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08 November 2000
Where, as is usually the case, there is more than one tenable opinion regarding a reader's query, we select for publication those readers' replies which reflect the widest range of possible answers. As a result, the views expressed are not necessarily our own and should be read with a critical spirit, not as definitive solutions.
Topics this week:
A developing scenario
Accounting for one-off property venture.
Life tenancy complications
Who is the settlor of appointed funds within a settlement?
Topics this week:
A developing scenario
Accounting for one-off property venture.
Life tenancy complications
Who is the settlor of appointed funds within a settlement?
Where, as is usually the case, there is more than one tenable opinion regarding a reader's query, we select for publication those readers' replies which reflect the widest range of possible answers. As a result, the views expressed are not necessarily our own and should be read with a critical spirit, not as definitive solutions.
Topics this week:
A developing scenario
Accounting for one-off property venture.
Life tenancy complications
Who is the settlor of appointed funds within a settlement?
Time gentlemen please
Gift of public house to son.
How to complicate life!
Two flats amalgamated into one residence.
A developing scenario
A higher rate tax self-employed client has made a £30,000 profit in the 12-month period to 30 September 2000 in the buying and converting of a property, leading to sale. His trade has no connection with this venture, for which there is no doubt that Schedule D rather than capital gains tax applies.
However, our concern relates to the split year treatment for the purposes of the 2000 tax return. Now that the account has been prepared, our initial thought was to apportion the net profit as £15,000 in the 2000 return and £15,000 in 2001.
However, substantial expenditure was incurred in the 6-month period to 5 April 2000 and had we been presented with details at that time, and immediately completed the return, a substantial tax refund could by now have been secured by virtue of the losses (carried back) and a considerable cash flow benefit by reporting the net profit in year 2001. There appears no reason why this latter method should not be applied now. Do readers envisage any problems with this method of six months accounts reporting? Is any challenge from the Revenue likely to ensue and, if so, on what grounds? Also should we make any entry on the 'additional space' section of the return? How should subsequent ventures be treated? Should each speculation be treated in isolation or 'pooled' for the purpose of the annual return?
(Query T15,704) BW.
'BW' assumes that his client's activities constitute a trade. This may not be the case, as discussed below. But I shall first assume that the activities do (or at least will) constitute a trade for tax purposes. It is also assumed that this was the first time that the client participated in such a venture.
In theory, there is no problem with a taxpayer adopting a 5 April accounting date. Indeed the legislation broadly encourages it, as such an accounting date avoids the need for overlap relief. But resistance may be met if the 2000 tax return has already been submitted without any reference to this activity that is now showing a significant loss.
One line of attack that the client is likely to face relates to when the trade actually commenced. This is significant because any expenditure incurred before this date will be treated for tax purposes as if it were incurred on the commencement date (section 401(1), Taxes Act 1988). As a result, if the commencement date were after 5 April 2000, the client's full profit would be correctly assessable in 2000-01.
The general rule is that the trade commenced when the client was first in a position to sell the stock of the trade. In similar situations, this will usually be when the property was first put on the market. Although it could be argued that the client could have sold the property at any time after it was first acquired, the fact that he intended to convert it first would suggest that a later date should be taken as the commencement date.
The Inland Revenue, however, is likely to contend that the venture is not in the nature of a trade, but rather a capital transaction. This is not so as to assess the profit for capital gains tax, but to bring the profit into the charge of income tax under Case VI of Schedule D under the provisions of section 776, Taxes Act 1988. As far as the client is concerned, this means that certain trading deductions, such as interest, will not qualify for relief. The profit would be assessable in the year in which the gain was made.
Development gains fall squarely within the remit of section 776; and the only escape route is by showing that the transaction was in the course of a trade rather than an isolated occurrence.
'BW' suggests that there may be other similar ventures in the future. If so, the client may be able to show that a trade is indeed being carried on following the decision in Leach v Pogson 40 TC 585. However, it would be advisable to show evidence that there is a genuine intention to make further purchases rather than consider each project as an isolated speculation.
To establish a trading motive, it can be helpful to apply the badges of trade tests enumerated by Sir Nicolas Browne-Wilkinson Vice-Chancellor, in Marson v Morton [1986] STC 463. The relevant tests here include:
* 'That the transaction in question was a one-off transaction.' If there are subsequent transactions, this will greatly assist 'BW's' client's claim to be carrying on a trade.
* 'Is the transaction in question in some way related to the trade which the taxpayer otherwise carries on?' We are told that this is not the case; this works against the client.
* 'What was the source of finance of the transaction?' If the client borrowed money to finance the investment, that would indicate a trading intention.
* 'Was the item which was purchased resold as it stood, or was work done on it or relating to it for the purposes of resale?' The conversion undertaken would indicate a trading intention.
* 'Was the item purchased resold in one lot as it was bought, or was it broken down into saleable lots?' If it was broken down, it is again some indication that it was a trading transaction.
* 'What were the purchasers' intentions as to resale at the time of purchase?' It is clear that the client intended to make a quick profit rather than hold on to the property. This would indicate a trading motive.
* 'Did the item purchased either provide enjoyment for the purchaser or pride of possession or produce income pending resale?' This test also seems to suggest a trading motive.
Whilst the application of these tests appears to suggest that the client was indeed trading, it should be remembered that the Vice-Chancellor emphasised that the tests are not comprehensive and no single item is decisive. Also, the wording of section 776 puts the onus on the taxpayer to show that the property transaction was actually part of a trade. In the circumstances here, it appears that a lot will depend on whether the client can show other projects being actively considered even if not actually pursued. Kalonymous.
The querist does not state what the expenditure prior to 5 April 2000 represented, but presumably it can be inferred that it covers the original cost of the property plus the expenditure up to that date on the conversion. If this is so, there has been no loss. The client has acquired and enhanced an asset, and a loss would only arise if the value had fallen below the cost. It is apparently not proposed to argue that the transaction represented a capital gain but, even if this were possible, no capital loss claim could arise until there was a disposal involving such a loss. Apparently, however, it is proposed to accept that the acquisition and disposal represented a trade or an adventure in the nature of a trade which, on the basis of the facts provided and the wealth of case law on this subject, seems the most likely outcome.
The position in the case of a trade or trading venture would be that accounts up to the chosen accounting date would be required. If the accounting date were 5 April 2000 no loss could be shown, as the cost of the property and of converting it would have to be brought in as ending stock in trade or work in progress at cost (or market value if lower which seems very unlikely). This valuation of stock and work in progress would almost certainly counterbalance the expenditure so that no loss would arise for tax purposes.
It is doubtful in any case whether an accounting date at 5 April 2000 is a realistic supposition. The querist does not state whether the transaction in question is the beginning of a series of property deals or simply a one-off transaction. If it is the latter, it is likely that the Revenue would insist that there was only one possible accounting period, viz. that beginning with the acquisition of the property (or the negotiations for it) and ending with the disposal. If the transaction was merely the beginning of a continuing trade of property-dealing, it would no doubt be possible to choose 5 April 2000 as the first accounting date; but the likely result for the part year would, as stated above, be a no profit/no loss result so the benefits hoped for by the querist would not materialise. A.L.H.S.
Life tenancy complications
A settlement created in 1977 gives the life tenant power to appoint by deed the trust fund for the benefit of the life tenant's sons subject to trust powers and provisions as the life tenant shall decide. The life tenant exercised this power in 1997 so that part of his fund is held on trust for his ten year old son if he shall attain 18. The Inland Revenue accepts that no disposal has occurred for capital gains tax purposes and the new fund remains part of the original settlement.
Do readers consider that the life tenant is the settlor of the new fund for income tax purposes so that the provisions of section 660B, Taxes Act 1988 would apply to the income from the original capital as well as from the income accumulations?
Even though no funds have been added to the settlement by the life tenant, do readers consider that the life tenant, by exercising his power of appointment, is the settlor for capital gains tax purposes of both the new fund made up of the original capital and any subsequent income accumulations fund? If so, is the trustee's annual exemption reduced, owing to the fact that the life tenant has made a number of other settlements since 6 June 1978?
(Query T15,705) C & C.
'C & C' is principally concerned with the operation of Part XV of the Taxes Act 1988 which, it will be recalled, provides an anti-avoidance code. The broad effect of this code is, in specified circumstances, to treat income arising under a 'settlement' as the income of the 'settlor' for tax purposes.
By exercising the power of appointment, the life tenant has caused the original settlement fund to be divided so that only a proportion of the original fund continues to support his life interest ('Fund A') with the balance of the fund ('Fund B') held by the original settlement trustees, but now for the benefit of the life tenant's infant son contingently on his attaining 18.
It is hard to see how the life tenant's voluntary act in effecting the appointment would not be within this deeming code, as the effect of the appointment is the provision by the life tenant of capital funds directly for the purposes of a settlement comprising the new trusts over Fund B, so making the life tenant a 'settlor' of Fund B within section 660G, Taxes Act 1988. In this respect the decisions in Commissioners of Inland Revenue v Buchanan 37 TC 365 and Arthur d'Abreu v Commissioners of Inland Revenue 52 TC 352 seem in point.
It is suggested that the position might be different had the power of appointment been exercisable by the original settlement trustees rather than the life tenant. Not only is the father regarded as a settlor of the capital originally comprising Fund B, he will also be the settlor of property which derives from the original capital, and this will include property and assets representing accumulated income from the original capital (section 660E(7)(b), Taxes Act 1988).
The effect of the Part XV code in this case is that the income of Fund B is treated for income tax purposes as that of the father but (see section 660B(1)(a), Taxes Act 1988) only in so far as that income is paid to or for the benefit of the son.
So, if the intention behind the appointment had been for the higher rate (40 per cent) taxpaying father to alienate part of his taxable income to the son, the goal can still be achieved, although with a lesser saving than perhaps originally envisaged, by the accumulation of Fund B's income until the son's 18th birthday.
It is anticipated that relevant powers of accumulation are available to the Fund B trustees either expressly or by the operation of section 31, Trustee Act 1925. Those powers will bring the income of Fund B into charge to 'the rate applicable to trusts' per section 686, Taxes Act 1988, with the result that the income is taxed on the Fund B trustees at 34 per cent.
If the balance of the income after the payment of tax is accumulated, it will not be treated as the father's income; thus, so long as the income is retained in the Fund B trust, no further income tax is payable. If this policy is being followed, care should be taken with distributions of capital which will be deemed to be of income so far as there is available retained or accumulated income.
If any of Fund B's income is paid to the son, that income is treated as the father's income and taxed on him but with the benefit of a 34 per cent tax credit. In these circumstances, whilst the income has not been successfully alienated, the father's income tax position seems no worse than that which existed before the appointment.
As for the capital gains tax annual allowance, the allowance is divided amongst all of the settlements comprised in a group of qualifying settlements (as defined in Schedule 1 to the Taxation of Chargeable Gains Act 1992); membership of the group is governed by the identity of the 'settlor' of settlements within the group, and since 'settlor' has the meaning given to it by section 660(G), Taxes Act 1988, Fund B could be grouped either with all other qualifying settlements created by the father, or with Fund A and any other qualifying settlements created by the donor of the original settlement. In these circumstances Fund B is allocated to the group comprised of the greatest number of settlements. Digby Bew.
The definition of the terms 'settlement' and 'settlor' for the purposes of Part XV, Chapter I, Taxes Act 1988 is contained within ibid., section 660G(1).
A 'settlement' essentially includes any disposition, trust, covenant, arrangement or transfer of assets, and so the question which falls to be answered is simply whether the settlor, in exercising a special power conferred upon him, has created a settlement within any of these categories of which he is the settlor.
In the ordinary sense, the settlor has clearly disposed of a part of the fund in which his life interest existed by exercising the special power conferred upon him in favour of his minor child; therefore, in my view, the exercise of the power as described by 'C & C' has created a settlement. Support for this analysis can be found in Commissioners of Inland Revenue v Buchanan 37 TC 365, where Lord Goddard found that the surrender of a life interest in favour of the protected life tenant's children was a disposal of that interest.
The important point to consider next is whether or not, as a direct consequence of that surrender of part of the fund in which the life tenant's interest subsisted, ibid., section 660B is at point to treat income arising from the original capital, together with accumulations thereon as income of the life tenant (qua settlor).
'C & C' does not state whether under the terms of the appointment the child's contingent interest carries the vested right in intermediate trust income or whether section 31, Trustee Act 1925 applies.
If section 31, Trustee Act 1925 is to apply, the child's contingent interest is subject to statutory accumulation and maintenance trusts and the income arising in the settlement trustees' hands will be subject to income tax at the rate applicable to trusts. If income is then accumulated until the child attains 18 years of age, no liability will fall on the life tenant (qua settlor) under section 660B because income is neither paid nor applied for the benefit of the unmarried minor child. Section 660B(1)(b) will not be at point here because the settlement created by the life tenant was made before 9 March 1999 (see section 64(6), Finance Act 1999).
If the minor child's interest carries a vested right to intermediate trust income, section 660B will apply if that income is paid or applied for the benefit of the unmarried minor child in the tax year in which it arose. The section treats income paid to such a child of the settlor as the settlor's income for tax purposes. If, however, there is a de facto accumulation, achieved by the trustees retaining the income for the absolute benefit of the child, the income will belong to the child in the year in which it arose and not the settlor.
The capital gains tax position is not so fortunate. This is because, on executing the deed of appointment, the child's fund will still remain settled property (hence no deemed disposal at that time under section 71(1), Taxation of Chargeable Gains Act 1992!). The question of who is to be regarded as the settlor of the whole settlement (for the purposes of the annual exempt amount) is then determined under paragraph 2(7) of Schedule 1 to the Taxation of Chargeable Gains Act 1992 which applies the income tax definitions in section 660G(1) and (2), Taxes Act 1988.
As the life tenant is regarded as a settlor for income tax purposes, he will also be regarded as a settlor for capital gains tax purposes. Paragraph 2(6) of Schedule 1 to the Taxation of Chargeable Gains Act 1992 therefore applies to regard the whole settlement as being created by the settlor who has created the largest group of settlements.
In the case cited by 'C & C', the annual exemption to be applied to the whole settlement will be reduced by the number of post 6 June 1978 settlements made by the life tenant (subject to a minimum of one-tenth of the full individual annual exempt amount, i.e. £7,200). Robert.
Time gentlemen please
In 1965 our client inherited a public house and adjoining living accommodation. A condition of the legacy was that it would ultimately pass to her eldest son, now aged 35.
Until 1985 our client traded as a sole owner. From 1985 until March 2000 the public house and the living accommodation were leased at a commercial rent. In March our client decided not to renew either lease and resumed self employment as a publican.
Our client no longer wishes to be involved in the management of the business, and plans to transfer the property and business to her son as soon as is possible. She is willing to be employed on a part-time basis.
The property and business have been valued in the region of £360,000. The same property would have had a March 1982 valuation of £160,000. Our client incurred costs in the region of £30,000 following a fire in 1987 and received no compensation or insurance monies.
We are concerned about the capital gains and inheritance tax issues that may surface from an imminent transfer, coupled with the possibility that our client's son may sell the business and property in the future. The idea of our client remaining owner for a four-year period which in turn should maximise her capital gains tax relief does not appeal to her. Readers' comments would be welcomed.
(Query T15,706) S&K.
I am struggling to find the capital gains issue that might create a problem. Is 'S&K' concerned to maximise the business asset taper relief? If we are only looking at the value of the property, there should be nothing to worry about, at least for capital gains tax.
A March 1982 value of £160,000 and indexation of 1.047 will give a base cost of £327,520. The additional cost of £30,000 has an indexation factor of 0.574, if the costs were incurred at the end of 1987. As a result, there can be no capital gain. The base cost exceeds the current value. In looking at the position, I have assumed that we have been given the value of the property alone. If any of the value relates to goodwill, there may be a further hoop to go through. Is the trade being disposed of the same trade that existed in March 1982, and how do we treat the goodwill relating to that business?
The foregoing has not taken into account the fact that this property may have been the client's principal private residence since 1982 so that the last three years of ownership and the period of residence will be exempt. Nevertheless, the conclusion seems to be that there is no gain to worry about, at least for the client.
Even if the value given includes an element for the value of the business, a perennial problem when looking at public houses, there will be some value in the property. The property has been the client's throughout. Therefore, proceeds to be allocated to the goodwill of the business will be less than £360,000.
A further point to note is that four years will not maximise taper relief. The property was not a business asset until March 2000. Therefore, 'S&K' will need to split the gain into business and non-business periods and apply the relevant taper. The maximum business taper will not be achieved until the non-business period drops out. So much for those who discussed the legislation in committee stage and said there was no issue.
Business property relief for inheritance tax gives rise to different issues. The living accommodation will not be business property. Also, there are two other issues to consider for business property relief: the period of ownership by the donor and whether the property is still to be owned by the recipient if death occurs within seven years of the gift. From the brief details in the query, it seems that the son is unlikely to own the property if his mother dies within seven years of the gift. She may or may not be entitled to business property relief but there will be no relief unless her son owns the property on her death. Therefore, we should probably forget the relief.
It seems that inheritance tax taper relief is likely to be more valuable in the circumstances described than business property relief. A transfer sooner rather than later appears to be more beneficial and 'S&K' should consider recommending this course of action. At least that way, the son will inherit the value of the property; there appears to be no gain after indexation and even though business property relief is not available yet, it is unlikely to be available anyway. J.W.G.
The £30,000 spent after the 1987 fire should be split between repairs, that are chargeable against the rental income, and any improvements which the client may have taken the opportunity to effect. The latter, duly indexed, augment the cost deductible from the deemed proceeds on transferring the property to her son.
The indexation factor from 31 March 1982 to 5 April 1998 is 1.048, making the 1982 value of £160,000 an effective cost of £327,680. So, ignoring professional costs and the possible addition of 1987 improvements, the surplus computed on a transfer now would be £32,320. Taper relief on business assets so far is 25 per cent, and the current personal exemption is £7,200, leaving a taxable gain of £17,040 to minimise. By waiting two more years, on the basis of current law, further taper relief would reduce that to £880.
One appreciates her desire to shed the burden of sole trading but, as she is still ready to work as an employee, what about a partnership? Let mother and son form a partnership with the agreement that profits and losses be allocated in such sums or ratios as the partners shall at the time of sharing agree. While her son assumes the management burden, she keeps the property and does such work as was her intended employment. Her agreed share of profit can be such sum as would otherwise be salary. Once taper relief has adequately matured, the transfer of property can proceed. All she has then to do is survive the gift by seven years. Man of Kent.
Extract from reply by 'Bear':
Presumably the 'condition' of the legacy amounts to no more than a moral duty, falling short of a precatory trust.
Private residence relief for the (apportioned value of) living accommodation is due for the periods 1982 to 1985 and from March 2000 onwards.
For an early disposal, some retirement relief is still available under section 163, Taxation of Chargeable Gains Act 1992, although the client would need to complete a full year's trading on her own. A transitional period as partner could help.
The hoped for March 1982 valuation could be eroded by the supposed 'condition' (above) but indexation allowance would double its contribution to base cost. It does not appear that the £30,000 spent in 1987 enhanced the property value for the purposes of section 38(1)(b), Taxation of Chargeable Gains Act 1992 and this might not therefore be an allowable expense.
How to complicate life!
A client purchased the ground floor flat of a two-storey property in 1993. In 1996 she purchased the first floor flat and occupied both properties as her home with an internal access door. Each flat was purchased by way of a separate mortgage.
Now she is considering letting the two properties separately and moving to a rented property. The mortgages will have to be converted to a 'buy to let' basis which will probably result in both being remortgaged. She would also like to increase the overall amount loaned to realise some of the equity in the property. Thoughts would be welcome on the following:
(a) If the loans are converted into one loan, will they qualify for interest relief against the rental income?
(b) Would the answer to (a) be different if the total loans did not exceed the amounts currently outstanding and equity was realised in a different way?
(c) Will the properties count as one for the purposes of principal private residence relief?
(d) Would the answer to (c) be different if the flats were sold at different times without being reoccupied?
(e) Will an election to treat the property as principal private residence, whilst renting another property, be permitted?
(f) Are there any other pitfalls?
(Query T15,707) Speedy.
'Speedy's' client appears to have acquired two separate interests in a single property: a leasehold interest in a ground floor flat in 1993 and a leasehold interest in a first floor flat in 1996.
Where a property is let, it becomes part of a Schedule A business and expenses are allowable under Schedule A in broadly the same way as under Schedule D (section 74, Taxes Act 1988). So interest payable on a loan is allowable provided it is incurred wholly or mainly for the purpose of the Schedule A business, for example to purchase or improve a property.
(a) 'Speedy's' client has two loans and the loan interest will qualify for relief when letting commences. (Mortgage interest relief was withdrawn from 6 April 2000.) If the loans are converted into one loan, the interest on the new loan will qualify for relief against rental income because the new loan will replace two qualifying loans.
(b) At the time the property is first let, the market value of the property represents capital introduced into a Schedule A business. Arguably, the client can withdraw her capital, repay her existing loans and take out a new larger loan up to the market value of the property to fund the Schedule A business. However, to the extent that the new loan exceeds the total of the two original loans, it is thought the Inland Revenue would seek to disallow part of the interest. There is an anti-avoidance provision in section 787, Taxes Act 1988 which says relief is not given 'if a scheme has been effected or arrangements have been made such that the sole or main benefit' is a reduction in a tax liability.
(c) Whether the principal private residence exemption in section 222, Taxation of Chargeable Gains Act 1992 applies to both flats as if they are one, will depend on the facts. In Honour v Norris [1992] STC 304 relief was denied where more than one flat was used as the taxpayer's main residence but the flats were in separate buildings. Provided both flats have been occupied by 'Speedy's' client as a single residence with access between the two, principal private residence relief should be available.
(d) It does not matter whether the flats are sold separately; what matters is the period during which each flat was occupied as an only or main residence. The gain will be time apportioned between the exempt and non-exempt periods of ownership. Lettings relief under section 223(4) will also be available.
(e) To be able to make a main residence election the taxpayer must occupy two more properties as her residence. If a property is let out and occupied by someone else, it cannot also be the landlord's main residence (unless it falls within a period of permitted absence within section 223(3), Taxation of Chargeable Gains Act 1992). 'Speedy's' new main residence will be the property she intends to rent and occupy herself.
(f) By remortgaging the property, 'Speedy's' client may find the rate of interest payable increases when she switches from a home loan to a 'buy to let' loan. G.S.
This is an unusual situation in that two flats, which would individually have qualified as residences, have been converted into one residence and are now being re-converted. I feel that these points are, however, transparent.
In response to the specific points:
(a) Provided that the capital raised is used for a qualifying purpose, the loan will qualify for tax relief. Any increase in the size of the loan would be for the purpose of putting money into the client's pocket rather than purchasing the property and thus would not qualify for relief, as the interest would not be applied wholly and exclusively for a qualifying purpose.
(b) Again, the capital would still be used for a qualifying purpose, so tax relief would be available.
(c) 'Dwelling-house' is not defined in the capital gains tax legislation and thus takes on its normal English meaning. The Oxford English Dictionary defines 'dwelling-house' as 'a house occupied as a place of residence' this would appear to include two flats which are jointly occupied as a single residence. Section 222, Taxation of Chargeable Gains Act 1992 grants relief from capital gains tax for gains arising on the disposal of a principal private residence. It is implicit from the question that the two flats were jointly occupied as a private residence (regardless of the fact that they could perhaps have been occupied separately), so relief is available for both as a single unit.
(d) For the entire period of residence, both flats would qualify for relief under section 222. If one flat were then let for a period, it would not qualify for relief as a private residence for that period. However, for any property which has been treated as a private residence at some time, an exemption from capital gains tax is granted for the final 36 months of ownership (section 223(3), Taxation of Chargeable Gains Act 1992). There is a further specific relief for properties which have been let under section 223(4). The gain attributable to the period of let is reduced by the lower of £40,000 and the actual gain.
(e) Residence is really a question of fact. The election would be ineffective without genuine residence see the dicta in Goodwin v Curtis [1998] STC 475. There has to be an intention to reside, on a long-term basis. Broadly, it would be necessary to physically occupy the flat to gain the exemption. However, if the flat were temporarily let and there was evidence that the client intended to re-occupy it, irrespective of whether he in fact did so, this might be seen as a continuing residence. A.D.
Extract from reply by 'Rookery':
There is no difference between these circumstances and building an extension except that 'Speedy's' client purchased a readymade extension. Lewis v Rook [1992] STC 171 established that the correct test was whether the subsidiary property is part of the entity occupied by the taxpayer as a residence. Amalgamating the properties by internal doors achieves that.
This is different from Honour v Norris [1992] STC 304, where the taxpayer failed in a claim that flats in the same vicinity but physically separate were eligible for exemption. Selling one flat and then the other should not alter the position. This is no different from the sale of part of a garden followed by the house.
'Speedy's' client will be entitled to residence exemption for both the periods of occupation and for the final 36 months. In addition he will be entitled to the matching exemption, of up to £40,000, within section 223(4), Taxation of Chargeable Gains Act 1992.
Topics this week:
A developing scenario
Accounting for one-off property venture.
Life tenancy complications
Who is the settlor of appointed funds within a settlement?
Time gentlemen please
Gift of public house to son.
How to complicate life!
Two flats amalgamated into one residence.
A developing scenario
A higher rate tax self-employed client has made a £30,000 profit in the 12-month period to 30 September 2000 in the buying and converting of a property, leading to sale. His trade has no connection with this venture, for which there is no doubt that Schedule D rather than capital gains tax applies.
However, our concern relates to the split year treatment for the purposes of the 2000 tax return. Now that the account has been prepared, our initial thought was to apportion the net profit as £15,000 in the 2000 return and £15,000 in 2001.
However, substantial expenditure was incurred in the 6-month period to 5 April 2000 and had we been presented with details at that time, and immediately completed the return, a substantial tax refund could by now have been secured by virtue of the losses (carried back) and a considerable cash flow benefit by reporting the net profit in year 2001. There appears no reason why this latter method should not be applied now. Do readers envisage any problems with this method of six months accounts reporting? Is any challenge from the Revenue likely to ensue and, if so, on what grounds? Also should we make any entry on the 'additional space' section of the return? How should subsequent ventures be treated? Should each speculation be treated in isolation or 'pooled' for the purpose of the annual return?
(Query T15,704) BW.
'BW' assumes that his client's activities constitute a trade. This may not be the case, as discussed below. But I shall first assume that the activities do (or at least will) constitute a trade for tax purposes. It is also assumed that this was the first time that the client participated in such a venture.
In theory, there is no problem with a taxpayer adopting a 5 April accounting date. Indeed the legislation broadly encourages it, as such an accounting date avoids the need for overlap relief. But resistance may be met if the 2000 tax return has already been submitted without any reference to this activity that is now showing a significant loss.
One line of attack that the client is likely to face relates to when the trade actually commenced. This is significant because any expenditure incurred before this date will be treated for tax purposes as if it were incurred on the commencement date (section 401(1), Taxes Act 1988). As a result, if the commencement date were after 5 April 2000, the client's full profit would be correctly assessable in 2000-01.
The general rule is that the trade commenced when the client was first in a position to sell the stock of the trade. In similar situations, this will usually be when the property was first put on the market. Although it could be argued that the client could have sold the property at any time after it was first acquired, the fact that he intended to convert it first would suggest that a later date should be taken as the commencement date.
The Inland Revenue, however, is likely to contend that the venture is not in the nature of a trade, but rather a capital transaction. This is not so as to assess the profit for capital gains tax, but to bring the profit into the charge of income tax under Case VI of Schedule D under the provisions of section 776, Taxes Act 1988. As far as the client is concerned, this means that certain trading deductions, such as interest, will not qualify for relief. The profit would be assessable in the year in which the gain was made.
Development gains fall squarely within the remit of section 776; and the only escape route is by showing that the transaction was in the course of a trade rather than an isolated occurrence.
'BW' suggests that there may be other similar ventures in the future. If so, the client may be able to show that a trade is indeed being carried on following the decision in Leach v Pogson 40 TC 585. However, it would be advisable to show evidence that there is a genuine intention to make further purchases rather than consider each project as an isolated speculation.
To establish a trading motive, it can be helpful to apply the badges of trade tests enumerated by Sir Nicolas Browne-Wilkinson Vice-Chancellor, in Marson v Morton [1986] STC 463. The relevant tests here include:
* 'That the transaction in question was a one-off transaction.' If there are subsequent transactions, this will greatly assist 'BW's' client's claim to be carrying on a trade.
* 'Is the transaction in question in some way related to the trade which the taxpayer otherwise carries on?' We are told that this is not the case; this works against the client.
* 'What was the source of finance of the transaction?' If the client borrowed money to finance the investment, that would indicate a trading intention.
* 'Was the item which was purchased resold as it stood, or was work done on it or relating to it for the purposes of resale?' The conversion undertaken would indicate a trading intention.
* 'Was the item purchased resold in one lot as it was bought, or was it broken down into saleable lots?' If it was broken down, it is again some indication that it was a trading transaction.
* 'What were the purchasers' intentions as to resale at the time of purchase?' It is clear that the client intended to make a quick profit rather than hold on to the property. This would indicate a trading motive.
* 'Did the item purchased either provide enjoyment for the purchaser or pride of possession or produce income pending resale?' This test also seems to suggest a trading motive.
Whilst the application of these tests appears to suggest that the client was indeed trading, it should be remembered that the Vice-Chancellor emphasised that the tests are not comprehensive and no single item is decisive. Also, the wording of section 776 puts the onus on the taxpayer to show that the property transaction was actually part of a trade. In the circumstances here, it appears that a lot will depend on whether the client can show other projects being actively considered even if not actually pursued. Kalonymous.
The querist does not state what the expenditure prior to 5 April 2000 represented, but presumably it can be inferred that it covers the original cost of the property plus the expenditure up to that date on the conversion. If this is so, there has been no loss. The client has acquired and enhanced an asset, and a loss would only arise if the value had fallen below the cost. It is apparently not proposed to argue that the transaction represented a capital gain but, even if this were possible, no capital loss claim could arise until there was a disposal involving such a loss. Apparently, however, it is proposed to accept that the acquisition and disposal represented a trade or an adventure in the nature of a trade which, on the basis of the facts provided and the wealth of case law on this subject, seems the most likely outcome.
The position in the case of a trade or trading venture would be that accounts up to the chosen accounting date would be required. If the accounting date were 5 April 2000 no loss could be shown, as the cost of the property and of converting it would have to be brought in as ending stock in trade or work in progress at cost (or market value if lower which seems very unlikely). This valuation of stock and work in progress would almost certainly counterbalance the expenditure so that no loss would arise for tax purposes.
It is doubtful in any case whether an accounting date at 5 April 2000 is a realistic supposition. The querist does not state whether the transaction in question is the beginning of a series of property deals or simply a one-off transaction. If it is the latter, it is likely that the Revenue would insist that there was only one possible accounting period, viz. that beginning with the acquisition of the property (or the negotiations for it) and ending with the disposal. If the transaction was merely the beginning of a continuing trade of property-dealing, it would no doubt be possible to choose 5 April 2000 as the first accounting date; but the likely result for the part year would, as stated above, be a no profit/no loss result so the benefits hoped for by the querist would not materialise. A.L.H.S.
Life tenancy complications
A settlement created in 1977 gives the life tenant power to appoint by deed the trust fund for the benefit of the life tenant's sons subject to trust powers and provisions as the life tenant shall decide. The life tenant exercised this power in 1997 so that part of his fund is held on trust for his ten year old son if he shall attain 18. The Inland Revenue accepts that no disposal has occurred for capital gains tax purposes and the new fund remains part of the original settlement.
Do readers consider that the life tenant is the settlor of the new fund for income tax purposes so that the provisions of section 660B, Taxes Act 1988 would apply to the income from the original capital as well as from the income accumulations?
Even though no funds have been added to the settlement by the life tenant, do readers consider that the life tenant, by exercising his power of appointment, is the settlor for capital gains tax purposes of both the new fund made up of the original capital and any subsequent income accumulations fund? If so, is the trustee's annual exemption reduced, owing to the fact that the life tenant has made a number of other settlements since 6 June 1978?
(Query T15,705) C & C.
'C & C' is principally concerned with the operation of Part XV of the Taxes Act 1988 which, it will be recalled, provides an anti-avoidance code. The broad effect of this code is, in specified circumstances, to treat income arising under a 'settlement' as the income of the 'settlor' for tax purposes.
By exercising the power of appointment, the life tenant has caused the original settlement fund to be divided so that only a proportion of the original fund continues to support his life interest ('Fund A') with the balance of the fund ('Fund B') held by the original settlement trustees, but now for the benefit of the life tenant's infant son contingently on his attaining 18.
It is hard to see how the life tenant's voluntary act in effecting the appointment would not be within this deeming code, as the effect of the appointment is the provision by the life tenant of capital funds directly for the purposes of a settlement comprising the new trusts over Fund B, so making the life tenant a 'settlor' of Fund B within section 660G, Taxes Act 1988. In this respect the decisions in Commissioners of Inland Revenue v Buchanan 37 TC 365 and Arthur d'Abreu v Commissioners of Inland Revenue 52 TC 352 seem in point.
It is suggested that the position might be different had the power of appointment been exercisable by the original settlement trustees rather than the life tenant. Not only is the father regarded as a settlor of the capital originally comprising Fund B, he will also be the settlor of property which derives from the original capital, and this will include property and assets representing accumulated income from the original capital (section 660E(7)(b), Taxes Act 1988).
The effect of the Part XV code in this case is that the income of Fund B is treated for income tax purposes as that of the father but (see section 660B(1)(a), Taxes Act 1988) only in so far as that income is paid to or for the benefit of the son.
So, if the intention behind the appointment had been for the higher rate (40 per cent) taxpaying father to alienate part of his taxable income to the son, the goal can still be achieved, although with a lesser saving than perhaps originally envisaged, by the accumulation of Fund B's income until the son's 18th birthday.
It is anticipated that relevant powers of accumulation are available to the Fund B trustees either expressly or by the operation of section 31, Trustee Act 1925. Those powers will bring the income of Fund B into charge to 'the rate applicable to trusts' per section 686, Taxes Act 1988, with the result that the income is taxed on the Fund B trustees at 34 per cent.
If the balance of the income after the payment of tax is accumulated, it will not be treated as the father's income; thus, so long as the income is retained in the Fund B trust, no further income tax is payable. If this policy is being followed, care should be taken with distributions of capital which will be deemed to be of income so far as there is available retained or accumulated income.
If any of Fund B's income is paid to the son, that income is treated as the father's income and taxed on him but with the benefit of a 34 per cent tax credit. In these circumstances, whilst the income has not been successfully alienated, the father's income tax position seems no worse than that which existed before the appointment.
As for the capital gains tax annual allowance, the allowance is divided amongst all of the settlements comprised in a group of qualifying settlements (as defined in Schedule 1 to the Taxation of Chargeable Gains Act 1992); membership of the group is governed by the identity of the 'settlor' of settlements within the group, and since 'settlor' has the meaning given to it by section 660(G), Taxes Act 1988, Fund B could be grouped either with all other qualifying settlements created by the father, or with Fund A and any other qualifying settlements created by the donor of the original settlement. In these circumstances Fund B is allocated to the group comprised of the greatest number of settlements. Digby Bew.
The definition of the terms 'settlement' and 'settlor' for the purposes of Part XV, Chapter I, Taxes Act 1988 is contained within ibid., section 660G(1).
A 'settlement' essentially includes any disposition, trust, covenant, arrangement or transfer of assets, and so the question which falls to be answered is simply whether the settlor, in exercising a special power conferred upon him, has created a settlement within any of these categories of which he is the settlor.
In the ordinary sense, the settlor has clearly disposed of a part of the fund in which his life interest existed by exercising the special power conferred upon him in favour of his minor child; therefore, in my view, the exercise of the power as described by 'C & C' has created a settlement. Support for this analysis can be found in Commissioners of Inland Revenue v Buchanan 37 TC 365, where Lord Goddard found that the surrender of a life interest in favour of the protected life tenant's children was a disposal of that interest.
The important point to consider next is whether or not, as a direct consequence of that surrender of part of the fund in which the life tenant's interest subsisted, ibid., section 660B is at point to treat income arising from the original capital, together with accumulations thereon as income of the life tenant (qua settlor).
'C & C' does not state whether under the terms of the appointment the child's contingent interest carries the vested right in intermediate trust income or whether section 31, Trustee Act 1925 applies.
If section 31, Trustee Act 1925 is to apply, the child's contingent interest is subject to statutory accumulation and maintenance trusts and the income arising in the settlement trustees' hands will be subject to income tax at the rate applicable to trusts. If income is then accumulated until the child attains 18 years of age, no liability will fall on the life tenant (qua settlor) under section 660B because income is neither paid nor applied for the benefit of the unmarried minor child. Section 660B(1)(b) will not be at point here because the settlement created by the life tenant was made before 9 March 1999 (see section 64(6), Finance Act 1999).
If the minor child's interest carries a vested right to intermediate trust income, section 660B will apply if that income is paid or applied for the benefit of the unmarried minor child in the tax year in which it arose. The section treats income paid to such a child of the settlor as the settlor's income for tax purposes. If, however, there is a de facto accumulation, achieved by the trustees retaining the income for the absolute benefit of the child, the income will belong to the child in the year in which it arose and not the settlor.
The capital gains tax position is not so fortunate. This is because, on executing the deed of appointment, the child's fund will still remain settled property (hence no deemed disposal at that time under section 71(1), Taxation of Chargeable Gains Act 1992!). The question of who is to be regarded as the settlor of the whole settlement (for the purposes of the annual exempt amount) is then determined under paragraph 2(7) of Schedule 1 to the Taxation of Chargeable Gains Act 1992 which applies the income tax definitions in section 660G(1) and (2), Taxes Act 1988.
As the life tenant is regarded as a settlor for income tax purposes, he will also be regarded as a settlor for capital gains tax purposes. Paragraph 2(6) of Schedule 1 to the Taxation of Chargeable Gains Act 1992 therefore applies to regard the whole settlement as being created by the settlor who has created the largest group of settlements.
In the case cited by 'C & C', the annual exemption to be applied to the whole settlement will be reduced by the number of post 6 June 1978 settlements made by the life tenant (subject to a minimum of one-tenth of the full individual annual exempt amount, i.e. £7,200). Robert.
Time gentlemen please
In 1965 our client inherited a public house and adjoining living accommodation. A condition of the legacy was that it would ultimately pass to her eldest son, now aged 35.
Until 1985 our client traded as a sole owner. From 1985 until March 2000 the public house and the living accommodation were leased at a commercial rent. In March our client decided not to renew either lease and resumed self employment as a publican.
Our client no longer wishes to be involved in the management of the business, and plans to transfer the property and business to her son as soon as is possible. She is willing to be employed on a part-time basis.
The property and business have been valued in the region of £360,000. The same property would have had a March 1982 valuation of £160,000. Our client incurred costs in the region of £30,000 following a fire in 1987 and received no compensation or insurance monies.
We are concerned about the capital gains and inheritance tax issues that may surface from an imminent transfer, coupled with the possibility that our client's son may sell the business and property in the future. The idea of our client remaining owner for a four-year period which in turn should maximise her capital gains tax relief does not appeal to her. Readers' comments would be welcomed.
(Query T15,706) S&K.
I am struggling to find the capital gains issue that might create a problem. Is 'S&K' concerned to maximise the business asset taper relief? If we are only looking at the value of the property, there should be nothing to worry about, at least for capital gains tax.
A March 1982 value of £160,000 and indexation of 1.047 will give a base cost of £327,520. The additional cost of £30,000 has an indexation factor of 0.574, if the costs were incurred at the end of 1987. As a result, there can be no capital gain. The base cost exceeds the current value. In looking at the position, I have assumed that we have been given the value of the property alone. If any of the value relates to goodwill, there may be a further hoop to go through. Is the trade being disposed of the same trade that existed in March 1982, and how do we treat the goodwill relating to that business?
The foregoing has not taken into account the fact that this property may have been the client's principal private residence since 1982 so that the last three years of ownership and the period of residence will be exempt. Nevertheless, the conclusion seems to be that there is no gain to worry about, at least for the client.
Even if the value given includes an element for the value of the business, a perennial problem when looking at public houses, there will be some value in the property. The property has been the client's throughout. Therefore, proceeds to be allocated to the goodwill of the business will be less than £360,000.
A further point to note is that four years will not maximise taper relief. The property was not a business asset until March 2000. Therefore, 'S&K' will need to split the gain into business and non-business periods and apply the relevant taper. The maximum business taper will not be achieved until the non-business period drops out. So much for those who discussed the legislation in committee stage and said there was no issue.
Business property relief for inheritance tax gives rise to different issues. The living accommodation will not be business property. Also, there are two other issues to consider for business property relief: the period of ownership by the donor and whether the property is still to be owned by the recipient if death occurs within seven years of the gift. From the brief details in the query, it seems that the son is unlikely to own the property if his mother dies within seven years of the gift. She may or may not be entitled to business property relief but there will be no relief unless her son owns the property on her death. Therefore, we should probably forget the relief.
It seems that inheritance tax taper relief is likely to be more valuable in the circumstances described than business property relief. A transfer sooner rather than later appears to be more beneficial and 'S&K' should consider recommending this course of action. At least that way, the son will inherit the value of the property; there appears to be no gain after indexation and even though business property relief is not available yet, it is unlikely to be available anyway. J.W.G.
The £30,000 spent after the 1987 fire should be split between repairs, that are chargeable against the rental income, and any improvements which the client may have taken the opportunity to effect. The latter, duly indexed, augment the cost deductible from the deemed proceeds on transferring the property to her son.
The indexation factor from 31 March 1982 to 5 April 1998 is 1.048, making the 1982 value of £160,000 an effective cost of £327,680. So, ignoring professional costs and the possible addition of 1987 improvements, the surplus computed on a transfer now would be £32,320. Taper relief on business assets so far is 25 per cent, and the current personal exemption is £7,200, leaving a taxable gain of £17,040 to minimise. By waiting two more years, on the basis of current law, further taper relief would reduce that to £880.
One appreciates her desire to shed the burden of sole trading but, as she is still ready to work as an employee, what about a partnership? Let mother and son form a partnership with the agreement that profits and losses be allocated in such sums or ratios as the partners shall at the time of sharing agree. While her son assumes the management burden, she keeps the property and does such work as was her intended employment. Her agreed share of profit can be such sum as would otherwise be salary. Once taper relief has adequately matured, the transfer of property can proceed. All she has then to do is survive the gift by seven years. Man of Kent.
Extract from reply by 'Bear':
Presumably the 'condition' of the legacy amounts to no more than a moral duty, falling short of a precatory trust.
Private residence relief for the (apportioned value of) living accommodation is due for the periods 1982 to 1985 and from March 2000 onwards.
For an early disposal, some retirement relief is still available under section 163, Taxation of Chargeable Gains Act 1992, although the client would need to complete a full year's trading on her own. A transitional period as partner could help.
The hoped for March 1982 valuation could be eroded by the supposed 'condition' (above) but indexation allowance would double its contribution to base cost. It does not appear that the £30,000 spent in 1987 enhanced the property value for the purposes of section 38(1)(b), Taxation of Chargeable Gains Act 1992 and this might not therefore be an allowable expense.
How to complicate life!
A client purchased the ground floor flat of a two-storey property in 1993. In 1996 she purchased the first floor flat and occupied both properties as her home with an internal access door. Each flat was purchased by way of a separate mortgage.
Now she is considering letting the two properties separately and moving to a rented property. The mortgages will have to be converted to a 'buy to let' basis which will probably result in both being remortgaged. She would also like to increase the overall amount loaned to realise some of the equity in the property. Thoughts would be welcome on the following:
(a) If the loans are converted into one loan, will they qualify for interest relief against the rental income?
(b) Would the answer to (a) be different if the total loans did not exceed the amounts currently outstanding and equity was realised in a different way?
(c) Will the properties count as one for the purposes of principal private residence relief?
(d) Would the answer to (c) be different if the flats were sold at different times without being reoccupied?
(e) Will an election to treat the property as principal private residence, whilst renting another property, be permitted?
(f) Are there any other pitfalls?
(Query T15,707) Speedy.
'Speedy's' client appears to have acquired two separate interests in a single property: a leasehold interest in a ground floor flat in 1993 and a leasehold interest in a first floor flat in 1996.
Where a property is let, it becomes part of a Schedule A business and expenses are allowable under Schedule A in broadly the same way as under Schedule D (section 74, Taxes Act 1988). So interest payable on a loan is allowable provided it is incurred wholly or mainly for the purpose of the Schedule A business, for example to purchase or improve a property.
(a) 'Speedy's' client has two loans and the loan interest will qualify for relief when letting commences. (Mortgage interest relief was withdrawn from 6 April 2000.) If the loans are converted into one loan, the interest on the new loan will qualify for relief against rental income because the new loan will replace two qualifying loans.
(b) At the time the property is first let, the market value of the property represents capital introduced into a Schedule A business. Arguably, the client can withdraw her capital, repay her existing loans and take out a new larger loan up to the market value of the property to fund the Schedule A business. However, to the extent that the new loan exceeds the total of the two original loans, it is thought the Inland Revenue would seek to disallow part of the interest. There is an anti-avoidance provision in section 787, Taxes Act 1988 which says relief is not given 'if a scheme has been effected or arrangements have been made such that the sole or main benefit' is a reduction in a tax liability.
(c) Whether the principal private residence exemption in section 222, Taxation of Chargeable Gains Act 1992 applies to both flats as if they are one, will depend on the facts. In Honour v Norris [1992] STC 304 relief was denied where more than one flat was used as the taxpayer's main residence but the flats were in separate buildings. Provided both flats have been occupied by 'Speedy's' client as a single residence with access between the two, principal private residence relief should be available.
(d) It does not matter whether the flats are sold separately; what matters is the period during which each flat was occupied as an only or main residence. The gain will be time apportioned between the exempt and non-exempt periods of ownership. Lettings relief under section 223(4) will also be available.
(e) To be able to make a main residence election the taxpayer must occupy two more properties as her residence. If a property is let out and occupied by someone else, it cannot also be the landlord's main residence (unless it falls within a period of permitted absence within section 223(3), Taxation of Chargeable Gains Act 1992). 'Speedy's' new main residence will be the property she intends to rent and occupy herself.
(f) By remortgaging the property, 'Speedy's' client may find the rate of interest payable increases when she switches from a home loan to a 'buy to let' loan. G.S.
This is an unusual situation in that two flats, which would individually have qualified as residences, have been converted into one residence and are now being re-converted. I feel that these points are, however, transparent.
In response to the specific points:
(a) Provided that the capital raised is used for a qualifying purpose, the loan will qualify for tax relief. Any increase in the size of the loan would be for the purpose of putting money into the client's pocket rather than purchasing the property and thus would not qualify for relief, as the interest would not be applied wholly and exclusively for a qualifying purpose.
(b) Again, the capital would still be used for a qualifying purpose, so tax relief would be available.
(c) 'Dwelling-house' is not defined in the capital gains tax legislation and thus takes on its normal English meaning. The Oxford English Dictionary defines 'dwelling-house' as 'a house occupied as a place of residence' this would appear to include two flats which are jointly occupied as a single residence. Section 222, Taxation of Chargeable Gains Act 1992 grants relief from capital gains tax for gains arising on the disposal of a principal private residence. It is implicit from the question that the two flats were jointly occupied as a private residence (regardless of the fact that they could perhaps have been occupied separately), so relief is available for both as a single unit.
(d) For the entire period of residence, both flats would qualify for relief under section 222. If one flat were then let for a period, it would not qualify for relief as a private residence for that period. However, for any property which has been treated as a private residence at some time, an exemption from capital gains tax is granted for the final 36 months of ownership (section 223(3), Taxation of Chargeable Gains Act 1992). There is a further specific relief for properties which have been let under section 223(4). The gain attributable to the period of let is reduced by the lower of £40,000 and the actual gain.
(e) Residence is really a question of fact. The election would be ineffective without genuine residence see the dicta in Goodwin v Curtis [1998] STC 475. There has to be an intention to reside, on a long-term basis. Broadly, it would be necessary to physically occupy the flat to gain the exemption. However, if the flat were temporarily let and there was evidence that the client intended to re-occupy it, irrespective of whether he in fact did so, this might be seen as a continuing residence. A.D.
Extract from reply by 'Rookery':
There is no difference between these circumstances and building an extension except that 'Speedy's' client purchased a readymade extension. Lewis v Rook [1992] STC 171 established that the correct test was whether the subsidiary property is part of the entity occupied by the taxpayer as a residence. Amalgamating the properties by internal doors achieves that.
This is different from Honour v Norris [1992] STC 304, where the taxpayer failed in a claim that flats in the same vicinity but physically separate were eligible for exemption. Selling one flat and then the other should not alter the position. This is no different from the sale of part of a garden followed by the house.
'Speedy's' client will be entitled to residence exemption for both the periods of occupation and for the final 36 months. In addition he will be entitled to the matching exemption, of up to £40,000, within section 223(4), Taxation of Chargeable Gains Act 1992.
