Spouses’ Wages – Legitimate Expense Or Tax Dodge?

A common element in the accounts of many self-employed individuals (and partnerships) is a deduction for the wages of family members, particularly a spouse (or civil partner). For example, in over 30 years as a tax practitioner I have seen countless claims for ‘wife’s wages’.

Most claims for deductions of this nature are valid and commercially justifiable. However, in some cases deductions are seemingly claimed routinely and on an arbitrary basis (e.g. £100 per week, or an amount just below the threshold at which National Insurance contributions become payable, or possibly at a level to utilise the spouse’s personal allowances). In such cases, it is important to remember that no deduction is allowed to the business proprietor for expenses not incurred ‘wholly and exclusively’ for the purposes of the trade (ITTOIA 2005, s 34(1)(a)). An identical rule applies to companies (CTA 2009, s 54(1)(a)), which are beyond the scope of this article.

Valid claim?

Disputes between taxpayers and HM Revenue and Customs (HMRC) (and its predecessor Inland Revenue) about deductions for wages in respect of family members (including spouses in some instances) have been the subject of a number of tax cases over the years. These cases have set a precedent for the general proposition that, to be a valid deduction, the following conditions must all be met:

  1. The amounts must be realistic and not excessive for the work done (e.g. Copeman v William Flood and Sons Ltd [1941] 1 KB 202);
  2. The payments must be recorded in the business records (and PAYE operated as appropriate) (e.g. Abbott v CIR [1996] SSCD 41); and
  3. The amounts must actually be paid to the spouse for the work done, and not be mere accounting entries (e.g. Moschi v Kelly CA 1952, TC 442).

Even if a spouse’s wages satisfies the above criteria, in order to claim a trading deduction for the period of account in question, the amount charged in the accounts must be ‘paid’ (as under ITTOIA 2005, s 37) within nine months from the end of that period, or the deduction is deferred to the period of account in which it was paid (s 36).

Too high

A tax deduction for excessive spouse’s wages is not necessarily ‘all or nothing’. The above ‘wholly and exclusively’ rule also provides that a partial deduction is not prohibited for any identifiable part or proportion of the expense which is incurred wholly and exclusively for the purposes of the trade (s 34(2)). HMRC guidance in its Business Income manual (at BIM47105) states that if the facts show that a “definite part or proportion” of the remuneration is not wholly and exclusively laid out or expended for the purposes of the trade, profession, or vocation, that part or proportion should be disallowed.

In Scott & Ingham v Trehearne [1924] 9 TC 69, commission on profits of 33.33% paid by a self-employed individual to each of his two sons was held to have been excessive on the evidence, and 10% was regarded as paid for services rendered and deductible from business profits.

More recently, in McAdam v Revenue and Customs [2017] UKFTT 838 (TC), following an enquiry into the taxpayer’s tax return for 2013/14 and review of his business records as a self-employed plumbing and heating engineer, HMRC concluded that the deduction claimed for wife’s wages was unreasonable. The taxpayer argued that a salary of £90 per week for his wife was not excessive for the duties she carried out “…to maintain the administrative and accounting functions and these duties extend, and are not restricted to, taking telephone enquiries, processing orders and checking part prices”. HMRC accepted that the taxpayer’s wife had done some work, but calculated that an appropriate wage would be £1,344 per annum, at an hourly rate of £8.

The First-tier Tribunal pointed out that it had been furnished with no credible evidence by the taxpayer to support even the wife’s level of working activities that HMRC was prepared to accept, let alone the “nine or ten hours per week” claimed by the taxpayer. The taxpayer’s appeal was dismissed.

Double trouble?

A payment for spouse’s wages that is partly disallowed as a business deduction for the self-employed individual is nevertheless likely to remain fully taxable income of the recipient. Alternatively, even if fully deductible, in some cases HMRC may argue that the wages are taxable income of the worker’s spouse instead, such as under the ‘settlements’ anti-avoidance rules (or, for companies, as remuneration of a controlling director rather than their spouse) (see BIM47106).

Practical point

In addition to the above criteria for a valid claim for spouse’s wages, evidence of the work done by the spouse and the time spent performing that work should be retained, and their rate of pay should be no higher than a commercial level.

The above article was first published in Business Tax Insider (July 2017) (www.taxinsider.co.uk).

Private Residence Relief: Tables Turned On HMRC!

Individuals who dispose of a dwelling house sometimes find themselves in disputes with HM Revenue and Customs (HMRC) over whether private residence relief (PRR) is due on the disposal of the property for capital gains tax (CGT) purposes (under TCGA 1992, s 222). Numerous cases have reached the courts and tribunal over the years.

Burden of proof

If PRR was claimed but HMRC has assessed CGT on the disposal of the dwelling house on the basis that PPR is not due, the onus is normally on the taxpayer to demonstrate that HMRC’s assessment is excessive (TMA 1970, s 50(6)). However, if HMRC has made a ‘discovery’ assessment (under s 29) outside the normal time limit for making an enquiry into the individual’s tax return, the burden of proof is on HMRC to demonstrate that a loss of tax has been brought about carelessly or deliberately by the taxpayer. This requirement can be important.

For example, In Munford v Revenue and Customs [2017] UKFTT 19 (TC), in June 2004, the taxpayer and his wife purchased a property (‘NW11’) for £4 million. On the same day, the taxpayer purchased a property (‘SW3’) in his sole name for £1,050,000. He sold SW3 on 21 March 2006 for £2,550,000.

The taxpayer’s tax return for 2005/06 contained no capital gains disclosure relating to the disposal, as it was claimed that he moved into SW3 on 26 November 2005 and vacated it on 7 January 2006, and that PRR applied to its disposal (elections had also been made to treat SW3 as the taxpayer’s main residence for a one week period). Subsequently, HMRC issued a discovery assessment for 2005/06, on the basis that no PRR was due. The taxpayer appealed.

Out of time?

In general, if HMRC wishes to dispute that PRR is due on the disposal of a property, it can open an enquiry into the taxpayer’s self-assessment return for the tax year of the disposal. The time limit for HMRC to open the enquiry in most cases is twelve months after the day on which the return was filed (TMA 1970, s 9A(2)(a)).

If the property disposal was not included on the individual’s tax return (i.e. on the basis that the entire gain was relieved by PRR), HMRC could dispute the relief by making a discovery assessment outside the normal tax return enquiry window. The ordinary time limit for a discovery assessment is four years after the end of the tax year to which it relates (TMA 1970, s 34(1)). However, if a discovery assessment is made to recover a careless loss of tax the time limit is six years, or if the assessment is made to recover a deliberate loss of tax it is twenty years (s 36(1), (1A)).

In Munford, HMRC’s discovery assessment for 2005/06 was issued on 23 July 2015, i.e. outside both the normal four year assessment time limit and the six year time limit for a careless loss of tax. The First-tier Tribunal noted that HMRC relied upon the twenty year time limit for its discovery assessment, which required a loss of tax to have been brought about deliberately by the taxpayer. HMRC therefore had to show that: (a) there was a loss of CGT; and (b) the loss was brought about deliberately.

With regard to (a), HMRC needed to prove that the taxpayer was not entitled to PRR on SW3. However, based on the facts and evidence, the tribunal did not agree with HMRC that the taxpayer acquired SW3 as an investment property. Furthermore, HMRC had not demonstrated that the taxpayer and his wife did not occupy SW3 as their private residence. Thus HMRC had not shown a loss of CGT on the disposal of SW3. That was sufficient for the taxpayer’s appeal to be allowed.

However, the tribunal went on to consider whether, if there had been a loss of CGT, it was brought about deliberately by the taxpayer. The tribunal concluded that HMRC had not discharged its burden of proving (on the balance of probabilities) that the taxpayer deliberately brought about a loss of tax in relation to SW3. Accordingly, the conditions for making an extended (i.e. twenty year) time limit assessment were not satisfied.

Practical point

If HMRC disputes a PRR claim, check that they are within the law for doing so. If HMRC issues a discovery assessment outside the normal time limits, be aware of the shift in the burden of proof from the appellant towards HMRC. This could make all the difference, as the tribunal indicated in the Mumford case:

“I should stress that my conclusion that HMRC have not succeeded in showing that [the appellant] did not occupy [SW3] as their private residence should not be taken as a positive finding that it was their private residence. Had the burden of proof been on them, it would have been necessary for the tribunal to take a very different approach to the evaluation of the evidence. It does not assist to speculate what the outcome of that process would have been.”

The above article was first published in Property Tax Insider (May 2017) (www.taxinsider.co.uk).

An Inheritance Tax-Free Rental Property Business?

Many individuals would like to have a rental property business, but may be concerned (among other things) about the possible eventual inheritance tax (IHT) liability on the value of the property portfolio. However, a valuable IHT relief may be available to alleviate the problem in certain circumstances.

Business property relief (BPR) applies to various types of ‘relevant business property’. For example, BPR can apply to a business (or an interest in it), or to shares in an unquoted company, if certain conditions are satisfied. The rate of BPR on these categories is up to 100%.

The ‘right’ business?

However, a business (or business interest) and unquoted company shares are not eligible for BPR if the business, or the business carried on by the company, consists wholly or mainly of dealing in securities, stocks or shares, land or buildings or making or holding investments (IHTA 1984, s 105(3)). These BPR exclusions are subject to certain exceptions (in s 105(4), (4A)), which are not considered in this article. The ‘wholly or mainly’ test applies to both unincorporated businesses and companies, but this article concerns single companies.

The exception from BPR for businesses wholly or mainly of making or holding investments means that (for example) the shareholders of a family or owner-managed company operating a rental property business (and nothing else) would generally not be eligible for BPR in respect of their shares.

BPR pitfalls

The above ‘wholly or mainly’ exclusion from BPR in respect of investment businesses etc. is an ‘all or nothing’ test. For example, shares in an unquoted company with business activities comprising 51% qualifying trading and 49% investment may qualify for BPR in full (although in practice it might be difficult to measure the respective activities accurately). On the other hand, the company’s shares would be eligible for no BPR at all if its business activities are 49% trading and 51% investment.

A separate potential BPR problem is an anti-avoidance provision for ‘excepted assets’ (IHTA 1984, s 112). The general rule is that an asset is an ‘excepted asset’ if either of two alternative tests apply. The first test is that the asset was not used wholly or mainly for the purposes of the business throughout the whole or the last two years of the relevant period. The second test is that the asset was not required for future use in the business.

If ‘caught’ by the excepted asset provisions, the effect is broadly that BPR (e.g. on a lifetime transfer of shares into a discretionary trust, or on death) is restricted by the value attributable to the excepted assets. Only that part of a transfer of value which relates to ‘relevant business property’ is reduced by BPR; the other part relating to the excepted asset is not reduced by BPR, and is chargeable to IHT as normal.

Thus (for example) using an unquoted trading company as a ‘money box’ for surplus cash (i.e. cash not required for present or future trade use) is unlikely to shelter those funds from IHT, as cash which is an excepted asset will generally restrict BPR on the shares. HMRC does not consider that holding surplus cash on deposit constitutes an investment business activity (see HMRC’s Shares and Assets Valuation manual at SVM111220).

A ‘hybrid’ business

By contrast, if the trading company was engaged in secondary rental property business activities, it may be possible for BPR to be available in respect of its shares, without restriction. HMRC accepts that a ‘hybrid’ company (i.e. trading and managing investments) that is mainly trading will not be subject to the excepted assets rule in respect of assets used in the investment element of the business (e.g. rental properties).

Consideration could therefore be given to the company operating an investment business that is ancillary to its qualifying trade, such as a rental property business. As mentioned, shares in a hybrid trading and investment company may be eligible for BPR in full (but see below). However, it is important that the rental property business activities are conducted as an integral part of the company’s hybrid business.

It will probably be necessary to satisfy HMRC that a ‘business’ is being carried on in respect of the rental properties, as opposed to being excepted investments (see IHTM25272). For example, HMRC guidance states: ‘A degree of activity is required to constitute a business, and whether investments involve sufficient activity must depend on their nature and the particular facts’ (SVM111220).

Practical point

It is vitally important that the company does not breach the ‘wholly or mainly’ excluded activities test, by ensuring that the company’s investment business activities do not predominate over its qualifying trading activities (see HMRC guidance at IHTM25265 and SVM111150). Otherwise, BPR may be lost in its entirety. The other conditions for BPR (e.g. the period of share ownership) should also not be overlooked. Expert professional advice is strongly recommended where necessary.

The above article was first published in Property Tax Insider (July 2017) (www.taxinsider.co.uk).

Share Disposals And Anti-Avoidance – Decisions, Decisions!

When an individual shareholder sells shares in a ‘close’ family or owner-managed trading company, he or she will probably expect the proceeds to be treated as a capital receipt. If the individual is liable to capital gains tax (CGT) on the share sale, in many cases the tax rate will be 20% (for 2018/19), although the CGT rate could be only 10% if the conditions for entrepreneurs’ relief are satisfied and a claim is successfully made.

CGT or income tax?

The above CGT rates of 20% or 10% will normally be more favourable than if the share sale proceeds were subject to income tax and the shareholder was a higher or additional rate taxpayer. Of course, HM Revenue and Customs (HMRC) recognises this. There is anti-avoidance legislation (i.e. the ‘transactions in securities’ rules) whereby HMRC can broadly counteract an income tax advantage in certain circumstances where a main purpose of the share sale was to obtain the advantage.

In the above example, if the company had sufficient distributable reserves and HMRC successfully argued that the share sale was ‘caught’ by the transactions in securities rules (in ITA 2007, ss 682-713), such as if the shares were sold to another company owned by the vendor with a view to claiming entrepreneurs’ relief on the sale, the income tax advantage subject to HMRC counteraction would broadly be the difference between the CGT payable if the ‘relevant consideration’ was received as capital, and the amount due if the vendor had received a dividend subject to income tax instead.

Seeking the ‘all clear’

Taxpayers (and advisers) seeking certainty about whether HMRC considers the above anti-avoidance rules would apply may submit a clearance application in advance of the proposed transactions (under s 701). Of course, full and accurate disclosure is required so that any clearance given by HMRC can subsequently be relied upon. HMRC guidance on clearance applications is available on the Gov.uk website (www.gov.uk/guidance/seeking-clearance-or-approval-for-a-transaction).

Unfortunately, there is no right of appeal if HMRC refuses to give clearance that a transaction is not ‘caught’ by the transactions in securities provisions and that no counteraction notice ought to be served.

Taking a chance?

Some taxpayers may therefore prefer to ‘take a chance’ and proceed with their share sale as planned without submitting a clearance application, in the hope HMRC will not consider that the anti-avoidance provisions apply to their transaction.

HMRC’s compliance and counteraction procedures under the transactions in securities rules (which had not been updated since the introduction of self-assessment in the 1990s) changed in Finance Act 2016. HMRC may now enquire into transactions if there is reason to believe that the taxpayer could be liable to income tax under the anti-avoidance rules, by issuing an enquiry notice to the taxpayer.

This HMRC enquiry notice should not be confused with tax return enquiry notices. One practical aspect of the transactions in securities provisions is that taxpayers are not required to self-assess income tax liabilities under those rules. However, taxpayers will generally need to disclose the transactions on their tax return, and self-assess any CGT liability.

HMRC calling

The normal time limit for HMRC to enquire into a tax return is twelve months after the day on which the tax return was filed (although that period can be extended if the return is submitted late), but HMRC may make an assessment within four, six or twenty years after the end of the tax year to which it relates (depending on the circumstances) if it ‘discovers’ an insufficiency of income tax or CGT.

By contrast, the time limit for HMRC to issue an enquiry notice under the transactions in securities provisions is within six years after the end of the tax year to which the income tax advantage relates (s 695).

Following an enquiry, if HMRC considers that the anti-avoidance rules apply, it may issue a notice showing the income tax advantage to be counteracted, and make adjustments to the taxpayer’s tax position. However, there is a right of appeal against a counteraction notice to the tribunal within 30 days. Alternatively, if HMRC considers that the anti-avoidance rules do not apply, it must issue the taxpayer with a ‘no-counteraction notice’.

Practical point

The lack of an appeal procedure against HMRC clearance refusals means that some taxpayers may prefer to self-assess a CGT liability rather than apply for clearance, and take their chances on whether HMRC issues a counteraction enquiry notice. Some taxpayers may even wish to self-assess their tax liability on that basis despite clearance having been applied for and refused. However, the required full disclosure is likely to result in an enquiry and the issue of a counteraction notice. Advisers should also consider their obligations under ‘professional conduct in relation to taxation’ in relation to disclosures.

The above article was first published in Business Tax Insider (June 2017) (www.taxinsider.co.uk).

Dilapidation Receipts – Income Or Capital?

Some tenants treat the residential property they rent with great care. Unfortunately, others do not, and the landlord may receive dilapidation payments from the tenant to enable the landlord to restore the property to its former condition at the end of a tenancy.

The question arises whether such a dilapidation payment should be treated as income in a similar way to rent in the landlord’s property rental business, or whether it is a capital receipt in the landlord’s hands and subject to capital gains treatment.

Loss of capital value

In Thornton v Revenue and Customs [2016] UKFTT 767 (TC), the taxpayer received rental income from 18 flats leased to a housing society under a tenants repairing lease, whereby the tenants were responsible for the upkeep of the flats. However, they did not do so. The flats were latterly vacant for at least a year, as they were unfit for habitation. The housing association continued to pay rent to the taxpayer whilst settlement negotiations were conducted to end the housing association’s liability under the lease, so that the taxpayer could recover the flats to prevent further disrepair. A settlement was subsequently reached, and the taxpayer received £250,000 in July 2010. The receipt was not included in the taxpayer’s profit and loss account for the year ended 31 August 2010, but was reflected in the balance sheet in the rental accounts as a creditor.

Following an enquiry into the taxpayer’s tax return for 2010/11, HM Revenue and Customs (HMRC) considered that the settlement should be treated as an income receipt. The taxpayer appealed. The First-tier Tribunal considered (following London and Thames Haven Oil Warves Ltd v Attwooll (Inspector of Taxes) [1967] CH 772) the issue to be the source of the legal right resulting in the taxpayer receiving the payment from the housing association. It found that the legal right derived from the lease and subsequent negotiations.

The tribunal considered that the nature of the liability was to make good the fall in capital value attributable to (and calculated by reference to) the dilapidations that the tenant had failed to make good. When the lease was terminated, due to the inaction of the housing association, the taxpayer had suffered a permanent diminution in the capital value of his investment, and the settlement was to make good that loss. The tribunal concluded that, in the circumstances, the receipt should be regarded as capital in the taxpayer’s hands.

HMRC’s view

HMRC’s guidance on the tax treatment of dilapidation payments by tenants to landlords (in its Property Income manual, at PIM2040) indicates that the tax treatment of such payments will depend on the particular circumstances.

For example, if the landlord subsequently disposes of the property or occupies it himself, HMRC accepts that the payment is likely to be treated as a capital receipt as compensation for failing to observe the terms of the lease as a result of which the property reverted to the landlord in a dilapidated condition.

However, if the payment is likely to have the effect of “filling a hole in the landlord’s profits” in terms of compensating the landlord for the lower rent the property can now command, HMRC considers that the payment should be treated as a receipt of the rental business. Alternatively, if the tenant pays a sum towards the cost to the landlord of carrying out the repairs required, in HMRC’s view the landlord should be able to claim a deduction for the net cost he bears.

In Thornton, the flats reverted to the landlord, but HMRC argued that the payment should be treated as an income receipt on the grounds that it covered the loss of rental income due to the dilapidated state of the properties. However, the tribunal noted that the landlord spent all of the payment and more on repairs, and concluded:

“Shortly put, we have identified that the nature of the liability in this particular case was to make good the fall in capital value attributable to, and calculated by reference to, the dilapidations that the tenant had failed to make good. When the lease was terminated, due to the inaction of [the housing association], [the taxpayer] had suffered a permanent diminution in the capital value of his investment and the settlement was to make good that loss.”

Practical point

Landlords should keep contemporaneous records in support of the factors resulting in dilapidation payments from tenants. The tribunal in Thornton considered that the case was not wholly in point with any case law authorities on the distinction between income and capital and was decided on the particular circumstances, so evidence may be important in establishing the tax treatment of such payments.

The above article was first published in Property Tax Insider (June 2017) (www.taxinsider.co.uk).

Penalties For Tax Return Errors – All Is Not Lost!

The penalty rules for errors in tax returns etc. potentially apply if a tax return contains an inaccuracy that results in a tax liability being understated. In addition, a penalty can apply if an error gives rise to false or inflated loss (FA 2007, Sch 24, para 1).

Errors involving losses

The amount of penalty for errors is based on ‘potential lost revenue’ (PLR). For example, if an error in an individual’s tax return results in a loss that reduces a tax liability, the PLR is broadly the additional tax due as a result of correcting the error.

If any part of a loss has not been used to reduce a tax liability, PLR is 10% of the part not used. This 10% rate is intended to recognise the uncertainty about what the tax value of the loss will be when it is eventually used to reduce a tax liability.

No chance of using the loss?

What happens if it is not possible to use a loss for any reason? If there is no reasonable prospect of the loss being used to reduce a tax liability, the PLR in respect of that loss is nil (FA 2007, Sch 24, para 7(5)). This rule can provide a useful escape from significant penalties in some cases.

For example, in Fry v Revenue and Customs [2017] UKFTT 158 (TC), the taxpayer was the sole director shareholder of a company (K Ltd). In 2003, the taxpayer lent funds to K Ltd. In December 2004, the taxpayer was issued with shares in conversion of his loan to the company. In his tax return for 2009/10, the taxpayer claimed capital loss relief (under TCGA 1992, s 253) of £10,736,038, on the basis that his loan to K Ltd had become irrecoverable in December 2009. Part of the loss (£202,071) was set against chargeable gains accruing to the taxpayer in 2009/10; the balance of the loss (£10,533,967) was carried forward.

However, HM Revenue and Customs (HMRC) refused his loss relief claim, on the basis that the taxpayer’s loan to the company had been converted into shares. The taxpayer withdrew the loss relief claim. In correspondence with HMRC, his agent pointed out that the taxpayer was resident in the USA but working in Switzerland, and that he was unlikely to be returning to the UK. Subsequently, HMRC concluded that the taxpayer was careless in submitting an incorrect tax return for 2009/10. The penalty was 15% of PLR. HMRC calculated the PLR as all of the tax which came into charge as a result of the inaccuracy being corrected, plus 10% of the unused balance of the loss claimed in the taxpayer’s return.

No penalty!

The First-tier Tribunal held that the error in the taxpayer’s tax return for 2009/10 was careless, so the conditions were met for a penalty to be imposed. However, the tribunal concluded in the circumstances that when the penalty was imposed (May 2015), there was no reasonable prospect of the remainder of the loss being used. The taxpayer was not resident in the UK, he was unlikely to return to the UK in the foreseeable future and, even if a return to the UK was contemplated at some point in the more distant future, it was unlikely that the taxpayer would wait until that point to realise capital gains. As there was no reasonable prospect of the remainder of the loss being used to reduce the taxpayer’s tax liability, the penalty relating to the unused part of the loss claimed was reduced to nil.

HMRC guidance (in its Compliance Handbook manual at CH82370) sets out a two-step process to determine whether there is a reasonable prospect of any part of a taxpayer’s loss being used. Step one requires HMRC to consider whether, in the current circumstances, there is a “legal or factual reason” why the loss cannot ever be used. If the answer is ‘no’, step two requires HMRC to assess the taxpayer’s personal circumstances, and ask if there is a reasonable prospect of the loss being used. It is unclear whether HMRC applied this test in Fry, but if so it is difficult (for me at least!) to see how it arrived at a different conclusion to the tribunal.

Practical point

The ‘no reasonable prospect’ let-out from penalties is well worth considering in potentially appropriate circumstances. For example, in the case of unused trading losses, HMRC accepts that there may be no reasonable prospect of using them if no further trading profits may arise, such as if the trade is ceasing (see CH82371). Making representations to this effect to HMRC or the tribunal can be worthwhile. In Fry, the reduction in PLR for unused losses reduced the penalties from £163,192 to £5,183.

The above article was first published in Tax Insider (July 2017) (www.taxinsider.co.uk).

Business Property Relief – Not So Fast!

Business property relief (BPR) is a potentially generous form of inheritance tax (IHT) relief, which can reduce transfers of ‘relevant business property’ (e.g. shares in an unquoted company) during lifetime or upon death at rates of up to 100% (or alternatively 50%), if certain conditions are satisfied (IHTA 1984, ss 103-114).

However, BPR will generally be denied if there is a ‘binding contract for sale’ of the business property at the time of its transfer (IHTA 1984, s 113). This is an anti-avoidance provision. The underlying principle of BPR is that relief should be available in respect of relevant business property, but not cash.

For example, if a chargeable lifetime gift of unquoted shares (on which BPR is claimed) was followed shortly afterwards by a sale of the company, it might be argued that the gift was effectively a transfer of part of the company’s sale price. HM Revenue and Customs (HMRC) may seek to apply the anti-avoidance rule in such circumstances (see below).

Not caught

There are two specific exceptions to the anti-avoidance rule on contracts for sale. The first exception can apply to some business incorporations, i.e. if the binding contract is for the sale of a business (or business interest) to a company which is to carry on that business, where the consideration is wholly or mainly the company’s shares or securities. It should be noted that an incorporation in the form of a business sale wholly or mainly for cash is not within this exception.

The second exception relates to company shares or securities, where the sale is made for the purpose of reconstruction or amalgamation (IHTA 1984, s 113(a), (b)).

Lifetime transfers shortly before sale

HMRC is alert to BPR planning such as chargeable gifts of business property made shortly before its sale to a third party (See HMRC’s Inheritance Tax manual at IHTM25291).

In the above example of a chargeable lifetime gift of unquoted shares followed by a sale of the company, the BPR position might be “carefully checked” by HMRC to see if there was a binding contract for sale at the date of transfer. If there was a binding contract, BPR will generally be denied. HMRC guidance (in its Shares and Assets Valuation manual at SVM111120) suggests that the following cases will be subject to close scrutiny:

  • Lifetime transfers where a sale of the company (or of part of the share capital including the transferred shares) occurred within six months following the transfer; and
  • Any other such case where a sale occurred outside the six months period, but the circumstances suggest that the sale may have been in prospect at the time of the lifetime transfer.

In those circumstances, HMRC is likely to request any paperwork relating to the original transfer of the shares, together with the subsequent sale of the company, to determine whether a binding contract for sale existed at the time of the original transfer.

Look ahead?

The binding contract for sale provisions were not in point in Swain Mason and others v Mills & Reeve (A Firm) [2012] EWCA Civ 498 as the share disposal in question had already taken place, but the case highlights the importance of considering the timing of business sales for BPR purposes in the particular circumstances. In that case, the claimants were executors of their late father’s estate. The deceased (CS) was the managing director and majority shareholder of a company, which was the subject of a management buyout (MBO) completed on 31 January 2007. CS had a history of ill-health, and he sadly died in February 2007 shortly after being admitted to hospital for a heart procedure.

The proceeds from the sale of the deceased’s shares became liable to IHT, whereas if CS had died while still owning the shares, no IHT liability would have arisen due to BPR. A claim of professional negligence was made against the defendant firm on the basis that, if due advice had been given, completion of the MBO would have been deferred until after the heart procedure. However, the court held (among other things) that the defendant firm had not been asked for advice on the potential tax consequences of CS’s death in the light of his forthcoming heart procedure. The claim was dismissed.

Practical point

HMRC accepts that, in certain specific circumstances (which are not considered in this article), particular types of agreement (e.g. options to purchase) may not constitute binding contracts for sale so as to prevent relevant business property from qualifying for BPR under the anti-avoidance provisions in s 113 (see HMRC’s Shares and Assets Valuation manual at SVM111120). However, care is needed, and expert professional advice should be sought if necessary.

The above article was first published in Business Tax Insider (May 2017) (www.taxinsider.co.uk).

Incorporation: A Borrowing Trap

Many landlords introduce properties into their rental businesses, which may have already been held for some time (e.g. gifted or inherited property). Those landlords are, in effect, introducing capital into the business, broadly equal to the market value of the property when it was introduced, less any outstanding mortgage, etc.

Allowable borrowings

HM Revenue and Customs (HMRC) guidance in its Business Income manual (at BIM45700) states that a business owner “may withdraw the profits of the business and the capital they have introduced to the business, even though substitute funding then has to be provided by interest bearing loans. The interest payable on the loans is an allowable deduction. This is on the basis that the purpose of the additional borrowing is to provide working capital for the business.”

Some property business owners may have previously (based on HMRC’s guidance in BIM45700) borrowed up to the value of a property when it was introduced into the property rental business, used the proceeds for a non-business purpose (e.g. cars, holidays), and claimed a deduction for the interest paid against rental profits. However, there was anecdotal evidence in 2017 of HMRC resisting interest relief claims for additional borrowings, unless those funds were used in the property business.

Following the introduction of a restriction in the deduction of interest and other finance costs related to residential property businesses, which applies to individual landlords from April 2017, some potentially affected landlords have considered incorporating their property rental businesses, as the restrictions on loan interest relief etc. do not apply to corporate landlords. However, incorporation could give rise to a capital gains tax (CGT) trap in certain cases.

Incorporation relief

For CGT purposes, the transfer of rental properties to a company upon incorporation will normally be treated as a disposal at market value. If the properties are standing a large capital gain, this could be a major obstacle to incorporation. However, CGT relief may be available in some cases.

The main form of CGT relief in these circumstances is rollover relief on the transfer of a business (e.g. a residential property rental business), commonly referred to as ‘incorporation relief’ (TCGA 1992, s 162).

Incorporation relief is subject to certain conditions, which are beyond the scope of this article. However, if the relief applies, the effect is broadly that the property gains attributable to the consideration received in the form of the company’s shares are deducted from the cost of those shares (i.e. the gains are effectively ‘rolled over’ and deducted from the cost to be allowed on a subsequent disposal of the shares).

The relief is potentially restricted to the extent that the company pays for the business. ‘Payment’ for these purposes can include the company taking over the business owner’s liabilities. However, by concession, HMRC does not restrict incorporation relief if business liabilities (e.g. property loans) are taken over by the company (see extra statutory concession D32).

Restricted relief?

However, the property gains that can be rolled over in this way cannot exceed the cost of the shares. For example, if the market values of the properties (plus other business assets) only marginally exceed liabilities, the base cost of the shares may be negligible. This could result in the amount of incorporation relief being restricted, and CGT immediately becoming due.

Suppose that a landlord (perhaps having read BIM45700) borrowed up to the value of the properties he introduced into his property rental business. He now wishes to incorporate the business. However, his properties are standing at a substantial capital gain. If the value of the business assets (i.e. mainly the properties) and liabilities (i.e. the property loans) taken over by the business are broadly similar, his shares in the company might only have a nominal value. Consequently, even if the business transfer is eligible for incorporation relief, the gains rolled over against the cost of the shares are likely to be minimal. A CGT liability would therefore arise in the tax year of incorporation.

Practical point

Outstanding borrowings and CGT reliefs are only two issues to consider. The decision whether to incorporate a property rental business must take both tax and non-tax implications into account, and care is needed.

The above article was first published in Tax Insider (May 2017) (www.taxinsider.co.uk).

Tax Return Penalties: HMRC’s Fatal Flaw

Everyone makes mistakes. Fortunately, HM Revenue and Customs (HMRC) has the power to suspend a penalty for a ‘careless’ error in a tax return (FA 2007, Sch 24, para 14). HMRC officers are instructed to consider the suspension of every penalty for a careless error (see HMRC’s Compliance Handbook manual at CH83131).

Suspending penalties

However, HMRC can only suspend a penalty broadly if compliance with the suspension condition would help the taxpayer to avoid becoming liable for further penalties for careless errors (Sch 24, para 14(3)). HMRC apparently interprets this condition to mean (among other things) that penalties cannot be suspended in respect of ‘one-off’ errors. This approach has resulted in a number of cases before the tribunal.

There is a right of appeal if HMRC decides not to suspend a penalty (and also against the conditions set by HMRC for the penalty to be suspended). On an appeal against HMRC’s decision not to suspend the penalty, the tribunal can order the penalty to be suspended only if it considers that HMRC’s decision not to do so was ‘flawed’ when applying the principles in judicial review proceedings (Sch 24, paras 17(4), (6)).

Professional help

Taxpayers who have made careless errors when preparing their own tax returns might propose a suspension condition that future tax returns are prepared by a suitably qualified professional. This has been considered to be an acceptable condition in some cases (e.g. Testa v Revenue and Customs [2013] UKFTT 151 (TC)). However, despite the tribunal’s comments in Testa, HMRC has not always looked favourably upon this suspension condition.

For example, in Duncan v The Commissioners for Revenue and Customs [2016] UKFTT 709 (TC), the taxpayer made careless errors in his tax return for 2012/13 (i.e. the omission of employment income of £30,000 paid as part of a severance payment, the omission of a beneficial loan of £1,466 from an employer, and the overstatement of pension contributions by £15,988). HMRC sought to impose a penalty in respect of those errors. The taxpayer requested that the penalty be suspended on certain conditions, which included that he appointed a qualified adviser to prepare his tax return for the next two years.

Flawed decision

HMRC refused to suspend the penalty, on the basis that they would only suspend a penalty where the inaccuracy resulted from a weakness in the person’s accounting or record keeping system, and where they could identify specific improvements which would help to prevent the person making the same or similar errors in future. HMRC considered that as the failure was mainly due to a lack of knowledge on termination payments and personal pension contributions, there was no weakness in the taxpayer’s accounting or record keeping system which could be addressed by a suspension condition.

The First-tier Tribunal noted that HMRC had apparently disregarded the taxpayer’s main proposed condition that he appoint a qualified adviser to assist with completing his tax returns for two years. The tribunal also found that HMRC erroneously considered that the purpose of the suspension provisions was to correct record keeping systems, rather than the wider purpose of enabling taxpayers to produce tax returns without careless errors. HMRC’s decision not to suspend the penalty was therefore flawed, as it was based on an error of law. The tribunal considered that a condition requiring the taxpayer to retain a qualified tax adviser to assist in the completion and submission of self-assessment tax returns for two years would assist him in producing tax returns free from careless errors. HMRC was ordered to suspend the penalty on that basis.

Practical point

HMRC appears to rely on its own guidance when considering whether to suspend penalties, which states its interpretation of the law. However, in Duncan the tribunal commented: “…while guidance on how to apply that discretion, such as department policy, can be helpful, it is still the case that HMRC should exercise that discretion and not simply follow policy without considering whether it is appropriate to a particular case where they have discretion.” Taxpayers and advisers should consider whether HMRC has applied the law correctly if it refuses to suspend a penalty for a careless error, and be prepared to appeal its decision to the tribunal, if necessary. 

The above article was first published in Tax Insider (February 2017) (www.taxinsider.co.uk).

Tax Return Estimates – Careless Or Deliberate?

The use of an estimated figure may sometimes be necessary when preparing a tax return. For example, records of a particular source of income may have been lost, and it might not be possible to obtain the relevant information from third parties.

Is it accurate? 

HM Revenue and Customs (HMRC) acknowledges that taxpayers will occasionally use estimates in their tax returns. For example, there is a box on an individual’s tax return to indicate if an estimated (or provisional) figure has been used and the individual intends replacing it with a final figure.

However, it is not necessary to tick this box if the taxpayer (or agent) wishes the estimate to be accepted as the final figure because it is not possible to provide the actual figure (see HMRC’s Self Assessment manual at SAM121190). Nevertheless, it is generally good practice to disclose the use of estimates in the additional information (or ‘white space’) section of the tax return, in order to reduce the possibility of HMRC making a ‘discovery’ outside the normal twelve month time limit for opening a tax return enquiry.

Penalties for inaccurate estimates

If a tax return estimate results in (say) an insufficiency of tax, HMRC may seek a penalty in respect of the inaccurate estimate. For example, a penalty can be imposed if a tax return error resulting in a loss of tax has arisen due to the person not taking ‘reasonable care’. HMRC may consider that an estimated figure was unreasonable, and charge a penalty on the basis that the inaccuracy was careless.

Worse still, in some cases HMRC may contend that the taxpayer’s behaviour giving rise to the penalties was deliberate rather than careless. A deliberate error can result in HMRC seeking higher penalties, and possibly imposing other sanctions (e.g. ‘naming and shaming’) in some cases.

In Chadburn v Revenue and Customs [2016] UKFTT 755 (TC) the taxpayer (a self-employed heating and plumbing engineer) submitted his tax return for 2009/10 showing estimated business turnover of £20,000, and estimated net profits of £20,000. HMRC opened an enquiry into his tax return for 2010/11. At that time, the taxpayer’s return for 2006/07 showed business turnover of £15,000 and net profits of £15,000; his 2007/08 return showed business turnover of £16,000 and net profits of £16,000 (his tax return for 2008/09 had not then been submitted).

The taxpayer’s accountants subsequently prepared accounts for the tax year 2009/10, showing turnover of £85,669 and net profits of £50,592 (and additional turnover of £8,119 was later identified from his building society accounts). HMRC raised assessments of additional profits for the tax years 2006/07 to 2011/12. In addition, HMRC raised penalty assessments for 2006/07 to 2009/10. The taxpayer appealed against the penalties.

The First-tier Tribunal found that the taxpayer’s behaviour for 2006/07 and 2007/08 was ‘negligent’ (i.e. the relevant test for those years). Submitting the same round sum figure for turnover and profit in a business that clearly involved expenses indicated that the taxpayer had not attempted to establish accurate figures for those returns (nb the penalty for 2008/09 was based on the failure to submit a return).

In addition, the tribunal concluded that the taxpayer could not have considered that his return for 2009/10 was accurate, as he knew that he had business expenses, which meant that turnover and profit could not be the same. Furthermore, the disparity between the figures in the return and the eventually established figures was substantial. Such a disparity meant that the taxpayer’s behaviour in submitting the return was regarded as more than a failure to take reasonable care and poor record-keeping. The taxpayer’s behaviour was deliberate and not careless, and his appeal was dismissed.

Practical point

It is important to keep accurate records, instead of relying on estimates. Poor record keeping may be regarded by HMRC as careless or possibly even deliberate behaviour if (say) a tax return error arises (unfortunately, the taxpayer’s approach in Chadburn was not considered to be reasonable or even careless), with potentially adverse implications in terms of additional tax (perhaps for a number of tax years), penalties and (in the case of deliberate errors) other HMRC measures being imposed.

The above article was first published in Tax Insider (March 2017) (www.taxinsider.co.uk).