The Chartered Tax Adviser Examination

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1 The Chartered Tax Adviser Examination November 2016 Suggested solutions Application and Interaction QUESTION 3 - TAXATION OF OWNER MANAGED BUSINESSES

2 REPORT ADDRESSING ISSUES RAISED AND ARISING FROM THE RECRUITMENT OF A NEW PRODUCT DEVELOPMENT DIRECTOR BY A B TURBINE PARTS LTD. Prepared by Nigel Matthews, Tax Partner, Chartered Tax Advisers, City Road, Bagtown BA1 2AB. Introduction This report addresses the issues raised in the letter dated 25 October It is intended to form the basis of discussions at a forthcoming meeting and to consider any tax and National Insurance (NIC) saving opportunities for the new Product Development Director and the company. Executive Summary a. Employment Contract General The company should consider paying up to 8,000 towards Chloe s relocation expenses by way of salary sacrifice. This will save Chloe income tax and National Insurance Contributions (NIC) and the company employer s NIC. The company could consider paying Chloe additional salary to share the saving with her. The company should also consider making additional employer pension contributions for Chloe by way of salary sacrifice to save Chloe income tax and NIC and the company employer s NIC. The company could consider sharing this saving with Chloe by paying her additional salary. The company should discuss with Chloe the arrangements to provide a company car. Substantial car benefits in kind may arise and it may be more tax and NIC efficient to pay Chloe a car allowance and for her to provide her own car. Share in Capital Growth The company could allot Chloe new shares at the current undiscounted market value as per the report prepared by EF Valuations Ltd. She would then share in the future capital growth of the company. As an alternative it is recommended that the company consider issuing share options under the Enterprise Management Incentive (EMI) Scheme. The exercise price should be the current undiscounted market value. Chloe would share in the capital growth but without having an immediate shareholding with attaching voting and dividend rights. The company should consider the tax implications for Gary on a future sale of his shares as a result of any dilution of his shareholding. b. Research & Development Research and Development tax reliefs are available to help fund the research costs for Chloe s idea. The reliefs would reduce Corporation Tax and/or generate tax credit repayments. A detailed analysis of the project and costs should be undertaken to ascertain if the qualifying criteria are met. c. Share Transfers and Capital Gains Tax Issues Arthur and Harriet should consider making share transfers to their children simultaneously with the property sale to potentially reduce the Capital Gains Tax (CGT) rate to 10% with the benefit of entrepreneurs relief (ER). The Inheritance Tax (IHT) implications must also be considered. 1

3 The Pension Scheme Trustees should register for Value Added Tax (VAT) and submit an option to tax the property to ensure that Transfer of Going Concern (TOGC) conditions can apply to avoid the need to pay VAT on the sale. This will also save Stamp Duty Land Tax (SDLT). Entrepreneurs Relief (ER) conditions must be considered for all shareholders and in particular the requirements that for the twelve months prior to disposal they must have a minimum 5% shareholding and be a company officer or employee. Possible recruitment of new Product Development Director i. Employment package general issues An outline employment package has been agreed with Chloe, the terms of which have been seen, but the following key areas have been identified as opportunities to save Chloe and the company tax and/or NIC: Relocation allowance Chloe and family intend relocating to the South. When an employee relocates for work reasons an exemption is available, provided certain conditions are satisfied, to pay up to 8,000 free from income tax and NIC. The conditions to be satisfied by Chloe and the company are as follows: Chloe must change her residence on taking up employment with the company and the relocation costs must be incurred in connection with this change. The change must be to allow Chloe to live within a reasonable travelling distance of the place of employment and Chloe s current residence must not be within a reasonable distance. The costs must relate to the disposal of the old residence, purchase of the new residence, transportation of belongings or travel and subsistence and must be incurred before 5 April 2018 assuming Chloe s employment begins in the current tax year. It is recommended that she is recruited on a reduced salary but with an agreement that the company makes a contribution of up to 8,000 towards qualifying relocation costs. This would save Chloe income tax and NIC on the amount and the company would avoid employer s NIC. The company can pay costs greater than 8,000 but the excess would be reportable on form P11D as a taxable benefit. Chloe would be liable to income tax on this benefit but not NIC. The company would be liable to pay Class 1A NIC. The arrangements must be contractually documented in line with HM Revenue & Customs (HMRC) salary sacrifice guidance. Chloe s salary will therefore be contractually lower which will impact on her income for mortgage purposes. Chloe s salary could be increased in future years when the relocation allowance has been fully used. The relocation payments made or reimbursed by the company will be fully allowable for Corporation Tax purposes. 2

4 Pension contributions The company will pay 2% of salary in employer pension contributions and Chloe intends paying 5% in personal pension contributions. Chloe and the company could agree to reduce her salary by way of salary sacrifice as above and to increase the employer pension contributions. This would save both Chloe and the company NIC. The employer s NIC saved could be used to make additional pension contributions. Chloe s employment contract must again meet the relevant HMRC salary sacrifice guidance. The contract would state the lower salary and the increased pension contributions. This will again affect her income for mortgage purposes. The pension contributions will be allowable for Corporation Tax purposes in the accounting period in which paid. Car benefit v personal car Chloe is to be provided with a company car. The company would report this benefit on form P11D and be liable to Class1A NIC. Chloe will be liable to income tax on the benefit calculated as a percentage of the car s list price with the percentage based on the car s CO2 emissions. The percentages can be as high as 37% giving rise to substantial annual tax charges. The company must also consider if private fuel is to be provided. This would be an additional taxable benefit. Alternatively, the company could consider paying Chloe a car allowance for her to purchase her own car. Although the car allowance is taxable and liable to NIC the net cost can often be far less that on the car benefit. The company will pay the same rate of NIC with the car allowance being Corporation Tax deductible. Any fuel allowance could also be included in the car allowance. If Chloe uses her own car for business purposes she could charge the company at the approved mileage rates of 45p per mile for the first 10,000 miles and 25p above 10,000 miles. The approved mileage payments are exempt from income tax and NIC. ii. Employment package Share in future capital growth The company intends to incentivise Chloe by giving her a share of 10% of the growth in value of the company from the date she starts employment to some future date, probably in the event the company is sold. The three areas considered and detailed are, a bonus scheme, a share allotment or the Enterprise Management Incentive (EMI) scheme. Bonus scheme The simplest method would be a bonus scheme linked to the increase in capital value of the company. Bonus payments would be liable to income tax and employee s and employer s NIC but would be allowable for Corporation Tax purposes. As a share sale is in prospect within five years the bonus could be paid when the company is sold with the amount based on the difference between the current undiscounted market value, as detailed in the EF Valuation Ltd report, and the sale price. The bonus could be paid annually but this would require a formula and method of calculation to be agreed. 3

5 New shares The company could immediately issue Chloe with new shares. The price to be paid for the shares should be the current undiscounted market value of the shares as detailed in the report prepared by EF Valuations Ltd. When shares are issued to an employee legislation exists to tax the employee on any discount given below the open market value under the shares by reason of employment legislation. Whilst a professional valuation has been obtained this can always be the subject of possible review by and potential negotiation with HMRC shares valuation division. HMRC do however take account of minority discounts and the risk of challenge would therefore appear very low. Chloe would need to consider how to pay for the shares. Based on a value of 90 per share and an issue of 1,111 shares (approximately 10% of the increased share capital 1,111/11,111) she would be required to pay 99,990. Chloe intends to either borrow this money from her bank or use part of the equity from the sale of her current property. Interest on any new loan to buy the shares would be tax deductible against her taxable income. Giving Chloe an immediate interest in the share capital of the company will give her legal rights as a shareholder. It is always recommended in this situation that a shareholders agreement is drawn up to deal with all relevant issues and to cover any potential future events. Chloe would have a right to dividends if they are declared on the same pro rata basis as the other shareholders. This could affect the existing dividend policy of the company. Her remuneration package would need to be adjusted to reflect any additional dividend income. The problem with an immediate share issue however is what happens if Chloe s idea does not succeed or she does not fit in to the company as she would already have direct share ownership. Share options As the key requirement of the company is to enable Chloe to share in the future capital growth a better alternative would be to use share options. Chloe would simply be issued options to acquire shares in the company at some future date based on the current undiscounted market value. The company could determine that the options are only exercisable in the event of a sale. Chloe would be given options to acquire 1,111 shares exercisable in the event of a future sale at the current undiscounted market value of 90 per share. The benefit to Chloe is that she would not need to pay for the shares until a future sale of the company and effectively out of her share of the sale proceeds. The benefit for the existing shareholders of the company is that they could continue with their current dividend policy. The company should consider an EMI scheme which is extremely effective for tax and NIC purposes. Provided the price payable for the shares at the time of exercise is at least equal to the market value at the date the options are granted (not at the date of issue) neither income tax nor NIC will be due at grant or on exercise. Based on the exercise price recommended this should not be a concern. If the potential tenfold increase in value of the company is achieved then on a future sale Chloe would make a gain of 720 per share ( 810 per share, 9m divided by 11,111, less the 90 exercise price). The total gain would therefore be 799,920 ( 720 x 1,111). This would be liable to CGT not Income Tax. 4

6 As the shares will not have been held for 12 months prior to disposal the gain, after deducting any available annual CGT exemption, would normally be taxable at either 18% or 28%. However, shares acquired under the EMI scheme are deemed to have been held from the date the options were granted. As a result, provided the grant was made more than 12 months prior to exercise, ER would be available and the gain taxable at 10%. A significant benefit for the company under the EMI scheme is that the difference between the market value at the date of exercise, not simply at date of grant, and the price to be paid for the shares would be allowable for Corporation Tax. The potential deduction based on the above increase in value, 799,920, which at 20% would represent a tax saving of 159,984. This saving would arise just prior to the sale of the company, when the options are exercised, and would be of significant benefit to the company. It would reduce the Corporation Tax liabilities and increase the asset value of the company which may help with any sale negotiations. The key conditions that the company/employee/option must satisfy under the EMI scheme are: The company must not be controlled by another company, must be a trading company in the UK and have no more than 250 employees at the time the options are granted. The employee concerned must work at least 25 hours a week or 75% of their working time and must not have a material, greater than 30%, interest in the share capital of the company. HMRC are not required to approve the terms of the options but the market value at the time the options are granted must be agreed with them. As noted above HMRC do apply a minority discount and this should therefore be relatively straightforward. After the EMI options are issued the company must notify HMRC within 92 days. Research & development expenditure The company is seeking advice regarding the research costs of up to 150,000 and any tax reliefs available. The key relief is under the research and development (R&D) scheme. The reliefs can either reduce the company s tax bill or, for some small or medium sized companies (SME s), even generate a cash sum that can help minimise the financial risk. Guidelines are available from the Department of Business, Innovation and Skills (BIS) as to what represents a qualifying R&D project but in general terms the company will need to show that Chloe s idea seeks to achieve an advance in science or technology. Specialist advice will need to be taken to ensure that Chloe s idea satisfies the relevant criteria. Greater information is needed and a detailed report will need to be prepared in support of any claim. It is possible, on the assumption that the company has never submitted an R&D claim before, to obtain advance clearance from HMRC that the project meets the relevant criteria. If the idea does meet the relevant criteria the costs will then need to be reviewed in detail as only certain specified costs qualify for the relief. As the company is an SME the claim would be under the SME scheme. 5

7 The expenditure must be revenue in nature and must meet certain other conditions. The following is a summary: The expenditure must be in respect of staff costs, externally provided workers, subcontracted activities, software and consumable or transformable items. Staffing costs are in respect of directors and employees who are directly engaged in the R&D and costs can be apportioned if some, but not all, time is so spent. This can include all emoluments including employer s NIC and employer pension contributions. The subcontracted R&D costs and costs in respect of externally provided workers must be undertaken directly on behalf of the company. If all parties are not connected then only 65% of the expenditure will qualify for the special reliefs unless an election is made and certain conditions are satisfied. There are restrictions for expenditure that is subsidised or is the subject of State Aid. If the expenditure is qualifying R&D expenditure an additional Corporation Tax deduction of 130% is given. Alternatively, a tax refund can be claimed at 14.5% of the enhanced figure. If for example all the 150,000 referred to is qualifying expenditure an additional Corporation Tax deduction of 195,000 could be claimed. Assuming a Corporation Tax rate of 20% this would give a total tax saving of 69,000 instead of the normal 30,000. If the expenditure is incurred in the year ended 31 August 2017 this would reduce the taxable profits or could even create a loss. If a loss is created this could be carried forward against future profits or could even be carried back to the previous year. The information provided shows taxable profits in the year ended 31 August 2016 of 75,000. A refund of 15,000 ( 75,000 x 20%) could therefore be claimed subject to the level of the losses, with any balance being carried forward. Alternatively, if the amounts involved do create a loss in 2017 a tax refund of up to 14.5% of the unused enhancement expenditure could be claimed. This will however reduce the profits available to carry forward. The comments made in respect of Chloe s idea do raise certain specific issues that need to be considered: i. Grant funding If the grants are any form of designated State Aid a claim for R&D relief cannot be made on any part of the expenditure. Even if not in the form of designated State Aid relief under the SME scheme could not be utilised to the extent of the grants. A lower claim under the large company scheme could be considered but these rules have not been detailed in this report. It is therefore recommended that before any grant applications are made a detailed review is undertaken as even a small amount of grant funding could put at risk the claim on all the costs. ii. Capital costs As only revenue costs qualify for R&D tax relief careful consideration will need to be given to the costs of producing a prototype of the machine. Whilst a claim cannot be made for capital costs a claim can be made for consumable costs. In this regard HMRC have given guidance on prototypes and, in particular, refer to relief being available for those constructed as part of and solely for use in the R&D process itself and not for resale. They do however state that the intention can subsequently change. It is the original purpose that must be considered. If the prototype costs are deemed capital, the 6

8 enhanced reliefs will not be available. The onus is on the company to show they meet the above criteria. There are, however, special 100% capital allowances on capital costs incurred on qualifying R&D projects in addition to the normal annual investment allowance, currently 200,000 per annum. The computer hardware would fall into this category and potentially the prototype costs. If therefore the 200,000 limit has been exceeded further capital allowances could be claimed. iii. Losses If the idea does not succeed, the substantial costs may have a detrimental effect on the normal ongoing trade of the company. If in the worst-case scenario, the company fails, Arthur could lose all the monies that he has invested. The company could therefore consider having the activities carried out in a separate limited company to protect the business from this commercial risk. This would however restrict the ability to relieve losses against previous period profits. In summary, it is recommended that a detailed review is carried out of the project and the costs involved to ensure the relevant conditions are satisfied to benefit from the significant tax reliefs that are available. Tax issues related to property sale, share transfers and potential sale Arthur and his wife intend to sell the property they own to the company pension scheme which will give rise to a capital gain. As they are connected persons for tax purposes this will be based on the open market value at the time of transfer. They are also considering giving their children an interest in the share capital of the company. It is important therefore to minimise the gains and rates of CGT. i. Disposal of property The gain on disposal of the property by Arthur and Harriet will therefore be the difference between the market value and the original cost, 450, ,000 = 200,000. As the property is owned personally the rate of CGT on the gain will be at 28%/18% (after using the annual exemptions if still available) as the gain would not qualify for ER purposes. The 18% rate is available to the extent that the basic rate tax band is unused with the excess being taxed at 28%. If, however the property sale could occur at the same time as a disposal of shares in the company, in particular a transfer of shares to the children, it may be possible to claim ER. A disposal of shares would be a material disposal for ER purposes and if the disposal of the property occurred at the same time it could satisfy the criteria to be an associated disposal and also qualify for ER at the lower 10% CGT rate. As the company is a trading company, Arthur and Harriet are both directors of the company and hold at least 5% of the ordinary share capital the relevant criteria to qualify for ER would be satisfied. Anti-avoidance legislation was recently introduced however to the effect that the share disposal must be of at least a 5% shareholding. As Harriet only holds 500 shares representing 5% of the shares she would need to gift all of them to her children at the time of the property sale. Similarly, Arthur would need to give at least 500 shares to the children. They could however consider inter spouse transfers in order that Harriet can have a shareholding for dividend planning purposes. It is therefore recommended that Arthur and Harriet each consider making gifts of 500 shares to each of their children at the same time as the property sale. 7

9 If these share transfers are made, then ER could apply under the associated disposal rules on the sale of the property to the pension scheme to reduce the rate of Capital Gains Tax to 10%. Certain restrictions however apply such that not all the gain on property sale would qualify for the 10% CGT rate. The 25% part that is let to unconnected third parties would not qualify as that part of the property has not been used by the company. In addition, the gain on the remaining 75% would also need to be restricted for the period post 6 April 2008 as it has been let at a full market rent. As the property was acquired in June 2005 only the period to 5 April 2008 would qualify for the 10% rate. The disposal of the property to the pension scheme will potentially be liable to VAT as Arthur and his wife have opted to tax the property. i.e. they have opted to charge VAT on all supplies relating to the property. However, as the property is let to various tenants the disposal may qualify as a TOGC to avoid the charging of VAT. As the pension scheme can register for VAT and opt to tax the rents the VAT charged on purchase could be recovered in any event. If the TOGC provisions apply however there would be a cash flow advantage as they would not need to pay the VAT in the first place. It is therefore recommended that the pension scheme registers for VAT and submits an option to tax. If the TOGC provisions do apply it will make a difference to the SDLT as the SDLT charge is always based on the VAT inclusive price. As no VAT would be due under the TOGC provisions SDLT would be saved on the VAT that would otherwise be chargeable. As this is a commercial property the commercial property SDLT rates would apply and be payable by the pension scheme. The IHT implications of the transactions must also be considered particularly in view of Arthur s ill health. The value of the property currently qualifies for a 50% exemption from IHT under the business property relief (BPR) provisions as a property owned personally but let to a company controlled by him and his wife. After the sale to the pension fund however the monies loaned to the company will not qualify for any BPR. It is strongly recommended therefore that a detailed IHT review is undertaken. ii. Gift of shares to children Any gift of shares to the children will be deemed to take place at market value for CGT purposes as they are connected persons. The gain will be calculated on the difference between the current market value and the tax base cost of the shares. This market value would be based on the share valuation report prepared by EF Valuations Ltd subject as above to possible negotiation with HMRC. As noted HMRC do take into account minority discounts for share valuation purposes and based on gifts of say 500 shares as above a value of 36 per share could be used for CGT purposes after a 60% discount as detailed. The base cost of the shares is a mixture of the original nominal value for the shares acquired when the company was created and the market value when Arthur s father died for the shares that were inherited. A proportion of this mixed cost/value was also transferred to Harriet. ER could be claimed on the capital gain to restrict the rate of CGT to 10%. Alternatively, gift relief could be claimed so that effectively the children acquire the 8

10 shares at the original base cost. Calculations should be prepared to consider the potential tax payable based on the number of shares to be transferred. The key conditions for gift relief are the same as for ER in terms of trading status and would therefore be satisfied. For IHT purposes the gift will be a potentially exempt transfer (PET) on which IHT would only become payable if the transferor dies within 7 years. If this did happen within the next 7 years, 100% BPR could normally be available. It is possible however in the interim that the company may have been sold. This would mean that BPR may not be available unless replacement property had been acquired. Even if BPR is not available a benefit of the PET is that if as expected the shares had increased in value the potential IHT will be based on the current lower value at the date of the gift. The valuation methods for CGT and IHT purposes are however different. For CGT purposes the isolated shares being gifted are valued. For IHT it is the diminution in value of Arthur s and Harriet s estates. The main difference potentially is in relation to the discount that could apply to the gift of a minority shareholding. For example, a 10% shareholding is likely to be worth less than 10% out of a 90% holding. The gift would potentially fall within the shares by reason of employment legislation but HMRC do accept in this situation that the gift would be by virtue of personal family reasons rather than by reason of employment. iii. Future share sale On a future sale the CGT position for each of the shareholders must be considered. We have assumed that the company is a trading company for ER purposes as there is no reason to assume otherwise. We recommended that the status of the company be kept under regular review as this is fundamental for ER relief. In particular, the company must not hold investment assets to a substantial extent, greater than a 20% extent. In addition, Arthur is concerned that nothing is done to have a detrimental effect on Gary the Finance Director. Arthur As Arthur holds greater than 5% of the shares in a trading company he will pay CGT at 10% with the benefit of ER on the excess over the original cost of the shares issued at formation and the value of the shares he inherited from his father less a proportion for the shares subsequently transferred to Harriet. Harriet If the recommendations are followed Harriet will gift all her shares to her children and subject to any subsequent transfers will not be a shareholder. If Arthur does subsequently transfer shares to her they must ensure that this is at least 5% and she remains a director. This criteria must be satisfied for the 12 months prior to any sale although if necessary it would be possible to transfer her shareholding back to Arthur prior to a sale to benefit from ER. 9

11 Gary Gary currently has a 5% interest in the share capital. If Chloe is issued with shares rather than options his shareholding percentage will drop and ER on a future sale of his shares would be lost. This would increase the potential CGT rate by up to 18% being the normal CGT rate of 28% less the 10% ER rate. This is another reason to recommend the use of share options as opposed to an immediate share issue for Chloe. The company could of course also offer Gary new shares at the undiscounted market value to protect his 5% position. He will need to take independent advice. Chloe If Chloe simply acquires a 10% shareholding on joining, then ER would be available after 12 months. If as is recommended EMI options are used a 10% rate will apply as detailed above. Children The shares gifted will be liable to CGT based on the difference between the sale price and either market value at the date of gift from Arthur or, if hold-over relief is claimed, the mixed cost/inherited value. In order to qualify for ER they must meet the 5% and officer or employee test for at least the 12 months prior to the sale. It is important that they become employees of the company or are appointed directors. 10

12 MARKING GUIDE TOPIC MARKS Employment package for Chloe Relocation allowance Conditions 1 8,000 limit 1 P11D for excess/class 1A` 1 Categories of qualifying expenditure 1 Reference to salary sacrifice 1 Effect on income for mortgage 1 Pension contribution Reference to increase in employer pension contribution 1 NIC savings 1 Salary sacrifice 1 Option to pay additional contribution with saving 1 Car benefits Calculation and basis of calculation 2 Refer to alternative of car allowance 1 Approved mileage rates 1 Bonus scheme Simplicity 1 Payment at time of sale 1 Liability to tax and NIC 1 Share issue Use of undiscounted marked value 1 HMRC review but refer to minority discount 1 Funding of purchase 1 Immediate interest in company 1 Effect on dividend policy and rights 1 EMI options Simple exercise just prior to sale 1 Cash flow benefit for Chloe 1 Benefit for existing shareholders ½ No income tax on exercise 1 Undiscounted market value at date of grant 1 11

13 CT saving for company Terms and conditions Value and notification ½ ½ ½ Total 28 Development of new machine Criteria under BIS 1 Innovation/advance 1 General discussions surrounding qualifying project 2 Advance assurance scheme 1 SME scheme 1 130% enhancement with examples 2 Carry back/carry forward relief % tax repayment 2 Types of qualifying costs 3 Grant funding 2 Capital costs 1 Prototype costs 2 Risk mitigation by separate entity 1 Total 20 Property sale and potential share transactions Property sale Discussion of CGT and rate of tax 1 Reference to associated disposal rules 1 Reference to material disposal 1 Potential for ER claim 1 Anti-avoidance with 5% de minimus 1 Link to share transfer 1 Restriction for part let to unconnected businesses 1 Restriction for letting at market value post 5 April Option to tax rules 1 TOGC 1 SDLT saving 1 IHT and reference to BPR rules 1 Share transfers to children Market value transaction 1 12

14 Valuation on minority shareholding basis with discount 1 Base cost a mixture of cost and inherited value 1 Hold-over relief 1 IHT as a PET 1 BPR rules 2 Appreciation in value saving 1 Different valuation method 2 Future share sales Comments relating to Arthur 2 Comments relating to Harriet 2 Comments relating to Gary 2 Comments relating to Chloe 1 Comments relating to children 1 Total 30 Presentation and higher skills 22 TOTAL