This paper sets out the response of the Chartered Institute of Taxation to Chapter 2 and Annexes A and B of the consultative document issued by the Treasury in July 2001. We broadly welcome the philosophy outlined in Chapter 1 but would point out that more progress needs to be made in this area, for example tackling the outdated and distortive Schedular system and dealing with some of the continuing complexities of the DTR regime. We shall be continuing to draw these matters to the Government's attention.
Chapter 2 of the document deals with two matters:
· relief for capital gains, and
· taxation of foreign dividends.
As regards foreign dividends, we appreciate that following the fundamental changes to the double taxation relief legislation, which took effect earlier this year, there is little appetite for further fundamental change in the near future. We would certainly agree that exemption would be counterproductive if it were to be accompanied by rules restricting tax relief for interest payable, which would risk undermining the international competitiveness of the UK as a parent or holding company location.
We are however concerned that in developing its policy in this area the Government appears to have taken an insufficiently urgent view of its European Union obligations. In the light of recent case law, there is a very serious question as to whether it is compatible with these obligations to fail to extend to dividends paid by EU resident companies the exemption enjoyed by UK source dividends. Even if this difference in treatment can be justified, this leaves the question of whether, under the double tax relief regime, the prevention of eligible unrelieved foreign tax arising on qualifying foreign dividends can be defended. It seems hard to identify any policy purpose behind this restriction other than to create a potential fiscal disadvantage on holding foreign subsidiaries through intermediate offshore holding companies. This is a significant discrimination in practice as many groups have such structures for a variety of reasons, not all of which are fiscally motivated (for example as a result of acquisitions of foreign groups). It is also a tax distortion of the sort rightly condemned in paragraphs 1.6, 1.16 and 1.18 of the consultative document itself.
We have the impression that these issues - which would not of course be entirely removed by the very limited exemption proposals in Annex B of the document - are to some degree understood but are not regarded as a priority to resolve. In our view compliance with EU and indeed all our international obligations is an aspect of the rule of law. The Government repeatedly, and rightly, condemns taxpayers who evade their legal obligations relating to tax. It should unambiguously and enthusiastically practice what it preaches. In this field, the Government should not use the rejection (for the immediate future) of exemption of dividends to close the door to any further changes in this area. In the short term it should actively seek to simplify the current regime by making it less discriminatory and distortive. There is also a strong case for a more fundamental longer term review of the implications of our EU and other international obligations for the shape of the tax system in this and possibly other areas.
As regards gains on substantial shareholdings, the discussions which have been held with the Revenue since the original Technical Note was issued in June 2000 have made considerable progress in developing a workable regime. We have been pleased to participate in the further discussions which the Revenue have organised since the publication of the present Consultative Document. We also agree with the general consensus which has developed in favour of an exemption rather than a deferral for the reasons which have already been set out in detail.
Accordingly, the rest of this paper comments on Annex A of the consultative document.
We would like to express our appreciation for the sustained and positive efforts made by the Inland Revenue throughout this period to identify and address issues arising from the proposals, for taxpayers as well as for the protection of the revenue, both in discussions and in the production of discussion papers such as the one we refer to under derivatives below. We would be pleased to take part in further discussions and consultation on the draft legislation and related matters arising.
Paras A.5 - A.8 - Qualifying shareholder company and “trading company”?
We do not see a valid public policy reason for denying the proposed relief to groups conducting bona fide commercial investment business. The benefits of attracting such businesses to locate holding companies in the UK, and the case for removing the distortive effects of taxation of capital gains from disposing of structural shareholdings, apply much as they do to trading groups.
If the Government were to reject this view, our view is that the “before and after” test proposed in para A.5 will work if the purposive definition of trading company and trading group applies, but that difficulties will be encountered if the activities definition applies. We understand the Revenue’s preference for an objective test, but we are concerned to ensure that any test is fair and does not undermine the purpose of the new relief. There appear to be two possibilities:
· to include a period of, say, twelve months either side of a disposal for the company to qualify, or
· to amend the activities test to include the intended activities of a company or group.
For example, a company may undertake activities in preparation for the commencement of trading, but may be sold before the trade actually begins. It is understood that the Revenue accept that activities which are preparatory to a trade being carried on will be taken into account in applying an activities test.
Another example might be the case where a potentially qualifying disposal is made of a company/sub-group comprising the group's only trading operations, and where there is a genuine intention to reinvest in trading operations, but this proves unviable and the investing company is then liquidated, which in most circumstances (including sale by a UK resident individual) would produce a taxable event at the next tier up. It seems to us that relief should be given to the original disposal in such circumstances.
In general, disposals by a liquidator in the course of liquidation should be within the scope of the proposals.
We comment further at the end of this paper on the question of possible exploitation by individuals in this area.
Paras A.9, A.10 - Qualifying investee company
Again, we do not think that qualifying investee status should be restricted to trading groups - these are not the only form of commercially desirable business venture.
We understand the Revenue’s concern about possible schemes being set up to convert income into capital. However, we believe that the proposed rule will be unnecessarily restrictive. An alternative way of dealing with the problem is to disqualify gains on shareholdings which are attributable to accumulated profits of an “offending” nature, such as are referred to in Sch 5AA TA 1988, for example.
If this view is rejected then similar points arise in relation to definitions as in the preceding section.
Paras A.11 - A.14 - What is a substantial shareholding?
It appears that the Government is keen to include shareholdings of less than 20% - or above 20% in a 'headline' sense but which fail the Schedule 18 test - which are structural rather than portfolio shareholdings. However, there is a problem in finding a workable definition. In our response to the Technical Note, we suggested that the criteria for equity accounting should apply. We remain of the view that the accounting test is likely to be the best 'soft test' available. We would point out that:
· this test is based on the exercise of influence over the investee company which is a good indication of the structural nature of the investment;
· many structural shareholdings will not meet a 20% test, especially on the 'Schedule 18' definition, which is restrictive, even if as we understand, and would prefer, the 'capital gains group' rather than 'group relief' version of the definition is to apply;
· whereas typically a 'soft test' risks being harder to apply under self assessment than a 'hard test', the reverse is true for an accounting test, at least for the majority of groups who will actually have had to apply it in drawing up accounts;
· it is a mistake to believe that soft tests are intrinsically manipulable but hard tests are not: for example, it would not be difficult to arrange to fail the Schedule 18 test, if a taxpayer had the objective of getting outside the proposed regime, by adoption of a particular share structure;
· a test which already applies in other contexts (in this case, public accounting and reporting) is likely to be less manipulable than a test adopted solely for fiscal purposes;
· the robustness of the test could be reinforced by a requirement as to the consistency of the accounting treatment adopted;
· the possibility of manipulation would be further reduced if the accounting test were adopted alongside the 20% Schedule 18 test, so that meeting either test triggered the exemption; and
· in practice, we understand that most difficulties encountered in ensuring compliance with FRS 9, the relevant accounting standard, relate to groups with more than 20% holdings - and commensurate actual influence - who wish to avoid equity accounting, either because of the administrative burden, or because the investee company is loss-making and they do not wish to report their share of the losses, or simply because of the risk of that eventuality given that they do not control, as opposed to influence, the underlying business. It may well be that the fiscal consequence of exemption (especially bearing in mind how limited the potential use of capital losses is likely to become after the next Finance Act) will on balance reduce rather than increase difficulties in enforcing compliance.
More fundamentally, the principle that tax consequences should not be given to accounting standards for fear of placing compliance with those standards under pressure should not be accepted. Correct accounting has no value in itself; its value lies in presenting a true and fair view of the business to actual users of accounts, including the fiscal authorities. The logical conclusions of such an approach would be to remove any alignment whatever between tax and accounts (a result which has never pertained historically and which would create extraordinary compliance burdens) and indeed to eliminate any commercial or practical reliance on accounts, which would then become purely academic products insulated from the pressures of life.
If the accounting standard cannot be accepted, then we suggest the following additional headings (apart from the main 20% Sch 18 heading) under which a shareholding could qualify:
· a shareholding of 5% or more in a consortium company (as defined for consortium relief purposes) should qualify;
· a shareholding attracting 10% or more of the voting power (as required for underlying tax relief purposes) should qualify.
It is possible that some non-structural shareholdings would then be brought within the regime, although both these tests are intended in part to distinguish portfolio from structural investments. However, it is inevitable that any 'hard test' will either exclude some who should be brought in, or include some who should be left out, or both. A threshold much lower than 20% would not be unusual internationally, especially considering that the consortium definition in particular, like the Schedule 18 definition, has a number of detailed conditions such that the low 5% 'headline figure' may give a misleading picture of the true level of effective threshold being applied. The risk is that the 20% test, on the restrictive Schedule 18 definition, may not turn out to be as competitive internationally as the Government hopes. Commercially, our perception is that use of joint venture arrangements is increasing, so these issues may be of more significance in the future than currently may appear to be the case.
Review of s179 TCGA 1992
The operation of s179 needs to be reviewed. It is clear that s179 will continue to be required in some form or other to protect the Revenue against the envelope trick. This was the original purpose of s179. That purpose has subsequently been extended to catch certain gains at the asset tier which are not reflected in gains on disposals of the transferee company. This extension has happened fortuitously rather than by decision. If potential capital gains at every tier in a complex group were always to be reflected in taxable disposals, then single economic gains would be subject to multiple taxation. We accept that many factors mitigate this in practice, our point is that this is a dubious criterion to be applying.
Six years is a very long time in business terms. Certainly it is not possible to plan events six years ahead. Therefore, in so far as s179 is a tax avoidance provision, the six year period is clearly excessive.
The following suggestions for reform are put forward:
· that the six year period under sub-section (1)(c) be reduced to two years (or possibly, that the application of the section should be made dependent on a motive test, with a rebuttable presumption as to motive being created by application of a two-year test);
· that the s179 gain should arise in the transferor company and be treated for all CG purposes including loss and rollover relief as a gain on an actual disposal; and
· that if the asset is in use for the purposes of a trade, and the disposal of the transferee company out of the group is an exempt disposal under the new rules, then there should be no s179 gain on that asset.
It is worth noting that there are various problems with s179 not specifically related to the proposed new relief. These should also be considered in any review of the section.
Paras A.19 - A.21 - Company migration
We understand the Revenue’s concern that one of the effects of the exemption for gains on substantial shareholdings is that it would apply in particular to gains arising under s185 TCGA 1992 when a holding company emigrates. In our view, the availability of the exemption is not, by itself, likely to cause parent companies to emigrate. A parent company is unlikely to emigrate purely for tax reasons and will not emigrate for tax reasons if the UK tax system as a whole is competitive, which is the government’s stated objective. Our view is that any anti-avoidance measures should be targeted at avoidance arrangements. We shall be pleased to participate in the further discussions on this issue.
Of the options listed in paragraph A21, we instinctively prefer the fourth approach as it is the only one that does not seek to have potentially significant effects going beyond the scope of the exemption proposal. We understand that difficulties (including EU compliance difficulties) have been encountered in developing this approach but would suggest that the difficulties of the other suggested approaches (including EU difficulties) are likely to turn out to be greater. We understand that one of the concerns in this area is the risk of foreign groups moving subsidiaries out from under intermediate UK holding companies. We would point out that there is a degree of tension between this concern and the objective which UK policy appears to be pursuing (as noted above) of discouraging UK groups from locating intermediate holding companies in other jurisdictions. This tension seems to us to add to the case made above for a fundamental review of UK compliance with EU and other international obligations. Otherwise the UK risks being permanently placed 'on the back foot' by these constraints when seeking to introduce worthwhile reforms alongside adequate revenue protection. The UK should be looking instead to steal a legitimate march on its competitors by being 'ahead of the game' in identifying the implications of these obligations and planning to move the tax system in a direction where it will be robust in the likely future environment of their more rigorous enforcement. It may well be that there will be a strong correlation between this direction and the direction favoured by the Government of removing unnecessary outdated and ineffective restrictions, and fiscal distortions to commercial behaviour. A good example of such a correlation is the introduction of more flexible group reliefs for which credit is claimed in paragraph 1.19 of the consultative document.
We think that the existing rules in s144 TCGA 1992 are adequate to deal with simple options over substantial shareholdings, and that the rule in s28 is adequate to cope with both options and forward contracts which are completed.
Reference is made in a discussion paper issued by the Revenue to the case where cross options are entered into in order to delay the date of a disposal. Our general view is that the principle established in Furniss v Dawson is adequate to protect the Revenue against abuse of cross options. Where the terms of an option are commercial, so that the option contract is capable of standing alone as a commercial transaction, the existence of a cross option which is also in commercial terms need not signify a tax avoidance motive. There may be a real possibility that neither option will be exercised.
We appreciate that the Westmoreland case casts doubt on this analysis where the terms of the relevant legislation are juristic rather than commercial concepts (a distinction which might, incidentally, turn out to be to some degree correlated with the hard and soft test distinction which has surfaced in discussions on this proposal). However as of now the distinction is so new and untested that it would be difficult for an aggressive tax planner to place great reliance on it. The same difficulty makes a sensible legislative response hard to formulate. Also, the potential mischief is the deferral of a capital gains disposal event, a potential problem the scope of which will be reduced, rather than increased, by the current proposal to exempt certain disposals from taxation on capital gains. Schedule 5AA provides the revenue with protection against the conversion of income into capital.
Where a forward contract is sold or closed out by a matching contract, there is no acquisition or disposal of the underlying shares by the holder. In the case of a sale, the purchaser may complete the purchase or sale, in which case the ensuing comments would apply to the purchaser.
Where options are exercised and forward contracts run to completion, then it may well be that there is a “limbo” period where no party has a qualifying interest in the shares concerned. In our view there is a danger of creating a pitfall here which should be avoided, if reasonably practicable to do so, even though it will only affect a limited number of taxpayers, typically those with holding periods close to the qualifying length. It seems to us that where the investment is actually held for a period pursuant to an acquisition it should be deemed to have been held, for the purposes of the qualifying test, from the date on which that acquisition occurs for CG purposes. Some sort of deeming provision is likely to be needed in any case to give effect to what seems the consensus view on repos (below).
Transactions in derivatives generally do not involve any transactions in the underlying shares to which they relate. Therefore, the derivatives legislation should apply to them without any special exemption.
As regards convertibles, we agree that securities which are not shares, but which are convertible into shares do not form part of a qualifying shareholding unless and until they are converted. We are not convinced that concerns over use of convertibles (and maybe options) to avoid gains and trigger losses are likely to be realised on a material scale given the limited value which capital losses can be expected to have - particularly as a taxpayer seeking to do this will risk losing the exemption on gains through having to make a commercial disposal before the actual shares are acquired and held for a qualifying period.
We agree that the policy approach taken by the repo and stock lending rules does not need to be changed in the light of the proposed exemption but some drafting changes are likely to be needed, in particular to deem securities to be held, for qualifying period purposes, by taxpayers who have acquired shares, and have been deemed by this legislation not to have disposed of them, albeit as a matter of fact they do not hold them.
Consideration has also been given to the situation where the acquisition of a substantial shareholding has been funded by foreign currency loans (or hedged by use of derivatives) and where the shareholding and the loan/derivative are matched for accounting purposes. Clearly anomalies could arise where a gain or loss on a disposal of the shares is not taxable or allowable, but a corresponding loss or gain on repayment of the currency loan/derivative falls to be relieved (gratuitously) or taxed (creating a tax frictional cost commercially related to disposals of substantial shareholdings which the policy purpose is to eliminate). Our view is that 'matched' FOREX gains and losses should be treated consistently with the underlying asset to which they are matched, ie in the case of capital assets rolled up and taxed/relieved as part of the capital gain/loss arising on disposal of the asset, or where that disposal is exempt, exempted.
Capital gains tax clearances
The operation of s137 TCGA 1992 may need to be reviewed in the context of the setting up of a new holding company to acquire shares in a qualifying company from individuals on a paper for paper basis where the target company is subsequently sold. At first sight the purpose test in the underlying legislation does afford the Revenue protection in this area.
020 7235 9381