This monthly update provides a brief analysis of the main tax events of recent weeks, plus an overview of key tax cases and international news.
It is compiled by Francesca Lagerberg of Smith & Williamson.
DEBATE RAGES OVER REVENUE RECOGNITION
Following the issue of the Accounting Standards Board's Application Note G on this subject just before Christmas, there has been much debate as to whether the adoption of
FRS 5 (mandatory for accounting periods ending on or after 23 December 2003) will entail substantial increases in work in progress for accounting and tax purposes.Broadly, the note will require revenue to be recognised in accounts at the point when a person who performs services has performed his contractual obligations and in exchange has obtained the right to consideration for those services. Any uplift created by adopting this practice - which would include partners' time - will create a one-off tax charge which would be taxed under Case VI of Sch D for the year in which the end of the first accounting period affected falls (eg, 2004/5 for a 30 April 2004 year end).
This is provided for by Sch 22 FA 2002 but unlike the similar one-off adjustments which arose from the ending of the old 'cash basis' in 1998, there is no provision to spread the liability forward. In a partnership there is the further anomaly that the charge falls on those who were partners in the previous accounting period (para 13(2)(a) Sch 22 FA 2002).
The Tax Faculty of the ICAEW has confirmed that: 'At present views differ on the accounting issues raised by Application Note G in relation to professional firms. One key concern is that firms will provide services under many different terms of engagement. The precise terms of engagement might lead to earlier recognition of income in certain cases. The ICAEW is currently seeking to provide authoritative clarification of the key issues and is in contact with key interested parties as part of this process.
The Tax Faculty has discussed the issue with the Inland Revenue. The Revenue's initial view is that the application note may not have a significant impact on the majority of professional firms, but is awaiting clarification from the accountancy profession. As soon as the issue has been clarified there will be further discussions with the Revenue in order that the tax implications can be fully considered.'
Opinions may differ on the impact of this change but it could clearly be very significant for some firms or sole practitioners who have previously followed accepted practice by including unbilled work in progress (WIP) at cost and excluding partners' time. For affected parties there appears a strong case for considering a spreading relief similar to that granted in 1998, and allocation among those who are partners in the period when the change is made, to avoid inequities and mismatches.
GOVERNMENT SHUTS DOWN TAX GILT SCHEMES
The government has brought forward legislation, effective from 15 January 2004, to close down schemes using strips of government bonds to set against other income.
The changes prevent income tax avoidance by individuals (other than those trading in securities) and trusts by use of transactions in strips of government bonds. The changes will affect para 14-15, Sch 13 FA 1996 (Discounted securities: income tax provisions).
Gilt strip schemes were widely marketed and basically enabled an individual to enter into arrangements with the intention of creating artificial losses.
For example, these could involve purchasing strips of government bonds at market prices, and disposing of them shortly afterwards, by the granting of an option at a low strike price. The person disposing of the strips does not suffer an economic loss because the low price is balanced by receipt of a non-taxable premium for the option over the strips.
The changes specify that, where there is a scheme or arrangement to obtain a tax advantage, market value will be substituted for the cost of acquisition and disposal proceeds. This will effectively limit the allowable loss to the loss (if any) that would arise based on market prices on the dates of purchase and sale.
A further change will also be made to disallow any loss arising on the actual or deemed disposal of a strip of a government bond to the extent the proceeds fall below the cost of acquisition. Other than for disposals that are part of a scheme or arrangement, this change will apply to losses on disposals of strips of government bonds acquired on or after 15 January 2004.
The changes will also introduce a new definition of 'market value' for the purposes of pricing strips at year-end deemed disposals and re-acquisition as well as for the new rule described above. This will be by reference solely to publicly available pricing information and will not take account of any way in which its value may have been affected.
The legislation supporting these changes will appear in the Finance Bill 2004.
Source: Inland Revenue press release dated 15 January 2004.
REVENUE CHANGES SME DEFINITION
From 30 January 2004 there is an important change in the definition of small and medium-sized enterprises (SMEs) as announced in an Inland Revenue press release of the same date.
The relevant thresholds are being increased to the permitted EU maximum.
The new thresholds will take effect in relation to financial years ending on or after 30 January 2004 with only minor exceptions.
The Companies Act 1985 defines a company as an SME for its first financial year if it meets two of more of the following requirements in that financial year. Once a company has qualified as an SME it will continue to be one unless it fails to meet two or more of the requirements for two years in a row. Where a large company reduces in size to become a small or medium-sized company, it must meet two or more of the requirements for two successive years. The old and new rules are as follows:
The old rules:
| Company size Turnover Balance sheet Number of (not more total employees than) (not more (not more than) than) Small 2.8m 1.4m 50 Medium 11.2m 5.6m 250 The new rules: The following increased thresholds will replace those above for financial years ending on or after 30 January 2004: Company size Turnover Balance sheet total Number of (not more (not more employees than) than) (not more than) Small 5.6m 2.8m 50 Medium 22.8m 11.4m 250 |
Secondly, SMEs can claim 40% first-year allowances (FYAs) on their spending on plant and machinery. And thirdly, small businesses can claim 100% FYAs on their spending on information and technology equipment between 1 April 2000 and 31 March 2004. However, there are some exceptions. Spending on assets for leasing, for example, does not qualify.
Note also that the audit exemption threshold will rise to 5.6m on 30
March 2004. The new audit exemption thresholds will take effect in relation to financial years ending on or after 30 March 2004.
Source: Inland Revenue press release dated 30 January 2004
SUBCONTRACTORS
Drafts of the new legislation on subcontractors in the construction industry, promised in the pre-Budget report in December 2003, can now be viewed on the Revenue's website at www.inlandrevenue.gov.uk.
Pre-owned assets and the proposed income tax charge
The potentially large scope of the proposals described in very broad outline in the pre-Budget report is giving rise to considerable comment and strong representations as to the possible effects. The Revenue's policy seems to be to catch transactions which did not attract an inheritance tax (IHT) charge when made (however long ago), and not to catch those which gave rise to a gift with reservation (GWR), although this was not clear from the few details announced in December. Lobbying has been invited on the level of the de minimis exclusions but officials have given the impression that the principles are non-negotiable. Some of the particular problem areas may include:
• Mr A buys a property and then puts it into the joint names of himself and his girlfriend Miss B, and they both occupy it. Technically this may be a GWR already but is very unlikely to be reported if Mr A dies while the arrangement is in force. If caught by the new rule there would be an annual income tax charge. If Mr A dies would there also be an IHT charge on the whole value and would there be credit for the income tax charge?
• Mr D is the settlor and beneficiary of an offshore trust which owns his UK home. He could be taxed under s87, TCGA 1992 on stockpiled gains up to the value of his benefit each year, but now could he be liable to income tax as well?
Valuation and compliance would also pose very substantial problems. When advising on gifts of assets clients need to be warned about the possible impact of these measures, even though at this stage this can only be done in very general terms.
TAX CASES
MacDonald v Dextra Accessories Ltd (Court of Appeal) The Court of Appeal has reversed the decision of the High Court and the special commissioners on one point: the meaning of 'potential emoluments' in s43, FA 1989.
This has important ramifications for any companies with open tax years where a deduction has been sought for contributions to employee benefit trusts (EBTs) where there has been no corresponding payment out from the trust. We have clients in this position. Any such deduction is likely now to be denied unless there is a payment out of what used to be known as 'emoluments'. This is a direct reversal of established Inland Revenue practice set out in its manuals concerning 'potential emoluments'.
Leave to appeal to the House of Lords has been refused by the Court of Appeal, although the taxpayer may well petition the Lords direct.
Broadly, the issue on appeal was whether or not payments into the Dextra EBT were potential emoluments. The Caudwell group created an EBT and companies within the group settled amounts on the trust. These were chiefly used for the provision of loans to directors within the nine months of the accounting period. If the payments into the trust were 'potential emoluments' no corporation tax deduction would be available until the amounts in question were actually paid as emoluments. Rather drastically, this meant that if they never became emoluments, (eg, because they were distributed as some other benefit) no deduction would ever be available.
Section 43, FA 1989 has since been revised for the introduction of ITEPA 2003 but this case was concerned with the original draft.
It was accepted by all parties that the EBT trustees were 'intermediaries'.
Were the amounts held by the trustees 'with a view' to their becoming relevant emoluments? The judges managed to find that they were, saying that 'with a view to' was a phrase that was to be interpreted flexibly and was 'apt to embrace the whole range of realistic possibilities available to the trustee'. This was the case notwithstanding that the trustees had actually used the trust fund to provide benefits (the loans) which were not emoluments. Parker LJ fully accepted that this could mean that for some amounts a deduction might never be available but just saw this as an inevitable conclusion from the structure.
Decision: For the Revenue.
Francesca Lagerberg is national tax director at Smith & Williamson, the accounting and financial advisory group. Francesca.lagerberg@smith.williamson.co.uk