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2011 review: the City

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The main tax changes in 2011 included the disguised remuneration rules, the report by Graham Aaronson QC in relation to a possible GAAR, changes to the rules relating to corporation tax on chargeable gains and, in particular, the value shifting legislation and the development of the new CFC regime. For 2012, further developments in relation to the GAAR and the new CFC regime are to be expected, there is a further reduction in the rate of corporation tax to 25% and the legislation for the new patent box is expected to be enacted.

A review of 2011 would not be complete without a discussion of the proposals for the fundamental reform of the CFC rules. Another subject that has made a big impact in the City are the rules on disguised remuneration and, in the area of avoidance, the final report by Graham Aaronson QC in relation to the introduction of a general anti-avoidance rule (or GAAR). The decision in Nationwide and the ongoing debate on the dividend legislation, together with changes in the taxation of capital gains, are also worth mentioning.

1. Disguised remuneration

The new disguised remuneration regime was introduced by FA 2011. But that is only part of the story. First published in December 2010, the legislation has already undergone two major revisions. Under the rules, which are aimed primarily at planning using employment benefit trusts (EBTs), when an employer attempts to allocate or ‘earmark’ cash or other assets for future delivery to employees, an immediate income tax and NIC liability will arise on the full value of the cash or assets.

Why it matters:The legislation is best described as ‘unwieldy’. Extensive changes were made as a result of comments on the consultation draft but these mainly took the form of an increase in the number of exceptions to the rules, so as to exclude arrangements which are non-abusive. However, these have only added to the rules’ length and complexity.

Given the stated purpose of combating tax avoidance, arrangements which do not have avoidance as their ‘main’ purpose should, in theory, be exempt from the regime. But the legislation is not phrased in those terms. The concern is, therefore, that standard commercial arrangements could still be caught by the legislation.

Lack of certainty is a major concern. Various questions arise. Which types of scheme will be caught? How will joint venture companies, private equity arrangements and earn-outs be affected? And, in the M&A context, greater consideration will need to be given to future exit arrangements and whether to include a new warranty and/or indemnity to deal with liabilities under this legislation, as well as the need for additional due diligence regarding targets and their EBTs.

2. Proposal for a GAAR

The final report by the GAAR study group headed by Graham Aaronson QC was published last month. It concluded that introducing a limited rule which does not apply to responsible tax planning but is instead targeted at abusive arrangements would be beneficial for the UK tax system.

Why it matters:The question is whether a GAAR on these terms would succeed in achieving the aims of its proponents while, at the same time, allaying the fears of its opponents.

The primary aim of the GAAR is to deter and punish abusive tax schemes. Two significant benefits to which this is expected to give rise are, first, to relieve the courts of the temptation ‘under the guise of purposive interpretation…to stretch the interpretation of tax legislation in order to thwart tax avoidance schemes which they regard as abusive’ and, secondly, to enable the UK’s tax legislation to be simplified by the removal of specific anti-avoidance provisions. A legitimate question to pose in that regard is whether either of these is likely to happen. The report acknowledges that there will be cases where it is uncertain whether the GAAR would apply. In relation to those circumstances, judges may well continue to strain the construction of particular legislation in order to reach what they consider to be a fair result and it is hard to see why a future government would willingly give up its existing armoury of specific anti-avoidance measures.

3. Value shifting

Various changes have been made this year to the rules relating to corporation tax on chargeable gains. In particular, the complicated value shifting rules have been replaced with a much shorter targeted anti-avoidance provision.

Why it matters:The value shifting legislation is aimed at arrangements which extract value out of a company before a sale in order to avoid tax on chargeable gains. The old provisions contained many traps for the unwary and it is not surprising that they were considered ripe for simplification. But tax advisers had got used to them and it is not at all clear that the new provision is an improvement from the compliance viewpoint.

It has long been accepted that the payment of a pre-sale dividend in order to avoid double taxation (absent the application of the substantial shareholding exemption) is acceptable if the dividend is paid out of taxed profits. That was achievable under the old provisions. The carve-out for arrangements consisting ‘solely of the making of an exempt distribution’ has been included to deal specifically with this point. But it is debatable whether it has achieved its purpose. It is difficult to see when value shifting arrangements would ever consist ‘solely’ of an exempt distribution. Unless the company keeps cash at hand, even the simplest pre-sale dividend will involve at least a loan relationships-related transaction in addition to the payment of the dividend itself. That provision could easily have been drafted in such a way as to avoid technical difficulties by replacing the reference to ‘the arrangements’ with a reference to the relevant ‘reduction in value’. As it is, we are stuck with having to rely on guidance in order to conclude that a ‘normal’ pre-sale dividend does not fail the new purpose test.

4. First Nationwide

In April 2011, HMRC lost its appeal in First Nationwide ([2011] STC 1540). The Upper Tribunal held that a dividend paid out of share premium account was an ‘overseas dividend’ for the purposes of the manufactured dividend rules and that a subscription was not a purchase for the purposes of the repo rules.

Why it matters:The dividend arguments raised by HMRC in this case have caused great uncertainty in the last couple of years. One of HMRC’s arguments is that a dividend paid out of share premium is not a dividend but instead a repayment of capital. First Nationwide’s position is that something which is a ‘dividend’ under the company law of the jurisdiction of the paying company is a dividend for the purposes of the UK tax legislation. Both the Upper Tribunal and the First-tier Tribunal have now found in favour of First Nationwide and it is therefore unfortunate that HMRC has been granted leave to appeal to the Court of Appeal as this uncertainty will continue into 2012.

The uncertainty caused by HMRC’s stance in this case has already led to the introduction of legislation (CTA 2010 s 1027A) to confirm that a distribution out of a reserve arising from a reduction of share capital (including any share premium) is to be treated in the hands of a corporation taxpayer as a distribution and not a repayment of capital but uncertainty still remains for individuals receiving such distributions. A working group has been assisting HMRC in identifying areas of difficulty within the distributions rules and HMRC intends to address the concerns by publishing comprehensive guidance and, where necessary, some further legislative tweaking to make the distributions rules work as they should.

For corporation taxpayers, before FA 2009, the relevant question was whether a payment from a foreign company was income or capital in the hands of the shareholder. Since FA 2009, however, the question is whether the relevant payment is or is not a distribution and therefore it is more important than ever that the issue of what is a dividend for tax purposes is resolved.

5. CFCs

The interim improvements implemented in FA 2011 have been generally well received. Meanwhile, the proposals for full CFC reform continue to be developed for inclusion in Finance Bill 2012.

The proposals announced on 30 June 2011 included a series of new exemptions, the most high profile of which was the finance company partial exemption (FCPE) which would generally tax income of an offshore finance company at an effective rate of 5.75% once the rate of corporation tax reaches 23%.

The current state of the proposals is reflected in draft legislation that was published on 6 December 2011.

Why it matters:There was some disappointment at the complexity of the proposed rules announced in June. The legislation published on 6 December 2011 represented an improvement in that it introduced a new ‘gateway’ test. For a company which does not satisfy all of the gateway conditions, it will not be necessary to consider the various specific exemptions laid down in the new legislation. The gateway test is intended to identify those profits that have been artificially diverted from the UK but the test applies only to trading profits and investment profits that are connected to the trade of the CFC. Other investment profits will generally be within the scope of the new regime, subject to other potential exemptions such as the FCPE. In relation to the FCPE, the government is considering whether to limit the charge to tax by reference to the aggregate net borrowing costs of the UK members of the group so that the rate can be lower than 5.75% in certain circumstances.

What’s ahead in 2012?

In addition to the full CFC reform and a decision by the government on whether to proceed with a GAAR, there are some other exciting events coming up:

  • Companies will benefit from the further incremental reduction in the rate of corporation tax to 25% from 1 April 2012.
  • No date has yet been set for the hearing of Prudential’s appeal to the Supreme Court on the issue of whether legal professional privilege should be extended to cover advice given by tax accountants. However, due to a backlog at the Supreme Court, we may have to wait as long as 2013 for this case to be finally resolved.
  • The legislation for the new patent box (which will apply a 10% rate of corporation tax to certain intellectual property profits arising after 1 April 2013) is included in Finance Bill 2012.