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Mark McLaughlin looks at two Income Tax anti-avoidance rules potentially affecting receipts of capital.

Introduction

The introduction of a higher Capital Gains Tax rate of 28% in respect of gains accruing from 23 June 2010 has gone some way to bridging the gap between Capital Gains Tax rates and the 50% top rate of Income Tax for individuals.

However, this 10% increase in Capital Gains Tax for higher rate taxpayers fell some way short of many commentators’ predictions, and means that there is still a potentially considerable incentive to structure transactions and arrangements in favour of generating capital, as opposed to income, receipts.

The disparity between the tax treatment of income and capital, together with lower rates of Capital Gains Tax than Income Tax at times over the years, has resulted in various anti-avoidance provisions to prevent the tax equivalent of alchemy, i.e., the ancient practice of attempting to turn base metals into gold.

Some of these provisions are relatively well-known, if not readily understood, such as the ‘Transactions in Securities’ code and the ‘Transactions in Land’ rules in ITA 2007 Part 13 chapters 1 and 3 respectively. Among those anti-avoidance measures which are perhaps less familiar are the ‘Sales of Occupation Income’ and ‘Transfers of Income Streams’ provisions (ITA 2007 Part 13 chapters 4 and 5A).

The ingenious and creative minds of advisers who may presently be devising arrangements specifically to turn income receipts into capital will no doubt take anti-avoidance rules such as these into account as appropriate.

However, for those involved in considering the tax implications of day-to-day transactions for their clients, need they be concerned about being caught out by those anti-avoidance provisions? If not, why not? (All references are to ITA 2007, unless otherwise stated).

Show Me the Money

Sales of occupation income anti-avoidance provisions have been with us in various forms for decades. One might be forgiven for asking why we should be bothered about them now.

However, while HMRC will no doubt seek to apply the legislation to transactions or arrangements at which it was targeted, see, for example, Black Nominees Ltd v Nicol (and cross-appeal) [1975] STC 372, I suspect that many other situations in which the legislation could strictly be applied have previously gone unchallenged.

If so, the Government’s urgent need to maximise tax revenues could change that approach at any time.

The sale of future income for a capital sum (say, to a wholly-owned company) might seem like an attractive proposition, particularly if the individual would otherwise pay Income Tax at 40% and/or 50% on those prospective earnings.

However, life is rarely that straightforward. The capital proceeds may be treated as income arising to the individual if the transaction has been effected to exploit the individual’s earnings capacity in an occupation, and a main object is the avoidance or reduction of an Income Tax liability (s 773(2)). The ‘main object’ requirement is broadly a motive test, which provides a potential let-out for commercially driven transactions. Liability to the Income Tax charge is not self-assessed in the sense that HMRC must demonstrate an avoidance motive, and there is no statutory clearance procedure.

The transactions or arrangements must be fully disclosed on the tax return - although in practice providing ‘full disclosure’ to HMRC’s satisfaction can be an achievement in itself, as evidenced by a raft of case law on the subject.

A further possible let-out from the Income Tax charge is that it applies to an ‘occupation’. This means that activities of a kind undertaken in a profession or vocation are caught, whether as a self-employed individual, an employee or office holder (s 774). Actors and sportsmen in particular appear to be on HMRC’s radar (see Business Income Manual BIM35960), but professionals such as accountants and solicitors are also potentially within the scope of the provisions. However, trading activities fall outside them.

Subject to an exception for sales of going concerns, the Income Tax charge can apply if three conditions are satisfied (s 777). These conditions (A to C in the legislation) are broadly as follows:

• The individual carries on an occupation wholly or partly in the UK, thus excluding activities carried on wholly abroad (Condition A);
• transactions are effected, or arrangements made, to exploit the individual's earning capacity in the occupation by putting another person in a position to enjoy income or receipts from the individual's activities in the occupation or anything derived from them (Condition B); and
• the transactions or arrangements result in capital amount being obtained by the individual or another person (Condition C).

Payments for copyrights, licences or franchises are specifically caught if the value of the right derives its value from the individual’s activities.

Example 1 - Sale of Occupation Income

Del, a sole practitioner accountant based in Peckham, sold a licence in respect of his income for the next three years to Rodney on 1 July 2010, for a capital sum of £150,000 payable on that date.

Each of the conditions A to C is satisfied. The capital sum would therefore be charged to Income Tax, on an arising basis (s 776(2)), in the tax year in which the capital sum is receivable (s 778(3)).

Del is therefore liable to tax on the deemed income for 2010/11.

All or Nothing

There is an important exception from the Income Tax charge for sales of going concerns (s 784). This exemption applies to capital receipts for the disposal of assets (including any goodwill) or a partnership interest, if the value is attributable to the profession or vocation as a going concern. A similar exemption applies to the disposal of shares in a company.

On the face of it, the exemption covers circumstances including the incorporation of a professional partnership, where the company acquires the partnership business for consideration.

However, this is subject to a further anti-avoidance rule. A potential restriction in the exemption applies broadly if the going concern value is derived to a material extent from future earnings attributable to the individual’s activities in the occupation. The exemption only operates in those circumstances if the individual will receive full consideration for the future earnings, such as a partnership profit share or employment income as a company employee (s 785).

Example 2 - Full Consideration

Following on from the first example, Del persuades Rodney to buy the practice instead. The practice and all its assets are independently valued at £250,000 as a going concern.

However, Rodney agrees to pay £325,000 in total on 1 July 2010, on the basis that Del will act as an unpaid consultant for 18 months following the sale of the practice. The proceeds of £250,000 fall outside the occupation income provisions (although there will be other possible tax implications to consider), but Del is potentially liable to tax on the additional £75,000 as deemed income of 2010/11.

A similar outcome could arise if Del and Rodney had been in partnership, and a capital sum was paid to Del upon his retirement, with Del continuing as a consultant thereafter, as above.
 
There is no definition of ‘full consideration’ in the above context.

However, most sales of businesses as going concerns are based on the current value of assets, and goodwill is often valued by taking account of past earnings.

A disposal at current market value upon the incorporation of a professional partnership carried on by individuals who become shareholders and employees of the company is therefore unlikely to attract HMRC’s attention as far as the sale of occupation income provisions are concerned.

On the other hand, more complicated structures such as the introduction of corporate partners into an existing partnership of individuals will probably demand greater care and attention.

What if a capital amount for occupation income is not received in cash, but in property or rights, such as company shares? There is a potential Income Tax charge further down the line in such cases. This charge arises, not when the capital sum is received, but when the asset is sold or otherwise realised. The provisions are difficult in that they can apply to direct and indirect transfers.

The value of a property or right can be traced through any number of companies, partnerships and trusts.

The individual may be assessed to Income Tax on a capital amount receivable by another person for the occupation income, e.g., where the right to the consideration was previously transferred, subject to a right of recovery in respect of any tax charged on that other person (s 786(3)).

The scope of the anti-avoidance provisions is deliberately wide. An Income Tax charge can apply to sales other than at market value, or the assignment of share capital, partnership rights and interests in settled property, or the creation and grant of options, or disposals upon the winding up of a company, termination of a partnership or the winding up of a trust, among other things.

If a transaction or arrangement results in other anti-avoidance provisions applying as well, e.g., the ‘settlements’ code in ITTOIA 2005 Part 5 chapter 5, or other Tax Acts legislation treating income as belonging to a particular person, those provisions apply instead.

Transfer of Income Streams

A further threat for individuals aside from the sales of occupation provisions is the transfers of income streams legislation (s 809AZA to s 809AZG), which was introduced in FA 2009 in relation to transfers, e.g., sales, exchanges and gifts, from 22 April 2009 (corresponding provisions for companies can be found in CTA 2010 Part 16 Chapter 1).

The transfers of income streams legislation itself replaced various other anti-avoidance provisions which had the effect of taxing the disposal of rights to receive income, without a disposal of the underlying asset, as income rather than capital, e.g., TA 1988 s 730 for dividends, and TA 1988 s 775A for annual payments.

The sale of a right to future income for a capital sum could be potentially attractive due to the reasons explained earlier. Unfortunately, the transfers of income streams provisions have made this outcome potentially more difficult to achieve.

In broad terms, the rules apply if the transfer of the right to ‘relevant receipts’ does not result from the transfer of an asset from which the income arises (s 809AZA(1)).

However, care is needed because the legislation effectively ignores certain asset transfers, namely agreements for annual payments and transfers under sale and repurchase agreements.

Note that the provisions apply to the transfer of a right. A straightforward application of income, e.g., a distribution of profits to a partner, or of trust income to a beneficiary, is not itself caught.

‘Relevant receipts’ in this context means prospective income or profits of the person making the transfer. The provisions apply not only to transfers by individuals, but also transfers involving partnerships of which the transferor or transferee is a member, and transfers to trustees of trusts in which the transferor is a beneficiary.

There is a limited tax avoidance motive test in the transfers of income streams legislation, but only in respect of partnerships. There is no statutory clearance procedure, although an application under HMRC’s non-statutory business clearance service is a possible alternative.

If caught by these provisions, the transferor is charged to Income Tax according to whether the transferred income stream represented income or profits (s 809AZB(1)).

However, the measure of the Income Tax charge is not the income stream itself, but either the sale proceeds for the right, or (if the consideration is substantially less than market value, or nil) its market value.

The income is treated as arising when the transfer takes place, unless the future receipts would have been trading or property income for tax purposes.

In that case, if part of the income would have been recognised under generally accepted accounting practice in another chargeable period, it is generally taxable accordingly.

Escaping the Charge

Fortunately, there are some exceptions and relaxations from the Income Tax charge. It does not arise to the extent that the transfer is otherwise charged to tax as income, or is brought into account as profits or for capital allowances purposes.

Nor does the charge apply to certain life or pension annuities, or to advances under certain structured finance arrangements (s 809AZC to s 809AZE).

A lease of land is treated as a transfer of the land itself, and the disposal of an interest in an oil licence (within CTA 2009 s 809) is treated as a transfer of the licence.

There is also an important exception in respect of partnerships. A transfer that reduces a partner’s share of profits (or losses) is treated as a transfer of partnership property.

However, the transfer must satisfy at least one of two conditions.

1. The first condition is that the transfer results in a proportionate reduction in the transferor’s share of partnership property and profits.
2. The second condition is a motive test, which is that there is no main purpose of the transfer to secure that the transferred income is not charged or brought into account for Income Tax (or Corporation Tax) purposes as income of any partner.

Example 3 - Transferring Property

Arthur and Terry are partners in a successful professional practice. They decide (as part of a tax planning exercise to shelter some profits at lower Corporation Tax rates) to introduce corporate partners into the business, by selling part of their partnership interests to newly formed companies.

Arthur sells a 25% interest to Arthur Ltd (wholly owned by Arthur), and Terry sells a 25% interest in Terry Ltd, which he wholly owns. Arthur’s and Terry’s property and income sharing ratios are reduced accordingly.

There has been a reduction in Arthur’s and Terry’s share in partnership profits, which is proportionate to the reduction in their shares in the partnership property.

The arrangements are therefore not caught by the transfers of income streams rules (s 809AZF(2)).

There is no need to consider the motive test (although the arrangement would not be caught in any event, as the corporate partners will take profit shares into account for Corporation Tax purposes).

However, consideration would need to be given to whether the sales of occupation income provisions potentially apply.

Now You See It…

The problem with anti-avoidance rules such as these two provisions is that although they are targeted and relatively obscure, they still often need to be considered in relation to some transactions and arrangements at which they were probably not aimed.

As announced in the Budget on 22 June 2010, the Government intends to consult informally on the possibility of introducing a General Anti-Avoidance Rule (GAAR), as part of a wider consultation on the tax policy making process.

Whatever one’s feelings might be about the feasibility and effectiveness of a GAAR, its introduction would at least reduce the volume of anti-avoidance legislation considerably and offer many practitioners some comfort from that common nagging thought, what am I missing?

The above article first appeared in 'Taxation' (5 August 2010), published by Lexis Nexis.