Entrepreneurs' Relief upon sale of a cash rich company

Entrepreneurs' Relief upon sale of a cash rich...

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If a contracting company is sold for an agreed price of £800,000 - 100% of the shares are sold - but, by prior agreement between the vendor and purchaser, £200,000 is left in the company bank account, so in effect the "sale price" is "inflated" by £200,000 to cover the "cash at bank", would the full amount of £800,000 qualify for entrepreneurs' relief, or should the claim reasonably be reduced?

The company has no other assets, and realistic working capital required is only about £10,000.

I ask this question because if the full amount does reasonably qualify for entrepreneurs' relief, it seems that a 40% tax-paying director can just leave all his "what would have been dividend income" in the company for a few years, accumulating in the bank account and adding to the final sale price, and only pay 10% tax on it at the end of the day. That doesn't seem reasonable to me.

Any views?

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By Kevin Kavanagh
20th Nov 2015 12:52

Am I missing something here?

Assuming this is an arm's length transaction, the purchaser and seller both think £800K is a fair price for all the share capital. In which case (assuming it qualifies as a trading company) the assets and liabilities are irrelevant, and  (again assuming the shareholder qualifies) entrepreneur's relief is available.

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By johngroganjga
20th Nov 2015 13:01

The question I think is whether the extent of the surplus cash prevents the company being a trading company for ER purposes.

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Replying to Refs1:
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By Stephen Harman
20th Nov 2015 14:05

It does genuinely trade. It just seems to me that a large amount of cash was left sitting in the company bank account - it has been in the account for a few years - just to maximise ER in a future anticipated sale.

 

 

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Portia profile image
By Portia Nina Levin
20th Nov 2015 13:13

If it sold to an unconnected third party it works just fine.

The unconnected third party is not going to pay £1 for each £1 of cash in the company though are they? Because for every £1 of cash in the company, they might only get 61.9p in their pocket when they take it out.

So I will take your company that is worth £800K, and if you leave £200K cash in there, I will only pay you £920K for it.

If the vendor is connected, this will fall foul of the transaction in securities rules and the entire £1,000K, less the cost of the shares, will be liable to income tax as a dividend.

Does that seem more reasonable, now that someone else has applied their brain to the problem for you?

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By Ruddles
20th Nov 2015 14:39

The question is whether or not the gain would be apportioned. The answer is no - either ER is available or it is not.

Portia makes a good point, but it may depend on who the buyer is. It is common for a corporate purchaser to pay £ for £ for the cash, since they can transfer that, tax-free, to the purchaser to finance the purchase. Or if the cash is required to provide working capital for the ongoing business, there is no extraction (or need to inject cash from taxed income) so again it would be usual to pay £ for £.

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Nichola Ross Martin
By Nichola Ross Martin
20th Nov 2015 14:50

If it does not need the cash

then it is surplus to working capital. You therefore have 25% of the company's assets that are being held as an investment of the owner (which is what you are saying). I think HMRC could have an issue with allowing ER on the shares as the owner's investments are more than 20% of assets although this scenario does not pop up in their manuals.

On a practical level it is fairly unlikely to be ever picked up on as the sale is to a third party and HMRC would need to know what was in the sale agreement and scrutinise the accounts in order to work out what was what. Of course they could chose to investigate the return on a random basis, or maybe they might decide to look at all ER claims one year. Sounds like that as a policy could be quite fruitful. 

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By johngroganjga
20th Nov 2015 14:59

Yes indeed it is either a trading company for ER purposes or it isn't. But at what point does the level of assets surplus to the requirements of the trade stop it from being one?

I think that is the question that the OP is asking,

There is a 20% rule of thumb is there not?

PS (EDIT) I am glad to see that Nichola has now answered the question, and confirmed that the OP's fears are well founded.

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Portia profile image
By Portia Nina Levin
20th Nov 2015 14:59

So we have an isolated 20% of assets test now? And forget all about income and management effort?

And if you check the law you will find that a company is a trading company if it carries on trading activities and its activities do not to a significant extent include non-trading activities.

Having a big bucket of surplus cash on the balance sheet is not really an activity, is it? The cash might be excluded assets for BPR purposes, but that is a different issue.

@ Ruddles Even if I were a corporate purchaser I still would not be prepared to pay £1 for each £1 of cash.

Because I would know that the only reason I was buying the cash was so that the vendor could only pay tax on it at 10%, rather than perhaps 32.5%.

So I would probably not go above 85p for each £1 of cash. It has to be worth my while or I do not want to help the vendor out by buying the cash.

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paddle steamer
By DJKL
20th Nov 2015 15:06

What I am curious about is what contracting activity, that needs no assets and only requires £10,000 of working capital, is worth £600,000? (£800,000-£200,000 cash)

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Replying to Wanderer:
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By Stephen Harman
20th Nov 2015 15:41

Contract cleaning - it just needs the wages in the bank.

 

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Replying to richard thomas:
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By DJKL
20th Nov 2015 15:51

Must have great customer

Stephen Harman wrote:

Contract cleaning - it just needs the wages in the bank.

 

Must have great customer base to have no debtors.

 

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Replying to Tom 7000:
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By Stephen Harman
20th Nov 2015 16:46

Net debtors and creditors is approximately zero.

 

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Replying to Jimess:
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By DJKL
20th Nov 2015 17:06

The fact there are

Stephen Harman wrote:

Net debtors and creditors is approximately zero.

 

The fact there are debtors and creditors possibly allows a reasonable argument as to why the business requires to keep a balance at bank of  far more than £10,000 as working capital;  say a significant bad debt(s) where the creditors are still payable but not all debtors are recoverable. 

Any business that has its trade worth £600k as a cleaning contractor has to have a fair turnover and a fair level of staffing to justify such a valuation, accordingly £10k just appears somewhat negligible in the context of the  implied turnover/ profits re the price tag supplied, so if your numbers are real this would be an area I would explore.

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By Ruddles
20th Nov 2015 15:40

I guess it depends on how friendly the parties are (and/or how keen the purchaser is) - more often than not both parties are happy to do whatever it takes to minimise HMRC's cut on the deal, regardless of which party actually makes the saving, provided that one side isn't disadvantaged in favour of the other.

We have seen lots of these deals where price was adjusted £ for £ because both parties may benefit - albeit the purchaser has to wait to see the benefit through the increased base cost in shares (assuming that subsequent disposal is chargeable). Even if there is no such benefit to the purchaser he is unlikely to be disadvantaged either.

The only immediate downside is an increase in Stamp Duty for the purchaser but it tends to be such a trivial amount that it is disregarded. Yes, the purchaser may try to agree a discount on the purchase price to reflect the vendor's tax saving, and why not, but in my experience that tends to be very much the exception.

So, I suppose we have the usual difference between hypothetical and real-world cases.

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By Martin B
20th Nov 2015 16:02

Entrepreneurs' Relief upon sale of a cash rich company

flagging

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By Ruddles
20th Nov 2015 17:03

So the company does in fact have other assets?

(And liabilities)

 

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Portia profile image
By Portia Nina Levin
20th Nov 2015 17:07

Personally I still think the 20% test is a red herring here.

Does it generate more than 20% of its income from its big bucket of cash? I doubt it.

Does its management spend more than 20% of its time stirring the bucket of cash? I doubt it.

Do its activities include activities other than trading activities to a substantial extent? I doubt it.

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By Ruddles
20th Nov 2015 17:16

I agree with Portia

A strict numerical analysis is unlikely to be appropriate here. And even if it were, we have new (but still insufficient) information that could alter that analysis - the asset part of the test looks at gross assets, so if debtor balances are substantial, the cash balance could become even more of an irrelevance.

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By Stephen Harman
20th Nov 2015 17:30

Having this discussion has made me realise that there's not really a problem in this case, because the creditors of the company amount to not far short of £100,000, so in a future sale agreement there can be a clause which states that all creditors of the company are to be "in effect" paid off prior to the sale, so the "net cash at bank" will effectively reduce by that amount, and it won't then be a "cash rich" company, even as far as the "20% rule" goes.

 

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By Ruddles
20th Nov 2015 19:06

Well, to play Devil's Advocate

And while still in agreement with Portia, if as you say debtors equal creditors then you have £100k of debtors. Paying off creditors leaves you with cash of £100k and debtors of £100k. So cash = 50% of assets. A little more than the 20% target. Of course, one needs also to take into account goodwill, which in this case would appear to amount to £600k (or is it £800k?). In which case, I'd agree that cash is likely to be less than 20%.

And what do you mean by paying off creditors "in effect"? They are either paid or they are not.

Although it is still all pretty academic because, like Portia, I don't think it is an issue.

 

 

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Replying to richard thomas:
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By Stephen Harman
20th Nov 2015 19:20

When I said "in effect" I

When I said "in effect" I meant that some creditors might not actually physically be paid off at the time of sale - so in that case an adjustment would be made in the final sale price calculation to reduce the "cash at bank" figure used, to compensate for the unpaid creditors:

e.g.  cash at bank on day of sale £200,000, less outstanding creditors which should have been paid off as per the sale agreement £100,000, therefor net cash at bank on day of sale £100,000.

Debtors are about £100,000, as you say, but I wouldn't think that they'd be included in the calculation of how cash rich the company is.

 

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By cparker87
21st Nov 2015 11:45

not assets
Tests are on activities (income/Management time/costs) not an arbitrary 20% of assets (which is BPR) make up of the balance sheet.

If ita all surplus cash from the trade then it is absolutely not a problem. It can even be managed as long as those activities are not "substantial"

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Nichola Ross Martin
By Nichola Ross Martin
21st Nov 2015 12:04

No debtors or debtors?

how we have go from no debtors to £100k debtors defeats me. I am out.

Before I go I want to qualify my response. I appreciate that some people take a view that accruing cash is not an activity. I think that it can be held to be an activity. It requires a non-dividend, possibly low remuneration strategy. For example, if a company is set up to be a savings vehicle for its owner, and that is what drives both owner and company, with the aim of building up a lot of cash and then securing ER then its activities could possibly be viewed as substantially non-trading activities. This has not been tested by the courts and it would be interesting to see what a judge might say. Having seen over recent years the way in which the tribunals and courts deal with tax schemes, you can see that this is the sort of thing that could be argued in different ways, until the cows come home. HMRC's manuals are sufficiently woolly on these points, admitting that "there is no simple formula" (see http://www.hmrc.gov.uk/manuals/cgmanual/cg64090.htm ) so don't get too stuck up on the 20% tests.

 

 

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Replying to Adam12345:
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By Stephen Harman
21st Nov 2015 15:40

I can't find anything about a 20% test re ER on the HMRC website anyway.

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By johngroganjga
21st Nov 2015 16:05

HMRC website
See CG64090 that Nichola has provided a link to. Last sentence in 1st paragraph.

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By Stephen Harman
21st Nov 2015 23:54

Yes, but that refers to 20% of activities not 20% of assets for "cash-rich" companies.

But even if it was applied and a goodwill figure was included, it would still pass a "20% of assets" rule:

If the company has no fixed assets, £100,000 debtors, £100,000 creditors, and £200,000 cash at bank; then 100% of its net assets are cash. Or 67% of its assets are cash.

And then maybe: " how much of that £200,000 is actual "trading cash"? Well ongoing payments of creditors if funded by ongoing receipts from debtors, and wages are £10,000 per week. So even with £100,000 kept at the bank in the unlikely event that debtors stop paying for a whole year, that means that £100,000 is non-trading cash.

So now the calculation goes: no fixed assets, £100,000 debtors, £100,000 creditors, £100,000 trading cash at bank, £100,000 "non-trading cash" at bank; so 50% of its net assets are "non-trading cash". Or 33% of its assets are "non trading cash".

But if a reasonable intangible asset goodwill figure of £600,000 is included, only 11% of its assets are "non-trading cash". So even if there was a "20% of assets" rule, it would still pass if sold for £800,000.

Even if it was sold for a total price of £400,000 it would still pass a "20% of assets" rule.

But ignoring this fictitious "20% of assets" rule, there aren't any activities carried out relating to the £200,000 cash at the bank. All the time of the owners is spent running the contracting business.

I think Portia's earlier comment summed up the situation really well.

 

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By johngroganjga
23rd Nov 2015 11:31

Fictitious?

If you think assets is not one of the tests HMRC refer to you need to look at the link again. It is in fact the second one they mention. But it's not a hard and fast rule. I called it a "rule of thumb". It's just one of a number of factors, all of which are rebuttable. All the points you make are no doubt useful rebuttals to have available against the day when HMRC along and say that the company is not a trading company for ER purposes. If the cash is not surplus cash at all that takes the wind out of their sails immediately. But if there is surplus cash of £200k and the whole company is selling for £800k it's more than 20%, but obviously much less than 20% in terms of management input and profit contribution.

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Replying to richard thomas:
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By Stephen Harman
27th Nov 2015 13:05

I didn't say that assets were not part of the HMRC test - I said that in the HMRC link, the "20% rule" did not refer to "assets". It referred to "activities".

 

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By Ruddles
22nd Nov 2015 10:53

My take

I think everyone is agreed that looking at assets alone - cash or otherwise - is not the way to go. However, it is a simple truth that a large cash balance can never aid the insubstantial investment activity argument - at best it will be ignored and not influence the argument either way.

It is the legislation that refers to substantial investment activity, without any definition. HMRC have set out how they interpret the legislation but that guidance is no more than that - ultimately, if there is disagreement, it will be for the tribunals and courts to settle the argument. HMRC's use of assets as one of the benchmarks is no more authorative than the arbitrary 20% figure itself. So, simply accept the fact that if you have what HMRC consider to be pointers towards non-trade status then you may need to be ready for an argument. There is no-one here that is going to be able to give you a conclusive answer as to whether the company is or is not trading for ER. We may all have our opinions on what arguments we would put to HMRC, but that is about it.

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By michaelblake
23rd Nov 2015 12:51

The Duck Test

Kevin Slevin wrote an interesting article on this issue in Taxation Magazine on 7 November 2012

 

http://www.taxation.co.uk/taxation/Articles/2012/11/07/295881/duck-test

 

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By Paul Hawes
23rd Nov 2015 13:56

flagging

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By johngroganjga
27th Nov 2015 13:14

And the nature of the asset base is listed as one of the factors to be looked at in considering activities.

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Replying to OldParkAcct:
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By Stephen Harman
27th Nov 2015 15:06

reply to johngroganjga
And a factor to which an individual 20% limit should not be applied. Below I have done a straight copy and paste from HMRC CG 64090 to which you referred - bottom of page 1.The bold "not" is not mine. It's in the HMRC wording for emphasis."Balance of indicators

The indicators discussed should not be regarded as individual tests to which a 20% “limit” applies."

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By geoffwolf
27th Nov 2015 13:40

???

I don't believe that the real question has been asked yet.

If debtors and creditors are both roughly £100K why are the creditors so high in a business that would appear at first sight to have wages as by far the largest expense item.

Are most of the creditors Director loan accounts?

 

 

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Replying to lionofludesch:
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By cparker87
27th Nov 2015 13:51

Why all the focus on creditors?

geoffwolf wrote:

I don't believe that the real question has been asked yet.

If debtors and creditors are both roughly £100K why are the creditors so high in a business that would appear at first sight to have wages as by far the largest expense item.

Are most of the creditors Director loan accounts?

 

 

Plenty of reasons.

 

Maybe its corporation tax + final VAT + PAYE + trade creditors + DLA?

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Replying to Paul Crowley:
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By Stephen Harman
27th Nov 2015 14:38

That's correct:

" corporation tax + final VAT + PAYE + trade creditors + DLA"

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By Justin Bryant
27th Nov 2015 13:59

I have heard

That if the accumulated cash has come from historic trading activity then HMRC are happy to ignore it re 20% test, but simple planning can be done to reduce any risk here.

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By Stephen Harman
27th Nov 2015 14:17

I think the Taxation Magazine link supplied by Kevin Slevin explains it well.

 

Also - I've seen cases in the past where directors want a large "cash at bank" figure in the accounts just to improve bank and potential customer confidence.

When contract cleaning companies tender for new contracts, the potential customer asks to see the accounts for the past few years, and obviously, all other things being equal, they're more inclined to offer the contact to the "cash rich" firm.

So on that basis, even cash sitting in the bank for a few years could still be deemed a "trading asset".

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By johngroganjga
28th Nov 2015 13:42

Yes - like I and everyone else keep saying it's a rule of thumb, guide, general indicator - call it what you will - not a hard and fast rule. Not sure what point you are making.

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By Stephen Harman
28th Nov 2015 21:33

Reply to johngroganjga

In the thread comments - Nichola said a 20% "of assets" rule might apply, you agreed; and then Portia, myself, Ruddles and cparker87 said it wasn't a 20% "of assets" rule. The point that we are making is that there is not a 20% "of assets" rule.

 

 

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By johngroganjga
28th Nov 2015 23:14

Oh dear. Assets is one of a variety of measures that the 20% test is applied to, Full stop. That is simply a matter of record - on the HMRC website, for what it is worth, - and referred to a number of times by me and others in the above thread in order to assist you.

What is the point you are trying to make?

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By Stephen Harman
29th Nov 2015 13:31

Reply to johngroganjga

I explained the point we were making in my previous reply to you.

 

 

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By johngroganjga
29th Nov 2015 13:39

You just said that there was no 20% of assets rule, which is clearly the opposite of the truth, so why do you keep repeating it?

Meaning "rule" as loosely defined of course - not hard and fast but one of the factors HMRC say should be looked at and taken into account. Why do you keep asserting that they don't?

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By Stephen Harman
29th Nov 2015 15:49

Reply to johngroganjga

I said there is no "20% of assets rule" because there is no "20% of assets rule". That is not the opposite of the truth.

 

Again I copy and paste from HMRC CG 64090, as I did in my earlier reply to you.

 

 

"The indicators discussed should not be regarded as individual tests to which a 20% “limit” applies." - assets being an indicator.

 

The "20% rule" applies to "activities", not "assets". I am simply making the same assertion as Portia, Ruddles, cparker87, michaelblake and Kevin Slevin.

 

Your last three questions to me haven't added anything to the discussion - I'm just being forced to repeat what I said earlier in the discussion. It's just wasting your time and my time.

 

 

 

 

 

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By johngroganjga
29th Nov 2015 16:01

Is your point that HMRC's reference to assets is not a "rule", but something else?

Or is your point that HMRC make no reference to assets being relevant at all?

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By Stephen Harman
29th Nov 2015 17:36

Reply to johngroganjga

Your two latest questions to me make no sense whatsoever if you read the preceding threads of the discussion and CG64090.

 

"20% of activities" is a rule. HMRC's reference to assets is as one of several indicators which could well be taken into account, when assessing if the "20% of activities" rule is complied with.

And for the third time I am forced to quote HMRC in CG64090: "The indicators discussed should not be regarded as individual tests to which a 20% "limit" applies."

And again please note that the bold "not" has been included in CG64090 by HMRC for emphasis. I have not personally put it in bold font.

 

The level of non trading assets is extremely relevant, obviously, when determining if a company is a genuine trading company for Entrepreneurs' Relief. If the Directors are spending a significant amount of their time dealing with stockbrokers for example, that might well point to the company being more of an investment company, rather than a trading company, so HMRC suggest - look at the activities of the Directors and assess how they spend their time, and how much of their time is spent on non trading activities. And that is where the "20% rule" comes in.

 

HMRC, in CG64090, say that there is no simple formula, but suggest some indicators which might be of use when assessing the company's status.

 

Now the actual level of non trading assets is obviously a very useful indicator, which can be used as a guide to how the Directors spend their time - but HMRC stress that the "20% rule" should not be applied to the individual indicators per se.

 

Again I am forced to say that the questions you keep asking me add nothing to the discussion - I am continually being forced to repeat what has already been explained and explored by others, or stated by me, in the earlier discussion thread.

 

Your endless questions are just wasting your time, my time, and the valuable time of anyone reading this part of the thread.

 

Today is Sunday - yet I am spending time just re-iterating what has already been stated during the week, and the same applied yesterday - Saturday.

 

I have tried to be courteous, and answer all your questions, but I must please ask you now to put an end to this discussion, and if things are still unclear, please re-read the discussion thread, and HMRC CG64090, or download the Kevin Slevin article published in Taxation magazine, which was linked to earlier by michaelblake.

 

 

 

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By Ruddles
29th Nov 2015 18:07

Because I've been (mis)quoted

The issue here seems to be one of semantics. There is in fact no 'rule' at all. The only 'rule', if one insists on using that term, is the legislation that refers to substantial non-trade activity. HMRC have set out how they interpret that legislation, making the point that the value of non-trade assets on (and/or off) the balance sheet is one of several factors that may need to be taken into account.  I'm at a loss as to why this has generated so much discussion.

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Replying to thevaliant:
By johngroganjga
29th Nov 2015 19:25

Exactly

Ruddles wrote:

The issue here seems to be one of semantics. There is in fact no 'rule' at all. The only 'rule', if one insists on using that term, is the legislation that refers to substantial non-trade activity. HMRC have set out how they interpret that legislation, making the point that the value of non-trade assets on (and/or off) the balance sheet is one of several factors that may need to be taken into account.  I'm at a loss as to why this has generated so much discussion.

Exactly. I don't disagree with a word of this, which of course is only what has been said several times previously in this thread, by me and others. There has been no disagreement about it, so I too am baffled as to why the thread has become so long.

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Portia profile image
By Portia Nina Levin
30th Nov 2015 10:28

Yes but...

What we need in these threads is somebody to have the last word. Why do you not say something final sounding John?

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By Ruddles
30th Nov 2015 10:45

Amen

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