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KEY POINTS
- Advancing income should mitigate 50% tax liabilities.
- A partnership case study with termination.
- The tax treatment of a payment made on the termination of a lease.
- Is there scope to make a capital rather than income payment?
- The effect of a change of accounting date.
- Payment date advanced, but liability may be reduced.
Many tax advisers are probably asking themselves what can be done for those who will suffer the 50% income tax rate in 2010/11.
This is likely to be a particularly acute problem for those who will be chargeable on a larger than usual amount of profits because of the termination of their business. I described the tax effects of termination in an earlier article (see The Damocles effect), and this was before an increase in tax rates was even a twinkle in the Chancellor’s eye.
The following case study illustrates something that may be considered, and also includes an interesting technical point on leases in passing.
Welcome to Paragon Towers
Mr and Mrs Paragon run a hotel in partnership. They acquired a 20-year lease of the property on 30 November 1989 by paying a premium of £3 million. The lease will expire at the end of November 2009 and the freeholder wants to sell the site so the lease will not be renewed. Statutory compensation for the termination of the business lease has been calculated at £460,000, twice the rateable value of the property.
However, the freeholder does not require the site immediately. An agreement has been reached under which the hotel business will continue for one more year, at the end of which the statutory compensation will be paid. During that year the rent will be reduced by £150,000.
An alternative has been considered: the rent will stay the same, but the compensation will be increased to £620,000 (slightly higher in total to reflect the timing of the payments and receipts).
The partnership prepares accounts to 31 July each year. In the year to July 2009, adjusted profits (after deduction of part of the lease premium as ‘extra rent’ in accordance with ITTOIA 2005, s 60 to s 67) were £480,000, split 60:40 between Mr and Mrs Paragon.
They expect profits to continue at roughly the same monthly figure right up to the closure of the business in November 2010 (this may be unrealistic, but it makes the numbers a great deal simpler). This profit forecast has been made on the basis of the reduced rental figure.
Paragon Towers was not so successful in the mid-1990s and Mr and Mrs Paragon have overlap profits brought forward of £24,000 and £16,000 respectively based on their profits in the year to 31 July 1997.
Mr and Mrs Paragon have, from time to time, considered incorporating their business – and they would surely have saved a fair amount of tax if they had done so.
However, they never did incorporate. They now think it is not worthwhile for the final period because they have decided to retire in November 2010 and would therefore liquidate the company at that point in any case.
The termination payment
HMRC’s Capital Gains Manual at CG72328 and following pages contains a useful analysis of the tax status of the compensation on termination of a business lease.
Even though the premium was paid for 20 years’ use of the land, a business tenant is entitled to apply for a further lease at the end of that period; and if the landlord wishes to oppose the grant of a new lease, compensation is generally due.
This will be equal to the rateable value of the property if the business has run for less than 14 years, and twice that if it has run for longer.
The case of Drummond (Inspector of Taxes) v Austin Brown [1984] STC 321 established that statutory compensation on the termination of a business lease does not derive from any asset and is therefore outside the scope of capital gains tax.
This seems a surprising and generous conclusion, but it is worth remembering that a substantial amount of the lease premium – considerably more than £460,000 – has never received any tax relief at all.
It cannot be deducted from profits because it is capital; on the other hand, it has ‘wasted away’ under the rules of TCGA 1992, Sch 8 and does not constitute a capital loss.
HMRC do not accept that the Drummond v Austin Brown case applies to all situations in which compensation is received on the termination of a lease – only to statutory compensation.
The Capital Gains Manual instructs inspectors to examine the lease itself to see if it provides for compensation. If it does, the compensation will be taxable – and presumably will not enjoy any deduction of base cost, because that has wasted away by the time the lease has expired.
If the compensation is higher than the statutory amount, or payable at a different time (e.g. for early termination by an impatient landlord), it is likely to be wholly or partly chargeable to capital gains tax. It may be possible to identify a statutory element which is free of tax, leaving the balance chargeable; or the circumstances may make the whole amount chargeable.
Higher compensation, lower rent
In the case of Paragon Towers, the year’s delay after the termination of the lease might cause HMRC to ask questions, but there seems to be little doubt that the £460,000 is simply statutory compensation and it should be tax-free.
If, instead, a higher amount is paid (and a lower rent charged), it seems likely that some or all of it will be chargeable to tax. If it were a capital gain, that would still represent a considerable saving – the excess of £160,000 would be charged at only 10% (after entrepreneurs’ relief) and profits subject to the higher income tax rates would be reduced by £150,000.
Even if the whole receipt of £620,000 was charged to capital gains tax, there could be a saving if the £150,000 extra rent enjoyed tax relief at a marginal rate of 50%.
However, it seems likely that the arrangement would be caught by ITTOIA 2005, s 99 et seq. (reverse premiums); the £160,000 would therefore be taxed as a revenue receipt of the trade and there would be no saving.
Overall, then, it seems that the simplest approach is also the best – the straightforward receipt of £460,000 on termination should be outside the scope of tax.
Profits
The cessation rules for income tax need to be considered very carefully when combined with a sharp increase in marginal rates of tax.
Table 1 shows the profits assessable if the current accounting date is retained.
Clearly, both Mr and Mrs Paragon will be 50% taxpayers on a considerable amount of profit. Still, they do have that tax-free compensation burning a hole in their pockets…
A better result can be achieved by changing the accounting date to 31 March 2010. The same total profit will be assessed in 2009/10 and 2010/11, but Table 2 shows what a difference it makes to the tax.
We can see from a comparison of Table 1 and Table 2, that £280,000 of profits have been moved from 2010/11 to 2009/10. As a result of the change of accounting date, this £280,000 will be taxed at 40% in 2009/10 rather than at 50% (and some at 40% on Mrs P, depending on her level of other income) in 2010/11.
The tax saving is up to £28,000, offset of course by the cashflow disadvantage of paying the tax a year early.
Because this change of accounting date is made in order to save tax, ITTOIA 2005, s 217 requires that there has been no other change of date in the preceding five years or the change will be disregarded in calculating the basis periods for income tax purposes.
The other conditions of s 217 appear to be satisfied, as long as notice is given to HMRC at the appropriate time (i.e. when the return for 2009/10 is submitted).
Conclusion
Anyone who is likely to be making more than £150,000 in 2010/11 should be considering ways to advance income into the relative haven of the 40% current top tax rate.
If current profits are running at a higher level than the overlap relief brought forward, a change of accounting date to 31 March is one way of doing this.
There does not have to be a termination of trade in prospect to make this advantageous, but saying ‘hasta la vista, baby’ to your client’s overlap relief by a change in accounting date may have the same effect.
Mike Thexton MA FCA CTA is a director of Thexton Training Ltd, author of the LexisNexis Online Quarterly VAT Update. He also presents courses on capital gains tax for Interactive Data.
