UK: Tax Update - 26 July 2010

Last Updated: 4 August 2010
Article by Smith & Williamson

1. General news

1.1. Report on June 2010 Budget

The House of Commons Treasury Committee report on the June 2010 Budget is available at:

The main conclusion is:

"The Chancellor told us that he had built a degree of caution into the fiscal mandate by seeking to achieve it a year early. We welcome this as a signal that if economic conditions demand it he may be prepared to take measures to stimulate the economy, even if these delay the current plans for cutting the deficit."

In relation to business aspects, there was a commitment to examine problems faced by SME's in raising credit, a commitment to consider the impact of the proposed bank levy (currently subject to consultation) and other proposed changes in the UK and international regulatory system, and an expression of encouragement for the Chancellor's willingness to reconsider the effect of his proposals in encouraging existing and potential share ownership schemes.

1.2. Autumn Finance Bill: an informal consultation

The Government has published draft legislation on technical tax measures, inherited from the previous administration, that are to be legislated in a Finance Bill to be introduced to Parliament in the autumn. Each document published (of which there are 32 in total) contains both the draft legislation and explanatory notes.

Comments are welcomed with details of the relevant HMRC contacts provided within each document. The consultation period closes on 3 September 2010. .

1.3. Office of Tax Simplification

The Chancellor and Exchequer Secretary have launched the Office of Tax Simplification to provide the Government with independent advice on simplifying the UK tax system. The Office has been established as an independent Office of the Treasury and should draw together expertise from across the tax and legal professions, the business community and other interested parties. Rt Hon Michael Jack and John Whiting have been appointed to lead the Office on an interim basis.

The Chancellor has initially asked the Office to take forward two reviews, which cover tax reliefs and small business tax simplification (including IR35).

  • Tax Reliefs Review: terms of reference:

The Office has been commissioned to review a list of all reliefs, allowances and exemptions within the taxes and duties administered by HMRC and identify those reliefs that should be repealed or simplified to support the Government's objective for a simpler tax system. The Government is particularly interested in identifying reliefs that are largely historic, not frequently used, create distortions in the tax system or are complex for business or HMRC to administer. The Office has been asked to produce an interim report by late autumn 2010 and a final report with recommendations to the Chancellor ahead of Budget 2011.

  • Small Business Tax Simplification Review, including IR35: terms of reference:

The Office is to provide an initial report to the Chancellor by Budget 2011 that identifies areas of the tax system that cause the most day-to-day complexity and uncertainty for small businesses and recommends priority areas for simplification. Once the Government has considered the initial report the Office will be asked to produce specific recommendations on tax simplification for small businesses. As part of the initial report, the Office will also explore alternative legislative approaches to IR35. IR35 (the intermediaries legislation) is legislation introduced in 2000 to counter avoidance of tax on employment income where workers receive payments from a client via an intermediary (usually a personal service company) and the relationship between the worker and the client would otherwise be one of employment.

Chancellor George Osborne said:

"The previous Government took a complex tax system and made it even worse. A decade of meddling and intervening has made the tax affairs of millions of families and businesses across the UK extremely complicated. We need to sort out this mess.

"Two years ago I promised to create the Office of Tax Simplification. Today, we're delivering on that promise. With its independent, expert advice it will be a permanent force for a simpler tax system.

"Simpler, more competitive taxes will help us show the world that Britain is open for business."

The Rt Hon Michael Jack, the Chair of the OTS, said:

"Entrepreneurship should never be stifled because of an overly complex tax system. That's why I am delighted that the Government have committed themselves to looking at ways to simplify the tax system, with an initial focus on small businesses.

"Simplification in a complex world is a real challenge, but it's one that has to be addressed if the tax system is not to hinder the economy's ability to grow."

John Whiting, the Tax Director of the OTS, said:

"I've long argued that we need a simpler tax system in the UK, so I'm delighted to be given the opportunity to take forward the Government's commitment in that direction.

"In our complex world a truly simple tax system for all is probably impossible, but working towards a simpler system will help all who deal with it: taxpayers, especially the unrepresented, tax advisers and tax authorities."

2. Employee benefits

2.1. Whether dividends can be emoluments for income tax and earnings for National Insurance

The Upper Court has heard an appeal and cross appeal from the First Tier Tribunal decision in PA Holdings (TC00063, 7 May 2009, [2009] UKFTT 95 (TC)).

The restricted share scheme originally put in place by PA Holdings was for employees to receive a dividend of 99p and share redemption proceeds of 1p, together in place of each £1 of cash bonus. In December 1999 funds were contributed to an offshore employee trust. The trust set up a company in January 2000 which became UK resident and the employee trust contributed funds to the company on 16 February 2000 as a capital contribution. Employees were awarded beneficial interests in the preference shares of the company and on 24 March 2000 a dividend of 99p on each 1p share was declared. The dividend was paid to a nominee and transferred to the award holders on 28 April 2000, with the 1p preference shares being redeemed on 19 November 2000. The arrangements were for the benefit of PA's employees to motivate them and encourage them in their performance. The scheme was presented to employees as part of the payment of bonuses. The scheme was repeated in future years.

The First Tier Tax Tribunal held that the payments were emoluments from employment, but as they were conditional shares they were exempt from tax under schedule E at the time because of s140A ICTA88. In addition it was held that the dividends were dividends or distributions taxable at the time under Schedule F which took priority for income tax where that income could be regarded as both a distribution and emoluments (the current legislation on priority for the same situation is at ITEPA03 s366(3)). Thus the dividend payments were not subject to the schedule E income tax charge. However as there was no equivalent to ICTA88 s20(2) in the Social Security and Benefits Act 1992, the dividends which were also earnings from employment, attracted a liability to Class 1 NI.

The appeal to the Upper Tribunal by HMRC was against the decision that the dividends were subject to Schedule F, on the basis of the decision in Hochstrasser and Mayes (1959 CH 55) in the light of the House of Lords' decision in Abbott v Philbin ((1960) 39 TC 82 (HL). PA appealed on the basis that the dividends could not be remuneration from PA, as they were dividends from another company (Ellastone Ltd), and they therefore attracted no NI liability.

The Upper Tribunal agreed with the First Tier Tribunal that, despite the dividends being from Ellastone, there was no doubt that they were paid in place of a bonus. In Hochstrasser v Mays ([1960] AC 376), the House of Lords held that employee compensation for any potential loss on disposal of their home on being relocated, was not emoluments, as it was not paid for services rendered (the source of payment was the housing agreement and not the employment contract, though these facts were specific to this case). However in the case of dividends in the PA scheme, there was a clear link to the services rendered. The Upper Tribunal also felt the same conclusion could have been reached by applying the Ramsay approach. The Upper Tribunal held that the clear statutory wording could not prevent a dividend from being taxed as a dividend rather than as earnings, despite the fact that they were emoluments from employment.

The Upper Tribunal also rejected the repetition of the argument that as the payments were dividends they could not be emoluments from earnings and therefore not subject to NI. They saw no reason for interpreting ICTA88 s19 and SSCAB92 s3 differently.

In summary the Upper Tribunal upheld the conclusions reached by the First Tier Tribunal, that PA Holdings won on the income tax point, while HMRC won on the National Insurance point. This was the basis of the settlement offer made some years ago by HMRC to those that had implemented the scheme.

HMRC guidance at NIM02115 stated (and still states) that "Dividends are derived from a shareholding and not employment. They cannot therefore be classed as earnings and do not attract NICs". There is a similar comments at NIM12012 "Directors receive dividends as shareholders in the company and not in their capacity as directors. Dividends are therefore not earnings for the purposes of National Insurance Contributions".

However it seems that where shares or options over shares are granted to employees, consideration may need to be given to the NI implications of dividends subsequently paid, in the light of HMRC guidance, practice and decided caselaw. We understand the case is being appealed further by PA Holdings Ltd.

3. Business tax

3.1. Group mismatches

A discussion document was published on 24 March 2010 on proposals to introduce principles based rules to target 'group mismatch' schemes.

These are schemes used by groups to exploit asymmetrical tax treatment of transactions in two or more group members (either intragroup or back to back with a third party). The outcome of the targeted scheme is a tax advantage from the arrangement.

Following this discussion document a meeting was held by HMRC on 23 July (at which Smith &Williamson were present) to discuss possible draft legislation with a view to issuing a consultation and formal draft legislation some time in mid to late September 2010.

The schemes HMRC is concerned about already have targeted legislation, but through the disclosure regime they have been notified of alternatives which seek to get round measures initially put in place to stop them. The legislation mentioned includes:

  • FA04 s51 (if a group exploits differences between UK GAAP and IAS in transactions between group members, UK GAAP prevails for both sides of the transaction;
  • FA (No 2) 2005: arbitrage rules: rules that seek to redress asymmetries in limited circumstances where there is inconsistent tax treatment of the entities or instruments involved (now in I(TOP)A 2010 part 6). These could apply to wholly UK transactions (for example shares or securities subject to conversion, and schemes involving a hybrid effect and a connected person), though might more typically be used in cross border situations;
  • FA 2006 (insertion of section 93C of FA 1996 – now section 453 of CTA): intra-group loan mismatch scheme - deduction for interest not matched by taxable receipt;
  • FA 2008 (insertion of section 94B of FA 1996 - now section 418 of CTA): intra-group convertibles: differing accounting treatments leading to an overall tax loss;
  • FA 2009: (insertion of section 418A of CTA) refinement of the 2008 measure on intra-group convertibles to block attempts to get around it;

An example of the schemes mentioned is what could be a hedge of a foreign operation with a sterling currency conversion option. The option would be exercised if sterling strengthens but not if it weakens, and due to the fact that the loan in the company owning the foreign subsidiary would not be taxed as hedging share sin a foreign operation, from a group perspective, there, would be a one-way foreign exchange P&L and tax effect for the group with a gain not being taxed. This 'scheme' (arising from the tax effect of the option for the group) was specifically targeted in Finance Act 2009 for accounting periods beginning on or after 22 April 2009, with the legislation in CTA09 s328A-s328H.

To avoid the need for continual additional legislation to block schemes as they are notified, HMRC proposed principled based legislation applying to transactions with specific characteristics, with the aim of restoring tax symmetry within the group.

Draft legislation was issued for discussion at the 23 July meeting, which it was recognised would require further refinement before issuing within a consultation document. It applies to loan relationships and derivative contracts only. While HMRC recognises that tax arbitrage can involve other types of transactions, their view was that the schemes they had seen since the 2005 legislation only involved loans and derivatives.

In an attempt to draft legislation providing greater certainty, the draft for the meeting contained HMRC's view of 'objective tests' for identifying group mismatch schemes (GMS) which generated a 'relevant tax advantage' which was not negligible (not defined). There was no purpose test, but one of three conditions had to be met, one of which included a formula assessing the probability of a tax benefit arising. The aim was to target schemes which from an economic perspective for the group were economically neutral pre-tax, but advantageous for the group post tax. The aim was to consider only companies within the charge to corporation tax, to include only domestic transactions and CFC's.

Where a transaction was caught, the 'scheme profits' and 'scheme losses' would be left out of account in determining the debits and credits for the loan relationship/derivative legislation. The assessment of whether a GMS was caught would occur at initiation of the original transaction or a subsequent change, and would involve looking at the results over the 'scheme period'. Tax asymmetry was defined as being caused by different levels of debits and credits being brought into account by the group, or different tax rates applying to each side of the transaction. The legislation did not consider timing effects.

There was some concern from participants that the draft legislation contained no purpose or motive test , potentially leading to much higher compliance costs. There was also concern that the probability factor in the formula for calculating the likelihood of a tax advantage would be a judgemental issue over which there could easily be differences of opinion. While initially reluctant, HMRC appeared to finally take on board the desirability of a purpose or motive test.

It became apparent that a number of refinements were required to definitions in the draft legislation. HMRC also agreed to reconsider the mechanics of how the draft legislation achieved symmetry, by either removing the net group debits from the transaction, or adjusting the results on a just and reasonable basis, in contrast to removing 'scheme profits' and 'scheme losses'. Some concern was expressed as to when a scheme period would end where loans involved did not have fixed settlement dates. A number of exclusions would need to be taken into account. Some of those discussed included where one party to the scheme was a securitisation company, where double tax arrangements applied to one party to remove the 'relevant tax advantage' of the "scheme". The legislation would also have to take account of changes to the rate of corporation tax introduced by legislation (i.e. the proposed staged reduction in the main rate of corporation tax). HMRC also commented they are considering how to legislate for the involvement of partnerships.

If the legislation is adopted the proposal would be to remove the following avoidance legislation in CTA09: s328A-328H, s418, s453, s660A – s660H, s695. In addition consideration would be given to a repeal of parts of the arbitrage legislation (now in I(TOP)A 2010 part 6).

It is interesting to consider how the proposed legislation might impact an interest free loan between related parties where the accounting treatment is different between borrower and lender. If FRS25 & 26 do not apply to the borrower, under FRS4 the loan would be recognised at proceeds less issue costs. In some situations, the provision of an interest free loan may imply that part of the proceeds relate not to the loan but to another benefit received by the borrower. In such circumstances a view could be taken that part of the proceeds effectively related to a capital contribution and not to the loan. A part of the proceeds could be accounted for as equity. The balance of the liability would then be accounted for using the effective interest rate method, with annual debits to the P&L to bring the loan back to its maturity value. Thus in periods after the period of receipt there will be loan relationship debits where there is no actual payment of interest. However at initial recognition, the amount allocated to equity would appear in the statement of changes in equity. For the purpose of the loan relationship regime, amounts shown in statements of changes in equity would be 'an amount recognised in determining a company's profit or loss' and so would be taxable at that point. Thus for the borrower, there would be equal and opposite taxable entries in respect of the loan over the whole period of the loan.

For a lender to which FRS25 & 26 do not apply, if the loan is accounted for as a fixed asset investment it may be initially accounted for at historic cost, and there would be no subsequent P&L entries for the period of the loan to maturity, unless the investment became impaired

If this applied in a group situation, looking at the period of the loan from inception to maturity, there would be no tax mismatch under the current draft proposals, as there are no plans to take account of the cashflow effect of timing differences. It is clear that where an adviser accepts a new appointment part way through one of these types of loan, it will be necessary to have knowledge of the history of group transactions, to determine whether certain anti-avoidance legislation applies to current and future periods.

3.2. Vodafone: CFC dispute with HMRC over Luxembourg subsidiaries and Indian Tax dispute

The following comment was included in Vodafone's press release on their interim management statement to 30 June 2010 regarding UK tax on Controlled Foreign Companies (CFCs):

"On 22 July 2010 Vodafone reached agreement with the UK tax authorities with respect to the CFC tax case. Vodafone will pay £1.25bn to settle all outstanding CFC issues from 2001 to date and has also reached agreement that no further UK CFC tax liabilities will arise in the near future under current legislation. Longer term, no CFC liabilities are expected to arise as a consequence of the likely reforms of the UK CFC regime due to the facts established in this agreement. The settlement comprises £800m in the current financial year with the balance to be paid in instalments over the following five years."

The Annual report for financial statements to 31 March 2010 commented that at the balance sheet date the group had a provision of £2.2bn with respect to this dispute (see notes 6 and 29 to the consolidated results –

With respect to Indian Tax the following comment is included in the groups June 2010 interim management statement:

"Vodafone International Holdings BV ('VIHBV') has filed a writ in the Bombay High Court challenging an order received from the Indian tax authorities confirming their view that they have jurisdiction to seek to recover withholding tax from VIHBV on the Hutchison transaction in 2007. The case is scheduled to be heard on 2 August 2010. VIHBV continues to believe that neither it nor any other member of the Group is liable for any tax and intends to defend this position vigorously."

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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