Share Sales – Reclassification of consideration by HMRC as an income receipt
11 August 2008
When an individual sells shares in a company he will expect to be taxed to capital gains tax on the proceeds received. Almost invariably this will be more beneficial than the proceeds being treated as an income receipt. For a higher rate taxpayer a capital receipt will be taxed at 18% with an annual exemption available whereas an income receipt will be taxed at 40%. However the recent cases of Lloyd v Revenue and Customs Commissioners and Snell v Revenue and Customs Commissioners highlight the danger that HMRC may use anti avoidance legislation to reclassify the receipt as an income receipt in certain circumstances.
Under section 703(1) of the Income and Corporation Taxes Act 1988 a tax advantage obtained by a taxpayer has the consequence that a transaction in securities could be counteracted by an assessment unless the taxpayer can show that the transaction was carried out for bona fide commercial reasons and that the transaction did not have as its main object (or one of its main objects) the obtaining of a tax advantage. These provisions have been rewritten into the Income Tax Act 2007.
In Lloyd, the shares in P Limited were held by the taxpayer, PH Limited (in which the taxpayer was also a shareholder) and two other director/shareholders. It was decided on commercial grounds to equalise the shareholdings and the method chosen to achieve this was for the taxpayer to sell his shares to PH Limited. This was funded by a dividend from P Limited to PH Limited. It was accepted that the appellant had received tax advice that the transaction should take place before the abolition of retirement relief in order to gain the advantage of that relief. The Special Commissioner found for HMRC stating:
"While the appellant may not have been particularly concerned with tax, Mr Childs must have been and we know from the meeting on 16 August 2002 that the fact that the then current tax year was the last opportunity of obtaining retirement relief had been explained to the appellant. I have accepted that the appellant had commercial reasons for carrying out the transaction and therefore that that this was one of his main objects in carrying it out. The tax treatment of the transaction was important to the existence and timing of the transaction. If the only object was for Holdings to acquire the appellant's shares there could have been a share-for-share exchange. The tax advantage cannot be said to be an effect rather than an object of the transaction. I find that the tax advantage was one of the main objects of the transaction".
In Snell the taxpayers wished to allow their sons to take over the running of the business which was operated by Oldco. They wished to protect their sons from any inherent liabilities within the company and were advised to sell the business of the company to a Newco.
Following advice from their accountants the plan became somewhat more elaborate in that two Newcos would be incorporated, one (Newholdco) holding the other (Newsubco). The business of Oldco would be transferred to Newsubco which would then dividend the value of the business (approximately £1.3 million) to Newholdco which would then issue shares to the taxpayers and also pay some cash.
As with Lloyd the transaction was challenged by HMRC on the basis that a tax advantage was obtained (the value of the business in Oldco which could have been distributed subject to income tax was effectively transformed to, in part, a capital payment taxable more generously). The Special Commissioner took a similar approach to Lloyd stating:
"By the time the transaction occurred the cash payment had been decided upon and it does not cease to be one of the main objects of the transactions just because there is another more important object. Mr and Mrs Snell made a conscious decision to obtain cash and indeed they chose the highest figure that their advisors were then recommending. That is in my opinion significant when judging the importance of that object within the transaction".
The value of the total transaction was approximately £1.4 million and the tax saving only £12,500 for each taxpayer, yet the Special Commissioner considered that this was more than de minimus.
It will be seen therefore that even though it would appear that the commercial objective was in both cases by far the overriding factor in selling the shares, the sale could have been undertaken in a way which did not achieve the tax advantage, and the taxpayer was aware of the tax advantage to be obtained.
Lloyd and Snell are consistent with recent case law in that the tax advantage can be found to be one of the main objects even though there is another object which is more important and more influential on the taxpayer. Also it is worth noting that once a tax advantage has been obtained the onus is upon the taxpayer to prove that the transaction was carried out for bona fide commercial reasons without the obtaining of a tax advantage being one of its main objects. This is very wide anti avoidance legislation which has not always been used to its fullest extent by HMRC but these cases may mark a change in approach.