Weekly Tax Update - Monday 04 July 2011

1. GENERAL NEWS

1.1. Office of Tax Simplification – future projects

The Office of Tax Simplification has written to the Exchequer Secretary to the Treasury as follows:

2. PRIVATE CLIENTS

2.1. PAYE reconciliations

We have received the following note from HMRC:

2.2. Gifts of pre-eminent objects and works of art to the nation

The Government has published proposals for consultation on a new scheme to encourage people to donate pre-eminent objects or works of art to the nation. In return, donors will receive a reduction in their income tax and CGT liability, based on a set percentage of the value of the object they are donating. The Government is seeking views on a number of areas of detailed policy design for the scheme and welcomes submissions from all interested parties. The consultation runs until 21 September 2011.

The aim of this new scheme is to stimulate lifetime giving by encouraging taxpayers to donate pre-eminent objects, or collections of objects, to the nation. In return, donors will receive a reduction in their tax liability based on a set percentage of the value of the object they are donating. The Government anticipates that this new scheme will appeal to owners of objects and collections who want to see them placed in appropriate institutions during their lifetime, and to be held in perpetuity for others to enjoy. Importantly, donating the object to the nation will ensure that the object will remain within the UK, bolstering UK heritage. This approach will also provide the Government with the means to ensure that the objects are made available to the public and are maintained in good condition.

The new scheme will share some elements with the existing IHT Acceptance in Lieu (AIL) scheme which will continue to operate in parallel with this new scheme. The Government envisages that the existing AIL panel of experts will form the basis of the expert panel that will assess gifts made to the nation under the new scheme. Both schemes will share the annual limit that has been available to date for the existing IHT AIL scheme (currently set at £20m per year).

There are also some differences between the two schemes. Importantly, to qualify for a tax reduction under the new scheme, the object has to be first and foremost a gift to the nation. Also, while the existing IHT AIL scheme covers pre-eminent objects, land and buildings, the new scheme will be limited to pre-eminent objects only. Donors may already claim income tax relief or corporation tax relief on gifts to charities of land and buildings.

www.hm-treasury.gov.uk/d/consult_gifts_of_art.pdf

2.3. High risk areas of the tax code: Relief for income tax losses

HMRC has issued a consultation document covering relief for income tax losses.

The Budget announced the intention to strengthen the legislative framework in areas of the tax code that have repeatedly been subject to avoidance. HMRC is aware from disclosures under the Disclosure of Tax Avoidance Schemes (DOTAS) regime and other sources that, despite the changes to the legislation, avoidance arrangements purporting to provide income tax losses are still being used by a small but significant number of people and involve substantial amounts of tax.

These arrangements may insert artificial steps intended to circumvent the anti-avoidance rules in place or may rely upon a set of facts (for example, that persons work actively in a trade for at least 10 hours a week) disputed by HMRC.

HMRC believes that the current legislation is effective against the avoidance arrangements that are currently in use, but is concerned that new arrangements are continually being devised. Furthermore, it may be necessary to carry out a detailed investigation of the arrangements and the activities of individual taxpayers to resolve the loss claim and to take the case to litigation.

Spotlight 8 (8 February 2010) warned taxpayers that HMRC considers that tax avoidance arrangements intended to generate trade losses for use against general income or capital gains do not meet the commercial and other fundamental requirements for relief so that no relief is available.

The policy objective is to strike the appropriate balance between ensuring that genuine business losses and employment losses are relieved while effectively deterring taxpayers from entering into tax avoidance arrangements intended to exploit these loss reliefs.

The availability of sideways loss relief for deduction against general income or capital gains has led to it being regularly targeted by persons seeking to abuse the intention of the reliefs for tax avoidance purposes. This has resulted in the introduction of a significant number of restrictions both historically and in recent years:

• general anti-avoidance rule preventing sideways relief where the main purpose of the arrangements is to obtain a tax advantage;
• the trade must be carried on commercially with a view to the realisation of profits;
• a cap of £25,000 on losses for non-active traders;
• loss restricted to the capital contribution in the case of a partner.

HMRC's view is that the current restrictions provide a robust defence against tax avoidance and that arrangements entered into with the intention of exploiting sideways loss relief do not achieve the tax advantage sought. However, they say that the avoidance increasingly relies upon some element of misrepresentation or concealment of the facts, thereby, disguising tax avoidance as commercial activity and artificial losses as trade losses.

The consultation paper says that although the types of tax avoidance involving sideways loss relief vary in detail they all share the basic characteristic that the amount of loss relief claimed greatly exceeds the actual economic loss, if any, to the taxpayer concerned.

Typical features of tax avoidance activity intended to access sideways loss relief include:

• a wealthy individual who derives most of their income from their day-to-day activities making an investment with a view to accessing losses for use as sideways loss relief against their general income and/or capital gains;
• the individual having no real involvement in a business, but claiming to be trading either alone or in partnership on the basis that they have invested money in the business;
• the structuring of an investment so as to put the investor at no risk of losing their money;
• the supplementing of the investor's own money by loan finance, often notional or circular, so that the amount of loss claimed is substantially in excess of the amount of the individual's own money put at risk;
• artificially created costs, expenditure not matched by taxable receipts, or assets and/or income located/diverted overseas.

In many cases, the individual taxpayer has no connection with, or expertise in, the type of activity supposedly generating the loss and has no involvement in the day-to-day running of the business. These individuals are subject to the maximum £25,000 cap on sideways loss relief that applies to "non-active" traders and limited partners. HMRC believe that this has led to non-active individuals claiming to be active on the basis that they undertake an activity loosely connected to that type of business for the required average of ten hours a week.

HMRC's view as set out in Spotlight 8 is that activities undertaken by these individuals, for example, reading scripts or medical journals, watching TV or DVDs etc. are not undertaken on a commercial basis with a view to a profit with the result that any trade loss would be subject to the sideways loss relief restrictions for nonactive traders and limited partners.

HMRC also has concerns about claims for losses arising in a property business atrtributable to a capital allowances or agricultural connection ("property loss relief against general income").

In addition HMRC is concerned about claims for employment losses. In the past such losses generally arose where the employee had a contract that made them liable for some of their employer's loss or an office holder was liable for expenses of the office. For example, a departmental manager may have been remunerated by a percentage of the profits of their department and responsible for a corresponding percentage of any losses, or a commercial traveller may have been liable for bad debts arising from orders obtained by them.

HMRC is aware of only a handful of legitimate claims made by employees in the past 45 years and none since the 1990s and suggests that with the introduction of national minimum wage for all employees except directors there is little likelihood of legitimate claims to the relief.

Legislation was introduced by Finance Act 2009 to counter losses arising on contrived employment arrangements, but HMRC is aware that tax avoiders continue to argue that these highly contrived arrangements involve valid claims to employment loss relief and that there is no tax avoidance purpose.

The consultation sets out a number of approaches that could be considered to achieve the policy objective of providing appropriate relief whilst deterring avoidance including:

• Principle-based legislation, for example restricting the relief to the amount of the economic loss irrevocably suffered in the trade, profession, vocation, property business or employment.
• Mechanistic rules, for example applying a £25,000 cap in any one tax year on losses that can be relieved against general income or capital gains.
• Administration of the claims, for example no repayment or credit for claims for losses in a tax year in excess of £25,000 until a claim is agreed by HMRC.

2.4. Income tax loss schemes – Spotlight 8

We continue to see schemes offering tax loss relief for the last three years which rely on the individual demonstrating that they are personally engaged in the business for 10 hours a week on average. In this connection the latest consultation paper includes a timely reminder about Spotlight 8 issued by HMRC in February 2010 and which is reprinted below:

Spotlight 8: Investments to obtain trade loss reliefs ('sideways loss relief') (8 February 2010)

HM Revenue & Customs (HMRC) are aware of schemes seeking to exploit sideways loss relief by generating trade losses for individuals. Typically, a large loss is generated, either in partnership or alone, by accounting for the arrangement as a trade and either writing down the value of trading stock or claiming deductions or allowances for purported trading expenditure. Often these schemes are funded in part by borrowing and may include a mechanism that means repayment is guaranteed. The individuals claim the loss as sideways loss relief against their other tax liabilities. HMRC's view is that these schemes fail to meet the commercial and other fundamental requirements for sideways loss relief so that no relief is available to the participants.

In addition to not meeting the fundamental requirements for sideways loss relief, HMRC's view is that individuals participating in these schemes also do not meet the requirement that at least ten hours a week are spent personally engaged in commercial activities of the trade carried on with a view to earning profits from those activities. HMRC's view is that the activities which these schemes claim are sufficient to meet the test, for example reading scripts or medical journals, watching TV or DVDs etc, are not undertaken on a commercial basis with a view to profit with the result that any trade loss would be subject to the sideways loss relief restrictions for non-active traders.

For arrangements made on or after 21 October 2009 a general restriction will also apply preventing sideways loss relief for a loss arising to a person from a trade, profession or vocation where a main purpose of the arrangements is to obtain a reduction in tax liability.

Whenever arrangements have been entered into to obtain a tax reduction by way of sideways loss relief HMRC will actively challenge these arrangements and the activities of individual participants and litigate, if necessary. HMRC will also withhold repayments of tax resulting from claims to sideways loss relief in appropriate cases.

3. BUSINESS TAX

3.1. HMRC toolkit on business profits

HMRC has issued the expected toolkit on business profits.

www.hmrc.gov.uk/agents/toolkits/business-profits.pdf

3.2. Corporate Capital Gains and value shifting

Finance Bill 2011 introduced refinements to the Corporate Capital Gains rules in relation to value shifting (Sch9), degrouping charges (Sch10), and capital losses on a change of ownership (pre entry losses – Sch11). This note highlights some of the benefits of the new degrouping provisions and highlights a potential trap with the value shifting provisions.

Degrouping

The changes on degrouping charges helpfully treat the gain triggered on a degrouping as extra consideration for the vendor company on the disposal of its subsidiary with the asset subject to the degrouping charge. Thus where the subsidiary being sold qualifies for the substantial shareholdings exemption so that any gain on disposal is exempt from corporation tax, the degrouping charge will now also be exempt. There are also provisions for facilitating the incorporation of a division and access to the substantial shareholdings exemption with the SSE time limit for the new company being assessed with respect to the length of time the CGT assets (but not, currently, assets subject to the corporate intangible asset regime) subject to incorporation were used by the group. These Finance Bill 2011 provisions will generally have effect from the date of Royal Assent. However in relation to the changes to degrouping provisions it is possible to make an election for them to apply with effect from 1 April 2011. Further information can be found in briefing note 161.

Value Shifting

An area of reform that might have received less attention is the simplification of the value shifting rules. These were previously covered by TCGA s30-s34 and have been simplified by amending s30 and replacing s31-34 with a newly drafted s31. The simplification can result in some differences which could be adverse for some taxpayers. This is illustrated below:

Assume a corporate structure as illustrated, with Sellerco unable to take advantage of the substantial shareholding requirement. Assume Sellerco has transferred a valuable asset to Buyerco at a time when the market value of the asset was 100 and base cost was 40, and either received from Buyerco cash of 100 or Buyerco shares of 100. Assume Buyerco has been sold outside the group within six years of the transfer of the valuable asset, and either itself qualified for SSE, or the degrouping charge has been assessed. When considering the rationalisation of the group and assuming Sellerco is no longer required, the question now arises as to how to deal with its winding up. Options could include a dividend of reserves followed by either a return of share capital, or a recapitalisation to create nominal share capital and a further distributable reserve.

In considering the winding up one would need to consider the value shifting provisions, as the Sellerco's base cost to Topco is 40, but its value (assuming no further increase since the transaction with Buyerco) is 100.

Under the pre Finance Bill 2011 provisions the value shifting rules under the old TCGA s31 were triggered in the case of distributions within a group followed by a disposal of shares if three conditions were met:

1. Sellerco had either: sold an asset subject to a s171 nil gain nil loss transfer; undertaken an exchange of shares treated as a re-organisation under s135 or 136; revalued an asset in its accounting records;
2. during the period beginning with the transaction referred to at (i) and ending immediately before the event potentially triggering a TCGA s30 disposal (of investment in Sellerco), there was no disposal of the 'asset with enhanced value' (such as A in the diagram above) to any person other than a disposal to a group company meeting the requirements for s171(1), and no s179 charge had arisen in that period on the 'assets with enhanced value';
3. immediately after the section 30 disposal the 'asset with enhanced value' (eg A in the above diagram) is owned by a person other than the person making that disposal (e.g. Topco in the above diagram) or a company associated with it.

Thus where Buyerco in the above example had been sold outside the group, condition (ii) above would not have been met, and the value shifting provisions would not have applied to the realisation of the value in Sellerco through winding it up.

Under the new rules the old s31 is replaced so that the value shifting provisions are triggered where three different conditions are met:

1. arrangements have been made whereby the value of those shares or securities, or any relevant asset, is materially reduced,
2. the main purpose, or one of the main purposes of the arrangements is to obtain a tax advantage, and
3. the arrangements do not consist solely of the making of an exempt distribution.

The last of these conditions seems to indicate that the only possible arrangement that can occur to avoid the application of the value shifting rules is the making of an exempt distribution and example 1 included in HMRC's draft guidance (http://www.hmrc.gov.uk/budget-updates/autumn-tax/shift-rules.pdf). The condition in (c) would be met for example where there are any other events apart from an exempt distribution (for example a capital reduction and distribution of the reserve created on reduction).

It might then be relevant to consider whether if Sellerco is wound up and its assets distributed this might meet the definition of a distribution. CTA10 1000 sets out the meaning of a distribution, which can include (at B) a distribution out of assets in the company except that which represents a repayment of share capital or is equal to any new consideration received by the dividend paying company for the distribution. However CTA10 s1002(2) and s1021 specify that in the case of Topco and its 100% subsidiary Sellerco this cannot amount to a distribution.

The result in the example highlighted above, unless Sellerco meets the conditions for substantial shareholdings exemption itself, there is a risk of the value shifting provisions being triggered to bring the increase in value of Sellerco over its cost into charge to corporation tax. This situation could arise where larger groups have undertaken corporate transactions, but for whatever reason, delayed the simplification of their corporate structures.

3.3. Controlled Foreign Companies Reform

HMT and HMRC have published a more detailed consultation document on extending the interim improvements to the regime already included in Finance Bill 2011. This consultation highlights the following main points:

• The new CFC regime will adopt a proportionate approach (in contrast to an entity approach). Thus the regime will determine what proportion profits, if any, of the CFC represent profits artificially diverted from the UK and bring them fully into the UK tax net.
• As currently, there will be a range of exemptions, but the proposals seek to modernise these to take account of modern business practices.
• It is proposed the new CFC regime will apply to the new foreign branch exemption regime.

Basic definitions for coming within the regime

• The definition of a controlled foreign company could have three options for approach: (i) principles based, (ii) accounting standards based, or (iii) a more mechanical approach.
• Consideration is being given to options for increasing the deminimis limit. Option (i) increases the limit from £200,000 to £500,000, but places a limit on the amount of investment income to be included (say 10%). Option (ii) considers increasing the deminimis limit in line with group turnover, so that there would be a range from a lower limit of £200,000 to an upper exempt limit of £1m.
• Reform of the excluded countries regime is being considered, with a preference for something designed along the lines of the existing excluded country regime. The lower level of tax will be based on the computation of UK taxable profits and assessed against tax actually paid overseas.
• There are some points still to be resolved, including how dual resident companies are dealt with. There is a proposal to consider that US LLCs (which do not have a territory of residence) could meet the excluded countries exemption and territorial business exemption.
• A temporary exemption period of up to 3 years is being considered for companies that are first brought within the CFC regime as a result of a commercial acquisition or re-organisation.

Specific exemptions

• Specific exemptions will apply where CFCs can meet one of the following:
• Territorial Business and Sector Specific Exemptions (TBEs). Three mechanical TBEs are proposed: (i) a profits rate safe harbour, (ii) a manufacturing trade safe harbour and (iii) a more general exemption for a CFC carrying on a commercial trade. In addition a principles based approach to exemption is also being considered – either as an alternative or a supplement to the mechanical exemptions.
• A general purpose exemption (GPE): this will fulfill the same role as the existing motive test.
• Specific exemptions could apply to certain overseas property investment and operating lease activities, and also to banking and insurance activities meeting certain requirements.

Monetary assets and intellectual property

• The new regime will in particular target CFCs that in the Government's view pose a high risk to the UK tax base. These will include CFCs involved with:
• Monetary assets. Recognising the move to a more territorial tax regime a finance company partial exemption system will be introduced to tax one quarter of the overseas finance income. Rather than focusing on balance sheet tests, the proposal is for an apportionment of either finance income or finance profit of the CFC (thus avoiding a debt equity ratio hurdle). There is also the suggestion that it may be possible to introduce a full exemption where profits are invested overseas and UK members of the group have no net borrowing costs. Along with partial exemption there will be a corresponding apportionment of the amount of applicable foreign tax credit that can frank any UK tax charge. There will need to be an appropriate level of local management and decision making in the CFC for the partial exemption to apply. As noted above, there will be an exemption for insurance and banking activities that meet certain criteria.
• Intellectual Property. CFCs that hold IP as a passive investment which is more than incidental to their activities will be targeted, and there is guidance on how the government envisages it would target these activities. Consideration is also given to a tapering charge depending on the length of time since the IP left the UK.

The document also sets out the government's interpretation of how EU law interacts with the way it proposes to operate, and currently operates, the CFC rules, though whether the sentiments expressed are discernible from the legislation will require further review.

Responses and input to the consultation are requested by 22 September 2011, so that draft legislation can be issued in the autumn for consideration, with finalised legislation scheduled for Finance Bill 2012.

www.hm-treasury.gov.uk/d/consult_cfc_detailed_proposals.pdf

4. VAT

4.1. Input VAT recovery on corporate acquisition costs

The Upper Tribunal has overturned the First Tier Tribunal decision in the BAA case concerning input VAT recovery on corporate acquisition costs (see Informal of 15 Feb 2010 for coverage of the FTT decision, also reproduced below; the acronyms used for the summary of the Upper Tribunal are the same as those referred to at the First Tier).

While the Upper Tribunal concluded that ADIL undertook an economic activity, it found that the costs, the input VAT on which was subject to this dispute, had no direct and immediate link to any taxable supply made by ADIL and that therefore the First Tier Tribunal had erred in law in its conclusions.

The Upper Tribunal disagreed with the First Tier Tribunal's interpretation of the Faxworld case. In that case a partnership (Faxworld GbR) incurred VAT on costs in setting up a business which it was always intended would be carried on in corporate form (eventually through Faxworld AG and to whom the business and assets were transferred). The circumstances of that transaction can be closely compared to the UK's transfer of a going concern (TOGC) rules, so that it is understandable that to maintain tax neutrality for VAT purposes, the activities of the partnership and the company could be understood to be a continuing fiscal unity. The Upper Tribunal concluded the circumstances surrounding Faxworld could be distinguished from those surrounding ADIL and BAA, as BAA was already carrying on taxable activities both before and after ADIL became part of the group and the pre-acquisition costs incurred by ADIL did not change that fact.

The Upper Tribunal noted the conclusions of the First Tier Tribunal that there was no evidence to support the contention that ADIL had the intention of joining the BAA VAT group prior to completion of the BAA takeover. ADIL initially applied to submit further evidence as to its pre-completion intentions, but subsequently withdrew. As there was no evidence of any intention to join the BAA VAT group prior to completion, and as ADIL made no supplies to BAA prior to completion, The Upper Tribunal concluded there was no direct and immediate link between the input VAT incurred by ADIL and subsequent taxable supplies by the VAT group.

As the Upper Tribunal concluded ADIL had not made taxable supplies as a result of the costs which were subject to the disputed VAT, it concluded that there was no possibility of ADIL being able to rely on HMRC's 'discretionary' powers to permit pre-registration input VAT recovery (the input VAT had not been incurred on making subsequent taxable supplies).

The points to take away from this are that in order for there to be input VAT recovery on pre-acquisition costs, it is important to show a direct and immediate link between the taxable supplies actually made as a result of the acquisition. The Upper Tribunal commented that the acquisition of shares was a different matter to the acquisition of a business and assets, and that all share transactions should be treated similarly for VAT purposes, whatever the business of the acquired target company.

While reference was made to Floridienne SA and another v. Belgian State (Case 142/99) [2000] STC 1044 for the proposition that the making available of capital – for example, by advancing capital by way of interest bearing loans – is not of itself a taxable activity, there was no further comment by the Upper Tribunal on HMRC's contention that the First Tier Tribunal's less restrictive view of the provision of loan finance should have been directed to conclude that there was no taxable activity.

On the assumption that this decision is not appealed, those businesses making corporate acquisitions should very carefully examine their entitlement to input VAT recovery on costs associated with the acquisition of shares.

www.tribunals.gov.uk/financeandtax/Documents/HMRC_v_BAA_Ltd.pdf

The summary of the First Tier Tribunal decision as reported in Informal of 15 Feb 2010

HMRC disputed the claim to input VAT recovery amounting to £6.7m by BAA plc. The disputed VAT related to residual input VAT claimed under of BAA's partial exemption method on costs incurred during the acquisition of BAA by Frerrovial, through a bid vehicle known as ADIL (Airport Development and Investments Limited – incorporated on 27 March 2006).

BAA plc became a wholly owned subsidiary of ADIL on 1 July 2006. ADIL had incurred acquisition costs in the period July to October 2006 the disputed amounts of which totalled around £38m (VAT after partial exemption being £6.7m). Once the acquisition was complete ADIL applied to join the BAA VAT group and was eventually admitted with effect from 22 September 2006. It is not clear from the case summary whether ADIL was registered for VAT before September 2006, but its intended business activity in the group was for supplies to other group members totalling around £100k annually and no supplies to members outside the VAT group. BAA's partial exemption special method permitted full recovery of input VAT on overhead costs. Any input VAT on costs incurred on services within 6 months of registration for VAT can be recovered provided they were incurred for the purposes of the business, and provided no sales have been supplied by the taxable person registering and provided the services were not performed on goods.

The majority of the disputed costs related to a £30m acquisition fee due to Macquarie bank which was part of a contract providing for £30m in respect of a successful acquisition and £20m in respect of successful funding negotiations for extended bank facilities. Despite the fact that ADIL intended to make sales within the group, no intragroup service invoices had been raised.

HMRC contended that the input VAT on disputed costs had been incurred solely on the acquisition of the business and not for any taxable supply made by the BAA group. In their opinion it was only once the acquisition was complete could the activities of ADIL be described as carrying on an economic activity where input VAT can be reclaimed on costs. They contended that there was no link between the activities pre and post the acquisition and that ADIL could not contemplate taking part in BAA's business until the acquisition was complete. The BAA VAT group contended that the VAT was incurred for the purpose of carrying on the airport business with ADIL acting in a strategic, governance and advisory capacity, including successfully negotiating further financing for the BAA group's future capital expenditure plans.

The Tribunal found that there was no distinction between the acquisition as an investment and the carrying on of the airport business by Ferrovial through ADIL. In particular HMRC's contention that the chain of events on which costs were incurred which could be carried through to relate to the business, was not broken once the acquisition was complete. Thus ADIL was held to be carrying on an economic activity. This was despite the fact that it did not actually make a taxable supply in its own right. Commenting that intragroup supplies were a non-event for VAT purposes, the Tribunal clarified that the principles outlined by the ECJ in the Faxworld case (C-137/02) entitled ADIL to take advantage of the taxable transactions of the BAA VAT group, and thus be regarded as a taxable person within the meaning of the Sixth Directive and entitled to recover input VAT as there was a direct and immediate link to the supplies of the BAA group as a whole.

While the BAA case concerned input VAT in connection with a business acquisition, it may be pertinent to also refer to the ECJ case of AB SKF (C-29/08) where it was held that input VAT connected with the disposal of a business could be reclaimed in line with the owner's input VAT recovery proportion, not withstanding that the disposal was of a wholly owned subsidiary (see informal 2 November 2009).

www.financeandtaxtribunals.gov.uk/judgmentfiles/j4720/TC00357.doc

5. TAX PUBLICATIONS

NTBN185 - IHT – How to avoid investigation

HMRC has increased its yield from IHT investigations. This note considers how to reduce the prospect of HMRC successfully challenging an IHT return.

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.