Second Exposure Draft - Savings and Investment Income of Individuals: Chapter 6.6

1. This chapter reworks the bulk of the provisions in Schedule 13 Finance Act 1996. Introduced by section 102 Finance Act 1996, and not amended since enactment, Schedule 13 is an almost self-contained block of legislation dealing with "Discounted securities: income tax provisions". It was intended to be a simplification of earlier legislation, itself not very old, covering a variety of charges to tax.

2. Before Schedule 13 Finance Act 1996, the income tax rules and corporation tax rules for discounted securities were dealt with together. Consequently, rules for individual taxpayers were entwined with matters affecting corporate taxpayers. They were therefore more complex than they needed to be for individuals. As part of the major changes made in the corporate field in 1996, with the introduction of the loan relationship rules, Schedule 13 Finance Act 1996 detached and simplified the income tax rules.

3. The old (that is, pre-Finance Act 1996) legislation covered

• deep discount securities - section 57 and Schedule 4;

• deep gains securities - section 94 and Schedule 11 Finance Act 1989;

• qualifying indexed securities - paragraph 2 Schedule 11 Finance Act 1989; and

• qualifying convertible securities - section 56 and Schedule 10 Finance Act 1990.

4. Schedule 13 Finance Act 1996 sought to create one homogeneous income tax regime for all the main types of security which could be said to involve deep discount-type transactions. It therefore covers deep discounts, deep gains, convertible securities and some indexed securities. As the income tax charge covers the whole profit on the transaction, discounted securities are outside the capital gains tax regime - sections 115(1) and 117(2AA) Taxation of Chargeable Gains Act 1992. Certain indexed securities, however, remain outside Schedule 13 (paragraph 3(2)(c) Schedule 13 Finance Act 1996) and these are within the capital gains tax regime.

5. Schedule 13 brought all the income tax rules together in one place and reduced over 60 pages of (sometimes tortuous) legislation to a mere eight. It also introduced new rules for "strips" of gilt-edged securities and a new relief against other income for losses sustained on discounted securities.

6. The legislation is well constructed. It starts with the charge to tax on a profit, provides relief for a loss, defines the key terms, and then moves on to some special cases. That is logical enough. Nevertheless, we have reordered the provisions to reflect our general approach to structure, grouping clauses dealing with related matters together. For example, the basic definition of "relevant discounted securities" is currently in paragraph 3. But the rules for "securities issued in separate tranches" and "excluded indexed securities" are in paragraphs 10 and 13, respectively, even though they are effectively part of that definition. In rewriting these provisions we have grouped them together under the heading "Deep gain securities".

7. As we are concerned at present only with the savings and investment income of individuals we have not rewritten provisions which relate to other persons such as pension funds. (Paragraphs 6 and 7 Schedule 13 Finance Act 1996).

8. In the commentary on this chapter, statutory references are to Schedule 13 Finance Act 1996 unless otherwise stated.

1. This clause sets out the charge to income tax right at the beginning of the chapter. It relates to the profit from "disposals of deep gain securities".

2. Currently, paragraph 1(1) of Schedule 13 Finance Act 1996 provides a specific charge to income tax under which "the profit from the discount on a relevant discounted security" is charged to income tax under Schedule D Case III or, where the profit comes from "a security out of the United Kingdom", under Schedule D Case IV. As our present plans envisage a separate block of provisions for foreign income we have reproduced only the Schedule D Case III charge here.

3. Although Schedule 13 refers to a "relevant discounted security", we have chosen the term "deep gain" security rather than, say, "discounted" security. This seems a more appropriate term to reflect both the nature of the security and the nature of the tax charge.

4. As explained in the introductory commentary on this chapter, Schedule 13 Finance Act 1996 covers deep discounts, deep gains, convertible securities and some indexed securities. Such securities may be issued "at a discount" to their par value, but that is not always the case. The main test to identify securities within the scope of the legislation compares the amount payable on redemption with the issue price of the security to see whether, under its terms of issue, it is capable of yielding a "deep gain" on redemption (paragraph 3(1)). The gain may therefore comprise a discount or a premium. A gain is "deep" if the amount payable on redemption could exceed the issue price by more than a specified percentage (paragraph 3(3) and (4)).

5. The profits charged to tax by Schedule 13 Finance Act 1996 relate to the gain made when the security ceases (for whatever reason) to be owned or, in certain circumstances, is treated as ceasing to be owned.

6. Subsection (2) provides that profits from disposals of certain securities are exempt from income tax.

1. This clause determines the basis of assessment and the person chargeable to income tax for the purposes of this chapter.

2. Based on paragraph 1(1) and (3), subsections (1) and (2) provide that the amount of profits from disposals of deep gain securities to be taxed in any year is the full amount of any profits arising from disposals made in the tax year. Subsection (3) is a signpost to rules to determine the tax year in which certain disposals are made.

3. Subsection (4) provides that the person chargeable to income tax is the person making the disposal. Subsection (5) is a signpost to rules to determine the person who is treated as making the disposal in certain situations.

1. This clause defines "deep gain security" for the purposes of Chapter 6.6. It is based on the definition of "relevant discounted security" in paragraph 3, but we have left out sub-paragraph (2) which list securities which are not relevant discounted securities.

2. The main test to identify relevant discounted securities is currently spread over paragraph 3(1), (3) and (4). The test compares the amount payable on redemption with the issue price of the security to see whether, under its terms of issue, it is capable of yielding a "deep gain" on redemption. In subsection (1) we have managed to distil it down to a single subsection.

3. A security is capable of yielding a "deep gain" if the amount payable on redemption could exceed the issue price by more than a specified percentage of the amount payable on redemption. In the rare case where the security has an expected life of 30 years or more, the percentage specified is 15%. In all other cases the percentage specified is equal to half the number of years between the date of issue and the date of redemption.

4. Put another way, a deep gain occurs where the amount payable on redemption could exceed the issue price and the potential difference amounts to more than ½% of the amount payable on redemption for each year of the security's life. For example, a five year bond issued for £90 and redeemable for £100 is a deep gain security because the gain of 10% is more than the specified 2½% (that is, ½% for each year of the bond's life).

5. There are many ways in which this can be expressed algebraically. Subsection (1) shows our choice but two other possibilities are

6. Which formula is most helpful?

7. Subsection (2) provides more information about the term "redemption". Where a security is redeemable at the holder's option, paragraph 3(5)(b) says that references to redemption "shall have effect as references to the earliest occasion on which the holder may require the security to be redeemed". In practice, "may" is read as "will" as the Inland Revenue policy is to apply the "deep gain" test by reference to the time when the security would normally be redeemed, not a time when it might be redeemed. Published guidance explains the situation.

"Securities normally contain clauses allowing the holder to seek redemption in the event of unexpected changes in the status of the issuer which could affect the security of the instrument. These are often described as "events of default". In practice we would consider standard "events of default" as being too remote to be occasions of redemption when looking at the provisions on relevant discounted securities. Rather, in deciding whether a bond was issued at a deep gain, we look at the date of redemption when the holder would expect the bond to be redeemed if it runs its expected course." (IM 1539a)

8. We have rewritten paragraph 3(5)(b) to take account of this practice. This is a change to the law but not to the policy. It is a minor change, always likely to operate in the taxpayer's favour.

9. Subsection (3) ensures that any interest which will be due when the security is redeemed is not treated as part of "the amount payable on redemption" in applying the "deep gain" test. It is derived from paragraph 3(6).

10. Subsection (4) defines "redemption period" for the purpose of the deep gain test. It explains how to deal with periods between the date of issue and the date of redemption which are not an exact number of years. This is based on the full out words in paragraph 3(4).

11. Where securities issued under a single prospectus are issued in tranches the current legislation provides, through paragraphs 3(2)(f) and 10, that either all the securities are treated as relevant discounted securities or none of them is. Subsection (5) is a signpost to those special rules.

12. Subsection (6) is a signpost to the list of securities which are not deep gain securities and a provision which extends the meaning of the term to include a strip of a gilt-edged security.

1. This clause contains the special rules for determining whether or not securities issued in tranches under a single prospectus are deep gain securities. Although these rules are effectively part of the current definition of relevant discounted security in paragraph 3 they are largely to be found in paragraph 10.

2. We have put these rules in a single clause adjacent to the provisions setting out the meaning of the term deep gain security (which include an appropriate signpost).

3. Broadly, where securities are issued in tranches under a single prospectus, either all of them are treated as deep gain securities or none of them is. There are two rules.

4. The first rule in subsection (2) derives from paragraph 3(2)(f). If any of the securities issued under a prospectus are not deep gain securities within the terms of 6.6.3 any securities issued subsequently will not be deep gain securities, even if they would be deep gain securities under the terms of 6.6.3.

5. The second rule in subsection (3) derives from paragraph 10. As a consequence of the first rule, where none of the original issue of securities under the prospectus is a deep gain security under the terms of 6.6.3, no security issued under that prospectus can be a deep gain security. The second rule, however, provides that if a particular condition is fulfilled all the securities issued under the prospectus will be treated, for the purposes of any acquisition or disposal, as if they were deep gain securities when they were acquired. And this applies even if the securities are not deep gain securities within the terms of 6.6.3 or are not deep gain securities because of the application of the first rule.

6. The condition mentioned in the previous paragraph is set out in subsection (4). It is that the aggregate nominal value of securities issued after the original issue (which would be deep gain securities, but for the operation of the first rule) comes to exceed the aggregate nominal value of all the other securities issued under the prospectus up to that time.

7. Once that condition is satisfied not only are securities already issued effectively recharacterised but all securities issued under the prospectus subsequently will also be deep gain securities.

8. In subsection (2) we have not rewritten the words "(disregarding that paragraph)" from paragraph 3(2)(f). They conflict with the words "subject to paragraph 10" at the beginning of paragraph 3(2)(f) which are clearly intended to prevail. Removing this unnecessary material is a change in the law. It will not affect anyone's tax liability.

1. This clause excludes certain specified securities from the scope of the general definition of deep gain security in 6.6.3.

2. In the current legislation, a list of securities which are not relevant discounted securities occurs right in the middle of defining what the term "relevant discounted security" means. We considered this list would be better put elsewhere, so we have put it in a separate clause. This both takes it out of the way of the definition of deep gain security and, with the aid of the signpost in 6.6.3(6), makes it easier to find.

3. One particular type of security excluded from the scope of the general definition in 6.6.3 is "excluded indexed securities". There is a signpost to the definition of this type of security.

1. Under the current legislation certain index-linked securities are excluded from the scope of the general definition in paragraph 3 and are not relevant discounted securities. These "excluded indexed securities" are currently defined in paragraph 13, some distance from the general definition of relevant discounted security. We have rewritten the provision as 6.6.6 and put it close to the general definition of deep gain security in 6.6.3.

2. Subsection (1) explains that a security is excluded if the amount payable on redemption depends on any future change in the value of certain assets or on the change in an index of the value of certain assets. Some such securities provide for a certain level of return to be guaranteed even if the value of the assets (or the index) does not increase by that amount or, indeed, decreases. A provision of that sort strictly means that the security cannot be an excluded indexed security. However, such a provision is disregarded so long as the guaranteed amount payable on redemption does not exceed the issue price by more than 10% of that price.

3. Subsection (2) defines "redemption period" for the purpose of this test. The definition differs from the one for the deep gain security test in 6.6.3(4) to allow flexibility for the chargeable assets referred to in subsection (1) to be valued on dates other than, but close to, the issue and redemption dates. Likewise, an index of the value of chargeable assets may not be computed for the actual issue and redemption dates and some approximation is required. This provision is based on paragraph 13(4).

4. Subsection (3) defines "chargeable asset" for the purpose of this test. The underlying premise is that where any disposals of assets would be within the scope of capital gains tax, then disposals of securities fully linked to the value of such assets should also be subject to capital gains tax and the securities excluded from the income tax regime.

5. In the current legislation a "chargeable asset" is defined, at paragraph 13(6), as an asset which on disposal can give rise to a chargeable gain for the purposes of the Taxation of Chargeable Gains Act 1992. In order to make this test work it is necessary to make some assumptions about the asset and these are set out in paragraph 13(7)(a) to (c). The legislation is rather complicated and difficult to follow. Under the Taxation of Chargeable Gains Act 1992 the disposal of any asset can give rise to a chargeable gain and it looks as though the only assumption required is the one in paragraph 7(c). We are therefore dropping the assumptions in paragraph 7(a) and (b). This change removes unnecessary material. It will not affect anyone's liability to income tax.

6. Subsection (4) prevents the retail prices index (RPI) and any similar index from being an index of the value of chargeable assets.

1. This clause defines the events giving rise to the income tax charge (or loss relief) relating to deep gain securities.

2. The current charge to income tax applies where someone "transfers" a relevant discounted security or "becomes entitled ... to any amount on its redemption" (paragraph 1(2)) and a profit is realised. Similarly, loss relief is available where those circumstances occur (paragraph 2(2)) and a loss is sustained. There are then provisions about the meaning of "transfer" (paragraph 4) and about "redemption" including the conversion of the security into shares or other securities (paragraph 5), as well as several provisions deeming transfers or redemptions to have occurred.

3. That seems unnecessarily complicated. The essential point is that the person no longer owns the security and has realised a profit, or sustained a loss, when ownership ceased. We have referred to the events giving rise to the tax charge (or loss relief) as "disposals" and all the circumstances in which a disposal occurs (apart from under the special rules applying for strips of gilt-edged securities) are described in this one clause.

4. Accordingly, under 6.6.1 tax is charged on profits from disposals of deep gain securities and 6.6.7 sets out those transactions which count as disposals.

5. Subsection (1) sets out the real transactions which count as disposals - redemptions, transfers and conversions.

6. Subsection (2) covers a deemed transaction which counts as a disposal. This is the deemed transfer of the deep gain security to personal representatives immediately before death, currently to be found in paragraph 4(2). It crystallises the increase in value at the time of death and ensures that there is no incentive for wealthy elderly people to invest in deep gain securities and hold them until they die, in the knowledge that the increase in value would escape income tax.

7. Subsection (3) explains who is treated as making the disposal in cases within subsection(1)(a) and (c).

8. For two of the transactions counting as disposals there are other provisions relating to the corresponding acquisitions. Subsection (4) provides a signpost to them.

1. As income tax is charged separately for each tax year we need to know how to allocate the profit or loss on the disposal of a deep gain security to the appropriate tax year. 6.6.2(1) and (2) provides for it to be allocated to the tax year in which the disposal occurs.

2. Usually the time at which a disposal occurs is clear enough. Sometimes, however, it is not clear: for example, where the holder of a security enters into an agreement to sell the security to someone else at some future date. This clause rewrites the rules in paragraph 4(3) and (4) about when certain transfers are treated as occurring. It provides for the security to be treated as transferred (or acquired) when the agreement is made, if the person receiving it becomes entitled to it at that time. Where an agreement to transfer a security is conditional, the agreement is treated as made when the condition is satisfied.

1. This clause provides for any loss sustained on the disposal of a deep gain security to be relieved by set off against other income of the same tax year. The relief has to be claimed and the claim has to be made within the normal time limit for a self assessment return to be made - before 1 February in the year following the tax year in which the disposal occurs.

2. The current loss relief is in paragraph 2, along with computational rules for losses. We have put the computational rules for profits and losses in a single clause (6.6.10) and therefore require a separate clause for the loss relief. In 6.6.9 it is out of the way of the computational rules but still easy to find.

3. Subsection (4) explains who may claim the loss relief - in effect, the person who would have been chargeable to income tax if a profit had been made.

4. Subsection (4)(b) fills a gap in the statute. Currently, paragraph 2 says nothing about relief for a loss (sustained on a deemed transfer under paragraph 4(2)(a)) being claimed by the personal representatives of the person who has died. In practice, they are allowed to claim loss relief. This is a change to the law but not to policy. It is in favour of the taxpayer.

1. In the current legislation there is a two-step method of computing the profit or loss arising from the discount on a relevant discounted security. First, the profit realised is computed (paragraph 1(2)). Secondly, "relevant costs" may be deducted to arrive at the amount of the profit chargeable to tax (paragraph 1(3)(a)). Likewise the loss sustained is computed (paragraph 2(2)) and then "relevant costs" may be deducted to arrive at the amount of the loss for which relief may be claimed (paragraph 2(3)(a)). This seems unnecessarily complicated and confusing.

2. We have therefore dropped the rules for computing whether a profit has been realised or a loss sustained. That can be done more simply in computing the amount of the profit to be charged to tax or the loss to be relieved. However, we have kept the rules for computing the profit or loss separate, although we have put them adjacent to each other in the first two subsections of this clause. We found this approach more straightforward than having a single, composite, rule for computing both profit and loss. We welcome comments on our approach.

3. Putting the two computational rules in one clause means we need only one rule (in subsection (3)) about deductible costs instead of the current two (paragraphs1(4) and 2(4)).

4. One consequence of the current method of computing profits and losses (see paragraph 1 above) is that where a profit is realised, but the relevant costs exceed the amount of the realised profit, there is no provision for the amount of that excess to be relieved. So, the relevant costs may be used to reduce a realised profit or increase a sustained loss but not to create a loss. If this is retained we will have to retain the two-step method of computation and cannot have the simpler one-step method of "amount payable on disposal less deductible costs". We intend therefore to change the law and the policy to allow relevant costs to create a loss. This minor change is in favour of the taxpayer.

5. We have also replaced the term "relevant costs" with the more informative "incidental expenses".

6. The incidental expenses may only be taken into account once. For example, where a gilt strip is held for several years it is treated as disposed of and immediately reacquired on each 5 April on which it is held - paragraph 14(4). The incidental expenses of the original acquisition are taken into account in computing the profit (or loss) on the first deemed disposal on 5 April. Subsection (4), derived from paragraph 15(2), ensures that those expenses are not taken into account again on any subsequent deemed disposal on 5 April.

7. For some disposals (for example, transfers between connected persons) the amount payable on the disposal is deemed to be the market value of the security at that time. Subsection (5) is a signpost to the rules in 6.6.11 dealing with such disposals.

1. This clause deals with the situations in which the amount payable on disposal has to be determined by the legislation. Currently these rules importing market values occur in three separate paragraphs. By grouping all the market value disposals together in a single clause we hope it will be easier for users to see when these rules apply.

2. There are now two rules. The general rule in these situations is put first and says that the security is treated as disposed of for an amount equal to its market value at the time of the disposal - subsection (1). There is then a list of disposals to which this rule applies - subsection (2).

3. After that we have put the second rule, which is a qualification of the first rule applying for a particular type of transaction. Where a deep gain security is converted into shares or other securities the security is instead treated as disposed of for an amount equal to the market value of the shares or securities acquired.

1. This clause deals with all the situations in which the acquisition cost of deep gain securities has to be determined by the legislation. Currently these rules importing market values occur in three separate paragraphs. By grouping all the market value acquisitions together in a single clause (using the same approach as for market value disposals in 6.6.11) we hope it will be easier for users to see when these rules apply.

2. There is now just one general rule. The security is treated as acquired for an amount equal to its market value at the time of the corresponding disposal - subsection (1). There is then a list of the disposals giving rise to acquisitions to which this rule applies - subsection (2).

3. We have included in the list the acquisition of a deep gain security as the result of the conversion of a security into shares or other securities - subsection (2)(e). Such an acquisition is not covered by the current legislation. Although it might be inferred from paragraph 5(2) that the relevant discounted security acquired is acquired for its market value at the time of the conversion, there appears to be a gap in the law. We have filled it. This change in the statute, but not in the underlying law, should provide greater certainty. It will not affect anyone's liability to income tax.

1. In the current legislation there is a special provision - paragraph 14 - to deal with certain transactions involving strips of gilt-edged securities. It brings all gilt strips within the definition of relevant discounted security. There are separate sub-paragraphs for the creation of strips (paragraph 14(2)), the demise of strips (paragraph 14(3)), and an annual charge that arises from holding gilt strips on 5 April (paragraph 14(4)). Other transactions involving gilt strips, such as an ordinary sale of a strip, are dealt with under the normal rules.

2. We spent some time integrating the special rules in paragraph 14 into the rest of the deep gain securities provisions. However, we understand that there are specialist investors interested only in gilt strips for whom this approach would not be helpful. So we concluded that, on balance, it would be better to retain a separate set of provisions for them. We have therefore put most of these rules for gilt strips into two separate clauses. We welcome comments on this approach.

3. This first clause contains some special rules for particular acquisitions and disposals of gilt strips. Subsection (1) treats gilt strips as deep gain securities and makes it clear that transactions other than these particular ones are dealt with under the normal rules.

4. The first special rule, in subsection (2), deals with the birth of gilt strips. Where a gilt-edged security which is not a strip (and therefore not a deep gain security - see 6.6.5(1)(b)) is "stripped", a rule is required to determine the acquisition cost of the strips acquired. The acquisition cost of each strip is computed by apportioning the market value of the underlying gilt-edged security between all the strips acquired. We have first described this apportionment and then expressed it as a formula. The current provision, paragraph 14(2), uses only the description. Is our dual approach helpful?

5. The next special rule, in subsection (3), covers a deemed transaction which counts as a disposal. This is the deemed transfer (followed by immediate reacquisition) of a gilt strip held on 5 April, currently to be found in paragraph 14(4). It applies only where no other disposal occurs on that day and ensures that anyone holding a gilt strip is taxed year by year on the increase in value of the strip. This is intended to prevent the gilt strips market becoming a tax avoidance vehicle: without such a provision there would be a big incentive for people to invest in strips, rather than in unstripped gilts (where interest would be taxed year by year), simply to defer their tax liability.

6. Subsection (4) contains another special rule to deal with the corresponding reacquisition.

7. Under the current provision, paragraph 14(4), the deemed reacquisition occurs on the next day - 6 April - but nevertheless for the same value as the disposal on 5 April. It seems simpler to say that the strip is treated as disposed of and immediately reacquired. This is a small change to both law and policy and it will not affect anyone's liability to income tax.

8. The deemed transfer and reacquisition of a gilt strip held on 5 April are also deemed not to involve any incidental expenses - paragraph 14(2).

9. The final special rule, in subsection (5), covers the situation, currently dealt with in paragraph 14(3), where two or more gilt strips are brought together and turned into a single gilt-edged security. Each strip is treated as disposed of for an amount equal to its market value at that time.

1. This second clause for gilt strips contains the powers currently in paragraph 14(5) and (6) for the Treasury to make regulations concerning the treatment of gilt strips. As elsewhere, we have put these powers into a separate section so that they are out of the way of the operative provisions but easy to find.

2. The powers enable the Treasury to respond to future developments in the gilt strips market by making whatever changes to the legislation are necessary. In addition, they allow the Treasury to provide how the market value of gilt strips should be determined. (For relevant discounted securities, "market value" generally means the same as it does for capital gains tax purposes but that does not apply for gilt strips - paragraph 15(1).)

3. For the moment we have set out the method for making the regulations - statutory instrument subject to the negative resolution procedure - but that will not be required if a provision equivalent to section 828 is included in the Income Tax Act.

1. The current legislation includes two separate provisions (paragraphs 11 and 12) dealing with the relationship between the rules for relevant discounted securities and two sets of rules of more general application designed to counter tax avoidance. This clause brings those provisions together under the heading "Anti-avoidance".

2. Subsection (1) disapplies the accrued income scheme for transfers of deep gain securities.

3. Subsection (2) on the other hand ensures that the rules designed to counter avoidance of tax by the transfer of assets abroad can apply by making it clear that profits from disposals of deep gain securities are regarded as income for the purposes of those rules.

1. This clause provides some minor definitions for the provisions in this chapter. They may be put elsewhere in the final version of the Income Tax Act.

2. The clause includes a new definition of "personal representatives". Current legislation uses different definitions for different purposes. (See, for example, sections 229(1) and 701(4) and section 111(3) Finance Act 1989.) But there is no definition for the purposes of Schedule 13. This new definition simplifies the vocabulary, does not include references to other (non-tax) legislation, and can be applied to different jurisdictions (within and outside the United Kingdom). It is a change in the statute, but not the underlying law. It will not affect anyone's tax liability.

1. This clause shows where to find definitions used in this chapter.