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Matthew Hutton MA, CTA (fellow), AIIT, TEP, author of Capital Tax Review, comments on the targetted Anti-avoidance rule for capital losses introduced in Finance Act 2007.

Matthew Hutton

Context

A letter to Taxation from John Barnett gives a useful commentary on some aspects of the new regime.  He comments that the draft legislation not only matches the policy objective, but enacts an entirely different set of rules. 

‘Tax advantage’ not ‘tax avoidance’

Crucial to this analysis is the use in the legislation of the phrase ‘tax advantage’ rather than ‘tax avoidance’.  As will be well known from other contexts, tax advantage is an extremely wide definition which encompasses not only tax avoidance, but also obtaining a straightforward relief specifically granted by Parliament.

Problems with the revised guidance notes

Of particular concern is the revised guidance notes (the ‘New Guidance’) issued on Budget Day. John believes that the New Guidance demonstrates the danger of allowing too wide a discretion to HMRC. In particular:

1. The New Guidance withdraws examples given in the Original Guidance (eg wife transferring loss-making asset to husband to offset his capital gains) — potentially affecting taxpayers who have already undertaken such transactions since 6 December in reliance on the Original Guidance.

2.  The New Guidance gives a number of examples which have conventionally been thought of as straightforward but which are apparently now unacceptable. For instance, a wife selling a loss-making asset knowing that her husband will subsequently repurchase it — often referred to as a ‘bed and spouse’ transaction — is now apparently caught. It is not clear from a later argument whether the perceived evil is that the husband might transfer the repurchased asset back to his wife or whether it is the fact that the wife sold the asset knowing that her husband might repurchase it.

3.  The New Guidance is inconsistent with itself. For instance, a person who sells an asset but buys it back 31 days later is not caught. But if his civil partner buys it back 31 days later, it appears that he may be caught.

4.  The New Guidance creates illogical differences between taxpayers. An individual who sells an asset and buys it back 31 days later is not caught. A company which does exactly the same thing apparently is caught.

5.  The New Guidance treats transactions differently which have the same commercial outcome. For instance, if trustees sell an asset at a loss and then transfer the proceeds to a beneficiary who buys the asset back, this may be caught.  But if the trustees instead transfer the asset to the beneficiary, making the same loss on the deemed disposal in the process this should not be caught.

6.  The New Guidance leaves gaps. For instance examples are given of acceptable and unacceptable transactions between spouses. But a whole range of possible circumstances in between these two extremes is not covered.

The problems with the New Guidance highlighted above make it abundantly clear why guidance is never a substitute for proper legislation.  The problems also highlight why the rule of law is invariably to be preferred to unbridled executive discretion.

(Taxation 12 April 2007 p 384 letter from John Barnett of Burges Salmon LLP)

Further comment from Emma Chamberlain

HMRC give fourteen examples. In seven of these the legislation is intended to apply:

• Losses on second-hand insurance policies (Example 1).
• Arrangements to swap the share capital of a company (Example 2).
• Matched options (Example 3).
• Sale of shares by husband to realise a loss which are then purchased back by wife and transferred back to husband (Example 5).
• Individual selling shares to realise a capital loss where arrangements are in place to enable him to buy them back after 30 days (Example 7).
• Trustees selling assets to realise a loss to set against a gain, but then appointing the cash to a beneficiary to enable him to buy back the asset (Example 9).
• Trustees make a deliberate transfer of value within TCGA 1992, Sch 4B to realise deemed losses (Example 13).

In seven examples the legislation is not intended to apply:

• Husband deliberately selling part of a share portfolio to realise a capital loss to mop up capital gains and his wife ‘unknowingly’ buying the shares back later (Example 4).
• Individual selling shares and buying back the same number 31 days later (Example 6).
• Trustees selling assets to realise a loss to set against a gain (Example 8).
• Individual selling assets at a capital loss to secure funds for an enterprise investment scheme investment (Example 10).
• Negligible value claim made on enterprise investment scheme shares (Example 11).
• Shareholders purchasing assets from a wholly-owned company which is then wound up and a loss is realised on the disposal of the company shares (Example 12). (This example is particularly confusing. What tax advantage arises by having the company sell the property and then distribute the cash on liquidation, compared to the more straightforward transaction of liquidating the company and transferring the property out on that liquidation?).
• Trustees distributing in specie assets which show a gain and a loss to beneficiaries in the same tax year (Example 14).
  It is difficult to determine from some of these examples when a particular transaction undertaken by a client will be caught by the legislation and when it will not be. Transfers between spouses and transfers out of trusts are particularly problematic.
  

Inter-spouse transfers

HMRC’s Example 4 visualises a husband selling shares to crystallise a loss in order to offset this against other gains he has made and, ‘unbeknown to him’, his wife buys back shares of the same class a few days later at the same price. The Guidance states that the arrangements do not fall foul of the TAAR. This implies that TAAR would apply if either of the following occurred:

• Mr H has shares which stand at a loss and Mrs H has shares which stand at a gain. Mr H transfers his shares to Mrs H in a no gain/no loss transaction and Mrs H sells both holdings of shares (and retains the proceeds). Clearly, arrangements (being the transfer from Mr H to Mrs H) have been made with the main purpose of obtaining a tax advantage (the reduction of Mrs H’s CGT liability), although the sale itself realising the loss has still been a genuine sale with a real economic loss. If HMRC do feel that the legislation applies in this case, it appears to be a departure from what was said in the initial draft guidance, when a similar example was given (Example 5 of the earlier draft guidance) and the HMRC comment in the draft guidance was that the legislation would not apply to transfers between spouses, ‘because there had been a genuine disposal from H to W which falls within the provision for disposals between spouses and civil partners, and there is a real loss that arises on a genuine commercial disposal’.
• It is more likely that Mr H would sell the shares to realise the loss knowing that Mrs H would buy them back a few days later — they may not be at the same price then and, if the couple are exposed to commercial risk, why should the fact that she buys them back and he sold them knowing she would probably do this make the loss unallowable? Suppose she bought back a slightly different number or at a different price or delayed a repurchase? The guidance suggests that even then a problem would arise, The example states that the buy back of the shares by Mrs H is ‘unbeknown to’ Mr H. If Mr H did not know about the actions of Mrs H but she was aware of what her husband had done, would the loss incurred by Mr H still be disallowed? How is Mr H to prove he did not know?

It is true that, on a strict reading of the legislation, such inter-spouse transactions would be caught. But If this is really the Government’s intention, it would be preferable to state openly in the Guidance that ‘bed and spousing’ and transfers between spouses cannot realistically be effected to crystallise a loss: this is important for many holders of small investment portfolios.

Realising a capital loss

HMRC’s Example 5 ’Sale of shares to realise capital loss’, states that:

‘As in Example 4, Mr H sells shares in a company, in order to crystallise a loss which can then be set against his chargeable gains arising in the year. Mr H makes arrangements for his wife Mrs H to purchase the same number and class of shares. Mrs H then transfers the shares back to Mr H on the following day. By virtue of TCGA 1992 s58 this is a no-gain no-loss transaction’

The Example concludes by stating that the loss of Mr H is disallowed.

Example 4 suggests that if Mrs H buys back shares originally owned by Mr H, this is only acceptable if he was not aware that she would do this. However, Example 5 seems to suggest that if Mr H sells shares in a company and Mrs H buys the same number and class back, this might be acceptable, provided she does not then transfer the shares back to Mr H on the following day.

Is the unacceptable characteristic the wife buying the same shares back with H knowing this would occur before sale (as Example 4 implies), or H selling knowing that W would buy them back on the basis that they would be transferred back to H (as Example 5 implies)? Would it make any difference if the number and class were different, even if he knew she would buy them back, or if Mrs H buys back the shares after 30 days? Do the intentions of Mrs H make any difference or is it only the purpose of Mr H that is relevant?

Trustee transactions

HMRC’s examples relating to trustees raise similar problems.

In HMRC’s Example 8, a body of trustees sell a capital asset and realise a chargeable gain. In the same year, they also sell an asset which is standing at a loss in order to crystallise that loss.  The loss can be set against the gain, and so no CGT is payable in that year.

Because each of these transactions is a genuine economic transaction HMRC state that the loss is allowable. Contrast their Example 9 where there is still a ‘genuine economic transaction’.

In Example 9, the same body of trustees have carried out the transactions as in Example 8 above. They realise a chargeable gain and a capital loss.  The trustees then appoint cash to a beneficiary of the settlement, Z, in order to allow him to buy back the asset on which the loss has been realised, and the beneficiary does so.

The additional step, and the fact that Z is a beneficiary of the settlement, suggests that the trustees have entered into arrangements which have a main purpose of securing a tax advantage. Where trustees have entered into arrangements with a main purpose of realising such an advantage the TAAR will apply and the losses will be disallowed.

But then consider HMRC’s Example 14. There, the trustees of a settlement wish to distribute an asset to a beneficiary of the settlement.  They are aware that this will give rise to a chargeable gain. They are also aware that they own a second capital asset which is standing at a capital loss. They therefore transfer that second asset to the beneficiary in the same year.  The loss which the trustees incur on the transfer of the second asset is set against the gain arising on the transfer of the first asset.

Although it is the case that the trustees have arranged to dispose of the two assets in the same tax year, there is no suggestion that the main purpose of the arrangements was to secure a tax advantage. The two disposals have been made with a view to taking advantage of the statutory relief in TCGA 1992 s2(2) in a straightforward way.  In such a case, the TAAR will not apply and the losses will be available to set against the chargeable gains.

Questions

Why is Example 14 permissible but Example 9 is not? The end result in both is the same, ie the beneficiary has the asset and the trustees have realised the loss.

In Example 9, the trustees appoint cash to a beneficiary of a settlement; the Guidance suggests that it is the motive of the trustees that is relevant here; i.e. if they appoint the proceeds to him with the aim of enabling him to buy back the asset at some point later, then the loss is not allowable, but if they have no such motive, then it is allowable. If that is right, how are the trustees to prove that they did not know what the beneficiary was going to do with the cash distribution? Must trustees tell beneficiaries not to buy back any shares sold? Beneficiaries have no duty to inform trustees of their actions.

The practical problems are significant and already apply to trustees who made disposals of assets at a loss in the period between 6 December 2006 and April 2007 and have made distributions to beneficiaries.

For example, can the beneficiary buy back no shares previously owned by the trustees, or are only the loss-making shares banned? What if the beneficiary’s spouse buys back the shares? Suppose the beneficiary buys the asset back using not the cash appointed to him, but other cash, and can easily afford to do so?

There may be good commercial reasons why the trustees have to realise cash to make a sale rather than advancing the asset in specie, eg because trustees have to pay some costs out of the sale proceeds and have no other cash available: so why should the fact that the beneficiary buys back some of the shares using some of the cash from the sale mean that the loss position is changed?

In Example 14, the trustees might have advanced the asset to the beneficiary with the motive of realising a loss, but apparently this does not matter.

Conclusions

The legislation needs improving and the guidance notes need clarifying, particularly given that they will be relevant to transactions that have already been carried out.

If no serious changes are to be made to the legislation then one simple improvement (on the assumption that the Government does not want to catch ordinary inter-spouse and trustee/beneficiary transactions) would be to have a de minimis exemption so that, for example, losses realised of less than £25,000 each year by any individual, trust or estate would not be disallowed even if strictly they are caught by the legislation.  This would at least move the more common transactions for families out of the line of fire of this legislation. 

(Taxation 19.4.07 p428 article by Emma Chamberlain Barrister 5 Stone Buildings)

Comment

Emma’s suggestion of a de minimis threshold was the subject of an Opposition amendment, which, however, after debate, was withdrawn.

The growing trend towards HRMC guidance is regrettable, as a movement away from simple objective focus on the legislation.  This is so not only with the guidance issued following the new TAAR – and the significant differences between the December 2006 and April 2007 versions – but also in other contexts, eg the guidance issued by HMRC to accompany the 2006 disclosure regime for direct taxes.

A similar general point was made by Jeremy de Souza as Chairman of the City of Westminster and Holborn Law Society Revenue Committee in  writing to HMRC.  Given that FA 1998 had put into TCGA 1992 the new 30-day identification rule for listed securities as s106A (with the clear implication that a buy-back of those securities by the same taxpayer outside the 30-day period would have no fiscal impact), surely any amendment of this principle should be addressed not by guidance but by a change to the legislation.

Enactment of the new statutory rule coupled with HMRC’s guidance will leave taxpayers and their advisers in a considerable state of uncertainty.  While in a case which is precisely on all fours with one of the examples in HMRC’s guidance where s16A is stated not to apply, that guidance might give the required degree of comfort, even there an entry in the additional information white space box on the self-assessment return could be considered sensible.  Otherwise, any loss-making transactions with family members or in the context of settlements should be both planned and reported with great care.  Ultimately, following a full description in the white space, it may be that a taxpayer will be able to relax only once the 12 month enquiry window has passed for that particular SA return.  And remember the general rule in TCGA 1992, s 18(3) that a loss arising on a transaction with a connected person can be set off only against a gain arising on a transaction with that connected person, whether in the same or a subsequent tax year.

More Information

The above article has been taken from Matthew Hutton’s Capital Tax Review, a quarterly update for professional advisers of private clients. For more information, visit http://www.taxationweb.co.uk/books/capital_tax_review.php

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