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Gordon giveth and Gordon taketh away

18 July 05

First half of two part article on the 2005 Budget and Finance Acts, looking at personal and company taxation

by Alan Barr


That the Chancellor is a son of the manse is well known. He will be more aware than most of the biblical allusion in the title to this article (Job 1, 21, although the exact phraseology does not appear in the King James version). Given the result of the general election, the Chancellor might prefer a continuation of the analogy – blessed be the name of Gordon. But this year’s Budget tax measures were a classic example of the necessary balancing act involved in running the UK tax system, with the added spice of an election just over the horizon. There were things given to some taxpayers in the Budget (if letting the electorate keep some more of their own money can legitimately be classified as a gift). But nearly as much was taken away – and if some predictions are correct, this is likely to be merely the start of the process of removing rather more from the taxpayer than is restored.

Given that it has become almost traditional to have our elections in the late spring, this year’s Finance Act legislative process is slightly unusual – but it followed the pattern now established for an election year. Thus a Finance Bill was introduced shortly before the dissolution of Parliament and the Finance Act 2005 received the Royal Assent on 7 April. This was as a result of a deal with the opposition – which had the ridiculous result that an Act of 106 sections and 11 schedules (containing 60% of what was included in the original Finance Bill, introduced shortly after the Budget and before the election was actually called) was enacted with four hours’ consideration in the House of Commons and half an hour in the Lords. It was passed without a single amendment, from the Government or otherwise.

This is madness – and seems completely unnecessary. It was necessary to pass a very short Finance Act, in order to impose income tax and do one or two other things. It might have been politically appropriate to include one or two other headline-catching items which could have been used in the election campaign. But apart from that, the rest could have come back in a decently considered Finance Bill after the election, which would require to be passed before 5 August 2005. And in the unlikely event that there had been a change of Government, that is all the more reason why a much truncated Finance Act would have been more appropriate than what has already been passed in April.

It is not as if we are not going to get another Finance Act this year. The second Finance Bill of the year is at time of writing winding its way through Parliament, with the benefit (or otherwise) of at least some parliamentary attention. Most of the Budget measures omitted from the first Finance Act will be enacted by the second – where they cannot be dealt with by the increasingly-used statutory instrument. Some parts of the first Finance Act 2005 will even be amended or repealed by the second.

The rush was not caused by a need for early legislation – a number of so-called anti-avoidance changes would have been able to take effect from Budget day, whenever they were passed.

Of course, Labour did win the general election. This may be likely to produce a period of relative stability, perhaps depending on how long the Chancellor remains in the job he doesn’t want to keep. Certainly a number of things (as is typical with Mr Brown) were set out for some years ahead. There was also the expected promise in the Labour manifesto of no change to the basic and higher rates of income tax – but very little else on tax. This may be a very wise omission, if the forecast need for further resources comes to pass. The next Budget may be one to watch, as governments tend to want to get bad news on tax out of the way early in a Parliament.

Apart from some threat in relation to national insurance, the other perennial source of temptation will lie in the less obvious taxes, such as SDLT, inheritance tax and the growing range of indirect taxes such as insurance premium tax and landfill tax.

The anti-avoidance regime continues to grow in its demands and its complexity, which brings both threats and opportunities for lawyers.

In general, it is fair to say that this Budget brought no very big changes, such as the introduction of SDLT, although there will again be a very large quantity of legislation. Thus there is, as usual, enough to worry about.

The basics (and a bit beyond)

Rates and allowances for income tax, corporation tax, capital gains tax, inheritance tax, stamp taxes and the pension schemes earnings cap are set out in the panel above.

Income tax and national insurance rates

The basic allowances continue to rise, but not by very much. They are tied to (very low) inflation and hence rise much slower than earnings. This leads to the phenomenon known as “fiscal drag”. This is being commented on more and more frequently. It involves a steadily growing number of taxpayers falling into the higher tax band. Trusts have now joined the 40% club, with effect from 2004-05. From the tax planning point of view, it becomes particularly valuable to try to make full use of allowances and basic rate bands.

The Revenue of course sees this as well. At the moment, it is basking in its success in what is known as the Arctic Systems case (Jones v Garnett [2005] EWHC 949 (Ch)), which is an attack on the use of dividend payments from companies owned by husband and wife, coupled with an attempt to split income between them so as to maximise reliefs. Basically, such a split will have to be justified by the work done – by either party. Thus a working spouse will have difficulties if they minimise the (taxable) salary extracted from a company so that they can maximise the dividends paid to a non- (or less) working spouse. This is an area where a bit of careful planning at the time of setting up a company – or of issuing shares to different parties – can have hugely beneficial effects in the future. If it is not done properly at the outset, it may very well be too late at a later stage.

Capital gains tax

The capital gains tax annual exempt amount was increased in line with statutory indexation to £8,500 for the tax year 2005-06 for individuals and personal representatives of deceased persons, with half this amount applicable to most trusts.

It was interesting that the Budget press releases confirmed that gains arising on the disposal of a principal private residence would continue to be exempt from capital gains tax – rumours to the contrary had been in circulation.

There are no real substantive changes to this complicated tax. However, there are new anti-avoidance provisions to prevent short-term non-residents exploiting double taxation treaties so as to avoid UK capital gains tax. This closes what had become quite a well-used method of avoiding large gains by spending a year in Belgium (of all places). Generally, it will now be necessary to lose UK residence for a full five years in order to escape CGT liability.

Also in the international field are measures to increase the range of assets which will be treated as located in the United Kingdom for CGT purposes. This will increase the scope of the CGT net for some persons who are not domiciled in the UK, and for non-residents who carry on a trade, profession or vocation in the UK through a branch, agency or permanent establishment. It will be worth seeing if this is the start of a more concerted attack on the general CGT exemption for non-residents, which is so crucial to property investment from overseas.

Inheritance tax

The inheritance tax threshold for the next three years was announced, enabling the Chancellor to refer to a nil rate band of £300,000, even if that does not come into effect until 2007-08. The tax continues to be important in terms of its overall “take” for the Government. Despite the large total rise over the next three years, it should be noted that the announced rise for next year is rather less than that announced for this year, in both absolute and percentage terms. Conceivably, it could be less than the normal rise which would come from inflation.

In relation to inheritance tax, perhaps the most significant change this year did not really involve that tax at all – it was the introduction, announced last year, of the income tax charge on pre-owned assets. In my view (although not in that of many others), this will not affect that many people who have not been engaged in fairly aggressive IHT planning. However, much work may be required to establish that this is the case. One possible area that will be affected is where an unmarried couple have transferred assets between themselves. This may particularly be the case where there has been a change in the ownership of their main residence, especially if they have sold one and bought another during their relationship. Previous advice (as to equalising their estates to maximise the use of the nil rate band) may even have led them into problems in this regard.

Corporation tax

As in 2004-05, the corporation tax main rate is 30%. The small companies rate is 19% for companies with taxable profits between £50,000 and £300,000, and the starting rate is zero for companies with taxable profits below £10,000. The corporation tax main rate for 2006-07 will also be 30%.

Marginal relief eases the transition from the starting rate to the small companies rate for companies with profits between £10,000 and £50,000. The fraction used in the calculation of this marginal relief will be 19/400. Marginal relief also applies to companies with profits between £300,000 and £1,500,000. The fraction used in the calculation of this marginal relief will be 11/400.

With the exception of the 0% starting rate, the various marginal thresholds have not changed for many years. Fiscal drag is starting to have an effect in relation to corporation tax as well as for income tax.

More on income tax

INDIVIDUAL SAVINGS ACCOUNTS AND OTHER INVESTMENTS

It was confirmed that the tax benefits of individual savings accounts, at the current levels (maximum total £7,000 per year, £3,000 in cash) would continue until at least 2009-10.

An announcement was tucked away, to the effect that interest accruing after the death of an investor would now be paid gross, which may increase the administrative burden in some executries.

The new child trust funds are now available – and it was confirmed that all FSA regulated retail investments would qualify as suitable investments.

EMPLOYMENT AND BENEFITS

There are minor changes made to the rules on the provision of company cars and fuel; and to those on the tax-efficient salary sacrifice arrangements to provide employees with computers or bicycles.

Of more substance is the increase to £15,000 of the tax-free amount which can be paid to support employees in full-time education in certain circumstances, along with confirmation that qualifying payments are also free from national insurance contributions.

Part-time workers are to be able to benefit from tax-free outplacement counselling and retraining courses.

GIFT AID AND ADMISSIONS

There is a restriction on charities attempting to dress up admission charges as donations qualifying for gift aid relief, although there is also an extension of the situations in which donations in return for admission can qualify as gift aid donations (e.g. where annual unrestricted admission is provided). Charities affected will find this combination of threat and opportunity significant.

THE TAXATION OF TRUSTS

Continuing the international theme, there are measures to prevent exploitation of double tax treaties by trustees resident in the UK for only part of a particular tax year – and also resident in a treaty partner for part of the same or an overlapping year. This is real anti-avoidance stuff.

Of more general interest is the first part of a more fundamental change in which discretionary trusts are to be taxed. The Inland Revenue has been engaged on a consultation exercise on trust taxation for some time. Some of the changes discussed will now be enacted. These include a special tax regime for trusts for vulnerable beneficiaries (who are however defined in a rather limited manner). This has been enacted in Finance Act 2005. At first sight, it seems incredibly complicated and perhaps is unlikely to be used very much.

Vulnerable persons include the disabled (including those lacking mental capacity); and minors (defined here as meaning those under 18), at least one of whose parents have died and for whom the parent has made provision in his or her will. The broad effect of the new rules is to provide for a claim to be made, as a result of which no more tax will be paid in respect of the relevant income and gains of the trust for that year than would be paid had the income and gains accrued directly to the beneficiary.

There is also to be a new standard rate band (of £500) for discretionary and accumulation trusts. For many very small trusts, the latter change will reduce administrative requirements, but the opposite may be the case for larger trusts.

Consultation continues on other possible reforms, including the possible “streaming” of income where trustees distribute trust income within or shortly after the end of the tax year. The broad aim of Revenue reforms in this area appears to be to make the use of UK trusts tax-neutral; but they will still be extremely useful vehicles for many purposes in estate planning. But again the situation is getting to be more complicated than previously.

CIVIL PARTNERS

The Finance Act (section 103) contains powers to make statutory instruments to put registered civil partners (same-sex couples, who can register their relationship with effect from 5 December 2005) on the same footing as married couples for tax purposes. This will involve a substantial quantity of revised legislation, and while most of the effects will be beneficial for civil partners (e.g. the spouse exemption for inheritance tax), there are exceptions (e.g. the availability of only one principal private residence relief for capital gains tax).

Alan R Barr, Brodies LLP and the University of Edinburgh

Part 2 in next month’s issue will cover changes to the SDLT regime and further matters affecting businesses.