Rules vs. principles

Francesca Lagerberg is a partner and the head of the national tax office at advisory firm Grant Thornton in London. She can be reached at +44 207 728 3454 and at francesca.lagerberg@gtuk.com.

When the new UK Chancellor Alistair Darling stood up on October 9 2007 to deliver the Pre-Budget Report (PBR) and announce radical changes to the capital gains tax (CGT) rules, private equity held its breath. A flat rate of 18 percent from next April was not anticipated. Neither was the removal of some long-established reliefs and exemptions, such as taper relief and indexation allowances. Now that the initial shock has passed, much consideration is being given to the report's potential winners and losers.

Losers
There has been plentiful press coverage of those who will lose out as a result of the proposed changes. These are, of course, primarily those who have business assets, such as private equity, and have held them for at least two years so that if they disposed of the asset under the current rules they would expect to obtain an effective tax rate of 10 percent. If they take no action before next April, they will find themselves facing an 80 percent increase in their tax bill, as the rate goes up from 10 to 18 percent. For many the increase could be larger, for example, those who will also lose any indexation allowance.

Affected taxpayers have the possibility of mitigating this tax hit if they act before April 2008. Many will have been investigating the possibility of making a disposal or a deemed disposal before that date. Professional advice will help in considering the best possibilities on the given facts, but most taxpayers will be postponing any final decision making until they see and consider the draft CGT legislation and guidance from Her Majesty's Revenue & Customs (HMRC). At the time of writing this was due to be released in December 2007.

Many taxpayers will also be hoping that the government has been listening to business and seeking to amend its initial proposals with some additional reliefs, although those with substantial investments in private businesses should not expect much.

Winners
Far less coverage has been given to the winners of the CGT changes. Some will have non-business assets, like buy-to-let properties, which at best under current rules would suffer a 24 percent effective tax rate upon disposal that would only be achieved after an extended holding period. Shorter holdings would result in a higher charge. Post April 2008 such taxpayers will have an 18 percent tax charge regardless of how long they have held the asset. This is a useful tax reduction.

Some others people will have assets (business or non-business) which they have not held long enough to qualify for the best potential current tax rate but for whatever reason they need to make a disposal. Under existing rules some could face a 40 percent tax charge. Again from April 2008 they will only have to pay 18 percent.

Overall, the CGT tax changes mean that for some the new-look rules are attractive. It also does not take a rocket scientist to work out that turning income into capital could be an attractive route post April 2008. At its starkest, a flat rate charge of 18 percent is far more interesting than a possible 40 percent charge. This raises the question of whether the government will introduce anti-avoidance legislation to stop the move from income to capital.

The GAAR
It is highly probable that HMRC has already begun pondering the question of whether anti-avoidance legislation is needed. It might wait to see what behavioral changes occur as a result of the CGT overhaul but the past few years of abundant anti-avoidance rules would suggest that it will not wait too long. It may even look to act before April 2008.

So what might the government do in its quest to prevent people exploiting the tax advantages of having capital? One possibility is the long-running saga of whether the UK tax system needs a General Anti-Avoidance Rule or GAAR. This discussion last reached a peak back in 1998 when a proposal was put forward to introduce an all-encompassing anti-avoidance rule. After much publicity the idea was shelved (as opposed to abandoned) due to the inability of the then Inland Revenue being able to offer a supporting clearance system to help taxpayers identify if they were caught or not.

The concept behind a GAAR is to have a back-stop provision to capture aggressive planning which exploits loopholes in the law but which is hard to close in advance. For example, the clever use of mismatching legislation can provide a window of opportunity for tax planning which is within the law. However, the absence of any real substance to the transaction or transactions could make it fall within an appropriately worded GAAR type provision without the need for HMRC to fall back on the courts to tackle the issue.

A GAAR could be a handy tool for HMRC to invalidate tax schemes which it found unacceptable but which no specific other rules appear to catch. It would need to be carefully defined as it must hit the intended target but not prevent businesses and individuals undertaking commercial transactions. The difficulty in the past has been in drafting a rule which has enough clarity to enable taxpayers to know when it bites. Particularly in an age of self-assessment, businesses and individuals need at least some degree of certainty as to whether their transactions are going to be within such a GAAR. The idea of offering a pre-clearance system from HMRC would resolve these concerns but the cost and resources needed to deliver that have been considered too great in the past.

The GAAR idea has been taken up in other countries to mixed effect. Canada and Australia have used the concept within their legislation although it has taken some time, and in some jurisdictions several rewrites, to make the rules function.

Some have suggested that the UK should simply enact the types of principles found in cases such as Furniss v Dawson and Ramsay, which were both cases that considered artificial transactions being used to generate a favorable tax outcome. This could be viewed as a GAAR by another means. However, the same definition problems would appear to apply in turning these cases into a meaningful law.

Moving forward with principles
Others have argued that if the UK moves towards more purposive legislation that clearly sets out its intent, the Courts would find it easier to resolve anti-avoidance issues. Oxford University Professor Judith Freedman has argued for a General Anti-Avoidance Principle (GANTIP). Speaking at the Tax Faculty of the Institute of Chartered Accountants in England & Wales (ICAEW) in November 2006 she set out her case for a principle that would include a motive test. Therefore if a scheme came before the courts it could use this GANTIP to say if this scheme had been known to Parliament when it enacted relevant law would it have been deemed acceptable or not.

The concept behind a GAAR is to have a back-stop provision to capture aggressive planning which exploits loopholes in the law but which is hard to close in advance. However, the absence of any real substance to the transaction or transactions could make it fall within an appropriately worded GAAR type provision without the need for HMRC to fall back on the courts to tackle the issue.

In recent years we have seen far more targeted anti-avoidance rules or TAARs. The Finance Act 2007, for instance, included targeted legislation aimed at the use of capital losses by individuals. Previously a TAAR was introduced to deal with the use of capital losses by companies. Could we have a TAAR preventing any income to capital conversion linked to the new CGT rules? It must be a real possibility.

Taking it on a stage, Mike Truman, editor of Taxation, speaking at this year's Hardman lecture for the ICAEW, argued that in many areas of tax law we could combine a principle based approach as per Judith Freedman, with targeted avoidance rules leading to an inevitable abbreviation ? the TANTIP (targeted anti-avoidance principle).

However, in the short term it is likely that a more traditional TAAR may appeal to HMRC.

The growth of anti-avoidance legislation shows no sign of slowing down. In addition the lure of an attractive tax rate will always make taxpayers consider moving to a more advantageous position where possible. The collision of these two factors means that the chances of some form of rule restricting a shift from income to capital in non-commercial circumstances must be a real possibility.

How this is likely to be achieved raises the possibility of some form of overarching rule ? be it a TAAR or a GAAR. The problem will of course remain of whether it is possible to draft something proportionate, clear and usable. The recent capital loss TAAR for individuals was heavily criticized for being drafted widely in the primary legislation and then softened in guidance. The latter is easily changed and cannot be relied on in court. Those who draft guidance move on and the logic behind their initial drafts gets lost in time leading often to a hardening of views in the future. It is much better to get the statute right rather than resort to explanation by guidance.

Professor Freedman has argued that a lack of certainty in an antiavoidance principle, if such a thing existed, would be part of its strength. A clear purpose clause in the legislation would be the steer and any scheme that came into question would ultimately be judged by the courts rather than be assessed by HMRC via any clearance procedure. She argues this would be more attractive and one might argue be more independent. However, there is a pragmatic problem here. Few want to have to rely on the courts, with the time and costs involved, to arbitrate on whether something does or does not work. A clearance procedure from HMRC with a court appeal option could provide the certainty needed.

The anti-avoidance issue will not go away and may prove to be just as problematic as the decisions facing the CGT losers in the new regime.