Tainted Taper

MALCOLM GUNN FTII, TEP provides a summary of a key issue for all tax advisers.

FOR SOME PEOPLE, Gordon Brown's biggest achievement has been to introduce low rates of tax, or some might prefer that to read the appearance of low tax rates. For others, his main achievement has been so much constant change that your head spins faster than on a ride at Alton Towers. As this magazine is strictly non-political, I offer no further comment, except to say that with taper relief you do not have to choose which camp to subscribe to, because both are accurate!

Taper relief does indeed offer the possibility of paying only 10 per cent tax on a gain, or even less, but that is not the full picture at all; there will be many disappointed taxpayers. The rules have been refashioned both repeatedly and radically and I believe that many tax advisers will be dizzy with all the resulting complications. This article is designed to clear away some of the fog as regards what is known as 'tainted taper'.

This is a very important topic indeed. If readers do not spot a tainted taper situation when advising a client, the result will be a very unhappy client. I am sure that Mr Tolley will not mind if, on this occasion, readers want to photocopy this article and pin it up wherever they like around the office, as it will be a little different from normal Taxation reading - more of a catalogue than an article. It is designed to be a guide to the main situations in which tainted taper arises.

What is it?

Tainted taper arises where the taxpayer has an asset which has changed its status during the period of ownership from non-business asset status to business asset status, or vice versa. It is all too easy to look at the current rules for taper relief, see that an asset has been held for two years, qualifying throughout as a business asset, and thus reach the conclusion that the full 75 per cent business taper deduction is available on the whole gain.

In a multitude of situations, this will not be the case. Once one brings into account the various changes in the rules which have occurred during the holding period for the asset, it may be found that part of that period is a non-business asset period and so part of the whole gain has to be apportioned on a time basis, with one part qualifying for business asset taper, and the other for non-business asset taper.

Remember that once you have done this apportionment the rate of taper in either case is that applicable to the full number of years in the holding period for the asset.

The taper relief rules divide broadly into those for shares and those for other types of assets. I will examine tainted taper in relation to shares first, and then look at the topic as it affects other assets.

Shares

This heading sub-divides itself into situations affecting employees and situations affecting investors.

Employees

Trading companies, whether quoted or unquoted:

Up to 5 April 2000 employees had to hold not less than 5 per cent of the voting rights in the company and they had to be full-time working officers of the company, or of another company in the same group, or in the same commercial association of companies. To be 'full-time', the employee had to devote substantially the whole of his time to the service of any of the companies in the categories just mentioned. Any employee who was not full-time could only obtain business asset status for his shareholding under the 25 per cent voting rights test applicable to investors (see below).

From 6 April 2000, all employee shareholdings in trading companies qualify as business assets. There is no requirement for the employment to be full-time; it can be part-time or it can be a non-executive directorship or it can be an office holder such as company secretary.

Accordingly, where an employee first acquires shares in his employer trading company after 5 April 2000, there will normally be no tainted taper problem. Tainted taper arises where a full time employee had less than 5 per cent of the voting rights and acquired his shares before 6 April 2000 whilst continuing to hold them after that date.

There will also be a tainted taper situation for part-time employees who acquired shares before 6 April 2000 with voting rights below the 25 per cent level.

Non-trading companies both quoted and unquoted:

In this category, employee shareholdings were non-business assets up to 5 April 2000.

From 6 April 2000 such shareholdings are business assets provided that the employee does not have a 'material interest' in the company: for 'material interest' there are a variety of tests but based on a 10 per cent requirement (voting rights, distribution rights), but probably the most important one is that more than 10 per cent of the issued shares of any particular class constitutes a material interest in the company.

Investors

Under this category, I deal with shareholdings held by those who have never had any employment with the company, or a relevant connected company.

Quoted trading companies:

Up to 5 April 2000 an investor's shareholding in the company qualified as a business asset if he or she held 25 per cent of the voting rights in the company.

From 6 April 2000, it is necessary for the investor to hold only 5 per cent or more of the voting rights.

Accordingly, investors with between 5 per cent and 24.99 per cent of the voting rights and whose shareholding dates back before 6 April 2000 will have a tainted taper situation.

Those holding 25 per cent or more of the voting rights have no tainted taper, as they are business assets throughout; those holding less than 5 per cent of the voting rights have non-business asset relief throughout.

Unquoted trading companies:

Up to 5 April 2000 the previous 25 per cent of the voting rights test applied for business asset status.

From 6 April 2000 all shareholdings in unquoted trading companies have business asset status.

Accordingly, tainted taper arises for shareholdings dated back before 6 April 2000 where the investor has less than 25 per cent of the voting rights.

Non-trading companies, whether quoted or unquoted:

Investors in these companies have never enjoyed business asset status. Tainted taper does not therefore arise.

Trusts with employee beneficiary

Taper relief in relation to shareholdings held by trustees once again divides into categories for 'employees' and 'investors'. In this case, the employee category relates to situations where a beneficiary of the trust has a relevant interest in possession (as defined) in the whole of the settled property, or the part of it that includes the shares concerned. From there on, the rules follow the same principles as set out above in relation to employee shareholdings in both trading and non-trading companies. Applying the rules to trusts, the requirements as to voting rights have to be satisfied by the trustees' shareholding, and the employee tests have to be satisfied by the beneficiary with the relevant interest in possession. Trustees who fail to qualify under these rules have the alternative possibilities set out below in relation to discretionary trusts.

As for employees, tainted taper arises where a trustee shareholding dates back before 6 April 2000 and the trustees failed to satisfy the 5 per cent voting rights test before that date, or alternatively the employee beneficiary failed to satisfy the full-time working test.

From 6 April 2000, all trustee holdings in trading companies, whether quoted or unquoted, qualify for business asset taper relief if a beneficiary with an interest in possession under the settlement is an officer or employee of the company.

Remember that there are more detailed rules relating to taper relief in trust situations; in particular 'sharing periods' can arise and if there is a change in the beneficiaries with interests in possession in trading company shares, this can 'taint' the taper calculation as well.

As regards trustee shareholdings in non-trading companies where there is an employee beneficiary, the rules follow those set out above for shares held by employees directly, once again applying the tests as to the shareholding (no material interest) to the trustees and the employment test (part-time or non-executive directorship, etc.) to the beneficiary.

Tainted taper arises in these cases where the trustees' shareholding dates back before 6 April 2000 and they have no material interest in the company.

Trusts: no eligible beneficiary

In the case of discretionary trusts there will never be an eligible beneficiary, as by definition no beneficiary will have an interest in possession in the trust. In these cases, the taper relief rules follow the same principles as those set out above for investors.

Therefore, up to 5 April 2000, discretionary trustees enjoyed business asset taper relief only if they held at least 25 per cent of the voting rights in a trading company, whether quoted or unquoted. From 6 April 2000, the test was reduced to 5 per cent or more of the voting rights and then only in relation to quoted trading companies. All trustee shareholdings in unquoted trading companies qualify for business asset status from 6 April 2000.

Accordingly, for discretionary trustees, tainted taper arises where the trustees have between 5 per cent and 24.99 per cent of the voting rights in a quoted trading company, and their acquisition date is prior to 6 April 2000.

In the case of discretionary trusts holding shares in unquoted trading companies, tainted taper arises in every case where the shareholding dates back prior to 6 April 2000, unless the trustees had 25 per cent of the voting rights at all times prior to that date.

Discretionary trust holdings in non-trading companies, whether quoted or unquoted, have non-business asset status throughout and accordingly no tainted taper situations arise.

The points made above as regards discretionary trusts apply equally to interest in possession trusts where none of the beneficiaries has any employment with the company concerned, or where the trust fails to qualify under the eligible beneficiary provisions.

Personal representatives

In the case of shares held in deceaseds' estates, there is no test relating to the beneficiaries of the estate. Only the voting rights held by the personal representatives come into the equation.

In the case of shares in trading companies, up to 5 April 2000, personal representatives had to hold at least 25 per cent of the voting rights in the company, whether it was quoted or unquoted.

From 6 April 2000, all holdings of personal representatives in unquoted trading companies have business asset status for taper relief, and in the case of quoted trading companies, executors must hold at least 5 per cent of the voting rights.

Therefore, for quoted trading companies, tainted taper arises for shareholdings where the death was prior to 6 April 2000 and the disposal by the executors is after that date and where the holding is between 5 and 24.99 per cent of the voting rights in the company.

In the case of unquoted trading companies, tainted taper arises where the death was before 5 April 2000, the disposal after that date, and the personal representatives held less than 25 per cent of the voting rights.

In the case of non-trading companies, there are no tainted taper issues for personal representatives as these holdings have never enjoyed business asset status.

Remember that where personal representatives transfer a shareholding to a beneficiary as legatee, his or her acquisition date is treated as being the date of death of the deceased. A special rule in paragraph 4 of Schedule A1 to the Taxation of Chargeable Gains Act 1992 allows the legatee to claim business asset taper relief by reference to the test which applies to the personal representatives during the time that they held the asset. Alternatively the legatee may himself satisfy the test for business asset status back to his or her deemed acquisition date, in which case paragraph 4 need not be invoked. The paragraph 4 rule is of less interest following Finance Act 2000, but it will still come to the rescue where the beneficiary needs to rely on the voting rights held by the personal representatives in order to secure business asset taper; the deeming of a legatee's acquisition to be on the date of death does not go so far as to deem the beneficiary also to have voting rights back to the date of death, and that is where paragraph 4 will help.

For example, assume that Mr Spectre died on 5 April 1999 owning 40 per cent of the shares in Tombstones Trading Ltd. The residue is divisible between his four sons. The executors transfer the shares to the sons in 2001.

Each son would have tainted taper were it not for paragraph 4, as up to 5 April 2000 they need to satisfy a 25 per cent voting rights test to secure business asset taper, and they had no votes themselves. Paragraph 4 ensures that they have full business taper throughout.

Assets other than shares

Tainted taper can also arise in relation to other types of asset to which business asset taper relief can apply, the most common example of which is land and buildings. It does not matter if rent is paid by the business.

The changes in this area took effect from 6 April 2000 and once again the position can be divided between employees and investors.

Employees

Up to 5 April 2000, business asset taper relief applied to other assets owned by an employee and used for the purposes of an employment with a trading company to which he was required to devote 'substantially the whole of his time'. The test also had a wider version which was broadly designed to deal with directorships of a group of companies absorbing substantially the whole of the director's time and where the asset was supplied for use by a trading company in the group.

From 6 April 2000 the test was simplified and the asset now need only be provided for the purposes of any office or employment with a person carrying on a trade.

As a result, tainted taper arises for directors and employees who failed the 'substantially the whole of his time' test before 6 April 2000 and who first supplied an asset for the purposes of an office or employment before that date.

A very similar change was made in relation to assets held by trustees and used for the purposes of an office or employment of an 'eligible beneficiary'.

A director might have no actual office or employment with a trading company in the group as his directorship might arise with the non-trading holding company of the group. Up to 5 April 2000 a separate test allowed business taper relief to apply to an asset owned by such a director and used by a trading company in the group, so long as the director qualified as a full-time working officer or employee and held not less than 5 per cent of the voting rights in the holding company.

From 6 April 2000 such a director can have business taper relief in respect of the asset supplied for a company's trade simply by virtue of his or her office or employment, whether or not it is full-time. The director could in fact qualify by virtue of other tests (for example if the company is unlisted). However, all this amounts to much the same thing as stated above; tainted taper broadly arises in relation to what the legislation used to treat as part-time employments and directorships where an asset was first used for the purposes of the employment before 6 April 2000.

Business taper relief can also be claimed in relation to assets used by a partnership, but there has been no change to the rule that the individual claiming the relief must be a member of the partnership. Where one or more trustees are members of a partnership carrying on a trade, the Finance Act 2001 enabled the trustees to claim business asset taper for any trust asset used in the partnership trade; this was backdated to 6 April 2000 but tainted taper will arise if the asset was first provided before that date.

Employees of non-trading companies

Up to 5 April 2000 employees supplying an asset for use by their non-trading employer were not eligible for business taper relief in respect of the asset.

From 6 April 2000, such employees do enjoy business asset taper relief so long as they do not have a 'material interest' in the company, or any company which controls it. Material interest is the 10 per cent test again, most commonly no more than 10 per cent of the issued shares in the company of any particular class.

Accordingly, tainted taper arises in these circumstances where the asset was supplied for use by the non-trading company before 6 April 2000.

Investors

Up to 5 April 2000, those supplying an asset for the use of a trading company or holding company of a trading group in which they had no office or employment were required to hold not less than 25 per cent of the voting rights in the company.

6 April 2000 marked the dawn of the age of enlightenment for these people. In place of the 25 per cent voting right test, they were spoilt for choice with alternatives: either the company may be unquoted or alternatively they may have not less than 5 per cent of the voting rights in the company. Obviously, by definition, the second of these tests is the one to look at where the company is quoted. The trading company test still applies, however.

Accordingly, for investors, tainted taper arises where an asset was first supplied to an unquoted trading company before 6 April 2000 and the owner of it did not satisfy the 25 per cent voting rights test up to that date.

For quoted companies, tainted taper arises where the person supplying the assets to the trading company (before 6 April 2000) holds between 5 per cent and 24.99 per cent of the voting rights in the company.

A similar scenario arises where an asset is supplied by trustees or personal representatives for use by a trading company. They have tainted taper in the same situation as set out immediately above for individuals.

A 'minor' amendment

Last, and probably least, the Finance Act 2002 contained 'minor amendments' to taper relief, including the meaning of trading company for this purpose. The new definition which is effective from 17 April 2002 makes it clear that certain pre-trading activities will not affect trading status. More importantly, a company set up to acquire at least a 51 per cent interest in a trading company or group is also catered for. There could conceivably be some companies whose status has changed as a result.

Other cases

So far, I have described what may be regarded as static types of tainted taper, these being situations where the facts have not changed throughout the relevant holding period, but the legislation has. Those cases were the main thrust of this article. Tainted taper will of course also arise where the underlying facts of a particular case have altered during the relevant holding period. This scenario is not quite so beguiling as the situation where the legislation produces tainted taper, because the alterations in the facts will send their own alarm bells. However, for good measure, the following illustrates some of the many scenarios which give rise to tainted taper under this heading.

Employee leaving the company

When an employee of a trading company, holding shares in it, leaves his or her employment, in the majority of cases this will result in a change in the status of the shareholding from business to non-business asset for taper relief purposes. The employee would need to hold 5 per cent of the voting rights in the company if the shares were to continue to be business assets.

Employee leaving unquoted company

Where the employment with an unquoted company ceases, whilst the individual continues to hold shares in it, so long as this event is after 5 April 2000 the status of the shares for taper relief purposes will be unaffected if the company is a trading company. If it is not a trading company, the status of the shares will change from business asset to non-business asset for taper relief purposes, assuming that the holding has been under the 10 per cent threshold.

Change in status of company

When a company goes into liquidation, it is still regarded as active, under the new test in paragraph 11A of Schedule A1 to the Taxation of Chargeable Gains Act 1992 so long as winding up activities continue, but it is quite likely that trading will then cease. As a result, the company will cease to be a trading company and where the taper relief status test requires investment in a trading company, there will be a change of status at that stage. For example, in a case of an unlisted company, the employee's shares will cease to qualify for business taper if the employee (perhaps a director) has a material interest in the company. However, where the winding up is carried out under the Revenue's Concession C16, see Mark Morton's article in Taxation, 25 July 2002 for the possibility of agreeing no tainted taper with the Inspector.

Apart from winding-up situations, a company may also move out of, and subsequently back in to, trading status if its investment assets temporarily rise above the Revenue's published 20 per cent guideline (see Tax Bulletin, Issue 53). This will not currently affect employees with less than a 10 per cent interest in the company, but employees, or more often directors, over that limit will be affected as also will outside investors. Taper calculations may therefore require a review of a company's activities throughout the holding period for a particular shareholder; how outside investors will manage this is perhaps best summed up: 'only with great difficulty'.

Part disposal of shares

Some of the business taper tests up to 5 April 2000 and others from that date require a minimum holding of voting rights in a company, as regards business taper upon shares in the company. For periods up to 5 April 2000, this can affect both listed and unlisted companies and from 6 April 2000 only holdings in listed companies can be affected. For example, an investor in an unquoted trading company required a 25 per cent of the voting rights before 5 April 2000 in order to qualify for business asset status at that time. Accordingly, a part disposal of a shareholding before that date taking the voting rights below the 25 per cent level would change the status of the shares from business to non-business, but then with effect from 6 April 2000 business status would be achieved once again. Accordingly, in dealing with business asset taper relief claims, the full history of a shareholding should be researched.

Not a doddle

Anyone who has managed to stay the distance so far will by now have appreciated how careful we need to be with taper relief calculations.

Issue: 3883 / Categories: