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Test drive

Last week, I looked at the substantial non-trading activities test in relation to capital gains tax business assets taper relief. For those who are or may be considering selling their shares in a private trading com- pany, this relief represents a massive improvement in the net return they would otherwise receive.

It is not that long ago that the starting point for most was 40 per cent tax on any gains realised after indexation.

For any gains of substance on sales of private company shares, there were strong incentives to seriously consider relatively complex planning or even a change of residence prior to the sale.

Before April 17, 2002, as well as the wholly trading or substantial effect tests discussed over the last two weeks, paragraph 11(4) Sch A1 TCGA 1992 provided that where “at the time of disposal of the shares, a close company was carrying on a business of holding investments” and within a specified period (broadly 12 months) prior to the disposal it was either not carrying on that business at all or the business was comparatively small, then taper relief would be restricted.

When a company began to carry on a business of holding investments or increased the size of that investment business, there was a change of relevant activity. Under the relevant change of activity test, taper relief accrued prior to the relevant change of activity was lost. The taper relief clock started again but only for non-business assets taper relief.

The aim of this provision was to prevent the artificial increase in business assets taper relief by transferring investments inside an otherwise qualifying trading company environment. However, the relevant change of activity test, with its penal consequences, ceased to have effect in relation to disposals on or after April 17, 2002.

It was replaced by a new provision under which any period after April 5, 1998 is not to count for taper relief on shares of a company during which the company is:

l A close company andl Not active.

For the purposes of this provision, any company that is carrying on business, preparing to carry on business or winding up a business is treated as active.

The alteration of the relevant change of activity test in paragraph 11 to an actively trading test represented a substantial relaxation and means that any close company, as long as it is actively trading, will not have taper relief denied by reason of holding investments (under paragraph 11).

So, for substantially trading companies worried about falling into the taper relief trap through holding investments, this second test should not be a concern. However, let us not underestimate the importance of the first substantial non-trading activity test.

Because of this test, any private trading company for which a sale of its shares is feasible at some time should think very carefully before actively investing funds. Regardless of the tax deferment opportunities offered by offshore single-premium bonds, would-be corporate investors must be alerted to the business assets taper relief risk before making any decision.

For companies considering alternatives, apart from the most obvious – the offshore single-premium bond – there are also collectives. An ordinary collective will yield some dividends as well as capital growth. Dividends will bear no further tax, being franked income. This is a point often overlooked when considering the taxation of a UK life fund which is in the same position. Any int- erest distributions will, however, suffer corporation tax at the appropriate rate.

When it comes to capital gains realised on collectives, remember that companies do not benefit from taper relief or the annual exemption. Companies do, however, qualify for indexation allowance, so only “real” realised gains are taxed.

For an ordinary collective that produces a mix of dividends and growth, a company should be in a position to defer tax for some time. However, investment decisions should not be based on tax alone and the potentially catastrophic impact on business assets taper relief really must be take into account if the company is to do something more positive than merely leave sums on deposit.

While I would always be the first to agree that, for most investment decisions, it is pure investment issues that are of primary importance while the tax planning is secondary, in the case of investment by private companies, the business assets taper relief issue could be so important as to prevent any investment at all taking place.

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