Memorandum by the Law Society of England
and Wales
GENERAL COMMENTS
The Bill contains a number of proposals which
continue to be the subject of considerable debate. We would note
that there are a number of provisions in the Finance Bill which
when the Bill was published were accepted by HMRC not to be in
final form. These will be subject to Government amendment. This
is indicative of the lack of time and consultation in seeking
to implement these proposals and hampers the ability of the professional
bodies to make constructive comment.
Entrepreneurs' Relief
This relief appears to have been modelled closely
on retirement relief—repeating many of the deficiencies
that were contained in that relief. It appears to have been drafted
in a hurry without full consideration being given to the alternative
business structures in place in the modern age. Also the relief
for trustees needs to be brought into line for the relief for
individuals so that the relief is effective and fair, rather than
full of traps for the unwary.
Residence and Domicile
In common with many other professional bodies
we believe that the effective date for the proposals (particularly
those dealing with the "anomalies") should have been
delayed until at least April 2009 in order to provide for proper
consideration and consultation.
The provisions are complex and intricate, and,
as indicated, in places currently incomplete. The speed of implementation
gave taxpayers little time to re-organise their affairs and any
re-organisation that was undertaken prior to 6 April 2008 was
effected in a cloud of uncertainty regarding the shape of the
rules in the their final form.
The UK taxpayer is used to a system under which
new rules are introduced to apply from a particular date, the
legislation is then fleshed out, subsequently debated in Parliament
and enacted, very often in a slightly different form. Historically
proposals enacted in this manner did not have retroactive effect.
These new rules have been sprung on foreign, often exceedingly
mobile, individuals out of the blue after years of Budget announcements
indicating that the rules were still under review but no changes
were proposed. Many of those affected by these new rules have
lost confidence in the UK as a jurisdiction that welcomes foreign
investment. Some took immediate action to reduce their links with
the UK. Others await the outcome of the deliberations to see if
the reputation of the UK can be salvaged.
SPECIFIC COMMENTS
1. CAPITAL GAINS
TAX
Repeal of sections 77-79 Taxation of Chargeable
Gains Act 1992
Certain changes (namely those effected by paragraph
5 of Schedule 2—the proposed repeal of sections 77 to 79
Taxation of Chargeable Gains Act 1992) have been introduced under
the heading "Rate: consequentials". The Explanatory
Notes (paragraph 9) state simply that "The introduction of
a single rate of CGT for trustees and individuals means that the
application of sections 77 to 79 would have no effect on the rate
at which the gains were charged to CGT. The sections will serve
no useful purpose in future, and are accordingly repealed".
The relevant provisions contain the rule whereby
gains of a UK-resident trust under which the settlor has an interest
are taxed on the settlor and not on the trustees. Whilst it is
true that the bald rate of tax payable by the trustees and by
the settlor will be the same, the repeal has two other important
consequences related to the amount on which tax is calculated
at that single rate:
— if a settlor has allowable losses
from the current or previous years, he is enabled to set these
against gains attributed to him from the trust. This amendment
will deny that offset, and will therefore (where personal losses
are present) increase the amount that is charged to tax; and
— similarly, if gains of a trust are
attributed to the settlor, the amount on which he must pay the
tax will be worked out with the benefit of his personal annual
exempt amount. This can operate either in favour of or against
HMRC: if the settlor had no other gains in the year, a larger
exemption is made available than would have been available to
the trustees; on the other hand, if the settlor had made personal
gains which use up his annual exemption, then repealing sections
77-79 allows the trustees to use their annual exemption which
would otherwise have been wasted.
Neither of these changes is "consequential"
on the change of rate, and it is noteworthy that, with a settlor
whose income makes him a higher rate taxpayer, there has been
no difference between the rate of CGT payable by him, or by the
trustees, for several years.
Vulnerable person's election
The provisions of Finance Act 2005 relating
to the vulnerable person's election proceed on the footing that,
but for such a person's disability or minority, property that
is in fact held in trust for him would almost certainly have been
given to him outright. They are designed to ensure that the vulnerable
person is not disadvantaged by the use of the trust. In the CGT
context, these rules have operated hitherto by treating him (where
the trustees so elect) as if he were the settlor of the trust,
thus bringing into operation TCGA 1992 sections 77-79 which attribute
the trust's gains (net of trust losses) to the vulnerable beneficiary:
Finance Act 2005 section 31. (If the beneficiary is not UK resident
but the trustees are, then a similar result is achieved by sections
32-33, giving relief to the trustees that is calculated on a corresponding
basis).
Paragraph 17 of the Explanatory Notes states
that "The result of the changes to section 31 of Finance
Act 2005 made by paragraph 16 of the Schedule is that where the
vulnerable person is resident in the UK, the trustees' liability
to CGT in respect of chargeable gains on the disposal of settled
property held for the benefit of the vulnerable person (described
as "qualifying trust gains") is reduced to the amount
of CGT that would have been payable by the vulnerable person in
respect of those gains if they had arisen directly to the vulnerable
person. This replaces the previous rule, which used section 77
of TCGA 1992, so that the vulnerable person was charged to CGT
as though the qualifying trust gains arose directly to him".
The amended section 31(2) and (3) as set out
in paragraph 16 fail to achieve the stated result. If qualifying
trust gains arose directly to the vulnerable person, he would
be enabled to set off personal losses (which could have been realised
before the onset of his disability and carried forward, or could
have arisen in respect of assets held on bare trust for him).
This is the result that is achieved by the existing rule which
imports the operation of TCGA 1992 section 77, taken with section
2(4)-(5) of that Act. Under the revised formulation of Finance
Act 2005 section 31, offset of those losses appears to be denied
by the words "[if ...] no allowable losses were deducted
from the qualifying trust gains", which should bar only the
deduction of losses that had accrued to the trustees (because
the trustees' liability without the election will have taken those
losses into account already).
Abolition of "kink test" and of "halving
relief"
The abolition of the "kink test" by
paragraphs 57 to 71 of the Finance Bill has the effect that the
acquisition value of an asset disposed of after 5 April 2008 is
always treated as its value on 31 March 1982.
The abolition of "halving relief"
by paragraphs 73 and 74 has the contrary effect that it remains
necessary to look back to an acquisition before 31 March 1982.
Halving relief was never more than a rough and
ready measure to recompense those who had acquired assets after
1982, but subject to a claim to holdover or rollover relief such
that (apart from the relief) their effective base cost would have
reflected a pre-1982 valuation or acquisition cost.
Now that every other provision in the capital
gains tax legislation uses 1982 values where otherwise an earlier
cost or value would apply, it is inequitable that halving relief
should be abolished but the abolition of "halving relief"
should be brought into line with the abolition of the "kink
test" by substituting a March 1982 value as the acquisition
cost.
2. ENTREPRENEURS'
RELIEF
There are various areas where we consider Entrepreneurs'
Relief falls short of what is appropriate, in many cases because
it is modelled on retirement relief. We set these out below.
Transitional period where assets used for purposes
of a business
Entrepreneurs' Relief will not be available
to an individual who makes a disposal of an asset which he has
not used personally in a business during the three years before
the disposal. Business Asset Taper Relief would however be available
after 5 April 2004 where the business was carried on by someone
other than the owner. The Law Society has proposed an amendment
to introduce an additional but temporary category of material
disposal of business assets which will give Entrepreneurs' Relief
to someone who used an asset for a business before April 2004,
and then permitted another person to use it for a business instead,
in the expectation that his business asset taper relief would
remain available.
The amendment proposed would will assist eg
a farmer who, after 5 April 2004 in the reasonable belief that
following changes made by Finance Act 2003 his tax rate would
remain at 10% because Business Asset Taper Relief treatment no
longer required the asset owner to be directly involved in the
business, retired and let his farm to a younger farmer. The amendment
gives the taxpayer in this position a period of five years to
make alternative arrangements, or to make a disposal within the
Entrepreneurs' regime. This is limited to taxpayers who had personally
carried on the business before handing over to another party,
so excluding the property investor. Without an amendment along
these lines, a retired farmer or other trader could well be wholly
denied Entrepreneurs' Relief by reason of no longer being directly
involved in the business.
Assets disposed of before business ceases
We also consider that Entrepreneurs' Relief
should be altered so as to provide that relief may apply to assets
disposed of during the 12 months before the cessation of business.
The amendment gives a time frame for disposing of assets similar
to that which applies for roll-over relief.
The purpose of the amendment is to prevent Entrepreneurs'
Relief being unfairly denied when, in the course of winding up
a business some assets are disposed of before the actual cessation
of the business. In the case of eg a farmer retiring, if he ceases
trading and sells the farm within three years after ceasing the
trade new section 169I(4) will ensure that he gets relief (so
relief covers assets disposed of on cessation of the business
and for a period afterwards). But if he sells part of the farm
say six months before cessation he may be denied relief under
the principle laid down in the case of McGregor v Adcock.
That case was under the now repealed retirement relief on which,
as mentioned above, much of Entrepreneurs' Relief is based. A
taxpayer aged 70 had farmed for over 10 years. He sold five acres
for which outline planning permission had been obtained. It was
held he was not entitled to the relief as he had not sold the
part of business but merely an asset. While Entrepreneurs' Relief
extends to the disposal of assets in use at the time of cessation
it should also apply to disposals before cessation.
Entrepreneurs' Relief should be extended to cover
trust businesses
Trustees can claim Entrepreneurs' Relief for
assets used by a beneficiary, where the beneficiary carries on
the business, but not where the business is carried on by them.
The Law Society has proposed that a new provision be introduced
to give relief in these circumstances.
Trustees are often empowered to carry on a business
and it can be advantageous for them to do so, for example to be
able to claim Inheritance Tax Business Property Relief and Capital
Gains Tax roll-over relief. Many trustees of farmland are involved
in the farming of the land. The amendment enables the trustees
to claim Entrepreneurs' Relief for the capital invested in the
business itself, just as they would have been entitled to Business
Asset Taper Relief.
Entrepreneurs' Relief should be extended to cover
trust shareholdings where an individual has an interest in possession
A "disposal of trust business assets"
only qualifies for entrepreneurs' relief when trustees own shares
in a company if:
— an individual has an interest in
possession in those shares; and
— the company is that individual's
"personal company", which means that, in his own right,
the beneficiary must have a shareholding of at least 5%; and
— the individual is an employee or
officer of the company.
In particular, as presently drafted, trustees
do not qualify for Entrepreneurs' Relief on the basis of a trust
shareholding of more than 5%, even where an individual who is
an employee has an interest in possession in that 5%, unless the
beneficiary also has a personal 5% or more shareholding in his
own right.
It is far from clear that this was the intended
effect of this provision. Even if it was, it is unfair to families
who, for historic reasons, hold family assets in trust.
Suppose a family company has two directors,
who are the widows of the founders of the company.
Both the founders have died, leaving their 50%
shareholdings, in one case, outright to his widow (who is also
the mother of his children) and in the other case to a trust giving
his widow an interest in possession for her life, but providing
that on her death, the shares pass to the founder's children (who
are the widow's stepchildren).
Since their respective husband's deaths both
directors have contributed equally to the success and growth in
value of the company. But because of family circumstances, one
shareholding qualifies for Entrepreneurs' Relief and the other
does not.
Entrepreneurs' Relief should be extended to assets
used for the purposes of a business carried on by a beneficiary's
company
The new section 169J Taxation of Chargeable
Gains Act 1992 gives trustees the right to claim Entrepreneurs'
Relief for land, or premises, or other assets used by a beneficiary
in his business provided the beneficiary is a sole trader, or
trades though a partnership. As presently drafted, if the beneficiary
trades through a company, the trustees can only claim relief if
they dispose of shares in that company.
It is illogical to discriminate between business
structures by denying the relief where the beneficiary trades
through a company. The amendment ensures that the Entrepreneurs'
Relief will be available for assets held in trust, and used by
the beneficiary for a trade, whether he trades as a sole trader,
or a partnership, or through a company. (For this purpose we have
suggested adopting the requirement that a company should be the
beneficiary's personal company, without in this case attributing
to the beneficiary any shares held by the trustees).
Entrepreneurs' Relief should not be restricted
by a non-business use or payments of rent to the extent this occurs
before 6 April 2008
Entrepreneurs' Relief will be restricted to
part of a gain arising where an asset disposed of was used for
non-business purposes during the taxpayer's ownership, or a rent
is paid for its use. The amendment limits the effect of these
restrictions as applied to periods of ownership before 6 April
2008.
Non-business use of an asset, after 5 April
1998 restricted the availability of Business Asset Taper Relief.
The new section 169P(4)(a) will have a retrospective effect by
bringing into account non-business use before April 1998 to restrict
the proportion of the gain taxed at 10% under Entrepreneurs' Relief.
A similar point arises with the new restriction where rent is
paid eg to a partner for use of an asset by the partnership. The
payment of rent would not restrict the Business Asset Taper Relief
before 5 April 2008. The new provisions should be altered to ensure
that the retrospective effect of the new rules is neutralised
by ensuring that non-business use before 6 April 1998, and payment
of rent before 24 January 2008 (when Entrepreneurs' Relief was
announced) for use of a business asset, do not restrict the Entrepreneurs'
Relief now available, and allows a transitional period of one
tax year for restructuring where these conditions would otherwise
be breached by the payment of rent contracted for before 24 January
2008.
EMI Options
Entrepreneurs' Relief is not available until
the shares have been held for one year. In the case of an employee
holding shares under an EMI option, this means that the relief
will not be available until one year after the exercise of the
option. As the purpose of the new relief should apply equally
to employee optionholders and shareholders to promote investment
and recruitment in companies, the Law Society has proposed an
amendment to allow the EMI optionholder to count his period of
ownership from the date of grant of the option in the same way
as paragraph 14, Part 4 Schedule 7D TCGA 1992 allowed taper relief
to be calculated from the date of grant.
3. RESIDENCE
AND DOMICILE
3.1 Residence Test
Generally the UK tax residence status of an
individual is determined by the number of days that he is present
in the UK. The rules are extremely complex but broadly there are
two "day-count" tests.
Under statutory provisions an individual is
UK resident if he spends 183 days or more in the UK in anyone
year.
Under the second test (in effect, developed
out of case law and set out in non-statutory guidance published
by HMRC called "IR20") the individual is UK resident
if he spends an average of 91 or more days in the UK calculated
over four UK years. This test is of particular relevance to "short
term" visitors to the UK who, when they visit the UK, do
not plan to spend a sufficient amount of time in the UK to be
resident from the day they first arrive. The test is relied upon
by many visitors to the UK, including persons who come to the
UK to undertake business transactions in the UK.
For the purposes of both tests days of arrival
to and departure from the UK were not counted.
It is proposed to alter the test of residence
by counting any day where the individual is present in the UK
at midnight (excluding only days spent by passengers in "transit").
Clause 22 introduces amendments to effect this
change for the purposes of the 183 day test.
The Explanatory Notes indicate that a change
is required because "recent case law has indicated that HMRC's
guidance on "day-counting" as it stands creates a degree
of uncertainty". The Explanatory Notes acknowledge the limitation
of the proposed legislative changes and state that changes to
the "91 day" test will be effected "in line with
the statutory amendment introduced in clause 22". A new version
of IR20 is, however, still awaited.
It is submitted that the uncertainty of the
"old" residence rules did not arise solely in the context
of the "day-counting" guidance. In recent cases (such
as Gaines-Cooper)—which largely relate to persons
leaving the UK rather than visitors to the UK—greater consideration
has been given to matters other than "day-counting".
IR20 does not give sufficient guidance to prospective visitors—or
those wishing to cease UK residence—on those issues. It
is, however, assumed that the only changes which will be made
to IR20 are those required to bring the guidance in line with
the changes proposed by clause 22 so that the past uncertainty
will continue.
Individuals should know whether their plans
will cause them to be UK tax resident or not and to that end we
would support the other professional bodies who are calling for
a clear statutory test to be introduced with effect from 6 April
2009, This would provide sufficient time for full consultation
on the proposals which have been previously submitted to HMRC.
It would also obviate the need for clause 22 at this time. We
submit that effecting a change to the "day-counting"
test this year and then introducing a statutory test in 2009-10
will further undermine the reputation of the UK tax system and
should be avoided.
3.2 Remittance Basis
A number of issues arise out of the proposed
complex rules. HMRC have indicated that amended legislation will
be published during the course of May reflecting Government amendment
of provisions which were not in final form when the Finance Bill
was published on 27 March 2008. The amended form of the legislation
is not yet available and accordingly the comments in this briefing
are made in relation to the legislation as published on 27 March
2008.
3.2.1 Compliance concerns
We are, alongside the other professional bodies,
concerned to ensure that the new rules do not impose unfair burdens
or requirements upon residents of the UK with which they are unable
to comply. In that context we would submit in particular:
— That the de minimus limits in section
809C should be increased to address the needs of those whose levels
of foreign income/gains may not previously have justified sophisticated
professional representation.
— Section 809D should apply where an
individual has a small amount of UK income (eg bank interest)
within the personal allowance—to avoid the need for a tax
return to be completed where no tax would be due (but a return
is required to claim the remittance basis).
— That persons who are resident and
domiciled (but not ordinarily resident in the UK) and who are
taxable on the arising basis by reference to gains (because of
their resident/domiciled status) should be entitled to the annual
capital gains tax exempt amount (section 809F).
— That the definition of "relevant
person" is too widely drawn, A liability could easily arise
on an individual where funds are remitted to the UK by a "gift
recipient" in circumstances over which the individual has
no control (eg an unconditional gift to an adult child which the
adult child then chooses to remit to the UK for the benefit of
his minor child—who, as the grandchild of the individual,
is a relevant person for the purposes of section 809K. Also in
the context of a divorce where a payment is made by the individual
to an ex-spouse which the ex-spouse then uses for the benefit
of the individual's child). In such circumstances the ability
of the individual to file a compliant SA return is compromised.
— That it will not be possible for
persons who have relied upon the long accepted "source ceasing"
rules to be able to produce evidence regarding the provenance
of funds the source of which ceased many years ago.
3.2.2 Deemed Remittances
The exchange of correspondence between Angela
Knight CBE of the British Banking Association and the Rt Hon Jane
Kennedy MP to Angela Knight CBE of BBA highlights the fact that
the Government did not have sufficient time to properly consider
the consequences of the draft legislation and the potential damage
to the UK investment management industry of that draft legislation.
The issues in relation to the draft legislation (and in particular
sections 809K and related provisions) are not confined to those
involved in the investment industry. Trustees of non-UK trusts
will be deterred from seeking advice from professional service
providers located in the UK for fear of making a remittance of
funds to the UK. We are informed by HRMC that the amended legislation
expected later this month will deal with the issues addressed
by the banking community but are less assured about the position
for other professional service providers. The provisions as drafted
do not support Government contention that the provisions are "comprehensive,
workable or fair".
3.2.3 Retrospection
In his letter of 12 February 2008 the acting
Chairman of HMRC gave certain reassurances regarding the manner
in which the legislation would be drafted. Once such reassurance
was:
"There will be no retrospection in the treatment
of trusts and the tax changes will not apply to gains accrued
or realised prior to the changes coming into effect".
We would submit that the legislation does have
retrospective effect and would draw attention to the following
in particular:
(a) Rebasing election
The rebasing provisions in paragraph
112 Schedule 7 do not seem to have any effect on offshore income
gains (OIGs) to the extent that they are not matched with capital
payments in the year they arise. (Broadly speaking, the OIG legislation
imposes an income tax charge on gains arising on a disposal of
an interest in a certain types of "roll up" investment
fund).
Paragraph 29 of the "Aligning
the capital gains tax treatment for non-UK resident trusts"
note issued on Budget day stated that "any rebasing election
made by the trustees will apply to OIGs in the same way as to
ordinary gains". However the Bill as issued on 27 March 2008
does not seem fully to reflect that statement.
Non-resident trustees will be able
to elect to rebase trust assets to market value as at 6 April
2008 so that trust gains accruing but not realised before 6 April
2008 will not be chargeable if matched to capital payments made
on or after 6 April 2008 to non-UK domiciled beneficiaries. However,
it seems that the rebasing election can only apply (under paragraph
112(5)(a)) to gains that are actually matched with capital payments
under sections 87 or 89(2) TCGA 1992.
OIGs are only matched under sections
87 or 89(2) if (as per section 762 ICTA 1988 as amended) capital
payments are made in the tax year in which the OIGs arise. If
this is not the case then (absent any defence under section 737-742
ITA 2007) OIGs are thereafter treated as income for the purposes
of chapter 2 of part 13 of ITA 2007. When matched in future years
it will not be under sections 87 or 89(2) TCGA 1992.
Accordingly the rebasing provisions
in paragraph 112 would not seem to have any effect on OIGs to
the extent they are not matched with capital payments in the year
they arise, as they are not matched under sections 87 or 89(2)
TCGA 1992 and the full gain will be chargeable to income tax which
seems unfair and contrary to the reassurances previously given.
The denial of rebasing to companies
held in personal ownership is unfair and penalises non-domiciliaries
who have not previously been able to take advantage of the use
of trusts.
Confirmation is required that gains
recognised on the transfer of assets into trust on or before 5
April 2008 will not be within section 809R if remittances are
made by the trustees to the UK after 6 April 2008. HMRC has long
accepted that gains deemed to be realised on the transfer of assets
to non-UK trustees could not be remitted to the UK. It should
be clear that section 809R relates only to gains realised on or
after 6 April 2008.
3.2.4 Remittances and Employment Income
(a) General Structure ofAlterations to ITEPA
The current scheme of the legislation
contained in the Income Tax (Earnings and Pensions) Act 2003 ("ITEPA")
is that there are a number of sections dealing with particular
circumstances. Section 15 contains the charge for general earnings
of employees who are resident, ordinarily resident and domiciled
in the UK, section 21 contains the charge on earnings other than
chargeable overseas earnings where an employee is resident or
ordinarily resident but not domiciled in the UK and section 25
contains the charge on general earnings from duties performed
in the UK for an employee who is resident but not ordinarily resident
in the UK. The two remittance based provisions are section 22
and section 26 which effectively provide exceptions to sections
21 and 25 respectively. Section 22 deals with chargeable overseas
earnings (those are earnings from duties performed abroad for
a non-UK employer by an employee resident or ordinarily resident
but not domiciled in the UK); such earnings are taxed on a remittance
basis. Section 26 deals with an employee who is resident but not
ordinarily resident in the UK where the employee has earnings
which are not in respect of duties performed in the UK—such
earnings which fall outside Section 25 are also on a remittance
basis.
The scheme of the changes is to extend
section 15 so as to apply it to "UK resident" employees.
In other words the restriction which currently limits section
15 to the UK domiciled employee is removed. The effect of extending
section 15 in this way is that sections 21 and section 25 are
no longer needed, and are accordingly repealed. Sections 22 and
26 are then updated to introduce the new remittance regime into
these provisions. As currently drafted there is no overlap in
ITEPA between section 15 on the one hand and sections 21, 22,
25 and 26 on the other. Each of the main charging provisions applies
to different circumstances, as described above. Furthermore, the
remittance based sections, sections 22 and 26 are carved out from
sections 21 and 25. As the provisions are proposed to be amended
section 15 covers ground also covered by the revised sections
22 and 26. The Law Society has proposed an amendment to make it
clear that earnings within sections 22 and 26 are not also charged
by section 15.
(b) PAYE issues
The provisions of Schedule 7 bring
the securities income of all UK resident employees within PAYE
but it is understood that Government amendments will be introduced
to exclude securities income taxable only on the remittance basis
from PAYE. This is the unspoken assumption underlying paragraph
34. Paragraph 34 allows an officer of Revenue and Customs to treat
an employee as if he has claimed the remittance basis for the
purpose of making a PAYE direction. It does not however allow
employers to make such an assumption in operating PAYE without
applying for a PAYE direction.
Where an employer anticipates that
an employee will claim to be on the remittance basis, it must
carry out an apportionment calculation to make its best estimate
of the PAYE due. If the employer is not able to assume that a
remittance claim will be made, it will be forced to deduct PAYE
from 100% of the income. This means that there is a significant
risk of an employer over-deducting PAYE and creating recovery
problems for employees.
Paragraph 34 also limits the operation
of the provisions to UK resident employees whereas section 690
applies to non-resident employees working in the UK.
(c) Share Schemes
As explained above the scheme of the
changes to ITEPA is to repeal sections 21 and 25 of ITEPA as part
of the alterations to the remittance basis and to extend the scope
of section 15 so it charges the general earnings of all UK resident
employees. This charge is then carried through to other parts
of the legislation. This has the unfortunate side effect that
shares in approved share incentive schemes have to be offered
to all employees who are UK resident, that is including those
employees who are resident but non-domiciled and whose earnings
are on a remittance basis and also those employees who are not
ordinarily resident in the UK and who have earnings from duties
performed outside the UK. It seems to us that there are no grounds
for making this change and the rules operate perfectly satisfactorily
as they are—indeed to make the change will force employers
to make offers of shares to employees who are not those who ought
properly to be within the scheme.
(iv) Restricted Securities and elections
Paragraph 31 has the effect of applying
the employment related securities rules in chapters 2 to 4 of
part 7 Income Tax (Earnings and Pensions) Act 2003 to employees
within the remittance basis.
Chapter 2 contains the "restricted
securities" rules. Under these rules, an election—a
section 431 election—can be made, to allow employees to
whom the rules apply to pay income tax on acquisition of the securities,
in the hope that the securities will grow in value, such that
any growth in value will be subject to capital gains tax. Section
431 elections are therefore an important way in which taxpayers
can manage their tax liabilities.
Section 431 elections have to be made
within 14 days of the acquisition of restricted securities. Securities
acquired by employees who are resident but not ordinarily resident
will only become restricted securities when the Finance Bill receives
Royal Assent and Schedule 7 takes effect. However, paragraph 76
of Schedule 7 provides that the amendments have effect where securities
are acquired on or after 6 April 2008.
As a result, it is not possible for
remittance basis employees to make a section 431 election where
they acquire such securities after 6 April but more than two weeks
before Royal Assent. This is clearly unacceptable (and presumably
unintentional—such a state of affairs is not justifiable
on policy grounds). Similarly, remittance basis employees who
take up duties in the UK some time after acquiring restricted
securities should be able to elect within 14 days of becoming
subject to the restricted securities regime.
4. ENCOURAGING
ENTERPRISE
We have no particular comments to make on clause
28, clause 29 and Schedule 11. These clauses increase the amount
of relief for EIS investments and alter certain provisions relating
to venture capital schemes to prevent venture capital schemes
(EIS, VCT and corporate venturing schemes) investing in ship building
and coal and steel production. This is in order to comply with
the EU guidelines on state aid to promote risk capital investment
in small and medium sized enterprises. EU requirements, we believe,
also led to changes in the Finance Act 2006 reducing the gross
assets of investee companies to £7 million immediately prior
to an investment being made (and £8 million immediately afterwards)
and to changes last year, in particular that the target companies
must have fewer than 50 employees.
There are a number of points that we would make
about the EIS and VCT schemes in general against the background
of the documents published on Budget Day by HM Treasury and HMRC:
1. The study on the impact of the EIS and
VCT schemes on company performance contains some quite interesting
conclusions, but not ones which particularly reveal any better
way of targeting these schemes. There was no particular evidence
that EIS or VCT schemes were associated with high or real gross
profit levels. Generally it appeared that VCT and EIS investments
were associated with lower profit margins than the control group
although profit margins improved over time. EIS and VCT companies
were associated with higher levels of investment and employees.
VCT investments generally had high gearing throughout the period
of the investment by the VCT and the target company. EIS investee
companies were associated with some evidence of lower gearing
to start with (perhaps because they had received equity investments
through the EIS scheme and could not raise debt), the gearing
increasing over time (presumably as the business results improved).
There seems to be higher sales turnover of VCTs and EIS and some
growth in labour productivity. The results of the study were not
particularly conclusive and the investments did not generally
lead to, or did not appear to lead to, a large number of high
growth companies being produced. It appears about 25% of companies
fell by the wayside. However, the policy point was made that it
was only a minority of young companies that would need external
equity finance in order to accelerate development in their early
years. Yet this small number of companies was likely to have a
disproportionately large impact on employment, creation and innovation.
The period of activity of the study appears to have been focused
on the years 1999-2005, which was associated with a boom in investment
in "high-tech" companies, followed by a collapse of
this sector. This has affected some VCTs.
2. The HM Treasury Paper "Enterprise:
Unlocking the UK's Talent" has a chapter dealing with "Access
to Finance", which one would expect to be the chapter most
closely associated with EIS and VCTs. Having said this there is
relatively little mention of these initiatives in this chapter,
there instead being mention of the SFLG (Small Firms Loan Guarantee
Scheme), Enterprise Capital Funds, Business Angels and so on.
The Enterprise Capital Funds are a relatively recent programme.
These generally take the form of limited partnerships with the
government as an investor. The government provides up to two thirds
of the capital in each ECF but takes only a limited share of profit
to encourage private investors to participate. The ECF initiative
has become popular in government, but this perhaps illustrates
the tendency for new initiatives to be introduced without overhauling
or abandoning any other initiatives. The result would appear to
be that any small business is faced with an array of possible
sources of capital or debt or subsidy, all of which have their
own sets of rules.
3. The EIS and VCT schemes are designed to
ensure, so far as possible, that money is invested in a company
and used by that company for the purposes of its trading activities.
(This is not always achieved. It is possible for money to be invested
in a company which buys another business. This is treated as,
subject to certain conditions being satisfied, a qualifying activity
for the purposes of both schemes. This is probably appropriate
as otherwise the business acquired might not be able to receive
further capital for expansion). Both schemes have very complex
rules. For example, in both schemes it is not possible for a company
invested in to control a company which is not a subsidiary. Moreover
if the money raised is to be invested in a company, that company
has to be controlled by a greater percentage ownership—often
90%. There are particular rules which cause problems with each
of the schemes. A VCT cannot control a target company which it
invests in. This means that it is always a minority shareholder
which can sometimes be out voted; if other investors are not VCTs
they will not have the same constraints as the VCT will have in
relation to decisions relating to an investee company—for
example should the target be taken over, perhaps, by a non-UK
company? Should it move its trade abroad? Should it raise more
capital and should shareholders participate? Questions of this
nature can cause VCT concerns which other investors may not have,
as they may affect the qualifying status of the investment for
the VCT.
4. Similar issues will arise for EIS investors,
although most constraints cease to apply after three years. The
same control issue arises with an EIS company—EIS relief
is not available to an individual if the company invested in is
controlled by another person, or if there are arrangements to
control it. An external investor, taking a minority stake could
cause an issue to arise because if he "acts together"
with other investors, he can become connected with them, which
aggregates the rights of these investors, and has the result they
may all control thereby preventing relief being available. Shareholders
agreements have to be carefully drafted to address this problem.
An additional test is that an EIS investor cannot be connected
with the company in which he invests, which means that he cannot
take and cannot with any person connected with him take, over
30% of the share capital or the share capital and loan capital,
voting rights, or be entitled to more than 30% of the assets in
the event of a winding up. Nor can an investor be a director.
It would appear that the effect of the relief is not to allow
an investor to invest in a company that he knows much about. The
fear is that if an investor has control he will manipulate the
company and transfer value in and out of it and that relief should
not be given to someone for investment in his own business—although
it has to be asked what is wrong with investing in your own business,
providing it is investment rather than recycling of capital. However
there are a whole series of protections within the legislation
which ought to prevent this occurring. The control test can be
a real disincentive when another party is investing in a company
where others have EIS relief or where a VCT holds a stake.
5. There is something of an obsession under
both sets of rules with asset backed investments. This means that
property based activities and activities involving farming and
market gardening are excluded from the schemes. It is thought
that such activities, because they are asset backed are "safe".
However, they may not be asset backed to a great extent, and even
if they are there may be considerable risk associated with the
activity regardless of whether there is asset backing.
6. The problem with the schemes such as EIS
is that there will always be intermediaries seeking to achieve
tax advantaged risk free investments. This causes there to be
considerable numbers of rules on the statute book which can often
deter the genuine case and prevent that investee company obtaining
relief. There are rules which, following upon this theme, requires
an investee company to invest the funds raised relatively rapidly
(80% within one year). The purpose of this rule, of course, is
to prevent the company becoming a safe "money box" company.
On the other hand to force an investee company to invest funds
rapidly may not be in the best interest of its business—it
may be preferable to not to invest funds that rapidly in order
to obtain the best return and to limit risk. There has been relaxation
of this rule over time, which is helpful, but it illustrates the
problems arising.
7. In many cases with EIS relief if there
is a breach of the rules the company simply ceases to qualify,
which means the tax relief on investment (that is the relief given
against income tax) becomes repayable. There are different periods
for this purpose; the main period, broadly, being three years
after the investment is made—with EIS companies (and VCT
investee companies) there is a tendency not to carry out activities
which might otherwise be in the company's interest if that would
give rise to a clawback of any tax reliefs. In other words the
tax relief becomes more important than the business objective.
8. The schemes generally assume that profits
will be realised from an exit—so there is a capital gains
tax exemption for the first disposal of a target company by an
EIS investor, and a VCT company does not pay capital gains tax
if it is on the disposal of shares in a target. However, a VCT
is also designed so that income can be generated with only one
tax charge. within the original investee company. A dividend is
not taxed in the hands of a VCT and neither is it taxed in the
hands of an investor of shares held in a qualifying limit. This
is potentially rather attractive as it could mean that the rates
of tax on distributed income and the rate of tax on capital gains
are not too dissimilar. It has to be said that VCTs do not often
pay dividends and we would anticipate that the same is true for
EIS companies. Probably with this in mind, EIS relief does not
appear to cover dividends which remain taxable in the hands of
the investor. The hoped for return is therefore in terms of an
exit. Yet the investment sizes of the companies is now quite low.
between £7 million and £8 million in gross assets. This
will mean that EIS investors may have to sell early as they cannot
take part in later funding and retain their reliefs as the later
funding may take the assets of the investee company over the assets
limit. This creates an issue for an EIS or VCT investor. If they
do retain their investment and do not take part in a subsequent
funding round (because no relief would be available for that investment)
they may find it much reduced in value following a later funding
round in which they do not participate. Investors are often penalised
for not taking part in a later funding round. The relief for an
owner manager is now entrepreneurs relief. This has different
conditions attaching to it from EIS, but also exempts capital
gains. This relief is not restricted by a gross assets test, which
means that different holders may be driven by different tax reliefs
and consequences. In addition (as for EIS investors) the owner
manager has a similar disincentive to take profits out of his
business in the form of remuneration or dividends as the overall
rate is higher than that on gains.
The above touches on some of the many issues
involved, which are complex and involve the interaction of the
reliefs with other reliefs and business behaviour.
7 May 2008
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