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Taxation of Unincorporated Businesses by Malcolm James

Malcolm James, author of ‘Taxation of Unincorporated Businesses’ outlines the ‘connected persons’ rule for capital gains tax purposes, and explains some important valuation provisions.

Disposal to Connected Parties

Where an asset is disposed of to a connected party, the disposal consideration will be the market value of the asset rather than the actual sale proceeds (TCGA 1992 s.18(1), & (2)).

Where an asset is sold to a connected person at a loss, the normal loss relief rules do not apply. The loss may only be offset against gains arising on future disposals to the same connected person whilst they are still connected (TCGA 1992 s.18(3), (4)).

Connected persons are defined as:

• siblings, lineal ancestors and descendants of the taxpayer and their spouses, i.e. brothers and sisters of full and half-blood, brothers and sisters-in-law, parents, step-parents, grandparents, children, sons and daughters-in-law, grandchildren. Uncles, aunts, nephews, nieces and cousins are therefore not connected persons for this purpose;

• above relatives of spouse, i.e. parents-in-law, brothers and sisters-in-law and stepchildren;

• spouses of the relatives of the spouse.

• husband and wife who separated in a previous tax year and who are not yet divorced (TCGA 1992 s. 286(2)). Once they are divorced they are no longer connected persons by virtue of having been married, but may be connected if one of the other conditions applies;

• business partners (TCGA s.286(4));

• spouses of business partners;

• relatives of business partners.

This does not apply to the disposal of partnership assets pursuant to bona fide commercial transactions’ between partners who would be unconnected, but for the fact that they are business partners (TCGA 1992 s.286(4)).

A trust is treated as being connected with the settlor and any person connected with the settlor at the time the settlement is made. The connection is, but, broken by the death of the settlor (TCGA 1992 s.286(3)).

A loss arising on the grant of an option to a connected person to buy or sell or enter into another transaction is only allowable if the subsequent disposal is made at arm’s length to an unconnected person (TCGA 1992 s.18(5)).

If a vendor retains a right or otherwise places a restriction on property being transferred to a connected person, the market value used in the computation is reduced by the lower of the market value of the right or restriction and the amount by which the value of the property would increase if the right or restriction were extinguished (TCGA 1992 s.18(6)).

This does not apply where:

• the enforcement of the right or restriction would effectively destroy or substantially impair the asset without bringing any advantage to the person making the disposal or a connected person;

• the right or restriction is on option, or other right, to acquire the asset;

• the right or restriction is a right to extinguish the asset in the hands of the person giving the consideration by forfeiture or merger.

(TCGA 1992 s.18(7))

Valuation of Assets

Where an asset needs to be valued (either to obtain a March 1982 value or because the asset is being transferred to a connected person), the asset is valued at its open market value. There are, but, special rules for quoted shares and securities. These are valued using the lower of:

• the ‘quarter-up’ principle, i.e. the lower price quoted plus one quarter of the spread ; and

• average of the highest and lowest marked bargains.

Example

On 31 March 1982 shares in Smith plc were quoted at 250 - 258p. The marked bargains on that day were 252p, 256p, 255p, 259p, 251p and 249p.

Using the ‘quarter-up’ principle the value is 250 + ¼(258 - 250) = 252p.
Average of the highest and lowest marked bargains the value is (259 + 249)/2 = 254p.

Shares will therefore be valued at the lower of the two figures, i.e. 252p.

Negligible Value Claim

Where the value of an asset has become negligible a taxpayer may make an election to this effect (TCGA 1992 s.24(2)(a)). Negligible is not defined in the legislation, but ‘small’ is defined as 5% of the acquisition cost of the asset, and it is the view of HMRC that negligible will therefore be considerably less than 5%. If a claim is accepted by HMRC, there is a deemed disposal of the asset, thus crystallising an allowable loss, and a re-acquisition at the negligible value. If the asset is subsequently sold, the allowable cost will be the negligible value, meaning that a gain may well arise if it regains some or all of its former value.
The disposal is deemed to have taken place at the date of the election, or may be backdated to any date starting two years before the beginning of the tax year in which the claim is made, provided the value of the asset was also negligible at that time (TCGA 1992 s. 24(2)(b)(iv)).

Value Shifting

These are anti‐avoidance provisions to counteract the transfer of the economic benefit of an asset from one person to another, without an actual disposal taking place. A common example involves shares but the provisions also apply in certain other situations where:

• an asset is sold and actions have artificially reduced the value of the asset so as either to reduce the amount of the gain or increase the amount of the loss, and a tax‐free benefit has been, or will be, conferred on the person making the disposal, or a person connected with him (TCGA 1992 s.30);

• certain transactions involving leases (TCGA 1992 s.29(4));

• the release or abrogation of rights or restrictions over an asset by the person entitled to enforce them (TCGA 1992 s.29(6)).

Under the value shifting provisions a disposal is deemed to have been made in these circumstances, even if no consideration passes. There will also be a deemed acquisition by the other party. In addition, where an asset is sold at a loss, the loss will not be allowable, insofar as it has been caused by value shifting transactions.

Where consideration passes the amount of the consideration used in the disposal computation will be adjusted by an appropriate amount in order to counteract the tax advantage.

October 2005

Malcolm James

Malcolm James is a Senior Lecturer in Accounting and Taxation at the University of Wales Institute, Cardiff.

The above article is adapted from ‘Taxation of Unincorporated Businesses’ published by Spiramus Press Ltd. To order Taxation of Unincorporated Businesses click here