Replies to Queries

We act for a property dealing company, which has a stock (of almost wholly residential properties) generating substantial rental income and which has been reported as Schedule A income in the corporation tax computations over many years. This rental income often exceeds 20% of the company's total income, particularly in years when few — or sometimes no — properties are sold.

The Inland Revenue maintains that business asset taper relief will not be due on the shareholders' sale of the company's shares because of the rental income. We maintain that the rental income is an integral part of the trading activity and could only be avoided by keeping the properties empty, which does not make commercial sense!

Readers' advice and suggestions to facilitate a successful claim for business asset taper relief would be welcome.

(Query T16,550) — A.W.

Whilst the facts here are relatively straightforward, the complexity of the taper relief rules means that a full response must be quite involved. At the heart of the query is the issue of whether or not the company is considered to be a trading company. However, it should be noted that this (in many cases) is neither sufficient nor necessary for the shares to qualify as business assets.

To add to the complexity, the definition of 'trading company' has changed since the introduction of taper relief. Whilst the Revenue maintains (Tax Bulletin 62) that the new legislation reproduces the old, but in clearer form, it is important to consider both definitions independently.

Until 16 April 2002, a company was a trading company if it existed wholly for the purpose of carrying on one or more trades or did so apart from any purposes that were capable of having no substantial effect on the company's activities. The precise meaning of this 'purposes' test is rather obscure and could involve considering the objects clause within the company's memorandum of association. However, it is also possible that one is required to enquire into the minds of the shareholders and directors. In either case, the test is rather unsatisfactory. Nevertheless, on the facts as provided, it would appear that there is a strong argument that the purpose of the company was to trade in the properties, and the rental income (notwithstanding its level) would seem to be merely incidental. I would therefore be fairly bullish about arguing that the company was a trading company under the old definition and not worry about the meaning of 'substantial'.

For subsequent periods, the legislation focuses on the company's actual activities ensuring that they 'do not include to a substantial extent activities other than trading activities' (TCGA 1992, Sch A1 para 22A). Here, the meaning of the word 'substantial' is critical. However, the word is not defined and one must rely on the Inland Revenue's guidance of 20%. It should be remembered though that this figure is entirely non-statutory and the courts are not bound by it.

The Revenue suggests that one should consider a number of sources (including the company's financial statements) to determine whether the non-trading activities are to be treated as 'substantial'. However, one should remember that a company's status is not determined by reference to accounting periods, but (strictly) considering each day at a time, although one is not required to consider the company's daily cash-flows. Ultimately, one must step back and consider what the company is actually doing; the legislation does, after all, refer to 'activities'.

The receipt of substantial investment income does not necessarily mean that the company is actively carrying on substantial investment activities — this would especially be the case if the company does little more than collect the rent. Instead, as the Revenue recognises (Tax Bulletin 53), it is necessary to consider how the directors (and other staff) occupy themselves. If the majority of the time spent (and costs incurred) is on the property dealing side of the business, then the company is arguably a trading company.

Additionally, the definition of 'trading activities' is relatively broad. In Sch A1 para 22A(2)(a), activities qualify if they are carried on either 'in the course of, or for the purposes of, a trade being carried on by it'. Whilst the letting of trading stock is probably not carried on 'for the purposes of' the company's trade, it is strongly arguable that such activities are carried on 'in the course of' the trade. This argument is strengthened by the fact that it would be commercially unwise to leave the properties empty and the letting probably also ensures that the properties retain their value.

Thus, it appears that the company has a strong chance of being considered a trading company. However, it should be noted that the facts provided are relatively sketchy and so this conclusion should be treated as merely indicative. — Kalonymous.

The article, 'A Substantial Qualification' (Taxation, 20 January 2005, page 370), looked at the legislation and offered some case studies and considered the application of the 'substantial extent' qualification, which emanates from TCGA 1992, Sch A1 para 22A (and para 22B), which defines a trading company as 'a company carrying on trading activities whose activities do not include to a substantial extent activities other than trading activities.'

The article considered the Revenue's interpretations and its view of a 20% limit to decide whether activities were substantial or not. In view of the admission that rental income often exceeds 20% of the company's total income in some years, one is tempted to say that business asset taper relief is correspondingly 'tainted'. But depending on the underlying reasons for the letting of the properties, it might be worth pursuing this point with the Revenue.

Tax Bulletin 53 and Tax Bulletin 62 refer to 'substantial' (the first as in the previous legislation's reference to 'purposes having no substantial effect' and the latter to para 22A's 'substantial extent'. The application of the 20% limit to the various aspects of a company's business is also considered.

The paragraphs below the heading 'substantial' on page 853 of Tax Bulletin 53 indicate non-trading factors; but page 855 (under 'surplus trading property') may give some hope, where the Revenue says that it would not necessarily regard let properties, surplus to trade purposes and which are to be sold, as indicating a non-trading purpose. (The Capital Gains Manual (CG17953o) makes a similar point.)

Tax Bulletin 62 (page 985) reiterates that substantial letting receipts may indicate non-trading status. But the Revenue does note (page 984) that 'an investment may be so closely related to the conduct of a trade that it effectively forms an integral part of the trade'. Pursuit of this general approach might give most hope of success; i.e. that the properties are trading assets, temporarily let and therefore not to be seen as non-trading assets subject to the 20% considerations. The Revenue does, for example, say (page 986) that 'the acquisition of property (whether vacant or already let) where it can be shown that the intention is that it will be brought into use for trading activities (i.e. for sale)' would not necessarily indicate a non-trading activity.

So the question is surely whether the let properties are trading or non-trading assets. Are they trading assets which have been put up for sale, but which for one (presumably short-term) reason or another have not been able to be sold and have therefore been let for relatively short periods to generate income before being put back on the market? Alternatively, are the properties being held to produce investment income? An examination of the history of the acquisition/construction of properties, periods of letting and subsequent sales may shed some light on what exactly is happening in the client's case.

Issue: 3993 / Categories: