Meeting Points

17 July 2002 / Ralph Ray

Issue: 3866 / Categories:

RALPH RAY FTII, TEP, BSc(Econ), Solicitor, consultant with Wilsons, Salisbury reports on the IBC Capital Gains Tax Planning Conference held in London on 17 May 2002.

Life interest with termination

RALPH RAY FTII, TEP, BSc(Econ), Solicitor, consultant with Wilsons, Salisbury reports on the IBC Capital Gains Tax Planning Conference held in London on 17 May 2002.

Life interest with termination

It is well established that if a life interest is terminated during the lifetime of the life tenant, normally through powers of revocation, there cannot be a gift with reservation problem, for example if the life tenant continues to occupy a property, because the termination is a deemed transfer of value for inheritance tax purposes and not a gift. Chris Whitehouse, barrister warned that there is a possible danger in circumstances where the consent of the life tenant has to be obtained to enable the termination to take place. This is because it is arguable that the requirement of giving consent could constitute a gift element. To prevent this risk, he advised avoiding the consent element. However, if the life tenant is one of the trustees, there should be no difficulty because that power is exercised in a fiduciary capacity.

Treaty relief for individuals

Section 10A, Taxation of Chargeable Gains Act 1992 provides that an individual who, having become neither resident nor ordinarily resident in the United Kingdom, disposes during his period of non-residence of assets which he owned at the time he became non-resident, is to be treated, if his period of non-residence is less than five full years of assessment, as though the gains he realised while temporarily non-resident accrued to him in the year of assessment when he resumes United Kingdom residence.

Barry McCutcheon, barrister asked: 'will a treaty protect gains which are actually realised during a year of assessment in which a taxpayer is treaty resident in, for example, Belgium, but which are deemed for United Kingdom tax purposes to accrue to him in a subsequent year of assessment when he has resumed residence in the United Kingdom?'. It is understood that the Revenue accepts that if treaty protection was available in the year of assessment in which the gain was realised, the individual will still have the benefit of treaty protection in relation to section 10A.

The Melville decision and developments

Chris Whitehouse gave the following illustration.

X wants to put investment property (valued at £1 million with a large in-built gain) into an accumulation and maintenance trust for his grandchildren. He wants to ensure:

that he does not have to pay capital gains tax; and

that inheritance tax will be avoided provided that he survives for seven years.

In its basic form, the 'Melville Trust' worked as follows.

It is set up as a discretionary trust.

After 90 days the settlor can direct the trustees to make an appointment in favour of any person (including himself).

During the 90-day period, the trustees cannot exercise dispositive powers (including presumably the power of advancement) without the consent of the settlor.

Clause 116 of the Finance Bill 2002 impacts on this inheritance tax avoidance scheme in that it provides that a 'settlement power' (as defined - basically a general power of appointment) ceased to be property for inheritance tax purposes from 17 April 2002.

However, Chris Whitehouse referred to likely scope for variants:

90-day discretionary trust subject thereto.

Contingent remainder interest in favour of the settlor which the settlor may wish to assign as a potentially exempt transfer, say to an accumulation and maintenance trust.

Tax treaty relief for section 87 trust gains

Relief under a double tax treaty may come to the rescue where non-resident trustees are about to realise a gain that will fall within section 87, Taxation of Chargeable Gains Act 1992 and become a stockpiled gain.

Barry McCutcheon advised that trustees holding assets pregnant with substantial gains, but under no commercial pressure to realise those gains, could avail themselves of treaty relief by transferring those assets to another settlement, thereby crystallising those gains without a sale to a third party.

Business and agricultural property relief pitfalls

Chris Whitehouse considered the following:

An accumulation and maintenance trust has held let agricultural land since 1995 which attracts 100 per cent agricultural property relief, i.e. the seven-year ownership condition is satisfied.

Jason acquires an interest in possession in 2003 and the trustees advance the land to him shortly thereafter.

For inheritance tax, neither the ending of the accumulation and maintenance trust nor the transfer of the land to Jason constitutes a chargeable occasion (see sections 71(4) and 53(2), Inheritance Tax Act 1984).

For capital gains tax purposes, holdover relief is given under section 165 of, and paragraph 3 of Schedule 7 to, the Taxation of Chargeable Gains Act 1992. Note in particular the requirements that the land is agricultural property within the meaning of Chapter II of Part V, Inheritance Tax Act 1984 'or would be so made if there were a chargeable transfer on that occasion'.

The pitfall is that the commencement of Jason's interest in possession started a new seven-year period for the inheritance tax agricultural property relief and if he dies or makes a gift within that period, that relief is not available. Moreover, as during this period if this is not agricultural property for inheritance tax, no capital gains tax holdover is available on the appointment to Jason. A similar problem exists with the two-year ownership requirement both for business property relief and agricultural property relief.

Offshore trustees and capital distributions

Timing may be important in achieving a successful capital gains tax strategy, said Brian Dunk.

Assume that an offshore settlement has funds of £2 million and section 87, Taxation of Chargeable Gains Act 1992 gains of £1 million. The trustees wish to distribute £1 million to each of a United Kingdom resident and a non-United Kingdom resident beneficiary.

(i) If distributions are made in the same year, the section 87 gains are apportioned so that the United Kingdom beneficiary has taxable gains of £500,000.

(ii) If the distribution to the non-United Kingdom beneficiary is made in the year prior to the distribution to the United Kingdom beneficiary, the section 87 gains are exhausted by non-taxable distributions to the non-United Kingdom beneficiary, so no tax is payable.

Flip-flop hangovers

The 'anti flip-flop' legislation of Schedule 4B to the Taxation of Chargeable Gains Act 1992, can have unexpected and unwarranted impact, observed Brian Dunk.

Assume that non-resident trustees own the entire shareholding in underlying company, base cost minimal. The company holds £2 million, being the proceeds of disposal of an asset as part of previous planning, and a beneficiary makes an urgent request for cash to fund short-term funding requirements. As a result, the trustees borrow £1 million from the company and loan cash to the beneficiary on commercial terms' and the beneficiary repays the loan within one month.

The result is that the trustees have outstanding trustee borrowing of £1 million and make a 'transfer of value' of £1 million. A Schedule 4B deemed disposal of a proportion of trust assets therefore occurs.

The proportion is one half, being the ratio of the amount of the borrowing (£1 million) to the value of the remaining assets (£2 million).

Gains of £1 million (one-half of £2 million) are deemed to arise accordingly.

Alternatively assume that non-resident trustees borrow £500,000 on commercial terms and use that sum towards the purchase of a property which costs £2.5 million. The trustees let the property on commercial terms to an unconnected third party. They hold other assets worth £2 million which stand at unrealised gain of £1 million.

As a result, the trustees make a 'transfer of value' of £2.5 million linked to trustee borrowing of £500,000, and a deemed disposal of the whole of the trust assets occurs - i.e. a gain of £1million.

Maximising the take when selling the family business

Before extracting funds from a company, Peter Vaines ATII, FCA, barrister, TEP suggested that the first question to be raised is the intended use of the money. If the proprietor is merely going to invest the money, there might be little point in extracting the funds from the company, even at a modest tax cost, when the company could make the investments itself. The income and gains on the investments are likely to be taxed much more generously in the company than in the hands of the individual.

A pre-sale dividend requires distributable profits. Where distributable profits are absent or inadequate, a stock dividend option is to be preferred as that can be effected at nominal value. It should be noted that a pre-sale dividend could be regarded as a transaction in securities giving rise to an adjustment under section 703, Taxes Act 1988 if some extra advantage were to be derived; see Commissioners of Inland Revenue v Laird Group Plc [2002] STC 722.

Tax treaty relief for section 86 trust gains

The issue of how trust gains may be sheltered under a double taxation treaty has generally arisen where gains realised by non-resident trustees will be attributed to the settlor under section 86, Taxation of Chargeable Gains Act 1992 and, for commercial reasons, the trustees anticipate realising a gain, e.g. because a company is to be sold.

Barry McCutcheon noted that at least three treaties - those with Mauritius (normally the best), New Zealand and Canada - afford protection in appropriate circumstances to gains realised by trustees.

The treaty position will be strengthened if, before the end of the year of assessment in which the gain is realised, the trustee who is treaty resident in Mauritius is replaced by one or more trustees resident in the United Kingdom. In that case:

the gains realised will be outside section 86, not because of the treaty, but because the trustees will have been resident in the United Kingdom for part of the year of assessment in question; and

the claim for treaty protection will simply be on the gain actually realised by the trustees.

If the trust, notwithstanding having become resident, is still a settlor-interested trust within section 77, Taxation of Chargeable Gains Act 1992, the position is more difficult. The better view is thought to be that the treaty 'intercepts' the gain realised by the trustees before it can be attributed to the settlor, but the position is far from certain, not least because section 77(1) provides that the trustees are not chargeable to capital gains tax on the chargeable gains that accrue to them. If treaty protection is not available, the gain will be attributed to the settlor and so still bear capital gains tax at 40 per cent.

The issue can in appropriate cases be side-stepped by converting the trust into a settlement which is outside section 77 before the beginning of the year of assessment in which the gain is realised.

Bear in mind that in order for the trustee to be treaty resident in Mauritius when the gain is realised, the trustee must, under Article 4(1) of the treaty, be a person liable to taxation under the Mauritian domestic legislation by reason of being domiciled or resident in Mauritius.

The capital gains tax immigration of the trust into the United Kingdom could be achieved in either of two ways:

the Mauritius trustee could be replaced by one or more trustees resident in the United Kingdom;

the Mauritius trustee could remain as a trustee, but joined by one or more trustees resident in the United Kingdom, in which case the trust would be deemed by section 69(1), Taxation of Chargeable Gains Act 1992 to be resident in the United Kingdom for capital gains tax purposes as from that time (assuming section 69(2) 'professional trustee' did not apply).

Offshore trust and option to buy back shares from the trustees

As a long-term planning technique, Peter Vaines advised that the shares in a family company might conveniently be settled on an offshore trust in which the settlor is not interested. However, the settlor would have an option to buy the shares back from the trustees at a low price. In due course, shortly before a sale, the settlor would exercise the option, purchase the shares and sell them on to the purchaser for full value.

The transaction between the settlor and the trustees would be a transaction between connected parties, so market value would be substituted for the option price for both the trustees' disposal and the settlor's acquisition. This should mean that the settlor would make little or no gain on his disposal. The trustees would be deemed to make a gain by reference to market value, but it could not be attributed to anybody else if the small proceeds of the sale are absorbed by trustee expenses; alternatively the gains attributed would be limited to the amounts distributed.

The whole plan might possibly be regarded as an arrangement or as a pre-ordained scheme and struck down on those grounds if it is done in haste. It can only be looked at as a long term plan.

Foreign domiciled individuals

In relation to foreign assets, any gain made by a United Kingdom resident, but foreign domiciled, individual will currently be taxed on the remittance basis (section 12, Taxation of Chargeable Gains Act 1992) but changes in the law to be announced in November probably are on the cards. Peter Vaines suggested that a solution could be to convert the shares in the United Kingdom company to bearer shares (or to issue bonus bearer shares) and to deposit them abroad. Bearer shares are located wherever the certificate is located, but they ought to be able to be marketed in the foreign territory; see Young v Phillips 58 TC 232. Almost certainly, this means merely that the shares are capable of being bought and sold there; not that there is an established stock market or bourse.

Stamp duty at 1.5 per cent is payable on the bearer shares issued, but not if they are denominated in a foreign currency.

Can an argument arise under section 127, Taxation of Chargeable Gains Act 1992, with bonus bearer shares to the effect that any sale would be attributable to the United Kingdom shares because the United Kingdom shares and the bearer shares are treated as a single holding? Probably not, but as a precaution the redemption of the existing ordinary shares would be a solution.

Divorce and Mesher orders in relation to the family home

Matrimonial breakdown and the principal private residence exemption was reviewed by Francesca Lagerberg, ACA, barrister, who advised that where there are minor children of the marriage, the divorce courts have to consider them first in any division of the marital home (section 25(1), Matrimonial Causes Act 1973). This can be achieved by imposing a trust, which preserves the former marital home for the benefit of the remaining spouse and children. This is known as a Mesher order from the decision in Mesher v Mesher and Hall [1980] 1 ALL ER 126.

Such orders mean that there is no actual disposal of the home by either spouse until the occurrence of a specified event, such as the youngest child reaching 18, or finishing full-time education, if later. This could frequently mean that when an actual disposal finally occurs, the absentee spouse will have a period of absence which exceeds the last three years of ownership and the other permissible absences in section 223, Taxation of Chargeable Gains Act 1992.

Fortunately, the Revenue treats a Mesher order as involving a disposal to a settlement as at the date of the court order. If the home was owned by both spouses as tenants in common, the 'staying' spouse will probably have no capital gains tax liability because principal private residence relief will cover the whole gain on his/her share. The 'quitting' spouse may be able to cover his or her gains by the final three years relief or Extra-statutory Concession D6.

When the trust ceases, the trustees are deemed to make a disposal under section 71(1), Taxation of Chargeable Gains Act 1992 of the whole interest in the house at its then market value. Because the house will normally have been occupied by the beneficiaries (the 'staying' spouse and the children) as their main residence, the whole gain during the trust period will usually attract principal private residence relief under section 225, Taxation of Chargeable Gains Act 1992 ('private residence occupied under the terms of settlement'). The whole interest then passes back to the (now) ex-spouses absolutely, so the absentee will normally want to arrange a sale as soon as possible after this to avoid any further taxable gains on his or her share (not to mention getting his or her hands on the proceeds!). There is an example of this treatment in the Revenue's Capital Gains Tax Manual at paragraph 65376.

An alternative to a Mesher order, that can also be imposed by a court, is the transfer of the home to the 'staying spouse', but with the imposition of a charge on its sale proceeds at a specified future date, payable to the other spouse. The Revenue's view is that this is a disposal by the 'leaving spouse' of an interest in the property in return for a different asset in the form of a charge.

On this view, the disposal of the interest in the home would appear to be treated in the same way as under a Mesher order (see above).

Taper relief update

Incorporations

Section 162, Taxation of Chargeable Gains Act 1992 provides for chargeable gains to be rolled over against cost of shares. The procedure is mandatory.

But there is a problem if incorporation is followed shortly afterwards by a sale of shares, given that any accrued taper on unincorporated business assets is wiped out.

Robert Jamieson FTII, MA, FCA advised that for businesses incorporating on or after 6 April 2002, sole traders and partners are now allowed to opt out of section 162 if they wish. (See clause 48 of the Finance Bill 2002.)

Time limits for making this election depend on whether shares have been sold by the end of the following tax year. If they have, the election must be made by the first anniversary of 31 January next following the year of incorporation; but if they have not, election is extended by one year.

With partnerships, each partner has a separate entitlement to decide whether or not to make election.

Liquidations and mixed use

Once a company has stopped trading (e.g. on liquidation), its shares are no longer business assets.

Watch out for these 'non-trading' periods and keep them as short as possible. Alternatively, consider an interim capital distribution shortly after the start of liquidation.

Another possibility is to transfer shares to a settlor-interested trust, but without making a holdover election.

The need for an alienation

Barry McCutcheon gave a reminder that it is vital to bear in mind that a gain will qualify for treaty protection only if it arises from the alienation of property.

Note that it is not sufficient that property is deemed to have been disposed of. So, for example, a deemed disposal by trustees under section 72(1), Taxation of Chargeable Gains Act 1992 on the termination on death of an interest in possession will not result in an alienation.

Flip-flop overkill

Brian Dunk warned that, in Schedule 4B to the Taxation of Chargeable Gains Act 1992 (trustee borrowings), there is no motive test; the trustee borrowing can be from any source and can predate 20 March 2000. The definition of 'transfer of value' is extremely wide and includes loans, even if made on commercial terms. Where the transfer is by way of loan, the value is equivalent to the entire asset.