Specific rules about patent royalties

This change also more fully aligns the mechanics of the legislative approach to patent royalties with that for annual payments.

Patent royalties will in future be deductible in calculating net income where appropriate, but tax will still be deducted and accounted for in respect of such payments. This involves repealing section 387 of ICTA and section 51 of ITTOIA (and the corresponding entry in the table in section 272 of ITTOIA) and, as a consequence, the latter part of section 388(5) of ICTA (interaction of section 387 payments with terminal loss relief).

This is in principle in taxpayers' favour, because of the removal of the restrictions in section 387(2) of ICTA, but should not change things in practice as any payment falling foul of them would be very unlikely to qualify as a trading deduction.

Specific rules for unauthorised unit trusts

In accordance with the general approach, trustees of UUTs will obtain a deduction in calculating net income of the amount of their deemed payments in a tax year (see clause 505). Those deemed payments, as now, will be equal to the amount shown in the trustees' accounts as available for distribution or investment.

They are no longer described as annual payments, because the charge on the recipient of them in Chapter 10 of Part 4 of ITTOIA is distinct from the charge on annual payments in Chapter 7 of Part 5 of that Act. But relevant rules relating to annual payments are applied to unauthorised unit trusts where necessary.

This change will make no difference to the amount of tax trustees of UUTs pay or to how it is collected, as it is in all cases collected through trustees' self assessment returns at present.

The relief that applies if, in previous tax years, taxable income has exceeded deemed payments will also remain unchanged. But it is now expressed in terms of tax rather than as an amount by which a deemed payment is reduced: see clauses 875(3) to (5) and 876.

Consequential amendments to London Olympic Games legislation

Sections 65, 67 and 68 of FA 2006 remove from certain persons the duty to deduct sums representing income tax from annual payments. The source legislation refers only to section 349(1) of ICTA; it does not refer to section 348(1), but only because that section provides a right to deduct rather than a duty to deduct. Accordingly, consequential amendments are made by Schedule 1 to ensure that no new duty to deduct arises in such cases as a result of this Change replacing the right to deduct under section 348(1) with a duty.

Consequential amendment to provision regarding designated international organisations

Section 582A(1) and (4) of ICTA removes the requirement to deduct sums representing income tax from annual payments and patent royalties within section 349(1) of ICTA made by designated international organisations. It applies to cases where deduction of tax is mandatory. Now that mandatory deduction has been extended to such payments that previously fell within section 348 of ICTA, clause 912 (which rewrites section 582A of ICTA) similarly applies to all payments within Chapter 6 of Part 14 of this Bill.

Related Changes

There are a number of related Changes, which are concerned with:

• when payments are regarded as being, or not being, made out of profits or gains brought into charge to income tax, not least in the context of trusts (Change 82);

• the rate at which tax is to be deducted, depending on the year in which the payment is made (Change 131);

• the deduction of tax from patent royalties which are annual payments (Change 132); and

• the interplay between charges on income and various reliefs and adjustments that relate to a later year, such as loss relief claims and farmers' and creative artists' averaging (Change 147).

This change is in principle favourable to some taxpayers. It also affects when and how tax is paid and administrative requirements. But the numbers affected are expected to be few (and the amounts involved small).

Change 82: Charges on income: when payments are made "out of" profits or gains brought into charge to income tax: clauses 450, 505, 958 and 959

This change concerns the rewrite of the phrase "out of profits or gains brought into charge to income tax", in the context of the general approach to the rules about charges on income (see Change 81).

The question whether a payment is made out of profits or gains brought into charge to income tax is easily answered if a payer has no income subject to income tax (such as a company, an exempt person, or an individual who happens to have no income). The difficulties arise where a payer has some income subject to income tax.

Where a payer does have some such income, a number of questions can arise in deciding whether or not the payment can be said to have been made out of that income, and there is a good deal of case law on the point. The significance of the point, under the new approach, is whether or not the payer can deduct the payment at Step 2 of the tax calculation (see clause 23 of this Bill).

The first issue is whether or not the income is sufficient overall. And this is the only question which now matters in the case of individuals - see CIR v Plummer (1979), 54 TC 1 HL on page 41 (Lord Wilberforce). So here it is necessary to compare the amount of the individual's modified net income (as given by clause 958) with the amount of the payment. For this purpose it is necessary to ignore this relief itself and any "non-qualifying" income as provided by clause 959.

In other instances the position is less straightforward and regard must be had to a number of decided cases. For persons other than individuals, additional tests can be discerned from these cases which outlaw deductions for payments which:

• are reimbursed (unless the reimbursement is taxable);

• can only lawfully be made out of capital or exempt income; or

• are treated by the payer as made out of capital or exempt income (when they need not have been) and this has a "real world" effect.

The following paragraphs provide more detail on cases that illustrate the three principles mentioned in the bullets above.

As to the first bullet: a number of cases (Dickson v Hampstead Borough Council (1927), 11 TC 691 KBD, Corporation of Birmingham v CIR (1930), 15 TC 172 HL, Scarborough Corporation v CIR (1947), 28 TC 147 KBD) have concerned statutory subsidies for interest payable on borrowings for capital works. (Such interest was then an annual payment.) The subsidies, which were not taxable in the recipients' hands, were for the gross amount of the interest, but in each case the corporation (which had taxed income) sought to obtain relief by retaining the tax deducted from the interest it paid. And in each case the courts held that this was inadmissible, and that the tax should be handed over.

As to the second bullet: in Sugden v Leeds Corporation (1913), 6 TC 211 HL the corporation borrowed money for two purposes: for investment into gasworks, waterworks and tramways ("municipal" undertakings), which were highly lucrative, and into sanitary works, which were not. There was in effect a statutory provision that the two funds could not be "mixed". The corporation had insufficient money in the "sanitary" fund to meet the interest, so paid the balance of interest (which then was an annual payment) out of the Consolidated Fund, the income of which was untaxed (the borough rates). It was held that the corporation could not use the income from the "municipal" fund to frank the payment, and was assessable for the tax on the balance of the interest. It was not that the corporation had acted outside its powers, but that, had it made such an actual payment out of the "municipal" fund, it would have been so acting.

As to the third bullet: in Central London Railway Co v CIR (1936), 20 TC 102 HL and Chancery Lane Safe Deposit and Offices Co Ltd v CIR (1965), 43 TC 83 HL the respective companies borrowed money for capital works and charged such interest to capital in their accounts. It was held that this policy was not a matter of "domestic bookkeeping" but had a real effect on persons' rights and liabilities (absolute or contingent), because the fund of distributable profits was affected. In CIR v Ayr Town Council (1938), 22 TC 381 CS on page 403, Lord Normand said:

Though the taxpayer is not bound by the mere form of the accounts, he is bound by the accounts so far as they have recorded a decision to debit the various funds in a particular way which has practical results apart from his right to retain Income Tax ..

And in the circumstances dealt with in the first two cases mentioned above it was held to be inadmissible for the taxpayer to state that for one purpose it had made a capital payment, while for another it had made the same payment out of taxed income.

Under the approach to rewriting sections 348 and 349(1) of ICTA, the regime that applies for deducting and accounting for tax will no longer depend on whether the payment is made out of income brought into charge to income tax. Accordingly the rules on relief for payments are rewritten without direct appeal to that concept. On this approach, the restrictions on relief for persons other than individuals discerned from the cases mentioned above must be set out explicitly.

This change is adverse to some taxpayers and favourable to others in principle. But it is expected to have no practical effect as it is in line with current practice.

Change 83: Relief for payments to trade unions and police organisations: claims requirement: clauses 457 and 458

This change introduces a claims requirement into the clauses giving relief for life insurance related parts of payments to trade unions and police organisations (which are based on section 266(7) of ICTA).

In general, relief for life insurance premiums is given without a claim - section 266(1) of ICTA. This reflects the fact that in relation to qualifying ordinary life insurance policies relief is given at source, by the policyholder paying a reduced premium to the insurance company. But it is less satisfactory in relation to the life insurance related part of payments made gross to trade unions and police organisations for which relief is available in calculating net income, given that other such reliefs, and personal allowances, have to be claimed.

In practice, box 15.10 of the self assessment return does require a claim to this relief. The introduction of a formal claims requirement brings the law into line with this practice and provides a mechanism for resolving disputes.

This change has no implications for the amount of tax due, who pays it or when. It affects (in principle and in practice) only administrative matters.

Change 84: Limits to relief for payments to trade unions and police organisations and payments for benefit of family members: clauses 457, 458 and 459

This change revises and simplifies the limits to relief for the life insurance related parts of payments to trade unions and police organisations under section 266(7) of ICTA and for payments to secure annuities etc under section 273 of ICTA.

The limits to relief are in section 274 of ICTA. They are in two parts.

Section 274(1) provides an overall limit of the greater of £1,500 and one-sixth of total income to the aggregate amount of premiums and other sums qualifying for relief under section 266. This rule did not impact on claims under section 266(7) and its linkage to other reliefs under section 266 (which are not being rewritten) is a needless complication. Accordingly, this part of the limit has been dropped. It did not apply to payments under section 273.

Section 274(2) and (3) provides a combined limit to relief under sections 266 and 273 in respect of any premiums or other sums that secure benefits other than capital sums payable on death. This is also complex, in that it combines premiums under section 266(1) with other payments under section 266(7) and section 273. And, in expressing the limit as it applies to payments under section 266(7) in terms of tax at the basic rate, it is inconsistent with the fact that the relief operates as a deduction in calculating net income. And relief under section 273 operates differently, as a tax reduction. It is much more natural to have independent limits applying to each provision.

The amounts of relief actually given under section 266(7) are small. While the existing limit to relief applies only to the part of any payment providing certain benefits, it is proposed to apply the limit to the whole of the qualifying payment. Although introducing a limit of £100 (corresponding to a qualifying payment of £200) is adverse in principle it is understood that no existing claims will be affected. And the fact that the relief will operate as a deduction in calculating net income rather than being limited to basic rate is taxpayer-favourable.

For relief under section 273 (ignoring the fact that other payments may have already used up some of the limit), the limit is £100 at basic rate. In strictness, the limit applies only to part of some payments under section 273, so again this aspect of the change is adverse in theory, but most or all payments under section 273 are solely to provide annuities to which the limit does apply. And in practice the limit has always been applied to all payments within that provision.

Each of the three provisions has been rewritten with an independent limit of £100. The exclusion of war insurance premiums from counting towards the limits (section 274(4)) is obsolete and has not been included.

This change is adverse to some taxpayers and favourable to others in principle and in practice. But the numbers affected and the amounts involved are likely to be small.

Change 85: Settlements: receipts not charged at special trust rates: clauses 481 and 806

This change ensures that receipts within section 686A of ICTA are not liable at the special trust rates when they arise to charitable trusts or to certain pension funds. It also ensures that the special trust rates do not apply to such receipts that are accumulated or discretionary income or would be but for being excepted by clause 480(3) of this Bill.

Certain amounts arising to trustees are liable at either the trust rate or the dividend trust rate regardless of whether or not the trustees would otherwise have accumulation or discretionary income.

Before FA 2006, the provisions applying the special trust rates were in the parts of the income tax code dealing with the types of amount concerned and section 686A of ICTA dealt only with distributions on the purchase by a company of its own shares. With effect from 6 April 2006, substituted section 686A brings together all the charges at the special rates.

Before 6 April 2006, section 686A(4) contained express exemptions from the charge at the special rates for charitable trusts and certain pension funds. These exemptions were not replicated in the substituted section although corresponding exemptions were retained in section 686. The exemptions are re-inserted in the re-write of section 686A (see clause 481 of this Bill).

The exemptions now apply to all the items within substituted section 686A, not just to distributions arising on the purchase by a company of its own shares. The exemption for charitable trusts is in clause 481(1) (see section 686A(4)(c) before 6 April 2006) and that for the pension funds concerned is in clause 481(5)(c) (see section 686A(4)(d) before 6 April 2006).

Prior to 6 April 2006, section 686A(4)(a) also ensured that there was no overlap between sections 686 and 686A. That has been replicated in clause 481(5)(a) and (b).

What was section 686A(4)(b) prior to 6 April 2006 has not been re-written on the basis that the corresponding exemption in section 686 was repealed by FA 2006.

Trustees liable at one of the special trust rates are subject to the deduction of income tax at source provisions applying to deposit-takers and building societies in Chapter 2 of Part 14 of this Bill. To ensure that clause 806 also applies in the same way as its source legislation in section 481(4A) of ICTA did prior to 6 April 2006, clause 806(2) also reinstates corresponding exemptions.

This change is in taxpayers' favour in principle and may benefit some in practice. But the numbers affected and the amounts involved are likely to be small.

Change 86: Settlements: taxation of amounts taxable under the accrued income scheme: clause 482 and Schedule 1 (section 720 of ICTA)

This change ensures that income arising to trustees under section 714(2) and 716(3) of ICTA is treated in the same way as all other receipts that are taxed at the trust rate.

Section 686A of ICTA, as substituted by FA 2006, brought together those receipts by trustees that are taxable at one of the special trust rates whether or not the trustees would otherwise have accumulation or discretionary income. But it did not include amounts taxable on trustees under the accrued income scheme. In the interests of simplification, these amounts are included in the re-write of section 686A. See Type 2 in clause 482. It follows that section 720(5) of ICTA is no longer necessary.

The inclusion of these amounts in the list in clause 482 means that the exemptions for charitable trusts and specified pension funds apply and that trustees' expenses may be set against the deemed income.

This change is in taxpayers' favour in principle and may benefit some in practice. But the numbers affected and the amounts involved are likely to be small.

Change 87: Settlements: trustees' expenses set against accumulated or discretionary income when incurred: clauses 484 and 485 and Schedule 2 Part 10 (trustees' expenses to be set against trustees' trust rate income)

This change alters the way that trustees' expenses are taken into account in measuring the trustees' liability on income liable at the dividend trust rate or at the trust rate, so that this is done by reference to when the expenses are incurred rather than when they are paid. It also introduces explicit rules about the relief available where the expenses exceed such income.

Accumulation or discretionary income, and certain other receipts of trustees, are liable to income tax at either the trust rate or the dividend trust rate. Section 686(2AA) of ICTA provides that where this "trust rate income" is applied in defraying allowable expenses the income is charged instead at the normal rate appropriate to the income concerned. The word "defraying" is considered to require that the expense must have been paid before it is taken into account.

For settlements in which a beneficiary has an "interest in possession", expenses are taken into account when they are incurred (see clause 500(1) of this Bill). This difference can give rise to practical difficulty, eg in relation to settlements that have both types of beneficiary. This change removes the difference, so that the rule in clause 484 also uses the "incurred" basis.

Clause 485 introduces explicit rules about the relief available where the trustees' expenses exceed the trustees' trust rate income in the tax year concerned. That clause also operates by reference to when the expenses are incurred (contrary to present practice). The rule is that excess expenses are carried forward and relief is given as soon as there is sufficient income available.

In general, expenses are not paid before they are incurred. This timing effect will normally be in trustees' favour.

This change will not alter the amount charged to tax. The most it will do is affect the timing of tax liability. In a small minority of cases this could mean a different rate of tax being applied. Any overall tax effect is likely to be negligible.

Change 88: Settlements: grossing up of trustees' expenses set against accumulated or discretionary income: clause 486

This change makes it clear that trustees' expenses are grossed up when set against the amount of income chargeable on the trustees at the trust rate or the dividend trust rate.

Trustees are chargeable under section 686(1) of ICTA at either the trust rate or the dividend trust rate on their accumulated or discretionary income. But section 686(2AA) provides that where that income is applied in paying allowable expenses the income is charged instead at the normal rate appropriate to that income.

Since the expenses are regarded as being paid out of income after it has suffered tax at the normal rate, the amount of income arising to trustees which is applied in defraying expenses is an amount of income sufficient to meet both that tax and the expenses. In order to arrive at this amount of income, the expenses have to be grossed up at the appropriate rate. The grossing up of expenses is accepted practice although it is not clear from section 686 itself.

In setting out how allowable expenses are taken into account, Steps 3 to 6 of clause 486(1) require those expenses to be grossed up at the normal rate for the type of income concerned.

This change is in taxpayers' favour in principle. But it is expected to have no practical effect as it is in line with current practice.

Change 89: Settlements: discretionary payments: provisions applying only to UK resident trustees: clauses 493 and 497 and Schedule 2 Part 10 (discretionary payments: trustees' tax pool)

This change makes it explicit that the Chapter dealing with the taxation of discretionary payments by trustees applies only to payments made and tax suffered while the trustees are UK resident.

Section 687 of ICTA contains rules regarding the liabilities of the trustees and the beneficiary when the trustees make a payment to a beneficiary in the exercise of a discretion. The rules can only operate sensibly where the payment is chargeable on the beneficiary as an annual payment under Chapter 7 of Part 5 of ITTOIA and it is well established that those provisions only apply where the payment arises in the United Kingdom.

The question can arise as to whether that test is satisfied in cases where UK resident trustees exercise discretion abroad or non-UK resident trustees exercise discretion in the United Kingdom. The approach adopted in practice is that section 687 of ICTA applies only to payments by UK resident trustees. Accordingly, clause 493 contains the condition that it only applies to UK resident trustees. It follows that where a payment is made by non-UK resident trustees:

• the payment does not carry any "tax credit" in the hands of the beneficiary; and

• the trustees are not liable for any tax in respect of the payment.

As a corollary to the provisions of section 687 of ICTA not applying to non-UK resident trustees, tax only enters the trustees' tax pool if it is tax suffered on income arising while the trustees are UK resident - see clause 497.

This change does not affect the operation of ESC B18, which enables UK-resident beneficiaries who receive discretionary payments to have a credit for the tax paid by non-UK resident trustees on United Kingdom source income.

This change is adverse to some taxpayers and favourable to others in principle. But it is expected to have no practical effect as it is in line with current practice.

Change 90: Settlements: tax statements for settlors: clause 495

This change allows the settlor of a trust to require a statement from the trustees where the income is regarded as that of the settlor rather than a beneficiary.

Section 352 of ICTA applies where trustees make a payment in the exercise of a discretion. It allows the recipient to require the trustees to provide a statement of the actual amount of the payment, the corresponding gross amount (grossing up at the trust rate) and the amount of tax deemed to have been deducted.

This is appropriate where the beneficiary is chargeable on the payment, but in a case where the settlor is chargeable under section 629 of ITTOIA it is that person who will need these details.

Accordingly, clause 495 says that it is the person who is treated as having paid the income tax on the payment who may require a statement from the trustees.

This change has no implications for the amount of tax due, who pays it or when. It affects (in principle and in practice) only administrative matters.

Change 91: Settlements: trustees' expenses reducing beneficiary's income: clauses 500, 503 and Schedule 1 (section 646A of ITTOIA)

This change makes explicit some of the rules about the way expenses incurred by trustees in connection with income to which a beneficiary is entitled reduce the amount of the beneficiary's income for tax purposes.

There are only two provisions in ICTA that concern the tax treatment of expenses in relation to income to which a beneficiary is entitled before it is distributed (where the beneficiary is regarded as having an "interest in possession"). These are:

• section 689A, which deals with the disregard of some expenses in the case of a non-resident beneficiary; and

• section 689B, which concerns the order in which expenses reduce the beneficiary's income.

While there are additional provisions in section 686(2AA) of ICTA that give some rules on the treatment of trustees' expenses in relation to accumulation or discretionary income, there is no corresponding provision for interest in possession trusts. The practices that have become established and which are reflected in these clauses are based on the principle that the income of a beneficiary is the income arising to the trustees so far as the beneficiary is entitled to it.

There are two ways in which this principle operates.

First, if the trustees' expenses are chargeable to income under a provision of the settlement, then irrespective of whether they would be so chargeable in the absence of that provision, the expenses are to be taken into account. This is subject to the existence of any law that in a particular case (for example by way of a court order) overrides the provision in the trust deed.

This is different from the rule that operates in relation to accumulated or discretionary income where the terms of the settlement are to be ignored, and from what it appears that section 689A provides for in this context.

If the deed is silent on whether a particular expense is chargeable to income then the expense is taken into account if it would be chargeable to income under general trust law.

These rules are reflected in clause 500. They mean that an expense is allowable if it is chargeable to income under the trust deed, even if it would be chargeable to capital under general trust law. Conversely, in cases where general trust law would require an expense to be charged to income, but the trust deed charges it to capital, then the change means that the expense is not allowable.

The second area concerns how trustees' expenses are taken into account in such cases.

The expenses do not affect the amount of income on the trustees are chargeable to tax, but operate to reduce the amount of the beneficiary's income. It is not that the beneficiary gets relief for the expenses as such; it is simply that the beneficiary is not entitled to the income used to pay the expenses. So, the beneficiary's income (as reduced by allowable expenses) is grossed up at the normal rate appropriate to that income to arrive at the gross amount which is to be treated as part of the beneficiary's total income.

This is not set out in the source legislation but, based on the decision in CIR v Lord Hamilton of Dalzell (1926), 10 TC 406 CS, it is the accepted way that expenses are taken into account. Clause 503 reflects this.

This change also provides rules about cases where the trustees' expenses exceed a beneficiary's income. Clause 500(1) applies in relation to the tax year in which the beneficiary's entitlement to income is reduced, whether the expense was incurred in that tax year or an earlier tax year. The reference to an earlier tax year means that the clause covers cases where the trustees' expenses in an earlier tax year exceed the income in that earlier year and so the trustees are "carrying forward" the excess.