a capital gains tax update (to include entrepreneurs’ relief) · a capital gains tax update (to...

A CAPITAL GAINS TAX UPDATE (TO INCLUDE ENTREPRENEURS’ RELIEF)

Robert Jamieson MA FCA CTA (Fellow) TEP

Wayfarers Barn, Steventon, Basingstoke, Hampshire RG25 3AY Tel: 01256 782828 Fax: 01256 782076 Mob: 07801 932500

E-mail: [email protected] Contents Page No. Company distributions – capital or income? 2 New challenge to entrepreneurs’ relief on own share purchases 5 Take care with percentages 8 Shares with no right to a dividend 10 Reimbursement of purchaser’s costs 13 Assets appropriated to trading stock 14 © September 2017

www.mercerhole.co.uk

http://www.mercerhole.co.uk/

A CAPITAL GAINS TAX UPDATE

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1. Company distributions – capital or income?

(a) S35 FA 2016 introduced a targeted anti-avoidance rule (TAAR) which applies to certain company distributions in respect of share capital on a winding up made on or after 6 April 2016. This TAAR comes in the form of a new S396B ITTOIA 2005 and specifically treats a distribution on a winding up as an income distribution, but only where certain conditions are met. The legislation is aimed at what is known as ‘phoenixism’: this is when a profitable company enters into a members’ voluntary liquidation and a new business is set up to replace the old one and to carry on the same (or substantially the same) activities. In this case, the shareholders receive all the value of the company in a capital form while the trade continues (albeit now in the new structure) exactly as before.

(b) Although there is no provision for a statutory clearance in this measure

(which seeks to extend the ‘transaction in securities’ legislation), HMRC are beginning to receive clearance applications from taxpayers and their advisers. In an effort to clarify the situation, they have written to the CIOT with a standard reply which they are now using in response to these requests. A copy of this letter can be found on the CIOT’s website (www.tax.org.uk). The letter includes a number of examples, but these should not be seen as a substitute for the detailed guidance which HMRC have just published in the Company Taxation Manual (see Paras CTM36300 – CTM36350).

(c) HMRC’s letter restates the four conditions which must be present in order

for the TAAR to apply:

(i) the individual receiving the distribution in respect of a winding up must hold an interest of at least 5% in the company;

(ii) the company must either be a close company when it is wound up

or have been a close company at some point in the two years before the start of the winding up;

(iii) within a period of two years from the date on which the distribution

was made, the individual is involved in a similar trade or activity – for this purpose, he may carry on the new business in his own name, through a partnership, through another company in which he has at least a 5% interest or through a person with whom he is connected (working as an employee for a spouse or some other connected person will meet this condition); and

(iv) it is reasonable to assume, having regard to all the circumstances,

that the main purpose (or one of the main purposes) of the arrangements is the avoidance or reduction of an income tax liability.

HMRC’s view is that the last condition will narrow the application of the TAAR to ‘circumstances where, when considered as a whole, the arrangements appear to have a tax advantage as one of the main purposes’. There then follow three examples which seek to illustrate this last point.

(d) The first example looks at Mr A who had been the sole shareholder of a

landscape gardening company for 10 years. He has recently liquidated

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his company and retired. In order to subsidise his pension, he continues to do a small amount of gardening for people in his local village on a self-employed basis. Clearly, the conditions set out in (c)(i) – (iii) above have been met – gardening for his neighbours is a similar trade to the landscape gardening activities which his former company carried on. However, when viewed as a whole, these arrangements do not appear to have tax avoidance as a main purpose. It was natural for Mr A to have wound up his company, given that it was no longer needed once his main trade had ceased. HMRC confirm that Mr A’s distribution in the winding up would still be treated as capital.

(e) The next example involves Mrs B, an IT contractor. Whenever she

receives a new contract, she sets up a limited company to carry out the work. When the contract is completed and the client has paid her bill, Mrs B liquidates the company and takes out the profits as capital. Here, too, the conditions in (c)(i) – (iii) above have been met, given that Mrs B’s latest company is carrying on a similar trade to the previous one. However, in HMRC’s view, these arrangements have a different outcome. They say:

‘It looks like there is a main purpose of obtaining a tax advantage. All of the contracts could have been operated through the same company and, apart from the tax savings, it would seem that would have been the most sensible option for Mrs B. Where the distribution from the winding up is made on or after 6 April 2016, (it) will be treated as a dividend and subject to income tax.’

This is a more controversial decision. Does this view depend on the type of trade which Mrs B carries on? If, for instance, she had been a property developer where it has long been the customary practice for each new development to be undertaken through a separate company which is closed down when the project is completed, would HMRC have been of the same opinion?

(f) The final example concerns Mrs C who has been running her

accountancy practice through a limited company for the last three years. She decides that the risk involved in operating her own business is not worth the effort and so she decides to accept a job at her brother’s established accountancy firm as an employee. Mrs C winds up the company and begins life as an employee. The conditions in (c)(i) – (iii) above are again met because Mrs C is continuing a similar activity to the business carried on by her company. Note that she is doing so as an employee of a connected party – if the firm which she joined did not belong to a close relative, the TAAR would not be invoked. With reference to this example, HMRC state:

‘Looking at the arrangements as a whole, it is not reasonable to assume that they have a tax advantage as a main purpose and so (the condition in (c)(iv) above) will not be met. Mrs C’s company was incorporated and wound up for commercial, not tax, reasons. Although she works for a connected party, it is clear that the other business was not set up to facilitate a tax advantage, (given that) it had been operating for some time. In these circumstances, the distribution from the winding up will continue to be treated as capital.’


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(g) There is an exemption from the TAAR – see S396B(7) ITTOIA 2005 – where the distribution received by the individual:

(i) does not exceed his CGT base cost; or

(ii) only comprises irredeemable shares (as would be the case in a

liquidation demerger).


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2. New challenge to entrepreneurs’ relief on own share purchases

(a) There is a significant difference between the rates of CGT – especially where entrepreneurs’ relief is in point – and the higher rates of income tax. Unsurprisingly, this encourages shareholder directors to extract value from their companies in the form of a capital gain rather than as a dividend or salary.

(b) When a shareholder sells shares back to his company under an own

share purchase arrangement, the proceeds are prima facie taxed as an income distribution. However, CGT treatment is available provided that all the following conditions are satisfied:

(i) the vendor has held the shares for at least the last five years;

(ii) the vendor is resident in the UK;

(iii) the purchase by the company has been made for the benefit of its

trade (and was not part of any tax avoidance arrangements);

(iv) the company is an unquoted trading company or an unquoted holding company of a trading group;

(v) the vendor’s shareholding (including associates’ holdings) has

been substantially reduced – or eliminated – by the own share purchase; and

(vi) the vendor and his associates are not connected with the

company immediately after the own share purchase.

In these circumstances, the company can apply to HMRC in advance of the purchase of own shares for a formal clearance that the sale proceeds will be subject to CGT rather than to income tax.

(c) If the company has sufficient financial resources to pay the shareholder in

full, the own share purchase can go ahead without further complications. However, where the company cannot afford to meet the agreed purchase price, it is now customary to settle the required payment in tranches spread over a number of years. These so-called ‘multiple completion contracts’ are seen as an increasingly useful solution to this corporate dilemma. The company enters into a single unconditional sale contract with the vendor, with legal completion of the buy-back taking place on a series of dates in the future in respect of separate tranches of shares within the agreement. The vendor must give up his beneficial interest in the repurchased shares on entering into the contract and so he cannot subsequently take dividends or exercise voting rights over the shares. If he was a director of the company, he would normally resign his position at this stage. As far as CGT is concerned, the disposal of the entire beneficial interest in the shareholding takes place at the date of the contract. The vendor therefore needs to ensure that he has the means with which to meet the full tax liability by the 31 January following the tax year in which the multiple completion contract is made. It is understood that HMRC accept that a multiple completion contract is a valid arrangement provided, of course, that beneficial ownership passes at the contract date – see ICAEW TR745.


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(d) Unfortunately, HMRC have recently started raising an objection to vendors making an entrepreneurs’ relief claim in respect of that part of the sale proceeds which relates to the subsequent tranches. Their position appears to be based on the argument that a company does not ‘acquire’ the shares from the vendor shareholder given that, with a private company, it must normally cancel the shares returned to it under such an arrangement. As a result, the provision in S28 TCGA 1992, which fixes the CGT disposal date as the exchange date of the contract, does not apply. HMRC go on to say that the payments received for the subsequent tranches represent lump sums derived from an asset and are therefore subject to the legislation found in S22 TCGA 1992. Applying this section, the gain is taxed at the time when the proceeds are received, and not at the contract exchange date. If HMRC are correct in pursuing this line, entrepreneurs’ relief will not apply to that part of the gain applicable to the shares disposed of in tranches in view of the fact that the vendor will no longer be a director of the company.

(e) It is worth emphasising that, when an own share purchase clearance is

obtained under S1044 CTA 2010, this simply confirms that the transaction is not treated as an income distribution. It does not provide confirmation that entrepreneurs’ relief income is available. So the fact that the taxpayer has received his clearance is of no real comfort in this regard.

(f) One expert commentator has stated:

‘HMRC’s potential argument goes against the currently accepted technical analysis, as demonstrated by every learned article on multiple completion purchases of own shares. I do not see that there is a “nice” legal point on the concept of “acquisition” in the context of (such transactions). Indeed, we would rely on this very point when it comes to claiming a capital loss on a purchase of own shares – since there is no acquisition, the connected party loss rules should not apply.

In my view, multiple completion purchases of own shares do not involve any form of tax avoidance. The arrangements simply enable the company to defer part of the purchase consideration in a Companies Act-compliant manner. In fact, under conventional analysis, all the CGT is paid up front on the basis of the contract date per S28 TCGA 1992 (see (c) above) – so where is the mischief in that?

So what we have here is HMRC taking a very literal approach to the operation of S28 TCGA 1992 in a way that was never even contemplated by the draftsman or indeed Parliament. I strongly suspect that the reason why this point is being taken has something to do with the denial of 10% CGT entrepreneurs’ relief to some “innocent” taxpayer.’

(g) Reference was made earlier to ICAEW TR745 which dates back to April

1989. To the best of one’s belief, HMRC have never retracted their agreement to this technical release and so, if necessary, there must be a proper ‘legitimate expectation’ argument to be run in relation to multiple completion contracts which have already taken place.

(h) The same commentator continues:

‘If this point was ever (argued at) an appellate tribunal, I do hope that it would take a reasonable balanced – and purposive – view of what is


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going on here: an apparent U-turn in HMRC’s tax treatment of entirely legitimate purchase of own share transactions just to deny entrepreneurs’ relief.’

(i) Should HMRC ever succeed with this contention, one suspects that tax

practitioners will increasingly be advising vending shareholders to retain a 5% ‘sentimental’ stake in their companies, as well as thinking up a good reason for them to stay on for the time being as a part-time employee in some capacity! But, hopefully, it will never come to this.


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3. Take care with percentages

(a) There has been an interesting decision involving entrepreneurs’ relief and shares in the First-Tier Tribunal case of Castledine v HMRC (2016).

(b) It is well known that, in order to qualify for relief, Ss169I and 169S TCGA

1992 require an individual to:

(i) have held at least 5% of the company’s ordinary share capital and voting rights throughout a period of 12 months ended with the share disposal; and

(ii) have been an officer or employee of that company throughout the

same period.

(c) The definition of ‘ordinary share capital’ is taken from S989 ITA 2007 which says:

‘Ordinary share capital, in relation to a company, means all the company’s issued share capital (however described), other than capital the holders of which have a right to a dividend at a fixed rate but have no other right to share in the company’s profits.’

(d) The taxpayer (C) had been the commercial director of Park Resorts Ltd

until his retirement in September 2007, six months after the company had been acquired by Dome Holdings Ltd. In C’s absence, the business did not prosper and so he was called back in December 2008 to assist in a financial rescue which turned out to be successful. The rescue included a restructuring of Dome Holdings Ltd’s capital, under which C was allocated 5% of the company’s ordinary shares.

(e) In 2011/12, C disposed of loan notes in Dome Holdings Ltd (acquired at

the time of the takeover) which were worth £600,000 and, in 2012/13, he disposed of a further tranche worth £500,000. Both of these transactions gave rise to chargeable gains, against which C claimed entrepreneurs’ relief. He still held his ordinary shares.

(f) Unfortunately, there was a problem. Dome Holdings Ltd had recently

issued additional deferred shares which had no rights to a dividend and no voting rights. Their sole value was the right to be redeemed at par on a capital realisation after £1,000,000 had been distributed in respect of each of a particular class of ordinary share. Given that there were more than 2,000,000 shares in the relevant class, this meant that, in reality, the deferred shares were worthless.

(g) Although C held exactly 5% of the company’s ordinary share capital, his

percentage interest in Dome Holdings Ltd dropped to 4.99% if the deferred shares were taken into account. In other words, if the deferred shares formed part of the company’s ordinary share capital, Dome Holdings Ltd was not a ‘personal company’ in relation to C.

(h) The deferred shares had been created on legal advice as a mechanism

for removing ordinary shares awarded to members of the senior management team of Dome Holdings Ltd if and when they left the company’s employment.


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(i) The First-Tier Tribunal agreed with HMRC that the definition of ‘ordinary share capital’ was clear. This definition has been part of the tax code since 1938 and there was no doubt that – worthless or not – the deferred shares fell within the wording.

(j) C’s barrister did not feel that this conclusion fitted very well with the stamp

duty case of Collector of Stamp Revenue v Arrowtown Assets Ltd (2003). In that case, the company had issued deferred shares for the purpose of bolstering its ordinary share capital in order to enable it to satisfy the tests for stamp duty group relief. It was decided that the shares were issued simply for the purpose of claiming the stamp duty relief and so should be disregarded. The argument in the present case was that the deferred shares should also be disregarded. They were no more commercial than the shares in Arrowtown. Unfortunately for C, this line did not find favour with the First-Tier Tribunal. Nevertheless it does not seem right that the issue of absolutely worthless deferred shares was ignored in Arrowtown, but in the Castledine case they were not. Having said that, one possible distinction is that, in Castledine, the shares were issued for a genuine commercial purpose, whereas they had no commercial rationale in Arrowtown.

(k) It goes without saying that tax advisers need to keep a careful eye on their

clients’ percentage shareholdings, particularly where there are unexercised share options which, if exercised, could dilute a holding below 5%.


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4. Shares with no right to a dividend

(a) In McQuillan v HMRC (2016), the First-Tier Tribunal held that a class of redeemable ordinary shares with no dividend entitlement constituted shares which have a right to a dividend at a fixed rate and therefore did not form part of the ordinary share capital of the company concerned.

(b) The taxpayer (M) and his wife set up a sandwich shop business in 1999.

In 2004, along with his sister (Mrs P) and her husband, M turned the operation into a company (Streat) with a view to franchising the business. Initially, Streat’s issued share capital consisted of 100 £1 ordinary shares, of which 33 were held by each of M and his wife. The remaining 34 shares were owned equally by Mrs P and her husband. Mrs P and her husband subsequently lent £30,000 to the company.

(c) The company’s business was successful and grew rapidly. In 2006, they

approached Invest Northern Ireland (INI), which is a regional business development agency, for a grant. INI agreed to provide the grant on condition that the £30,000 loan was converted into shares and that these shares would not be repaid before March 2009. At a board meeting on 12 June 2006, it was duly resolved that the £30,000 advance be converted into 30,000 redeemable ordinary shares of £1 each. These new shares carried no votes and were redeemable at par from March 2009 onwards on a date to be agreed by the directors.

(d) Towards the end of 2009, a much larger business offered to buy up

Streat. This was accepted. At a board meeting on 14 December 2009, the directors resolved that the 30,000 redeemable ordinary shares be repaid at par with immediate effect. Nine days later at a further meeting, it was resolved to pay a dividend for the period ended 31 October 2009 of £700 per share. This was the only dividend which Streat ever paid. On 1 January 2010, the purchasers acquired all 100 £1 ordinary shares and the four shareholders then ceased to have any involvement with Streat.

(e) M and his wife claimed entrepreneurs’ relief in respect of their capital

gains on the CGT pages of their 2009/10 tax returns which, following an enquiry, HMRC refused to allow. HMRC’s stance was that the 30,000 redeemable ordinary shares counted as ‘ordinary share capital’ and so, although M and his wife had been directors of Streat throughout, they did not satisfy the requisite 5% shareholding test for the one-year period ended with the date of their disposal. On this basis, M, for example, had held 33 shares out of a total issued share capital of 30,100 shares for most of that one-year period, ie. a holding of just over 0.1% of the company’s ordinary share capital.

(f) It should be borne in mind that S989 ITA 2007 defines ‘ordinary share

capital’ as: ‘all the company’s issued share capital (however described), other than capital the holders of which have a right to a dividend at a fixed rate but have no other right to share in the company’s profits’.

(g) Having expressed sympathy with the taxpayers’ plight, the First-Tier

Tribunal concluded the argument by stating that having no right to a dividend is equivalent to a right to a dividend at a fixed rate. They


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contrasted Streat’s actual position with an alternative (hypothetical) structure under which the redeemable ordinary shares could have carried a fixed dividend of a purely nominal amount (eg. 1/15000th of a £ per share). They also referred to the subsequent change in CGT law which took effect on 6 April 2008 when entrepreneurs’ relief was introduced. The First-Tier Tribunal reasoned that, where the meaning of a legislative provision is not clear, ‘considerations of common sense may be relevant under ordinary principles of statutory interpretation’. The redeemable ordinary shares were therefore ignored and M and his wife were after all entitled to make their entrepreneurs’ relief claim.

(h) HMRC appealed against this judgment and, on 6 September 2017, the

Upper Tribunal overturned the earlier decision. The Upper Tribunal judges did not consider that there was any ambiguity or difficulty about the meaning of S989 ITA 2007. The legislation, in their opinion, does not countenance a right to no dividend as being a right to a dividend at a fixed rate. They went on:

‘It is in our view plain, on the literal meaning of S989 ITA 2007, that to be within (the) excluded class the shares in question must have a right to a dividend. Once it is determined, as a matter of fact, that the shares carried no right to a dividend, there is no question of the shares falling outside the definition of “ordinary share capital”.’ Streat was not therefore a personal company as far as M and his wife were concerned. As a result, entrepreneurs’ relief was not available to the founding shareholders.

(i) After a discussion about the impact of the First-Tier Tribunal’s finding in

Castledine v HMRC (2016), HMRC v McQuillan (2017) concludes with these words:

‘Like the First-Tier Tribunal, we sympathise with the circumstances in which (M and his wife) have found themselves. We recognise that they are the kind of entrepreneurs for whom the relief was devised. They saw an opportunity to develop a business in a particular market and they devoted their time, energy and resources to building up a successful company with all the risks and rewards that that involves. The statistics (M’s accountant) cited to us at the hearing about the rapid growth of the business in terms of outlets, employees and turnover are undoubtedly impressive. They are understandably aggrieved that they should be denied relief in circumstances where, through a commercial requirement of a grant-provider, a loan to Streat was converted into shares with no change in the economic substance and which remained a financial liability for accounting purposes, where they say they would have been entitled to taper relief under the law as it then stood and where, after the shares had been issued, there had been a change in the law so as to deny them relief. A definition such as that in S989 ITA 2007 is apt to produce results which appear unfair. There will be deserving cases that fail to qualify for relief and non-deserving ones that do qualify. Such a definition may enable those who are well-advised to fall within its terms, whilst leaving a trap for the unwary. There is certainly a case for the legislation to be reviewed to address what may understandably be perceived as unfairness in


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particular cases, of which this is one. That will, however, be a matter for Parliament if it determines that such a change should be made.’


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5. Reimbursement of purchaser’s costs

(a) When calculating the capital gain on the sale of a property, S38 TCGA 1992 permits the deduction of a number of specific costs. Put briefly, these are:

(i) the property’s original acquisition value;

(ii) the expense of enhancing the value of the property;

(iii) the expense of establishing, preserving or defending the vendor’s

title to, or rights over, the property; and

(iv) any incidental costs of the disposal.

(b) Normally, all these costs would have been paid for by the vendor. However, in O’Donnell v HMRC (2017), the First-Tier Tribunal had to consider whether a vendor’s reimbursement of certain items of expenditure which were incurred by the purchaser of a property was allowable against the vendor’s capital gain.

(c) S38 TCGA 1992 expressly permits deductions for fees and other amounts

paid for various professional services (such as those of surveyors, valuers, accountants and legal advisers), together with any transfer or conveyance costs incurred wholly and exclusively for the purposes of the disposal.

(d) O’Donnell v HMRC (2017) is a complicated property case, but, drilling

down to the essential point, the Tribunal decided that the vendor’s reimbursement of the purchaser’s legal costs facilitated the sale because it was part of the agreement reached in connection with the deal. This meant that the relevant expenditure was, in the end, incurred by the vendor and that it met the ‘wholly and exclusively’ test.

(e) Taxpayers should note both the potential availability of, and the limits on,

the deductibility of purchasers’ costs on a property disposal. The fact that some costs are primarily those of the purchaser does not necessarily prevent the vendor from accessing a deduction, but each case must be analysed carefully to ensure that:

(i) any such payment is only made by the vendor by way of

reimbursement;

(ii) the amount reimbursed falls within the categories set out in S38 TCGA 1992; and

(iii) there is no reason for the reimbursement other than to secure that

the disposal goes ahead.


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6. Assets appropriated to trading stock

(a) Where a chargeable asset acquired by a trader as a fixed asset or an investment is subsequently appropriated by him for use as trading stock, the general rule is that the trader is treated as having sold the asset for its market value at the time of the appropriation (S161(1) TCGA 1992). This gives rise to a chargeable gain or allowable loss and the amount brought into the trading accounts is the market value of the item in question.

(b) Collection difficulties might, however, arise, given that tax on any

chargeable gain could become due and payable some time before there was an actual disposal of the asset. This is sometimes referred to as a ‘dry’ tax charge. In order to deal with the problem, traders are allowed to make an election under S161(3) TCGA 1992, as a result of which:

(i) no chargeable gain or allowable loss arises on the appropriation to

trading stock; and

(ii) the market value of the asset in the trading accounts is reduced by the amount of the chargeable gain or increased by the amount of the allowable loss.

The effect of this election is that the trading results will now include the totality of any income profit or loss and any capital gain or loss accruing on the asset over the whole period of ownership.

(c) An election under S161(3) TCGA 1992 must be made:

(i) for CGT, by 12 months after 31 January next following the tax year containing the last day of the period of account in which the asset was appropriated to trading stock; and

(ii) for corporation tax, within two years of the end of the accounting

period in which the asset was appropriated to trading stock.

(d) Illustration

John is a second-hand bookseller. He also collects antiquarian books as a hobby. In March 2004, he acquired a set of rare books for his personal collection at a cost of £26,500.

In January 2017, when the market value of the set was £70,000, he decided to offer it for sale through his business. John’s CGT computation is:

£

Market value on appropriation 70,000 Less: Cost 26,500

–––––– CHARGEABLE GAIN £43,500

––––––


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If John elects to roll the gain over into the value of the set in his trading accounts, no chargeable gain will arise. Instead, the cost of the set for the purpose of working out John’s trading profit will be reduced to:

£

Market value on appropriation 70,000 Less: Chargeable gain 43,500

–––––– COST OF SET IN TRADING ACCOUNTS £26,500

––––––

On the assumption that the books were eventually sold for £74,700, John’s trading profit will be £74,700 – £26,500 = £48,200. Depending on how quickly the books sold, John might well prefer to pay CGT rather than income tax on his appropriation profit. His CGT rate would presumably be 20% rather than a charge of 40% or 45% under income tax.

(e) However, what about the position where there is a loss? In that case, the

effect of a S161(3) TCGA 1992 election is to convert an amount which is classified as an allowable loss while the asset was held as a fixed asset or an investment into a more flexible trading deduction. This is a widely recognised planning point which was often used by, for example, property developers during the recent property troubles.

(f) Unfortunately, the Chancellor has decided that this form of tax planning is

a step too far. For appropriations into trading stock made on or after 8 March 2017, Cl 26 F(No2)B 2017 disallows the election facility where there is a loss in order to ensure that the loss retains the character which it had when it accrued. Elections can still be made where there is a gain.

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