Section 776 And All That

KEITH GORDON MA, ACA, CTA explains why the anti-avoidance provisions in section 776, Taxes Act 1988 may sometimes prove beneficial to the taxpayer.

SOME YEARS AGO, soon after qualification, I was asked by a colleague to set out for him the steps an individual needed to take in order to become non-resident and non-ordinarily resident, and so be able to make a capital gain free of United Kingdom tax. This was pre-Finance Act 1998, when it was sufficient for a taxpayer to be working overseas for a complete tax year. I duly complied with the request and presented my findings.

I learnt, during our subsequent discussions, that the client was on the verge of making a gain in the region of £40 million. Curiosity got the better of me, and I asked how such a gain might be realised. My colleague proceeded to tell me that the client had acquired a plot of land.

I stopped my colleague in his tracks and asked if he had considered section 776, Taxes Act 1988. Without going into details, it appears that he had not and, to the best of my knowledge, the client did not spend a year in fiscal exile.

Section 776

Section 776 emanates from the days when capital gains were taxed at lower rates than the top rate of income tax, and replaced legislation that was introduced several years before the introduction of capital gains tax. It is headed 'Transactions in land: taxation of capital gains', and its purpose is clearly set out in its first subsection. This reads:

'This section is enacted to prevent the avoidance of tax by persons concerned with land or the development of land.'

It may be thought that the provision can therefore only be invoked when tax avoidance can be shown. However, section 776(2) suggests far more broadly that the provision applies wherever:

'(a) land ... is acquired with the sole or main object of realising a gain from disposing of the land; or

'(b) land is held as trading stock; or

'(c) land is developed with the sole or main object of realising a gain from disposing of the land when developed;

'and any gain of a capital nature is obtained from the disposal of the land.'

Section 776(2) also makes it clear that the provision applies even if the gain is realised:

• by a connected person (rather than the person who holds, acquires or develops the land); or

• in an indirect method or series of transactions; or

• for another person.

In Yuill v Wilson [1979] STC 486, the Court of Appeal resolved this debate by holding that there must be some intention to avoid tax for section 776 to apply. Following the later case of Page v Lowther and another [1983] STC 799, the Revenue's view, published in the Inspector's Manual at IM4723, is that the avoidance condition is to be viewed objectively rather than subjectively.

This means that even where the conditions of section 776(2) are met, section 776 can apply provided that tax would otherwise be avoided. However, the taxpayer need not have sought to avoid tax.

Effect of the legislation

When the conditions are satisfied, the gain is not treated as a capital gain. Instead, the whole gain is assessable under Schedule D, Case VI in the tax year in which the gain is realised.

Under the taper relief régime, up to 75 per cent of a capital gain can be excluded from charge. However, section 776(6) makes it clear that taper relief cannot reduce the amount charged to income tax under these rules. While that subsection seems to be generously worded, by allowing a gain to be computed in any way that is 'just and reasonable in the circumstances', it states that the only deductions available are those for 'such expenses as are attributable to the land disposed of'.

Private residences

Section 776(9) states that the anti-avoidance rule does not apply if the gain would otherwise be exempt from capital gains tax under the rules for main residence relief (sections 222 et seq, Taxation of Chargeable Gains Act 1992). Further, if the gain on a private residence is outside the scope of the main residence exemption because of section 224(3) (gain on a residence which was acquired partly or wholly with an intention to make such a gain), that gain is still not brought into income tax under section 776 and, therefore, remains subject to the rules of capital gains tax.

It should be noted that section 776(9) only applies to gains made by individuals, whereas the capital gains tax exemption is extended to trusts by virtue of section 225, Taxation of Chargeable Gains Act 1992. It is suggested that this is an oversight rather than a deliberate anomaly. I would be interested to learn of any readers who have come across an Inspector who has taken this point and the eventual outcome.

Similarly, on a literal and narrow interpretation of section 776(9), it is possible that capital gains tax treatment would not be available in cases of partial exemption. For example, suppose that a home were a main residence for the first five years of ownership and then, in the absence of any election, etc., a second property became the person's main residence for a further period before the first property is disposed of. Assuming that this further period is longer than three years, the capital gains tax rules would require some of the gain to be brought into charge. The wording of sections 222 to 226 suggests that there is a single gain, only part of which is chargeable (section 223(2)). Had the second period not existed or been less than three years, the whole gain would have been exempted from tax under section 223(1).

Assuming that the Revenue were to take this point (and again I am not aware of it happening in practice), this could mean that eight years' worth (in this example) of exemption would be forgone, and the whole gain would then be subject to income tax. This is, however, subject to any possible exclusion if there had been a late decision to develop the site (as discussed below).

Late decisions

A further relaxation applies in the case where section 776 is invoked because of the development of land. This applies in respect of any part of the gain that is attributable to a period before the formation of the intention to develop the land, provided that the land was not originally:

• acquired with the sole or main object of realising a gain from disposing of the land, nor

• held as trading stock (section 776(7)).

In such cases, the part of the gain that relates to the period before the formation of the intention to develop the land will be subject to the capital gains tax rules, and only the part relating to the later period can be brought into the scope of section 776.

The legislation clearly states that this apportionment must consider two factors: time and fairness. In other words, it is not simply a case of a straightforward time apportionment, i.e., dividing the gain in respect of the number of months before and after the change of intention. Instead, one should consider what would have been the gain had the property been sold at the time the intentions changed at the then market value, with any excess being subject to income tax. See Example.

Example

If, at the point when the decision to develop was made, the property's value would show a loss, then section 776(7) is of no value at all, as there is no gain to exclude. The Inspector's Manual at paragraph IM4735, however, reaches a different conclusion in what the Revenue calls 'slice of the action' cases. Such a case is one where a landowner receives a guaranteed sum for the land being developed and then a percentage of future profits made by the developer. In these circumstances, the Revenue would treat the guaranteed sum as indicative of the fair value of the land at the time in which an intention to develop is formed. According to the Revenue, this sum is outside section 776, but all contingent sums are within the scope of the section.

The Revenue line may be beneficial to taxpayers in some situations and should be borne in mind. However, it is submitted that this does not reflect the true meaning of the legislation.

Hiding behind the corporate veil

It might be thought that the provisions could be circumvented if land were owned by a company, and the shares of the company were sold instead of the land. However, such a transaction would fall within the scope of section 776(2)(i) which includes 'property deriving its value from land'.

However, to ensure that this does not catch out genuine property-trading companies, this does not apply if:

• the land is held by the company as trading stock (section 776(10)(a)(i)); or

• the company is a parent company of a group where a 90 per cent subsidiary owns the land as trading stock (section 776(10)(a)(ii)).

Further conditions must also be satisfied. These are that:

• the land is disposed of in the normal course of the company's trade; and

• all the gain arising from the transaction is kept within the company, so as to be taxed within the company (section 776(10)(b)).

This relaxation does not apply if a gain from land is sheltered through a company by a series of transactions that are caught by section 776(2)(ii).

Diverted gains

Section 776(8) is concerned with gains that are diverted to other persons in order to avoid section 776, and ensures that the gain is taxed on the original owner.

Clearance procedures

A clearance procedure is available under section 776(11) where a taxpayer is concerned with:

• land (or any property deriving its value from land) that may be viewed as acquired with the object of realising a gain; or

• land that may be viewed as developed with the object of realising a gain on development.

However, the clearance procedure is not available in respect of land that is held as trading stock and that may be caught under section 776(2)(b).

The clearance procedure is particularly useful as it can apply prospectively, and the Inspector has to give a ruling within 30 days of receiving the details in writing. Clearance requests should be sent to the taxpayer's normal tax district.

Geographical considerations

Section 776(14) deals with residence and the location of the land. It provides that non-residence does not preclude the section from operating. The only geographical condition is that 'all or any part of the land in question is situated in the United Kingdom'.

One assumes that the Revenue would not seek to tax gains that arise in respect of overseas land on non-residents. However, it is thought that in most cases this point would be irrelevant.

Trading stock

It is worth reflecting on the computations that are necessary when land (or any other asset, in fact) is appropriated from trading stock to be held as a capital item. Section 161(2), Taxation of Chargeable Gains Act 1992 provides that the base cost for capital gains tax purposes is the amount brought into the trade's tax computations. The orthodox view is that this is the market value when the asset is removed from trading stock (following Sharkey v Wernher 36 TC 275). I believe that the principle in Sharkey v Wernher is more limited in scope, and a 21st century court would not necessarily apply it in many trading situations.

Where land is involved, with the result that section 776 comes into play, it is necessary to determine what base cost can be used to calculate the gain. Section 776(6) provides that this should be done in such a way that is 'just and reasonable in all the circumstances', and this would seem to allow the notional sale value (brought in under section 161(2)) to be used.

Alternatives to section 776

Section 776 only applies to gains 'of a capital nature'. Thus any trading gain is outside its scope and, in the past, some taxpayers have tried to show that their transactions in land were of a trading nature rather than isolated capital transactions. Even when the gain arose on the first transaction, it was possible (following Leach v Pogson 40 TC 585) to argue that the nature of one transaction could be coloured by the subsequent transactions in a series. The Revenue asserts that the tests for whether there is a trade are wider when land is concerned (see Marson v Morton [1986] STC 463 and Inspector's Manual at paragraph IM2606).

The advantages of treating transactions as arising from a trade include a greater availability of deductions under the Schedule D, Case I rules, and the ability to wash out any remaining income by making adequate provisions to a pension scheme. While these advantages remain, it should be noted that the erosion of the National Insurance upper earnings limit will make Case I gains less attractive than Case VI as far as individuals are concerned.

Conversely, the ability to treat Case I profits as relevant earnings for pension purposes might make them more attractive than the Case VI option. However, the effective reduction in the real value of the earnings cap together with the ability to nominate a basis year will, over time, again make the Case I advantages less significant.

So, again, what is essentially an anti-avoidance provision will often provide some taxpayers with some measure of relief.

Keith Gordon is a chartered accountant and tax adviser. He is a director of ukTAXhelp Ltd, a company specialising in providing tax advice to other professional businesses, and can be contacted by e-mail: keith.gordon@ukTAXhelp.co.uk. The views expressed in this article are those of the author.

Issue: 3893 / Categories: Comment & Analysis