It is not easy to work out whether gains from a non-resident company should be classed as income or capital within an offshore trust. International Investment looks at some key indicators of how such receipts should be classified
Many offshore structures include at least one non-resident company. Receipts received from these are not always easily identifiable as income or capital. In trust terms, understanding the nature of these receipts received is key to ensuring the receipt is dealt with in accordance with the terms of the trust.
In tax terms, understanding the nature of receipts from non-resident companies is important so that trustees can determine whether a receipt might be received as potentially taxable income.
The classification of receipts received from non-resident firms is governed by extensive case law. This clearly demonstrates that the form or mechanics of a transaction is a very important consideration in determining whether a receipt from a non-resident company is received as income or capital.
In the case of Hill vs Permanent Trustee Company of New South Wales, the Privy Council held that if a company sells most of its land and assets and ceases to carry on business and then declares a dividend of the capital profits, the dividend should be treated as an income receipt in the hands of the shareholder. The Privy Council decided that even though the substance of the transaction represented a return of capital reserves to the shareholders, the form the transaction took meant the receipt should be treated as income. In this case, the mechanics of the transaction was paramount.
Notwithstanding Hill, the mechanics of a transaction will not always be conclusive. For example in Re Lee (deceased) Sinclair vs Lee and another, in the Chancery Division, Hill was not followed. It was held that the principle any payment by a company to its shareholders except by way of an authorised reduction of capital was to be treated as a division of profits and income in nature was merely a guideline. The court held that "to apply this guideline and regard the transaction as a distribution of profits, akin to payment of a dividend in specie and hence income… would exalt company form over commercial substance to an unacceptable extent".
In the trust case Bouch vs Sproule, the directors of a company proposed to declare a bonus dividend, allot partly paid-up new shares to each shareholder and apply the bonus dividend in part payment of the new shares. The House of Lords held that the real nature of the transaction was that the firm did not pay or intend to pay any sum as dividend but intended to and did appropriate the undivided profits as an increase of the capital stock and, therefore, the bonus dividend was received as capital.
In the Court of Appeal tax case IRC vs Wright, the court held that where a firm declares a bonus out of undivided profits which it offers genuinely either in cash or in the form of bonus shares, the distribution is likely to be a capital one, particularly if the bonus shares are worth more than the nominal value of the cash alternative because the likelihood is that a shareholder would take the shares. The court found that the company had clearly intended to capitalise its accumulated profits.
It is clear that the company's intention was also of relevance to the question of whether a payment or a transfer from a non-resident company is an income or capital receipt.
The case law demonstrates that a court may be prepared to look beyond the mechanics used to achieve a transfer or payment made by a non-resident company and stress other factors. Of course, this causes uncertainty when planning transactions.
When classifying a receipt from a non-resident firm as income or capital, or when planning transactions involving non-resident firms, offshore trustees should consider the following:
• If a dividend is used in any part of the transaction the receipt may be income in nature. If the mechanics used are of a wholly capital nature, then the receipt should be capital in nature.
• If the non-resident company intends to capitalise profits, the receipt is probably capital in nature whatever form the transaction takes.
• Although the company law to which the non-resident firm is subject must be carefully considered, it should be possible to issue share capital so that such issue is received as capital.
• If it is desired that transfers or payments by a non-resident firm be received as capital, the issue of redeemable shares and debentures should be avoided because the possibility of repayment is not consistent with the transaction being capital in nature.
• Funding of new subsidiaries of a non-resident firm should be considered carefully, particularly if the plan is to avoid the generation of income.
• Trustees should not assume that just because a transfer or payment from a non-resident company is made by way of dividend that such transfer or payment will be received as income.
It can be difficult to work out whether receipts received from non-resident companies should be classed as income or capital
Whether it is capital or income is easy for UK resident companies, all set out in the Income and Corporate Taxes Act 1988
For non-UK companies it is governed by extensive case law, so far less clear cut.
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