(Don't) Roll Me Over

RICHARD CURTIS explains a new facility to disapply rollover relief on incorporation.

SINGING THE BLUES may not be the tax practitioner's usual way of dealing with problems. 'I woke up this morning and my taper relief had done gone' seems somewhat lacking in the normal poignancy; but there may be a few accountants or advisers out there, glass of bourbon in hand, who will nod sagely in agreement. We thought that we had a satisfied client, but our best laid plans for their happy future are dashed by an unforeseen event - so it goes. There you were, you had just met, the engagement letter had been signed and an incorporation had given you a great opportunity to demonstrate your tax planning techniques. Then, just as you thought that there was a long and fruitful and fee-paying future in front of you, the company goes off with someone else. It is that old story, 'accountant meets client, accountant loses client' and just to make it worse, confidentiality means that you cannot even share your woes with the barman.

But wait, perhaps the blues will have a happy ending courtesy of section 162A, Taxation of Chargable Gains Act 1992, 'election to forgo rollover relief on transfer of business'. Forgo a tax relief - what is going on? Does this mean accountant can win client back again?

Section 162 of the Taxation of Chargeable Gains Act 1992 allows an individual or partnership to defer the capital gains tax liability that would otherwise arise on the disposal of his business assets to a limited company in exchange for shares.

Basically, the proportion of the gain relating to the 'old assets' (e.g. business premises and goodwill) is deducted from the 'cost' of the new assets (viz. the shares in the new company). So, Mr Quo has a music shop business and the chargeable assets of the freehold shop and goodwill are valued at £200,000, of which £100,000 is chargeable gain. He transfers these assets (and the other non-chargeable business assets worth, say, £50,000) to Headbangers Limited and in exchange he receives 10,000 shares. The shares would therefore be worth £250,000 but, for capital gains tax purposes, section 162 allows the gain that would otherwise fall into charge to be 'rolled over' against the deemed acquisition cost of the new assets (the shares). So for capital gains tax purposes, they now have a deemed cost of £150,000.

No formal election needs to be made, but all of the assets of the old business, with the possible exception of cash, must be transferred for the relief to be obtained. As the Revenue states in its Capital Gains Tax Manual at paragraph CG66974, 'section 162 relief applies automatically'.

Section 49, of the Finance Act 2002 inserted a new section 162A into the Taxation of Chargeable Gains Act 1992, which has effect for transfers of a business on or after 6 April 2002.

Subsection (1) states that 'Section 162 shall not apply where the transferor makes an election under this section'. Why would you want to do this? - in two words - 'taper relief'. As Malcolm Gunn has already mentioned in 'Tainted Taper' (see Taxation, 14 November 2002 at pages 156 to 159), this relief has now become so complicated that the adverse effects of what appeared to be a simple concept at the outset are now starting to show up in the most unlikely places.

Previously, if, for some reason, a taxpayer did not want the section 162 rollover provisions to apply, he or she would have to ensure that all of the conditions were not satisfied. However, taper relief adds an extra complicating factor to those to be considered on an incorporation, especially if a sale is envisaged or takes place shortly afterwards.

In a normal section 162 rollover relief situation, taper relief does not come into effect. Because the gain on the old assets is rolled over, there is no chargeable gain from which taper relief can be deducted and the relief that accrued on the 'old' asset is lost and entitlement to relief on the 'new' assets must restart from the date of the transfer. This is not necessarily a problem if the new asset is held for at least two years, at which time the full business asset taper relief will be achieved.

However, there are two main scenarios where the ability to make an election to disapply a rollover under section 162 will be beneficial.

Suppose that a business is incorporated and section 162 relief applies, but an unexpected offer to purchase the business is received within two years. In these circumstances, less (or none if the sale was within twelve months) taper relief will probably be due than if rollover had not been claimed on the transfer, but taper relief had applied at that time.

The Example, taken from the Finance Bill 2002 Explanatory Notes, illustrates this point.

Perhaps in a 'mirror image' to the above sale scenario, the ability to make an election could also prevent a large liability 'crystallising' if a planned sale does not materialise.

The situation envisaged here is if, say, Mr Quo incorporates his business to facilitate a planned sale.

Knowing that the sale is supposed to take place within a year after incorporation, he ensures that not all assets are transferred to the company so that section 162 cannot apply. He obtains his full entitlement to taper relief, but still has a liability to pay on 31 January 2004. However, by that time he expects that his shares in the business will have been sold, thus putting him in funds to pay this. Unfortunately, the sale falls through and his ownership of the business and the shares continues. He still faces a capital gains tax liability, but has received no consideration from which this can be paid.

Section 162A will mean that if such a planned incorporation takes place, there will be no need to ensure that it falls outside of section 162. Rollover relief will apply, protectively, on the initial transfer for shares and then an election under section 162A can disapply the relief once the sale has safely taken place.

Sections 162A(1), (2) and (3) provide that an election must be made to disapply section 162. The election must be made by 'the second anniversary of the 31 January next following the year of assessment in which the transfer took place'. If the transfer of Mr Quo's business took place in the year ending 5 April 2003, the election must therefore be made by 31 January 2006.

There is an exception to this rule if the transferor has disposed of the 'new assets' (the shares) by the end of the year of assessment following the year in which the transfer took place. In those circumstances, section 162A(4) provides that the election must be made one year earlier. So in this example, if the shares received by Mr Quo in the year ended 5 April 2003 were sold by him in the year ended 5 April 2004, he would have to make the election by 31 January 2005.

The following points should also be noted.

• With regard to transfers of the new assets between a husband and wife, if this falls within section 58(1), Taxation of Chargeable Gains Act 1992 (transfers at no gain/no loss), section 162A(5) provides that the transfer is disregarded for the purposes of section 162A(4). In other words, the time limit is not foreshortened, but a subsequent disposal (unless it is also within section 58(1)) is treated as a disposal by the transferor. There is nothing unexpected here; this is simply an extension of the normal 'husband and wife' rules.

• Section 162A(6) empowers the Revenue to give effect to the election by discharge, repayment, making assessments, etc.

• In cases of joint ownership of a business, section 162A(7) provides that each person has a separate entitlement to make an election and this will apply only to his or her share of the gain on the old assets and to the new assets that are attributable to him or her. Section 162A(8) specifically mentions that, in Scotland, as well as in the rest of the United Kingdom, this includes ownership by a partnership of two or more persons.

• Subsequent reorganisations of the company are covered by section 162A(9). This, in addition to stating that expressions used in section 162A have the same meaning as in section 162, goes on to state that 'references in this section to new assets include any shares or debentures that are treated by virtue of one or more applications of section 127 [Taxation of Chargeable Gains Act 1992] … as the same asset as the new assets'. Again, this is another logical confirmation that the capital gains tax attributes of the first new assets are carried over into replacement shares, etc.

So, what at first sight might seem an odd concept - forgoing a valuable rollover relief - now looks like being a useful tool. When dealing with incorporations, practitioners will not have to 'keep their fingers crossed' for the following two years before full business asset taper relief is achieved again. Mr Quo's accountant will be able to make the rollover under section 162, lay down his client's file for a year or two (a forward diary review note might be beneficial in such cases), but still know that the Revenue will let him in with a section 162A election if this is necessary to restore the status quo of his client's taper relief entitlement. Our accountant wins back a happy client and, who knows, perhaps there is even an old 'hit' tune that will become their song.