Update: personal tax and trusts

There have been a few instances recently where a taxpayer has felt that he should be taxed in a particular way as a result of the law or HMRC practice which applied when a taxable event occurred, and should not be subject to a later, retrospective change in law or practice, due to his 'legitimate expectation'.

R (on the application of Hewitson) v Revenue & Customs Commissioners [2010] EWHC 97 concerned retrospective changes to the law relating to the use of 'intermediary-based' tax avoidance schemes. The taxpayer was a self-employed IT consultant who was resident in the UK and who sought to rely on the UK/Isle of Man double tax agreement to obtain treaty relief which would result in no income tax liability in the Isle of Man and no income tax liability in the UK. The first tax year covered by his claim was 2001/02. HMRC disputed the claim in this year and in succeeding years.

The Finance Act 2008 contained amendments to provisions in the Income Tax Trading and Other Income Act (ITTOIA) 2005, which were designed to counter the abuse of double tax agreements. The Finance Act 2008 provides that the amendments to the ITTOIA 2005 are treated as always having had effect and that the changes had a similar effect on the legislation prior to the ITTOIA 2005.

The taxpayer claimed that the change had retrospective effect and that it was in breach of the Human Rights Act 1998.

It was held that legislation was required to give the intended effect to the double tax agreement and to ensure that the proper amount of tax was paid. The court said that Parliament was entitled to legislate with retrospective effect to ensure a fair balance between those taxpayers generally who paid the correct amount of tax in the normal way and those who sought to use double tax agreements through artificial schemes.

Defining non-resident status

R (on the application of Gaines Cooper) v HM Revenue & Customs [2010] EWCA Civ 83 was an appeal to the Court of Appeal by the taxpayer for a judicial review of the interpretation by HMRC of booklet IR20, which sets out guidance on the residence and ordinary residence status of individuals. The taxpayer contended that he had not been resident in the UK and had not been ordinarily resident in the UK in the tax years 1993/94 to 2003/04. The special commissioners decided in 2006 that, on their interpretation of IR20, the taxpayer was resident and ordinarily resident in the UK for those tax years. The taxpayer sought judicial review, which was heard by the Court of Appeal. The appeal was heard with another similar appeal on the interpretation of IR20 (R (on the application of Davies and James) v HMRC).

Although the taxpayer claimed to have left the UK permanently or indefinitely and consequently ceased to be resident and ordinarily resident in the UK, the court held that he needed to demonstrate a distinct break from former social and family ties within the UK in order to meet the requirement for 'permanently or indefinitely' as requested by IR20. The taxpayer claimed that HMRC had changed their approach in 2004/05 to require taxpayers to show that they had made a distinct break from the UK and therefore there was a legitimate expectation on his part that he would be treated in the way set out in IR20 prior to the change of approach.

The cases of Levene v Inland Revenue Commissioners and Inland Revenue Commissioners v Combe already required that, in order to cease to be UK resident, a taxpayer must leave the UK for a 'settled purpose' in order to produce a distinct break and cut pre-existing ties with the UK.

The special commissioners had not altered their interpretation of IR20. Therefore, the application for judicial review was refused.

In addition, the taxpayer had not returned to the UK during his periods of absence for more than 91 days in any tax year. Although IR20 provided that if that day count was exceeded non-resident status would be lost, the converse did not necessarily apply. Therefore, if a number of return visits was not exceeded, it did not follow that the taxpayer had left permanently or indefinitely. The important point was to establish non residence in the first place.

This case highlights the inconsistency between the guidance contained in IR20 and the law on non residence, as set out in the decided case law. When this case was initially heard by the special commissioners and decided in favour of HMRC, there were calls for a statutory definition of residence and non residence to replace the confusing and inconsistent case law. Now that this case has been heard and decided by the Court of Appeal, an introduction of a statutory definition of residence may move a step forward.

HMRC statement of practice

The case of Mansworth (HMIT) v Jelley [2002] EWHC 442 (Ch), heard in the Court of Appeal, decided that where shares were acquired on exercise of an employee share option (employee shares) the acquisition cost for capital gains tax purposes was to be the market value of the shares at the time of exercise (rather than the actual acquisition cost). The result was that, if an employee disposed of his shares shortly after exercising his option, he would make little or no gain for capital gains tax purposes.

In January 2003, HMRC issued guidance on the CGT treatment of employee shares. That guidance stated that the CGT acquisition cost should be a sum equal to the market value of the shares on the exercise of the option plus the amount, if any, charged to income tax on exercise. That produced a beneficial position for taxpayers, in that if a taxpayer were to dispose of his shares shortly after exercising his option, he would, in most cases, make a capital loss.

The 2003 Finance Act changed the law with effect from 10 April 2003 so that CGT base cost for the shares became the exercise price plus any amount charged to income tax on exercise. There therefore remained an opportunity for taxpayers to bank large losses on share acquisitions before 10 April 2003 on the basis of the HMRC guidance.

On 12 May 2009, HMRC issued further guidance, which effectively said that their guidance issued in 2003 was wrong. The 2009 guidance specified that the base cost of the shares acquired prior to 10 April 2003 on exercise of an unapproved option was the market value of the shares.

As a result, a taxpayer who has acquired shares on the exercise of a share option before 10 April 2003, but has not yet sold those shares, may claim to have a legitimate expectation that he should be able to sell the shares with the base cost that he had assumed to apply at the time. HMRC intend to apply the new interpretation of the law to all disposals of employee option shares including cases where there is an open enquiry or an appeal.

HMRC do not generally accept that their published guidance in January 2003 created any sort of legitimate expectation on the part of the taxpayer, but they accept that there may be cases where a 'legitimate expectation' exists because the taxpayer can show that he acted in reliance upon the old guidance and suffered detriment as a result. The problem is that if the shares have not yet been sold, the taxpayer has not yet suffered any detriment.

Business assets

There have been two recent cases concerning the treatment of business assets, both of which went against the general understanding of the law. One case related to taper relief for capital gains tax and that the other related to business property relief for inheritance tax.

In Jefferies v HMRC [2009] UKFTT 291 (TC), the taxpayer sold a building which comprised a part which was exclusively his main residence and another part which was exclusively used for business purposes. The main residence exemption from CGT therefore applied to a proportion of the gain on the sale of the building and taper relief would apply to a proportion of the gain. This case related to what those relative proportions should be.

HMRC argued that a gain had to be apportioned on a pro-rata basis on a business and a non-business gain prior to the application of taper relief, so that the chargeable part had to be split under the mixed use rules. That approach would significantly dilute business asset taper relief.

The First-tier Tribunal did not agree with that approach, on the basis that it was not 'just and reasonable'. The tribunal thought that it would be just and reasonable to apportion the gains so that the whole of the taxpayer's chargeable gain which remained after private residence relief should be eligible for business asset taper relief.

From time to time, a case comes along which is a good example of how a type of tax relief applies in practice. This is one such case, but it is a pity that taper relief has now gone and it is too late to use this knowledge.

The second case, HMRC v Nelson Dance Family Settlement [2009] EWHC 71 (Ch), was an appeal of the special commissioners' decision two years ago in which they decided that business property relief applied to a lifetime chargeable transfer of land which did not involve either the transfer of an entire business or a part of the business. The property comprised assets which were used in the taxpayer's business, but the value transferred was attributable to the value of relevant business property and therefore was eligible for business property relief.

The appeal was heard in January 2009 and denied the appeal, agreeing with the view of the special commissioners.

The decision means that (subject to any successful appeal by HMRC) the law has been different to the commentary on it in leading publications on inheritance tax.

This provides a number of significant planning opportunities. For example, it may be possible to remove investment assets from a company which carries on mixed activities to ensure that the company is a predominantly trading company. It remains to be seen whether this decision will be appealed again, but, if not, it may lead to a change in legislation.