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Mark McLaughlin CTA (Fellow) ATT TEP looks at the proposed amendment of the anti-avoidance rules on transactions in securities.

Introduction

When it comes to HMRC proposals to simplify legislation, one might be forgiven for being a little apprehensive. The pension ‘simplification’ rules spring to mind, for example.

However, if there is a part of the tax law where some clarity and certainty would be warmly welcomed, it is surely the anti-avoidance legislation on transactions in securities (TiS).

HMRC issued a 65-page consultation document, Simplifying Transactions in Securities Legislation, on 31 July 2009. It contains various HMRC proposals, which are intended to clarify the existing legislation dealing with income tax advantages.

The original TiS provisions were introduced in 1960 and were designed to prevent arrangements to turn income into capital; remember that this was a time when Capital Gains Tax did not exist. However, there is likely to be little nostalgia for the provisions, even as they now stand. Times change and so does the efficacy of tax legislation, although whether the TiS legislation was ever fit for purpose is a matter of opinion.

A Brief History of Transactions in Securities

For those unfamiliar with this subject, perhaps I should start with a very short description of the purpose of the current rules, which allow HMRC to ‘counteract’ a tax advantage obtained by a taxpayer in consequence of:

1. a transaction in securities; or
2. the combined effect of two or more transactions in securities; or
3. the combined effect of one or more transactions in securities and the liquidation of a company.

The term ‘transaction in securities’ has a very wide meaning including transactions of whatever description relating to securities (including their purchase, sale or exchange, issue or securing the issue of new securities, etc.).

The term ‘securities’ is also widely defined. The TiS rules will not apply if conditions A and B in ITA 2007 s 685 are met.

Condition A is that the transaction or transactions are effected for genuine commercial reasons, or in the ordinary course of making or managing investments.

Condition B is that enabling Income Tax advantages to be obtained is not the main object or one of the main objects of the transaction or transactions.

Clearance Applications for Transactions in Securities

If there is doubt as to whether transactions (or proposed transactions) may fall foul of the TiS rules so that a counteraction notice could be issued (ITA 2007 s 698 for Income Tax purposes from 6 April 2007 or TA 1988 s 703 for Corporation Tax purposes generally and for Income Tax purposes before 6 April 2007), then an application may be made to an HMRC officer for a ‘clearance’ that the provisions will not apply to the transactions.

Many small to medium-sized practices will, at best, submit only a handful of statutory clearance applications under ITA 2007 s 701 to HMRC each year. Some will no doubt be uncertain whether transactions potentially fall within the TiS provisions at all, because (to quote HMRC) the rules are ‘extremely complex and unnecessarily burdensome’.

However, firms (quite understandably, in my view) invariably want the comfort of a letter stating HMRC’s satisfaction that the transaction(s) is not is one in relation to which a counteraction notice should be given – in other words, it is not ‘caught’ by the anti-avoidance rules.

HMRC state that in 2008 nearly 6,000 clearance applications were made, of which 98% were accepted, with 90% of those being processed in less than eight days because there was very little risk of the TiS provisions applying. These statistics are a damning indictment of the existing legislation and the uncertainty it causes.

This article therefore focuses on whether HMRC’s proposals are likely to result in non-specialist advisers relying on the legislation (and/or HMRC guidance) and submitting fewer clearance applications as a result.

The consultation document only deals with changes to ITA 2007 s 682 to s 713, and all references are therefore to ITA 2007 unless otherwise stated.

For Corporation Tax purposes, the current legislation (TA 1988 s 703 to s 709) is being rewritten, for inclusion in Corporation Tax Act 2010.

Reform of the Transactions in Securities Legislation in a Nutshell

HMRC’s stated aim of its proposed reform of the TiS legislation is to

 ‘…create clearer, more focused legislation, supported by guidance, which should help customers understand the specific behaviour being targeted, improve certainty about how and when the legislation applies and consequently reduce compliance burdens meeting the twin aims of the simplification review of simplicity and revenue protection.'

The proposed changes to be introduced from 6 April 2010 include the following.

• Redefining and quantifying ‘Income Tax advantage’.
• Introducing a new ‘fundamental change of ownership’ rule.
• Replacing ‘relevant company’ in the legislation with ‘close company’ (adopting the definition of close company in TA 1988 s 414 to s 415).

Out with the Old…

Under HMRC’s proposals, the existing TiS legislation in ITA 2007 Part 13 Ch 1 would not completely disappear. Sections 682 to 694 would be replaced, leaving the procedures relating to counteraction notices largely unchanged.

However, s 699, which limits the Income Tax assessed when a counteraction notice is served in circumstances D and E (see below) would be repealed, although there is an effective limitation within the proposed new s 686 (‘Income tax advantage’). In addition, the definition of ‘transaction in securities’ in s 713 is moved elsewhere (proposed new s 683(2)).

The legislative changes would also signal the end of ‘circumstance D’ and ‘circumstance E’ as we presently know them in s 689 and s 690 respectively.

These are the provisions dealing with relevant companies; a ‘relevant company’ currently being defined in s 691, broadly, as a company controlled by five or fewer persons or any company if its shares are unlisted and are not regularly subject to dealings on a recognised stock exchange.

As mentioned, the term ‘relevant company’ is to be replaced by ‘close company’. These companies will typically be owner-managed and family businesses of the kind dealt with by the small and medium-sized practice mentioned earlier.

Circumstance D can presently apply in various circumstances, including the sale of a company’s shares where the consideration received represents the value of assets available for distribution as a dividend and where the sale proceeds are received in cash.

Circumstance E can generally apply if the consideration received is in the form of non-redeemable shares or securities (HMRC counteraction being deferred until the shares or securities are repaid). Both sections are difficult because they are drawn so widely.

It is therefore perhaps unfortunate that HMRC has based some of the new legislation on them, and proposes to include additional guidance on both circumstances in its internal manuals.

…In with the New?

In broad terms, under the proposed new TiS provisions a person is potentially caught if the following conditions are satisfied (proposed new s 683):

• the person is a party to one or more transactions in securities; and
• certain defined circumstances are present; i.e., if conditions A or B (sound familiar?) are in point, and there is no ‘fundamental change of ownership’ (see below); and
• a main purpose of the person being a party to the transaction(s) is to obtain an ‘Income Tax advantage’, as defined (the ‘purpose test’, or what is sometimes referred to as the ‘motive defence’, ‘escape clause’ or ‘commercial let-out’, in s 685); and
• the person obtains an Income Tax advantage.

The definition of ‘transactions in securities’ is virtually the same as at present. The all-important circumstances mentioned in the second bullet point above are set out in a proposed new s 684 (‘Receipt of consideration in connection with distribution by or assets of close company’).

‘Condition A’ is largely based on the current circumstance D, except that it also includes part of circumstance E (i.e., the direct or indirect transfer of assets from one relevant company to another). ‘Condition B’ replaces the remainder of circumstance E.

A person must be in receipt of relevant consideration for either condition to apply. There is a different definition of ‘relevant consideration’ depending on whether condition A or B is satisfied; did someone mention ‘simplification’?

The purpose of this is apparently to distinguish that consideration in the latter case comprises issued shares or securities in a close company.

A Fundamental Change of Ownership

The proposed legislation (new s 685) excludes circumstances otherwise caught by conditions A or B if there is a ‘fundamental change of ownership’ of the close company as a result of the transaction(s) in securities.

In the context of a vendor shareholder, this broadly means that at least 75% of the company’s ordinary share capital (carrying an entitlement to at least 75% of distributions and voting rights) are held by one or more unconnected persons; and ‘connected persons’ sharing the same meaning as s 993. This condition would need to be met for a period of at least two years from when these conditions were first met.

HMRC explains its rationale behind the 75% threshold as being based on the current practice to grant clearances ‘in most cases’ where there has been a 75% change in ownership. HMRC add that ‘the new exclusion therefore removes from the legislation those TiS which would typically be granted rapid clearance’.

It is a pity that – to my knowledge – this previously unpublished practice was not publicised, such as by a Statement of Practice or inclusion in the Company Taxation Manual, as it would no doubt have saved many advisers considerable time and effort in drafting unnecessary clearance applications.

No Income Tax Advantage

If the connection test is not satisfied, that is not necessarily the end of the road for the shareholder. The TiS provisions will not bite if the purpose test is not satisfied, or if no Income Tax advantage is obtained.

The proceeds potentially subject to counteraction by the TiS legislation depend on the extent of any ‘Income Tax advantage’, with a new statutory definition proposed (new s 686), replacing the current one in s 683.

An Income Tax advantage is obtained, broadly, if the amount of any Income Tax payable on the basis that the relevant consideration was a qualifying distribution exceeds any Capital Gains Tax payable in respect of it (or if the consideration would be liable to Income Tax if paid as a qualifying distribution and no Capital Gains Tax is payable).

However, deducted from this figure is any amount of relevant consideration in excess of the maximum that could have been paid as a qualifying distribution.

Example 1 illustrates how this calculation might work in practice.

By contrast, if (say) 20% of the shares in Example 1 were owned equally by two other shareholders, the amount that would be available for distribution to David would be £480,000 x 80% = £384,000.

This would be the figure for ‘relevant consideration’ used in the calculation of the ‘Income Tax advantage’ subject to counteraction.

What’s the Big Deal?

The amount of the Income Tax advantage subject to HMRC counteraction is basically the difference between the Capital Gains Tax payable (after any reliefs and exemptions) if the ‘relevant consideration’ (as reduced, if appropriate) were received as capital, and the amount due if the same figure were treated as a dividend subject to Income Tax.

Unfortunately, there are no proposed de minimis limits for counteraction purposes.

Example 2 illustrates the quantification of the ‘Income Tax advantage’ for potential counteraction. It assumes that the share transaction takes place in 2010/11, when the top rate of Income Tax on distributions is set to become 42.5%. This underlines the potential added significance of the TiS provisions, particularly if the Capital Gains Tax rate remains at 18%.

The proposed legislation gives statutory effect to HMRC’s concessionary practice to give credit for any Capital Gains Tax paid on amounts returned as Chargeable Gains (see the Company Taxation Manual at CTM36840).

Taxed by Guidance?

The consultation document includes a draft outline of the structure and contents of proposed TiS guidance in the HMRC manual for illustration purposes.

At present, there are 17 paragraphs in the section of the Company Taxation Manual dealing with the provisions. By my count, the proposed guidance contains an eye-watering 108 paragraphs.

Most of these paragraphs have not yet been produced but, based on the draft guidance which has so far been published, advisers can brace themselves for a considerable amount of bedtime reading.

Still, HMRC state that this is in response to significant demand from customers and advisers, so we only have ourselves to blame!

The proposed guidance includes a section entitled ‘specific areas of difficulty’, which will feature paragraphs dealing with ‘incestuous transactions’, the interaction with ESC C16, management buyouts and group scenarios.

The consultation document states that ESC C16 is causing problems for its ‘customers’. It is curious why HMRC perceives ESC C16 to be a problem area, as I have yet to see any definitive evidence that this is the case.

I suspect that in reality it is causing HMRC more problems than its customers, and would suggest that any concerns HMRC may have about the abuse of ESC C16 are more illusory than real.

Nevertheless, I am slightly worried about whether legislative effect will be given to ESC C16, at least in its present form.

There is something to be said for providing detailed guidance to give greater depth and clarity. HMRC believes that doing so will ‘…improve understanding of the legislation and reduce customers’ uncertainty and compliance costs’ and that this will, in turn, result in a decrease in the number of clearance applications.

However, in practice, I fear that the price of shorter legislation will be that taxpayers are taxed in accordance with HMRC guidance as to how it interprets the legislation.

Taxing by guidance is not ideal to say the least, as the problems involving HMRC6 – on residence, domicile and the remittance basis – illustrate. It is to be hoped that the draft guidance will at least be put out for consultation in its entirety.

For Better or Worse

For example, the inclusion of a purpose test is likely to cause uncertainty in practice, irrespective of the extent of guidance available. A purpose test is subjective in nature, being essentially a matter of opinion and judgment. It raises issues such as what is the measure of a ‘main’ purpose? Is it (say) 5% or 51% of the overall purpose?

How does one measure one ‘purpose’ against another? On whom does the burden of proof fall (presumably the taxpayer if a clearance application is made, or HMRC before the tax tribunal)?

The fact that key technical phrases in the draft legislation are subject to detailed interpretation by HMRC in the proposed guidance does not bode well in my view.

Will the Amended Legislation and Proposed Guidance Result in Fewer Clearance Applications?

The new regime will probably reduce what HMRC has targeted in terms of unnecessary clearances through the proposed introduction of a 75% change of ownership test, although if there are any further ‘safe harbours’, it would be helpful to add them to the legislation.

However, the purpose test is bound to result in some uncertainty. In those cases, taxpayers (and their advisers) may be faced with a difficult choice; i.e.:

• rely on HMRC’s detailed guidance (bearing in mind that it will have no statutory basis);
• submit a statutory clearance application (the clearance procedure would remain unchanged, although submitting them would seemingly defeat one of the objectives of HMRC’s proposals); or
• proceed with the transaction(s), fully disclose them on the tax return as appropriate as a Capital Gain, and hope for the best. Note that an Income Tax liability under the TiS legislation is not self-assessed (at least not at present); HMRC must issue a counteraction notice).

A further option would perhaps be to seek the opinion of tax counsel. I predict that this will continue to be a popular choice among many firms with limited exposure to large business deals.

In any event, the proposals seem a little wide of the mark in terms of providing clarity and certainty. The consultation period ended on 30 October 2009. The new legislation is expected to be introduced in FA 2010, with effect from 2010/11.

Mark McLaughlin CTA (Fellow) ATT TEP is a tax consultant to professional firms, managing editor of TaxationWeb. He is also the editor of Bloomsbury Professional’s Tax Planning Annual 2009-10.