Taxation logo taxation mission text

Since 1927 the leading authority on tax law, practice and administration

It's Official - Excerpts from the Inland Revenue's sixtieth Tax Bulletin.

28 August 2002
Issue: 3872 / Categories:

Particular transfer pricing risk areas

* Existence of tax haven entities outside the controlled foreign company rules that are profitable despite the absence of significant activities carried out in their bases.

* Instances of mismatches between the likely scale of tax haven operations and the level of profits allocated to them.

* Profit margins in the United Kingdom are lower than in the group generally and there are reasons to believe that this should not be the case.

Particular transfer pricing risk areas

* Existence of tax haven entities outside the controlled foreign company rules that are profitable despite the absence of significant activities carried out in their bases.

* Instances of mismatches between the likely scale of tax haven operations and the level of profits allocated to them.

* Profit margins in the United Kingdom are lower than in the group generally and there are reasons to believe that this should not be the case.

* United Kingdom company possesses the resources to generate high margin profits yet produces only a routine low margin profit.

* Royalty or management fee payments that do not appear to make commercial sense and which substantially impact on United Kingdom bottom line.

* Poor performance over a number of years when there is no obvious prospect of super profits in later years to justify the risk of continuing losses.

* Any period in which changes in intra group contractual arrangements purport to adjust the risk profile, and hence the reward, of the United Kingdom group.

There are no de minimis limits or safe harbours in United Kingdom transfer pricing legislation, but regard should be given to both the potential tax at risk and the level of difficulty in establishing the arm's length price.

Private finance initiative projects

The Revenue has clarified the approach it takes to establishing the scope of trades carried on by private sector entities involved in private finance initiative projects.

The scope of a particular trade is essentially a question of fact. In some private finance initiative cases, the Revenue has accepted that the scope of the trade includes design and construction services as well as other support services. Each case will depend upon its own particular facts and it is not, therefore, possible to provide a definitive checklist of all the factors to consider. However, the intention of the operator, the terms of the PFI agreement, as well as what the operator actually does, are all relevant factors. The question is what trade is actually carried on, not what trade the operator claims to carry on. However, where the facts are equivocal, the intention of the operator may well be a relevant factor in reaching a conclusion.

Internationally mobile employees

The subject of shares and share options and internationally mobile employees was considered in articles in Tax Bulletins 55 (October 2001) and 56 (December 2001). This further article clarifies certain aspects and also deals with other questions on international issues that have been raised on taxation and National Insurance with regard to shares and share options.

Is relief by allocation of taxing rights only available if the five factors detailed in Tax Bulletin 55 are present?

The article was written to give certainty in the most common situation where double taxation arises, which is when all five factors are present. But this has been interpreted as meaning that relief by time apportioning the gain will be due only when all of the factors are present. This is incorrect. There are other situations in which some relief by allocation of taxing rights may be appropriate, for example if the employment ceased shortly before the options were exercised. Such cases will be considered on their own facts.

Does an employment continue if the employee changes contractual employer on being relocated?

If the employers were in the same group of companies and the change did not affect the employee's stock option rights, then the United Kingdom would normally regard it as one employment for the purposes of apportioning the option gain attributable to the United Kingdom.

If the employee is resident and ordinarily resident in the United Kingdom both when the option is granted and when it is exercised, can the gain ever be time-apportioned in the United Kingdom? Example 4 of the Tax Bulletin 55 article implies that it can.

The statement that 'a claim may be relevant under the employment income article of the double taxation agreement' does not mean that relief would be due by leaving out of account a part of the gain that related to overseas employment. It was meant to reflect that relief by means of credit might be available if the United Kingdom recognised that another country had a valid claim to tax part of the gain because it could be said to be derived from employment performed there.

Does it matter whether the option is over shares in an overseas or a United Kingdom company?

In general, no; the source for double taxation treaty purposes will be the employment, and where it is carried on.

Is any relief due on an option gain if an employee were resident in the United Kingdom at the date of grant, but resident in a non-treaty country at the date of exercise?

The whole gain is taxable in the United Kingdom under section 135, Taxes Act 1988. If there were overseas tax payable on any part of the share option gain, the United Kingdom would consider unilateral relief on a claim. However, unilateral relief may only be given by means of giving credit, not by time-apportioning a gain. The amount of unilateral relief may never exceed what would be available if a double taxation treaty with the country existed.

Why is National Insurance payable on the full gain rather than the amount taxable under pay-as-you-earn?

The National Insurance legislation is clearly underpinned to the amount of tax chargeable under section 135 on any gain, not what is eventually taxed after relief. There are no contribution relief provisions under Social Security legislation, European Union legislation, reciprocal agreements or double contribution conventions.

Can an interest in the shares of a foreign company gain exemption from the conditional shares legislation under section 140A, Taxes Act 1988, by virtue of the shares being only forfeitable through that company's 'articles of association' under section 140C(3)?

The Revenue has looked critically at section 140C(3) and now accepts that its previous interpretation of the term 'articles of association' was too narrow. Consequently, it considers that the exemption in section 140C(3) should also be available to non-United Kingdom companies if the condition referred to in section 140C(3) is set out in a document broadly equivalent to United Kingdom articles of association. It will be a question of fact whether the foreign document is of equivalent status and performs an equivalent function to United Kingdom articles of association.

A number of issues arise where taxpayers followed previous Revenue advice and accepted that there was no exemption under section 140C(3). Under the previous practice, they would be charged to tax and National Insurance for the year in which forfeiture was lifted rather than the year in which the shares were awarded. Under the revised practice, tax and National Insurance will be charged for the year in which the shares were awarded rather than the year in which forfeiture was lifted.

Adopting the previous practice could have led to either a higher or a lower tax and National Insurance charge at a later date. Taxpayers following the previous practice will not have been charged tax and National Insurance for the year in which the shares were awarded and would be expecting to pay (or have already returned and paid) tax and National Insurance when the risk of forfeiture was lifted.

As a consequence of following the previously stated practice, the acquisition cost of such shares for capital gains tax purposes would be the amount on which Schedule E was charged when the risk of forfeiture was lifted. The Revenue's revised practice will give rise to a different acquisition cost for capital gains tax purposes based on the amount on which Schedule E is charged when the time the shares are awarded.

Where the return was already submitted on the basis of previous advice, the Revenue will take no action. Exceptionally, where the time limit has not yet expired for amending the return, the taxpayer will be able to amend the return. Where the return has not been submitted, it should be submitted in accordance with the new advice.

Employees who believe that they may have been overcharged to tax in an assessment, and which they have paid, because of the Revenue's previous advice may make a claim for error or mistake relief under section 33, Taxes Management Act 1970.

Where a capital gain/loss on shares subject to this change of practice is or has been made, similar rules will apply to it as to the income tax gain described above. The base cost for capital gains tax purposes will be the value of the shares self-assessed for income tax purposes.

Composite service companies

The employees of a typical composite service company are normally paid a small wage or salary for the work they do. However, the employees are also usually shareholders of the composite service company, and each employee will usually hold a different class of shares in that company. So, for example, employee A will hold class 'A' shares, employee B will hold class 'B' shares, and so on. The employee's shareholding will then usually entitle him to receive dividends based on the amounts received by the composite service company for the services the employee performs for the client's business.

Regardless of how the composite service company is organised, it will need to consider the service company legislation (Schedule 12 to the Finance Act 2000 and the Social Security (Intermediaries) Regulations 2000) in exactly the same way that any other service company has to. This legislation applies equally whether the service company employs only one or two workers or whether, as a composite service company, it employs many workers.

In some cases, the number of employees/shareholders in a composite service company exceeds 20. This makes no difference to the applicability or otherwise of the service company legislation. This legislation will apply in any situation where the relevant conditions are met and the worker either holds five per cent of the shares in the service company, or receives payments which could reasonably be taken to represent remuneration for services provided by the worker to the client.

Instruments of variation

An article in the Bulletin explains the new procedures introduced in Finance Act 2002 for dealing with the inheritance tax and capital gains tax treatment of instruments of variation. In particular these changes will mean that it is no longer appropriate to send such instruments to the Revenue in most cases.

If the instrument of variation results in a change to the inheritance tax payable on death, a copy should be sent to the office dealing with the inheritance tax liability. Otherwise the signatories should retain the instrument or a copy until it is needed.

Thereafter, a copy of the instrument of variation should only be sent to the Revenue if it is asked for during an enquiry.

The Revenue proposes to issue a checklist (form IoV2) which will help advisers to see whether the proposed instrument of variation meets the requirements of Inheritance Tax Act 1984 and Taxation of Chargeable Gains Act 1992. This is available from capital taxes offices, and is also included in the revised version of booklet IHT8, available from www.inlandrevenue.gov.uk.

The foregoing are extracts from longer articles in the Tax Bulletin which is Crown copyright, and to which reference should be made for details of the full text. For information regarding subscription, contact Bryan Kearney on 020 7438 6373. It is also available free of charge at www.inlandrevenue.gov.uk.

Issue: 3872 / Categories:
back to top icon