Tax and the City briefing for June 2013

Key recent developments are as follows.

Inglorious episodes

HMRC will be relieved at the dismissal of UK Uncut’s application for judicial review of a settlement with Goldman Sachs (UK Uncut Legal Action Ltd v HMRC [2013] All ER (D) 212 (May)).

Goldman had, along with several other taxpayers, implemented national insurance contributions (NIC) planning but, unlike the others, did not avail itself of a 2005 settlement opportunity to pay the NIC claimed in full without interest. In November 2010, representatives of the bank met with David Hartnett (then HMRC’s permanent secretary for tax) and an agreement was reached in respect of a number of disputed matters, including the NIC claim. Hartnett, not having consulted with HMRC lawyers, had mistakenly thought that HMRC was legally precluded from claiming the interest on the NIC; he was also not then aware of the need for High Risk Corporates Programme board approval of the settlement. Consequently, it was agreed in the meeting that the bank would pay the outstanding NIC (together with certain other disputed tax liabilities), but not the interest, and both sides apparently left the meeting believing that a deal had been struck. It was only later that the Hartnett errors came to light – errors which led the judge to describe the settlement as ‘not a glorious episode in the history of the Revenue’ – and the question was whether HMRC was entitled to and/or should renege on its agreement.

Ultimately, HMRC decided to abide by the terms agreed in the November meeting. Following a leak, UK Uncut instigated judicial review proceedings, arguing that the decision infringed HMRC’s litigation and settlement strategy (LSS) and was unlawful because it took into account irrelevant considerations, including damage to the relationship between HMRC and Goldman Sachs and potentially (to the extent HMRC could be regarded as conducting settlement discussions in bad faith) other taxpayers, as well as the potential embarrassment for HMRC and the chancellor if the bank carried out its threat to withdraw from the code of practice on taxation for banks, which it had only recently adopted.

Relying in part on Sir Andrew Park’s findings in his report to the National Audit Office, the judge was persuaded that the terms of the settlement represented best value for money for taxpayers and were consistent with the LSS. HMRC would therefore have reached the same decision regardless of certain irrelevant considerations (such as personal embarrassment), and it was not unreasonable for HMRC to take into account factors such as its reputation and its ongoing relationships with taxpayers.

Innocent until proven guilty?

The UK Uncut action has not made HMRC any less determined to avoid being seen as going easy on the banks, or as cosying up to some taxpayers at the expense of others. A consultation document published on 31 May outlines a number of proposals designed to introduce ‘codified consequences’ for banks not adopting or not complying with the code of practice on taxation for banks, essentially by naming and shaming (the paradox of attaching legal consequences to non-compliance with a ‘voluntary’ code seemingly being lost on HMRC).

The code was introduced in 2009 to encourage banks to follow the spirit of the law in their tax-related activities, with the approach then being largely one of ‘carrot’ – a more open and constructive relationship between the bank and HMRC. For ‘carrot’, now read ‘stick’. This is because:

• any bank wishing to be subject to the strengthened code must unconditionally confirm or reconfirm its commitment to its code obligations;
• HMRC will publish at Autumn Statement 2013 a list of banks which have newly adopted or readopted the code; and
• from 2015, HMRC will be required to publish an annual report listing the adopters and non-adopters and, at its discretion, the name of any bank which has adopted the code but is not, in HMRC’s view, complying with it.

Most controversially, HMRC will be self-appointed arbiter of what amounts to non-compliance, with a bank’s only recourse if it considers itself to have been unfairly named and shamed being a judicial review. If the bank undertakes a ‘potentially abusive transaction’ – a transaction potentially within the ambit of the new general anti-abuse rule (GAAR) and the subject of a referral to the GAAR advisory panel – for its own account and does not immediately self-assess to counteract the relevant tax advantage, the bank will be treated as non-compliant. It will then be for the tax assurance commissioner to decide whether to name it in the next annual report. If the potentially abusive transaction is one promoted or facilitated by the bank, then the bank has no means of getting back on what HMRC would regard as the compliant track. That the potentially abusive transaction may turn out to be one which the courts decide is not GAAR-able is not deemed worthy of mention.

Corporate debt and derivatives

There are echoes of the ‘we will decide how much tax is due’ approach in the consultation document entitled Modernising the Taxation of Corporate Debt and Derivative Contracts (dated 6 June 2013). The loan relationship (LR) regime introduced in 1996 and the derivative contracts (DC) regime introduced in 2002 sought to align tax treatment with accounting treatment, but this has not produced the ‘right’ answer in a number of (largely avoidance-driven) cases. HMRC proposes that a newly reformed regime will use the accounts as a starting point but explicitly acknowledges that the accounting measure may be overridden in circumstances where it would not result in the economic profit or loss on a LR or DC being brought into account over time.

Other proposals (to some extent informed by impending new accounting standards in the form of FRS 101 and FRS 102) include:

• recognising as taxable profit and loss only items appearing in the income statement (P&L) – a measure expected to have largely timing implications only and to reduce complexity;
• changing the treatment of connected party debt, including taxing the debtor on a release and allowing corresponding relief to the creditor;
• changing the treatment of intra-group transfers to minimise the scope for a mismatch between the tax and accounting treatment;
• modifying the rules applicable to LRs and DCs held through partnerships, with a view to reducing avoidance;
• excluding from the scope of the regime exchange gains and losses on financial instruments held for investment purposes;
• radical changes to the debt restructuring rules, including removing the exemption for debt-to-equity swaps (meaning any amounts taken to the income statement would be taxable);
• replacing the bond fund rules with some rules closely targeted at offshore debt funds; and
• a new regime of targeted anti-avoidance rule (TAAR) covering any manipulation of the rules, along with a clarified version of the existing unallowable purpose rule.

Some existing loopholes will be closed down in FB 2014, with the fully overhauled regime being introduced in FB 2015.

Partnership-based avoidance

It was announced in Budget 2013 that HMRC would be clamping down on the use of limited liability partnerships (LLPs) to avoid or reduce payroll taxes, and on arrangements which shift partnership profits away from individuals paying high rates of income tax to corporates and other vehicles which either escape tax or pay it at a lower rate on those profits. The consultation document was published on 20 May (A Review of Two Aspects of the Tax Rules on Partnerships).

In the case of a general or limited partnership, a number of tests apply to determine whether an individual involved in the partnership business is truly a partner or, in substance, an employee. These tests are not currently applied to LLP members, who benefit from a rule which deems them to be self-employed partners. HMRC proposes to change this so that an LLP member who either would be classified as an employee applying the usual tests, or is not exposed to fluctuations in profitability or the risk of loss, will be treated as a ‘salaried member’, with consequential payroll tax consequences. Any arrangements implemented with a main purpose of ensuring that neither of these conditions is met will be disregarded.

Partnership arrangements may involve some or all of the profits which would otherwise arise to, and be subject to, income tax and NIC in the hands of an individual partner instead being allocated to, for example, a corporate partner who is subject to tax at the lower corporation tax rate, or in certain circumstances not taxable at all. The individual will have a direct or indirect economic interest in the corporate partner and will ultimately benefit from the corporate partner’s share. Sometimes it will be a case of the corporate partner being used to ‘park’ profits contingently allocated to partners (deferred awards subject to vesting) or which are required to be kept in the business as working capital – in each case, allocation to the individual would create an immediate tax charge, even though he has not made a drawing. HMRC proposes to introduce a rule which would result in the individual, to the extent of his economic interest in the corporate partner, being taxed on the corporate partner’s share, if a m
ain purpose of the arrangements is to secure an income tax advantage for the individual.

Another arrangement involves changing profit/loss sharing ratios over time, so that any early year losses or reliefs accrue to highly taxed individual partners who can use them to shelter other income and gains, with any later year profits accruing to, for example, a more lowly taxed corporate partner. If the allocation arrangements have a main purpose of securing this result, relief will be denied.

A third type of arrangement involves a lowly taxed partner contributing capital in return for an increased profit share, with the contributed capital then being withdrawn by a highly taxed partner – effectively in lieu of profit share – with the intended analysis being that the withdrawn capital is not subject to tax. Under a proposed new rule, the capital withdrawn will be subject to the same tax treatment as if the more highly taxed partner had been allocated the relevant profits.

There have been some eye-watering estimates in the financial press of the tax savings currently being realised – $20bn has been mentioned – mainly in the private equity and hedge fund sector.