Anti-avoidance

Anti-avoidance

Avoidance Miscellany

MIKE THEXTON describes some anti-avoidance provisions in the Finance Act 2004 relating to personal tax issues.

NTI-AVOIDANCE PROVISIONS are a recurring theme of the Budget and they feature heavily in the Act. Some of them were separately announced in advance. In each case, the main outcome is that it is no longer possible to do the clever plan that is described. Sometimes it is excessively complicated to explain the point of the scheme that can no longer be used, so these notes explain rather the main practical implications of the restrictions going forward.

Film partnerships

In a film scheme, investors put in money (usually having borrowed some of it) to obtain an immediate 40 per cent income tax relief arising from the 100 per cent allowance for investment in British films. This can be a tax deferral, because the income stream from the film, necessary to pay off the borrowing and the interest on it, is taxable. However, some schemes have arranged a tax-free exit, allowing the investor to get back tax relief greater than the personal investment, then walk away from the tax on the income stream and the repayment of the borrowing, generally by selling after two years and realising a capital gain which is less heavily taxed.

These schemes have been severely restricted by successive Revenue announcements on 10 December 2003, 10 February 2004 and 26 March 2004. The tax-free exit arrangements should be closed down by a clawback of relief where a film investor receives a lump sum which is not taxed as income. This limits the loss relief to the actual economic loss suffered while the investor is a partner; if the money is recovered later, the loss relief will be withdrawn. The new legislation can be found in sections 119 to 130, Finance Act 2004.

New rules apply to a person who has received loss relief under section 380 or 381, Taxes Act 1988 or section 72, Finance Act 1991 in relation to a film trade which has taken advantage of the reliefs at sections 40A to 40C and 41 to 43, Finance Act (No 2) 1992 or section 48, Finance Act (No 2) 1997. It also applies where interest relief has been claimed under section 353, Taxes Act 1988 on a loan to buy the interest in the film partnership. Where such a person makes a disposal of rights to profits from the trade, and the receipt on that disposal is either not taxable, or else the net losses already relieved are greater than the net contribution to the trade, then there will be a clawback by way of an income tax charge. This applies to disposals after 10 December 2003.

Sections 120 to 123 define disposal of a right to profits, the losses claimed, capital contribution, the computation of the chargeable amount, film-related losses, and non-taxable consideration.

Non-taxable consideration means not chargeable to income tax, so a receipt which is chargeable to capital gains tax would be caught. In general, if an income tax charge arises on a disposal, it takes precedence over capital gains tax, so the same receipt is not supposed to be subjected to both taxes. See section 37, Taxation of Chargeable Gains Act 1992.

Non-active partners

A new restriction applies to non-active partners in the first four years of a trade. It is similar to the rule that has applied in the past to limited partners and members of limited liability partnerships, in that they cannot claim more sideways loss relief against their general income and gains (and also interest deductible from general income under section 353, Taxes Act 1988) than they have capital at risk in the business (usually the amount that they have already contributed to it). The restriction will apply, under section 124, Finance Act 2004:

A non-active partner is one who spends less than ten hours a week (on average through the basis period) involved in the business. A running total must be kept of contributions to the trade and amounts claimed by way of section 353, 380, 381 or 72 claims. Any amount which cannot be relieved sideways can be carried forward against profits from the trade, or they may be relieved against other income or gains in a later year if the partner makes a further contribution to the trade.

Members of Lloyd's are specifically excluded from these rules, but it should be appreciated that these rules otherwise apply to all partnerships, not just film partnerships, and not just tax mitigation arrangements with an element of artificiality.

Example

A partnership is established between X and Y. X is an inactive partner, and she contributes £10,000. In the first year of trading, she is allocated a loss of £14,000. She can claim £10,000 against her other income, but has to carry £4,000 forward.

In the second year of trading, she contributes a further £3,000 to the partnership. She can then claim a further £3,000 of loss against her other income, and £1,000 will be carried forward.

An extra clause added late to the Finance Bill further restricts loss claims by partners in film partnerships where there is an agreement guaranteeing the partner a minimum amount of income. It seems likely that this is aimed at particular types of scheme. Those who want to invest in films, or who want to invest in tax mitigation products, will need to understand all these rules in considerable detail.

New rules make sure that inactive individuals in a partnership will be charged to income tax on the disposal of a licence or similar agreement. This has apparently been a non-taxable exit route for some film partnerships. The explanatory notes to the Finance Bill state that there has been no specific law dealing with licences in a comprehensive way before this. Even now, the new rule only applies to inactive partners making a disposal on or after 10 February 2004, after making a loss in the first four years of the trade and claiming for it against other income or gains. So there is still no general law dealing with the treatment of disposals of licences.

Manufactured dividends and gilt strips

The rules on manufactured dividends permitted a scheme whereby an individual could create a payment which was deductible from general income at 40 per cent, but which was matched by dividend income which was only taxable at 32.5 per cent. The net result would be a reduction in tax liability without any actual cost. The rules were tightened to prevent this on 6 November 2003, and extended to trusts and to a capital gains tax version of the scheme on 17 March 2004.

The rules on gilt strips allowed individuals to create a deductible amount that was matched by a non-taxable receipt, again creating a tax reduction without a real economic cost. These arrangements were closed from 15 January 2004, with some further restrictions applying from 17 March; see sections 138 to 139, Finance Act 2004.

Corresponding deficiency relief

When a single premium life insurance policy is partially encashed, a chargeable event gain will arise if the amount withdrawn exceeds a limit of five per cent of the original investment for each year for which the policy has been held. If the policy is fully encashed after a chargeable event gain, the overall gain on the policy is calculated, and if that is less than the gain already taxed, a corresponding deficiency relief is available in the year of full encashment. In the case of a United Kingdom insurance policy, the gain is only chargeable at higher rates of tax, and the relief is only given at higher rates.

These rules have been used by husbands and wives, who were effectively regarded as a single person for the taxation of these policies. The lower-taxpaying spouse would create the gain on partial encashment (not taxable, because it was realised by a basic rate taxpayer), then transfer the policy to the higher-rate taxpaying spouse for realisation of a corresponding deficiency (and a tax reduction) the next year.

It will now only be possible to claim corresponding deficiency relief where the claimant was the person who was chargeable on the earlier gain, so it will not be possible to pass this relief between husband and wife in this way. See section 140, Finance Act 2004.

The new rule applies to policies issued or added to, or assigned, on or after 3 March 2004. It therefore appears that it will still be possible to claim the corresponding deficiency relief if the lower-taxpaying spouse triggered the gain and transferred the policy before that date, even if the higher-taxpaying spouse does not cash the policy in until 2004-05.

Gifts to charity

A late amendment to the Bill closed down a further avoidance scheme with effect from 2 July 2004, and is contained in section 139, Finance Act 2004. The provision denies gift aid relief where there is a gift of shares, securities or real property to a charity, and the charity takes on a related obligation.

It appears that some circular arrangements must have been designed which could generate the appearance of a gift qualifying for the relief, but which in reality more nearly resembled a sale. The relief is restricted to the net benefit to the charity, the excess of the value of the gift over the amount of the related obligation.

This is an extract from 'The Finance Act Cycle', a CD-ROM based training package written by Mike Thexton MA, FCA, CTA for BPP Professional Education. For further information or to order ring 0845 226 2422.

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