Something Nasty

RICHARD CURTIS reports on the Sixth Sitting of Standing Committee F in its review of the Finance Bill.

MY CONCISE OXFORD Dictionary has the following entry: 'nasty adj. highly unpleasant, annoying, objectionable'. I cannot seem to recall its use before in the field of taxation, but perhaps that is because, previously, I have led a sheltered existence, protected from the brickbats that are occasionally thrown around by the Honourable Members of Standing Committee F. On the other hand, 'stealth' has become a well-known term in both the tax and military technology worlds, but in the Committee's Sixth Sitting a new phenomenon appears - the 'stealth tax nasty' - you have been warned!

Losses and gains

Clause 47 of the Finance Bill 2002 increases the amount of trading losses that can potentially be set against chargeable gains. Previously, the maximum loss was restricted by reference to the tapered gain, then set against the gains for the year and taper relief recalculated by reference to that net figure. A trading loss could not, therefore, extinguish a gain, even when it exceeded it. Clause 47 has effect from 2004-05 and later years and will allow the trading loss to be set against gains before the taper calculation. A taxpayer with trading losses in 2002-03 and 2003-04 will be able to elect for the new treatment to apply for those years.

Example 1 illustrates the position before and after this change.

Opposition Treasury Spokesman, Mr Howard Flight, noted that whilst the measure would now allow a taxpayer to reduce capital gains to nil, it would mean a loss of the benefit of taper relief: 'That could penalise sole traders who need to realise funds by selling a business asset and use the cash raised to turn the unprofitable business around. The tax saved by each £10,000 of trading loss used in this way is £1,000 for assets held for more than two years, but £4,000 of tax could be saved if the loss were used against trading income'. This provision was 'a stealth tax nasty' and in its place he proposed that taxpayers should be able to calculate the trading loss to be set off after the benefit of either the taper relief or the annual capital gains tax exemption. In this way, they would lose the benefit of one or other of these capital gains tax reductions, but not both.

Ruth Kelly pointed out that the proposal not only added an extra layer of complication and another election, but also was in contradiction to the taxation of income principle that loss relief was given without taking personal allowances, etc. into account. The proposal was withdrawn and clause 47 was passed.

Foregoing rollover relief

When a business is incorporated, section 162, Taxation of Chargeable Gains Act 1992 can apply (without the need for election) to roll over the gain on the unincorporated business. Clause 48 will allow, with effect from 6 April 2002, a taxpayer to elect that this relief should not apply. This will be beneficial where the company is disposed of shortly after incorporation by increasing the amount of taper relief that is potentially available.

The Opposition proposed an amendment that would allow taxpayers to elect that the relief be disapplied to a proportion of the gain. This would cater for circumstances where only a proportion of the shares in the new business were to be sold, thus maximising taper relief entitlement on that proportion and rollover relief on the retained shares.

Ruth Kelly said that, whilst the proposal might benefit some taxpayers, it would again introduce unnecessary complications for the majority. The proposal was withdrawn.

Mr Flight also introduced the Opposition's new clause 5. This proposed that if a business had been incorporated and the taxpayer had then elected to disapply the rollover relief provisions, when calculating the taper relief for the unincorporated business, the period from incorporation to disposal of the incorporated business could be taken into account for taper relief purposes. So, if the taxpayer had owned a business for one year, eleven months prior to incorporation and then sold it one month after incorporation, he would benefit from two years rather than one year's worth of taper relief.

As well as being complicated, Ms Kelly noted that the proposal also ignored possible mixes of assets acquired at different times and the fact that some might be non-business assets. The amendment was withdrawn and clause 48 stood as part of the Bill.

Shares acquired on the same day

At present, shares of the same class in the same company, which are acquired in different transactions on the same day, are 'pooled' for capital gains tax purposes, so that their average cost is taken into account in future disposals. Clause 49 allows the taxpayer to elect that, where shares acquired under an approved share scheme or by the exercise of a qualifying option under paragraph 1(1) of Schedule 14 to the Finance Act 2000 (enterprise management incentives) where paragraph 44 applies, are acquired on the same day as other shares of the same class, they can be treated as separate transactions. The shares with the higher capital gains tax cost canthen be treated as disposed of in priority to those with the lower cost. The purpose of the clause is to avoid an unexpected capital gains tax charge where a taxpayer sells shares to raise funds to pay an income tax liability; for example, where an option to acquire shares under an unapproved share scheme has been exercised.

Mr Flight proposed an amendment to the clause whereby two further types of enterprise management incentive options (falling within paragraphs 45 and 46 of Schedule 14 to the Finance Act 2000) should also be included. To some celebration from the Opposition, Ruth Kelly advised that the Government would (having given it 'careful consideration') accept this amendment. Emboldened, Mr Flight then proposed a new amendment that the clause should apply for shares disposed of after 6 April 2002, rather than only those acquired after that date. Ms Kelly rebutted this. The clause was in response to representations relating to liabilities on future acquisitions and, if it related to previous acquisitions, it would cause confusion in that some of the previously acquired sharesmay have already been disposed of under the old identification rules. Clause 49, amended as agreed above, stands as part of the Bill.

Personal losses and settlor's gains

Clause 50 proposes that, in most circumstances (there being special rules where the settlor of a non-resident trust has been non-resident), a settlor who has gains attributed to him from a settlement (e.g. because he retains an interest in it) will be able to set personal losses against those gains. The settlement gains will be attributed before taper relief, but, after any loss relief, the settlor will be able to deduct taper relief from net settlement gains at the rate that would have been attributable to the trustees. The clause will take effect from 2003-04, but with the option for a settlor also to elect that the provisions should apply for any or all of the years 2000-2001, 2001-02 and 2002-03.

Example 2 illustrates the rules before and after the changes made by clause 50.

On the basis that the general purpose of the legislation was to 'look through' the trust to the settlor, Mr Flight could not see why the new clause should 'work one way and not the other'. Should not the trust losses be deemed to be those of the settlor so that they could then be set against any of the settlor's gains?

Ms Kelly rejected this amendment as it would open up tax avoidance possibilities, allowing settlors to make a 'one-way bet against the Exchequer'. The present position of allowing the settlement to carry forward trust losses and set them against gains reduced the gain attributable to the settlor and thus reduced the tax that the settlement would need to reimburse the settlor. For those who established trusts for non-tax reasons this was beneficial, as it left more funds in the trust for the beneficiaries. The Opposition's alternative would allow the settlor to time losses for tax advantageous purposes and it was estimated that the proposed amendment would cost approximately £25 million per annum, 'without taking account of any behavioural change caused by people exploiting [the amendment] for tax purposes'.

Clause 50 stood as part of the Bill.

Deeds of variation

With effect from 1 August 2002, clause 51 removes the requirement of beneficiaries to notify the Inland Revenue within six months of a variation (made within two years of death) if this is to be effective for capital gains tax purposes. The clause was approved.

Research and development

Clause 52 introduces Schedule 12, which extends an enhanced research and development tax relief to large companies from 1 April 2002. Companies will be able to deduct 125 per cent of qualifying expenditure in computing their taxable profits (small and medium sized enterprises can deduct 150 per cent). There was some debate regarding the differences in rules between small and large companies:

• the relief is at a higher rate for smaller companies (which generally find it more difficult to find finance);
• loss-making small companies can be paid a credit, whereas large companies cannot (because they were more likely to be able to make future use of a loss brought forward);
• was tax relief the best method of encouraging research and development (would this work happen anyway)?; and
• were there other ways to encourage such work (e.g. government sponsored prizes for initiation in particular fields)?

It was recognised that research and development should be encouraged and Dawn Primarolo advised that the value of the United Kingdom's relief for large companies would be second only to Canada in the G7 group of countries: 'We are trying to create an environment in which research and development are undertaken in this country'. This is why the relief for large companies is targeted at the company undertaking the research and development rather than (as for small and medium-sized enterprises) the company funding it.

Mr Flight proposed an amendment that small enterprises could elect to be treated, instead, as a large company for the purpose of claiming research and development tax relief, because the conditions for small enterprises were more onerous. Ms Primarolo thought it strange that such an enterprise would want to do this and thus be eligible for a reduced rate of relief. She also felt that such enterprises with links to larger companies would then come under pressure to 'opt-out' so that the large company could claim relief instead. With regard to concerns about a medium-sized company crossing the 'threshold' and becoming 'large', she pointed out that such a company could continue to qualify for the relief for the year following that in which it actually met the small and medium-sized criteria.

The Paymaster General also pointed out that 'there has not been a stampede to the Treasury's door from SMEs saying that they want the scheme for large companies instead, because it is less generous!'. Mr Flight felt that the take-up level by such companies of the research and development tax credit had been disappointing, but agreed to withdraw his amendment.

A second amendment sought to restrict United Kingdom tax relief if relief was being given in another country for the same work. Ms Primarolo convinced the Opposition that the operation of double tax relief and the double taxation agreements should ensure that there was no 'double dipping'. However, she did add that 'if it turned out that something untoward was going on, and there was what we politely call "tax leakage", we would deal with it'. This amendment was also withdrawn.

Other amendments dealing with various aspects of outsourced staff costs and accommodation, etc. funded through service companies were also discussed. There was concern that specialist research and development work (for example, designing 'stealth' characteristics for fighter aircraft) could fail to qualify because of technicalities. However, these amendments were withdrawn after acknowledgement that 'it is difficult to draw lines' and 'we are in uncharted territories'. The Paymaster General confirmed that guidance or practice notes would be produced and that discussions regarding the operation of the new tax credit would continue into the future.

A Government amendment to the Finance Bill on this subject replaced the word 'any' with 'that' in the second line of paragraph 11(2) of Schedule 12, to ensure that the relief was given when the research and development expenditure appeared in the company's profit and loss account. This change took account of circumstances where expenditure had been deferred to a future year to match it with related income. As expected, this amendment, as well as Schedule 12 itself, was approved and will stand as part of the Finance Bill.

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