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Cash basis persons rules – Are you aware of these changes?

The Taxation (Business Tax Measures) Act 2009 (enacted on 30 March) introduced a couple of fairly major changes to the cash basis person rules, which have gone relatively unnoticed by practitioners.  The Act was enacted ostensibly to provide a suite of tax relief measures for small to medium enterprises but carries both good and bad news in the cash basis persons sphere.

The good news is that the scope of “cash basis persons” has been broadened. Previously, only natural persons could qualify to account for their financial arrangements on a cash basis. This requirement has been removed.  Section EW 54 now allows any person and entity to be a cash basis person as long as the existing thresholds are met.  This change is likely to benefit small businesses that meet the thresholds because they would no longer be required to pay tax on financial arrangement income that they have not actually received.

The bad news, however, is that Inland Revenue has at the same time been given increased powers to prevent taxpayers from accessing the benefits of the cash basis regime.  Inland Revenue has always been able to void a person’s status as a cash basis person for a class of financial arrangements if the class had been structured and promoted to defer a tax liability.  But this power, which is contained in section EW 59, has now been extended to allow a taxpayer’s cash basis person status to be voided if the counterparty is an associated person who is not a cash basis person.

The latter change will be concerning for the large number of taxpayers who have entered into transactions meeting that description.  For example, it is common for an individual cash basis person shareholder to advance funds to a non cash basis company under a zero coupon note, giving rise to deductions for the company during the term of the arrangement as interest accrues with no corresponding income recognition to the shareholder until the interest is actually received at the end of the arrangement.  Assuming that the shareholder and the company in the example are associated, Inland Revenue will now be entitled to treat the shareholder as a non cash basis person.

This introduces an elevated level of uncertainty to what was previously a relatively clear area of the law.  Together with the increased scope of the associated persons rules once the Taxation (International Taxation, Life Insurance and Remedial Matters) Bill is passed, this change, which was introduced without consultation or comment, has scuppered a generally well understood and accepted tax planning tool for small businesses.  We suspect that many financial advisers are unaware of the change and it could prove a fertile ground for audit activity over the next few years.

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