Whose Purpose Is It?

ANDREW WHITE MA, FCA considers the meaning of the word 'purpose' in determining whether shares qualify as business assets for taper relief.

There can be little doubt that the introduction of taper relief in 1998, while welcome in many respects, has added an additional layer of complexities to an already difficult area of tax law.

In June of this year, the Inland Revenue published Tax Bulletin 53 which sought to clarify its thinking on a number of matters of interpretation in relation to the legislation. Many of its views, not least in relation to the definition of a 'security', have already given rise to some heated debate amongst tax professionals. However, the aspect which will be considered here in more detail is the question of shares qualifying as business assets and, more particularly, the definition of 'trading company' for this purpose.

The question has of course become one of considerable importance. When taper relief was first introduced, the legislation granted a much more generous relief to 'business assets' than to other assets. The effect of this generosity has been extended in subsequent Finance Acts, not only in the rate of relief available in terms of the length of the holding period required, but also in the definition of 'business asset' itself. From April of next year, a higher rate taxpayer will be able to enjoy a capital gains tax rate of just 10 per cent after only two years on the disposal of any shares in an unquoted trading company without reference to questions of employment or size of holding which were features of the original legislation. Thus, the question of what constitutes a trading company for this purpose becomes crucial.

Trading company

The legislation itself is to be found in Schedule A1 to the Taxation of Chargeable Gains Act 1992. Paragraph 4 lays down that business asset treatment will apply to shares held in 'qualifying' companies. Paragraph 6 sets out the various tests which determine whether a company is a qualifying company for this purpose. Apart from the new relief which extends the business asset definition to non-trading companies in which the employee-shareholder does not have a material interest, all of these tests are governed by the overall requirement that the company must be 'a trading company or the holding company of a trading group'. Paragraph 22 states that a trading company is a company which is 'either:

(a) a company existing wholly for the purpose of carrying on one or more trades; or

(b) a company that would fall within paragraph (a) above apart from any purposes capable of having no substantial effect on the extent of the company's activities.'

'Purpose'

Tax Bulletin 53 devotes over 3,000 words to the interpretation of this part of the legislation and related issues. Yet it is the word 'purpose' to which insufficient attention may have been given.

The first point to examine is why the question of purpose is so important. It may be instructive to contrast the legislation on taper relief with that of business property relief for inheritance tax. 'Relevant business property' for the purposes of that relief is defined in section 105(3), Inheritance Tax Act 1984 which states that 'a business or interest in a business, or shares in or securities of a company, are not relevant business property if the business … consists wholly or mainly of one or more of the following, that is to say, dealing in securities, stocks or shares, land or buildings or making or holding investments'.

Note the passive phrase 'consists of' and contrast this with the reference in the taper relief legislation to the active 'purpose' tests. In other words, a business can be denied business property relief simply because, as a matter of fact, it consists wholly or mainly of one of the proscribed activities. The question of the taxpayer's purpose is not relevant. There is no requirement to ascertain how the existing state of affairs came about.

The legislation dealing with taper relief, on the other hand, specifically refers to 'purpose'. In other words, it is not good enough simply to consider the extent of the company's activities at any point in time. We must also ask whether or not the company exists for the purpose of carrying out these activities. But whose purpose should we be considering when attempting to answer this question?

The Inland Revenue is clearly of the view that it is the purposes of the company, as represented by its board of directors, which are paramount. Consider the following extract from Tax Bulletin 53:

'Purposes, in the case of companies, can probably only be established by looking at the intentions of the directors at a particular moment as well as looking at the transactions themselves. This is important because similar transactions by different companies (e.g. buying shares) may be for different purposes.'

But is this correct? Surely the question which should be asked is not 'what is the purpose of a particular activity decided upon by the directors?' but rather 'what is the purpose behind the shareholders' decision to form the company and to allow it to continue to exist?'. The distinction is a fine one, but nonetheless real. The legislation refers to 'a company existing for the purpose of …'. This means that we must consider the purpose for which the company exists. In other words, we must ascertain why the shareholders brought the company into existence in the first place and why, at any given point in time, they allow it to continue to exist.

Investment income

Elsewhere in the Tax Bulletin, the Inland Revenue states:

'Whether something is wholly for a trading purpose can only be considered in light of the requirements of the company's trade. One common situation is where a company sets aside funds and receives investment income. The fact that investment income is generated does not automatically lead to the conclusion that a company's purpose is not wholly trading. Whether the generation of income from investments is or is not evidence of a non-trading purpose must ultimately depend on the nature of the company's trade and whether the holding of the investment is closely related to the conduct of that trade. If it can be shown that holding any investment is integral to the conduct of the trade or is a short-term lodgement of surplus funds held to meet demonstrable trading liabilities, then this is unlikely to be taken as evidence of non-trading purposes. For example, if a company has surplus funds which it intends to use for an expansion of the trading business in the near future, and it invests these in equities in the short term, then it may be that the company's purpose continues to be wholly trading during the period those equities are held.'

The implication that the generation of investment income must be related to the conduct of the trade in order not to jeopardise the 'wholly trading' purpose of the company is in my view fallacious. The logical conclusion to this argument is that any trading company which generates a cash surplus (presumably the ultimate aim of any trading company?) must either invest that surplus in non interest-bearing accounts or pay it out immediately in the form of dividends to shareholders in order to demonstrate that the company does not exist for any purpose other than to carry on one or more trades.

Leaving aside for the moment the 'insubstantial' test in subparagraph (b) of the definition, I would submit that a company in these circumstances would satisfy the requirements of subparagraph (a). The fact that a trading company may receive substantial deposit interest arising from cash surpluses generated from its trading activities does not lead one inescapably to the conclusion that it exists other than wholly for the purpose of carrying on a trade. The decision of the directors to earn interest on those surpluses or of the shareholders not to distribute the surpluses is not in the majority of cases relevant to the question of why the company exists. This question is to do with the very purpose of the company's existence and not the purpose of the board of directors in pursuing any particular course of action.

Even if this argument does not find favour, there is the escape route of subparagraph (b). This states that even a company which does not exist 'wholly' for the purpose of carrying on one or more trades may nevertheless qualify for the business rate of taper relief if it could be said to exist wholly for that purpose were it not for any purposes capable of having no substantial effect on the extent of the company's activities. The Revenue sets out various circumstances in which it believes that advantage may be taken of this subparagraph and these all involve judging the extent of the company's activities by reference to an arbitrary figure of 20 per cent. Thus, for example, where the turnover receivable from non-trading activities, or the value of the non-trading assets or the expenses incurred by, or the time spent by officers of, the company on non-trading activities are all below 20 per cent of the relevant total, the Inland Revenue would, in most circumstances, judge the company to be qualifying.

This interpretation seems to me to be flawed.

As has been demonstrated above, the level of investment income received or value of non-trading assets held does not necessarily go to the question of purpose. But let us suppose for a moment that it does.

Consider the example of a company which has been trading for many years and has built up a sizeable cash mountain. Let us assume, for the purpose of the analysis, that its non-trading assets account for 80 per cent of the value of the total assets held by the company and similarly that 80 per cent of its turnover is derived from deposit interest. None of this cash is required for the purpose of the trade that the company carries on and, moreover, the figures are constant year on year.

In 1998, the company consults its accountants about plans for the future. The trade continues to be profitable but the shareholders are anxious to discuss an exit strategy for the medium term. Conscious of the new taper relief, the accountants advise that if the company can keep going until April 2002, at that point it can be liquidated and the shareholders can receive capital distributions subject to maximum taper.

In those circumstances, there can be little doubt that the company no longer exists wholly for the purpose of carrying on a trade. There is an additional purpose – that of extending the life of the company for the purpose of maximising the taper.

The company therefore fails test (a). In the view of the Revenue, in applying the arbitrary 20 per cent tests, it will also fail leg (b). But should it?

Another purpose?

Would the company exist wholly for the purpose of carrying on a trade were it not for the fact that one of the reasons for its continued existence was to extend the taper period? More crucially, is this purpose capable of having any substantial effect on the extent of the company's activities? The answer must surely be 'no'.

If the non-trading income and the proportion which it represents does not alter, then how can this additional purpose have any effect at all? It is not enough simply to measure the income or asset values by reference to the arbitrary percentages.

What is more important is to consider the difference in these values from the position that existed prior to this purpose coming into existence. If there is no significant difference, then how can it be said that the company exists for a purpose that has a substantial effect on the extent of its activities? What substantial effect?

In such a case, it may be thought that it would be open to the Revenue to argue that there has always been a separate purpose to the company's existence – perhaps to earn investment income. But this argument would be difficult to sustain unless there was a significant cash injection by the shareholders at the outset. In any event, it is an illogical argument.

A tax reason

Prior to the advent of taper relief, it would have been more efficient for shareholders to receive a dividend taxed at an effective rate of 25 per cent than for the company to suffer corporation tax and for the shareholders then to pay 40 per cent capital gains tax on a winding-up. It is only the availability of taper relief itself that tips the balance and encourages companies to retain funds. In the majority of cases, it remains the case that companies retain non-trading assets and generate non-trading income. This is not because this is one of the purposes of the company's existence, but simply because the position has arisen as a result of those responsible not taking sufficiently close interest in the company's activities to realise what is happening. This does not, in my submission, constitute a purpose of the company's existence.

Tax Bulletin 53 is a genuine attempt by the Inland Revenue to clarify its thinking in this area for the benefit of taxpayers and their advisers. As Kevin Slevin rightly said in Taxation, 5 July 2001 at pages 342 to 345, it has gone as far as we could expect and is probably as frustrated as are we on this side of the fence by the way in which the legislation has been drafted. Its views do not, however, have the force of law and I believe it is the responsibility of all advisers to consider carefully the merits of any individual case to ascertain whether or not the business rate of taper may be available, irrespective of the outcome of the '20 per cent test'.

Andrew White is a partner in Gordon Leighton & Co, London W1.

Issue: 3828 / Categories: