Feature

posted 2 Jun 2003 in Volume 8 Issue 4

Finance Bill 2003: The private-client perspective

The November pre-Budget statement and even the Budget itself may have lulled private-client practitioners into a false sense of security. In fact, the Finance Bill 2003 has now been published, takes two volumes and reveals a plethora of detailed changes, which could affect private clients. Emma Chamberlain, a barrister at 5 Stone Buildings, outlines the key areas of particular interest to practitioners.

National insurance and income-tax changes

The starting, basic and higher income-tax rates are unchanged for 2003/04 at, respectively, 10 per cent, 22 per cent, and 40 per cent. The rate applicable to the income of discretionary and accumulation trusts (non-settlor interested) remains unchanged at 34 per cent and the schedule F trust rate on dividends is also unchanged at 25 per cent. Trustees, of course, are not directly affected by the 1 per cent increase in national insurance, which takes effect from 6 April 2003.

The national insurance hike provides an even greater incentive for the self employed to incorporate and remunerate themselves by way of dividends. Share arrangements, whereby company proprietors hold different classes of shares so that dividends can be paid on different shares without the need for waivers, are also more likely. Note, however, that the Revenue is attacking arrangements where shares are held by husband and wife, with the husband doing the major work for the company and both drawing out the profits by way of dividends. The settlements legislation is being invoked so that the dividend income received by the wife is taxable on the husband. There are ways of refuting this argument, but some care is needed. The latest Revenue Tax Bulletin gives some examples of where the Revenue may take this point.

Capital-gains tax (CGT) changes

The annual exempt amount has now increased to £7,900 for 2003/04 for individuals. Individuals with gains in excess of this will be liable to CGT at rates of 10 per cent, 20 per cent or 40 per cent, in line with the rules for savings income. Gains will thus be charged at 10 per cent where the gains, when added to taxable income, do not exceed the starting rate limit of £1,960. Gains falling between the starting rate limit and the basic rate limit (£30,500) will be taxed at 20 per cent and gains in excess of this latter amount will be taxed at 40 per cent.

Trusts will still pay CGT at the rate of 34 per cent (both interest in possession, discretionary and accumulation, provided they are not settlor interested) and the annual CGT exemption for most trusts becomes £3,950. A number of measures have been introduced as a result of the Capital Gains Tax Policy Review, a simplification of which is set out below.

Change in reporting requirements

For 2003/04, individuals, trustees and personal representatives will not have to report gains if their total proceeds do not exceed £31,600 (four times the exempt limit for individuals) and either:

Their pre-taper gains before deducting losses do not exceed the annual CGT exemption;
There are no allowable losses and there is no CGT liability once taper relief has been applied to the gain.

Thus, if a taxpayer wants to claim losses they will need to fill in a capital-gains page. However, disposals of CGT-exempt assets such as chattels (not houses) and transfers between spouses do not count towards the proceeds limit of £31,600.

Note that even trustees benefit from the reporting limit of four times the annual individual exemption.

Change in reporting requirements: Example

Suppose Mr Dixon sells an asset realising a gain of £10,000 and a loss of £4,000. The total proceeds are £25,000. Even though his aggregate sale proceeds do not exceed £31,600 and there is no CGT, he will still be required to report the disposal in his tax return because gains before taper relief and before any allowable losses exceed the annual exemption. On the other hand, if the gain post-taper relief had been £3,000 then the client is not obliged to report the disposal.

Business-asset taper relief

There have been changes to the taper-relief regime in almost every year since the Finance Act 1998. The year 2003, is no exception although the changes are more limited than in previous years. Remember that following the acceleration of rates introduced in the Finance Act 2002, gains on business assets will qualify for taper relief at 75 per cent after two years of ownership. Thus, for a higher rate taxpayer, the gain on a disposal of the asset will be 10 per cent (40 per cent of 25 per cent).

Taper relief is an immensely complicated tax, particularly given that an asset, which did not qualify as a business asset prior to 6 April 2000 and does now qualify, will be subject to the apportionment provisions and separate calculations. Separate calculations will need to be made of the tax liability in each of those periods.

A new apportionment provision and, therefore, a further complication has been introduced by clause 159, presumably as a result of extensive lobbying from the property industry.

Up to now, let property has only qualified for business-assets taper relief if either:

It is furnished holiday accommodation;
It is used by a partnership of which the property owner is a partner;
It is used by a qualifying company, such as an unlisted trading company or a listed trading company, where the owner is an employee or owns five per cent voting of the shares.

Post 5 April 2000, it was not necessary for the property owner to be a shareholder or employee of the unlisted trading company in order to get business-assets taper relief.

It has now been decided that all assets used for the purposes of a trade carried on by individuals, trustees, personal representatives or qualifying companies will qualify for business-assets taper relief irrespective of whether the asset owner is involved in the carrying on of the trade. The new provisions will only take effect for periods of ownership from 6 April 2004 and the intention is that the landlord’s letting decision should be neutralised between incorporated and un-incorporated businesses.

Interestingly, it is only necessary that the property be used for trading purposes. If, for example, a piece of land is let to a solicitor’s firm who then sublet the premises to another partnership, business-assets taper relief can still be obtained on the whole, provided all the premises are used for trading purposes.

Business-asset taper relief: Example

An individual A owns a business park divided into separate units and lets out five of the units. All lettings commenced after 6 April 1998 but before 6 April 2004. Unit 1 is let to individual B, who uses it for her trade. Unit 2 is let to a partnership C whose membership consists of companies, one of which is an unlisted trading company. The partnership uses the unit for the purposes of its trade. Unit 3 is let to a listed trading company, which uses it for the purposes of its trade; A is not employed by this company and does not own five per cent of the shares in it. Unit 4 is let to partnership D, whose members are all individuals (one of whom is A), but the premises are not used for the purposes of a trade. Unit 5 is let to an unlisted trading company, which uses it for its trade and A owns no shares in the company.

For periods of ownership before 6 April 2004, while the units are let as described, the business-assets status of those units for taper-relief purposes in relation to A will be as follows:

Unit 1 will not qualify for business-assets taper relief;
Unit 2 will not qualify for business-assets taper relief;
Unit 3 will not qualify for business-assets taper relief;
Unit 4 will not qualify for business-assets taper relief;
Unit 5 will qualify for business-assets taper relief from 6 April 2000.

From 6 April 2004:

Unit 1 will qualify for business-assets taper relief;
Unit 2 will qualify for business-assets taper relief;
Unit 3 will not qualify for business-assets taper relief;
Unit 4 will not qualify for business-assets taper relief;
Unit 5 will qualify for business-assets taper relief.

Losses on disposals of right to unascertainable deferred consideration

Suppose land is sold for £1m of which £500,000 is payable immediately and £500,000 on successful planning permission being obtained.

Tax will be paid on the whole £1m even though some of the consideration is deferred and may be conditional. The Revenue will refund the tax when it is satisfied that the additional amount will not be paid (see section 49 TCGA 1992). Instalment relief can be claimed in certain circumstances if the consideration is paid in instalments exceeding 18 months (see section 280 TCGA 1992).

However, suppose an asset (for example, shares or land) is sold for, say, £1m cash, plus an additional amount calculated on a formula basis related to the post-sale profits for the next two or three years.

Under the principles established in Marren v Ingles [1980] STC 500, the expected net value of the right has to be included as part of the vendor’s taxable consideration for the disposal of the asset. Thus, in the above example, if the right is valued at, say, £10,000, the taxpayer will be taxed on proceeds of £1,010,000 and taper relief will be available on such proceeds in the usual way.

As and when the earn-out payments are received, further CGT disposals arise in respect of the earn-out right itself representing capital sums derived from the right to receive the earn-out and not the disposal of the underlying property.

If, for example, the taxpayer eventually receives £20,000 from the earn-out, he is then treated as making a further gain on the disposal of the right of £10,000, but this right is a non-business asset and, therefore, taper relief at the lower rate will only be available after three complete years from the sale date.

If, however, nothing is received on the earn-out, then the taxpayer has effectively realised a loss of £10,000, which could not, until now, be carried back to reduce his original capital gain. Thus, the taxpayer has suffered tax on an amount that exceeds his overall economic gain from the earn-out transaction.

Clause 161 now provides that a taxpayer can elect for an allowable loss, which would otherwise accrue to him in one tax year to be treated as accruing to him in an earlier tax year in respect of the gains from the earlier transaction.

It is always likely to be worth making the election, even where there are gains in the year in which the loss arises, especially if the loss goes back to pre-taper relief years leaving the full gains of later years to be chargeable after taper-relief allowance.

The election must be made no later than the first anniversary of 31 January, immediately following the end of the year of the loss. Thus, if the year of the loss is 2004/05, the taxpayer must give notice no later than 31 January 2007 (see example below).

Losses on disposals of right to unascertainable deferred consideration: Example

In December 2000, that is, tax year 2000/01, Mary disposes of her original asset consideration for cash of £200,000 and a right to receive a further cash sum of an amount that is uncertain because it depends on future events valued at £50,000. She realises a gain of £100,000 chargeable to CGT and pays CGT on the gain for the tax year 2000/01.

In June 2003, that is, 2003/04 tax year, she disposes of a right to the further payment of £40,000 and realises a loss for CGT purposes of £10,000. She elects to treat that loss as a loss of the tax year 2000/01 reducing her net-gain liable to CGT for £90,000. Any tax overpaid as a consequence of the election will be repaid to her.

The loss cannot be carried back earlier than the year in which the earn-out right is conferred.

Earn-out deals – shares/loan notes clause 160

Suppose an earn-out is structured so that it is satisfied only in the form of shares and/or loan notes in the acquiring company (when the relevant earn-out consideration is determined). Under the finance bill 2003, where the vendor’s earn-out right can only be satisfied by shares and/or loan notes in the acquirer, this is automatically deemed to be a security. Thus the vendor avoids the “up-front” tax charge based on the value of the right. This clause reverses the elective provisions in section 138A.

It is possible to elect to opt out of this automatic treatment.

Offshore trusts – clause 162 and schedule 29

These provisions amend schedule 4C. This is one of the schedules dealing with transfers of value linked to trustee borrowing introduced by FA 2000. Schedule 4C deals with the position where, as a result of the transfer of value linked with trustee borrowing, chargeable gains are treated as accruing to an offshore trust, but are not charged on the settlor under section 86 on an arising basis (see example below).

Offshore trusts: Example

Offshore trust had substantial unrealised gains. Trustees would borrow in year 1, advance to trust B. In year 2, trust A would realise gains, but by that time the settlor and all defined persons were excluded. Effectively, the unrealised gains in trust A would escape the section 86 charge and would not be carried forward into trust B for the purposes of section 87. Any stockpiled gains realised prior to the flip-flop would be carried across in the normal way under section 90.

Schedule 4B was enacted to counter the flip-flop scheme. Whenever there was a transfer of value linked with outstanding trustee borrowing (widely defined), unless it was employed for normal trust purposes, the result was a deemed disposal of the trust assets remaining.

In the above example, on the transfer of the borrowing to trust B, trust A will, post FA 2000, be deemed to have made a disposal of the assets remaining in trust A. These gains would be taxed on the settlor if section 86 was applicable or else they would go into a separate pool under schedule 4C.

That, in itself, gave rise to a further scheme. If, in the above example, there had been unrealised gains of say £400,000 but stockpiled gains realised prior to 1998 of £1m, the Finance Act 2000 opened up a way of preventing section 87 gains from being carried across to trust B, to the extent that the transfer was under schedule 4B linked to trustee borrowing. If, for example, the trust was largely liquid, trust A could borrow a substantial sum and make a corresponding advance to trustees. The effect of section 90(5)(a) was that the section 87 gains in trust A did not carry forward to trust B, thereby enabling tax-free distributions to be made from trust B later.

Clause 162 in schedule 29 now amends the anti-avoidance legislation further. If there is a deemed disposal under schedule 4B, a pool of schedule 4C gains arises, but this includes not merely the schedule 4C gains, but also any gains in the section 87 pool as at the end of the tax year in which the transfer linked to the trustee borrowing occurs. Note: Schemes pre-April 2003 can be caught if the transferee settlement has not yet ended.

The new legislation creates many anomalies, including the need for four or five separate pools of gains and different base costs.

Schedule 4C gains going into the pool after 8 April can no longer be washed out on payments to non-residents or non-domiciliaries.

Reversal of Mansworth v Jelly [2003] STC 53

Under this decision, the Court of Appeal decided that, where shares were acquired under an option granted to an employee, the acquisition cost was the market value of the shares at the time the option is exercised. However, the Revenue announced that in the case of shares acquired under certain unapproved employee share options, the acquisition costs were further increased by any amount charged to income tax in respect of the exercise. Thus, if the shares were sold shortly after the option was exercised, as was generally the case, a significant capital loss would inevitably arise equal to the amount on which income tax was paid on the exercise.

The government has reserved the effect of the decision in Mansworth v Jelly, but only in respect of options exercised on or after 10 April 2003 (not even budget day). Where options are exercised on or after 10 April 2003, the market value rule will not apply to substitute market value for the amount payable when the option is exercised.

Inheritance tax

The inheritance tax nil-rate band threshold has gone up by the statutory indexation for 2003/04 from £250,000 to £255,000.

There were no changes stopping Eversden or home-loan schemes. However, the Court of Appeal has just given judgement in favour of the taxpayer, presumably in time for the Revenue to amend the Finance Bill if they wish.

Residence and domicile

The Treasury and Inland Revenue have published a 42-page background paper on residence and domicile as a basis for debate. While most of this summarises existing tax systems in the UK and internationally, it concludes with principles that the government sees as the basis for any reform of the current rules. The stated objective is that any rules should be fair, support the competitiveness of the UK economy, and be clear and easy to operate. The proposal is to establish rules that:

Provide objective criteria for determining when a long-term or temporary connection is severed, suspended and restored;
Establish an appropriate divide between long-term and temporary connections to the UK;
Are transparent, provide clear and unambiguous outcomes, and minimise the compliance burden on individuals and their employers;
Present minimal opportunities for exploitation or avoidance.

There is likely to be a move away from domicile as a defining factor in UK taxation. New rules will distinguish between residents with a long-term or temporary connection to the UK. Those with a long-term connection will be liable to tax on worldwide income, gains and assets.

Emma Chamberlain is a barrister at 5 Stone Buildings. She can be contacted at: emma@jmchamberlain.freeserve.co.uk.