The Law is an Ass!
Malcolm Gunn FTII, TEP discusses the share identification rules and capital gains tax notional disposals.
My last article in this illustrious magazine was, so I said, my wild idea for the week. After reading what follows here, readers might conclude that I have now completely left my senses. Or you might find this all totally logical and reasonable. I promise you that you will fall into one camp or the other and that there is no middle ground!
A major mistake?
The Law is an Ass!
Malcolm Gunn FTII, TEP discusses the share identification rules and capital gains tax notional disposals.
My last article in this illustrious magazine was, so I said, my wild idea for the week. After reading what follows here, readers might conclude that I have now completely left my senses. Or you might find this all totally logical and reasonable. I promise you that you will fall into one camp or the other and that there is no middle ground!
A major mistake?
Major Shock bought some shares in Flimsy Fold-Up Scooters Ltd five years ago for £100. Out of the blue, the scooters suddenly started selling well and his shares became worth £20,000. One morning he opened his paper and saw a report about scooters being unsafe and so he rang his broker straight away and told him to sell the shares. The broker duly carried out the bargain. He then noticed that the report related to one type of motorised scooter and another news item said that the fold-up scooters were likely to be best sellers this Christmas. The major phoned the broker immediately to cancel the first transaction but the broker said that, under current Stock Exchange rules, bargains cannot be cancelled. So the major instructed the broker to buy back the shares.
A capital gains tax problem?
Before long, the major will be on the phone to his accountant in great trepidation. He has realised a profit of £19,900 and is very worried about the capital gains tax position. What would your advice to the major be?
I am sure that readers of this magazine would not even have to open their Yellow Books. The basic capital gains tax rule for securities of the same class in section 105, Taxation of Chargeable Gains Act 1992 is that securities sold and reacquired on the same day are matched with each other. The major might be lucky enough to have a capital gains tax loss on the two transactions in Flimsy Fold-up Scooters Ltd, owing to the brokerage charge.
It would not even matter if the transactions were carried out overnight. The Government, in its enthusiasm to stamp out the practice of bed and breakfasting, introduced a rule in the Finance Act 1998 that shares disposed of one day and reacquired within a period of 30 days are to be identified with each other. Thus the original acquisition at a cost of £100 goes forward after the recent transactions and only gets into a capital gains tax calculation when there is a sale without a repurchase, or where the repurchase is more than 30 days later.
A statutory fiction
The capital gains tax legislation is very keen on deeming people to sell things and buy them back straightaway. There are too many circumstances where this rule applies to list here, but for example one of the main circumstances is when a person becomes absolutely entitled to funds from a settlement. If it is a discretionary trust, there is a hold-over relief, but that has its limitations: a non-resident beneficiary cannot have the benefit of it (although a beneficiary resident in the European Union might want to take issue with this limitation).
When the beneficiary of an accumulation and maintenance trust becomes absolutely entitled to his share of the funds, there will be a notional disposal. The lucky ones will benefit from hold-over relief, but there are unlucky ones who received an income entitlement at 18 and capital at 25. There is no hold-over in that situation.
In the case of a trust with a life interest in possession, an appointment of funds out of the trust, whether to the life tenant or to another beneficiary, will give rise to an immediate notional disposal and there is no hold-over relief in that situation unless one is dealing with business assets.
There is a migration charge in section 80, Taxation of Chargeable Gains Act 1992 which applies when resident trustees become non-resident for capital gains tax purposes. This operates by treating the trustees as selling the trust assets and immediately reacquiring them.
In a corporate context, if shares are transferred between group companies and the transferee company then leaves the group within six years, a notional disposal of the shares is treated as having taken place at the time of the intra group transfer.
This is just a selection of some of the notional disposal cases in the legislation and I expect readers will already be one step ahead of me with what is coming next.
The identification rules
If Major Shock had no capital gains tax problem on his sale and repurchase of Flimsy Fold-up Scooters Ltd shares, then why should the trustees or companies in the circumstances mentioned above be treated any differently? The legislation deems them to have sold assets on a stated eventuality and to have bought them back immediately afterwards. It does not give us any further instructions. It leaves us to work out what this means in terms of the legislation. We have already seen what it means when we advised Major Shock about his capital gains tax position. Surely therefore the same rule must be applied to the trustees and the companies who make notional disposals?
Obvious or not?
I suspect that if anyone fancies trying this argument on with the Revenue in an actual case which has arisen since 5 April 1998, he or she might get a letter back pretty quickly which does not quite say 'naff off and stop being so silly', but it will have suitable Revenue-speak to that effect. It is perfectly obvious that notional disposals in the Act are designed to produce a capital gains tax effect and not to be huge mathematical exercises which all amount to absolutely nothing at all.
The answer is of course that, however obvious it may be what the legislation is trying to do, the law in this area could be 'a ass', which is what Dickens declared it to be. The Revenue would have to come up with something better than 'it's obvious what it means'.
Metrolands and all that
Students of statutory construction will know that deeming provisions cannot be taken to absurd lengths. In Commissioners of Inland Revenue v Metrolands (Property Finance) Ltd [1981] STC 193 the following general principle of law in relation to deeming provisions was proved and applied to a development land tax provision:
'When a statute enacts that something shall be deemed to have been done, which in fact and in truth was not done, the court is entitled and bound to ascertain for what purposes and between what persons the statutory fiction is to be resorted to.'
This principle came from an earlier bankruptcy case in which it had been applied to a deemed surrender of a lease and the court had applied the deeming as if the lease had been surrendered as between the lessor on the one hand and the bankrupt lessee on the other.
Imaginary states
An even earlier foundation stone for this general principle was laid in East End Dwellings Co Ltd v Finsbury Borough Council [1951] 2 All ER 587 which concerned the amount of a payment under a war damage Act. The court held as follows:
'If you are bidden to treat an imaginary state of affairs as real, you must surely, unless prohibited from doing so, also imagine as real the consequences and incidents which, if the putative state of affairs had in fact existed, must inevitably have flowed from or accompanied it.'
However, the judgment went on to say that:
'it does not say that you must cause or permit your imagination to boggle when it comes to the inevitable corollaries of that state of affairs.'
Avoid absurdity
Going back even further, in an 1881 decision on a bankruptcy case (Re Levy, ex parte Walton) it was held as follows:
'it appears to me to be legitimate to say, that, when the statute says that a lease, which was never surrendered in fact, is to be deemed to be surrendered, it must be understood as saying so with the following qualification, which is absolutely necessary to prevent the most grievous injustice and the most revolting absurdity'
All this is very powerful stuff in itself, but we still come back to the point that the capital gains tax legislation as it stands requires us, on certain occasions, to imagine that an asset has been sold and bought back and it leaves us to work out what the result of this is. Do the matching rules as they stand lead to a 'revolting absurdity'? The answer must surely be 'No'! No-one would suggest that there is any absurdity in the matching rules as they apply to the transactions of Major Shock with his Flimsy Scooter shares, so why is there any absurdity when we apply those very same rules to a deemed disposal?
Parliament's intentions
At a recent meeting of the Editorial Board of Taxation, this issue was briefly discussed and reference was made to the case of de Rothschild v Lawrenson [1995] STC 623. Readers may recall that this was another case in which the legislation had got itself into a tangle. An anti-avoidance charge on non-resident settlements could not, on the wording of the legislation, be applied because of the impact of another anti-avoidance provision.
The case related to an offshore trust in which the settlor had an interest. In such cases, the legislation requires one to work out the amount on which the trustees would be chargeable to tax if they were resident in the United Kingdom. The problem is of course that if they were resident, they would not be chargeable at all, but rather the settlor would be. So one goes round in a circle and gets absolutely nowhere.
Lord Justice Nourse said that 'I do not believe that our processes of statutory construction are so wanting in technique and imagination as to allow such a state of affairs to ensue'. He held that it was not appropriate to apply an anti-avoidance provision relating to resident settlements when carrying out computations applicable to a non-resident settlement.
Counsel for the taxpayer in the case appeared to accept that his argument was fairly outrageous, but that was not his fault. He was simply reading the legislation and applying it.
Once again, this is powerful stuff, but it is still a little wide of the mark for the notional disposal problem under discussion here. No-one is attempting to apply a set of provisions designed for one circumstance to a completely different scenario. Nor can it be said that it means that the legislation on notional disposals never applies. It still has full effect for assets other than securities, for example land. Furthermore, cases such as Crowe v Appleby [1976] STC 301 told us years ago that land can have a different treatment from securities where there is a notional disposal out of a trust.
What is being suggested is that securities have a special identification régime in the capital gains tax legislation. If a fund affected by a notional disposal is invested in assets of that type, then that fund must be governed by the régime laid down by Parliament for those assets. It is not open to the Inland Revenue to pick and choose when it would like to apply that régime and when it would rather not have it apply.
Over to you
I am now going to bow out gracefully with the final comment that all this is nothing to do with me! I first became aware of the point at this year's Chartered Institute of Taxation Trinity Conference, from the session by Richard Bramwell QC, and discussion of it surfaced again more recently in Key Haven's Personal Tax Planning Review, Volume 7, Issue 3 (article by Robert Venables QC). I suspect that the point is not going to go quietly away and readers will have to decide for themselves between the 'total logic' and 'total nonsense' camps. But if you have any clients affected by post 1998 notional disposals, at the very least you may have to consider whether the argument should be put forward to the Revenue.
