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Entrepreneurs’ relief: The elephant test

A ‘trading company’ can sometimes be difficult to identify for capital gains tax ER purposes. To make matters worse, the statutory definition is relatively brief. Whilst HMRC’s guidance is helpful in many cases, it is only that – guidance, not legislation, so does not have the force of law.

At times, it is necessary to resort to a non-tax solution to a tax conundrum. One such example is the elephant test. The ‘elephant test’ can be paraphrased as ‘something that is difficult to describe, but you know one when you see one’. It might be disappointing to discover that HMRC’s perception of what an elephant looks like differs from yours when it comes to identifying a ‘trading company’. However, as this article points out, that is not necessarily fatal to an ER claim.

There may be trouble ahead…

ER is available to individuals on (among other things) a material disposal of business assets, including company shares where one of several alternative conditions (A, B, C or D) is satisfied.

Probably the most common of these is Condition A (TCGA 1992, s 169I(6)). This is broadly that throughout a two-year period (one year for disposals before 6 April 2019) ending with the date of disposal the company is the individual’s ‘personal company’ (as defined) and is either a trading company or the holding company of a trading group, and the individual is an officer or employee of the company (or a trading group member).

Condition B is considered further below, while Conditions C and D are not relevant to this article.

As indicated above, ‘trading company’ is briefly defined for ER purposes (in TCGA 1992, Sch 7ZA, para 2). It follows the same meaning as the relief for gifts of business assets (as modified by special ER provisions for joint venture companies) and states that ‘trading company’ means a company carrying on trading activities whose activities do not include to a substantial extent activities other than trading activities (TCGA 1992, s 165A(3)).

This definition gives rise to at least two questions:

(1) what are ‘trading activities’? and

(2) how do you measure ‘substantial’ in this context?

Be ‘prepared’

On the first question, a number of activities potentially count as ‘trading activities’ for ER purposes. These include activities carried on by the company in the course of, or for the purposes of, a trade being carried on by it; and also activities for the purposes of a trade that it is preparing to carry on.

HMRC guidance on preparatory activities in the context of a single company (in the Capital Gains manual at CG64060) states that this encompasses the situation where a particular trade is about to be started but the company has to carry out certain activities first (e.g. developing a business plan for carrying on the trade, acquiring premises, hiring staff, incurring pre-trading expenditure for the purposes of the trade to be carried on).

However, what about a situation where a company’s activities involve preparing to resume a trade it previously carried on? This point was considered in Potter v Revenue & Customs [2019] UKFTT 554 (TC); more on this later.

Is it ‘substantial’?

The second question poses a relatively common difficulty, because there is no statutory definition of ‘substantial’ for ER purposes. HMRC guidance states (at CG64090) that it means “more than 20%”; but more than 20% of what? HMRC adds that some or all the following measures or indicators might be taken into account in reviewing a particular company’s status:

  • Income from non-trading activities;
  • The asset base of the company;
  • Expenses incurred, or time spent, by officers and employees of the company in undertaking its activities;
  • The company’s history; and
  • Balance of indicators.

HMRC points out that these indicators should not be regarded as individual tests to which a 20% “limit” applies, but that they may be useful in establishing whether there is substantial overall non-trading activity. It may be that some indicators point in one direction and others point the opposite way. HMRC advocates weighing up the relevance of each in the context of the individual case and judging the matter “in the round”.

The natural inclination is perhaps to focus on quantifying the 20% measures, without considering (for (e) above) if there are non-trading ‘activities’ in the first place. This is potentially a crucial point.

Is there an ‘activity’?

For example, in Potter , the taxpayers (husband and wife) were the director shareholders of a company (G), which until 2009 was involved in the London Metal Exchange (LME). G’s business was to trade in the LME and to broker credit deals to provide the finance to enable clients to engage in high value trading at the LME. G traded successfully and built up reserves of over £1 million when the financial crash happened in 2008/09. To safeguard its reserves, G used approximately £800,000 of those reserves to purchase two six-year investment bonds, which matured in November 2015. The capital was locked up during that period, but the bonds paid interest of £35,000 a year.

As a result of the financial crash, the volume of G’s trading declined dramatically. The last invoice issued by G was in March 2009, although Mr P continued to actively seek business. However, due to a number of unfortunate personal issues, the company was put into voluntary liquidation in June 2015.

The liquidation of a company is a disposal of the shares in the company, which generally takes place when the liquidation proceeds are paid. In this case, the disposal occurred on 11 November 2015. The taxpayers claimed ER in respect of the disposal of their shares, on the basis that G continued to be a trading company up to June 2014 (when Mr P was admitted to hospital for a perforated bowel). HMRC refused the ER claim, and the taxpayers appealed.

At this point, it is worth considering Condition B for ER purposes in the material disposal of business assets test mentioned earlier (TCGA 1992, s 169I(7)). This is broadly that the ‘personal company’, ‘trading company’ and ‘officer or employee’ requirements are met throughout the two-year period ending with the date on which the company ceased to be a trading company (or trading group member), and that date is within three years ending with the date of the disposal.

Consequently, in order to satisfy the above condition, G’s trade must not have ceased before 12 November 2012 and the company must have been a trading company for at least one year ending with 12 November 2012 (or any later date before 11 November 2015). The First-tier Tribunal had to consider whether G was a trading company at any time after March 2009 (i.e. when it issued its final invoice), and if so, whether it was a trading company in the one-year period leading up to 12 November 2012 (or later).

Thankfully for the taxpayers, the tribunal found that G was carrying on trading activities at least up to November 2012. The tribunal’s view was that G was carrying out activities for the purposes of preparing to carry on its old trade once the economic environment permitted it.

Substantial non-trading activity

However, that was not the end of the matter. The tribunal next had to consider whether G was disqualified as a trading company because its activities included investment activities to a ‘substantial’ extent. The tribunal noted that once the company had put its money into the bonds it did not (and indeed could not) do anything else in relation to them for six years until they matured. There were no investment activities. The asset and income position of the company were factors pointing towards investment activities, but the expenses incurred and time spent by the directors/employees were factors pointing to trading activities.

Standing back to look at the company’s activities as a whole and asking “what is this company actually doing?” (i.e. akin to the elephant test mentioned earlier), the tribunal’s answer was that the activities of the company were entirely trading activities directed at reviving the company’s trade and putting it in a position to take advantage of the gradual improvement in global financial conditions. The tribunal concluded that G’s activities did not, to a substantial extent, include activities other than trading activities. ER was due, and the taxpayers’ appeal was allowed.

Don’t touch anything!

The tribunal’s conclusion in Potter was that there were no ‘activities’ by the officers/employees of the company involving the six-year bonds, and therefore no ‘investment activities’ (such as keeping the investments under review, considering whether to retain or change them, etc.). This case may be helpful in similar circumstances where a company has traded successfully and accumulated trading profits over a number of years. The decision in Potter (subject to any successful appeal by HMRC) indicates that applying surplus funds in investments that require no time or effort by officers or employees in managing them should not count against the company when determining whether it has substantial non-trading activities. Hopefully, this means that HMRC will now apply the elephant test more often!

Mark specialises in inheritance tax, although he has a broad experience on other tax matters. He is the editor and co-author of a number of tax publications published by Bloomsbury Professional, including ‘Inheritance Tax’ and ‘Ray & McLaughlin’s Practical Inheritance Tax Planning’. He is also a contributor of articles for professional publications, and is a member of the Chartered Institute of Taxation’s Succession Taxes and Capital Gains Tax & Investment Income Sub-Committees.

The TACS Partnership is an independent firm of tax specialists who have been providing expert advice for over 25 years. Its clients include high net worth individuals, taxpayers facing HMRC enquiries, accountancy and legal firms seeking specialist tax advice for their clients, and limited companies, both family owned and fully quoted. Visit www.tacs.co.uk.

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