UK: Weekly Tax Update - Monday 13 June 2011


1.1. Scanning – Changing the way HMRC handle customer post

HMRC has announced the first phase of the Scanning capability for handling customer correspondence relating to its compliance checks has now been implemented. This first phase includes enquiries into Self Assessment returns of non-business customers and compliance checks on employers. The plan is to implement scanning for the large majority of its compliance checks during 2011-12.

Scanning the incoming mail is supposed to mean that the documents and letters received will be linked to the customer case record and available to Caseworkers within 36 hours and should help to reduce the risk of post going astray. A single PO Box address and case reference will be used to identify the mail that is part of this process and these details will be shown on our outgoing mail.


2.1. Pensions: Draft secondary legislation

HMRC has published further sets of draft regulations relating to the age 75 changes, for comment.

Transfers of Sums and Assets regulations - These make amendments to the existing regulations providing for transfers from a drawdown arrangement to another drawdown arrangement.

Relevant Annuity Regulations - Containing minor consequential amendments to existing regulations

Prescribed Manner of Determining the Amount of Annuities Regulations - Containing minor consequential amendments to existing regulations

2.2. First-Tier Tribunal: TC01151 - Nicholas Pike

Income tax – whether a security was a relevant discounted security – security paying on redemption a sum calculated as 7.25% per annum accruing daily - whether "interest" includes sums not paid periodically – yes – appeal dismissed

HMRC had denied the claim for relief on a loss of £3,463,563 for income tax purposes arising from the discount on a relevant discounted security ("RDS") as defined in Schedule 13 Finance Act 1996. On 31 March 2000 Mr Pike's company created loan stock which was allotted to Mr Pike who paid £6 million for it. Clause 2.1 of the loan stock instrument ("the Instrument") provided:

"In these conditions "the Redemption Proceeds" means, in respect of any repayment or redemption of the Principal Amount in full or in part pursuant to the Certificate, a sum being the aggregate of: (i) the Principal Amount to be repaid or redeemed; and (ii) an amount equal to 7.25% per annum of the Principal Amount to be repaid or redeemed, accruing on a daily basis from and including the date of the Certificate up to and including the date of repayment or redemption."

The loan stock was repayable after 13 years. Assuming it was not redeemed early, Mr Pike would be repaid £11,780,974 which was calculated as £6 million plus 7.25% of £6 million per annum for the 13 years outstanding. Nothing would be payable to Mr Pike until the principal amount was redeemed.

A few days later, Mr Pike established a settlement and transferred the loan stock into the Trust which at the time of the transfer had an open market value of £2,536,437. In his tax return Mr Pike stated this was calculated on the basis that although the 7.25% return would be commercially acceptable if the return was virtually risk free, the investment in AIM was far from being risk free as the company would be investing in risky investments with no fixed rate of return. This reduced the value at issue of the loan stock to the above figure, being less than half of what was actually paid for it, since the implicit discount rate used to value the loan stock was 12.25%, substantially higher than a risk free rate.

Mr Pike considered that the loan stock was a relevant discounted security and that the provisions of Schedule 13 to the Finance Act 1996 ("Schedule 13") applied and made a claim for loss relief in his return for the year ended 5 April 2000.

The Judges set out their thoughts on the difference between 'interest' and 'premium on redemption'.

The argument put forward was that there was a distinct line between 'interest' and 'premium on redemption'. Interest would be, and a premium could be, calculated by reference to an underlying debt and represent consideration for use of money over time. The difference was that interest would be paid periodically whereas a premium would be paid at redemption and would be an indistinguishable part of the single payment made when the loan was extinguished.

In the Judges' opinion the authorities do not require interest to be paid periodically and interest can be interest even if it is paid in a single lump sum at the end of the loan. The Judges did not think whether something is interest or not can depend on the label that a person chooses to give to it as English law would be very different if it gave effect to the description litigants used rather than the underlying nature of the transaction they entered into.

They found that the natural and ordinary meaning of interest is that it is a sum of money calculated by reference to an underlying debt which is payment by time for the use of the money borrowed and which accrues from day to day, whether or not it is paid periodically. In this case it was clearly a charge for the use of money over time as it was calculated by reference to an interest rate per annum accruing daily.

Taking all factors into consideration, it was the Judges' conclusion that the additional sum payable to Mr Pike on redemption of the loan stock was interest even though it was not payable periodically. The loan stock was therefore not a relevant discounted security and the appeal was dismissed.

Although not directly relevant to the reasons for dismissing the appeal the Judges also found that the transactions were all part and parcel of a single avoidance scheme, from which they inferred Mr Pike must have known when he purchased the security on 30 March 2000 that he would transfer it at a loss 5 days later and that therefore he must have known on 30 March 2000 that its issue price of £6million was considerably in excess of its market value. Had they been persuaded the security in this case was a RDS, did it necessarily follow that Mr Pike paid £6million for his security?

Mr Pike gave £6million to the company and in return he got a security with a face value of £6million. But he did so knowing that in return he would get an asset worth approximately £2.5million. This was not a case of making a bad bargain: Mr Pike did not pay £6million hoping it was worth £6million or more. It was an integral part of the tax avoidance scheme that the security was in fact worth considerably less than this and the scheme could not have worked if Mr Pike had paid what the security was actually worth.

Further, the excess of the amount paid over the value of the security was in no real sense given away by Mr Pike. It was given to the Company of which he was the shareholder of 999 of its 1000 issued shares. He owned the Company to which he paid a very substantial overvalue for a security.


3.1. Consultation: Lower rate when leaving 10% of estate to charity Basic outline

Budget 2011 included the announcement that the Government will introduce a lower rate of inheritance tax (IHT) where people leave a charitable legacy of 10% or more of their estate when they die. The 10% charitable legacy will be based on the value of the estate after deducting IHT reliefs and exemptions with the change expected to apply for deaths on or after 6 April 2012.

The proposal is for deaths on or after 6 April 2012, estates that include charitable legacies of at least 10% of the net estate will benefit from a 36% rate of IHT (compared with the main IHT rate of 40%). Whether or not the 10% threshold has been met ('the 10% test') will be determined by comparing:

  • the total value of charitable legacies for IHT purposes; and
  • the value of the net estate for IHT purposes as reduced by:
  • any available nil-rate band;
  • the value of assets passing to a surviving spouse or civil partner; and
  • other IHT reliefs and exemptions (e.g. business or agricultural property relief) - apart from the charitable legacy itself.

If the 10% test is passed, the estate will qualify for the reduced rate of IHT.

An example of the principle is set out below showing how the minimum charitable legacy to pass the 10% test would be calculated, and how the incentive will work. It compares the effects of that legacy on the IHT liability, and its impact on the amount remaining for other beneficiaries, at present and under the new regime proposed from April 2012.

Example 1

An estate is valued at £850,000 and the available nil-rate band is £325,000. The minimum charitable legacy to pass the 10% test would be calculated as follows:



From April 2012

Estate value



less charitable legacy



less available nil-rate band



net estate for 10% test purposes



less minimum charitable legacy to pass 10% test



taxable estate



IHT due

£189,000 (@40%)

£170,100 (@36%)

The amount left for distribution to non-charitable beneficiaries, (i.e. the estate value less any charitable legacy and IHT due)would be:



With no charitable legacy, the amount available for beneficiaries would be £640,000 (the estate value less IHT due (£210,000) on the estate). The charitable legacy results in a reduction in the amount left to other beneficiaries of:



As a proportion of charitable legacy



The example also shows how leaving a charitable legacy under the new rules will still result in an overall cost to the beneficiaries compared to not leaving anything at all to a charity in a Will. This clearly fits in with the Chancellor's statement that "No beneficiaries will be better off".

However what if the current Will already left something to charity? Using the above example but assuming the current Will left charitable bequests totalling £30,000.

Example (Smith & Williamson)

An estate is valued at £850,000 and the available nil-rate band is £325,000. Illustration showing how a charitable bequest of £30,000 is increased to pass the 10% test:



From April 2012

Estate value



less charitable legacy



less available nil-rate band



net estate for 10% test purposes



less minimum charitable legacy to pass 10% test



taxable estate



IHT due

£198,000 (@40%)

£170,100 (@36%)

The amount left for distribution to non-charitable beneficiaries, (i.e. the estate value less any charitable legacy and IHT due)would be:



Increase in the charitable legacy



Increase in distributable estate


£ 5,400

Based on these figures, the non-charitable beneficiaries in our above example will be better off. There is no indication in the consultation document whether there would be a restriction to the tax saving of the reduced IHT rate where the balance of the estate available for distribution is increased.

It does however say:

1.17 As now, a charitable legacy will still result in an overall cost to the beneficiaries compared to not leaving anything at all to a charity in a Will. The measure will reduce that cost but not to such an extent that the reduction in IHT would exceed the amount of the charitable legacy.

It is acknowledged that because the benefit of the reduced IHT rate will be dependent on whether or not the amount of the charitable legacy is sufficient for the estate to pass the 10% test there will be a 'cliff edge' effect.

Where the amount of the charitable legacy is close to the critical 10% point, a small difference to the amount of the legacy could have a larger impact on the estate's IHT liability. The document states that there are no plans to apply any taper or other mechanism to mitigate this.

Scope of consultation

The consultation document covers the following areas:

  • application of the 10% test and the reduced IHT rate - whether the reduced rate should be limited to the free estate or extended to other components of the estate;
  • the nature of the legacy - some practical issues around valuation of assets, types of charitable legacies, claims, and avoidance;
  • instruments of variation - notifying charities about legacies;
  • administrative issues - issues connected with forms, guidance and Wills;
  • other issues - mainly applicable to specific situations; and
  • the impacts of the policy - comments and information about the assumptions made about impacts and level of take up.

The following details have already been decided and so are not the subject of this consultation:

  • the level of the reduced IHT rate;
  • the expected commencement date;
  • the minimum proportion of the net estate that must be left to charity.

In addition there are other aspects which are not being considered under this consultation:

  • the overall policy of introducing a reduced rate of IHT to encourage charitable legacies;
  • the range of entities, legacies to which will contribute to passing the 10% test;
  • the reliefs and exemptions which will be deducted to arrive at the 'net estate'.


4.1. Patent Box Regime – further details

On 10 June HM Treasury and HMRC published further details on their proposed design of the patent box regime to be made available for companies. The design of the regime is intended to be broad in scope, formulaic in approach, applies to profits (not receipts) and is intended to benefit active ownership rather than passive holding of patents.

The aim is to provide an additional incentive for companies in the UK to retain and commercialise existing patents and to develop new innovative patented products. It is thought this will encourage companies to locate the high-value jobs associated with the development, manufacture and exploitation of patents in the UK and maintain the UK's position as a world leader in patented technologies.

The computational aspects of the regime seem quite complex, but it is helpful the originally proposed cut off date for qualifying patents (first commercialised after 29 November 2010) has been removed.

Qualifying patents

Patents can qualify for the regime regardless of when commercialised, though it is proposed that they meet any one of the following requirements:

  • Independently validated as innovative and useful by a patent authority such as UK's Intellectual Property Office or the European Patent Office.
  • Covered by supplementary protection certificates (SPCs). These apply to intellectual property (IP) associated with pharmaceutical and agrochemical products and act to extend the protection afforded by the qualifying patents.
  • Other types of IP such as regulatory data protection, granted to new pharmaceutical and agrochemical products which cannot be patented; and plant variety rights.

The benefits of the Patent Box will be accessible both through legal ownership and through holding an exclusive licence to exploit a patent commercially. The licence can be limited by field or territory, provided that it still results in effective market exclusivity.

The regime will be accessible by those who acquire patents as well as those who develop them, and also to those who operate under joint venture, partnership or cost sharing arrangements. However all patent box claimants will be required to meet a development test to demonstrate they remain actively involved in the ongoing decision making connected with the exploitation of the patent. The proposals are that development work exceeds a predefined proportion of acquisition costs or project costs, or alternatively a judgemental process will be development.

Qualifying income

The patent box will include worldwide income generated from qualifying patents. It will include all royalties or licence fees received for use of an invention covered by a currently valid qualifying patent, regardless of whether the invention is used by the licensee in an industrial process or incorporated into patented products sold by them.

Income from the sale of any products incorporating at least one invention covered by a currently valid qualifying patent will be included. The incorporation of the invention or inventions into the product must be genuinely commercial and the patent must not have been added just with the intention of making the product qualify for the Patent Box.

Income from sales of spare parts for a qualifying product will be included, as will income from patent compensation and damages. Service income will however be excluded from the regime.

For those using a patented industrial process to produce a product, the divisionalised approach mentioned above can be adopted to arrive at an arms length patent income for the regime.

Income from the sale of patents will be included, though it is not clear from the consultation document how any pre-commercialisation costs used to develop the patent would be dealt with (i.e. whether apportioned through the apportionment process of directly allocated to reduce patent sale income).

Any income or profits which fall within the North Sea ring fence regime will not qualify for the Patent Box. However, any other income related to patented technology in the extractive industries will qualify in the same way as any other patented product or process.

For the accounting year in which a patent is successfully granted, the company will be able to claim Patent Box benefits for any income which arose between the patent application and the date of grant, for up to four years prior to grant. However, no Patent Box benefits will apply to profits made prior to the patent application.

Computational points

The proposed design calculates qualifying patent profits by:

  1. identifying the proportion of corporation tax profit directly attributable to income from qualifying patented products;
  2. deducting an apportionment of expenses (apportioned by the ratio of patent income to total income). R&D costs could be deducted at their actual level (rather than at the enhanced level available through an R&D tax relief claim). Interest receipts and finance expenses would not be taken into account for patent box income or expenses;
  3. determine 'residual profits' by deducting a standard 15% mark up on certain apportioned costs. The mark-up is intended to represent 'routine' profit expected whether or not there is a patent. Certain costs will be excluded from the mark-up computation, such as outsourced activities, raw material costs and licence fees paid for patent or trademark use; and
  4. reduce 'residual profits' further by the ratio of direct patent expenses (such as R&D and patent filing costs relating to the patent) to total direct patent and direct non-patent expenses (such as marketing, selling and promotion costs that relate to the return due to the brand).

In certain cases the government envisages anomalies in the allocation of profits to the patent box regime and in such instances it appears the regime may permit, or require a divisionalisation of a company's business (using OECD guidelines) in order to work out the allocation of profits and expenses.

The regime will be optional, but once the option has been made for the regime, the allocation of profits or expenses on a whole company or divisionalised approach will need to be on a consistent basis. Changes from one basis to another will only be permitted where there is a change that reflects a genuine long-term change in the company's commercial activities. There will be additional computational effort and documentation required with divisionalisation.

An alternative to (iv) above is to apportion the balance of profit between returns to patents and returns to other attributes such as brands, using a judgemental approach. However the Government's preferred method is the above formulaic approach. If the judgemental approach is adopted there would be a simplified approach to determining the patent box income for smaller claims (those of less than £500,000), where 50% of the residual profit at (iii) above would be determined as referable to patents.

As the proposed regime uses transfer pricing principles, it is proposed that those companies opting into the patent box regime that are otherwise exempt from transfer pricing would be required by notice to adopt transfer pricing. This new power would only be used in clear cases of avoidance or manipulation of profits.

Relief for losses would be obtained in the year of being incurred by relief against total profits as normal (i.e. offsettable against profits taxable at the main corporation tax rate or small profit rate as appropriate), but would be carried forward to reduce patent box profits in future years.

It would be possible to leave the regime at any time, but once the decision is made to leave it would not be possible to re-enter the regime for five years.

The model proposed is based on a mature patent business where it is assumed current year R&D costs will be a reasonable representation of pre-commercialisation costs for the next generation of patents and products. This will not be the situation for all businesses, for example those that develop one or only a few patents and related products or those with long development timescales. In the situation where current R&D costs are not representative of annual pre-commercialisation costs, the Government intends to develop claw back provisions so that costs allocated to the patent box regime represent costs post development.

Other points

  • No Patent Box benefits will apply to profits made prior to the patent application.
  • Double tax relief will continue to be available to patent box income, both in respect of withholding tax and tax on overseas profits; any changes required are to be worked through once the design of the regime is in more final form.
  • Consideration is being given to anti-avoidance.
  • It is thought the existing non-statutory clearance process will be sufficient to cater for any clearances required under the regime.
  • The effective 10% rate of corporation tax will be applied to the patent profits by multiplying them by the main (or small profit) rate less the patent box rate and dividing the result by the main (or small profit) rate.


The patent box regime will apply to patent profits arising on or after 1 April 2013. The November 2010 consultation proposed that it only applied to patents first commercialised after 29 November 2010. However instead of a cut off date for introduction, a phasing in of the regime is now proposed that will bring in all qualifying patent profits, whenever the patent was commercialised. In the first year of operation the regime will apply to 60% of qualifying patent profits, increasing by 10% each year until the regime applies to 100% of qualifying profits from 1 April 2017.

4.2. EIS and EMI qualifying company changes introduced by F(No 3)A 2010

As was well trailed F(No3)A 2010 changed the qualifying company condition for those companies wishing to make use of the Enterprise Investment Scheme (EIS) incentive, to include a UK permanent establishment condition (see item 4.6 of Informal 4 October 2010). It also made a similar change to the Enterprise Management Incentive (EMI) scheme, though in a different way. The purpose for the two different UK permanent establishment condition requirements does not appear to be immediately obvious.


The EIS rules require that the issuing company has to meet the qualifying business activity requirement throughout period B (ITA07 s183(1). Period B is the period beginning with the issue of shares and ending before the termination date relating to the shares, with termination date being the later of 3 years after issue or three years after the commencement of the qualifying trade.

The meaning of qualifying business activity (ITA07 s179) for shares issued before 6 April 2011 was that the issuing company or its qualifying 90% subsidiary carried on the qualifying trade. Qualifying trade required the company (or its qualifying 90% subsidiary) to carry on the qualifying trade wholly or mainly in the UK. Where the company did not meet the qualifying business activity requirement throughout period B, EIS relief would be withdrawn (see ITA07 s234(3)).

Under the rules in operation for shares issued on or after 6 April 2011, the references in ITA07 s179 to the qualifying trade being carried on wholly or mainly in the UK in relation to 'qualifying business activity' have been removed. A new condition has been added that the issuing company must have a permanent establishment in the UK (and meet a financial health condition) throughout period B.

Thus, whereas previously the issuing company did not need to have a permanent establishment in the UK, for shares issued on or after 6 April 2011, it does. In particular new s191A(8) specifies that a company does not have a permanent establishment in the UK if it only controls a company that is UK resident or that has a UK permanent establishment.

Possible solutions could be for the overseas company to set up a UK permanent establishment to carry out management services to subsidiaries, or for the overseas company to set up a UK LLP to carry on the UK trade.


F(No 3)A 2010 also introduced a UK permanent establishment requirement for the qualifying company and removed the requirement for the qualifying trade to be carried on wholly or mainly in the UK. However the permanent establishment requirement for the EMI scheme requires either the company itself to have a UK permanent establishment, or be the parent company of a group any member of which exists wholly for the purpose of carrying on one or more qualifying trades and is doing or preparing to do so and has a UK permanent establishment. Thus this permanent establishment requirement is more relaxed than that required for the issuing company for EIS purposes.

4.3. Research & Development response and consultation

HM Treasury and HMRC have published a response and consultation document following the November 2010 R&D tax credits consultation. The main points covered are:

Method of tax relief and PAYE/NIC limit on tax repayments

Respondents commented that a better way of giving tax relief would be as a credit against the corporation tax liability due rather than as an enhanced deduction in calculating taxable profits. This would be of benefit particularly to larger companies in loss making periods, as only SME's can currently surrender R&D losses for a tax repayment, subject to the amount of PAYE and NI paid.

Also start up companies with limited payroll costs, who might use subcontractors for R&D work, are limited by the PAYE/NIC cap on R&D tax credit repayments.

The Government is receptive to these comments and will consider the evidence for attracting internationally mobile R&D activities from giving relief through a tax credit rather than enhanced deduction. It will also publish draft legislation in the autumn for Finance Bill 2012 to remove the PAYE/NI limit on tax repayments.

Externally provided workers

It was recognised the rules permitting relief for subcontractors working for large companies (compared to those working for SMEs) can be overly restrictive. Further consultation is proposed for the autumn on widening the availability of R&D relief through the use of subcontractors.

Qualifying costs

No new types of cost were identified for addition to the current list, however it was recognised there was uncertainty around the exclusion for production costs (for example for prototypes) and draft guidance clarifying HMRC's interpretation is promised shortly (though there will be no statutory definition of "production").

It was also recognised there were difficulties in the methods for claiming for qualifying indirect costs and whether this really assisted the R&D activity. Further consultation is proposed in the autumn on the merits and clarity of claiming for qualifying indirect activities.

The claims process

A pilot will be introduced in the autumn for voluntary advance assurance on the validity of an R&D tax relief project for small companies and new start ups.

The going concern condition

Under the current 'going concern' definition, the key issue is whether the last published accounts were prepared on a "going concern" basis. The problem is that the last published accounts may relate to a period some time ago, and the company's circumstances may have changed – for better or worse – since that time. The government will therefore consult on a change to the EU definition of 'in difficulty' as currently used for the EIS and VCT regimes.

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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Richard Mannion
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