As we approach the end of the tax year – and hopefully the start of spring – a lot of people will go into frantic mode as they discover that they may need to do some last minute tax planning.
It happens every year. In the next few weeks, expect your local friendly bank and other financial institutions to send you an invitation to invest in their ISA product, and even closer to the deadline, expect to see adverts telling you that you can even apply online. The things that our respected banks and building society do to get an honest crumb!
But one sort of tax planning actually depends on delaying, rather than acting early.
(This article can be downloaded in pdf format at Academia.edu.)
Suppose we have an individual, who we shall call Mr Grumpy, and suppose that this august person has a property that he wishes to sell to Mr Needy. Mr Grumpy doesn’t live in the property, so he can’t qualify for the principal private residence relief on capital gains.
The sale is due to take place towards the middle or possibly the end of March. Mr Grumpy will have a substantial capital gains tax (“CGT”) bill for the tax year 2012/13, which will not be covered by his annual allowance. This makes him grumpy – and he gets grumpier when his tax accountant tells him there is no way he can get out of this.
However, although the tax must be paid, he doesn’t have to pay it “immediately”. Normally tax incurred in the 2012/13 tax year has to be paid by the end of January 2014. But by some careful tax planning, Mr Grumpy can delay paying until the following year.
How does he do this? By using options
Or, more accurately, the answer should be “cross options”, as there are two of them.
Mr Grumpy and Mr Needy enter into an option arrangement whereby:
- Mr Grumpy – who wants to sell – grants Mr Needy an option to buy the property. In return:
- Mr Needy – who wants to buy – grants Mr Grumpy an option to sell him the property.
In both cases, the options have a limited period during which they can be exercised. Furthermore, neither option is exercisable until a specified date which shall be after 5 April 2013 – in other words, the options can only be exercised – and therefore, the property can only be sold during the following tax year.
There are in fact three CGT events:
- The granting of the cross options (two events); and
- The subsequent sale of the property.
We shall look at these in reverse order, beginning with the property sale, as this is the transaction that we – and Mr Grumpy – are most interested in.
How is the property taxed?
For CGT purposes, the disposal of property, or any other capital asset, is taken to be the date of the contract1. This is the case even if completion takes place at a later date. So in Mr Grumpy’s case, the contract is made when the option(s) are exercised, and as noted already, this cannot occur until the following tax year.
Note that the granting of the options does not constitute a disposal of the property. A contract of sale can only come into force upon exercise. Until that event occurs, there is no obligation on Mr Grumpy to transfer title and no obligation on Mr Needy to pay the purchase price.
It is true that the options do create a contract – but both parties are not binding themselves to a property sale. Instead, they are binding themselves to enter into a sale but only if the other party calls upon them to do so. If the options were to expire without being exercised at all, Mr Grumpy would remain the owner of the property and Mr Needy would keep his money – in these circumstances, there could never have been a contract of sale in the first place.
How are the options taxed?
However, the granting of the options does constitute a disposal for CGT purposes 2. The options themselves constitute assets and it is these assets, rather than the property, that are being disposed of. Does this mean there is an additional tax burden?
The short answer is no, provided the options are drafted correctly.
Firstly, when an option is exercised and property is sold, the CGT treatment of the option is simply subsumed under the property sale 3. In short, the grant of the option together with the sale contract are treated as a single transaction, and the purchase price for the property will include any consideration that was paid under the option contract.
This should mean that we don’t need to bother about the options. Note however, that in our scenario there are two options not one. It only takes one option to be exercised to bring into force the property sale. What about the other option?
For example, on 7 April 2013, Mr Needy writes to Mr Grumpy to tell him he wants to go ahead with the transaction. Mr Grumpy doesn’t need to exercise his option – is there a tax charge here?
Technically, there is a disposal, and perversely it falls on Mr Needy who actually granted the option to Mr Grumpy – the person granting the option is the one who has made a disposal. One doesn’t normally expect the buyer of property to pay capital gains tax! However, the amount is miniscule provided the options are drafted carefully.
It is important to avoid any wording that suggests that each option is granted in consideration for the other. In these circumstances the CGT calculation would have to take account of the option values. This brings a double headache, one of valuation and then a possible substantive tax charge.
All that is required is for the documentation to state that each option is granted upon the payment of £1 consideration. The CGT calculation will be based on this amount, which is nominal.
Hopefully Mr Grumpy will be a little less grumpy on hearing that he can defer his tax bill. On the other hand, some people are never satisfied!
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