Tax Doctor:
Mark McLaughlin
CTA (Fellow) ATT TEP

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October 2005

Q:

I have been a company director and 50% shareholder for many years. The company owns a chain of mini-supermarkets, which has been trading very successfully. We have not withdrawn all the profits the company made, as we had no particular need for all the income. Consequently, the company has quite a large bank balance. We have recently received an offer for the company. I understand that if we sell the company’s shares, the capital gains tax rate could be 10% with full business asset taper relief. However, our accountant tells us that the surplus cash at bank could jeopardise the taper relief. Is this the case?

A:

It could be. On a sale of your shares, a Capital Gains Tax (CGT) liability appears likely, broadly on the difference between the sale proceeds and original cost of the shares (although the cost is enhanced by an inflationary allowance known as indexation, for ownership periods un to April 1998). The gain is reduced by taper relief, according to the number of whole years for which the shares were held after 5 April 1998. Chargeable gains are ‘tapered’ based on the ownership period and whether the shares were a ‘business asset’ or a ‘non-business asset’. The rates of taper relief are more generous for business assets than for non-business assets. The 10% rate of CGT mentioned in your query assumes that you are a 40% taxpayer, and that full business asset taper is available (by contrast, the lowest effective CGT rate for a 40% taxpayer based on maximum non-business asset taper relief is 24%, although this is subject to a ten year ownership period).

Only certain types of asset qualify for business asset taper relief, including shares in an unquoted trading company. The present definition of ‘trading company’ for taper relief purposes is a company whose non-trading activities are not substantial. HM Revenue & Customs (HMRC) take the view that ‘substantial’ means over 20% of the most appropriate measure. HMRC have stated that ‘Some or all of the following are among the measures that might be taken into account in reviewing a particular company’s status.’ It goes on to list certain tests of trading company status, i.e.

1) income from non-trading activities;
2) the company’s asset base (i.e. non-trading assets in proportion to total assets);
3) expenses incurred, or time spent, in undertaking the company’s activities (i.e. the proportion of total time or costs spent on non-trading activities); and
4) the company’s history and background (if appropriate).

HMRC also state: ‘it may be that some indicators point in one direction and others point the opposite way. We would weigh up the impact of each of the measures in the context of an individual case.’

The test that often causes the most difficulty for owner managed companies is the second of these measures, the ‘asset base’ test. In your company’s case, surplus cash (i.e. funds not required for present or future trading activities) constitutes a non-trading asset. The amount of surplus funds must be measured against the value of the company’s total assets. If the proportion of surplus cash (and any other non-business assets) to total assets exceeds 20%, this would fall within HMRC’s definition of ‘substantial’ and could result in the company not being regarded as a trading company for taper relief purposes.

However, when measuring surplus cash against assets, remember to include market values of assets, which may be higher than the asset values shown in the accounts. In addition, not all of the company’s cash balance will be surplus to requirements. Businesses need working capital to meet their day-to-day running costs. Your company’s working capital requirement should therefore be calculated, and deducted from the ‘surplus cash’ figure (your accountant should be able to assist you on this point). Finally, not all business assets may be included on the company’s balance sheet. The most common example is internally generated (as opposed to purchased) goodwill. If surplus cash exceeds 20% of total assets excluding goodwill, it may be worthwhile ascertaining the extent of any goodwill, and to obtain a professional valuation if appropriate.

Even if surplus cash exceeds 20% of net assets, HMRC should not automatically consider that the company is a non-trading company for taper relief purposes. Each case must be reviewed and considered on its merits. In cases of doubt, it is possible to ask HMRC for a ruling as to the company’s status for a particular year or period. This process is described in HMRC’s Code of Practice 10 entitled ‘Information and advice’, which can be accessed from the HMRC website. As your accountant has expressed reservations about the trading status of your company for taper relief purposes, in order to achieve certainty on this issue he may wish to carefully prepare and submit an application for a Code of Practice 10 ruling. The application should set out the case for a ruling that the company is a trading company.

Mark McLaughlin

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