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07 March 2001
Anti-Avoidance Tactics – II
OWEN CLUTTON BA, LLB, BCL, ATII, solicitor and partner in Macfarlanes continues his examination of the capital gains tax anti-avoidance rule in Finance Act 2000.
THE SCOPE OF a number of anti-avoidance rules covering a diverse number of topics were considered in the first article. This article will review the provisions of the new Schedule 4B of the Taxation of Chargeable Gains Act 1992 introduced by Schedule 25 of the Finance Act 2000.
OWEN CLUTTON BA, LLB, BCL, ATII, solicitor and partner in Macfarlanes continues his examination of the capital gains tax anti-avoidance rule in Finance Act 2000.
THE SCOPE OF a number of anti-avoidance rules covering a diverse number of topics were considered in the first article. This article will review the provisions of the new Schedule 4B of the Taxation of Chargeable Gains Act 1992 introduced by Schedule 25 of the Finance Act 2000.
Anti-Avoidance Tactics – II
OWEN CLUTTON BA, LLB, BCL, ATII, solicitor and partner in Macfarlanes continues his examination of the capital gains tax anti-avoidance rule in Finance Act 2000.
THE SCOPE OF a number of anti-avoidance rules covering a diverse number of topics were considered in the first article. This article will review the provisions of the new Schedule 4B of the Taxation of Chargeable Gains Act 1992 introduced by Schedule 25 of the Finance Act 2000.
The new provisions are designed to counteract what came to be known as flip-flop schemes. These schemes were intended to circumvent in particular the provisions of sections 77 and 86, Taxation of Chargeable Gains Act 1992 under which the settlors of trusts would be assessed to gains made by the trustees. In essence the schemes involved the following steps:
In year 1, the trustees of a trust (trust 1) would borrow money against the security of the trust assets and advance the borrowed money to a new trust (trust 2).
In the same year, the trustees of trust 1 excluded the settlor and spouse and other beneficiaries within the settlor class as beneficiaries of trust 1.
In year 2, the trustees of trust 1 would dispose of the trust assets and realise gains.
In the same year, the trustees of trust 2 would transfer assets to the beneficiaries of trust 2 which could include the settlor.
The trustees of trust 1 would then repay the borrowing from the sale proceeds.
As the settlor was no longer interested in trust 1 in the year that the gain was realised, it was argued that gains made by that trust would not be attributable to the settlor under section 86 (section 77 in the case of a United Kingdom resident trust). There were great practical problems in flip flop schemes, but they were nonetheless resorted to with increasing frequency following the introduction of the Finance Act 1998 which extended the scope of section 86.
Schedule 4B
Schedule 4B is very wide ranging. It provides (in paragraph 10) that the trustees of a trust are deemed to have disposed of and immediately reacquired the whole (or a proportion) of each of the chargeable assets that form part of the settled property if the following conditions are met:
the trustees make a 'transfer of value';
in the year of the transfer of value, the trust is within the settlor charging provisions of sections 77 or 86, or the beneficiary charging provisions of section 87;
the transfer of value made by the trustees is 'linked' with a trustee borrowing.
The deemed disposal by the trustees is deemed to be at market value and at arm's length (paragraph 10(2)(b)) and so the gain cannot be held over.
Wide definitions of terms
The scope of the new provisions can be seen from the width of the terms used. A transfer of value is widely defined in paragraph 2. It is not limited to transfers being made to beneficiaries. It includes loans as well as outright advances. While the term is well known in the context of inheritance tax, as far as the writer is aware it is the first time that it has been used in the context of capital gains tax. The meaning of the term as defined in paragraph 2 is also entirely different from the inheritance tax definition.
The amount or quantum of the transfer of value is also addressed. The quantum of the transfer of value, where a loan is made, is the value of the cash or asset loaned (paragraph 2(3)). Compare this with the much lower quantum of a capital payment for the purpose of section 87 where a loan or free use of an asset is conferred, as in Billingham v Cooper [2000] STC 122. The quantum of the transfer of value is relevant in determining the extent of the trustee's deemed disposal (see further below).
The term trustee borrowing is defined in paragraph 4 and includes certain transfers of assets to trustees.
A transfer of value is linked with a trustee borrowing if at the relevant time, i.e. when the transfer of value is made, there is any outstanding trustee borrowing (paragraph 5). There is no need, therefore, for the trustee borrowing to have been directly used to make the transfer of value. There is outstanding trustee borrowing to the extent that a loan taken out by the trustees is outstanding and the proceeds of the trustee borrowing have not been (i) taken into account in relation to an earlier transfer of value or (ii) applied for 'normal trust purposes' (see paragraph 6).
The proceeds of a trustee borrowing are treated as having been applied for 'normal trust purposes' if either of the following are satisfied (paragraph 6). Firstly, if the proceeds have been used by the trustees in paying 'bona fide current expenses' incurred by them in administering the settlement or any of the settled property. Secondly, the borrowing will have been applied for normal trust purposes if the funds have been applied by the trustees, (i) in paying for 'an ordinary trust asset' and the payment has been made under a transaction at arm's length, and (ii) the asset forms part of the settled property immediately after the transfer of value has been made (or the asset is represented by other assets), and (iii) the amount so paid is an allowable deduction for capital gains tax purposes. It should be noted that the definition of normal trust purposes can be amended by regulation (paragraph 9).
The question then arises as to what assets qualify as an 'ordinary trust asset'. The definition is contained in paragraph 7 and is quite restrictive. The term ordinary trust asset comprises shares or securities (as defined in section 132), tangible property movable and immovable and any other property which is used for the purposes of a trade, profession or vocation carried on by the trustees or a beneficiary with an interest in possession in the trust assets. It should be noted that the definition does not cover intellectual property.
The deemed disposal
There is a limiting factor which renders the application of the rules less harsh. Unlike the deemed disposal of trust assets which is provided for in Schedule 4A where consideration is received on the sale of trust interests (see part one of this article), in the case of Schedule 4B the whole of the trust assets will not automatically be deemed to have been disposed of. The rules on this are detailed and are contained in paragraphs 11 and 12.
Only a proportion (and not the whole) of each chargeable asset will be deemed to have been disposed of if the amount of the value transferred by the trustees is less than the 'effective value of the remaining chargeable assets' held by the trustees. This proportion is the proportion of the 'effective value' of the 'remaining chargeable assets' which is represented by the value transferred by the trustees or, if less, by the amount of the outstanding trustee borrowing. In any other case the whole of each chargeable asset is deemed to have been disposed of.
It should be noted that in calculating the effective value of the remaining chargeable assets the amount of the trustee borrowing attributable to those assets is deducted.
The definitions used here are important.
The term 'remaining chargeable assets' is defined (paragraph 10(1)) as being chargeable assets which form part of the settled property immediately after the time when the transfer of value is effectively made or completed. The effective completion of a transfer means the point at which the person acquiring an asset from trustees becomes unconditionally entitled to the subject matter of the transfer.
An asset is a chargeable asset if a gain on a disposal of the asset by the trustees would be a chargeable gain.
The term 'effective value of the remaining chargeable assets' is important in applying the formulae set out in paragraph 11 in order to determine the proportion of each chargeable asset deemed to be disposed of. This term is defined as meaning the aggregate market value of the remaining chargeable assets as reduced by so much of that value as is attributable to trustee borrowing (paragraph 11(3)).
Paragraph 12 then elaborates on this. The value of an asset is attributable to trustee borrowing to the extent that the trustees have applied the proceeds of the borrowing in acquiring or enhancing the value of the asset, or the asset represents an asset which was acquired by the trustees applying the proceeds of trustee borrowing in this way.
The rules may be explained best by looking at the formulae set out in paragraph 11 of Schedule 4B and some examples.
If the value transferred is less than the outstanding trustee borrowing and it is also less than the effective value of the remaining chargeable assets, the proportion of each chargeable asset deemed disposed of is as follows.
VT divided by EV
where VT is the value transferred and EV is the effective value of the remaining chargeable assets.
Example 1
A trust has chargeable assets of £100 and Sterling cash of £100. The trustees pay to a beneficiary £10 funded by a bank loan of £12. The proportion of each chargeable asset deemed disposed of is:
10/100=10 per cent
If the value transferred is not less than the outstanding trustee borrowing but is less than the effective value of the remaining chargeable assets the formula is:
TB divided by EV
where TB is the amount of the outstanding trustee borrowing. If in the circumstances above the payment to the beneficiary was £15 then the proportion of each chargeable asset deemed disposed of would be:
12/100=12 per cent
In other cases the deemed disposal is of the whole of each chargeable asset. This will be the case, therefore, if the value of the transfer of value exceeds the effective value of the remaining chargeable assets, and not, in this case restricted to the amount of the outstanding trustee borrowing.
Example 2
A trust has chargeable assets of £100 and Sterling cash of £100. The trustees borrow £12 and pay the beneficiary £112 funded by the loan plus the Sterling cash. Because the value transferred exceeds the effective value of the remaining chargeable assets the whole of each chargeable asset is deemed to have been disposed of even though the trustee borrowing was only £12.
While these formulae are generally helpful in targeting the scope of the avoidance rules this last provision seems wider than is necessary.
Overview
A number of comments generally on Schedule 4B are worth making.
Narrow definition
The definition of ordinary trust asset is not wide. Intangible assets such as intellectual property are not covered, and neither are foreign bank accounts or foreign currency. On the face of it a trustee borrowing money and placing it on deposit in a foreign currency account does not apply the money for normal trust purposes. This will represent an outstanding trustee borrowing which could bring Schedule 4B into play.
Loans to underlying companies
Normal trust purposes does not include an onward loan by trustees to an underlying company. It would only qualify if the loan was evidenced by a security within the meaning of section 132 being issued by the company.
Internal borrowings
A borrowing from an underlying company, even if wholly owned by the trust and funded only by the trust, would be a trustee borrowing within the meaning of Schedule 4B and bring the Schedule into play if a distribution were made to a beneficiary or some other transfer of value were made by the trustees.
This is a particular trap. It can be avoided by a payment of a dividend to the trustees rather than by a loan if the company has distributable profits.
Resident settlor interested trusts
Schedule 4B applies not only to non-resident trusts, but also to United Kingdom resident trusts in which the settlor is interested under section 77. Many domestic United Kingdom trust structures which may seem a world removed from the adventurous terrain of flip-flop schemes are within the new provisions. The only trusts not within Schedule 4B are United Kingdom resident trusts from which the settlor and spouse are excluded from benefit.
Application worldwide
These provisions will affect settlements which may only at some later stage have any connection with the United Kingdom, as all non-resident settlements are, since the Finance Act 1998, potentially within section 87, Taxation of Chargeable Gains Act 1992 regardless of the residence or domicile of the settlor. Paragraph 3, defining what is meant by a settlement within section 87, is very wide. No existing United Kingdom beneficiary is required to bring the Schedule into play. A trust with no current United Kingdom connection at all could trigger disposals under Schedule 4B giving rise to gains (in addition to gains on actual disposals) which could be visited on future United Kingdom beneficiaries receiving capital payments many years hence.
The pool of gains
The allocation of gains arising under Schedule 4B should be born in mind. This is dealt with in Schedule 4C which applies where gains are not attributed to the settlor on an arising basis under section 86. The Schedule 4B trust gains are treated as a separate pool and can be attributed to beneficiaries receiving capital payments under the settlement to which the Schedule 4B trust gains accrued and also in certain circumstances to a beneficiary receiving a capital payment from a transferee settlement. Transferee settlement here is defined by reference to the transfer of value by the transferor settlement and means any settlement which is the recipient of the transfer of value.
Wide ranging provisions
It will be seen from this article that the provisions of Schedule 4B are detailed and can apply in a number of situations far removed from the 'flip-flop' schemes against which the Schedule was primarily directed. While the provisions are extremely wide ranging and can apply in a number of perfectly innocent situations, such as the borrowing of money by trustees from an underlying investment holding company, there is some proportionality in the way the deemed disposal formula works.
OWEN CLUTTON BA, LLB, BCL, ATII, solicitor and partner in Macfarlanes continues his examination of the capital gains tax anti-avoidance rule in Finance Act 2000.
THE SCOPE OF a number of anti-avoidance rules covering a diverse number of topics were considered in the first article. This article will review the provisions of the new Schedule 4B of the Taxation of Chargeable Gains Act 1992 introduced by Schedule 25 of the Finance Act 2000.
The new provisions are designed to counteract what came to be known as flip-flop schemes. These schemes were intended to circumvent in particular the provisions of sections 77 and 86, Taxation of Chargeable Gains Act 1992 under which the settlors of trusts would be assessed to gains made by the trustees. In essence the schemes involved the following steps:
In year 1, the trustees of a trust (trust 1) would borrow money against the security of the trust assets and advance the borrowed money to a new trust (trust 2).
In the same year, the trustees of trust 1 excluded the settlor and spouse and other beneficiaries within the settlor class as beneficiaries of trust 1.
In year 2, the trustees of trust 1 would dispose of the trust assets and realise gains.
In the same year, the trustees of trust 2 would transfer assets to the beneficiaries of trust 2 which could include the settlor.
The trustees of trust 1 would then repay the borrowing from the sale proceeds.
As the settlor was no longer interested in trust 1 in the year that the gain was realised, it was argued that gains made by that trust would not be attributable to the settlor under section 86 (section 77 in the case of a United Kingdom resident trust). There were great practical problems in flip flop schemes, but they were nonetheless resorted to with increasing frequency following the introduction of the Finance Act 1998 which extended the scope of section 86.
Schedule 4B
Schedule 4B is very wide ranging. It provides (in paragraph 10) that the trustees of a trust are deemed to have disposed of and immediately reacquired the whole (or a proportion) of each of the chargeable assets that form part of the settled property if the following conditions are met:
the trustees make a 'transfer of value';
in the year of the transfer of value, the trust is within the settlor charging provisions of sections 77 or 86, or the beneficiary charging provisions of section 87;
the transfer of value made by the trustees is 'linked' with a trustee borrowing.
The deemed disposal by the trustees is deemed to be at market value and at arm's length (paragraph 10(2)(b)) and so the gain cannot be held over.
Wide definitions of terms
The scope of the new provisions can be seen from the width of the terms used. A transfer of value is widely defined in paragraph 2. It is not limited to transfers being made to beneficiaries. It includes loans as well as outright advances. While the term is well known in the context of inheritance tax, as far as the writer is aware it is the first time that it has been used in the context of capital gains tax. The meaning of the term as defined in paragraph 2 is also entirely different from the inheritance tax definition.
The amount or quantum of the transfer of value is also addressed. The quantum of the transfer of value, where a loan is made, is the value of the cash or asset loaned (paragraph 2(3)). Compare this with the much lower quantum of a capital payment for the purpose of section 87 where a loan or free use of an asset is conferred, as in Billingham v Cooper [2000] STC 122. The quantum of the transfer of value is relevant in determining the extent of the trustee's deemed disposal (see further below).
The term trustee borrowing is defined in paragraph 4 and includes certain transfers of assets to trustees.
A transfer of value is linked with a trustee borrowing if at the relevant time, i.e. when the transfer of value is made, there is any outstanding trustee borrowing (paragraph 5). There is no need, therefore, for the trustee borrowing to have been directly used to make the transfer of value. There is outstanding trustee borrowing to the extent that a loan taken out by the trustees is outstanding and the proceeds of the trustee borrowing have not been (i) taken into account in relation to an earlier transfer of value or (ii) applied for 'normal trust purposes' (see paragraph 6).
The proceeds of a trustee borrowing are treated as having been applied for 'normal trust purposes' if either of the following are satisfied (paragraph 6). Firstly, if the proceeds have been used by the trustees in paying 'bona fide current expenses' incurred by them in administering the settlement or any of the settled property. Secondly, the borrowing will have been applied for normal trust purposes if the funds have been applied by the trustees, (i) in paying for 'an ordinary trust asset' and the payment has been made under a transaction at arm's length, and (ii) the asset forms part of the settled property immediately after the transfer of value has been made (or the asset is represented by other assets), and (iii) the amount so paid is an allowable deduction for capital gains tax purposes. It should be noted that the definition of normal trust purposes can be amended by regulation (paragraph 9).
The question then arises as to what assets qualify as an 'ordinary trust asset'. The definition is contained in paragraph 7 and is quite restrictive. The term ordinary trust asset comprises shares or securities (as defined in section 132), tangible property movable and immovable and any other property which is used for the purposes of a trade, profession or vocation carried on by the trustees or a beneficiary with an interest in possession in the trust assets. It should be noted that the definition does not cover intellectual property.
The deemed disposal
There is a limiting factor which renders the application of the rules less harsh. Unlike the deemed disposal of trust assets which is provided for in Schedule 4A where consideration is received on the sale of trust interests (see part one of this article), in the case of Schedule 4B the whole of the trust assets will not automatically be deemed to have been disposed of. The rules on this are detailed and are contained in paragraphs 11 and 12.
Only a proportion (and not the whole) of each chargeable asset will be deemed to have been disposed of if the amount of the value transferred by the trustees is less than the 'effective value of the remaining chargeable assets' held by the trustees. This proportion is the proportion of the 'effective value' of the 'remaining chargeable assets' which is represented by the value transferred by the trustees or, if less, by the amount of the outstanding trustee borrowing. In any other case the whole of each chargeable asset is deemed to have been disposed of.
It should be noted that in calculating the effective value of the remaining chargeable assets the amount of the trustee borrowing attributable to those assets is deducted.
The definitions used here are important.
The term 'remaining chargeable assets' is defined (paragraph 10(1)) as being chargeable assets which form part of the settled property immediately after the time when the transfer of value is effectively made or completed. The effective completion of a transfer means the point at which the person acquiring an asset from trustees becomes unconditionally entitled to the subject matter of the transfer.
An asset is a chargeable asset if a gain on a disposal of the asset by the trustees would be a chargeable gain.
The term 'effective value of the remaining chargeable assets' is important in applying the formulae set out in paragraph 11 in order to determine the proportion of each chargeable asset deemed to be disposed of. This term is defined as meaning the aggregate market value of the remaining chargeable assets as reduced by so much of that value as is attributable to trustee borrowing (paragraph 11(3)).
Paragraph 12 then elaborates on this. The value of an asset is attributable to trustee borrowing to the extent that the trustees have applied the proceeds of the borrowing in acquiring or enhancing the value of the asset, or the asset represents an asset which was acquired by the trustees applying the proceeds of trustee borrowing in this way.
The rules may be explained best by looking at the formulae set out in paragraph 11 of Schedule 4B and some examples.
If the value transferred is less than the outstanding trustee borrowing and it is also less than the effective value of the remaining chargeable assets, the proportion of each chargeable asset deemed disposed of is as follows.
VT divided by EV
where VT is the value transferred and EV is the effective value of the remaining chargeable assets.
Example 1
A trust has chargeable assets of £100 and Sterling cash of £100. The trustees pay to a beneficiary £10 funded by a bank loan of £12. The proportion of each chargeable asset deemed disposed of is:
10/100=10 per cent
If the value transferred is not less than the outstanding trustee borrowing but is less than the effective value of the remaining chargeable assets the formula is:
TB divided by EV
where TB is the amount of the outstanding trustee borrowing. If in the circumstances above the payment to the beneficiary was £15 then the proportion of each chargeable asset deemed disposed of would be:
12/100=12 per cent
In other cases the deemed disposal is of the whole of each chargeable asset. This will be the case, therefore, if the value of the transfer of value exceeds the effective value of the remaining chargeable assets, and not, in this case restricted to the amount of the outstanding trustee borrowing.
Example 2
A trust has chargeable assets of £100 and Sterling cash of £100. The trustees borrow £12 and pay the beneficiary £112 funded by the loan plus the Sterling cash. Because the value transferred exceeds the effective value of the remaining chargeable assets the whole of each chargeable asset is deemed to have been disposed of even though the trustee borrowing was only £12.
While these formulae are generally helpful in targeting the scope of the avoidance rules this last provision seems wider than is necessary.
Overview
A number of comments generally on Schedule 4B are worth making.
Narrow definition
The definition of ordinary trust asset is not wide. Intangible assets such as intellectual property are not covered, and neither are foreign bank accounts or foreign currency. On the face of it a trustee borrowing money and placing it on deposit in a foreign currency account does not apply the money for normal trust purposes. This will represent an outstanding trustee borrowing which could bring Schedule 4B into play.
Loans to underlying companies
Normal trust purposes does not include an onward loan by trustees to an underlying company. It would only qualify if the loan was evidenced by a security within the meaning of section 132 being issued by the company.
Internal borrowings
A borrowing from an underlying company, even if wholly owned by the trust and funded only by the trust, would be a trustee borrowing within the meaning of Schedule 4B and bring the Schedule into play if a distribution were made to a beneficiary or some other transfer of value were made by the trustees.
This is a particular trap. It can be avoided by a payment of a dividend to the trustees rather than by a loan if the company has distributable profits.
Resident settlor interested trusts
Schedule 4B applies not only to non-resident trusts, but also to United Kingdom resident trusts in which the settlor is interested under section 77. Many domestic United Kingdom trust structures which may seem a world removed from the adventurous terrain of flip-flop schemes are within the new provisions. The only trusts not within Schedule 4B are United Kingdom resident trusts from which the settlor and spouse are excluded from benefit.
Application worldwide
These provisions will affect settlements which may only at some later stage have any connection with the United Kingdom, as all non-resident settlements are, since the Finance Act 1998, potentially within section 87, Taxation of Chargeable Gains Act 1992 regardless of the residence or domicile of the settlor. Paragraph 3, defining what is meant by a settlement within section 87, is very wide. No existing United Kingdom beneficiary is required to bring the Schedule into play. A trust with no current United Kingdom connection at all could trigger disposals under Schedule 4B giving rise to gains (in addition to gains on actual disposals) which could be visited on future United Kingdom beneficiaries receiving capital payments many years hence.
The pool of gains
The allocation of gains arising under Schedule 4B should be born in mind. This is dealt with in Schedule 4C which applies where gains are not attributed to the settlor on an arising basis under section 86. The Schedule 4B trust gains are treated as a separate pool and can be attributed to beneficiaries receiving capital payments under the settlement to which the Schedule 4B trust gains accrued and also in certain circumstances to a beneficiary receiving a capital payment from a transferee settlement. Transferee settlement here is defined by reference to the transfer of value by the transferor settlement and means any settlement which is the recipient of the transfer of value.
Wide ranging provisions
It will be seen from this article that the provisions of Schedule 4B are detailed and can apply in a number of situations far removed from the 'flip-flop' schemes against which the Schedule was primarily directed. While the provisions are extremely wide ranging and can apply in a number of perfectly innocent situations, such as the borrowing of money by trustees from an underlying investment holding company, there is some proportionality in the way the deemed disposal formula works.
