AS I LEARNT during my time working at a firm of solicitors, in drafting a document you can give terms or persons to be regularly referred to in it any definition you like, however appropriate or inappropriate. If you wanted to, you could therefore have something like: 'This deed is made between Mrs Beatrice Growler (herein after called "the old battleaxe") and Mr George Growler (herein after called "the mean machine") and their son Kevin Growler (herein after called "the hopeless specimen")'.
AS I LEARNT during my time working at a firm of solicitors, in drafting a document you can give terms or persons to be regularly referred to in it any definition you like, however appropriate or inappropriate. If you wanted to, you could therefore have something like: 'This deed is made between Mrs Beatrice Growler (herein after called "the old battleaxe") and Mr George Growler (herein after called "the mean machine") and their son Kevin Growler (herein after called "the hopeless specimen")'. In the circumstances you might conclude that these definitions were highly appropriate but there is nothing to stop the draftsman using other phrases of definition which might be wholly inappropriate, or even confusing; Mrs Growler could be called 'Miss World 2002' and Mr Growler be 'kindness personified', for the definitions are simply shorthand labels for drafting purposes only. The only inhibition on the choice of definitions is perhaps the desire to get the bill paid afterwards.
The draftsman of the capital gains tax legislation in 1965 was well up to speed with all this. Unfortunately, in at least one respect, as his fee would be paid anyway, he decided to choose a highly confusing and strange term of definition and my guess is that it took many of us at least twenty-five years to discover what he had done. It was a rotten trick. We do not need the law to be giving us signposts pointing the wrong way.
In fairly general terms, the misleading label mattered less prior to the introduction of taper relief in 1998, but following the changes to the capital gains tax rules, which were deemed to be necessary at that time, it is now crucial to have a proper understanding of the area concerned.
The draftsman's bright idea
The misleading label in the legislation is in section 104(3), Taxation of Chargeable Gains Act 1992 and is the word 'securities'. The section goes on to say that 'securities' means 'shares or securities' – and nobody will want to quarrel with that – but it also means:
'Any other assets where they are of a nature to be dealt in without identifying the particular assets disposed of or acquired'.
All this is buried in Part IV of the Act which has the main heading 'shares, securities, options, etc.'.
So if your client has a foreign currency account which is not for personal expenditure outside the United Kingdom, I doubt whether you would think of looking in Part IV of the Act to see what the rules are for working out gains in relation to the account. It is as if the draftsman's rickety signpost says 'to the seaside this way' but it is actually the only way inland as well.
The main heading for this Part of the Act should not have been 'securities' at all. It should have been 'fungibles'. No doubt the draftsman thought he was being helpful because the word 'fungible' is not used in common parlance – I bet you have never heard it on Coronation Street or EastEnders. So as the most commonly encountered example of a fungible asset is shares and securities, this must be why the section collects everything within its ambit under that label.
The Revenue's Capital Gains Tax Manual helpfully tells us, at paragraph 50222, that 'a fungible asset is one in which it is not possible to identify the individual components of a holding because they are identical. For example, all ICI ordinary shares are the same. If a person sells some of their shares, they cannot identify which shares have been sold'.
Of course in the case of private company shares they are commonly numbered, but there is no point to be made out of this because section 106A, Taxation of Chargeable Gains Act 1992 says that the share identification rules in the Act have effect notwithstanding any other identification made by the transfer document.
The Revenue's manual also gives the example of milk quota as another fungible asset falling under the identification rules or securities. But there are all sorts of other examples as well. It is likely that most commodities which are not exempt as tangible wasting assets (see section 45 of the Act) will be of a fungible nature; so too is the interest of a tenant in common in a jointly held property (and I am grateful to Maurice Parry-Wingfield for pointing this out to me some time ago). The interest of a partner in the goodwill of the partnership concerned is also a fungible asset and indeed if the partnership owns fixed assets or property which are not themselves fungible assets, I do not see why the fractional interests of the partners in those fixed assets are not themselves fungible, although there seems to be a commonly held viewpoint that they are not.
Does it matter?
What is the practical impact of all this on capital gains tax calculations? The answer is that following the Finance Act 1998 the calculations with all fungible assets have become very much more complicated. Up to that time there was a pooling system in operation and indexation relief was given by means of an indexed pool. This system was considered incompatible with taper relief which requires individual dates of acquisition to be established for the purposes of calculating the holding period for the asset. Thus, in an ironic twist of fate, taper relief meant that assets which by their very nature in the real world have to be pooled could no longer be pooled for capital gains tax purposes. Each individual acquisition after 5 April 1998 must be separately identified, tabulated and have a separate capital gains tax calculation including its own taper relief.
This rule is entirely unsuited to fungible assets. Many of these types of assets are the sort of thing which a person might acquire and dispose of in all sorts of irregular bits and pieces. For example, if a United Kingdom trader opens a foreign currency bank account for overseas business, the account will be a chargeable asset and the calculations in relation to it could be mind-boggling. The identification rules will follow that for shares and securities and, according to the legislation, one should be identifying money in and money out firstly to acquisitions and disposals on the same day, secondly to acquisitions within thirty days after a disposal and then on a last in, first out basis. Every little transaction in and out needs its own separate calculation.
One might perhaps argue that the account itself is only one asset and so the credits to it are enhancement expenditure, and the withdrawals are part disposals out of the one asset. However, my understanding is that the Revenue does not see the position this way.
Non-domiciliaries
For non-domiciliaries, the position could be even worse. Unless they can show that a foreign currency bank account is exempt under section 269, Taxation of Chargeable Gains Act 1992 (and if the money is used for remittance to the United Kingdom it will be difficult to satisfy the test that it was acquired for personal expenditure outside the United Kingdom), the account will be a chargeable asset and the foreign currency gains will be taxable on the remittance basis. The big drawback is that whilst such gains will be taxable, losses arising will be non-allowable because of the general rule for losses of non-domiciled individuals in section 16(4) of the Act. Non-domiciliaries cannot claim loss relief in respect of foreign situs assets; it is a one way street in the Revenue's favour.
Partnerships
I understand that similar difficulties arise with goodwill and other capital assets held by major partnerships. Changes in capital sharing ratios might be frequent with the introduction and retirement of partners and also unexpected deaths of others. One might hope that the same day rule will rarely interfere, but the reacquisition of goodwill on the death of a partner within thirty days of goodwill reduced on the introduction of a partner will be a complication one could do without in all the calculations. In a sizeable partnership, once again the problem will be mind-boggling.
Other problems
The identification rules for fungible assets have already caused headaches for the legislature. Some were set out in my article in Taxation, 9 November 2000 entitled 'The Law Is An Ass'. For example, when a person becomes absolutely entitled to assets in a trust, there is a deemed disposal by the trustees. As this is a sale and reacquisition, does not the same day rule apply so that there is virtually no gain? The Revenue's Tax Bulletin issued in April 2001 says that the Revenue's view is that the same day rule 'which matches securities of the same class does not apply in any case where a particular shareholding is deemed to be disposed of and the same asset reacquired'. More reasoning was not given, but there seems to be an inference that the reference to 'securities of the same class' means they must be different securities. This does not seem particularly persuasive. If Harry gives Bert a golden delicious apple and Bert immediately gives it back because he does not want it, has not Harry reacquired an apple of the same type as he gave away? It seems indisputable that he has.
A second problem relates to the emigration charge in relation to trusts. If the trustees sell all their shares before emigrating and then reacquire them within thirty days but after emigrating, they will only hold cash at the time of emigration. There should then be no tax charge. The same article in the Tax Bulletin disputes this view, saying that because the thirty day rule matches the pre-emigration disposal with the post-emigration reacquisition, it must follow that for capital gains tax purposes the original shareholding is deemed to have been held throughout. This again seems far-fetched, and is disputed by leading tax counsel. The legislation does not go so far as to deem the original holding as having been retained. It simply lays down the rules for identifying sale proceeds with acquisition costs for the purposes of computing gains. There is no deeming provision to say that the identification process treats the shares as having been held on every day in the intervening period.
Corporate partners
If a partnership includes a number of individuals and also a corporate partner, not only is the preparation of trading accounts an unduly complex matter (one set being required to comply with income tax rules, and another to comply with corporation tax rules), but any adjustment of goodwill between the corporate partner and the other partners seems to involve a skirmish between differing capital gains tax identification rules. The corporate partner is still under the old pooling system with indexation relief whereas the individual partners ceased to be able to pool acquisitions of goodwill after 5 April 1998. Adjustments of goodwill between the two types of partner may well be at cost price rather than market value, under the Revenue's longstanding Statement of Practice on partnerships, but the separate identification rules for the two add yet more layers of complexity to an already difficult situation.
Solutions
One suggested way round the problem for partnerships (gleaned from a recent Chartered Institute of Taxation seminar), whether or not including a corporate partner, is not to have the income sharing ratio the same for capital sharing. In this way it should be a little easier to control changes in the sharing ratio, although unexpected deaths or retirements could no doubt easily upset all the careful planning. It will in any event be best to keep regularly updated records of all movements in goodwill so that a historic research exercise never becomes necessary.
The problems for non-domiciliaries with their foreign accounts used for remittances to the United Kingdom are particularly insidious. Many will not have the slightest knowledge of any problem which will only surface after many years if and when the Revenue decides to open an enquiry into their affairs. The clients will probably not take kindly to any suggestion that a tax adviser should manage debits and credits to foreign accounts with a view to minimising tax problems.
A concessionary practice is recorded in the Revenue's Capital Gains Manual at paragraph 78333:
'Provided the practice is followed consistently and produces a reasonable overall result, you may accept that a net figure for deposits and withdrawals be computed for each calendar month or part month within a tax year or accounting period. To find the acquisition costs and disposal proceeds, each monthly deposit or withdrawal thus computed should be converted into sterling at the average rate of exchange for the month; any reasonable method of arriving at this average is acceptable, again provided it is followed consistently. Identification and indexation apply in the normal way for the purpose of computing the gains on the withdrawals.'
This is a helpful short cut, but still leaves a tax position for any longstanding underlying balance on an account when it is withdrawn (and does the Revenue expect the 30-day post acquisition rule to be operated when there is a 30-day month?).
One practitioner said recently that he side steps this issue by advising non-domiciliaries to remit funds from a sterling account overseas. I am not sure that this is the complete answer but it does move the problem one step further away.
Reform ideas
The current problem with fungibles largely stems from the desire in 1998 to contain the loss of tax under claims for taper relief under the new capital gains tax rules. However, this objective could be largely achieved if the new identification rules were confined to shares and securities; other fungible assets could then be treated to taper relief from the earliest acquisition, in the same way as enhancement expenditure on other assets is dated back for taper to the earliest acquisition and also in the same way that merging assets have backdated taper relief. The Exchequer's small loss would be far outweighed by the simplification of matters for the taxpayer.
Business property
Some fungible assets will be eligible for inheritance tax business property relief and I have not even touched on the further problems which occur in this area. However unwelcome the identification rules are for capital gains tax purposes, at least there are some rules! The inheritance tax legislation has no identification rules to enable one to establish clearly in any particular case whether or not the two year period of ownership test is satisfied, and so it leaves you to argue the toss with the Capital Taxes Office. Perhaps the rickety signpost in the capital gains tax legislation is after all slightly better than no signpost whatsoever.
