THE TAXATION OF

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					                  The Association of Investment Trust Companies

                          THE TAXATION OF
                  INVESTMENT TRUST COMPANIES (‘ITCs’)


Section   Topic

  1       The General Scheme of Taxation

  2       Approval as ITC

  3       The Close Company Test

  4       The UK Residence Test

  5       The Income Test

  5.1     Income
  5.2     Wholly or Mainly
  5.3     Eligible Investment Income
  5.4     Security
  5.5     Table - Income from / not from Shares and Securities
  5.6     Eligible Rental Income

  6       The Investment Test

  6.1     Introduction
  6.2     Holding
  6.3     Value
  6.4     Investments
  6.5     Exceptions

  7       The Share Capital Test

  7.1     Ordinary Share Capital
  7.2     Listed

  8       The Distribution of Surpluses Test

  9       The Retention Test

  9.1     Income v Retained Income
  9.2     Relaxation of the Test


   1 THE GENERAL SCHEME OF TAXATION
1.1    ITCs are companies and therefore, subject to specific provisions to the contrary, all
       corporate tax legislation applies to them.

1.2    The main areas of corporate tax legislation which do not apply to ITCs by virtue of a
       specific provision are:

                      a)     Exchange Gains and Losses1
                      b)     Currency Contracts and Options2

1.3    The main areas of corporate tax legislation that apply only to ITCs are:

                      a)     Approval as Investment Trust3
                      b)     Loan Relationships : Investment Trusts4

1.4    In addition to those areas mentioned in 1.2 above, the majority of TCGA 1992 does
       not apply to ITCs by virtue of their exemption from tax on chargeable gains. 5

2      APPROVAL AS ITC

2.1    The most significant piece of tax legislation relating to ITCs is s842 ICTA 1988,
       which deals with the conditions that a company must meet to obtain approval as an
       ITC and therefore obtain its exemption from tax on chargeable gains.

2.2    In order to be approved as an investment trust a company must pass seven tests for the
       accounting period concerned. In brief these are that:

           a) The company is not a close company („The Close Company Test‟).

           b) The company is resident in the UK („The UK Residence Test‟).

           c) The company‟s income consists wholly or mainly of eligible
              investment income („The Income Test‟).

           d) No holding in a company represents more than 15% by value of the
              investing company‟s investments („The Investment Test‟).

           e) The company‟s ordinary share capital is listed on the London Stock
              Exchange („The Share Capital Test‟).



1
  s152(4) ICTA 1988
2
  s154(3) ICTA 1988
3
  s842 ICTA 1988
4
  Sch 10 FA 1996
5
  s100(1) TCGA 1992



                                              2
            f) The distribution as dividend of surpluses arising from the realisation of
               investments is prohibited by the company‟s Memorandum or Articles
               of Association („The Distribution of Surpluses Test‟).

            g) The company does not retain more than 15% of its eligible investment
               income („The Retention Test‟).

2.3     It is important to appreciate that Tests 1,2,4,5 and 6 must be complied with throughout    Comment [HW1]:
        the accounting period concerned and that to breach any of them, even for one day,
        would strictly mean that approval should not be given. The nature of tests 3 and 7
        mean that they can only be applied after the end of the accounting period concerned.

2.4     Each of the seven tests are now considered in more detail.

3       THE CLOSE COMPANY TEST

3.1     The rules regarding close company status are extremely complicated. However, it is
        extremely unlikely that a „normal‟ ITC could breach this test owing to the requirement
        for the company‟s shares to be listed on the London Stock Exchange.

3.2     In brief, for a company to be a close company it must be under the „control‟ of five or
        fewer „participators‟ (i.e. shareholders, although the definition is actually much
        broader), or any number of participators who are directors.6 Although the definition
        of control7 is also extremely broad it is difficult to see how, except under exceptional
        circumstances, this could be the case for an ITC, being a publicly quoted company.

3.3     In addition, even in the very unlikely event that an ITC were a close company, its
        quoted company status might mean that it would not be treated as a close company
        due to a specific exemption for quoted companies.8

3.4     The combination of the above rules means that the close company test is unlikely to
        be a major issue.

4       THE UK RESIDENCE TEST

4.1     A company will be treated as UK resident for tax purposes if:

                a)     it is UK incorporated;9 or

                b)     it is „centrally managed and controlled‟ in the UK.




6
  s414(1) ICTA 1988
7
  s416 ICTA 1988
8
  s415 ICTA 1988
9
  s66(1) FA 1988



                                               3
4.2       The question of what constitutes central management and control is beyond the scope
          of this article but an ITC is likely to be treated as resident in the UK if that is where
          the Board Meetings of the company are held.10

4.3       As a result, it is possible for an overseas incorporated company to obtain approval as
          an ITC by moving its central management and control to the UK and thereby
          becoming UK resident for tax purposes. Although this means that the company would
          become subject to UK corporation tax, it has the advantage that the company would
          then have access to one of the largest range of double tax treaties in the world and
          therefore benefit from a lower rate of withholding tax on the dividends it receives
          from overseas companies.

5         THE INCOME TEST

          The legislation requires that:

                  „the company‟s income is wholly or mainly from eligible investment
                  income.‟11

5.1       Income

5.1.1     The Inland Revenue‟s view is that „income‟ is gross statutory income (computed on
          normal taxation principles), including the amount of tax credit on franked investment
          income, before the deduction of management expenses, charges, income tax,
          corporation tax and before the granting of any tax relief, including double tax relief.

5.2       Wholly or mainly

5.2.1     „Wholly or mainly‟ is interpreted by the Inland Revenue as being greater than 70%.
          This is reduced to greater than 50% in a new ITC‟s first accounting period. It should
          be noted that this concession only applies to a company‟s first accounting period (not
          the first period it applies for approval as an ITC), as it is aimed at the difficulties faced
          by newly formed ITCs where delays may occur between the raising of capital and the
          investment of funds. In such circumstances an ITC often puts most of the subscription
          monies on deposit pending investment, which generates income not from shares and
          securities.

5.2.2     In certain circumstances, an ITC can obtain approval if eligible investment income
          falls slightly short of 70% and the circumstances which gave rise to the test being
          breached are unusual and unlikely to continue. However, this is very much at the
          discretion of the Inland Revenue.


5.3       Eligible Investment Income

10
     SP 1/90
11
     s842(1)(a) ICTA 1988



                                                   4
5.3.1     Eligible investment income means either:

                  a)        income from shares and securities; or

                  b)        eligible rental income.12

5.4       Security

5.4.1     There is no precise definition of the term security. However, the Inland Revenue have
          agreed with the AITC that the definition in s132 TCGA 1992 will apply. This states
          that:

                  „“security” includes any loan stock or similar security whether of the
                  Government of the United Kingdom or of any other government, or of
                  any public or local authority in the United Kingdom, or elsewhere, or
                  of any company, and whether secured or unsecured.‟13

5.4.2     The question as to what constitutes a „similar security‟ has been addressed in a
          number of cases. Some of the factors that have been considered relevant in case law
          are:

              a) The debt must have the characteristics of a marketable security, and it
                 should be capable of being marketed, sold or assigned.

              b) It must be in the nature of an investment (i.e. a debt whose value
                 fluctuates in accordance with interest rates and one which has an active
                 and readily available market on which it can be traded).

              c) It need not be a secured debt.

              d) Interest should be payable to the lender (or at least the terms of the
                 debt must be such that it is capable of being held as an investment -
                 e.g. it would be so if it were issued at a discount or repayable at a
                 premium).

              e) There should be stated terms of repayment of the debt.

              f) The debt should be for a specified amount and for a defined term.

              g) The debt should be capable of being issued or subscribed for.

5.4.3     Notwithstanding the above general principles, case law has indicated that there are no
          hard and fast rules as to what constitutes a security and that the term has no precise

12
     s842(1AA)
13
     s132(3)(b) TCGA 1992



                                                   5
        meaning. The Inland Revenue, however, have indicated that they believe „that the
        term security implies a degree of permanence in the investment in question.‟

5.5     Income from / not from Shares and Securities

5.5.1   The table below summarises what qualifies as income from shares and securities and
        what does not:

        Income from Shares and Securities              Income not from Shares and Securities

        Dividends                                      Bank deposit interest
        Gilt interest                                  Certificate of Deposit interest
        UK Treasury Bill income                        Short-term local authority loan interest
        Loan stock interest                            Trading profits on futures and options
        Distributions by authorised unit trusts        contracts
        Some overseas scrip dividends                  Underwriting commission
        Non-trading profits on interest rate           UK scrip dividends
        and debt contracts                             Sterling Commercial Paper

        Foreign Treasury Bills vary according to the terms under which they are issued (for
        example, US Treasury Bills are accepted to be securities, but Australian Treasury Bills
        are not.)

5.6     Eligible Rental Income

5.6.1   Eligible rental income was included within the definition of eligible investment
        income in order to allow approval for Housing Investment Trusts („HITs‟). Although
        it is anticipated that HITs‟ eligible investment income will be almost exclusively
        eligible rental income and that other ITCs‟ eligible investment income will be almost
        exclusively income from shares and securities, there is nothing in the legislation to
        prevent an ITC having a mixture of both.

5.6.2   Eligible rental income is defined as rents or other receipts deriving from the letting of
        „eligible properties‟. Where an ITC has eligible rental income, the rate of corporation
        tax chargeable on this income (less allowable expenses) is set at the small companies
        rate (currently 21%).

5.6.3   Eligible properties are residential properties in which the ITC first acquires its interest
        after 31 March 1996 and which are subsequently let on assured tenancies providing:

               a)      the ITC‟s interest is either a freehold interest or an interest
                       under a long lease at low rent;

               b)      each property is unlet or let on an assured shorthold tenancy
                       when acquired;




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                  c)        each property has not cost the ITC more than £125,000 in
                            Greater London and £85,000 elsewhere; and

                  d)        the ITC has not made any arrangement for letting the property
                            when it acquires its interest.

6         THE INVESTMENT TEST

6.1       Introduction

6.1.1     The investment test is the most complicated of the investment trust tests due to the
          existence of various anti-avoidance rules that exist relating to groups (which will be
          dealt with in a later session). Whilst investment trusts do occasionally fail to obtain
          approval for other reasons (e.g. the income test), the fact remains that the investment
          test holds the most traps for the unwary. Unlike the income test, where it is
          sometimes possible to identify a problem before the end of the accounting period and
          take corrective action (e.g. by purchasing shares close to their pay dates) the
          investment test, once breached, would strictly mean that approval should not be given
          for the accounting period concerned.

6.1.2     The legislation requires that:

                  „no holding in a company, other than in an investment trust or a
                  company which would qualify as an investment trust but for [the
                  ordinary share capital test], represents more than 15 per cent by value
                  of the investing company‟s investments;‟14

6.1.3     It is important to note that the restriction only applies to holdings in a company.
          Therefore an ITC can hold an unlimited amount of gilts, local authority stock etc.

6.1.4     Put simply, in order to test whether the investment test has been breached one has to
          calculate the value of the ITC‟s largest „holding‟ in a company, divide it by the total
          value of all its „investments‟ and see whether this is greater than 15%.

6.2       Holding

6.2.1 „Holding‟ is defined as:

                  „the shares or securities (whether of one class or more than one class)
                  held in any one company;‟15

6.2.2     As a result it is necessary to aggregate the value of all the shares and securities in a
          company to arrive at the value of the holding in the company.


14
     s842(1)(b) ICTA 1988
15
     s842(3)(a) ICTA 1988



                                                  7
6.3        Value

6.3.1      In practice, in the case of quoted investments, stock market values can be taken.
           Where unquoted investments are concerned, the Inland Revenue will normally accept
           directors‟ valuations, although the Inland Revenue reserve the right to consult Share
           Valuation Division if necessary.

6.4        Investments

6.4.1      The term investments is understood to mean all assets capable of producing income.
           This would mean that interest bearing bank deposits would constitute an investment
           but current accounts would not. Similarly, it is assumed that interest-bearing
           intercompany loans are investments but interest-free intercompany loans are not. For
           similar reasons, property owned for the purposes of generating rental income would
           be an investment, whereas property occupied by the ITC for the purposes of its
           investment business would not.

6.5        Exceptions

6.5.1      The normal 15% by value test is subject to two exceptions.

6.5.2      The first, as stated above (6.1.2), is where the holding is in another ITC, in which case
           no limit applies. This exception also applies to a company which would have been
           able to obtain approval but for the ordinary share capital test. The Inland Revenue
           accept that holdings in authorised unit trusts can fall into this exception, even though
           authorised unit trusts are not strictly companies.

6.5.3      The second exception applies:

                   „to a holding in a company which, when it was acquired, represented
                   not more than 15 per cent by value of the investing company‟s
                   investments.....so long as no addition is made to the holding.‟ 16

6.5.4      This is important because it means that, providing the investment test is met when the
           holding is acquired, the ITC does not need to be concerned about any future increases
           in value of the holding, providing it is not added to. This exception applies even if
           the company was not an ITC at the time when the holding was acquired.



7          THE SHARE CAPITAL TEST

           The legislation requires:



16
     s842(2)(b) ICTA 1988 et seq



                                                   8
                   „that the shares making up the company‟s ordinary share capital (or,
                   if there are such shares of more than one class, those of each class) are
                   listed in the Official List of the Stock Exchange;‟17

7.1       Ordinary Share Capital

7.1.1     Ordinary share capital is defined as:

                   „all the issued share capital (by whatever name called) of the company,
                   other than capital the holders of which have a right to dividend at a
                   fixed rate but have no other right to share in the profits of the
                   company;18

7.1.2     As a result, it is possible for an ITC to have some classes of share capital (e.g. fixed
          rate preference shares) which are not listed.

7.2       Listed

7.2.1     Prior to FA 1996, the test referred to shares having to be „quoted on‟ the Stock
          Exchange rather being „listed in the official list‟. The requirement to be „quoted‟ did
          cause some ITCs problems at the beginning and end of the company‟s life. As a
          result, there were a couple of concessions relating to the quotation test which it is
          assumed still apply.

7.2.2     First, for an ITC‟s first accounting period, providing the company‟s shares are quoted
          within one month of the beginning of the accounting period (or if the company was a
          private company which has converted into a public company, within one month of the
          commencement of the company‟s first accounting period following conversion), it
          will be treated as if the shares have been quoted for the whole period. This
          concession was introduced to deal with the delay between the company receiving the
          subscription monies and the day the shares actually became quoted.

7.2.3     The second concession relates to an ITC in liquidation. A quoted company going into
          liquidation normally loses its quotation when the liquidator is appointed. In practice,
          the Revenue are prepared to continue the exemption from chargeable gains during
          liquidation, providing the assets are disposed of while the ordinary share capital is
          still listed and the other tests are met. Disposals after the shares are removed from the
          Official List would be subject to tax on chargeable gains. Although FA 1996 has
          brought the legislation more into line with this concession, the concession is still
          relevant as, strictly, the listing would have to be retained for the first twelve months of
          liquidation in order to meet the test, which may not be the case.

8         THE DISTRIBUTION OF SURPLUSES TEST


17
     s842(1)(c) ICTA 1988
18
     s832(1) ICTA 1988



                                                   9
          The legislation requires that:

                  „the distribution as dividend of surpluses arising from the realisation of
                  investments is prohibited by the company‟s memorandum or articles of
                  association;‟19

8.1       The Revenue have confirmed that their practice as regards this test is only to examine
          the Memorandum or Articles to ensure that the necessary prohibition exists. The
          question of whether there has been any actual breach of this prohibition in the
          accounting period is a matter of company law, not taxation law, and is therefore
          irrelevant for the purposes of the test. Such a breach would not cause the ITC to fail
          the test.

9         THE RETENTION TEST

          The legislation requires that:

                  „the company does not retain in respect of any accounting period more
                  than 15 per cent of its eligible investment income.‟20

9.1       Income v Retained Income

9.1.1     Ignoring eligible rental income, the Revenue‟s position with regard to the application
          of the retention test is that it is necessary to compare an ITC‟s „income‟ from shares
          and securities with „retained income‟. If the amount retained is greater than 15% of
          the income from shares and securities then the ITC will have failed the test.

9.1.2     „Income‟, for the purposes of the retention test, generally has the same meaning as for
          the income test (i.e. gross statutory income before deducting expenses etc.). It is
          therefore a tax based measure.

9.1.3     „Retained income‟, however, is regarded by the Revenue as the amount shown as
          retained in the accounts, being the increase over the accounting period in the amount
          of the unappropriated profits before any transfers to or from reserves but after
          allowing for proper provision for liabilities. It is therefore an accounts based
          measure.

9.1.4     The Revenue have stated in the past that, for an accounts based measure of retained
          income to apply, the accounts must have been prepared under normal accounting
          principles which have been consistently applied (subject to legitimate changes, such
          as when required in order to comply with the SORP). They have also stated that they
          will not normally query any provision for corporation tax or ACT written off as
          irrecoverable in the accounts. As ITCs are likely to be complying with the SORP, the
          accounts measure of retained income should be used.

19
     s842(1)(d) ICTA 1988
20
     s842(1)(e) ICTA 1988



                                                  10
9.2     Relaxation of the Test

9.2.1   The retention test is relaxed in two circumstances. The first is that the retention test
        will be treated as being met if the amount that the company would be required to
        distribute in order to meet the test is less than £10,000 or, if the accounting period is
        less than 12 months, a proportionately reduced amount.21

9.2.2   The second is where the company is required to retain income by virtue of a
        restriction imposed by law (e.g. because the revenue account at the end of the
        previous accounting period stood at a deficit and the current year‟s net income is
        required to make good that deficit) and the amount that is retained is greater than 15%
        of the company‟s income from shares and securities.22

9.2.3   The second relaxation does not apply where the amount of income actually retained
        exceeds the amount required to be retained by virtue of a restriction imposed by law
        and the amount of the excess, plus any distributions made during the period, is greater
        than £10,000, or a proportionately reduced amount.23




21
   s842(2C) ICTA 1988
22
   s842 (2A) ICTA 1988
23
   s842(2B) ICTA 1988



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