Revenue Law Principles and Practice

[*441]

19 CGT--basic principles

Updated by Andrew Farley, Partner Wilsons

I Introduction [19.2]

II Calculation of the gain [19.21]

III Losses for CGT [19.61]

IV Calculating the tax payable [19.81]

V Meaning of 'disposal' [19.111]

VI Capital gain or income profit? [19.141]

'It is impossible to draw an unambiguous distinction between "capital" gains and "income" gains and the attempt to do so necessarily results in great uncertainty for the taxpayer because a particular transaction may or may not be found by the courts to fall on one side of the line or the other' (Carter Commission, Canada, 1966). [19.1]

I INTRODUCTION

1 Background

Capital gains tax (CGT) was introduced in FA 1965 and was first consolidated in the Capital Gains Tax Act 1979 (CGTA 1979) and then in the Taxation of Chargeable Gains Act 1992 (TCGA 1992). It was largely introduced to tax profits left untaxed by income tax. Income tax, in the much quoted dictum of Lord Macnaghten, was and is a tax on income. Thus, it does not (save in exceptional cases where capital is deemed to be income) tax the profit made on a disposal of a capital asset. However, since 1965, the taxpayer may be charged to CGT on any capital gains after deducting any available exemptions and reliefs.

The then Chancellor of the Exchequer, Mr James Callaghan, in his 1965 Budget speech introducing CGT, explained:

'Yield is not my main purpose ... The failure to tax capital gains is ... the greatest blot on our system of direct taxation. There is little dispute nowadays that capital gains confer much the same kind of benefit on the recipient as taxed earnings more hardly won. Yet earnings pay tax in full while capital gains go free ... This new tax will provide a background of equity and fair play... ' [19.2]

a) Overlap with income tax

CGT aims to tax only what is untaxed by income tax and, normally, there will be no CGT on a transaction that is chargeable to income tax. Hence, in the [*442] case of certain transactions which might attract both taxes, CGT is chargeable on only so much of the transaction as is not charged to income tax, as, for instance, on the purchase and sale of assets which qualify for capital allowances (see [19.66]) and the grant of leases at a premium where part of the premium is assessable to income tax under the income from property business rules (formerly Schedule A): see [12.81]).

There is, however, no general rule against double taxation that prevents the same sum from being subject to two different taxes and in Bye v Coren (1986) Scott J (whose judgment was upheld in the Court of Appeal) held that 'whether it is so subject is a matter of construction of the statute or statutes which have imposed the taxes'. TCGA 1992 s 37 will provide relief in most cases since it states that once an income tax assessment has become final in respect of a sum of money the same person cannot be subject to a CGT assessment on that same sum. There is, of course, nothing to prevent the Revenue from raising alternative assessments (eg to income tax and CGT) on the same sum of money (Bye v Coren, above and IRC v Wilkinson (1992)).

For the use of trading losses to reduce chargeable gains, see FA 1991 s 72 which is discussed at [11.61] [19.3]

b) The changing face of CGT

The scope of the tax has fluctuated since its introduction in 1965. The charge on death was removed in 1971 and criticism that the tax was levied on inflationary gains was largely removed by the introduction of an indexation allowance in 1982 and by the rebasing of the tax to 1982 (introduced in FA 1988). This trend towards limiting the scope of the tax was, however, reversed by changes made in FA 1989. These concerned lifetime gifts where the position from 1980 had been that in most cases tax could be postponed by the exercise of a hold-over election (provided for in FA 1980 s 79 as subsequently amended). It is now only possible to make such an election in a limited number of cases (see Chapter 24). As a result, CGT may be charged and on a gift of assets where hold-over relief is not available so that the curious position is that a tax aimed at catching profits will often apply to gifts (deemed profits) whereas the tax intended to catch all gifts (CTT now IHT) will only apply to lifetime gifts which are not potentially exempt transfers (albeit the extent of such gifts has increased considerably with the enactment of FA 2006) or which are made in the period of seven years before the death of the donor!

The yield from CGT is under 1% of the total revenue raised in direct taxes. In his 1984 Budget Speech the Rt Hon Nigel Lawson MP acknowledged the 'unfairness and complexity' of the CGT legislation. In his 1985 Budget Speech he declared that the right way to reform the tax was to improve the indexation allowance thereby ensuring that a charge was levied only on real and not inflationary gains. As a result of a number of changes that he then introduced he felt able to conclude that 'the tax is now on a broadly acceptable and sustainable basis'. Three years later, his views had altered, and a further reform (rebasing the tax from 1982 instead of 1965) was introduced in FA 1988 to remedy the 'manifest injustice' of taxing 'paper profits resulting from the rampant inflation of the 1970s'. Gordon Brown has inherited the mantle and after a widespread consultation process FA 1998

introduced far-reaching reforms of the tax for individuals, trustees and PRs (but not for companies) in the form of taper relief. The Press Release of 17 March 1998 announced:

'The reform will help investment through encouraging longer-term holding of assets by reducing the effective rate of CGT ... It will stimulate entrepreneurial activity by rewarding longer term investment in businesses. The changes will lead to simplification of the CGT system by progressively removing indexation, a major complicating feature.'

Not surprisingly, the system has in fact become more complex and taper relief itself has been subject to major revisions in FA 2000, FA 2001, and FA 2002, with further amendments in FA 2003. In 'Enterprise for All-the challenge for the next Parliament' (18 June 2001) there is the following:

'The Government will also consult whether there are worthwhile and good value for money options to simplify capital gains tax within the existing policy framework.'

Unfortunately, the problem of complexity has proved rather more intractable than anticipated. [19.4]

2 Basic principles

CGT is charged on any gain resulting when a chargeable person makes a chargeable disposal of a chargeable asset. Tax is charged on so much of the gain as is left after taking into account any exemptions or reliefs and after deducting any allowable losses. The tax is payable on 31 January following the year of assessment (which is on a current year basis: TCGA 1992 s 7). It is, therefore, sensible to make disposals early in a tax year in order to achieve the greatest delay in the payment of tax-provided, of course, that all other things are equal (it is never advisable to let tax considerations dictate investment decisions).

The tax was introduced in 1965 and was not retrospective. Accordingly, it only taxed gains arising after 6 April in that year. Thus, where an individual acquired an asset in 1960 for £10,000 and sold it in 1970 for £20,000, thereby realising a gain of £10,000, only such part of the gain as accrued after 6 April 1965 was charged (see [19.37]). For assets owned on 31 March 1982, the chargeable gain may be computed on the basis that the asset in question had been acquired in March 1982 at its then market value (TCGA 1992 s 35). This rebasing of the tax is discussed in detail at [19.38] and means that gains accruing between 1965 to 1982 have now been removed from the tax charge. [19.5]

a) Who is a chargeable person? (TCGA 1992 s 2)

Chargeable persons include individuals who are resident or ordinarily resident in the UK trustees, PRs and partners. In the case of partners, each partner is charged separately in respect of his share of the partnership gains (TCGA 1992 s 59, see Chapter 44). Although companies are not chargeable persons for CGT purposes, the corporation tax to which they are subject is [*444] levied on corporate profits that include chargeable gains. Non-residents are-in general-not taxed on a disposal of UK sit us assets (see Chapter 27). [19.6]

b) What is a chargeable asset? (TCGA 1992 s 21(1))

A number of assets are not chargeable to CGT and the gain on the disposal of certain other assets is exempt from charge (for details see Chapter 22).

Apart from these exclusions, however, all forms of property are assets for CGT purposes including options, debts, incorporeal property, any currency (other than sterling), milk quota (Cottie v Coldicott (1995)) and property that is created by the person disposing of it (eg goodwill which is built up from nothing by a trader).

An asset which cannot be transferred by sale or gift may be within the tax charge. In O'Brien v Benson's Hosiery (Holdings) Ltd (1979), for instance, a director under a seven-year service contract paid his employer £50,000 to be released from his obligations. The employer was charged to CGT on the basis that the contract, despite being non-assignable, was an asset under s 21(1) so that the release of those rights resulted in 'a capital sum being received in return for the forfeiture or surrender of rights' (TCGA 1992 s 22(1)(c); see further [19.112]).

In Marren v Ingles (1980) shares in a private company were sold for £750

per share, payable at the time of the sale, plus a further sum if the company obtained a Stock Exchange quotation and the market value of the shares at that time was in excess of £750 per share. Two years later a quotation was obtained and a further £2,825 per share was paid. The House of Lords held that the taxpayers were initially liable to CGT calculated on the original sale price of £750 per share plus the value of the contingent right to receive a further sum (their Lordships did not attempt to put a value on it; was it nominal?). That right was a chose in action (a separate asset) which was disposed of for £2,825 per share two years later, leading to a further CGT liability (see [19.26]).

A 'right' may be used in both a colloquial and a legal sense. In its wider colloquial sense a right is not an asset for CGT purposes: it must be legally enforceable and capable of being turned into money. In Kirby v Thorn EMI plc (1988) the Revenue initially argued that the right to engage in commercial activity was an asset for CGT purposes with the result that if the taxpayers agreed to restrict their commercial activities in return for a capital payment, that sum would be brought into charge to tax. This argument was rejected on the basis that freedom to indulge in commercial activity was not a legal right constituting an asset for CGT purposes. On appeal, the Revenue produced an alternative argument that the taxpayers had derived a capital sum from the firm's goodwill and that therefore the payment in question was chargeable to CGT. In this argument it was successful. [19.7]

c) What is a chargeable disposal?

This topic is considered at [19.111] ff. 'Disposal' is extended to include cases where a capital sum is derived from an asset (for instance, insurance money paid for the damage or destruction of an asset). [19.8]-[19.20] [*445]

II CALCULATION OF THE GAIN

The chargeable gain is found by taking the disposal consideration of the asset and deducting from that figure allowable expenditure (often called the 'base cost'). The disponer's acquisition cost is usually the main item of expenditure. If the allowable expenditure exceeds the disposal consideration, the disponer has made a loss for CGT purposes which may be used to reduce the chargeable gains that he has made on disposals of other assets (see TCGA 1992 s 2(2) and [19.61]).

EXAMPLE 19.1

A sells a painting for £20,000 (the disposal consideration) He bought it six months ago for £14,000 (the acquisition cost) and has incurred no other deductible expenses. His chargeable gain is £6,000. If A sold the picture for £10,000 he would have an allowable loss of £4,000.

Inevitably, the calculation of disposal consideration and allowable expenditure is not always as simple as in Example 19.1: for instance, the chargeable gain may be reduced by taper relief (see Chapter 20).

The onus is on the taxpayer to establish what (if army) part of the disposal consideration is not within the charge to CGT (see Neely v Rourke (1987)). [19.21]

1 What is the consideration for the disposal?

a) General

When the disposal is by way of a sale at arm's length, the consideration for the disposal will be the proceeds of sale. For disposals between husband and wife the disposal consideration is deemed to be of such a sum that neither gain nor loss results (TCGA 1992 s 58: a 'no gain/no loss' disposal), irrespective of the actual consideration given. It should also be noted that the Civil Partnership Act 2004 (CPA 2004), which gives legal recognition to same-sex couples, became law in November 2004 and comes into effect on 5 December 2005. Broadly, the Act allows same-sex couples to make a formal legal commitment to each other by entering into a civil partnership through a registration process. A range of important rights and responsibilities flows from this, including legal rights and protections. For tax purposes, registered same-sex couples will be treated the same as opposite-sex couples-disposals between registered same-sex couples will be deemed to be 'no gain/no loss' disposals. Where the disposal is not at arm's length, however, the consideration for the disposal is taken to be the market value of the asset at that date. This applies to gifts, to disposals between 'connected persons' (where the disposal is always deemed to be otherwise than by bargain at arm's length), to transfers of assets by a settlor into a settlement and to certain distributions by a company in respect of shares (TCGA 1992 s 17(1)(a)). In the case of disposals by excluded persons who are exempt from CGT (including charities, friendly societies, approved pension funds, and non-residents), the recipient is taken to acquire the asset at market value.

[*446] EXAMPLE 19.2

(1) Sarah gives her husband a Richard Eurich painting for which she had paid £10,000. He acquires the picture for such sum as ensures neither gain nor loss results to Sarah, ie for £10,000 plus an indexation allowance to April 1998 (if appropriate): see further [19.321 and for the taper relief position [20.33]).

(2) A gives a Ming vase worth £40,000 to the milkman. The consideration for the disposal is taken to be £40,000. If, instead, A sold the vase to his son B for £10,000 (or, indeed, for £60,000), B is a 'connected person' and the consideration for the disposal is taken to be £40,000.

(3) Anna, a long-term resident of Peru, gives a house in Mayfair worth £1.5m, which she had acquired in 1989 for £20,000, to her son Paddington who is a UK resident. Anna is not chargeable to CGT on her gain because she is an excluded person and Paddington acquires the property at a value of £1.5m.

The market value of the asset is taken to be the disposal consideration whenever the actual consideration cannot be valued or the consideration is services (TCGA 1992 s 17(1) (b) but note that this provision does not apply to the exercise of an option: see [19.118]).

EXAMPLE 19.3

A, an antiques dealer, gives B, a fellow dealer, his country cottage worth £40,000 in consideration of B entering into a restrictive covenant with A, whereby he (B) agrees not to open an antique shop in competition with A. The consideration for the disposal is taken to be £40,000.

This market value rule can work to a taxpayer's advantage by giving the recipient a high acquisition cost for any future disposal in a transaction where the disponer is not charged to CGT on the gain (known as 'reverse Nairn Williamson' arrangements). To some extent this is prevented by TCGA 1992 s 17(2) which provides that, where there is an acquisition without a disposal (eg the issue of shares by a company) and either no consideration is given for the asset, or the consideration is less than its market value, the actual consideration (if any) given prevails. [19.22]

EXAMPLE 19.4

A Ltd issues 1,000 £1 ordinary shares to B at par when their market value is £2 per share. The issue of shares by a company is not a disposal. This is, therefore, an acquisition of a chargeable asset by B without a disposal. Were it not for s 17(2), B's acquisition cost of the shares would be £2,000. As it is, B's acquisition cost is what he actually paid for the shares: ie £1,000.

b) Connected persons

'Connected persons' for CGT purposes fall into four categories (TCGA 1992 s286).

(1) An individual is connected with his spouse, his or her relatives and their spouses. Relatives include siblings, direct ancestors (parents, grandparents), and lineal descendants (children, grandchildren) but not [*447] lateral relatives (uncles, aunts, nephews and nieces). Marriage continues for these purposes until final divorce (see Aspden v Hildesley (1982)).

(2) A company is connected with another company if both are under common control. A company is connected with another person if he (either alone or with other persons connected with him) controls that company.

(3) A partner is connected with a fellow partner and his spouse and their relatives except in relation to acquisitions and disposals of partnership assets under bona fide commercial arrangements (eg where a new partner is given a share of the assets).

(4)A trustee is connected with the settlor, any person connected with the settlor and any close company in which the trustee or any beneficiary under the settlement is a participator (for the definition of close company and participator, see Chapter 41). He is not connected with a beneficiary as such and, once the settlor dies, ceases to be connected with persons connected with the settlor (see RI 38, February 1993). [19.23]

EXAMPLE 19.5

A would like to 'unlock' the unrealised losses on a number of his assets. He disposes of the assets into a trust in which he enjoys a life interest. The result is to crystallise the loss but, because of the connected persons rule, that loss will only be available to set against gains on disposals between the same parties (see [19.62]). Accordingly, A disposes of assets showing a gain to the same trustees. Now the loss can be offset against that gain and, if those assets are immediately sold by the trustees, no chargeable gain will result to them.

c) The market value of assets

Market value is the price for which the asset could be sold on the open market with no reduction for the fact that this may involve assuming that

several assets are to be sold at the same time (TCGA 1992 s 272).

The market value of shares and securities listed in The Stock Exchange

Daily Official List is taken as the lesser of:

(1) the lower of the two prices quoted for that security in the Daily Official List, plus one quarter of the difference between the two prices (quarter-up);

(2) half way between the highest and lowest prices at which bargains were recorded in that security on the relevant date excluding bargains at special prices (mid-price).

Unquoted shares and securities are valued on a number of criteria including the size of the holding and, therefore, the degree of control of the company.

TCGA 1992 s 19 modifies the basic rule: it applies when assets are fragmented (ie when one transferor makes two or more transfers to connected persons and the transfers occur within six years of each other).

EXAMPLE 19.6

Alf owned a pair of Ming vases which as a pair were worth £100,000 but separately each was worth only £40,000. In January 2003 he gave one to his daughter and in the foliowingJuly the other to his son. [*448]

(1) The disposal to his daughter was for an original market value of £40,000. However, as it is linked to the later disposal to his son, the assets disposed of by the two disposals are valued as if they were disposed of by one disposal and the value attributed to each disposal is the appropriate proportion of that value. The market value of the two vases is £100,000 and the appropriate proportion is £50,000. (Notice that this revaluation of an earlier transaction will lead to an adjusted CCT assessment.)

(2) The later disposal, occurring within six years, is a linked transaction. Again the original market value (£40,000) is replaced by the appropriate proportion (£50,000).

(3) Compare the CGT rules on a disposal of sets of chattels (see [22.23]) and the IHT associated operations provisions (see [28.101]).

(4) With the removal of general hold-over relief in the case of disposals by way of gift these rules are of increased importance.

Disposals to a spouse (and registered same-sex couples from 5 December 2005) are treated as giving rise to neither gain nor loss (TCGA 1992 s 58: [19.22]) but may form part of a series in order to determine the value of any of the other transactions in that series. [19.24]

d) Deferred consideration

Where the consideration for the disposal is known at the date of the disposal (which will normally be the date of contract: TCGA 1992 s 28 and see [19.126]) but is payable in instalments (TCGA 1992 s 280) or is subject to a contingency (TCGA 1992 s 48), the disponer is taxed on a gain calculated by reference to the full amount of the consideration receivable with no discount for the fact that payment is postponed. 1f, in fact, he never receives the full consideration his original CGT assessment is adjusted. [19.25]

EXAMPLE 19.7

(1) A bought land two years ago for £50,000. He sells it today for £100,000 payable in two years' time. A is taxed now on a gain of £50,000 despite the fact that he has received nothing and with no discount for the fact that the right to £100,000 in two years' time is not worth £100,000 today. If A had been 'connected' with his purchaser, market value would be substituted for the actual consideration under s 17 thereby enabling a 'discount' to be taken into account. (For the CGT position when the purchase price is paid in instalments, see [19.94].)

(2) 0Mucky sells four oil rigs for a consideration of $38.6m payable by instalments over nine years. At exchange rates prevailing at the date of disposal this produced a gain of £6.7m. Taking rates at the time when each instalment was paid, however, Mucky realised a loss of £2.7m. The basic CGT rule for foreign currency transactions is that the gain is to be computed by taking the exchange rate equivalent of the allowable expenditure at the time when it was incurred and the rate equivalent of the disposal consideration at the date of disposal (see Capcount Trading v Evans (1993)). Accepting this position, will Mucky succeed in arguing that because of the change in exchange rates part of his consideration was irrecoverable under TCGA 1992 s 48? Not according to the Court of Appeal who held that 'consideration' meant what was promised (ie dollars) rather than any sterling equivalent (see Loffland Bros North Sea Inc v Goodbrand (1998)). [*449]

e) Marren v Ingles

It may be that the deferred consideration cannot be valued because it is dependent on some future contingency. In Marren v Ingles (1980) (see [19.7]) part of the payment for the disposal of shares was to be calculated by reference to the price of the shares if and when the company obtained a Stock Exchange listing. The taxpayer's gain at the time of the disposal of the shares could not be calculated by reference to such unquantifiable consideration. Accordingly he was treated as making two separate disposals. The first was the disposal of the shares. The consideration for this was the payment that the taxpayer actually received plus the value (if any) of the right to receive the future deferred sum (a chose in action). The value of the chose in action then formed the acquisition cost of that asset. Hence, once the deferred consideration became payable, the taxpayer was treated as making a second disposal, this time of the chose in action. He was, therefore, chargeable on the difference between the consideration received and whatever was the acquisition cost of that asset.

The House of Lords did not attempt to value the chose in action. In all probability its value would have been nominal, with the result that on the first disposal (of the shares) the gain would have been calculated by reference only to the cash received, whilst on the second disposal (of the chose in action) the entire consideration received would constitute a gain. There is no element of double taxation involved in the Marren v Ingles situation. Instead, the CGT is collected (in effect) in two instalments with the result that the taxpayer may be better off than A, in Example 19.7(1), above, who is taxed on money years before receiving it. Of course, taper relief will often not be available on the disposal of the chose in action but in the event that the chose is subsequently sold at a loss, relief may be available against the gain on the disposal of the original asset (see TCGA 1992 s 279A-D inserted by FA 2003). [19.26]

2 What expenditure is deductible?

Once the disposal consideration is known, the chargeable gain (or allowable loss) can be calculated by deducting allowable expenditure. This is defined in TCGA 1992 s 38 as 'expenditure incurred wholly and exclusively' in: [19.27]

a) Acquiring the asset

The purchase price or market value, including any allowed incidental costs (such as stamp duty), or where the asset was created rather than acquired (eg a painting), the cost of creating or providing it, may be deducted (TCGA 1992 s 38(1)(a)). In certain circumstances a deemed acquisition cost will be deducted. This is the case, for instance, when an asset is acquired by inheritance (probate value being the acquisition cost) and when the 1982 rebasing rules apply (market value in 1982 being the acquisition cost: see TCGA 1992 s 35(2)). [19.28]

b) Enhancing the value of the asset

Expenditure on improvements must be reflected in the state or nature of the asset at the time of its disposal (TCGA 1992 s 38(1)(b)). It is presupposed [*450] that the asset is in existence when the expenditure is incurred (Garner v Pounds Shipowners and Shipbreakers Ltd (2000)). Thus, in the case of land, the costs of an application for planning permission which is never granted are not deductible, whereas the costs of building an extension are. Also deductible under this head are the costs of establishing, preserving or defending title to the asset (eg the costs of a boundary dispute and, in the case of PRs, a proportion of probate expenses-see also Lee v Jewitt (2000) where the costs of a partnership dispute were incurred in defending the taxpayer's title to goodwill).

In Chany v Watkis (1986) the taxpayer agreed to pay his mother-in-law a cash sum (9,400) if she surrendered up vacant possession of a house which he wished to sell. Between exchange of contracts on the property and completion this agreement was varied by mutual consent. Instead of the cash sum, the taxpayer agreed to build an extension onto his own home and allow her to occupy it rent-free for life. It was held that the cash sum would have been deductible in arriving at his gain on sale of the house if it had been paid (since vacant possession enhanced the value of the house). The same principle applied to a consideration in money's worth (the rent-free accommodation) and the case was remitted to the Commissioners for them to determine the value of this consideration. Two matters are worthy of note: first, that expenditure incurred post-contract but pre-completion was taken into account and the phrase 'at the time of the disposal' in s 38(1) (b) must be construed accordingly; and, secondly, that the taxpayer's mother-in-law was a protected tenant, of the property (and had been before he purchased the house) and hence the agreement with her was a commercial arrangement. [19.29]

c) Disposing of the asset

The incidental costs of disposal that are deductible include professional fees paid to a surveyor, valuer, auctioneer, accountant, agent or legal adviser; costs of the transfer or conveyance; costs of advertising to find a buyer and any costs incurred in making a valuation or apportionment necessary for CGT (TCGA 1992 s 38(1)(c)). Expenses incurred in making a valuation and in ascertaining market value include the costs of an initial valuation to enable a tax return to be submitted but do not include costs of negotiating that value with the Revenue nor costs of appealing an assessment (Caton's Administrators v Couch (1997)). Other taxes, such as IHT on a gift, are not deductible.

The requirement in TCGA 1992 s 38 that expenditure must be 'wholly and exclusively' incurred makes use of the same test for allowable expenditure as that found for income tax under ITTOJA 2005 s 34 (see [10.137]). For CGT purposes, however, the words have been interpreted relatively liberally. In IRC v Richards' Executors (1971), PRs who sold shares at a profit claimed to deduct from the sale proceeds the cost of valuing the relevant part of the deceased's estate for probate. The House of Lords held that they could do so even though the valuation was for the purposes of estate duty as well as for establishing title (ie even though the costs were 'dual purpose expenditure').

'Expenditure' within TCGA 1992 s 38 must be something that reduces the taxpayer's estate in some quantifiable way. Thus in Oram v Johnson (1980) the taxpayer who bought a second home for £2,500, renovated it himself and later sold it for £11,500 could not deduct the notional cost of his own labour. [*451]

On a deemed disposal and reacquisition (see [19.47]) notional expenses are not deductible (TCGA 1992 s 38(4)), but actual expenses are. Thus, in IRC v Chubb's Settlement Trustees (1971), where the life tenant and the remainderman ended a settlement by dividing the capital between them so that there was a deemed disposal under (now) TCGA 1992 s 71, the costs of preparing the deed of variation of the settlement were deductible (the result of this case is to leave TCGA 1992 s 38(4) as a prohibition on the deduction of imaginary expenses!). [19.30]

d) Disallowed expenditure

The deduction of certain items of expenditure is specifically prohibited. For instance, interest on a loan to acquire the asset (TCGA 1992 s 38(3)); premiums paid under a policy of insurance against risks of loss of, or damage to, an asset; and, most important, any sums that a person can deduct in calculating his income for income tax. Additionally, no sum is deductible for CGT purposes which would be deductible for income tax, if the disponer were in fact using the relevant asset in a trade; in effect therefore, no items of an income, as opposed to a capital, nature will be deductible. For example, the cost of repair (as opposed to improvement) or of insurance of a chargeable asset, both of which are of an income nature, are disallowed as deductions for CGT. [19.31]

EXAMPLE 19.8

A buys a country cottage in 1997 for £200,000 to rent to high net worth individuals. He spends £30,000 in installing a gold plated bathroom and £14,000 on mending the leaking roof. Over the following five years he spends a further £500 on repairing leaking radiators and £400 on general maintenance. He pays a total of £3,000 on property insurance. He sells it in 2005 for £650,000.

His chargeable gain (ignoring indexation and taper) is:

. £ £

Sale proceeds 650,000

Less:

Acquisition cost 200,000

Cost of improvements 30,000 230,000

. ------- --------

. £420,000

The cost of repairs, maintenance and insurance are not deductible for CGT because they are deductible in computing his income under the property income rules of ITTOIA 2005 (formerly Schedule A). The insurance premiums are specifically disallowed under TCGA 1992 s 205.

If A had bought the cottage as a second home, his gain on sale would still be £420,000; the other items are disallowed as deductions for CGT because they are of an income nature. [*452] 3 The indexation of allowable expenditure

a) Rationale for an indexation allowance

Before 1982 CGT made no allowance for the effects of inflation on the value of chargeable assets and, accordingly, it taxed both real and paper profits. FA 1982 afforded a measure of relief by introducing an indexation allowance for disposals of assets on or after 6 April 1982 (1 April in the case of companies); FA 1985 made major improvements to that allowance in respect of disposals on or after 6 April 1985 (or 1 April) but FA 1994 introduced restrictions to prevent the allowance from creating a loss. Generally items of allowable expenditure were index-linked (to rises in the RPI), so that the eventual gain on disposal should represent only 'real' profits (see TCGA 1992 ss 53-57). [19.32]

b) The changes of FA 1998

The allowance has been abolished for months after April 1998 in the case of individuals, PRs and trustees. It continues, however, to apply in calculating the chargeable gains of companies (TCGA 1992 s 53(1A)). In its place an entirely new relief, taper relief, was introduced (see Chapter 20). The current position for individuals, etc is, therefore, as follows:

(1) assets acquired before April 1998 will continue to benefit from an indexation allowance but only for the period ending with that month;

(2) assets acquired in April 1998 or at a later time will not benefit from indexation. Eventually, therefore, this allowance will wither away, but the process will occupy many years.

EXAMPLE 19.9

Roy has run his family business for 20 years since inheriting it from his father. He sells it in May 2005. In calculating Roy's gain he will benefit from:

(1) indexation relief until April 1998 on (presumably) the 1982 value of the business (see [19.38]); and

(2) business asset taper relief (see [20.20]).

The ending of indexation was presented as a simplifying measure:

'The calculation of the allowance is a major complicating feature of the present CGT system and its eventual withdrawal, together with the withdrawal of retirement relief, will lead to significant simplification.'

(Press Release, 17 March 1998) [19.33]

c) Basic rules of indexation

It is calculated by comparing the RPI for the month in which the allowable expenditure was incurred (ie due and payable) with the index for the 'relevant month' which (except for companies) is April 1998 (TCGA 1992 [*453] s 54(1A)). Assuming that the RPI has increased, the allowable expenditure is multiplied by the fraction

. RD-RI

. -----

. RI

where RD is the index for the relevant month and RI is the index for the month in which the item of expenditure was incurred or March. 1982 if later (this fraction, calculated to three decimal places, produces the 'indexed rise' decimal which is published by the Revenue each month). The resultant figure (known as the 'indexation allowance') is a further allowable deduction in arriving at the chargeable gain on disposal of the asset.

As the allowance is linked to allowable expenditure, it follows that, where an asset has a nil base cost (for instance, goodwill built up by the taxpayer) there can be no indexation allowance.

ESC D42 makes provision for the situation where a leaseholder acquires a superior interest in the land so that his interests merge and the inferior interest is extinguished. Strictly, the indexation allowance on the total costs of the two acquisitions (as wasted, if appropriate: see [19.49]) should be calculated only from the date of the later acquisition of the superior interest but by concession the allowance on the acquisition cost of the earlier, inferior, interest can be calculated from the date of its acquisition. [19.34]

EXAMPLE 19.10

A painting was bought for £20,000 on 10 April 1991 and sold for £100,000 on 30 June 2005. RPI for April 1991 is (say) 300; RPI for April 1998 is (say) 500. The indexed rise is:

. (500-300)

. --------- : ie 0.667 (correct to three decimal places)

. 300

Indexation allowance is: £20,000 x 0.667 = £13,340

Therefore, the chargeable gain is:

. £ £

Sale proceeds 100,000

Less:

Acquisition cost 20,000

Indexation allowance 13,340 33,340

. ------ -------

Chargeable gain £66,660

. =======

Assume that the painting was restored on 12 November 1994 for £2,000. RPI for November 1994 is (say) 400. Indexation allowance is £13,340, as above, plus:

. (500-400)

. £2,000 x --------- = £500

. 400

Therefore, the chargeable gain is £64,160 (£66,660 - £2,000 - £500). Taper relief on the basis that the picture was not a business asset will he available (see Chapter 20). [*454]

d) The indexation allowance and capital losses

The indexation allowance cannot create or increase a capital loss: it only operates to reduce or extinguish capital gains (TCGA 1992 s 53(1) (2A)). [19.35]

EXAMPLE 19.11

Main acquired an asset for £100,000. He disposes of it for £110,000 and his indexation allowance is £15,000. Alain can use £10,000 of the indexation allowance (only) thereby wiping out his gain. If he had sold the asset for £90,000 none of the allowance would be used. 1f he had sold it for £125,000 then the full allowance would be available to reduce the gain to £10,000.

4 Taper relief (TCGA 1992 s 2A; Sch A1 inserted by FA 1998 and amended by FAs 2000-2003)

These provisions are considered in detail in the next chapter. [19.36]

5 Calculation of gains for assets acquired before 6 April 1965

Only gains after 6 April 1965 are chargeable (TCGA 1992 s 35(9)). Accordingly, for assets acquired before 6 April 1965, the legislation contains rules determining how much gain is deemed to have accrued since that date. Generally, the gain is deemed to accrue evenly over the whole period of ownership (the so-called straight-line method: TCGA 1992 Sch 2 para 16(3)). The chargeable gain is, therefore, a proportion of the gross gain calculated by the formula:

. period of ownership since 6 April 1965

Gross gain x ----------------------------------------------- = chargeable gain

. total period of ownership

EXAMPLE 19.12

(The indexation allowance, 1982 rebasing and taper relief have been ignored.)

. £

A bought a picture on 6 April 1964 for 5,000

He sells it on 6 April 2005 for 19,000

. ------

His gain is £14,000

His chargeable gain is: £14,000 x 40/41 = £13,658

In applying this formula, the ownership of the asset can never be treated as beginning earlier than 6 April 1945 (TCGA 1992 Sch 2 para 11(6)) so that if it was acquired before that date it is deemed to have been acquired on that date.

In Smith v Schofield (1993) the taxpayer inherited a Chinese cabinet and French mirror (combined value £250) on the death of her father in 1952. [*455] She sold both items early in 1987 for a price that, after deducting incidental costs of sale and the deemed acquisition cost, left a net gain of £14,088. That figure had to be further reduced for CGT charging purposes by (1) the indexation allowance which would be calculated on the value of the assets in March 1982, and (2) by the straight-line allowance for chargeable assets owned on 6 April 1965. The House of Lords decided that the indexation allowance must be deducted first, and then time apportionment applied with the result that the chargeable gain was £7,189. Had time apportionment been applied first, thereby reducing the gain to £8,864, and then the indexation allowance deducted in full, the chargeable gain would have been only £6,224. Commenting on the decision, Lord Jauncey had some regrets:

'I reached this decision with regret because its effect is that an allowance which was given to offset the effect of inflation on gains accruing from and after 1982 is in part being attributed to notional non-chargeable gains accruing prior to 6 April 1965, a situation which cannot occur where an election of valuation on that date is made. In the present case the effective value of the indexation allowance will be reduced by more than one-third .. I should be surprised if Parliament had intended such a result.'

These rules are of limited importance in view of the rebasing provisions. [19.37]

6 Calculation of gains on assets owned on 31 March 1982 (rebasing)

The following rules apply to disposals of assets that were owned on 31 March 1982 by the person making the disposal. [19.38]

a) Basic rule

Assets that the taxpayer owned on 31 March 1982 are deemed to have been sold by that person and immediately reacquired by him at market value on that date. Rebasing involves the taxpayer in incurring expenses in agreeing with the Revenue a valuation figure for the relevant asset in March 1982 (TCGA 1992 s 35). [19.39]

EXAMPLE 19.13

Jacques' valuable collection of porcelain cost £12,000 in 1970; it was worth £100,000 on 31 March 1982 and has just been sold for £175,000. In computing Jacques' capital gain arising from his disposal, rebasing to March 1982 will result in a reduction in the gain from £163,000 to £75,000 (before considering the indexation allowance and taper relief).

b) Qualifications

In cases where a computation based on the actual costs and ignoring 1982 values would produce a smaller gain or loss, rebasing will not generally apply so that it is that smaller gain or loss which will be relevant. In cases where one computation would produce a gain and the other a loss, there is deemed to be neither. [19.40] [*456]

EXAMPLE 19.14

(1) Assume that under rebasing the disposal of an asset would show a loss of £60,000 whereas ignoring 1982 values the loss would be only £35,000. In this case the £35,000 loss will be taken.

(2) Alternatively, assume that the disposal would show a gain of £25,000 if rebasing applied but only £15,000 if it did not. The smaller gain (;E15,000) will be taxed.

(3) Under the rebasing calculation there is a gain of £50,000 on the disposal of a chargeable asset: on the alternative calculation ignoring 1982 values, however, there is a loss of £2,000. In this case there is deemed to be neither gain nor loss. (Similarly if the loss had been produced by rebasing and the gain under the alternative calculation.)

(4) Assume that there is a loss of £6,000 if the asset is rebased to 1982 but, on the alternative calculation, a loss of £20,000. In this case mandatory rebasing will occur with the result that the loss is restricted to £6,000.

e) The election

Because the qualifications discussed above require the taxpayer to keep pre-1982 records and will usually involve alternative calculations, the taxpayer is given an election for rebasing to apply to all disposals of assets which he held on 31 March 1982. This election may be made at any time before 6 April 1990 or (if no election has been made by that time) within two years from the end of the tax year in which the first relevant disposal (ie of assets owned at 31 March 1982) occurs or within such longer period as the Board may allow (see SP 4/92). The election is irrevocable and will apply to all disposals of assets owned on 31 March 1982 by the particular taxpayer (TCGA 1992 s 35(5)). In SP 2/89 the Revenue indicated that it will always exercise its discretion to extend the election time limit to (at least) the date on which the statutory time limit would expire (ie five years after 31 January following the year of disposal) if the first relevant disposal was one on which the gain would not be chargeable (eg a disposal of private cars; chattels which are wasting assets; gilt-edged securities). [19.41]

d) Technical matters

A crucial feature of the rebasing rules is the determination of when an asset was acquired by the taxpayer. In exceptional cases, the ownership period of another person can be included in deciding whether the asset was owned on 31 March 1982. These are situations where the disponer acquired the asset as a result of a no gain/no loss disposal that took place after 31 March 1982 and was made by a transferor who had owned the asset before that date.

EXAMPLE 19.15

(The indexation allowance on the no gain/no loss disposal has been ignored.)

Doris inherited a gold snuff box on the death of her father in 1977. Its probate value was £10,000. In 1983 she gave it to her husband, Sid, on their wedding anniversary. In March 1982, the box was worth £25,000 and in 1983 £28,000. Sid has just sold the box for £35,000.

(1) The 1983 transfer between spouses was made at no gain/no loss so that Sid is treated as having acquired the box for £10,000. [*457]

(2) In calculating the gain on sale, Sid is treated as having held the asset on 31 March 1982 so that the market value at that date (25,000) will be his allowable base cost.

In certain other situations ownership of an asset may be related back to an earlier date: generally these are cases where the asset is treated as forming part of or replacing an earlier asset. This, for instance, is the case where securities are issued as the consideration for a company takeover under TCGA 1992 ss 135-137 (see Chapter 26).

Rebasing of the acquisition cost to market value on 31 March 1982 was introduced by FA 1988 in relation to disposals on and after 6 April 1988. Accordingly, where an asset held on 31 March 1982 had been disposed of before 6 April 1988 no rebasing would have applied; but FA 1988 (now TCGA 1992 Sch 4) provides that where the gain on such a disposal has been held-over or rolled-over the gain ultimately realised is relieved by deducting half that held-over or rolled-over gain. This was a rough-and-ready substitute for recomputing the held-over or rolled-over gain so as to give effect to March 1982 rebasing. [19.42]

EXAMPLE 19.16

Simpkin, who has been a partner in an estate agency business, sells his interest in goodwill in 1983. The acquisition cost of the goodwill was nil: its value in 1982 was estimated at £85,000. When he sold the goodwill in 1983 he obtained £100,000 that he then rolled over into a farm purchased in 1985 at a total cost of £210,000. As a result of roll-over relief (see [22.72]), the base cost of the farm in Simpkin's hands was reduced to £110,000. As the farm was acquired in 1985 there is no question of March 1982 rebasing. However, on the eventual sale of the farm, one half of the rolled-over gain will be relieved so that Simpkin's base cost will be £110,000 + £50,000 (one half of the rolled-over gain) = £160,000.

7 Part disposals

a) General rule

The term 'disposal' includes a part disposal, so that whenever part of an asset or an interest in an asset is disposed of it is necessary to calculate the original cost of the part sold before any gain on it can be computed (TCGA 1992 s 42). This applies, for instance, to a sale of part of a landholding or to the grant of a lease (for leases, see [19.47]).

The formula used for calculating the deductible cost of the part sold is:

. A

C x ------

. A+B

Where C = all the deductible expenditure on the whole asset A = sale proceeds of the part of the asset sold B = market value of part retained (at the time when the part is sold).

The indexation provisions applied in the same way for part disposals as for disposals of the whole, except that only the apportioned expenditure was index-linked [19.43] [*458]

EXAMPLE 19.17

Ten acres of land were bought for £10,000 on 1 January 1991. Four acres of land were sold for £12,000 on 1 October 2005 (the remaining six acres were then worth £24,000). RPI for January 1991 is (say) 250. RPI for April 1998 is (say) 340.

Acquisition cost of the four acres sold is:

. £12,000

£10,000 x ------------ = £3,333

. £36,000

Indexation allowance is: £3,333 x 0.360 = £1,200

Therefore the chargeable gain is:

. £ £

Sale proceeds 12,000

Less:

Acquisition cost 4,000

Indexation allowance 1,200 5,200

. ----- ------

. £6,800

. ======

(The amount of taper relief will depend on whether the land was a business asset: see Chapter 14.)

b) Cases when the formula is not used

The part disposal formula need not be used (thereby removing the need to value the part of the asset not disposed of) when the cost of the part disposed of can easily be calculated. In particular, there are special rules relating to a part disposal of shares of the same class in the same company (see Chapter 21 Part III).

Further the rules will not be applied to small part disposals of land (TCGA 1992 s 242) if the taxpayer so elects. Where the consideration received is 20% or less of the value of the entire holding and does not exceed £20,000 (or is 'small' in the case of a disposal to an authority with compulsory powers of acquisition: see s 243) the transaction need not be treated as a disposal. Instead, the taxpayer can elect to deduct the consideration received from the allowable expenditure applicable to the whole of the land.

Similar principles apply to small capital distributions made by companies (see [26.21] and for the meaning of 'small', see Tax Bulletin, February 1997). [19.44]

8 Wasting assets (TCGA 1992 ss 44-47)

a) Definition

A wasting asset is one with a predictable useful life not exceeding 50 years. 1f the asset is a wasting chattel (ie an item of tangible movable property such as a television or washing machine), there is a general exemption from CGT (see [22.21]). In the case of plant and machinery qualifying for capital allowances there are special rules (see [19.66]). Short leases of land are [*459] likewise subject to their own rules (see [19.471ff); freehold land, needless to say, can never be a wasting asset. The main types of asset subject to the ordinary wasting asset rules are:

(1) tangible movable property with the exception of commodities dealt with on a terminal market (TCGA 1992 s 45(4));

(2) options with the exception of quoted options to subscribe for shares in a company; traded options quoted on a recognised stock exchange or recognised futures exchange; financial options and options to acquire assets for use in a business (TCGA 1992 s 146);

(3) purchased life interests in settled property where the predictable life expectation of the life tenant is 50 years or less (TCGA 1992 s 44(1) (d)(4) patent rights; (5) copyrights in certain circumstances; and (6) leases for 50 years or less (for leases of land, see [19.471). [19.45]

b) Calculation of gain on disposal

On disposal of any of the above assets any gain is calculated on the basis that the allowable expenditure on the asset is written down at a uniform rate over its expected useful life so that any claim for loss relief will be limited. Consistent with the general principles that apply to such assets, it was only the written down expenditure that was entitled to the indexation allowance. [19.46]

EXAMPLE 19.18

The copyright is sold for £2,600 on 1 April 2005. Assume the RPI for March 1982 is 250; RH for April 1998 is 350. The gain on disposal is calculated as follows:

Calculate written down acquisition cost:

. ( 14 years)

£2,800- (£2,800 x --------) = £737

. ( 19 years)

The indexation allowance is: £737 x 0.4 = £294

Therefore the chargeable gain is:

. £ £

Sale proceeds 2,600

Less:

Acquisition cost 737

Indexation allowance 294 1,031

. -----

Chargeable gain (subject to taper relief) £1,569

[*460]

9 Rules for leases of land (TCGA 1992 s 240, Sch 8)

a) Basic rules

The grant of a lease out of a freehold or superior lease is a part disposal. The grant of a lease for a 'rack rent' and no premium will not attract any CGT charge: sums charged to income tax are excluded from the consideration in computing the gain for CGT (TCGA 1992 s 37(1)). [19.47]

b) CGT on premiums

The gain is computed by deducting from the disposal consideration (ie the premium) the cost of the part disposed of, calculated as for any part disposal (see [19.43]). Included in the denominator of the formula as a part of the market value of the land undisposed of is the value of any right to receive rent under the lease. In Clarke v United Real (Moorgate) Ltd (1988), the court held that a premium included any sum paid by a tenant to his landlord in consideration for the grant of a lease and therefore caught payments to the landlord covering past and future development costs. The definition of 'premium' in TCGA 1992 Sch 8 para 10(2) does not address the giving of consideration other than by payment of a sum, eg where a lease is granted in consideration of the tenant undertaking works of improvement to the demised or other premises. This is in contrast to the position for income tax where the value (to the landlord) of an undertaking by the tenant to carry out development r improvement works to the demised premises (though not to other premises of the landlord) is treated as a premium (ITTOIA 2005 s 278 and see [8.83]). On general principles the value of a tenant's undertaking to carry out development or improvement works would constitute consideration for the lease; and in so far as this notional premium is not subject to income tax (for example, because the works relate to other premises of the landlord) it would be taken into account in computing the landlord's chargeable gain (or allowable loss) on the part-disposal arising from the grant of the lease. [19.48]

c) The wasting asset rules for leases

A lease which has 50 or less years to run is a wasting asset. It does not depreciate evenly over time, however, so that on any assignment of it, its cost is written down, not as described in [19.46], but according to a special table in TCGA 1992 Sch 8 (on the duration of a lease, see Lewis v Walters (1992) deciding that the possibility of extending the term under the Leasehold Reform Act 1967 should be ignored).

Where a sub-lease is granted out of a lease that is a wasting asset, the ordinary part disposal formula is not applied. Instead, any gain is calculated by deducting from the consideration received for the sub-lease, that part of the allowable expenditure on the head lease that will waste away over the period of the sub-lease. [19.49]

EXAMPLE 19.19

A acquires a lease of premises for 40 years for £5,000 (that lease is, therefore, a wasting asset). After ten years he grants a sub-lease to B for ten years at a premium of £1,000. [*461]

A's gain is calculated by deducting from the consideration on the part disposal (ie £1,000), such part of £5,000 as will waste away (in accordance with TCGA 1992

Sch 8 para 1) on a lease dropping from 30 years to 20 years.

d) Income tax overlap

Any part of a premium that is chargeable to income tax under the property

income provisions of ITTOJA 2005 (formerly Schedule A) (see Chapter 12)

is not charged to CGT. Thus, on the grant of a short lease out of an interest that is not a wasting asset (eg the freehold) there must be deducted from the premium received such part of it as is taxed under ITTOIA 2005. The part disposal formula is then applied (see [19.43]) but in the numerator (though not in the denominator) the sum representing the sale proceeds of the part disposal is the premium received less that part taxed under ITTOLA 2005. [19.50]

EXAMPLE 19.20

A buys freehold premises for £200,000. He grants a lease of the premises for 21 years at a premium of £100,000 and a rent. The value of the freehold subject to the lease and including the right to receive rent is now £150,000.

Of the premium of £100,000, £60,000 is taxed under ITTOIA 2005 (ie the premium less 2% x 20 ie less 40%: see [12.82]). A's chargeable gain is, therefore:

. £

Consideration received 100,000

Less: amount taxed under ITTOIA 2005 60,000

. -------

. 40,000

Less: cost of the part disposed of

. 32,000

. £40,000

. £200,000 x -------------------

. £100,000 + £150,000

Chargeable gain (ignoring indexation and taper) £8,000

e) Tenants and lease surrenders/regrants

For the position of a tenant who extends his lease, often by surrendering the old lease in return for the grant on a new long lease and payment of a premium, see ESC D39 ([19.124]); for the calculation of his indexation allowance ESC D42. A reverse premium received by a tenant as an inducement to enter into the lease will not normally attract a CGT charge: see CG 70833 and for the income tax rules, see [12.87]. [19.51]-[19.60] [*462]

III LOSSES FOR CGT

1 When does a loss arise?

A loss arises whenever the consideration for the disposal of a chargeable asset is less than the allowable expenditure incurred by the taxpayer (but excluding any indexation allowance). Losses are not tapered (see [19.63]).

EXAMPLE 19.21

If an antique desk was bought for £12,000, restored for £1,000 and then sold for

£11,000, a loss of £2,000 would result.

Although the disposal of a debt (other than a debt on a security) is usually exempt from CGT, a loss that is made on a qualifying loan to a trader may be treated as a capital loss (see TCGA 1992 s 253 and [22.43]).

If an asset is destroyed or extinguished; abandoned, in the case of options that are not wasting assets ([19.118]); or if its value has become negligible (see 1119.117]), the taxpayer may claim to have incurred an allowable loss. [19.61]

2 Use of losses

Losses must be relieved primarily against gains of the taxpayer in the same year, but any surplus loss can be carried forward and set against his first available gain in future years without time limit.

Losses cannot be carried back and set against gains of previous years except for the net losses incurred by an individual in the year of his death (TCGA 1992 s 62(2) and [21.41]). Capital losses cannot generally be set against the taxpayer's income for tax purposes. The only exception is for losses arising as a result of investment in a corporate trade under TA 1988 s 574 (see [11.121]). Similarly, income losses cannot generally be set against an individual's capital gains: although this rule is also subject to an important exception whereby trading losses which cannot be relieved against the taxpayer's income may be set against his chargeable gains for both the year when the loss was incurred and one preceding tax year (see FA 1991 s 72 and [11.61]) and as a result of changes in FA 2000 payments under the Gift Aid scheme may be covered by tax on chargeable gains (see [53.82]).

A loss that is incurred on a disposal to a connected person can only be set against any gains on subsequent disposals to the same person (TCGA 1992 s 18(3) and see [19.22]).

For the exceptional relief when a loss arises on the disposal of certain rights to unascertainable consideration (as in Marren v Ingles situations) see TCGA 1992 s 279A-D inserted by FA 2003. [19.62]

3 Losses and taper relief

a) Basic principles

Unlike gains, losses are not tapered. Relief for losses is therefore available for the full amount of the loss and this is obviously of benefit to taxpayers: [*463] curiously therefore, if an asset has been owned for the maximum period only 25% (business assets) or 60% (non-business assets) of any gain is chargeable, but all of any loss is allowable! However, the use of losses is not straightforward and the following points should be noted:

(1) Losses must be deducted from gains before those gains are tapered. In effect, therefore, part of the loss relief may be lost by being attributed to that portion of the gain that would not, in any event, be taxed: TCGA 1992 s 2(2) and s 2A(2).

(2) Losses may be set off against gains in the way that is most advantageous to the taxpayer (TCGA 1992 s 2A(6)). [19.63]

EXAMPLE 19.22

Zee realises gains on two separate assets in the same year of assessment.

Asset 1 is a business asset and the gain before taper is £10,000. The period for which the asset has been held (the taper period) is four years.

Asset 2 is a non-business asset and the gain before taper is £8,000; taper period

seven years.

In the same year he makes a loss of £5,000 on the sale of a third asset.

For the purposes of computing the taper relief, the loss is set against the gain which qualifies for the least taper relief so that the tax reduction provided by the taper is the maximum. The loss is therefore set against the gain on asset 2 because as a non-business asset it qualifies for reduction to only 75% of the untapered amount, whereas the gain on asset 1 will be reduced to 25%.

So of the net gain of £3,000 (8,000 - loss of £5,000), 75% is chargeable,

ie £2,250.

Of the gain of £10,000 on asset 1, 25% is chargeable, ie £2,500.

The gains chargeable, subject to Zee's annual exemption, total £4,750.

b) Attributed gains

There are three situations in which trust gains may be attributed to an individual, namely:

(1) under TCGA 1992 s 77 (see [19.85]). (2) under TCGA 1992 s 86 (see [27.94]). (3) under TCGA 1992 s 87 (see [27.111]).

When taper relief was introduced in 1998 it was provided that these attributed gains were to be the trust gains after taper but they could not then be reduced by personal losses of the individual. Although unfortunate for taxpayers, the logic was that the attributed gains had already benefited from taper (on the basis of the trustees' ownership period) so that further relief was not due.

FA 2002 has changed the position for gains attributed to settlors in 2003-04 et seq by virtue of (1) and (2) above (and settlors can also elect for this treatment for all or any of the tax years 2000-01, 2001-02 and 2002-03). Under the new provisions the mechanics are as follows:

(1) gains are attributed to the settlor before deduction of any taper relief;

(2) the settlor may then offset his personal losses against those gains to the extent that those losses cannot be relieved against his personal chargeable gains;

(3) taper relief will then apply to the net gains at the trustees' rate of relief.

The following example contrasts the 'old' and 'new' rules. [19.64] [*464]

EXAMPLE 19.23

. Old rules New rules

Trust £100,000 £100,000

Less trust losses -f20,000 -£20,000

Net trust gains £80,000 £80,000

Gain after taper £20,000 No taper relief applied

relief:

. (in this example 25% of

. the gain is charged to

. tax)

Gain attributed to £20,000 £80,000

settlor

Settlor

Personal gains £50,000 £50,000

Attributed gain £20,000 £80,000

Less personal -£60,000 -£60,000

losses (deducted from personal (deducted first from

. gains only-£10,000 personal gains, then from

. carried forward for attributed gain)

. possible use if the individual has gains in a

. later year)

Net gains £20,000 £70,000

Gain after taper relief No taper relief £17,500

. on attributed gain (applied to attributed gain

. at the rate at which the

. trustees would have applied

. it--so in this example 25%

. of the gain is charged to

. tax)

Deduct annual -£8,200 -f8,200

exemption

Chargeable to CGT £11,800 £9,300

Tax paid (at 40%) £4,720 £3,720

Reimbursement from £4,720 £3,720

the trust

c) Link up with annual exemption

The position of losses and the annual exemption is considered at [19.86] ff. [19.65]

4 Restriction of losses: capital allowances

Generally, chattels that are wasting assets are exempt from CGT (see [22.21]).

That exemption does not, however, extend to an item of plant or machinery [*465] if throughout the taxpayer's period of ownership it has been used in a trade and the taxpayer has claimed (or could have claimed) capital allowances in respect of any expenditure on the asset. It follows that if capital allowances are not available, eg because the asset is never brought into use in the business, the CGT exemption will apply: see Burman v Westminster Press Ltd (1987). Other assets that qualify for capital allowances, such as industrial buildings, are chargeable assets because they are not wasting.

A gain that is charged to income tax will not be charged to CGT; and a loss

will not be allowable for CGT if it is deductible for income tax. Thus, for CGT purposes the gain or loss on a disposal of plant and machinery and other assets qualifying for capital allowances is calculated in the usual way (and not written down in the case of wasting assets) and any gain is charged to CGT only to the extent that it exceeds the original cost of the asset.

EXAMPLE 19.24

. £

Year 1: Machine bought for 10,000

WDA at 25% 2,500

Year 2: Machine sold for 12,000

There is a balancing charge for income tax of £2,500 (ie to the extent of the capital allowance given-see further Chapter 41). The excess of the sale price over the acquisition cost (£2000) is chargeable to CGT.

However, it is rare for plant and machinery to be sold at a gain; it is more likely to be sold at a loss, in which case the loss is not allowable for CGT to the extent that it is covered by capital allowances. Capital allowances may

reduce a loss to nil, but they cannot produce a gain. [19.66]-[19.80]

EXAMPLE 19.25

. £

Machine bought for 4,000

Sold later for 2,000

Capital allowance given of 2,000

Loss for CGT is:

Disposal proceeds 2,000

Less: acquisition cost 4,000

Capital loss (2,000)

Credit for capital allowances 2,000

Allowable loss £Nil

[*466]

IV CALCULATING THE TAX PAYABLE

1 Rates (TCGA 1992 s 4)

a) Fusion with income tax

CGT was formerly charged at a flat rate of 30%. Changes in FA 1988, however, resulted in the abandonment of this single rate and the appropriate rate now depends upon the identity and circumstances of the disponor. In his 1988 Budget Speech, the then Chancellor (Nigel Lawson) explained these changes as follows:

'In principle, there is little economic difference between income and capital gains, and many people effectively have the option of choosing to a significant extent which to receive. And, insofar as there is a difference, it is by no means clear why one should be taxed more heavily than the other. Taxing them at different rates distorts investment decisions and inevitably creates a major tax avoidance industry ... I therefore propose a fundamental reform ... I propose in future to apply the same rate of tax to income and capital gains alike ... Taxing capital gains at income tax rates makes for greater neutrality in the tax system. It is what we now do for companies. And it is also the practice in the United States, with the big difference that there they have neither indexation relief nor a separate capital gains tax threshold.' [19.81]

b) Individuals

CGT is taxed at the rate of income tax applicable to the taxpayer, which will be either:

(1) the starting rate (10% for 2006-07); or (2) the lower rate (20% for 2006-07); or

(3) the higher rate (40% for 2006-07).

These terms are considered at [7.120].

CGT is charged at the taxpayer's marginal income tax rate (TCGA 1992 s 4, as amended). Accordingly, capital gains realised in a particular tax year may push the individual into the higher rate that will apply to that gain.

The following diagram illustrates the position and shows that gains from non-resident trusts attributed to settlors are treated as the highest slice of a taxpayer's gains:

CAPITAL GAINS Offshore trust gains attributed under

. TCGA 1992 s 86

. Other gains

INCOME Dividends

. Savings income

. Other income (eg earned and rental income)

For many taxpayers linking the rates of income tax and CGT resulted in an increase in the rate of tax applicable to capital gains from 30% (in 1987-88) to 40%. [19.82] [*467]

EXAMPLE 19.26

(1) Bill has no income in the tax year 2006-07 but realises chargeable capital

gains of £10,000. His rate of tax on those gains is 10% on the first £2,150 and thereafter 20%: note that he cannot reduce the gain by deducting his unused personal allowance.

(2) Had Bill's gain been £33,500, CGT would be charged as follows: first £2,150 at 10% next £31,150 at 20% final £200 at 40%.

c) Companies

Companies are subject to corporation tax, not CGT, but that tax is charged on corporate profits including chargeable gains. The rate of tax charged on such gains in the financial year to 31 March 2007 is therefore either 19% (small company rate) or 30%. [19.83]

d) Personal representatives

PRs are subject to tax at 40%. Given that this rate may be higher than the beneficiaries' rates care should be exercised if assets in the estate showing a gain on probate value are to be sold (see [21.81]). [19.84]

e) Trustees

Trustees are taxed at 40% with effect from tax year 2004-2005, except where the settlor or his spouse has an interest in the settlement when tax is assessed on the settlor as if the gains had been realised by him and not by the trustees (TCGA 1992 ss 77-78).

A settlor retains an interest for these purposes if there are any circumstances in which the settled property, or any derived property, is payable to, or applicable for the benefit of, the settlor or the settlor's spouse or civil partner, or may become so payable or applicable in the future.

As can be appreciated these provisions are widely drawn so that they could catch, for instance, a situation where money was lent to the settlor by his trustees. Compare the income tax rules in ITTOIA 2005 Part 5 Chapter 5: see [16.98].

With effect from 6 April 2006, a settlor also retains an interest in the settlement if any settled property is, will or may become payable to any unmarried minor child or step-child of his ('a dependent child'). A settlor will not, however, be regarded as having an interest in the settlement:

(a) in respect of any time during which he has no living dependent children even if such children are capable of benefiting under the terms of the settlement, or

(b) in the tax year during which he ceases to have dependent children.

A settlor caught by the settlor-interested provisions has the right to recover the CGT from the trustees on production of a certificate from his Inspector certifying the CGT attributable to the trust gains. [19.85] [*468]

2 The annual exemption

The amount of the annual exemption depends on the capacity in which the person makes the gain. [19.86]

a) Individuals

The first £8,800 (for 2006-07) of the total gains in a tax year are exempt from CGT (TCGA 1992 s 3).

EXAMPLE 19.27

£ £

A sells a painting in July 2006 for 23,150 Original cost of painting in 1996 8,700

Indexation allowance to April 1998 (say) 1,000 9,700

. ----- ------

Chargeable gain 13,450

Less 35% taper (non-business asset rate, including 8,742

the bonus year)

Less: annual exemption for 2006-07 8,800

Gain charged to CGT £(nil)

If the exemption is unused in a tax year it is lost since there is no provision to carry it forward (contrast the IHT annual exemption). It applies to gains after any reduction attributable to taper relief. [19.87]

b) Personal representatives

In the tax year of the deceased's death and the two following tax years, PRs have the same annual exemption as an individual. In the third and following tax years they have no annual exemption and so are charged to CGT on all chargeable gains they make (see [21.64]). [19.88]

e) Trustees

Trustees generally enjoy only half the annual exemption available to an individual, ie £4,400 (for 2006-07). Where the same settlor has created more than one settlement since 6 June 1978 the annual exemption is divided equally between them. Four post-June 1978 settlements, for instance, would each have an exemption of £1,100. This is subject to a minimum exemption per trust of one-tenth of the individual's annual exemption, ie £880 (for 2006-07). Thus, if a settlor creates 12 settlements they will each have an exemption of £880.

Where the settlement is for the mentally or physically disabled, the trustees have the same exemption as an individual, ie £8,800 (for 2006-07) (subject to similar rules for groups of settlements). [19.89] [*469]

d) Husband and wife and registered same-sex couples

Husband and wife are both entitled to a full exemption (see further Chapter 51). Any unused annual exemption cannot be transferred to the other spouse.

CPA 2004, which gives legal recognition to same-sex couples, became law in November 2004 and comes into effect on 5 December 2005. Broadly, the Act allows same-sex couples to make a formal legal commitment to each other by entering into a civil partnership through a registration process. A range of important rights and responsibilities flows from this, including legal rights and protections. For tax purposes, registered same-sex couples will be treated the same as opposite-sex couples-disposals between registered same-sex couples will be deemed to be 'no gain/no loss' disposals. [19.90]

3 Order of set-off of capital losses

Current year losses must be deducted from current year gains in full.

EXAMPLE 19.28

A makes chargeable gains of £4,000 and incurs allowable losses of £3,000 in the tax year. His gain is reduced to £1,000 and is further reduced to zero by £1,000 of his annual exemption. He is forced to set his loss against gains for the year which would in any event have escaped tax because of the annual exemption.

Unrelieved losses in any tax year can be carried forward to future tax years without time limit though they must be deducted from the first available gains. However, the loss need only be used to reduce later gains to the amount covered by the annual exemption and not to zero. Losses carried back from the year of death are treated in the same way (TCGA 1992 s 62(2)). Losses of one spouse can only be used to reduce the gains of that

spouse-they cannot be set against gains of the other spouse. [19.91]

EXAMPLE 19.29

A makes the following gains and losses:

Tax year Gain Loss

. £ £

2004-05 4,000 9,000

2005-06 7,500 3,000

2006-07 13,000 Nil

In Year I A 'pays no CGT and carries forward an unused loss of £5,000. His annual exemption for that year is wasted. In Year 2 A's gain is reduced to £4,500 and he pays no CGT as this is covered by his annual exemption. The £5,000 loss from Year 1 does not reduce his gain to zero. It is carried forward to Year 3. In Year 3 £4,500 of the £5,000 loss carried forward from Year 1 is used to reduce his gain to £8,500. He has £500 of loss remaining to carry forward.

4 Use of trading losses

The relief enabling trading losses to be offset against capital gains under FA 1991 s 72 is considered at [11.61]. [19.92] [*470]

5 When is CGT payable?

a) General rule

CGT is assessed on a current year basis and is normally payable in full on 31 January following the year of assessment unless a return is issued after 31 October following the year of assessment and there has been no failure to notify chargeability under TMA 1970 s 7 when the date becomes three months from the issue of the return (TMA 1970 s 59B). Interest is charged on tax remaining unpaid after the due date. [19.93]

b) Payment by instalments

CGT may be paid in instalments in two cases. First, when the consideration for the disposal is paid in instalments over a period exceeding 18 months running from the date of the disposal or later and the taxpayer elects to pay by instalments. The instalments of tax can be spread (in the discretion of the Board) over a maximum of eight years provided that the final instalment of tax is not payable after the final instalment of the disposal consideration has been received (TCGA 1992 s 280).

Secondly, CGT may be paid by 10 annual instalments when there is a gift of any of the following assets and if hold-over relief is not available on the disposal:

- land;

- a controlling shareholding in any company;

- a minority holding in an unquoted company (TCGA 1992 s 281).

In these cases, the outstanding instalments carry interest and all outstanding instalments plus interest become payable in full if the gifted asset is sold (even if sold by someone other than the donee) unless the gift was made to a donee who was not 'connected with' the donor.

Finally, in a Marren v Ingles type case (see [19.26]) an incidental result of two disposals having occurred is that tax on the overall gain of the disponor will be paid in two or more stages. Of course, when the deferred consideration is received it will only attract taper relief if it arises after the third anniversary of the original disposal at the non-business asset rate. [19.94]

c) Reporting requirements (TGGA 1992 s 3A)

Individuals do not normally have to complete the CGT section of their tax return if:

(i) their chargeable gains for the year do not exceed the annual exemption; and

(ii) the total proceeds from their chargeable disposals in the year do not exceed four times the annual exemption (this is 'the disposal proceeds limit').

There are corresponding provisions for PRs and trustees. So far as (i) is concerned, 'chargeable gains' means chargeable gains after taper relief unless there are allowable losses in which case the expression means the chargeable gains before both losses and taper relief. [19.95] [19.110].

V MEANING OF 'DISPOSAL'

1 General

A 'disposal' is not defined for CGT. Giving the word its natural meaning, there will be a disposal of an asset whenever its ownership changes or whenever an owner divests himself of rights in, or interests over, an asset (eg by sale, gift or exchange). Additionally, the term is extended by the legislation to cover certain transactions which would not fall within its commonsense meaning. Thus, in certain circumstances, trustees of a settlement are treated as disposing of and immediately reacquiring settlement assets at their market value (deemed disposals: see [19.41]).

A part disposal of an asset is charged as a disposal according to the rules considered earlier ([19.44]). Death does not involve a disposal (see Chapter 21). [19.111]

2 Capital sums derived from assets (TCGA 1992 s 22)

When a capital sum is derived from an asset there is a disposal for CGT. This is so whether or not the person who pays the capital sum receives anything in return for his payment (see Marren v Ingles (1980)).

All legal rights that can be turned to account by the extraction of a capital sum are assets for CGT purposes. The test is whether such rights can be converted into money or money's worth and the mere fact that they are non-assignable does not matter so long as consideration can be obtained in some other way (for instance, by surrendering the right). This is apparent from the case of O'Brien v Benson's Hosiery (Holdings) Ltd (1979) (see [19.7]). In Marren v Ingles (1980) (see [19.26]) the right to receive an unquantifiable sum in the future was considered to be an asset, a chose in action, from which a capital sum was derived when the right matured.

The rights must, however, be legally enforceable. Thus, the receipt of a sum by a person in return for his agreement eg to restrict his future activities is not a disposal because it is not a disposal of an asset (the right to work is not a legal right, although it may be a right of man!). The position is different, however, if the restrictive agreement means that a capital sum has been derived from the goodwill (an asset) of the taxpayer's business. In this case there will be a disposal under s 22 (see Kirby v Thorn EMI plc (1988)).

Four specific instances of disposals are given in s 22:

(1) where a capital sum is received by way of compensation for the loss of, or damage to, an asset (for instance, the receipt of damages for the destruction of an asset). It should be noted that there is only a disposal where a capital sum is received and so if the receipt is of an income nature, it is charged to income tax and not to CGT: an example is compensation received by a trader for loss of trading profits-see, for instance, London and Thames Haven Oil Wharves Ltd v Attwooll (1967) and Lang v Rice (1984): [10.103]. For compensation payments made under the Foreign Compensation Act 1950 and similar payments, see ESC D50;

(2) where a capital sum is received under an insurance policy for loss of or damage to an asset; [*472]

(3) where a capital sum is received in return for the forfeiture or surrender of rights. This category includes payments received in return for releasing another person from a contract (O'Brien v Benson's Hosiery (Holdings) Ltd (1979)); or from a restrictive covenant; but not a statutory payment on the termination of a business tenancy since that sum is not derived from the lease (Drummond v Austin Brown (1984));

(4) where a capital sum is received for the use or exploitation of assets, eg for the right to exploit a copyright or for the right to use goodwill created by another person. In Chaloner v Pellipar Investments Ltd (1996) Rattee J commented of this provision 'those words are apt to include capital sums received as consideration for the use or exploitation of assets title to which remains unaffected in their owner (eg by the grant of a licence) but are not apt to include capital sums received as consideration for a grant of the owner's title to the assets, whether in perpetuity or for a term of years. He therefore held that the subsection did not catch consideration for the grant of a lease which took the form of the agreement by a developer to develop other land owned by the lessor (see [19.48]).

In the case of disposals falling within (1)-(4) above the time of disposal is when the capital sum is received, not when the contract (if any) was made (see [19.126]).

The receipt of a capital sum from an asset under categories (1) and (2) above need not be treated as a disposal or part disposal if the asset has not been totally lost or destroyed. Instead, the taxpayer can elect to deduct the capital sum from the acquisition cost of the asset thereby postponing a charge to CGT until the eventual disposal of the asset (TCGA 1992 s 23). However, this relief is only available if one of three conditions is satisfied:

- the capital sum is wholly used to restore the asset; or

- if the full amount of the capital sum is not used to restore the asset, the amount unused does not exceed 5% of the sum received. Where the sum unused exceeds 5% the asset is treated as being partly disposed of for a consideration equivalent to the unused sum; or

- the capital sum is 'small' compared with the value of the asset (for the meaning of 'small' see Tax Bulletin, February 1997 and [26.21]).

- Restoration relief is modified in its application to wasting assets. [19.112]

EXAMPLE 19.30

A buys a picture for £20,000 that is now worth £30,000. It is damaged by rain from a leaking roof and A receives £8,000 compensation with which he restores the picture. The £8,000 received is deducted from the cost of the asset (reducing £20,000 to £12,000), but its expenditure on restoration qualifies as allowable expenditure on a future disposal so that for CGT the cost of the asset remains £20,000 and A is in the same position as if the damage had never occurred. Assume, however, that A restores the picture for £7,600. The £400 unused does not exceed 5% of £8,000. It is, therefore, deducted from the total allowable expenditure that is reduced to £19,600. Alternatively, if A received compensation of £1,500 which he does not use to restore the picture, A need not treat this receipt as a part disposal (since the amount is 'small'). Instead, he can elect to deduct £1,500 from his acquisition cost, so that the picture has a base value of £18,500 on a subsequent disposal. [*473]

3 Total loss or destruction of an asset (TCGA 1992 s 24(1))

Total loss or destruction of an asset is a disposal for CGT purposes and, where the owner of the asset receives no compensation, it may give rise to an allowable loss equal to the base costs of the taxpayer. Where the asset is tangible movable property, however, the owner is deemed to dispose of it for £6,000 thereby restricting his loss relief (TCGA 1992 s 262(3)). This limitation derives from the fact that gains on such assets are exempt from CGT insofar as the consideration does not exceed £6,000 (see [22.22]). As a corollary, therefore, loss relief on the disposal of these assets is not available to the extent that the consideration received is less than £6,000.

EXAMPLE 19.31

A buys a picture for £10,000 which is destroyed by fire; A is uninsured. Although the picture is now worthless, A's allowable loss is restricted to £4,000.

Land and the buildings on it are treated as separate assets for these purposes. Where the building is totally destroyed both assets are separately deemed to have been disposed of and reacquired, and it is the overall gain or loss which is taken into account.

Where the taxpayer later receives compensation or insurance moneys for an asset which is totally lost or destroyed, this would appear to be a further disposal for CGT purposes under TCGA 1992 s 22 since it is a capital sum derived from an asset (the right under the insurance contract). In practice, however, the Revenue treats both disposals (ie the entire loss of the asset and the receipt of capital moneys) as one transaction (see also the discussion of this problem by Hoffmann J in Powison v Welbeck Securities Ltd (1986)). 1f the taxpayer uses the capital sum within one year of receipt to acquire a replacement asset, he may claim to roll over any gain made on the disposal of the destroyed asset against the cost of the replacement asset; this relief does not apply to wasting assets. If only part of the capital sum is used in replacement, only partial roll-over is available (TCGA 1992 s 23(4), (5) and (6)).

EXAMPLE 19.32

A buys a picture for £6,000 that is destroyed when its value is £10,000. He receives insurance money of £10,000 and uses it towards the purchase of a similar picture for £12,000. A has made a gain of £4,000 on the original picture (£10,000 - £6,000) on which he need not pay CGT. Instead he may deduct the gain from the cost of the new picture so that his base cost becomes £8,000 (£12,000 - £4,000).

Assume that A buys the new picture for only £7,000 and claims roll-over relief.

Amount of insurance money not applied in replacement = £3,000 (£10,000 - £7,000).

£3,000 is therefore A's chargeable gain, instead of the £4,000 he made on the picture. The relief is limited to £1,000 which is given by reducing A's base value for the new picture from £7,000 to £6,000.

The same relief applies where the asset destroyed is a building. The gain on the old building can be rolled over against the cost of the new building. Any gain deemed to have been made on the land cannot, however, be so treated and will, therefore, be chargeable. [19.113] [*474]

4 Compensation, damages and Zim Properties

a) The Zim case

In Zim Properties v Proctor (1985) a firm of solicitors acting for the taxpayer in a conveyancing transaction were allegedly negligent, with the result that a sale of three properties owned by the taxpayer fell through. An action in negligence against the solicitors was eventually compromised and compensation of £69,000 was paid to the taxpayer. Undoubtedly, this was a capital sum, but was it derived from the disposal of an asset? Warner J held that it arose from the right of action against the solicitors that, as it could be turned into a capital sum by negotiating a compromise, was an asset for CGT purposes. Although the ownership of the properties put the taxpayer in the position to enjoy that right of action, the sum was not derived from the properties themselves, because, after receipt of that sum, the taxpayer still owned the properties. [19.114]

b) The difficulties created by the Zim decision

First, not all rights to payment or compensation are themselves 'assets' for CGT purposes. Warner j cited as an example the right of a seller of property to payment of the price. The relevant asset in such a case must be the property itself (contrast, however, Marren v Ingles, discussed at [19.26]). A further example is shown by Drummond v Austin Brown (1984) where a tenant's right to statutory compensation on the termination of his lease under the Landlord and Tenant Act 1954 was not subject to CGT; it was neither compensation for loss of the lease, nor was it derived from that lease (contrast Davenport v Chilver (1983) where the right to statutory compensation for confiscated property was held to be an asset). There are also a number of statutory exemptions: eg for damages following personal injury.

Secondly, the date of acquisition of the right of action will in many cases be unclear. In Zim Warner J held that the asset was acquired at the time when the taxpayer acted upon the allegedly negligent advice -- entered into the sale contracts -- although this matter is not free from doubt (see the House of Lords judgments in Pirelli v Oscar Faber (1983)).

Thirdly, the question of how to calculate the acquisition cost of this asset, namely the taxpayer's right to sue, was left unclear (see also Marren v Ingles and O'Brien v Benson's Hosiery). Arguably, it was acquired otherwise than by bargain at arm's length, so that the market value (if any) of the right should be taken at the moment of its acquisition (see TCGA 1992 s 17(1), discussed at [19.22]: it may be doubted, however, whether the taxpayer is able to satisfy the requirements in s 17(2) (b) and failure to do so would result in a nil acquisition cost).

Finally, as the purpose of damages is to compensate the claimant, the award in such cases would need to be grossed up if the damages themselves are to be reduced by taxation. [19.115]

c) ESC D33

Some of the difficulties resulting from the Zim case have been solved by ESC D33 that affords relief from CGT in two ways. [*475]

First, 'where the right of action arises by reason of the total or partial loss or destruction of or damage to a form of property which is an asset for CGT purposes, or because the claimant suffered some loss or disadvantage in connection with such a form of property, any gain or loss on the disposal of the right of action may by concession be computed as if the compensation derived from that asset and not from the right of action'. As a consequence, part of the acquisition cost of the chargeable asset may be deducted from the gain in accordance with the usual part-disposal rules (see [19.43]).

EXAMPLE 19.33

(1) Because of the negligence of his land agent, Lord Q's sale of a plot of land to Out of Town Supermarkets Ltd falls through. The agent is forced to pay £70,000 in compensation to Lord Q. Instead of treating this sum as consideration on the disposal of a separate chose in action it may he treated as arising on a part disposal of the land itself. Accordingly, part of the expenditure attributable to that land may be deducted in arriving at Lord Q's chargeable gain.

(2) Zara, because of the negligence of her solicitor, ends up with less money from the sale of her main residence than would otherwise have been the case. Because the underlying asset (her main residence) is exempt from CGT (see Chapter 23) any compensation paid by the solicitor will likewise escape tax.

Secondly, if there is no underlying asset. In this case, any gain accruing on the disposal of the right of action will be exempt from CGT.

EXAMPLE 19.34

Zappy, a wealthy taxpayer, suffers a massive income tax liability because his professional adviser negligently fails to shelter that income from tax by arranging for Zappy to invest in an EIS and in an industrial building in an enterprise zone. Substantial compensation is therefore paid to Zappy and because there is no underlying property that is an asset for CGT purposes, the sum is not subject to charge.

The logic behind this is that as the compensation merely puts the taxpayer into the position he would have been in but for the negligence, there should be no tax charge since the benefit which he was entitled to (a lesser income tax liability) is not itself subject to charge. It should be noted that the Zim case has no application to compensation payments that attract an income tax charge (see, for instance, London and Thames Haven Oil Wharves Ltd v Attwooll (1967) at [10.103]) whilst its application in the context of warranties and indemnities on a company takeover is discussed in Chapter 47. [19.116]

5 Assets becoming of negligible value (TCGA 1992 s 24(2))

Where an asset becomes of negligible value (eg shares and securities in an insolvent company) the taxpayer is deemed to have disposed of and immediately reacquired the asset at its market value (nil) thus enabling him to claim loss relief. This disposal is deemed to occur in the tax year in which the Revenue accepts the claim or at any earlier time specified in the claim [*476] provided that: (a) the taxpayer owned the asset at that earlier time, (b) the asset had become of negligible value at that earlier time; and (c) that earlier time was not more than two years before the beginning of the year of assessment in which the claim is made (Williams v Bullivant (1983) and see Lamer v Warrington (1985)). The Revenue considers that 'negligible' means considerably less than 5% of the original cost (or March 1982 value).

Should the value of the asset subsequently increase, the result of claiming relief under s 24(2) will be that on a later disposal the base value will be nil so that all the consideration received will be treated as a gain and there will be no question of claiming any indexation allowance. [19.117]

6 Options (TCGA 1992 ss 144-147)

The grant of an option (whether to buy or to sell an asset) is a disposal, not of a part of the asset that is subject to the option, but of a separate asset, namely, the option itself at the date of the grant. The gain will be the consideration paid for the grant of the option less any incidental expenses (see Strange v Openshaw (1983)). In Garner v Pounds Shipowners and Shipbreakers Ltd (2000) P Ltd granted an option to M to purchase its land which included a term that P Ltd was to use its best endeavours to obtain the release of restrictive covenants and would only receive the option fee if it was successful. In the event the covenants were released in return for a payment of £90,000 by P Ltd and the option was never exercised so that the option fee (399,750) was retained by P Ltd. The House of Lords held that P Ltd's obligations regarding the release of the covenants, even though involving the probable payment of sums to third parties, did not affect the amount of consideration received for the grant of the option (ie the option fee), nor were the sums paid by P Ltd deductible under TCGA 1992 s 38(1): the expenditure was not incurred in providing the asset disposed of (the option), nor was the expenditure reflected in the state or nature of the option at the time it was granted (see [19.28] and [19.29]).

EXAMPLE 19.35

(1) A grants to B for £3,000 an option to buy A's country cottage in two years' time for £30,000 which is its current market value. A has made a gain of £3,000 from which he can deduct any incidental expenses involved in granting the option. (This is an option to buy.)

(2) A pays B £3,000 in return for an option from B enabling A to sell that country cottage to B in two years' time for £30,000. (This is an option to sell.) B has made a gain of £3,000 less any incidental expenses.

If the option is exercised, the grant and the exercise are treated as a single transaction for both grantor and grantee. In the case of an option to buy (ie binding the grantor to sell) the consideration received for the grant of the option is treated as part of the consideration for the sale. Any CGT that has been charged on the grant itself will be either set off or repaid.

In the case of an option to sell (ie binding the grantor to buy) the consideration received for the option is deducted from the acquisition cost of the asset to the grantor. [*477]

EXAMPLE 19.36

As in Example 19.35, assuming that A had deductible expenses of £15,000:

(1) when B exercises the option and pays A £30,000 for the house, A's gain is:

. £

Proceeds from sale of house 30,000

Consideration for option 3,000

. ------

. 33,000

Less: deductible expenses 15,000

. -------

Chargeable gain £18,000

B's acquisition cost is £30,000 plus the cost of the option, ie £33,000 (both items may, in appropriate cases, be index-linked from the dates when the expenditure was incurred).

(2) when A exercises the option and sells the house to B for £30,000, A's gain is:

. £ £

Proceeds of sale 30,000

Less: cost of option 3,000

deductible expenses 15,000 18,000

Chargeable gain £12,000

B's acquisition cost of the cottage is only £27,000 (ie £30,000 reduced by the amount that he received for the option).

The date of acquisition for taper relief is the time when the option is exercised (or 6 April 1998 if later), not when the option is granted.

The Revenue (now HMRC) took the view that the market value rule in TCGA 1992 s 17 (see [19.22]) did not normally apply to shares acquired as a result of the exercise of an option but this view was not upheld by the Court of Appeal in Mansworth v Jelley (2003). As a consequence the taxpayer's acquisition of the shares on exercising the option was deemed to be at market value so that on his immediate disposal of the shares no gain arose. TCGA 1992 s 1 44ZA, inserted by FA 2003, reversed the effect of Mansworth v Jelley and, broadly speaking, disapplies the market value rule (in cases where it would otherwise apply) in relation to options exercised after 9 April 2003. In Mansworth v Jelley-type circumstances the taxpayer's gain is now calculated by deducting the sum actually paid on exercise, not the (higher) market value of the asset acquired.

An option is a chargeable asset so that, if disposed of other than by exercise or abandonment (see below), there may be a chargeable gain or allowable loss on ordinary principles. In particular, an option which has a predictable life of 50 years or less will be a wasting asset unless it is an option to subscribe for shares that is listed on a recognised stock exchange; a traded option; a financial option; or it is an option to acquire assets to be used in a trade. Consequently the cost of acquiring the option will be written down over its predictable life on a straight-line basis (see [19.46]). [*478] The abandonment of an option that is a wasting asset is not a disposal (but notice that a capital sum received for relinquishing an option will be chargeable under TCGA 1992 s 22(3): see Golding v Kaufman (1985); BTR, 1985, p 124 and EG 12340). [19.118]

7 Appropriations to and from a trader's stock in trade (TCGA 1992 s 161)

There are two cases to consider. First, where a trader acquires an asset for private use and later appropriates it to his trade. As a general rule, this is a disposal and CGT is payable on the difference between the market value of the asset at the date of appropriation and its original cost.

EXAMPLE 19.37

A owns a picture gallery. He buys a picture for private use for £5,000 and transfers it to the gallery when it is worth £15,000. He has made a chargeable gain of 10,000. Later he sells the picture to a customer for £30,000. The profit on sale of £15,000 (£30000 - £15,000) is chargeable to income tax under ITTOIA 2005 (former Schedule D Case I).

However, the trader can elect to avoid paying CGT at the date of appropriation by transferring the asset into his business at a no gain/no loss value (see s 161 (3A) for time limits in making the election). When the asset is eventually sold, the total profit will be charged to income tax as a trading receipt. So, in the above example, were A to make the election he would pay no CGT, but instead he would be liable to income tax on a profit of £25,000 (30,000 - £5,000). Because the gross gain is deferred and charged to income tax by the election any taper relief accrued will be permanently lost. Whether the election should be exercised or not must depend upon the particular facts of each case. CGT may be more attractive as a choice of evils with its annual exemption, but income tax, on the other hand, will be paid later (on eventual sale) and the profit so made may be offset against personal allowances or unused capital allowances.

Secondly, where an asset originally acquired as trading stock is taken out for the trader's private use. In this case, there is no election and the transfer is treated as a sale at market value for income tax purposes (see Sharhey v Wernher (1956) at [10.115]). The taxpayer will have market value as his CGT base cost. [19.119]

EXAMPLE 19.38

One of the pictures in A's gallery cost him £6,000. He removes it to hang it in his

dining room when its market value is £16,000. He later sells it privately for £30,000.

On the appropriation out of trading stock, A is treated as selling the picture for its market value (£16,000) and the profit (£10,000) is assessed to income tax. The gain on the subsequent sale (£30,000 - £16,000 = £14,000) is chargeable to CGT.

8 Miscellaneous cases

a) Hire-purchase agreements (TCGA 1992 s 27)

Although the hirer does not own the asset until he pays all the instalments, the owner is treated as having disposed of the asset at the date when the hirer [*479] is first able to use it (usually the date of the contract). The consideration for the disposal is the cash price payable under the contract. These transactions rarely give rise to a CGT charge, however, either because the asset is exempt (eg a private car or a chattel worth less than £6,000) or because it is a wasting asset. Further, the contract will normally be a trading transaction falling within the income tax charge (for an illustration where these provisions were held to apply to the sale of a taxi-driver's licences, see Lyon v Pettigrew (1985)).

In the rare case where there is a CGT charge and the hire term ends without title passing (eg because the hirer defaults) tax is adjusted, or discharged, according to the amount the owner actually received. [19.120]

b) Mortgages and charges (TCGA 1992 s 26)

Neither the grant nor the redemption of a mortgage is a disposal. Where the property is sold by a mortgagee or his receiver, the sale is treated as a disposal by the mortgagor. [19.121]

c) Settled property

On the happening of certain events the trustees are deemed to have disposed of the trust assets and immediately reacquired them (see Chapter 19). [19.122]

d) Value shifting (TCGA 1992 ss 29-34)

There are anti-avoidance provisions intended to charge a person who passes

value to another without actually making a disposal (see [26.61]). [19.123]

e) Lease extensions (ESC D39)

The ESC provides that a tenant who surrenders his lease in return for the grant of a new lease over the same premises does not make a disposal or part disposal of the old lease provided that the terms of the new lease (other than its duration and the amount of rent) are the same as those of the old lease. It does not address the position of the landlord. The concession can apply to transactions between connected persons provided that the terms of the transaction are equivalent to those that would have been made between unconnected parties bargaining at arm's length. [19.124]

f) Relief for exchanges of joint interests in land (ESC D26)

Roll-over relief along the lines of that in TCGA 1992 ss 247-248 in the case of

compulsory acquisitions (see [22.82]) is available when a joint holding of land is partitioned (so that each joint owner becomes a sole owner of part of the land) or when a number of separate joint holdings are partitioned.

[19.125]

9 Time of disposal

a) Timing -- the general rule

A disposal under a contract of sale takes place for CGT purposes at the date of the contract, not completion, with an adjustment of tax if completion [*480] never occurs (TCGA 1992 s 28(1): contrast s 38(1)(b) -- see [19.29]). By contrast, a disposal arising from the receipt of a capital sum under TCGA 1992 s 22 is treated as taking place when the capital sum is received (see [19.112]).

See Jerome v Kelly (2003) for authority for the proposition that TCGA 1992 s 28 not only serves to fix the time of a disposal but also the identity of the person making the disposal for CGT purposes. [19.126]

b) Conditional contracts

If the contract is conditional, the disposal takes place when the condition is fulfilled (s 28(2) and see Hatt v Newman (2000)). The subsection specifically provides that when a contract is conditional on the exercise of an option (eg a put or call option) the disposal occurs when that option is exercised. In order to decide whether a contract is conditional for these purposes the contract in question has to be construed in order to determine whether any conditions stipulated therein are truly conditions precedent to any legal liability or whether they are merely conditions precedent to completion. In the former case there is a conditional contract for CGT purposes: in the latter, the contract is unconditional (Eastham v Leigh London and Provincial Properties Ltd (1971)).

EXAMPLE 19.39

Lord W agrees to rant a lease to Concrete (Development Company) Ltd if they obtain satisfactory planning permission to develop the relevant land as a business park. The contract to grant the lease is conditional on satisfactory permission being obtained and so the relevant part disposal will occur only if and when that happens.

Where a local authority compulsorily acquires land (other than under a contract), the disposal occurs when the compensation is agreed or when the authority enters the land (if earlier). In the case of gifts, disposal occurs when the ownership of the asset passes to the donee (usually the date of the gift). Where a capital sum is derived from an asset, the disposal occurs when the sum is received (TCGA 1992 s 22(2) and see Chaloner v Pellipar Investments Ltd (1996)). [19.127]-[19.140]

VI CAPITAL GAIN OR INCOME PROFIT?

With the linking of the rates of CGT to the income tax rates of the taxpayer, much conventional tax planning designed to ensure that capital profits rather than income were received by a taxpayer, was rendered redundant. A number of anti-avoidance sections, notably TA 1988 s 776, became of reduced importance. The distinction between capital and income receipts remains important, however, and the following are some of the factors to bear in mind. As will be apparent the facts of each individual case will largely determine whether the taxpayer is better off receiving a sum as capital or income. (See Hitch v Stone (2001) for an example of agreements being entered into with the object of converting capital sums into income. The agreements were dismissed by the Court of Appeal as shams.) [19.141] [*481]

I Consequences of realising a capital gain

Tax on the gain will not be due until 31 January of the following tax year and in computing the chargeable gain not only may an indexation allowance to April 1998 and taper relief be available, but in addition the annual exemption may be deducted. Income profits are commonly taxed in the year of receipt without any allowance for indexation or an annual exemption. It is also important to remember that CGT is only levied when a disposal has occurred and therefore it may be possible to arrange disposals in the most advantageous tax year. There is the ability to defer the gain from CGT by rolling it over into a qualifying investment under the amended EIS provisions (see [50.89] ff.). [19.142]

2 Taxation of income profits

Receiving a profit as income may be advantageous for the taxpayer in that the sum may be reduced by personal allowances, charges on income, unused losses, and there is the possibility of obtaining limited income tax relief by investing in an EIS (see [50.52]). [19.143] [*482] [*483]

20 Taper relief

Written and updated by Emma Chamberlain, BA Hans (Oxon), CTA (Fellow), LRAM, Barrister, 5 Stone Buildings, Lincoln's Inn

I Introduction [20.1]

II General principles [20.20]

III Comments and conclusions [20.62]

I INTRODUCTION

Taper relief came into effect in respect of disposals made on or after 6 April 1998 and affords relief on the surplus of chargeable gains over allowable losses in a tax year. Losses must, therefore, be deducted before the relief, but they are set off against gains in the way that is generally most advantageous for the taxpayer (see Examples 21.1 and 21.2). Gains are, however, only eligible for taper relief if the relevant asset has been owned for a minimum qualifying period which in the case of business assets is one year: for other assets it is three years. The relief applies to individuals, trustees and PRs but not to companies. [20.1]

EXAMPLE 20.1

Mr D sells ICI shares in 2006 acquired in 2002 realising a gain of £10,000 after deduction of the base cost and he has separately realised a loss of £4,000. The net gain is therefore £6,000. The ICI shares are non-business assets since Mr D owns less than 5% voting shares and is not an employee of ICI.

The ICI shares have been owned for four complete years. The percentage of gain chargeable is 90% (see the non-business assets Table at [20.21]). The chargeable gain is 90% of £6,000 not 90% of £10,000. The losses are deducted first before any taper relief. This result is less favourable to the taxpayer.

If Mr D was also selling shares that qualified for business assets taper relief (RATR) in the same year he would be allowed to deduct the loss against the ICI shares first and not from the shares that qualify for BATR. This is more favourable to him since he is not then wasting business assets taper relief. However, if he sold assets that qualified for BATR in 2006 and sold the ICI shares in a later tax year, he Would have to use the loss of £4,000 against the gain realised on the business asset before being able to deduct BATR. He cannot carry the loss forward to deduct against the ICI shares sold in the later tax year.

Thus a taxpayer should ensure that in a year he makes a disposal of assets which qualify for full BATR, any losses already realized or brought forward from previous years are used against disposals of assets qualifying for non-BATR in the same tax year. [*484] If there are unused trading losses the excess losses may be treated as capital losses and can therefore be offset against the individual's chargeable gains for the year of the loss and/or the previous year (see FA 1991 s 72). For excess trading losses in 2004-05 and later years the maximum amount of trading losses which can be relieved under FA 1991 s 72 is computed before, not after, the deduction of taper relief. This is more favourable to the taxpayer. (For worked example and more detailed explanation see Tolleys Tax Digest Issue 41 page 9 Maximising Taper Relief by Robert Jamieson.)

Taper relief is one of the most complex areas of capital gains tax in relation to individuals partly because the rules changed in almost every year between 1998 and 2003. Since each set of new rules was generally only effective from the date of the change and taper relief depends on qualifying over a continuing period of ownership, great care must be taken to check that the asset qualifies under both the old and new rules. [20.2]-[20.19]

II GENERAL PRINCIPLES

1 How is the relief given?

For disposals made between 6 April 1998 and 5 April 2000 the gain was multiplied by the percentage in the table in TCGA 1992 s 2A(5) that is set out below. This means that the gain on an asset sold with maximum business assets taper relief is effectively taxed at 10% for a higher rate taxpayer while the gain on an asset which qualifies for maximum non-business assets taper relief is effectively taxed at 24% -- a marked difference. There is no suggestion that the regime governing taxation of non-business assets will be relaxed.

Gains on disposals of business Gains on disposals of non-business assets assets

Number of whole Percentage of Number of whole Percentage of

years in quali- gain chargeable years in charge- gain chargeable

period able period

1 92.5 -- --

2 85 -- --

3 77.5 3 95

4 70 4 90

5 62.5 5 85

6 55 6 80

7 47.5 7 75

8 40 8 70

9 32.5 9 65

10 or more 25 10 or more 60

For disposals after 5 April 2000 and before 6 April 2002 relief on a disposal of a business asset was substantially improved by the introduction of the following amended table: [*485]

Period business asset held Percentage of gain Equivalent rate for

. (years) chargeable higher rate CGT

. payer (%)

. 0-1 100 40

. 1-2 87.5 35

. 2-3 75 30

. 3-4 50 20

. >4 25 10

From 6 April 2002, the relief on a disposal of business assets was further improved as follows:

Period business asset held (years) Percentage of gain chargeable

. 0-1 100

. 1-2 50

. >2 25

The effect of the relief is to reduce the 'percentage of gain chargeable': ie taper relief wipes out part of the chargeable gain.

TCGA 1992 s 2(2) provides for the calculation of the pre-taper gain that is arrived at by deducting from the disposal consideration:

(1) items of allowable expenditure (including when appropriate an indexation allowance);

(2) retirement relief (if relevant); and

(3) current year and brought forward losses (see Example 20.1).

It is the resultant gain that may attract taper relief. See Example 20.2 for basic application of the rules. [20.20]

2 The qualifying holding period

As can be seen from the table above, while relief on business assets is now given once the asset has been owned for only one year, for a non-business asset a three-year period is required. Because the relief depends on the number of 'whole years' in the qualifying holding period, for assets already owned on 6 April 1998 that period is measured in terms of tax years, but for later acquired assets it is the 12 months running from the date of acquisition (TCGA 1992 s 2A(8)). Relief on business assets is substantially greater: under the original table the level of relief was 7.5% pa (as compared with 5% for non-business assets). For disposals on or after 6 April 2002, however, full business taper (at 75%) is available after only two years' ownership and after one year, relief at 50% will be given. Note, however, the important and curious effect of the apportionment rules which mean that someone holding an asset which did not qualify as a business asset until 6 April 2000 will not qualify for full taper relief until 6 April 2010-see Example 20.6 and Example 20.7.

When the relief was introduced in 1998, taxpayers who owned the relevant asset on 17 March 1998 (which was Budget Day) were credited with a 'bonus year' of ownership: the bonus year remains for non-business assets but was abolished for disposals after 6 April 2000 of business assets. However, where [*486] an asset qualifies as both a business and non-business asset during the period of ownership the bonus year is still relevant when apportioning the gain-see Example 20.6.

In summary, a taxpayer disposing of a business asset now which they acquired two years ago and was a business asset throughout that period will pay capital gains tax at an effective rate of 10%. A taxpayer disposing of a non-business asset in say May 2007 which was owned prior to 17 March 1998 and has been a non-business asset throughout that period, will pay capital gains tax at an effective rate of 24%-the lowest rate that can be paid on a non-business asset. [20.21]

EXAMPLE 20.2

Bob has run an electrical business since acquiring all the shares from a distant relative in June 1994. He paid £600,000 for the shares that are now worth £1.5m. In May 1999 he acquired a Mark Gertler picture ('Still Life with Pomegranates') for £20,000 for which he has received an offer of £35,000.

(1) If he sold the business for £1.5m at any time during the tax year 1999-2000 his gain would have been calculated as follows: Step I deduct from sale proceeds (a) acquisition cost: £600,000; (b) indexation allowance to April 1998: (say) £50,000. Net gain = £850,000. Step 2 apply taper relief to £850,000. The shares are a business asset and because they were owned on 17 March 1998 attract two years' relief (ie the bonus year and 1998-99 tax year). Accordingly 85% of the gain is chargeable = £722,500. Note: It is assumed that Bob did not qualify for retirement relief: had he done so it would have been deducted at step 1.

(2) If Bob were to sell the Gertler during the tax year 1999-2000:

(i) he does not benefit from any indexation allowance (which ceased before he bought the picture);

(ii) nor will he benefit from taper relief (as a non-business asset he would need to retain it for three whole years (ie until May 2002) in order to obtain a 5% reduction in his chargeable gain).

The £15,000 gain is, therefore, taxed in full.

Note:

(a) If Bob realised losses, these are set against the gains in the order which is most beneficial to the taxpayer--Bob will therefore set them against the gain on the Gertler in order to maximise the taper relief on his shares (the use of losses is considered at [20.63].

(b) Bob's annual exemption is set against the total gains after relief, ie £722,500 + £15,000.

(3) If Bob were to sell both assets during the tax year 2000-01, the revised business assets rules apply to the shares: At step 2 instead of three-year taper (including the bonus year) he is only credited with two years' taper giving a reduction of 25% but this is better than three years at the old rates (which would have reduced the gain by only 22.5%). The treatment of the Gertler would be unaltered.

(4) If Bob were to sell both assets during the tax year 2001-02, there would still be no relief on the Gertler but relief on the business is now at 50%.

(5) Finally, if the sale is in the tax year 2002-03, relief on the business asset is now at 75% (the maximum) and the Gertler now attracts relief at 5% (from May 2002). [*487]

3 Timing points

Because relief is given on the basis of whole years in the qualifying holding period:

(1) in the case of assets owned on 5 April 1998 whole years in the qualifying holding period expire on 5 April (ie are calculated by reference to tax years). It may, therefore, be advantageous to sell early in the tax year rather than late in the previous year;

(2) for assets acquired after 5 April 1998, years are calculated from the date of acquisition to the date of disposal;

(3) will there be an incentive in the case of non-business assets-to retain the asset for longer than would otherwise be the case in order to benefit from enhanced taper? In the case of business assets it may be preferable to sell the asset early if it ceases to qualify for relief in order to prevent the rate of tax going up -- see Example 20.5;

(4) there is no restriction in the relief if the value of an asset is enhanced by subsequent expenditure. Assume, for instance, that A purchased a piece of land for £1,000 in Year 1: in Year 10 he constructed a house on it at a cost of £100,000 and in Year 11 he sold the property for £500,000. The entire gain benefits from full taper relief (on the basis of a non-business asset). This can be relevant to jointly held property -- see Examples 20.3 and 4;

(5) similarly, where an asset is derived from another asset in the same ownership it is treated as acquired when the original asset was acquired. An asset is derived from another asset where assets have merged, an asset has divided or has otherwise changed its nature or different rights of interest in or over any asset have been created or extinguished at any stage and the value of any asset disposed of is thus derived from one or another assets previously acquired into the same ownership. See Sch Al para 14(1);

(6) It is sensible to ensure that losses are only crystallised in years when there are gains attracting little or no taper relief. Otherwise taper relief is wasted. It may be possible to convert a capital loss to an income loss by making a s 574 TA 1988 claim (relief for losses on unlisted shares in trading companies) if it could only otherwise be set against a tapered gain.

EXAMPLE 20.3

Joe owns the leasehold interest in Goblins Palace acquired in April 1998. He later buys the freehold in April 1999 (thereby extinguishing the lease).Joe is deemed to have acquired the entire land in April 1998 for taper relief purposes.

EXAMPLE 20.4

A, B and C hold land as tenants in common inherited on the death of their mother in April 1997. A dies in 2003 leaving his share to B who then buys out C in 2004. B sells in 2006. What is his taper relief position?

As tenant in common B held a fractional share in the whole asset, ie the freehold. When he increased his fractional share this was a merger of assets within s 43. Schedule Al, para 14 means that B will qualify for non-business assets taper relief cm his entire eain based on a neriod of ownershio since April 1997 (with the [*488] bonus year therefore available.) In calculating the gain B will take as his acquisition cost one third of the probate value of the land in April 1997, the probate value of the one third held by A at his death and the purchase price he pays C for his one third share. (6) the 'relevant period of ownership' is the shorter of:

(a) the holding period; and

(b) the last ten years of the qualifying holding period (but the bonus year is ignored for these purposes).

This period determines how much of a gain attracts business assets taper, and is therefore relevant when the taxpayer's use of the asset changes from business to non-business and vice versa (see Examples 21.4 and 21.5 for apportionment rules). (7) The gain is never tapered to zero. In the case of business assets

qualifying for the maximum relief, the effective capital gains tax rate after taper is:

(a) for individuals: 10% (40% x 25) if they are higher rate taxpayers or 5% (20% x 25) if they are basic rate taxpayers or 2.5% (10% x 25) if they have no other taxable income or gains;

(b) trustees (and PRs) 10% (Note this increased with effect from 2004-05 because the rate of capital gains tax for trustees increased from 34% to 40% pre-taper relief). (Despite the Trusts Modernisation programme (see Schs 12 and 13 Finance Act 2006) this remains unchanged unless an election has been made for the trust to be taxed under the vulnerable persons provisions (see FA 2005 s 37) or it is settlor interested in which case gains realised by the trustees are taxed on the settlor at his rates under TCGA 1992 s 77.

It is important, however, to be aware that if an asset was owned prior to April 2000 it needs to qualify as a business asset under both old and new rules if the full business assets taper relief is to be obtained. (see Example 20.5). [20.22]

4 What is a business asset?

The relevant definitions are in TCGA 1992 Sch Al (and see Tax Bulletin, Issue 53,June 2001 and Tax Bulletin, Issue 62, December 2002 for the meaning of a 'trading company' which is discussed later). The rules distinguish between shares and other assets. [20.23]

a) Qualifying companies

Shares can qualify for business assets taper relief if the company is a trading company or the holding company of a trading group and the taxpayer is an individual, the trustees of a settlement or PRs (a 'qualifying company').

Shares in foreign trading companies can also qualify but note TCGA 1992 s 13 may tax gains realised by certain foreign 'close' companies and any gains realised by the company (as opposed to gains on the shares themselves) will not qualify for taper relief but only for indexation relief. In this section, references to trading company should be taken to mean a company that is a trading company for business assets taper relief purposes. The rules are [*489] generally tighter than those for inheritance tax, so shares in a company may qualify for business property relief under the inheritance tax legislation but not for business assets taper relief under the capital gains tax legislation. [20.24]

b) When is BATR available on shareholdings in trading companies

For periods of ownership up to 6 April 2000, in order to qualify for BATR ai least 25% of the voting rights in the trading company had to be exercisable by the taxpayer: alternatively, the shares qualified if at least 5% of the voting rights were exercisable by the taxpayer who was a full-time officer or employee of the company. In the case of a trust, the alternative 5% test was only appropriate if there was an eligible beneficiary (defined broadly as one who had an interest in possession in the whole of the settled property) who was a full-time officer or employee. These old rules are still relevant if the taxpayer owned the asset before 6 April 2000 even if there are disposals after that date and it must always be checked to ascertain if the taxpayer qualified under the old rules. There was no difference in the rules between unlisted and listed trading companies-the same minimum voting requirements of 5% if full-time employee or 25% if not were required. As from 6 April 2000 a distinction was drawn between unlisted and listed companies. The thresholds for shareholdings in unlisted and listed trading companies of 5% for full-time employees and 25% for others were removed so that the following shareholdings now qualify as business assets:

(1) all shareholdings in unlisted trading companies (no minimum voting requirement or work required);

(2) all shareholdings held by officers or employees in listed trading companies; (in the case of trusts the eligible beneficiary needs to be the employee -- see post) and

(3) shareholdings in a listed trading company where the holder is not an employee but can exercise at least 5% of the voting rights.

For the position of shares in non-trading companies, see [20.31].

All employees including (since April 2000) part-time employees of the listed trading company in which they hold shares (or any group company, etc) will qualify. Officers of a trading company are treated in the same way as employees. The changes in 2000 and 2002 were not retrospective: consequently a shareholding in a qualifying trading company owned before 6 April 2000 might have been a non-business asset if the minimum voting requirements were not met but could become a business asset from that date thereby producing apportionment problems on sale (see Examples 21.4 and 21.5).

The company must exist for the purpose of trading commercially and for profit but subject to that, provided it satisfies the definition of a trading company for taper relief (see [20.27] fI), there is no restriction if non-business assets, such as investment property, are also owned by the company. Compare in this respect holdover relief under TCGA 1992 s 165 where the company has to be a qualifying trading company for BATR purposes (from 6 April 2003) but relief can also be restricted by reference to the underlying assets in the company-see also [22.72]).

Listed companies are those quoted on a recognised stock exchange. HMRC publish an updated list of such exchanges on its website. NASDAQ is a recognised stock exchange. AIM listed companies are not treated as listed [*490] companies for these purposes and therefore any shareholding in such a qualifying trading company will now be eligible for BATR irrespective of the percentage owned or whether the shareholder works in the business. [20.25]

EXAMPLE 20.5

Harry owns 5% of shares in a qualifying unlisted trading company Makepiece Ltd.

He has held the shares since 1995 and has never worked in the business. He sells the shares in April 2004. Up until April 1998 his base cost can be indexed. From April 1998 to 6 April 2000 lie can claim non-BATR and has the benefit of the bonus year since the shares were owned pre-17 March 1998. From 6 April 2000 to the date of sale the shares qualify for BATR. Of the total gain, 2/6 will qualify for non-BATR with the benefit of the bonus year and 4/6 will qualify for full BATR. Obviously if lie holds the shares beyond 2004 the adverse effect of the non-business asset qualifying period will lie diluted.

For the taper relief position on trustees and beneficiaries holding shares and other assets see [20.38]).

c) Other business assets

The asset must be owned by an individual, a partnership, the trustees of a settlement or PRs and generally used in a trade carried on by the owner or by a qualifying company, although note changes in FA 2003 s 160 discussed below which extend BATR to let property used for trading purposes by third parties in certain circumstances. Assets used partly for trading purposes are subject to an apportionment. Relief is also given if the asset is used by an employee for the purpose of his employment with a trader.

A trade for these purposes means 'anything which is a trade, profession or vocation within the meaning of the Income Tax Acts' (TCGA 1992 Sch Al para 22(1)). Hence farming, property development and furnished holiday lettings are a trade, but the activities of a commercial or residential landlord are not. [20.26]

EXAMPLE 20.6

(1) Tim acquires shares in an AIM company in 2000. In 2004 lie discovers that it is about to get a full listing. When that happens the shares will cease to be business assets. He does not work in the business.

(2) Tara has worked for a listed company, Supamarket plc, for many years and has built up a small shareholding in the company. She is sacked in June 2002. Her shareholding was not a business asset until 6 April 2000, but was a business asset from 6 April 2000 to June 2002. After she is sacked her shares cease to be business assets.

(3) On 16 March 1998 the 'Laundry Discretionary Trust' was established by Mr Clean to hold 20% of the shares in Clean It Ltd.

(a) Until 6 April 2000 the shares did not qualify as business assets.

(b) From 6 April 2000 they became business assets. (c) Assume that the trustees sell the shares on 6 April 2004. Their gain must be apportioned on a time basis:

(i) the business asset period runs from 6 April 2000 to 6 April 2004 and is 48 months long; [*491]

(ii) the non-business period runs from 6 April 1998 to 6 April 2000 and is 24 months long;

(iii) the total period of ownership is 72 months or six years.

Hence one-third of the gains (24/72) receives non-business taper over the period 6 April 1998 to 6 April 2004 (six years ownership plus the bonus) so that 75% of one-third of the gain is taxed; and two-thirds of the gain receives business assets taper over the same period (six years-no bonus) so that only 25% of two thirds of the gain is taxed.

Note: An apportionment will be required if the disposal by the trustees occurs at any time before 6 April 2010: only after that date can the non-business period of ownership be ignored. The apportionment is done on the basis of months, not complete years, so if the trustees had sold in June 2004 a further two months' business assets relief would have been available (50/74).

(4) The apportionment rules lead to anomalies. For example, Ray acquires 3,000 shares (3%) in SelIwell-an unlisted trading company-in February 1998. The purchase price was £3,000. He buys a further 10,000 (10%) shares from a retiring director in April 2000. The purchase price was still £1 a share = £10,000.

He and the other shareholders have now received an offer to buy the company for £1m and Ray wants to know his CGT rate if lie sells on, say, 10 April 2002. He will receive 13% of the sale price = £130,000.

The gain (ignoring the minimal indexation on the first 3,000 shares) is £117,000.

The 10,000 shares lie acquired in April 2000 will qualify for full business assets taper relief at 25% and therefore lie pays tax at an effective rate of 10% on these shares.

For half the relevant period until April 2000 the other 3,000 shares were not business assets. Therefore half the gain on these qualifies for non-business assets taper relief (with the bonus year) and half the gain qualifies for business assets taper relief. The overall rate of tax is about 22% on those shares.

If he had acquired all his shares in April 2000 lie would have qualified for the 10% rate on all his shares. Until 5 December 2003 it had been common to try and lose a non-business assets taper relief period by transferring the shares to an interest in possession trust for the settlor and claiming holdover relief (see para [20.39]). After that date such an approach is no longer possible since holdover relief is not possible on transfers to settlor interested trusts. In any event, such a transfer post 21 March 2006 could also result in an inheritance tax charge since it will be treated as a chargeable transfer (see FA 2006 Sch 20 and IHTA l984 s 5(1)(a) as amended: an inter vivos interest in possession trust for the settlor is no longer treated as part of the settlor's estate and therefore he makes a transfer of value).

5 What is a trading company?

a) Pre-FA 2002 position

A trading company was defined pre-FA 2002 in TCGA 1992 Sch Al para 22 as a company 'existing wholly for the purpose of carrying on one or more trades or a company that so exists apart from any purposes capable of having no substantial effect on the extent of the company's activities'. The company could be non-UK resident and the trade did not need to be carried on in the I JR [*492] Compare the definition of relevant business property for the purposes of inheritance tax relief (IHTA 1984 s 105(3)) where shares are not relevant business property if the business consists wholly or mainly of one or more of the following, that is to say, dealing in securities, land or buildings or making or holding investments. There is no purpose test and the test is 'wholly' or 'mainly' not 'substantially' (see [31.47].

Tax Bulletin No 53, June 2001, set out the Revenue's views of what the Revenue considered the terms 'trading company' and 'holding company of a trading group' to mean in the context of taper relief under the pre-FA 2002 legislation and, since FA 2002 was not designed to produce any changes in practice, this interpretation should still be referred to. It was confirmed that only actual activities, not the scope of the company's powers under its memorandum, were to be taken into account. In other words, the Revenue would judge a company not from its objects clause but from its behaviour.

However, it should be noted that the Revenue indicated: 'Purposes ... can only be established by looking at the intentions of the directors at a particular moment as well as looking at the transactions themselves. This is important because similar transactions by different companies (eg buying shares) may be for different purposes.'

In the situation where a company retains funds that it invests (so receiving investment income), the Revenue does not automatically consider that such a company's purpose is no longer wholly trading:

Whether the generation of income from investments is or is not evidence of a non-trading purpse must ultimately depend on the nature of the company's trade and whether the holding of the investment is closely related to the conduct of that trade. If it can be shown that holding any investment is integral to the conduct of the trade or is a short-term lodgement of surplus funds held to meet demonstrable trading liabilities, then this is unlikely to be taken as evidence of non-trading purposes. For example, if a company has surplus funds which it intends to use for an expansion of the trading business in the near future, and it invests these in equities in the short term, then it may be that the company's purpose continues to be wholly trading during the period those equities are held.'

The Revenue comments on the common problem where property held by a company is surplus to its immediate business requirements:

'We would not ... regard the following as necessarily indicating non-trading purposes: letting part of the trading premises; letting properties that are no longer required for the purposes of the trade, where the objective is to sell those properties; subletting property where it would he impractical or uneconomic in terms of the trade to assign or surrender the lease ... the acquisition of property where it can be shown that the intention is that it will be brought into use for the purposes of the trade.'

Minutes of the directors' meetings may be relevant here as evidencing future intentions.The test is not dissimilar to the one used for excepted assets in IHTA 1984 s 112 and see also Barclays Bank Trust Co Ltd v IRC [1998] STC (SCD) 125.

Even if the investments cannot be considered to be integral to the trade, a company will continue to be a 'qualifying company' if its purposes are trading 'apart from any purposes capable of having no substantial effect on the extent of the company's activities'. The Revenue considers that 'substantial' [*493] means more than 20% and, in considering whether any company's non-trading purposes are capable of having a substantial effect it takes into account the following:

(1) turnover receivable from non-trading activities; (2) the asset base of the company;

(3) expenses incurred or time spent by officers and employees of the company in undertaking its activities; (4) the historical context of the company.

The Revenue considers that the basis for measurement will vary according to the facts in each case. For example, 'holding on to an asset which has increased in value may indicate non-trading purposes if the company lacks liquid resources to develop it or too much time is spent looking after it-the historical context of the company may be relevant.'

Compare the factors identified for the purposes of IHT business property relief by the Special Commissioner in Farmer v IRC (1999). This decision was approved by the Court of Appeal in IRC v George [2004] and it is felt by some that HMRC's summary of the various factors to be taken into account in both Tax Bulletins 52 and 62 for periods pre- and post-16 April 2002 do not give full weight to this decision. In Farmer the Commissioner considered profits to be a critical factor insofar as business property relief was concerned but HMRC refer to turnover rather than profits and in Tax Bulletin 62 refer to 'receipts' in the context of 'income from non-trading activities'. Is this a reference to turnover or profits? Similarly it is not clear whether the reference to 'asset base of the company' is a reference to net or gross assets, although HMRC in practice apply a gross assets test. [120.27]

b) The definition of trading company and holding company post-i 6 April 2002

Finance Act 2002 Sch 10 adopted a new definition of trading company and holding company for business assets taper relief purposes, based on the substantial shareholding exemption (see [41.75]).

Trading company now means 'a company carrying on trading activities whose activities do not include to a substantial extent activities other than trading activities (para 22A(1))'.

Trading activities is then defined and includes preparatory activities and the acquisition of an interest in a company that becomes a trading subsidiary.

The new definition is not retrospective but only applies for periods of ownership and disposals on or after 17 April 2002. Therefore the old rules will still need to be examined to ascertain the position in respect of earlier periods of ownership even if disposals take place after 5 April 2002. However, in Tax Bulletin 62 the Revenue noted: 'For taper relief, the changes to the wording of the definitions of trading company and trading group align the statute with existing practice. They are not intended to alter the substance of the original definitions, or to have different meanings before and on or after 17 April 2002'. The emphasis on activities rather than purposes is generally helpful to the taxpayer. However, see article by Mark McLaughlin in Taxation, l4July 2005 for problems in HMRC practice in determining trading company status.

There are other problems where the company has organised its activities in a group structure. A holding company of a trading group was defined pre-17 April 2002 as a company whose business (disregarding any trade [*494] carried on by it) consisted wholly or mainly of the holding of shares in one or more companies which are its 51% subsidiaries. This meant that where a holding company also carried out some trading activities and some property investment activities the trading activities had to be ignored in assessing whether it was wholly or mainly holding shares but the investment activities could not be ignored. Intra-group activities were generally ignored (eg the holding company letting property to a trading subsidiary).

The definition has now been amended with effect from 17 April 2002 so that holding company simply means a company that has one or more 51% subsidiaries irrespective of its other activities. In Tax Bulletin 62, December 2002, the Revenue shed further light on the definitions of trading company and group.

It will now at a company's request after the end of an accounting period 'respond positively' by expressing a view on the company's taper relief status for that period. This can be useful for clients who are selling shares and taking loan notes or shares in another company where they may have a material interest (see below) or if they do not work in the company and wish to know whether or not the company is a trading company. If the company shares do not qualify for business assets taper relief then any sale may need to be structured quite differently (for example, using a pre-sale dividend). For those wanting a Revenue ruling on whether a company is qualifying, the company should write to its Inspector setting out:

- the reason why it is seeking the Inspector's opinion and the period over which the company wants the Inspector to consider its status;

- all the facts that the company considers relevant in measuring the extent of its trading and non-trading activities and, where appropriate, the assumptions it has made in describing what it expects its activities to comprise over the part of the period falling after the latest point for which data is available;

- why the company considers that there is uncertainty as to its status;

- the company's conclusion as to its status, and why it considers, if applicable, that the measures that point in that direction outweigh those pointing in the opposite direction; and

- what disposal is being contemplated and when it is expected that the transaction will be completed.

The Inspector will offer his or her opinion whenever this is practicable and, if this differs from the company's view, explain the reasons for that difference. It appears that it has not always been easy to obtain consistent rulings from HMRC. For further information on COP 10 rulings see para CG17953r of the Capital Gains Manual.

It should be noted that in relation to 'unused' cash balances which appear to represent more than 20% of the company's gross assets, the problem may in fact disappear if the other balance sheet assets are shown at their current market values. HMRC also seem to consider that the source of the cash reserves is relevant. If the cash represents undrawn trading profits they are apparently more relaxed than if the cash represents the sale proceeds of an investment from some years ago. (See Tolley's Tax Digest Issue 41 -- Maximising Taper Relief by Robert Jamieson.) [20.28] [*495]

6 Relief for joint venture companies

a) The original relief

TCGA 1992 Sch Al para 23 introduced, with effect from 6 April 2000, the concept of 'qualifying shareholdings' in 'joint venture companies'. The amendment was designed to extend the benefit of business assets taper relief to certain cases where companies took part in joint ventures and held shares in companies that were not 51% subsidiaries.

Therefore, before 6 April 2000, if A held shares in Newco I which owned 50% of Newco 2, a trading company, no business assets taper relief was available for A. Newco 1 had to own at least 51% of Newco 2 and therefore be a holding company of a trading group.

The first effect of Sch Al para 23 is that a share of the activities of the joint venture companies in which a company participates can now be taken into account in assessing whether the 'investing company' or group is trading.

The second effect of the changes is that employees of a joint venture company who own shares in the listed parent trading company owning the joint venture company will be entitled to business assets taper relief regardless of the level of their interest. They do not need to hold 5% of the voting rights.

Note, however, that the joint venture company (in the above example Newco 2) had to have 75% or more of its ordinary share capital held by not more than five companies. In addition Newco 1 (again following the above example) had to hold more than 30% of the ordinary share capital of Newco 2. [20.29]

b) FA 2002 improvements

FA 2002 eased these conditions with effect for periods of ownership post- 5 April 2002. The investing company (Newco 1) only needs to hold 10% or more in Newco 2 instead of 'more than 30%'. In addition the requirement is that 75% of Newco 2's share capital needs to be held by not more than five persons rather than by not more than five companies. The difficulty is that these improvements have not been made retrospective in effect, so again one needs to examine the position pre- and post-April 2002. In addition, loans made by a trading company (in the above example Newco 1) to a joint venture company (Newco 2 above) could cause problems to the status of Newco 1 so the financing of a joint venture must be examined carefully. [20.30]

7 Relief for employee shareholdings in non-trading companies (TCGA 1992 Sch Al para 6 as amended by FA 2001)

These changes, effected by FA 2001, were backdated to disposals after 5 April 2000. Under the amended rules an individual is entitled to business assets taper relief on shares in any company in which he is employed as an officer or employee (or if he is employed in a company having a relevant connection with that company) provided that neither he nor a person connected with him has a material interest in that company or, if it is controlled by another company, in that other company. Note therefore that: [*496] (1) employees of property investment companies (for instance) may now qualify for business assets taper: of course, if the relevant shares were held before 6 April 2000 an apportionment calculation will be required on any disposal (see Example 20.6(3));

(2) 'connected person' bears the normal CGT meaning: see TCGA 1992 s 286 and [19.23];

(3) a 'material interest' is defined in para 6A as possession or control of more than 10% of any of the issued shares; of any class of issued shares; of voting rights; of the right to profits available for distribution; or of rights to assets on a liquidation;

(4) in the case of trusts an 'eligible beneficiary' must be the officer or employee: hence discretionary trusts cannot benefit from this extended business taper relief. Note that an eligible beneficiary can be an interest in possession beneficiary without necessarily having a qualifying interest in possession under the new inheritance tax rules. See [20.44]. [20.31]

8 Relief for property let to a qualifying company or used for trading purposes

A new apportionment provision and therefore a further complication was introduced by FA 2003 s 160 with effect from 6 April 2004, presumably as a result of extensive lobbying from the property industry.

Formerly let property (broadly) only qualified for business assets taper relief on a disposal by an individual if:

(a) it was furnished holiday accommodation; or

(b) it was used for the purposes of a trade carried on by a partnership of which the property owner was a partner; or

(c) it was used for the purposes of a trade carried on by a qualifying company. Prior to 6 April 2000 it was necessary for the owner of the land either to be a full-time employee and own 5% of the shares or to hold 25% of the shares. Post-6 April 2000 a listed company is qualifying in relation to an individual if the person is an employee whether or not full-time or the individual owns 5% or more voting shares; lettings of land to an unlisted trading company can now qualify for full business assets taper relief post-5 April 2000 even if there is no minimum ownership and the landowner is not an employee.

(d) It was used for the purposes of any office or employment held by an individual with a person carrying on a trade such as an unlisted trading company or a listed trading company where the owner was an employee or owned 5% voting shares. (Full-time employment is no longer required after 5 April 2000.) [20.32]

EXAMPLE 20.7

Assume that Archer is a farmer and that he lets agricultural land (a) to Tom Cobbler a neighbouring farmer or (b) to Dan Gurner Ltd (an unquoted farming company). In the first situation the land was a non-business asset in Archer's hands until April 2004 (see below) but in (b) because Dan Gurner Ltd is a qualifying company (see TCGA 1992 Sch Al para 6(1)(b)) business assets taper is available from April 2000 (see TCGA 1992 Sch Al para 5(2)(b)). [*497]

This was probably an accident of drafting resulting from the definition of qualifying company. However, the Government has now extended the relief so that from 6 April 2004 business assets taper relief is available on almost all disposals of land let for trading purposes. FA 2003 provides that all assets used for the purposes ofa trade carried on by individuals, trustees, personal representatives, partnerships whose members include such persons or qualifying companies will qualify for business assets taper relief irrespective of whether the asset owner is involved in the carrying on of the trade. The new provisions will only take effect for periods of ownership from 6 April 2004 and the intention is that the landlord's letting decision should now be neutral as between incorporated and unincorporated businesses.

Note:

- Interestingly, it is only necessary that the property is used for trading purposes. If, for example, a piece of land is let to a solicitors' firm who thensublets the premises to another partnership which uses it for trading, business assets taper relief can still be obtained on the whole provided all the premises are used for trading purposes.

- What happens if there is a period, say, of fitting out the premises prior to starting the trade? HMRC appear to accept that this qualifies for BATR.

- What if some of the premises are not used for trading purposes and some are? Arguably para 9 providing for apportionment does not work adequately since an asset is a business asset if it is used wholly or partly for the qualifying purposes. There is no need then to look at the actual purposes for which the whole land is used and full relief is available! HMRC do not accept this interpretation.

- Note the difficulties that can arise where there is one building, part of which is used for trading purposes and part is not. See EG Manual 17959 and Taxation article, 14 July 2005 'Flatly Incredible' by Mike Truman. [20.33]

EXAMPLE 20.8

An individual A owns a business park divided into separate units and lets out five of the units. All lettings commenced after 6 April 1998 but before 6 April 2004. Unit 1 is let to individual B who uses it for her trade. Unit 2 is let to a partnership C whose membership consists of companies, one of which is an unlisted trading company. The partnership uses the unit for the purposes of its trade. Unit 3 is let to a listed trading company that uses it for the purposes of its trade. A is not employed by this company and does not own 5% of the shares in it. Unit 4 is let to a partnership D whose members are all individuals (one of whom is A) but the premises are not used for the purposes of a trade. Unit 5 is let to an unlisted trading company that uses it for its trade and A owns no shares in the company. For periods of ownership before 6 April 2004 while the units are let as described, the business assets status of those units for taper relief purposes in relation to individual A will he as follows:

- Unit 1 -- will not qualify as a business asset because, although it is being used for the purposes of a trade carried on by an individual, that individual is not individual A.

- Unit 2 -- will not qualify as a business asset as although the partnership uses the asset for the purposes of its trade, individual A is not a member of the partnership. [*498]

- Unit 3 -- will not qualify as a business asset as the listed trading company is not a qualifying company by reference to individual A.

- Unit 4 -- will not qualify as a business asset because it is not being used for a trade even though A is a partner.

- Unit 5 -- will qualify for BATR from 6 April 2000 but not for the period of letting before 6 April 2000, as prior to this date, the unlisted trading company was not a qualifying company by reference to individual A for the purposes of its trade. For periods of ownership from 6 April 2004 while the units are let as described, the business assets status of those units for taper relief purposes in relation to individual A will be as follows:

- Unit 1 -- will qualify as a business asset as it is being used by an individual for the purposes of her trade even though individual A is not the trader.

- Unit 2 -- will qualify as a business asset as at least one member of the partnership (the unlisted trading company) is a qualifying company by reference to individual A and the partnership is using the premises for the purposes of its trade.

- Unit 3 -- will not qualify as a business asset as the listed trading company is not a qualifying company by reference to individual A.

- Unit 4 -- will not qualify as a business asset because the partnership does not use the unit for the purposes of a trade.

- Unit 5 -- will qualify as a business asset as it is being used by a company that is a qualifying company by reference to individual A for the purposes of its trade. On balance it is preferable for A to consider letting to partnerships or sole traders provided they use the asset for trading purposes because then she is not required to consider the qualifying status of the company and whether or not it is a trading company for business assets taper relief purposes. She also avoids the worry then of the unlisted trading company becoming listed and then ceasing to be a qualifying company in relation to A (see Unit 3 in example above).

9 Incorporation

a) The rules pre-6 April 2002

On the incorporation of an unincorporated business, the transfer of the business assets to the company is a disposal for CGT purposes. In order to ensure that CGT is not a bar to the act of incorporation, relief under TCGA 1992 s 162 provides for any net chargeable gains on the disposal of such assets to be rolled over against the acquisition cost of shares in the new company. This defers the charge to tax on the rolled over gain until the shares themselves are disposed of (see [22.100]).

Unlike roll-over relief under s 152, incorporation relief under TCGA 1992 s 162 was, until FA 2002, mandatory if the relevant conditions were satisfied. This could be unfortunate if incorporation was followed shortly afterwards by the sale of shares in the company, given that the rolled over gain did not attract taper relief and that the taper relief clock was reset to start afresh. [20.34]

b) Flexibility in FA 2002

FA 2002 s 48 now provides a facility for individuals and trustees to elect (with effect for transfers of a business on or after 6 April 2002) for s 162 not to [*499] apply in relation to the transfer of an unincorporated business to a company. This is helpful if, for example, there is an unexpected offer to buy the business shortly after incorporation.

Similarly this flexibility will help to ease the process in cases where an individual has incorporated as part of the sale of the business but where the sale subsequently falls through. Previously, a well-advised taxpayer would have structured the deal so as to fall out of incorporation relief in order to maximise his taper entitlement and would then be faced with an immediate tax charge. One of the effects of this new measure is that he can now go ahead and structure the transaction so as to obtain relief under TCGA 1992 s 162 but opt out of relief if the sale goes ahead as planned (see further Example 22.15).

The time limits for making the necessary election are as follows:

(1) The second anniversary of 31 January next following the tax year in which the incorporation took place. So if the business is incorporated in March 2003, the election must be made by January 2006; or

(2) if the shares acquired at the time of the incorporation have all been disposed of by the end of the tax year following that in which the transfer of the business took place, the election must be made no later than the first anniversary of the 31 January next following the tax year in which that transfer took place. So if incorporation takes place in March 2003 (2002-03) and the shares are all sold or given away in 2003/4, the election must be made by 31 January 2005 (ie within the normal time limits for amending a self-assessment return).

If the shares acquired at the time of the incorporation have not all been disposed of by the end of the tax year following that in which the transfer of the business took place, the deadline for the election is extended by one year. The time limits therefore effectively give a two-year wait and see window.

Any transfer of shares between husband and wife will not be treated as a disposal for the purpose of triggering the shorter time limit.

Following the incorporation of a partnership, each partner has a separate entitlement to make the election-the fact that one partner makes the election does not require his fellow partners to do the same. [20.35]

10 Replacement of business assets-roll-over relief

Until the advent of taper relief, the rules for roll-over relief meant that there was generally no fiscal disincentive stopping businesses replacing their business assets (for example, premises) as opposed to enhancing existing assets.

However, the introduction of taper relief means that it can now be preferable to enhance rather than replace an existing asset in order to preserve existing taper relief. See Example 20.9. [20.36]

EXAMPLE 20.9

Suppose that brother and sister Emma and John run their own businesses. They both acquired their factories in April 1998 paying £100,000. Suppose that in April 2004, Emma sells her premises for £200,000 and buys new premises for £400,000.

At the same time John spends £200,000 enhancing his existing premises. [*500] Suppose that on eventual sale in April 2005 both factories are worth £600,000 and Emma and John wish to calculate the capital gains tax that would be payable if they sold up. The net cash flows are the same but the tax effects can differ considerably.

In John's case, the calculation would be as follows:

. £

Proceeds 600,000

Less:

Original cost (100,000)

Enhancement cost (200,000)

. ---------

Untapered gain 300,000

. =========

As the factory has been owned for more than two years, 75% taper relief is available reducing the chargeable gain to £75,000. The fact that he enhanced the value of the asset only one year before does not matter. The tax payable is £30,000.

Emma can either claim rollover relief or not but in both cases will be worse off than John.

Suppose a rollover relief claim is made:

. £ £

Proceeds 600,000

Less: original cost 400,000

Less: rolled over gain (100,000)

. ---------

. (300,000)

. ---------

Untapered gain 300,000

. =========

However, since the replacement premises were acquired less than two years previously, the taper relief available is only 50% and can therefore only reduce the gain to £150,000. This will mean that Emma's tax is twice that of John's.

Suppose Emma does not make a claim for roll-over relief. She is better off than before but still has to pay more capital gains tax and earlier than John.

She would have to pay capital gains tax on the gain from the first disposal of £100,000. That disposal on 6 April 2004 would have been subject to 75% taper relief-leaving £25,000 chargeable = £10,000 capital gains tax payable in January 2006.

She makes a further gain in 2005 (£200,000) which qualifies for 50% taper relief so has to pay capital gains tax of £40,000 on £100,000. Total tax liability = £50,000.

It will often be sensible for the trader (in the above case Emma) to make a provisional rollover relief claim under s l53A which at a later date she can replace with a formal claim under TCGA 1992 s152 or else withdraw once she has had a chance to consider likely future events. This will allow her a longer time to revoke the claim than if she made a s 152 formal claim from the start.

11 Holdover relief

Similar points arise in relation to gifts although, as with roll-over relief, the problem is less acute now that full BATR is available after only two years. Arty gift or sale ends the taper relief period and the donee cannot take over the donor's period of ownership (see generally Chapter 24). [20.37] [*501]

EXAMPLE 20.10

Mrs Goodfellow qualifies for full 75% BATR on the shares in her successful golf business worth £20 million. She decides to do some inheritance tax planning and gives half her shares to her daughter. She claims holdover relief under s165 in order to avoid paying CGT on the gain of say £10 million. Six months later there is a sale of the company for £25 million. Mrs Goodfellow pays 10% tax on her gain of £12.5 million.

The daughter does not qualify for any taper relief and will pay 40% CGT on the full gain of £12.5 million including the gain held over. It would be better then for Mrs Goodfellow not to make a holdover claim (or revoke it within the necessary time limits) and pay immediate CGT of £1 million on the gift. Then at least the daughter acquires the shares at the high cost of £10 million and will pay 40% CGT on only £2.5 million and not on £12.5 million. Note, however, that the position is still worse than if Mrs Goodfellow had given no shares away at all since in that case she would have paid 10% on the entire gain of £25 million.

The fact that the douce does not take on the donor's period of ownership for taper relief purposes used to be helpful in washing out the effect of the apportionment provisions described in Example 20.5 above. [20.38]

EXAMPLE 20.11

Assume the facts are the same as in Example 20.5 but instead Harry decides to settle shares in Makepiece Ltd on an interest in possession trust for his children in 2001. He claims holdover relief under TCGA 1992 s 165. When the company is sold in 2006 the entire gain in the hands of the trustees qualifies for full IIATR and the trustees will pay CGT at an effective rate of 10%. Note that the earlier non-BATR period has effectively been washed out. Until 10 December 2003 it was possible to use this device and wash out gains by gifting to a senior interested trust. However, holdover relief is no longer available on gifts to settlor interested trusts and therefore Harry could no longer wash out the 'tainted period' and settle the shares on interest in possession trusts for himself or his spouse post December 2003 or (in respect of disposals from 6 April 2006) for his minor children and claim holdover relief. See FA 2004 Sch 21 and FA 2006 schedule 12 para 3 amending s 77 TCGA 1992 so that trusts for minor children are now settlor interested.

Note also that an inter vivos interest in possession trust set up on or after 22 March 2006 will be treated as a relevant property settlement and will be an immediate chargeable transfer by Harry although it may be possible to claim business property relief. Hence such planning is likely to be rare now although it is possible that assets held within a trust for some years may have a tainted taper relief period that the trustees wish to wash out. Note there is no restriction on holdover relief in respect of disposals out Of settlor interested trusts.

EXAMPLE 20.12

Harry setup a trust for himself and his wife in 2000. The trust is discretionary. The assets in the trust comprise let land (to a sole trader farmer) which only qualifies for business assets taper relief from 6 April 2004. Prior to that date the let land was a non-business asset. The plan is to sell the land in April 2008. The trustees decide to advance the land back to the senior, holding over the gain. Note that there may be an exit charge for inheritance tax purposes since the transfer is out of a discretionary trust. Holdover relief is still available under s 260 even though the [*502] transfer is back to the settlor. The settlor then holds the land which is let to the sole trader farmer for a further two years prior to selling it and claiming full business assets taper relief untainted by the pre-2004 period.

It is possible to revoke a holdover claim (which might be desirable in the above example if there was an unexpected sale of the property shortly after advancement to the settlor). HMRC allow revocation of a claim before the expiry of the normal time limits for enquiries into tax returns.

If Harry emigrates within six years from the end of the tax year of the advancement, the held over gain is clawed back under TCGA 1992 s 168. In these circumstances it appears that the held over gain clawed back is the chargeable gain without the benefit of the trustees' taper relief although presumably, since a chargeable gain is deemed to accrue to the donee in the year of emigration, taper relief can be claimed on the clawed back gain by reference to the holding period of the donee (Harry) rather than the donor (the trustees).

If this sort of device is used, care is needed on implementation. Has the gift been effected properly (in terms of following the formalities on transfer of shares laid out in the articles)? Are the trustees (or the beneficiary) registered as the new owners? [20.39]

12 Foreign assets

TCGA 1992 s 12(1) provides that where a non-domiciled person disposes of a foreign asset, chargeable gains are taxed in the year (or years) in which the gains are remitted to the UK. Para 16(4) ensures that in this situation taper relief is calculated by reference to the actual period of ownership of the asset and not the period up until when the gain is remitted. The same provision applies where TCGA 1992 s 279(2) applies to defer liability where the taxpayer is unable to remit the proceeds to the UK because of the laws of the country where the gain accrued, or actions of its government. [20.40]

EXAMPLE 20.13

In June 2000 a non-domiciled UK resident taxpayer acquired shares in a foreign company that do not qualify for business assets taper relief and disposed of them in June 2004. The gain is remitted to the UK in June 2005. There will be four and not five whole years in the qualifying period for taper relief in respect of the gain that accrued in January 2005, which runs from June 2000 to June 2004. The delay in remitting the gain does not affect the length of the qualifying holding period.

Non-resident companies

Taper relief does not apply to gains that are attributed to members of non-resident companies under TCGA 1992 s 13. Although such gains are chargeable to capital gains tax they are computed according to the rules applicable for gains chargeable to corporation tax and hence indexation continues to be available.

EXAMPLE 20.14

A, a UK resident and UK domiciled person, owns 100% of a Jersey investment company that realises indexed gains of £100,000. Such gains are attributed to him under s 13. No taper relief is available. If A later sold the shares in the Jerseyco then taper relief would be available on those shares. [*503]

13 Spouses -- interaction of taper relief and the identification rules

The rules on transfers of shares and other assets between spouses and (from 5 December 2005) civil partners, are complex: see Tax Bulletin 54, August 2001, where the Revenue set out its view on the way taper relief works when shares have been transferred from one spouse to another before sale. These views do not find universal acceptance in relation to disposals of part shareholdings-see articles in Taxation 18 October 2001.by Mike Thexton and in 22 November 2001 by Maurice Parry Wingfield. The problem highlighted in the Tax Bulletin will arise where the shares being transferred by the donor were not all acquired on the same day and the transferee spouse disposes of only some of them later.

As a general rule the transferee spouse-for taper relief purposes only, not for identification purposes-is treated as having acquired the asset when the transferor spouse did and the no gain no loss rule in TCGA 1992 s 58 continues to apply. Thus when the asset is eventually disposed of by the transferee spouse, the periods of ownership of the spouses are aggregated, both to decide the number of complete years of ownership and to determine the extent to which the asset was a business asset during that period. In the case of shares, for identification purposes the transferee spouse is treated as acquiring them at the actual date of acquisition. This may enable the annual exemption to be used or losses preserved (see Example 20.15). [20.41]

EXAMPLE 20.15

Michael has 1,000 shares in IGA, a listed company, 500 acquired in 1990 and 500 acquired in 1999. Each holding is worth £1,000. The 1990 holding shows a gain. The 1999 holding is breaking even. If he sells 500 shares now he does not realise a gain since the sale is identified with the 1999 holding. If he wants to use his annual exemption he has failed. But if instead he gives 500 shares to his wife Susan these are treated as being out of the 1999 holding (LIFO) and if he then sells his remaining shares he has realised a gain and used his annual exemption. If Susan sells later she is treated as holding the shares since 1999.

For shares in a company to qualify as a business asset it is necessary to determine whether the company was the qualifying company of the transferee spouse throughout the whole of the period of ownership falling after 5 April 1998. If the company was not the qualifying company of the transferee spouse throughout the whole period of ownership, the gain must be apportioned. [20.42]

EXAMPLE 20.16

Michael acquires 500 shares in ICA in 1990. He works in ICA but gives them all to Susan in April 2002 because he wants her to have the dividends. She sells the holding in April 2006. Susan does not work for the company and so the shares qualify for effectively nine years' non-business assets taper relief (with the bonus year) with 65% of the gain being chargeable. No business assets taper relief is available. Susan does not work in the listed company and owns under 5%.

If Michael had sold the shares in 2006 and made no gift then business assets taper relief would have been available from the period after 5 April 2000 because he does work in the listed company. By giving them to Susan all business assets taper relief has been lost. [*504] Where an asset other than shares is transferred between spouses the rule is different. The asset can qualify for business assets taper relief depending on the extent to which the asset satisfies the business use tests during the combined period of ownership. However, in this case it is necessary to review both the period during which the asset was held by the transferee spouse and the period during which the asset was held by the transferring spouse.

For the period after the gift, the asset will be a business asset at any time if the conditions are satisfied by the transferee spouse. For the period before the gift, the asset will be a business asset at any time if the conditions are satisfied by either of the spouses. [20.43]

EXAMPLE 20.17

Michael farms land that is owned by Susan. Susan transfers the farmland to Michael. If Michael then sells it will be a business asset throughout the period of ownership because of his business use.

If Michael farms and owns the land and then gives it to Susan who does not farm, there is no business assets taper relief after the date of the gift. Some business assets taper relief is still available for Michael's period of ownership.

14 Taper relief and trusts

Trustees qualify for taper relief in the same way as individuals, wherever they are resident. However, in considering whether an asset owned by a trust qualifies for business or non-BATR one must have regard not only to the trustees' position but also to the position of the beneficiaries (in relation to interest in possession trusts).

As noted earlier, from 6 April 2000, all trusts holding shares in unlisted trading companies will qualify for BATR whatever their level of holding and irrespective of the type of trust. However, trusts holding shares in listed trading companies will only qualify if the trustees hold more than 5% of the voting shares or an eligible beneficiary is an officer or employee (not necessarily full time) in the company or its subsidiary. An eligible beneficiary is one who has a relevant interest in possession (defined as an interest in possession not being an annuity or fixed-term entitlement unless the beneficiary will become absolutely entitled to the property at the end of the fixed term). Schedule 20 amended the definition of qualifying interest in possession for inheritance tax purposes and introduced certain amendments to the capital gains tax legislation in relation to the deaths of those holding interests in possession which arose post 21 March 2006. No amendment was made to the definition of relevant interest in possession for taper relief purposes. Hence it would appear that a beneficiary who is an employee and has an entitlement to income which arose post 21 March 2006 is still an eligible beneficiary for the purposes of the taper relief legislation even though his interest is not a qualifying interest in possession for inheritance tax purposes.

Where there are multiple seniors of the same trust the shares cannot be cumulated so as to create a single umbrella settlement that would then qualify for relief. [20.44] [*505]

EXAMPLE 20.18

A, B and C each own 3% in ICA, a listed trading company. They cannot transfer their respective holdings into a single trust in order to get over the 5% threshold. The trust now owns 9% of the shares in ICA but for taper relief purposes it is as if the shares are held in three separate settlements.

Trustees who trade on their own account or in partnership, or own assets used in a trade by an 'eligible' beneficiary or a qualifying company, will also qualify for BATR. (Note, however, that for trustees in partnership BATR is arguably only available on the asset in question from April 2000-see para 5(3)(a).)

If the beneficiary has an interest in part only of the trust, he is an eligible beneficiary in relation to an asset if the asset is included within the part of the trust assets in which he has an interest in possession. Where the trust holds unlisted shares this will no longer matter but in relation to listed shares or in respect of periods pre-6 April 2000 the rate of taper relief could alter depending on which fund held the shares.

EXAMPLE 20.19

Suppose Chris sets up a trust for his two children Joe and Dot each with an interest in possession in half the trust. He settles 10% shares in his unlisted company Timeshare in February 1998 and some cash that is used to buy a house now rented out. Dot works in Timeshare full time.Joe mends old ears in his own business. The trustees do not appropriate the assets to any particular fund and therefore although Dot is an eligible beneficiary for the entire period from April 1998 only part of the shares will qualif' for BATR up to April 2000 since Joe is not an eligible beneficiary. The gain on a later disposal will need to be apportioned. After April 2000 the trustees qualify in their own right anyway since the shares are unlisted.

If instead Chris had specifically given all the shares to Dot's fund and the cash to Joe's fund, all the shares would have qualified for full BATR.

It was possible prior to 22 March 2006 to dilute the effect of the apportionment rules by the trustees appointing the shares out to a new trust for Joe and Dot depending on whether holdover relief is available without restriction (see Example 20.11). There are now a variety of problems with this. First the restrictions in FA 2004 Sch 21 and FA 2006 Sch 12 limit holdover relief if the new trust is settlor interested or becomes so within the clawback period (six years from the end of the tax year of the disposal). That definition has been extended from 6 April 2006 to include minor children. Moreover if a beneficiary adds to the trust within the clawback period it becomes settlor interested and the original held over gain can be clawed back. Therefore, Joe and Dot should not add to such a trust from which they can benefit within the clawback period. Even though the shares did not originate from them, holdover relief can still be clawed back if the second trust becomes settlor interested.

Second, a transfer of assets from one trust to another may cause inheritance tax problems. In the above example, Joe and Dot have interests in possession. If they take interests in possession under the new trust then prior to 22 March 2006 this would have been a non-event for inheritance tax purposes. If the transfer to the new trust takes place post-21 March 2006, the [*506] interests in possession taken byJOe and Dot are not qualifying interests under the transitional serial interest provisions. Hence they end up making chargeable transfers for inheritance tax purposes and putting the assets comprised in the new trust within the relevant property regime! [20.45]

Taper relief and private residence relief

The availability of principal private residence relief usually means that taper relief is irrelevant on disposals of houses that qualify for relief under TCGA 1992 s 223. However, there is a difficulty where there is a disposal of residential property that had some exclusive business use.

If part of a dwelling house is used exclusively for the purposes of a trade or business the gain must be apportioned and no principal private residence relief is due on that part of the gain. Unfortunately such gain does not then qualify for full business assets taper relief and therefore the rate of tax is not 10% as might otherwise be expected. This is because Sch Al para 9 provides that where the asset is used for both business and non-business purposes the chargeable gain must be apportioned on a pro rata basis into a business and non-business gain prior to the application of taper relief.

EXAMPLE 20.20

John works as a dentist from his home. One quarter of the rooms are used exclusively for the purposes of his business. On sale in 2006 (after owning the home for seven years) he makes a gain of £100,000. Given that the gain arises wholly in respect of business use, he might expect that the computation will be as below:

Gain 100,000

Exempt as main residence 75,000

Chargeable gain before taper 25,000

Business taper relief 75% 18,750

Chargeable 6,250

In fact, this is wrong in principle: the computation must reflect the fact that the whole of the chargeable gain arises on a single asset which has been used as to only one-quarter for business purposes. The correct computation is as below:

Gain 100,000

Exempt as main residence 75,000

Chargeable gain before taper 25,000

Business taper relief (at 75%)

on 25% of gain 4,687

Non-business taper relief

(at 25%) on 75% of gain 4,687

Chargeable 15,625

[20.46]

15 Anti-avoidance provisions

a) Relevant changes of activity

TCGA 1992 Sch Al para 11 provided that, on a disposal of shares in a close company, taper relief was restricted if, after 5 April 1998, the company had [*507] started to trade or started, or had significantly increased the size of, a business of holding investments. Any such event was known as a 'relevant change of activity'. If there was a 'relevant change of activity' the taper relief clock was reset to zero and any accrued taper relief was forfeited. The provision caught a number of innocent transactions but could fairly easily be circumvented.

Paragraph 11 was repealed by FA 2002 in relation to disposals of shares on or after 17 April 2002. A new para l1A was inserted, which operates from 17 April 2002 onwards in respect of disposals, but affects earlier periods of ownership.

The replacement rule provides that any period after 5 April 1998 does not count for taper relief purposes (either business or non-business) if the company is a close company and is not 'active'. Any company that is carrying on a business, preparing to carry on a business or winding up the affairs of a business will be treated as active. However, holding small amounts of cash on deposit or shares in non-active companies may not be regarded as active. See Tax Bulletin, October 2002.

The new rule is much simpler although the definition of 'active' may still lead to some anomalies. The Revenue explained in the Treasury Explanatory Notes to the Finance Bill 2002 the aim of the new provisions. One of the aims was to provide protection against transactions seeking excessive taper relief. For example, an individual could set up a company in year 1, do nothing with it for several years, in year 8 use it to acquire an asset and in year 10 sell the company. Without this provision the individual could effectively obtain ten years' non-business assets taper relief on the gain on an asset held for only two years. Note though that disallowing the first eight years would only be a disadvantage for the individual if when the company became active it was not a trading but an investment company. The rules prevent him claiming 10 years non-business assets taper relief.

The rule also aims to prevent individuals from being accidentally disadvantaged if they use a long-held dormant company to start up a trade. In the above example, if the company was trading between year 8 and 10 the individual might expect to get full business assets taper relief. Instead without this provision ignoring periods when the company is inactive the individual would find that part of the gain on disposal was a gain on a non-business asset and part on a business asset. [20.47]

b) Value freezing

In some cases it may be sensible to try and postpone the disposal date for CGT purposes in order to maximise business assets taper relief but still endeavour to fix the deal now commercially. The classic mechanism for achieving this is through use of put and call options. The time of disposal of any asset disposed of under an option is the time of exercise of the option and not when the option was granted: see TCGA 1992 Sch Al para 13. However, such cross-options may breach the anti-avoidance provisions in para 10 which prevent taper relief continuing to accrue where the owner is not exposed to the risk of loss or the possibility of profit to any substantial extent. Substantial in this context means more than 20%. However, note that provided the owner of the asset continues to be exposed to a substantial extent to the possibility of either profit or loss then the anti-avoidance [*508] provisions do not apply. Hence bank guaranteed loan notes issued on a takeover of a company's shares do not bring para 10 into play because it only provides protection from downward, not upward, movements in the value. [20.48]

c) Value shifting

There are two types of value shifting provisions found in the legislation. The first provision, TCGA 1992 s 29, is discussed at [26.611 but Sch Al para 12 only applies to disposals of shares or securities in a close company (as defined in TA 1988 s 414).

Under the normal capital gains value shifting rules in s 29 the concern arises where value is moved out of existing assets and that then creates a deemed taxable deemed disposal to the extent of the value reduction. By contrast, the taper relief value shifting rules do not themselves create a deemed disposal but rather penalise the recipient of the shift by causing a resetting of the taper relief clock. If para 12 applies the effect is penal because all taper relief built up is lost. If there is 'a relevant shift of value' into shares in the close company from other shares, any period before the time of the later shift in value will not count for taper relief.

The relevant shift of value is defined in para 12(3) as taking place whenever a person who has control of a close company exercises his control so that value passe out of that holding into the shares which are later disposed of. However, if the value passing into the shares from the relevant holding is insignificant, or when the shift of value takes place the qualifying holding period for the relevant holding is at least as long as the qualifying holding period for the shares into which the value is shifted, then para 12(4) excludes the provisions. [20.49]-[20.60]

EXAMPLE 20.21

A owns shares in two companies: he owns 900 shares in X Limited acquired for £900 in 2002 which are now worth £9,000 and 100 shares in Y Limited acquired for £100,000 in 2010 and now worth £991,000. He receives an offer to sell the shares in Y Limited. Before disposing of the shares in Y Limited, A arranges that X Limited acquires all of the shares in Y Limited in consideration of X Limited issuing 100 shares. The revised holding of X Limited is now 1,000 shares worth Lim. 900 of these were acquired in 2002 and the remaining 100 shares would be deemed to have been acquired in 2010 and are worth at most £100,000 (10% of the whole). There has been a value shift into the 900 shares that are now worth £900,000. Thus when the 1,000 shares are sold the gain on the 900 shares would (apart from para 12) qualify for more taper relief having the benefit of a longer qualifying holding period.

In those circumstances, for the 900 shares the period tip to the date of transfer of value is treated as a period that does not count for taper relief. The qualifying holding period of the 100 shares deemed to have been acquired in 2010 will run from 2010. The qualifying period of the 900 shares is effectively nil. Taper relief before the shift of value is completely ignored.

Value shifts before 5 April 1998 are ignored for taper relief purposes. There is no motive test and, therefore, paragraph 12 can inadvertently apply. [*509]

EXAMPLE 20.22

Suppose two siblings Chris and Kate own two companies A Limited and B Limited. Chris owns 100% of A Limited and Kate owns 100% of B Limited. Chris has carried on his business in the company for 20 years. Kate has only just started the business.

Chris and Kate decide that they would be better off amalgamating the businesses. Kate decides to sell her shares to Chris for a fixed sum but HMRC determine that this is less than market value. There has been a shift of value into Chris' shares as the company A Limited has acquired B Limited at an undervalue. All Chris' accrued taper relief is lost.

Similar problems can arise if there is an alteration of any rights attaching to shares that can affect the value of those shares. Reclassification of shares that then give different dividend rights will need some care.

Curiously there is no value shift where an asset is gifted to a company and the gain held over under s 165 because there is no diminution in value in any other shareholding.

16 Miscellaneous-postponed gains

In certain cases, where gains are postponed or held over but eventually crystallise, the taper relief is not calculated by reference to the date on which such gains crystallise but by reference to the original period of ownership. For example, where gains are realised when someone is not resident or ordinarily resident here they are not chargeable then. However, if that person becomes UK-resident within five years of leaving then (unless double tax treaty relief is available or the assets were acquired when he was non-resident-see Chapter 27) the gains then crystallise in the tax year of return. The taper relief is, however, calculated by reference to the date when the assets were originally sold not by reference to the date of return.

Similarly if gains are deferred by taking QCB5 in exchange for shares on a sale of the company (s 116) or investing in a company qualifying for EIS relief (TCGA 1992 Sch 5B), when the QCBs or EIS shares are sold, taper relief on the deferred gain is calculated by reference to the holding period of the original asset disposed of. The subsequent holding period of the QCB or EIS shares is irrelevant. (Note though that if capital gains tax exemption is not available on the EIS shares, nevertheless gains arising from increases in value of the EIS shares over the EIS period of ownership do qualify for further taper relief.) [20.61]

EXAMPLE 20.23

A sells some shares which qualify for 30% taper relief. The gain before taper is £100,000. He decides not to pay any capital gains tax and reinvests £100,000 in an EIS company, claiming deferral relief. Note that in order to avoid a capital gains tax charge he has to invest the gross gain before, not after, calculating his taper relief. He owns more than 30% in the company so can only claim deferral relief not income tax relief.

Five years later his shares in the EIS company are sold for £150,000. £100,000 of this represents the gain deferred and will still only qualify for 30% taper relief. The five-year period of ownership is ignored. The other £50,000 represents the gain during the EIS period and will qualify for 75% business assets taper relief.

Earn outs can pose particular problems given that the earn out right is a separate chose in action. [*510]

EXAMPLE 20.24

B sells some shares which qualify for full business assets taper relief. He receives cash of £1m plus an earn out based on defined profits for the next two years. That earn out right is valued at £500,000. He is taxed on the sale of shares as if he received consideration of £1.5m with business assets taper relief. However, if he receives the earn out consideration two years later which is (say) £750,000 he is treated as making a gain of £250,000 which will not qualify for any taper relief because the earn out right is a non-business asset and he has held it for less than three years.

III COMMENTS AND CONCLUSIONS

(1) Taper relief may discourage the making of lifetime gifts: see [24.29].

(2) The phasing out of retirement relief will not in all cases be compensated for by the introduction of taper relief: see [22.85].

(3) For the use of losses, see [19.631 and for the relationship with the annual exemption, see [19.87].

(4) Trustees with effect from 6 April 2004 suffer CGT at 40% so that they no longer benefit from the 34% rate of tax. However, trusts are still useful as an umbrella to hold assets, permitting the interests of beneficiaries to be changed whilst the trust qualifies for full taper relief and the period of ownership is unbroken.

(5) Taper relief a it affects PRs is considered at [21.63].

(6) For the impact of taper relief on the payment of pre-sale dividends, see [47.36] and on company sales involving loan notes and consideration see [47.40].

(7) In the case of EMI share option schemes (see FA 2000 Sch 14 para 57 and see [9.71]) taper relief on a disposal is calculated as if the shares had been acquired when the original option was granted. (Contrast the general practice under TCGA 1992 Sch Al para 13.)

(8) The provisions on let property introduced in FA 2003 with effect from 6 April 2004 further complicate the apportionment provisions. The result is that commercial lettings qualify for much more favourable capital gains tax relief than inheritance tax business property relief.

(9) For HMRC's view on certain taper relief aspects of partnerships (particularly in relation to goodwill), see Tax Bulletin, October 2002.

(10) The abolition of holdover relief on gifts into settlor interested trusts has made the resetting of the taper relief clock more problematic and in any event such trusts are no longer tax neutral following the 2006 Budget changes.

(11) The taper relief regime should become simpler as time passes because the old pre-April 2000 and April 2002 rules will gradually become redundant. [20.62]

21 CGT-death

Updated by Emma Chamberlain, BA Fions (Oxon), CTA (Fellow), LRAM, Barrister, 5 Stone Buildings, Lincoln's Inn

I General [21.1]

II Valuation of chargeable assets at death [21.21]

III CGT losses of the deceased [21.41]

IV Sale of deceased's assets by PRs [21.61]

V Losses of the PRs [21.81]

VI Transfers to legatees (TCGA 1992 s 62(4)) [21.101] VII Disclaimers and variations (TCGA 1992 s 62(6)) [21.121]

I GENERAL

On death the assets of the deceased of which he was competent to dispose are deemed to be acquired by the personal representatives (PRs) at their market value at death. There is an acquisition without a disposal: an uplift in the value of the assets but no charge to CGT (TCGA 1992 s 62(1)). Hence, death generally wipes out capital gains.

EXAMPLE 21.1

Included in T's estate on his death in October 2004 is a rare first edition of Ulysses that T had acquired in 1990 for £10,000. It is worth £100,000 at death. The gain of £90,000 is not chargeable on T's death. Instead his PRs acquire the asset at a new base value of £100,000. Note however, that held over gains in a trust are not wiped out on the death of the life tenant although gains on assets accruing over the trust's period of ownership which are subject to a 'qualifyinginterest in possession (see post) are generally wiped out on the death of life tenant provided the property then does not revert to the original 'disponer' or settlor (see TCGA 1992 ss 72-73)

EXAMPLE 21.2

Suppose T was the life tenant of a pre-22 March 2006 interest in possession trust and the book had been given to the trust by his mother in, say, 1982 with the benefit of a holdover claim. The gain held over was £20,000. On T's death, the held over gain of £20,000 gain becomes chargeable then and only the balance of the gain (£70,000) is wiped out on death (see TCGA 1992 s 74). (Ignore for the moment issues on rebasing discussed in Chapter 19.) It may be possible to make another holdover claim to avoid paying tax on the £20,000 if T's death is a chargeable transfer. [*512] Contrast the position if mother had given T the book outright rather than into trust and claimed holdover relief. In these circumstances there is no clawback of the held over gain on T's death.

Note that FA Act 2006 has amended TCGA 1992 55 72 and 73 so that if the interest in possession arises on or after 22 March 2006 there is no deemed disposal or base cost uplift to market value on the death of the life tenant unless:

(a) the interest is an immediate post-death interest (IPDI); or

(b) a transitional serial interest (TSI); or

(d) an 18-25 trust where the person dies under 18; or

(e) a bereaved minor trust. The effects of all this can be summarised as follows:

EXAMPLE 21.3

Husband dies leaving his assets on interest in possession trusts for his wife or a child in his will. (Section 31 is excluded if the child is a minor so they take immediate entitlement to income.) In either case this is an IPDI. On the death inheritance tax will be chargeable and capital gains tax base cost uplift is available.

If the wife or child's interest is terminated during her lifetime and the beneficiaries take absolutely this is a PET and a disposal for capital gains tax purposes at market value. No holdover relief is available.

EXAMPLE 21.4

Husband has an interest in possession on a pre-March 2006 trust. He dies in 2009 and his wife takes an interest in possession. This is a transitional serial interest under IHTA s 49BB and on both husband and wife's deaths there is a base cost uplift for capital gains tax purposes.

EXAMPLE 21.5

Father dies leaving his estate on a bereaved minor trust for his two children, Amy and John. They are each given entitlement to income before they are 18 and Amy dies at 17. There is no inheritance tax charge (IHTA s 71B(2) (b� but a base cost uplift for capital gains tax purposes. (TCGA s 72(1B)) (Contrast the pre-Budget position.)

EXAMPLE 21.6

Mother dies leaving her estate on trust for her only child Mary at 25. Mary is made entitled to the income from the age of 16 with capital at 25. If she dies under 18 then a base cost uplift for capital gains tax purposes is available under s 72(1A) (b) even if the property remains settled. There is no inheritance tax charge. (LIfTA s 71E(2)(b))

If Mary dies after reaching 18 but before 25 there is no base cost uplift for capital gains tax purposes but there is an inheritance tax exit charge even though the trust continues. (IHTA s 71F(2))

If the 18-25 trust is extended so that Mary does not take outright at 25 there is an inheritance tax charge then. If she later dies after 25 retaining her interest in [*513] possession there is no inheritance tax charge then unless the trust ends (in which case there is an exit charge at maximum 6%) and no capital gains tax uplift since the property is within the relevant property regime.

EXAMPLE 21.7

If mother had left her estate on trust for Mary at 30 with Mary taking entitlement to income at 18, note that even though she has an interest in possession it is not qualifying for inheritance tax purposes and this is not an 18-25 trust. On Mary's death there is no inheritance tax payable unless the trust ends (in which case there is an exit charge at 6% maximum) and no base cost uplift for capital gains tax purposes. If the trust does end on Mary's death holdover relief would be available.

EXAMPLE 21.8

H sets up a trust during his lifetime giving his adult child an immediate interest in possession. Prior to 22 March 2006 the child took a qualifying interest in possession. Unless the child is disabled this is no longer the case. On the death of the child there is no base cost uplift for capital gains tax purposes but no inheritance tax charge unless the trust ends in which case there is an exit charge but the property is not taxed at 40% as part of the child's estate.

PRs are deemed to have the same residence, ordinary residence and domicile status as the deceased had at the date of death but the remittance basis-which is available to a UK-resident but non-domiciled individual in respect of a disposal of non-UK situs assets-does not apply to PRs: see TCGA 1992 s 62(3); s 65(2) and [27.1]. Note that PRs are also charged on the gains of non-resident companies apportioned under TCGA 1992 s 13. The exclusion for non-domiciliaries only applies to individuals.

Like trustees, PRs are treated as a single and continuing body of persons and liability is imposed on any PR: HMRC will, therefore, assess UK PRs on the estate's worldwide gains even though those PRs may have no control over foreign assets which are vested in foreign PRs. Any one of them is assessable and chargeable on behalf of the body as a whole.

Because PRs are deemed to take the deceased's residence status, UK personal representatives of a non-resident deceased are outside the charge to capital gains tax. However, this exemption only applies while they are acting in their capacity as PRs; once they become trustees (eg assets are assented to them as trustees) they are taxed as UK residents. [21.1]-[21.20]

II VALUATION OF CHARGEABLE ASSETS AT DEATH

i Basic rule

The assets of the deceased are valued at their open market value at the date of death. If an asset has been valued at that time for the purpose of calculating a charge to inheritance tax that figure will constitute the CGT acquisition cost of the deceased's PRs (TCGA 1992 s 274). When the IHT-related property rules apply the resultant figure may be artificially high (see [28.70]).[21.21] [*514]

2 Relevance of s 274

Section 274 refers to the value of an asset being 'ascertained for the purpose of that [ie IHT] tax'. In cases where the deceased's estate does not attract IHT (eg because it is wholly left to a surviving spouse or where the property qualifies for 100% agricultural or business relief) the value will not have been ascertained and so the figure returned on the IHT account will not fix the CGT value (see Tax Bulletin, April 1995, p 209). There is no reduction in the CGT cost because business or agricultural property relief reduces the value transferred for IHT purposes. [21.22]

3 IHT revaluations

Where property valued on death as 'related property' is sold within three years after the death, or land is sold within four years of death, or listed securities within one year, for less than the death valuation, the PRs may substitute a lower figure for the death valuation and so obtain a reduction in the IHT paid on death (see [30.7]). Not surprisingly, this lower figure will also form the death value for CGT so that the PRs cannot claim CGT loss relief. As an alternative to reducing the estate valuation, the PRs may prefer to claim a CGT loss on the disposal. This would be advantageous where they have made chargeable gains on disposals of other assets in the estate and where no repayment of IHT would result from amending Lise value of the death estate. Note, though, Stonor (executors of Dickinson) v IRC 2001 STC (SCD) 199 where it was held that the executors could not substitute the higher sale price for probate value where the estate was left to charity because no values had been ascertained for inheritance tax purposes. Presumably the executors had wanted to do this in order to avoid a capital gains tax problem on a sale when the assets had increased in value from probate. [21.23]

4 General conclusion

Ideally, for CGT purposes, the PRs want a high value for the assets because of the tax-free uplift, whereas in the case of estates where IHT is payable they want as low a value as possible. Generally since IHT will be levied on the entire value not just on the gain, a low valuation is usually desirable unless the assets in question qualify for business property relief or agricultural property relief. [21.24]-[21.40]

III CGT LOSSES OF THE DECEASED

Losses of the deceased in the tax year of his death must be set against gains of that year. Any surplus loss at the end of the year of death can be carried back and set against chargeable gains of the deceased in the three tax years preceding the year of death, taking the most recent year first (TCGA 1992 s 62(2): for the treatment of such losses in calculating taper relief, see [19.63]). Any tax thus reclaimed will, of course, fall into the deceased's estate for IHT purposes! Losses are not set against the gains of any year if and to the extent that they would cause the basic annual capital gains tax exemptions to be wasted. [21.41]-[21.60] [*515]

IV SALE OF DECEASED'S ASSETS BY PRS

1 Rate of tax

A sale of the deceased's chargeable assets by his PRs is a disposal for CGT purposes and will be subject to CGT on the difference between the sale consideration and the market value at death (less any available taper relief accrued since death). PRs paid tax at a rate of 34% until 6 April 2004. For disposals on or after that date, the rate of tax has been increased to 40%. These rules apply even if the beneficiaries under the will would not themselves be subject to CGT (typically UK charities). In appropriate cases, therefore, assets should be vested in the beneficiary before sale (see [21.105]). In December 2003 four discussion papers were issued by the Revenue intended to prompt debate about the tax regime for trusts and estates.

As a result of the responses received, a consultation document was published in August 2004 making more definite proposals. Various changes to the way in which chargeable gains of estates are taxed (a subject which is discussed further at [21.105] below) were suggested. In the discussion papers issued in December 2003, one idea had been to stream gains through to beneficiaries where the proceeds of the sale were passed on to them within a reasonable period but this proposal was abandoned as too complex. The second idea was to allow PRs to make an election to be treated as though the asset disposed of had been transferred to the beneficiary immediately before the disposal. This would be very useful if the PRs needed to retain some assets or their net sale proceeds in order to pay inheritance tax liabilities but nevertheless wanted a beneficiary to be able to take advantage of his or her exempt tax status or personal reliefs.

This idea was also abandoned by the Government. Instead the last proposal was that for the year of death and the subsequent two tax years, there would be a capital gains tax rate of 20% up to a capped limit for PRs combined with the individual annual exempt amount. The 20% rate would often be lower than a beneficiary's personal rate of tax but it would not help PRs deal with exempt residuary beneficiaries such as charities (see below). The proposals were thought likely to come into effect from 6 April 2006 but, in fact, while most of the other trust modernisation changes have been implemented in FA 2006 the proposals for deceased estates have been put on hold. [21.61]

2 Deductions and allowances

a) Incidental expenses

The normal deductions for the incidental expenses of sale are available and PR8 can deduct an appropriate proportion of the cost of valuation of the estate for probate purposes (IRC v Richards' Executors (1971) and see Administrators of the Estate of Caton v Couch (1997)). Although HMRC publish a scale of allowable expenses for the cost of establishing title (see SP 8/94), PRs may claim to deduct more than the 'scale' figure when higher expenses have been incurred. [21.62] [*516]

b) Indexation and taper

For deaths before April 1998, the PRs enjoyed the benefit of the indexation allowance. As with individuals that relief has now been replaced with taper relief (see Chapter 20) and the position for PRs is as follows:

(1) On the sale of an asset business taper will be available provided that it was used for the purposes of a trade carried on by the PRs or by a qualifying company (TCGA 1992 Sch Al para 5(4)). In the case of disposals before 6 April 2000, shares were business assets if the company was a trading company and the PRs had 25% of the voting rights. With the changes in the definition of business assets in FA 2000 all shareholdings in unlisted trading companies are now business assets (TCGA 1992 SchAlpara 6(3)).

(2) On a disposal by a legatee for the purposes of calculating his period of ownership he is treated as acquiring the asset at the date of death (TCGA 1992 s 62(4)(b)) thus extending his qualifying holding period. For taper relief purposes, the period of ownership by the PRs can be incorporated within the legatee's period so as to increase the amount of business taper available if the PRs would have qualified for business assets taper relief in their own right. (TCGA 1992 Sch Al paras 4(5)) and 5(5)). However, the legatee's rate of taper can be adversely affected if the PRs do not qualify for taper relief. [21.63]

EXAMPLE 21.9

In 1999 Marx left 10% of the shares in CP Ltd to the managing director, Engels. The shares are vested in Engels two years after Marx's death and he promptly sells them. Although Engel's ownership period is related back to Marx's death and despite the fact that in his hands the shares would have qualified for business taper, for Engels to get business taper the PRs would have needed to qualify during the two-year administration and before April 2000 because they held less than 25% of the shares in Marx Ltd they did not qualify. From April 2000 the shares were business assets: accordingly this is a case where Marx's gain will need to be apportioned between business and non-business periods of ownership (see further Example 20.5 for effect of apportionment rules and Capital Gains Tax Reform: The FA 1998-published in November 1998 by the Inland Revenue-at para 2.86).

c) Annual exemption

PRs enjoy an annual exemption from CGT of £8,800 in the tax year of death (for 2006-07) and in each of the two following tax years they receive the annual CGT exemption applicable to individuals. Thereafter they have no exemption, so that if it is intended to sell property in the estate and that sale will result in a chargeable gain, it may be advantageous to vest the asset in the appropriate beneficiary for him to sell. This will ensure that the beneficiary's annual exemption and personal losses (if any) will be available to reduce the chargeable gain. Now that the rate for disposals by PRs is 40% rather than 34% there may be little advantage in their making the disposal unless they have significant losses. The facts of each case have to be examined. [21.64]

EXAMPLE 21.10

(1) Dougali died in May 2001. In June 2005 a valuable Ming vase then worth £100,000 (probate value in 2001 £40,000) is to be sold. Administration of the [*517] estate has not been completed. The proceeds of sale will be split equally between Dougall's four children. The following possibilities should be considered:

(a) the PRs could first appropriate the vase to the four children who could then sell it taking advantage of four CGT annual exemptions (£34,000 in all being £8,500 each in 2005-06). The resultant gain. (say £26,000) is attributed equally (£6,500 per child) and taxed at the appropriate rate on the child which may be less than 40% if they are not higher rate taxpayers. Accordingly, maximum total tax bill will be £10, 40&, or

(b) the PRs could themselves sell the vase and realise gains of £60,000. No annual exemption will be available and the rate of CGT will be 40%. Accordingly, the maximum tax bill will be £24, 000.

(2) Continuing Example 21.1, if the PRs sell the book in March 2005 for

£130,000, they have made a gross gain of £30,000 from which they can deduct their annual exemption for 2005-06 of £8,500 (if unused), the incidental expenses of sale and a proportionate part of the cost of valuing the estate for probate in November 2003. No taper relief will be available.

(3) Different issues arise when an asset is to be sold and the residuary beneficiary who will be entitled to all or the bulk of the proceeds of sale is not subject to CGT (eg because they are a UK charity or non-UK-resident): see [21.105] and [53.411.

3 The principal private residence

Where PRs dispose of a private dwelling house which, both before and after the death, was occupied by a person who is entitled on death to the whole, or substantially the whole, of the proceeds of sale from the house, either absolutely or for life, PRs were by concession given the benefit of the private residence exemption from CGT (ESC D5 and for principal private residence exemption, see Chapter 23). The concession addressed the sort of situation where a house-owner died and his widow and perhaps some children occupied the house. 'Substantially the whole' meant 75% of the proceeds. The concession did not cover disposals of part of the house or an interest in the house or grounds. Nor did it help the child who moved into the house after the death of the mother.

FA 2004 now gives statutory force to the ESC and ensures that the position for PRs is more consistent with the capital gains tax exemption available to trustees under TCGA 1992 s 225. Schedule 22 provides that relief is available if the people who occupied the house immediately before and after the death are together entitled to at least 75% of the net proceeds of disposal. Disposals of part are covered [21.65]-[21.80]

EXAMPLE 21.11

Bill and his brother Ben live in Bill's house. On his death Bill leaves the house to Ben who goes on living in it. The property has to be sold by the PRs to pay for Bill's funeral. Any gain will be exempt.

V LOSSES OF THE PRS

Losses made by the PRs on disposals of chargeable assets during administration can be set off against chargeable gains on other sales made by them. Any [*518] surplus losses at the end of the administration period cannot be transferred to beneficiaries (contrast losses made by trustees on a deemed disposal under TCGA 1992 s 71 which can in certain limited circumstances be passed to a beneficiary when the trust ends: [25.45]). Accordingly, when PRs anticipate that a loss will not be relieved, they may prefer to transfer the loss-making asset to the relevant beneficiary so that he can sell it and obtain the loss relief. If PRs do realise losses then they should ensure that they sell an asset that shows a gain before the administration of the estate is complete in order to fully utilise the loss relief. Even if the asset has not been formally assented to a beneficiary, if the administration of the estate is complete and residue ascertained, HMRC may argue that the loss is not allowable against the gain realised later on the basis that the disposal is being done by the PRs as bare trustees for the beneficiaries and at their direction. See HMRC Capital Gains Manual 30730. [21.81]-[21.100]

VI TRANSFERS TO LEGATEES (TCGA 1992 s 62(4))

1 Basic rule

On the transfer of an asset to a legatee, the PRs make neither a gain nor loss for CGT purposes and the legatee acquires the asset at the PRs' base value together with the expenses of transferring the asset to him. The base cost will in appropriate cases be a fraction of the probate value: for instance, if a 60% shareholding (valued at death as a majority holding) was split between the deceased's four sons each would receive a 15% holding with a base cost equal to one-quarter of the probate valuation of the 60% holding. [21.101]

EXAMPLE 21.12

The PRs transfer the book (see Example 21.1) to the legatee (L) under the will in March 2006 when it is worth £130,000. The cost of valuing the book as a part of the whole estate in November 2005 was £1,000 and the PRs incurred incidental expenses involved in the transfer of the book in March 2006 of £150. L sells the book inJuly 2006 for £140,000. On the transfer by the PRs to L, no chargeable gain accrues to the PRs and L's base cost is:

. £

Market value at death 100,000

Valuation cost 1,000

Expenses of transfer 150

Base cost of L £101,150

When L sells the book in July 2006 for £140,000 he is charged to CGT on his gain that is £38,850 (fl40,000 -£101,150) as reduced by any allowable expenditure that he has incurred or available annual CGT exemption. (No taper relief will be available given that the PRs and L have not together owned the book for three years.)

2 Who is a legatee?

A legatee is defined in TCGA 1992 s 64(2) as any person taking under a testamentary disposition or on intestacy or partial intestacy, whether benefi-[*519]-cially or as a trustee. This definition covers only property passing under the will or on an intestacy to a beneficiary so that to the extent that a beneficiary contracts with the PRs to purchase a particular asset or to obtain a greater share in an asset he is not taking that asset qua legatee. In EG Manual 30772 HMRC cite Passant v Jackson (1986) as authority for the view that, where a residuary legatee pays some balancing sum to the executors in order to acquire a property in the deceased's estate, he does not acquire the asset qua legatee. However, in the author's opinion, Passant is not authority for this view. In that case, a residuary legatee wished to retain a property worth more than the net value of the estate. He paid the executors a balancing payment to cover the shortfall and they executed an assent in his favour. On a subsequent disposal, the legatee sought to include both the probate value of the property and the sum he paid to the executors in his acquisition cost but this claim was rejected. However, the court said nothing to suggest that on the original acquisition by him from the executors he did not acquire qua legatee. He was not allowed to include the cash sum he paid the executors to reduce the overall gain on the later sale, but that is a very different point. The HMRC Manual seems incorrect on this point: see CG30772.

A donatio mortis causa is treated for these purposes as a testamentary disposition and not as a gift, so that the douce acquires the asset at its market value on the donor's death and the donor is not treated as having made a chargeable gain. [21.102]

3 Taking under a will trust

Difficult questions may arise when a person receives assets under a trust created by will or under the intestacy rules. Does he receive them as a legatee (in which case there is no charge to CGT) or as a beneficiary absolutely entitled as against the trustee, in which case there is a deemed disposal under TCGA 1992 s 71 which may be chargeable if the property has increased in value (see Chapter 25)? The answer depends upon the status of the PRs (have they turned into trustees at the relevant time?) and the terms of the will (see Cochrane's Executors v IRC (1974) and IRC v Matthew's Executors (1984)).

During the course of administration PRs are the sole owners of the

deceased's assets, albeit in a fiduciary capacity (Stamp Duties Comr (Queensland) v Livingston (1965)) so that there is no trust of particular assets at that time (although the beneficiaries will own a chose in action). Accordingly, if, before the completion of administration or the vesting of assets in themselves as trustees (whichever first occurs), the property ceases to be settled for CGT purposes, when it is transferred to the relevant beneficiary he will take qua legatee (see Example 21.13(2) below and Marshall v Kerr (1994) at [21.124]). [21.103]

EXAMPLE 21.13

(1) T dies leaving his house to executors on trust for his three children all of whom are over 18, in equal shares absolutely. Whether the children receive the assets before the administration is completed or after the executors have assented to themselves as trustees does not matter since they take as legatees. [*520] For CGT purposes joint ownership does not result in the property being settled (TCGA 1992 s 60: see further Chapter 25).

(2) T dies in 2006 leaving his property to executors on trust for his widow for life and then for his three children absolutely, all of whom are over 18. If the widow dies before the executors become trustees, any distributions to the children will be received by them as legatees since, for CGT purposes, the trust ended on the widow's death. If, however, the widow dies after the executors have become trustees, the property is settled, so that the children receive assets as persons absolutely entitled as against the trustees with a consequent deemed disposal under TCGA 1992 s 71 (there will be no charge in this case because the event leading to their entitlement was the death of the life tenant: contrast the position if the interest had terminated inter vivos-see Chapter 25).

(3) Z leaves his residuary estate on discretionary trusts. Within two years of his death the assets are distributed amongst his children so that:

(a) for 11-IT purposes, IHTA 1984 s 144 ensures that the distributions are 'read back' into Z's will (see [30.145]);

(b) although holdover relief under TCGA 1992 s 260 will not be available (see [24.61]), provided that the children become entitled during the administration period and the assets are not vested in the trustees first, HMRC accept that the children will take qua legatees. Furthermore HMRC's view is that such appointment is not a disposal of a chose in action of the legatee (which would be disastrous since such chose would have a nil base cost). See Taxation Practitioner, September 1995, p 23.

4 The deceased's main residence

When the former matrimonial home of the deceased passes to his surviving spouse there is an uplift in the base value of the property on death in the usual way. On a subsequent disposal by that spouse, any gain since death will be exempt from CGT if the house has been occupied as that spouse's main residence. Even if it has not, by virtue of ICTA 1992 s 222(7), the deceased's period of ownership is deemed to be that of the surviving spouse in deciding what proportion of the gain (if any) is chargeable (see [23.82]). [21.104]

EXAMPLE 21.14

T bought a house in 1996 for £50,000. It was his main residence until his death in 2000 when it was worth £150,000. His wife (W) whom he married just before his death never lived there with him, but became entitled to the house on his intestacy. T's administrators transferred the house to Win 2001. She occupied it as her main residence since T's death until 2002 and then went abroad until 2006 when she returned and sold the house for £250,000.

For the purpose of the main residence exemption, W can claim that she has occupied the house as her main residence for nine out of the ten years that it has been in the ownership of herself or T, ie:

1996-2000 (4 years) Occupied by T as his main residence

2000-2002 (2 years) Occupation by W.

2002-2006 (4 years) Abroad from 2002 but last three years of ownership disregarded (TCGA 1992 s 223(1))

W is, therefore, charged on a proportion of the gain: [*521]

1) Sale consideration (250,000) - base cost (150,000) = £100,000 (assuming no other allowable expenses).

(2) Fraction chargeable: £100,000 x = £10,000.

Were it not for s 222(7), she would be charged on a larger proportion of the gain, ie:

. 1

. £100,000 x -------------------------------- = 16,667

. 6 (length of her ownership)

Of course if the husband had not occupied it during his period of ownership then s 222(7) could prove disadvantageous to the wife because then her period of ownership would be 10 years of which only half would qualify for principal private residence relief.

5 Exempt legatees

Assume that the estate includes land which is showing a substantial gain over probate value and which is to be sold. The relevant beneficiary is a UK charity. If the PRs sell the land in the course of the administration, tax at a rate of 40% will be payable: by contrast if the land is assented to the charity which sells it no CGT will be payable (see TCGA 1992 s 256). In cases where the estate is to be divided amongst several charities the PRS may appropriate the assets in partial satisfaction of the charities' entitlement and hold it as bare trustees for those charities. The sale will then be taxed on the basis that it was by the charities so that the s 256 exemption will apply (for the CGT treatment of bare trusts, see [25.3]). Note also the following:

(1) similar considerations apply if the legatee is non-UK-resident and so outside the CGT net;

(2) what if the PRs need part of the sale proceeds (eg to pay administration costs). Consider vesting the asset in the charity (eg by declaration of trust) but subject to a lien in favour of the PRs. Does this mean the sale proceeds are not entirely applied for charitable purposes so that the capital gains tax exemption under s 256 is denied? It is suggested that the PRs may want to ensure that, where the estate comprises a variety of assets, some are advanced separately to the charities and only these are made subject to the lien with the balance being taken by the charities free of any lien. That at least minimises the risk.

If the assets are vested in the charity, HMRC require evidence that the charity has approved the sale and complied with the provisions of the Charities Act 1993.

There are other options but none are straightforward and unfortunately FIMRC appear to have abandoned the idea of allowing PRs to elect for disposals to be taxed as if made by legatees. [21.1051-[21.120]

VII DISCLAIMERS AND VARIATIONS (TCGA 1992 s 62(6))

1 Basic rule

Subject to conditions, which are the same as for IHT (see [30.153]), any variation of the deceased's will or of the intestacy rules, or any disclaimer, made in both cases within two years of the deceased's death may be treated: [*522]

(1) as if it were not a disposal (s 62(6) (a)); and

(2) as if it had been effected by the deceased or, in the case of a disclaimer, as if the disclaimed benefit had never been conferred (s 62(6) (b)).

As with inheritance tax, the instrument must be made in writing within two years of the death and the variation (or disclaimer) must not be made for consideration in money or money's worth other than consideration consist- ing of the making of a variation or disclaimer in respect of another of the dispositions. The variation can be made regardless of whether the adminis- tration of the estate is complete or whether the property has already been distributed in accordance with the original disposition. The same property cannot be subject to more than one variation. [21.121]

EXAMPLE 21.15

A dies leaving a house Blackacre to B and a house Whiteacre to C. B would rather have Whiteacre and C would rather have Blackacre. They enter into a deed of variation such that A is deemed to have left Whiteacre to B and Blackacre to C. Although each one does the variation in consideration of the other beneficiary also varying his interest, this does not prevent reading back.

EXA1LPLE 21.16

Facts as in Example 21.1. L is entitled under T's will to the book worth £100,000. Within two years of T's death L varies the will so that the book (now worth £140,000) passes to his brother B. Provided that the appropriate statement for reading back (formerly election) is made (see [21.122]) this will be treated as if T's will had provided for the book to pass to B. Accordingly, B acquires the asset at its market value at death (1100,000) as legatee plus any additional expenses of the PRs.

2 'Reading back' (TCGA 1992 s 62(7) as amended)

a) The 'reading back' decision

Prior to 1 August 2002 the above treatment did not apply to a variation unless the person or persons making the instrument so elected within six months of the instrument (or such longer period as the Board may allow). From that date the requirement for a separate election was abolished: if 'reading back' is desired the instrument of variation itself must now so provide. [21.122]

b) To read back or not

In many cases, it will be desirable that the variation is read back for both CGT and IHT purposes. This is not necessary, however, since the decisions are independent of each other with the result that a taxpayer may decide to read back for IHT purposes without doing so for CGT and vice versa. Careful thought should be given to this problem. Consider the following: [21.123]

EXAMPLE 21.17

(1) A will leaves quoted shares worth £100,000 to the testator's daughter. She transfers the shares within two years to her mother (the testator's surviving spouse). The shares are then worth £106,000. [*523]

For IHT reading back will be desirable as the result will be to reduce the testator's chargeable estate at death by £100,000 since the shares are now an exempt transfer to a surviving spouse.

For CGT the election to read the disposal back should not be made since, if the daughter makes a chargeable disposal, her gain will be £106,000 - £100,000 = £6,000 which will be more than covered by her annual CGT exemption. Her mother will then acquire the shares at the higher base cost of £106,000.

(2) A will leaves quoted shares worth £100,000 to the testator's surviving spouse.

Alter they have risen in value to £140,000 she decides (within the permitted time limit) to vary the will in favour of her daughter. For IHT it is debatable whether the disposition should be read back. If it is, £100,000 will constitute a chargeable death transfer so that, assuming that the nil rate hand has already been exhausted, tax will be charged at 40%. If it is not, the widow will make a lifetime gift of 1140,000 that, if she survives by seven years, will be free of all tax. On the other hand, if it is likely that she will only survive her husband by a few weeks, then it will be necessary to consider whether it is better for £100,000 to be taxed as part of her dead husband's estate or for £140,000 to be taxed on her death. For CGT the disposal should be read back into the will since otherwise there will be a chargeable gain of £140,000 - £100,000 = £40,000. Generally reading back is desirable for capital gains tax purposes when the administration of the estate is not completed in order to avoid certain 'chose in action' problems. See HMRC Capital Gains Manual 31900 onwards for a somewhat puzzling interpretation of the position.

3 Marshall v Kerr (1994)

a) The issue

The testator died in 1977 domiciled in jersey and Mrs Kerr (UK-resident and domiciled) became entitled to one half of the residuary estate. By a deed of family arrangement executed in January 1978 made before the administration of the estate had been completed, her half share was to be retained by the PRs (ajersey resident company) as trustees for, inter alia, Mrs Kerr. In due course gains were realised by those trustees and capital advanced to Mrs Kerr. If the settlement had been created by Mrs Kerr then the rules of TCGA 1992 s 87 applied and capital payments made to her attracted a CGT charge (see chapter 27). Given that she had transferred property to trustees, on general principles she would be treated as the settlor of that trust: but was this conclusion displaced by the deeming provision in s 62(6) whereby if a variation is made within two years of death-provided that the appropriate election is made-it takes effect 'as if the variation had been effected by the deceased'? [21.124]

The Inland Revenue successfully argued in the House of Lords that Mrs Kerr rather than the deceased was the settlor for capital gains tax purposes. [21.125]

EXAMPLE 21.18

Boris, domiciled in France, leaves his villa in Tuscany and moneys in his Swiss bank account to his son Gaspard, UK-resident and domiciled. By a variation of the terms [*524] of his will made within two years of Boris' death, the property is settled on discretionary trusts where the trustees are resident in Jersey for the benefit of Gaspard and his family.

For IHT purposes, reading hack ensures that the settlement is of excluded property. Hence on Gaspard's death the trust is not subject to UK tax and there is no ten-year anniversary or exit charge provided that no UK situs assets are held on those dates (see [35.5]).

For CGT purposes, the settlement has been created by Gaspard, a UK-resident domiciliary, so that the charging provisions in TCGA 1992 s 86 ff (see Chapter 27) will apply given that he and other defined persons can benefit from the trust.

For income tax purposes, the settlement has been created by Gaspard and as he and his wife can benefit all trust income will be taxed on him wherever the trustees are resident or the assets are sited.

Note that there is no need for the Trustees to be non-resident to obtain continuing favourable inheritance tax treatment-the requirements for excluded property for inheritance tax purposes are simply that Boris the settlor must not be UK domiciled or deemed domiciled at his death (when he is treated as establishing the trust) and that the assets are non-UK situs. Hence for capital gains tax reasons it may be easier to have UK-resident trustees in order to avoid any offshore tax implications although Gaspard will still be subject to capital gains tax on any trust gains and to income tax on trust income, this time under TCGA 1992 s 77 and ITTOIA 2005 s 625 respectively.

The case does not affect the IHT treatment of instruments of variation and disclaimer: see RI 101 (February 1995).

In any event the whole question of who is the settlor has now been put on a statutory footing. Schedule 12 of the Finance Act 2006 introduces statutory provisions on identification of the settlor where there is a variation of a will or intestacy -- see s 68C TCGA 1992 as amended. If property becomes settled property as a result of the variation, the person making the variation is treated as the settlor. If property was already settled under the will or intestacy and then becomes comprised in another trust as a result of the variation, the deceased person, not the person making the variation, is treated as the settlor for capital gains tax purposes. This is presumably on the basis that if several persons act to vary their entitlements under a will trust and settle the assets in a new trust, it would be difficult to establish who is the settlor. The position is unclear where a variation merely amends or varies a will trust rather than transferring the property to a new settlement or where the person making the variation, eg the life tenant, simply varies their own interest under the settlement. Does the settled property then become comprised in a new trust? Is the life tenant the settlor of the new trust? Suppose the life tenant assigns her interest to a discretionary trust under which income is rolled up. If the trustees then make gains, it would appear that she is not taxed on those gains even though she may be a beneficiary under the trust.

The drafting is in so-called plain English and, as frequently seems to be the case, leaves something to be desired in terms of clarity. [21.126]

22 CGT-exemptions and reliefs

Written (in part) and updated by Natalie Lee, Barrister, Senior Lecturer in Law, University of Southampton

I Miscellaneous exemptions [22.2]

II Chattels [22.21]

111 Debts [22.41]

IV Business reliefs [22.71]

In many cases a gain on the disposal of an asset will not be chargeable either because the gain itself is exempt or because the asset is not chargeable. Even if a gain is chargeable, there are various reliefs whereby the tax can be ininimised or deferred indefinitely. As already noted at [19.87], there is an annual exemption for an individual whose gains do not exceed £8,800 (for 2006-07) in the tax year; trustees are generally entitled to half of the exemption available to individuals: ie £4,400 unless they are trustees of settlements for the disabled when they enjoy the same exempt amount as individuals (see [19.89]). The principal private residence relief is considered in Chapter 23. [22.1]

I MISCELLANEOUS EXEMPTIONS

Exempt assets Certain assets are not chargeable to CGT. The taxpayer, therefore, realises no chargeable gain or, often more significantly, no allowable loss on their disposal.

Non-chargeable assets include sterling (TCGA 1992 s 21), National Savings Certificates, Premium Bonds and Save As You Earn deposits (s 121), and private motor vehicles (s 263). Gains and losses arising on the disposal of investments in a Personal Equity Plan and an Individual Savings Account are disregarded. [22.2]

Exempt gains The following gains are exempt from CGT:

(1) damages for personal injuries and betting winnings (s 51 and see ESC D33);

(2) gains on the disposal of decorations for valour unless the decoration was acquired for money or money's worth (s 268);

(3) gains on the disposal of foreign currency obtained for private use (s 269). A foreign currency bank account is a chargeable asset (a debt) unless the sum in that account was obtained for the personal expenditure of an individual or his family outside the UK (s 252). Where several accounts in a particular foreign currency are owned by the same [*526] of his will made within two years of Boris' death, the property is settled on discretionary trusts where the trustees are resident in jersey for the benefit of Gaspard and his family.

The case does not affect the IHT treatment of instruments of variation and disclaimer: see RI 101 (February 1995).

The drafting is in so-called plain English and, as frequently seems to be the case, leaves something to be desired in terms of clarity. [21.126]

22 CGT-exemptions and reliefs

Written (in part) and updated by Natalie Lee, Barrister, Senior Lecturer in Law, University of Southampton

I Miscellaneous exemptions [22.2]

II Chattels [22.21]

111 Debts [22.41]

IV Business reliefs [22.71]

In many cases a gain on the disposal of an asset will not be chargeable either because the gain itself is exempt or because the asset is not chargeable. Even if a gain is chargeable, there are various reliefs whereby the tax can be minimised or deferred indefinitely. As already noted at [19.871, there is an annual exemption for an individual whose gains do not exceed £8,800 (for 2006-07) in the tax year; trustees are generally entitled to half of the exemption available to individuals: ie £4,400 unless they are trustees of settlements for the disabled when they enjoy the same exempt amount as individuals (see [19.89]). The principal private residence relief is considered in Chapter 23. [22.1]

I MISCELLANEOUS EXEMPTIONS

Exempt assets Certain assets are not chargeable to CGT. The taxpayer, therefore, realises no chargeable gain or, often more significantly, no allowable loss on their disposal.

Exempt gains The following gains are exempt from CGT:

(1) damages for personal injuries and betting winnings (s 51 and see ESC D33);

(2) gains on the disposal of decorations for valour unless the decoration was acquired for money or money's worth (s 268);

(3) gains on the disposal of foreign currency obtained for private use (s 269). A foreign currency bank account is a chargeable asset (a debt) unless the sum in that account was obtained for the personal expenditure of an individual or his family outside the UK (s 252). Where several accounts in a particular foreign currency are owned by the same [*528] He sells all three paintings at different times to his sister B for £6,000 each. He thereby appears to fall within the chattel exemption on each disposal. The Revenue can, however, treat the three disposals as a single disposal of an asset worth £30,000 with a base value of £12,000 so that A has made a gain of £18,000.

III DEBTS

1 What is a debt?

A debt is a chargeable asset (TCGA 1992 s 21). It is not defined and bears the common law meaning of 'a sum payable in respect of a liquidated money demand recoverable by action' (Rawley v Rawley (1876)). It can include a right to receive a sum of money that is not yet ascertained (O'Driscoll v Manchester Insurance Committee (1915)) or a contingent right to receive a definite sum (Mortimore v IRC (1864)). However, for the purposes of CGT, it cannot include a right to receive an uncertain sum at an unascertained date; there must be a liability, either present or contingent, to pay a sum which is ascertained or capable of being ascertained at the time of disposal (Marren v Ingles (1980): see [19.26]). [22.41]

EXAMPLE 22.3

Barry agrees to sell his Ming vase to Bruce for £15,000 plus one half of any profits that Bruce realises if he resells the vase in the next ten years. The disposal consideration received for the vase is £15,000 plus the value of a chose in action. As that chose is both contingent (on resale occurring) and for an unascertained sum (half of any profits) it is not a debt. The chose in action is a separate asset and a CGT charge may arise on its disposal (see [19.261 and note that if that disposal results in a loss, relief may be available against gains of earlier years: see TCGA 1992 s 279A-D inserted by FA 2003).

2 The general principle

A disposal of a debt by the original creditor, his personal representatives or legatee is exempt from CGT unless it is a debt on a security (see [21.44]).

'Disposal' includes repayment of the debt (TCGA 1992 s 251). Since a contractual debt will normally give a creditor merely the right to repayment of the sum lent, together with interest, the disposal of a debt will rarely generate a gain and the aim of s 251 is to exclude the more likely claim for loss relief, particularly where the debt is never repaid. This provision only applies to the original creditor so that an assignee of a debt can claim an allowable loss if the debtor defaults, unless the assignee and the creditor are connected persons (s 251(4)).

If the debt is satisfied by a transfer of property, that property is acquired by the creditor at its market value. Since this could operate harshly for an original creditor who can claim no allowable loss, s 251(3) provides that on a subsequent disposal of the property, its base value is taken as the value of the debt. [22.42] [*529]

EXAMPLE 22.4

A owes B £30,000 and in full satisfaction of the debt he gives B a painting worth £22,000. B does not have an allowable loss of £8,000. However, if B later sells the painting for £40,000 he is taxed on a gain of £10,000 only (£40,000 -£30,000).

3 Loans to traders

The harshness of TCGA 1992 s 251 is mitigated by s 253, allowing original creditors to claim loss relief in respect of a qualifying loan. The loan must have become irrecoverable and the creditor must not have assigned his rights. Creditor and debtor must not be married to each other nor be companies in the same group. A 'qualifying loan' must be used by a UK-resident borrower wholly for the purpose of a trade (not being moneylending) carried on by him and the debt must not be 'on a security'. The relief is extended to include a loss arising from the guaranteeing of a 'qualifying loan' (see s 253(4) and Leisureking Ltd v Cushing (1993)). [22.43]

4 Debt on a security

The legislation distinguishes between debts that can normally only decrease in value and those which may be disposed of at a profit. It, therefore, provides that a 'debt on a security' is chargeable to CGT even in the hands of the original creditor (TCGA 1992 s 251).

The term 'debt on a security' lacks both statutory and satisfactory judicial0 interpretation despite a number of cases (for instance, Cleveleys Investment Trust Co v IRC (1971); Aberdeen Construction Group Ltd v IRC (1978); W T Ramsay Ltd v IRC (1981)). It has a limited and technical meaning and '[it] is not a synonym for a secured debt' per Lord Wilberforce in Aberdeen Construction Group Ltd v IRC above. The word 'security' is defined in TCGA 1992 s 132(3) as including 'any loan stock or similar security whether of the Government of the UK or elsewhere, or of any company, and whether secured or unsecured'. Despite the word 'including' the Revenue has stated that it regards the definition as exhaustive (see CCAB June 1969 although this is not referred to in EG 53421 which refers to this definition as being 'of limited use').

In Taylor Clark International Ltd v Lewis (1998) Robert Walker J, whose views were upheld by the Court of Appeal, concluded that the basic requirements for a debt on security were:

(1) the debt had to be capable of being assigned; (2) it had to carry interest;

(3) to have a structure of permanence; and (4) to provide proprietary security.

Relief was denied in this case which involved an interest-bearing loan with security from a parent company to its subsidiary. The loan was essentially impermanent and not intended to be marketable or dealt in even though it was assignable. However, the fact that it was in a foreign currency was not significant.

For the Revenue's views on the meaning of a 'debt on security', see CG 33425 and note that for taper relief purposes shares include securities, see TCGA 1992 Sch Al para 22(1) and see [47.40]. [*530] With the introduction of a new regime for the taxation of company loan relationships most debt held by companies has been removed from the capital gains charge: instead profits and losses on such debt together with interest are charged or allowed as income. [22.44]

5 Qualifying corporate bonds

Gains on the disposal of a 'qualifying corporate bond' (which includes most company debentures) are exempt from CGT under TCGA 1992 s 117 (see [41.92]). [22.45]-[22.70]

IV BUSINESS RELIEFS

1 The problems and the taxes

A number of CGT reliefs relate to businesses both incorporated and unincorporated. Their aim is to enable businesses to be carried on and transferred without being threatened by taxation. This chapter is concerned only with CGT reliefs: bear in mind a disposal of a business will normally involve other taxes.

The disposal may be by way of gift (including death) or by sale. If by way of gift, the relevant taxes will be CGT, income tax and IHT. For CGT, hold-over relief under TCGA 1992 s 165 (as amended) may be available on a lifetime gift; on a death, there will be no CGT (sec Chapter 19). Where the transfer is a sale, income tax and CGT may apply.

The CGT business reliefs may apply to a disposal of:

(1) a sole trade/profession;

(2) a part of a trade/profession (eg a partnership share);

(3) shares in a company; and

(4) assets used by a company or partnership in which the owner of the assets either owns shares or is a partner.

In a number of cases relief is given by a deferment of the CGT charge and this is usually done by deducting the otherwise chargeable gain from the acquisition cost of a new or replacement asset (roll-over or hold-over relief). For the Revenue's views on the order of reliefs, see EG 60210. Careful note should be taken of the impact on taper relief when roll-over or hold-over relief applies. [22.71]

2 Roll-over (replacement of business assets) (TCGA 1992 ss 152-159)

a) Basic conditions for relief

Where certain assets of a business are sold and the proceeds of sale wholly reinvested in acquiring a 'new' asset to be used in a business, the taxpayer can elect to roll over the gain and deduct it from the acquisition cost of the new asset. Tax is, therefore, postponed until that asset is sold and no replacement qualifying asset purchased. The new asset must be bought within one year before or three years after the disposal of the old one, and once it is acquired, it must 'on the acquisition' be taken into use for the purposes [*531] of the taxpayer's trade. The Revenue has the power to extend this time limit and, whilst the exercise of the power can be challenged by judicial review, the Commissioners cannot themselves exercise it (Steibeit v Paling (1999)). This point was reiterated in R (on the application of Barnett) v IRC (2004), in which case, it was made clear that, although the Board was under a duty to take into account relevant findings by the Commissioners, the issue of whether the taxpayer had been prevented from re-investing in further property by circumstances beyond his control was a question for the Revenue and it was entitled to conclude that such circumstances did not exist. A gap between the time of acquisition and the time when it is used in the trade will mean that the exemption will not be available (see Campbell Connelly Co Ltd v Barnett (1993) and Milton v Chivers (1996) holding that while 'on the acquisition' did not imply immediacy, it did exclude dilatoriness: see also Joseph Carter & Sons v Baird (1999)). [22.72]

EXAMPLE 22.5

A makes a gain of £50,000 on the sale of factory 1, but he immediately buys factory 2 for £120,000. He can roll the gain of £50,000 into the purchase price of factory 2 thereby reducing it to £70,000 (actual cost £120,000 minus rolled-over gain of £50,000). Note that the gain that is rolled over takes no account of any taper relief that would have been available to A. This important matter is considered further at [21.791.

b) Prior acquisitions of replacement assets

It will be appreciated that the 'new' asset can be acquired before the disposal of the old asset-the Revenue accepts that the requirements are met if 'the old assets, or the proceeds of the old assets, are part of the resources available to the taxpayer when the new assets are acquired'. An important limitation on the relief was, however, confirmed by the Court of Appeal in Watton v Tippett (1997) where the taxpayer, having purchased certain freehold land and buildings (unit 1) for a single unapportioned consideration, within 12 months of that purchase sold part of the same land and buildings (unit IA) and claimed to roll over the gain made on that disposal into the land and buildings retained by him (unit lB). Rejecting this claim the court held that it was critical to identify the asset acquired and disposed of and unit lB had not been acquired as such. The position would have been different if two separate properties had been purchased albeit for a single unapportioned consideration given that this could be apportioned under TCGA 1992 s52(4). [22.73]

EXAMPLE 22.6

If A acquires factory 1 (as in the above example), but almost immediately sells part of it, he cannot roll any gain over into the acquisition cost of the remainder of the factory retained by him. It is a part disposal of a single asset; the consideration for that single asset cannot, according to Watton v Tippett (above), be apportioned.

If A acquires two adjacent factories (1 and 2) at the same time but under separate contracts, and immediately sells factory 2, A can roll over any gain into the acquisition cost of factory 1: this is not a part disposal of a single asset, but rather a disposal of a severable part of the taxpayer's assets, with separate [*532] consideration attributable to the 'old' asset (factory 2) and 'other' assets (factory 1). Note that s 152 does not as such require 'new' assets to be acquired; rather it refers to the consideration being applied in acquiring other assets (and see, for instance, ESC D22 permitting expenditure on improvement to existing assets).

c) Qualifying assets

The assets must be comprised in the list of business assets in TCGA 1992 s 155. These are land and buildings; fixed plant and machinery; ships; aircraft; hovercraft; goodwill (for a discussion of whether part of a taxpayer's chargeable gains related to the sale of goodwill, see the Special Commissioners decision in Balloon Promotions Ltd v Wilson (2006)); satellites, space stations and spacecraft; milk and potato quotas, fish quota, the EU quotas for the premium given to producers of ewes and suckler cows and payment entitlements under 'the single payment scheme' (a new system of support for farmers under the EU Common Agricultural Policy). This list can be added to by Treasury Order. The old and new assets need not be of the same type, however, eg a gain on the sale of an aircraft can be rolled over into the purchase of a hovercraft. Further, although the old asset must have been used in the taxpayer's trade during the whole time that he owned it (otherwise only partial roll-over is allowed), it could have been used in successive trades provided that the gap between them did not exceed three years. [22.74]

EXAMPLE 22.7

A inherited a freehold shop in 1989 when its value was £36,000. The shop was kept empty until 1993 when he started a fish and chip shop. He sold the shop in 2006 for £60,000 and purchased new premises for £75,000.

His total gain in 2006 (excluding indexation) is £24,000 and the premises have been used for business purposes during twelve-sixteenths of the ownership period. Hence £18,000 of the gain is rolled over but the balance (6,000) is taxed.

d) Occupation for business purposes

The assets that are sold must be occupied as well as used for the purposes of the taxpayer's business. If the property is occupied by his partner or employee, he must be able to show that their occupation is representative (ie attributed to him) to obtain the relief. For occupation to be representative it must either (1) be essential for the partner or employee to occupy the property to perform his duties; or (2) be an express term of the employment contract (or partnership agreement) that he should do so, and the occupation must enable him to perform his duties better. If either of these conditions is proved, the Revenue accepts that the property is used for the purpose of the owner's trade (see Anderton v Lamb (1981)). The new asset need not be used in the same trade as the old but can be used in another trade carried on by the taxpayer simultaneously or successively, provided in the latter case that there is not more than a three-year gap between the ceasing of one trade and the start of another (see SP 8/81). There is nothing to prevent the taxpayer from rolling his gain into the purchase of more than one asset or to require him to continue to use the new asset in a trade throughout his period of ownership. ESC D22-25 extend the [*533] relief, inter alia, to cover improvements to, or capital expenditure to enhance the value of, existing assets; the acquisition of a further interest in an asset already used for the purposes of the trade; and the partition of land on the dissolution of a partnership. [22.75]

e) Non residents and foreign assets

Relief is not available to a non-UK resident who sells a chargeable asset (ie one used in a trade carried on through a UK branch or agency) and then purchases a new asset that is not chargeable because it is situated outside the UK (TCGA 1992 s 159). Relief is, however, available if he acquires further UK branch or agency assets and is also given to a UK resident who rolls over into the acquisition of a qualifying asset wherever situated (and even though he may be non resident at the time of acquisition: see EG 60253). [22.76]

f) Partnerships, companies and employees

This relief is available to partnerships and to companies and it can be claimed for an asset that is owned by an individual and used by his partnership or personal company. In such cases, however, the relief is only available to the individual and the replacement asset can not be purchased by the partnership or company (Casseli v Crutchfield (No 2) (1997)). Employees may claim the relief for assets owned by them so long as the assets are used (or, in the case of land and buildings, occupied) only for the purposes of the employment. (Note, however, that it is not necessary for the asset to be used exclusively by the employee in the course of his employment so that relief may apply even if the asset is provided for the general use of the employer: see SP 5/86.) [22.77]

g) Restrictions on the relief

There are certain restrictions on the relief.

First, if the new asset is a depreciating asset (defined as a 'wasting asset' -- see [l9.45] -- or one which will become a wasting asset within ten years, such as a lease with 60 years unexpired) the gain on the old asset cannot be deducted from the cost of the new. Instead, tax on the gain is postponed until the earliest of the three following events:

(1) ten years elapse from the date of the purchase of the new asset; or

(2) the taxpayer disposes of the new asset; or

(3) the taxpayer ceases to use the new asset for the purposes of a trade.

ESC D45 exempts from tax gains arising when the new asset ceases to be used in a trade because of the death of the taxpayer.

If, before the deferred gain becomes chargeable, a new asset is acquired (whether the depreciating asset is sold or not), the deferred gain may be rolled into the new asset (see TCGA 1992 s 154).

EXAMPLE 22.8

Sam sells his freehold fish and chip shop for £25,000 thereby making a gain of £12,000. One year later he buys a 55-year lease on new premises for £27,000 and seven years after that acquires a further freehold shop for £35.000. [*434]

(1) Purchase of 55-year lease: this lease is a depreciating asset. The gain of £12,000 on the sale of the original shop is, therefore, held in suspense for ten years.

(2) Purchase of the freehold shop: as the purchase occurs within ten years of the gain, roll-over relief is available so that the purchase price is reduced to £23,000.

Secondly, if the whole of the proceeds of sale are not reinvested in acquiring the new asset there is a chargeable gain equivalent to the amount not reinvested and it is only the balance that is rolled over. Accordingly, if the purchase price of the new asset does not exceed the acquisition cost of the old, all the gain is chargeable and there is nothing to roll over (contrast 'reinvestment relief' which required the gain only to be reinvested: see the reinvestment provisions of the Enterprise Investment Scheme (EIS): Chapter 15). TCGA 1992 s 50 that excludes from the computation of the gain expenditure on the acquisition of an asset met by a public authority, is only applicable in computing any gain arising on a future disposal of the asset. It does not have the effect of reducing the cost of acquisition of the asset with the effect of limiting any hold-over relief available (Wardhaugh v Penrith Rugby Union Football Club (2002)). The new asset must, of course, be purchased for use in a business so that if there is an element of non-business user relief will be restricted accordingly.

EXAMPLE 22.9

A buys factory l for £50,000 and sells it for £100,000 thereby making a gain of £50,000. A buys factory 2 for £80,000. The amount not reinvested (£20,000, ie £100,000 - £80,000) is chargeable. The balance of the gain (£30,000) is rolled over so that the acquisition cost of factory 2 is £50,000. If factory 2 had only cost £50,000 the amount not reinvested would equal the gain (ie £50,000) and be chargeable.

In Tod v Mudd (1987) the taxpayer sold his accountancy practice and with his wife bought premises to carry on business as hoteliers in partnership. The premises were bought as tenants in common with a 75% interest being held by Mr Mudd and 25% by his wife and it was agreed that they would be used as to 75% for business purposes and 25% for private purposes. The partnership agreement stated that the business of the partnership should be conducted on that portion of the premises attributable to Mr Mudd's share. The court held that roll-over relief should be given to Mr Mudd but only on 75% of 75% of the purchase price because his interest as a tenant in common constituted a share in the whole property and not in a distinct 75% portion thereof. Accordingly, because of the way in which this arrangement had been structured, roll-over relief was restricted. There are a number of ways in which matters could have been organised so that full relief would have been given to Mr Mudd. First, he could have bought the whole of the new premises for business use and then given 25% to his wife. Secondly, he could have purchased an identified and separate portion of the premises (75% thereof) in his sole name and for business use leaving his wife to purchase the remaining portion for private purposes. Finally, the defective arrangement could have been cured had Mr Mudd bought out Mrs Mudd's 25% share within three years of the disposal of his accountancy practice.

Business reliefs 535

If the taxpayer knows that the price of the new asset will be too low to enable him to claim roll-over (or full roll-over) relief and he is married, it may be advantageous to transfer a share in the old asset to his wife before it is sold although this ruse could be challenged under the Ramsay principle (Chapter 42). [22.78]

EXAMPLE 22.10

H buys factory 1 for £50,000 and transfers 2/5 of it to his wife W. The factory is sold for £100,000. H's gain is £30,000 ([3/5 x £100,000]-[3/5 x £50,000]). W's gain is £20,000 ([2/5 x £100,000]-[2/5 x £50,000]).

H's share of the proceeds of sale is £60,000. H then buys factory 2 for £50,000. The proceeds of sale are not wholly reinvested in factory 2 and, therefore, H is charged to CGT on £10,000 (£60000 - £50,000). The balance of his gain £20,000 (£30,000 - £10,000) can be rolled over, leaving him with a base value for factory 2 of £30,000. H and W between them are taxed on a gain of £30,000 instead of (as in Example 22.9) H being taxed on a gain of £50.000.

h) Problems if the relief is claimed

Roll-over relief should not be claimed where the taxpayer makes an allowable loss on the sale of the old asset since he cannot add this loss to the base value of the new asset. Nor should he claim the relief where the gain does not exceed his annual exemption. Even if his gain does exceed the exempt limit, it may not be worth claiming the relief, as the claim cannot be to hold over only a part of the gain and the effect of rolling over a gain is a loss of accrued taper relief. [22.79]

EXAMPLE 22.11

Unlucky acquires land and buildings for his trade in 1994 at a cost of £200,000. In February 1998 because of pressure on space he disposes of this property for £500,000, acquiring replacement premises in April 1998 for £750,000. The gain he elects to roll over. A similar situation arises in July 2004: the sale proceeds are £1.2m which are ploughed back into new premises costing £1.5m. In May 2006 Unlucky retires selling the premises for £2m. The CGT computations are as follows:

Scenario 1

a) Sale in February 1998

. £ £

Proceeds 500,000

Cost 200,000

Indexation (say) 20,000 (220,000)

. ------- --------

Gain to roll over 280,000

. ========

b) Sale in July 2004

. £ £

Proceeds 1,200,000

Cost 750,000

Less: rolled-over gain 280,000 470,000

. ------- ---------

Gain to roll over 730,000

. =========

[*536]

e) Final sale in May 2006

. £ £

Proceeds 2,000,000

Cost 1,500,000

Less: rolled-over gain 730,000 770,000

. --------- ---------

Chargeable gain 1,230,000

Taper relief by reference to period of ownership of 'new asset' ONLY -- one year.

1,230,000 x (615,000)

50%

. --------

Gain charged £615,000

Notes:

(1) Note that no allowance is made for the period April 1998-July 2004 in the taper relief calculation. Accrued taper is lost on a roll-over (a similar situation occurs on a held-over gain on a gift of business assets (see [24.29])).

(2) Contrast the position if instead of moving, Unlucky had expanded his existing site (eg by building an extension). No loss of taper results: the gain would become:

Scenario 2

. £ £

Proceeds 2,000,000

Cost 200,000

Indexation 20,000

Enhancement (1) 250,000

Enhancement (2) 300,000 770,000

. ------- ---------

Chargeable gain 1,230,000

. ---------

Taper relief (April 1998-May 2005)-7 years

1,230,000 x 75% (922,500)

--------------- ---------

Gain charged £307,500

(3) This problem is either less acute, or may not exist at all, with respect to a disposal of business assets on or after 6 April 2002, when maximum taper relief is available after a holding period of only two years. Accordingly, in scenario 1, had Unlucky retired and disposed of the premises just two months later (in July 2006) the gain, calculated as follows, would be identical to that in scenario 2.

. £ £

Proceeds 2,000,000

Cost 1,500,000

Less: rolled-over gain 730,000 770,000

. --------- ---------

[*537]

Chargeable gain 1,230,000

Taper relief by reference

to period of ownership

of new asset

ONLY -- two years. 1,230,000 x 922,500

. 75%

. ------------

. Gain charged £307,500

. ========

i) Self-assessment and provisional relief where an intention to reinvest

TCGA 1992 s 153A allows taxpayers to obtain provisional relief in advance of the reinvestment of the proceeds from the sale of the assets. At such time as the conditions for the granting of the relief have been satisfied, the provisional relief will be replaced by that actual relief. [22.80]

j) Intellectual property roll-over for companies (FA 2002 Sch 29)

The Government introduced a new code for taxing intellectual property, goodwill and other intangible assets with effect from 1 April 2002. These rules apply only to companies. Under this regime, gains in respect of intangible fixed assets are chargeable to corporation tax as income with relief for the costs of acquiring and enhancing such assets. Included in the provisions is a new reinvestment relief, closely based on CGT roll-over relief (Sch 29 Part 7). Tax on the profits of the disposal of intangible assets within the code are deferred if the proceeds are reinvested in new assets (that are also within the code) within one year before or three years after the disposal of the original asset.

Conditions for relief are:

(1) The old assets must have been used throughout the period of ownership by the company selling them as fixed assets for trading or business purposes. An asset may meet this condition where it was an asset for only part of that period, provided that it was a chargeable intangible asset at the time of realisation and for a substantial part of the period it was held. A 'reasonable' apportionment then produces a separate asset meeting the condition.

(2) The 'new' intangibles must be within the code, and must be similarly used.

(3) The proceeds of disposal of the old assets must exceed their cost. This requirement will always be satisfied on the realisation of assets, such as internally generated goodwill, which have no cost for tax purposes.

Full deferral will only be available when the entire proceeds of the sale of the 'old' intangibles are reinvested; where this is not the case, the profit eligible for relief will be reduced by the amount not reinvested. Where there is a part disposal, eg where a licence is granted to exploit a patent for a period of time, the cost of the asset to be taken into account is reduced to the appropriate proportion'. The appropriate proportion is the cost reduced in the ratio that the reduction in the 'accounting value' (net book value) of the asset on the part disposal bears to the accounting value immediately before the disposal. Where there is a disposal of what is left of an asset following an [*538] earlier part disposal, the cost is the 'adjusted cost', which is obtained by deducting the appropriate proportion of the cost taken into account on the previous part disposal from the original cost. [22.81]

EXAMPLE 22.12

Tech Gear Ltd acquired for £100,000 the patent to TDNA, a by-product of DNA, which the company believes will revolutionise computer technology over the coming years. In September 2005, Tech Gear granted a licence for £80,000 to Quick Systems Ltd for the exploitation of the patent for a period of five years. In July 2006, Tech Gear assigned the patent to the computer giants JCN plc for £200,000.

The part disposal to Quick Systems Ltd

. £ £

Proceeds of part disposal 80,000

Cost for tax purposes of old asset 100,000

Book value immediately prior to disposal 40,000

Book value immediately after disposal 30,000

Appropriate proportion:

£100,000 x (£40,000 -£30,000) = 25,000

----------------------------- ------

. £40,000

Gain 55,000

If expenditure on a new asset exceeds the proceeds from the partial disposal of the old asset (80,000), full reinvestment relief in respect of the gain of £55,000 may be claimed. If, however, expenditure is less than £80,000 but is more than £25,000 (the appropriate proportion), partial relief may be available.

The disposal of the remainder of the asset to JGN plc

. £

Proceeds of disposal 200,000

Adjusted cost: £100,000 - £25,000 75,000

. --------

Gain £125,000

3 Roll-over relief on compulsory acquisition of land (TCGA 1992 s 247)

This form of roll-over relief is limited to the disposal of land (or an interest in land) to an authority exercising or able to exercise compulsory purchase powers. Any gain arising can be rolled over into the cost of acquiring replacement land. Similar restrictions to those which apply to the replacement of business assets roll-over relief (see [21.72]) apply: for instance, the replacement asset must not have a limited life expectancy and, for full relief, all the disposal consideration must be reinvested. Further, reinvestment into property qualifying for the main residence relief is not allowed. [22.82] [*539]

4 Extensions of TCGA 1992 s 247

The Revenue allows s 247 relief to be claimed by landlords when leasehold tenants exercise their statutory rights to acquire the freehold reversion (see revised SP 13/93 and Tax Bulletin, June 1999, p 672) and, by concession, when two or more persons sever their joint interests in land (or in milk or potato quotas: ESC D26). No charge arises irrespective of the s 247 concession when persons pool their resources and subsequently extract their shares from the pool. (See Example 25.3(2) and the cases there cited.) [22.83]

5 Retirement relief

Following a five-year period of phased withdrawal, retirement relief is no longer available for 2003-04 and subsequent years. For details of the relief, reference should be made to earlier editions of this book. [22.84]

Whilst retirement relief has been replaced by taper relief (see Chapter 20), it should be noted that there are cases where the latter will never adequately compensate for the loss of retirement relief. For example, the taxpayer who sold his business in 2002-03 realising a gain of £50,000 would have paid no tax had he satisfied the necessary conditions for retirement relief, however, if he were to sell in 2003-04 or later years, maximum taper relief would merely reduce his chargeable gain to £12,500. In order to avoid that scenario, some taxpayers crystallised retirement relief, eg by settling the business on life interest trusts (a disposal which would have triggered retirement relief) under which the taxpayer was a beneficiary (typically the life tenant) and continued to run the business. [22.85]

One matter that is worthy of note is that where there is an unconditional contract to sell a business entered into before 5 April 2003 (when retirement relief was still available) but not completed until after that date (when relief is no longer available), the operation of ESC D31 will deny retirement relief since the date of completion is treated as the date of disposal. [22.861-[22.98]

6 Postponement of CGT on gifts and undervalue disposals (TCGA 1992 s 165)

This provision is considered in detail in Chapter 24. [22.99]

7 Roll-over relief on the incorporation of a business (TCGA 1992 s 162 and s 162A)

a) The relief

This relief takes the form of a postponement of, rather than an exemption from, CGT. It applies when there is a disposal of an unincorporated business (whether by a sole trader, a partnership, or trustees but not by an unincorporated association) to a company and that disposal is wholly or partly in return for shares in that company. Any gains made on the disposal of chargeable business assets will be deducted from the value of the shares received (the [*540] gain is 'rolled into' the shares) and the relevant assets are acquired by the company at market value (ie there is a 'step-up' in their value). (Note that a similar relief is available for companies which transfer a trade carried on outside the UK to a non-resident company: see TCGA 1992 s 140.) [22.100]

b) Conditions to be satisfied

The business must be transferred as a going concern; a mere transfer of assets is insufficient. Further, all the assets of the business (excluding only cash) must be transferred to the company. As only a gain on business assets can be held over, it will be advisable to take investment assets out of the business before incorporation. The Revenue accepts that 'business' has a wider meaning than 'trade': managing a landed estate would, for instance, qualify as a business (see EG 65712).

EXAMPLE 22.13

On the incorporation of a business in consideration for the issue of fully paid shares, there is a gain on business assets of £50,000. The market value of the shares is £150,000. The gain is rolled over by deducting it from the value of the shares so that the acquisition cost of the shares becomes £100,000 (£150,000 -£50,000). The assets are acquired by the company at market value of (say) £150,000.

Where only a part of the total consideration given by the company is in shares (the rest being in cash or debentures), only a corresponding part of the chargeable gain can be rolled forward and deducted from the value of the shares. That part is found by applying the formula:

. market value of shares

Gain rolled forward = total gain x --------------------------------

. total consideration for transfer

In practice, the assumption of liabilities by the company is not treated as consideration for this purpose (see EG 65746 and ESC D32).

EXAMPLE 22.14

A transfers his hotel business to Strong Ltd in return for £160,000, consisting of £10,000 shares (market value £120,000) and £40,000 cash. The chargeable business assets transferred are the premises (market value £130,000), the goodwill (market value £10,000) and furniture, fixtures etc (market value £20,000). On the premises and the goodwill A makes chargeable gains of £35,000 and £5,000 respectively.

. ( £120,000)

£40,000 - (£40,000 x --------) = £40,000 - £30,000 = £10,000

. ( £160,000)

and the acquisition cost of the shares is £120,000 - £30,000 = £90,000 (ie £9 per share).

Taper relief may be available on a subsequent disposal of the shares if the relevant conditions are satisfied. [22.101] [*541]

c) Deferring tax on the sale of an unincorporated business

If it is desired to sell an unincorporated business s 162 may be used to defer any CGT liability on the sale. The business is first incorporated and s 162 ensures that the vendors will not be subject to CGT until they dispose of their shares in that company. As the company acquires the business assets at market value, however (under TCGA 1992 s 17: see [19.22]), the trade can immediately he resold to the intended purchaser without any CGT charge (see Cordon v IRC (1991)). [22.102]

d) Election to disapply the s 162 roll-over relief

FA 2002 inserted a new s 162A into TCGA 1992 that applies to transfers of a business after 5 April 2002. Provided that the relevant conditions are met the roll-over relief under s 162 had always been mandatory: it is the purpose of s 162A to enable a taxpayer to opt out of that relief. In two cases, in particular, this may be beneficial:

(1) Sid incorporates his business and before two years have elapsed

(ie before he has become entitled to full business assets taper he receives an unexpected offer for the business which he accepts).

(2) Sad agrees to sell his business and as part of the arrangement first incorporates. The sale then falls through. To maximise taper relief prior to 6 April 2002 Sad would have ensured that the conditions of s 162 were not met in order to preserve his entitlement to business assets taper. With the loss of the sale, Sad would be exposed to a CGT charge in the incorporation.

In both cases the arrangements may now he structured so that s 162 relief is given on the incorporation, but the taxpayers may opt out of that relief if this becomes desirable (see also [20.32]).

EXAMPLE 22.15

On 25 April 2006, B incorporates his trade as Y Ltd. He transfers all the assets of the business to the company in consideration for all the shares of Y Ltd. CGT incorporation relief applies.

Incorporation of business

Value of shares received in consideration £650,000

Acquisition cost of assets used in the business Less £200,000

(6 April 1998)

Net chargeable gains on disposal of business assets £450,000 (rolled-over into deemed acquisition cost of shares)

On 20 May 2006, B receives an unexpected offer to sell his shares in Y Ltd.

Sale of shares

Consideration £700,000

Acquisition cost of shares £650,000

less net chargeable gain rolled

Over £450,000

. --------

. £200,000

[*542]

Deemed acquisition cost less £200,000

. --------

Gain chargeable to tax (after less than one year no £500,000

taper relief: 100% of gain chargeable)

Instead B elects on 31 October 2006 for incorporation relief not to apply. Therefore the two disposals above are recalculated as follows.

Transfer of 'unincorporated business

Value of shares received in

Consideration £650,000

Acquisition cost of assets of

business (6 April 1998) less £200,000

Net chargeable gains on disposal

of business assets £450,000

Untapered gain chargeable to tax £450,000

. --------

Gains chargeable (after two years £112,000

business asset taper relief: 25% of gain chargeable)

Sale of shares

Consideration £700,000

Acquisition cost of shares less £650,000

. --------

Untapered gain chargeable to tax £50,000

(after less than one year no taper relief: 100% of gain chargeable)

Total gains chargeable to tax £162,500

The time limits for opting out of s 162 relief are as follows:

(1) If all the shares acquired on incorporation have been disposed of before the end of the tax year following incorporation the election must be made no later than 31 January following the end of the later tax year. (Hence if incorporation is in 2005-06 and the sale occurs in 2006-07, the election has to be made at the latest on 31 January 2008).

(2) In other cases the deadline is extended by one year, ie for an incorporation in 2005-06 to 31 January 2009. This may be attractive because if the shares are sold in 2006-07 full business taper relief may not be available. [22.103]

8 Relief on company reconstructions, amalgamations and takeovers

The relief afforded by TCGA 1992 ss 135-137 in respect of 'paper for paper exchanges' is considered in Chapter 47.

If there is a bonus or rights issue so that the existing shareholders are allotted shares or debentures in proportion to that existing holding, the new securities are treated as acquired when the original shares were acquired. The price for this combined holding will then be the sum originally paid for [*543] the original shares plus whatever is paid for the new securities (TCGA 1992 ss 127-130). Altering the rights attached to a class of shares or the conversion of securities can similarly be achieved without an immediate charge to CGT (TCGA 1992 ss 133-135). [22.104] [*544]

23 CGT-The main residence

Updated by Natalie Lee, Barrister Senior Lecturer in Law, University of Southampton

I When is the exemption available? [23.1]

II Meaning of 'dwelling house' and 'residence' [23.21]

III How many residences can qualify for the exemption? [23.41]

IV Miscellaneous problems [23.61]

V Effect of periods of absence [23.81]

VI Expenditure with a profit-making motive [23.101]

VII Second homes [23.121]

VIII Link up with IHT schemes [23.141]

I WHEN IS THE EXEMPTION AVAILABLE?

The most important exemption from CGT for the individual taxpayer, and the one which probably affects more taxpayers than does any other, is from any gain made on the disposal of the principal private residence (TCGA 1992 ss 222-226). There is no similar relief for IHT purposes; only if the house is a qualifying farmhouse will APR be available on the 'agricultural value' whilst RPR will be given on part of any property used 'exclusively' for business purposes.

The CGT exemption is available for any gain arising on the disposal by gift or sale by a taxpayer of his only or main residence, including grounds of up to half an hectare or such larger area as is required for the reasonable enjoyment of the dwelling house (TCGA 1992 s 222). [23.1]-[23.20]

II MEANING OF 'DWELLING HOUSE' AND 'RESIDENCE'

I Meaning of a 'dwelling house'

What qualifies as a dwelling house is a question of fact. In Makins v Elson (1977) the taxpayer bought land intending to build a house on it. In the meantime, he lived there in a caravan. He never built the house and later sold both land and caravan at a profit. The caravan was held, on the facts, to he a dwelling house; the most significant of these facts being that it was connected to the mains services as well as to the telephone system and that it was resting on bricks so that it was not movable. In contrast, in Moore v Thompson (1986) the court held that since there was no supply of water or electricity, the caravan in question was not a dwelling house. [23.21] [*546]

2 'Residence': a degree of permanence

Although permanent residence is not a condition for the application of relief, a distinction has to be drawn between a permanent residence and temporary accommodation. In Goodwin v Curtis (1998), the taxpayer agreed to purchase (by way of sub-sale) a farmhouse from a company with which he was connected. The purchase by the company was completed on 7 March and the taxpayer put the property on the market at that time, only completing his purchase on 1 April. The taxpayer then occupied the property living there seven days a week and had a telephone connected. On 3 April, however, he completed the purchase of a small cottage to which he moved when he sold the farmhouse on 3 May 1985. The taxpayer paid £70,000 for the farmhouse and sold it for £177,000! The Court of Appeal confirmed the findings of the commissioners that relief was not available notwithstanding the taxpayer's occupation of the property. There was not the required 'degree of permanence, continuity and the expectation of continuity' (to use the language of Vinelott J in the High Court) for the occupation to amount to a residence. According to Millett U, the nature of the taxpayer's personal circumstances together with the size of the house indicated that his occupation was a 'stop gap measure' (in passing it may be suggested that size of the house should not be a factor of any significance: a single person should qualify for relief on an eight-bedroom mansion!). This case demonstrates that the intention of the taxpayer at the time of acquisition is central to the availability of the relief. Where there is a clear intention to reside permanently in a dwelling house, relief will be available even if that intention is thwarted after only a brief period of occupation. However, even actual occupation for a reasonable period may be insufficient to attract the relief where no continuity of occupation is intended. [23.22]

3 A 'residence': the entity test

So far as the term 'a residence' is concerned, a major problem is whether, in any given situation, two or more units can constitute a single residence. Selling a house with additional accommodation available either for staff or aged relatives is not unusual and there now exists a substantial body of case law, but from which no clear or satisfactory guidelines have emerged. In Batey v Wakefield (1982), the first in the series of cases, a separate bungalow within the grounds of the taxpayer's house and found by the General Commissioner as fact to have been used by a caretaker to enable him to perform the duties of his employment with the taxpayer, was considered by the Court of Appeal to be exempt from CGT on its sale. The court concluded that it was necessary to identify the entity that could properly be described as constituting the residence (the 'entity' test). Fox LJ commented:

'in the ordinary use of English, a dwelling house, or a residence, can comprise several dwellings which are not physically joined at all'.

In his view, the fact that the bungalow was physically separate from the main dwelling house was 'irrelevant'.

This was followed by Vinelott J in Williams v Merrykes (1987) who echoed the words of Fox LJ when he summarised the approach to be taken: [*547]

'what one is looking for is an entity which can be sensibly described as being a dwelling house though split into different buildings performing different functions'. [23.23]

4 The curtilage test

However, in Markey v Sanders (1987), Walton J, ignoring the, entity test, indicated that two conditions had to be satisfied: first, that occupation of the secondary' building had to increase the taxpayer's enjoyment of the main house and, secondly, that the other building had to be 'very closely adjacent' to the main building. He decided that a staff bungalow some 130 metres distant from the main residence and standing in its own grounds did not satisfy the second of the two conditions and so could not be treated as part of a single residence, with the result that, on its disposal, CGT was chargeable.

The Court of Appeal had the opportunity to review these decisions in Lewis v Rook (1992) which concerned the sale of a cottage some 200 yards from the main house and which had been occupied by the taxpayer's gardener. Giving the judgment of the court, Balcombe LJ concluded that no building could form part of a dwelling house that included the main house unless the building was 'appurtenant to, and within the curtilage of the main house' (the 'curtilage' test). In applying what he believed to be 'well-recognised legal concepts' in the interpretation of the term 'dwelling house' or 'residence' and rejecting the previous approach of treating the matter as a question of fact, Balcombe LJ concluded that the main residence exemption was inapplicable.

It is a cause for concern that the word 'curtilage' appears nowhere in the CGT legislation, although in other contexts it has been held to mean 'a small area about a building', and that the court appears to be preferring the restrictive approach in Markey v Sanders to the flexibility of Batey v Wakefield and Williams v Merrylees.

Honour v Norris (1992) largely turned on its own facts with the judge rejecting as an 'affront to common sense' the suggestion that a number of separate flats in a square could constitute a single dwelling house.

Revenue thinking in this area was set out in RI 75 August 1994 where it is stated:

'Where more dispersed groups of buildings have a clear relationship with each other they will fall within a single curtilage if they constitute an integral whole. In the Leasehold Reform Act case of Methuen-Campbell v Walters, quoted with approval in Lewn v Rook, the Court held that "for one corporeal hereditament to fall within the curtilage of another, the former must be so intimately associated with the latter as to lead to the conclusion that the former in truth forms part and parcel of the latter". Whether one building is part and parcel of another will depend primarily on whether there is a close geographical relationship between them. Furthermore, because the test is to identify an integral whole, a wall or fence separating two buildings will normally be sufficient to establish that they are not within the same curtilage. Similarly, a public road or stretch of tidal water will set a limit to the curtilage of the building. Buildings which are within the curtilage of a main house will normally pass automatically on a conveyance of that house without having to be specifically mentioned. There is a distinction between the curtilage of a main house and the curtilage of an estate as a whole and the fact that the whole estate [*548] may be contained within a single boundary does not mean that the buildings on as within the curtilage of a main house.' (See also EG 64245.) [23.24]-[23.40]

III HOW MANY RESIDENCES CAN QUALIFY FOR THE EXEMPTION?

I Property owned by the taxpayer but used as a residence by a dependent relative

Prior to 6 April 1988, a maximum of two houses qualified for exemption; the only or main residence and a property owned by the taxpayer but used as a residence by a dependent relative rent free and for no other consideration.

This exemption for dependent relatives does not apply to disposals on or after 6 April 1988 (when mortgage interest relief was similarly withdrawn from dependent relative accommodation, see [7.52]). However, transitional relief continues to be available so long as the dependent relative conditions were satisfied either on 5 April 1988 or at any earlier time. Where this relief is claimed, ESC D20 permits payment by the relative of rates and of the costs of repairs to the dwelling house attributable to normal wear and tear without prejudicing the condition that the dwelling house must have been provided free and without consideration. In contrast, any payments made by the occupier towards repayment of a mortgage would lead to a loss of relief.

If qualifying occupation ceased before 6 April 1988 or ceases thereafter, the subsequent re-occupation of the property by a dependent relative will not be included in calculating the amount of any gain which, when the property is sold, is exempt from CGT. [23.41]

EXAMPLE 23.1

Thoughtful's widowed mother-in-law has lived since 1980 rent free in a bijou cottage owned by Thoughtful. He does not provide similar accommodation for any other dependent relative.

(1) As an existing arrangement, Thoughtful will continue to be entitled to the CGT exemption on any disposal of the cottage so long as his mother-in-law continues to live there on the same terms.

(2) If the cottage is sold after 6 April 1988 and a small flat purchased as a replacement, no CGT will be charged on the sale but the flat will not qualify for CGT relief.

(3) If, instead, Thoughtful's mother-in-law ceases to occupy the cottage as her main residence either before or after 6 April 1988 but at some stage thereafter resumes occupation, no CGT exemption will be available to Thoughtful in respect of the gain attributable to his mother-in-law's later period of occupation.

2 Husband and wife

Husband and wife and civil partners (see generally [51.130] and [23.42]) can have only one main residence whilst they are living together (TCGA 1992 s 222(6)). For the operation of the election (which is considered below) when a couple marry or enter into a civil partnership see EG 64525. [23.42][* 549]

3 Where the taxpayer has more than one residence

The question of whether a particular property is a taxpayer's only or main residence is sometimes a difficult one to answer. If only one property is occupied by him as a residence the exemption prima facie applies to that property. Where the taxpayer has two residences, only the residence which is his main residence can qualify for relief. Any problems that might arise in deciding which of two residences is the main residence are obviated since the taxpayer can elect for one to be treated as his main residence (TCGA 1992 s 222(5)). Of course, the election is only available in respect of residences' and cannot be used to convert a dwelling house which is not in use as a residence into one for the purpose of obtaining relief (see EG 64486). The election can be backdated for up to two years to the date when the second residence was acquired and can be varied at any time, the variation also being effective for the two previous years. In Griffin v Craig-Harvey (1993), the taxpayer's argument that an election could be made at any time during the period of ownership of a dwelling house to take effect for a period of up to two years prior to the date of the notice, was rejected. Vinelott J held that an election could only be made within two years of the acquisition of a second or subsequent residence. This decision has practical implications for taxpayers owning more than one residence who may find themselves out of time to make the necessary election.

Failure to make an election means that the self-assessment return of the taxpayer has to resolve the question on the basis of the facts and this may be decided not simply by the periods of time spent in each residence.

An election can and should be made if a taxpayer occupies a property as a residence under a tenancy agreement (but not under a licence, where the occupier has only a personal, and not a proprietary, interest) whilst at the same time owning a second property (see further ESC D21). [23.43]-[23.60]

EXAMPLE 23.2

Barber having lived in Spitalfields for many years acquires a luxury flat on the Essex coast in June 2004. At the same time he puts the Spitalfields house up for sale. When the house is sold he intends to rent a pied-à-terre in London.

(1) By June 2006 he should elect whether Spitalfields or the flat is his main residence in respect of the period from June 2004.

(2) The last three years of ownership are ignored in applying the main residence exemption (see [23.83]) and so if Spitalfields is sold by June 2007 or if he expects it to sell within the following year he should elect for the flat to be his main residence.

(3) When he acquires the rented property in London he will again have two residences and should therefore elect within two years for the Essex flat to be his main residence.

(4) If, instead of renting a property in London, he moves into job-related accommodation under a service occupancy, an election cannot be made and relief will remain available for the Essex flat. This is because his rights, which derive from the contract of service, are personal only and create no proprietary rights in his favour (for residences occupied under licence, see RI 89, October 1994). [*550]

IV MISCELLANEOUS PROBLEMS

1 Land used with the house

Land of up to half an hectare (or permitted larger area) is exempt only if it is being used for the taxpayer's own occupation and for the enjoyment of his residence. In Longson v Baker (2001), the court had to determine whether 7.56 hectares (18.6 acres) of land should be included with a sizeable farmhouse and stabling for the purpose of obtaining the relief. It was held that the issue of whether a larger area of land was 'required' for the reasonable enjoyment of the dwelling house was a matter of fact. Further, it was held that bearing in mind that the commissioners were to have regard to 'the size and character of the dwelling house', the particular requirements of the owner of the house (in the present case, the grazing of horses) were irrelevant. Evans-Lombe J commented as follows:

'In my judgment it cannot be correct that the dwelling house at a farm requires an area of land amounting to more than 18 acres in order to ensure its reasonable enjoyment as a residence, having regard to its size and character.

I have come to the conclusion that it may have been desirable or convenient for the taxpayer to have a total area of 7.56 hectares to enjoy with the farm, but such an area is not in my judgment required for the reasonable enjoyment of the farm as a residence having regard to its size and character.'

(For a criticism of the case, see Taxation, 8 February 2001, p 429.)

It should be noted that the legislation as it relates to the land (in contrast to the dwelling house) refers to the position at the date of disposal. Thus, a gain made on a disposal of land will not be exempt if the residence has already been sold. In Varty v Lynes (1976) the taxpayer sold his house and part of the garden. Later he sold the remaining part of the garden with the benefit of planning permission. It was held that this second disposal was chargeable and the whole gain, including that which had accrued whilst the garden land was occupied by the taxpayer along with the house, was taxed. Had the taxpayer sold the garden before or at the same time as the house, any gain would have been exempt. Brightman J suggested that his construction of s 222(1)(b) created an anomaly in that 'if the taxpayer goes out of occupation of the dwelling house a month before he sells it, the exemption will be lost in respect of the garden'. However, the current Revenue practice as explained in Tax Bulletin, August 1994, p 148 is not to apply arguments based upon that dictum, so that contemporaneous sales of the house and the garden (even if for development) benefit from the exemption.

What constitutes land for the enjoyment of a principal private residence was considered in Wakeling v Pearce (1995). In that case, the taxpayer had cultivated a garden and maintained a washing-line in a field which was separated from her residence by another property not owned by her. The use of the field declined over the years, but it continued in a reduced form until its eventual sale as two building plots. The Special Commissioner held that the field was enjoyed with the residence and that there was no statutory requirement that the land should adjoin or be contiguous with the residence. Following its decision not to appeal against this decision because of the particular circumstances of the taxpayer, the Revenue published its interpre-[*551]-tation of the legislation (RI 119, August 1995). Attributing to the terms 'garden' and 'grounds' their normal, everyday meaning, the Revenue regards a garden as land devoted to cultivation of flowers, fruit or vegetables but that grounds cover 'enclosed land serving chiefly for ornament or recreation surrounding or attached to the dwelling house or other building'. So where land surrounds the residence and both are in the same ownership, the land qualifies for relief unless it is used for other purposes such as trade or agriculture. Relief will not be lost by reason only of the fact that the land is not used exclusively for recreational purposes or if there is a building on the land, provided that it is not being used for business purposes. Where land is physically separated from the residence, relief cannot be claimed merely by reason of the fact that it is used as a garden and that the two are in common ownership; by the same token, mere separation is not by itself sufficient to deny relief. The practice of the Revenue is to allow a claim in respect of land which can be shown to be 'naturally and traditionally the garden of the residence, so that it would normally be offered to a prospective purchaser as part of the residence'. [23.61]

EXAMPLE 23.3

(1) Bill is the owner of a village house that he purchased along with a small garden across the road from the residence. He later bought a further area of land upon which he built a tennis court. This land is separated from his house by the neighbouring property, and is reached by means of an informal path. Bill has recently sold all of his land, whilst retaining his residence.

It is common in villages for a garden to be across the road from the residence. If it can be shown that this was such a village, then Bill is entitled to relief under TCGA 1992 s 222(1) (b) for this part of his garden, even though separated from his residence, on the ground that it is a garden that would 'normally be offered to prospective purchasers as part of the residence'. The land upon which the tennis court stands is unlikely to qualify for relief. Although Bill may regard it as part of the garden, it was bought because the existing garden was inadequate for a tennis court, and could not be viewed as being 'naturally and traditionally' the garden of the residence.

(2) Assume that Sally owns a property with 7 hectares of land. It is accepted that some 6 hectares of the land does not attract the principal private residence relief and the relief is given on the land 'which, if the remainder were separately occupied, would be the most suitable for occupation and enjoyment with the residence' (see TCGA 1992 s 222(4)). Difficult valuation issues may arise: for instance the non-qualifying land may well have no permitted access. Is this a factor to be taken into account in apportioning the sale consideration if the whole property is sold?

2 Houses held in trust

Where trustees dispose of a house that is the residence of a beneficiary who is entitled to occupy it by the terms of the settlement the relief applies (TCGA 1992 s 225: it does not matter that the beneficiary pays rent to the trustees). For disposals after 10 December 2003, relief is only available where an actual claim for it is made by the trustees. Sansom v Peay (1976) decided that the section applied both where the relevant beneficiary enjoyed an interest in Possession in the property and where the trust was discretionary so that [*552] occupation was entirely a matter for the discretion of the trustees. The decision in this case has repercussions for IRT since the Revenue will argue that the beneficiary in whose favour the discretion has been exercised thereby acquires an interest in possession in the settlement (see SP 10/79). [23.62]

EXAMPLE 23.4

'Westwinds' is held in trust for Julian for life remainder to his children on attaining 40. In exercise of their overriding powers the trustees advance £10 on trust for the children with separate trustees and then grant those trustees a reversionary lease over Westwinds to commence in ten years time when Julian will he aged 90.

Notes:

(i) It is not considered that this arrangement creates reservation of benefit problems for IHT purposes. Although Julian makes a transfer of value he does not make a gift.

(ii) If the house were to be sold during Julian's life it is considered that the trustees would benefit from the full principal private residence exemption (subject to a claim for it being made) albeit that Julian's residence was by virtue of the encumbered freehold interest. This is because the settlement is treated as a single composite settlement for CGT purposes and because the wording of s 225 merely requires occupation of trust property by a beneficiary as his main residence.

3 Use of a house for a business

If part of the house is used exclusively for business purposes, a proportionate part of the gain on a disposal of the property becomes chargeable (TCGA 1992 s224 and for IHT BPR, see IHTA 1984 s 112(4)). However, as long as no part is used exclusively for business purposes no part of the exemption will be lost. Doctors and dentists who have a surgery in their house are advised to hold a party in that surgery at least once a year (and to invite their tax inspector!). [23.63]

4 Letting part of the property

Where the whole or part of the property has been let as residential accommodation, this may result in a partial loss of exemption. However, the gain attributable to the letting (calculated according to how much was let and for how long) will be exempt from CGT up to the lesser of £40,000 and the exemption attributable to the owner's occupation. This relief does not apply if the let portion forms a separate dwelling (TCGA 1992 s 223(4)). The Revenue has stated that the taking of lodgers will not result in a loss of any of the exemption provided that the lodger lives as part of the family and shares living accommodation (SP 14/80).

In Owen v Elliott (1990) the taxpayer carried on the business of a private hotel or boarding house on premises which he also occupied as his main residence and argued that he was entitled to relief since taking in hotel guests amounted to 'residential accommodation'. The Court of Appeal accepted this and rejected the argument that the occupation had to be by [*553] persons making their home in the premises let as opposed to paying guests staying overnight or on holiday. Leggatt LJ that:

'The expression "residential accommodation" does not directly or by association mean premises likely to be occupied as a home. It means living accommodation, by contrast, for example, with office accommodation. I regard as wholly artificial attempts to distinguish between a letting by the owner and a letting to the occupant; and between letting to a lodger and letting to a guest in a boarding house; and between a letting that is likely to be used by the occupant as his home and one that is not.' [23.64]

EXAMPLE 23.5

A sells his house which he has owned for 20 years realising a gain of £120,000. He occupied the entire house during the first ten years. For the next six years he let one-third of it and for the final four years the entire property.

. £ £

Total gain 120,000

Less: exemptions

(i) 10 years' occupation 60,000

(ii) 6 years' occupation of

2/3 (460,000 x 2/3 x 6/10) 24,000

(iii) final 3 years' ownership

($60,000 x 3/10) 18,000 102,000

. ------ -------

Gain attributable to letting 18,000

Less: exemption (part) 18,000

. -------

Chargeable portion £ NIL

5 Disposals by Pits

Statutory effect has now been given to an extra-statutory concession (ESC D5), giving the benefit of the principal private residence exemption to PRs on their disposal of a private dwelling house which, both before and after the death, was the only or main residence of one or more individuals who, on the death of the testator, are entitled to 75% of the net proceeds of sale from the house, either absolutely or for life (TCGA 1992 s 225A, inserted by FA 2004: see [21.104]). The new provision will supersede the concession with effect for disposals on or after 10 December 2003, from which time the relief will only be available where a claim for it is actually made by the personal representatives. [23.65]

6 Disposals by legatees

A spouse who inherits a dwelling house on the death of the other spouse also

inherits the other spouse's period of ownership for the purpose of calculating the relief (TCGA 1992 s 222(7) (a); and see TCGA 1992 s 62; RI 75, [*554] August 1994). In other cases the beneficial period of ownership begins on the date of death and if the beneficiary does not become resident until a later date the period prior to becoming resident will not qualify for relief (unless failing within the final 36-month period prior to disposal): see RI 75,

August 1994. [23.66]-[23.80]

V EFFECT OF PERIODS OF ABSENCE

1 General rule

To qualify for the exemption, the taxpayer must occupy the property as his only or main residence throughout the period of his ownership: for these purposes only the period of ownership after 31 March 1982 counts (TCGA 1992 s 223(7)). As a general rule, therefore, the effect of periods of absence is that on the disposal of the residence a proportion of any gain will be charged. That proportion is calculated by the formula:

. period of absence

Total gain x ------------------

. period of ownership

[23.81]

2 Husband and wife, and same-sex couples

Special rules operate for husband and wife and same-sex couples who have entered into a civil partnership (see [51.130]) since in deciding whether a house has been occupied as a main residence throughout the period of ownership one spouse can take advantage of a period of ownership of the other (TCGA 1992 s 222(7) (a): see [21.104] for an illustration of this rule).

[23.82]

3 Permitted absences

Despite the general rule that absences render part of the gain chargeable, certain permitted absences are ignored. These include, by concession, the first 12 months of ownership in cases where occupation was delayed because the house was being built or altered, or up to a period of two years where there are good reasons for exceptional delay (SP D4). More important, the last three years of ownership are likewise ignored (TCGA 1992 s 203(1)) and this may prove helpful on a matrimonial breakdown. It also means that a. taxpayer owning two houses can, by careful use of his election, obtain a tax, advantage, subject, of course, to the necessity of making the election within two years of the second or subsequent acquisition. [23.83]

EXAMPLE 23.6

Janet acquires a property in Raynes Park in June 2004 that she lets until June 2006. She then occupies the property as her main residence until selling it in April 2007. Because she has occupied the property as her residence there is no CGT charge on any gain arising during her final three years of ownership.

Expenditure with a profit-making motive 555

4 Periods allowed under s 223

TCGA 1992 s 223(3) allows other periods of absence to be ignored provided that the owner had no other residence available for the exemption during these periods and that as a matter of fact he resided in the house before and after the absence in question. These periods are:

(1) any period or periods of absence not exceeding three years altogether; (2) any period when the taxpayer was employed abroad; and

(3) a maximum period of four years where the owner could not occupy the property because he was employed elsewhere.

The proviso for residing in the house before and after an absence does not require that it should be immediate. [23.84]

5 Absence because of employment

The Revenue accepts that if the absence exceeds the permitted period in (1)-(3) above it is only the excess which does not qualify for the exemption.

The requirement that the taxpayer should reside after the period of absence will not apply in (2) and (3) if that is prevented by the terms of his employment (ESC D4). 1f he is required either by the nature of his employment or as the result of his trade or profession to live in another accommodation (job-related accommodation') he will obtain the exemption if he buys a house intending to use it in the future as a main residence. It does not matter that he never occupies it and that it is let throughout, provided that he can show that he intended to live there. He should, of course, be advised to make the main residence election since he is occupying other (job-related) property (unless this occupation derives from his contract of service). [23.85]-[23.100]

VI EXPENDITURE WITH A PROFIT-MAKING MOTIVE

The principal private residence exemption does not apply if the house was acquired wholly or partly for the purpose of realising a gain, nor to a gain attributable to any expenditure that was incurred wholly or partly for the purpose of realising a gain (TCGA 1992 s 224(3)). The acquisition of a freehold reversion by a tenant with a view to selling an absolute title to the property would appear to fall within this provision. 1f so, the portion of the gain attributable to the reversion would be assessable. The Revenue has, however, indicated that expenditure incurred in obtaining planning permission or obtaining the release of a restrictive covenant would be ignored for the purpose of s 224(3). The requirement of motive makes this provision difficult to apply, but the Revenue view is that only where the primary purpose of the acquisition was an early disposal at a profit will it be invoked (RI 75, August 1994). In Jones v Wilcock (1996) the taxpayer and his wife had lived in their home for nearly five years. In trying to establish an allowable loss, he argued that the exemption should not apply since he had acquired his home With the object of selling it at a profit. The Special Commissioner rejected this argument, saying that the word 'intention' did not always equate with purpose' and that the taxpayer had bought the property in order to provide himself and his wife with a home. An eventual gain was a hope, possibly an expectation, but it was not a 'purpose' within s 224(3). [23.101]-[23.120] [*556]

VII SECOND HOMES

Principal private residence relief is not available on second homes and taxpayers will commonly find that on the disposal of such properties a substantial chargeable gain is produced. It is not possible for husband and wife to have separate main residences and the Revenue will resist any suggestions that a minor child has acquired a main residence separate from his parents. Further, by virtue of FA 2004, principal private residence relief is no longer available for disposals on or after the 10 December 2003 if the gain includes a gain that was held over on one or more previous disposals, for example, on the house being transferred into trust (TCGA 1992 s 226A). If, however, one or more of such disposals were made before 10 December 2003, the relief will continue to apply to that part of the gain referable to the period prior to the 10 December 2003. Because of the operation of these transitional provisions, it is advisable to trigger a disposal of the property sooner rather than later. [23.121]-[23.140]

EXAMPLE 23.7

Mr Wealthy wished to give his seaside cottage (then valued at £200,000) to his son Oliver, but was concerned to postpone the payment of any CGT on its disposal (which would have realised a gain of £120,000 before any taper relief). Accordingly, on 1 February 2003, he settled the property on discretionary trusts. No IHT was payable since the transfer fell within Mr Wealthy's available nil rate band, and CUT hold-over relief was successfully claimed. The trustees permitted Oliver to occupy the cottage as his only residence from 1 May 2003 to November 2006. On 10 December 2006, the trustees sell the cottage for £220,000 (net of incidental costs). The trustees have a gain of £140,000. TCGA 1992 226A denies the availability of principal private residence relief to the whole gain although, because the gifts related to a transfer before 10 December 2003, the transitional rule applies so that the trustees are entitled to the relief in respect of the period from the 1 February 2003 to 9 December 2003 (312 days). Their total period of. ownership was 1408 days. Accordingly, they are entitled to principal private residence relief of £31,022.73 (£140,000 X 312/ 1408). They remain chargeable on a gain of £108,977.30. Note that even though the period between 10 December. 2003 and 10 December 2006 is part of the final three years of the trustees' ownership of the property, principal private residence relief is not available: the transitional provisions specifically prevent any period on or after 10 December. 2003 from qualifying for relief as part of the final three years of ownership.

VIII LINK UP WITH IHT SCHEMES

A number of arrangements have been entered into in recent years with a vie to mitigating IHT on main residences. For instance:

(i) 'Ingram arrangements' Under these arrangements the taxpayer reserved lease for (say) 20 years and gifted the freehold interest to his children.

(ii) Reversionary leases: In practical terms a similar arrangement to (i) but conceptually quite distinct. The taxpayer grants a long lease (commonly 999 years) to his children to take effect in (say) 21 years. He continues to occupy the property as a result of his retained freehold interest.

(iii) On the death of Mr H his will provides for the IHT nil rate sum to be held on discretionary trusts with the residue passing to Mrs H (his [*557] wife). Mr H's share in the main residence (he will frequently be a tenant in common as to a 50% beneficial share) will often be held by the trustees of the nil rate trust.

In these cases whilst IHT saving is the goal it is important that the arrangements do not ignore any potential CGT liability. Thus if in due course the property will be sold (typically by the children on the death of the parents) then in all these cases there is likely to be a chargeable gain given that the children will not acquire the property for market value on the death of their parents. There is, therefore, a risk that IHT savings will be offset (at least in part) by subsequent CUT liabilities. (23.1411 [*558]

24 CGT-gifts and sales at undervalue

Updated by Andrew Farley, Partner Wilsons

I Introductory [24.2]

II Gifts of business assets (TCGA 1992 ss 165-169; Sch 7) [24.21]

III Gifts of assets attracting an immediate IHT charge (TCGA 1992 s 260(2) (a)) [24.61]

IV Disposals from accumulation and maintenance trusts and children's trusts (TCGA 1992 s 260(2)(d), (da) and (db)) [24.91]

V Miscellaneous cases [24.111]

VI Payment of tax by instalments [24.131]

'Mr Turner has really argued his case on broader lines than I have so far indicated, and has used language, though moderate and reasonably temperate, as to the ways of Parliament in misusing language and in effect "deeming" him into a position which on any ordinary use of the words "capital gains" was impossible to assert. He in effect says "Here is a discreditable manipulation of words. The Statute is not truthful. Words ought to mean what they say".' (Russell LJ in Turner v Follett (1973) 48 TC 614 at 621.) [24.1]

I INTRODUCTORY

1 A gift as a disposal at market value

A disposal of an asset, otherwise than by way of a bargain at arm's length, is treated as a disposal at the open market value (TCGA 1992 s 17). A donor is, therefore, deemed to receive the market value of the property that he has given away even though he has in fact received nothing (Turner v Follett (1973)). A disposal between connected persons is treated as a transaction 'otherwise than by way of bargain at arm's length' (and hence taxed as a disposal at market value: see TCGA 1992 s 18(2); for the definition of connected persons see [19.23]). [24.2]

EXAMPLE 24.1

Jackson sells a valuable Ming vase to his son Pollock for £10,000 which is the price that he had paid for it ten years before. The market value of the vase at the date of sale is £45,000. This disposal between connected persons is deemed to be made otherwise than by way of bargain at arm's length so that market value is substituted for the price actually paid and Jackson is deemed to have received £45,000. Pollock is treated as acquiring the vase for a cost price of £45,000. [*560] 2 IHT overlap

In addition to being treated as a disposal at market value for CGT purposes, a gift of assets may be chargeable (or potentially chargeable) to IHT. Only limited relief is available against this double charge (see further [24.32]).

First, in calculating the fall in value of the transferor's estate for IHT purposes, his CGT liability is ignored. IHT is not, therefore, charged on CGT paid by a donor (see [28.63]).

Secondly, if the CGT is paid not by the transferor but by the transferee, the amount of that tax will reduce the value transferred for IHT purposes (IHTA 1984 s 165(1)). Normally CGT is paid by the transferor but there is nothing to stop the parties from agreeing that the burden shall be discharged by the transferee.

EXAMPLE 24.2

Mr Big transfers a freehold office block to his daughter Martha Big. Assume that the value of the freehold (ignoring IHT business relief) is £750,000 and that the CGT amounts to £250,000.

(1) If the CGT is paid by Mr Big the diminution in his estate for IHT purposes is £750,000 (ie it is not £750,000 £250,000).

(2) If the CGT is paid by Martha the diminution in Mr Big's estate is reduced to £500,000 (ie £750,000 - £250,000)

In certain situations CGT on a lifetime gift may be postponed if a holdover election is made and these are considered in the following sections. [24.3]-[24.20]

II GIFTS OF BUSINESS ASSETS (TCGA 1992 ss 165-169; Sch 7)

1 When does s 165 apply?

There must be a disposal by an individual although this is extended to trustees (see TCGA 1992 Sch 7 para 2-this includes the deemed disposal made by trustees under TCGA 1992 s 71 on the termination of a trust: see [25.47]). The disposal must be 'otherwise than under a bargain at arm's length' and therefore includes both gifts and undervalue sales. In general the recipient can be any 'person', a term which embraces not just individuals but also trustees and companies. However, relief is not available when shares or securities are transferred to a company (s 165(s) (ba): note that all other business assets attract the relief if gifted to a company). [24.21]

2 What property is included?

The section is limited to gifts of business assets, defined as follows (s 165(2)):

'an asset is within this sub-section if--

(a) it is, or is an interest in, an asset used for the purposes of a trade, profession or vocation carried on by--

(i) the transferor, or [*561]

(ii) his personal company, or

(iii) a member of a trading group of which the holding company is his personal company, or

(b) it consists of shares or securities of a trading company, or. of the holding company of a trading group, where--

(i) the shares or securities are not listed on a recognised stock exchange, or

(ii) the trading company or holding company is the transferor's personal company.'

Accordingly, under s 165(2)(b)(i), ATM shares can benefit from the relief but the disposal of a qualifying corporate bond (QCB) does not attract relief (see [41.93]). [24.22]

a) Which assets qualify?

It should be noted that any asset is included provided only that it is used for the purposes of a trade, profession or vocation (contrast, for instance, roll-over reinvestment relief (see [22.72]) which is limited to certain categories of asset). A mere disposal of assets suffices: it is not necessary for the disposal to be of part of the business.

Non-business assets do not attract relief. Similarly, if the assets disposed of are shares, the amount of the gain eligible for hold-over relief may be restricted if the company owns chargeable assets other than business assets. This restriction only applies if the transferor has had a significant interest in the company within the 12-month period before the disposal, ie if the company has been his 'personal company' at some time within this period or, in the case of trustees, if they have owned at least 25% of the voting rights at some time within this period. Where the restriction applies the proportion of the gain eligible for the relief is the proportion which the market value of the company's business assets bears to the market value of the company's total chargeable assets: TCGA 1992 Sch 7 para 7. [24.23]

b) Used for the purposes of a trade

Whether an asset is used for the purposes of a trade may be a moot point: for instance, would the relief be available on a gift of a valuable Munch oil painting (The Sick Corpse) which has adorned the offices of a funeral parlour for many years?

Where the asset has been used for a trade for only part of the period of ownership or, in the case of a building, where only part of the building has been used for a trade, the gain eligible for the relief is, in each case, reduced proportionately: TCGA 1992 Sch 7 paras 5 and 6. [24.24]

c) APR land

Land qualifying (or which would qualify on a chargeable transfer being made) for 100% or 50% IHT agricultural property relief is specifically [*562] included as a business asset for these purposes (TCGA 1992 Sch 7: for APR, see [31.61] if). Accordingly let land may qualify for the relief. [24.25]

EXAMPLE 24.3

Let agricultural land is owned by the trustees of the Milford Grandchildren's Trust. The trust was established in 1981; in 2002 Debbie becomes entitled to an interest in possession in the entire trust fund on becoming 21. In 2006 when she is 25 the trust ends.

For IHT purposes The ending of the trust in 2006 is not an occasion of charge (see IHTA 1984 s 53(2)).

For CGT purposes the ending of the trust results in a deemed disposal under TCGA 1992 s 71 (see [25.47]) and hold-over relief under s 165 will not he available.

This is because the land would not attract APR: although the land has been owned by the trustees for more than the required seven years, in 2002-when Debbie became entitled to an interest in possession-a new ownership period began and, of course, she has only owned the land for four years.

Note: As a result of the changes to the IHT treatment of trusts introduced by FA 2006 the acquisition of an interest in possession in most trusts after 21 March 2006 will not now trigger a new ownership period for IHT.

d) Meaning of 'personal company' and 'trading company'

An individual's 'personal company' is defined as one in which the individual owns not less than % of the voting rights (TCGA 1992 s 165(8)(a)). 'Trading company' has the same meaning as for taper relief (see [20.28]). [24.26]

e) Trustees

These definitions and requirements are modified in the case of business assets owned by trustees. Broadly, in the case of assets, the relevant 'trade, profession or vocation' must either be that of the trustees or of a beneficiary with an interest in possession in the settled property; and in the case of shares in a trading company, unless the shares qualify as being not listed on a recognised stock exchange, at least 25% of the voting rights at the company's general meeting must be exercisable by the trustees. [24.27]

3 The election

Hold-over relief under the section will only be given on a claim being made in the prescribed form by both transferor and transferee (save where the transferee is a trustee when only the transferor need elect: TCGA 1992 s 165(1)). The donor is treated as disposing and the donee as acquiring the asset for its market value at the date of the gift minus the chargeable gain which is held over. This postponement of tax continues until the donee disposes of the asset although, if the donee in turn makes a gift of the asset, a further hold-over election may be available. In the event of the donee dying still owning the asset, the entire gain is wiped out by the death uplift in value. Since the election is to hold over a gain which would otherwise be [*563] chargeable, in principle it is necessary to agree the amount of that gain with the Revenue so that the election should be accompanied by relevant valuations. In SP 8/92, however, the Inland Revenue published a revised statement of practice whereby computation of the gain (and hence formal valuation of the asset) is in many cases not required. Both transferor and transferee must request this treatment in writing and provide full details of the asset transferred (the date of its acquisition and the allowable expenditure) or, alternatively, a calculation of the gain based on informally estimated valuations. Once such a request has been accepted it cannot subsequently be withdrawn. In the majority of cases, taxpayers will be only too happy to avoid the time and trouble (not to mention the expense) involved in agreeing valuations with the Revenue.

EXAMPLE 24.4

(1) Sim gives his ironmonger's business to his daughter Sammy in 2005. For CGT purposes any gain resulting from this gift of chargeable business assets may be held over on the joint election of Sim and Sammy.

(2) Jim settles his ironmonger's business on trust for his son jack absolutely contingent on becoming 30 (Jack is aged 10). As in (1) above, s 165 will apply: however in this case only Jim need elect. When the trust ends, eg on jack becoming absolutely entitled to the business, a further hold-over election may then be made by the trustees and Jack to postpone payment of tax which would otherwise arise under TCGA 1992 s 71.

(3) Oliver is the sole shareholder and director of a computer company (ACC Ltd) and owns the freehold site used by the company. He gives away his shares to his four daughters equally and the freehold to his son.

Section 165 relief is available to postpone tax on all five gifts since ACC is Oliver's personal company.

When the election is made:

'(a) the amount of any chargeable gain which, apart from this section, would accrue to the transferor on the disposal, and

(b) the amount of the consideration for which, apart from this section, the transferee would be regarded for the purposes of CGT as having acquired the asset or, as the case may be, the shares or securities, shall each be reduced by an amount equal to the held-over gain on the disposal.'

EXAMPLE 24.5

Smiley gives Karla shares in his family company worth £35,000. Smiley's allowable expenditure for CGT purposes (including any indexation allowance until April 1998) is £10,000. They make a joint election under s 165 so that Smiley's chargeable gain (35,000 - £10,000 = £25,000) is reduced to nil. Smiley is effectively treated as disposing of the shares for £10,000 and, as his expenses are £10,000, he has made neither gain nor loss. Karla is treated as acquiring the shares for the market value consideration (£35,000) less the held-over gain (p25,000) ie for £10,000.

Assume that within 12 months of the gift Karla sells the shares for £41,000 incurring deductible expenses of £2,000. He will be assessed to CGT on a gain calculated as follows: [*564]

. £ £

Sale proceeds 41,000

Less:

Acquisition costs 10,000

Deductible expenses 2,000 12,000

. -------

Chargeable gain £29,000

Notes:

(1) Of this gain, £4,000 is attributable to Karla's period of ownership (£29,000 - £25,000) and £25,000 represents the gain held over on the gift from Smiley. (2) Karla's deemed acquisition costs will include the value of Smiley's indexation allowance until April 1998 (if any) but any taper relief built up by Smiley will be lost (see [24.291.

No time limit for making this election is prescribed in the section and hence the general rule laid down in TMA 1970 s 43 applies: namely the claim must be made within five years from 31 January in the tax year following that in which the disposal occurred (ie a period of some five years and ten months). There is a standard claim form which must be used in all cases (although photocopies of the form will be accepted). [24.28]

4 The effect of taper relief

Taper relief reduces the amount of gain on which tax is charged; it does not affect the calculation of the gain itself. By contrast, indexation (which taper replaced) operated as a further deduction in computing the gain. This contrast is significant when calculating the gain that is to be held over under either s 165 or s 260. Moreover, unlike indexation the donee receives no credit for the accrued taper relief of the donor: his taper relief is calculated by reference only to the period for which he personally owned the asset. [24.29]

EXAMPLE 24.6

Calculus acquired a farm for £1m on 6 April 1998. On i January 2005 he gives the farm to his son when its value has increased to £10m. As he has owned the farm for more than two years only 25% of Calculus' gain of £9m will be taxed (tax of £900,000 at a 40% rate) If they elect to hold over the gain, however, the son's base cost is only Lim. If he were immediately to sell the farm therefore he would suffer tax of £3.6m (40% x £9m). In cases when a would-be donor has substantial accrued taper there is a disincentive to making a gift of the asset. Note the following points:

(a) with the reduction of the business asset taper period to two years the disincentive is not as great as when taper was first introduced in 1998;

(b) the parties may delay claiming hold-over relief in case the son sells the farm before he has built up 75% relief.

5 The annual exemption and retirement relief

The legislation does not permit CGT annual exemption (see [19.86]) to be combined with an election under s 165, ie it is not possible to set off the [*565] annual exemption against part of a chargeable gain and apply hold-over relief to the balance. Either the whole chargeable gain must be held over or it must be subject to CGT but with the benefit of the annual exemption. Where any gain will not exceed the annual exemption, the s 165 election should not be made: and even if the gain just exceeds the exemption it may be preferable to pay a small CGT charge. In appropriate cases it will be possible to obtain the best of both worlds, ie to make two disposals, the first of an asset where the gain is covered by the annual exemption and the second of other business assets where hold-over relief under s 165 is claimed. Unlike the annual exemption, retirement relief operated by reducing the gross gain made by a taxpayer on the disposal of a business or part of a business so that only the balance (if any) remaining was chargeable gain (TCGA 1992 Sch 6 para 6; and see Chapter 22). (Retirement relief was abolished from tax year 2003-04). [24.30]

6 Sales at undervalue

Although s 165 applies both to gifts and sales at undervalue, if the actual consideration paid on a disposal exceeds the allowable CGT deductions of the transferor, that excess is subject to charge. It is only the balance of any gain (ie the amount by which the consideration is less than the full value of the business asset) which may be held over under s 165. For the Revenue's attitude when assets are transferred on a divorce, see Tax Bulletin August 2003, p 1051.

EXAMPLE 24.7

Julius sells shares in his family company worth £25,000 to his brother Jason for £16,500. Julius has allowable deductions for CGT purposes of £11,500. The CGT position is:

(1) Total gain on disposal: £25,000 -£11,500 = £13,500.

(2) Excess of actual consideration over allowable deductions:

£16,500 - £11,500 = £5,000.

(3) Gain subject to CGT ((2) above) is £5,000, as reduced by any taper relief. After deducting Julius' annual exemption the tax payable will be nil.

(4) Balance of gain, £8,500 (ie (1) - (2)) can be held over under s 165.

If the partial consideration is less than the allowable deductions it is ignored so that a CGT loss cannot be created. [24.31]

EXAMPLE 24.8

Assume in Example 24.7 that the sale price was £11,500 and the allowable deductions £16,500 instead of the other way around. The total gain of £8,500 could be held-over under s 165. The sale price of £11,500 would be ignored: Julius would not have made a loss for CGT even though he sold the shares for an amount less than his allowable deductions; and Jason's initial base cost would still be £16,500 (market value less held-over gain) and would be unaffected by the actual consideration paid by him.

7 The inter-relationship between hold-over relief and IHT

The overlap between CGT and IHT in the area of lifetime gifts and gratuitous undervalue transfers has already been noted (see [24.3] [*566]

When chargeable gains are held over under s 165 the transferee can add to his CGT acquisition costs all or part of the IHT paid on the value of the gift. This principle applies whoever pays the IHT.

EXAMPLE 24.9

Wendy gives shares in her family cookery company ('Cook-Inn & Co') to her daughter, Kim. The chargeable gain arising of £100,000 is held over under s 165 and Kim therefore acquires the shares at a value of £75,000. For Il-IT purposes the gift by Wendy is a PET when made and therefore no tax is payable at that stage.

Assume, however, that Wendy dies within seven years so that the gift then becomes chargeable and that IHT of £20,000 is paid. Kim can add that sum to her base cost for CGT purposes which therefore becomes £95,000 (75,000 + £20,000).

Notes:

(1) A similar principle applies in the case of lifetime gifts which are subject to an immediate IHT charge. The IHT payable on the lifetime chargeable transfer, including the increased amount payable if the transferor dies within the following seven years, can be added to the transferee's base cost for CGT.

(2) Although the IHT paid is added to Kim's base cost in order to reduce her gain on a subsequent disposal of the shares, this sum is not an item of deductible expenditure for CGT purposes and therefore did not benefit from the indexation allowance.

(3) It may be that Kim has already disposed of the shares before the death of her mother. Nevertheless she is entitled to have her allowable expenditure increased by the IHT resulting from Wendy's death and therefore an adjustment will be made to any CGT paid on the disposal of the shares.

There are two limits on the amount of IHT that can be added to the donee's CGT base cost.

First, the maximum amount permissible is the IHT attributable to the gift.

This means that if IHT had been paid by the transferor on a chargeable lifetime gift so that 'grossing-up' applied, it is only the IHT charged on the value of the gift received by the donee which can be used (grossing-up is discussed at [28.124]).

Secondly, IHT which is added to the transferee's base cost cannot be used to create a CGT loss on a later disposal by the transferee. Accordingly, in Example 24.9 above, if Kim were to sell the shares after the death of Wendy for £90,000 she would only be able to use £15,000 of the IHT payable on Wendy's death since this could have the effect of wiping out any chargeable gain and she cannot use the remaining £5,000 to create a CGT loss (TCGA 1992 s165(10). [24.32]

8 Non-UK residents

a) Individuals

Section 165 hold-over relief is not available if the transferee is neither resident nor ordinarily resident in the UK (TCGA 1992 s 166). This limitation is necessary since disposals by such a person are outside the CGT net! In addition, any held-over gain will be triggered if, whilst still owning the asset in question, the transferee emigrates before six complete tax years have expired after the tax year of the disposal to him: TCGA 1992 s 168.

Gifts of business assets (TCGA 1992 ss 165-169; Sch 7) 567

EXAMPLE 24.10

In 1998 Imelda's father gave her shares in the family company. A gain of £80,000 was held over so that she had an acquisition cost of £10,000. In 2005 she took up permanent residence in Spain. The held-over gain of £80,000 becomes chargeable 'immediately before' she ceased to be UK resident at the rates in force in the tax year of emigration.

If the shares had increased in value to £130,000 by 2005, there is no question of charging that increase which is attributable to her period of ownership; any loss would likewise be ignored.

The CGT in such cases is payable primarily by the transferee, but if tax remains unpaid 12 months after the due date it can be recovered from the transferor (TCGA 1992 s 168(7)). In such an event the transferor is given a right to recover a corresponding sum from the transferee (TCGA 1992 s 168(9)) although, if the Revenue has not obtained payment from the transferee, the transferor is unlikely to succeed!

The emigration charge will not apply if the transferee leaves the UK because of work connected with his office or employment and performs all the duties of that office or employment outside the UK, provided he does not dispose of the asset whilst outside the UK (if so the gain is taxed unless the disposal is to a spouse) and resumes UK residence within three years of his initial departure; otherwise the gain is taxed (TCGA 1992 s 168(5)).

It will obviously be unnecessary to invoke this emigration charge if, before becoming non-resident, the transferee had made a disposal of the asset (TCGA 1992 s 168(1)(b)). That disposal will either have triggered the held-over gain or, if it was by way of gift and a s 165 election had been made, the asset pregnant with gain will now be owned by another UK resident, so that the Revenue is not threatened with a loss of tax. If that prior disposal was merely a part disposal, so triggering only a part of the held-over gain, the balance will be chargeable on emigration.

An exception to the provision that the transferee who emigrates after the disposal of the asset will not be subject to a charge is when that prior disposal is to the emigrating transferee's spouse. If that spouse had also disposed of the asset, however, resulting in a, CGT charge on the gain originally held over, that further disposal will be treated as if it had been by the transferee so that the emigration charge will not apply (TCGA 1992 s 168(3)). [24.33]

b) Companies

Section 167 deals with gifts to foreign controlled companies and prevents hold-over relief from being available: a company is foreign controlled for these purposes if it is controlled by a person or persons who are neither resident nor ordinarily resident in the UK and who are connected with the disponer (for the meaning of control, see TA 1988 s 416: [41.123]). [24.34]

EXAMPLE 24.11

Z, a UK resident, transfers his business to Q Ltd, a company which is owned as to 51% by Z and as to 49% by an offshore structure. Hold-over relief under s 165 will be available. [*568]

Notes:

(1) If Z is non-UK domiciled there will be attractions in Q Ltd being incorporated outside the UK (so that its shares will be non-UK situs assets which is significant both for CGT and IHT purposes given Z's non-domiciled status) but which is UK resident by virtue of its management being situated in the UK ([18.10]).

(2) There is no trigger of the held-over gain if in the future further shares in Q Ltd are issued to non-resident shareholders.

(3) The restriction noted at [24.21] prevents hold-over relief being available on a disposal of shares to Q Ltd.

9 Other triggering events

Apart from the emigration of the transferee, a gain held over on creation of a settlement will become chargeable on the death of the life tenant (this matter is discussed at [25.51]). A subsequent sale of the property by the donee will also result in the held-over gain becoming taxable and it should be noted that, because rebasing was not available when the gift was made between 1982 and 1988, in such cases there will be a 50% reduction in the amount of the held-over gain which is taxed (see also [19.42]).

EXAMPLE 24.12

Diane acquired a business for £10,000 in 1980. By 31 March 1982 its value had increased to £25000. In June 1986 she gave it to her niece when its value was £40,000 and both entered into a hold-over election. In July 2005 the niece sold the business for £50,000. Ignoring the indexation allowance, taper relief and any incidental expenditure and assuming that the business comprises only chargeable business assets, the CGT position is as follows:

(1) In 1986 the niece acquired the assets at a base cost of £10,000 (ie £40,000 minus the held-over gain of £30,000).

(2) In 2005 her gain on disposal is £40,000 but one half of the gain held over in 1986 (ie £15,000) is not subject to charge so that the chargeable gain is £25,000 (£40,000 - £15,000).

Note: The mechanism of TCGA 1992 Sch 4 para 1 means that it is the niece's acquisition cost in 1986 which is increased by £15,000 (to £25,000). This beneficially affects the calculation of the indexation allowance.

A subsequent gift of the property will not trigger a charge provided that a further election is made: on the death of the transferee any held-over gain is wiped out (though note the special rules when a gain is held over on creation of a settlement and the interest in possession beneficiary subsequently dies: see [25.51]). [24.35]

EXAMPLE 24.13

Boy Sam settled his family trading company shares on trusts for his companion Justin for life, remainder to his mother, Iris. Under a power in the settlement the trustees subsequently advanced the shares to Justin. No CGT arose on the creation of the settlement provided that Boy Sam so elected (in this case an election by the settlor alone sufficed) nor on the deemed disposal under TCGA 1992 s 71(1) resulting from the termination of the settlement when the property was advanced in specie to Justin (provided that the trustees and Justin so elected). As in the case of outright gifts, therefore, CGT may be postponed until the assets are sold.

Gift, of assets attracting an immediate IHT charge 569

10 Anti-avoidance

There are anti-avoidance provisions denying hold-over relief (under both TCGA 1992 s 165 and s 260 - see 25.65) on a transfer to a settlor-interested settlement (TCGA 1992 ss 169B - 169G). For this purpose a settlor has an interest in a settlement where any property in the settlement (or any property derived from that property) may be, or is, used for the benefit of the settlor or his spouse or any minor unmarried child of his (who is not in a civil partnership)

'Child' includes step-child. The extension to cover minor unmarried children applies to all settlements, whenever created, from 6 April 2006 (FA 2006) and many settlements which have not been settlor-interested for CGT purposes will automatically become so on 6 April 2006 as a result of this provision.

The legislation is designed to prevent a gain being, in effect, transferred to trustees who are in a position to realise the gain at less tax cost (because of available reliefs or losses) than the settlor, with the settlor then able to benefit directly or indirectly from the resulting funds.

The obvious counter of transferring property to a settlement that is not a settlor-interested settlement but which subsequently becomes settlor-interested is prevented by means of a clawback of hold-over relief (and a corresponding increase in the trustees' base cost). This occurs if the settlement becomes settlor-interested within six years of the end of the tax year in which the gift was made. One effect of the FA 2006 legislation is that a settlement could become settlor-interested inadvertently eg if a settlor makes a settlement for the benefit of his children, all whom are adult at the time the settlement is made, and he then acquires minor step-children on re-marriage. But a saving provision applies for pre-6 April 2006 disposals to a settlement from which the settlor's minor children could, and still can, benefit: if hold-over relief under s 165 was claimed on the disposal there will not be an immediate clawback of the relief as a result of the extended meaning now given to settlor-interested settlements.

Note: If held-over gains are clawed back and charged to CGT there will be no taper relief on those gains even though taper relief would have been available if the settlor had chosen to pay the CGT and not elect for hold-over relief. [24.36]-[24.60]

III GIFTS OF ASSETS ATTRACTING AN IMMEDIATE IHT CHARGE (TCGA 1992 s 260(2) (A))

The second situation where hold-over relief is available on a gift or undervalue sale, is if the relevant disposal 'is a chargeable transfer within the meaning of the IHTA 1984' or would be such a transfer but for the availability of the annual exemption. A chargeable transfer of business or agricultural property qualifying for 100% relief from IHT is eligible for relief under this provision notwithstanding that no IHT will actually be due.

A gain arising on the disposal of a qualifying corporate bond (QCB) cannot be held over under this section. [24.61] [*570]

1 When is there an immediate IHT charge on inter vivos gifts?

Lifetime transfers which are PETs (now reduced in scope considerably by FA 2006) do not attract an immediate IHT charge: accordingly, in such cases hold-over relief under this section is not available and this applies even if the PET subsequently becomes chargeable because of the death of the transferor within seven years.

The circumstances in which s 260(2) (a) hold-over relief is available have been considerably enlarged as a consequence of the changes to the IHT treatment of trusts introduced by FA 2006, with most disposals into, and out of, settlements now being chargeable transfers for IHT. Relief under s260(2) (a) is available in the following cases with effect from 22 March 2006: (1) on the lifetime disposal of assets to all new trusts made on or after 22 March 2006 (except where the trust is a disabled trust under IHTA 1984 ss 89 or 89A: most disposals to such trusts will be PETs);

(2) on the lifetime disposal of assets on or after 22 March 2006 to all pre-existing trusts (whether discretionary, interest in possession or accumulation and maintenance);

(3) on the disposal of assets by trustees out of all new trusts made on or after 22 March 2006, except where the disposal is made on the lifetime termination of an immediate post-death interest (see [33.4]) in favour of a beneficiary absolutely entitled (such a disposal will be a PET) Note: disposals to minors from trusts under IHTA 1984 ss 71A or 71D are not chargeabls transfers for IHT but nevertheless qualify for hold-over relief under new paragraphs of s 260(2) inserted by FA 2006: see [24.911-[24.1101;

(4) on the disposal of assets by trustees out of.

- pre-existing discretionary trusts

- pre-existing interest in possession trusts, except where the disposal is made on the lifetime termination of the pre-existing interest in possession, or of a transitional serial interest (see [33.4]), in favour of a beneficiary absolutely entitled (such a disposal will be a PET)

- pre-existing accumulation and maintenance trusts which enter the IHT relevant property regime on 6 April 2008 or on an interest in possession arising before that date. (For hold-over relief on disposals from such trusts prior to them entering the relevant property regime see [24.91]-[24.110]).

In addition, relief under s 260(2) (a) is available:

(5) On a gift between individuals or on the creation of a disabled trust in circumstances where such gifts fall outside the definition of a PET. Such cases are rare: see [28.41].

Because s 260 specifies that to come within its terms the disposal must be to and by either an individual or the trustees of a settlement, gifts to and by companies do not attract hold-over relief even though they are not PETs. (Unless, of course, the gift to a company is of a business asset other than shares when relief may be available under s 165 as discussed at [24.21].) [24.62] [*571]

2 The relief

The relief afforded by s 260 is broadly the same as that given under s 165. Relief under s 260 does, however, take precedence over the s 165 relief (TCGA 1992 s 165(3)(d)) and this may have attractions when what is contemplated is a transfer of shares in a family company which owns non-business assets since there is no apportionment requirement under s 260 (contrast s 165 at [24.27] and see Capital Taxes, 1990, p 52).

An election is required in the same terms as under s 165; the effect of holding over the gain is the same (ie the asset is disposed of and acquired at market value less held-over gain); the transferee must be either UK resident or ordinarily resident and subsequent emigration may trigger the charge. Unlike s 165 there is, however, no restriction on the type of asset for which relief may be claimed. [24.63]

3 Practical uses of s 260(2) (a)

To date the main situations where hold-over relief under s 260(2) (a) has been employed have been when a discretionary trust has been either created or ended. These have been the principal occasions on which an immediate IHT charge has arisen and hence a gain on a chargeable asset entering or leaving a trust has been held-over. The following example illustrates the various permutations that are now available for s 260(2) (a) hold-over relief following the considerable extension of IHT lifetime chargeable transfers by FA 2006. [24.64]

EXAMPLE 24.14

(1) In May 2006, Jake transfers his portfolio of stocks and shares (worth £500,000) into a new trust for the benefit of his adult children; the transfer results in an immediate IHT charge and therefore any gain on the investments can be held over if Jake (alone) elects under s 260(2) (a). Note that any IHT paid by Jake (ignoring grossing-up) can be deducted by the trustees in arriving at the CGT charge on a subsequent disposal of the shares (and this sum may be increased should an extra tax charge result from the death of Jake within seven years of establishing his trust: see [24.32]).

(2) Joseph establishes a new trust by transferring land worth £255,000 to the trustees. As his first chargeable transfer, IHT will not be payable since it falls within Joseph's nil rate band. Despite this, hold-over relief under s 260(2) (a) is available since the transfer by Joseph is chargeable to IHT albeit at a nil rate. This gives the best of all worlds: no IHT but CGT hold-over. (Note that s 260(2) (a) also applies if a transfer of value which would otherwise attract an immediate IHT charge is covered by the transferor's annual exemption.)

(3) Were the trustees of Joseph's trust subsequently (eg six months later) to appoint the cottage to a beneficiary outright, there should still be no IHT charge but again CGT hold-over relief will be available.

(4) Thai and Thad, trustees of the Mallard discretionary trust, appoint chargeable assets to Billy Beneficiary. This being a trust of 'relevant property' for IHT (see [28.1I-[28.20]), an 'exit' charge will arise (see [34.23]) and therefore any chargeable gain can be held over on the joint election of Thai, Thad and Billy. Note, however, that an appointment out of a relevant property trust within three months of its creation does not give rise to any IHT charge (see [34.25]) and that appointments out of a relevant property trust [*572] established by will made within two years of the testator's death are 'read back' into that will (see [30.145]). Therefore CGT hold-over is not available in either ease.

(5) Trustees Toni and Ted, in exercise of powers conferred on them by the settlement, resettle the trust property (non-business assets) into a new settlement. This is a deemed disposal under s 71(1) for CGT purposes but any resulting gain may only be held over if it is also a chargeable event for IHT. With many inter-settlement transfers after 22 March 2006 this will not he the case since the property will have moved from one 'relevant property' settlement to another and no IHT 'exit' charge will arise due to the operation of IHTA 1984 s 81 (see [34.32]) which deems the property to remain comprised in the transferring settlement. If, by contrast, trustees exercise their powers so as to appoint new trusts of the same settlement (eg by terminating a pre-22 March 2006 life interest and appointing fresh discretionary trusts) then although this will give rise to a lifetime chargeable transfer for IHT there will be no deemed disposal at all for CGT purposes since the trust assets will not have left the settlement (and so hold-over relief will not need to be considered).

(6) In 1990 Seth made an accumulation and maintenance settlement in favour of his infant grandchildren, Gus and Zac, by which each would acquire a life interest in an equal half share on reaching 25. In fact Gus acquired an interest in possession in his share under Trustee Act 1925 s 31 on reaching 18 in January 2005 and he was then treated as becoming the beneficial owner of his share for IHT under IHTA 1984 s 49(1). Zac, however, does not acquire an interest in possession in his share until reaching 18 in November 2006 and, as a. result of FA 2006 IHTA 1984, s 49(l), does not apply to his share at that point, and the share enters the IHT relevant property regime instead. After some deliberation the trustees consider both Gus and Zac to be financially responsible and, in order to curtail the IHT charges on Zac's share, they decide in March 2007 to exercise their powers of advancement by terminating the settlement in its entirety and transferring the assets out to Gus and Zac. Many of the assets are standing at a substantial gain.

The disposal of assets to Gus will not be a chargeable transfer for IHT since he is already deemed to be the beneficial owner of his share. Accordingly hold-over relief under s 260(2) (a) will not be available for the disposal to him. The disposal of assets to Zac, however, will result in a small IHT 'exit' charge, and therefore hold-over relief under s 260(2) (a) will be available on the disposal of assets to him. Note: Assuming they have the necessary power the trustees might consider appropriating the chargeable assets showing the large gains to Zac's share with the chargeable assets showing no gains and the non-chargeable assets such as cash and gilts being appropriated as necessary to achieve equality.

(7) In May 1990 property was settled on A & M trusts for Sid by which he will acquire a life interest in the trust fund on attaining the age of 25. Sid will reach 25 in June 2010 and, because of the trustees' express power to accumulate the income until that time, he has not become entitled to an interest in possession under Trustee Act 1925 s 31 even though he is now over 18. To reduce future IHT charges to acceptable proportions the trustees decide to alter the terms of the trust with effect from 6 April 2008 SO that Sid will become absolutely entitled to the capital on reaching 25 and the trust also satisfies the other conditions of IHTA 1984 s 71D. The special charge prospectively payable under s 71E on transfers to the beneficiary between the ages of 18 and 25 is considered an acceptable price to pay in order to avoid the heavier 10-yearly anniversary charge that would otherwise be due under the relevant property regime in May 2010 shortly before Sid [*573] reaches 25. The trustees exercise their power of advancement to transfer some of the trust assets to Sid over the period from April 2008 and the remainder are transferred to him when he becomes absolutely entitled on attaining age 25. Each such transfer to Sid will be a chargeable transfer for IHT (by virtue of s 71E) and will therefore qualify for hold-over relief under s260(2) (a).

Note: care should be taken in arranging transfers from a s 71D trust shortly after the beneficiary has reached 18 because the special charge under s 71E does not apply to transfers to the beneficiary during the first three months after his/her 18th birthday. Accordingly hold-over relief under s 260(2) (a) will not be available on disposals during this brief period.

4 Anti-avoidance

The anti-avoidance measures described at [24.36] in relation to transfers to settlor-interested settlements apply equally to hold-over relief under s 260. However, hold-over under s 260 is subject to an additional anti-avoidance provision in relation to main residence relief (see TCGA 1992 s 226A; and for main residence relief see chapter 18). Where gifts relief has been claimed under s 260, private residence relief is denied. The legislation was designed to prevent arrangements such as that in the following example. [24.65]

EXAMPLE 24.15

Tarquin owns a house that is not his only or main residence. It has a market value of £500,000 and would realise a chargeable gain of £400,000 (before taper relief) if he sold it. Tarquin would like to sell the house and give the proceeds to his adult son, Torquil.

Tarquin therefore gifts the house into a discretionary trust, claiming relief under s 260(2) (a) (note that if the settlement were settlor-interested, the anti-avoidance described at [24.36] would be in point). Under the terms of the settlement, the trustees allow Torquil to occupy the house as his main residence. A few months later, Torquil leaves the house, and the trustees sell it for £510,000. The resultant gain of £410,000 is not chargeable because of main residence relief (see [24.62]). The trustees can then distribute the proceeds to Torquil.

The anti-avoidance provisions (introduced by FA 2004) operate to deny main residence relief in these circumstances.

Because of the time allowed to make a hold-over election (see [24.28]) it may be that the trustees' disposal takes place before a hold-over claim has been made, so that the anti-avoidance rule would not be in point. If a claim is made subsequent to the trustees' disposal, main residence relief will be withdrawn and all necessary tax adjustments made.

Conversely, if a hold-over election is in place, and it is desired to make main residence relief available, the claim may be revoked. [24.661-[24.90]

IV DISPOSALS FROM ACCUMULATION AND MAINTENANCE TRUSTS AND CHILDREN'S TRUSTS (TCGA 1992 s 260(2) (D), (DA) AND (DB))

Accumulation and maintenance (A & M) trusts were the creature of the IHT legislation where they were accorded privileged treatment and kept out of the relevant property regime with its anniversary and 'exit' charges. With [*574] effect from 22 March 2006 A & M trusts can no longer be created and the privileged IHT treatment for existing ones will end on 6 April 2008 at the latest unless their terms are changed before that date so that the beneficiaries become absolutely entitled to the capital by the time they reach 18.

The hold-over position under s 260(2) (a) on disposals to existing A & M trusts is dealt with in [24.62].

Whilst the trust still qualifies as an A & M trust the disposal of assets to beneficiaries -- whether on the termination of the trust or on an advance to a beneficiary -- will qualify for hold-over relief even though this will not be a chargeable transfer for IHT. This is by virtue of the special hold-over relief that has applied to disposals from A & M trusts under TCGA s 260(2) (d). It should be noted that relief under s 260(2) (d) is not available if the beneficiary acquired an interest in possession before 22 March 2006, since the trust will have ceased to qualify as an A & M trust at that time: see (6) in Example 24.14. (A beneficiary under an A & M trust often acquires an interest in possession at age 18 or 21 even though the trust deed gives him a life or absolute interest only on reaching 25.)

As a result of the IHT changes introduced by FA 2006 the acquisition by a beneficiary of an interest in possession on or after 22 March 2006 will cause the trust to enter the IHT relevant property regime. In any event the trust will enter the regime on 6 April 2008 at the latest unless their terms are changed before that date in the manner indicated above. Once the trust has entered the relevant property regime disposals of the trust assets will qualify for hold-over relief under s 260(2)(a) (see again (6) in Example 24.14). [24.91]

EXAMPLE 24.16

(1) Property is settled on an A&M trust for Floyd on attaining 18. Floyd reaches 18 in January 2007 and becomes absolutely entitled to the assets; the A&M trust ends, and a hold-over election is possible under s 260(s) (d) (whatever the nature of the trust assets).

(2) Assume in (7) in Example 24.14 that the trustees, instead of converting the A & M trust to a s 71D trust, calculate that less IHT will be payable if they allow the trust to enter the relevant property regime on 6 April 2008 but transfer several of the trust assets out to Sid in March 2008, just before the trust ceases to qualify as an A & M trust and enters the relevant property regime. Such transfers to Sid will be free of IHT but hold-over relief under s 260(2) (d) will be available on the disposals (whatever the nature of the trust assets).

FA 2006 has established two successors to A & M trusts:

(1) Trusts for minors under IHTA 1984 s 71A (see [34.118]). These can be set up by will or intestacy or under the Criminal Injuries Compensation Scheme. The main condition is that the minor has to be entitled to the capital on attaining the age of 18 (or earlier).

(2) Trusts under IHTA 1984 s 71D (see [34.118]). The main condition here is that the beneficiary has to be entitled to the capital on attaining the age of 25 (or earlier). Trusts under s 71D can come into existence in one of two ways. Firstly, like s 71A trusts, they can be created by will or intestacy or under the Criminal Injuries Compensation Scheme. Secondly, they can be created out of an existing A & M trust by the trustees [*575] altering the terms of the trust so that it satisfies the s 71D conditions immediately it ceases to qualify as an A & M trust (which will be on 6 April 2008 at the latest).

Both s 71A and s 71D trusts are outside the IHT relevant property regime of anniversary and 'exit' charges, and the special charge imposed on transfers out of s 71D trusts applies only on transfers when the beneficiary is aged between 18 and 25. Accordingly transfers from a s 71A or s 71D trust to the beneficiary up to (or on) his/her 18th birthday are not chargeable transfers for IHT but, as with disposals from A & M trusts, a special hold-over relief is accorded to such disposals: TCGA s 260(2)(da) and (db). [24.921-[24.110]

EXAMPLE 24.17

In 2000 property was settled on A & M trusts for Harry, then aged 2, by which he would obtain an interest in possession in the trust fund on reaching 25. In March 2008, just before the trust loses its A & M status on 6 April 2008 and would otherwise enter the IHT relevant property regime, the trustees exercise their powers so that the trust will satisfy the s 71D conditions with effect from 6 April 2008 including the principal requirement that Harry will become entitled to the capital at 25. Shortly before Harry reaches 18 in 2016 the trustees decide to avoid all IHT charges and end the trust by advancing all the trust assets out to Harry on the occasion of his 18th birthday. The transfers will be free of IHT and the disposals will qualify for hold-over relief under s 260(2) (db). See Note to (7) in Example 24.14 for the trap if the disposals to Harry were made immediately after his 18th birthday.

V MISCELLANEOUS CASES

Hold-over relief under s 260(2) is also available in the following situations where the relevant transfer is exempt from any IHT charge:

(1) transfers to political parties under IHTA 1984 s 24;

(2) transfers to maintenance funds for historic buildings under IHTA 1984 s 27 and for disposals out of settlement to such funds;

(3) transfers of designated property under IHTA 1984 s 30;

(4) transfers of works of art under IHTA 1984 s 78.

It may also be noted that there are other provisions in the CGT legislation which result in a postponement of tax. Share exchanges under TCGA 1992 ss 135-137 (considered at [26.3]) and relief on the incorporation of a business under s 162 (discussed at [22.100]) are examples whilst disposals between husband and wife are always taxed on a no gain/no loss basis irrespective of any actual consideration paid ([19.22]). [24.111]-[24.130]

VI PAYMENT OF TAN BY INSTALMENTS

1 General rule

CGT must generally be paid on 31 January following the tax year when the disposal occurs and, even if the disponer receives payment in instalments, there is no general right to pay the tax by instalments (see TCGA 1992 s 7 and [19.93]). [24.131] [*576]

2 Payment by instalments

Section 281 qualifies this general principle in the case of gifts of certain property (but not, apparently, for sales at undervalue) and also in the case of deemed disposals of settled property. Even in these cases, however, the ability to pay by instalments will broadly be available only if the relevant chargeable gain could not have been held over under either s 165 or s 260 (notice, therefore, that failure to make the election will not give the right to pay tax by instalments).

The property on which tax may be paid by instalments is land (including any estate or interest in land); a controlling shareholding; and a minority shareholding in a company neither listed on a recognised stock exchange nor dealt in on the Unlisted Securities Market.

The person paying the CGT must give notice if he wishes to pay by instalments: tax is then paid by ten equal yearly instalments starting on the usual payment date (ie 31 January following the tax year of the disposal). Interest is charged on the unpaid CGT and is added to each instalment. The outstanding tax can be paid off at any time and must be paid off if the gift was to a connected person or was a deemed disposal of settled property and the relevant assets are subsequently sold for valuable consideration. [24.132]

EXAMPLE 24.17

In July 2005 Bob gives his seaside cottage to his daughter Thelma. The resulting CGT of £50,000 may be paid by ten equal annual instalments on the appropriate notice being given by Bob (who is to pay that tax). The first instalment of £5,000 falls due on 31 January 2007 and subsequent instalments will carry interest on the unpaid balance of the CGT.

3 Payment by a donee

TCGA 1992 s 282 provides that if a donor fails to pay the tax referable to the gift the Revenue may look to the donee for payment (for a criticism of the drafting of this provision sec PTPR (Personal Tax Planning Review), vol 4, p lO7). [24.133]

[*577]

25 CGT-settlements

Updated by Sarah Laing, CTA, Chartered Tax Advisor, CPE Consulting Ltd

I What is a settlement? [25.2]

II The creation of a settlement [25.21]

III Actual and deemed disposals by trustees [25.41]

IV Resettlements and separate funds [25.81]

V Disposal of beneficial interests [25.111]

VI Relief from, and payment of, CGT [25.141]

VII Trusts with vulnerable beneficiary [25.149]

The legislation distinguishes between UK-resident trusts and non-resident trusts. The latter are considered in Chapter 27. So far as the former are concerned, the legislation generally seeks to tax gains that arise (or are deemed to arise) on property comprised in the trust fund and not on a disposal of the interests of the beneficiaries. Actual disposals by the trustees and certain deemed disposals may trigger a charge, but disposals of beneficial interests will normally be exempt. [25.1]

I WHAT IS A SETTLEMENT?

1 Definition

A 'settlement' is sometimes referred to as a trust, implying that they share the same meaning. However, a settlement can include any disposition, trust, covenant, agreement, arrangement or transfer of assets.

Finance Act 2006, Schs 12 and 13 contain provisions to redefine settled property from 6 April 2006 as any property held in trust other than property held as nominee, bare trustee for a person absolutely entitled, an infant or disabled person (TCGA 1992 s 60). References in the legislation to a settlement are construed as references to settled property and the meaning of settlement is determined by case law. This measure effectively aligns what is treated as a settlement for the general purposes of income tax and tax on chargeable gains. The effect is that income tax will be charged on income arising to the trustees of a 'settlement' with the definition of settlement being derived from existing trust law and case law, and 'settled property' being defined in the tax legislation (TCGA 1992 s 68A) [25.2] [*578]

2 Nominees and bare trusts

Property is not settled where 'assets are held by a person as nominee for another person, or as trustee for another person absolutely entitled as against the trustee'. The provision covers nomineeships and bare or simple trusts. [25.3]

EXAMPLE 25.1

Tim and Tom hold 1,000 shares in DNC Ltd on trust for Bertram, aged 26, absolutely. This is a bare trust since Bertram is solely entitled to the shares and can at any time bring the trust to an end (see Saunders v Vautier (1841)). The shares are treated as belonging to Bertram so that a disposal of those shares by the trustees is treated as being by Bertram and any transfer from the trustees to Bertram is ignored.

3 Beneficiaries under a disability

Where the property is held on trust 'for any person who would be [absolutely] entitled but for being an infant or other person under a disability' it is not settled. [25.4]

EXAMPLE 25.2

(1) Topsy and Tim hold property for Alex absolutely, aged nine. Because of his age Alex cannot demand the property from the trustees and the trust is not simple or bare. Alex is, however, a person who would be absolutely entitled but for his infancy and he is (for CGT purposes) treated as owning the assets in the fund.

(2) Teddy and Tiger hold property on trust for Noddy, aged nine, contingent upon his attaining the age of 18. At first sight it would seem that there is no material difference between this settlement and that considered in (1) above since, in both, the beneficiary would be absolutely entitled were it not for his infancy. Noddy, however, is not entitled to claim the fund from the trustees. Unlike (1) above, Noddy's entitlement is contingent upon living to a certain age, so that, were he to ask the trustees to give him the property, they would refuse because he has not satisfied the contingency. This distinction would be more obvious if the settlement provided that the contingency to be satisfied by Noddy was the attaining of (say) 21 (see Tomiinson v Glyns Executor and Trustee Co (1970)). The property in this example is, therefore, settled for the purposes of CGT.

4 Concurrent interests

Where property is held for 'two or more persons who are or would be jointly [absolutely] entitled' the property is not settled. The word 'jointly' is not limited to the interests of joint tenants, applying to concurrent ownership generally. It does not, however, apply to interests that are successive, but only covers more than one beneficiary concurrently entitled 'in the same interest' (see Kidson v MacDonald (1974); Booth v Ellard (1980); and IRC v Matthew's Executors (1984)). [25.5]

What is a settlement? 579

EXAMPLE 25.3

(1) Bill and Ben purchase Blackacre as tenants in common in equal shares. The land is held on a trust of land, but for the purposes of CGT the property is not settled and is treated as belonging to Bill and Ben equally (Kidson v MacDonald (1974)).

(2) Mr T and his family hold 72% of the issued share capital in T Ltd (their family company). They enter into a written agreement as a result of which the shares are transferred to trustees and detailed restrictions, akin to pre-emption provisions in private company articles, are imposed. The beneficial interests of Mr T and his family are not, however, affected. Subsequently the shares are transferred out again to the various settlors. In such a 'pooling arrangement' the shares will be treated as nominee property with the result that there is no disposal for CGT purposes on the creation of the trust nor on its termination (cp Booth v Ellard (1980) and see Jenkins v Brown and Warrington v Sterland (1989) in which a similar result was arrived at (surprisingly?) in the case of a pooling of family farms. See further [22.83]). (3) Thal and Tal hold property on trust for Simon for life, remainder to Karl absolutely. Both are adult. Although Simon and Karl are, in common parlance, jointly entitled to claim the fund from the trustees, they are not 'jointly absolutely entitled' within the meaning of s 60. The property is settled for CGT purposes.

5 Meaning of absolute entitlement

It is the concept of being 'absolutely entitled as against the trustee' which lies at the root of the three cases mentioned in s 60. Section 60(2) provides that:

'It is hereby declared that references in this Act to any asset held by a person as trustee for another person absolutely entitled as against the trustee are references to a case where that other person has the exclusive right, subject only to satisfying any outstanding charge, lien or other right of the trustees to resort to the asset for payment of duty, taxes, costs or other outgoings, to direct how that asset shall be dealt with.'

The various rights against the property possessed by trustees and mentioned in s 60(2) refer to personal rights of indemnity; they do not cover other beneficial interests under the settlement.

EXAMPLE 25.4

Jackson is entitled to an annuity of £1,000 pa payable out of a settled fund which is held in trust for Xerxes absolutely. The property is settled for CGT purposes (Stephenson v Barclays Bank Trust Co Ltd (1975) and contrast X v A (2000) where in exercise of their lien trustees retained trust property against a beneficiary absolutely entitled-it is considered that in this case the property had ceased to be settled for CGT purposes).

A person can become absolutely entitled to assets without being 'beneficially' entitled (see [25.81]). [25.6]

6 Crowe v Appleby and trustee appropriations

Section 60(2) does not offer any guidance on the question of when a beneficiary has 'the exclusive right... to direct how [the] asset in [the [*580] settlement] shall be dealt with'. Under general trust law beneficiaries will not be able to issue such directions unless they have the right to end the trust by demanding their share of the property (see eg Re Brockbank (1948)). Difficulties may arise where one of a number of beneficiaries is entitled to a portion of the fund.

EXAMPLE 25.5

A trust fund is held for the three daughters of the settlor (Jane, June and joy) contingent upon attaining 21 and, if more than one, in equal shares absolutely. Jane, the eldest, is 21 and is, therefore, entitled to one-third of the assets. Whether she is absolutely entitled as against the trustees to that share depends upon the type of property held by the trustees and the terms of the settlement. The general principle is that she will be entitled to claim her one-third share, but not if the effect of distributing that slice of the fund would be to damage the interests of the other beneficiaries and nor if the trustees are given an express power of appropriation.

(1) If Jane is absolutely entitled to her share that portion of the fund ceases to be settled (even though Jane leaves her share in the hands of the trustees). (2) But, if the fund consists of land, Jane will not be absolutely entitled (see Crone v Appleby (1975)). Hence, the settlement will continue until all three daughters either satisfy the contingency or die before 21. Only then will the fund cease to be settled since one or more persons will, at that point, become jointly absolutely entitled. (For problems that can arise on a division of a controlling shareholding see Lloyds Bank plc v Duker (1987).)

What assets other than land are subject to a similar rule? HMRC (at CG 37560) comment as follows:

'In Stephenson v Barclays Bank Trust Co Ltd Walton J said that as regards shares in a private company in very special circumstances, and possibly mortgage debts, the person with a vested interest in a share of the property might have to wait for sale before he could call upon the trustees to account to him for his share. The principle of Crone v Appleby therefore may apply to other indivisible assets. A good example would be an Old Master painting or valuable antique, or indeed a single share in a company.'

If the trustees have an express power to appropriate assets in satisfaction of the share of a beneficiary, HMRC's view is:

(1) that any gain on the deemed disposal is calculated on the assets actually appropriated and not on a proportion of the total gain on all assets in the settlement; and

(2) pending the trustees making an appropriation, tax is not charged. [25.7]

7 Class closing

In deciding whether the class of beneficiaries has closed so that those in existence (who have satisfied any relevant contingency) have become absolutely entitled the medical impossibility of further beneficiaries being born to a living person is ignored. Hence a settlement on the children of A who attain 21 and if more than one in equal shares will remain settled property until the death of A even though he may have become incapable of having further children before that time (Figg v Clarke (1996)). [25.8]-[25.20] [*581]

II THE CREATION OF A SETTLEMENT

1 General rule

The creation of a settlement is a disposal of assets by the settlor whether the settlement is revocable or irrevocable, and whether or not the settlor or his spouse is a beneficiary (TCGA 1992 s 70). If chargeable assets are settled, a chargeable gain or allowable loss will result unless holdover relief is available (as to which see Chapter 24). [25.21]

2 The 'connected persons' rule

As the settlor and his trustees are connected persons (TCGA 1992 s 18(3): see [19.23]), any loss resulting from the transfer will only be deductible from a gain realised on a subsequent disposal by the settlor to those trustees. Apart from being connected with the settlor, trustees will also be connected with persons connected with the settlor who will often be beneficiaries. However, it has been confirmed by HMRC that:

'if the settlor dies the connection with the trustees and relatives and spouse of the senior is broken. Therefore if, for instance, the beneficiaries of the settlement are the children of the late settlor, the trustees are not connected with those beneficiaries, even if one or more of the children are trustees' (RI 38, February 1993). [25.22]-[25.40]

EXAMPLE 25.6

(1) Roger settles his Van Gogh sketch 'Peasant with Pig' worth £200,000. His allowable expenditure totals £50,000. He also settles his main residence. The beneficiaries are his wife Rena for life with remainder to their two children, Robina and Rybina. For CGT purposes, the following rules apply:

(a) Main residence This is exempt from CGT.

(b) The Van Gogh This is treated as disposed of for its market value (£200,000) and, hence, Roger has made a gain of £150,000.

(2) Robin wishes to sell his share portfolio but that will realise a substantial gain. He owns real property (which he wishes to retain) that would realise a loss if sold. Robin transfers both assets to trustees on a life interest trust for himself. This triggers the gain on the investments that will be offset by the loss on the land. The trustees immediately sell the portfolio (in due course the trustees may under a power in the settlement return the assets to Robin). Robin has therefore sheltered his gain.

III ACTUAL AND DEEMED DISPOSALS BY TRUSTEES

A charge to CGT may arise as a result of either actual or deemed disposals of property by the trustees. Trustees are taxed at the rate applicable to trusts (40% for 2004-05 onwards) irrespective of the type of trust involved: the only exception is where the settlor has reserved an interest in his trusts under TCGA 1992 ss 77-79 when the gains are attributed to him (see [19.85]). From 6 April 2005 a standard rate band of £500 was introduced for all trusts paying tax at the rate applicable to trusts (ICTA 1988 s 686D(3), inserted by [*582] FA2005 s 14). The standard rate band has been increased to £1,000 from 6 April 2006 (FA 2006 s 89 Sch 13 para 4(1)(b)). The introduction of this rate band is designed to ensure that trusts with small amounts of taxed income have no further liability and no longer have to submit a self-assessment return each year. Note that where a settlor has made more than one settlement, the band is restricted to the lesser of £200 or £1,000 divided by the number of settlements made (ICTA 1988 s 686E, inserted by FA 2006 s 89 Sch 13 para 4(2)). [25.41]

I Transfers of property on a change of trustees

When the property is transferred from old to new trustees this is not treated as a CGT disposal since trustees are treated as a single and continuing body (TCGA 1992 s 69(1)). Note, in particular:

(1) the position when UK resident trustees are replaced by non-residents (see [27.57]);

(2) if part only of the trust property is appointed into trusts administered by non-resident trustees, given that there is a single composite settlement for CGT purposes the continuing UK trustees will be accountable for gains realised offshore (see Roome v Edwards (1981) and [25.82]). [25.42]

2 Actual disposals and trust losses

When chargeable assets are sold by trustees, normal principles apply in calculating the gain (or loss) of the trustees. If the disposal generates a loss it may be set off against gains of the same year or of future years made by the trustees. [25.43]

3 Use of trust losses by a beneficiary

a) The Old Rule

Prior to 16 June 1999, if a beneficiary became absolutely entitled to trust property any loss which had accrued to the trustees in respect of that property (including a carried forward loss) and which could not be offset against trustee gains for that year occurring prior to the beneficiary becoming so entitled was transferred to that beneficiary. If more than one beneficiary became so entitled, the loss was apportioned between them (TCGA 1992 s 71(2) and see [25.48])). (Note that a trust loss was therefore more favourably treated than losses made by PRs: see [21.811.) [25.44]

b) Restricted use of losses try beneficiaries

As a result of these rules being abused the availability of losses to a beneficiary was then severely restricted. Only on the occasion when a beneficiary becomes absolutely entitled to trust assets (so that the trustees make a deemed disposal which produces a loss: see [25.48]) may that loss be [*583] passed to a beneficiary and then only to be offset against a future gain on a disposal of the property that he received from the trust (TCGA 1992 s 71(2). [25.45]

EXAMPLE 25.7

In May 2006 Daisy becomes absolutely entitled to one half of the assets in her grandmother's trust. At that time the trustees have unused capital losses of £25,000 and the assets to which Daisy becomes entitled are worth £30,000 less than when acquired by the trustees.

(1) None of the realised losses of £25,000 accrue to Daisy: they remain avai1able for use by the trustees against future disposals of trust property. (2) The loss that occurs on the s 71 deemed disposal is, however, available to Daisy but only to be set against future gains on a disposal of that trust property. (Note: This loss would not be available to Daisy if the trustees could use it either against gains realised earlier in the tax year 2006-07 or against gains arising on the s 71 deemed disposal.)

c) Adding property to the trust

EXAMPLE 25.8

The Jokey Trust has unused realised capital losses. Bill purchases an interest in the trust; adds assets to the trust which are pregnant with gain (claiming holdover); those assets are sold by the trustees thereby utilising the trust losses and the cash is paid out to Bill.

TCGA 1992 s 79A provides that in the circumstances of Example 25.8 the trustees' losses may not be set against the gain. Note that for this section to apply:

(1) a transferor must add assets to the settlement claiming holdover relief; and

(2) that person (or someone connected with him) must purchase an interest in the settlement.

Accordingly an original beneficiary may add property to use the trust losses. [25.46]

4 The exit charge: TCGA l992 s 71(1)

a) The general rule

Section 71(1) provides for a deemed disposal of the chargeable assets in the trust fund, whenever a person becomes absolutely entitled to any portion of the settled property (an 'exit charge'). The section is a 'deeming' provision and treats the assets in the fund as being sold by the trustees (so that it is the trustee rate of CGT which is relevant) for their market value at that date and immediately reacquired for the same value, thereby ensuring that any increase in value in the chargeable assets is taxed (except in the situation discussed below). The deemed reacquisition by the trustees is treated as the act of the person who is absolutely entitled to the fund as against the trustees (see TCGA 1992 s 60(1)). [25.47] [*584]

EXAMPLE 25.9

Shares in Dovecot Ltd are held by trustees for Simone absolutely, contingent upon her attaining the age of 25. She has just become 25 and the shares are worth £100,000. The trustees' allowable expenditure is £25,000. She is now absolutely entitled to the fund and the trustees are deemed to sell the shares (for £100,000) and to reacquire them (for £100.000). On that deemed disposal they have realised a chargeable gain of £75,000 (£100,000 - £25,000) that may benefit from taper relief in the normal way. The shares are now treated as Simone's property so that if she directs their sale in the future and £107,000 is raised she will have a chargeable gain of £7,000 (£107,000 - £100,000).

b) Losses

A loss arising on the deemed disposal which occurs under s 71 will be deducted from 'pre-entitlement gains', defined as gains accruing to the trustees in that same tax year (but before the s 71 deemed disposal) or accruing on the deemed disposal. Subject to that, the loss is passed to the beneficiary under s 71(2) as discussed in [25.45]. How is this rule affected by the existence or otherwise of connected persons? The Revenue has confirmed that the beneficiaries' entitlement to the loss under s 71 is not affected by this rule. Indeed, it seems odd that there was ever any doubt about the matter bearing in mind that the utilisation of losses is only restricted if the relevant disposal is to a connected person. On the termination of a trust the legislation provides not for a disposal of the settled properly to the relevant beneficiary but rather for a deemed disposal by the trustees (see RI 38, February 1993). [25.48]

c) Deemed disposal triggered by the death of a beneficiary entitled to an interest in possession: TCGA 1992 s 73

The termination of an interest in possession because of the death of the beneficiary may result in a deemed disposal by the trustees under s 71(1) if on that occasion the settlement ends (ie a person becomes absolutely entitled to the trust assets). Although there is a deemed disposal and reacquisition, no CGT (or loss relief) is charged (or allowed) on any resultant gain (loss): see [25.541 for the definition of an interest in possession. This corresponds to the normal CGT principle that on death there is an uplift in value but no charge to tax (see Chapter 21; and, for the IHT consequences, Chapter 33).

EXAMPLE 25.10

Property consisting of shares in Zac Ltd is held on trust for Irene for life, or until remarriage and thereafter to Dominic absolutely.

(1) If Irene dies There will be a deemed disposal and reacquisition of the shares at market value by the trustees (TCGA 1992 s 71(1)), but CGT will not be charged. The property henceforth belongs to Dominic.

(2) If Irene remarries The life interest will cease with the same consequences as in (1), save that CGT may be chargeable.

If the interest is in a part only of the fund, the death of the beneficiary will result in an uplift in the appropriate portion of each asset in the fund without [*585] any CGT charge thereon (TCGA 1992 s 73(2)) although assets may be appropriated by the trustees in satisfaction of that share in which case the uplift is in respect of those assets only (see [25.7]).

The above treatment also applies to interests in possession which are not life interests but which came to an end on death. For instance, if the income of a trust fund was settled on A until the age of 40 and thereafter the entire fund passed to B and A died aged 35 (see, for the definition of an interest in possession, [25.54]). [25.49]

d) Reverter to settlor

if the death causes the properly to revert to the settlor, the 'reverter to disponer' exception applies (see TCGA 1992 s 73(1)(b) and [33.34]). The death of the beneficiary in these circumstances does not lead to a charge to IHT and, hence, the normal tax-free uplift provisions are modified to ensure that there is no double benefit. For CGT therefore the death will cause a deemed disposal and reacquisition, but for such a sum as will ensure that neither gain nor loss accrues to the trustees (a no gain/no loss disposal). Curiously, the position is different if property reverts to the settlor as life tenant. In this case a full uplift is given. [25.50]

EXAMPLE 25.11

In 1999 Sue settled property on trust for Samantha for life. In 2006 Samantha dies whereupon the property reverts to Sue and the acquisition value and allowable expenses of the trustees are then £15,000 (value at the death of Samantha is £25,000). There is a deemed disposal and reacquisition by the trustees for £15,000 (to ensure neither gain nor loss). Contrast, however, the position if on Samantha's death the property reverted to Sue on a life interest trust. Despite the IHT exemption still applying, for CGT purposes the usual death uplift applies (see 25.54]).

e) Holdover relief and the tax-free death uplift

Normally, a tax-free uplift occurs when the death of the interest in possession beneficiary gives rise to a s 71(1) disposal. However, if the settlor had made an election to holdover his gain when he created the settlement, that held-over gain is not wiped out on the subsequent death of the life tenant but instead is chargeable at that time (TCGA 1992 s 74: for holdover relief, see generally Chapter 24).

Following the imposition of the inheritance tax regime for discretionary trusts on other types of trust in the Finance Act 2006, holdover relief for CGT purposes now applies to certain other types of transfer. Transfers into and out of a trust that come within the IHT relevant properly rules will automatically be eligible for holdover relief under TCGA 1992 s 260(2)A. It should be noted, however, that changes to the holdover regime generally remove the ability to elect for this relief to apply where a settlement is created for the benefit of a settlor's minor children. Where assets remain in trust following the death of life tenant, there will be no CGT-free uplift on death unless a succeeding interest in possession meets the new IHT rules. [*586]

EXAMPLE 25.12

Property was settled on trust for Frank for life with remainder to Brian absolutely.

The settlor elected to holdover the gain of £12,000 when he created the settlement. When Frank dies, the total gain on the deemed disposal made by the trustees under s 71 is £40,000. The CGT position is:

(1) There will be a tax-free uplift on the death of Frank, but only for gains arising since the creation of the settlement. Of the total gain of £40,000, £28,000 is, therefore, free of CGT.

(2) The remaining £12,000 gain (the gain held over by the senior) is subject to tax on Frank's death (unless a further claim for holdover relief is made at that time).

The result of s 74 is a partial revival of the CGT charge on death that is explicable as an anti-avoidance measure. Assume that Bertha wished to give her daughter Brenda an asset on which there was a large unrealised capital gain and on a gift of which a holdover election was available. They could have elected for holdover relief, but that would have resulted in Brenda taking over the gain. As an alternative, therefore, Bertha could have settled the asset on an aged life tenant, who was expected to die imminently, and given the remainder interest to Brenda. No CGT would have arisen on the creation of that settlement if Bertha elected for holdover relief and, were it not for s 74, the death of the life tenant would have wiped out all gains leaving Brenda with the asset valued at its then market value. [25.51]

f) The anti flip-flop legislation

FA 2000 inserted provisions (TCGA 1992 s 76B and Sch 4B) aimed at 'flip-flop' arrangements which were widely employed in non-UK resident trusts. The legislation is, however, drafted sufficiently widely to catch UK trusts where the only benefit of the scheme was a 6% tax saving. Where these anti-avoidance rules apply, the trustees are deemed to dispose of and to reacquire trust assets at market value. The provisions are considered at [27.93]. [25.52]

g) Allowable expenditure on a deemed disposal

By its very nature a deemed disposal will rarely lead to any expenditure. TCGA 1992 s 38(4) (which prohibits notional expenditure) seems somewhat redundant, especially in the light of IRC v Chubb 's Settlement Trustees (1971) which permitted the deduction of actual expenses incurred upon the partition of a fund (see [19.30]). [25.53]

5 The termination of an interest in possession on the death of the beneficiary, the settlement continuing (TCGA 1992 s 72)

The death of a beneficiary entitled to an interest in possession, in cases where the settlement continues thereafter (ie where TCGA 1992 s 71(1) does not operate), results in a deemed disposal and reacquisition of the assets in the fund by the trustees at their then market value (TCGA 1992 s 72). CGT will not normally be imposed, and the purpose of s 72 is the familiar one of ensuring a tax-free uplift. [*587]

The termination of an interest in a part of the fund, where the settlement continues thereafter, results in a proportionate uplift in the value of all the assets.

An interest in possession for these purposes includes an annuity-the relevant provisions in s 72 are as follows:

'(3) This section shall apply on the death of the person entitled to any annuity payable out of or charged on, settled property or the income of settled property as it applies on the death of a person whose interest in possession in the whole or any part of settled property terminates on his death.

(4) Where, in the case of any entitlement to an annuity created by a settlement some of the settled property is appropriated by the trustees as a fund out of which the annuity is payable, and there is no right of recourse to, or to the income of, settled property not so appropriated, then without prejudice to subsection (5) below, the settled property so appropriated shall, while the annuity is payable, and on the occasion of the death of the person entitled to the annuity, be treated for the purposes of this section as being settled property under a separate settlement.'

EXAMPLE 25.13

Property is held on trust for Walter for life and thereafter for his son Vivian contingently on attaining 25. Walter dies when Vivian is 24. The CGT consequences are:

(1) Death of Walter: There is a deemed disposal of the property under TCGA 1992 s 72; there is a tax-free uplift. The settlement continues because Vivian is not yet 25.

(2) Vivian becomes 25: There is a further deemed disposal under s 71(1) and CGT may be charged on any increase in value of the assets since Walter's death.

As with deemed disposals under s 71(1) (see [25.51]) on the death of a life tenant the full tax-free uplift on death does not apply to a gain held over on the creation of a settlement which becomes chargeable. The uplift does, however, apply if the property becomes held on an interest in possession trust for the settlor ('reverter to settlor' no gain/no loss treatment (s 73(1)(b), see [25.50]) is limited to the s 71 charge). [25.54]

6 Conclusions on deemed disposals under TCGA 1992 ss 71 and 72

The ending of general holdover relief in 1989 had important consequences for settlements. In particular, if it is no longer possible to postpone payment of the tax, the termination of a trust may result in a substantial tax liability. For instance, in the case of a life interest settlement rather than bringing the settlement to an end (whether by agreement between the beneficiaries or by exercise of overriding trustee powers), it may be preferable to wait for the death of the life tenant. In the ease of discretionary trusts, because there will normally be a chargeable transfer for IHT on the settlement ending, it remains possible to holdover any capital gains.

Resettlements of property (considered at [25.81]) should normally be avoided since the act of resettlement will (in most cases) itself trigger a CGT charge. Note, however, that not every change in beneficial interests results in a deemed disposal: for instance, if a life interest terminates, for a reason [*588] other than the death of the beneficiary and the settlement continues, there is no deemed disposal for CGT purposes. This is also the case when a beneficiary merely acquires a right to the income of the trust.

[25.55]-125.80]

EXAMPLE 25.14

Property is settled upon trust for Belinda for life or until remarriage, and thereafter for Roger contingent upon his attaining 25. If Belinda remarries when

Roger is ten, the CGT position is:

(1) The remarriage of Belinda: Belinda's remarriage terminates her life interest, but there is no deemed disposal as Roger is not at that time absolutely entitled to the fund. Hence, there are no CGT consequences.

(2) When Roger attains 18: He will become entitled to the income from the fund as a result of the Trustee Act 1925 s 31, There is no CGT consequence.

(3) When Roger attains 25: There is a deemed disposal under s 71(1), and (unless the property comprises business assets) holdover relief will not be available.

1V RESETTLEMENTS AND SEPARATE FUNDS

1 Basic rule

From 6 April 2006, where property is transferred from the trustees of one settlement to another, the settlor of the property disposed of by the trustees of the first settlement will be treated from the time of the disposal as having made the second. Property which was provided for the purposes of the first settlement, or which is derived from it, will be treated from the time of the disposal as having been provided for the purposes of the second settlement (TCGA 1992, s 68B).

When property is transferred from one settlement into another, different, settlement a CGT charge may arise under TCGA 1992 s 71(1) because the trustees of the second settlement (who may be the same persons as the trustees of the original settlement) become absolutely entitled to that property as against the original trustees (see Hoare Trustees v Gardner (1978)). [25.81]

2 When does property become comprised in a separate settlement?

Exactly when a resettlement occurs as the result of the exercise by trustees of dispositive powers (eg of appointment and advancement) contained within the trust deed is still a matter of uncertainty (see especially Roome v Edwards (1981); Bond v Pickford (1983); and Swires v Renton (1991)). In Roome v Edwards, Lord Wilberforce stressed that the question should be approached in a practical and common sense manner' and suggested that relevant indicia included separate and defined property, separate trusts and separate trustees, although he emphasised that such factors were helpful but not decisive and that the matter ultimately depended upon the particular facts of each case. He contrasted special powers of appointment which, when exercised, will usually not result in a resettlement of property, with wider powers (eg of advancement) which permit property to be removed from the original settlement.

In Bond v Pickford (1983), the Court of Appeal distinguished between two types of power:

(1) a power in the narrower form (such as a power of appointment); and

(2) a power in the wider form (typically a power of advancement).

The distinction depends on whether the trustees are permitted to free settled property from the original settlement and transfer it into a new settlement. In the absence of an express provision enabling them to do this such action would be prohibited because of the principle that trustees cannot delegate.

Powers in the narrower form cannot create a new settlement: so far as powers in the wider form are concerned their exercise will not necessarily create a new settlement. In Swires v Renton (1991), Hoffmann J stressed that the classic case involving a new settlement would be where particular assets were segregated, new trustees appointed, and fresh trusts created exhausting the beneficial interest in the assets and providing full administrative powers so that further reference back to the original settlement became redundant. The absence of one or more of these features leaves open the question whether a new settlement has arisen: the question then has to be decided on the basis of intention. In the Renton case, for instance, despite exhaustive beneficial trusts, the administrative powers of the original settlement were retained and the appointment made other references to it thereby indicating that a new settlement had not been created. SP 7/84 generally conforms to the recent cases and indicates that the exercise of a power in the wider form will not create a new settlement if it is revocable, non-exhaustive, or if the trustees of the original settlement still have duties in relation to the advanced fund.

In order to provide maximum flexibility, settlements should have dispositive powers which are in the narrower and wider form so that the trustees can then decide whether it is their wish to create a new settlement or not. [25.82]

3 Separate funds within a single settlement

It is common for settlements (and especially A&M trusts) to split into separate funds that often have separate trustees managing assets which have been appropriated to that fund. Because these funds are treated as part of a single settlement (a 'composite settlement') for CGT purposes various difficulties arise as illustrated in the following example. [25.83]-[25.110]

EXAMPLE 25.15

The Bladcomb family trust was created in discretionary form in 1965 since when 90% of the assets have been irrevocably appointed on various interest in possession trusts with the remaining 10% being appointed on A&M trusts for infant beneficiaries. The various funds are administered by the original trustees of the 1965 discretionary trust. On these facts the property has remained comprised in the original settlement for CGT purposes. Accordingly:

(1) Even if separate trustees are appointed for part of the assets held on interest in possession trusts, the trustees of the original 1965 trust will remain liable for any CGT attributable to that portion of the assets.

(2) Only one annual exemption is available for gains realised in any part of the settled fund. [*590] (3) A loss made in one fund will be used to offset a gain in another (because the settlement is a single entity). Should some form of 'compensation' be paid to the fund losing the benefit of the loss (but, if so, how is this calculated?)

V DISPOSAL OF BENEFICIAL INTERESTS

1 The basic rule

The basic rule is that there is no charge to CGT when a beneficiary disposes of his interest (TCGA 1992 s 76(1): contrast the disposal of an interest in an unadministered estate). The rationale is that gains in the trust are taxed (see above) so that to charge tax on the disposal of the interest of a beneficiary would be a form of double taxation. There is, however, a growing list of exceptions-which is added to each year as tax avoidance schemes seek to exploit the basic exemption. And, of course, if a trust is viewed as akin to a company, in which not only are corporate gains taxed but also disposals of shares are chargeable, it may be thought that the rationale behind the general rule is misconceived. [25.111]

2 Position of a purchaser

Once a beneficial interest has been purchased for money or money's worth, a future disposal of that interest will be chargeable to CGT. The consideration does not have to be 'full' or 'adequate': ie any consideration however small will turn the interest into a chargeable asset. An exchange of interests by two beneficiaries under a settlement is not, however, treated as a purchase so that a later disposal of either interest will not be chargeable.

When a life interest has been sold, the wasting asset rules (see [19.45]) may apply on a subsequent disposal of that interest by the purchaser. [25.112]

EXAMPLE 25.16

Ron is the remainderman under a settlement created by his father. He sells his interest to his friend Algy for £25,000. No CGT is charged. If Algy resells the remainder interest to Ginger for £31,000, Algy has made a chargeable gain of £6,000 (3l,000 - £25,000).

3 Purchaser becoming absolutely entitled to any part of the settled property

The termination of the settlement may result in the property passing to a purchaser of the remainder interest (of course, he may also become entitled to such property in other situations, eg if an advancement is made in his favour). As a result, that purchaser will dispose of his interest in return for receiving the property in the settlement (TCGA 1992 s 76(2)). The resultant charge that he suffers does not affect the deemed disposal by the trustees (and the possible CGT charge) under s 71(1). [25.113]

EXAMPLE 25.17

Assume, in Example 25.16, that Ginger becomes entitled to the settled fund which is worth £80,000. He has realised a chargeable gain of £49,000 (£80,000 - £31,000).

In addition, the usual deemed disposal rules under s 71(1) operate.

4 Disposal of an interest in a non-resident settlement

TCGA 1992 s 85(1) provides that the disposal of an interest in a non-resident settlement is chargeable: the basic exemption conferred by s 76(1) is therefore excluded in such cases although it is expressly provided that no charge arises under s 76(2) if the beneficiary becomes absolutely entitled to any part of the trust fund (this charge is therefore restricted to a purchaser of the interest). When the trust was originally UK resident the appointment of non-resident trustees triggers an exit charge (see [27.57]) and some protection against a double charge if a beneficial interest is subsequently sold is provided by s 85(3):

'in calculating any chargeable gain accruing on the disposal of the interest the person disposing of it shall be treated as having:

(a) disposed of it immediately before the relevant time, and

(b) immediately reacquired it, at its market value at that time.'

Although not happily drafted, the purpose of the subsection is to fix the acquisition cost of the disponor at the date when the trustees emigrated (ie his acquisition cost will take into account the gains then realised and subject to UK tax). On first reading, the provision might be thought to impose a second charge at that time but this is not thought to be the case.

An infelicity in the drafting is that the provision is said to be relevant for the purpose of calculating the chargeable gain of the disponor: it should also be relevant in arriving at any allowable loss which he may have suffered!

EXAMPLE 25.18

The Halibut trust was set up in 1988 with Jason Halibut being entitled to the residue of the trust on the death of his sister, Rose. The trustees became non-UK resident in 2006 and Jason sold his remainder interest shortly afterwards for £150,000.

Analysis:

(1) Jason has made a chargeable disposal (TCGA 1992 s 85(1));

(2) in order to compute his chargeable gain (if any) the market value of his interest when the trust became non-resident needs to be ascertained.

FA 2000 amended s 85 to prevent what might be termed 'the in and out scheme'. Assume that a non-resident trust has stockpiled gains (for the meaning of this term, see [27.112]) and is now a cash fund. UK trustees are appointed so that the trust becomes resident and subsequently it is exported (by the appointment of further non-resident trustees). On the latter event s 85(3) would operate to increase the base costs of all the beneficial interests but, given that the assets in the trust are sterling, there will be no exit charge. Accordingly a beneficiary could sell his interest (effectively extracting stockpiled gains) tax free. From 21 March 2000 the disposal of a beneficial interest in a settlement that had stockpiled gains at 'the material time' (ie when it ceased to be UK resident) will not benefit from the uplift in value under s85(3). [25.114] [*592]

5 Disposal of an interest in a settlement that had at any time been non-resident (TCGA 1992 s 76(1A), (lB) and (3))

This provision was introduced by FA 1998 and was something of a panic measure aimed at various schemes intended to avoid any charge on gains which had accrued in foreign trusts by repatriating the trust and a beneficiary then disposing of his interest. Various points should be noted about this provision:

(1) it catches the disposal of an interest if the settlement had at any time been non-resident or if it had received property from a non-resident settlement;

(2) like s 85(1) there is no charge if (or to the extent that) the beneficiary becomes entitled to the trust property;

(3) it would seem to overlap with s 85 and, in effect, makes that provision redundant. [25.115]

6 Sale of an interest in a 'settlor interested' trust (TCGA 1992 s 76A and Sch 4A)

a) Basic rule

These rules took effect from 21 March 2000 and when they apply the trustees, provided that they are UK resident, are treated as disposing and reacquiring trust assets at market value (ie there is a deemed disposal). Tax is then calculated at either the settlor rate (if the settlor still has an interest in the trust) or at the rate applicable to trusts and may be recovered by the trustees from the beneficiary who sold the interest. [25.116]

b) When is a settlor interested in his trust?

The normal provisions of TCGA 1992 s 77(2) apply: see [19.85]. For a charge to apply the trust must either have been a settlor interested trust at any time in the previous two years or must contain property derived from a trust which had been settlor interested at any time in the previous two years. Notice that the disposal can be by any beneficiary: the legislation is not limited to disposals by the settlor. The settlor must, however, be either resident or ordinarily resident in the UK.

Finance Act 2006, Sch 12 amends TCGA 1992 s 77 from 6 April 2006 to extend the definition of a settlor-interested trust to include accumulation and maintenance trusts set up by parents. The legislation provides that a settlor has an interest in a settlement where property is or may be comprised in a settlement, or may become payable for the benefit of the settlor's dependent child, or the child derives any benefit from it whatsoever either directly or indirectly. [25.117]

c) The mischief under attack

The intention is to prevent exploiting the s 76(1) exemption by individuals who place assets in trusts (instead of selling the assets) and retain an interest that is sold. However, the scope of the legislation is not so limited and may catch the wholly innocent. [25.118]-[25.140]

1teoef from, and payment o], (i(,1 593

EXAMPLE 25.19

(1) Dodgy put assets into a trust making a holdover election to avoid the payment of any CGT. He is absolutely entitled to those assets on attaining 35 (which is, say, in three months time). He sells this interest to Tug and Thug, trustees of a settlement with realised capital losses.

(a) under general principles the sale by Dodgy will not attract a CGT charge (TCGA 1992 s 76(1));

(b) when Tug and Thug become absolutely entitled a further holdover election is available and when they dispose of the assets they can offset the resultant gain by their unused trust losses.

In these circumstances s 76A provides that when Dodgy sells his interest the trustees make a deemed disposal of the trust property and the tax charge (at Dodgy's rates) will be borne by him.

(2) The Tinkerbell estate was resettled in 1990 and Teddy, the current life

tenant, will therefore be considered to be a settlor. His son, Syd, is the remainderman but is tired of waiting for his inheritance and so sells his interest. Section 76A will apply and Syd will suffer a wholly undeserved CGT charge!

VI RELIEF FROM, AND PAYMENT OF, CGT

I Payment

CGT attributable to both actual and deemed disposals of settled property is assessed on the trustees at a rate of 40%: in exceptional cases the settlor's rate will apply, see [19.85]. If the tax is not paid within six months of the due date for payment, it may be recovered from a beneficiary who has become absolutely entitled to the asset (or proceeds of sale therefrom) in respect of which the tax is chargeable. The beneficiary may be assessed in the trustees' name for a period of two years after the date when the tax became payable (TCGA 1992 s 69(4)). [25.141]

2 Exemptions and reliefs

Exemptions and reliefs from CGT have been discussed in Chapter 22, but note the following matters in the context of settled property:

Main residence exemption May be available in the case of a house settled on both discretionary and on interest in possession trusts (see Sansom v Peay (1976) and [52.62]). However, there are restrictions where holdover relief is claimed on the property entering the trust (see [25.65]). [25.142]

The annual exemption Trustees are generally allowed half of the exemption appropriate to an individual (for 2006-07, half of £8,800 = £4,400). [25.143]

Death exemption As already discussed, the tax-free uplift will be available for most trusts. [25.144]

Roll-over relief Available only if the trustees are carrying on an unincorporated business. [25.145] Trust rate band. From 6 April 2006 a £1,000 rate band is available to all trusts paying tax at the rate applicable to trusts.[25.146] [*594]

Deferral relief for chargeable gains Available if the beneficiaries are either individuals or charities. [25.147]

3 Taper and trusts

Taper relief replaced the indexation allowance for trustees as it did for individuals from April 1998 (see generally Chapter 20). The following points may be noted about the application of taper to trusts:

(1) Before 6 April 2000 discretionary trustees only qualified for business taper on company shares if they owned at least 25% of the shares. With the change from that date it may be necessary to apportion gains between business and non-business periods of ownership when the disposal occurs (see Example 20.2(3));

(2) Trusts may be used as an umbrella to obtain a full taper period (see [20.62]).

(3) Assume that trustees wish to let farmland forming part of the trust fund. If it is let to the adjoining farmer (a sole trader) the land is a non-business asset for taper purposes. By contrast if let to the neighbour's family farming company then because this is a 'qualifying company' for taper purposes the asset will attract business assets taper. This quirk in the legislation has been corrected in FA 2003 but only in respect of disposals after 5 April 2004 and to periods of ownership after that date. Time apportionment problems may therefore arise. [25.148]

VII TRUSTS W1TIH VULNERABLE BENEFICIARY

1 Introduction

FA 2005 introduced new rules, backdated to 6 April 2004, so that trusts set up for the most vulnerable, for example, for the disabled, are taxed as if the beneficiary had received the income and gains directly. (The income tax aspects of the new rules are dealt with in Chapter 16.). CGT aspects are summarised in the following paragraphs.

FA 2005 ss 23-45, create a new tax regime for certain trusts with vulnerable beneficiaries (defined by s 23 as disabled persons or relevant minors). They determine which trusts and beneficiaries will be able to elect into the regime and where a claim for special tax treatment is made for a tax year, provide for no more tax to be paid in respect of the relevant income and gains of the trust for that year than would be paid had the income and gains accrued directly to the beneficiary.

A claim for special tax treatment for a tax year may be made by trustees if (FA 2005 s 25):

'(a) in the tax year they hold property on qualifying trusts for the benefit of a vulnerable person; and

(b) a vulnerable person election has effect for all or part of the tax year in relation to those trusts and that person.' [25.149]

2 Qualifying trust gains: special capital gains tax treatment

The provisions relating to trust gains are set out in FA 2005 s 30. This section applies to a tax year if [*595]

(a) in the tax year chargeable gains accrue to the trustees of a settlement from the disposal of settled property which is held on qualifying trusts for the benefit of a vulnerable person ('the qualifying trusts gains');

(b) the trustees would (if not for the new regime) be chargeable to capital gains tax in respect of those gains;

(d) a claim for special tax treatment under s 30 for the tax. year is made by the trustees.

It is worth noting that a claim cannot be made if the vulnerable person dies during the year in question (FA 2005 s 30(3)). [25.150]

3 UK-resident vulnerable persons: s 77 treatment

Under the new regime, a charge to CGT on the settlor with an interest in the settlement (TCGA 1992 s 77(1)) will apply in relation to the qualifying trusts gains as if:

(a) the vulnerable person were a settlor in relation to the settlement;

(b) the settled property disposed of, and any other settled property disposed of at any time when it was relevant settled property, originated from him; and

Property is 'relevant settled property' at any time when it is property held on the qualifying trusts for the benefit of the vulnerable person, and the trustees would (if not for these new rules) be chargeable to CGT in respect of any chargeable gains accruing to them on a disposal of it. [25.151]

4 Non-UK resident vulnerable persons: amount of relief

The trustees' liability to CGT for the tax year will be reduced by an amount equal to:

TQTG -VQTG

Where:

TQTG is the amount of CGT to which the trustees would (if not for these

new rules) be liable for the tax year in respect of the qualifying trusts gains, and

VQTG is calculated using the formula TLVA -TLVB

Where:

TLVB is the total tax liability of the vulnerable person (see below), and

TLVA is what the total tax liability of the vulnerable person would be if it

included tax in respect of notional s 77 gains).

TL\TB is the total amount of income tax and capital gains tax to which the

vulnerable person would be liable for the tax year:

(a) if his income for the tax year were equal to the sum of his actual income for the tax year (if any) and the amount of the trustees' specially taxed income (if any) for the tax year; and

(b) if his taxable amount for the tax year (under TCGA 1992 s 3) were equal to his deemed CGT taxable amount for the tax year (if any).

TLVA is what TLVTB would be if the vulnerable person's taxable amount for the tax year (under TCGA 1992 s 3) were equal to the sum of the amount mentioned in (b) above and his notional s 77 gains for the tax year. [25.152] [*596]

26 CGT-companies and shareholders

Updated by Peter Vaines, Squire, Sanders & Dempsey

I CGT problems involving companies [26.1]

II Capital distributions paid to shareholders [26.21]

III The disposal of shares [26.411

IV Value-shifting [26.61]

I CGT PROBLEMS INVOLVING COMPANIES

1 CGT and corporation tax

Companies and unincorporated associations are not subject to CGT; instead chargeable gains are assessed to corporation tax. Broadly, and with the important exception of taper relief, the principles involved in computing the chargeable gain (or allowable loss) are the same as for individuals.

Disposals from one company in a group (as defined) to another will generally be treated as taking place at a value giving rise to neither gain nor loss (TCGA 1992 s 171). Any gain is deferred until the asset is sold outside the group or if the company owning the asset leaves the group within six years of the transfer (TCGA 1992 s 179). [26.1]

2 Company reorganisations

The basic principle is that there is neither a disposal of the original shares nor the acquisition of a new holding: instead, the original shares and new holding are treated as a single asset acquired when the original shares were acquired. When new consideration is given on a reorganisation (for instance, on a rights issue), that is added to the base cost of the original shares and treated as having been given when they were acquired (TCGA 1992 ss 126-13]). [26.2]

3 Company takeovers and demergers

If the takeover is by means of an issue of shares or debentures by the purchasing company (a 'paper for paper exchange'), CGT on the gain made by the disposing shareholder may generally be postponed until the consideration shares are sold (TCGA 1992 ss 135-137). If the consideration for the acquisition is partly shares and partly cash, the cash element is treated as a [*598] part disposal of the shareholding and s 135 will apply to the balance. The purchaser must obtain more than 25% of the shares in the target company subject to a number of conditions. Furthermore the transaction must be effected for bona fide commercial reasons and not form part of any scheme or arrangement of which the main purpose or one of the main purposes is to avoid a liability to CGT or corporation tax. An advance clearance may be sought (TCGA 1992 s 138).

Where the assets of the target company are acquired for a cash consideration, any chargeable gain arising on those assets will be chargeable on the target company. An exemption might apply, such as the substantial shareholdings exemption, see [41.75] or a deferral such as roll-over relief under TCGA 1992 ss 152-159 (see [22.72]). From the point of view of the target's shareholders, they may be left with the problem of what to do with a 'cash shell' company see Chapter 47.

TCGA 1992 s 192 contains provisions aimed at facilitating arrangements whereby trading activities of a single company or group are split up in order to be carried on either by two or more companies or by separate groups of companies, see Chapter 47. [26.3]

4 Incorporation of an existing business

TCGA 1992 s 162 provides relief in cases where an unincorporated business is transferred to a company as a going concern in return for the issue of shares in the company. The relief enables the gains on the business assets transferred to the company to be rolled over into the acquisition of the shares. (For detailed examination of the rules see [22.100].) [26.4]-[26.20]

II CAPITAL DISTRIBUTIONS PAID TO SHAREHOLDERS

A capital distribution (whether in cash or assets) is treated in the hands of a shareholder as a disposal or part disposal of the shares in respect of which the distribution is received (TCGA 1992 s 122(1)). 'Capital distribution' is restrictively defined to exclude any distribution that is subject to income tax in the hands of the recipient (s 122(5) (b)). As the definition of a distribution is extremely wide (see [42.1]) the CGT charge is confined to repayments of share capital and to distributions in the course of winding up.

EXAMPLE 26.1

(1) Prunella buys shares in Zaha Ltd for £40,000. Some years later the company repays to her £12,000 on a reduction of share capital. The value of Prunella's shares immediately after that reduction is £84,000.

The company has made a capital distribution for CGT purposes and Prunella has disposed of an interest in her shares in return for that payment. The part disposal rules must, therefore, be applied as follows:

(i) consideration for part disposal: £12,000 (ii) allocation of base cost of shares:

. A £12,000

£40,000 x ----- £40,000 x ---------------- = £5,000

. A+B £12,000 + 84,000

Capital distributions paid to shareholders 599

(iii) gain on part disposal: £12,000 - £5,000 = £7,000.

(2) Stanley buys shares in Monley Ltd for £60,000. The company is wound up and Stanley is paid £75,000 in the liquidation. Stanley has disposed of his shares in return for the payment by the liquidator and, therefore, has a chargeable gain of £15,000 (75,000 - £60,000).

If the company had been insolvent so that the shares were worthless, Stanley should claim loss relief on the grounds that his shares had become of negligible value (see TCGA 1992 s 24(2); Williams v Bullivant (1983); and 19.l17]). He has an allowable loss of £60,000. Income tax relief may be available for this loss under TA 1988 s 574 (see [11.121]).

These rules are also applied when a shareholder disposes of a right to acquire further shares in the company (TCGA 1992 s 123). The consideration received on the disposal is treated as if it were a capital distribution received from the company in respect of the shares held.

Under s 122(2), if the inspector is satisfied that the amount distributed is small, the part disposal rules are not applied but the capital distribution is deducted from the allowable expenditure on the shares. The result is to increase a subsequent gain on the sale of the shares (in effect the provision operates as a postponement of CGT). For these purposes, a capital distribution is treated as small if it amounts to no more than 5% of the value of the shares in respect of which it is made. However, a revised approach was announced in Tax Bulletin 27 in February 1997 as a result of dicta in O'Rourke v Binks (1992) which noted that the purpose of the legislation was to avoid the need for an assessment in trivial cases, an approach that would have regard to the likely costs of carrying out the part disposal computation and the likely tax consequences in each case. As a result, in addition to the 5% test, HMRC now considers that s 122(2) can apply in cases where the distribution is £3,000 or less (see EG 57836).

Under s 122(4) where the allowable expenditure is less than the amount distributed the taxpayer may elect that the part disposal rules shall not apply and that the expenditure shall be deducted from the amount distributed. In O'Ruurke v Binks (1992), the Court of Appeal held that the capital distribution must be small for the purpose of this subsection and that what was 'small' was a question of fact for the Commissioners.

On a liquidation there will often be a number of payments made prior to the final winding up and each is a part disposal of shares (subject to the relief for small distributions) so that the shares will need to be valued each time a distribution is made (see SP 1/72).

EXAMPLE 26.2

Mark purchased 5,000 shares in Rothko Ltd for £5,000. The company has now made a 1:5 rights issue at £1.25 per share. Mark is, therefore, entitled to a further 1,000 shares but, having no spare money, sells his rights to David for £250. At that time his 5,000 shares were worth £7,500. As the capital distribution (£250) is less than 5% of £7,500 the part disposal rules will not apply. Therefore, £250 will be deducted from Mark's £5,000 base cost. (NB Mark may prefer the part disposal rules to apply since any gain resulting may be covered by his annual exemption.) [*600] III THE DISPOSAL OF SHARES

1 Introduction

a) Pre-FA 1982 system

Before FA 1982, the CGT rules were relatively straightforward and involved treating identical shares as a single asset. This 'pooling' system involved a cumulative total of shares with sales being treated as part disposals from the pool and not as a disposal of a particular parcel of shares. Special rules applied where all or part of a shareholding was acquired before 6 April 1965.

1126.41]

b) FA 1982 regime-operative from 6 April 1982 to 6 April 1985

Shares of the same class acquired after 5 April 1982 and before 6 April 1985 were not pooled. Instead, each acquisition was treated as the acquisition of a separate asset. A disposal of shares was then matched with a particular acquisition in accordance with detailed identification rules that applied even where the shares were distinguishable from each other by, for instance, being individually numbered. Shares were therefore treated as a 'fungible' asset. These rules were introduced because of the indexation allowance which made it necessary to know whether the shares disposed of had been acquired within 12 months (when no allowance was available) or, in other cases, to calculate the indexation allowance by reference to the original expenditure. [26.42]

c) The 1985 regime-operative from 6 April 1985 to 6 April 1998

Major changes in the indexation allowance in 1985 enabled a form of pooling to be re-introduced. Shares of the same class acquired after 5 April 1982 and still owned by the taxpayer on 6 April 1985 were treated as one asset and further acquisitions of the shares after that date formed part of this single holding (TCGA 1992 s 104). There was an indexed pool of expenditure for each class of share and, if shares in the pool were acquired between 1982 and 1985, the initial value of this pool on 6 April 1985 comprised the acquisition costs of the relevant shares together with the indexation allowance (including an allowance for the first 12 months of ownership) that would have been given had the shares been sold on 5 April 1985.

If identical shares were acquired after 6 April 1985 they were added to the share pool with the cost of their acquisition increasing the indexed pool of expenditure (a similar result occurred if a rights issue was taken up).

EXAMPLE 26.3

Silver acquired 10,000 ordinary shares in Mines Ltd for £10,000 in August 1982 and a further 5,000 shares (cost £7,500) in November 1984. Assume 'indexed rise' from August 1982 to April 1985 was 0.25 and from November 1984 to April 1985 was 0.01.

The value of qualifying expenditure and of the indexed pool of expenditure on 5 April 1985 was as follows: [*601]

(1) Qualifying expenditure £

(i) 1982 purchase 10,000

(ii) 1984 purchase 7,500

. ------

. £17,500

. =======

(2) Indexed pool of expenditure £

(I) at 0.25 on 1982 purchase 2,500

(ii) at 0.01 on 1984 purchase 75

(iii) add acquisition costs 17,500

. ------

. £20,075

. =======

When some of the shares were sold the part disposal rules were applied to both the qualifying expenditure and the indexed pool of expenditure. The indexation allowance was then found by deducting a proportion of the qualifying expenditure from a proportion of the indexed pool. The allowance could only be used to reduce a gain-not to create or increase a loss. [26.43]

EXAMPLE 26.4

In March 1997 Silver sold 7,500 of the shares for £18,750 (the value of his remaining holding was £18,750). Indexation from April 1985 to March 1997 was 0.15.

(1) Proportion of qualifying expenditure

18,750

------ x £17,500 = £8,750

37,500

(2) Proportion of indexed pool

Indexed pool at March 1997:

£20,075 x 1.15 = £23,086.25

18,750

------- x £23,086.25 = £11,543.125

37, 500

(3) Indexation allowance available

£11,543.125 - £8,750 = £2,793.125

(4) Gain

£18,750 - (8,750 + £2,793.125) = £7,206.875

2 The regime introduced by FA 1998

a) Basic rule

With the introduction of taper relief, which depends upon the length of ownership of an asset, the government decided to end pooling for individuals, PRs and trustees. As a result: [*602]

(1) acquisitions of shares on or after 6 April 1998 are not pooled (except for reorganisations being rights or bonus issues under TCGA 1992 s 127 (see [26.2]));

(2) pools at 5 April 1998 are preserved as a single asset (a 's 104 holding'). [26.44]

Where shares of the same class are acquired on the same day they are treated as having been acquired by a single transaction unless some of the shares are 'approved scheme shares' and the appropriate election is made: see TCGA 1992 s 105A and [9.421.

b) The new identification rules

Each acquisition of shares is treated as a separate asset and so new acquisition rules prescribe the order of disposals on the basis of 'last in first out' (LIFO). The order of disposals is therefore as follows (subject to what is said in the next section about bed and breakfasting):

(1) the most recently acquired unpooled shares;

(2) shares from a s 104 holding (this is treated as a single asset when the pool first came into being);

(3) 1982 pools (see [26.47]);

(4) shares held on 6 April 1965 (see [26.48]);

(5) later acquired shares. [26.45]

c) Bed and breakfasting

In simple terms, bed and breakfasting involved the disposal of shares on day one and their repurchase on day two: a transaction that was commonly employed to realise a loss on the shares for relief against other gains, or to realise a gain to enable the annual exemption to be utilised.

EXAMPLE 26.5

Alberich has unused CGT losses. He owns shares which have an unrealised gain and which he wishes to retain. He sells the shares at close of business one day and repurchases them at the start of business the next.

TCGA 1992 s 105 was introduced to match securities bought and sold on the same day but was able to be avoided by buying back the following day. FA 1998 introduced a more widespread provision aimed at stopping bed and breakfasting by providing that disposals are to be matched with acquisitions in the following 30-day period (matching with the first securities acquired during this period): see TCGA 1992 s 106A(5). This brought an end to traditional bed and breakfasting whilst leaving some continuing opportunities: for instance, A sells his shares and his wife purchases an identical shareholding; or the disposal is triggered by the transfer to a trust for A. These simple arrangements are not caught by this provision but any transfers into trust must now take into account the inheritance tax implications following the FA 2006.

The '30-clay rule' may produce surprising results, see the example below. [26.46] [*603]

EXAMPLE 26.6

(1) Rover is returning to the UK after a period of non-residence. He 'bed and breakfasts' his investment portfolio with the intention that on his return to the UK his base cost will be market value. The 30-day rule will apply and needs to be taken into consideration by Rover (see Tax Bulletin, April 2001, p 839).

(2) With effect from 22 March 2006 the rules are amended so that they do not apply where the person acquiring the shares is neither resident nor ordinarily resident in the UK. This follows the case of Davies v Hicks (2005) which highlighted the mismatch of the bed and breakfast rules with the exit charge arising when a trust ceases to be resident and ordinarily resident in the UK. In that case the trustees successfully argued that the exit charge under s 80 TCGA 1992 involved a deemed disposal and reacquisition of the shares by trust. However, under TCGA 1992 s 106A(5), the bed and breakfast rules applied to eliminate the gain on the deemed disposal. To correct this anomaly s 106A(5) will not apply to any acquisition on or after 22 March 2006 by a person who is neither resident nor ordinarily resident, nor a person who is resident but is treated as non-resident by reason of a Double Taxation Agreement: s 106A(5A).

3 Shares acquired after 5 April 1965 and before 6 April 1982

Shares and securities of the same class acquired after 5 April 1965 and before 6 April 1982 are treated as a single asset with a single pool of expenditure (hence, they must not be aggregated with identical shares subsequently acquired). For the purpose of the indexation allowance and the rebasing rules the market value of the shares on 31 March 1982 will generally be treated as the taxpayer's acquisition cost (TCGA 1992 s 109). [26.47]

4 Shares acquired before 6 April 1965

For unquoted shares any gain is deemed to accrue evenly (the 'straight-line method') and it is only the portion of the gain since 6 April 1965 that is chargeable. The disponer may elect to have the gain computed by reference to the value of the shares on 6 April 1965. This election may only reduce a gain; it cannot increase a loss or replace a gain by a loss. Where different shares are disposed of on different dates the general rule of identification is last in, first out (LIFO) (TCGA 1992 Sch 2 paras 18-19).

For listed shares and securities the general principle is that a gain is calculated by reference to their market value on 6 April 1965 (the rules for ascertaining the market value are laid down in TCGA 1992 Sch 2 paras 1-6). If, however, a computation based upon the original cost of the shares produces a smaller gain or loss, it is the smaller gain or loss that is taken. If one calculation produces a gain, and one a loss, there is deemed to be neither.

As an alternative to the above procedure, the taxpayer may elect to be charged by reference to the market value of either all his shares or all his securities or both on 6 April 1965 (ie pooling on 6 April 1965). The original cost becomes wholly irrelevant and can neither reduce a gain; nor reduce a loss; nor result in' neither gain nor loss (TCGA 1992 Sch 2 para 4). [*604] Section 109(4) permits this election to be made within two years after the end of the year in which the first disposal of such securities occurs after 5 April 1985 (31 March for companies). If the election is made, pre-1965 shares are treated either as part of the taxpayer's 1965-82 pool or as forming a separate 1965-82 pool (see [25.47]). [26.48]-[26.60]

IV VALUE-SHIFTING

Complex provisions designed to prevent 'value-shifting' are found in TCGA 1992 ss 29-34. Although the sections are not limited to shares, the commonest examples of value-shifting involve shares.

Under s 29 three types of transaction are treated as disposals of an asset for CGT purposes, despite the absence of any consideration, so long as the person making the disposal could have obtained consideration. The disposal is deemed not to be at arm's length and the market value of the asset is the consideration actually received plus the value of the 'consideration foregone'. Instances of value-shifting are to be found in the following paragraphs. [26.61]

1 Controlling shareholdings (see EG 58853)

Section 29(2) applies when a person having control (defined in TA 1988 s 416) of a company exercises that control so that value passes out of shares (or out of rights over the company) in a company owned by him, or by a person connected with him, into other shares in the company or into other rights over the company. In Floor v Davis (1979) the House of Lords decided that the provision could apply where more than one person exercised collective control over the company, and that it covered inertia as well as positive acts. [26.62]

EXAMPLE 26.7

Ron owns 9,900 ordinary I shares in Wronk Ltd and his son, Ray, owns 100. Each share is worth £40. A further 10,000 shares are offered by the company to the existing shareholders at their par value (a 1:1 rights issue). Ron declines to take up his quota and all the shares are subscribed by Ray. Value has passed out of Ron's shares as he now holds a minority of the issued shares. He is treated as making a disposal of his shares by reason of s 29(2).

2 Leases

Section 29(4) provides as follows:

'If, after a transaction which results in the owner of land or of any other description of property becoming the lessee of the property, there is any adjustment of the rights and liabilities under the lease, whether or not involving the grant of a new lease, which is as a whole favourable to the lessor, there shall be a disposal by the lessee of an interest in the property.' (And see EG 58860.) [26.63] [*605]

EXAMPLE 26.8

Andrew conveys property to Edward by way of gift, but reserves to himself in the conveyance a long lease at a low rent. As the lease is valuable, the part disposal will give rise to a relatively small gain. Andrew later agrees to pay a rack rent so that the value of Edward's freehold is increased. When the rent is increased tax is charged on the consideration that could have been obtained for Andrew agreeing to pay that increased sum.

3 Tax-free benefits resulting from an arrangement

In contrast to s 29, s 30 applies only if there is an actual disposal of an asset. It strikes at schemes or arrangements, whether made before or after that disposal, as a result of which the value of the asset in question (or a 'relevant asset', as defined) has been reduced and 'a tax-free benefit has been or will be conferred on the person making the disposal or a person with whom he is connected; or on any other person'. When it applies, the inspector is given power to adjust, as may be just and reasonable, the amount of gain or loss shown by the disposal (s 30(4)). This widely drafted provision will not operate if the taxpayer shows that the avoidance of tax was not the main purpose, or one of the main purposes, of the arrangement or scheme. Further, it does not catch disposals between husband and wife (within TCGA 1992 s 58); disposals between PRs and legatees; or disposals between companies that are members of a group. TCGA 1992 s 31 extends the scope of these provisions to circumstances where a distribution is made out of profits created by an intra group transfer to reduce the value of a shareholding prior to sale.

EXAMPLE 26.9

H Ltd has two subsidiaries, A Ltd and B Ltd. A Ltd is to he sold for a gain of £1 million. A Ltd has distributable profits of only £300,000 but it has a valuable property which it sells intra group to B Ltd for a profit of £700,000. No tax arises on this transfer by reason of TCGA 1992 s 171 but A Ltd still increases its distributable profits.

A Ltd pays a dividend of £1 million to H Ltd and A Ltd is then sold for a nominal sum. The idea is for the tax on the £1 million to be avoided.

Section 31 applies here to bring s 30 into play, allowing HMRC to make a just and reasonable adjustment to the capital gain to counteract the tax-free benefit intended to be obtained from these arrangements. [26.64] [*596] [*597]

27 CGT-The foreign element

Written and updated by Emma Chamberlain, BA Hons (Oxon), CTA (Fellow), Barrister, 5 Stone Buildings, Lincoln's Inn

I General [27.1]

II Remittance of gains by a non-UK domiciliary [27.21]

III CGT liability of non-residents [27.41]

IV Non-resident trustees [27.45]

V Taxing the UK settlor on trust gains (TCGA 1992 s 86, Sch 5) [27.91]

VI Taxing UK beneficiaries of a non-resident trust (TCGA 1992 ss 87 if) [27.111]

I GENERAL

I Territorial scope: residence as the connecting factor

a) UK residents

An individual who is resident or ordinarily resident in the UK during any part of a year of assessment is taxed on his worldwide chargeable gains made during that year: 'resident' and 'ordinarily resident' have their income tax meanings (TCGA 1992 s 2(1): s 9(1) and see [18.2]). There are two qualifications to this general proposition.

First, where the gain is on overseas assets and cannot be remitted to the UK because of local legal restrictions, executive action by the foreign government or the unavailability of the local currency, CGT will only be charged when those difficulties cease (TCGA 1992 s 279).

Secondly, an individual who is resident, but not domiciled, in the UK is liable only to CGT on such gains on overseas assets as are remitted to the UK For the location of assets, see TCGA 1992 s 275 and note that a non-sterling bank account belonging to a non-UK domiciliary is located overseas (TCGA 1992 s 275(1)). Accordingly, the remittance basis is applicable to the account. Note also that non-domiciliaries are not entitled to loss relief in respect of the disposal of assets situated outside the UK (TCGA 1992 s 16(4)). Hence offshore gains cannot be reduced by offshore losses in such cases. See Example 27.4. [27.1]

b) Non-residents

A person who is neither resident nor ordinarily resident in the UK is generally not liable to CGT on gains even if resulting from a disposal of assets [*598] part disposal of the shareholding and s 135 will apply to the balance. The purchaser must obtain more than 25% of the shares in the target company subject to a number of conditions. Furthermore the transaction must be effected for bona fide commercial reasons and not form part of any scheme or arrangement of which the main purpose or one of the main purposes is to avoid a liability to CGT or corporation tax. An advance clearance may be sought (TCGA 1992 s 138).

4 Incorporation of an existing business

II CAPITAL DISTRIBUTIONS PAID TO SHAREHOLDERS

EXAMPLE 26.1

(i) consideration for part disposal: £12,000 (ii) allocation of base cost of shares:

. A £12,000

£40,000 x ------ = £40,000 x -------------- = £5,000

. A+B £12,000+84,000

[*599]

(iii) gain on part disposal: £12,000 - £5,000 = £7,000.

EXAMPLE 26.2

III THE DISPOSAL OF SHARES

1 Introduction

a) Pre-FA 1982 system

b) FA 1982 regime-operative from 6 April 1982 to 6 April 1985

c) The 1985 regime-operative from 6 April 1985 to 6 April 1998

EXAMPLE 26.3

The value of qualifying expenditure and of the indexed pool of expenditure on 5 April 1985 was as follows: [*601]

(1) Qualifying expenditure £

(i) 1982 purchase 10,000

(ii) 1984 purchase 7,500

. -------

. £17,500

(2) Indexed pool of expenditure £

(i) at 0.25 on 1982 purchase 2,500

(ii) at 0.01 on 1984 purchase 75

(iii) add acquisition costs 17,500

. -------

. £20,075

. =======

EXAMPLE 26.4

In March 1997 Silver sold 7,500 of the shares for £18,750 (the value of his remaining holding was £18,750). Indexation from April 1985 to March 1997 was 0.15. (1) Proportion of qualifying expenditure

18,750

------ x £17,500 = £8,750

37,500

(2) Proportion of indexed pool

Indexed pool at March 1997:

£20,075 x 1.15 = £23,086.25

18,750

------ x £23,086.25 = £1,543,125

37,500

(3) Indexation allowance available

£11,543.125 -£8,750 = £2,793.125

(4) Gain

£18,750 - (8,750 � £2,793.125) = £7,206.875

2 The regime introduced by FA 1998

a) Basic rule

With the introduction of taper relief, which depends upon the length of ownership of an asset, the government decided to end pooling for individuals, PRs and trustees. As a result: [*602]

(1) acquisitions of shares on or after 6 April 1998 are not pooled (except for reorganisations being rights or bonus issues under TCGA 1992 s 127 (see [26.2]));

(2) pools at 5 April 1998 are preserved as a single asset (a 's 104 holding'). [26.44]

b) The new identification rules

Each acquisition of shares is treated as a separate asset and so new acquisition1 rules prescribe the order of disposals on the basis of 'last in first out' (LIFO).1 The order of disposals is therefore as follows (subject to what is said in the1 next section about bed and breakfasting):

(1) the most recently acquired unpooled shares;

(2) shares from a s 104 holding (this is treated as a single asset when the pool first came into being);

(3) 1982 pools (see [26.471);

(4) shares held on 6 April 1965 (see [26.48]);

(5) later acquired shares. [26.45]

c) Bed and breakfasting

In simple terms, bed and breakfasting involved the disposal of shares on day1 one and their repurchase on day two: a transaction that was commonly1 employed to realise a loss on the shares for relief against other gains, or to1 realise a gain to enable the annual exemption to be utilised.

EXAMPLE 26.5

TCGA 1992 s 105 was introduced to match securities bought and sold on the same day but was able to be avoided by buying back the following day. FA1 1998 introduced a more widespread provision aimed at stopping bed and1 breakfasting by providing that disposals are to be matched with acquisitions1 in the following 30-day period (matching with the first securities acquired1 during this period): see TCGA 1992 s 106A(5). This brought an end to1 traditional bed and breakfasting whilst leaving some continuing opportuni-1 ties: for instance, A sells his shares and his wife purchases an identical1 shareholding; or the disposal is triggered by the transfer to a trust for A.1 These simple arrangements are not caught by this provision but any transfers1 into trust must now take into account the inheritance tax implications1 following the FA 2006.

The '30-day rule' may produce surprising results, see the example below. [26.26] [*603]

EXAMPLE 26.6

(1) Rover is returning to the UK after a period of non-residence. He 'bed and1 breakfasts' his investment portfolio with the intention that on his return to1 the UK his base cost will be market value. The 30-day rule will apply and1 needs to be taken into consideration by Rover (see Tax Bulletin, April 2001, p1 839).

(2) With effect from 22 March 2006 the rules are amended so that they do not apply where the person acquiring the shares is neither resident nor ordinarily resident in the UK. This follows the case of Davies v Hicks (2005) which1 highlighted the mismatch of the bed and breakfast rules with the exit charge1 arising when a trust ceases to be resident and ordinarily resident in the UK.1 In that case the trustees successfully argued that the exit charge under s 801 TCGA 1992 involved a deemed disposal and reacquisition of the shares by trust. However, under TCGA 1992 s 106A(5), the bed and breakfast rules1 applied to eliminate the gain on the deemed disposal. To correct this1 anomaly s lO6A(5) will not apply to any acquisition on or after 22 March1 2006 by a person who is neither resident nor ordinarily resident, nor a1 person who is resident but is treated as non-resident by reason of a Double1 Taxation Agreement: s 106A(5A).

3 Shares acquired after 5 April 1965 and before 6 April 1982

Shares and securities of the same class acquired after 5 April 1965 and before1 6 April 1982 are treated as a single asset with a single pool of expenditure1 (hence, they must not be aggregated with identical shares subsequently1 acquired). For the purpose of the indexation allowance and the rebasing1 rules the market value of the shares on 31 March 1982 will generally be1 treated as the taxpayer's acquisition cost (TCGA 1992 s 109). [26.47]

4 Shares acquired before 6 April 1965

For unquoted shares any gain is deemed to accrue evenly (the 'straight-line1 method') and it is only the portion of the gain since 6 April 1965 that is1 chargeable. The disponer may elect to have the gain computed by reference1 to the value of the shares on 6 April 1965. This election may only reduce a1 gain; it cannot increase a loss or replace a gain by a loss. Where different1 shares are disposed of on different dates the general rule of identification is1 last in, first on (LIFO) (TCGA 1992 Sch 2 paras 18-19).

For listed shares and securities the general principle is that a gain is1 calculated by reference to their market value on 6 April 1965 (the rules for1 ascertaining the market value are laid down in TCGA 1992 Sch 2 paras 1-6).1 If, however, a computation based upon the original cost of the shares1 produces a smaller gain or loss, it is the smaller gain or loss that is taken. If1 one calculation produces a gain, and one a loss, there is deemed to be1 neither.

As an alternative to the above procedure, the taxpayer may elect to be1 charged by reference to the market value of either all his shares or all his1 securities or both on 6 April 1965 (ie pooling on 6 April 1965). The original1 cost becomes wholly irrelevant and can neither reduce a gain; nor reduce a1 loss; nor result in neither gain nor loss (TCGA 1992 Sch 2 para 4). [*604] Section 109(4) permits this election to be made within two years after the end of the year in which the first disposal of such securities occurs after 5 April 1985 (31 March for companies). If the election is made, pre-1965 shares are treated either as part of the taxpayer's 1965-82 pool or as forming a separate 1965-82 pool (see [25.47]). [26.48]-[26.60]

IV VALUE-SHIFTING

Complex provisions designed to prevent 'value-shifting' are found in TCGA 1992 ss 29-34. Although the sections are not limited to shares, the commonest examples of value-shifting involve shares.

1 Controlling shareholdings (see EG 58853)

EXAMPLE 26.7

2 Leases

Section 29(4) provides as follows:

EXAMPLE 26.8

3 Tax-free benefits resulting from an arrangement

EXAMPLE 26.9

A Ltd pays a dividend of £1 million to H Ltd and A Ltd is then sold for a nominal sum. The idea is for the tax on the £1 million to be avoided.

27 CGT-The foreign element

Written and updated by Emma Chamberlain, BA Hons (Oxon), CTA (Fellow), Barrister, 5 Stone Buildings, Lincoln's Inn

I General [27.11

II Remittance of gains by a non-UK domiciliary [27.21]

III CGT liability of non-residents [27.41]

IV Non-resident trustees [27.45]

V Taxing the UK settlor on trust gains (TCGA 1992 s 86, Sch 5) [27.91] VI Taxing UK beneficiaries of a non-resident trust (TCGA 1992 ss 87 if) [27.111]

I GENERAL

I Territorial scope: residence as the connecting factor

a) UK residents

First, where the gain is on overseas assets and cannot be remitted to the UK because of local legal restrictions, executive action by the foreign government or the unavailability of the local currency, CGT will only be charged when those difficulties cease (TCGA 1992 s 279).

Secondly, an individual who is resident, but not domiciled, in the UK is liable only to CGT on such gains on overseas assets as are remitted to the UK For the location of assets, see TCGA 1992 s 275 and note that a non-sterling bank account belonging to a non-UK domiciliary is located overseas (TCGA 1992 s 275(1)). Accordingly, the remittance basis is applicable to the account. Note also that non-domiciliaries are not entitled to loss relief in respect of the disposal of assets situated outside the UK (TCGA 1992 s 16(4)). Hence offshore gains cannot be reduced by offshore losses in such cases. See Example 27.4. [27.1]

b) Non-residents

A person who is neither resident nor ordinarily resident in the UK is generally not liable to CGT on gains even if resulting from a disposal of assets [*608] situated in the UK (but see [27.41]). A trust is not UK-resident if a majority of the trustees are non-resident and the trust is administered outside the UK. As a result of changes made by FA 1998 as amended by FA (no 2) 2005, an individual who is 'temporarily non-resident' (as defined) is taxed on certain gains realised whilst non-resident on his return to the UK (see further [27.3]). [27.2]

2 The temporary non-resident individual (TCGA 1992 s 10A)

As CGT is only charged on individuals either resident or ordinarily resident in the UK it could be avoided by the simple expedient of becoming resident and ordinarily resident outside the UK and then disposing of the asset. [27.3]

a) Position before 17 March 1998

'Residence' and 'ordinary residence' are interpreted in the same way as for income tax (see [18.2]). Absence for three complete tax years ensures that the individual is neither resident nor ordinarily resident in the UK. In addition there is a long-established practice whereby an individual going abroad for full-time employment is regarded as neither resident nor ordinarily resident from the date of his departure until the date of his return provided that absence abroad extended over at least one complete tax year. See JR 20 for a full statement of HMRC's position in this area. As a taxpayer's residence is determined for a complete tax year, an individual resident in the UK at any time during that year is taxed on gains realised at any time during the year (TCGA 1992 s 2). It is only by concession that the year may be split into periods of residence and non-residence (see amended ESC D2: [27.6]). [27.4]

b) TCGA 1992 s I OA -- position on or after 17 March 1998

The basic rules on whether an individual is resident in the UK have not been altered although, with effect from 17 March 1998, ESC D2 has been substantially amended to limit the circumstances when the year may be split.

If the following conditions are satisfied an individual who becomes non-resident is taxed on his return to the UK on gains realised during the period of non-residence:

(1) The individual was UK resident or ordinarily resident for at least some part of four of the seven tax years preceding the year of departure.

(2) The individual becomes non-UK resident for less than five complete tax years.

(3) During his period of absence he disposes of assets which he had owned when he left the UK or he receives capital payments from an offshore trust (see TCGA 1992 s 87: [27.111]); or a trust of which he was the settlor realises a gain in circumstances where he would be taxed on those gains on an arising basis if he were UK resident and domiciled (TCGA 1992 s 86: see [27.91]); or gains from an offshore company are attributed to him under TCGA 1992 s 13 (see [27.43]). In all these situations the individual is taxed as if the gains accrued to him in the year of return to the UK Because no distinction is made between one interven-[*609]-ing year and another it follows that the annual exempt amount is only available for the year of return (that being the year in which the gains are deemed to accrue) and that losses realised in later intervening years may be offset against gains from earlier years deemed to accrue in the year of return.

A number of further points should be noted about this provision:

(1) it applies to losses as well as gains;

(2) it does not (with certain exceptions) apply to disposals of assets which the taxpayer acquired at a time when he was non-resident (s IOA(3)) ('the after-acquired assets rule');

(3) the normal limitation period for CGT assessments is extended to two years after 31 January next following the year of return in order to catch gains made in the year of departure;

(4) gains (and losses) are calculated in the normal way at the time when the asset is disposed of, as if the taxpayer were then UK resident. Tax will, however, be charged at rates current in the year of return;

(5) there are special rules to prevent a possible double charge under TCGA 1992 ss 86 and 87 (sec [27.911 and [27.111]);

(6) until Budget 2005 it was thought that the charge could be neutralised by relief under a double tax treaty (see s 1 OA (10)). HMRC have now said that they do not accept this view (see [27.20]);

(7) the taper relief rules on return to the UK are set out at [20.61]. [27.5]

EXAMPLE 27.1

Don was born and bred in the UK but on 30 March 1999 he leaves the UK to take up a three-year contract of employment in Belgium. His broker liquidates his portfolio on 3 April and during his absence Don sells his country cottage and a valuable Ming vase given to him by his wife as a leaving present. He returns to the UK in March 2004 having extended his original contract. The CGT position is as follows:

(1) Don remains resident in the UK in the tax year 1998-99 so that the disposal of shares on 3 April is chargeable (note that ESC D2 does not apply: see [27.6]).

(2) Because Don returns in March 2004 he has not been out of the UK for five complete tax years so that the disposal of the country cottage is prima facie brought into charge in tax year 2003-04 (his year of return). Likewise the sale of the Ming vase that, because it was acquired from a spouse, is not excluded under the after-acquired assets rule. Don may try to claim protection under the double tax treaty with Belgium so that his gain on the Ming vase will be exempt from CGT (although the gain on the real property could never be protected under the double tax treaty). It was thought by practitioners that although the gain is deemed to accrue to the taxpayer in the year of return (when he becomes UK-resident) HMRC accepted that if the gain was actually realised at a time when he was resident in Belgium, treaty relief could apply. This view has now been rejected-see [27.81.

(3) If Don acquires an asset such as a picture in the tax year after departure le while non-resident (and not relying on the split year) and sells the picture in the tax year before he returns to the UK then any gain is not chargeable on him. Equally any loss would not be allowable.

(4) If Don had gone abroad on or before 16 March 1998 he will not be chargeable on gains made while not resident or ordinarily resident on any of the assets even though he may return within five wars. [*610]

3 Splitting the tax year (ESC D2 as amended)

As already indicated, CGT is charged on individuals resident or ordinarily resident at any time during a tax year on gains made during the course of that year. Heavily amended ESC D2 enables the year to be split so that gains arising after someone ceases to be resident are untaxed whilst gains arising before someone becomes resident here are similarly outside the tax net. Observe the following restrictions, however:

(1) the concession does not apply to trustees;

(2) like any concession it will not apply 'if any attempt is made to use it for tax avoidance' (see R v IRC, ex p Fulford-Dobson (1987));

(3) in the case of an individual becoming UK resident on or after 6 April 1998 split-year treatment will only apply if he has satisfied the s 10A five-year test (see [27.5]). An individual leaving the UK on or after 17 March 1998 will only benefit from split-year treatment if he was not resident in the four out of seven years of assessment referred to in s 10A (see [27.5]). Therefore, in Example 27.1 Don could not benefit from split-year treatment for gains realised in the year of departure even if he leaves the UK permanently and therefore for more than five years. [27.6]

4 Other matters

Two other matters should be noticed. First, any CGT losses should be realised prior to departure; and, second, care should be taken to ensure that arrangements with a potential purchaser, made before going non-resident, do not amount to a disposal at that time. Accordingly, careful thought is required before a conditional contract is concluded or put and call options granted. See EG Manual 25800 onwards for HMRC's view on this.

HMRC comment as follows:

'There are three circumstances where Capital Gains Tax liability may arise where

the date of disposal appears to be after the date of emigration. These are where it

can be shown that

1 there was a binding agreement or contract for sale on or before the date of emigration 2 a business was carried on in the UK through a branch or agency in the period from the date of emigration to the date of disposal 3 an attempt has been made to use ESC D2 for tax avoidance.'

As already noted, ESC D2 does not apply to trustees nor to gains realised on the disposal of assets of a business carried on in the UK through a branch or agency and has limited applicability since most people emigrating will have to make the disposal in the tax year after departure in order to ensure that the gain is realised when they are not resident or ordinarily resident in the UK for the complete tax year.

HMRC may argue that a binding contract has been reached particularly where there is a sale of shares. Put and call options should be used with care. HMRC accept that there can be no binding agreement for the disposal of land unless the contract is in writing. [*611]

If shares in a company have been sold in consideration of receiving shares or loan notes issued by the purchasing company, HMRC may argue that s 135 does not apply (see example 27.2). Even if a clearance has been obtained under s 138 this will be invalidated if the taxpayer had definite plans to go abroad at the time of the sale and he did not disclose this in the clearance. See Snell v HMRC Sp 532 2006 where a company was sold for a mixture of shares and loan notes. The main shareholder subsequently became nonresident and disposed of his loan notes free of capital gains tax. HMRC successfully argued that the arrangements for the issue of loan notes in exchange for shares had a tax avoidance motive and therefore no deferral relief was available. The Special Commissioner held that the paper for paper provisions were not intended to be an exemption mechanism for somebody who wished to use them as a prelude to becoming non-resident: 'We find that he had the purpose of becoming non-resident before redeeming the loan notes and accordingly that one of his main purposes, indeed the only main purpose of effecting the arrangement, was the avoidance of capital gains tax.' [27.7]

EXAMPLE 27.2

Luke owns all the shares in a food distribution company S Limited. He receives an offer from a rival company FD Limited to buy S Limited for £20 million cash. Luke and the purchaser reach an informal agreement on terms in February 2003. Luke emigrates in March 2003 and the actual agreement is signed on 6 April 2003. HMRC may ask to see the papers surrounding the sale in order to establish whether a binding oral agreement had been reached in February before Luke left the UK.

Alternatively Luke sells the company in March just before emigration in consideration of receiving guaranteed loan notes from the purchaser which he cashes in six months after the sale in October 2003 after he has left the UK intending to stay away for five complete tax years. In the light of Ynel4 HMRC may well successfully argue on the above facts that there was a disposal in March 2003 and not in October 2003 when the loan notes were encashed and that TCGA 1992 s 137(1) applies so that there is no s 135 relief.

5 Finance (No 2) Act 2005

The capital gains tax rules on non-residence have been tightened up further. As noted above, the general rule in TCGA 1992 s 2 is that gains accruing on the disposal of an asset only attach to taxpayers who are either resident or ordinarily resident in the UK in the tax year of disposal. TCGA 1992 s 10A provides for an exception: where a UK resident becomes non-resident but resumes UK residence within five tax years then any gains in the intervening years of non-residence on disposals of assets acquired before becoming non-resident become chargeable to capital gains tax as if such gains 'were gains ... accruing to the taxpayer in the year of return'. However, s 10A was stated to be 'without prejudice to any right to claim relief in accordance with any double taxation relief arrangements' (s 10A(10)).

Hence it had been assumed that a capital gains article in a standard double tax treaty (such as between Belgium and the UK) which gave sole taxing rights on disposals of most assets to the country where the alienator was [*612] resident at the time of disposal, would apply to prevent a charge under s 10A in the year of return. This also appeared to be HMRC's stated view-see CG Manual 26290: 'although section 10A requires gains accruing in the intervening years between UK departure and return to be assessed to tax there is no intention that this charging provision should override the terms of any double taxation agreement. This will mean any exemption agreement specifically given under an agreement between the UK and another taxing state should be taken into account in arriving at any UK liability.'

On this basis Don in Example 27.1 above would have been protected under the Belgium treaty from a capital gains tax charge on the Ming vase even if not the country cottage. (The double tax treaties do not usually protect gains realised on land situated in the UK.)

HMRC now state that, while they originally accepted the view that a DTA can override a charge under s 10A, this is no longer the case. F(No 2)A 2005 s 32(6) simply omits s 10A(10). The change has effect in any case in which the year of departure is 2005-06 onwards. However, the explanatory notes state 'the reason it is being removed is that it is considered unnecessary: its continuing presence in s 10A might cause doubt to be cast on the effects of other tax provisions which do not contain a corresponding statement.' HMRC suggest that the only double taxation relief is that the individual is allowed to obtain a credit for the foreign tax he has paid (if any)!

It is doubtful whether HMRC's present view is correct or that this view can be altered in respect of past arrangements in this way. If chargeable gains or losses are treated as. accruing in the year of return it is surely those sanie gains that are protected by double taxation agreements and which arose during the year of disposal when the disponer was non-resident. Such gains are just taxed at a different time under s b A.

The HMRC view also leaves taxpayers who have already come back to the UK having relied on a double tax treaty and not spent the full five years out of the UK since March 1998 in a position of some uncertainty.

There have been some changes for taxpayers who became dual resident. Section 32 also deals with persons who are dual resident but are treated under the tie-breaker provisions as resident in the foreign state, so are treaty non-resident. Such persons were never within the scope of s 10A at all because, although treaty non-resident, they never ceased to be resident or ordinarily non-resident in the UK. Hence they did not need to rely on a five-year absence provided they maintained residence in both states and under the tie-breaker provisions could be treated as resident in the foreign state.

Whenever a person becomes treaty non-resident on or after 2005-06 they will in future be treated as non-resident for the purposes of s 10A. Hence they will need to do their full five years abroad in order to avoid a capital gains tax charge on disposals of assets. However, as with non-residents under general law, assets acquired and disposed of while treaty non-resident will not be subject to the five-year rule.

Although a treaty non-resident taxpayer will now be treated as non-resident for the purposes of s bA, gains attributed to him under the ss 86-87 offshore settlement regime and TCGA 1992 s 13 will not be postponed until the tax year of arrival back in the UK. In effect gains attributed under such [*613] provisions will continue to be taxed as at present, ie on the basis that the taxpayer is treated as resident in the UK throughout the time.

If HMRC's view is correct, prior to 16 March 2005, persons who were genuinely non-resident in a jurisdiction where there was a double tax treaty protecting them from gains are worse off than persons who remained UK-resident under general law who were merely treaty non-resident! On HMRC's view, the former have had to stay out for five years throughout the period since March 1998. The latter have not had to unless their departure is on or after 16 March 2005. (See Example 27.3.) [27.8]-[27.20]

EXAMPLE 27.3

Assume the facts are as in Example 27.1 but Don never loses his UK residence (eg he spends at least 120 days here each year). However, he has a permanent home in Belgium and no such home in the UK. Under the tie-breaker tests he is treated as resident in Belgium and should not be chargeable on his return in March 2004 on the Ming vase.

II REMITTANCE OF GAINS BYA NON-UK DOMICILIARY (SEE HMRC MANUAL EG 25350 FF)

An individual who is resident or ordinarily resident, but not domiciled, in the UK is chargeable to CGT only on the remitted gains from overseas assets, with no relief for any overseas losses. The definition of remittance is wide and catches a sum resulting from the gain which is paid, used or enjoyed in the UK or brought or sent to the UK in any form (TCGA 1992 s 12(2)) and a transfer to the UK of the proceeds of sale of assets purchased from the gain. Anti-avoidance provisions in ITTOIA 2005 ss 833-834 (formerly TA 1988 s 65) designed to catch disguised remittances are extended to CGT. The section applies, for example, where a loan (whether or not made in the UK so long as the moneys are remitted to the UK) is repaid out of the overseas gain (see [18.34]).

Use of losses on foreign-sited assets against remitted gains or gains realised on UK situated assets is not possible for the non-UK domiciliary. [27.21]

EXAMPLE 27.4

Freda is resident but not domiciled here. She has a second home in Cornwall that shows a large capital gain. She wishes to sell the home. She has realised substantial losses from the disposal of her foreign investments managed by a broker in Switzerland. She cannot set those losses against the gains on the Cornish home. Nor can she set the losses against the gains from any other foreign or UK investments. If Freda remits some of the gains from her foreign investments she will pay tax on the gains at the rates prevailing at the time of remittance.

It is not possible to 'divide up' the gain from the original capital and remit only the original capital. The position is different from a separation of the income and capital (see Example 27.5).

EXAMPLE 27.5

Freda has invested £1 million in shares in a German bio-tech company BTI Limited. These produce £20,000 dividends each year that she receives into her [*614] overseas income account. She eventually sells BTI shares for £2 million. She remits £1 million to the UK. She cannot argue that the £1 million represents the original capital and that the gain has not been remitted even if the sale proceeds have been split up. HMRC will tax her on half the remittance on the basis that remittances are treated as taxable gain in the proportion that the gains bear to the total amount in the account-see EG Manual25401. However, the dividend income that has been paid to the overseas income account is not taxable unless remitted here.

A foreign domiciled taxpayer who is UK-resident would be better holding all foreign assets which are likely to show a gain through a trust in order to bypass the remittance rules on capital gains and indeed avoid capital gains tax even on UK-situated assets.

EXAMPLE 27.6

Freda buys £1 million worth of shares in BTI Limited. She settles the shares in an offshore trust from which she can benefit. There is no deemed remittance and the trust acquires the shares at market value of £1 million. The trustees sell the shares two years later realising a gain of £0.5 million. The trustees then pay some of the capital to Freda in the UK. There is no taxable remittance on Freda since neither ss 86 or 87 apply (see below) and s 12 is not applicable. (Note that in certain circumstances if the trust has accumulated income there may be an income tax charge on Freda.) Even if the shares settled were UK situated and the trustees sold the shares at a gain and distributed the proceeds to her in the UK, there would still be no tax chargeable on Freda-the remittance basis does not apply.

(See [20.401 for taper relief position of remittances on foreign assets.)

Review on domicile

During the course of 2003-04 the Government conducted a review of the status of foreign domiciliaries and consulted on whether the rules should be changed. It appeared likely that changes would be made not only to the remittance basis but also to the residence rules. In particular there were fears that the generally favourable capital gains tax regime for non-UK domiciliaries involving offshore trusts would end. However, it appeared the Government could reach no firm conclusion on what should be done. At the end of 2003 they said they 'will move forward with a formal consultation paper on possible approaches to reform' but in paragraph 5.103 of the Budget Red Book stated:

"The Government is continuing to review the residence and domicile rules as they affect the taxation of individuals and is considering various aspects of this issue in the light of the responses to the paper published at Budget 2003. The Government remains determined to proceed on the basis of evidence and in keeping with its key principles. It would welcome further contributions to the debate which would then be taken forward by the publication of the consultation paper setting out possible approaches to reform."

Something similar was said in 2004. In the 2006 Budget the Government said it was keeping the matter under review and will proceed on the basis of evidence and in keeping with its principles. Hence the matter has not been dropped although it appears that nothing very definite is being contemplated at the moment! The inheritance tax changes contained in BN25 do affect foreign domiciliaries adversely in various ways. [*615]

F(No 2)A 2005 did introduce changes to the Sims of assets for capital gains tax purposes and extend the statutory code set out under TCGA 1992 s 275. These changes will affect foreign domiciliaries who are resident here and rely on the remittance basis to avoid a charge to CGT. They do not affect persons who are resident, ordinarily resident and domiciled here.

Changes to TCGA 1992 s 275 mean that the situs of any intangible asset will be treated as being in the UK if any right or interest comprised in the asset is governed by, exercisable in or enforceable under or is subject to the law of the UK. The same is true of futures or options over such intangibles. The situs of such futures or options will be governed by the situs of the underlying asset.

Furthermore all shares in and debentures of UK incorporated companies whether registered or not will be treated as situated in the UK. Foreign domiciliaries will now need to operate through foreign incorporated holding companies that wholly own UK incorporated and resident companies with the holdco preferably held through an offshore trust for greater CGT safety and to avoid the remittance basis. Alternatively the UK-resident company will need to be foreign incorporated (but watch TA 1988 s 739).

Those foreign domiciliaries who restructured their holdings in UK incorporated companies so as to dispose of bearer shares, hoping to sell at a time when the bearer instrument is held abroad and thereby take advantage of the remittance basis, will no longer be protected from a CGT charge unless the bearer shares were also placed in an offshore trust.

Note that for IHT purposes no statutory changes to the situs of bearer shares have been made. When analysing the situs of any asset one now has to consider the statutory code on situs for capital gains tax purposes, inheritance tax purposes and in the absence of any express statutory provisions, the common law rules. Double tax treaties can also change the sims of particular assets for certain tax purposes. [27.22]-[27.40]

III CGT LIABILITY OF NON-RESIDENTS

1 Individuals

A non-resident individual (excluding the 'temporary non-resident' whose position has been considered above) escapes tax even on disposals of assets situated in the UK except where he carries on a trade, profession or vocation in the UK through a branch or agency (TCGA 1992 s 10(1)). In such cases he is taxed on any gain that arises on a disposal of assets used or previously used for the business or held or acquired for that branch or agency (eg a lease of premises). The charge under s 10 cannot be avoided by removing assets from the UK or by ceasing to trade in the UK In both cases a deemed disposal at market value will occur (compare the deemed disposal which results from the migration of a foreign company). Further, ESC D2 does not apply when disposals of assets used by a branch or agency are made during the year of emigration. Such disposals will therefore continue to be made by a UK resident and to attract a tax charge: in the following tax year disposals will fall under the s 10 charge with a deemed disposal arising on the final cessation of the trade. [27.41] [*616]

2 Companies

a) General rule

A non-resident company is excluded from liability to CGT except when it trades in the UK through a branch or an agency. Thus, a non-resident investment company is never liable to CGT. [27.42]

b) Anti-avoidance

There are provisions designed to prevent UK-resident and domiciled individuals from using these rules to avoid the payment of CGT by the formation of non-resident companies. Note that there is no motive test. The legislation, in TCGA 1992 s 13, was substantially amended as a result of increasing evidence that its provisions could be circumvented, for instance by the use of guarantee companies. The recast section applies in the following circumstances:

(1) Chargeable gains must accrue to a company which is not resident in the UK but which would be a close company if it were so resident (note that such gains are calculated by reference to a continuing indexation allowance: for the definition of a close company, see [41.122]).

(2) The gain is attributed to a 'participator's' interest in the company to the extent of that interest and there is an attribution process that involves looking through multiple layers of intermediate holdings with final attribution being on a just and reasonable basis. 'Participator' has the TA 1988 s 417 meaning as further amplified and will catch all interests in shares as well as the interest of loan creditors. Trustees can be participators but the provisions do not 'look through' to their beneficiaries (ie the gains are attributed to the trust but further provisions may then charge the gain on the settlor (see TCGA 1992 s 86) or to beneficiaries (see TCGA 1992 s 87)).

(3) No assessment is made if the participator's interest in the company is less than 10% (increased from 5% by FA 2001).

(4) Gains made on the disposal of most assets of a trading company that are used in the trade are not apportioned (TCGA 1992 s 13(5)). Thus, problems really arise only for the shareholder of a non-resident investment or holding company.

(5) Losses made by the non-resident company cannot be used to reduce its gains before apportionment, nor can the losses as such be apportioned except to the extent that a shareholder has had a gain apportioned to him in that tax year and the apportioned loss would eliminate or reduce the gain. See Example 27.7.

(6) A shareholder can be reimbursed by the company for tax paid on apportioned gains without a further charge. Otherwise, he can deduct the tax paid from any gain made on a subsequent disposal of the shares. In calculating the gain realised by the company and assessed under s 13, indexation relief is applied: taper relief (see Chapter 20) does not apply although taper relief will apply to the gain realised by the taxpayer on a disposal of the shares of the company itself.

(7) Under the former provisions an assessment was discharged if, within two years of the relevant disposal, the gain was distributed by way of [*617] dividend; distribution of capital or on a winding up of the offshore company. That position has now been altered so that on a subsequent distribution the s 13 assessment stands but any tax paid thereon is allowed as a credit against any liability arising on the distribution. That disposition must occur before the earlier of:

(a) three years from the end of the period of account in which the gain accrued; and

(b) four years from the date on which the gain accrued.

(8) If the non-resident company is situated in a country with which the UK has a double tax treaty, gains realised by the company may be protected by the treaty and so be outside s 13 (see Bricom Holdings v IRC (1997)). FA 2000 has altered this position in the case of trustee shareholders by providing that 'nothing in any double taxation relief arrangements' shall prevent the attribution of gains to trustees under s 13 (see TCGA 1992 s 79B inserted by FA 2000). Individuals remain protected by treaty relief in these circumstances!

(9) Section 13 does not apply if the UK-resident participator is not domiciled here. [27.43]

EXAMPLE 27.7

Xcon Limited is a Guernsey company owned as to 90% by two non-UK residents and 10% by Eddie, a UK resident and domiciled person. Xcon Limited holds equities. Eddie will suffer a charge under s 13 on 10% of the indexed gains realised by Xcon.

In 2003-04 Xcon realises losses of £2 million and gains of £1 million from the disposal of some equities. The losses can be set off against the gains made by Xcon Limited in the same tax year and can be used against gains made in the same tax year by other non-resident companies in which Eddie has an interest and which have been apportioned to Eddie under s 13. However, Eddie cannot use the surplus losses in Xcon Limited against his personal gains nor can those Xcon losses be carried forward to use against future gains Xcon may make in later tax years. If not used in 2003-04 they are lost forever.

EXAMPLE 27.8

In the early 1980s the Wonka family set up a jersey trust that owned all the shares in a Netherlands Antilles ('NA') company that in turn owned all the issued share capital of a Californian corporation (CC). Assume that the latter company owned substantial property interests around Los Angeles that have just been sold showing a substantial gain. The settlor is deceased.

(1) That gain realised by CC maybe apportioned to NA: see TCGA 1992 s 13(9).

(2) In turn, the apportioned gain may be further apportioned to the Jersey trust (TCGA 1992 s 13(10)) and to the extent that the trust makes capital payments to UK beneficiaries, those apportioned gains may attract a UK tax charge.

Notice that the provisions whereby the profits of a 'controlled foreign company', including an investment company, may be apportioned to its UK resident corporate members do not apply to its chargeable gains (see TA 1988 s 747(6): and see [41.161]). [*618]

IV NON-RESIDENT TRUSTEES

I Background

The CGT treatment of offshore trusts has undergone a number of radical changes of which the following is a brief summary. [27.45]

a) From 1965 to 1981

FA 1965 s 42 imposed a charging system for non-UK-resident trusts that led to major difficulties and was ultimately abandoned in 1981. [27.46]

b) From 1981 to 1998

FA 1981 s 80 introduced a charging system based on capital distributions received by UK domiciled and resident beneficiaries provided that the trust had been established by a UK senior. One consequence was that offshore trusts could be used to defer indefinitely the payment of CGT and, in addition, there was no exit charge when a UK trust migrated. Section 80 (now TCGA 1992 s 87) was supplemented by changes introduced in FA 1991 and FA 1998. [27.47]

An exit charge From 19 March 1991 an exit charge has been levied on UK trusts which migrate: see TCGA 1992 ss 80-84 and Example 27.11. [27.48]

Settlor charge In cases where a 'defined person' can benefit under the trust, gains realised by non-UK-resident trustees result in a CGT charge on the UK-resident and domiciled settlor: TCGA 1992 s 86 and Sch 5. [27.49]

The 'interest' charge An interest charge supplements the s 87 charge in cases where capital distributions are not made promptly out of a non-resident trust in which the trustees have realised gains (TCGA 1992 ss 91-97). The effect can be that higher rate taxpayers will pay at rates of up to 64% on gains realised by offshore trusts. See also [27.119] and Examples 27.20 and 27.21. [27.50]

c) FA 1998 changes

These amounted to a further tightening of the screws involving:

(1) an extension of the senior charge to settlements created before the 1991 changes (before 1998 the settlor charge was only relevant to settlements created or 'tainted' on or after 19 March 1991);

(2) including 'grandchildren' in the class of 'defined person' for the purpose of that charge if the trust was established or tainted after 16 March 1998;

(3) extending the capital payments charge to trusts where the settlor was not domiciled or resident in the UK;

(4) widening the tax charge on disposals of beneficial interests in a settlement;

(5) new rules to deal with the charge when the settlor or beneficiary is temporarily non-resident. [*619]

This process was continued by anti-avoidance measures in FA 2000, FA 2003 and F(N0 2)A 2005. [27.51]

2 Exporting a UK trust

a) Why export?

Moving a trust offshore has usually been undertaken in order to obtain all or some of the following benefits: protection from a reintroduction of exchange control; deferment of CGT; and deferment of income tax. So long as the settlor and any spouse are excluded from benefit, UK income tax will be avoided unless beneficiaries ordinarily resident in the UK receive a benefit and the trust produces 'relevant income' (TA 1988 ss 739-740 and see [18.111]). For CGT, provided that the settlor charge does not apply, TCGA 1992 s 87 will not lead to any UK tax charge so long as capital payments are not made to UK domiciled and resident beneficiaries. Because of the wide definition of 'defined person' (and hence of the settlor charge), however, it is now relatively uncommon for UK domiciled residents to set up new offshore trusts or to export existing trusts.

Even if the settlor is dead, the penalty charge referred to in [27.119] may make the tax advantages very marginal unless it is intended that no UK-resident and domiciled beneficiary is to receive capital payments from the trust. [27.52]

(b) When is a trust non-resident?

The rules changed in FA 2006 with effect from 6 April 2007. Prior to 6 April 2007, a trust is non-resident for CGT purposes when a majority of the trustees are neither resident nor ordinarily resident in the UK and the general administration of that trust is ordinarily carried on outside the UK (TCGA 1992 s 69(1)). There is a proviso to s 69(1) for professional trustees. Where a person who is resident in the UK carries on a business consisting of or including the management of trusts and is acting as a trustee in the course of that business he is treated in relation to the trust for capital gains tax purposes only as non-resident if the whole of the settled property consists of or derives from property that was provided by someone not at the time of making that provision domiciled, resident or ordinarily resident in the UK. Note, however, that this let-out does not apply for income tax purposes and therefore is of limited use if the intention is to keep the trust non-resident for income tax purposes. See Chapter 18.

FA 2006 Sch 12 amends s 69 so that from 6 April 2007 the test for residence of trustees will be the same for income tax and capital gains tax purposes. The rules have been aligned to the existing income tax rules. From 6 April 2007, where a trust is created by a settlor who is resident, ordinarily resident and domiciled in the UK, all the trustees must be resident outside the UK if the trust is to be non-resident. If the settlor is non-resident and not domiciled in the UK it is only necessary that there is one non-resident trustee for the trust to be treated as non-resident for both income tax and capital gains tax purposes. If the senior is not UK domiciled but is UK resident at the date of setting up or funding the trust, all trustees must be non-resident. Note that [*620] the place where the administration of the trust is carried out will no longer be relevant for capital gains tax purposes. Despite representations from the various professional bodies, the exemption for professional trustees will be abolished on the basis that it constitutes 'state aid'. Note that if the trust property is transferred from one trust to another, the residence of the settlor has to be tested both at the time the original trust was funded and at the time of the transfer. See s 68B and s 69(2C) TCGA 1992.

EXAMPLE 27.9

Mr A was not resident or domiciled here when he died leaving assets in trust. The trustees comprise two friends resident in the UK and one non-resident. The trust is non-resident for income tax purposes but currently resident for capital gains tax purposes unless one of them is a professional. From 6 April 2007 it will no longer be resident here for capital gains tax purposes.

By contrast:

EXAMPLE 27.10

Mr A was resident but not domiciled here when he died leaving assets in trust. The trustees comprise one UK resident and two non-UK residents and the general administration is carried on abroad. The trust is currently resident here for income tax purposes and non-resident for capital gains tax purposes. From 6 April 2007 it will become UK resident for capital gains tax purposes and income tax purposes.

ESC D2 (see [27.6]) does not apply to trustees and hence the tax year is not split so that the UK trustees may be taxed on gains realised later in the tax year after foreign-resident trustees have been appointed. [27.53]

c) Can UK trusts be exported?

Many trusts start off abroad but where a trust is to be moved abroad, what is the position where the trust is originally UK and all the beneficiaries are resident here? The equitable rules on the appointment of overseas trustees were set out by Pennycuick VC in Re Whitehead's Will Trusts (1971) as follows:

'The law has been quite well established for upwards of a century that there is no absolute bar to the appointment of persons resident abroad as trustees of an English trust. I say "no absolute bar" in the sense that such an appointment would be prohibited by law and would consequently be invalid. On the other hand, apart from exceptional circumstances, it is not proper to make such an appointment that is to say, the court would not, apart from exceptional circumstances, make such an appointment; nor would it be right for the donees of such a power to make an appointment out of court. If they did, presumably the court would be likely to interfere at the instance of beneficiaries. There do, however, exist exceptional circumstances in which such an appointment can properly be made. The most obvious are those in which the beneficiaries have settled permanently in some country outside the UK and what is proposed to be done is to appoint new trustees in that country.'

This dictum would suggest that appointing non-resident trustees is acceptable but usually 'improper'. (Trustee Act 1925 s 36(1) might imply that [*621] residence outside the UK for more than 12 months is unacceptable for a trustee whilst s 37(1)(c) may create difficulties for emigrations pre-1 January 1997 given that a non-UK corporate trustee cannot be a 'trust corporation': see Adam & Co International Trustees Ltd v Theodore Goddard (2000).) However, since Re Whiteheads Will Trusts judicial attitudes have changed so that provided that the export can be shown to be for the beneficiari�s' advantage (eg in saving tax) the courts are not likely to interfere (see Richard v Hon A B Mackay (1987)).

HMRC may not be able to object to the appointment since they do not have locus standi but any UK trustee should consider taking indemnities from the new overseas trustees in case beneficiaries at some future date allege that breaches of trust have been committed and seek to set aside the appointment. It is also sensible to include in any trust instrument an express power for the existing trustees to retire in favour of non-resident trustees. [27.54]

d) The CGT export charge (TCGA 1992 s 80(2))

When trustees of a UK settlement become neither resident nor ordinarily resident in the UK, they are deemed to have disposed of assets in that settlement and immediately to have reacquired those same assets. This deemed disposal is closely modelled on that which applies when a person becomes absolutely entitled to settled property (see [25.47]) and on the exit charge which is levied when a non-UK incorporated company ceases to be UK-resident (TCGA 1992 ss 185: see [41.154]).

Imposing the exit charge gives rise to a number of problems. When, for instance, does the charge come into effect? Section 80(1) defines the phrase 'relevant time' as meaning any occasion when trustees become non-UK-resident provided that the relevant time falls on or after 19 March 1991.

A second problem is when do trustees become non-UK-resident? A simple view would he that this would occur whenever UK trustees (Alan and Ben) are replaced by, say, two jersey trustees (Cedric and Desmond). Certainly, if s 80 stood alone, such a simple change in the trusteeship would be 'the relevant time'. However, the section must be read in the light of the rest of the CGT legislation and under s 69(1) it is provided that:

'The trustees of the settlement shall for the purposes of this Act be treated as being a single and continuing body of persons ... and that body shall be treated as being resident and ordinarily resident in the United Kingdom unless the general administration. of the trusts is ordinarily carried on outside the United Kingdom and the trustees or a majority of them for the time being are not resident or not ordinarily resident in the United Kingdom.'

Replacing A and B with C and D will satisfy part of s 69(1) but there is a 'frequently overlooked' second limb in that provision: namely that the administration of the trust must be conducted outside the UK. Until that occurs, the trustees remain UK-resident.

So far as timing is concerned, the deemed disposal is said to take place 'immediately before' the relevant time: accordingly the disponors are the retiring UK trustees who, given that the CGT year cannot generally be split, also remain liable for gains realised by the new trustees in the tax year in which they are appointed (SP5/92 para 2). [*622]

EXAMPLE 27.11

Trustees of the Fisher Trust hold valuable land. The settlor is dead. The land shows a substantial gain. They decide that they wish to sell the land. If they sell the land they realise a gain taxed at 40%. They, therefore, decide instead to retire in favour of jersey trustees in February 2005 and in May 2005 the jersey trustees sell the land.

The effect of s 80 is that there is a deemed disposal of the land in February 2005 and therefore that the original trustees of the Fisher Trust realise a gain at that point. They pay tax at 40% and will need to ask the jersey trustees for funds if the UK trustees have not made a sufficient retention to pay this tax.

Who is liable to pay the export charge? Because the deemed disposal is by the retiring UK trustees they are primarily responsible. It is therefore important that they retain sufficient assets to cover this liability. TCGA 1992 s 82 further provides that if tax is not paid by those trustees within six months of the due date, any former trustees of that settlement who held office during the 'relevant period' can be made accountable. The relevant period (broadly) means the 12-month period that ends with the emigration (although not backdated before 19 March 1991). Assume, for instance, that A and B, two professional trustees, retire on 1 January 1999 in favour of two family members. Those family trustees subsequently (on 1 July 1999) retire in favour of two non-UK-resident trustees, C and D, such retirement being without the prior knowledge of A and B. On these facts, the appointment of C and D constitutes the 'relevant time' for s 80 purposes and any gain arising as a result of the deemed disposal will therefore be payable on 31 January in the following tax year (ie on 31 January 2001). If not paid within six months of that date HMRC may demand that tax from all or any of A, B and the family trustees. However, a former trustee can escape liability if he shows that 'when he ceased to be a trustee of the settlement there was no proposal that the trustees might become neither resident nor ordinarily resident in the UK' (s 82(3) and SP 5/92 para 5). It is advisable to put a suitable clause in all deeds of retirement (where appropriate) to demonstrate that emigration was not in mind at the date the trustee stepped down.

The deemed disposal is of 'defined assets' which (predictably) includes all the assets that constitute the settled property at the relevant time. The term does not include UK assets used for the purpose of a trade carried on by the trustees through a UK branch or agency. This is because such assets remain within the UK tax net even after the trustees become non-resident: hence there is no need to subject them to the deemed disposal (see [27.41]).

Section 81 deals with involuntary exports and imports. Assume that the trustees of a settlement are Adam (UK-resident) and Cedric (a jersey-resident accountant) who does all the paperwork and performs the administrative tasks for the trustees. Adam dies with the result that the conditions laid down in s 69(1) are satisfied and the trust ceases to be UK resident. On these facts, there was no intention to export the trust. Imposing an exit charge in such a case would be unjust and hence s 81 prevents the charge arising provided that within six months of Adam's death the trustees of the settlement become again UK resident. Not surprisingly, the exit charge remains in force for those defined assets that are disposed of during the period of non-UK residency (ie between the death and the resumption of residence).

Finally, the converse situation (a non-resident settlement becoming UK resident because of the death of a trustee) is provided for in sub-ss (5)-(7). Reverting to non-resident status within six months of the death will not generally trigger the s 80 exit charge subject only to an exception where the period of UK residence has been used to add assets to the settlement claiming holdover relief on that transfer. Resuming non-resident status will result in a deemed disposal at market value of such assets. See also Green v Cobham (2002) for the difficulties that can arise where a trustee who was professional retires hence ceasing to be a professional, and the trust inadvertently becomes UK-resident for capital gains tax purposes. [27.56]

EXAMPLE 27.12

Suppose that in Example 27.11 above the asset held by the Fisher Trust was not land but instead the trustees held shares in a listed company RZX Limited. HMRC's view was that this made no difference and s 80 still applied to impose a charge. See IR Tax Bulletin, April 2001 and their example 2 for further details.

However, this view was rejected in Davies v Hicks 2005 STC 850. The case related to the interaction of the bed and breakfast rules with the exit charge on the export of a settlement. It enabled UK-resident trusts to be exported without a tax charge through use of the identification provisions and then do a round the world scheme-see below.

The bed and breakfast provisions are designed to prevent the establishment of a capital loss by the sale and subsequent repurchase of the same assets. TCGA s 106A provides that where securities are sold they must be identified with securities of the same class acquired by the same person in the period of 30 days. This eliminates any loss assuming that the values remain similar. The argument successfully run in Hicks was therefore that when UK trustees sold shares, retired in favour of non-UK trustees who reacquired the shares within 30 days, s 106A required the security disposed of to be identified with the securities reacquired, thereby eliminating any gain which would otherwise have arisen under general principles (unless in that short period the shares had increased in value). Did s 106A(5) (a) deem the shares to remain in trustee ownership throughout as the Revenue maintained or did the trust emigrate with cash? Park J held the latter applied. There was nothing in s 106A that deemed the trustees still to hold shares at the date of export:

'1 cannot accept in this case that a provision which was intended to identify which shares acquired by a particular taxpayer should be matched with shares sold by the same taxpayer can be deemed to have had effects going far beyond that and requiring it to be imagined, for a quite different statutory purpose, that the assets held by the taxpayer at a different time did not consist of the actual assets then held by him, but rather consisted of different assets altogether.'

(There is some analysis of how far deeming provisions should be taken generally in para 26 of the judgment. Arguably the same analysis could apply to avoid capital gains tax on export of a trust where there is no actual sale and reacquisition but merely a deemed disposal and reacquisition of securities by virtue of s 106A itselfi) [*624] This loophole was often combined with what was commonly known as 'a round the world' scheme.

This involved trustees resident in, say, jersey retiring in favour of trustees resident in a foreign jurisdiction with a suitable treaty. While in that country (eg New Zealand) the new non-resident trustees sold an asset but before the end of the same tax year, UK-resident trustees were appointed. The aim was to avoid ss 86-87 by avoiding any time when there was a single and continuing body of trustees with dual-resident status. The analysis was that ss 86-87 would be inapplicable because of the trustees being resident in the UK at some time in the year of assessment but at a different time from the disposal. Arguably s 77 would not apply because the treaty would protect the gain.

It could be argued that a treaty cannot protect against either a s 77 or s 86 charge-see Bricom (1979) STC 1179. If it is not as such the gains realised by the trustees that are deemed to be the gains taxable on the settlor but a notional sum equal to such gains then no relief is due. The argument that a double tax treaty can protect against s 77 but not s 86 gains is based on the idea that under s 86 there has to be determined the gains that would accrue to the trustees if the trustees were resident in the UK throughout the year. By contrast s 77 uses a different wording and requires a calculation first of what gains the trustees would actually be taxable upon in the UK in the absence of s 77 before then attributing such gains to the settlor. The trustees arguably would not be taxable upon any gains that are protected by a treaty. The scheme was also used in respect of non-settlor interested trusts.

In 2003 the Revenue amended the Mauritius and Canada treaties to stop trusts emigrating there. Last year the New Zealand treaty was amended. Now more radical action has been taken and the whole scheme stopped.

Under F(No 2)A 2005 s 33 a new TCGA 1992 s 83A was inserted so that nothing in any double tax treaty precluded a charge to capital gains tax arising when:

(a) the trustees were, at some time in the year of claim, resident in the UK; and

(b) were not resident in the UK at the time of disposal.

The new measure applied to disposals of settled property on or after 16 March 2005. The idea is to ensure that either the settlor is chargeable if the trust is settlor interested within s 77 or that the trustees are chargeable if the trust is not senior interested.

However, until FA 2006, TCGA 1992 ss 105 and 106A could still be used to nullify the effect of s 80 on shares if the UK trust emigrated because no amendment had been made to these sections. This could be helpful if the settlor was also likely to go non-UK resident for five years and wanted to export his trust.

FA 2006 s 74 amends TCGA 1992 s 106A and will apply in respect of acquisitions of shares made on or after 22 March 2006 irrespective of when the disposal was made. The bed and breakfasting rules are disapplied where the person making the disposal of securities acquires them at a time when he is non-resident or treaty non-resident.

The position of beneficiaries who dispose of their interests in a trust after it has been exported is considered at [27.120]. [27.57]-[27.90] [*625]

V TAXING THE UK SETTLOR ON TRUST GAINS (TCGA 1992 s 86, Sch 5)

l Introduction

These provisions resemble (although they are more severe!) those in TCGA 1992 s 77 which deals with UK-resident trusts: see [19.85]. When they apply, gains realised by the trustees, which would have attracted a UK CGT charge had the trustees been resident, are taxed as gains of the settlor and form the top slice of his taxable gains for that year (although such gains can now be reduced by the 'personal' tosses of the senior--see [27.98]). As in the s 77 rules, the gains are not reduced by a trustee annual exemption whilst losses realised by the trustees (although available to set against future gains which they may make) are not treated as losses of the settlor. The settlor is given a statutory right to recover any tax that he suffers from his trustees, but the extent to which this right may be enforced in a foreign jurisdiction is uncertain (see Example 27.15 and also see EG 38321). It is not, however, thought that a right of reimbursement is the same as the enforcement of foreign revenue laws: see Lord Mackay of Clashfern in Williams & Humbert Ltd v W & H Trade Marks (Jersey) Ltd (1986) where he commented that 'the existence of (an) unsatisfied claim to the satisfaction of which the proceeds of the action will be applied appears to me to be an essential feature of the principle (that foreign revenue laws will not be enforced)'. The proper law of the settlement may also be relevant here. Where the settlement is English law, in practice reimbursement may be easier to enforce. See discussion in Trusts and Estates Law and Tax Journal, July/August 2004, p 5.

Two key questions need to be answered. First, which settlements are caught and, secondly, when does a settlor retain an interest for these purposes? The answers to both questions were affected by changes made by FA 1998. [27.91]

2 'Qualifying settlements'

So far as the first question is concerned, the original rules applied to 'qualifying settlements' which were defined in Sch 5 para 9 as settlements created 'on or after 19 March 1991' which could benefit defined persons (see 29.95). Old settlements were therefore generally outside the scope of the rules (and were known as 'golden trusts') but para 9(2) provided that in four situations such settlements could become qualifying settlements (see further SP 5/92): this is known as 'tainting'). [27.92]

EXAMPLE 27.13

(1) The Jonas Family UK Trust was set up in 1982. In 1996 the trustees become non-UK-resident. Not only did that event trigger an exit charge but, in addition, because the settlement was exported after 18 March 1991 it became a 'qualifying settlement'.

(2) The Popeye Settlement had been resident in Liechtenstein since 1989. In 1996:

(a) A court order was obtained in Vaduz whereby the beneficial class was widened to include the settlor. Ths had the effect of turning the turst [*626] into 'a qualifying settlement'. By contrast, in settlements where the trustees have always had the power to add beneficiaries and exercised that power to add a 'defined person' after March 1991 it was not thought that the terms of the trust had been varied so that it became a 'qualifying settlement'. (In SP 5/92 it is stated that 'where the terms of the trust include a power to appoint anyone within a specified range to be a beneficiary, exercise of that power after 19 March 1991 will not be regarded as a variation of the settlement'. When the trust has a general power to add anyone the position remains unclear.)

(b) The trustees distributed funds to the settlor's spouse who was not a beneficiary. The effect of what was a breach of trust was to convert the trust into 'a qualifying settlement' since she was now a person who had enjoyed a benefit (and was a 'defined person') and she was not a person who might have been expected to have enjoyed such a benefit from the settlement after 18 March 1991.

Such an addition, whether by the settlor or another, had the effect of turning the trust into a 'qualifying settlement' and Julian would be taxable under s 86 in respect only of gains realised from property added byjulian. This provision had to be watched carefully: it did not apply in cases where there was an accretion to settlement funds (eg where the trust received dividends or bonus shares from a company in which it had investments) nor if the settlor added property to discharge the administrative expenses of the trust (not the company) to the extent that such expenses could not be discharged out of. trust income. (On the meaning of 'administrative expenses' and further details on tainting see the important SP 5/92 para 26).

3 The 1998 changes to 'qualifying settlements'

From 6 April 1999, pre-19 March 19911 settlements capable of benefiting a 'defined person' (see [27.95]) were brought within the tax charge on the settlor, ie gains realised on or after that date by the trustees are taxed on him (FA 1998 s 132). The following matters are worthy of note:

(1) From 17 March 1998 to 6 April 1999 there was a 'transitional period'.

During this time the trust could, for instance, have become UK-resident, been wound up, or been converted into a 'protected settlement' (considered below). However, if the trust remained offshore and was not converted into a protected settlement gains realised during this period were also taxed on the settlor (unless it did not benefit defined persons) but they were deemed to accrue in the following tax year, ie on 6 April 1999.

(2) The settlor charge could have been avoided if during the transitional period all 'defined persons' were excluded from benefit. Alternatively, the charge was avoided if the beneficiaries were limited to infant children of the settlor; to grandchildren; to unborn persons, to future spouses etc, albeit that these persons would be within the class of 'defined persons'. Such a trust is known as a 'protected seulement. see TGCA 1992 Sch 5 para 9(10A). A settlement cannot be made protected after 6 April 1999.

(3) A settlement which is currently qualifying because it benefits defined persons can be made non-qualifying at any time and the settlor will [*627] then escape the s 86 charge on future trust gains provided the trust is non-qualifying for the entire tax year when the gain is made. The rules for making a settlement non-qualifying differ depending on whether the trust was set up pre-17 March l998-see [27.95].

EXAMPLE 27.14

The Larg jersey Trust was set up in 1988. The settlor, joseph, is life tenant with remainder to his infant children. With the introduction of the 1998 changes, the trustees immediately and in the exercise of powers under the settlement:

(1) appointed half the fund to Joseph absolutely. This was a deemed disposal by the trustees on which joseph was subject to CGT both on the gains realised by the trustees from the disposal and on stockpiled gains realised prior to March 1998 since he had received a capital payment (see [27.111]);

(2) the trustees then (and before 6 April 1999) excluded joseph from all future benefit in the trust with the result that as the only beneficiaries were his infant children the settlement became a 'protected settlement'. So long as it retains this status, future gains will not be taxed on the settlor.

(4) Protected settlement treatment is lost if the settlement is tainted (see [27.92]). In addition, privileged treatment ceases in a year where the conditions are not satisfied: notably in the tax year following a beneficiary attaining 18 (in Example 27.14 above, the year after the first child of Joseph Larg becomes 18).

(5) The 1998 changes may have catastrophic results for settlors given that they may not be able to recover tax from the trust.

EXAMPLE 27.15

On his divorce in l990,Joseph Kset up ajersey trust for the benefit of his children under which he was prohibited from benefiting. He is estranged from his children. In 2000 the children become absolutely entitled to the trust fund leading to a gain of £2m. Joseph is taxed on this gain with no prospect of recovering tax either from the trustees or his children. (Given that the trust is governed by jersey law it is far from certain that courts in that country will recognise Joseph's right to reimbursement even if it does not amount to the enforcement of a foreign revenue debt.) See, however, the Jersey case of Re the T Settlement (2002) 4 ITLR 820 where the settlor was expressly excluded from benefit but the Court nevertheless permitted a

variation of the trust in order to allow the trustees to reimburse her the capital gains tax due under s 86. It was held that the variation would be for the benefit of unborn beneficiaries in that it included the discharge of certain moral obligations on their behalf. If the trust is made UK-resident, future gains realised will not be taxable on Joseph since it will no longer be a settlor-interested trust.

Capital gains tax problems are now likely to arise on divorce as a result of the inheritance tax changes in FA 2006.

EXAMPLE 27.16

John and Carolyn decide to divorce in 2007. They are both resident and domiciled in the UK. John's main asset is the offshore trust which he set up in 1991 and in which he has an interest in possession. It has Dm s 87 gains and £0.5 m unrealised gains. The trust is worth £4m. The main wealth of the family is contained in the trust and it is agreed that Carolyn should get half of this. However, if a payment of £2m is made to her or John outright, there will be s 87 gains attributed to the recipient of 1m since these are treated [*628] trigger unrealised gains which are now taxed on John. The parties decide to split the trust assets but retain them in a trust structure. Pre-22 March 2006 half the trust fund could have been appointed over to a UK-resident interest in possession trust for wife with the husband excluded. Although this may have triggered s 86 gains on the settlor (and posed certain s 87 risks for the wife if the transfer could be regarded as a capital payment to her) at least going forward John was not taxed on the future gains of the new trust assuming minor children of the settlor were excluded. £0.5m of the s 87 gains would be transferred to the new trust under s 90 (ie half the gains equal to half the sum appointed across). The two trusts could then operate independently.

Any new post-21 March 2006 trust will no longer qualify as an interest iii possession trust for Carolyn but will instead fall within the relevant property regime. In addition there is an upfront 20% inheritance tax since IHTA s 10 does not apply to transfers out of trusts. Hence it will be necessary to keep the funds within the existing trust and have one fund held on interest in possession trusts for Carolyn (which will qualify as a transitional serial interest if set up pre-6 April 2008) and one fund retained on interest in possession trusts for John. The difficulty is that even though John is excluded from Carolyn's share, he still suffers capital gains tax on all future unrealised gains even if the trust is brought back to the UK (s 77 would then operate). The problem could be avoided if a sub-fund election was made under FA 2006 Sch 12 but the conditions necessary for sub-fund elections make it unlikely to be workable. John will need to consider how he is reimbursed for capital gains tax arising on future disposals out of Carolyn's fund if he is excluded from benefit on her part.

(6) TCGA 1992 s 76B and Sch 4B (inserted by FA 2000) were introduced to prevent the settlor charge being avoided by a 'flip-flop' arrangement (see [27.96]). [27.93]

4 Which settlors are caught by the offshore trust provisions?

Apart from the settlement needing to 'qualify', the legislation under which gains realised by offshore trusts are taxed on the settlor only applies in years when the settlor is both domiciled and either resident or ordinarily resident in the UK. Gains realised in other years are not taxed as the settlor's and nor are gains realised in the tax year when the senior dies. Thus s 86 does not apply to offshore trusts provided the settlor is not domiciled here. However, note that if in the future there is a change to the current domicile rules or the legislation changes, offshore trusts set up by non-UK domiciliaries could be caught in the future. [127.94]

EXAMPLE 27.17

Red (domicile of origin New Zealand) is the senior and life tenant of an offshore trust that realises substantial gains. He is aged 90 and until now has successfully claimed he is not UK domiciled even though he has lived in the UK for many years. He does not pay tax on any gains realised by the trustees even if such gains are remitted to him or they are UK situated assets. (See also Example 27.6 above.) In 2005-06, HMRC successfully determine that he is domiciled here because he now has no intention to leave the UK. He will be taxed on an arising basis under s 86 on all gains realised by the trustees after that date, whether or not they make capital payments to him. Even if no changes are made to the law of domicile as such or Red's New Zealand domicile continues, it is easy to envisage the Government changing the current legislation so that gains realised by an offshore trust [*629] are taxable on a foreign domiciliary who is resident in the UK if remitted here or gains from UK-situated assets realised by trusts are taxable on foreign domiciliaries who are settlors of such trusts.

5 Meaning of a 'defined person'

Gains will be taxed on the settlor only if a 'defined person' benefits or will or may become entitled to a benefit in either the income or the capital of the settlement. When the rules were introduced in 1991 a 'defined person' was identified as follows:

'(a) the settlor;

(b) the settlor's spouse;

(d) the spouse of any such child;

(e) a company controlled by a person or persons falling within paragraphs (a) to (d) above;

(f) a company associated with a company falling within paragraph (e) above.'

The list was formidable (contrast the provisions of s 77(3) in relation to UK trusts) and it was particularly worthy of note that children (including step-children) of whafrue-r age were included. A deliberate policy decision was taken not to apply the provisions of s 77 to offshore trusts but to include a far wider class of persons. Note the trap that exists for a settlor in cases where a UK trust has been created in favour of his children which is then exported. Although the settlor is otherwise excluded from all benefit under the rules of the trust, the effect of the export is to create a qualifying settlement with the result that gains will be taxed as the settlor's since defined persons (his children-even if they are geriatric adults) will or may benefit.

The only exclusion of real significance from the above list of defined persons was grandchildren and this omission was rectified by FA 1998. In respect of offshore trusts created on or after 17 March 1998 the list of defined persons is extended to catch:

(a) any grandchild of the senior or his spouse; (b) the spouse of any such grandchild; and

Note, however, that grandchildren trusts established before 17 March 1998 are not brought within the settlor charge unless the trust is tainted (eg by the addition of further property). Therefore, if the senior wishes to avoid a s 86 charge a trust established before 17 March 1998 can be made exclusively for the benefit of the grandchildren and their issue at any time thereafter provided it is not tainted. [27.95]

EXAMPLE 27.18

Johnny set up an offshore trust for himself and his issue and his brothers and sisters and their issue in 1990. The trust has realised no gains since 1998. It has not been added to or tainted J 200334 the trustees want to realise a substantial gain from the sale of a piece of land. Provided that Johnny, his spouse, children and their spouses and any company controlled by them are permanently excluded from any benefit in the tax year before the disposal: ie in 2002-03, then any gains [*630] realised by the trustees in the following tax year will not be taxed on Johnny. The only beneficiaries will then be his siblings, their issue and his grandchildren and remoter issue. None of these are defined persons in respect of settlements established before 17 March 1998. Note that the settlement is not a protected settlement and therefore the change in beneficiaries does not need to be done prior to April 1999 but can be done at any point provided the trust is not tainted after 16 March 1998. If no change to the class of beneficiaries is made in 2002-03, any gains realised in 2003-04 by the trustees will be taxed on Johnny under s 86 unless he dies in that year.

6 Anti-flip-flop legislation

TCGA 1992 s 76B and Sch 4B (inserted by FA 2000) were introduced to prevent the settlor charge under s 86 being avoided by a 'flip-flop' arrange- ment. These provisions have been supplemented by further changes in FA 2003 although these changes do not increase the s 86 charge but affect the s 87 pool (see [27.122]). [27.96]

EXAMPLE 27.19

Year 1: Trustees of the A Trust, which has no stockpiled gains and only unrealised gains, borrow against the security of the trust assets and advance the cash to the B Trust (which includes eg the senior as a beneficiary); they then exclude 'defined persons' from the ATrust.

Year 2. A Trust disposes of assets to pay off loan, whilst the cash is advanced out of B Trust to the settlor in Year 2.

Under this arrangement no gains were read through to the B Trust (because there were no stockpiled gains which had been realised before Year 2) so that the distribution (in Year 2) from B Trust was tax free: the only disposal in the A Trust occurs at a time when the settlor charge does not apply.

The amending legislation introduced by FA 2000 applies if three conditions are satisfied:

(a) the trustees make a transfer of value (as defined: for instance, the transfer of moneys, to B Trust);

(b) in the year of transfer s 86 (the settlor charge), s 87 (the capital payments charge) or s 77 (UK trusts senior charge) apply to the trust;

If these conditions are satisfied, then if a transfer of value occurs on or after 21 March 2000, the trustees are deemed to dispose of the assets in A Trust and immediately reacquire them at market value. In a case where s 86 applies the resultant gain will be taxed on the senior in the normal way. See also [27.122] for the effect of FA 2000 and FA 2003 on beneficiaries of non-settlor interested offshore trusts and on the s 87 pool of gains.

7 Attributed trust gains and personal capital losses (FA 2002 s 51)

a) Background

Although capital losses are not themselves tapered, TCGA 1992 s 2A(1) states that losses must be deducted from gains before the application of taper. This is the case both for current year losses and for those brought forward from earlier years (see [20.20]). [*631]

The gains of settlor-interested trusts are attributed to settlors under TCGA 1992 ss 77 and 86. The original rule was that, where there are attributed gains, taper relief would already have been taken into account in computing the figures; therefore, it was not permitted for settlors to deduct their personal (untapered) lossses from the tapered trust gains attributed to them. Equally trust losses cannot generally be deducted from personal gains.

An individual who had large personal capital losses brought forward and whose only chargeable assets were held in a settlor-interested trust could not, from 1998-99 onwards, make any further use of those losses as and when his trust realised gains. [27.97]

b) FA 2002 changes

FA 2002 provides that the gains attributed to seniors for 2003-04 onwards will be the amount of the trust gains before the deduction of taper relief. 1f the settlor has personal capital losses, he must set them against his own chargeable gains first, but they can then be deducted from the gains attributed to him under TCGA 1992 ss 77 and 86. Taper relief is then applied.

The senior is assessed to tax on these tapered gains and he is still entitled to claim from the trustees of the settlement reimbursement of the tax paid in respect of the attributed gains.

Note that there is no election procedure from 2003-04. The relief is mandatory. The settlor cannot choose to set personal losses against attributed trust gains in priority to personal gains even if that gives a better taper relief position.

Although this regime did not come into force until 6 April 2003, a settlor could elect for these new arrangements to apply for the tax years 2000-01, 2001-02 and 2002-03. Elections could be made for one, two or all three of these years. This means that there is a need to review past tax returns already submitted where there have been personal losses and senior-interested trust gains.

Elections must be made no later than 31 January 2005. Note that trust losses of settlor-interested trusts cannot be set against personal gains of the settlor. [27.98]

c) The section 87 beneficiary

Contrast the position of s 87 gains imputed to UK-resident and domicilied beneficiaries of offshore trusts following the receipt of a capital payment. Personal losses of the beneficiary cannot be set against such attributed gains taxed under s 87. [27.99]-[27.110]

VI TAXING UK BENEFICIARIES OF A NON-RESIDENT TRUST (TCGA 1992 ss 87 II)

I Basic rules

Subject to the senior charge which may apply if a 'defined person' has an interest in a qualifying settlement (see [27.92]), TCGA 1992 ss 87ff apply to non-resident trusts in respect of gains made from 1981-82 onwards where the [*632] trustees are not resident nor ordinarily resident in the UK during the tax year. Prior to 17 March 1998 for the section to apply the settlor had to he domiciled and either resident or ordinarily resident in the UK at some time during the tax year or when the settlement was made. Hence, if the settlor was UK domiciled and resident at the date of the trust's creation the rules of s 87 always applied. If the settlement was originally created by a non-domiciled settlor, who subsequently became a UK domiciliary, it was caught by these rules only for those years when the settlor was UK resident and ceased to be caught on his death. Trusts set up by non-resident but UK domiciled settlors were also not caught by s 87 until the settlor became resident here.

As a result of disquiet caused by the 'Robinson trust', in the case of gains realised in an offshore trust and capital payments received by UK resident and domiciled beneficiaries on or after 17 March 1998 the residence and domicile of the senior became irrelevant. Section 87, therefore, now extends to all non-resident trusts irrespective of when set up and whether or not the avoidance of UK tax was one of the motives of the settlor. However, it will only attribute trust gains realised post 16 March 1998. (Contrast the provisions of TA 1988 ss 739-740 which are subject to a 'purpose' defence in s 741: see [18.1131.)

'Settlement' and 'settlor' are defined as for income tax (see ITOIA 2005 s 620(l)) and settlor includes the testator or intestate when the settlement arises under a will or intestacy (TCGA 1992 s 87(9)).

EXAMPLE 27.20

(1) Sergei, domiciled and resident in France, has settled his holiday home in Nice on an overseas trust for his daughter, Nina, who is domiciled and resident in England. As a result of the new rules introduced by FA 1998 capital payments (including (it may be: see below) the use of the property by Nina) are within the CGT net. Assuming that no gains are realised in the trust, any tax charge will be postponed until, for instance a beneficiary becomes entitled to the property or it is sold (note (1) that the property may benefit from main residence relief and (2) that Nina's beneficial interest is a chargeable asset: see [27.120]).

(2) John Kaput moved to the West Indies in 1920 and settled his island paradise on trust for his Scottish descendants who become absolutely entitled to the property in 2005 when the trust period ends. On this occasion a tax charge will arise and, since the beneficiaries receive a capital payment on absolute entitlement, it will be necessary for beneficiaries to include in their tax returns a calculation showing gains realised by the trust since 17 March 1998!

(3) The trustees of a non-UK settlement set up by Irek, a Russian actor now deceased, hold the trust property for Irek's four grandchildren; two of whom, Adam and Ivan, are now resident and domiciled in the UK. Any capital payments made by the trustees to Adam and Ivan prior to 17 March 1998 are not taxable on them even if gains are realised post-I7 March 1998. Gains and losses accruing to the trustees before 17 March 1998 and capital payments received before 17 March 1998 are wholly ignored. However, if the trustees now realise gains in 2003-04, any capital payments Adam and Ivan have received after 16 March 1998 can be taxed on them (see section 2 below -- operation of the s 87 charge). There may be some possibility of washing out gains by payments first to the non-UK beneficiaries if such [*633] payments are made in an earlier tax year before payments to UK-domiciled and resident beneficiaries although note at [27.1221 the changes in FA 2003 which can limit this.

Section 87 is now the catch-all charge: first consider if gains are taxed on the settlor (if they are, that is the end of the matter) but if they are not, then the s 87 rules must be applied. [27.111]

2 Operation of the section 87 charge

The charging system operates as follows:

a) Trust gains ('stockpiled gains')

The trust gains for each year must be calculated ('the amount on which the trustees would have been chargeable to tax ... if they had been resident and ordinarily resident in the UK in the year'). Non-resident trustees are not entitled to the benefit of a CGT annual exemption, but the normal uplift in value in the settled assets will occur on the death of a life tenant in possession (see [25.49]); the principal private residence exemption may apply (see Chapter 23); and taper relief is applied to reduce the gain. In computing this total, gains made in offshore companies may be attributed to the trustees (see TCGA 1992 s 13(10)). The anti 'flip-flop' rules introduced by FA 2000 (see [27.122]) provide for a separate pool of stockpiled gains is to be drawn on when the normal gains have been exhausted (TCGA 1992 s 85A, Sch 4G). [27.112]

b) Capital payments

The gains realised by the trustees will be attributed to beneficiaries and subject to CGT to the extent that they receive 'capital payments' unless otherwise taxed as income. A 'capital payment' is widely defined (see TCGA 1992 s 97(1) and (2)) to include, inter a/ia, the situation where a beneficiary becomes absolutely entitled to the trust property as well as to 'the conferring of any other benefit'.

This can include, for example, rent-free occupation of houses owned by a trust, use of pictures owned by a trust as well as loans to beneficiaries.

In Billingham v Cooper, Edwards v Fisher (2001) it was decided that the provision of an interest-free loan which was repayable on demand conferred a benefit on the borrower (a beneficiary of the trust) every day for which the loan was left outstanding. That benefit was a 'payment' within s 97(2) and a capital payment by virtue of s 97(1). The value of the benefit could be quantified retrospectively and the legislation would be applied year by year. Two other matters are worthy of note:

(1) It was accepted that a fixed period loan (eg for ten years) conferred a benefit once and for all at the date of the loan and that there was no subsequent conferment of a benefit.

(2) The Court of Appeal rejected the argument that no benefit was received (or its value was nil) on the basis that if interest had been charged it would have gone to the beneficiary (who was life tenant of [*634] the settlement). The following extract from the judgment of Lloyd J at First Instance was expressly approved by the appeal court:

'It seems to me that the legislation does not call for or permit a comparison of the position that the recipient might have been in if a different transaction had been undertaken by the trustees. There are too many different possible comparisons for that to be a tenable approach. The proper comparison is with the position of the recipient if the actual loan had not been made rather than if some other transaction had been entered into. The recipient of the actual loan, if it had not been made, would not have had the use of the money lent.

It seems to me that this is particularly clear from the fact that the sections are directed to attributing gains not only to beneficiaries but also among beneficiaries in circumstances in which more than one beneficiary has received a capital payment, which of course is not true of either of these cases.

I accept it is not sensible to suppose that the person entitled to income has a special status which exempts him from this treatment or requires him to be treated more favourably than other beneficiaries.'

More controversially HMRC argue that a settled advance by the trustees in favour of a particular beneficiary can be a capital payment within s 97. Suppose the trustees of an accumulation and maintenance offshore trust with a dead settlor decide that they wish to defer Michael's absolute entitlement to capital at 25? He would otherwise become entitled to one third of the trust fund and be subject to capital gains tax on the stockpiled gains. (Since he is the eldest child he will have the disadvantage of being taxed on all the stockpiled gains so far realised and effectively then 'wash out' the gains to the benefit of the others.)

They have no overriding powers of appointment. They do have a wide power of advancement and, therefore, exercise this power so as to make a settled advance for the benefit of Michael perhaps by way of resettlement of one third of the trust fund (say £2 million) so that he does not become absolutely entitled. Is this a capital payment? Even if he has no right to demand the capital can HMRC argue that he has received a capital payment up to the value of the assets advanced? Michael may only have a revocable life interest-in these circumstances can he really be taxed on the whole capital value?

The difficulty is that there is essentially a conflict between ss 90 and 97. TCGA 1992 s 90 provides that a proportion of outstanding trust gains are carried forward to the transferee settlement when a transfer of assets is made between settlements. However, s 97(2) provides that a payment includes the conferring of any benefit and s 97(5) (b) then states that a payment is received by the beneficiary if it is paid or 'applied for his benefit'.

The power of advancement can by definition only be exercised if it is for the benefit of a beneficiary. HMRC apparently take the view that the precise terms of the settlement under which a child takes is irrelevant and the value of that interest is also immaterial because if the application is for his benefit it is squarely within s 97(5)(b). The alternative view is that s 97(5)(b) is concerned with payments made to a third party but where the beneficiary still receives full value. For example, payments made to the school in settlement of fees that are a parent's liability on behalf of a child could be classed as payments applied for the benefit of a parent. [*635]

In the above example Michael had not in reality received anything like £2 million since the actual value of his settled interest is far less than this. If HMRC's view is right and the 64% rate applies, then he would have to find tax of over £1 million out of his personal funds! [27.113]-[27.114]

c) Method of attribution

Trust gains are attributed to all beneficiaries who receive capital payments as follows. The first beneficiary to receive a payment has (unless he is not resident here and the trust is caught by the FA 2003 changes-see [27.122]) attributed to him all the gains then realised by the trustees to the extent of the benefit which he receives. This can produce unfair results: assume, for instance, that Bill and Ben become absolutely entitled to an overseas trust fund worth £200,000 in equal shares when they become 25. The trust fund has realised gains of £100,000 when Ben becomes 25 (Bill will become 25 in a following tax year). All the gains are attributed to Ben.

When more than one capital payment is made in a single tax year, gains are attributed to the payments pro rata (TCGA 1992 s87(5)). If a capital payment is made at a time when there are no trust gains, subsequent gains may be attributed to that beneficiary (s 87(4)). Finally, if no capital payments are made, trust gains are carried forward indefinitely until such a payment occurs (s 87(2)). (For the position of a non-UK domiciled or resident beneficiary who receives capital payments, see [27.117].) [27.115]

EXAMPLE 27.21

A non-resident discretionary settlement has four beneficiaries, two of whom (A and B) are UK domiciled. Over three years the fund has no income and makes the following net gains and capital payments. No capital payments have been made to the non-UK-resident or domiciled beneficiaries.

. A B

Year l £ £ £

Capital payments 10,000 5,000

Net gains £6,000 apportioned 4,000 2,000

. ------ -----

Capital payments c/f 6,000 3,000

. A B

Year 2 £ £ £

Capital payments 3,000 6,000

Including payments b/f 9,000 9,000

Trust gains 20,000

Amount apportioned 18,000 9,000 9,000

. ------

Gains c/f £2,000

[*636]

. A B

Year 3 £ £ £

Capital payments 15,000 5,000

Trust gains 10,000

Gains b/f 2,000

. -------

Amount apportioned £12,000 9,000 3,000

Capital payments c/f £6,000 £2,000

d) Section 740 tie-in

A capital payment made by trustees may be treated as income in the hands of the beneficiary under TA 1988 s 740 (see Chapter 18). Such payments are charged to income tax up to the trust income for that year; income from previous years is included to the extent that such income has not already been charged to a beneficiary. It is only the excess that is treated as a capital payment for the purpose of the apportionment of trust gains. [27.116]

EXAMPLE 27.22

The same settlement as in Example 27.21, except that the following payments made to A and B over three years are first treated as income under TA 1988 s 740.

. A B

Year l £ £ £

Trust payments 20,000 10,000

Trust income £12,000

Charged to income tax on

A and B 8,000 4,000

. 12,000 6,000

Trust gains £15,000

Apportioned for CGT 10,000 5,000

Payments c/f £2,000 £1,000

. A B

Year 2 £ £ £

Payments b/f 2,000 1,000

Payments made 10,000 11,000

. ------ ------

. 12,000 12,000

Trust income 30,000

Charged to income tax on

A and B 24,000 12,000 12,000

Income c/f £6,000

Trust gains made in Year 2

and c/f £12,000

[*637]

. A B

Year 3 £ £ £

Trust payments 10,000 10,000

Trust income 8,000

Trust income b/f from year 2 6,000

. ------

Charged to income tax

on A and B £14,000 7,000 7,000

. ------ ------

. 3,000 3,000

Trust gains 4,000

Trust gains b/f from year 2 12,000

. ------

. 16,000

Apportioned for CGT 6,000 3,000 3,000

Trust gains c/f £10,000

e) The non-UK beneficiary

A beneficiary who receives a capital payment is subject to CGT on the attributed gains provided that he is UK domiciled and resident (TCGA 1992 s 87(7)). Accordingly, a non-UK-resident may have trust gains attributed to him (subject to FA 2003-see [27.122]) but will not suffer any tax on those gains. The UK beneficiary cannot deduct his personal losses from the gain attributed to him (contrast the position of a settlor beneficiary and s 86 gains and losses) but may deduct his annual exemption and the balance will then attract tax at 10%, 20% or 40% as appropriate. In calculating his liability offshore gains will be treated as the lowest part of his total gains for the year (thereby enabling him to benefit from the beneficiary's annual exemption and, in appropriate cases, reducing any surcharge: see [27.119] and see CG 38321 in the context of the charge on the settlor). [27.117]

f) Offshore losses

If non-resident trustees make losses these will be set off against future gains made by those trustees in the normal way for the purposes of calculating s 87 gains attributable to a beneficiary. Note, however, important qualifications to the general provisions dealing with losses:

(1) Such losses do not pass to a beneficiary who becomes absolutely entitled to the trust assets (see TCGA 1992 s 16(3) and s 97(6)).

(2) If losses have been realised in the trust prior to when it became 'qualifying' and the trust gains then fall within the s 86 charge being realised after it became qualifying (eg in the case of a 'pre-1991 trust'), the existing realised losses cannot be used to reduce future gains which are taxed on the settlor. Such gains may be reduced by losses that are also realised during the period of the settlor charge). The existing losses from the period when the trust was non-qualifying may be used against future trust gains arising after the settlor charge has ceased to apply, eg when the settlor has died or the trust is imported. [*638]

(3) Losses which have arisen during a period of settlor charge cannot be used by the trustees against future gains that may otherwise be taxed under s 87.

(4) Gains attributed to a beneficiary under s 87 cannot be reduced by that beneficiary setting such gains off against personal losses.

EXAMPLE 27.23

Bonzo (now dead) created a non-UK-resident settlement in the mid 1980s. Capital payments have not so far been made by the trustees and the gains (losses) of the settlement are as follows:

Tax year Gain (loss)

1986-87 250,000

1987-88 (75,000)

Assume further that the Bonzo family now wish to import this trust and that there are some assets in the fund showing an unrealised gain and some showing an unrealised loss.

(1) The trust can be imported by the appointment of a majority of UK resident trustees. Future gains will be taxed at 40% with effect from 2004-05. Note that the stockpiled gains realised in the past will still remain on the clock until such time as capital payments are made.

(2) The trust has realised gains of £250,000 from 1986-87 that will remain on the settlement 'clock' and so attract a tax charge as and when capital payments are 'made to UK beneficiaries.

(3) The loss of £75,000 in 1987-88 may be offset against future trust gains including gains realised by UK resident trustees.

(4) If, however, Bonzo was still alive and was domiciled and resident here, and the trust is within s 86 if non-UK resident or s 77 if UK-resident, the loss realised in 1987-88 could not be used against gains realised by the trust now.

A charge under s 87 can be deferred so long as the trustees avoid making capital payments. The charge can be avoided altogether if such payments are made to a non-UK-resident or non-UK-domiciled beneficiary or distributions are made to UK-resident and domiciled beneficiaries which do not exceed their annual capital gains tax exemptions. Gains may, therefore, be washed out of the trust by the making of such payments in the tax year prior to distributions to UK-resident and domiciled beneficiaries provided the trust is not caught by FA 2003 -- see [27.122].

Following the introduction of 'temporary non-residents' by FA 1998, difficulties may arise if a settlor-who would otherwise be subject to the s 86 charge-ceased to be UK-resident. As a result the capital payment rules in s 87 will apply, but if the settlor returns to the UK within five years of his departure gains during his absence will be attributed to him on his return (see [27.5]). To prevent a double charge such gains will not include capital payments made to UK-resident and domiciled beneficiaries (although note that no deduction is made for payments to non-resident beneficiaries: see TCGA 1992 s 86A). [27.118]

3 The supplementary (interest) charge

A 'supplementary' charge may apply to beneficiaries who receive capital payments on or after 6 April 1992. Because it is intended to be supplementary to the s 87 charge, this extra levy will not apply if the recipient beneficiary is non-resident or non-domiciled (TCGA 1992 ss 91-95).

The charge operates as an interest charge on the delayed payment of CGT following a disposal of chargeable assets by non-resident trustees. It is, however, limited to a six-year period and, therefore, the time covered by the charge begins on the later of (a) 1 December in the tax year following the year in which the disposal occurred, and (b) 1 December six years before 1 December in the year of assessment following that in which the capital payment was made. It ends in November of the year of assessment following that in which the capital payment is made. The rate of charge is 10% pa of the tax payable on the capital payment (this percentage may be amended by statutory instrument). The minimum period is two years so the minimum charge is 20%. For a higher rate taxpayer, the effective maximum rate is 64%.

EXAMPLE 27.24

The Moisie Liechtenstein Trust realises capital gains in the tax year 1998-99 and a capital payment is made to a UK domiciled and resident Moisie beneficiary on 1 July 2004.

(1) That beneficiary will be assessed to CGT on the capital payment received (at current rates at, say, 40%).

(2) The interest charge will apply for the period from 1 December 1999 to 30 November 2005 at 4% per annum so that the interest charge continues to run after the capital payment has been made. In all, six years will be subject to the additional charge (being 24%) thereby giving a capital gains tax rate of of 64% 40 + 24) Note that if the beneficiary does not suffer a CGT charge -- for instance because he is able to set his annual exemption against the gains attributed to him-there is no interest charge.

The precise mechanics governing the supplementary charge are complex, with capital payments being matched first with total trust gains at 6 April 1991 and then on a first-in first-out basis. By way of concession, however, trustees are given at least 12 months in which to distribute gains since the interest charge does not apply to gains realised in the same or immediately preceding year of assessment.

EXAMPLE 27.25

In 1996-97 the Cohen Offshore Settlement has accumulated trust gains of £100,000. Although the interest charge begins to run on 1 December 1997 no charge is levied on capital distributions made before 6 April 1998.

To what extent has the charge encouraged the break-up of existing offshore trusts? Much turns on the facts of individual cases but it should be remembered that one way of avoiding the s 87 charge-distributing to non-residents-generally still remains available to 'wash-out' all the potential tax including this interest charge provided the trust is not caught by the FA 2003 provisions. For the wealthy family, who view their trust as a roll-up fund that they do not need to dip into, a 10% charge may be seen as a relatively small impost, given that the deferred tax may be an insignificant percentage of the total offshore fund. [*640] finally, remember that because income from offshore trusts may be taxed less heavily (at a maximum rate of 40%) trustees should, in appropriate cases, ensure that income rather than capital is distributed. [27.119]

4 Disposal of a beneficial interest in an offshore trust

The basic rule is that disposals of beneficial interests in non-resident trusts are subject to charge (TCGA 1992 s 85(1) disapplying s 76(1)). The following points should be noted about this section.

First, what happens if the interest of a beneficiary terminates not as a result of any voluntary action on his part but by act of the trustees: eg where a life interest is terminated by the trustees under a power reserved to them in the settlement? In this case it is thought that the termination will not amount to a disposal for CGT purposes since whilst it is true that under the legislation certain involuntary disposals (eg a sale under a compulsory purchase order) are subject to charge (so that a voluntary act on the part of the disponor is not always required) even in these cases there is a transfer of assets as opposed to a mere forfeiture of rights. So far as a forfeiture of rights is concerned there is no disposal unless a capital sum is paid or deemed to be paid on that event (TCGA 1992 ss 22-24). If the trustees, therefore, exercise overriding powers of appointment and, say, terminate the settlor's life interest in favour of trusts for his children, there should be no tax charge on the settlor because he has made no disposal of his beneficial interest as such. If the trustees can exercise their overriding powers but only with the consent of the settlor, is there any disposal in these circumstances? The better view is that the giving of consent by the settlor in relation to an offshore trust is not a disposal within s 85 although HMRC's view is not entirely clear on this point. In the past HMRC have indicated that if no consideration is given to the consent there is no disposal by the beneficiary. The beneficiary in question may be able to release the requirement for his consent before any appointment by the trustees is actually contemplated.

Note that if the consent is treated as some sort of disposal of a chose in action asset for capital gains tax purposes, variations of any settlement whether UK-resident or not, where the beneficiary has to consent might be problematic!

Second, note that the effect of s 85 may mean that even if the settlor wants to be excluded from the trust (along with all defined persons) in order to avoid the s 86 charge, it may not be possible to do this easily without triggering a s 85 charge because the terms of the trust are such that the settlor can only be excluded if he positively surrenders his life interest. This would be regarded as a deemed disposal on which the settlor would be liable to capital gains tax (since the life interest is likely to have a low or nil base cost.) The only alternative to avoiding the s 86 charge is to wait until the death of the settlor before realising gains or to import the trust (although the

settlor and spouse would still need to be excluded in order to avoid a s 77 charge and again this may prove difficult to engineer without a s 76/s 85 charge and see point 5 below). For this reason it is generally sensible to ensure that all offshore trustees have wide powers of appointment, exclusion etc in order to be able to rearrange the beneficial interests without triggering unexpected charges under s 85. [*641]

Third, the section makes it clear that although a disposal of such an interest is subject to charge this does not apply when the beneficiary becomes absolutely entitled as against the trustees in respect of any property (eg if an advance is made to him or on the deemed disposal occurring on the termination of the trust).

Fourth, if a UK-resident trust is exported thereby triggering a deemed disposal of the settled property ([27.57]) a beneficiary is treated as disposing of his interest at that time for the purpose of providing him with a market value at that date which will be used in calculating his gain on a subsequent disposal of the interest (see [25.1131]. This provision was used to avoid tax as illustrated in the following example:

EXAMPLE 27.26

The Itchyfoot Settlement has substantial stockpiled gains and is a cash fund. The trust is imported and then exported. The beneficiaries then disposed of their interests at no gain and the s 87 charge was avoided.

FA 2000 amended s 85 so that from 21 March 2000 there is no uplift in the value of the interests of the beneficiaries if a settlement is exported at a time when it has stockpiled gains.

Fifth, note that disposals of beneficial interests in a trust which was at any time non-UK-resident (or which had received property from such a trust) were brought into charge in respect of disposals occurring on or after 6 March 1998. This matter is considered further at [25.115]. [27.120]-[27.121]

5 Anti-flip flop legislation-FA 2000 and FA 2003

As noted earlier, FA 2000 attempted to stop flip flop schemes by introducing Schedules 4B and 4G. Essentially where Trust A borrows and does not apply the borrowing for 'normal trust purposes' (narrowly defined) but makes a 'transfer of value' (widely defined to include capital transfers, loans on commercial terms etc) there is a deemed disposal of all the trust assets remaining in Trust A (resultant gains fall into the Schedule 4G pool'). FA 2000 prevented the use of old-style flip flop schemes which had effectively worked by delaying the realisation of gains until a later year. The pre-2000 flip flop schemes generally involved settlor interested trusts where the intention was to avoid a s 86 charge on future gains (see Example 27.19).

However FA 2000 introduced a loophole that was exploited where trustees wished to reduce or eliminate the future pile of stockpiled gains that could be attributed to beneficiaries on future capital payments. See Example 27.27.

The FA 2000 provisions have created a number of problems: there is no motive test so perfectly innocent transactions which involved no tax avoidance and no diminution in the trust assets could be caught. For example a trust that borrowed from one underlying company and lent funds to another wholly-owned company to enable that company to make an investment would he caught. The safest course for offshore trusts (and indeed UK-resident trusts which had s 87 gains or were within s 77) was to avoid trustee borrowing at all, although curiously, companies wholly owned by trustees could borrow and were not caught by the legislation (see Tax Bulletin, issue 66 p 1048). [*642] The loophole referred to above was contained in s 90(5) (a) which prevented s 87 gains from being carried across to the transferee settlement (trust B) to the extent that the transfer was (under Schedule 4B) linked with trustee borrowing. The legislation that had aimed to stop s 86 avoidance thus opened up extensive opportunities for s 87 tax avoidance as illustrated in the following example. [27.122]

EXAMPLE 27.27

Offshore Trust A has £1m stockpiled gains and is worth £1m. It holds mostly cash or assets showing no gain. It borrows £1m and in 2002 appoints all the borrowed funds of £1 million to Trust B. On a simple reading under the pre-FA 2003 legislation, since there was a transfer of value linked to trustee borrowing, s 90(5) (a) provided that the stockpiled gains of £1m did not pass across into Trust B. Trust B took £lm free of the stockpiled gains. There was a deemed disposal of the assets remaining in Trust A but since these showed no gains this did not matter. There was nothing to go into the Schedule 4C pool.

Such 'section 90' schemes were widely used in an attempt to get rid of the stockpiled gains which could not easily be washed out where all the beneficiaries were UK-resident. Often the penalty charge meant that if any capital payments were made to beneficiaries these would be taxed at 64%. Therefore the incentive to get rid of the stockpiled gains was high. The Government response to the s 90 avoidance scheme has been aggressive. FA 2003 s 163 introduced further changes to Schedule 4C. These changes are complex but the effects can be summarised as follows:

(a) FA 2003 changes are relevant wherever trustees of a settlement have made a transfer of value linked to trustee borrowing after 20 March 2000 even if the original settlement (Trust A in the above example) has ceased to exist. Since, as noted above, a transfer of value linked to trustee borrowing can occur in a number of unexpected instances where there is no avoidance motive, the position must be checked wherever trustees have borrowed.

(b) The provisions in FA 2003 do not affect beneficiaries who have received capital payments from Trust 2 prior to 9 April 2003. Thus in Example 27.27 if Trust B had distributed the entire £1m to the relevant beneficiaries by 9 April 2003, such beneficiaries are not caught by the FA 2003 legislation arid such payments are tax free if the s 90 scheme works (although the scheme may fail for other reasons eg if Trust B was a sham).

(c) FA 2003 now provides that the Schedule 4C pool comprises not only the Schedule 4B gains realised on the deemed disposal but also any outstanding s 87 gains in the transferor settlement at the end of the tax year in which the transfer was made. Thus in Example 27.27, Trust B no longer takes £1m cash free of the s 87 gains. All those s 87 gains fall into the Schedule 4G pool (along with any deemed Schedule 4B gains) and can be allocated to any future payments made to beneficiaries of either Trusts A or B.

(d)The fact that (as in Example 27.27) no gains may be realised on the deemed disposal under Schedule 4B is irrelevant. If there is a transfer of value linked to trustee borrowing then the anti-avoidance legislation [*643] is triggered and a Schedule 4G pool is formed comprising the Schedule 4B trust gains plus the s 87 stockpiled gains.

(e) For the purposes of calculating the Schedule 4G pool, the outstanding s 87 gains are calculated ignoring payments to non-resident or exempt beneficiaries in the tax year of the transfer of value (or subsequently) although payments to non-resident beneficiaries that took place prior to 9 April 2003 can reduce the s 87 stockpile.

(f) The old s 87 stockpile in Trust A is reduced to nil. There is just one Schedule 4G pool overhanging both trusts. [27.123]

EXAMPLE 27.28

In 2003-04, Trust A borrows £2 million and appoints the cash to Trust B in June 2003. There is a deemed disposal of all the assets remaining in Trust A as at June 2003 (say shares in RS Limited worth £0.6 million with a base cost of £0.1 million) which disposal, therefore, realises a Schedule 4B gain of £0.5 million ignoring taper relief. The level of stockpiled s 87 gains in Trust A at the end of 2003-04 is £1 million. The Schedule 4G pool is therefore £1.5 million and can be attributed to future capital payments made to beneficiaries out of either Trust.

Trust B then makes distributions of £1.5 million to Eric and John, both not domiciled in the UK The following tax year Trust B distributes the balance of the fund, being £0.5 million to Fiona who is resident and domiciled here. The distributions to Eric andJohn do not reduce the Schedule 4C pool of gains (which remains at £1.5m) although Eric and John do not suffer a CGT charge. Fiona pays tax on the entire £0.5 million distributed to her. Similarly, if Trust A makes any distributions to Eric and John, such distributions will not reduce the Schedule 4C pool hanging over Trust A and future capital payments to UK-resident and domiciled beneficiaries will be taxed.

(g) Thus the risk of triggering a transfer of value is not only that one creates a deemed disposal of the remaining assets in the original settlement but also that one has also lost the opportunity to structure future capital payments tax efficiently-gains cannot be 'washed out' by making distributions to non-chargeable beneficiaries.

(h) The deemed disposal of the remaining assets in the original settlement means that those assets are rebased for all future purposes. [27.124]

EXAMPLE 27.29

Facts as in Example 27.28 except that Trust A actually sold RS shares 11 months later in May 2004 for £0.7 million. The gain realised then would be £0.1 million (which gain would not fall into the Schedule 4G pool unless a further transfer of value is made) not £0.6 million.

(j) Presumably in Example 27.28 taper relief is available on the deemed disposal in June 2003 calculated on a period of ownership from the date of acquisition up to June 2003. No further taper relief is available on the actual disposal in May 2004 because the shares have not been held for 12 months. The actual gain of £0.1 million realised on a later actual disposal of RS shares is a s 87 gain which is not attributed to Trust B and can still be washed out on future payments by Trust A to non-resident or non-domiciled beneficiaries. It is only the Schedule 4G gains that cannot be washed out. [*644] (j) The interest charge can also apply to Schedule 4C gains and, to maximise the adverse effects, the legislation provides that Schedule 4G gains of earlier years are attributed to beneficiaries before gains of later years.

(k) When there are both s 87 and Sch 4G gains the earliest gains of either type are attributed to beneficiaries first. Where the s 87 and Sch 4G gains are of the same year, the Sch 4G gains are attributed first. This maximises the penalty charge.

(l) There are wide anti-avoidance provisions catching further transfers to other trusts. Thus if in Example 2727any of Trusts A, B or G later makes a further transfer of value creating a further Schedule 4G pool then that pool can be visited on any of the beneficiaries who receive capital payments from Trusts A, B or G even if say, the beneficiaries are excluded from the Trust which made the further transfer of value. [27.125]

EXAMPLE 27.30

The facts arc as in Example 27.28 except that Trust B makes no distributions to Eric and John. Instead Trust B transfers one-third of its fund to Trust G for the benefit of Eric and his issue and one-third to Trust D for the benefit ofJohn and his issue and retains the remaining one-third for the benefit of Fiona and her issue. John and Eric are excluded from Trust B; Fiona and John are excluded from Trust G and Fiona and Eric are excluded from Trust D. Trust C realises further s 87 gains of say £1 million in later tax years (which cannot at that point be attributed back to Trusts A, B or D) and eventually in 2009-10 makes a further transfer of value linked to trustee borrowing. The Schedule 4G pool that then arises is £1.2 million. Since all the settlements remain relevant settlements for the purposes of Schedule 4G due to the first transfer of value made in 2003-04, that £1.2 million pool can now be attributed to any capital payments made to any of the beneficiaries of Trusts A to D. Each trust's original pool of Schedule 4G gains has been retrospectively increased. In this case, the only person who would be concerned is Fiona since the other beneficiaries are not domiciled here, but she has no control over what Trust G does. There is also no obvious way in which she or indeed Trust B can require the trustees of Trust G to provide the necessary information to the trustees of Trust B regarding the calculation of the Schedule 4G pool.

Thus once a transfer of value linked to trustee borrowing has been made, each transferor and transferee settlement will need to keep monitoring any future transfers of value linked to trustee borrowing as well as the capital payments each trust makes and to whom, in order to establish whether the Schedule 4G pool has been reduced. Trustees of transferee and transferor settlements should ensure that in these circumstances they make suitable provision in the documentation to require all trustees to provide the relevant information in the future. [27.126]

6 Offshore trusts: information (TGGA 1992 s 98A, Sch SA)

FA 1994 widened the information provisions to catch all non-resident trusts, not just those in which a defined person retains an interest. Accordingly, they apply to additions to an existing trust; to the establishment by a UK setdor of a foreign settlement and indeed to a foreign settlement created by a [*645] non-UK-resident and domiciliary who subsequently becomes resident and domiciled and, finally, to the export of a UK trust. In all cases details of the date when the settlement was created; name and address of persons delivering the return and details of the trustees must be provided. [27.127]