Hit for Six - John Battersby looks at recent increased tax charges for private companies with international operations.

It has taken England over 40 years to repeat its 1957 victory over the West Indies in a five test series in England. Almost as long-running is a serious anomaly in the tax treatment of overseas operation of close and non-close companies.
The general rule
Section 13, Taxation of Chargeable Gains Act 1992 has its origins with full capital gains tax in 1965. Its purpose was to protect tax revenues by preventing individuals deferring United Kingdom tax by owning assets through a non-United Kingdom company. The section applies to attribute to companies, individuals or trustees (including non-resident trustees) an appropriate share of gains made where a non-United Kingdom company (which would be close if it were United Kingdom resident) sells an asset which is not tangible property used in a trade. Gains are attributed through any number of non-United Kingdom companies (which again would be close if they were resident in the United Kingdom).
Section 13 does not apply to all companies with interests overseas as this would adversely affect normal commercial investment. The dividing line for section 13 was drawn by using the existing definition of a close company, which reflects a view that such companies are more likely to be used by individuals for such tax planning. However, this test does not relate to size or turnover and there are now many close companies which are larger than their non-close competitors.
Enter the Finance Act 2000
Section 94, Finance Act 2000 extends the provisions of section 13, Taxation of Chargeable Gains Act 1992 by introducing new section 79B. Prior to the changes, the effects of section 13 were mitigated in countries which had double tax agreements with the United Kingdom, where those treaties included appropriate capital gains tax provisions. An increasingly popular form of tax planning in recent years (sometimes referred to as the 'Belgian Wheeze') took advantage of double tax treaties by realising gains in countries which have favourable régimes for capital gains tax, but also have a double tax agreement with the United Kingdom.
While it is not unreasonable to close what may be perceived as a loophole in the legislation, the provisions of section 94 are much more far-reaching than this and some of its effects may be less obvious. In broad terms, section 94 sets out to charge resident trustees owning shares in a close company (or similar non-resident company) on gains in the corporate structure which would otherwise be protected by a double tax treaty. Non-resident trusts are also affected by the section.

Example
A long standing United Kingdom private company has four shareholders: individuals A and B who each own 30 per cent, C the trustees of an employee benefit trust set up by the company's founder X with 20 per cent, and D the trustees of a charitable foundation set up by X in his lifetime also with 20 per cent. This United Kingdom company itself owns European operations through a French company.


Before Finance Act 2000, if France Co made a gain by disposing of an asset, the United Kingdom/France double tax agreement (Article 13(3)) provides that the gain is taxable only in France. This prevents section 13 operating, and is the standard capital gains tax article in United Kingdom tax treaties (although each one should be reviewed). As a result, any proceeds of disposal can be reinvested and used to enhance the activities of the United Kingdom company. If the proceeds are distributed to the United Kingdom parent company, United Kingdom tax will be payable. Similarly, if the proceeds reach the trustees or the other United Kingdom shareholders from the United Kingdom company this will give rise to a United Kingdom tax charge. There is therefore no loss to the United Kingdom Exchequer from the operation of the double tax agreement.
Under the provisions of section 94, where the French company makes a gain, 40 per cent (in the example) of that gain is immediately attributed through the United Kingdom company to trustees C and D on the basis that they own 40 per cent of the shares in the company. This includes the charitable trustees. Nothing is attributed to the shareholders A and B because they are individuals.
In contrast, if this company were listed on a recognised stock exchange, and at least 35 per cent of A and B's shares were owned by the public, section 94 would have no effect. It is not clear why trustees C and D are regarded as tax avoiders in one case and not in the other.
Adverse effects of the provisions
As every practitioner will know, many trusts are established for reasons far removed from tax planning for overseas gains. Trustees can become shareholders in private companies for a number of reasons: no individual members of the family may have the necessary commercial experience or wish to control the business; or the assets may be too large to be held by individuals but need to be preserved for future generations.
There are many family companies with trustee shareholders which have established overseas operations for entirely commercial purposes. None of these can be said to be for avoidance of United Kingdom capital gains tax, but trustees have been classified as 'tax avoiders' simply by being shareholders. Section 94 affects all trustee shareholders, including trustees of employee benefit trusts, of charitable trusts and of pension funds. This leads to the bizarre result that if the individual shareholders of a non-close company decide to create a trust for the benefit of employees to own, say, 75 per cent of the shares, its trustees become subject to section 94 and are deemed tax avoiders.
During the debates on the Finance Bill it was implied that there would be few genuine cases caught in this way. This writer is aware of several very significant cases currently and would be very interested to hear of more.
Under section 94, not only do these trustees have the injustice of being labelled tax avoiders, but they will suffer the cost of the additional tax and compliance burden imposed under self assessment. Where, as could easily be the case, there is a series of overseas companies who themselves have made further overseas investments, the compliance burden is verging on the impossible. The trustees will be relying on foreign individuals understanding and applying United Kingdom capital gains tax rules to provide the necessary information. Existing minority shareholders have no opportunity to require their fellow shareholders to prepare the necessary information, while new shareholders do in theory.
Increased tax burden and double taxation
Payment of the tax can itself pose additional problems for the trustee shareholders. The trustees have no funds to pay the tax. There may even be no gain at all as the calculation can produce a gain for United Kingdom purposes simply from exchange rate changes. It will therefore be necessary either for the United Kingdom company to make a distribution of funds that it would otherwise have used for reinvestment, which may well cause additional United Kingdom tax to be payable, or perhaps to pay the tax itself on behalf of the trustees.
Since the gain has been attributed to the trustees, at least 34 per cent tax will be payable on the gain. Indeed the tax rate could be 40 per cent or even 64 per cent (where gains apportioned to offshore trustees are taxed on United Kingdom settlors or beneficiaries under sections 86 and 87, Taxation of Chargeable Gains Act 1992). In contrast, if the gain were attributed back to the United Kingdom company, as happens for a gain in a non-treaty country, the tax rate would be no more than 30 per cent and may be less.
It is not clear if the limited credit mechanism in section 13(5A) provides satisfactorily for the various trust tax issues that can arise. If it does not, there will be double taxation as well as unfair taxation.
Charitable trusts and pension funds
In the case of both charitable trusts and pension funds, the additional tax charge reduces the amount available for charitable purposes or for the provision of pensions. Although such entities are normally free from capital gains tax if they use their gains appropriately, section 94 as drafted removes the normal exemption. It is clearly not possible to apply what is a deemed gain for charitable or pension purposes. This has already deterred pension funds from investing in an overseas close company, but there is no corresponding penalty for investing in a non-close company. So pension funds looking to diversify and spread risk by investing in say non-United Kingdom property might be advised not to do so through a company that could become close.
Possible solutions
The provisions of section 94 ignore the commercial reasons why shares are held in trust and overturn the long established fiscal policy of broad equality in tax burden between trusts and individuals. The real problem is that section 13 enforces what is now a false distinction between close companies and non-close companies with overseas operations. In recent years it has become much easier to invest overseas, markets have opened up; and for many commercially-driven companies it has become a necessity to exploit overseas markets to survive. This applies as much to large private companies as it does to large public companies and therefore the current close company dividing line is no longer appropriate. In the light of the ever more global world market, it is time to rethink the provisions of section 13.
The Inland Revenue has to advise Ministers to act to stop unnecessary tax leakage. However, it is difficult to see what unacceptable tax leakage arises where funds are used by commercial groups for reinvestment or otherwise remain within the corporate structure, as they cannot be distributed to the trustees or their beneficiaries without further tax charges.
One solution, put forward during the Finance Bill debates, would be to apply a motive test to all transactions potentially caught by section 13. The motive test could work along the same lines as that for section 739, Taxes Act 1988 (prevention of avoidance of income tax in relation to the transfer of assets abroad). Section 94, Finance Act 2000 and section 13, Taxation of Chargeable Gains Act 1992 would then apply in all situations where there is a United Kingdom tax avoidance and not a bona fide commercial motive. For clarity, a clearance procedure (of the type used for section 135, Taxation of Chargeable Gains Act 1992 – exchange of securities for those in another country) should be available before any offshore gains are realised.
In the Finance Bill debates, the Paymaster General (Dawn Primarolo) announced that she had requested the Revenue to carry out a review of section 13 and the new section 79B. Anyone affected or interested should leave her in no doubt that the current provisions are unjust and discriminatory. A motive test seems to be one possible way to remedy the situation; there may be others. Nevertheless the iniquities highlighted by the provisions of the recent Finance Act suggest that we must not wait for England to beat Australia (which I hope, but do not expect, to happen in 2001) before a radical reappraisal of how overseas gains are taxed in groups headed by close companies.
John Battersby is a partner in KPMG.

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