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The General Anti-Abuse Rule - part three

This month's article concludes the series on the subject of the General Anti-Abuse Rule (the GAAR).  To briefly summarise, the GAAR is a special statutory rule that targets tax avoidance schemes which, because they are complex and/or novel, are outside of the general tax legislation.  Only schemes that are abusive are within the ambit of the GAAR.

This month I will consider how HMRC can counteract the tax advantages that arise from abusive tax arrangements, and look at examples of the GAAR in operation.

Counteraction of a tax advantage

If a taxpayer implements a tax saving scheme that falls with the definition of an abusive arrangement, then the GAAR may operate so as to counteract the abusive tax advantage which they are trying to achieve.

Where such tax advantages arise and HMRC can show the GAAR applies, the arrangements will be counteracted by the making of just and reasonable adjustments, whether in respect of the tax in question or any other tax to which the GAAR applies. So, for example, where an abusive arrangement may attempt to reduce or eliminate a charge to capital gains tax, it is still possible for the counteraction to involve an adjustment to income tax.

HMRC must comply with the appropriate procedural requirements before making any such adjustments. In particular, any time limits imposed elsewhere in the tax legislation apply to the power to make adjustments under the GAAR.

Adjustments are deemed to have effect for purposes other than just counteracting the tax advantage. They might, for example, adjust the base cost of an asset for a future capital gains disposal event. Counteraction adjustments may be made in respect of any period and may affect any person. The legislation sets out when a counteraction is regarded as final.

When a counteraction of a tax advantage becomes final, the taxpayer has 12 months in which to claim a consequential adjustment. Such an adjustment can only be a relieving adjustment and cannot increase the taxpayer's liability. Its aim is to ensure there is not excessive taxation. For example, if counteraction involved acceleration of a tax charge, then double taxation would result if tax is later charged in respect of the same amount.

The legislation deals with the application of existing administrative provisions for certain taxes to claims for consequential adjustments under the GAAR and so provides a consequential adjustments claim procedure in respect of each of the taxes covered by the GAAR.

Rules set out the means by which a consequential adjustment may be made and stipulate that time limits imposed by or under any other enactment do not constrain the making of consequential adjustments under the GAAR.

In any proceedings before a court or tribunal in connection with the GAAR, HMRC must show that there are tax arrangements which are abusive and that the adjustments made to counteract the resulting tax advantages are just and reasonable.

A court or tribunal, in determining any issue in connection with the GAAR, must take into account HMRC guidance (as approved by the GAAR Advisory Panel at the time the tax arrangements were entered into) and any opinion of the GAAR Advisory Panel about the arrangements.

Examples of the GAAR in operation

One of the main requirements of the GAAR rule is that the legislation is clear as to when the rule may operate. In order to assist in providing this clarity, HMRC have issued some guidance notes in which they consider a number of planning situations and analyse whether they would apply the GAAR. Two of these examples cover planning that is in common use within the financial services sector.

Here I consider how HMRC considers that the GAAR may apply to those arrangements. Both use trusts as a means of tax planning - see Pilot Trust (see 1) and the Discounted Gift Trust (see 2). Both are dealt with in the HMRC Guidance Notes under the headings shown below.

(1) Pilot trusts

(a) Background

The assets in a trust may be chargeable to IHT under the relevant property regime. This means that a charge to tax can arise on the value of the settled property on every tenth anniversary of the trust (a "periodic charge"). A pro-rata charge can arise whenever property leaves the trust (an "exit charge"). In determining the inheritance tax rate on these occasions, the value of all the property in all the trusts established by the same settlor on the same day - 'related settlements' - is taken into account. (Section 62 IHT Act 1984).

(b) The arrangements

Bob might wish to leave his estate of £1.75 million in trust for each of his 7 grandchildren. He wants to minimise any IHT that might apply on the trust after his death. Bob could establish one trust under his Will for the benefit of all of his grandchildren. However it is then very likely that this trust will be subject to periodic/exit charges in the future because its value will exceed the nil rate band. Even if Bob creates a separate trust for each of his grandchildren under his Will, IHT is still likely to apply because all of the trusts will be related settlements for IHT and so their values added together for IHT purposes. In light of this Bob could establish one trust per day over a period of 7 days, settling £100 on each. He could then revise his Will so that he leaves a specific legacy of £250,000 free of tax to each settlement. Following his death, his executors pay the legacies to the trustees of each of the trusts.

(c) The taxpayer's analysis

On Bob's death, his estate will be subject to IHT and the tax will be borne by the residuary estate. But going forward, each trust will benefit from its own nil-rate band and the funds added to each of the other trusts by Bob's Will will not be taken into account in arriving at the rate of tax because, having been established on different days, the trusts are not related settlements. Provided that the value of the property in each trust remains below the IHT nil rate band, the trusts will not pay any tax.

(d) The GAAR analysis 

(i) Are the substantive results of the arrangements consistent with any principles on which the relevant tax provisions are based (whether express or implied) and the policy objectives of those provisions?

The relevant property regime was introduced in 1982, imposing IHT charges on property held in trusts that are settlements. Trusts that are established on the same day are all related settlements and the value of property, immediately after they commenced, in related trusts is taken into account in determining the rate of tax that is charged on each trust.

In this case, because the trusts were created on consecutive days, they are not related trusts and so the rate of tax is calculated without reference to the other trusts, notwithstanding that the substantial addition of funds came about as a result of a single event - Bob's death.

(ii) Do the means of achieving the substantive tax results involve one or more contrived or abnormal steps?

Had Bob's Will established a single trust for the benefit of all of his grandchildren, that trust would have been subject to IHT. And, if seven separate trusts had been established by his Will, they would have been related settlements so each would have been taken into account with the other to establish the rate of tax. Establishing the 'pilot' trusts on separate days before death had no purpose other than to put the trusts in a tax-advantaged position.

(ii) Do the tax arrangements accord with established practice and has HMRC indicated its acceptance of that practice?

This type of planning was considered by the Court of Appeal in the case of Rysaffe Trustee v IRC [2003] STC 536. HMRC lost the case and on the basis that the Government have not chosen to subsequently change the legislation, HMRC must be taken to have accepted the practice.

(e) Conclusion

Whilst the arrangements may be viewed as contrived, because they accord with established practice accepted by HMRC they are not regarded as abusive and therefore not subject to the GAAR.

(2) Discounted gift schemes

(a) Background

Where an individual gives assets away, but continues to use or enjoy the assets or otherwise benefit from them, the assets are treated as if they were still owned by the donor and are subject to IHT on death under the reservation of benefit provisions. These provisions were introduced in 1986 and (subject to certain statutory let outs) generally prevent the taxpayer from enjoying property after he has given it away.

(b) The arrangements

The settlor establishes a single premium bond in trust. Under the terms of the trust, he retains certain rights/benefits. For example, the rights retained may be in a series of single premium policies maturing on successive anniversaries of the creation of the trust or to future capital payments if the settlor is alive at specific future dates.

The arrangement is viewed as a "carve-out" (or "shearing arrangement") so that provided the settlor's retained rights are clearly defined he is not treated as making a gift of the property he retains. The rights are therefore split into a retained fund for the settlor, which is effectively held on a bare trust for the settlor's benefit, and a settled fund from which the settlor is excluded and which is held for other beneficiaries such as the settlor's children. The retained fund comprises the right of the settlor to withdraw a certain fixed amount - usually 5% of the initial capital invested each year. For IHT purposes, the settlor is treated as making a transfer of value equal to the amount of the investment less the present value of the retained rights.

(c) The taxpayer's analysis

When an individual (let's call him Tom) establishes a Discounted Gift Trust, the trust will precisely define the interest he has retained and the interest he has given away. Because he cannot benefit in any way from the gifted interest, there is no gift with reservation (GWR).

As Tom has effectively 'carved out' an interest for himself within the trust, the transfer of value for IHT purposes is not the full value of the property transferred to the trustees, but is reduced by the value of the retained interest. This gift will cumulate with his taxable estate should Tom die within 7 years.

The arrangement does not give rise to a charge under the pre-owned assets tax (POAT) regime because HMRC has confirmed in guidance that the retained fund is held on bare trust for the settlor. Hence the para 8 Sch 15 FA 2004 pre-owned assets charge does not apply to this retained fund (i.e. because it is not a settlement) and nor does it apply to the gifted settled fund because the settlor is excluded from this.

(d) The GAAR analysis 

(i) Are the substantive results of the arrangements consistent with any principles on which the relevant tax provisions are based (whether express or implied) and the policy objectives of those provisions?

S102 FA 1986 imposes a GWR charge on death where the individual disposes of gifted property and enjoys a benefit in the 7 years prior to death.

In the Ingram case, the House of Lords held that the policy of the legislation was to identify precisely what property had been given away by the donor and what (if anything) was retained. They noted that there is nothing in principle within the GWR provisions that stops the donor carefully dividing up property, giving away a defined amount and retaining the remaining property. Continued enjoyment of the latter does not amount to a reservation in the former. Arrangements of the type adopted are known as "shearing" operations.

Subsequently in 1999 (and in order to prevent Ingram planning) Ss102A-C FA 1986 were introduced to stop shearing arrangements in relation to certain carve out schemes over land. Hence the policy on such arrangements has clearly been altered by legislation and the effect of the GAAR in relation to such tax schemes must be considered in this light. However, this does not mean that all "carve out" arrangements have been stopped. The House of Lords has indicated that such arrangements are not necessarily against the policy behind the legislation and no legislative action has been taken in relation to other types of assets to stop such arrangements. The discounted gift scheme can be seen as a classic shearing operation which involves property other than land.

(ii) Do the means of achieving the substantive tax results involve one or more contrived or abnormal steps?

Creating two distinct funds or a carve out may be considered contrived.

(iii) Do the tax arrangements accord with established practice and has HMRC indicated its acceptance of that practice?

These arrangements accord with established practice. HMRC's manuals do not suggest that the GWR provisions should apply to a Discounted Gift Trust and confirm that the pre-owned assets regime does not apply. HMRC's Technical Note of May 2007 provides guidance on how the value transferred should be calculated. HMRC will challenge cases where this methodology is not adopted.

(e) Conclusions

Arguably, the Discounted Gift Trust contains a contrived step. It could be said that it is outside the "spirit" of the GWR rules in allowing the taxpayer to break up property into different fragments, some of which are gifted and some of which are kept. However, the House of Lords has held that carve out arrangements where the taxpayer has carefully defined what he has given away are not caught by the GWR rules and the Government has not sought to disturb this ruling in relation to assets other than land. In addition, the arrangements accord with established practice and so are not within the scope of the GAAR.

Conclusion

It is important to appreciate that the GAAR is designed to counteract the tax advantage which the abusive arrangements would otherwise (i.e. in the absence of the GAAR) achieve. This means that it will usually be necessary to determine whether the arrangements would achieve their tax avoiding purpose under the rest of the tax code (i.e. the non-GAAR tax rules), before considering whether the arrangements are "abusive" within the meaning of the GAAR.

Also, in many cases, the existing (non-GAAR) tax rules will be effective to defeat abusive tax arrangements, and so in such cases HMRC will not need to rely on the GAAR. However, there may be cases where abusive schemes would succeed in the absence of the GAAR, which is the very reason why the GAAR has been introduced.

The continued and increasing Government action against abusive tax avoidance schemes should serve to strengthen the position and attraction of the vast majority of the financial planning strategies being used by advisers for the benefit of their clients. Advisers should, as a result, seriously consider taking what is an excellent opportunity to communicate the benefits of informed financial planning.