Sense of proportion

KEY POINTS

• Motive test for transferring assets abroad.
• Gains on assets held through a non-UK resident company.
• EU says the rules are disproportionate.
• Upward or downward harmonisation.
• Certainty may be a long time coming.

The European Commission announced in February that it had issued a formal request to the UK government to amend two key anti-avoidance provisions, on the grounds that they were discriminatory and therefore contrary to EU law.

The provisions are the transfer of assets abroad rules in ITA 2007, Part 13 Chapter 2 and the attribution of gains to members of non-UK close companies under TCGA 1992, s 13. These have long been a key part of the government’s armoury against tax avoidance, the first having originally been enacted in the 1930s.

The European Commission argues that these provisions restrict the exercise of two of the fundamental freedoms of the European single market, i.e. the freedom of establishment and the free movement of capital.

While the European Court of Justice has held, for instance, in Thin Cap Group Litigation C-524/04, that a restriction on the freedom of establishment is justifiable in the context of wholly artificial arrangements entered into for tax reasons alone, the commission has stated that it considers that the above two provisions are ‘disproportionate’, going beyond what is necessary to protect the UK tax base.

Transfer of assets abroad

The transfer of assets abroad rules apply where each of four conditions is met:

• there has been a transfer of assets made or procured by an individual;
• as a result of the transfer and/or any associated operations, income has become payable to a person abroad;
• the individual who originated the transfer has power to enjoy that income in some way as a result of the transfer and/or any associated operations; and
• the individual is ordinarily resident in the UK in the year of liability. There is, however, no requirement that the individual be resident or ordinarily resident in the UK at the time of the original transfer.

‘Power to enjoy’ is very widely defined and includes actual or potential benefit, arrangements designed to accrue the income for the transferor’s benefit and non-fiduciary powers of control.

Where the rules apply, all income of the person abroad, which may be a company, a trust or a partnership, that is earned as a result of the original transfer and any associated operations will be taxed on the original transferor on an arising basis, whether or not that person actually receives any of the income in that tax year.

There is also a subsidiary charge which applies where an ordinarily resident individual, other than the transferor, receives a benefit which is not otherwise chargeable to income tax out of assets which are available as a result of the transfer.

Typical situations in which an individual or family business may be caught include the examples: Harry, James and Richard. They are all ordinarily resident in the UK.

Motive test

There is a motive test which, if met, exempts individuals from liability to this charge. This test was controversially amended in December 2005, so that two different sets of conditions apply.

For transactions effected on or before 4 December 2005, individuals will be exempt from the charge if they are able to satisfy HMRC that the avoidance of tax was not the purpose, or one of the purposes, for which the transfer or any associated operations was effected, or that the transfer and any associated operations were genuine commercial transactions and were not designed for the purpose of avoiding liability to taxation.

HMRC have specifically stated that they consider ‘genuine commercial transactions’ to refer only to the furtherance of a trade or business, and not to the making or managing of investments. This is a subjective test which looks at the actual motives of the individual in carrying out the transfer.

The aim of the change was to make the test more objective. For transactions effected after 4 December 2005, the exemption only applies if the individual is able to satisfy HMRC that it would not be reasonable to draw the conclusion from all the circumstances of the case that the purpose of avoiding liability to taxation was the purpose, or one of the purposes, for which the relevant transactions were effected.

If this condition is not met, the exemption will still be available if HMRC are satisfied that the transfer and all associated operations were genuine commercial transactions, and that it would not be reasonable to draw the conclusion that any one or more of those transactions was more than incidentally designed for the purpose of avoiding liability to taxation.

The sting in the tail of the post-4 December 2005 test is that in determining the purposes for which any transaction is effected, the motives not only of the taxpayer, but also of anyone who has designed, advised on or implemented the transactions must be taken into account.

Thus, where advisers have been asked to consider UK tax issues in preparing their advice, HMRC are able to draw the conclusion that the design of the resulting transactions has included the purpose of avoiding liability to taxation. The taxpayer will then need to disprove this conclusion to obtain the exemption.Non-UK companies

The above provisions apply only to individuals. TCGA 1992, s 13, however, applies both to individuals and companies. It addresses the avoidance of tax on capital gains by holding assets through a non-resident company which the taxpayer controls. On disposal of the assets, any gains would, in the absence of s 13, be outside the charge to UK tax.

The provisions apply where a gain accrues to a non-resident company which is either under the control of five or fewer participators or is under the control of participators who are directors, and a person who is resident or ordinarily resident in the UK is a participator in that company. A participator is any person who has a share or interest in the capital or income of the company.

A just and reasonable proportion of the gain is attributed to all UK participators; this will usually be in proportion to their shareholding in the company. Generally speaking, a just and reasonable apportionment will not result in any proportion of the gain being attributed to a loan creditor, unless that creditor has a genuine economic interest in the gains of the non-resident company.

There is no charge to tax on any participator to whom the proportion of the gain attributable does not exceed 10%. The gain is calculated as though it had been made by a UK resident company, with indexation.

It is then taxed in the normal way, so that if the participator is an individual, the attributed gain is subject to capital gains tax at 18% or 28% after the annual exemption, if available.

There is no charge on UK participators if the asset sold was used only for the purposes of a trade carried on by the non-resident company outside the UK.

There is no motive test for TCGA 1992, s 13, so the rules will apply wherever a non-trading asset is sold by a non-resident close company. It is not uncommon for an owner-managed business to be held through a non-resident holding company, or to be transferred before disposal to a non-resident company.

If non-trading assets are held within that business, care must be taken when disposing of that business to avoid suffering an immediate charge on attribution of the gains made by the non-resident company.

The TCGA 1992, s 13 charge does not apply where a double tax treaty exists between the UK and the country of residence of the non-resident company which provides that gains of the type realised by the non-resident company are taxable only in its territory of residence. Where the charge does apply, relief is available for any foreign tax paid.

Where the shares in the non-resident company are held by a non-resident trust, gains made by the company are apportioned to the shareholding trust. While the trust itself will not usually be liable to UK capital gains tax, the gains of the trust may be charged on UK resident settlors and beneficiaries.

The objection

Under the EC Treaty, domestic legislation must be consistent with the fundamental freedoms. These include the freedom of establishment and the free movement of capital.

Article 43 prohibits any restrictions on the freedom of establishment of nationals of a member state in the territory of another member state. This prohibition extends to restrictions on nationals of any member state setting up subsidiaries in the territory of any member state.

Article 56 prohibits ‘all restrictions on the movement of capital between member states and between member states and third countries’.

In light of ECJ direct tax case law, a potentially unlawful restriction may be defined as any situation in which a member state’s tax system results in a difference in treatment of taxpayers in similar circumstances.

For instance, a taxpayer investing in his home state is not subject to tax on income from that investment, while a taxpayer exercising his freedom to invest in another member state would be subject to tax on the same income.

On the face of it, the provisions in question are contrary to both Article 43 and Article 56. This is because they impose an earlier and frequently more substantial tax charge on taxpayers who own shares in a non-resident company, or who have an interest in any other non-resident income-earning entity, than that which is imposed on taxpayers whose investments are within the UK.

Thus, they restrict the right of UK residents to exercise their freedom to establish subsidiaries or to invest in other member states.

However, Article 56 is subject to the assertion in Article 58 of the right of all member states ‘to take all requisite measures to prevent infringements of national law and regulations, in particular in the field of taxation’.

Since both the transfer of assets abroad rules and the provisions of TCGA 1992, s 13 are anti-avoidance provisions, the argument has always been that they are necessary to prevent the artificial use of offshore structures to avoid UK tax.

The reasoned opinion issued on 16 February sets forth the view of the European Commission that these rules are ‘disproportionate, in the sense that they go beyond what is reasonably necessary in order to prevent abuse or tax avoidance’.

In Cadbury Schweppes C-196/04, the ECJ held that the UK’s controlled foreign company (CFC) rules constituted a restriction on the freedom of establishment. Such a restriction was justifiable only if the arrangements caught by the legislation were ‘wholly artificial arrangements’. Thus, if a CFC had real commercial substance, the legislation should not apply to it.

With regard to the transfer of assets abroad legislation, there is a motive test which should, in theory, allow genuine commercial arrangements to escape the charge. However, in practice, particularly since the rule change in 2005, it is very difficult to pass this test.

Even before 2005, the courts had held in R (on the application of Carvill) v CIR [2002] STC 1167 that the onus is on the taxpayer to prove that there is no tax avoidance purpose in order to be able to claim the benefit of this exemption, and not on HMRC to prove that such a purpose does exist.

Furthermore, despite rulings to the contrary in cases such as Beneficiary (SpC 190), HMRC hold the stated view that if a transaction involves a foreseeable reduction in tax, that must be one of its purposes, regardless of the transferor’s actual subjective intentions.

In addition, unlike most other anti-avoidance provisions for which a motive test exists, e.g. CFCs and transactions in securities, no formal advance clearance procedure is available to give taxpayers certainty before completing their tax returns.

In TCGA 1992, s 13, there is neither a motive test nor an advance clearance procedure. It is thus impossible for a holder of at least 10% of the share capital of a non-UK resident company to avoid a charge on the disposal by that company of non-trading assets, regardless of the intention of either the shareholder or the company.

Avoiding discrimination

There are two main ways in which a government may amend legislation to eliminate discrimination and comply with EU law: upward harmonisation and downward harmonisation.

Upward harmonisation entails improving the situation of the party which was formerly discriminated against, to treat both the advantaged and disadvantaged party equally well.

Examples of this approach in the past include the recent introduction in the UK of dividend exemption rules which cover dividends received both from the UK and from overseas, where previously UK dividends were exempt from UK tax, while dividends from overseas were taxable with a credit for overseas tax paid.

Downward harmonisation involves removing the benefit to the advantaged party by imposing a charge on or removing a relief from all parties. This is the approach taken by the UK in 2004 when it extended the transfer pricing rules, previously applicable only to transactions between the UK and other jurisdictions, to transactions taking place wholly within the UK.

In the current case, downward harmonisation might involve extending the anti-avoidance rules set out above to wholly domestic transactions, perhaps with additional exemptions or the introduction of a more user-friendly motive defence.

However, the administrative burden that such an approach would impose for the sake of very little additional tax revenue makes such an approach unlikely.

A more likely alternative, and one which the government is likely to prefer to the complete abolition of such key anti-avoidance provisions, would be to relax the motive test for the transfer of assets abroad provisions and introduce one for the attribution of gains to members provisions. Then only genuinely abusive transactions would be caught by the rules in the future.

This could be accompanied by the introduction of a formal clearance procedure to give taxpayers certainty that transactions without a tax avoidance motive are not caught by the rules.

There has been no indication as yet of the approach which will be taken. The issue of a reasoned opinion is the first formal stage in the European Commission’s infringement procedure, and the government has been given two months to respond.

Its initial response was to state that it did not accept that it was infringing EU rules (although this is to be expected). It may now decide to amend the rules, and it will be interesting to see whether there are any announcements in this regard in the Budget.  

Alternatively, it may decide to sit it out and argue that the current rules are not contrary to EU law. In that case, the commission may decide to institute proceedings against the UK government in the ECJ. The current uncertainty could then persist for years to come as the case grinds its way through the court.

What should clients do?

Given the uncertainty about the future of these provisions, taxpayers may wish to review their position. If they are currently subject to charges under either the transfer of assets abroad rules or TCGA 1992, s 13, they may decide to make a claim for such income or gains to be exempt from tax on the basis that the rules are contrary to EU law.

Clients who are considering putting into place structures which involve offshore companies or trusts may also be tempted to use an EU jurisdiction such as Cyprus or Malta in preference to other offshore destinations.

A word of caution must be sounded on the length of time that may elapse before we have certainty on the tax treatment of such an investment, and many taxpayers may now choose a purely UK structure to gain certainty on their tax treatment at an earlier stage.

Whatever the outcome, taxpayers and advisers alike will eagerly await further developments in this area.

Liz McCarthy PhD CA CTA is a freelance tax writer, specialising in anti-avoidance, capital gains tax and domestic and international corporate tax. Contact her by email or tel: 07973 715396.

Issue: 4297 / Categories: Comment & Analysis , EU