Flatly incredible - II

LITTLE DID I realise when I wrote the half page piece 'Flatly incredible?' (Taxation, 14 July 2005, page 406) that so many more pages were going to come out of it. In Ch-ch-changes (Taxation, 11 August 2005, page 509) I made the case for more openness from HMRC about changes to their manuals and the seemingly defunct Business Economic Notes. The follow-up to that has dominated our Feedback pages in subsequent issues, and shows no signs of going away. However, I want now to return to the substantive issue of the part disposal rules which sparked this whole debate off.
It arose from a change to paragraph CG17959 in the Capital Gains Manual. Without completely repeating what I wrote previously, the problem is HMRC's interpretation of the rules for part disposals. To simplify the example in 'Flatly incredible?', assume that you bought the freehold of a building that had a shop on the ground floor and a flat above. You trade from the shop and let the flat out as an investment. After two years you sell the flat. What taper relief is due — business or non-business?
The sensible answer would be 'non-business'. However, HMRC's answer is that you should get half business asset taper relief and half non-business asset taper relief (the latter being nil after only two years). Their argument deserves some detailed attention.

Revenue argument

Although it is not spelled out in detail in the Capital Gains Manual, it appears that the argument is based on the interaction of TCGA 1992, s 42 and Sch A1. Section 42 deals with part disposals. It starts:

'Where a person disposes of an interest or right in or over an asset, and generally wherever on the disposal of an asset any description of property derived from that asset remains undisposed of, the sums which under paragraphs (a) and (b) of section 38(1) are attributable to the asset …'

The amounts attributable under s 38 are the costs of acquisition, which s 42 provides a process for apportioning. It follows that the 'asset' is the whole, not just the part disposed of.
Schedule A1 paragraph 9 explains how to calculate the taper relief when an asset has mixed business and non-business use. It again refers to the 'asset', and it appears that HMRC consider that the word means the same as it does in s 42. However, it is by no means clear that it does. The paragraph starts 'This paragraph applies in the case of the disposal by any person of an asset'. The asset disposed of in the example is the flat; the fact that this was a part disposal from an asset which was a freehold for the purposes of s 42 does not mean that it means the same for paragraph 9.

Subsequent sale

The next problem is what happens on a subsequent sale. Say that the shop was sold a further two years later; in HMRC's view the asset (as a whole) was used 50% for business in the first two years and 100% in the last two, so it will attract business asset taper relief on 75% of the gain in total.
But how? The gain on the flat is a part disposal, which is what gives HMRC's interpretation a way in on the first sale, through the meaning of 'asset' in s 42. But the disposal of the shop is not a part disposal. A s 42 disposal requires something to be left 'undisposed of', and here there is nothing left. The asset disposed of is the shop, which has always been used 100% for business use, so the full gain should attract business asset taper relief. Yet the result of this would be that too much taper relief had been given overall.

Another way

There is a way to avoid the problem created by HMRC's interpretation, other than arguing about the meaning of the section. Paragraph CG17695 says, in a footnote, 'Where part disposals are calculated in accordance with Statement of Practice D1 (see CG 71850 onwards) it is only the use of the part being disposed of that needs to be considered'.
Statement of Practice D1 deals with part disposals of land. It refers specifically to part of 'an estate', and all the examples given are of a field being sold from a much larger holding of land. D1 says that, as an alternative to the statutory basis, it is possible to agree that the piece being disposed of is a separate asset, to which 'a fair and reasonable' apportionment of cost is made. The cost so apportioned is then deducted from the base cost of the remainder.
Whilst the statement does not mention separate flats, etc. in a building, the guidance in CG71851 says that the part disposed of must be the entire interest in what is recognisable as a separate asset. That seems to apply just as much to a flat and a shop in the same building as it does to a field in a farm.
The alternative method being non-statutory, the guidance accepts that the taxpayer can at any time insist on the statutory method being applied to a part disposal, but that the alternative method would not then be available for subsequent part disposals. It is not generally possible, however, to switch to using the alternative method after the statutory method has already been used for one or more part disposals.

Advising clients

So how should we advise clients in the light of this? Should we be recommending that they use the alternative method, the statutory method, or switching from alternative to statutory — and what would happen if they did?
Taking the example of the single flat above the shop, and assuming that the value increases by a flat 10% a year, there is no difference between the two methods, provided that the Revenue's view (namely that the last disposal is also to be treated as a part disposal) is accepted (see Example 1).

Example 1

Assume the property cost £200,000 initially, of which half relates to the shop and half to the flat.

This is the same as the total gain on the shop being treated as business and that on the flat being treated as non-business.

However, it is more likely that prices will rise on a compound basis. Assume that the increases are 10% for each of the first two years and then 20% for each of the next two (to illustrate the point more clearly).

Example 2

If the alternative basis were used, the sale of the shop would generate £60,000 of business gains, and that of the flat £20,000 non-business gains.

However, an even more aggressive approach is to switch to the statutory basis when it becomes beneficial. Assume that the sales in the examples above were the other way round, and that the shop was sold after two years, the flat after four. Assume also that HMRC are right about the second sale being a part-disposal. Even if they are not correct, the problem in Example 3 would still be an issue where the property was split into three or more parts, in that the switch could be made for any except the last disposal.

Example 3

Shop sold after two years, flat after four. Prices rise by 10% a year.

Sale of shop after two years, gain calculated on the alternative basis — £20,000 gain all business.
Sale of flat after four years, elect for statutory basis:
£40,000 gain split 25%/75% — £10,000 business, £30,000 non-business

Don't I remember …?

Now this may be ringing bells with some readers. Wasn't there a similar problem a few years ago when someone took advantage of the practice for holding over gains on a reconstruction, which was extended past the statutory provisions, and wasn't it stopped by a change to the law? In any case, surely HMRC have six years to make a discovery in relation to the first sale, and put that onto the statutory basis too?
To deal with the latter first, it probably depends on what was put on the tax return. To protect against any subsequent change of heart by HMRC, it might be wise in any situation where the gain under the alternative basis is lower, to make an entry in the white space which says 'The gain has been calculated in accordance with Statement of Practice D1, which produces a lower gain than the calculation under the strict statutory basis'. Without such a clear indication that the assessment is strictly 'insufficient', Langham v Veltema [2004] STC 544 might allow the Officer to make a discovery, even though the use of the alternative basis was quite clear and accepted, on the grounds that they did not know for sure that the assessment was insufficient — the statutory basis could have resulted in a lower gain. With the statement in the white space, it seems to me that the assessment will be final once the enquiry window has closed.
On the former point, yes there was a case on reconstructions — Fallon & Kersley v Fellows [2001] STC 1409, and it resulted in TCGA 1992, 284A and 284B. They apply where any concession (defined so as to include a statement of practice) is used to obtain 'the benefit of any capital gains relief' which is then later 'repudiated'. In that situation, the benefit is charged to capital gains tax.
There are two problems when trying to use this to change the treatment of the gain on the first sale. The first is that repudiation is defined in terms of avoiding 'recoupment' of a gain, which would otherwise arise if a concession had not been relied on, and it is hard to see how a different proportion for business and non-business asset taper relief fits that definition. This is reinforced by the heading to the section, which refers to 'Concessions that defer a charge'.
The second, and potentially even more fatal, problem is in the definition of a capital gains relief. This is defined by s 284A(4)(a) as a relief 'the effect of which is that the amount of chargeable gains taken to have accrued to that person in that period is less than it otherwise would have been'. However, taper relief does not affect the chargeable gains accruing; these are added together in TCGA 1992, s 2 and the losses deducted. Only after this is taper relief deducted by virtue of s 2A, which is why losses get deducted from the untapered gains. The reduction in tax is not therefore a capital gains relief as defined in the section.

What now?

So there probably are things that we could be doing to take advantage of the mess that the law is in. Should we be doing so? Personally, I am uncomfortable with deliberately setting out to use a concessionary basis initially, with a view to taking advantage of this by switching to a statutory basis later, after the enquiry window has closed. But advisers have a problem when such approaches are apparently available — are they then negligent if they do not draw them to the attention of their clients, so that they can at least decide whether or not to take advantage of them?
I actually think it would be helpful to all concerned if HMRC would close the loophole. Their argument on the last 'part-disposal' seems weak, and if they lose it the result is capricious, whereas it can at least be said of their current view that it gives broadly the right result in the end. But it does so by requiring complicated calculations relating to the use of the 'whole asset', which bear no relation to the reality of what is being sold. It would be far better if the taper relief on a part disposal was calculated simply on the basis of the use of that part, and not on the basis of the use of the whole. 

Issue: 4024 / Categories: Comment & Analysis , Capital Gains