The difference between the rules governing deductibility of expenses under ITTOIA - Essay Example

QUESTION 9 PAGES “The difference between the rules governing deductibility of expenses under ITTOIA 2005 on one hand and under ITEPA 2003 on the other is indefensible. Both rules should be replaced by the criterion of ‘reasonably incurred for the purposes of ........” Explain and discuss with reference to relevant authorities. Introduction A study traces that the subject on the deductibility of expenses incurred coming from income earned while taxable income is computed comes from the idea that the right to deduct is taken from the fact that it is not the receipts but the profits are taxed.1 This became a principle which was carried from the very early years of taxation laws to the present forms which incorporates the imposed restrictions under the “wholly and exclusively” rule. This rule is basically the gist of this paper as this is the evolution of the governing laws on deductibility of expenses from Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003) to Income Tax (Trading and Other Income) Act 2005 (ITTOIA 2005). The rules on deductibility of expenses differ greatly between the two acts. This is why the above adage came to being. A more reasonable expense rule is being sought after, especially by those most affected. This is what this paper will be exploring. Tax Deductibility of Expenses The section 34(1) of the ITTOIA 2005 provides, in reference to the deductibility of expenses based on trading income, that upon calculations of trade profits, deductions cannot be done on (a) expenses that are not incurred exclusively and wholly for trade purposes or (b) losses that were not due to the trade. This “wholly and exclusively” rule can also be found in income tax from employment. Basic Principles and Case Law Development The United Kingdom rules on the deductibility of business expenses are underscored by some principles which derived from statutory rules applied based on case laws. Basically, what this means is that only expenses that are entirely and proximately incurred in or connected with the aid of earning an income that is a business-oriented process would be liable to tax deduction if there is no prohibitions as provided for by public policy or applicable statutory rules. In the same manner, expenses that are not on revenue account and are capital in nature or those which are considered to be a profit distribution or division are not allowed.2 Several case laws exemplify the court approach with the task of setting out rules that underpins the application of principles that would determine the deductibility of expenses on business matters. The decisions taken from the Court of Appeals and the House of Lords have formed into 4 basic rules. Firstly, it should be established that the outlays, which are relevant, should have been incurred for the trade’s benefit, not that of the trader. Likewise, the question on whether or not the mentioned outlays were wholly incurred for trade purposes is a factual question based on court evidence. Secondly, during the determination of the court of taxpayer’s object in making the expense and at the time of the payment, it is not limited to any of the taxpayer’s conscious motives of the taxpayer. The court should however go further in examining the subjective intentions of the taxpayer in operating when the expenses were made. After considering significant consequences, not incidental ones, which are inextricably and inevitably involved in the expense, the court can now conclude whether or not the subjective intentions are the actual purpose of the expenditure made. Thirdly, it is the court’s right to differentiate Thirdly, the court may distinguish a supplemental secondary “object” of a certain expense that operates at the same time with a primary “object” from simple incidental “effect” of the expense, in that while the secondary “object’s” presence would have the dual purpose serve thus disqualifying the expense from deductibility, the incidental “effect’s” presence, as long as it is , provided it is significant, would be simply forfeited, not disqualified. Fourth and last, it should first be determined by the tribunal of fact what the principal purpose of the taxpayer is in making the expense. Once done, it should attribute business or personal motivations to the said purpose based on the analysis and conclusions brought about by the facts. What should be answered here is not whether the taxpayer intentionally sought to gain a business or personal advantage through expenditure but rather what his purpose is in making the expense. Tax Deductibility of Expenses of Economic Income In the taxation of employment income, the existing laws evolved from those originating from the Napoleonic wars.3 It went through various phases of changes until it arrived at the present income taxation regime. Certain provisions are incorporated in the taxation laws which refer to the deduction of expenses incurred during the employment of an employee, more particularly during the times when the employer is nor willing or not able to incur the said expenditures for their employee custom, trade usage or agreement between them. The rules which are relevant to such situation are found in the Income Tax (Earnings and Pensions) Act 20034 which basically provides that deductions are allowed at a certain amount taken from the earnings of the employee as long as the employee is obliged to gain and pay for said expense being the one employed and if said expense is gained wholly and exclusively, as well as necessarily, in the pursuit of his duties as an employee. The same type of deductions can also be allowed for expenses on travel if done in the line of duty as an employee. One common subject with regard to employment income tests is the so-called objective requirement of necessity. Not only should the expense be gained by the employee being the employment holder, not only should the expense be “wholly and exclusively” incurred while performing his job, it should be established that the expenses is gained or incurred necessarily in the employee’s performance of his work or as an attendance to anything his employment may necessitate. Such requirement renders the said employment income tests more rigorous that the old ones, which can lead to challenges and discrepancies to tax planning. While the existing case laws on the travelling expense requirement can be chequered, the interpretation of case laws, as well as the introduction of possible reforms may be necessary especially with the modern business practices and for the avoidance of tax-induced distortions on the decisions of management. It was being considered that the foundation of the “wholly and exclusively rule” may be traced back from the Income Tax Act of 1806. According to Tiley,5 the deductibility rule may have originated from the lack of an express prohibition, since the right to deduct has been assumed from the fact that it is coming from trade profit that are taxed, not receipts. The ruling has evolved into the present form as incorporated in the Income Tax (Trading & Other Income) Act 2005 providing for the deductibility of expenses rules, are those which are already mentioned above, i.e., the wholly and exclusively rule (a) and (b). Towards a reasonable rule: dissection and apportionment The complementary concepts of apportionment and dissection under the “but for” rule on reasonable business expenses are joined together in such a way that the expenses which are accurately attributed to be for purposes of the business could be deducted. Illustrations of how the rule s on dissection are provided by both statute 6 and case law.7 This effectively segregates identifiable but discrete aspects of personal expenses that are non-deductible from expenses that are for business purposes which are deductible. Dissection rules alone can however be of little help in the resolution of the great difficulties brought about by mixed-purpose expenditures. This is because a huge number of activities of individuals as well as associated expenditures are involved in both personal and business aspects simultaneously. As experts observed, many individuals enjoy their jobs but many are not fond of social occasions, especially those that are related to their work. However, many of said socials occasions, be it enjoyed or not, are good for achieving certain goals that are beneficial to the business.8 If the dissection rules as well as the apportionment rules are permitted, a more economically efficient and robust solution can be attained which can address the problems brought about by mixed-purpose expenditures. Conclusion This paper touched on the disadvantages of the gist of the ITTOIA 2005 and ITEPA 2003 Acts, also known as the all or nothing rule, otherwise referred to as the “wholly and exclusively” rule as applied to expenditure that would identify which ones are deductible for purposes of income tax. The current theories touching on economy give very useful insights into the deductibility rule formulations. With the United Kingdom context involving schedular taxation and legal precedents, there is no doubt that these approaches are not easily applied. However, it is argued that a ‘but for’ rule on reasonable business expenses, as applied on a sectoral basis would resolve these problems. Practical tools such as the apportionment and dissections rules can be used to handle the problems posed by mixed purpose expenditures which can result into economically efficient outcomes that the actual legal tests being done at present which are based on the distinctions between secondary objects and incidental effects of an outlay.9 Likewise, sectoral application may prove to be sensitive enough to distinguish between similar circumstances which needed varying deductibility rules applied to it, thereby avoiding difficult choices between the application of broader convenience tests or narrow legalism. Lastly, the “but for” rule for reasonable business expenses can very well evolve and develop, based on the changes in the workplace and with the current modern market. This rule can handle the problems and challenges brought about by contemporary commercial practices, e.g. telecommuting, “hot-desking”,10 business entertainment, corporate hospitality, etc. All these are done in a practical manner with the purpose of promoting economically advantageous results which facilitates, instead of impeding, economic activities of taxpayers. To achieve tax reform, the need for more in-depth analysis and research would be necessary mainly because the possibilities of undesirable results, e.g., losses should be carefully considered.11 To sum it all up based on the adage at the beginning of this paper, i.e., “the difference between the rules governing deductibility of expenses under ITTOIA 2005 on one hand and under ITEPA 2003 on the other is indefensible. Both rules should be replaced by the criterion of ‘reasonably incurred for the purposes of ........”, the two Acts are focused on two different items, namely, income taxation for the ITEPA 2003 and business taxation for the ITTOIA 2005. The focus is the rules on the deductibility of expenses. Both Acts make use of the “wholly and exclusively” rule which many find to be indefensible and unfair. This paper made the recommendations based on the UK context and which is considered to be a better and fairer ruling for the deductibility of expenses. QUESTION 2 (a) Samira and Orla purchased a house in London in 1983 for £85,000 and lived there until January 1991 when they went to live in Chicago because Orla was posted to work there. They stayed abroad until December 2003 and during that time they let their house to tenants. Samira and Orla returned to their London house in January 2004 and in 2005 they purchased a second house in Devon for £155,000 where they stay at weekends and for two weeks in the summer. They have now decided to sell both properties and retire to Spain. The London house is worth about £545,000 and the Devon house is worth around £270,000. Describe the capital gains tax consequences of the above events. Capital gains tax is the tax imposed on the profit gained when disposing or selling an asset. An asset is considered disposed if the owner ceases to own it. This can happen when the asset is sold, exchanged for something else, given away as gift or transferred to someone. In the case above, the two houses owned by Samira and Orla are assets that are to be disposed. This type of asset is a property. Generally, the selling of a property entitles the owner to “Private Residence Relief”. With this type of relief, there will no need to pay the Capital Gains Tax when the home is disposed of. However, this applies only if the home is lived in the whole time the owner owned it and considered it to be the main/only home. To work out the Private Residence Relief, it is necessary that the owner work out the period the home was owned, i.e., from the time it was bought to the day it was sold. The last 36 months will not be counted as it is considered to be a relief. This applied even during the times the owner did not live there. However, there are restrictions to the relief. In this case, the restriction that would apply would be the part wherein the owner let out the home. It is noteworthy that even if owners did not live in the house, they could still be entitled to the full relief if they cannot live in the house because the owner/s has to work outside of UK and it was the main home during those times. The law states, in cases of owners letting all or part of their home, that they cannot get the full amount of the Private Residence Relief when they sell the house but get another type of relief, i.e., “Letting Relief”. Under this relief, the maximum due that can be relieved is whichever is the lowest of £40,000, the amount of gain made on the letting of the home or the amount due if Private Residence Relief is applied. Given the above rules and the situation at hand, Samira and Orla should first declare which is the main home that would be granted relief. Owners of more than two homes can only get relief from one. It would be wise to choose the London home since it is the more expensive one and therefore, will fetch a higher amount of relief. Likewise, Samira and Orla did not live in the Devon time all the time they owned it since they are there only on weekends and several weeks during summer. Since they have not used the London/main house for 13 years but let it out during those times, they will not be able to get the full amount of the “Private Residence Relief”. They can instead get the “Letting Relief” or whichever is lower, as mentioned above. The rule on working out of UK cannot apply to them because they have gained profit out of the house by letting it during the time they were gone. As for the Devon house, they need to pay the full capital gains tax based on the price by which it was sold.12 (b) They have now decided to sell both properties and retire to Spain. The London house is worth about £545,000 and the Devon house is worth around £270,000. Although they will ship most of their furniture to Spain, they have decided to sell their small collection of 20 English watercolour paintings – they purchased the watercolours over a ten year period from 2001 for around £500 each and today each painting is worth an average of £2,750. Samira will also sell her prized first edition of ‘Captain Cook’s diaries’ which she purchased in 1980 for £5,000 and which is now valued at £200,000 and her collection of signed FA cup final programmes which she purchased in 2004 for £8,000 and is now worth £17,500. Describe the capital gains tax consequences of the above events. As already mentioned, Capital Gains Tax is a tax on the profit or gain you make when you sell or otherwise ‘dispose of’ an asset. Aside from real properties such as homes, other personal possessions necessitate the need to pay capital gains tax when sold. Paintings, antiques, jewellery, etc. are examples of such possessions. However, there are some rules that will relieve the owner from such tax. In this case, the relevant rule is that wherein personal possessions that are each priced at £6,000 or less during the time it was sold will not be liable for capital gains tax. Moreover, if the personal possession is owned jointly, which is the case in the situation at hand, each owner’s share of the sold possession would each be considered and if found to be £6,000 or less, then capital gain tax will not be imposed on it. Another rule that will be significant in the given situation is the one on “Sets of Possessions”. Under this, what is considered “set” are possessions that are complementary to each other and would be worth more if sold together than separately. If this is the case, the capital gains tax will be imposed on those set of personal possessions sold at an amount of the set that is more than £6,000. Given the aforementioned rules and with the situation at hand, Samira and Orla had to pay full capital gains tax based on the purchase price when they dispose of the “Captain Cook Diaries. With regard to the watercolour paintings, it is not clear if they are the types that complement each other or if they are worth a bigger amount if sold together. All that was mentioned was that all 20 are English watercolour paintings. Thus, under the assumption that they will fetch the same amount whether or not sold together, they will be relieved of capital gains tax based on the rule that their price is less than £6,000 individually. As for the signed FA cup final programmes, it is clear from the description that these are several programmes. However, selling them together will fetch a much higher price than if they are sold separately. Given that the present value is £17,500, it is assumed that it will be sold at that price or close to that price. Therefore, even if the joint ownership rule is applied, the amount is still liable for capital gains tax since it is more than £6,000. To sum it up, Samira and Orla had to pay full capital gains tax for the signed FA cup programmes and the Captain Cook Diaries. They however need not pay capital gains tax for the water colour paintings if sold individually.13 References Edgar, T. (1997) The Concept of Taxable Consumption and the Deductibility of Expenses under an Ideal Personal Income Tax Base, in R. Krever ed. Tax Conversations, Great Britain: Kluwer Law International, p. 300. Gazelle v Servini [1995] STC (SDC) 324. Income Tax (Earnings and Pensions) Act 2003. Income Tax (Trading and Other Income) Act 2005. John Tiley (2005) Revenue Law, 5th ed. (Hart Publishing: Oxford-Portland, Oregon), p. 417. Maas, R. W. (2005), Taxation of Employments, West Sussex: Tottel Publishing, pp. 97, 113-114. Mallalieu v Drummond [1983] STC 124, CA; [1983] STC 665, HL. Watkis (Inspector of Taxes) v Ashford Sparkes & Harward [1985] STC 451 at 468. www.hmrc.gov.uk Read More