Two Friendly Volumes

MALCOLM GUNN FTII, TEP takes a look at the latest Finance Bill.

THE FINANCE BILL is friendly to neither the pocket nor the planet. I suggested to the counter assistant at the Stationery Office that it should be given away since it is in the Government's interests that we know what the law of the land is, but £24.50 was still collected off my credit card. As to the planet, there are two hefty volumes which will have made their mark on a rain forest somewhere.

It did cross my mind as to why the Budget itself was delivered at an inordinately late time, when only a matter of days later all the relevant provisions are there in black and white, so surely things must have been settled long before 17 April? Nevertheless, far be it from me to grumble as the two volumes are relatively friendly to the taxpayer, or at least as friendly as any tax statute can be. A glance through all the various provisions reveals that anti avoidance is not glaring out of many of the provisions and in most cases there is much in this Bill which introduces welcome change.

Taper relief

Apart from the fact that, as far as gains on business assets are concerned, the Bill almost takes us back to the pre capital gains tax era which endured up to 1965 (- now minimal tax liability after two years), Schedule 10 to the Bill makes what it describes as 'minor amendments' to the capital gains taper relief provisions. For a start, paragraph 8 of the Schedule introduces the important provision which deems unmarketable loan notes and debentures to be securities for the purposes of the taper relief provisions where such assets are issued in exchange for shares, commonly on the sale of a private company. Of course, there were many who said that this was the law all along, but at least paragraph 8 puts it all beyond further argument. The new definition applies to disposals after 5 April 2001 and it is further stated that for such disposals the provision has full retrospective effect for taper relief purposes. This represents quite a dramatic reversal of the Revenue's previous interpretation set out in the June 2001 Tax Bulletin and is one which is very welcome. The new definition does not apply in certain situations where it would not be to the advantage of the taxpayer, for example in the case of securities in a close company which is caught by the change of activity rule in paragraph 11 of Schedule A1 to the Taxation of Chargeable Gains Act 1992 (on which more in a moment).

Trading

The trading company test has also been refashioned. The previous rule in paragraph 22 of Schedule A1 required a company to exist wholly for the purposes of carrying on a trade, and allowed only non-trading purposes which were capable of having 'no substantial effect on the extent of the company's activities'. Much ink and column space in this publication has been devoted to those few words.

The new test requires a company to be carrying on trading activities and those activities must not 'include to a substantial extent activities other than trading activities'. Temporary periods without a trading activity are catered in the next part of the definition, which allows preparations for trading or for acquiring the share capital of another trading company to count as trading activities. It will be noted that the nebulous word 'substantial' is still there in the definition and so I guess some more ink and column space will yet be needed. In the context of the new corporation tax relief for disposals of 'substantial shareholdings' by companies, one cannot help noticing that substantial means a 10 per cent interest; if 10 per cent were read across into the taper relief provision, a harsh new régime would have dawned. Fortunately the draftsman appreciated this and the corporation tax provision helpfully states that 'this is without prejudice to what is meant by substantial where the word appears in other contexts'.

Another taper relief change allows all the activities of members of a group to be treated as one business, and intra-group activities are disregarded. Once again, this is a helpful change, in that it allows more clearly for subsidiaries in a group whose sole purpose is, for example, to hold properties occupied by other members of the group.

The change of activity rule

Until the Finance Bill, shareholders in close companies enjoyed a special provision which could knock out all their accrued taper relief and restart the clock at zero; this was the dreaded paragraph 11 of Schedule A1. The rule reset the taper clock whenever there was a 'relevant change of activity' involving the company, such as commencing to trade. It also had this effect if, at the time of disposal of shares in the company, it was carrying on a business of holding investments and there was previously a time when such a business was not carried on or when it was very small. Strangely, the latter provision was easily side-stepped in appropriate situations by ceasing the investment business in the company before any disposal of the shares.

These much maligned rules have now been repealed with effect for disposals on or after 17 April 2002. In their place, there is a new rule to the effect that any periods of time during which a close company is not active (as defined) is not to count for the purposes of taper relief. There is thus no resetting of the taper relief clock but simply a void period during which no taper relief is accruing. As in most cases one will only be looking to build up two years of acceptable activity by the company, the new provision will hopefully not often give rise to problems. This is all the more so because, in a remarkable about-turn, a close company is active if it is carrying on a business of holding investments, whereas investment businesses were one of the targets of the previous rule. Inactivity means holding cash, assets of insignificant value, shares in another inactive company, making loans to certain connected parties.

Obviously, the abolition of paragraph 11 and the introduction of the new active company rule does not mean that close trading companies need no longer worry about investment businesses. There is still the test for what constitutes a trading company, and what does not, as detailed above and this requires that investment activities are not substantial.

Those who used the old paragraph 11 as a device to reset their taper relief clocks will not be best pleased by the repeal of that paragraph. It no longer has any effect for disposals after 17 April 2002 and so for these the clock has now not been reset at all, and they continue to face the problems of taper apportionments from which they were trying to escape.

Company sales of shareholdings

Despite my parting with the full £24.50 for the Bill, it represents defective goods since Schedule 8, introducing the relief for companies disposing of substantial shareholdings, has no paragraph numbers at all! At first I thought it was a new-fangled drafting idea but I do not believe that modernisation of the tax system has quite reached that far yet.

The Schedule sets out an amazing relief, which was at one time set to apply only to 30 per cent shareholdings, but this has been reduced down to a requirement of only 10 per cent. Companies have never had it so good. A whole tax planning industry has not quite been wiped out but certainly cut down to size. There are, of course, important conditions and the main one is that both the company being sold and also the vendor company must be trading companies within the same definition as applies for taper relief purposes, described above. If the activities of either vendor or subsidiary include 'to a substantial extent' non-trading activities, there is no relief at all, not even a proportionate relief. Nor will it do to shunt investment assets out of either company with a view to getting the relief on a sale, as the conditions have to be applied over the full qualifying period of time which starts up to two years before the date of disposal. Advance planning will, however, succeed if it is carried out ahead of the two-year period and so no doubt there will be much planning work for corporate groups to undertake over the next few months.

Melville and all that

Yet another friendly provision in the Bill relates to the capital gains tax scheme which surfaced in Melville v Commissioners of Inland Revenue [2001] STC 1271. Variations of the scheme will still work and, in fact, the variations were in any event regarded by many as the best way of proceeding.

To recap, the basic strategy was to hold over a capital gain to a discretionary trust, whilst minimising the chargeable transfer for inheritance tax purposes by the settlor retaining a power to appoint the funds back to himself. Paragraph 116 of the Finance Bill now decrees that any power exercisable in relation to settled property is no longer 'property' for inheritance tax purposes - exactly the point argued by the Revenue in the Melville case. So the scheme in its basic variety no longer works.

What does work, however, is the alternative scheme which is where the settlor has a deferred interest under the terms of the trust. This still requires an initial discretionary period, but that should be followed by either a fixed term interest in possession to the settlor, enduring for say fifty years, or, more simply, a full reversionary interest retained by the settlor. During the discretionary trust period, the settlor may give away whatever interest he has retained in the trust which arises after the initial discretionary period. These schemes are unaffected by the Finance Bill.

The Budget day press release made a cryptic remark about avoidance schemes and the Finance Bill now reveals what was in mind here. Suppose that a settlor forms a trust with £500,000 in which he has a short term interest, following which the funds are subject to a general power of appointment exercisable by his son. The son could sell his general power to a friendly charity for, say, £495,000 and the settlor, his father, could then purchase the power from the charity for the full £500,000, thus giving it a small profit. The gift in settlement would not be a transfer of value as the settlor has an interest in possession and the bargains with the charity would be either covered by the charity exemption or the exemption for commercial bargains. The result would be a tax-free transfer of £495,000 to the son. The Finance Bill prevents the purchase by the father of the power from the charity from benefiting from the charity relief and states that it is to be a transfer of value. This is an abstruse avoidance scheme which did the rounds about twenty years ago with reversionary interests but clearly the Revenue has never forgotten about it.

Bad debts and VAT

Paragraph 22 of the Bill introduces the new user-friendly VAT bad debt relief. I have always enjoyed writing those nice letters to bad debtors - 'in view of your default the amount due from yourselves has been claimed as a bad debt and as a result Her Majesty's Customs and Excise now require you to repay the VAT claimed in respect thereof'. I will have to find some different fun in life now as bad debt relief is to become automatic after six months of non-payment and the notice to the debtor will no longer be necessary.

The important point for the present is that the new rule will be brought in by statutory instrument and will take effect from a future appointed day. Therefore the existing system continues for the time being. Once the new system is brought into force, the other side of the coin is that any supplier's invoice which remains unpaid after six months will no longer be eligible for input tax relief. If relief has been claimed for it, an adjustment must automatically be made in the input tax account.

Elevated status for a concession

… Or was it never a concession in the first place? To be precise, it was a Statement of Practice, which sounds as though it was half way between a concession and an interpretation of the law. The Statement was SP5/85 which gave birth to the term 'press release reconstructions', which term apparently gave rise to a belief that if something was called a reconstruction, then it must be a reconstruction. The High Court decision in Fallon v Fellows [2001] STC 1409 positioned itself half way between the two viewpoints! If the reorganisation of a company's share capital into separate new categories of shares was carried out as part of a plan to demerge the two groups of shareholders, there was no reconstruction. If, however, the separation of the two groups had been in place for some time, there might be a reconstruction if subsequently the company's business were subdivided between two new companies.

Schedule 9 to the Bill introduces the new statute to replace the Statement of Practice and is effective from 17 April 2002. Paragraph 4 of a new Schedule 5AA to the Taxation of Chargeable Gains Act 1992 makes it clear that the procedure carried out in Fallon v Fellows will now be a reconstruction, even though in that case Mr Justice Park thought that the division of the company into A and B shares endured for probably no longer than about half an hour.

This amounts to a statutory override for most tax purposes of the decision in Brooklands Selangor Holdings Ltd v Commissioners of Inland Revenue [1970] 1 WLR 429 and because of the read-through of references to the capital gains provision into various sections in the Taxes Act 1988 there will now be few situations where general law applies in a tax context as regards what is and what is not a reconstruction.

There is unfortunately no amendment to the stamp duty relief in section 75, Finance Act 1986. This applies a very stringent relief to certain reconstructions, but in any event section 75 contains its own (very hard to satisfy) rule and so one was rarely worried about whether or not there was a reconstruction for that purpose.

Charities

In keeping with modern life as we know it, a new relief, introduced as recently as 2000, is being amended. I always thought it odd that the relief for gifts to charities in the Finance Act 2000 was restricted to quoted investments or authorised units and, sure enough, the current Finance Bill now extends the relief. Gifts of freehold or leasehold interests in land in the United Kingdom to charity are now also brought within the relief. Although they did not know it at the time, taxpayers could make such tax efficient gifts with effect from 6 April 2002, or 1 April in the case of companies. A procedure must be followed, and in particular the charity has to issue a certificate to the donor before tax relief can be claimed.

Clause 97 of the Bill introduces the new carryback relief for cash donations to charities under gift aid. This has a delayed start date as it only applies to gifts made on or after 6 April 2003 and then only to gifts made 'on or before the date on which the donor delivers his return for the previous year of assessment', and in any event no later than the 31 January filing date for that return; an election must be made to the Revenue within these time limits. I would suggest that this provision needs serious reconsideration. As it stands, no firm will be able to file the returns of clients until shortly before the 31 January deadline, in case the client should make a gift aid donation and want it carried back. As drafted, if the return has been filed the possibility for carryback expires at that time and the firm will be open to criticism from the client.

Mandatory e-filing

Clause 132 of the Bill introduces mandatory electronic filing of employers' end of year returns. This will apply to the largest employers with 250 or more employees for the year 2004-05 onwards and will be phased in for all other employers up to 2010 when all returns must be submitted electronically. Big business will have no problem with this at all, but what about elderly people employing cleaners, helpers, and other domestic staff? The burdens on them of operating pay-as-you-earn are already disproportionately heavy and to require them to adopt electronic filing seems to me to be plain wrong. There is a final poke in the eye for these vulnerable employers in the Treasury's 2002 Budget Report where it describes this measure as 'easing the burden of payroll'.

Paragraph 132 is widely drafted and some suspect that it heralds the dawn of a new era: mandatory electronic filing of all self assessment returns, probably to start in about 15 years time. Paragraph 132 is the heavy boot of a dictatorial Government.

Trading losses and capital gains

I stand corrected! I am by no means the only one to have misunderstood the Budget day press release which announced an amendment to the provision (section 72, Finance Act 1991) which enables trading losses to be set against capital gains. I scorned a change which is actually very much in the taxpayer's favour and is in response to representations! In my defence I plead that the press release was misleading in its general description of the measure.

Maurice Parry-Wingfield has contacted me to explain that under the existing rule, the maximum amount of trading losses which can be set against chargeable gains are those gains as reduced by taper relief, but disregarding the annual exemption. That amount is then converted into an allowable loss and set against the gross untapered gains for the year (as with other allowable losses). This mathematical process can result in only some of the trading losses being used, whilst some of the gains remain in charge to capital gains tax, less the applicable taper relief.

This was an anomaly which sprang up on the introduction of taper relief and the Revenue has kindly agreed to change the rule so that the maximum losses which can go against gains are calculated by reference to the untapered gains and not the tapered gains.

This comes into full effect for trading losses sustained in the year 2004-05 and thereafter. An optional relief along similar lines is also introduced for 2002-03 and 2003-04 and Maurice Parry-Wingfield explains this as follows:

Termination payments

Schedule 6 to the Bill makes some 'minor amendments to Schedule E charge' mainly in relation to the termination payment provision in section 148, Taxes Act 1988. It will be recalled that section 148 charges termination payments in excess of £30,000 to tax under Schedule E, insofar as they are not otherwise chargeable. Various Schedule E benefits have a specific exemption and these are now also excluded from being brought into account for the purposes of section 148. Examples are mobile phones, computer equipment and work-related training.

There is also a provision headed 'Priority of charges under sections 148 and 595, Taxes Act 1988', the latter being the charge on the employee in respect of payments into an unapproved retirement benefit scheme. Now, the charge under section 595 applies only if, 'disregarding section 148', it is not otherwise chargeable to tax. Since section 148 has both a charging provision and an exemption, it is a little difficult to see exactly what the priority is! I believe that the intention is to disregard the charge under section 148 so that section 595 ranks before section 148, but all will no doubt be revealed in the Treasury Notes on Clauses, not available at the time of writing.

A weighty tome

There have been many complaints about the size of the Finance Bill and this is partly the result of various major changes in the tax system converging at one time: the new reliefs for research and development expenditure and disposals of shares by companies and the new régimes for loan relationships, Forex and for intangibles. Mostly, however, it is a friendly Bill and it is pleasing to note that representations on various topics have been taken on board.

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