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TaxationWeb by Mark McLaughlin ATII TEP

Mark McLaughlin CTA (Fellow), ATT, TEP examines important recent changes affecting capital gains tax holdover relief.Parts of the tax legislation remind me of my first car. The vehicle was fairly old, but it ran reasonably well on the whole. However, not having much money to spend in those days on car repairs and such like, it was often a case of ‘patch up and make do’. Unfortunately, this strategy did not always work, and the repair bill often seemed out of proportion to the original breakdown.

The Taxes Acts are similar to my old car in some ways. When problems arise, the existing mechanics are tweaked, and additional bits bolted on. The capital gains tax restrictions affecting gifts relief and changes to principal private residence relief introduced in FA 2004 are cases in point. The problem, in the Government’s view, was that both categories of relief were being ‘widely exploited for tax avoidance purposes’.

In the first of two articles, I will look at the resulting repairs to the gifts relief legislation. The second article will consider the changes to only or main residence. All references are to the TCGA 1992, unless otherwise stated.

Avoidance vehicle

Prior to the restrictions in gifts holdover relief under ss 165 and 260 , transferring assets with the benefit of gifts relief was often used in legitimate tax planning arrangements or, as the Government prefers to call them, ‘tax avoidance schemes’. For example, unquoted trading company shares standing at a gain could be transferred to an interest in possession settlement with the benefit of s 165 relief, in which the settlor had an interest. This would reset the taper relief clock where the status of the shares had been tainted by a non-business period since 6 April 1998, and start a new business asset ownership period in the trustees’ hands.

Another arrangement broadly involved reducing the value for inheritance tax purposes of a transfer to a discretionary trust on which s 260 holdover relief would be claimed, by the settlor retaining a reversionary interest, which may later be assigned to another settlement, or possibly terminated. The Government saw such uses of gifts relief as abusive, and introduced provisions to counter them with immediate effect, and with no prior consultation.

Legislative repair

The restriction of holdover relief under ss 165 and 260 was announced in the Chancellor’s Pre-Budget Report on 10 December 2003, and applies in the main to disposals from that date. Ss 169B to 169G were subsequently introduced by FA 2004 (s 116 and Sch 21 ). These rules can apply to trusts with or without an interest in possession. They affect not only outright gifts, but sales at undervalue. In addition, the gifts relief holdover restrictions do not necessarily apply to the settlor of a settlor-interested settlement, but to the transferor making the disposal, who could be another individual or the trustees of another settlement ( s 169B(1) ).

The restrictions apply not only to settlor-interested trusts, but also if the settlor is capable of acquiring an interest through one or more ‘arrangements’, which is very widely defined to include ‘any scheme, agreement or understanding, whether or not legally enforceable’ ( s 169G(1) ). There is also a rule to prevent this ‘settlor-interested’ condition applying by interposing a chain of transfers to individuals or settlements, with gifts relief potentially available upon each transfer (s 169B(3)). This alternative condition broadly applies if:

• a chargeable gain would arise on the disposal assuming that gifts relief was not available;

• allowable expenditure in calculating the gain would be reduced by gifts relief on an earlier disposal by any individual (irrespective of whether that disposal was made before or after 10 December 2003); and

• immediately after the disposal, that individual has an interest in the settlement, or there are arrangements to acquire such an interest.

If a holdover claim has not yet been made when the gifts relief restrictions first bite, any possibility of a later claim is blocked. A revoked claim under s 165 or 260 is treated as never having been made.

Relief clawback

In addition, gifts relief is clawed back if the trust becomes settlor-interested within the following six tax years, or if there is an arrangement within the clawback period for a settlor to acquire an interest, for disposals by an individual or the trustees of another settlement from 10 December 2003. Similar anti-avoidance provisions to those restrictions affecting chains of transfers mentioned earlier also apply (s 169C(3)). Gifts relief claims under s 165 or 260 cannot be made once the rules are triggered. Note that it is sufficient for the ‘arrangement’ to subsist within the six-year clawback period, even though a settlor may perhaps acquire an interest some years later.

The clawback charge on the transferor takes the form of a chargeable gain equal to the held-over gain on the original disposal. This charge bites when the rules are first considered to apply, e.g. the tax year in which the settlement becomes ‘settlor interested’ as defined. However, taper relief is calculated up to the date of disposal, i.e. the taper relief clock stops running when the transferor made the disposal, not the date of the relief clawback (Sch A1 para 16(2)(da)). At least the clawback rules do not apply to transferors who (dutifully, perhaps!) die before the provisions first apply. On subsequent disposals of an asset upon which relief was claimed under s 165 or 260, gains (or losses) are calculated without taking the original held-over gain into account, including by a beneficiary to whom the trustees subsequently transferred the asset ( s 169C(8) ).

The transferor of an asset into trust may not have an interest in the settlement, but the trust could become ‘settlor-interested’ if another person subsequently becomes a settlor (see Example 1 ).

Example

Anthony owns 51% of the ordinary share capital of Lisbon Ltd. The company is an unquoted trading company managed by Hayley, his adult daughter. In January 2004, Anthony wished to give Hayley his shares in Lisbon Ltd. However, Hayley was shortly to be married, and Anthony wished to protect the shares from his untrustworthy future son-in-law. Anthony therefore transferred the shares to the Hayley Life Interest Settlement, and claimed gifts relief under s 165. A chargeable gain of £400,000 was held over.
In December 2006, Hayley discharges costs incurred by the trustees. As she thereby becomes a ‘settlor’ of Hayley’s Life Interest Settlement, the held-over gain is clawed back. Anthony’s gain of £400,000 becomes chargeable in 2006-07. However, Anthony can at least claim 75% business asset taper relief, which had accrued up to his share disposal in January 2004, resulting in a taxable gain of £100,000, his annual exemption being used elsewhere.

The definition of ‘settlor’ in s 169E catches individuals not only on a straightforward transfer of assets into trust, but also the indirect provision of trust property. On this basis, a beneficiary could, inadvertently or otherwise, become a settlor, albeit perhaps in relation to a relatively small part of the trust property, such as by making an interest-free loan to the trustees, or by writing off a loan, or by agreeing to meet trust expenses. This would appear sufficient to trigger a clawback of gifts relief, regardless of whether the asset donor has an interest. This rather extreme effect could be reduced in the forthcoming Budget, perhaps by restricting the clawback in gifts relief according to the extent, if any, of the donor’s interest as a ‘settlor’ of the trust. However, I very much doubt it, as the clawback of relief where the transferor of the asset does not himself have an interest in the settlement was actually an intentional effect of the legislation (see the explanatory note to Finance Bill 2004 regarding this provision, at para 23).

To the extent that a clawback charge arises in respect of land, a non-controlling holding of unquoted shares or a controlling holding of shares, the resulting capital gains tax liability may be paid in instalments over ten years plus interest, if the relevant conditions for payment by instalments on gifts are satisfied (see s 281). The instalments start to run from the due date for the clawback charge. Any tax arising from the clawback charge that remains unpaid within 12 months after it becomes due may be assessed and charged on the recipient trustees, subject to a right of recovery from the donor ( s 282(2), (6)(b) ).

The Inland Revenue has information powers in relation to the rules preventing gifts relief on disposals to settlor-interested trusts. A notice may be issued to any past or present settlement trustee, beneficiary or settlor, and to a spouse of the settlor, requiring particulars within not less than 28 days (s 169G). Penalties may be imposed for failing to comply with an information notice ( TMA 1970, s 98 ).

Exceptions

The gifts relief restriction and clawback rules do not apply to disposals to trustees in a tax year for which an election has been made under TA 1988, s 691(2) , for income of all or part of the settlement to be applied for the maintenance of an historic building. Nor do the rules apply to disposals to the trustees of a disabled trust. For this latter exception to apply, the interested settlor, or each of them, if more than one, must be a disabled beneficiary, disregarding any actual or potential benefits of the spouse.

The meaning of ‘disabled person’ for these purposes is based on the statutory disabled trust provisions for inheritance tax purposes ( IHTA 1984, s 89(4) ), which defines disabled person broadly in terms of mental disorder or the receipt of attendance allowance or disability allowance by virtue of entitlement to the highest or middle rate care component ( s 169D(7) ).

Settlor-interested

It is important to identify the settlor or settlors, and to establish whether that individual has an interest in the settlement. An individual is regarded as the ‘settlor’ for these purposes in relation to a settlement if any settled property originates from him ( s 169E(1) ). Reciprocal arrangements with another person are also caught. An interest in a settlement may be held by virtue of benefits obtainable by the settlor’s spouse, although separated or widowed spouses are generally excluded. There are also exceptions to the treatment of an individual as having an interest in a settlement, in certain limited circumstances relating to death ( s 169F(4), (5) ).

The definitions of settlor, to property originating from a settlor, and to the settlor having an interest in the settlement, seem largely drawn from the ‘settlor-interested’ anti-avoidance provisions in ss 77 to 79. In Trennery v West and other appeals [2005] SWTI 157, the House of Lords recently considered the meaning of ‘derived property’ (in s 77(2) ), as this can be sufficient for a settlor to have an interest in the settlement for those purposes. Similarly, derived property can cause an individual to have an interest in the settlement in the gifts relief restriction provisions, as the term is defined to include ‘property directly or indirectly representing proceeds of income from that property’ (s 169F(6)). If gifts relief is an important consideration, a trust power excluding any individual who adds property to the trust, i.e. not necessarily the original settlor, and spouse from benefiting directly or indirectly should be included and applied by the trustees to the letter.

Transfers of assets to settlor-interested interest in possession trusts can still be useful if holdover relief is not required, e.g. if the object is to preserve maximum business asset taper relief for shareholders by transferring shares in a qualifying company into trust, where the company is in the process of being wound up following the cessation of trading (a non-business asset period). The timing of the transfer and subsequent capital payments needs to be considered carefully in cashflow terms. Transfers by trustees may still be subject to holdover relief claims, as before the restrictions.

Mark McLaughlin is Editor of www.taxationweb.co.uk

This article was first published in ‘Taxation’ on 24 February 2005, and is reproduced with kind permission of Lexis Nexis UK. The second part of this article will follow shortly