

Between: Inland Revenue Commissioners
And: Oswald

Court:

Judges:
Lord ThankertonLord Russell of Killowen
Lord MacMillan
Lord Porter
Lord Simonds

Subject References:
REVENUE
INCOME TAX
Mortgage of reversionary interest
Capitalization of mortgage interest
Falling in of reversion
Income tax in respect of capitalized interest

Legislative References:
Income Tax Act, 1918 (8 & 9 Geo. 5, c. 40) - All Schedules Rules, r. 21

Hearing date: 12-14 March 1945
Judgment date: 19 April 1945

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Judgment by:
Lord Thankerton (including background)

By deeds executed respectively in 1899, 1901, and 1905, a mortgagor mortgaged her reversionary interest in certain settled funds to secure payment of sums amounting to 3,100l. It was provided that interest in arrears might at the option of the mortgagee be capitalized and added to the principal.

The mortgagee died in 1920 and the mortgagor in 1933. No interest having been paid after 1906, the mortgagee's trustees in 1935 executed an instrument capitalizing so much of the interest due as was capable of being capitalized. In June, 1938, the reversion fell into possession so that they became entitled to call for payment of principal and interest. The amount available was sufficient to discharge the principal, leaving only 4,399l. available to discharge arrears of interest. In September, 1938, the mortgagee's trustees executed a further instrument of capitalization. In 1940 the respondent, the surviving trustee of the settlement, handed over the whole of the funds remaining in his hands to the mortgagee's trustees, who claimed that there was owing to them a total sum of 8,301l., calculated on a net capitalization basis, i.e., after deduction of income tax. The revenue claimed that the respondent was assessable under r. 11 of the All Schedules Rules Income Tax Act, 1918, for the income tax chargeable in respect of the sum of 4,399l.:-

Held

(1.)

that the unpaid interest was not paid within the meaning of r. 21 by virtue of the instruments which capitalized it, and

(2.)

that whatever was paid out of the available fund to the mortgagee's trustees over and above the original capital loans was in law a payment of interest and, not being made out of profits or gains brought into charge, must suffer deduction of income tax, the payer being accountable to the Inland Revenue for the tax so deducted.

Inland Revenue Commissioners v. Lawrence, Graham & Co. [1937] 2 K.B. 179 , overruled.

Decision of the Court of Appeal reversed.

Appeal from the Court of Appeal.

The facts, stated by Lord Thankerton, Lord Macmillan and Lord Porter, were as follows: in 1899, Mrs. Elfrida Beyfus, the mortgagor mortgaged a reversionary interest to which she was entitled under a deed of settlement, dated June 8, 1885, the settlement of R. W. Cosier, to Mrs. Emma Louise Liberty, afterwards Lady Liberty, the mortgagee, to secure the sum of 2,300l. borrowed from her with interest at five per cent. per annum by equal quarterly instalments. In 1901 the mortgagor further charged her reversionary interest to the mortgagee to secure a further advance of 500l. with interest at five per cent per annum by equal quarterly instalments.

This interest was paid up to May 18, 1905. On January 10, 1905, the mortgagor assigned to Jonas Wolfe and certain other parties the sum of 500l., part of her reversionary interest, but subject to the mortgages of 1899 and 1901. On May 18, 1905, the mortgagor executed a further charge of her reversionary interest to the mortgagee to secure a further advance of 300l., and it was thereby provided that interest on the three sums of 2,300l., 500l. and 300l. should thenceforth be paid at the rate of five and a half per cent. per annum, subject to a proviso for the reduction of the rate to five per cent. on punctual payment. This further charge contained the following provision:-

"And it is hereby further agreed and declared that all interest which shall fall due on the said sums of 2,300l., 500l. and 300l. whether by virtue of the foregoing covenants or the covenants contained in the hereinbefore recited indentures and shall not be paid within twenty-one days after the dates thereby and hereby appointed for payment thereof may at the option of the mortgagee be capitalized as from such last mentioned appointed date and be added to the principal moneys hereby secured so as to form one aggregate sum charged on the property hereby mortgaged and carrying interest at the rate aforesaid and the mortgagor doth hereby covenant with the mortgagee to pay to the mortgagee the interest on such capitalized interest at the rate aforesaid on the aforesaid days therein-before and herein appointed for payment of interest and nothing in this proviso contained shall prevent the mortgagee notwithstanding the capitalization of the interest from subsequently exercising all the rights powers and privileges of a mortgagee as if the interest had not been paid or capitalized and it shall be lawful for the mortgagee to treat a portion of the interest as capitalized and a portion as if no option as aforesaid had been expressed by the mortgagee."

Interest was paid on the advances up to August 18, 1906, but after that date no interest was paid. The mortgagee died on May 2, 1920, and the borrower died on January 11, 1933.

No representation was taken out to the estate of the mortgagor, who left no estate other than the equity of redemption in the reversionary interest which she had mortgaged, but the will and codicils of the mortgagee were duly proved by H. C. Black-more and V. W. G. Ranger, the surviving executors nominate. On August 9, 1935, the mortgagee's trustees, executed an instrument whereby, in exercise of the power conferred by the indenture of further charge dated May 18, 1905, they capitalized as from May 18, 1935,

"so much of the interest fallen due on the principal sums of 2,300l., 500l. and 300l. .... as is now capable of being capitalized"

and added

"the interest so capitalized to the principel sums so as to form one aggregate sum charged on the property mortgaged by the said indenture of further charge and carrying interest at the rate thereby provided."

On September 13, 1938, the mortgagee's trustees executed a further instrument under which they capitalized in similar terms, as from August 18, 1938,

"so much of the interest fallen due on

(a)

the principal sums of 2,300l., 500l. and 300l. .... and on

(b)

the interest thereon previously capitalized as is now capable of being capitalized by virtue of the provisions"

of the further charge dated May 18, 1905. The mortgagor's reversionary interest in the Cosier settlement, then in the hands of the respondent, as sole surviving trustee thereof, fell into possession on June 29, 1938. After paying all proper charges and expenses the fund available in satisfaction of the mortgage was 7,438l. 12s. 5d. The sum, as appropriated by the mortgagee's trustees, in accordance with the agreement hereafter mentioned, was sufficient to repay the three principal sums in full and to leave a balance to meet in part the accrued interest. The mortgagee's trustees claimed that there was owing to them a sum of 8,301l. 8s. 2d., and this they calculated first by taking simple interest on the 3,100l. from August 18, 1906, to May 18, 1935, deducting the appropriate amount of income tax due from year to year and capitalizing the balance and adding it to the original debt, and secondly, by treating the sum so capitalized in a similar manner up to August 18, 1938, and then capitalizing the balance of interest as before. After that date interest less tax was charged on the final sum so capitalized, but no further capitalization was resorted to.

The Inland Revenue authorities claimed that, before making payment to the mortgagee's trustees, the respondent ought to deduct and pay income tax on the interest capitalized. The mortgagee's trustees disputed this contention and, following negotiations, an agreement in writing was come to between the two sets of trustees on July 20, 1939. By that document it was agreed that, after deducting certain proper charges and expenses out of the fund, the respondent should transfer the residue to the mortgagee's trustees to be appropriated in payment of

(1.)

all proper costs, charges and expenses,

(2.)

the capital sums of 2,300l., 500l. and 300l., making 3,100l. in all, and

(3.)

all interest (including capitalized interest) owing under the mortgages.

A further term of this agreement was that one-half of the funds so appropriated should forthwith after such appropriation be placed in the joint names of the two sets of trustees as a security for the complete indemnity of the respondent, personally undertaken by the mortgagee's trustees, against all claims by the Crown and all costs of the respondent in connexion with such claims. In pursuance of this agreement on various dates in January and February, 1940, the respondent handed over to the mortgagee's trustees all the funds (both capital and interest) then remaining in his hands (i.e., securities, valued at 7,438l. 12s. 5d., and specified in the schedule, and 166l. 6s. 6d. cash representing income), and one-half thereafter stood in the name of the mortgagee's trustees and the other half in the joint names of the two sets of trustees. The appropriation was as follows:

An assessment to income tax for the year ended April 5, 1940, was made on the respondent, as sole surviving trustee of the Cosier settlement, in the sum of 6,500l. in respect of the tax alleged to be deductible by him under r. 21 of the General Rules applicable to All Schedules of the Income Tax Act, 1918, on his paying over to the mortgagee's trustees the available fund in his hands so far as representing arrears of interest. The Special Commissioners discharged the assessment on the ground that the case was ruled by the decision of the Court of Appeal in Inland Revenue Commissioners v. Lawrence, Graham & Co., Ld. ^[F1] On a case stated Macnaghten J. and the Court of Appeal affirmed the decision of the Special Commissioners, also holding that the case was governed by the decision in that case. The Commissioners of Inland Revenue appealed to the House of Lords.

Sir Donald Somervell A.-G., J. H. Stamp and R. Hills for the appellants. The respondent was rightly assessed to income tax as the person by or through whom interest was paid out of a capital fund to the representatives of the mortgagee's estate. Despite the capitalizations the arrears of interest never lost their character of interest and, accordingly, the respondent, when making payment to the mortgagee's trustees of the proceeds of the mortgagor's reversionary interest, is bound to deduct income tax on the part of the sum which represents arrears of interest.

Tax can only be deducted when there is an actual payment to the trustees. There must be deducted a sum equivalent to tax at the rate then in existence on so much of the fund as is rightly appropriated to interest, including capitalized interest. On the capitalizations no interest was in fact paid by anyone from which tax could be deducted. What was called capitalization was not a payment of interest and the interest remained unpaid. Accordingly, the appellants' simple contention is that the case should be dealt with on the basis that the interest is being paid by the respondent: see In re Morris. Mayhew v. Halton; ^[F2] In re Jauncey. Bird v. Arnold; ^[F3] Cross v. London & Provincial Trusts, Ld., ^[F4] and Hunter v. The King. ^[F5] Paton v. Inland Revenue Commissioners ^[F6] provides the true explanation of the effect of capitalization in this case, namely, that the interest is capitalized, not because it is in fact paid but because it has in fact not been paid.

Assuming that the decision in Inland Revenue Commissioners v. Lawrence, Graham & Co., ^[F7] by which the Court of Appeal held itself bound in the present case, is right, the reasoning in it is applicable only to cases in which the agreement provides for capitalization of the net sum, whereas in the present case the agreement does not so provide. In this case the capitalization was not rightly calculated, and the gross sum of interest, arrived at without deducting an amount of income tax in respect of each year, should have been found. However, Inland Revenue Commissioners v. Lawrence, Graham & Co. ^[F7] was wrongly decided and should be overruled. It implies that agreement between the parties can produce the same effect as the application of r. 21, and that this can be done by reducing the amount capitalized. But if there were a payment of interest no form of words could exclude the full operation of r. 21.

Tucker K.C. and Scrimgeour for the respondent. On the true construction of the deed of 1905 the interest, which might at the mortgagor's option be capitalized, and added to the principal moneys, was only the net interest which the borrower liable on the due date to pay in cash to the mortgagee. The provision for capitalization should not be construed as entitling the mortgagee to add to principal and so obtain further interest on that proportion of the interest which the borrower would have been entitled or bound to deduct in respect of income tax if she had in fact paid the interest in cash on the due dates.

"Payment" under rr. 19 and 21 of the All Schedules Rules, which cannot be read in a narrow sense, must mean more than payment in cash or legal tender. A bill of exchange may be received in satisfaction of a net amount. Payment may be by means of a set off or a supervening agreement to accept something other than legal tender of the sum due. The agreement may provide for the acceptance in satisfaction of any form of property or any right against the debtor which would in law be good consideration for the discharge of a debt. The debtor can properly say to the creditor:

"I owe you Xl. Will you take something in substitution?"

If the creditor agrees, the debt is discharged and there is a new obligation. That transaction in such a case as this gives rise to a right and duty of deduction of tax. The deduction is calculated on the sum which would have been paid if the interest debt had been satisfied in cash. In such a case there is no need to put 100l. in nates on the table, paying 50l. and taking back 50l. Deduction in account is different. Inland Revenue Commissioners v. Lawrence, Graham & Co. ^[F8] was rightly decided and is not inconsistent with Paton v. Inland Revenue Commissioners, ^[F9] and is indistinguishable from the present case.

There it was held that on the capitalization of each instalment of interest the borrower and the mortgagee should be deemed to have agreed that a capital charge for the net amount of the interest less tax should be accepted by the mortgagee in full satisfaction for the sum due by way of interest. This amounted to payment at the date of capitalization, and in making the payment those who made it were obliged to deduct tax at the rate then due. The payment must be taken to have been made as and when the interest fell due by the person then owing the interest, i.e., either the borrower or those representing her estate.

Certainly until after the reversionary interest fell in, it could not be the respondent or his predecessors as trustees of the Cosier estate. These trustees in transferring to the mortgagee's trustees so much of the assets in their hands as was applicable to the payment of interest were handing over a sum from which tax had already been deducted. They received and paid a tax-free asset and did not become liable for the tax notionally deducted. The respondent was never under any obligation to pay interest; he was not paying a debt of his own. His only obligation was to hand over the property to the persons entitled to it. The rest of the estate of the deceased borrower, had there been any, would have been liable for the tax. Moreover, the respondent was not, in any event, a "person by or through whom" any payment of interest was made, within the meaning of r. 21. He merely handed over the securities specified in the schedule to the agreement of July, 1939. He did not hand over money and so could not deduct tax. Furthermore, the appellant's general contention would lead to difficulties in reconciling these provisions with the surtax provisions in the Finance Acts.

[They referred to Inland Revenue Commissioners v. Holder; ^[F10] Holder v. Inland Revenue Commissioners; ^[F11] Earl of Caernarvon v. Inland Revenue Commissioners; ^[F12] Marland v. Inland Revenue Commissioners; ^[F13] Inland Revenue Commissioners v. Cull; ^[F14] Cross v. London & Provincial Trusts, Ld.; ^[F15] Rhokana Corporation, Ld. v. Inland Revenue Commissioners; ^[F16] O'Callaghan v. Newstead; ^[F17] Allchin v. Coulthard; ^[F118] In re Sebright. Public Trustee v. Sebright; ^[F19] In re Morris. Mayhew v. Halton; ^[F20] Raghunandan Prasad Singh v. Income Tax Commissioner; ^[F21] Income Tax Commissioner v. Maharajadhiraja of Darbhanga; ^[F22] and the Income Tax Act, 1918, s. 1; sch. D., para. 1 (a); All Schedule Rules, rr. 19, 21, 23, sub-r. 2; the Finance Act, 1927, ss. 38, 39, and the Finance Act, 1938, s. 25.]

Sir Donald Somervell A.-G. in reply. A deduction of tax cannot be made under r. 21 unless there is a fund or some expectation of a fund to meet the tax. The rule proceeds on the footing that the whole payment can be made. In Inland Revenue Commissioners v. Cull, ^[F23] Greene M.R. was dealing with r. 19 and not r. 21. The effect of the agreement of 1939 was not to absolve the respondent from liability. The intention of the parties was to protect him in respect of his possible liability, not to do anything to preclude deduction and payment of the tax. [He referred to Raghunandan Prasad Singh v. Income Tax Commissioner. ^[F24] ]

The House took time for consideration.

April 19. Lord Thankerton (read by Lord MacMillan) -

My Lords, this appeal arises on a case stated by the Special Commissioners, who had discharged an assessment to income tax for the year ended April 5, 1940, on the respondent, as sole surviving trustee of the Cosier settlement, in the sum of 6,500l., made under r. 21 of the General Rules applicable to schedules A, B, C, D and E of the Income Tax Act, 1918. The decision of the Special Commissioners has been affirmed in both courts below. The main question is whether by virtue of the two instruments dated August 9, 1935, and September 13, 1938, whereby the mortgagee's trustees exercised the option conferred by the indenture of further charge dated May 18, 1905, the unpaid interest so capitalized was paid within the meaning of r. 21 of the General Rules applicable to all schedules, the material part of which provides as follows,

"(1.)

Upon payment of any interest of money, annuity or other annual payment charged with tax under sch. D, or of any royalty or other sum paid in respect of the user of a patent, not payable, or not wholly payable out of profits or gains brought into charge, the person by or through whom any such payment is made shall deduct thereout a sum representing the amount of the tax thereon at the rate of tax in force at the time of the payment."

The Special Commissioners, Macnaghten J, and the Court of Appeal have all held that the present case is ruled by the decision of the Court of Appeal in Inland Revenue Commissioners v. Lawrence, Graham & Co., ^[F25] which has not been previously considered by this House. The Crown challenge the correctness of that decision, and I shall now deal with it.

That case related to a mortgage and two further charges on the security of a reversionary interest; the mortgage contained a provision for the automatic conversion of unpaid half-yearly interest into principal money, carrying interest. Except that the clause operated automatically instead of resting on the optional exercise of a power, as in the present case, I find no material difference between the cases as regards the present question, nor can I see that that difference affects the decision of the present question. In both cases the Court of Appeal considered on construction whether the sum to be capitalized was the gross amount of interest or the net sum - i.e., after deduction of income tax, and in both cases the Court of Appeal has held that it was the net sum. But, my Lords, it seems to me, with all respect to the learned judges, to be idle to consider that question until and unless you have found that there was a payment of interest within the meaning of r. 21 at the time of the capitalization, as otherwise you cannot find "the amount of the tax thereon at the rate of tax in force at the time of the payment." In Lawrence, Graham & Co.'s case ^[F26] the judgment of the court (Lord Wright M.R., Romer and Greene L.JJ.) was delivered by Romer L.J. and it will suffice to quote one passage from the judgment: ^[F27]

"Turning once more to the rule it will be seen that it imposes on every such person an obligation to deduct out of the interest a sum representing the tax thereon. It is plain that this does not necessitate the actual setting aside of cash to meet the tax. A deduction in account is sufficient. If instead of paying the full amount of the interest the debtor pays to his creditor the interest less the tax, he has fulfilled his obligation, even though the payment exhausts his cash in hand or, if paid by cheque, leaves nothing standing to his credit at his bankers. So long as the net interest and no more reaches the hands of the creditors the Crown has no cause for complaint.

Nor can the Crown be concerned with the form in which the net interest reaches the hands of the creditor. The creditor may, if he thinks fit, agree to accept in full satisfaction of the net amount a bill or a bond or a chattel provided that the money value of what he gets in exchange does not exceed the net interest due. If this be so, a mortgagor and a mortgagee may validly agree that, in the event of failure by a mortgagor to pay the net interest as it falls due, the mortgagee will from time to time accept in full discharge of the mortgagor's liability to pay it a capital charge for a like amount upon the mortgage security.

As and when each charge takes effect the tax will have been deducted within the meaning of the rule, for the capital charge merely takes the place of a payment by the mortgagor of the net amount and can never exceed that net amount in money value. In our judgment the arrangement that was made between the mortgagor and the society in the present case was of that nature."

My Lords, I am not concerned in the present case to consider the first part of this passage in the suggestion that the debtor, if he have only enough money to pay the net amount, is entitled to pay it all to the creditor, having made the prescribed deduction from an amount which he does not possess. It is clear that the interest due may be paid in money's worth in such a way as to discharge the debtor's liability for the interest.

But I find myself quite unable to agree that the debtor's liability for the interest was discharged as the result of the arrangement between the mortgagor and the society in that case. I cannot but think that the learned judges did not sufficiently bear in mind the distinction between debt and security. In my opinion there was no discharge of the debtor's liability for the overdue interest and the result of the arrangement was the improvement of the security, and an increased liability for interest by the overdue interest being made to carry interest.

The same result was effected in the present case by the exercise of the option conferred by the indenture of further charge dated May 18, 1905. Accordingly, I am of opinion that Lawrence, Graham Co.'s case ^[F28] was wrongly decided. Though Lord Greene M.R. thought otherwise in the present case, I am of opinion that this case falls within the principle of the decision of this House in Paton v. Inland Revenue Commissioners, ^[F29] in which it was held that the practice of banks to add interest to principal by half-yearly rests did not constitute as between the bank and its customer a payment of interest by the customer within the meaning of s. 36, sub-s. 1, of the Act of 1918, so as to entitle the trustee of the customer's estate to recover the amount of income tax thereon. As my noble and learned friend Lord Macmillan states: ^[F30]

"It is a condition of a claim for repayment of tax on bank interest under s. 36, sub-s 1, that the taxpayer shall have 'paid' to his bank the interest in respect of which he claims repayment of tax. In my opinion this means that the taxpayer must really, and not merely notionally, have have paid the interest; there must be payment such as to discharge the debt; the payment must be a fact not a fiction."

I may add three dicta which appear to me well to describe the substance of the transaction presently under consideration. First, from the judgment of Lord Sterndale M.R. in In re Morris. Mayhew v. Halton: ^[F31]

"When these sums of interest come to be paid at the end of the time, when payment is made, although interest has been charged upon them, and, although as a matter of bookkeeping, they have from time to time been added to capital, they do not cease to be interest of money - that is to say, they are overdue interest upon which interest has been paid."

Secondly, a sentence from the judgment of my noble and learned friend Lord Russell of Killowen - then Russell J. - in In re Jauncey. Bird v. Arnold: ^[F32]

"In the case of such a provision as is contained in the present deed, which enables the interest to be capitalized, the interest is not capitalized because it is in fact paid, but because it has in fact not been paid."

Thirdly, a passage from the judgment of the Privy Council in Raghunandan Prasad Singh v. Income Tax Commissioners, ^[F33] which was delivered by my noble and learned friend Lord Macmillan, and which in my opinion, is equally applicable in the law of England. In 1904 a new mortgage had been accepted for an amount which included both the principal and the arrears of interest due under a previous mortgage of 1894, which was then discharged. The question was whether the mortgagees had thereby received payment of the arrears of interest; if so, the assessment appealed against would be out of time, but this view was rejected by the Board. Lord Macmillan said:

"Their Lordships are of opinion that there was in the circumstances no realization of the principal and interest of the original mortgage of 1894, and that when the assessees received the new mortgage for Rs. 7,33,135, which included the principal and interest of the original mortgage, they did not thereby receive payment, or the equivalent of payment, of the principal and interest of the original mortgage. No doubt the grantors of the new mortgage were not identical with the grantor of the original mortgage and the property mortgaged was greater in extent, but the substitution effected cannot in any real sense be described as the equivalent of a realization of the original mortgage, principal and interest.

What happened was that the assessees received a new and substituted security for an existing debt. To give security for a debt is not to pay a debt. If the assessees had received payment in kind of the amount outstanding on the original mortgage, in the shape, say, of realizable shares or bonds, the case would have been different, but they merely received further and better security for their debt. It is, in their Lordships' view, quite immaterial that the assessees discharged the original mortgage and all liability under it, for that was merely an incident in the transaction whereby the new security was substituted for the old."

Accordingly, I am of opinion that there was no payment of interest within the meaning of r. 21, by virtue of the two instruments dated respectively August 9, 1935, and September 13, 1938, executed by the mortgagee's trustees.

The respondent submitted a further contention that he was not a person by or through whom any such payment was made within the meaning of r. 21, on the ground, as I understood, that he was merely handing over the investments specified in the schedule to the heads of agreement dated July 20, 1939. This contention is clearly untenable, as the heads of agreement make provision for the Crown's claim against the respondent and provide for the retention of one half of these investments in joint names as a security for the indemnification of the respondent, personally undertaken by the mortgagee's trustees, against all claims by the Crown and all costs by the respondent in connexion with such claim. I am therefore of opinion that the appeal succeeds, that the judgments appealed against should be set aside, and that the assessment should be upheld, subject to adjustment of the figures in accordance with the decision of this House. The case should be remitted to the Special Commissioners for that purpose. I move accordingly.