23 September 2019 - Article
Important Changes to the section 741 TA 1988 Defence
In our Pre-Budget Report 2005 Stop Press we wrote that the Government announced its proposal to amend the section 741 TA 1988 defence in the Finance Act 2006 with effect from 5 December 2005. Draft legislation was issued at the time of the Pre-Budget Report.
By way of recap, section 739 TA 1988 seeks to impose a charge to tax on an individual ordinarily resident in the UK where that individual has made a transfer of assets and, broadly, as a consequence of that transfer and any associated operations, income becomes payable to persons resident or domiciled outside the UK. Section 740 TA 1988 applies where a UK ordinarily resident individual, not liable to tax under section 739 TA 1988, receives a benefit out of those assets. In both cases the remittance basis of taxation is preserved where the individual in question is non-UK domiciled.
Before 5 December 2005, neither provision would have applied if the taxpayer could show HMRC that the transfer and any associated operations were either (i) not made for the purpose of avoiding liability to taxation or (ii) bona fide commercial transactions not designed for a tax avoidance purpose.
Broadly speaking, the proposed changes to the section 741 defence (which are addressed in our Pre-Budget Report Stop Press and therefore not repeated here) are designed to give a statutory footing to certain views put forward by HMRC over the past few years as to how the provision operates. To determine whether the new provision applies, a more objective view must now be taken and the intentions of professional advisers will be taken into account. Aside from the obvious concern that the defence will be harder to obtain in the future, the draft legislation gives rise to a number of other concerns including the following:
- If a structure falls within the new test as a result of actions carried out after 4 December 2005, only income arising after that date will be taken into account for section 739 purposes, however all historic income will be taken into account for section 740 purposes (in the event that a benefit from those assets is subsequently received). Potentially, this means that even if HMRC have historically agreed that the section 741 defence applies, the future loss of the defence would bring into account section 740 income that arose during the period when it was accepted that the defence applied. This is clearly retrospective legislation and would cause significant problems for trustees who, in reliance upon an agreement with HMRC that the defence applied in the past, may well not have taken steps to calculate the income as it arose. It is felt that only income arising after an ‘offending’ (i.e. tax avoidance motivated) transaction should be capable of being brought into account.
- There is an urgent need for guidance as to what is considered to be ‘tax avoidance’ by HMRC in this context. We do not consider that a number of common activities such as segregating income and capital and paying away relevant income on a regular basis should be regarded as tax avoidance. Such steps are taken simply to optimise the application of particular clearly defined rules and it is submitted should therefore fall within the ‘mitigation’ category. However, it is by no means certain that HMRC will take the same view. By way of example, if historic income can later be brought into account for section 740 purposes (in the event that a defence is lost some years later), could taking steps now to mitigate this risk (such as decanting the income each year) itself be construed as avoidance?
Given that there is now a statutory footing for professional advice to be taken into account, trustees could be left having to walk a difficult tightrope between (a) not wishing to seek tax advice for fear of being accused of considering avoidance; and (b) running the risk of a breach of trust claim for triggering unnecessary tax charges!
It will be interesting to see whether any of these issues are dealt with in the Finance Bill 2006. However, for the time being trustees should think very carefully before taking any steps that could be regarded as having any tax avoidance motive.
Trustee Expense Allocation
A draft discussion paper on trust management expenses was issued by HMRC in September 2004 with the intention that clearer guidance on this issue could be agreed with trust representatives (including the Society of Trust and Estate Practitioners ‘STEP’) for the HMRC Trusts, Estates and Settlements Manual (which is available on the HMRC website). It had been hoped that this guidance would be agreed by September 2005 but this proved impossible. During this process it became clear that although most of the draft guidance was largely agreed by the trust representatives, a common view could not be reached on the allocation of trustee remuneration (ie out of income, capital or a combination of the two). Following discussions with STEP, it was agreed not to hold up the publication of the remainder of the guidance because of this lack of agreement. The guidance that was issued on 31 January 2006 is inconclusive on trustee remuneration but it does set out the opposing views as follows:
- The HMRC view is that, on general principles, such payments are linked to the management of the trust fund as a whole and therefore, should be regarded as payable out of capital.
- The view of the trust representatives is that the HMRC view does not represent an accurate summation of the relevant case law and that as trustee fees are annual recurrent expenses they reflect work done on behalf of both income and capital.
It is understood that a case on this point is due to be heard by the Special Commissioners in the next few months. However, until this issue has been settled by the courts, trustees may wish to consider taking a more cautious view as regards the deductibility of trustee expenses against income.
One particular issue that offshore trustees may be addressing at this time of year is stripping out relevant income for section 740 purposes and in this regard they may wish to consider allocating trustee fees against capital. Trustees may also wish to revisit the historic position and consider paying away additional sums in respect of expenses that may transpire not to be deductible against income. Of course, given the proposed changes to the section 741 defence addressed above, stripping out relevant income may become more important to many trustees.
Particular issues may arise in relation to US resident trusts with UK resident beneficiaries as there is far greater flexibility to deduct expenses against income under the US rules. Therefore, a structure that is considered to be ‘dry’ of income for section 740 purposes because all income is regularly decanted by the US trustees, may in fact still contain income for UK purposes.
If the courts do hold that trustee fees cannot be deducted against income at all (except in exceptional circumstances), this may raise some difficult questions for trustees who have historically met part (or all) of their annual trustee fees out of income and made capital distributions to UK resident beneficiaries. In such event, there may be a risk that section 740 should have applied to the distributions in question to the extent that the relevant income had been reduced by the payment of trustee fees. Trustees of interest in possession trusts may also have to consider whether life tenants should be paid more income as regards historic periods.
In short, a shift in the expense allocation rules can be dealt with relatively easily going forward but may cause considerable historic problems unless a practical approach is adopted by HMRC.