ITA 2007 s 720 and TCGA 1992 s 13 are arguably the two most important pillars in the UK personal taxation code. Whenever they have been challenged, HMRC have moved quickly to bolster them.
So the announcement on 16 February 2011 by the European Commission (EC) potentially has a profound impact on the structure of UK tax legislation and how individuals operate their businesses and hold their investments.
On that date the EC formally requested the UK to amend the anti-avoidance measures on the basis that they are ‘disproportionate, in the sense that they go beyond what is reasonably necessary in order to prevent abuse of tax avoidance’.
The EC announcement only refers to the use of a company but s 720 is much wider – it applies for example to monies held via an offshore trust or partnership. It is unclear whether the action will be taken against the rules in their totality or only on transfers to a non-UK but EU resident company.
The UK government has two months to make a satisfactory response, failing which the Commission may refer the UK to the European Court of Justice (ECJ). If referred to the ECJ, the case may take a number of years to be heard. At the time of writing the response of HMRC is unknown and it is possible HMRC may take pre-emptive action to avoid a referral.
How will HMRC respond?
That we are entering a period of uncertainty is clear. What is less clear is how HMRC will respond, how profound an impact the announcement will ultimately have and how great the opportunity for taxpayers is in the interim.
It is impossible, and indeed dangerous, to predict HMRC’s response. On one level, they might be expected to take the announcement in their stride and draw comfort from the parallels with the challenges to the CFC legislation.
If this were the approach adopted by HMRC, then the structural impact might be limited. It will perhaps nevertheless be the biggest ‘wake-up call’ yet for personal tax advisers on the impact of EU law on their advice (it is not the first – see for example Manninen (Case C-319/02), but it is certainly the most important).
Some advisers have felt for some time that s 720 would ‘fall’ to the EU argument and accordingly advised clients to hold UK income assets (eg, rental property) in an EU company on the basis the income could roll up tax free.
Some very ambitious structures were erected on the back of such advice; ‘ambitious’ because many seemed to proceed on the basis that the EU location was all it took to side step the operation of s 720. Having regard to Cadbury Schweppes (Case C-196/04), the need for a genuine business operation to support such planning seemed to be the more prudent view.
Thus HMRC may simply take the view that the existing provisions are justified where they are used purely as a revenue protection (tax avoidance) mechanism. The recent Court of Appeal decision in the Thin Cap GLO (Test Claimants in the Thin Cap Group Litigation (Claimants, Appellants and Respondents) v HMRC [2011] EWCA Civ 127) case will encourage HMRC in this line of reasoning. The Court held the UK thin cap rules (ie, the pre-2004 rules only applying to cross-border financing of companies) were EU-compliant because they were proportionate to the needs to ‘protect the balanced allocation of taxing rights’ and ‘prevent tax avoidance’. The Court held there was no need for a separate commercial justification test; in effect they thought this was no different from the arm’s-length test. Thus a loan that did not meet the arm’s-length test was not commercial.
This case supports HMRC’s interpretation of recent ECJ cases to say they can apply anti-avoidance rules to the extent a transaction/structure would not have been created in an arm’s-length situation or is not commercial. Anti-avoidance rules do not have to be all or nothing and the threshold to protect the taxpayer is not simply that the structure actually exists; there must be commercial substance commensurate to the income producing activity.
There is therefore a strong logic for the view which says we will end up with rules (or an interpretation of the existing ones) which requires the taxpayer to show that the investment had a genuine business purpose and was commercial and was not purely tax driven.
Section 13 has no ‘bona fide commercial’ defence and if the effect of the EC intervention is to prompt one this would be a welcome development. In contrast, s 720 et seq has such defence but the scope and operation of the provision has long been a subject of dispute (particularly the question of whether it was a subjective or objective test). Taxpayers will only welcome further amendments to this provision if it adds clarity and genuinely facilitates commercial transactions.
A less likely response to the EU challenge, but still possible, is that HMRC see this as an opportunity to impose similar tax charges on UK companies. One cannot rule out that the UK Budget on 23 March will see a throwback to the former apportionment rules for close companies. The added attraction of such a development for HMRC is that it would negate the increasingly common strategy of introducing a corporate partner into partnerships. Such a development may also trigger a closer alignment – perhaps even a merger – of the income and corporation tax rules.
What action should be considered now?
Pending the next developments, taxpayers will be considering what actions they should be taking in the light of the EC’s announcement.
The nature (if any) of the steps will depend on the existing position. Taxpayers currently suffering tax on income under ITA 2007 s 721, where the relevant transfer was to a person tax resident in the EU, may wish to consider making a claim to exempt such income. Similarly, taxpayers who are suffering an attribution of gains realised by non-UK resident companies may wish to consider making a claim based on EU law.
Existing structures should be reviewed to see if any action should be taken – for example, possibly extracting profits now rather than retaining them in a ‘cash box’ company. Those contemplating new investment structures should also pause for thought before proceeding – is the best vehicle now an offshore (but EU) company or perhaps a UK one? Should existing structures be moved to an EU vehicle?
The next few months will be very interesting.
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David Kilshaw, Partner, KPMG
