Transfer of assets abroad and attribution of gains rules: consultation published

Practical Law UK Legal Update 1-520-6482 (Approx. 10 pages)

Transfer of assets abroad and attribution of gains rules: consultation published

by PLC Private Client

Background

Attribution of gains made by non-resident close companies

As a general rule:

Non-UK tax resident companies that do not carry on a trade in the UK through a permanent establishment or agency are not subject to UK tax on their capital gains.
Capital gains realised by a company are not taxable in the hands of its shareholders.

However, non-UK resident close companies that would be close companies if UK resident are subject to anti-avoidance rules contained in section 13 of the Taxation of Chargeable Gains Act 1992 (TCGA 1992) (section 13). Section 13 permits any capital gains that such close companies realise to be brought within the UK tax net by attributing those gains to UK resident shareholders and certain other persons with an interest in the company (subject to a minimum attribution in any case of 10% of the chargeable gain), including the trustees of non-UK resident trusts. (Although non-UK resident trustees would not, themselves, be subject to tax on the attributed gains, those gains may be further attributed to a UK resident settlor or beneficiary of the trust under the rules contained in sections 86 and 87 of TCGA 1992.)

Gains on assets used only for the purposes of a trade carried out outside the UK are excluded from the charge under section 13, but there is currently no motive test excluding arrangements whose purpose does not include tax avoidance.

For further information on the operation of section 13, see PLC Tax, Practice note, Controlled foreign companies and attribution of gains: tax: Attributing capital gains to the UK. For HMRC's guidance on section 13, see HMRC: Capital Gains Manual: CG57200: Charge on members of non-resident companies.

For information on the operation of sections 86 and 87 of TCGA 1992, see Practice note, Taxation of offshore trusts: overview: The CGT charge on the settlor: section 86 of TCGA 1992 and The CGT charge on the beneficiaries: section 87 of TCGA 1992.

Transfer of assets abroad rules

Chapter 2 of Part 13 of the Income Tax Act 2007 (ITA 2007) contains wide and complex anti-avoidance provisions known as the transfer of assets abroad rules. Broadly, these rules apply where assets have been transferred by an individual ordinarily resident in the UK to an overseas company, trust or other entity with an aim of reducing the transferor's UK tax liability. Where they have effect, the rules attribute income arising in the overseas entity to either the UK resident transferor or other UK resident individuals who benefit from the transfer.

No charge arises under these rules if the taxpayer satisfies an officer of HMRC that either of the following exemptions applies:

There was no tax avoidance purpose behind any of the relevant transactions.
All of the relevant transactions were genuine commercial transactions on arm's length terms and any tax avoidance purpose was incidental.

(Sections 737 and 738, ITA 2007.)

For further information on the rules, see Practice notes, Income tax: anti-avoidance and secondary liability: Transferring assets abroad and Taxation of offshore trusts: overview: If neither the settlor, his spouse, his minor children can benefit. For HMRC's guidance on the rules, see HMRC: International Manual: INTM600000: Transfer of assets abroad.

The government is consulting separately on the abolition of the concept of ordinary residence for tax purposes from 6 April 2013. Under the present proposals, from that date, the transfer of assets abroad rules will apply to individuals who are resident in the UK under the proposed statutory residence test. For information about those proposals, see Private client tax legislation tracker 2011-12: Statutory residence test and abolition of ordinary residence. For information about the current definitions of "residence" and "ordinary "residence", see Practice note, Residence and ordinary residence: definitions for UK tax purposes.

European Commission request to amend rules

On 16 February 2011, the European Commission formally requested that the UK amend its tax rules on the transfer of assets abroad and the attribution of gains made by non-resident close companies.

The Commission considers that both regimes are incompatible with the fundamental EU rights to freedom of establishment and free movement of capital, because the restrictions they impose are disproportionate (that is, they go beyond what is reasonably necessary to prevent abuse or tax avoidance and any other requirements of public interest). If the UK does not amend the rules, the Commission has power to refer the matter to the Court of Justice of the European Union. (See Legal update, European Commission challenges UK transfer of assets abroad and attribution of gains rules.)

EU law allows member states to restrict freedom of establishment to counteract tax abuse if the restrictions target "wholly artificial arrangements" that do not reflect economic reality, for example, because they are designed to escape the tax normally due on profits generated by activities carried out in that state (Cadbury Schweppes plc v Commissioners of the Inland Revenue (and related appeal) (Case C-196/04); see PLC Tax, Practice note, ECJ direct tax cases: where are they now?: Cadbury Schweppes).

The UK government announced in December 2011 that it would introduce legislation in the Finance Bill 2013 to amend the rules, and confirmed this in the 2012 Budget (see Legal update, 2012 Budget: key private client tax announcements: Transfer of assets abroad and attribution of gains rules).

HMRC consults on proposed amendments

On 30 July 2012, HMRC published a consultation document, including draft legislation, proposing amendments to both section 13 and the transfer of assets abroad rules (see Source). In each case, some of the proposed amendments would have retrospective effect from 6 April 2012 and others would have effect from 6 April 2013.

The aim of the proposed amendments is to make the legislation compatible with EU law, by allowing individuals to pursue genuine economic activity across borders, while continuing to protect UK tax revenue. The drafting of the amendments draws on the principle in Cadbury Schweppes and other EU case law (see European Commission request to amend rules), and also on principles in the OECD Model Tax Convention on Income and on Capital (OECD model) and other OECD sources. (For information about the OECD model, see Practice note, Double tax treaties: an introduction: Interpretation of DTAs.)

The government is also taking the opportunity to review the rules more generally and invites suggestions for further improvements.

Amendments to section 13 from 6 April 2012

The draft Finance Bill clause amending section 13:

Expands the categories of assets excluded from charge to include those used in genuine economic activity (see Business establishment test).
Introduces a motive test (see Motive test).
Provides that furnished holiday lettings outside the UK will fall within the existing exclusion of trading assets in certain circumstances (see Furnished holiday lettings).

These amendments will have retrospective effect for disposals on or after 6 April 2012, although a taxpayer may elect for them not to apply to disposals made in the tax year 2012-13. The election must be made within four years from the end of the tax year (for capital gains tax (CGT) purposes) or accounting period (for corporation tax purposes) in which the disposal was made.

The consultation document also mentions that if section 13 is amended, equivalent changes will be needed to section 18P(2) of the Corporation Tax Act 2009 (CTA 2009), which prevents gains in close companies from falling within the elective exemption from corporation tax for profits arising in a foreign permanent establishment of a UK resident company (see PLC Tax, Practice note, Foreign permanent establishments exemption) (paragraph 2.5, consultation document).

Business establishment test

Section 13 will not apply to chargeable gains on a disposal of an asset if either of the following applies:

The asset is used only for the purposes of economically significant activities carried on outside the UK by the disposing company through a business establishment in a territory outside the UK.
The asset is effectively connected with any part of a business establishment in a territory outside the UK through which the disposing company carries on:
- a trade wholly or partly outside the UK; or
- economically significant activities outside the UK.

The following definitions apply for this purpose:

Business establishment means a permanent establishment as defined by sections 1141 to 1144 of the Corporation Tax Act 2010 (see PLC Tax, Practice note, Companies: UK residence and permanent establishments: Definition of "permanent establishment" under domestic UK law).
Economically significant activities means activities that:
- consist of the provision by the company of goods or services to others on a commercial basis and with a view to the realisation of profits on a scale commensurate with the size and nature of the establishment; and
- involve the use of employees, agents or contractors in numbers, and with the competence, commensurate with the realisation of profits on that scale.
A business (or part of a business) that consists of making investments does not fall within this definition, although the government has indicated that an active investment management company will qualify if its activities are conducted on an arm's length basis. (The consultation document refers to a more detailed discussion of this point in Annex I of the June 2011 Consultation on Controlled Foreign Companies (CFC) Reform, as to which, see PLC Tax, Legal update, Full CFC reform: consultation document published (detailed update): Comment.)
The consultation document asks whether it would be helpful to provide further guidance on this definition (see Proposed guidance on definition of "economically significant activities").
Effectively connected has the same meaning as under the OECD model (as explained in the commentaries to Articles 10 to 12).

Motive test

The new motive test in the draft legislation provides that section 13 will not apply to chargeable gains on the disposal of an asset where it is shown that neither the disposal, nor the acquisition or holding, of the asset by a company formed part of a scheme or arrangements of which the main purpose, or one of the main purposes, was the avoidance of liability to CGT or corporation tax. (This is slightly out of line with the consultation document, which refers to the need to show that there is "no tax avoidance motive at all" (emphasis added) (paragraph 2.15, consultation document).

The motive test will apply as an alternative (not an additional requirement) to the other exclusions from charge under section 13.

Furnished holiday lettings

Furnished holiday accommodation outside the UK that is let commercially, or an interest or right in that accommodation, can qualify as a trading asset.

The letting must meet the requirements of Chapter 6 of Part 4 of CTA 2009, subject to the following adjustments:

The definition of "relevant period" in section 266 of CTA 2009 is replaced with the following definition:
- the period of 12 months ending with the date of the disposal and each of the two preceding periods of 12 months; or
- if the company has been the beneficial owner of the accommodation (or interest or right) for longer than 36 months, the period of 12 months ending with the date of the disposal and each of the preceding periods of 12 months throughout which the company has been the beneficial owner.
The elections that can be made under sections 268 and 268A of CTA 2009, in respect of lettings that do not meet the letting condition in section 267(3) ("under-used accommodation"), do not apply.

For information about the rules in CTA 2009, see Private client tax legislation tracker 2010-11: Furnished holiday letting rules.

Amendments to section 13 from 6 April 2013

The consultation document also invites views on the following points, without making any specific proposals:

The size and nature of the de minimis participation limit of 10% for minority shareholders. The document mentions that a threshold of 25% has been suggested and raises the question of whether the application of section 13 should depend not only on participation, but on whether a member has influence over the actions of the disposing company.
How a de minimis approach to small liabilities might be designed, so as to reduce compliance costs, and what a reasonable level would be.
The extent of problems caused by section 13 for non-UK resident companies operating as public investment funds, and the defining characteristics of those funds.
The interaction of section 13 with double taxation agreements (DTAs). Where a DTA does not expressly provide that section 13 may apply to gains of an overseas company, HMRC currently accepts that section 13 is disapplied by DTAs containing a provision similar to Article 13(5) of the OECD model (which allocates taxing rights to the state in which the person making the disposal is resident, except for any categories of gains subject to express provisions; see Practice note, Double tax treaties: an introduction: Capital gains). The consultation does not ask any specific questions on this point, but states that HMRC will review its current practice as part of this exercise.

Any amendments relating to these points would take effect from 6 April 2013.

Amendments to transfer of assets abroad rules from 6 April 2012

The draft Finance Bill clause amending Chapter 2 of Part 13 of ITA 2007:

Excludes non-UK incorporated but UK resident companies from the rules (by deleting section 718(2)(a) of ITA 2007).
Adds a further exemption from charge based on objective criteria designed to identify genuine economic activity (see Qualifying arm's length transactions). This exemption would apply even where the transaction was influenced by tax considerations (paragraph 3.17, consultation document).

These changes will have retrospective effect from 6 April 2012.

Qualifying arm's length transactions

A new section 742A of ITA 2007 will provide that if a relevant transaction is a qualifying arm's length transaction (QALT), income will be left out of account to the extent that the taxpayer satisfies an officer of HMRC that it is attributable to the transaction.

A QALT is a relevant transaction that meets all of the following conditions:

It is effected on or after 6 April 2012.
It is an arm's length transaction within the meaning of section 738(3) of ITA 2007.
It is effected for the purposes of economically significant activities carried on (or to be carried on) outside the UK.

Activities are economically significant for this purpose if they both:

Consist of the provision of goods or services on a commercial basis and with a view to the realisation of profits on a scale commensurate with the activities.
Involve the use of employees, agents or contractors in numbers, and with the competence, commensurate with the realisation of profits on that scale.

This definition is the same in substance as the definition proposed in the amendments to section 13 (see Business establishment test). (The first limb differs slightly because the definition for section 13 refers to the provision of goods or services "by the company" and profits on a scale commensurate with "the establishment", but the second limb is identical.)

As in the section 13 amendments, a business (or part of a business) that consists of making investments does not fall within the definition (but an active investment management company may qualify; see Business establishment test).

The government does not intend that this new exemption should allow arrangements that it considers abusive to qualify for exemption where they would not have qualified under the current rules, but intends it to produce the same results by means of an objective test, rather than a motive test, in order to comply with EU law.

Proposed guidance on definition of "economically significant activities"

The government considers that the proposed definition of "economically significant activities" is clear and simple, and that it will usually be straightforward to determine whether a transaction is for the purpose of such activity.

However, the consultation document states that, where this is not straightforward:

It will be necessary to carry out a functional and factual analysis of the business activities, taking into consideration whether there are people genuinely:
- making decisions;
- managing the economic ownership of assets; or
- assuming risk
outside the UK in relation to the provision of goods or services.
The precise nature of the functions that are relevant for this purpose will vary according to the type of activities involved and will need to be analysed carefully where the new exemption is claimed.

The government's approach draws on that taken by the OECD for attributing profits to a company's permanent establishment in a foreign territory (see OECD: 2010 Report on the Attribution of Profits to Permanent Establishments).

The consultation document asks whether the definition is sufficiently clear and functional, and whether it would be helpful for HMRC guidance to refer to the OECD report.

Apportionment of income to qualifying and non-qualifying transactions

Where there is a QALT, income will be left out of account only "so far as" (that is, to the extent that) the taxpayer satisfies an officer of HMRC that it is attributable to the QALT. Therefore, the new exemption may be only a partial exemption.

The government proposes that income should be apportioned on a "just and reasonable" basis where necessary, but the draft legislation does not include any specific rules on attribution (although a sub-clause is set aside for this). The consultation document asks what any attribution rule should look like.

Amendments to transfer of assets abroad rules from 6 April 2013

The consultation documents asks for views on three further points:

Whether it is necessary to have rules matching income arising to a person abroad with benefits received by a UK individual (as there currently are for capital gains under sections 87 and 87A of TCGA 1992).
Whether it would provide greater clarity and certainty for taxpayers to have a more extensive provision relieving double charges than section 743 of ITA 2007, and in which other circumstances a double charge could arise. (Currently, HMRC exercises discretionary powers to prevent double charges not provided for in legislation.)
Whether it would make the application of double taxation treaties (DTTs) clearer to specify that what is taxed under the transfer of assets charge is a deemed amount, not the actual income of the foreign person. (Currently, there is disagreement between HMRC and some taxpayers about whether DTT provisions can lead to double non-taxation where taxing rights are awarded to a jurisdiction that does not tax the income arising there.)

Any amendments relating to these points would take effect from 6 April 2013.

Next steps

The consultation closes on 22 October 2012. HMRC will review the proposals in the light of responses, with a view to introducing legislation in the Finance Bill 2013. It will also publish a summary of responses.

To follow the progress of the consultation, see Private client tax legislation tracker 2011-12: Transfer of assets abroad and attribution of gains rules and PLC Tax, Tax legislation tracker: miscellaneous: Transfer of assets abroad and attribution of gains.

Comment

While the government is aiming to bring both sets of rules into line with EU law without making significant changes to their effect, the proposed amendments should be beneficial for any genuinely commercial arrangements that would fall foul of the existing rules. More than ever, it will be sensible to maintain separate holding structures for commercial and non-commercial activities. Taxpayers establishing new commercial ventures that may benefit from the new exemptions should consider using a fresh holding structure for these post-6 April 2012 arrangements.

The government clearly believes that the new concept of "economically significant activities" is the answer to the concerns raised by the European Commission, and it would not be surprising to see this concept extended to other areas if similar concerns arise in future.

The government's impact assessment (which forms part of the consultation document) acknowledges the additional burden that the new QALT test will place on HMRC, because of the functional analysis required where it is not clear whether activities are economically significant. A similar burden will inevitably fall on taxpayers and their advisers, and we can expect test cases on arrangements that are close to the line.

The exclusion of investment businesses from economically significant activities mirrors other parts of the tax code, such as inheritance tax business property relief (BPR). While it is helpful that the government has expressly stated that investment management can be economically significant activity, the emphasis on the need for "active" management has echoes of HMRC's approach to BPR cases such as those involving caravan parks and property lettings.

The possibility of partial exemption from the transfer of assets abroad rules under the QALT adds an extra layer of complexity, as it may be necessary to apportion income between qualifying and non-qualifying transactions. What is not clear to us is whether there can be a QALT at all where a transaction is effected partly for the purposes of economically significant activities and partly not. (By contrast, it is clear that a chargeable gain is excluded from charge under section 13 only if it accrues on the disposal of an asset used only for the purposes of economically significant activities.) This may be because the drafting of the transfer of assets abroad provisions is at a less advanced stage.

The government's proposals on the amendments required for EU law purposes are quite specific, although the consultation document makes it clear that the draft legislation requires further work. By contrast, the discussion of possible further changes to take effect from April 2013 is very broad brush, effectively relying on consultees to come up with ideas. Practitioners who regularly advise in these areas may want to take the opportunity of suggesting improvements on points that cause particular difficulties in practice.

The consultation document does not discuss the impact of the government's plans to abolish the concept of ordinary residence, but simply refers to the separate consultation on that topic.

Source

HMRC: The attribution of gains to members of closely controlled non-resident companies.

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Transfer of assets abroad and attribution of gains rules: consultation published | Practical Law