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MALCOLM GUNN FTII, TEP examines the rules relating to relevant discounted securities and excluded indexed securities.
MALCOLM GUNN FTII, TEP examines the rules relating to relevant discounted securities and excluded indexed securities. THIS WEEK I return to the fray with an examination of two fairly modern creatures of statute: relevant discounted securities and excluded indexed securities. These marvels of Inland Revenue science appeared on the scene in Schedule 13 to the Finance Act 1996, and somewhat surprisingly for new tax inventions, they have had quite a peaceful life since. The Finance Act 1999 introduced a change to block an avoidance device and the Finance Act 2002 dealt with a possible anomaly, but apart from that all has been quiet on the statutory front.
Case law
As long ago as 1943, the Court of Appeal laid down principles in the case of Lomax v Peter Dixon & Son Ltd 25 TC 353 to the effect that 'there is no presumption that a discount at which the loan is made or a premium at which it is repayable is in the nature of interest'. Where a reasonable commercial rate of interest is due on a loan and the facts support the view that any discount on issue or premium on redemption is in the nature of compensation for the capital risk undertaken by the lender, the discount or premium is not liable to income tax under Schedule D, Case III. The Court of Appeal said that different considerations would apply where there was no reasonable commercial rate of interest; in that case any discount or premium will 'normally, if not always, be interest'. This of course left matters delightfully vague where a loan carried some interest and also a premium on redemption. The courts are very fond of saying that 'the answer depends on the precise facts and circumstances', but that is not a lot of help to the taxpayer who needs to know the answer in his particular case. Schedule D, Case III still contains a charge in respect of 'all discounts' but for most practical purposes, the 1996 legislation is now the place to start when investigating the tax treatment of a discount or a premium. The legislation does not apply for corporation tax purposes, since there are the separate loan relationship rules applicable to companies. First and foremost, it must be recognised that there must be a security before the rules apply. I briefly discussed this in last week's issue of Taxation and suggested that this probably means that there should be some documentation for the loan in question. However, it must be said that this is not an infallible test and in the case of Lomax v Peter Dixon, the Special Commissioners thought that the loans in that case were not securities; initially there was a simple debt and later an agreement was entered into for repayment of it and numbered loan notes were annexed to the agreement. The Court of Appeal did not discuss the question of whether or not the notes were securities. A relevant discounted security is one which could, at any stage, be redeemed to produce a 'deep gain'. When the legislation talks about deep gain, it actually means 'pretty small gain' because this is defined to mean:Deep gain
(a) where any possible redemption date is less than thirty years after the date of issue, a premium over one-half per cent per annum of the redemption figure gives rise to a deep gain;
(b) in any other case, namely where the earliest redemption date is over thirty years after the issue date, the maximum premium is 15 per cent of the redemption figure.
There is a pro rata provision for redemption dates which are not on anniversaries of the date of issue. Any deep gain is liable to income tax and not capital gains tax, but in computing the gain, interest which is to be added at the date of redemption is not taken into account. Note that the percentages are of the redemption amount and not the issue price. So one must be careful not to start the arithmetic at the wrong end of the deal; see Example 1.
Example 1
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A security is issued at 95 and is repayable after 10 years at 100. The gain will be 5; is this a deep gain? |
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Tested by reference to the issue price, it slightly exceeds 5 per cent (10 years at one half per cent). However, the legislation lays down the test by reference to the redemption amount and 5 does not exceed 5 per cent of 100, so the security is not a relevant discounted security. |
Before 15 February 1999
The legislation was changed in the Finance Act 1999 to counter an avoidance opportunity. Prior to 15 February 1999, one measured the possibility of deep gain by reference to the earliest redemption date, and so this left open the possibility of manipulating the terms on an early redemption date, when in practice there would not be any redemption on that date, so as to make the security fall either in or out of the legislation as desired.
After 14 February 1999
The rules now require the deep gain test to be applied to any possible redemption date, and not necessarily the earliest one. The Finance Act 1999 changes were designed to prevent previous avoidance schemes, whilst not impinging unfairly on others. One previous scheme was to have a provision for early redemption at par at the option of the holder, when in practice there would be no redemption on that date because the holder would be much better advised to wait until normal redemption when a large premium might be payable. This is now prevented by rules introduced in 1999. On the other hand, the new legislation does not catch normal commercial provisions designed to enable the holder to secure early redemption in order to protect his or her own interests. So the position after 14 February 1999 is that one no longer looks at early redemption dates which do not coincide with other specified redemption dates:
(i) where redemption on that date is considered unlikely and it will arise only on the occurrence of an event adversely affecting the holder or on default by any person;
(ii) where there may be redemption at the option of the issuer of the security, so long as the issuer is not connected with the lender/holder of the security;
(iii) where there may be redemption at the option of the issuer so long as the particular provision is not one designed to give rise to a tax advantage.
The last of these three is slightly puzzling at first sight, but I assume that it is designed to prevent arrangements where there may be early redemption by the issuer at a large premium, but on normal redemption dates repayment is to be at par. If this is part of a tax-avoidance scheme in which early repayment is expected, then the early redemption terms are to be taken into account in determining whether or not the security is within the rules. If those terms are not part of a scheme, they are disregarded. The draftsman of the Finance Act 1999 rules envisaged that some would undoubtedly try to get round them by having a security issued in the first place to an unconnected person. One could then have a term for early redemption at the option of the issuer, giving rise to a deep gain on that event, and otherwise with redemption at par. That redemption date could then be disregarded and the security subsequently acquired by a connected person who could expect early redemption outside the rules and subject only to capital gains tax. Hence the legislation includes provision to prevent this type of planning. Likewise those connected parties who are caught by the anti-avoidance legislation may as a result create a relevant discounted security, but after it is disposed of to a third party there may be no reason for the anti-avoidance rules to apply. In such a case, there is provision for the security to cease to be a relevant discounted security at the time when it changes hands.
Exceptions from the rules
There are some general exceptions from the scope of the relevant discounted securities provisions. These are:
(a) company shares
(b) gilt edged securities, but not gilt strips
(c) excluded indexed securities
(d) life assurance and capital redemption policies
(e) securities issued under the same prospectus as an earlier issue which was not an issue of relevant discounted securities
As regards excluded indexed securities, these will become relevant discounted securities if they pass into the hands of a person connected with the issuer and if they would otherwise have been caught by the connected party rules for relevant discounted securities at the time of issue.
Charging provisions
All profits arising from relevant discounted securities are liable to income tax, normally under Case III of Schedule D, but alternatively for overseas securities, within the scope of the provisions under Case IV of that Schedule. Likewise, losses realised on such securities qualify for income tax relief, so long as a claim is made by the 31 January which falls approximately 21 months after the year of assessment. The income tax relief has given rise to intriguing use of the securities for tax planning purposes in order to provide shelter against other chargeable income. However, schemes which work by the issue of the security at an excessive price were blocked by section 104, Finance Act 2002. The income tax charge is geared to a transfer of the securities, whether by sale, exchange or gift, and this includes transfer on death, which equally gives rise to income tax liability where the value of the security is then above its issue price. There is no opportunity for holdover relief or no gain, no loss transfer to spouse.
Finance Act 2002
A possible defect in the interaction of the rules on earn-outs with those on relevant discounted securities was dealt with by section 104, Finance Act 2002. Any such security issued under an earn-out right is to be treated as issued at market value on the issue date.
Excluded indexed securities
Paragraph 13 of Schedule 13 to the Finance Act 1996 excluded certain securities from the scope of the relevant discounted security legislation, where the profit to be eventually realised on redemption of the securities is geared to the change in value of chargeable assets for capital gains tax purposes. So, for example, if the value of a security is determined by the value of certain quoted shares on a stock exchange, or even an index of quoted shares, this will be typical of an excluded indexed security. The idea is clearly that it would be unfair to charge the gain on such a security to income tax, when it is geared to the value of assets which if held directly would be within the scope of capital gains tax. To qualify as an excluded indexed security, the holder of it must have an entitlement to receive on redemption the issue price of it increased or decreased by the percentage change in the appropriate chargeable assets over the period from issue to redemption. Care must be taken to ensure that the redemption price cannot exceed this value, nor should it be less than it, although there is a provision which the Revenue describes as allowing a 'limited amount of lagging where there are difficulties in obtaining valuations on the date of issue or redemption'. The percentage change has to be applied to the full issue price, without issue costs being deducted, and the Revenue view is that any interest accrual should be left out of the issue price for the purposes of the calculation. The Revenue allows a small amount of rounding, so that the redemption amount can be expressed to four places of decimals rounded to the nearest figure below. The terms of the security may allow for a minimum redemption figure of up to 10 per cent below the issue price. (This is the general interpretation of paragraph 13(5) of Schedule 13, although it does not read this way to me.) Apart from that the security must be linked only to the value of chargeable assets. A security linked to the change in any retail prices index is not within the provisions. Except in tax avoidance situations or where the security is issued to a connected party, early redemption at the option of the issuer of the security, or at the option of the holder in order to protect his or her position in the event of unforeseen adverse events, is permitted on terms not geared to the value of chargeable assets.
The rules in practice
Of course if you were to wander about Kings Cross Station with a survey asking people whether they are interested in relevant discounted securities or excluded indexed securities, the response might well be that you should seek medical help. These terms are not recognised in the investment community and the most common example of a relevant discounted security is a zero coupon bond. Any other loan stock which is capable of being redeemed at a premium in excess of the one-half per cent per annum threshold will also be a relevant discounted security, even if it carries a commercial rate of interest. Both of these types of security, as mentioned in last week's article, can arise where there is a loan between individuals or trustees and it is not necessary for the security to be one issued by a corporate body. Nevertheless, most such securities will be issued by companies, although the way to escape the income tax charge is to have zero dividend preference shares, as company shares are never relevant discounted securities. Example 2 illustrates the relevant discounted security rules in practice.
Example 2
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Mr Big's company issued a loan note to Mr Tot paying 2 per cent interest per annum and 1 per cent on redemption for every year it is held. Mr Tot had hoped to escape tax on the 1 per cent uplift within the capital gains tax qualifying corporate bond rules. |
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Mr Tot will be disappointed. The 1 per cent uplift exceeds the half per cent per annum allowed by the relevant discounted security rules and so he will be liable to income tax annually on the 2 per cent interest and on maturity in addition he will be liable to income tax on the 1 per cent per annum uplift paid. Alternatively on earlier disposal any profit he makes, however large or small, will be liable to income tax under Schedule D, Case III. |
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If instead Mr Big were to offer a loan at 2.5 per cent per annum interest with half per cent per annum uplift on redemption, the half per cent per annum uplift should be tax free so long as the loan note is carefully drafted to fall within all the paragraph 3 of Schedule 13 to the Finance Act 1996 rules. The security could include a term for early redemption at the option of the company upon payment of a 1 per cent uplift per annum, and such uplift will be tax free so long as Mr Tot is not connected with the company (which he is not on the bare facts given) and so long as this term is not inserted for any tax advantage. |
Example 3 illustrates the rules as they may apply in cases of private loans between individuals. Cases like this are likely to arise in situations where one is least expecting specialist rules of this type to apply, as the concept of a security will naturally lead one to expect a company to be involved. This is not so and readers would be well advised to keep these rules in mind wherever there are written loan agreements between individuals.
Example 3
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Mr Big lends £100,000 to his son Tiny to buy a flat while he is at university. Mr Big appreciates that Tiny cannot pay him any interest, but by the same token he cannot afford to give up any return on his money. So the deal is that no interest is to be paid during the currency of the loan, but when the flat is sold Tiny is to pay Mr Big back the original money plus an adjustment according to the change in the Halifax house price index over the period of the loan. |
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If the agreement is simply an oral one between father and son, the loan may not be a security. In that event the Finance Act 1996 rules will not apply and according to the decision in Lomax v Peter Dixon & Co Ltd the uplift on redemption is likely to be chargeable to income tax in the hands of Mr Big. |
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If Mr Big sets up the loan by way of deed secured by way of mortgage on the flat, it may be that this transforms the loan into a security and in that event it will be an excluded indexed security. The gain on repayment would in that event be within the capital gains tax régime for Mr Big. |
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If there is provision for early redemption within, say, two years by Tiny upon payment of an interest charge only on the mortgage, this will take the loan outside the rules for excluded indexed securities and it will then be a relevant discounted security. Any redemption of the loan at any time will then give rise to a 'deep gain' chargeable to income tax in the hands of Mr Big. |
