Solving the Taper Trap

MARTIN DAWSON and SANDRA MACMILLAN discuss some solutions for those with mixed rates of taper relief.

Some of the current debate on the subject of taper relief seems to assume that post 5 April 2002 taper relief of 75 per cent (leading to a headline rate of capital gains tax of ten per cent) is a virtual certainty. Many also seem to be under a misapprehension that those vendor shareholders exiting before then, can bridge the four-year clock simply by exchanging their shareholding for a loan note (structured as a non-qualifying corporate bond) that satisfies the definition of a security, as previously debated.

The above paragraphs taken in isolation may well be correct, but it is to be hoped that this issue of Taxation, with this article and that of Peter Rayney on this particular theme, will correct any widespread fallacies on the subject.

The situation has been brought into sharper focus following the November 2001 pre-Budget report which has reduced the qualifying holding period to two years for the disposal of business assets post 6 April 2002.

The legislation effectively imposes hurdles at two tiers: a shareholder level and a corporate level. It is only when both these hurdles have been effectively cleared that a shareholder can take comfort with his claim for taper relief.

The purpose of this article is to consider the practical day to day issues that are likely to arise at shareholder level and how we can side-step these to keep on track to ten per cent. A later article will take a look at issues within the corporate arena and how we tackle these. The articles do not look extensively at other taxes such as income tax or inheritance tax, and hence when addressing a particular issue we are only looking at the taper relief implications and not the rationale for a particular structure being in existence. The articles are not intended to be exhaustive and we are sure many more practical issues are likely to become apparent as the legislation (and Revenue interpretation) evolves.

All references are to Schedule A1 to the Taxation of Chargeable Gains Act 1992 unless stated otherwise.

Family shareholdings

It may often be the case that, possibly for historical income tax savings, non-working spouses (or perhaps children) own shares in an unquoted family trading company. The problems here are alluded to in Peter Rayney's article but to recap briefly, while all shareholdings in trading companies, irrespective of size and the working status of the shareholder, qualify for business asset taper relief with effect from 6 April 2000, this was not the case during the period 6 April 1998 to 5 April 2000.

In the earlier period, shareholdings only qualified for business asset taper relief if shareholders satisfied one of the following:

• they were able to exercise at least five per cent of the voting rights of the company and were full-time working officers or employees of the company (or one in which there is a relevant connection); or
• they were able to exercise at least 25 per cent of the voting rights of the company.

Therefore where a disposal is likely to occur before 2010, consideration should be given to improving the shareholder's taper relief history. This may be achieved by the gift of the appropriate shareholding into a (settlor interested) interest in possession trust with the benefit of holdover under section 165, Taxation of Chargeable Gains Act 1992.

Care will need to be exercised as to whether the company itself passes the various taper relief tests (covered in a forthcoming article, but broadly the balance sheet must not contain any more than a nominal amount of chargeable non-business assets, otherwise there may be a restriction of holdover). It is often overlooked that this restriction only applies if (in the 12 months before making the disposal) the shareholder owns more than 25 per cent of the company, or it was his personal company (five per cent test) (see section 7(1) of, and Schedule 7 to, the Taxation of Chargeable Gains Act 1992).

Consideration should also be given as to whether the shareholder originally borrowed to finance his share acquisition since sections 360 to 363, Taxes Act 1988 may well operate to deny future tax relief on the basis that a 'disqualifying recovery of capital has been made', following the gift into trust.

The non-working spouse may alternatively consider transferring his shareholding to the spouse employed by the company. Since inter-spouse transfers are deemed to take place at no gain/no loss, there is no disposal for taper relief purposes. Indeed the legislation recognises this and rewinds the transferee's taper clock back to when the transferor's began, or 6 April 1998 if later (see paragraph 15(2)). The position with regard to inter-spouse transfers can be tricky (see Taxation, 18 October 2001 at pages 60 to 63). However, in overview, whether or not the shares qualify for business asset taper relief depends solely upon the recipient shareholder's taper position and not that of the transferor partner. The Inland Revenue's Capital Gains Tax Manual (at paragraph 17945) highlights some of the points to consider with respect to inter spouse transfers.

Thus, providing the original shareholding of the recipient spouse has remained a business asset throughout, the shares transferred will rank as a business asset throughout, similar to the way in which retirement relief operates.

Trust shareholdings

Rather like individual shareholdings, the legislation imposes tests on the trustees, which they must satisfy before any disposal can attract business asset taper relief. Again, different rules operate pre and post 6 April 2000.

Broadly, with effect from 6 April 2000 it should be possible to ensure that all United Kingdom family trust holdings (whether they be interest in possession or discretionary) in their respective family trading companies, will qualify for business asset taper relief. Previously, a discretionary trust would have had to hold more than 25 per cent of the voting rights of the company to have qualified.

Therefore certain trustees may (like their individual counterparts) have tainted taper histories. Those likely to realise disposals in the short term (more than four years) should give consideration to cleansing the taper history of their shareholdings. A solution might be to appoint the shares absolutely, or alternatively appoint them into a new trust, with the benefit of a holdover election.

However, care should also be exercised in other areas (depending upon the circumstances). Consider the case where beneficiaries would shortly become absolutely entitled to the shares in a family trading company, thereafter it is envisaged that they will sell their shares. Looking at taper relief in isolation, accrued taper relief within the trust would be lost and the individuals would be selling with very little (if any) taper.

Employee benefit trusts

Employee benefit trusts have grown considerably in popularity over the last few years and now feature in many levels of tax planning. On the one hand they can be used to warehouse/subscribe for share capital in conjunction with the granting of (say) employee management incentive share options; alternatively they may feature in developing tax efficient remuneration strategies.

Whatever their original use, it is not uncommon to find such trusts holding shares in the sponsoring company. Paragraph 17 (special rules for property settled by a company) deals specifically with the taper relief treatment of such shareholdings. They operate to exclude from business asset taper relief any shareholding held by an employee benefit trust where the settlor is the company and the company has an interest in the settlement at the time of the disposal.

While virtually all sponsoring company contributions are irrevocable payments into the trust (to avoid the argument that they are simply loans following Rutter v Charles Sharp & Co Ltd [1979] STC 711), an indirect benefit is usually retained by the company by way of enhanced goodwill and motivation of the workforce. This excludes any shareholdings from directly benefiting from business asset taper.

Consideration may therefore need to be given to cleansing any employee benefit trust shareholdings. Various possible solutions exist, including the use of shareholdings in conjunction with a management/employee share scheme, and sponsoring company buy back of shares (subject to section 703, Taxes Act 1988 clearance).

Offshore structures

Taper relief has no territorial restrictions, and hence is not restricted simply to United Kingdom gains.

If a capital gain arises and it is assessable to United Kingdom capital gains tax, it will generally be found that taper relief (whether it be business asset relief or otherwise) will operate to reduce an element of that gain. However, as might be expected, taper relief does not operate to give the same relief twice.

Where a gain is realised by an overseas company (that would be close if United Kingdom resident) and is imputed on a resident individual by virtue of section 13, Taxation of Chargeable Gains Act 1992, no taper relief will be available as taper relief does not apply to gains made by corporates.

Similarly where a United Kingdom resident establishes a non-resident trust and is charged to a capital gain by virtue of section 86 (attribution of gains to settlors with interest in non-resident or dual resident settlements), then section 86(4A) denies any taper relief on this imputed gain, since the trustees themselves will also qualify for taper relief and hence an element of double counting would otherwise take place.

It is therefore important that the original purpose and structure of offshore arrangements are reviewed closely, and the relationship between settlor and beneficiaries is understood.

Bonus issues and rights issues

The principal shareholders within a company may wish to inject further cash into the company by way of a further issue of share capital. While it would not be uncommon to subscribe for a fresh issue of shares, consideration ought to be given to structuring the subscription as a rights issue as opposed to a new subscription. Correctly structured, this will lead to obvious taper relief advantages, since a rights issue is treated as a reorganisation.

Liquidations

In the event of a company likely to go into liquidation, consideration (as far as it is possible) should ideally be given to the shareholder's taper relief position.

Post liquidation, its shares will no longer attract business asset taper relief (as the company is no longer trading). Further, depending on what actions the liquidator has to take, he may even fall foul of the provisions of paragraph 11 (enveloping). In essence, the Revenue may choose the argument that the company has newly commenced the trade of that of an investment company. While paragraph 11 does contain certain let-outs (and the Revenue's 53rd Tax Bulletin expands on these), care needs to be taken. Clearly a long drawn out liquidation, with a large return of value, should be avoided.

Plan ahead

It is to be hoped that the above will operate as an aide-mémoire to practitioners and flag those common areas where the shareholder tests could well be breached. In the final article we will look at the company tests that will also need to be side-stepped if the exiting shareholders (and their advisers) are to benefit from a good night's sleep.

Martin Dawson is a tax partner and Sandra MacMillan a tax manager in the Manchester office of HLB Kidsons. Practitioners' queries are welcomed at either mdawson@kimanch.hlbkidsons.co.uk or smacmillan@kimanch.hlbkidsons.co.uk. The views expressed in this article are those of the authors alone.

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