The business asset maze

ANDREW HUBBARD ventures into the labyrinthine concepts of business assets.

WHEN THESEUS RETURNED to Athens after slaying the Minotaur, his ship was preserved by the Athenians. As its old planks decayed, they were gradually replaced by new and stronger timbers. Eventually, according to Virgil, not a single plank of the original remained. The philosophers then posed the problem:

'Was the ship still Theseus's ship or was it a totally new ship? And if it was a new ship, at what point did it cease being Theseus's ship?'

No, your editor has not got his publications mixed up: this is Taxation and not The Journal of Hellenic Studies and there is a tax angle to my anecdote. I am not about to embark into a long dissertation on free depreciation for ships, let alone produce my long-awaited paper on 'Some problems in the Cretan-Athenian double tax treaty with particular reference to the taxation of government employees on active service'. The Virgilian connection struck me while I was considering my favourite topic of the moment: capital gains tax taper relief.

Following the thread

You don't see the connection yet? Let's lead into it gently. Suppose that the Athenian government had introduced differential rates of capital gains tax on the disposal of ships: a low rate for 'old' ships and a high rate for 'new' ships? How would Theseus complete his Athenian self-assessment tax return? (apart from being more justified than most in saying 'it's all Greek to me!').
If he was required to look at the status of the ship on acquisition, then clearly the ship is an old ship and entitled to the lower rate. If, instead, the rules required him to look at the status of the ship at the date of disposal, then clearly it is a new ship. However, what if the rules required him to look over the entire period of ownership? The ship started off as being 'old', but when did it change: indeed did it ever change?
Is the analogy now beginning to ring any bells? What if we swap the idea of the original ship with a trading company and each new plank as a small amount of cash or other investment? (To keep things simple here I will refer only to cash for the rest of this article, but it is the principle that I am most concerned about.) We started off with something which was quite clearly a trading company qualifying for business asset taper relief and ended up with something which was just a cash box, and as such not on the face of it qualifying for business asset taper relief. Yet our problem is the same as Theseus's ship. If we have to look over the period of ownership, when was the point at which it ceased to meet the qualifying conditions? I have to say that I find this an almost impossible problem to resolve. We are into the realm of metaphysics and my CTA does not offer me much assistance here.

The daily maze

Assume that on day one (D1) our company qualifies for business taper, because it has no surplus cash and that on D1 + 1 it turns a tiny proportion of its business assets into cash by a sale of an item of trading stock. Nobody will argue that on D1 + 1 it has changed its status for taper relief purposes. What happens on D1 + 2 when there is again a tiny conversion of business asset into cash? If we accept the logic of the previous day, then we must also accept that at the end of the second day it still qualifies. Logically, therefore, if there is the same incremental increase every day a company which qualifies for business asset taper relief on day X will always qualify on day X + 1. Thus on the last day, when it has turned its last business asset into cash it will still qualify for business asset taper relief!
This is absurd, you will say, but if the company does not qualify for business asset taper on this last day there must have been a point at which its status changed? When was this? What about the day on which the cash exceeds 20% of the net assets? On day Y a company has net assets of £1,000 of which £200 is cash. On day Y +1 it sells an item of trading stock at a £5 profit. It now has net assets of £1,005, of which £205 (20.39%) is cash. As far as the company is concerned, this is a normal day like any other: it is doing exactly the same thing on day Y + 1 as it was doing the previous day. It would also be absurd to suggest that something so fundamental had happened to the company overnight to turn it from a trading company for business asset taper relief purposes into a non-trading company. And what happens on day Y + 2, when the weekly wage bill is paid and the cash disappears? It would be the height of absurdity to suggest that this is another fundamental event which turns it back into a trading company for taper purposes.
If (as I think that we must) we accept that the point at which the 20% test — which is after all only HMRC practice — is breached does not automatically change the company's status, then when does the status change? Again assuming that there are only incremental increases in cash in the future (to say nothing of similar decreases in cash), it is surely equally impossible to identify the point at which the status changes thereafter.

Reality and myth

Of course real life is not always like this 'mythical' example. Where a company sells a major asset for cash and invests that cash in an investment portfolio there is a definite moment at which one can say that something has happened and has thus perhaps triggered a change in status. Similarly, if the directors formally review the position and make some decisions about the cash (whatever those decisions might be), an event has happened which might be a point at which taper relief status changes.
However, in the case of a company which is unquestionably a trading company on day one and which builds up cash reserves gradually over time through normal trading, there is no event on which anything changes and therefore, as a matter of logic, no date on which business asset taper relief status changes. If a client is completing a self-assessment return on the basis that his company was a trading company throughout the period of ownership and HMRC wanted to argue that there was a period of non-qualifying status, they would have to establish the date on which the change took place. In order to compute the capital gain arising on a disposal of a company which was not a qualifying company throughout the period of ownership, one must be able to identify the periods which did and which did not qualify. This is a precise test which depends on actual numbers of days. If HMRC cannot point to a date on which status changed then I do not see how they will be able to demonstrate that the client's tax computations are incorrect. There may well be a feeling that the company at the end of the period is materially different from the company at the beginning of the period, but tax computations do not work on a 'gut feeling' basis.

Black or white

Continuing on my theme, I seem to recall that even our hero Theseus caused a tragedy by mixing up black and white and the problem here is, of course, that not for the first time, the tax system has imposed a black or white, yes or no, test to an area of life which is composed of shades of grey. Business is a dynamic environment and cannot be fitted within an abstract framework. Here it does, I think, work to the taxpayer's advantage. If you get up in the morning confident that your company is a trading company and nothing material happens to change its status by the time you go to bed, then even if over time all of the immaterial changes add up to something which might in total be a material change, I believe that business asset taper relief will be due throughout the period.
In the room at home in which I am writing this there are several photographs of me. The older ones show me with a full head of hair: the more recent ones do not! If a higher rate of tax was introduced for bald people and no definition was introduced for baldness, when would I have to pay the higher rate? Between any two days the amount of hair on my head hardly changes so there is no day on which I could say: 'OK, I admit it, today I am bald!' So I would still pay tax at the full-hair rate even though I've no hair left. Gradual, almost imperceptible, change cannot be accommodated within an all or nothing framework. Take a grain of sand away from a heap of sand and it remains a heap of sand.

A philosophical question

So, where does this leave business asset taper relief in the very common case where nothing dramatic ever happens to a trading company, but by the time that it is sold it is holding a large amount of cash? In my view (and this is a personal view) it will qualify for business asset taper relief throughout. We know that HMRC have been recruiting accountants recently: at this rate they will soon have to start recruiting philosophers!
Next week, 'Timeo Danaos et dona ferentes*' — Theseus's accountant gets sued after advising on TCGA 1992, s 165. Then again, perhaps not! 
Andrew Hubbard is a tax director of Tenon, accountants and business advisers.
* 'I fear the Greeks, even when they are bearing gifts of business assets ...'.
 

Issue: 4026 / Categories: Comment & Analysis