Shelter For Sale

JIM HAWKINS discusses a marketed scheme.

A TAX SHELTER scheme is being marketed until the end of March. It relies upon the fact that the Capital Allowances Act 2001 allows expenditure incurred by small enterprises on information and communications technology to be completely written off against tax in the tax year in which it occurs.

Individual investors become partners in a limited liability partnership (GenTech), which means that their maximum potential liability is limited to the total amount they have invested in the partnership. The partnership then invests money into qualifying technology companies and takes over the intellectual property rights of the technology. It then enters into an agency exploitation agreement with the technology company, or some other organisation, which exploits the technology on behalf of the partnership.

The minimum investment is £5,000, and the illustrations are based on this figure. The partnership borrows a further £17,000 on the individual investor's behalf, so that his or her total investment, and maximum liability, is £22,000. This loan is guaranteed by the technology company receiving the investment, which places £17,000 on deposit. In the event of commercial failure, this £17,000 discharges the individual's loan liability.

A higher rate taxpayer will receive more or less immediate tax relief of £8,800, i.e., 40 per cent of £22,000. This means that the overall investment is initially cash positive to the tune of £3,800. It is anticipated that over the ten-year life of the scheme, profits will be made which will be divided between the partners after expenses have been paid. These profits will be liable to income tax, but the interest on the £17,000 loan should be a trading expense to set off against those profits.

The clever idea behind the scheme is that in a worst-case scenario where the investment produces no return, the investor is £3,800 better off. The guarantor (the technology company) will be required to pay the loan. However, if the partnership has previously converted to a limited company, and also transferred in the loans, as suggested by the sponsors, the only value in the company will be the intellectual property rights, which will revert to the guarantor. The original investor will have discharged any liability for the loan.

Tax implications

What is the attitude of the Inland Revenue likely to be? There are two possible risk areas. Firstly, it might claim that the partnership is not trading. Secondly, it might seek to establish that this is an artificial tax avoidance scheme.

The sponsors have taken counsel's opinion on various aspects of the scheme. However, the question of actual trading has not been addressed in that opinion. Counsel specifically says: 'It does not appear from the information memorandum precisely how the intellectual property is intended to be exploited by [the] Partnership'. In confirming the availability of tax reliefs, counsel prefaces his remarks with the statement: 'Subject to the trade being carried on on a commercial basis and with a view to the realisation of profits in the trade …'.

The sponsors take the view that although the partnership is not directly exploiting the technology, rather giving a third party an agency to do it on its behalf, this does not prejudice the trading status.

Counsel is of the opinion that Ramsay/Furniss can have no application in relation to the proposed transactions and arrangements save (possibly) in respect of the question whether for capital allowance purposes, the partnership will have incurred the (or the whole of the) expenditure. He opines that it has, and considers that Ensign Tankers (Leasing) Ltd v Stokes [1992] STC 226 does not apply.

However, it remains to be seen whether the Revenue will accept the validity of the scheme.

The aim of the partnership is certainly to seek out and exploit successful technologies. Nevertheless, if it were to invest in no-hope situations, a £5,000 investor who is a higher rate taxpayer would be £3,800 better off very shortly after making that investment, with nothing else to pay.

Furthermore, it must be said that it is a slightly unusual arrangement to give an organisation £21,000 when it only needs £4,000, and it then puts the balance of £17,000 on deposit to secure your borrowings on its behalf.

Commercial implications

The information memorandum on the scheme assumes a six per cent rate of interest on the £17,000 loan. It also states that of the £22,000 total investment, there are partnership costs of £1,000. How much needs to be generated to cover interest and costs? Loan interest amounts to £1,020 and annual management expenses will be £25 in this case. The annual income, therefore, needs to be £1,045. This represents a return of 4.75 per cent on the investment.

However, it would seem that only £4,000 of the total investment ends up actually working: £17,000 has been put on deposit and initial costs have accounted for £1,000. If we assume four per cent interest on this deposit, it will produce £680, leaving a balance of £365 to be generated by the working capital. This represents over nine per cent return on that working capital.

If income exceeds this figure, a higher rate taxpayer will have a total liability of 41 per cent of the excess, i.e., 40 per cent income tax and one per cent National Insurance charge. Essentially, in these circumstances, the Revenue will claw back over the years some or all of the tax relief which the investor initially received. The scheme becomes a cashflow exercise, and a main significant benefit is likely to be any increase in the value of the underlying investment.

Jim Hawkins is with Financial Information Research Exchange, tel: 01785 812426, which supplies tax mitigation advice to independent financial advisers via a fortnightly bulletin.

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