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Taxation by Mark McLaughlin CTA (Fellow) ATT TEP

Mark McLaughlin CTA (Fellow) ATT TEP explains why a company’s ‘trading company’ status may depend on the HMRC official considering its Code of Practice 10 application.It is unfortunate that there is very often a necessity for tax advisers to include phrases like ‘it all depends …’ and ‘subject to …’ in their advice to clients. I can imagine that many clients interpret such phrases as ‘ifs’ and ‘buts’ and ask themselves ‘does he really know what he’s talking about?’! I have to confess that when it comes to predicting how HMRC will react in certain situations the answer is ‘probably not’!

Russian roulette

In my article ‘ National Lottery? ’ ( Taxation , 14 July 2005), I extolled the virtues of applications to HMRC for Code of Practice 10 (COP10) rulings on ‘trading company’ status for capital gains tax taper relief purposes (well, it seemed like a good idea at the time). However, subsequent experience has left me wondering whether such COP10 applications are the tax equivalent of Russian roulette!

Just to recap, a particular taper relief problem with many companies is the level of surplus funds retained from trading operations, which may be invested or simply retained in the company’s bank account. This can cause difficulties when establishing trading company status if non-trading income generated and/or surplus funds are ‘substantial’ (i.e. more than 20 per cent) in comparison with the company’s net assets. The Capital Gains Manual (at paragraph CG17953p) lists four possible measures of taper relief status, some or all of which:

‘are among the measures that might be taken into account in reviewing a particular company’s status.’

Those measures are:

• the income from non-trading activities;

• the asset base of the company;

• the expenses incurred or time spent by officers and employees of the company in undertaking its activities; and

• the company’s history.

How many tests?

I expect that many tax advisers (and HMRC officials) have previously restricted their analysis of a company’s status to one or more of these four tests. However, following a recent COP10 trading company status application with which I have been involved, it seems that the key word in the previous passage from CG17953p is ‘among’. This apparently opens the way for HMRC officials to introduce their own, additional, measures if they deem it appropriate. Presumably, tax advisers are equally disposed. I say ‘presumably’ because the Capital Gains Manual is primarily aimed at providing guidance to HMRC officials. In addition, Tax Bulletin 53 (which first introduced the measures of trading status) states: ‘ We [emphasis added] would weigh up the impact of each of the measures to balance the effects of measures that point in different directions in coming to a view’. I would therefore not be surprised if some HMRC officials sought to reject the introduction of additional measures by advisers.

Of course, the Capital Gains Manual does not carry the force of law. However, the four measures in paragraph CG17953p did at least provide something of a level playing field between tax advisers and HMRC officials for establishing trading company status. Or so I thought. Until very recently, in the COP10 applications I have submitted, the HMRC official making the status ruling never strayed outside the above four measures. Indeed, the rulings given were generally acceptable within those parameters.

However, in another case in which I have been involved, HMRC ruled that the company in question (XYZ Ltd) was not a trading company, as a result of the level of surplus funds held. In reaching this conclusion, the officer applied what appeared to be an alternative test not mentioned in the Capital Gains Manual or in the Tax Bulletins . This further test measured the proportion of investment income to trading profit.

Receipts or income?

The first measure of trading company status in HMRC’s Tax Bulletin 53 is headed ‘Turnover receivable from non-trading activities’.

The text under that heading introduces this measure in the following terms:

‘If receipts from the letting were substantial in comparison to the combined letting and trading income …’ [emphasis added].

The above heading changed in Tax Bulletin 62 to ‘Income from non-trading activities’, and was adopted in the Capital Gains Manual .

The manual’s text in paragraph CG17953p states as follows.

‘If receipts from the letting were substantial in comparison to the combined letting and trading receipts …’ [emphasis added].

Interpreting the tests

I have always interpreted this test to mean that the measure was of trading turnover against non-trading receipts, and I assumed that the amendment in paragraph CG17953p merely emphasises that the proper test is to compare receipts with receipts (after all, that is what the sentence actually says).

In the case of XYZ Ltd, a turnover-based test was a pointer towards trading company status. However, the officer applied a profits test instead.

XYZ Ltd is a high turnover, but low profit margin, retail company. The level of investment income, whilst insignificant compared to business turnover, was substantial in comparison with the company’s trading profits.

The ‘asset base’ test indicated that non-trading assets were substantial.

The officer concluded that the company could not be regarded as a trading company.

I pointed out that by applying the measures outlined in the manual at paragraph CG17953p and disregarding the alternative measure introduced, it was possible to arrive at a different conclusion regarding the trading company status of XYZ Ltd. However, the officer did not address this point, considering that as the COP10 ruling had been given, the matter was closed.

In a subsequent letter to the area director, I pointed out that there was an issue regarding the apparent inconsistent treatment of COP10 applications on trading company status, as previous applications made to other area offices had not resulted in further tests being introduced beyond those set out in the published guidance.

The area director’s response was that the introduction of a profit-based test of trading and non-trading activity could be an appropriate measure for some companies, but not others, and was therefore reasonable in the ruling for XYZ Ltd.

Inconsistency

It therefore seems that many HMRC officers remain within the boundaries of the four published tests because it is more convenient and perhaps less controversial for them to do so.

I understand that the HMRC policy specialists in this area expect that the four published tests will be sufficient to cover the vast majority of cases, but consider that those tests are not exclusive in the sense that other tests might be introduced if considered appropriate in particular cases. They also acknowledge that there is inconsistency between the reference to ‘income’ from non-trading activities in the heading of the first measure, and the expression ‘receipts’ in the text. However, if the policy specialists are content for officers to introduce additional tests in COP10 rulings, this inconsistency in expressions effectively becomes irrelevant.

Dealing with the problem

Whilst I have no problem with officers using any relevant and meaningful measure of trading company status, the apparent lack of consistency in COP10 rulings remains a real cause for concern. The possibility that the same COP10 application, if submitted for the same company, but to different tax offices for a particular accounting period, could in theory result in opposing conclusions by Inspectors makes this application of the COP10 process unsatisfactory and potentially unfair.

Of course, whilst a taxpayer cannot appeal against a COP10 ruling, it does not have to be accepted either. The Code states as follows.

‘We will not discuss a post-transaction ruling we have given and you cannot appeal against it. But you do not have to accept the ruling and you can still act on the basis of your own view of the appropriate tax treatment, for example, when completing your return.

‘You should say that you have received a post-transaction ruling when you send in your return and whether you followed the ruling in completing your return.

‘If you disagree with a post-transaction ruling and have completed your return in accordance with your view of the correct tax treatment, then we will deal with the difference of opinion when we check your return. If the difference cannot be resolved you will be able to appeal against the Revenue’s assessment or amendment of your self assessment in the usual way.’

Rather than highlighting disagreement with the COP10 ruling and facing the prospect of an enquiry into the shareholder’s self assessment return and a possible trip to the Commissioners after a share transaction has taken place, company owners and their advisers may prefer to take their chances by drawing their own conclusions regarding trading status when the need arises. Of course, the self assessment return may still be the subject of an enquiry by HMRC, and in addition the issue of discovery and adequate disclosure following Langham v Veltema [2004] STC 544 means that the possibility of a tenable alternative view on trading company status should be drawn to HMRC’s attention in any event.

A way forward

These problems can be avoided. Inconsistency in COP10 rulings could be rectified to a large extent by HMRC adopting a more consistent approach. If the four tests in paragraph CG17953p are non-exclusive, the guidance should explicitly say so. Further, the guidance should be expanded to include all possible measures of trading company status. After all, how many more can there possibly be? Until then, unfortunately we seem to be stuck with ‘… it all depends …’.

Mark McLaughlin CTA (Fellow), ATT, TEP is a tax consultant to professional firms, and editor of Taxationweb.

This article was first published in Taxation, 27 October 2005