Tax Issues for Unincorporated Businesses

By

Ros Martin

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1. Autumn statement ........................................................................................................................... 3

2. Computational issues: allowability of expenditure ..................................................................... 4

3. Status ............................................................................................................................................... 23

4. The business structure .................................................................................................................. 34

5. Corporate partnerships .................................................................................................................. 40

6. Pensions for the self employed .................................................................................................... 48

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1. Autumn statement

About the only thing of any huge interest to the unincorporated business in the autumn

statement was further detail on the announcement made at the time of the Summer Budget 2015

that the government wants to digitise the tax process. The clear aim appears to be to modernise

the tax system and provide a more real-time working basis of individual and business tax affairs,

which one would expect, will lead to the advance of tax payments in many cases in due course.

Key details so far are:

the re-announcement of digital tax accounts for all small businesses and individuals to

be introduced by 2016/17

requiring most businesses, landlords and the self employed to update HMRC quarterly

regarding their tax affairs by 2020 - we await further details in the consultation due in

2016 although some news reports are suggesting this could be implemented as early

as 2018.

the intention to consult on ways to simplify tax payments with suggestions of tax

payable as profits arise (already now announced for capital gains tax arising on the

disposal of residential property with payment due 30 days after completion from April

2019).

2. Computational issues: allowability of expenditure

We are increasingly seeing HMRC being creative in making arguments about the disallowability

of expenditure in accounts, particularly unincorporated business. Enquiries are opened where

individuals are asked to provide a detailed analysis of even relatively low amounts in their

accounts. This is not just about businesses who are not very good at keeping records which

demonstrate the difference between private and business expenditure (although there are plenty

of these too!) but where there is a genuine dispute between HMRC and the business about the

nature of expenditure.

Expenditure is deductible in computing profits for the purposes of tax if they meet two tests:

The expenditure is revenue in nature rather than capital

The expenditure is incurred wholly and exclusively for the purpose of the trade

In reality it is the ‘wholly and exclusively’ argument which needs to be considered closely as it

is not a straightforward area to consider.

2.1. Wholly and exclusively

The basic principle is that expenditure must be incurred wholly and exclusively for the purpose

of the trade.

The ‘wholly and exclusively’ test can be divided into three parts:

The purpose of the expenditure must be identified, since in order to be allowable, the sole

purpose for incurring the expenditure must be for the purpose of their trade.

If there is duality of purpose, then (subject to the next point) there is no deduction but

duality needs to be differentiated from an incidental benefit arising from the expenditure

since this does not automatically preclude a deduction

If there is more than one purpose but the expenditure is capable of being apportioned

between business and non-business elements then the business element will still be

allowable.

Each of these will be considered in turn.

The purpose of the expenditure

The question that has to be asked is why the expenditure is being incurred; what are the aims

of incurring the expenditure?

The Courts have considered this issue and have largely concluded that the phrase ‘for the

purposes of the trade’ really means ‘for the purpose of enabling a person to carry on and earn

profits in the trade’ but that is not necessarily going to be of any help in contentious cases.

The facts of each case have to be ascertained. If HMRC are going to try and disallow

expenditure using this legislation they are going to have to demonstrate that there was another

purpose for the expenditure. All expenditure has an underlying purpose; it cannot simply be

argued that there is not a trade purpose if no other obvious purpose can be identified. There

should be evidence to support that view although it would ultimately be up to the First Tier

Tribunal to make a finding of fact in any case which was presented before them.

What a strict adherence to the identification of a clear purpose means is that it is not the

nature of the expenditure which determines whether there is an allowable deduction. An example

of this is entertaining expenditure. A solicitor takes a client out for lunch. If the purpose of the

meeting is to discuss business but the only time that a meeting could be arranged is at lunchtime,

it is likely that the purposes of the expenditure is to facilitate the business meeting. However, if

the client is, in fact, an old family friend who happens to be passing by and happens to invite the

solicitor out for lunch on a social basis, then it is unlikely that the purpose can be said to be a

trade purpose. Of course, these are two extremes and there will be many situations between

these extremes where the purpose cannot be easily isolated.

When considering what the purpose of the expenditure might be, it is important to look for a

non-trade or private purpose.

Duality of purpose

Since the legislation states that the expenditure must be wholly and exclusively for the

purposes of the trade, if there is a duality of purpose then no deduction can be claimed. This is

subject to apportionment of expenditure which is covered in the next section.

As has been discussed above in relation to establishing the primary purpose of expenditure,

the question of any secondary purpose is also a question of fact.

However, it is important to distinguish between a secondary purpose to expenditure and the

provision of an incidental benefit by virtue of the expenditure which will not affect the deductibility.

This is why it is important not to try and determine the purpose of expenditure by reference to the

effect that follows from the payment.

Subconscious purpose

There are a number of tax cases where the subconscious non-trade purpose of expenditure

has precluded a deduction being claimed for the expenditure. These are difficult cases since, by

its nature, a subconscious purpose cannot be proved or disproved to exist and so its existence is

subject to a certain amount of conjecture. Many of the cases relating to this type of expenditure

are quite well known mainly because they are controversial in their findings.

The most famous case is probably that of Mallalieu v Drummond. Miss Mallalieu is a barrister

and claimed a deduction for the cost of replacing and laundering the clothes that she had to wear

in Court. She argued that she had to dress in accordance with Bar requirements but that for

‘civilian’ purposes she dressed in a more adventurous manner such that her Bar clothes were a

quasi uniform. She argued that whilst the wearing of court clothes necessarily spared her private

wardrobe from wear and tear this was not a consideration in her mind when she bought her court

clothes any more than was the preservation of her warmth and decency.

The leading judgement in this case is a clear analysis of the position in relation to the wholly

and exclusively argument. However, Lord Brightman explained that he could not confine his

consideration to the conscious purpose for acquiring the disputed clothing. Whilst it was accepted

that Miss Mallalieu thought only of the requirements of her profession when purchasing the

clothing he felt it inescapable that one object (albeit not a conscious motive) was the provision of

the clothing that she needed as a human being.

This does not mean that specialist clothing or uniforms are disallowed by this decision since the

subconscious motive is not important in those cases although it can be difficult to see why this

argument could not apply in those cases. It is often speculated whether if Miss Mallelieu had not

travelled to court in those clothes but had changed into them when she got there whether the

outcome might have been different.

Apportionment of expenditure

Although the legislation talks about ‘wholly and exclusively’ there is nothing in s.74(1)(a) which

precludes apportioning expenditure.

Where a definite part or proportion of an expense is wholly and exclusively laid out or

expended for the purposes of the trade profession or vocation, it is not HMRC policy to disallow

that part or proportion on the ground that the expense is not as a whole so laid out or expended.

There must be an ability to split the expenditure for such an apportionment to be made. So

the costs of running a car can be split into private and business because it is possible to accurately

identify the amount it is used for each activity. The costs of providing clothing for work which

have a subconscious private purpose cannot be apportioned because it is impossible to quantify

the private proportion of the expenditure. So none of the expense is allowed.

There is no statutory guidance relating to apportionment. The main case which considers this

is actually a Schedule E case (now employment income) called Westcott v Bryan. Schedule E

deductions are only allowed if the expenditure is wholly, exclusively and necessarily incurred in the

performance of the duties so the wholly and exclusively point is relevant here. The principle

established in that case are:

where there is use of something, both by an employer for their own purposes and as a

benefit by a director, there should be an apportionment,

there are no fixed rules or precise formulae about how to do the apportionment,

the apportionment must be based on the facts of the case, and lead to a result which is fair

and reasonable

The specific issue was addressed recently by the FTT.

A freelance journalist and author decided to write a book entitled 'A Year on a Pontoon'. He

claimed a deduction for expenses of £10,000 incurred in moving a boat which he owned to

southern France and living there for a year. HMRC rejected the claim on the basis that the

expenditure had not been wholly and exclusively incurred for the purpose of his profession as an

author, but was partly incurred for personal reasons. H appealed. The First-tier Tribunal dismissed

his appeal, finding that 'the expenses incurred had a duality of purpose', but the Upper Tribunal

remitted the case for rehearing. Judge Bishop held that it appeared that the First-tier Tribunal had

erred in law by failing to consider ITTOIA 2005 s 34(2) which is the legislation which permits

apportionment where an identifiable proportion is incurred for the purposes of the trade. The

rehearing did agree that some of the expenditure – such as the costs of moving the boat the

France were allowable although not the normal living expenses.

2.2. Current issues: travelling expenses

We are seeing a concerted effort on the part of HMRC at the moment in relation to travelling

expenses. This is no doubt going to be galvanized by successes at the First Tier Tribunal and

beyond.

The cost of travelling from home to work is generally not allowed for tax purposes, unless the

individual is an itinerant trader. This is because the object of the journeys to and from work is not

to enable a man to do his work but to enable him to live away from it. This principle was

established in Newsom v Robertson. Mr Newsom was a barrister who carried on his profession

partly at his chambers in Lincoln’s Inn and partly at his home in Whipsnade. It was accepted that

he did do work at home in the evenings and weekends (and during the week when Courts were

not sitting). He claimed the costs of travelling between home and chambers but this was rejected.

In the High Court, Danckwerts J said that the expenditure was not allowable because it was

incurred for the purpose of allowing the taxpayer to travel between his place of residence and his

place of work. It did not matter that the taxpayer carried on his profession in two places,

Chambers and home:

‘It is quite true that the Appellant carries on his profession at two places, but he travels

between those two places not simply for the purposes of carrying on his profession, but also

because his home, as the Commissioners have found, is at the Old Rectory, Whipsnade. He travels

backwards and forwards between his home and his chambers in 15, Old Square because he has to

live somewhere, and because he wishes to go backwards and forwards between his chambers and

his home. It does not seem to me that it makes any substantial difference that he also carries on

his profession and does a lot of work at a place which happens to be his home. His motive, his

object and his purpose in travelling between these places, as it seems to me, are mixed.’

A similar decision was reached in Sargent v Barnes, in which a dentist had a laboratory which

was located between his surgery and his home (though nearer his home). Every morning and

evening he called in at the laboratory en route between home and surgery, and claimed the costs

of travelling between the laboratory and the surgery. It was held that in spite of the laboratory

visits, the trips between home and surgery retained a dual purpose which disqualified the

expenditure.

There are cases where you can claim travelling expenses but only where it can be shown that

the taxpayer’s home is his base of operations, i.e. his home is also his place of work. In Horton v

Young, the taxpayer was a bricklayer who entered into contracts with a builder for work on a

number of widely separated sites. He had no office other than his home, and the general

commissioners found as a fact that he negotiated contracts and maintained his business records in

the lounge of his house. The commissioners had allowed the travelling expenses only as regards

journeys between sites, and not between home and a site. The Court of Appeal held that all

travelling expenses were deductible, since the taxpayer’s home was his base of operations. At first

instance, Brightman J said at p. 64:

‘In my view, where a person has no fixed place or places at which he carries on his trade or

profession but moves continually from one place to another, at each of which he consecutively

exercises his trade or profession on a purely temporary basis and then departs, his trade or

profession being in that sense of an itinerant nature, the travelling expenses of that person

between his home and the places where from time to time he happens to be exercising his trade

or profession will normally be, and are in the case before me, wholly and exclusively laid out or

expended for the purposes of that trade or profession. I have used the adverb “normally” because

every case must to some extent depend on its own facts.’

The new emphasis on this point is illustrated in the recent case involving a consultant called Dr

Samadian. The case went to the FTT in 2012 where Dr Samadian argued that his business

mileage to and from his home office and a private hospital were wholly and exclusively allowable

expenditure. The first tier tribunal noted that the consultant geriatrician had a dedicated home

office, but did not accept that this office was a starting point for calculating private practice

business mileage for habitual journeys.

At the Upper Tribunal, Samadian argued that he should be able to reclaim travel expenses for

journeys between NHS and private hospitals, and between his home and private hospitals as they

are, in his view, incurred wholly and exclusively for the purposes of his private practice.

The tribunal noted that the consultant works full-time in the NHS at certain hospitals, but also

has a private practice as a self-employed medical practitioner. It also looked into his home office

arrangement and consulting rooms he hires at two private hospitals to see patients. In addition, he

also occasionally conducts home visits. Samadian travels via car between these locations and to

and from the NHS hospitals. He has an agreement in place with HMRC as to whether the expenses

of particular journeys are or aren’t deductible as expenses wholly and exclusively for the purposes

of private practice.

In spite of this arrangement, some disagreements still remained: HMRC resisted his claim that

travel between NHS and private hospitals was deductible.

The upper tribunal found that Samadian's home office was necessary to perform his work, but

because there was a pattern of “regular and predictable attendance” at other locations - the

private hospitals, for instance - they were places of business.

The tribunal dismissed his appeal, saying that the first tier tribunal’s decision was “correct in all

its essentials” and that the categories applied for treating travel expenses as deductible or non-

deductible would attract broad public acceptance. In short, it ruled that while the home office can

be recognised as a place of business and a use of home claim allowed, the travel from that place

of business in the home will not necessarily be allowable, unless it is in pursuit of an ‘itinerant’

business journey.

It also said:

Travel expenses for journeys between places of business for purely business purposes are

treated as deductible.

Travel expenses for journeys between home (even where the home is used as place of

business) and places of business are treated as non-deductible (other than in very

exceptional circumstances)

Travel expenses for journeys between a location which is not a place of business and a

location which is a place of business are not deductible

This principle has been followed up in the the FTT case of Mr Jones, a self-employed

consultant anaesthetist in private practice travelled from his home, where he carried out the

administration and management of his private practice, to hospitals where he performed duties at

surgical operations. The appellant's private practice involved him working with an operating team

brought together by the surgeon in charge of the operation in question, with the surgeon offering

the appellant work and the surgeon controlling the timing and location of the surgery. The

appellant could either accept or refuse the offer of work from a surgeon. In the year in question

the appellant travelled between home and two hospitals as part of this work and HMRC disallowed

those travel expenses.

The FTT considered whether the two hospitals the appellant visited were places of business for

the appellant. The FTT asked if there was a pattern of regular and predictable attendance to carry

out significant professional functions as more than just a visitor, and found that there was. In the

FTT's view, on the point that the appellant was in effect a ‘subcontractor’, in relation to his

instructing surgeons, potentially militated against a pattern of fixed and regular attendance at

particular locations, and if such a scenario came to pass, the appellant might well not have

satisfied the criterion of having a pattern of regular and predictable attendance at any particular

location, the reality however was that in the year in question the appellant travelled from his home

to only two hospitals which strongly indicated a pattern of regular and predictable attendance and

even though there was a range in the number of days between operations this did not change the

pattern.

2.3. Current issues: fines and legal costs

Another area where we are seeing a resurgence in activity from HMRC is in respect of fines

and legal fees. The basic issue is that where a penalty is intended as punishment then it will not

be allowable but where the payment is intended to provide restitution for damages caused by

normal trading operations then it will be allowable. But what about the legal costs?

As a general rule, damages incurred as a result of normal trading operations are allowable.

Penalties for infraction of the law are not.

Strong & Co of Romsey Ltd was a brewing company and it owned licensed houses and carried

on the trade of innkeepers as well as brewers. Trade at the particular inn involved in the case was

conducted through a manager. A customer sleeping in the inn was injured when a chimney fell on

him. The chimney fell because the brewery failed to ensure that its servants discharged their duty

to see that the premises were in proper condition. The brewery had to pay £1,490 in costs and

damages. The brewery claimed the damages as a deduction in computing its profits. The House of

Lords denied a deduction for the expenditure.

Lord Davy explained at page 220:

‘I think that the payment of these damages was not money expended “for the purpose of the

trade”. These words are used in other rules, and appear to me to mean for the purpose of

enabling a person to carry on and earn profits in the trade, &c. I think the disbursements

permitted are such as are made for that purpose. It is not enough that the disbursement is made

in the course of, or arises out of, or is connected with the trade, or is made out of the profits of

the trade. It must be made for the purpose of earning the profits.’

Lord Davy's remarks have been quoted with approval in many subsequent decisions. But

judges have also warned against applying them in too narrow a sense.

The Lord Chancellor, Earl Loreburn, described the statutory provisions and their effect at page

219:

‘A deduction cannot be allowed on account of losses not connected with or arising out of such

trade. That is one indication. And no sum can be deducted unless it be money wholly and

exclusively laid out or expended for the purposes of such trade. That is another indication. Beyond

that the Act is silent.

In my opinion, however, it does not follow that if a loss is in any sense connected with the

trade, it must always be allowed as a deduction; for it may be only remotely connected with the

trade or it may be connected with something else quite as much as or even more than with the

trade. I think only such losses can be deducted as are connected with it in the sense that they are

really incidental to the trade itself. They cannot be deducted if they are mainly incidental to some

other vocation, or fall on the trader in some character other than that of trader. The nature of the

trade is to be considered.’

However, penalties incurred for breaching the law are not allowable.

In the case of CIR v EC Warnes & Co Ltd, the company, which carried on the trade of oil

merchants, had been sued for a penalty under S 5(1) Customs (War Powers) Act 1915. The

penalty was for breach of certain orders and proclamations relating to the requirements of the

Board of Customs and Excise with respect to a consignment of oil shipped by the company to

Norway.

The action was settled by consent on the agreement of the company to pay a mitigated

penalty of £2,000 (to cover the costs of the Crown) and on all imputations as to the company's

moral culpability being withdrawn. The company incurred £560 legal costs.

The company claimed a deduction for the penalty and its legal costs against its trading profits.

In the High Court, Rowlatt J expressed the view that a penal payment for infringement of the

law could not be a loss arising out of the trade.

The part of Rowlatt J's judgment on which the above guidance is based is set out at pages

231-232:

‘I may shelter myself behind the authority of Lord Loreburn, who, in his judgment in the House

of Lords in Strong & Co [of Romsey] v Woodifield said that it is impossible to frame any formula

which shall describe what is a loss connected with or arising out of a trade. That statement I

adopt, and I am not sure that I gain very much by going through a number of analogies; but it

seems to me that a penal liability of this kind cannot be regarded as a loss connected with or

arising out of a trade. I think that a loss connected with or arising out of a trade must, at any rate,

amount to something in the nature of a loss which is contemplable, and in the nature of a

commercial loss. I do not intend that to be an exhaustive definition, but I do not think it is possible

to say that when a fine, which is what it comes to, has been inflicted upon a trading body, it can

be said that that is “a loss connected with or arising out of” the trade within the meaning of this

Rule. As I say, it is impossible to say what is such a “loss”, but I have a clear view that this is not,

and I can say no more than that.’

Following on from this, legal expenses incurred in the normal day to day conduct of the trade

are likely to be allowable. The costs of entering, amending or leaving a trading contract are

allowable. The costs arising from a breach of the law are not allowable. Costs incurred to settle an

action alleging breach of the law are also not allowable.

2.4. Capital expenditure

The most fundamental principle governing the rules under which profit is calculated for the

purposes of determining amounts chargeable to tax is that capital income and expenditure are

excluded. Capital receipts are potentially brought into charge under the capital gains tax

legislation and capital expenditure may attract relief under the capital allowances legislation,

assuming that it is qualifying expenditure for the particular allowance being claimed. It is rare for

100% capital allowances to be available and so the capital relief is seen as less attractive than

being able to claim that expenditure is revenue.

The legislation does not define what is capital expenditure, although s74(1) ICTA 1988 does

exclude specific items including those which could be described as capital in nature. As remarked

by Sir Wilfred Greene MR in CIR v British Salmon Aero Engines [1938] 22 TC 29 when asked to

decide whether something was capital or revenue:

‘it is almost as true to say that the spin of a coin would decide the matter almost as

satisfactorily as an attempt to find reasons’.

The capital allowances legislation does tell what is not capital expenditure. So s4 CA 2001

states that

‘(2) Capital expenditure and capital sums do not include, in relation to a person incurring the

expenditure or paying the sums

(a) any expenditure or sum that may be deducted in calculating the profits or gains of a trade,

profession or vocation or property business carried on by the recipient, or

(b) any expenditure or sum that may be deducted in calculating the emoluments of an

employment or office held by the person’

There is an equivalent definition for capital expenditure and capital sums from the point of

view of the person receiving the payment.

There is also a disallowance for payments which may be made under deduction of tax at

source, being annual payments within s348 or s349(1) ICTA 1988 (eg interest and royalties)

although a capital sum payable on a sale by a non-UK resident of UK patent rights is not excluded,

although s524 ICTA 1988 requires it to be treated as an annual sum from which tax must be

deducted.

It is therefore necessary to look at Case Law to establish how capital expenditure can be

identified, although even they have failed to come up with a universal definition. In Vallambrosa

Rubber Co Ltd v Farmer [1910] 5 TC 529, the Lord President said

‘…in a rough way I think it is not a bad criterion of what is capital expenditure as against what

is income expenditure to say that capital expenditure is a thing that is going to be spent once and

for all, and income expenditure is a thing that is going to recur every year’.

This is perhaps too wide a definition, and the more common definition is that of Viscount Cave

in the case of Atherton v British Insulated and Helsby Cables Ltd [1925] 10 TC 155. He said

‘. . . when an expenditure is made, not only once and for all, but with a view to bringing into

existence an asset or an advantage for the enduring benefit of a trade . . . there is very good

reason (in the absence of special circumstances leading to an opposite conclusion) for treating

such an expenditure as properly attributable not to revenue but to capital.’

The case concerned the creation of a pension fund and so the enduring benefit here was not

even a tangible one, and Viscount Cave also pointed out that the expenditure does not need to

actually achieve its purpose.

In Anglo Persian Oil Co Ltd v Dale [1931] 16 TC 253, Lord Romer approved Mr Justice

Rowlatt’s gloss on the phrase ‘enduring benefit’, in that it meant enduring in the way that fixed

capital endures, not in the sense that for a good number of years you are relieved of a revenue

payment. Indeed this was confirmed in the case of Hancock v General Reversionary & Investment

Co Ltd, [1918] 7 TC 358 where it was stated that a payment to relieve revenue payments will only

be a capital payment if it has a clear secondary capital effect.

The case of Strick v Regent Oil Co Ltd [1965] 43 TC 1 emphasises that no all-embracing

formula has been evolved, and that Viscount Cave’s dictum in the Atherton case must not be taken

as an exhaustive definition nor be applied as an arbitrary rule. Lord Upjohn, in the Regent Oil case

remarked that Parliament had wisely never given any statutory guidance in the matter; it had been

content to leave the determination of these difficult matters to the common sense of the tribunals

and Judges before whom they are bought.

Repairs and renewals

The distinction is probably most difficult when one considers expenditure on an existing asset,

the question being whether it is a repair (revenue) or an improvement (capital). Another way of

posing the question might be: is the expenditure for the purpose of maintaining the asset in its

present state and/or at its present value, or is the effect to alter the very nature of the asset (so as

virtually to bring into existence a new asset) and/or to increase its intrinsic value?

Assets bought in a defective condition

Sometimes an asset is acquired in need of repair such that after it is acquired the purchaser

expends money on repairs to it. In general terms, if the repairs expenditure would have been

revenue expenditure if there had not been a change in ownership, it is normally revenue

expenditure when it is expended by the new owner. However it may be capital where

The asset was not in a fit state for use in the trade until the repairs had been carried out or

could not continue to be used in the trade without being repaired shortly after acquisition.

There is evidence in, for example, the contract for the sale of the asset or in negotiations

leading up to the contract or in the surrounding circumstances that the purchase price was

substantially less because of the dilapidated state of the asset

The cases supporting this view are as follows:

In Law Shipping Co Ltd V CIR [1923] 12 TC 621 a company bought a secondhand ship when

its four-yearly Lloyd’s survey was overdue. They received exemption from the survey until after

the ongoing voyage was completed and following the survey £59000 of expenditure had to be

incurred. They claimed that the majority of this related to the period after the acquisition of the

ship but this was rejected by the courts such that £51000 of this was deemed to be capital. There

was evidence that the purchase price was reduced because of the state of the vessel.

In the case of Jackson v Laskers Home Furnishers Ltd [1956] 37 TC 69, the company leased

premises as a shop, which having been empty for 18 years had become very dilapidated and was

unfit for occupation. They covenanted to reinstate the premises, which cost them around £2300,

and as a result the early years rent was at a peppercorn. The cost of the work was found to be

capital, with Judge Danckwerts saying

‘It seems to me plainly that it was work of a capital nature … and was dealing with the

accumulation of repairs or alterations of the premises to suit their business. Therefore it had

nothing in common with the current expenditure on repairs which fall to be made that the only

possible and reasonable conclusion upon the facts is that this work and expenditure was of a

capital nature…’

In the case of Odeon Associated Theatres Ltd v Jones [1971] 48 TC 257, the company

purchased a number of cinemas during the Second World War. From the beginning of the war

until the 1950s only essential maintenance was allowed and this was inadequate to keep the

theatres in a proper state of repair. The effect on cinema attendances was insignificant because

all venues were in a similar position. The costs of the repairs, when finally undertaken, was

allowed as a revenue deduction because there was no evidence that the purchase price of the

cinemas was less because of their state and their profit-earning potential was not adversely

effected by their state at any time.

Entirety

If the thing that is replaced is the whole asset, ie the entirety, then it must be capital. In the

case of Bullcroft Main Collieries Ltd v Grady [1932] 17 TC 93, the colliery chimney had been

replaced. It was a structure quite separate from the other surface buildings, connected to the

furnaces only by the flues and was therefore a structure in its own right, an entirety. Its

replacement was therefore not a repair but the replacement of a capital asset. This is contrasted

by the case of Samuel Jones & Co (Devonvale) Ltd [1951] 32 TC 513 where a chimney was

replaced, but a chimney that was ‘physically, commercially and functionally an inseparable part of

an entirety’, that is the factory.

The Bullcroft decision was followed in Margrett v The Lowestoft Water & Gas Co [1935] 19 TC

481 where a reservoir was replaced with a new one some distance away. This was an important

case, because it disallowed any deduction for the notional costs of repairing the old reservoir.

They had chosen not to repair the old reservoir, instead building a new one and therefore no

deduction could be made.

In Brown v The Burnley Football and Athletic Co Ltd [1980] 53 TC 357, the company incurred

expenditure on replacing a stand at the football ground, claiming that the football ground was the

entirety. However, the Courts found that the ground had not been designed or built according to

one plan, it had been erected piecemeal, with each part having its own design and function. The

stand was therefore an entirety in its own right and the replacement of it was capital.

Improvements

In W P Lawrie v CIR [1952] 34 TC 20, the business was carried out in a wooden building with a

roof of asbestos or corrugated iron sheeting and glass supported by brick piers. The roof was

leaking and the piers were shaky. They were advised to reconstruct the roof rather than trying to

repair and decided to enlarge the building whilst they were at it. Whilst the Courts accepted that

the building was the entirety, and the replacement of the roof could have been a repair, the end

product was definitely a new improved building, so the costs were capital. Again, there was no

deduction allowed for the notional costs of repairing the roof. This was followed in the case of

Thomas Wilson (Keighley) Ltd v Emmerson [1960] 39 TC 360 which also involved the extension of

a building.

However, the case of Conn v Robins Brothers Ltd [1966] 43 TC 266 did offer some hope.

The company traded from premises part of which was about 400 years old and part about 200

years old. It was in an advanced stage of decay, with a rotten roof and floor timbers and

crumbling stone and brickwork. The property was refurbished and modernised but the Courts

found that the improvements were not capital in nature. The improvements were inevitable

because of the age of the building and the fact that techniques have changed, it would have been

impossible to restore the building to its original condition.

Website creation costs

HMRC have recently updated their toolkit on capital v revenue expenditure. One difference

from the earlier wording is in the treatment of website creation costs. The new version from

HMRC states: ‘Even though expenditure on website development may be shown in the accounts

as advertising, marketing or IT costs, this does not necessarily mean that it is allowable as revenue

expenditure. In order to identify the correct tax treatment the exact nature of the website costs

should be examined. Application and infrastructure costs, including domain name, hardware and

operating software that relates to the functionality of the website, should normally be treated as

capital expenditure. Design and content development costs should normally be treated as capital

expenditure to the extent that an enduring asset is created. One such indication might be an

expectation that future revenues less attributable costs to be generated by the website will be no

less than the amounts capitalized.’

This focuses on whether an enduring asset is created and differs from the previous wording

which focused on the purpose of the website. If the function of website was solely to advertise or

promote the business then the development costs were allowed as revenue. This view has now

changed.

Capital allowances would normally be available for these costs.

2.5. Capital allowances

Capital allowances can only be claimed on qualifying expenditure. The legislation does not

contain a definition of either machinery or plant and our definitions of these things have again

been evolved almost entirely from Case Law. However, there was an attempt at legislating to

clear up some of the confusions regarding this in 1994, since consolidated into CAA 2001.

S21 CAA 2001 starts off by stating that expenditure on the provision of plant or machinery

does not include expenditure on the provision of buildings. There is then a list (‘List A’) of assets

treated as buildings. S22 CAA 2002 repeats the process, indicating that expenditure on plant or

machinery does not include expenditure on the provision of structures or other specified assets.

List B then lists excluded structures and other assets.

List A: Assets treated as buildings

1. Walls, floors, ceilings, doors, gates, shutters, windows and stairs.

2. Mains services, and systems, for water, electricity and gas.

3. Waste disposal systems.

4. Sewerage and drainage systems.

5. Shafts or other structures in which lifts, hoists, escalators and moving

walkways are installed.

6. Fire safety systems.

List B: Excluded structures and other assets

1. A tunnel, bridge, viaduct, aqueduct, embankment or cutting.

2. A way, hard standing (such as a pavement), road, railway, tramway, a park for

vehicles or containers, or an airstrip or runway.

3. An inland navigation, including a canal or basin or a navigable river.

4. A dam, reservoir or barrage, including any sluices, gates, generators and

other equipment associated with the dam, reservoir or barrage.

5. A dock, harbour, wharf, pier, marina or jetty or any other structure in or at

which vessels may be kept, or merchandise or passengers may be shipped or

unshipped.

6. A dike, sea wall, weir or drainage ditch.

7. Any structure not within items 1 to 6 other than—

(a) a structure (but not a building) within Chapter 2 of Part 3 (meaning of

“industrial building”),

(b) a structure in use for the purposes of an undertaking for the extraction,

production, processing or distribution of gas, and

(c) a structure in use for the purposes of a trade which consists in the provision

of telecommunication, television or radio services.

S23 CAA 2001 then lists items which might fall within List A and B but which are excluded from

the exemption, by virtue of particular legislation. These are:

o thermal insulation of industrial buildings (s28 CAA 2001)

o fire safety (s29 CAA 2001)

o safety at designated sports grounds (s30 CAA 2001)

o safety at regulated stands at sports grounds (s31 CAA 2001)

o safety at other sports grounds (s32 CAA 2001)

o personal security (s33 CAA 2001)

o software and rights to software (s71 CAA 2001)

S23 CAA 2001 also includes List C, which lists expenditure unaffected by s21 and s22. It

should be noted that this does not automatically mean that capital allowances are available on

those items, it just means that they are not specifically excluded. It is necessary to consider the

Case Law to determine actual eligibility to capital allowances.

List C: Expenditure unaffected by sections 21 and 22

1. Machinery (including devices for providing motive power) not within any

other item in this list.

2. Gas and sewerage systems provided mainly—

(a) to meet the particular requirements of the qualifying activity, or

(b) to serve particular plant or machinery used for the purposes of the qualifying

activity.

3. [no category 3 exists as it was repealed in 2008]

4. Manufacturing or processing equipment; storage equipment (including cold rooms);

display equipment; and counters, checkouts and similar equipment.

5. Cookers, washing machines, dishwashers, refrigerators and similar equipment;

washbasins, sinks, baths, showers, sanitary ware and similar equipment; and

furniture and furnishings.

6. Hoists

7. Sound insulation provided mainly to meet the particular requirements of the

qualifying activity.

8. Computer, telecommunication and surveillance systems (including their wiring or

other links).

9. Refrigeration or cooling equipment.

10. Fire alarm systems; sprinkler and other equipment for extinguishing or

containing fires.

11. Burglar alarm systems.

12. Strong rooms in bank or building society premises; safes.

13. Partition walls, where moveable and intended to be moved in the course of the

qualifying activity.

14. Decorative assets provided for the enjoyment of the public in hotel, restaurant or

similar trades.

15. Advertising hoardings; signs, displays and similar assets.

16. Swimming pools (including diving boards, slides and structures on which such

boards or slides are mounted).

17. Any glasshouse constructed so that the required environment (namely, air, heat,

light, irrigation and temperature) for the growing of plants is provided automatically

by means of devices forming an integral part of its structure.

18. Cold stores.

19. Caravans provided mainly for holiday lettings.

20. Buildings provided for testing aircraft engines run within the buildings.

21. Moveable buildings intended to be moved in the course of the qualifying activity.

22. The alteration of land for the purpose only of installing plant or machinery.

23. The provision of dry docks.

24. The provision of any jetty or similar structure provided mainly to carry plant or machinery.

25. The provision of pipelines or underground ducts or tunnels with a primary purpose of

carrying utility conduits.

26. The provision of towers to support floodlights.

27. The provision of—

(a) any reservoir incorporated into a water treatment works, or

(b) any service reservoir of treated water for supply within any housing estate or other

particular locality.

28. The provision of—

(a) silos provided for temporary storage, or

(b) storage tanks.

29. The provision of slurry pits or silage clamps.

30. The provision of fish tanks or fish ponds.

31. The provision of rails, sleepers and ballast for a railway or tramway.

32. The provision of structures and other assets for providing the setting for any ride at an

amusement park or exhibition.

33. The provision of fixed zoo cages.

Actually having expenditure included in list C does not mean that allowances will be due. It

just means that they might – we then have to look back at the case law again to see whether

there are any principles which might allow or disallow the expenditure. So it is not an entirely

straightforward process.

Example

Looking at a practical example of how the legislation works, let us say that we have a prefab

building put up by a contractor to provide shelter and recreational space for workers at a building

site. The route through the legislation would be as follows:

If we assume the hut will be kept for at least two years, it is capital expenditure

The hut might be a building or it might be a structure so it could be within either

s21 or s22

It is not covered by any of the specific provisions in s23 but item 21 at list C refers

to ‘moveable buildings intended to be moved in the course of the qualifying activity’

This does not by itself mean that the hut can qualify for allowances, but does mean

that we have the opportunity to consider the case law principles in establishing the

case

In fact, HMRC guidance actually tells us that they will accept that allowances are

due in this case

3. Status

In determining the status of any individual, it is the contractual relationship between the two

parties that is crucial. This would usually be judged by looking at the written contract between the

two parties involved. There has been a recent case, involving a company called Autoclenz, which

shows that the actual written contract can be completely disregarded even if it is not a sham

contract. This is an unfortunate development and it is being quoted by HMRC officers in status

cases. It makes it more important that the terms of a contract are real and not just put in place to

present a particular scenario.

There is no statutory definition in law for employment and self-employment. The line between

the two is established by case law. Whilst there is a vast body of case law, there are particular

cases which have developed specific important principles.

The starting point is always Ready Mixed Concrete (South East) Ltd v Minister of Pensions and

National Insurance. In this case, MacKenna J made a famous speech encapsulating the key tests

of employment:

A contract of service exists if these three conditions are fulfilled

(i) The servant agrees that, in consideration of a wage or other remuneration, he will

provide his own work and skill in the performance of some service for his master.

(ii) He agrees, expressly or impliedly, that in the performance of that service he will be

subject to the other’s control in a sufficient degree to make that other master.

(iii) The other provisions of the contract are consistent with its being a contract of service.

The actual tests considered are wider than this. However, this is not a matter to be

determined merely by running down a checklist or adding up the number of factors pointing

towards employment and comparing that result with the number pointing toward self employment.

Different factors will have more or less relevance depending on the facts being considered and it is

a matter of evaluating the overall picture that emerges from a review of the relationship between

the parties involved. These issues are considered below.

3.1. Control

The issue of control is a difficult one because anyone providing services, whether as an

employee or as a self-employed worker, is subject to some element of control.

It has always been seen by HMRC as an important criteria, backed by comments by Cooke J in

the case of Market Investigations Ltd v The Minister of Social Security who said:

‘…nor can strict rules be laid down as to the relative weight which the various considerations

should carry in particular cases. The most that can be said is that control will no doubt always

have to be considered, although it can no longer be regarded as the sole determining factor’.

However, it should be remembered that there can be control without employment being the

inevitable result. In the case of Ready Mixed Concrete (South East) Ltd v Minister of Pensions and

National Insurance the owner-driver of a concrete mixing lorry wore the company uniform and had

to comply with company rules. It was clear the company did have control over him but he was

held to be self-employed. MacKenna J said

‘An obligation to do work subject to the other party’s control is a necessary though not always

a sufficient, condition of a contract of service. If the provisions of the contract as a whole are

inconsistent with its being a contract of service, it will be some other kind of contract and the

person doing the work will not be a servant. The judge’s task is to classify the contract … He may,

in performing it, take into account other matters besides control’

Where the work is done

Even if the contract indicates that work is to be done in a place specified by the client, it can

be possible that this is just part of the contractual arrangement. However the success of this

argument can depend on the nature of the work.

What the worker does

To agree that there is no control over what the worker does, HMRC would be looking for a

situation where the individual is contracted to undertake a specific task and cannot be directed to

do another job.

When the work is done

If the client specifies the hours to be worked, then it can be difficult to argue that no control

exists. However, if the worker has to accord with specific hours, for example for health and

safety reasons, it is possible to argue again that this forms part of the terms and conditions of the

contract only.

How the work is done

Control is clearly exercised if the worker is told how to do the work and their work is then

checked. In relation to the latter point, a distinction has to be made between checking as an

exercise of control and checking to ensure that the terms of the contract are met.

3.2. Substitution

If the contractual obligations are to be performed by a specified individual, with no rights to

send a substitute for that individual, it can often be difficult to argue that the contract represents

anything other than a contract for employment rather than self-employment. However, the

relevance of this can be underplayed if the client would simply have no need for a substitute ie if

they have a bank of people that they can use to undertake the work.

The other argument made by HMRC in this area is that, even where the contract includes a

right to send a substitute that because this has never been exercised it is not a real right. That is,

it has only been included to try and present a self-employed relationship. In the absence of any

evidence to suggest that the client will not accept a substitution, this argument should be resisted.

It is also important that where a substitute is sent, or can be sent, it is the worker who will

continue to ceive the payment and he will then be responsible for paying the substitute.

In summary a real substitution right is often fatal to an argument that an individual is an

employee; the absence of one is not fatal to an argument that someone is self-employed.

3.3. Business operation

One of the features of someone who is self-employed in relation to a specific contract is that

he has a business organisation and to be seeking other opportunities to exploit any skills he has.

To establish self-employment, there should be no restriction on any of the contractors working for

other people and it may be that some do so. This can be a difficult area if, as a matter of fact, an

individual is only working for one client and is not seeking other work.

However, if the individual does have the trappings of a business – this would include a website,

stationary, business cards, paperwork – then even if he is only working for one client it is possible

to argue that this is a strong indicator of self-employment.

3.4. Benefiting from sound financial management

One marker of self-employment is that an individual can benefit, in terms of increased profit,

by better financial management of their business and, possibly more importantly, could make

losses. A self-employed person can influence his profit margin by adapting his behaviour. He will

bear the loss that a poor decision may bring. This is not a risk to which an employee is exposed.

This would usually be demonstrated by fixed fees for work being undertaken (rather than being

paid a daily or hourly rate), clauses indicating that unsatisfactory work must be rectified at the

worker’s own expenses, no additional payment for expenses and no payment for overtime worked.

However there is an extra facet to this. Individuals who risk their own money by buying

assets, bearing their running costs, paying for overheads and materials and being responsible for

maintaining their expertise through training are likely to be self-employed because employees

simply do not bear these types of costs. This is particularly true if you can demonstrate that

someone is actually incurring costs to try and get work eg travelling to speculative meetings with

prospective clients at their own cost.

3.5. Mutuality of obligation

The concept of mutuality of obligation basically means any relationship where one party is

obliged to offer work to the other party and/or one party is obliged to accept work if offered by the

other party would inevitably be treated as employment. It is often ignored as irrelevant by HMRC

but a series of recent employment law cases have highlighted its importance to the extent that

most employment lawyers now believe it is the only issue which is relevant in determining status.

In a case called Bunce v Potsworth Ltd t/a Skyblue, a welder worked through an agency for rail

track companies. He claimed unfair dismissal on the basis that he was an employee. The Court

upheld a finding of fact by the employment tribunal that there was a lack of mutuality of

obligations between the agency and the individual and this was fatal to his claim to be an

employee. This reinforced the view in Bridges and others v Industrial Rubber plc that the

contractual absence of a promise to provide work and the counter promise to do it is inconsistent

with a contract of employment regardless of the other conditions of the working relationship. The

decision in that case completely contradicts the view of HMRC that all that is necessary for

mutuality of obligation to exist is that ‘the engager must be obliged to pay a wage or other

remuneration and the worker must be obliged to provide his or her own work or skill’. This view

was actually supported in Netherland Ltd v York where John Avery-Jones, the Special

Commissioner, commented on the fact that the agreement to pay a rate of so much per day was in

effect mutuality of obligation. However, this was a case where the individual was contractually

offered and obliged to work five days a week for the end client which would have probably

constituted a mutuality of obligation in any case. The comments of the Special Commissioner

certainly contradict a large chunk of employment law decisions.

It is interesting that HMRC will often argue that an individual who had been offered and

accepted work over a long period of time has established a mutuality of obligation with their client.

This view does not appear to be supported by any of the above cases, even those won by HMRC.

3.6. Other factors

HMRC will often look to see whether someone is part of the organisation; paying particular

regard to whether an individual is presented as an employee to the outside world. The use of this

test has been significantly discredited in recent legal cases on status but it is something which is

still argued in status disputes by Inspectors. Employment contracts would normally feature such

things as sick pay, holiday pay and rights on termination of the employment. HMRC will also

consider whether all individuals undertaking similar work have the same status.

3.7. Partnership

It is an often overlooked point that if someone is genuinely a partner is a partnership (looking

at the things which make them such a person within partnership law) they cannot be an employee

of whoever they are working for. HMRC do not always acknowledge or appreciate this point but it

can be a powerful argument since it is not necessary to consider any of the above factors in

disputes relating to partnerships – there are a completely different set of rules to think about.

Partnership law tells us that in determining whether a partnership does or does not exist,

regard shall be had to the following rules:

(1) Joint tenancy, tenancy in common, joint property, common property, or part ownership

does not of itself create a partnership as to anything so held or owned, whether the

tenants or owners do or do not share any profits made by the use thereof.

(2) The sharing of gross returns does not of itself create a partnership, whether the persons

sharing such returns have or have not a joint or common right or interest in any property

from which or from the use of which the returns are derived.

(3) The receipt by a person of a share of the profits of a business is prima facie evidence that

he is a partner in the business, but the receipt of such a share, or of a payment contingent

on or varying with the profits of a business, does not of itself make him a partner in the

business; and in particular–

(a) The receipt by a person of a debt or other liquidated amount by instalments, or

otherwise out of the accruing profits of a business does not of itself make him a

partner in the business or liable as such:

(b) A contract for the remuneration of a servant or agent of a person engaged in a

business by a share of the profits of the business does not of itself make the servant

or agent a partner in the business or liable as such:

(c) A person being the widow or child of a deceased partner, and receiving by way

of annuity a portion of the profits made in the business in which the deceased

person was a partner, is not by reason only of such receipt a partner in the business

or liable as such:

(d) The advance of money by way of loan to a person engaged or about to engage

in any business on a contract with that person that the lender shall receive a rate of

interest varying with the profits, or shall receive a share of the profits arising from

carrying on the business, does not of itself make the lender a partner with the

person or persons carrying on the business or liable as such. Provided that the

contract is in writing, and signed by or on behalf of all the parties thereto:

(e) A person receiving by way of annuity or otherwise a portion of the profits of a

business in consideration of the sale by him of the goodwill of the business is not by

reason only of such receipt a partner in the business or liable as such.

3.8. What happens if HMRC recategorised someone?

There are a number of procedures which might be followed by HMRC in the event that they

consider that a worker who has previously been regarded as self-employed is, in fact, an

employee. The main issue is the extent to which HMRC may decide to pursue tax and NICs for

earlier years. The best case scenario would be that HMRC allow earlier years to remain in place

but that PAYE be operated going forward. It is increasingly rare to find HMRC adopting this

approach.

HMRC will hope that they can agree and negotiate a settlement with the employer but this is not

always possible if the employer feels that they are being unfairly targeted or if they are unhappy

about the status decision in the first place.

Collecting tax

The first issue is whether HMRC are going to go back to earlier years. The guidance states: ‘Status

is an inaccuracy like any other and recovery action should be taken for all years where there has

been a failure to operate PAYE and/or NICs’.

However, it then goes on to say:

To make a recovery for earlier years you should

•establish the facts for all in date years during which there is a potential failure (even if

the failure has continued for a number of years you cannot assume that the terms and

conditions of the engagement will have remained the same throughout)

•consider whether in respect of each year HMRC has a strong case

•concede any or all years where HMRC has a weak position and document the

reason(s) for the decision which has been taken.

•The decision whether or not to settle a case and for what years must be made on the

basis of an honest and realistic assessment of the strength of the case for each year. A

strong case should be viewed as one in which you believe that for the year in question

there is at least a 60% chance of success at the First-tier Tribunal.

Note: In establishing the chances of success you must, in conjunction with your

manager,

•make sure the guidance on fact-finding has been correctly followed

•make a fair and reasonable judgment on the strength of the case based on

•your knowledge of the facts of the case, thereby

•assessing the chances of success.

Tax can be collected from the employer using a Regulation 80 determination. However there are a

number of other options and the HMRC office must consider if any of those might apply first

because they cannot be utilised once a Reg 80 determination has been issued.

Where an amount intended to represent tax on a relevant payment (ie the amount paid by the

employer to the employee) has been self-assessed or an amount has been paid as a payment on

account of the liability, HMRC must consider if the provisions of Regulation 72F apply.

If this is not relevant, HMRC must consider if either Condition A or B of Regulation 72 apply which

would allow the tax to be collected from the employee rather than the employer.

If a Reg 80 determination has been issued but not paid, HMRC also have the possibility of

transferring the liability to the employee under Regulation 81.

If either of the second two options above applies then HMRC will also need to ensure that the

employee’s self assessment return is amended to remove the liability to tax on the income as self

employed income.

Regulation 72F determination

This is often described as the ‘Demibourne’ principle since it was a case involving a taxpayer of

that name which led to a change in the legislation as the Courts commented on the inequity of the

previous provisions. The provisions arise from a situation where an individual has paid tax as a

self-employed person and then are recategorised as an employee as there is a difficult over the

extent to which tax already paid may be offset against the employer’s PAYE liabilities for earlier

years. The Demibourne case confirmed the right of HMRC to deny offset of tax but was felt to

give no protection to the employee and so secondary legislation was introduced. It is not perfect

but it can be helpful in some cases. The change applied from 6 April 2008.

3.8.1. HMRC may issue a direction permitting employers to offset tax paid by the individual in

certain specified circumstances. The employer is then relieved of a PAYE liability that

would otherwise be due to the extent of any amount specified in the direction for the tax

year. The direction can be issued where conditions are met as follows:

the employee has received relevant payments (which can include notional payments) in

relation to which the employer should have applied PAYE;

the employer has deducted or accounted for less tax under PAYE than is required;

HMRC are satisfied that a liability to tax has been self-assessed on the income in question

by, or on or behalf of, the employee (or has been included in a self-assessment payment

on account or as a sub-contractor deduction);

one of the following ‘trigger events’ has occurred on or after 6 April 2008 (but none of

them has occurred before that date):

o the employer has been issued with a notice of determination which includes tax on

the relevant payment;

o the employee's self-assessment return has been received and includes an

adjustment for a PAYE credit in relation to the relevant payments;

o the employee's amended self-assessment return, or an overpayment relief claim

(previously error or mistake claim), has been received and includes an adjustment

for a PAYE credit in relation to the relevant payments; or

o HMRC have received a letter of offer to agree an amount in settlement of the

employer’s liability to pay an amount of tax, including tax on the relevant payment

in question.

HMRC have indicated that where the conditions for making a direction are satisfied they will

exercise the power to make a direction unless there are exceptional circumstances such as

evidence that the employer has deliberately failed to operate PAYE with no collusion on the part of

the employee in the expectation that they would benefit from the new legislation if discovered. A

failure to operate this discretion where the conditions are met should therefore always be

challenged although employers have no right of appeal against any refusal to make a direction.

By contrast, an employee may appeal against the making of a direction on any of the following

grounds:

they did not receive a relevant payment;

the tax specified in the direction is incorrect because an amount of tax in respect of the

relevant payment or payments in question has not been self-assessed (or paid on account

or deducted as a sub-contractor deduction);

there has been no trigger event; or

a trigger event occurred before 6 April 2008.

An employer remains potentially liable to penalties on the full amount of tax which should have

been deducted. Interest will only be charged on any balance of tax remaining payable by the

employer after the direction has been made.

Regulation 72 determinations

A Regulation 72 determination will remove the employer’s PAYE liability by transferring it to the

employee. Condition A or condition B must be met.

Condition A is met if HMRC are satisfied that the employer

took reasonable care to comply with the PAYE Regulations and

the failure to deduct the correct amount of tax was due to an error made in good

faith.

Employees to whom liability is transferred can appeal against that decision on the basis that the

error was not made in good faith. Although it is rare for appeals to succeed there have been some

recent successes. There is likely to be a case to answer in status cases unless it can be shown

that the case is really borderline. In clear cases of employment rather than self-employment it will

be difficult to argue that there is an error made in good faith.

If the employer cannot pay what is due then Condition B may apply which would again allow the

liability to be transferred to the employee. The conditions are:

the employee or director received payments knowing that the employer had wilfully

failed to deduct the correct amount of PAYE from their earnings and

the prospects of recovery from the employee or director are reasonably good

HMRC will only use this is there is evidence that the employee or director really did

have some input into the PAYE that should have been deducted. It is more common to

find this used in cases of PAYE failure rather than status disputes. The individual can

appeal against the determination.

Regulation 81 determinations

This applies where HMRC have issued a Reg 80 determination and it has not been paid within 30

days. It allows the liability to be transferred to the employee. The condition is that HMRC are of

the opinion that the employee in respect of whose relevant payments the determination was made

has received those payments knowing that the employer has wilfully failed to deduct the amount

of tax which should have been deducted from those payments. This is fairly similar to Condition B

above.

Summary

To summarise, the main possibility in relation to payment of liabilities after a status review is the

Demibourne option on the basis that tax has already been paid on the income through self-

assessment. If the employer does not pay the tax then HMRC might pursue the employee under

Reg 81.

4. The business structure

Why do people operate different through different business structures? Many will be swayed

by the comments of friends and maybe advisors. Some will have very strong views about the

most appropriate option to take. Most practitioners are familiar with the basic mechanisms for

working out if it is more cost effective from a tax perspective to be operating through different

structures. What issues need to be considered when a person decides to commence in trade?

There is no generic answer; each situation has to be judged on its own merits. Issues such as

commercial realities, personal preferences, the future plans of the business, retirement plans, and

attitude of the owners and the possibility of a future sale all have to be taken into account.

Neither is the decision final; there may be reasons why a business structure will change during the

life of a business and it is the reality for most businesses that this will occur. The same basic

issues arise with decisions about changing the structure although these tend to be motivated by

something specific such as tax planning.

There are a series of issues that need to be considered when making any decision about the

business vehicle:

What is the expected profit of the business and how will this be taxed?

What are the income needs of the individual? How will this be generated and what is the

tax cost?

Are there any VAT issues?

Will the business need outside investment and will the vehicle allow this?

Will there be employees and will the structure allow this?

Will there be any problems with the legal status of the business; is there any need for

limited liability?

Are pensions an issue and can the business structure support required pension planning?

Will there be losses and how could they be best utilised?

Are there any IR35 or status issues?

Are there any issues about the individual managing the requirements of the chosen

business structure?

What are the long term aims of the business in terms of proprietor’s involvement and

method of liquidating value?

The basic issues in relation to each unincorporated structure is summarised below.

Sole trade

The proprietor is taxed on all profits regardless of whether the profits are drawn out or not

All profits attract Class 4 NICs and Class 2 NICs must be paid

VAT must be paid once the threshold is exceeded

Investment into the business can only really be made via loans

Employees will be dealt with under PAYE; it is difficult to share profits other than by

increasing remuneration

There is no separation of the business and the proprietor who has personal liability for all

business debts

Personal pensions can be established

Losses generated can be offset against other income subject to the relevant conditions

being satisfied

Partnerships

The partner is taxed on his share of profits regardless of whether the profits are drawn out

or not

All allocated profits attract Class 4 NICs and Class 2 NICs must be paid

VAT must be paid by the business once the threshold is exceeded

Investment into the business can only really be made via loans

Employees will be dealt with under PAYE; it is difficult to share profits other than by

increasing remuneration

Partners are joint and severally liable for all the partnership debts

Personal pensions can be established

Losses generated can be offset against other income subject to specific anti-avoidance

legislation

Limited liability partnerships

The partner is taxed on his share of profits regardless of whether the profits are drawn out

or not

All allocated profits attract Class 4 NICs and Class 2 NICs must be paid

VAT must be paid once the threshold is exceeded

Investment into the business can only really be made via loans

Employees will be dealt with under PAYE; it is difficult to share profits other than by

increasing remuneration

Liability to partnership debts is limited

Personal pensions can be established

Losses generated can be offset against other income subject to specific anti-avoidance

legislation assuming these are trading losses (not investment LLPs)

Investments can be made by way of loan or capital

Of course, a person cannot set up a partnership without having a partner, although it is more

common these days for a person to have a corporate partnership which would enable them to be

in partnership with themselves effectively. In reality the big decision tends to be incorporated

versus non-incorporated. If a partnership is the best vehicle it is then going to be ‘normal’ versus

LLP.

Setting up an LLP is more complicated but is fairly similar to setting up a company. The same

is true of the ongoing compliance (non-tax issues) which have to be undertaken with an LLP. So

annual returns have to be filed with Companies House and they have to be notified of changes in

relevant information. The fact that information has to be filed at Companies House means that

certain (limited) information is published and in the public domain as it is with companies

generally. This can be off-putting. The only way of limiting liability in relation to a partnership and

not having such publically available details is to be a limited partner in a general partnership. The

downside is that a limited partner cannot participate in the management or running of a limited

partnership.

So what might be the prime motivators in using an unincorporated business and then which

type of such a business?

Limiting liability

A business which is intrinsically risky will often mean a proprietor will want to use a company

or an LLP. The theory is that the loss of the proprietor of an LLP is limited to his investment in the

share capital of the company. In new businesses which require finance, this may be illusory as

those lending money will often require personal guarantees from the members before they lend.

Of course, it is not this type of liability that many will be concerned about but more the effect

of litigation. Many professional partnerships have become LLPs in order to limit the partners’

exposure to risk if the partnership is successfully sued by a dissatisfied client. Whilst such

businesses will almost certainly have PI cover, this may not cover the liability in larger cases. It

may be of relevance in other businesses where the activities being undertaken are intrinsically

risky. Of course, there is always the possibility that the negligence of individual members of an

LLP can be penalised – either through the criminal or civil courts – and this is an increasing risk

which again mitigates the benefits of limited liability.

Losses

What about a business which might make a loss? Losses arising from a trade, profession or

vocation carried by an individual as sole trader or in partnership may be utilised in various ways.

Firstly losses can be set against other income arising in the year of loss or the previous year.

In the early years of a new trade there is a further relief. Where a loss in incurred in the year

of assessment in which the trade commences or any of the next three years, the trader may set

that loss against his total income for the previous three years, taking the earliest years first. This

is a powerful relief which can generate significant tax repayments to subsidise the early costs of

trading.

Finally, where all income is exhausted, any outstanding losses can be set off against any

capital gains arising in the current or previous year.

Any losses then remaining would be relieved against profits arising in subsequent years from

the same trade.

Losses are only available for sideways relief where the business is being operated with a view

to a profit and this is an area which HMRC are increasingly challenging.

In the case of Beacon Estates (Chepstow) v HMRC the main activity of the company was the

construction and management of property. However, its director decided to branch out into the

boat chartering business and, after an 18 month search, purchased a 92 foot yacht aptly called

Supertoy.

Although the chartering rates were high, an expensive refurbishment programme meant that

the business only became profitable after three years, in 2001. Unfortunately, in 2003 Supertoy

suffered a 'catastrophic engine failure' leading to huge repair and legal costs.

The issue was the allowability of the losses of the chartering business. This, in turn, depended

on whether the chartering business had been carried on with a view to profit (ICTA 1988 s 393A

and CTA 2010 s 44).

The UT observed that this was an objective test requiring 'a realistic possibility' of profit. The

FTT added that the legislation does not impose any time limit.

The UT pointed out that the business had been carried out on a commercial basis. The

significant losses could be explained by the need to re fit the yacht and the engine issues. More

importantly, the FTT noted that charters had been agreed for 2014 and that the yacht was

marketed and managed through professional charter agents.

However, it is important to remember that there are anti-avoidance provisions which limit

availability of loss relief for members of LLPs particularly.

4.1. The uses of LLPs in general terms

Clearly the offering of limited liability is important for many businesses but it is also true those

businesses for which liability is never going to be a significant issue become LLPs. There is also a

tendency for LLPs to be treated as being the ‘in’ business structure implying some sophistication

for the people participating in such businesses.

Overseas aspects

LLPs for holding property can offer some interesting advantages where non UK investors and tax

exempt funds are involved.

For non UK residents investing via a tax transparent structure such as an LLP, the UK liabilities

on income are restricted to the basic rate band and there is no CGT on the disposal of the property

(subject to the new anti-avoidance provision to be introduced from next year). For tax exempt

funds, the use of an LLP will not prejudice the tax exempt status.

In appropriate cases, tax transparent structures offer significant advantages in comparison to

the use of overseas structures to acquire UK property:

There is no necessity to conduct the central management and control of the

business overseas to maintain non-UK residency. This can enable UK-based fund

managers to focus on commercial aspects of the business without costs and

administrative burdens imposed by an overseas structure.

Where there are UK resident investors, the range of anti-avoidance measures

targeting overseas structures, for example ITA 2007 s 720 and TCGA 1992 s 13,

should not apply. Furthermore, the offshore funds rules, under which a capital

disposal by UK resident individuals can be subject to income tax at rates up to

45%, cannot apply to UK entities.

For tax exempt investors, a tax transparent structure offers a clear potential

benefit compared with overseas entities, which would be subject to income tax,

that cannot be recovered, on rental income

Offering employees a stake in the business

One of the main reasons why many larger businesses are considering converting to LLPs is that

they offer greater flexibility in offering key employees a stake in the business.

Many businesses will wish to offer incentives but realise that if there is a corporate structure the

only possibility is to offer those employees shares. There will be tax implications unless the shares

are acquired at market value, complications if there are restrictions placed on the shares and a need

to have some kind of internal share market for sale of shares unless the company is listed. Giving an

employee an equity stake in an LLP does not give any such complexities. There is no requirement

for an equity interest in an LLP to be transferred at market value so that there is much greater

simplicity associated with partners joining and leaving the LLP.

Furthermore, it is possible to set up a structure initially where the existing value of the business

remains with the existing business (usually a limited company) and it is only the future increase in

the value of the business which lodges with the ‘new’ LLP members.

The other advantage which this provides is that if individuals do dispose of their equity interests

in the LLP for value, and all other conditions are met, then entrepreneurs’ relief will be available

without having to have a minimum holding requirement which is necessary for the sale of shares to

attract the same preferential relief.

Finally, there is a national insurance saving in making individuals partners (who will pay Class 2

and Class 4 NICs) rather than the more costly Class 1 employers and employees contributions.

There can be a downside for the employee who becomes a member of an LLP in that they will

give up some of the legal protections which apply to employees. As a member of an LLP they will

not be exposed to the liability issues which are associated with a normal partnership so that is not an

issue.

Other issues

The use of LLPs particularly to give entitlement to Entrepreneur’s relief (particularly for

companies) has disappeared with changes to the legislation in FA2015. Previously any trading

activities carried on by the LLP could be treated as if directly undertaken by the member of the LLP

which would enable trading company status to be achieved where a share in an LLP was held.

This is no longer available since 18th March 205.

5. Corporate partnerships

As stated above, there is nothing to restrict an LLP or normal partnership having a corporate

member and this is increasingly common in many different types of businesses, particularly in the

wake of the additional rate tax rate of 45%. However HMRC have become increasingly concerned

about the use of corporate partnerships and so significant anti-avoidance provisions were

introduced as part of FA 2014. The disguised salary provisions outlined above are part of these.

5.1. Profit sharing in mixed partnerships

HMRC have become concerned over recent years about the extent of perceived avoidance of

income tax through the use of ‘mixed’ partnerships, typically corporate partnerships where income

is shifted into the corporate partner to avoid additional rates of income tax. This has led to the

introduction of the current proposals which deal with partnerships where there is a member not

subject to UK income tax (normally a limited company).

The new legislation will become s850C to s850E ITTOIA 2005.

The legislation aims to shift profits from a non-individual member in a partnership (usually a

company but it could include trusts for example) to an individual where it is perceived that the

allocation is tax motivated. The structure of the legislation is this:

A, an individual member of a partnership has been allocated a share of the profit, or a zero

result (but not a loss) for an accounting period, and

There is a non individual member (B) of the partnership, which has also been allocated a

share of the profit for the period, and

Condition X or condition Y is met.

Condition X

It is reasonable to suppose that amounts representing A’s deferred profit are included in B’s

profit share, and in consequence, A’s profit share and the relevant tax amount are lower than they

would otherwise have been.

Deferred profit is defined by new s850C(8) means any remuneration, benefits or returns the

provision of which to A has been deferred, whether conditionally or otherwise.

The relevant tax amount is defined by s850C(9) is the total amount of tax which would

otherwise be charged on A and B’s income apart from this section.

Condition Y

This condition is met where:

B’s allocation of profit is in excess of the appropriate notional profit, and

A has the power to enjoy B’s profit share (referred to as A’s power to enjoy), and

It is reasonable to suppose that the whole or any part of B’s profit share is

attributable to A’s power to enjoy, and both A’s profit share and the relevant tax

amount are lower than they would have been had it not been for A’s power to enjoy.

The result is a saving in tax.

A has the power to enjoy B’s profit share if:

A is connected with B under s993 ITA 2007 (definition of connected persons) with the

exclusion of the connection arising from mutual partnership, or

Any of the following enjoyment conditions are met, here treating A as A and any

person connected to A other than B, so this would certainly include spouse of A:

o Some or all of B’s profit share is in fact so dealt with by any person as to be

calculated at some time to enure for the benefit of A, whether in the form of

income or not

o The receipt of B’s share of the profits operates to increase the value of assets

held by or for the benefit of A

o A receives or is entitled to receive at any time any benefit provided out of B’s

profit share

o A may become entitled to benefit from B’s profit share by the exercise of one

or more powers of any person, or

o A is able to control (*directly or indirectly) the application of B’s profit share.

If Condition X or Y is met, the s850C(4) requires that A’s profit share is increased by so much

as B’s profit share as it is reasonable to suppose is attributable to A’s deferred profit share or

power to enjoy.

The amount reallocated to A will be determined on a just and reasonable basis, but cannot

reduce B’s allocation below the “appropriate notional profit”. The operation of the allocation first

applies deferred profit share, and then A’s power to enjoy.

B’s appropriate notional profit

The first stage in the operation of the legislation is to consider B’s appropriate notional profit

since this cannot be allocated to A. This share is calculated as the sum of:

A return on capital equivalent to a commercial rate of interest on the capital

contributed by B to the firm (less amounts paid in respect of this which are not part

of B’s profit allocation), plus

A return for services provided to the firm by B (but not involving any other partner of

the firm in addition to B) priced on an arm’s length basis.

The appropriate notional return on capital is simply a commercial rate of interest on the capital

contributed. This is not a specific rate as the appropriate commercial rate will vary:

The commercial rate will reflect the level of risk involved.

Where the level of capital varies during the relevant period of account, the notional

return must be calculated from time to time and on these varying amounts.

The return for services in almost all cases will be the cost to the company in providing the

services plus a modest mark-up. What the mark up should be will be open for debate.

Anti avoidance – A is not a partner in the firm

In order to prevent avoidance in the run up to the implementation of these provisions, new s

850D applies the same rules where A is not a partner in the firm, but performs services personally

for the firm, and it is reasonable to suppose that A would have been a partner in the firm, had it

not been for new s 850C. This is extended to include where A is a member of another partnership

associated with the firm (i.e. it is a member of the first firm). Where this condition is met, A is

treated as a member of the first firm and the above provisions are applied in the same way.

Examples

Example 20

The INV LLP has a property business. It has 15 individual members, including X. In addition to

being an individual member, X is also a member as Trustee of the XXX Settlement.

The INV LLP is a mixed membership partnership as it has 15 individual members and X in his

capacity as trustee of the XXX Settlement.

Example 21

B Ltd has invested £10,000 in the ABC LLP. It receives no return on this other than its profit

share.

ABC LLP is paying 2% on loans on the commercial market, reflecting its good credit rating. This

represents a commercial rate, so B Ltd has an appropriate notional return on capital of £200.

Example 22

Continuing with the example 21 above, B Ltd is a member of ABC LLP and provides advertising

services for ABC LLP. The work is carried out by A, who is also a member of ABC LLP. B Ltd

provides no other services to ABC LLP.

B Ltd is treated as providing no services as the only service provided involves another member

of the LLP. Therefore, the appropriate notional consideration for services is nil.

Example 23

A and A Ltd are the members of A LLP. A controls A Ltd.

As A controls A Ltd, A and A Ltd are connected and, as such, A has the power to enjoy any

profits of A LLP which are allocated to A Ltd.

Example 24

A and B Ltd are the partners in the AB partnership. A has no interest in B Ltd, which is wholly

owned by B, who is not connected to A.

A and B Ltd are only connected by being fellow partners in the AB partnership. As such, they

are not connected and the excess profit allocation rules do not apply.

Example 26

MMM LLP has as members, A, B and C, together with X Plc. A has a small investment in X Plc

as part of a share portfolio. B has a small investment as she used to work for X Plc and received

the shares under an incentive scheme. There are no other arrangements by which they can

benefit from the profit share of X Plc.

It would be unrealistic to say that the profit share of X Plc has been increased because A and B

have shares. Their holdings are such that they could not have influenced the allocation of profits

to X Plc. If the particular facts show that any economic connection between the individual and

non-individual members does not result in profit being shifted from the individual partners to the

non-individual, the mixed membership partnership legislation will not apply.

Example 27

Oldco Ltd had been trading for many years. A few years ago P, the owner of Oldco Ltd decided

that he wants to retire He set up an LLP, whose members are P, Oldco Ltd and a number of

individuals whom he hoped would take over the business.

Oldco Ltd receives the profit share agreed when the business was transferred to the LLP. This

share reflects its founding role in the business and is based on the fact that it contributed the

business to the LLP. P receives a small personal profit share that is commensurate with the work

he does.

The facts show that Oldco Ltd receives a profit share reflecting the fact that it transferred its

business to the LLP (and that the same profit share would have been received by Oldco Ltd if P

fully withdrew from the business, including as an LLP member). Looking at these facts, the

legislation would not apply. In essence, profit is not being shifted because of the connection

between the parties it is arising to the company by virtue of its previous involvement in the trade.

Example 31

The membership of ABC LLP consists of three individuals, A, B and C, who decide that they

want to retain funds in the LLP for working capital. In order to avoid the retained profits being

taxed at higher income tax rates, they introduce a corporate member, ABC Ltd, which is fully

owned by A, B and C.

ABC Ltd does not provide any services and only a nominal amount of capital. A, B and C work

out what they wish to draw personally and allocate the balance of the profit to ABC Ltd.

The profit share allocated is invested or retained in the partnership by the company member as

additional partnership capital or advances.

The individual members are in a position to enjoy the sums allocated to their company. The

three individual members are taxed on an additional profit, split on a just and reasonable basis,

equal to the profit share allocated to ABC Ltd, less a sum that represents an appropriate notional

return on the nominal amount of capital introduced by ABC Ltd.

Example 32

D is a member of DEF LLP. With the agreement of the other members, D introduces as a

member, D Ltd, a company that is owned by his wife. D continues as a member, only now he does

some work for the LLP through D Ltd. D Ltd provides only a nominal amount of capital.

The only change is that the profit share, previously allocated to D, is now allocated partly to D

himself, but mainly to D Ltd.

D Ltd is owned by the wife of D, so a connected person is in a position to enjoy the profits of

D. D is taxed on an additional profit equal to the profit share allocated to D Ltd. Whilst D Ltd is

providing services to DEF LLP, the reality is that the work is such services as are being provided by

D, another member. These services are ignored in determining the appropriate notional

consideration for services. D Ltd provides no other services, so the appropriate notional

consideration for services is nil.

Avoidance of provisions by using all corporate partners

It would be comparatively easy to get around the new mixed partnership rules by removing all

individual partners with corporate members. A, B and C (individuals) who are members of an LLP

together with their own companies A Ltd, B Ltd and C Ltd might decide to reduce the LLP to the

three companies only, so that it is no longer a mixed partnership.

The legislation (through new s 850D) cover this situation by looking at individual A who

performs services for a firm at any time in a period of account which period produces a taxable

profit, some of which is allocated to a non individual member of the firm (B).

Where it would be reasonable to suppose that A would have been a partner in the firm in the

current or a preceding accounting period were it not for s 850C, and either condition X or Y is met,

the legislation deems A to be a partner in the firm for the purposes of s 850C and thus the

reallocation of profit bites.

Condition X is that it is reasonable to suppose that amounts representing A’s deferred profit

shares are included in B’s profit share.

Condition Y is that B’s profit share exceeds the notional appropriate profit, and A has the

power to enjoy B’s share of the profit, and it is reasonable to suppose that the whole or part of

B’s profit share is attributable to A’s power to enjoy.

Example 33

X, Y, Z and XYZ Ltd are the members of the XYZ LLP. In response to the new legislation, they

decide that all the individual members should cease to be members of the LLP with effect from 6

December 2013 being replaced by their personal service companies.

X, Y & Z continue to work for the XYZ LLP, it is reasonable to suppose that they would have

continued to be members but for the introduction of the legislation. Under S850D, X, Y & Z are

treated as members and the mixed membership partnership legislation applied accordingly. Their

share of the firm’s profit, determined under the mixed membership rules, is chargeable to income

tax for the tax year in which the relevant period of account ends.

Assuming this period straddles the 6 April 2014 (the date the legislation comes into effect),

then this period is split into two notional periods with the latter having a commencement date of 6

April 2104. Only the profits attributable to this latter period will actually be re-allocated to X, Y & Z.

Example 34

M, N, O and MNO Ltd are the members of the MNO LLP. In response to the new legislation,

they decide that from 1 April 2014 all the individual members should become members of the MNO

New LLP. From 1 April 2014, the members of MNO LLP will be MNO Ltd and MNO New LLP. Whilst

M, N & O are the members of the MNO New LLP.

Under S850D (8), it is assumed that M, N & O would have been members of the MNO LLP. The

mixed membership partnership legislation applies on the basis that they are deemed to have been

members of the MNO LLP.

The loss allocation issues for mixed partnerships

HMRC have taken the opportunity afforded by changing partnership provisions generally to

tighten up the loss relief rules for partnerships with mixed members.

The new rules apply once again to mixed partnerships when there are trading or business

losses allocated to individual members of a mixed partnership. The rules do not apply where the

partnership comprises only of individuals and there is no intention to introduce a non individual

partner. New proposed ss 116A and 127C identify the situation where the new loss restriction

applies. S 116A applies to trading losses, and 127C to property business losses (including overseas

property businesses).

In both cases, the loss is not available for relief where A (an individual) incurs a loss as a

member of a partnership, and A’s loss arises wholly or partly:

Directly or indirectly in consequence of, or

Otherwise in connection with

relevant tax avoidance arrangements.

Here, relevant tax avoidance arrangements is defined as arrangements to which A is party, and

the main purpose or one of the main purposes of which is to secure that losses are allocated or

otherwise arise in whole or in part to A, rather than a person who is not an individual, with a view

to A obtaining relevant loss relief.

In the case of both trading and property losses, the relief is barred both as sideways relief (and

against capital gains for trading losses) and carry forward relief, so no relief is available at all for

these losses.

The measure comes into force in relation to 2014-15, with a straddling period split on a time

basis.

Example 35

An LLP has 100 individual members and 1 company member. Each of the individual members

introduces capital of £40,000 and the company member provides capital of £60m (total capital

£100m). The LLP spends the £100m on an asset that qualifies for 100% upfront tax relief

generating a £100m tax loss (but not an accounting loss) in the first year of business but with a

significant income stream in later years.

The profit sharing agreement provides that:

In year 1, all the profits or losses are allocated to the individual members; and

In year 2 onwards, all or most of the profits are allocated to the company member.

The LLP agreement is written so that the individuals can claim the loss relief. It is clearly one of

the main purposes. The excess loss allocation legislation (S127C) prevents the individual obtaining

relief for these losses.

6. Pensions for the self employed

Not a huge amount of flexibility exists for the self employed in relation to pensions as they are

limited to setting up and contributing to a personal pension fund.

There are no limits on contributions that can be made to a registered pension scheme;

however, there is a limit to the extent to which tax relief can be claimed on pension contributions.

Contributions are given tax relief at source with tax relief at the individual’s marginal rate being

available if they are a relevant UK individual. A relevant UK individual is an individual who is under

75 years of age and has chargeable relevant UK earnings in the tax year or is UK tax resident at

some point during the tax year or has been UK tax resident at some time in the previous five tax

years as well as when they joined the scheme or has for that tax year general earnings from

overseas Crown employment subject to UK tax.

Member or employer contributions in excess of the annual allowance will be subject to the annual

allowance charge.

The annual limit for relief restricts tax relief on personal contributions to the greater of 100%

of relevant UK earnings and £3,600. Relevant UK earnings are defined as:

Employment income such as salary, wages, bonus, overtime and commission providing it is

chargeable to tax

Income derived from the carrying on or exercise of a trade, profession or vocation whether

individually or in partnership

Income derived from the carrying on of a UK or EEA furnished holiday lettings business

Income arising from patent rights and treated as earned income

General earnings from an overseas Crown employment subject to tax

UK earnings which are not taxable in the UK due to the operation of a double tax agreement

are not available to be treated as relevant UK income for these purposes.

The annual allowance is £40,000 for 2014/15 onwards but there is the possibility of carrying

forward unused allowances for up to three years (on a FIFO basis) as long as the UK relevant

earnings are sufficient. For most individuals with a money purchase type scheme, it is the amount

that is paid into the pension scheme, although consideration needs to be made of the pension

input period.

There is also a maximum value that the pension is allowed to rise to, called the lifetime

allowance. Pension funds in excess of that amount are subject to a special tax charge at the time

benefits are crystallised. This has been as high as £1.8M but is reducing to £1M (see below). The

excess is taxed at 55% if taken out as a lump sum or 25% if retained in the scheme.

The new rules for crystallisation of pension benefits

One of the most significant announcements of the Budget 2014 was the fact that the pension

system was to be reformed from 2015 to allow greater flexibility for the pensioner in the way that

they access their pension benefits. This might encourage individuals to save more into their

pension fund.

The first thing to note is that age at which a normal individual can crystallise their pension

benefits remain at 55. It will increase once the normal state pension age reaches 67 but that is

some years away and who knows what the regime will be by then!

The pre-Budget 2014 regime

An individual who had reached 55 could take up to 25% of the pension pot tax-free. With the

remainder there were five options:

Withdraw all the money and pay tax at 55%

Buy an annuity which is an insurance product which pays a fixed sum to someone

normally for the remainder of their life

Adopt ‘capped drawdown’ which allowed an individual to take income from their

pension (with the remainder invested as before) but this was capped at a maximum

of 120% of the equivalent annuity (ie the amount of annuity which the same capital

sum would have purchased)

Adopt ‘flexible drawdown’ which operated like capped drawdown but where there

was no limit on the amount that could be drawn from the pot each year. This was

only available to someone who has guaranteed income in retirement of £20,000 per

annum.

For those with smaller amounts of pension savings, there were a couple of additional things

you could be done but only once the individual had reached the age of 60:

If overall pension savings were of less than £18,000 then an individual could apply

trivial commutation and take the whole amount as a lump sum, with the 75% not

covered by the tax-free allowance being taxed at the individual’s marginal rate

If any pension pot was worth less than £2,000 it could be taken as a lump sum

under the ‘small pot’ measures. You could do this with two pension pots.

Anyone who died before the age of 75 having not taken tax-free cash or income could pass on

their pension pot as a tax-free lump sum. Otherwise any lump sum paid from the fund was

subject to a 55% tax charge. Whilst no IHT was payable on this there was not really any benefit

given that the 55% charge was greater than the IHT!

Finally, there was the possibility of getting the whole of the member’s pension fund tax free if

the individual had entitlement to a serious ill-health lump sum. This is available if the individual is

aged less than 75 and has a life expectancy of less than 12 months. This is not used as much as

you might think for reasons which are explained below.

Changes from Budget 2014

As a prelude to the changes which were to be introduced in 2015, certain changes were made

to the above rules with effect from 27 March 2014:

The capped drawdown rate was increased to 150% of the equivalent annuity rate

The guaranteed income needed to access flexible drawdown was reduced to

£12,000

The trivial commutation limit was increased to £30,000

The small pension pot limit was increased to £10,000 and could apply to three

pension pots

Pension flexibility from April 2015

The focus of the changes from 6 April 2015 has been on the ability of individuals to treat their

pension fund almost like a bank account once they reach the age of 55. Careful should enable tax

savings to be made. There has been less comment about the possibilities of planning around the

position on death.

Flexible access to pensions from age 55

Pension investors aged at least 55 will have total freedom over how they take an income from

their pension. The value in the fund can be crystallised in a number of ways:

Take the whole fund as cash in one go

Take smaller lump sums as and when needed

Take a regular income via income drawdown or via an annuity

There is an important caveat to this though. You can only withdraw in a particular way if the

pension scheme rules allow you to do this. For example, many pensions specifically preclude the

holder from withdrawing all of their money in one go (to avoid the penal tax charge highlighted

above) and so the pension holder will not be able to do this even though the tax analysis has

changed. This is unhelpful and we will consider this point below.

Funds will fall under one of two sets of rules:

‘flexi access drawdown’ – in this scenario the first 25% of any uncrystallised funds

can be taken as a lump sum which will be free of tax, with anything above that

being taxed at the member’s marginal rate of tax

‘uncrystallised funds pension lump sum’ rules – no initial lump sum is withdrawn but

each withdrawal will be 25% tax-free and the balance taxable at the marginal rate.

For pre-April 2015 flexible drawdown funds, these will automatically become flexi-access

drawdown funds. Those funds in capped drawdown prior to April 2015 can be converted to flexi-

access drawdown funds. If they are not converted, any funds added on or after 6 April 2015 will

be treated under the old regime too. It is perceived that most funds will be converted into flexi-

access drawdown funds.

What planning arises from the potential to spread the 25% tax free element across all

payments rather than getting it all up front? Someone with a pension fund worth £100,000 will

have the choice of:

Taking the £25,000 tax-free cash all at once with any subsequent withdrawals taxed

as income

Making a series of withdrawals over time and receiving 25% of each withdrawal tax-

free.

Let us assume that this pension is being used to top-up income and so the likely level of

withdrawal is, say, £5,000 per annum. We will assume he is a basic rate taxpayer.

In the first case, he would have no tax to pay on £25,000 and then there would be a tax

charge of £1,000 per year, leaving him with net income of £4,000. Assuming a rate of growth of

the remaining fund of 3% per annum, he would run out of money after about 20 years. He would

have extracted around £105,000 of value out of his fund over the period after tax (being £25,000

plus 20 years of £4,000). This would go down to £85,000 if he was a higher rate taxpayer.

In the second case, his annual income would be £4,250 as he would be saving the tax on

£1,250 of the payment each year. Again, assuming growth of the residual fund of 3% he would

run out of money after about 30 years. He would have extracted £127,500 after tax from the fund

(being 30 years of £4,250). This increased amount is also a product of having more money

remaining in the fund for longer so that there is benefit achieved in the growth in value of the

residual fund as well as the tax saving. The figure would go down to £105,000 if he was a higher

rate taxpayer.

Of course this type of calculation makes an assumption about the life expectancy and many

people would feel they want to get the money upfront and benefit from it! Indeed many people of

a certain age will know what they are going to spend their lump sum on when they retire and will

take some persuading to change their mind.

The key issue is to try and achieve a lower rate of tax charge on the income than was given in

tax relief on the contribution although this is not always possible. The following table shows the

rate of return on a £10,000 investment in a pension fund which achieved higher rate tax relief:

Higher rate

when withdrawn

Basic rate

when withdrawn

Non taxpayer

wen withdrawn

Gross pension

contribution

10,000 10,000 10,000

Tax relief

(40%)

(4,000) (4,000) (4,000)

Net cost to

investor

6,000 6,000 6,000

Fund value 10,000 10,000 10,000

Withdrawal

from fund

Tax free

amount (25%)

2,500 2,500 2,500

Taxable

amount

7,500 7,500 7,500

Tax at marginal (3,000) (1,500) Nil

rate

Amount after

tax

4,500 6,000 7,500

Total net

withdrawal

7,000 8,500 10,000

Excess over net

contribution

1,000 2,500 4,000

Rate of return

(gross)

10% 25% 40%

Rate of return

(net)

16.67% 41.67% 66.67%

Restrictions on how much can be made in pension contributions

Pension contributions can be made up to £40,000 per annum subject to availability of net

relevant earnings and the capacity to carry forward unused allowances from previous years

(although see below for changes to this basic premise). From April 2015 where an individual has

made any withdrawals from a defined contribution pension in addition to any tax-free cash, new

contributions to that scheme will be limited to £10,000 per annum. There are three exceptions:

The pension is worth £10,000 or less and it is taken as a small pot.

The individual is in capped drawdown before April 2015 and withdrawals remain

within the current drawdown limit

The pension is taken as a lifetime annuity (other than a flexible annuity) or scheme

pension (except where fewer than 12 people are entitled to one under that

scheme).

Investors already in flexible drawdown are currently not able to make further contributions but

from April 2015 they will be able to start making new contributions of up to £10,000 per annum.

Pension funds on death

What happens when an individual dies with undrawn funds in their pension fund? These rules

are also being relaxed. The new provisions are explained below.

Scenario 1: policy holder dies before age 75 and before any pension benefits have been taken.

If the death benefits are to paid out to the beneficiary as a lump sum, this is tax-

free but the pension is tested against the lifetime limit. The pension does not form

part of the estate for IHT purposes.

If the death benefits are to be paid out to the beneficiary either via drawdown or an

annuity, there is no tax on the fund at the point of transfer and the income will be

tax free. The pension fund is not tested against the lifetime allowance and does not

form part of the estate for IHT purposes.

Scenario 2: policy holder dies before age 75 and pension benefits have been taken.

If an annuity is being paid, this can continue to be paid to the beneficiaries (where

applicable) tax free.

If the pension fund is in drawdown and death benefits are to paid out to the

beneficiary as a lump sum, this is tax-free but the pension is tested against the

lifetime limit. The pension does not form part of the estate for IHT purposes.

If the pension fund is in drawdown and death benefits are to be paid out to the

beneficiary either via drawdown or an annuity, there is no tax on the fund at the

point of transfer and the income will be tax free. The pension fund is not tested

against the lifetime allowance and does not form part of the estate for IHT

purposes.

The tax impact of scenarios 1 and 2 are the same other than where an annuity continues to be

paid to beneficiaries post-death.

Scenario 3: policy holder dies after age 75 and pension benefits have not been taken.

If the death benefits are to paid out to the beneficiary as a lump sum, this is taxed

at 45% although this will change to the marginal rate of tax of the recipient after 6

April 2016. The pension is not tested against the lifetime limit. The pension does

not form part of the estate for IHT purposes.

If the death benefits are to be paid out to the beneficiary either via drawdown or an

annuity, there is no tax on the fund at the point of transfer and the income will be

taxed at the recipient’s marginal rate. The pension fund is not tested against the

lifetime allowance and does not form part of the estate for IHT purposes.

Scenario 4: policy holder dies after age 75 and pension benefits have been taken.

If an annuity is being paid, the value protection lump sum will be taxed at 45%,

reducing to the recipient’s marginal rate after 6 April 2016.

If the pension is in drawdown and death benefits are to paid out to the beneficiary

as a lump sum, this is taxed at 45% although there is a proposal to change this to

the marginal rate of tax of the recipient after 6 April 2016. The pension is not

tested against the lifetime limit. The pension does not form part of the estate for

IHT purposes.

If the pension is in drawdown and the death benefits are to be paid out to the

beneficiary either via drawdown or an annuity, there is no tax on the fund at the

point of transfer and the income will be taxed at the recipient’s marginal rate. The

pension fund is not tested against the lifetime allowance and does not form part of

the estate for IHT purposes.

Again scenarios 3 and 4 are broadly similar.

What happens when the beneficiary dies? The same basic tax treatment applies for any

beneficiary. The tax charges will depend on whether the beneficiary is 75 or older and the tax

treatment is as outline above for a pension fund already being paid out.

These changes are significant because they mean that putting funds into a pension fund can

now become part of IHT planning. Previously the penal 55% tax charge meant having excess

funds in a pension at death was viewed as catastrophic. If individuals have sufficient assets to

fund their retirement, pension funds can remain within a pension wrapper indefinitely rather than

being paid to a beneficiary, affording an opportunity to make provision for subsequent

generations. This has an advantage over other planning as there remains the possibility of

accessing the fund if circumstances change.

Tapering of annual allowance for high income individuals

From 6 April 2016, the existing £40,000 annual allowance for those with ‘adjusted income’

above £150,000 is tapered.

Adjusted income is the individual’s taxable income, net of any loss reliefs, adding back any

pension contributions made on a ‘net pay’ basis and also adding any employer pension

contributions. Lump sum death benefits taxable as the individual’s income (see above) are

excluded.

Tapering will not apply, however, where the individual has threshold income of no more than

£150,000 less the normal annual allowance for the tax year, so for 2016/17 an individual with this

‘threshold income’ of no more than £110,000 will not have their annual allowance tapered.

Threshold income is the individual’s taxable income, net of any loss reliefs, plus any salary

sacrifice amounts in relation to pension contributions where the agreement was entered into on or

after 9 July 2015, plus pension contributions paid in the tax year entitled to relief at source.

Threshold income is before adding back employer contributions, to allow for situations where

employers only top up pension funds on an ad hoc basis. For example, a large top up (say) every

3 years would not trigger the restriction where income is normally below £110, 000.

Individuals entering into a salary sacrifice or flexible remuneration arrangement on or after 9

July 2015 in order to reduce their threshold income will have the amount of income given up

added back to the their threshold income.

There are anti-avoidance provisions to prevent a higher annual allowance being received

through a reduction to their adjusted or threshold income, but where that reduction is offset by an

equivalent increase in their adjusted or threshold income in a different tax year.

For each £2 of adjusted income above £150,000, an individual’s annual allowance reduces by

£1.

Once an individual’s income reaches £210,000 or over, their annual allowance will be £10,000.

The annual allowance is rounded up to the next whole £ where necessary.

Example 8

Jessie has total (taxable) income of £140,000 in 2016/17. Her employer made a pension

contribution of £35,000 on her behalf in the tax year.

This means she has threshold income above £110,000 and adjusted income above £150,000 so

her annual allowance is tapered.

Her final annual allowance will be £40,000 – 50% x (£175,000 - £150,000) = £27,500.

In the absence of any unused allowance from 2013/14, 2014/15 and 2015/16, Jessie will be

liable to an annual allowance charge in 2016/17 of (£35,000 - £27,500) £7,500.