The First-tier Tribunal’s decision in a recent case has potentially significant ramifications with respect to the entitlements of holders of American and other depositary receipts to the underlying shares. The tribunal found that ADR holders were not beneficially entitled to the underlying shares; they merely owned a bundle of contractual rights.
The First-tier Tribunal (the tribunal) case of HSBC Holdings plc and The Bank of New York Mellon Corporation v HMRC joins a long list of cases where the point being litigated is not the only important issue ( UKFTT 163 (TC)).
The decision, which considered the treatment of American depositary receipts (ADRs), must be viewed with caution, not least because the arrangements were governed by US law. However, it has potentially significant ramifications for holders of ADRs and other depositary receipts (DRs) (see box "What are depositary receipts?").
The case concerned stamp duty reserve tax (SDRT) on the issue of ADRs. However, the tribunal also considered the entitlements of ADR holders to the underlying shares. It decided (despite finding the evidence inconclusive) that ADR holders were not beneficially entitled to the underlying shares; they merely owned a bundle of contractual rights.
The tribunal's reasoning focused on the distinction between rights arising from a trust (which splits legal and beneficial ownership between trustees and beneficiaries, respectively) and contractual rights. The key factors in its decision on this point were as follows:
ADR holders had similar rights to shareholders but they derived from a deposit agreement and not the underlying shares. Those rights included:
contractual rights to dividends and to vote which reflected (but did not precisely mirror) the rights attaching to the underlying shares; and
rights to redeem or withdraw underlying shares.
The deposit agreement did not create an express trust and the tribunal saw no reason to imply one.
The deposit agreement was designed to enable investors to trade securities representing overseas shares on the US stock market. No beneficial interest in the underlying shares was required.
New York law does not deem there to be a trust relationship between depositary and ADR holders. On the contrary, it treats ADRs as securities rather than securities entitlements for certain purposes.
The depositary bank could beneficially own the underlying shares. It gave consideration by issuing ADRs that it was obliged to redeem for shares.
Tax practitioners have always been reasonably cautious about the tax treatment of DRs. However, HM Revenue & Customs' (HMRC) published practice states that a DR holder has two separate assets: a beneficial interest in the underlying shares, and the DR (paragraph 50241, Capital Gains Manual).
The taxpayer in HSBC Holdings argued that HMRC's position in litigation was inconsistent with its published practice. However, the taxpayer failed on the grounds that HMRC publications are not always technically accurate and, in any event, this was not a judicial review of HMRC.
Below are some potential implications of the HSBC Holdings judgment for DR holders. In practice, a number of these issues are most likely to affect UK resident investors in overseas securities:
The judgment casts doubt on the capital gains treatment of DRs in mergers and acquisitions. If DR rights are merely contractual, the relieving provisions for reorganisations and reconstructions (for example, sections 135-136, Taxation of Chargeable Gains Act 1992) (TCGA) will not apply to those obtaining or disposing of DRs. A shareholder would be treated as though it had not disposed of its original shares but a DR holder would dispose of a chargeable asset (namely, its bundle of contractual rights) with no relief and no cash consideration with which to fund the tax payment.
Corporate DR holders may fail to qualify for other capital gains reliefs requiring beneficial ownership of shares or interests in shares, such as the substantial shareholding exemption (SSE). It may be arguable that a DR is an asset related to shares, but that is of little help when the main SSE conditions are also required to be met (including the holding of shares or an interest in shares) in order to obtain relief for such an asset.
For inheritance tax purposes, if DR rights are purely contractual, the situs of a DR holder's assets (that is, where they are treated as being based) will depend on the circumstances and terms of the deposit agreement (the jurisdiction where the depositary is based and the governing law of the contract will be relevant) and not the situs of the underlying shares (which is usually where the shares are registered). For example, most ADR programmes are likely to have US situs.
It is not immediately obvious how the UK's double taxation agreements will apply to arrangements involving ADRs, particularly if other jurisdictions treat DR holders as the owners of the underlying shares (for example, the experts' views mentioned in paragraphs 111 and 112 of the judgment suggest that the US may well take a different view).
The judgment will potentially affect transactions involving other depositary arrangements and clearance services such as CREST depositary interests, Euroclear and Clearstream.
HMRC's inconsistent approach does little to convince taxpayers to engage and build relationships with HMRC. Certainty and consistency need to be taken more seriously as a policy matter. Taxpayers are already painfully aware that guidance does not have the force of law (it can be withdrawn without notice, consultation or significant administration) and is not infallible.
More positively, recipients of DR payments representing dividends should be treated as receiving manufactured dividends (and therefore as receiving actual dividends) for UK tax purposes (section 573, Income Tax Act 2007; section 784, Corporation Tax Act 2010). Therefore, the application of the corporate distribution exemption and dividend tax rates for individuals should not be affected.
The first step is for HMRC to decide whether to appeal the case, having lost on the lawfulness of imposing SDRT on the issue of the ADRs under the Capital Duties Directive (69/335/EEC). If so, we may see further discussion of the beneficial ownership issue.
HMRC needs to reconsider its published guidance on DRs. It is being lobbied by professional bodies to continue its former practice so as not to disrupt commercial activity, particularly mergers and acquisitions. However, if HSBC Holdings is right, HMRC may not be able to publish updated guidance or make an extra-statutory concession. It may need to legislate (see R v Her Majesty's Commissioners of Inland Revenue ex parte Wilkinson (FC)  UKHL 30).
Legislating for this issue in relation to future transactions need not be particularly onerous, save for defining appropriately the relevant arrangements. Similar issues arise when a shareholder enters into a repo over its shares (that is, a sale and repurchase transaction). That scenario is dealt with by legislation deeming the repo "borrower" to continue to hold the shares for general chargeable gains purposes and for the purposes of the SSE (section 263A and paragraph 12, Schedule 7AC, TCGA). These examples provide a reasonable starting point for a change of law to put the position beyond doubt.
Hilary Barclay is Senior Counsel in the Corporate Tax Group at Macfarlanes LLP.
Depositary receipts are financial instruments issued by depositary banks. They are a typical feature of UK and international public company mergers and acquisitions, largely because they allow investors to trade securities on exchanges in jurisdictions where there are regulatory restrictions on underlying shares. For example, American depositary receipts are traded on US stock exchanges in relation to overseas shares that are not registered in the US.