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New tax avoidance scheme highlighted

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16th Sep 2016
Tax Writer Taxwriter Ltd
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HMRC has warned taxpayers against using a new ER-based scheme to reduce tax payable on earnings to 10%.

How it works

The scheme is described in the latest tax avoidance “spotlight” by HMRC: Capital Gains Tax: Entrepreneurs’ Relief tax avoidance scheme. It has three stages:

  1. A taxpayer who owns a personal service company (PSC) in the UK sells that company to an organisation based in Cyprus. This sale is correctly taxed as a capital gain. If the taxpayer has owned at least 5% of the PSC for a year or more, the gain will be eligible for entrepreneurs’ relief (ER), so will be taxed at 10%
  2. The taxpayer continues to be a director of the PSC after its sale to the Cyprus entity, and continues to work through that PSC in the UK
  3. The scheme providers claim that the monthly payments the taxpayer receives in return for his work through the PSC are capital payments subject to ER, and thus taxed at 10%

Why it may fail

HMRC clearly believes that this tax scheme doesn’t work, although it doesn’t specify why. I suggest the potential failure of this scheme is connected with the valuation of the disposal of the PSC and the timing of receipts.

When the PSC is sold in stage one, its value at that point is subject to CGT (assuming small or nil base cost), so ER can be claimed on that gain. The owner may also be paid an “earn-out”, which is an amount based on value the PSC will generate in the future– i.e. the earnings created at stage three.

The earn-out must be taxed at the same date as the proceeds from the PSC sale to qualify for ER. For that to happen the value of the earn-out must be determined at the time of the sale of the PSC. If the earn-out is based on the earnings at stage three it is difficult to see how it can be determined accurately at stage one.

Where the value earn-out can’t be determined until stage three it becomes a separate right known as a “chose in action”. That right is subject to CGT, but when the cash is received, not at stage one. The disposal of the chose in action is not eligible for ER, as it is not a disposal of shares or of a business, so CGT is due at 20% (or the rate applicable when the chose in action is disposed of).

Risk

It is possible to draft an agreement that sells the PSC for an amount that includes the value of all future income to be earned by the PSC within say the next four years. The taxpayer would have to pay CGT on the full sales value (the gain) at stage one, before he receives the future income, although the entire sale value would qualify for ER and so be taxed at 10%.

However, if the PSC doesn’t achieve the expected income over the next four years, the sales proceeds would be reduced and the original gain would have to be recalculated. This can be done with an election under TCGA 1992, s 49, which must be submitted within four years of the end of the tax year when the PSC was sold.

The scheme can therefore only be used for a maximum of four years by each taxpayer, and the CGT will have to be paid up front.   

Penalties

HMRC warns that it will investigate anyone found to be using this scheme, before the taxpayer has even submitted their tax return.

When the tax return is submitted including a claim for ER, that claim will be challenged and CGT will be demanded at the full rate, plus interest and penalties on any underpaid tax. 

Replies (15)

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By Justin Bryant
16th Sep 2016 13:03

No TAA issues presumably (under EU law as long as there is substance in Cyprus), but likely to be caught by the panoply of anti-avoidance re contractors, MSC, disguised remuneration etc., so this scheme looks worse than useless (as you get nasty s222 ITEPA 2003 tax on tax with P7A, not to mention potential GAAR penalties from yesterday onwards).

Thanks (0)
By SteveHa
16th Sep 2016 13:34

TBH, if the Revenue don't go for disguised remuneration, but simply attack ER, then the scheme still works. All that the user would lose would be the benefit of 10% tax rate, and would instead be taxed at 20%.

This would still be better than 40 - 45% tax, NI and employer's NI.

I would expect the challenge to be disguised remuneration, though.

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By Justin Bryant
16th Sep 2016 17:54

If that wasn't enough, there is also Sales of Occupation Income (Sections 773 to 789 ITA 2007), TiS, s809AZA etc. to consider here.

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By the_Poacher
17th Sep 2016 21:37

This really is ugly avoidance. Whilst the NHS crumbles around us some folks enter into schemes like this to avoid contributing their fair share.

Thanks (13)
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By Laura Hazell
19th Sep 2016 12:16

Schemes which have been designed purely to avoid tax, can and have been rejected on the basis that they go against the 'spirit' of the relevant legislation. Parliament did not intend for ER to be used in this way.

Thanks (4)
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By graweb901
19th Sep 2016 14:16

It's not worth commenting on the details of the scheme because a) HMRC has already spun the "facts" to suit their purposes and b) HMRC plainly does not have enough facts to be able to identify and target the mischief and therefore actually produce a reasoned antidote.
This has become a feature of HMRC policy. They publish a vague statement that "anything that looks like this we might challenge" and then spend 5 years collecting data before actually trying to apply the rule of law r to get into Tribunal. By then many people who have never seen the original statement, are poorly advised, are greedy, who believe the sales pitch, have been sucked in.
For HMRC though this is a win win. They can point to the original vague and inaccurate statement as "evidence" of doing their job and then charge the unfortunate/ill advised/greedy etc tax, interest penalties and increase the tax yield.
That such a process reduces still further (perhaps to historic low levels?) confidence in the tax system in general and HMRC in particular appears to be of no consequence to HMRC's policy makers. I now HMRC has a difficult job but it has to be said that some of the individuals seem to delight in causing misery.

Thanks (2)
Replying to graweb901:
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By xyz123
19th Sep 2016 18:20

I'm not sure I understand this reply. HMRC's note looks quite clear bearing in mind it is supposed to be readable to a normal person. It certainly does not look vague. There does not seem to be a need for a reasoned 'antidote' either as the disguised remuneration legislation seems to be designed to catch this type of arrangement. You also have GAAR as well. You say that "by then people have never seen the original statement" but that is the beauty of putting out statements like this on the internet, then having journalists comment on them and then being discussed on internet forums. It means that anyone trying to find out more about the schemes is put on alert. Also, you seem to say that this reduces confidence in the tax system. I think it increases it. It makes people aware that there are dodgy things going on that you wouldn't touch with a barge pole. It also makes clear that HMRC do target dodgy schemes, that they do care about this sort of thing. Surely that increases confidence for everyone who pays their taxes in the normal way (i.e. without contrived and abnormal schemes). But I think HMRC do need to go a few stages further - one is to publish this sort of thing promptly. The second is to get the cases quickly to the tribunals.

Thanks (1)
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By graweb901
19th Sep 2016 14:16

It's not worth commenting on the details of the scheme because a) HMRC has already spun the "facts" to suit their purposes and b) HMRC plainly does not have enough facts to be able to identify and target the mischief and therefore actually produce a reasoned antidote.
This has become a feature of HMRC policy. They publish a vague statement that "anything that looks like this we might challenge" and then spend 5 years collecting data before actually trying to apply the rule of law r to get into Tribunal. By then many people who have never seen the original statement, are poorly advised, are greedy, who believe the sales pitch, have been sucked in.
For HMRC though this is a win win. They can point to the original vague and inaccurate statement as "evidence" of doing their job and then charge the unfortunate/ill advised/greedy etc tax, interest penalties and increase the tax yield.
That such a process reduces still further (perhaps to historic low levels?) confidence in the tax system in general and HMRC in particular appears to be of no consequence to HMRC's policy makers. I now HMRC has a difficult job but it has to be said that some of the individuals seem to delight in causing misery.

Thanks (1)
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By graweb901
19th Sep 2016 14:17

It's not worth commenting on the details of the scheme because a) HMRC has already spun the "facts" to suit their purposes and b) HMRC plainly does not have enough facts to be able to identify and target the mischief and therefore actually produce a reasoned antidote.
This has become a feature of HMRC policy. They publish a vague statement that "anything that looks like this we might challenge" and then spend 5 years collecting data before actually trying to apply the rule of law r to get into Tribunal. By then many people who have never seen the original statement, are poorly advised, are greedy, who believe the sales pitch, have been sucked in.
For HMRC though this is a win win. They can point to the original vague and inaccurate statement as "evidence" of doing their job and then charge the unfortunate/ill advised/greedy etc tax, interest penalties and increase the tax yield.
That such a process reduces still further (perhaps to historic low levels?) confidence in the tax system in general and HMRC in particular appears to be of no consequence to HMRC's policy makers. I now HMRC has a difficult job but it has to be said that some of the individuals seem to delight in causing misery.

Thanks (1)
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By geoffmw1
19th Sep 2016 14:42

Why would anyone effectively work for nil remuneration. This might work if there really was value in the clientele of the PSC that enables the purchaser to eploy someone to carry on the work and still make a profit.

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By AndrewV12
20th Sep 2016 08:55

I am not an expert on tax avoidance schemes, but it has all of the ingredients, A UK Company sets up a scheme overseas, complicated rules, complicated scenarios.

Summarising the above .....mmmmm its a tax avoidance scheme.

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By P2
20th Sep 2016 15:39

Look at how long HMRC held back their attacks on film investment schemes. I can see the same thing happening here.

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By stephenAburwood
21st Sep 2016 09:36

The fundamental point here is the nature of the "earnout"

HMRC have made it perfectly clear in the past that in order for the "earnout" to qualify as such it is necessary for the employee in the continuing business to receive a market rate "salary", which could presumably be either normal earnings or a dividend stream. Failure to demonstrate that will lead to the "earnout" being treated as earnings - which in my view it clearly is.

Thanks (1)
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By David Gordon FCCA
21st Sep 2016 14:46

I have warned clients about these schemes. As I understand it employment is a matter of fact. If the "Work" by factual description is work done by an individual which, disregarding the stuff in this particular contract, might be classified by a tribunal as employment. Then it is subject to PAYE.
Over the years ther have been many schemes which sought to convert employment income into capital. They have all failed because in theses matters the Tribunals will look to, and give precedence to the physical realities of the matter.

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By Justin Bryant
05th Oct 2016 10:07

Yes; if the courts can recharacterize a divided as disguised earnings as in PA Holdings, they can certainly do the same here with the so-called earn-out, so that is an additional problem with this scheme.

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