No Sunshine in Cyprus

HMRC issue warning over CGT avoidance scheme

HMRC have issued a warning to taxpayers not to use an avoidance scheme which takes advantage of Capital Gains Tax Entrepreneurs’ Relief (ER), that turns income into a capital again thereby avoiding income tax and NIC.

How the scheme works

The scheme works in three stages:

1. An individual sells their beneficial ownership in their company, e.g a PSC, to a Cypriot entity and takes up employment with that same Cypriot organisation.
2. The individual remains a director of their company and the company continues to invoice for their services even though their employment is now with a company in Cyprus.
3. Promoters of the scheme claim the monthly payments the individual receives, in return for their work via the UK company which are capital in nature and therefore qualify for ER taxable at 10%, rather than being employment income subject to income tax and NIC.

Why doesn’t it work?

Whilst HMRC believes the scheme fails, unsurprisingly they fail to explain why, apart from considering it to be highly contrived.  The promoters say the scheme is legal as it is a simple business transaction but the Revenue argue otherwise, as it involves a number of artificial steps that are common in tax avoidance schemes.

Without knowing the mechanics of this scheme it is likely that HMRC’s dislike for it concerns the valuation of the disposal of the company shares and future consideration, ie the monthly fees described at (3) above. These monthly fees are likely to be what is known as ‘earn-outs’.

An earn-out is an expression that is used to describe a deal that involves ‘contingent variable’ consideration. The value of the right to receive the earn-out is taxed as part of the initial sale consideration so it is logical to be as realistic as possible about the future fees to be paid to the individual as they qualify for ER. Any subsequent earn-out gains are taxed at normal CGT rates so it is better to have as much of the fees as possible included in the initial valuation so as to take advantage of ER and a CGT rate of only 10%.

Substantiating the earn-out valuation will require reaching agreement with HMRC and herein may well lie the stumbling block, as HMRC are highly unlikely to accept that there is any future consideration to be had but rather employment income. The Revenue have already said that anyone using this scheme will have their tax return enquired into and that they will seek full payment of the tax due plus interest and penalties, where appropriate. An investigation into their tax affairs may even take place before the submission of the tax return.

The guidance forms part of HMRC’s Spotlights and can be found here, ‘Capital Gains Tax: Entrepreneurs’ Relief tax avoidance scheme’.