Keith M Gordon MA (OXON) FCA CTA Barrister believes that the taper relief rules do not work properly in the real world.

It is now nine years since the Chancellor introduced the taper relief rules for calculating liabilities to capital gains tax.  From 6 April 2007, it will be possible for non-business assets to qualify for the top rate of non-business taper relief (40%) – provided that they were owned before Budget Day 1998 (17 March 1998) and the anti-avoidance provisions in paragraphs 10 to 12 do not apply.  It is therefore an opportune time to review the rules and to see how they work in practice.

Simplification or complication?

Whilst the rules are sometimes seen as the Chancellor’s “baby”, there had previously been calls from the private sector to abandon indexation relief in favour of a simpler system that reduces gains by reference to the period that an asset has been owned for.

Furthermore, the press release issued on Budget Day 1998 announced that the new rules would lead to a simplification of the capital gains tax system.

However, in my view, the rules have had the opposite effect.  For example, the private sector had argued that any taper relief should eventually allow all gains arising on a disposal of an asset to disappear from charge once the asset had been owned for a certain period of time.  Under the scheme introduced in the Finance Act 1998, however, chargeable gains cannot be fully tapered out and so full records need to be kept going back to the date of acquisition – even if this stretches back over several decades.

Furthermore, the capping of taper relief gives rise to certain illogicalities.  One of the ‘themes’ of taper relief is that the value of the relief is supposed to increase the longer that an asset has been owned.  However, if the Chancellor wants to encourage the long-term retention of assets, why is it that business assets and non-business assets earn no further relief after a period of ownership of two and ten years respectively?

Tainted taper

Since 2000, most practitioners have become sorely aware of the notion of tainted taper relief – the situation in which an asset has been a business asset for only part of the period of ownership (or, as will become relevant from next April [2008], during the last ten years of ownership, if shorter).

The rules dealing with such situations were actually present when the taper relief provisions were first introduced.  However, the ‘tainted taper’ scenario became a problem only after the Finance Act 2000 changes.  Ironically, the Finance Act 2000 contained two changes both of which were, on the whole, favourable to taxpayers: the first was to broaden the definition of qualifying company (allowing more shares and other assets to qualify as business assets with effect from 6 April 2000); the second was the acceleration of business asset taper relief so that business assets needed to be held for only four years (rather than the original ten) to qualify for the top rate of taper relief – this 4-year qualifying period has since been reduced to two.

The tainted taper relief issue was caused by the fact that these two favourable changes were not accompanied by a third change which would have ensured that one did not have to look back over ten years of ownership when an asset has qualified as a business asset throughout the last two years (previously 4 years).

Whilst the problems first introduced in 2000 are becoming progressively less significant, tainted taper relief is still an issue and will continue to give taxpayers unexpected tax liabilities until the rules are overhauled.

Accelerated rate of taper relief for business assets

Practitioners will know that business assets qualify for 50% taper relief after one year and 75% taper relief after two.  However, what has always puzzled me is why the taper “curve” is steeper when an asset first qualifies for relief (after one year) rather than when it notches up its second tranche of relief a year later.

The only reason I can suggest is that the legislation refers to the percentage of the gain that remains chargeable (see section 2A(5) of the Taxation of Chargeable Gains Act 1992).  That presumes that 100% is chargeable when an asset has not yet been owned for a year, which is then halved after one year (to 50%) and then halved again (to 25%) after two.  From a purely verbal perspective, one can see the attraction about the chargeable gain halving progressively each year.  However, had anyone in the Treasury policy team looked at it from a numerical perspective, they would have realised that progressive halving of chargeable gains is considerably different from the more logical alternative, the progressive doubling of relief.

Other difficulties with taper relief

If one looks closely at the taper relief legislation, one finds other areas where the rules are not compatible with the rest of the capital gains tax code.

In the rest of this article, I will summarise five such problem areas.

Acquisition and disposal date

It is well known that taper relief depends partly on how an asset is used during the period of ownership.  This is defined in paragraph 2 of Schedule A1 as the period between the acquisition date and the disposal date.

However, as is equally well known, section 28 provides that these dates are determined by the time that contracts are entered into (or become unconditional, if later) and not when the contracts are completed.  Therefore, part of the statutory period of ownership will often include a period before a taxpayer has any control over how the asset is used.  Conversely, the period of ownership will often exclude a period in which the asset is fully used by the taxpayer and under the taxpayer’s control (albeit subject to a contractual obligation relating to its disposal).

Depending on the circumstances, this can lead to a tainting of the taper relief even though the taxpayer’s own use of the asset has been fully compliant with the taper relief rules.  I understand that HMRC will not usually take this point when the period between exchange and completion is small but I am not aware of any published guidance as to what is meant by small.

Rollover and deferral reliefs

It is similarly bizarre that claims for rollover and holdover relief are in respect of gains before the calculation of any taper relief.  The upshot of this is that any accrued entitlement to taper relief on the first disposal is lost and any taper relief ultimately given is based entirely on:

• in the case of rollover relief, the period of ownership relating to the replacement asset or
  
• in the case of holdover relief, the transferee’s period of ownership.

Now that business assets qualify for the top rate of taper relief after just two years, this is less of a problem than it had been.  However, it reveals yet more sloppy thinking when the legislation was first introduced.

Transfers between spouses and civil partners

It is widely known that the rules relating to the transfer of assets between spouses and civil partners (paragraph 15 of Schedule A1) are defective giving unexpected windfalls to some couples and equally unexpected tax liabilities to others.  This topic can merit an article in its own right.  For the purposes of this article, however, it is safe to say that this is an area where practitioners need to take extra care.

Assets derived from other assets

Paragraph 14 provides rules for cases when an asset has derived from another asset – for example if a leasehold interest merges with the freehold.  Superficially, these rules replicate the tax treatment of such situations found elsewhere in TCGA 1992.  However, as soon as one delves beneath the surface, one realises that such situations are not properly dealt with by the taper relief rules.

I covered those provisions in two articles published in Taxation: ‘Taper Complexities’, 29 April 2004 and ‘Merging and Diverging Interests’, 22 May 2003. 

It is not appropriate to revisit them in detail in this article.  Instead, I will reproduce the final sentences of the second of those articles:

The above represents some of the questions that can arise if one has to consider the application of paragraph 14. More complex examples could be composed, highlighting further anomalies. …

It is normally advisable for anyone who is calculating taper relief to check his workings several times. However, when paragraph 14 is in point, it may be more appropriate (and simpler) just to check one’s professional indemnity cover.

Share identification rules

Finally, I will consider an issue that has not been widely publicised but could give rise to some unexpected tax liabilities.

Suppose an individual bought some quoted shares (representing non-business assets) on 1 May 2001.  On 12 April 2003, that individual sold those shares but repurchased them a week later.  Suppose, for the purposes of this example, that the cost of repurchase equalled the original disposal price.  Finally, suppose that the individual sells the shares on 2 May 2007 (and does not subsequently reacquire them), realising a substantial gain for capital gains tax purposes.

Under the share identification rules, the gain would be calculated by comparing the May 2007 net proceeds with the total purchase cost incurred in May 2001.  However, what is the rate of taper relief available?

Assuming the share identification rules apply to taper relief, one would say that the shares had been owned for six years meaning that 20% relief is available.

However, logic might suggest that one should deduct a week to reflect the period in 2003 that the shares were not actually owned by the taxpayer.  This would reduce the taper relief to 15%.  Whilst this might make sense from a logical perspective, the legislation makes no allowance for this.  It simply looks at the interval between the date of acquisition and the date of disposal.

On the other hand, it is arguable that the share identification rules do not actually apply for the purposes of taper relief.  After all, the share identification rules (especially since the anti-bed-and-breakfast rules were introduced with effect from 17 March 1998) contemplate taxpayers disposing of assets before they have even acquired them whereas the taper relief legislation is clearly predicated on the more real situation of a taxpayer acquiring an asset before it can be disposed of. 

If that is the case then, for the purposes of taper relief, one must consider the actual period of ownership.  In the above example, that would give rise to a taper rate of 10%.  However, it is not possible to give such a clear-cut answer if the transactions in April 2003 and May 2007 concerned only part of the shareholding?

The share identification rules were introduced (originally in the Finance Act 1962 and again in the Finance Act 1965) to avoid such difficulties.  However, if the taper relief régime does not encompass these rules, the chaos that had previously been avoided might now have to be faced.

Conclusion

As seems to be the case so much with tax law these days, ill-thought out policies and unnecessary complexity can blight even the best of ideas.

If the Chancellor really believes that the introduction of the taper relief rules heralded a simplification of the rules, it is about time that he looked for a new job.

Article Added Monday, 02 April 2007 | 3767 Hits

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