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Taxation by Mark McLaughlin CTA (Fellow) ATT TEP

Mark McLaughlin CTA (Fellow), ATT, TEP, considers a problem with Code of Practice 10 taper relief rulings on trading company status, and offers a possible solution.It always worried me when HM Revenue & Customs (HMRC) announce a clarification of legislation. Past experience causes apprehension that the ‘clarification’ is going to leave me even more uncertain than before! A recent example of this is HMRC’s guidance on the definition of ‘trading company’ for capital gains tax taper relief purposes and the measures to be applied when determining trading company status.
Practical difficulties in establishing trading company status in the context of ‘substantial’ non-trading activities were described in ‘ A Substantial Qualification ’ by Paul Hodge and Matt Reid (see Taxation , 20 January 2005). Tax Bulletin 53 states that tax districts ‘… should respond positively’ if a company wishes to establish its status as a trading company (or holding company of a trading group) for taper relief purposes. Tax Bulletin 62 adds: ‘… Inspectors will, where there is uncertainty as to the company’s status, respond to requests for their view in accordance with Code of Practice 10 …’.

The facility to obtain a ruling on a company’s status for taper relief purpose is attractive to many professional advisers and is frequently used. However, in the writer’s experience, other advisers are reluctant to use this facility due to concerns over a lack of certainty or consistency; furthermore, one or two HMRC Inspectors seem reluctant to provide it! This article considers the common issue of surplus cash on the balance sheet of a single company and the application of Code of Practice 10 (COP10) rulings, both in the context of taper relief rulings on trading company status and generally. All references are to the TCGA 1992, unless otherwise stated. The interpretation of HMRC on the meaning of ‘trading company’ and related issues can be found in the Capital Gains Manual at paras CG17953 to CG17953r, which are based on Tax Bulletin 62 . References in this article to the Capital Gains Manual are to paragraphs from that manual, unless stated otherwise.

Surplus cash

A particular problem with many companies seems to be the level of retained surplus cash if it is considered ‘substantial’ because it represents more than 20 per cent of total assets. This measure of trading status was considered in Andy Wells’ article ‘To a substantial extent’ (see Taxation, 2 June 2005) and applies in the context of relief for gifts of business assets under s 165 as it does for taper relief purposes.

What the law says

As mentioned in the article by Paul Hodge and Matt Reid, trading company indicators for taper relief purposes applied by HMRC (i.e. turnover, asset base, and expenses incurred by or time spent by officers and employees of the company in undertaking its activities) have seemingly been drawn from Dr Brice’s decision in Farmer and Another (Executors of Farmer, Deceased) v CIR (SpC 216) [1999] SSCD 321, which concerned inheritance tax business property relief. These ‘tests’ as they apply for taper relief purposes were first described in Tax Bulletin 53, published in June 2001. At that time, the term ‘trading company’ was defined in statute (Sch A1 para 22(1)) as follows.

‘Trading company’ means a company which is either:

(a) a company existing wholly for the purpose of carrying on one or more trades; or

(b) a company that would fall within paragraph ( a ) above apart from any purposes capable of having no substantial effect on the extent of the company’s activities’ (emphasis added).

In the context of a company asset base test and the holding of surplus cash, the purposive approach required by a literal interpretation of the statute seemed perfectly logical, i.e. the question to ask was: ‘did the company hold the cash for a non-trading purpose, and if so, was that non-trading purpose capable of having a substantial effect?’

However, the trading company definition was subsequently changed in Finance Act 2002 to its present form (Sch A1, para 22A(1)):

‘In this Schedule "trading company" means a company carrying on trading activities whose activities do not include to a substantial extent activities other than trading activities’ [emphasis added].

The official line

So on a literal interpretation of the current legislation, the asset base test as it applies to surplus cash involves considering what has been done in applying those surplus funds for non-trading activities. However, the explanatory note to the Finance Bill 2002 clause explains that the change was introduced to ‘clarify’ the definition of trading company, and was ‘… not intended to alter the substance of the existing definition’. It states:
‘The wording of the existing definition is based on the purposes of a company. The Inland Revenue has made it clear that it would infer the purposes from the actual activities that the company enters into.’

It goes on to say that ‘The change in wording therefore aligns the statute with existing practice.’

The change from purpose to activity applies to disposals from 17 April 2002 and in relation to periods of ownership from that date. However, if the change was merely to ‘clarify’ the definition, why was the change not given retrospective effect? In my view, Finance Act 2002 changed the test when considering the company’s asset base and surplus cash, irrespective of the comment in Tax Bulletin 62 that the changes ‘… are not intended to alter the substance of the original definitions, or to have different meanings before and on or after 17 April 2002’.

However, leaving aside this difference of opinion, Tax Bulletin 62 states that ‘activities’ means what the company does, including ‘trading operations, making and holding investments, planning, holding meetings and so forth’. Does the simple lodgement of surplus funds from trading in the company’s business bank account constitute an activity? The view of HMRC seems to be that it does, and that the decision in Jowett v O’Neil and Brennan Construction [1998] STC 482 (in which the holding of cash was held not to amount to a business activity for corporation tax small companies relief purposes) is the exception rather than the general rule.

Business purpose?

It should be remembered that the asset test is based on current values, and will often include goodwill, which may not be included on the company’s balance sheet. In addition, companies generally require cash for working capital for use in their day-to-day trading activities. The level of funds for this purpose must be deducted when considering the extent to which cash at bank is surplus. Working capital requirements will vary depending on the size and nature of the trade.

The extent to which cash is surplus or needed for business purposes was considered (albeit for inheritance tax purposes) in Barclays Bank Trust Company v CIR (SpC 158) [1998] SSCD 125 . The Special Commissioner in that case considered whether a company’s cash at bank was an excepted asset for the purposes of business property relief. It was accepted that the company, which sold bathroom and kitchen fittings, needed cash equivalent to approximately 25% of its turnover for the purposes of its business. Whilst this decision is clearly not a binding authority for taper relief purposes, it does perhaps offer a ‘rule of thumb’ in situations where business capital requirements are difficult to establish.

Making and holding investments (which HMRC would have us believe includes the accumulation of trading receipts in a company’s bank account) can be part of a company’s trading activities. Funds may be invested or set aside for present or future trading purposes. This is acknowledged in the Capital Gains Manual at paragraph CG17953i, which cites as examples a travel agent’s bonding requirements and the earmarking of funds by a company for future trade expansion. Activities carried on by a company in conducting or in acquiring or starting to carry on a trade, are included in the list of ‘trading activities’ in Sch A1 para 22A(2).

If ‘activities’ means ‘purpose’ as HMRC suggests, then cash balances required for future trading purposes are not surplus at all. Of course, evidence to substantiate the future trading purpose, such as board minutes, correspondence or formal business plans, should underline this point in a taper relief trading status ruling application. However, activities are only considered to be trading activities if the funds are utilised ‘… as soon as is reasonably practicable in the circumstances’. Paragraph CG17953l suggests that reasonable delays due to circumstances beyond the company’s control will not count against it. In some cases, HMRC Officers are understood to have adopted a ‘wait and see’ approach and have delayed making a COP10 ruling until a later time, such as on the submission of accounts for a subsequent period. A similar approach by the company could work in its favour, but for other reasons, as a fourth measure of ‘substantial’ is the company’s history of non-trade receipts (see paragraph CG17953p), which allows receipts to be measured over a longer than usual timescale.

What HMRC say

There does seem to be uncertainty amongst HMRC Officers regarding the taper relief treatment of surplus cash. In the writer’s experience, this has manifested itself in some inconsistent rulings on the trading status of individual companies under COP10. In the majority of cases dealt with by the writer, Officers have ruled without hesitation that the company is a trading company for taper relief purposes despite surplus cash in the company’s bank account exceeding 20 per cent of the company’s net assets. This is presumably on the footing that the activities of lodging trading receipts in the company’s bank account, and of managing surplus cash balances, did not involve spending substantial amounts of time.

Conversely, other Officers have been reluctant or unwilling to offer a positive ruling in very similar circumstances. The most persistent problem in those cases seems to be that the activities test is being equated with a quantitative test in terms of surplus funds and net assets. The apparent inconsistency of treatment by HMRC officials on this issue has given rise to something of a lottery. Measuring surplus cash and investments against net assets and applying a 20 per cent test to determine whether non-trading activities are substantial is a somewhat arbitrary, though not unreasonable, test. Unfortunately, in the writer’s opinion, the wording of the legislation does not support that approach. This is causing uncertainty for practitioners, and seemingly for some Officers as well. Either the asset base test should follow the wording of the legislation and be measured in terms of activities or the law should be changed to accommodate HMRC’s quantitative approach, if (as Tax Bulletin 62 indicates) that reflects what the legislation was meant to state.

Code of Practice 10

COP10 is rather promisingly entitled ‘information and advice’. A ruling under COP10 is a useful facility, which can be applied for a number of purposes aside from determining taper relief trading status. For example, it can be used to obtain guidance on the application of the corporation tax loan relationship ‘unallowable purposes’ rule in FA 1996, Sch 9 para 13 (subject to the limitations set out in the Company Taxation Manual at paragraph CT12680); employment status opinions in advance (in the circumstances described in the Employment Income Manual at paragraph EIM129); and stamp duty land tax pre- and post-transaction rulings satisfying COP requirements (see Stamp Duty Land Tax Manual at paragraph SDLT51000). However, the majority of COP10 applications in recent times have surely been in connection with taper relief trading company status rulings.

In terms of COP10 rulings for taper relief purposes, most HMRC officials will at least provide a ruling for or against trading company status. However, in some cases rulings are conditional, or judgment is deferred pending further information. In one COP10 letter, the Officer’s response to the writer’s conclusion that the company was a trading company was along the lines of: ‘well, you seem to understand the legislation, and do not appear to have any uncertainty, so you do not really need a COP10 ruling from me’! However, a further letter referring to the guidance at paragraph CG17953r that ‘You should be able to give a firm opinion on the status of a company for periods that have ended where all the relevant facts have been provided’ eventually did the trick and elicited a positive ruling.

The content of a COP10 application is very important, as a ruling by HMRC is not binding without full and accurate disclosure. A list of information generally required in a COP10 application is contained in its Appendix 1. In addition, a list of information and explanations specifically required for taper relief trading company status applications is contained in paragraph CG17953r. In particular, the company (or its advisers) must broadly conclude its own status and explain how it reached that conclusion. COP10 letters for taper relief purposes, and generally, may therefore require some careful thought and drafting. The importance of this task should not be underestimated.

A better way?

In conclusion, paragraph CG17953p states that ‘some or all’ measures of trading status ‘might be taken into account in reviewing a particular company’s status’, and when those measures point in opposing directions it advises Officers to ‘… weigh up the impact of each of the measures’ to balance the effect in coming to a view. However, some HMRC officials seem to focus on a single indicator, which is usually the company’s asset base. It is time that greater emphasis was placed on ‘activities’ and on other, more relevant, indicators than the amount of surplus cash on the company’s balance sheet. Companies and advisers must therefore follow paragraph CG17953r to the letter, and take the opportunity in COP10 applications to state why it is considered that ‘… the measures that point in one direction outweigh those pointing in the opposite direction’.

A more sensible approach must surely be to adopt the Special Commissioner’s approach in the Farmer case and ‘… to stand back and consider the business in the round’. This type of approach is encouraged for business property relief purposes in the new version of the Inheritance Tax Manual at para IHTM25263, which instructs Officers that: ‘… you should look at the main categories of the business, and to its assets and sources of income and gains, over a reasonable period ...’.

Whilst it is accepted that an ‘elephant test’ exercise of standing back and taking an overall view of the company involves some degree of subjectivity, in cases where the only real issue in a trading status ruling is surplus trading receipts sitting in the company’s bank account, it ought to lead to the conclusion of trading company status on a far more consistent basis than at present.

Second thoughts!

Even where the existing measures of trading company status give conflicting indications, I am confident that the vast majority of Taxation readers would know a ‘trading company’ when they saw one. After all, the vast majority will undoubtedly have considerable experience of working and advising in the ‘real world’ of commerce. The big question is: can one can be confident that HMRC officials, particularly those with academic knowledge, but little or no practical commercial experience, would consistently draw similar conclusions? On second thoughts, perhaps a ‘checklist’ approach might be better…

This article was first published in Taxation on 14 July 2005