Tax Aspects of Buying and Selling Companies (Hawksmere Report)

THOROGOOD PROFESSIONAL INSIGHTS

A SPECIALLY COMMISSIONED REPORT

TAX ASPECTS OF BUYING AND SELLING COMPANIES Martyn Ingles

Blank page

A Thorogood Report

TAX ASPECTS OF BUYING AND SELLING COMPANIES

Martyn Ingles

Published by Thorogood

Other Thorogood Reports:

10-12 Rivington Street London EC2A 3DU. t: 020 7749 4748

Tax Planning Opportunities for Family Businesses in the New Regime

f: 020 7729 6110 e: [email protected] w: www.thorogood.ws

Christopher Jones

© Martyn Ingles 2000 Maximising Value on the Sale of a Business Peter Gray

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form

Practical Techniques for Effective Project Investment Appraisal

or by any means, electronic, photocopying, recording or otherwise, without the prior permission of the publisher.

Ralph Tiffin

This Report is sold subject to the Employers Liability and Industrial Diseases

condition that it shall not, by way of trade

Fred Collins

otherwise circulated without the publisher’s

Unlocking Shareholder Value Paul Nichols

or otherwise, be lent, re-sold, hired out or prior consent in any form of binding or cover other than in which it is published and without a similar condition including this condition being imposed upon

Employment Law Aspects of Mergers and Acquisitions

the subsequent purchaser.

Michael Ryley

any person acting or refraining from action as

No responsibility for loss occasioned to a result of any material in this publication can

Intellectual Property Protection and Enforcement Lorna Brazell

be accepted by the author or publisher.

A CIP catalogue record for this Report is available from the British Library. ISBN 1 85418 189 0 Printed in Great Britain by printflow.com

Acknowledgement These notes are based on the text of a course originally presented by my colleague Bob Trunchion of MacIntyre Hudson,whom I thank for providing the bulk of the text.I have updated the notes to take account of the significant changes to Capital Gains Tax business asset taper that were introduced in Sections 65 and 66 of the Finance Act 2000. I would also like to thank Nicki Cole for all her hard work.

The author Martyn Ingles BSc FCA ATII Martyn qualified as a Chartered Accountant in 1982 and has specialised in taxation ever since.He became an Associate member of the Chartered Institute of Taxation in 1983 whilst working for Arthur Andersen in London. For ten years he worked for The Financial Training Company Ltd, lecturing in taxation and other accounting subjects to students preparing for their accountancy and taxation examinations, as well as CPE and CPD courses. In January 1997 he returned to professional practice joining Horwath Clark Whitehill,where he became a partner in October 1998.His main area of interest, other than tax aspects of buying and selling companies, is tax planning for the family business and he lectures on this and other taxation issues on both internal and external courses. A member of the ICAEW Tax Faculty committee and its honorary treasurer,Martyn joined MacIntyre Hudson in April 2000 where he continues to be involved in the provision of taxation training for accountants, lawyers and other professionals.

Contents

1

INTRODUCTION

Economic cycle ...........................................................................................2 Other matters ..............................................................................................2 Company and contract law .........................................................................3 Pension funds ..............................................................................................5

2

TAXATION ISSUES

Introduction ................................................................................................7 The proposed sale .......................................................................................8 Advising the vendors ...................................................................................9 Pre-sale planning .......................................................................................10

3

SALE OF ASSETS OR SALE OF SHARES?

The sale of assets .......................................................................................19 The sale of shares ......................................................................................25

CONTENTS

4

INLAND REVENUE CLEARANCES AND ANTI-AVOIDANCE IN GENERAL

Anti-avoidance ..........................................................................................32 The introduction of a general anti-avoidance rule ...................................33 Capital Gains Tax anti-avoidance provisions ............................................35 Documentation .........................................................................................38 Mawsley Machinery Ltd v Robinson ........................................................38

5 6 7

ADVISING THE PURCHASER

Purchase of assets or purchase of shares? ................................................44 Stamp duty ................................................................................................45

PROTECTING LOSSES

Anti-avoidance ..........................................................................................47 Revenue practice ......................................................................................47

WARRANTIES AND INDEMNITIES

Introduction .............................................................................................51 Corporation Tax – company purchase schemes .......................................51 Types of subject matter ............................................................................53

CONTENTS

8

CASE STUDY: A CORPORATE VENDOR

The target and vendors .............................................................................56 Pre-sale re-organisation .............................................................................57 The sale ....................................................................................................60 Other non tax implications ......................................................................63 Other tax matters .....................................................................................63 Issues for the purchaser ...........................................................................64

9

HIVE DOWNS AND MANAGEMENT BUY-OUTS

Tax and the hive down .............................................................................69 Management purchase and tax effects .....................................................71

APPENDIX 1

Summary of IR20....................................................................................72 Becoming not resident and not ordinarily resident ..................................73 Becoming not resident when there is no full-time contract of employment .............................................................74 Foreign earnings deduction ......................................................................75 Capital Gains Tax ......................................................................................75 Comment ..................................................................................................76

2

Stock dividend scheme..........................................................................78

3

Impact of pre-sale dividend..................................................................82

4

Using loan notes.....................................................................................86

5

Deferred consideration .........................................................................88

CONTENTS

6

Taxation of the income of discretionary trusts ................................91 Assessing the impact of the changes to dividend income taxation from 6 April 1999 ..........................................................92 Illustration: Discretionary trust taxation ...................................................94

Throughout this Report,where reference points are made they are pre-fixed with the letter ‘R’ as shown below: R

Introduction ECONOMIC CYCLE O T H E R M AT T E R S C O M PA N Y A N D C O N T R A C T L AW PENSION FUNDS

chapter

1

CHAPTER

1:

INTRODUCTION

Chapter 1: Introduction

Economic cycle With the current state of the economy, considerable corporate activity is being undertaken.This often involves the acquisition by one entity and the sale by another of either assets or shares. This Report looks at the sale of a company/assets from the vendor’s point of view, the purchase of a company/assets by a purchaser and how they could be structured from a tax point of view.

Other matters It is easy to forget that tax is probably no more than 40% of the story.‘Never let the taxation tail wag the commercial dog.’ The first task of any purchase or sales advice is to primarily ascertain the objectives of the client.As the client is likely to have little or no experience in this area,they will be looking for complete advice on how to structure the deal.They will look for advice on: •

Company law

•

Taxation

•

Dealing with the other sides solicitors, accountants etc

•

Investigations (due diligence)

•

Negotiations

•

Transaction formalities

•

The structure of the deal.

It is not possible, or relevant, to cover all of these areas in this Report but a brief look is needed at some company law aspects.

2

CHAPTER

1:

INTRODUCTION

Company and contract law An increasingly complex set of company law provisions now surround even the sale/purchase of a private company.The participants (and their advisors) forget these at their peril. Breaches can lead to: •

Contracts being void/voidable

•

Civil actions

•

Criminal sanctions.

Who are the people most likely to be worried by company law aspects? •

Liquidators

•

Administrators

•

Receivers

•

Creditors (secured and unsecured)

•

Purchasers

•

Vendors (especially in earn-outs)

•

Auditors

•

Minorities

•

Shareholders of parent companies

•

Employees

•

The Inland Revenue.

In most of the above areas the sale of assets at under/over value could lead to the application for redress and there is no need for this Report to consider these areas! However, if the Revenue are unwilling to use an anti-avoidance section, they have been known to use company laws, including: •

Ultra vires acts

•

Share premium accounts.

3

CHAPTER

1:

INTRODUCTION

The main problem areas are: R Sections 108 to 110 CA 1989

1

Ultra vires •

R Sections 151 to 155 CA 1985

2

Financial assistance •

R Section 153 CA 1985

•

3

Extraction of assets at an undervalue –

Loss reorganisation for no or excessive payment (trade and capital)

–

Transfers of assets

–

Guarantees of borrowings (especially purchasers)

–

Hiking up or down assets pre-sale for intercompany debt, that are then used by the purchaser to secure funds to repay intercompany debt.

Defences –

General defence – principle purpose is not for acquisition of shares or for giving assistance

–

By special resolution, auditors and directors confirm solvency statutory declaration.

Share premium accounts •

4

Ensure transactions fall within powers of articles,(and especially objects clause of memorandum) despite relaxations.

Watch transfers of assets prior to sale.If profit is not taken in by transferor, does transferee need to create share premium account?

Goodwill •

Does goodwill arise and require to be written off?

These issues will be looked at as the Report develops.

4

CHAPTER

1:

INTRODUCTION

Pension funds The lack of a pension fund can be a severe problem for the sale of a private company. Inadequate provision for a pension ties the vendor to asking for a price for the company that may be too great for a purchaser to raise the required funds. An ‘independent’pension fund severs this need and can be used to extract profits in a highly tax efficient way. The law in this area is complex and the following need to be watched: •

Trust law

•

Employment law

•

Tax law

•

Social security law.

Specialist advice will be required on the sale of a business on the ability to transfer all or parts of the fund with the business. When the sale agreement is reviewed so should the actuarial position of the fund: •

Deficiency needs funding – efficient structuring of sale proceeds.

Where a surplus arises, the vendors should consider in advance of a sale how these should be dealt with: R Sch 22 ICTA 1988

•

Refund of company contributions (subject to 40% Corporation Tax).

R SI 1987 No 412

•

The purchasers could have a contributions holiday.

•

Divide the scheme into several schemes prior to the sale, so that the target business can leave the group with its own appropriately funded pension scheme.

•

Hive down the trade or business into a different company which does not adhere to the pension scheme at all so that the business can be sold, separate from the director/owner’s pension fund (if a private company).

5

Taxation issues INTRODUCTION THE PROPOSED SALE ADVISING THE VENDORS PRE-SALE PLANNING

chapter

2

CHAPTER

2:

TAXATION

ISSUES

Chapter 2: Taxation issues

Introduction The purpose of this chapter is to consider a number of taxation issues that should be considered when buying and selling a business, from both the point of view of the purchaser and the vendor. In view of the breadth of this subject this chapter has been centred around the analysis of one particular case study. This enables the taxation issues to be directed to a particular set of circumstances and for the alternative courses of action faced by both sets of parties to the transaction, in terms of taxation, to be considered. The alternative strategies that are available are almost without limit, even for a fairly straightforward case study.Accordingly, we will concentrate on the more important strategies and those issues that are likely to have a significant impact on the overall taxation position.

Case study The target Aldridge plc is a UK resident, unquoted trading company that was incorporated and commenced trading in 1967. All the company’s trading activities are carried out in the UK. For the purposes of this case study it is not important to establish the precise nature of the trading activities, suffice it to say that they are within the scope of Schedule D Case 1. The company’s accounting reference date is 31 March and the most recent accounts show that it has distributable profits of approximately £10 million.

7

CHAPTER

2:

TAXATION

ISSUES

The vendors When the company originally commenced trading, it had an issued share capital of 1,000 ordinary shares of £1 each. Since then the issued share capital has been increased to 100,000 ordinary shares of £1 each, all fully paid. The shares are currently owned as follows: A.Aldridge (Founder Shareholder and Chairman)

55,000

B.Aldridge (Daughter of Founder Shareholder and Managing Director)

5,000

A.Aldridge Accumulation & Maintenance Trust

20,000

A.Aldridge Discretionary Trust

20,000 100,000

The following additional information about the vendors is also relevant: •

A.Aldridge, aged 56, was until recently a full-time working director of the company but now only spends an average of 15 hours per week working in a managerial capacity.

•

B. Aldridge, A. Aldridge’s eldest daughter, is aged 28 and has recently become Managing Director of the company.

•

A. Aldridge has two other children, a son at university and another daughter at school.

•

The A.Aldridge Accumulation & Maintenance Trust was set up for the benefit of the settler’s children a number of years ago and has UK resident trustees.

•

The A. Aldridge Discretionary Trust was set up for the benefit of the settler’s children, grandchildren and remoter descendants.

•

The shares were worth £2.5 million in total in March 1982.

The proposed sale The Aldridge family have been approached by a potential purchaser (who could be either another company or an individual for the purposes of this case study) with an offer to acquire either the company, or the business carried on by the company, for a total consideration in the region of £20 million. The form of consideration has not yet been determined and it could be either wholly in cash,or wholly in some form of paper,or a mixture of both.The possibility of deferred consideration/earn-out has not been ruled out.

8

CHAPTER

2:

TAXATION

ISSUES

It is possible that A. Aldridge and B. Aldridge may be required to stay on as directors of the company for up to two to three years after the sale. It is intended that exchange and completion should take place simultaneously,with the target date being set by both parties at 1 October 2000.

Advising the vendors Background It is important when advising the vendors to ascertain what their intentions and aspirations are.For instance,is the major shareholder and his family happy to simply sell the business, maximise the net of tax proceeds and live off the investment income, or do they intend reinvesting all or part of the proceeds? Are the two individual shareholders prepared to emigrate to avoid the potential Capital Gains Tax (CGT) liabilities on the sale? Is there any part of the business or any assets owned by the company that the vendor and his family wish to retain? Are the vendors happy to take a form of paper consideration,the value of which may be dependent on future profits or on the performance of the purchasing company? It is also important to recognise in this case study and very often in real life that there are a number of different vendors and in particular there are two trusts which will have objectives which are probably, and should be, independent of the individual shareholders.This can give rise to conflicts of interest,and in such situations the vendors may need to be,and probably should be,separately advised. In spite of the above, it is likely that a single advisor, or group of advisors, will be acting on behalf of all the shareholders in certain aspects of the transaction,such as dealing with Inland Revenue clearances and the like,where there is a common interest.The advisor must not forget that there will be conflicts of interest.

9

CHAPTER

R S 87 TCGA Introduction

2:

TAXATION

ISSUES

Pre-sale planning Most of the pre-sale planning relates to the disposal of shares rather than the disposal of the business and assets. In this case study there has already been a significant amount of pre-sale planning in that 40% of the share capital is owned by trustees and therefore over one-third of the potential capital gain on the transaction will be taxed to UK CGT at a lower rate – 34% rather than 40%,assuming that the trusts have been properly structured and that none of the anti-avoidance provisions apply. Previously, the residence of the trusts would have been important, as UK Capital Gains Tax would only have been likely to become due if and when capital payments were made to UK domiciled (and either resident or ordinarily resident) beneficiaries from a non-resident trust.Unfortunately,the creation of new offshore trusts which give CGT deferral/exemption are no longer allowed,due to the FA 1991 and 1998 rules.Indeed consideration should be given to bringing any offshore trusts onshore immediately. Just as importantly, the inherent wealth has been spread around the family group and does not remain concentrated in just one person,which is sensible for both a tax (Inheritance Tax (IHT) especially) and non-tax point of view (divorce, bankruptcy etc).

Should the accumulation and maintenance or discretionary settlement be exported? By the UK trustees resigning and appointing non-resident trustees it should be possible to effectively make this settlement non-resident prior to disposal of the shares, whereupon any capital gain arising to the non-resident trustees will not be liable to UK Capital Gains Tax. R S. 80 TCGA

However,by exporting these trusts this will give rise to an immediate Capital Gains Tax charge as the trustees will be deemed to have disposed of all the trust assets and reacquired them at their market value at that time. Given the proximity to the sale, it is likely that the market value will be agreed at or very near to the eventual proceeds due to the trusts.

R S. 86 TCGA

The above will also bring into charge any gain held over at the time the shares were originally settled on the trust. Furthermore any gain arising upon the sale will be visited back upon this settler. These points make the export of trust unattractive.

10

CHAPTER

R S 165 TCGA

2:

TAXATION

ISSUES

Should A. Aldridge give away some shares prior to the sale? Clearly A. Aldridge can make a gift of shares,say to another trust or to an individual prior to the sale and any capital gain arising by reason of the gift can be held over. Such a strategy may only really be worthwhile if the donee has a substantial relief available to mitigate the tax. For example, a gift of shares to Mr Aldridge’s spouse might be appropriate if she has substantial capital losses that could be utilised when she sells the shares, or current trading losses which could be set against any presale dividend.However,sufficient gifts to utilise annual exemption and lower rate bands should always be considered subject to the benefits being commensurate with the costs savings: Savings: Annual exemption Savings rate Tax saved

R Finance Bill 2000 Clause 66

£7,200 x 40%

2,880

£28,400 x 20%

5,680 £8,560

The relaxation of the definition of business assets for the purpose of taper relief means that Mrs Aldridge would qualify for business asset taper on any size of shareholding and would inherit her husband’s period of ownership. Transferring shares so as to maximise the use of capital gains exemptions within the family, or to a UK Accumulation & Maintenance trust to reduce the marginal rate of tax to 34%, may be of only marginal benefit and may not be commercially acceptable. Even a gift to a UK Interest in Possession (IIP) trust for his children would only reduce the marginal rate of CGT to 34% and would put the taper clock back to zero!

Should any of the individual shareholders become non-residents? Mr Aldridge will have a substantial capital gain that could be avoided if he were to become non-resident and not ordinarily resident in the UK prior to the disposal of the shares.Becoming non-resident will compromise any availability of retirement relief. The major strategies are outlined in Appendix 1.Mr Aldridge could either become non-resident and not ordinarily resident by the five-year route, or by the use of more aggressive stances which can result in shorter periods abroad, such as the Brussels Route.This exploits a quirk in the UK/Belgium double tax treaty and Belgium’s CGT rules. Special advice is needed in this area.

11

CHAPTER

R ESC D2

2:

TAXATION

ISSUES

Note:Residence for CGT purposes is for a complete year of assessment and although an extra statutory concession is available to give non-residence status from the date of departure,this is only in some restricted situations (see Appendix 1).This concession has to be read in conjunction with the following statement that is issued in connection with all concessions: ‘A concession will not be given in any case where an attempt is made to use it for tax avoidance.’ If deferral of the contract date is a problem then the contract can be made conditional, with the condition being satisfied after 5 April 2001.Or some form of paper could be received, say redeemable loan stock in the purchaser, which will be redeemed so that its capital gain is realised in a later tax year. It is also possible that B.Aldridge might consider emigrating,although the amounts of tax at stake in her case are much smaller. The commercial and personal aspects of emigration should not be ignored.

Should Mr Aldridge be considering inheritance tax planning? Currently, Mr Aldridge owns shares which are worth approximately £11 million (by reference to the proposed sale price) but have an effective Inheritance Tax value of nil, by virtue of 100% Business Property Relief (BPR).After the sale, Mr Aldridge will own £11 million of cash or near cash assets,which will almost certainly not attract BPR.His Inheritance Tax position has worsened considerably.Specific advice should be taken as early as possible, especially as the ability to hold over capital gains will be substantially restricted once the sale has taken place.

Should any IHT planning be considered for the trusts? The Discretionary Trust is certainly worth considering as, out of the two, it has the least favourable treatment for Inheritance Tax purposes. Presently it owns a 20% interest in the company,valued on a minority basis (i.e.substantially less than the value of its eventual share of the proceeds) but it is also eligible for 100% Business Property Relief.Once the sale has been made,the value of the trust fund will be £4 million,without any Business Property Relief,and this will significantly increase any IHT due on the 10-year anniversary charge or on an existing charge. Whilst the trust property can still be valued on the basis of a minority shareholding, it may be sensible to consider a pre-sale appointment of all or part of the trust fund into new trusts,for instance Accumulation & Maintenance Trusts for beneficiaries under the age of 25 (i.e. the settler’s children or grandchildren) or interest in possession in favour of,say,the settler’s three children.Such a power

12

CHAPTER

2:

TAXATION

ISSUES

can clearly only be exercised if the trustees have been given it in the first place, but it may be worth considering for all the trusts – especially the Discretionary Trust – before the sale takes place. In any case, the position must be reviewed regularly. It may be that the trust IHT rate is zero or very low (the rate of IHT paid on the creation of the trust or at its last ten years anniversary). Even if no BPR is available after the sale,as the proceeds are contained in stock market type investments, exit charges on assets appointed to, say a life interest trust for each of the children,could be very low if done before the ten year anniversary following the changes from business assets to investments.

Should any CGT planning be considered for the trusts? With the accumulation and maintenance settlement it will be clear that whilst Belinda Aldridge has attained the age of 25 and therefore has a life interest in the underlying shares,the other children have not acquired life interests.In that case the CGT rate will be 34% for the settlement. Consideration under the old rules prior to 5 April 1998 would therefore be given to advancing under the powers of the trust deed, the appropriate life interest.This would have reduced the CGT rate to 23%. Now the rate would be 34% regardless. It should also be noted that unless the beneficiaries are full-time working officers then the holdings will be classed as investment assets. Further consideration should be given to CGT holdovers when the trust terminates.

Pre-sale dividend Aldridge plc has approximately £10 million distributable profits and accordingly it will be possible to pay a maximum pre-sale dividend, subject to company law requirements, of up to £10 million and effectively reducing the sales proceeds to be paid by the purchaser by this amount. Normally such a strategy will produce a more satisfactory tax position, providing payment of the dividend does not reduce any capital gains relief that the vendors might have and also providing the company can relieve the ACT.The abolition of ACT and the reduction of tax credits etc since April 1999 must be taken into consideration. However, a pre-sale dividend must be considered to be a highly effective way of extracting funds for a corporate vendor. Such a strategy is less effective, and may be totally ineffective, where the total gain,assuming a dividend is not paid,would be totally or mostly relieved through some capital gains relief,or where all or some of the shareholders are not resident and they are not going to pay Capital Gains Tax anyway.

13

CHAPTER

2:

TAXATION

ISSUES

The enhanced business asset taper now also has a significant impact and makes such planning non-viable once 50% relief has accrued.From 6 April 2001 onwards the impact of 50% business asset taper reduces the effective CGT rate to 20%,which is clearly less than the 25% effective income tax rate on a pre-sale dividend strip. Appendix 3 sets out the calculations comparing a straight sale for £20 million proceeds,net of disposal costs,with a situation where there is a pre-sale dividend of £10 million net and then a sale for £10 million and assumes a disposal date of 1 October 2000. It should be noted that if the sale had taken place before 5 April 1999 ACT would have been due. For the purposes of the calculations it has been assumed that the market value per share for all shareholdings as at March 1982 was £25 each and that indexation since that date is at the rate of 100%. The calculations show that overall, there is a substantial saving through paying a dividend. It should be noted that the position could be worse for the A & M Settlement and the Discretionary Trust after 5 April 1999 depending on the distribution policy of the trusts (see Appendix 6).

Stock dividend scheme Where a company has limited reserves which restrict its ability to pay a pre-sale dividend it may consider using an enhanced ‘stock’ dividend.A ‘stock’,‘bonus’ or ‘scrip’dividend is where a company offers a bonus issue of shares to its shareholders as an alternative to a cash dividend. An enhanced stock dividend is where the difference between the market value of the shares subject to the stock dividend alternative is at least 15% greater than the cash dividend foregone.The company must have sufficient reserves to meet the cash dividend and the nominal value of the bonus issue shares. Inland Revenue Statement of Practice A8 treats the shareholder as having received a distribution equal to the market value of the shares, as opposed to the cash dividend foregone, which would be the case if the value was within 15%.The attraction from a Capital Gains Tax planning point of view is that the base cost of the shares is uplifted to market value thereby reducing the capital gain.The shareholder would be charged to income tax at an effective rate of 25% (if higher rate) on the stock dividend with minimal or no capital gain.This is compared to Capital Gains Tax at 40% (subject to taper) without the stock dividend. See Appendix 2 for more details and an example based on that in the Inland Revenue CGT Manual.

14

CHAPTER

2:

TAXATION

ISSUES

Pre-sale dividends and corporate vendors Whilst not strictly related to this case study, the position where the vendor is a corporate entity should be considered.As was pointed out above, the receipt of a dividend by a corporate entity is treated as franked investment income. It does not give rise to any further Corporation Tax. Accordingly, therefore, a pre-sale dividend is already attractive to some corporate vendors at the current time. It has, however, become particularly attractive since the abolition of ACT on the 5 April 1999.Where a dividend is paid, this will prove to be an efficient method of cash extraction. Let us assume that Aldridge plc is owned by Alan Limited. If Alan Limited receives a £10 million dividend prior to the sale, and the proceeds are obviously reduced accordingly,instead of suffering Corporation Tax on the capital gain, the £10 million dividend will be received without further tax implication. It would appear, as a general rule of thumb, that where there are sufficient distributable reserves, a pre-sale dividend up to a sufficient CT utilised the base value plus indexation would give the optimum taxation result. R Section 703 • TA 88

R Marwood Homes Ltd v IRC 56 SWTI 1999

It must be remembered that there is specific anti-avoidance legislation in this area and pre-sale dividends,whilst generally efficacious,do require specific planning. This specific anti-avoidance legislation enables the Revenue to counter any taxation advantages obtained by a taxpayer company,where it receives an abnormal amount by way of dividend,which results in an increased amount of relief from tax.Unless the company does it for bona fide commercial reasons,none of which had as their main objectives or one of their main objectives the obtaining of a tax advantage. With the abolition of ACT and the greater advantages of paying dividends that this will ensue, it can be expected that the Revenue will be looking to invoke Section 703 more frequently than in the past.

15

CHAPTER

2:

TAXATION

ISSUES

Should there be a demerger if part of the company’s activities/assets are to be retained? It is possible that the vendors wish to sell the main trading activity, or one of the trading activities, of Aldridge plc but retain the remaining activities, which could include assets managed as investments. If it is important to still sell the target business in the form of a company and for the shareholders to receive the sale proceeds personally,perhaps because they are eligible for retirement relief,then it may be sensible to consider dividing the activities of the company on a share for share basis prior to the sale, so that the shareholders are left with two new companies,one holding the business and assets to be sold and the other holding the business and assets to be retained.

R S. 213 (11) (d) ICTA

The demerger provisions of Section 192 TCGA and Sections 213 – 218 of ICTA cannot be used, as a demerger is not permitted if the main purpose, or one of the main purposes, is the sale of one of the businesses after it has taken place. However, a reconstruction using the provisions of Section 136 and 139 TCGA, together with statement of practice number SP5/85 may be possible.The advantage of the reconstruction is that it enables the activities of the company to be broken down into separate companies owned directly by the original shareholders of Aldridge plc, and without there being any Capital Gains Tax or Corporation Tax on capital gains. It is likely that such a strategy should take place well before a sale and perhaps at a time when the vendors are considering disposing of part of the company’s business, but before they have looked for purchasers.

16

CHAPTER

2:

TAXATION

ISSUES

Should the vendors take tax exempt terminal payments from the company prior to the sale? R S. 188 (4) ICTA

There is a temptation for vendors of shares, where they are also officers or employees of the company being sold,to effectively take part of the sale proceeds as a termination payment from the company,with a consequent reduction in the actual share consideration.The attraction is, of course, to take advantage of the £30,000 exemption for ex-gratia/compensation payments. It is almost certain that the Inland Revenue will attempt to challenge the Schedule D deduction for the termination payment on the basis that it is effectively part of the proceeds for the share disposal (and therefore capital).This will also probably have the effect of eliminating the £30,000 exemption in the hands of the recipient. It should also be noted that the Revenue announced their intention to attack payments in lieu of notice aggressively from mid-1996 onwards and have done so since. It is likely that clearance by the Revenue would be denied if the proposals contained a ‘tax free’ ex gratia payment.

R Snook v Blasdale (1952) 33 TC 244

There is case law to support the Revenue’s position. It should be noted that ex-gratia payments made to a vendor shareholder may not attract the £30,000 exemption if the vendor is at or close to retirement age.

R SP 13/91

Whilst termination payments made in the above way are almost certainly going to be challenged,a preferable route would be to maximise pension contributions for the vendors, within Inland Revenue maxima, prior to the sale. Payments in excess of the maximum could be made to a FURB but this would be NI able.

17

Sale of assets or sale of shares? THE SALE OF ASSETS THE SALE OF SHARES

chapter

3

CHAPTER

3:

SALE

OF

ASSETS

OR

SALE

OF

SHARES?

Chapter 3: Sale of assets or sale of shares?

The sale of assets Advantages Among the advantages of a sale of assets rather than a sale of shares are the following:

R S. 152-159 TCGA

•

An asset sale enables the vendor to determine precisely which assets are sold and to retain those that he wishes to keep. Conceivably, the same result can be obtained by segregating the assets to be sold and the assets to be retained,using the reconstruction provisions. Although the conditions for the relief have to be met,it tends to be more expensive and it also requires some advance warning of the impending sale.

•

Any warranties that the vendor may be required to give will be kept to a minimum.

•

Business asset rollover relief may well be available to the vendor company if proceeds from the sale of chargeable assets are reinvested in qualifying assets used for the purposes of a trade.

•

Any capital gains arising in the company, on the sale, may be mitigated by unused capital losses brought forward,or other trading losses in the company that can be used.

•

The capital gains base cost of the shares might be quite low whereas the capital gains base cost of assets owned by the company could be much higher. Selling the assets with a much higher base cost is likely to produce a smaller capital gain,particularly when indexation is taken into account.

Disadvantages Among the major disadvantages of a sale of assets as opposed to a sale of shares are the following: •

If the proceeds of the sale in the company are then to be distributed to the shareholders,either by dividend or on a winding-up,there is almost certainly going to be a measure of double taxation.

19

CHAPTER

3:

SALE

OF

ASSETS

OR

SALE

OF

SHARES?

•

The vendor, when retaining the company, will retain its history, which may include being responsible for liabilities to third parties, litigation, potential redundancy costs if staff are retained, etc.

•

Following on from the above the vendor company will also be liable for any VAT liabilities from the past and also for potential VAT liabilities on the sale of assets, where it is not possible to successfully argue that it was a disposal of a going concern.

•

If part of the business is sold, this could give rise to a discontinuance of some or all of the company’s trading activities.Which could give rise to, amongst other things, balancing charges.

•

Disposal of the assets of a company may give rise to balancing charges, that will increase taxable profits in the vendor company.

Attractiveness A sale of shares may prove to be attractive for the following reasons:

R S. 163-164 TCGA

R Section 767A and B 1997 Budget Release IR7

•

A sale of shares allows a pre-sale dividend if that is attractive,and assuming it is permissible for company law reasons.

•

The proceeds will be received directly by the shareholders and will only be taxed once in their hands. Other consequences such as balancing charges etc can be avoided through having a share sale, as opposed to an asset sale.

•

The vendor shareholders may be able to obtain retirement relief on the disposal, or reinvestment relief should they reinvest in qualifying unquoted trading companies.

•

The responsibility for the liabilities of the company pass with the company to the purchaser, this of course is subject to any warranties and indemnities the vendor might be required to give.Vendors must also remember that if a purchaser fails to pay Corporation Tax due for periods up to the sale, that tax may be recovered from the vendor.

•

If the vendor does not require cash proceeds immediately,perhaps because he would like to defer the gain and emigrate several years later,then paper for paper consideration, such as loan stock, could be considered.

20

CHAPTER

3:

SALE

OF

ASSETS

OR

SALE

OF

SHARES?

Apportioning the consideration R EV Booth (Holdings) v Buckwell (1980) STC 578

A major issue with asset sales, which also gives an opportunity for tax planning, is the apportionment of the overall purchase consideration between the various assets and liabilities that are being sold. Often the apportionment will be arrived at after negotiation between the parties and will represent,normally,a compromise between the vendor’s objectives and the purchaser’s objectives. Some care with the apportionment can give rise to tax benefits to both parties but their interests will often conflict. As far as the vendor is concerned,it is likely that the shareholders in the company will want to make sure that all the reliefs available that can be deducted from the sale proceeds in the company can be utilised.Accordingly,if the capital assets of the company (for instance freehold premises) have a high base value then it would be desirable to ensure that the amount of consideration apportioned to that asset is high enough to ensure that the cost deductible and the indexation allowance are fully relieved.Increasing the proportion of the proceeds attributable to capital assets will also be attractive where there are unused capital losses brought forward or where there is an intention to reinvest the proceeds and rollover the capital gain. Alternatively, it may be that the vendor has unused trading losses which would be lost once the trade is sold.In this situation apportioning more of the sale price to stock or to assets on which capital allowances have been claimed,so that balancing charges will arise,may be advantageous.In this way it may be possible to establish a larger profit which can absorb all or most of the unused losses brought forward. The purchaser will normally seek to establish a high value for those items being acquired,which will eventually represent a deduction from profits.In particular, higher values attributable to capital assets on which capital allowances can be claimed or to stock which will be written-off in the profit and loss account, will generally be more beneficial than a high value attributable to capital assets. Alternatively, if the purchaser is looking to reinvest in assets to rollover a capital gain, then he might wish to see the converse position where the value of those assets acquired is higher at the expense of assets which will not attract rollover relief. Normally the allocation of the sales price amongst the various assets will be shown in the sale agreement and this is important not only for contractual purposes but as evidence to show the Inland Revenue. However,this does not prevent the Inland Revenue examining the apportionment of the consideration and case law shows that they have the power to reallocate the sales price where it is appropriate.

21

CHAPTER

3:

SALE

OF

ASSETS

OR

SALE

OF

SHARES?

In practice the Inland Revenue tend not to seek a reapportionment of the sale price unless it is obvious that the apportionment made is totally artificial and purely designed to avoid tax. In most situations they will accept that an apportionment freely negotiated between the parties to the contract will be a commercial one. If the proposals set out in the consultation document on ‘The Reform of Intellectual Property’to be included in Finance Bill 2001,proceed,they will enable the purchaser to obtain a tax deduction for the amortisation of intangibles such as trade marks, brand names, and even goodwill.The likely change is that the tax treatment will follow the accounting treatment, as determined by FRS10 and will allow a tax deduction for the acquisition of goodwill for the first time in the UK.This may well tilt the balance in favour of asset sales rather than share sales, as there is no Corporation Tax deduction for the cost of shares.

Capital allowances The disposal of the trade causes there to be a cessation in the vendor company and the company’s Corporation Tax accounting period then ends. Where part of a business is sold, this may constitute the cessation of the whole trade carried out by the company,or simply be treated as reducing the existing trade. R S. 24 (6) (c) (v) CAA

If there is a permanent discontinuance of the trade, balancing adjustments will be computed in respect of plant and machinery using the actual sale proceeds as provided for in the sale agreement. Where the disposal is of part of a business,but it results in the whole trade being discontinued,it is important to remember that there will be balancing adjustments on all assets (including those retained as part of the ongoing business). For the assets retained, it will be the market value that is taken into account when computing the balancing adjustment.

R S. 4 (1) CAA

The cessation of the business does not give rise to balancing adjustments for Industrial Buildings Allowance purposes.Adjustments in that situation only arise on the disposal of the relevant interest (for instance disposal of a freehold factory site on which IBAs have been claimed).

R S. 4A CAA

A clawback of IBAs can be avoided if the vendor does not dispose of the relevant interest but grants a subordinate interest in the property to the purchaser, such as a very long lease. Although this strategy can be highly effective, it must be remembered that the Finance Act 1994 contained provisions to prevent this strategy working where the relevant buildings were situated in Enterprise Zones.

22

CHAPTER

R Sch 16 Para 6 FA 97 R amending Sects 59A, B & C, R CAA 1990

3:

SALE

OF

ASSETS

OR

SALE

OF

SHARES?

For fixtures and fittings on which P&M allowances have been claimed, antiavoidance legislation is available to ensure that capital allowances cannot be accelerated by a sale or a balancing charge avoided. An election can be made, however, to determine the allocation of sale proceeds but this cannot exceed: •

The amount incurred by the vendor on the plant

•

The total sale price.

Trading losses R S. 343 ICTA

R S. 100 ICTA

On the sale of the business, the cessation of the trade will mean that any losses not otherwise utilised at that point will be unavailable for carry forward (unless the trade has been transferred to a company under 75% common control).It should be noted that the amendments to the valuation of stock at cessation provisions do not affect the position between unconnected parties and losses can be transferred if care is taken by the appropriate valuation of stock (and related amendment to other valuations). If losses are unavailable for carry forward, it is important to make sure that the capital gains on asset disposals are made before the cessation in order to ensure that the losses can be used. Back to our case study: Aldridge plc eventually sells the current assets and the trade as a going concern on 31 August 2000.The purchaser does not wish to buy the freehold factory site and this is sold to a pension fund on 1 September 2000, realising a capital gain of £150,000. The shortened accounting period to 31 August 2000 (the date of cessation) shows trading losses of £100,000 which cannot be used against any other income of the company in current or previous accounting periods. In this situation the trading losses to 31 August 2000 will be lost and cannot be set-off against the capital gains.If the factory site had been sold prior to the cessation of the trade,then trading losses would have been offsettable against the disposal of the factory site.

23

CHAPTER

3:

SALE

OF

ASSETS

OR

SALE

OF

SHARES?

Capital losses The disposal of certain chargeable assets as part of a business sale could give rise to capital gains and capital losses.If these happen in the same accounting period, the losses should be offset against the gains. Care should be taken to ensure that capital gains are not realised in a piecemeal disposal of a trade in an accounting period,prior to the disposal of assets generating losses, as capital losses cannot be carried back to previous accounting periods. R Para 5 VAT (Special R Provisions) Order 1992

VAT Normally where there is a disposal of assets then VAT will be applicable.Furthermore where there is a cessation of a trade then there is a deemed taxable supply of all goods then held by the business. However, the disposal by a person of assets as part of the transfer of a business as a going concern can be treated as neither a supply of service nor a supply of goods. The main conditions for this relief are as follows: •

The assets are to be used by the transferee carrying on the same kind of business,whether or not as part of any existing business,as that carried on by the transferor.

•

In a case where the transferor is a taxable person,the transferee is already, or immediately becomes as a result of the transfer, a taxable person.

•

Where part of the business is transferred,that part is capable of separate operation.

Where protection is sought from VAT on the transfer, by virtue of the above, the sale agreement should provide for what happens if Customs & Excise disagree, so that VAT becomes chargeable on all or some of the assets.Generally,the contract will need to make sure that in such situations the vendor can raise a VAT invoice and recover the VAT from the purchaser and that the purchaser can insist on an invoice being produced so that it can recover the VAT input tax.

24

CHAPTER

3:

SALE

OF

ASSETS

OR

SALE

OF

SHARES?

Passing the sale proceeds to the shareholders If the whole business and all the assets are sold then all that is retained is a company with a ‘cash pot’. As referred to above, passing out the proceeds in such a situation can give rise to a certain amount of double taxation and the following routes, or a mixture of them, should be considered:

R ESC C16

•

Paying a dividend.

•

Liquidating the company so that the assets are distributed as part of a capital distribution –

As a less expensive alternative to the last point,dissolving the company under Section 652 Companies Act 1985 which, by concession, is treated as capital distribution.

The sale of shares Form of consideration If the consideration for the purchase of the shares is a fixed amount to be paid in cash,then the capital gains consequences are fairly straightforward,with a capital gains computation being prepared in the normal way (see Appendix 3). An important factor may be determining the date of the sale.This will normally be the date of exchange of contracts unless the contract is conditional,whereupon the disposal date will be the date on which that condition (which must be a condition precedent) is satisfied. Determining the date of sale will affect the availability of retirement relief,the calculation of taper relief,and the tax year in which the disposal takes place. Conditional contracts can be used to defer the disposal point past 5 April into a new tax year and therefore postpone the Capital Gains Tax by twelve months. R ESC D31

By concession, for retirement relief purposes only, the Revenue are prepared to accept the completion date as the date of disposal,if business activities continue beyond the date of unconditional contract, although care needs to be had with the interaction of this concession into the phasing out of retirement relief. In Mr Aldridge and his daughter’s case delaying the disposal date until after 5 April 2001 will increase business asset taper from 25% to 50% and full 75% taper would be available after 5 April 2002.

25

CHAPTER

3:

SALE

OF

ASSETS

OR

SALE

OF

SHARES?

Although the total amount of consideration may be fixed, it may be that all or part of it is payable in a ‘paper’ form. For instance, the purchase consideration of £20 million could be £5 million in cash and £15 million in shares or redeemable loan stock to be issued by the purchasing company. The receipt of cash consideration gives rise to a part disposal on which Capital Gains Tax may well arise but with part of the gain being deferred until the paper consideration is realised (see Appendix 3). R S 135-138 TCGA

The deferral for paper for paper consideration will be available if the conditions of Section 135-138 apply to the transaction.This includes the purchasing company holding more than one quarter of the ordinary share capital of Aldridge plc after the transaction. Where loan stock is used,special rules will apply if this falls within the definition of Qualifying Corporate Bond (QCB).The gain at the time of disposal attributable to that element of the consideration is deferred until the QCB is disposed of or redeemed, but no further taper relief accrues. Where redeemable loan stock is used, the Revenue will normally not allow relief if it is redeemable within six months of the transaction,as they take the view that it is tantamount to being cash. Loan stock must also be on normal commercial terms,particularly with reference to the interest rate and terms of redemption. In order that taper relief continues to accrue on the new paper acquired it will often be desirable to structure the loan note as a non-QCB by,for example,providing for conversion into another currency.

Capital gains: taxation of securities R S.88 FA 97

To counter doubts over the status of capital gains inherent in certain securities that change into Qualifying Corporate Bonds,provisions were introduced to treat such changes as a conversion of securities.This ensures that any existing gain will remain liable to tax, although it may still be deferred under existing rules until the security is disposed of. The rules apply to any disposals of shares/securities on or after 26 November 1996.It does not matter when the conversion either to or from a QCB occurred. The changes are best illustrated by an example: George bought shares in Michael Limited a number of years ago for £1,000. In March 1996 Michael Limited was taken over by Desert plc.The terms of the takeover were that all the shares in Michael Limited were acquired in exchange for

26

CHAPTER

3:

SALE

OF

ASSETS

OR

SALE

OF

SHARES?

securities in Desert plc.George’s shares were now worth £10,000 and he received £10,000 of securities which contained a right to convert into US Dollars at any time before 31 December 1996 (it would have been immaterial as to whether or not the conversion rights had to be exercised pre or post Budget Day in November 1996).The securities were redeemable at any time after 31 December at the option of the holder.George never exercised the right to convert into dollars but had half his securities of £5,000 redeemed on 4 April 1997 and the balance just into the new tax year. The securities in Desert plc are non-QCB’s at the time of issue.For CGT purposes, therefore, they are treated under the conversion of securities rules, as the same asset as the original shares in Michael Limited with a base cost of £1,000.When the right to convert into dollars lapsed the securities became QCB’s but did not trigger a disposal for Capital Gains Tax purposes but there could be no triggering of the deferred charge under Section 116 TCGA. The gain of £9,000 (before indexation) would therefore be exempt.Whether this contention is correct will be established through the courts. Under the Finance Act 1997 rules, the above redemptions take place after 26 November 1996 and therefore the revised Section 132 TCGA 1992 ensures that the change from non-QCB to QCB is treated as a conversion of securities.Thus a gain of £9,000 is computed at the time of conversion but held over pending the disposal or redemption of the QCB.

Deferred consideration and earn-outs Part of the consideration for the disposal may be an unquantifiable amount,either payable in cash or in paper, which is normally determined by reference to the performance of the business for a specific period after the acquisition. R S.89 FA 97

Extra statutory concession D27,allowing unascertainable deferred consideration to be treated as a security such that capital gains may be deferred, has been put onto a statutory footing.Claims to apply the concession will not be allowed after November 1996 other than for rights acquired before 26 April 1988.

R 1980 STC 500

Under the case of Marren v Ingles,a right to receive deferred consideration was held to be a separate asset for CGT purposes.As a consequence,where a shareholder receives shares through an earn-out provision on a take over, whilst there will be a CGT disposal on the ultimate disposal of the new shares obtained through the earn-out, there could be two earlier occasions of charge – on the acquisition of the earn-out right as part of the consideration of the original shares and also when the earn-out right is disposed of in exchange for the shares in the take over company.D27 allows the right to that unascertainable consideration to be treated

27

CHAPTER

3:

SALE

OF

ASSETS

OR

SALE

OF

SHARES?

as a security and hence defers a gain to the ultimate disposal of the new shares earned through the earn-out provision. The reason for the change was not just to put the extra statutory concession on to a statutory footing but was to clarify the position where QCBs formed part of the earn-out consideration. A new Section 138A of the TCGA 1992 was inserted to allow the vendor of shares to treat the earn-out right as a security of the new company and as a non-qualifying corporate bond where: •

The earn-out right is to be satisfied by the issue of shares or debenture in the take over company

•

As consideration for the transfer by the vendor of shares or debentures in the old company

•

The value or quantity of new shares is unascertainable (probably hinging on the attainment of profit targets in Newco etc).Therefore if the vendor elects and the share for share deferral provisions apply to the balance of the consideration (or would if appropriate) then the earn-out right shall be treated as a security of the new company and as a non qualifying corporate bond, hence the gain can be deferred. The election is irrevocable and is subject to the one-year ten-month rule for individuals/two years for companies.Obviously the decision as to whether or not to elect must be considered in great detail and will be influenced as to the availability of retirement relief on the initial/subsequent disposal.

The matter is best illustrated with an example: George also holds shares in Harrison Limited.Again he has had them for a large number of years and they cost him £1,000. Harrison Limited is taken over by McCartney Limited.The consideration to George being £5,000 in cash,plus £5,000 in shares,plus the right to receive shares in McCartney Limited over the following two years, subject to the attainment of profit targets.These rights are valued at £2,000 at the time of the take over (this will be down to negotiation with SVD and this will involve looking at projections of profits, ascertainability of targets, as well as looking at the shares in McCartney Limited and their potential value). Following the earn-out period George actually receives £4,000 of shares in McCartney Limited through the earn-out which he sells five years later for £8,000. Retirement relief is not in point and therefore George elects for the earn-out to be treated as a security.

28

CHAPTER

3:

SALE

OF

ASSETS

OR

SALE

OF

SHARES?

The tax consequences of the disposal are therefore as follows: i

Cash sum received

5,000

less proportion of cost of shares in Harrison Limited 5000 5000 + 5000 + 2000

x £1000

a)

Cash

b)

Shares on take over

c)

Value of earn-out right

Chargeable gain (subject to Indexation and taper) ii

Cash received on disposal of shares in McCartney Limited from earn-out

417

£4,583

8,000

less proportion of cost of shares from earn-out 2000 5000 + 5000 + 2000

x £1000

Chargeable gain (subject to Indexation and taper)

167

£7,833

The base cost of the earn-out right and subsequent conversion of earn-out right to shares in McCartney Limited is £167, which is deemed to be the same asset as the original shares in Harrison Limited and therefore indexation runs from the original acquisition date of 1982.Therefore, when the shares are eventually sold for £8,000,subject to indexation,the gain arising will be £7,833.Obviously if the securities in McCartney Limited were QCBs at the date that the earn-out was satisfied by the QCBs, the gain would be calculated at that point and then deferred to the ultimate disposal of the QCBs.

29

Inland Revenue clearances and anti-avoidance in general ANTI-AVOIDANCE THE INTRODUCTION OF A GENERAL ANTI-AVOIDANCE RULE C A P I TA L G A I N S TA X A N T I - AV O I D A N C E P R O V I S I O N S D O C U M E N TAT I O N M A W S L E Y M A C H I N E R Y LT D V R O B I N S O N

chapter

4

CHAPTER

4:

INLAND

REVENUE

CLEARANCES

AND

ANTI-AVOIDANCE

IN

GENERAL

Chapter 4: Inland Revenue clearances and anti-avoidance in general It is normally prudent to obtain clearance under Section 707 TA 1988 to make sure that the general anti-avoidance provisions on a disposal of shares do not apply. It is very unlikely that in most straightforward sales,such as that in the case study in the previous chapter, that there will be a problem with Section 703 et seq. Where there is a paper consideration and a deferral of the gain is required,clearance will normally be advisable under Section 138 TCGA 1992. It is important to realise the scope of any clearances given by the Inland Revenue under the above section numbers. Clearance, which is given by specialist Inland Revenue offices, is normally to confirm, or otherwise, that they believe the transaction is to be ‘effected for bona fide commercial reasons and does not form part of a scheme or arrangement of which the main purpose, or one of the main purposes,is avoidance of tax’.The wording used in Section 707 TA 1988 is slightly different to the above. R Matrix Securities Limited R v IRC 1994 STC 272

The clearance,when given,does not confirm that any relief being sought is available and that the requisite conditions for that relief have been satisfied. For instance, although the Revenue may confirm under Section 138 that the transaction is bona fide etc,if there is paper consideration then it does not confirm that the conditions for relief are satisfied.The availability of the relief is a matter for the Inspector of Taxes to determine after the event. It is important therefore not to place too much reliance on the obtaining of Revenue clearances. Other Revenue clearances may be considered,for instance under Section 776 TA 1988.If Aldridge plc is involved in land,for instance it is a property development company, then this aspect may need to be considered.Although it is possible to obtain clearance, it is understood that none has ever been given by the Inland Revenue under this provision. It must be remembered that clearances are only valid to the extent that full information has been imparted to the Inland Revenue.

31

CHAPTER

4:

INLAND

REVENUE

CLEARANCES

AND

ANTI-AVOIDANCE

IN

GENERAL

Anti-avoidance Up to the current time, the Inland Revenue have had two approaches to dealing with creative tax planning.Tax evasion has always been illegal and the various professional organisations bear down heavily on any solicitor or accountant who assists their client in tax evasion.The penalties enforced by the regulatory authorities will also be substantial and are likely to involve a term of imprisonment for even a first offence. Tax avoidance, however, is permissible, although under the current climate it is generally referred to as tax planning or mitigation. However, the Revenue and the other regulatory authorities,are continuously looking to close loopholes,ambiguities and lacunas which result in a loss of taxation yield from transactions. The mechanisms by which they can do this currently are either: •

Via specific legislation designed to hit a particular type of transaction, as there are clearances for most of these.

•

Via the development of judge made law, which enables the substance of a transaction to be looked at where part official or pre-ordained steps are inserted within a transaction to obtain a tax advantage (the Ramsay principle).

Unfortunately,the Government perceives that it is inequitable for taxpayers who can afford for good advice to pay significantly less tax on similar transactions to those who cannot afford or do not avail themselves of assistance.The morals of this are not debated in this Report! However,the Government is considering the introduction of a general anti-avoidance rule and it is vital that all solicitors and accountants involved in commercial practice are aware of the potential consequences of the proposals.

32

CHAPTER

4:

INLAND

REVENUE

CLEARANCES

AND

ANTI-AVOIDANCE

IN

GENERAL

The introduction of a general anti-avoidance rule A consultative document was made available on the Revenue’s website in the autumn of 1998.It was a 25-page document and it proposed,amongst other things, that a GAAR would be subject to a clearance system to achieve some measure of certainty. The document dealt only with anti-avoidance in relation to direct taxes and related to the corporate sector rather than individuals, as this is the area where some of the most contrived and costly avoidance takes place. But if it is felt to be in the wider interests of the Exchequer and of taxpayers as a whole, the Government could consider extending it at a later date. The key elements of the paper were: •

Why a GAAR is being considered

•

How key elements of a GAAR might be worded

•

The tax consequences of applying a GAAR

•

Advance clearances.

Whilst the GAAR was not brought into the 1999 or 2000 Finance Acts,the Government preferring specifically targeted anti-avoidance rules, it is clear that the matter has not been dropped completely.

Why a scheme is being considered R W T Ramsay v CIR 54TC101 R Furniss v Dawson 55TC324

Many countries have had general anti-avoidance legislation for many years but this country has always fought shy of such rules,instead relying on specific legislation for specific avoidance measures,backed up by flexible judge made law arising from such well known cases as Ramsay and Furniss v Dawson.This gives the Revenue flexibility to react to developments as they occur.However,it has become apparent that there is now an increased level of sophistication being applied by corporations, especially in the formulation of contrived avoidance schemes. With such schemes, the taxpayer has currently little to lose and much to gain from their success. It would appear that such schemes are costing the Treasury large sums in lost revenue. It is perceived that a GAAR would remove the need for some litigation (although initially it is likely to lead to a short-term increase as the boundaries of a GAAR are explored).Another major perceived advantage is that a GAAR will assist the Revenue in defeating contrived schemes before taxation revenues are lost.Currently, where a contrived scheme exploits a lacuna or loophole in the existing specific legislation, there is little the Revenue can do to stop the loss of tax until the law is changed, as the only alternative would be retrospective legislation.

33

CHAPTER

4:

INLAND

REVENUE

CLEARANCES

AND

ANTI-AVOIDANCE

IN

GENERAL

How key elements of a GAAR might be worded The way it could be worded will be based upon how it is likely to work. It is proposed that the GAAR would build upon the Ramsay principle but would go further. Currently Ramsay will be applied where there is a preordained series of transactions which are almost certain to happen and which have no commercial substance other than the avoidance of tax and should be considered as a whole. With the GAAR,it is proposed that it would no longer be necessary for a scheme to have to be split into steps or to consider when the steps occurred – merely the substance or purpose behind the transaction. The rule would work by starting with a clause to define the purpose of the legislation to assist judges in its application and would be followed by a number of definitions such as ‘tax avoidance’itself! Whilst a wide definition would ensue, safeguards will be introduced (protected transactions) so that commercial transactions (‘acceptable tax planning’) will not be caught.It would be triggered by a purposive test, which would identify tax driven transactions, whose main purpose or one of whose main purposes, was to avoid tax. A transaction could be either a multi or single stage event.

Tax consequences of applying a GAAR It is proposed that where a person undertakes a tax driven transaction, it will be recharacterised for tax purposes so that the transaction (single or composite) will be taxed as a corresponding normal transaction – one that would have happened if tax avoidance had not been intended.

Burden of proof Whilst we are already within the era of self-assessment for companies and matters such as transfer pricing must now be self-assessed, it is proposed that the initial burden of proof should lie with the Revenue, to identify where a transaction has taken place,where the main reason or one of the main reasons was the avoidance of tax. However, having identified that there is a difference between the normal way of doing the deal and the actual way that gives a tax advantage, it will be for the taxpayer to prove that the transaction fell within acceptable tax planning. If they cannot, tax is levied as if the normal transaction had been undertaken.

34

CHAPTER

4:

INLAND

REVENUE

CLEARANCES

AND

ANTI-AVOIDANCE

IN

GENERAL

Clearances and administration It is clear that the application of the GAAR should be controlled centrally,so that there is consistency of approach throughout the country.It is also suggested that there should be an advance clearance service made available.Whilst this will be an absolute necessity as a safeguard for taxpayers,it will prove to be a nightmare for the Inland Revenue.Currently the Revenue are organised so that their specialists are organised into different sections for different clearances – i.e.Section 703 Group, CGT Clearances etc.As a GAAR clearance would have to be all encompassing – looking at taxes and duties – obvious difficulties will arise in providing a sufficient body of persons capable of dealing, at the highest levels, with the clearances. It is accepted that clearances must be given promptly but the proposal that the Revenue have 30 days for a response is unfortunately at variance with the speed of modern day commerce. Consideration to this limit must be given. However,the proposal that there should be a publication of anonymised decisions on clearance applications and general consents and warnings should assist taxpayers in deciding what is at the boundary of acceptable tax planning and therefore needs a clearance application and what does not (which will be the vast majority of transactions)! This is to be welcomed. The final part on clearance is that, given the level of complexity and the nature of the applications, the speed of turn around required and the binding nature of any clearance compared to the sums of money involved,a proposal has been made that the Revenue should be able to charge for the clearance,although the document merely proposes two alternatives – namely a flat rate per application or a rate per hour involved.

Capital Gains Tax anti-avoidance provisions Rather than introduce a GAAR,the Finance Act 2000 includes several specifically targeted measures to block a number of CGT avoidance schemes.The measures are contained in Sections 89 to 95 and their associated Schedules and take up some 21 pages of legislation.

Restriction of gifts relief Sections 89 provides for the ending of Capital Gains Tax relief for gifts of business assets on the transfer of shares or securities to companies.The relief is not available for transfers on or after 9 November 1999 (the date of the announcement to end the relief).

35

CHAPTER

4:

INLAND

REVENUE

CLEARANCES

AND

ANTI-AVOIDANCE

IN

GENERAL

The gift of a chargeable asset may give rise to a Capital Gains Tax liability.The liability may be deferred, however, if the gift is of qualifying business assets and a claim to gifts holdover relief is made. Qualifying assets include assets used in a trade or profession and shares or securities in an unlisted trading company. The holdover under s165 TCGA 1992 on the gift of shares to a company was an integral step in a number of avoidance schemes and,with the enactment of Section 89 Finance Act 2000, which takes only half a page of legislation, virtually all of the schemes specifically targeted by Sections 90-95 Finance Act 2000 have become either entirely impractical or of only very limited effect. Section 89 withdraws relief in the limited circumstances where shares or securities are transferred by individuals or trustees to companies. S165 TCGA relief continues to be available for all other transfers of business assets, including the transfer of assets used in a trade when a business is incorporated.

Disposal of interest in settled property New measures in Section 90 in Finance Act 2000 provide for a Capital Gains Tax charge to arise in certain circumstances where a beneficiary of a trust sells his or her interest in it to someone else on or after 21 March 2000.The trusts principally concerned are UK trusts in which the settler has an interest or where any of the trust property is derived from a trust that was a settler-interested trust at any time in the previous two tax years.The effect of the provisions is to treat the underlying assets to which the interest relates as though they are disposed of by the trustees and immediately reacquired by them at market value. Prior to 21 March 2000 any gains arising on the disposal of an interest in (as opposed to the underlying assets of) a UK trust were not generally chargeable to CGT by virtue of Section 76 TCGA 1992 but this exemption was being exploited by individuals who placed assets such as shares in family companies (which were standing at a gain) in trusts in which they retain an interest that is subsequently sold to someone else.They were effectively using the CGT exemption to sell the underlying assets tax-free to third parties.

Transfers of value by trustees linked with trustee borrowings The provisions in Section 91 Finance Act 2000 are designed to counter an avoidance device that has become commonly known as a ‘flip flop’. This is a device for extracting gains from a trust tax-free,or with a significant tax saving,using borrowed money.The basic idea was to exclude the settler from benefit under the trust before the disposal took place – the disposal taking place in a separate tax year.

36

CHAPTER

4:

INLAND

REVENUE

CLEARANCES

AND

ANTI-AVOIDANCE

IN

GENERAL

The way in which this was done was broadly as follows.The trustees of the first trust would borrow money from a bank; they would then settle that money on a second trust – trust 2.The settler of trust 1 would be excluded from benefit under trust 1 but was still able to benefit under trust 2.In the later tax year there was a disposal of the assets in question by the trustees of trust 1 so that there was a gain in trust 1.The settler had been excluded from benefit so that the gain could not be attributed to the settler.The trustees were off-shore,outside the UK Capital Gains Tax charge and they then had the money to repay the bank.The monies had been settled in trust 2, the settler could benefit from trust 2 and as the monies were cash,when the monies were appointed to the settler there was no Capital Gains Tax charge. The new provisions counter the ‘flip flop’ by providing for gains on chargeable assets remaining in the trust to be crystallised in the hands of trustees.This will happen if the trustees transfer value out of the trust at a time when they have outstanding debt and the proceeds from that debt have not been wholly used for normal trust purposes. A ‘transfer of value’is,broadly,the transfer,or lending,of money or any other asset by the trustees to another person.The gains are crystallised because the trustees are deemed to dispose of the whole or part of each of the chargeable assets remaining in the trust after the transfer and to reacquire them immediately at market value.

Capital loss schemes A number of schemes have been implemented in recent years involving the purchase and utilisation of trust capital losses.Section 75 Finance Act 1999 blocked one such scheme but other variations had been developed to circumvent these rules, by enabling individuals with large potential capital gains to buy their way into trusts with actual or potential losses. The latest variant of the scheme involved making the purchaser a beneficiary of the whole trust on which the capital losses subsisted,the purchaser of the interest would then transfer an asset (such as family company shares) into the trust with holdover relief,the trustees would sell the asset,realise a gain and set it off against their brought forward capital loss. To counter these schemes,Section 92 Finance Act 2000 prevents losses accruing to trustees being set against gains on assets that have been transferred into the trust using gifts hold-over relief, where the transferor or a connected person has acquired an interest in the trust and any consideration has passed in connection with the acquisition. We can expect further specific anti-avoidance legislation to develop as the Revenue identifies further avoidance schemes.

37

CHAPTER

4:

INLAND

REVENUE

CLEARANCES

AND

ANTI-AVOIDANCE

IN

GENERAL

Documentation Quite clearly the point that comes from the above is that with all drafting of documentation and letters of advice, a key point that must be borne in mind is that whilst tax planning will always be important the commerciality of a transaction is paramount. Whether under existing judge made law, existing specific avoidance legislation, or under the future general anti-avoidance rules, it must be recognised that the Inland Revenue have access to advisors letters via the process of discovery, as the matter proceeds to appeal and documentation should be drafted in the knowledge it could be made available to the Inland Revenue.This is well illustrated by the Mawsley Machinery Special Commissioners decision outlined below.

R [1998] STC (SCD) 236

Mawsley Machinery Ltd v Robinson K was the managing director and controlling shareholder of the taxpayer company. In 1992 he decided he would retire in 1998.His fellow directors could not afford to buy him out and he did not want them to lose control when he realised his shareholding, so the company created a discretionary trust to receive K’s shares on retirement.The trustee of the trust was a subsidiary company and K and other directors of the company were appointed as directors of the trustee company. It was expressed to be for the benefit of all the company’s employees (an EBT) although K regarded it as a vehicle to enable it to purchase his shares when he retired and thus for the other directors to keep control of the taxpayer company. The company paid the trust three substantial annual payments between 1994 and 1996 and deducted these payments from its profit computations.The Inspector disallowed those deductions, because (1) they were capital not revenue and (2) even if they were revenue they were not wholly and exclusively laid out for the purpose of the company’s trade since the primary purpose of the trust was to acquire K’s shares.The company appealed. The Special Commissioner held: •

In considering whether a payment was capital or revenue, which was a question of law,the nature of the payment and the nature of the advantage obtained by the payment were of particular importance.However,looking to the purpose in this case,which was to build up a capital fund to enable a capital purchase of K’s shares on his retirement, the payments were capital and therefore non-deductible.

•

In considering whether expenditure was wholly and exclusively laid out or expended for the taxpayer’s trade, the primary inquiry was to

38

CHAPTER

4:

INLAND

REVENUE

CLEARANCES

AND

ANTI-AVOIDANCE

IN

GENERAL

ascertain the taxpayer’s particular object in making the payment.Once that was ascertained its characterisation was a matter for the commissioners,not the taxpayer.Here the object was to build up a trust fund to buy K’s shares which was a convenience for K, even though it was also a benefit to other employees and perhaps also to the trade. The words wholly and exclusively were important. The taxpayer company’s appeal was dismissed.

Comment An EBT can be a very useful vehicle for longer term planning for exit routes for shareholders, whether they are employees who receive incentive shares or controlling directors,but take care with any such arrangements.Attention to detail in surrounding correspondence,drafting of the documentation and in planning ahead is important. An EBT can borrow sums of money to assist in providing an exit route.This may be preferable to effectively building up a capital or sinking fund or could be used in conjunction with one. Clearly however, any correspondence must stress that the trust and the contributions must be for the benefit of the employees. Having a QUEST (Qualifying Employee Share Trust) or ESOP as they are sometimes known (Employee Share Ownership Plan), will assist as these have Revenue approval. To obtain approval,it will be necessary to demonstrate the benefit to the employees. Once approval has been obtained, tax relief is facilitated, so long as the normal rules are adhered to. The benefit of a QUEST is further enhanced by the fact that so long as certain other conditions are complied with,where any gain arises on the disposal of shares by the shareholder to the QUEST, this may be rolled into the acquisition of any other chargeable assets such as limit trusts or holiday homes.With the abolition of retirement relief this could prove to be a highly attractive exit route.However, the benefit to employees must be the paramount reason behind the trust rather than the provision of an exit route to the shareholder.Accordingly,consideration should be given to putting in place a further share scheme to assist with the passing of the shares in an efficient manner to the employees/key executives who remain after the retirement of the appropriate shareholders.

39

CHAPTER

R S 163-164 TCGA

4:

INLAND

REVENUE

CLEARANCES

AND

ANTI-AVOIDANCE

IN

GENERAL

Capital losses Capital losses arising in the same year or brought forward will be available to offset against the gain on the share disposal.It should be remembered that such capital losses could not be increased by indexation losses. Care must be taken with the order of offset where two or more assets with differing taper are being disposed of. Where the vendor holds assets that stand at a capital loss then consideration should be given to realising those losses, if it is commercially acceptable, in the year in which the share disposal takes place. One or more of the vendors may be eligible for retirement relief if the qualifying conditions are satisfied.If the sale is before 5 April 2001,then retirement relief will only exempt the first £150,000 of gain. After that the relief will be restricted further. Where the consideration is satisfied wholly in paper then the transaction will not be treated as a disposal at that point. Retirement relief will not be available and it may be that the vendor,who would otherwise have qualified for retirement relief on the sale,will never qualify because the company in which he now owns shares or loan stock is not his ‘personal’ company. To avoid this problem the vendor can make an election under para 2 schedule 6 TCGA 1992 to have his disposal treated, so that the relief in provisions under Section 135 etc does not apply (in other words the relief for paper for paper transactions is disapplied). This election must take place within 22 months of the end of the year of assessment in which the share exchange takes place and it works on an all or nothing basis. The downside is, therefore, that the whole gain becomes taxable subject to the availability of retirement relief. For example: If A.Aldridge receives his £11 million share of proceeds entirely in redeemable loan stock issued by the purchasing company,Section 135 etc TCGA should apply so that the transaction is not treated as a disposal at that point. No CGT would be due by reason of that transaction. It is unlikely that the purchasing company would be A.Aldridge’s personal company within the meaning of Para 1 Schedule 6 TCGA.If A.Aldridge has no other business interests which may entitle him to retirement relief on a potential future disposal, then to take advantage of retirement relief on the present disposal, an election will have to be made under Para 2 Schedule 6 TCGA.This will, however, apply to the whole transaction so that substantial Capital Gains Tax will be due (see Appendix 3) and the benefit of receiving consideration in the form of redeemable loan stock will be lost.

40

CHAPTER

4:

INLAND

REVENUE

CLEARANCES

AND

ANTI-AVOIDANCE

IN

GENERAL

In this case a sensible compromise would be to ensure that part of the £11 million consideration is received in cash, say £600,000, so that retirement relief can be realised in full against the gain on the cash element, with the remainder of the gain effectively being deferred until the £10.4 million of loan stock is redeemed. The calculations would show that with £600,000 cash proceeds and £10.4 million of loan stock the initial Capital Gains Tax is kept within manageable proportions but this does ensure, however, that retirement relief is used in full, giving rise to an overall Capital Gains Tax saving of £150,000 (£375,000 x 40%). This election will lose its attraction as retirement relief is phased out.

Reinvestment relief The vendor may also be eligible to obtain the benefit of reinvestment relief under EIS rules, as amended. By reinvesting in qualifying unquoted trading companies within the permitted period reinvestment relief is effectively unlimited.It is also possible that the reinvestment by the vendor could obtain Income Tax relief effectively reducing the net tax on the sale,still further where he is not connected with the company. Also, as a result of the Finance Act 1995 the availability of a VCT should not be ignored. However, there is still an overriding maximum investment into VCT’s of £100,000 per annum.On larger gains this is unlikely to shelter substantial amounts of tax. It should be remembered that where the purchaser is a management buy out linked with an ESOP then additional Capital Gains Tax relief will be available to the vendor where the ESOP is a statutory ESOP and the vendor reinvests the proceeds into chargeable assets of whatever nature. When advising the vendor of a company approaching retirement age,where there is no obvious succession, consideration should be given to a long-term strategy for the eventual sale of the company.It may be that the management are the only potential purchasers who are men of ‘straw’. A campaign spread over a number of years to fully fund approved and unapproved pension schemes can lead to a substantial reduction in the net assets of the company whilst providing,in a very tax efficient fashion, for the future retirement of the shareholder.The use of a management buy out and ESOP can then be sufficient to raise the additional finance to achieve the full market value anticipated by the vendor. This is done in a highly tax efficient way.

41

CHAPTER

4:

INLAND

REVENUE

CLEARANCES

AND

ANTI-AVOIDANCE

IN

GENERAL

Corporation Tax liability of the company The vendor should obviously give consideration to the Inland Revenue’s ability to collect taxes remaining unpaid by the company for accounting periods up to and including that in which the sale took place from the vendor in some circumstances.

42

Advising the purchaser PURCHASE OF ASSETS OR PURCHASE OF SHARES? S TA M P D U T Y

chapter

5

CHAPTER

5:

ADVISING

THE

PURCHASER

Chapter 5: Advising the purchaser As with advising the vendors, it is important to establish the intentions of the purchasers, their tax position and what tax benefits, if any, they hope to obtain from the purchase itself.For example,one of the key objectives behind the purchase may be to secure a qualifying investment for an individual to obtain deferral of capital gains under the EIS reinvestment relief provisions.Alternatively,the target company may have substantial tax losses, which the purchaser would like to preserve and use.If an asset purchase is desired,then the availability for tax relief on assets acquired (for instance capital allowances on plant and machinery) may be important.

Purchase of assets or purchase of shares? The main advantages and disadvantages of asset sales as opposed to share sales have been considered in the last chapter. Subject to the commercial benefits of not acquiring a company, with all the problems that brings with it, the main tax aspects from the purchasers point of view are dealt with below. The purchaser may desire an asset purchase because it may enable him to establish a high cost for particular assets,either for claiming capital allowances on,or perhaps in the case that certain assets are going to be sold shortly thereafter.For instance, if the purchaser wishes to acquire the whole business, but intends to sell the freehold premises, it may be important to acquire the assets directly, as that can establish a higher base cost for the premises than might be available if the company simply acquired. The proposals set out in the discussion document ‘The Reform of the Taxation of Intellectual Property’,if they proceed in the Finance Bill 2001,will enable the purchaser to obtain a tax deduction for the amortisation of intangibles such as trade marks, brand names, and even goodwill.The likely change is that the tax treatment will follow the accounting treatment as determined by FRS10 and will allow a tax deduction for the acquisition of goodwill for the first time in the UK. This may well tilt the balance in favour of asset sales rather than share sales, as there is no Corporation Tax deduction for the cost of shares.

44

CHAPTER

R S. 164A TCGA

5:

ADVISING

THE

PURCHASER

Where the purchaser is an individual he may wish to defer a capital gain and therefore he needs to either acquire a new company in which to subscribe for shares which acquires the business,or to acquire the target company itself.Either way may give EIS reinvestment relief subject to the usual qualifying conditions being satisfied.

Stamp duty The recent increases in the rate of stamp duty to 4%, where the consideration exceeds £500,000, have made this an important factor when considering the purchase of a company or the underlying trade and assets.There is a 3.5% differential compared to the 0.5 % rate that continues to apply to the purchase of shares.

45

Protecting losses ANTI-AVOIDANCE REVENUE PRACTICE

chapter

6

CHAPTER

6:

PROTECTING

LOSSES

Chapter 6: Protecting losses

Anti-avoidance If the target company has substantial corporate tax losses brought forward then the availability of these to the purchaser is of some importance. R S. 768 TA 1988

Anti-avoidance provisions provide for such trading losses to be disallowed where there is a change in ownership of the company and where the following applies: •

Where in any period of three years there is both a change in the ownership of the company and a major change in the nature or conduct of a trade carried on by the company

•

At any time after the scale of the activities in a trade carried on by a company has become small or negligible, and before any considerable revival of the trade,there is a change in the ownership of the company.

Considerable care therefore has to be taken to make sure that the above provisions are not invoked.This may prove difficult where a company has been trading at a loss, as to make it profitable it may be necessary to make fundamental changes to the way it operates. R Willis v Peeters Picture R Frames Ltd (1983) STC 453

There is considerable case law in this area that needs to be considered when contemplating the impact of this provision.

Revenue practice Statement of Practice Number SP10/91 (revised 22 April 1996) sets out the Revenue’s view as to what they will and will not regard as a major change in the nature or conduct of a trade. For instance, the following will not be regarded as a major change in the nature or conduct of a trade: •

Changes to increase efficiency

•

Changes which are needed to keep pace with developing technology

47

CHAPTER

6:

PROTECTING

•

Changes concerned with developing management techniques

•

Rationalisation of a company’s product range by withdrawing unprofitable items and, possibly, replacing them with new items of a kind related to those already produced.

LOSSES

Examples of changes that are not to be regarded as major changes are the following: R S 245 ICTA

•

A company manufacturing kitchen fitments in three obsolescent factories moves production to one new factory (increasing efficiency).

R S 245A ICTA

•

A company manufacturing kitchen utensils replaces enamel with plastic, or a company manufacturing timepieces replaces mechanical with electronic components (keeping pace with developing technology).

R S 768A ICTA

•

A company operating a dealership in one make of car switches to operating a dealership in another make of car satisfying the same market (not a major change in the type of property dealt in).

R S 767A & B ICTA 1988

•

A company manufacturing both filaments and fluorescent lamps (which filament lamps form the greater part of the output) concentrates solely on filament lamps (a rationalisation of product range without a major change in the type of property dealt in).

R S 768B ICTA 1988

•

A company whose business consists of making and holding investments in UK quoted shares, etc, changes its portfolio of shares (not a change in the nature of the investments held).

Examples of where a major change would be regarded as occurring include: •

A company operating a dealership in saloon cars switches to operating a dealership in tractors (a major change in the type of property dealt in).

•

A company owning a public house, which is to operate a discotheque in the same, but converted, premises (a major change in the services or facilities provided).

•

A company fattening pigs for their owners, which is to buy in pigs for fattening (a major change in the nature of the trade,being a change from providing a service to being a primary producer).

•

A company switches from investing in quoted shares to investing in real property for rent (a change in the nature of investments held).

48

CHAPTER

6:

PROTECTING

LOSSES

There are other provisions concerning losses where a company is sold which apply in a similar manner and these include: •

Prevention of carry-forward of surplus ACT

•

Prevention of carry-back of trading losses to a period prior to the acquisition

•

Prevention of the use of company purchases schemes to avoid Corporation Tax

•

Prevention of excess management charges being carried forward.

49

Warranties and indemnities INTRODUCTION C O R P O R AT I O N TA X – C O M PA N Y P U R C H A S E S C H E M E S T Y P E S O F S U B J E C T M AT T E R

chapter

7

CHAPTER

7:

WARRANTIES

AND

INDEMNITIES

Chapter 7: Warranties and indemnities

Introduction R Hurlingham Estates v Wilde R & Partners [1997] STC 627

Where there is a sale of a company there will undoubtedly be a need for an extensive tax warranty and tax indemnity.It is important that whilst accountants should review the relevant documentation,the drafting should be completed by somebody with the appropriate skills, usually a solicitor. In view of recent cases, the accountant must be aware that if he appears to take responsibility for areas he will be liable for omissions and errors not just in his area of expertise.

Corporation Tax – company purchase schemes R S. 767a & S. 767b TA 1988

Section 135 FA 1994 introduced legislation to counter what have been termed company purchase schemes. Such schemes had operated as follows: 1.

A profitable company transfers its business to another group company leaving only sufficient cash to meet outstanding Corporation Tax.

2.

That company is sold for a share of the unpaid tax.

3.

The new owner enters into arrangements to remove the Corporation Tax liability.

4.

The cash is extracted from the Company and usually the country.

The particular mischief dealt with by the legislation is that whilst the Revenue would frequently and successfully attack the arrangements in point 3 above, as the company had been stripped of all assets, the tax due could not be collected. The FA 1994 legislation enables the Inland Revenue to collect any unpaid tax from the persons who previously controlled the company or from companies under the control of such persons. R 1997 Budget Release IR7 R 112–114 F (no 2) A 1988

Note that the Finance Act 1998 extends these clawback provisions to areas where a transaction is undertaken prior to the sale, such as a hold over claim, which crystallises long after the sale.

51

CHAPTER

7:

WARRANTIES

AND

INDEMNITIES

The Revenue confirms that the liability extends to companies previously under the same control.They suggest that anyone buying any company will want to consider seeking an indemnity from the vendor, to deal with the possibility that the company purchased is faced with a liability under the new provisions,in that the vendor has sold another company in the three-year time envelope prior to the sale under the above scam. The Revenue will seek to obtain any tax found to be outstanding from those who previously controlled the company and companies controlled by those persons in the first instance.In the case where a company which has been sold could be liable on the sale of a previous group member,the Revenue have stated they will pursue the previous group first and in any case, they will not seek collection under the legislation from a company where the sale took place prior to 30 November 1993.

Reasons If, after the introduction of the legislation, the vendor makes a payment direct to the Revenue under warranty with the purchaser,in respect of the target company’s tax liability,the payment will be treated as reducing the consideration for the disposal of the shares. Purchase and sale of a business would involve a sale contract.The contract will define the matters subject to the agreement. Breach of the contract could lead to the contract becoming void or voidable.For this to arise,one of the fundamentals or conditions of the contract must have been breached. However, commercially, there could be many factors which,whilst not fundamental to the contract,could result in financial loss to the purchaser.These points effectively concern the nittygritty over the condition of the assets purchased. On the purchase, therefore, of a business or a company, to remove any ambiguity between what the purchaser thinks they have bought and the vendor thinks they have sold, the purchasers’ solicitor (generally) would insert into the contract the comprehensive set of warranties as to the condition of the company or business. These warranties will leave the vendor to disclose to the purchaser any potential problem areas.One of the reasons therefore for this procedure is so the purchaser can flush out any problem areas of which,despite the results of their investigations, they would remain unaware. Commercially, they can then judge whether or not a reduction of the purchase price should be negotiated prior to contracts being exchanged. Any problem areas will normally be included within a formal disclosure letter by the vendor to the purchaser. The disclosure letter is an exceptionally important document as generally no claim is possible under the warranties if a matter has been adequately disclosed in this letter. Any representations in the above documentation, which prove to be untrue, could lead to a claim by the purchaser against the vendor to damages.

52

CHAPTER

7:

WARRANTIES

AND

INDEMNITIES

Indemnities are promises by the vendors to pay fixed or certain amounts if any events,as detailed in the appropriate deed,(generally payments of liabilities) arise. It is normally found that warranties and indemnities exist over more or less the same items in a purchase agreement.The warranty and disclaimer letter is used by the purchaser to extract full information. Remember that a claim for damages against the vendor will only succeed if it can be proved that the purchaser has suffered real damage.The indemnity is included to ensure that, should a liability arise, the vendor makes the appropriate payment (under contract) without the purchaser having to prove loss. Extra-statutory concession D33 deals with the tax treatment of payments by the vendor under any warranties or indemnities.Whilst strictly the right to receive damages arises under the deed (a chosen action) and is therefore taxable to Capital Gains Tax immediately with effectively no deferral available, generally the payments will be treated as a reduction in the purchase price (i.e. the base cost of acquisition) to the purchaser and a commensurate reduction of the sales proceeds to the vendor (i.e. a revision under Section 49 TCGA 1992).

Types of subject matter Whilst warranties and indemnities will primarily be given over taxation matters, it is important that they should be obtained on all areas of the company.The following are examples of the most common areas: •

Ownership of shares

•

Inter-group arrangements

•

Accounts

•

Events since the last accounts date

•

Indebtedness

•

Litigation

•

Compliance with statutory and other enforceable obligations

•

Ownership of assets

•

Employment law aspects.

53

CHAPTER

7:

WARRANTIES

AND

INDEMNITIES

With regard to the taxation warranties and indemnities, it is very difficult to give a comprehensive list but the following matters might be important: •

Provision for Corporation Tax has been made in the accounts.

•

All Returns (CT200s,P35s,etc) have been submitted to the appropriate authority,whether it is the Inland Revenue,Customs & Excise or overseas authorities.

•

The appropriate tax has been paid on time.

•

PAYE has been correctly operated on all payments made or treated as made to employees and ex-employees of the company and the appropriate P11Ds have been submitted.

•

The group position should be investigated: –

Group income elections

–

Group relief

–

Surrenders of ACT.

•

Intra-Group transactions – CGT – base values losses – rollover relief.

•

Purchase of own shares.

•

Anti-avoidance; such as series of transactions, etc.

The above list is not exhaustive and where the accountant is acting for the purchaser, he must ensure that the warranties and indemnities produced by the purchaser’s solicitor are sufficiently comprehensive and up-to-date to isolate any problem areas.The vendor’s accountant should be querying the warranties and indemnities given to restrict them, only to the ones which he considers to be necessary to the client’s business and also trying to negotiate the largest de minimus level to prevent series of small claims arising on a regular basis.

54

Case study: A corporate vendor T H E TA R G E T A N D V E N D O R S P R E - S A L E R E - O R G A N I S AT I O N THE SALE O T H E R N O N TA X I M P L I C AT I O N S O T H E R TA X M AT T E R S ISSUES FOR THE PURCHASER

chapter

8

CHAPTER

8:

CASE

STUDY:

A

CORPORATE

VENDOR

Chapter 8: Case study: A corporate vendor

The target and vendors Jones plc is an industrial conglomerate whose businesses are mainly in the light engineering and electronics sectors.Over a number of years,it has however acquired some fairly diverse businesses and has now decided to concentrate upon its core. Accordingly, it has decided to dispose of the division involved in plastics manufacture.In the 1970’s and 1980’s the ability to manufacture plastics to order was useful in the enlargement of the group, however, economies of scale and environmental regulation imply that this is no longer the case and very large capital expenditure would be required over the next five to ten years to ensure that the company: a)

remains competitive and

b)

keeps up-to-date regulatory wise.

The company’s Board has therefore decided that strategically, the division does not fit in with the balance of the group trade and therefore a disposal (orderly) is planned. The assets and liabilities are as follows: Description Freehold land (Owned since 1982) Market value Cost and book value Plant & machinery (Owned for five years) Book value Market value (TWDV £350) Stock Book value Market value Net current assets Book value

£000

£000 2,500

1,000 1,000 1,500 300 400

200

200

£ 2,500

£ 4,600

56

CHAPTER

8:

CASE

STUDY:

A

CORPORATE

VENDOR

Pre-sale re-organisation Hive down Whilst the sale of assets could be contemplated (with all the same implications), it is more likely that a separate subsidiary would be formed into which the division would be passed.This type of pre-sale re-organisation is frequently used where the eventual sale is not urgent and there is time for the matter to be planned. In this situation, plans to reduce the potential tax charge on the eventual disposal can be effected. However, as stated before, the company law and other aspects cannot be ignored.At the time that the hive down of the business is contemplated, the due diligence enquiries of the eventual purchasers should be considered including items such as: •

Any transfers of property should take place with bank consent where charges are in point.

•

Any leasehold land is transferred subject to the superior interest consents.

•

There were no over or under payments so that the insolvency rules could not be invoked or the matter could not be considered to be ultra vires in any way.

Newco would be formed for a relatively nominal share value and the assets transferred across at book value.The proceeds are therefore likely to be left on loan account. As can be seen,there is a substantial difference between the market value of the assets and their book value, which is not recognised at this stage.

Capital Gains Tax R S.171 TCGA 1992

The transfer of the assets from Jones plc to Newco is an intra group transfer (it is 100% owned) and accordingly the transfer can take place without any Capital Gains Tax implications.Effectively,the assets go across at what is called a no gain/no loss value.A CGT computation is done and the proceeds are taken to be their historical base costs with indexation up to the time of transfer.

57

CHAPTER

8:

CASE

STUDY:

A

CORPORATE

VENDOR

Whilst the capital gain has been deferred at this stage, any sale of the subsidiary within six years will give rise to a capital gains charge in Newco.The company leaving the group is treated as if it had sold them at the date of transfer.The Capital Gains Tax on Newco on a disposal is therefore as follows: Description Freehold land – on transfer – deemed proceeds Cost Indexation (say 100%) Base Value to Newco Gain Plant and machinery on transfer – deemed Cost Indexation (say 20%) Base value to Newco Gain

£000

£000 2,000

1,000 1,000 2,000 – 1,200 1,000 200 1,200 –

(Assumes no exempt assets in P & M (unlikely)) On Newco being sold, the current values at the date of sale of the underlying assets are immaterial but the purchasers of Newco must be aware that they will be faced with the following CGT liability: £000 Freehold land – deemed proceeds Base value Indexation thereon @say 5%

£000

Gain

2,500 2,000 100 2,100 400

P & M – deemed proceeds Base value Indexation thereon @say 5%

1,500 1,200 60 1,260

Gain Tax @ 30%

240 640 192,000

58

CHAPTER

8:

CASE

STUDY:

A

CORPORATE

VENDOR

When a purchaser makes an offer for the share capital of the company it will have to discount that offer for the tax which will become due on Newco leaving the group. Alternatively, Jones plc might agree to indemnify the purchaser against the liability and sufficient monies could be set aside on an escrow account for the specific purpose of meeting the liability when it becomes due.Prudence would dictate that a combination of the two methods could be used.This is because it is very difficult to establish these inherent CGT liabilities with any accuracy prior to an actual disposal.

Balancing charges and losses The transfer will be intra group and therefore will fall within the provisions of Section 343 ICTA 1988,which deals with the transfers of businesses under common control. It must be remembered that theoretically on the pre-sale reorganisation that involves the transfer of the business of the plastics division to Newco, that business constitutes a trade, which has technically ceased.This would give rise to a balancing charge and potentially to other adjustments. Fortunately, this will not be the situation,even if the transfer of trade occurs only a brief period before the ultimate sale of Newco to a third party.Accordingly,therefore,assets will pass across at their tax written down value for capital allowances purposes and any losses will be available against future profits of the new company. As noted above,however,the purchaser must be careful to ensure that he continues to run the plastics division in Newco the same way as it was carried on before. It there is a major change in the nature or conduct of the business within the appropriate period (three years) then the losses would fall.

Stamp duty R S.42 Finance Act 1930

R S.27 Finance Act 1967 as R amended

As there is 100% ownership of Newco by Jones plc, no stamp duty arises on the transfer.However,if an immediate sale is intended,then stamp duty may arise.Indeed the legislation is sufficiently widely drafted so that if arrangements exist, the exemption will be denied. Arrangements are very widely drawn and it should be said that the exemption is unlikely to be available if negotiations are continuing between the ultimate purchaser and the vendor at the time of the hive down.Even if there are no apparent purchasers on the horizon,the closer to the ultimate sale the transfer/hive down occurs,the higher the danger of the stamp duty exemption being revoked. As the stamp duty would be paid by Newco, this is an item that the purchaser’s solicitors would need to investigate.

59

CHAPTER

8:

CASE

STUDY:

A

CORPORATE

VENDOR

The sale When a reasonable period has elapsed after the pre-sale reorganisation, Jones seeks a purchaser for the plastics company.Whilst the purchaser may well turn out to be from the UK,given current trading patterns,it is very likely that the purchaser will be based abroad in, say, the EU. Eventually a purchaser is found from within the EU by the name of Magiplass SA.This company is looking to expand its market share in the UK and has decided that this would be most efficiently achieved by the acquisition of existing facilities.Accordingly, an offer is made by Magiplass SA (subject to contract) for the share capital of Newco with a consideration of £4M in cash and a further £4M in cash subject to profit targets over the next two years.The cash consideration will be reduced by the extent of the intra group loan account set up on the hive down which Magiplass agrees to repay on acquisition.It should be noted that if there was any chance that this would happen actually at the date the intra group loan account was set up,this would compromise a stamp duty exemption on the hive down. It is fairly normal for some or all of consideration to be contingent upon either profit ascertainment or certification of a level of net assets. Here it is assumed that the profit targets are fairly rigorous and negotiations are entered into with the shares valuation division and the present value (at the date of contract) of that right to the deferred income is valued at £2M.Accordingly,the Capital Gains Tax implications are as follows: Gain on initial sale £000 Proceeds

Cash total Less loan account NPV of earn-out Less cost of shares Indexation

£000 4,000 2,000 2,000 2,000 4,000

500 ––––– 500 £3,500

Gain Gain on deferred consideration assuming full £4M realised Proceeds from earn-out Cost (in tax terms) Indexation Gain Total gain

4,000 2,000 100 2,100 1,900 £5,400

60

CHAPTER

8:

CASE

STUDY:

A

CORPORATE

VENDOR

However,it must be realised that the tax on the gain on initial sale must be funded by Jones plc from the cash resources paid on the initial sale.This will mean that proportionately the tax is very high on the initial sale.It must also be understood that if Newco does not achieve its targets and no payments are made under the deferred consideration,this means that the right has been sold for nothing,giving rise to a capital loss.This cannot be carried backwards against a gain that arose on the initial sale.If the deferral period is only a short period,such that the initial gain and deferred consideration arose in the same accounting period,then obviously an offset is available.This unfortunately is highly unlikely. Accordingly, loan notes would be suggested.As was noted in the previous case study,this enables the gain arising on the loan notes to be deferred until realisation. It may be that the loan notes are qualifying corporate bonds.Again, as has been pointed out in the previous case study, although no gain crystallises at the time that the loan notes are issued, the gain is frozen and falls in when the loan note is eventually disposed of.If therefore the loan has become worthless,the Capital Gains Tax will still become payable but there will be no cash to pay for it where the holders are individuals.However with Corporation Tax,a loss may arise under the loan relationship rules. Accordingly,therefore,specific steps will probably be taken to ensure that the loan notes do not qualify as QCB’s. As Magiplass is a foreign company, it is possible that the loan notes will be in foreign currency, specifically taking them outside of the QCB definition. It must be understood, however, that Jones plc will therefore have the exposure to fluctuations in that foreign currency.

61

CHAPTER

8:

CASE

STUDY:

A

CORPORATE

VENDOR

Commercially, Jones plc would also need to look to the security offered by Magiplass offering loan notes.It may be that they will be required to be guaranteed by a major bank,although this is likely to prove expensive.However,the taxation consequences which follow from taking loan notes instead of cash on the deferred consideration (assuming all other assumptions remain as above) are as follows: £000 Gain on initial sale Cash Less loan account Less cost

£000 4,000 2,000 2,000

£500,000 x 2,000,000 2,000,000 + 2,000,000

250

Indexation (nil)

––––

Gain

£1,750

Gain on deferred consideration on redemption of loan notes at full face value Proceeds Less cost (500-250) indexation

4,000 250 10 260 £3,740

Total gain

£5,490

Whilst the total gain is more or less the same amount,the second alternative defers the time at which the tax arises substantially and provides greater security should the loan notes not realise the full amount.

62

CHAPTER

8:

CASE

STUDY:

A

CORPORATE

VENDOR

Other non tax implications Apart from the taxation issues,there are all the normal matters to be considered: •

Due diligence enquiries.

•

Lock out agreements (Magiplass will be unwilling to enter into the expense of conducting negotiations and investigations without a lock out clause).

•

Confidentiality agreements, first of all so that any market sensitive information cannot be released and secondly if the deal does not proceed Magiplass is unable to make use of the information obtained.

•

Environmental issues. Magiplass would be unwise to purchase the company without a full environmental report.This is likely to be at the cost of both Jones and Magiplass.

•

Security of loan notes.

Other tax matters Apart from the immediate points, there are certain other taxation points which require attention.

Stamp duty This should not be a problem as stamp duty is at 1/2 % on the cash received, plus a valuation of the deferred consideration.Theoretically,if this cannot be quantified then the earn-out would not be subject to stamp duty. However, it is more likely that the full amount would be stampable. The exact amounts would require quantification depending on the ascertainability of the earn-out target.

Pre-sale dividend If Newco has been trading for a number of years before the sale to Magiplass occurs, a pre-sale dividend may be relevant.

Clearances In all cases the appropriate clearances should be obtained.

63

CHAPTER

8:

CASE

STUDY:

A

CORPORATE

VENDOR

Issues for the purchaser There are several matters that Magiplass should consider when deciding to undertake a transaction.These include: 1. Tax rates The tax rates prevailing in the UK compared to Magiplass’ country. If the tax rates in Magiplass’ country of origin are higher than in the UK it may make sense for any borrowings to be taken out in the country of origin so that a greater deduction can be obtained against the remittance of profits. Consideration would have to be given to the imposition of a sub-holding company in the United Kingdom,to facilitate deduction where UK rates were higher than the foreign rates. 2. Capital structure Given that Magiplass will need to repay the intra group loan account at the very least and if a UK sub-holding company is available,would need to fund the set up of that, consideration should be given to the capital structure.A mixture of debt and equity will ensue. 3. Advantages of debt Interest paid by Newco,either to the intermediate holding company or directly to the parent company, will be deductible (assuming profits are made) by Newco (subject to the ‘thin capitalisation’ rule – see below) and may suffer amounts of withholding tax.Dividends,however,are paid out of post tax profits and are not as efficient methods of extracting profits as interest.They will be taxable in the country of receipt and may or may not receive a full double tax credit. 4. The advantages of equity/‘thin capitalisation’ The holding of equity would require some or all of the profits to be remitted via dividends.Where all or even some profits are remitted through interest, the Inland Revenue will consider very carefully the capitalisation of the company to ensure that it is not ‘thinly capitalised’.This is where the debt: equity ratio or gearing of the company, is considered excessive compared with the norm for that industry.The UK Revenue regard a debt: equity ratio above 1:1 as excessive and may seek to disallow a portion of the interest and re-characterise that portion as a distribution.The other factor that the Revenue may consider is interest cover,i.e.the loan interest divided into the profits before interest and tax.They would normally regard interest cover of three times as reasonable.

64

CHAPTER

8:

CASE

STUDY:

A

CORPORATE

VENDOR

5. Advantages of management charges Where management charges for services provided via the intermediate holding company or parent company can be justified, these are efficient methods of extracting the profits from the United Kingdom.They are paid gross to the parent company and, whilst they will be taxed in the parent company’s accounts,should be deductible in Newco. However,the management charges must be commensurate with the services provided. 6. Transfer pricing Great care must be taken to ensure that any supplies of goods and services made to and from the UK are made at an arm’s length price or the Inland Revenue may attack the pricing structure. Since the introduction of Corporation Tax self-assessment there is a requirement that arm’s length prices should be used in the preparation of a UK company’s Corporation Tax return.

65

Hive downs and management buy-outs TA X A N D T H E H I V E D O W N M A N A G E M E N T P U R C H A S E A N D TA X E F F E C T S

chapter

9

CHAPTER

9:

HIVE

DOWNS

AND

MANAGEMENT

BUY-OUTS

Chapter 9: Hive downs and management buy-outs

The target and vendors This final case study looks at the position where a hive down could be the prelude to a management buy-out.Holding Company plc is a UK industrial conglomerate. One of its companies, Working Company Limited, based in Dagenham, has unfortunately been making losses for some time.No obvious purchaser exists.The company is producing a very poor return on capital and is depressing the group results.A decision is made to close the company. The management of Working Company Limited,however,consider that they may be able to turn the company around and offer to take the company over for a nominal amount and a repayment of certain debts. A direct purchase of Working Company’s shares would not be attractive to the management as they would be purchasing all the contingent liabilities that could arise. On the other hand, the company is bound to have significant tax losses, which would not be available to the management team on a purchase of assets.Accordingly, a hive down must be the first stage.A new company,Working Company (1999) Limited is formed long before the management express any firm interest in proceeding. Into that are transferred the trade and some assets.This is completed on 31 December 1999.

67

CHAPTER

9:

HIVE

DOWNS

AND

MANAGEMENT

BUY-OUTS

A summary of the balance sheet of Working Company Limited and the hive down prices, together with certain other information, is outlined below: Notes Freehold factory Plant Stock and WIP Trade debtors Trade creditors Bank overdraft

Financed by: Share capital Retained profits Loan from Parent Co. 3

1 2

Accounts or Book value 80,000 75,000 45,000 43,000 (80,000) (120,000) 43,000

Sale price 120,000 37,000 20,000 43,000 (80,000) (120,000) 20,000

1,000 11,000 12,000 31,000 £43,000

Notes: 1.

The factory cost – £80,000 – and indexation to the date of transfer is £28,000.The IBA position is irrelevant for the mechanics of the hive down so long as the Inland Revenue accept that this transfer has been correctly effected. If a cessation is deemed to have occurred, then a balancing adjustment will arise in the old Working Company.

2.

The plant has a tax written down value of £20,000.Again, this should be irrelevant if the hive down is effected correctly.

3.

Working Company would have a substantial liquidity problem without the support of Holdings.This is a long-term loan and will not be assumed by the management.

4.

Working Company has £70,000 of unrelieved tax losses, which the management need to assist with cashflow in the early years of the buy out.

68

CHAPTER

9:

HIVE

DOWNS

AND

MANAGEMENT

BUY-OUTS

The taxation consequences of the hive down are as follows:

Tax and the hive down 1. Freehold factory The freehold factory is being transferred intra group and is therefore on a no gain no loss basis (S.171 TCGA 1992).

R S 343(4) ICTA 1988

2. Transfer of trade There are several implications on the transfer of the trade.The first has been referred to above, in that it allows the assets to be passed across without crystallisation of any balancing adjustments on the capital allowance and IBA computations. However, the main advantage of a transfer of trade from one company to another,in these circumstances,is that the losses will follow the trade if the transfer is effected correctly.Unfortunately,to ensure that excessive relief is not obtained,the loss transfer will be restricted where liabilities remain in the transferor company. It is necessary in those circumstances to restrict the losses by the amount that any relevant liabilities exceed any relevant assets retained within Working Company.The restriction in Working Company’s case is as follows: 1)

After the hive down,the only asset left in Working Company is the £20,000 loan account with Working Company 1999 Limited.This is the only relevant asset of the company.

2)

The profit and loss account on the hive down looks as follows: Retained profit brought forward

11,000

Factory profit

40,000

Loss on P & M

(38,000)

Loss on stock

(25,000)

Accumulated loss

£(12,000)

69

CHAPTER

3)

9:

HIVE

DOWNS

AND

MANAGEMENT

BUY-OUTS

This gives Working Company a closing balance sheet of: Loan to Working Company 1999 (relevant asset)

£20,000

Financed by Stock capital Accumulated loss:

1,000 (12,000) (11,000)

Loan from holdings (relevant liability)

31,000 £20,000

The tax losses available to the management (subject to major changes of trade during the appropriate period) are as follows: £ Tax losses brought forward Add loss on transfer of stock Less anti-avoidance restrictions Relevant liability Relevant asset

£ 70,000 25,000 95,000

31,000 (20,000) (11,000)

Tax losses available to Working Company 1999 Ltd

£84,000

70

CHAPTER

9:

HIVE

DOWNS

AND

MANAGEMENT

BUY-OUTS

Management purchase and tax effects Factory: Deemed proceeds Less: Cost Indexation Chargeable gain

£

£ 120,000 80,000 28,000 108,000 £12,000

Technically, the tax is due by Working Company 1999 Limited and therefore falls to be a responsibility of the management.It may be however that the management obtain an indemnity from Holdings regarding this liability. The trading position of Workings (old and new) should be considered in great depth. The profit and loss account prior to reorganisation showed a small profit brought forward despite the existence of tax losses. It may be that the company is only marginally loss making and possibly some of these losses are created by the imposition of group structures. Accordingly, therefore, the Revenue may try to argue that on the reorganisation,Working Company’s goodwill was transferred to Working Company 1999 Limited and when 1999 left the group,that gain also crystallised.It is unlikely that such an argument would be successful but the management should be advised to obtain the appropriate indemnities and to ensure that no consideration was attributable to the goodwill in the price paid for the shares. A final point that should be made is that generally, debtors and creditors would be retained in Working Company. This would save the stamp duty on the transfer if the exemptions mentioned in the previous case study were not available.The existence of a management buy-out team at the date that the hive down is proposed could lead to the Revenue insisting that arrangements are in place at the eventual disposal and therefore deny the stamp duty exemption.

71

Summary of IR20 B E C O M I N G N O T R E S I D E N T A N D N O T O R D I N A R I LY R E S I D E N T BECOMING NOT RESIDENT WHEN THERE IS NO FULL-TIME CONTRACT OF EMPLOYMENT FOREIGN EARNINGS DEDUCTION C A P I TA L G A I N S TA X COMMENT

appendix

1

APPENDIX

1:

SUMMARY

OF

IR20

Appendix 1: Summary of IR20 The following is a summary of the rules set out in the Inland Revenue booklet on residence IR20 and the changes introduced by the Finance (No 2) Bill 1998.

Becoming not resident and not ordinarily resident To become not resident and not ordinarily resident whilst working overseas under a contract of employment,it is necessary to comply with the following conditions: 1.

The employment must be for full-time service under a contract of employment overseas.

2.

All the duties of the employment,apart from incidental duties,must be performed outside the UK.

3.

The absence from the UK and the employment itself must both extend to cover a complete tax year.

4.

Any interim visits to the UK during the period should: •

In total be less than 183 days in any one tax year

•

Average less than 91 days per tax year.

5.

Provided the above conditions are met,an individual is normally treated as being not resident and not ordinarily resident from the day following the date of departure to the date preceding the date of return (but see below with regard to the position for Capital Gains Tax).

6.

On presentation of a completed form P85,the Inland Revenue will normally give a provisional ruling on the residence position,which will be confirmed at a later date. Early submission of form P85 is recommended.

7.

The number of days spent in the UK is crucial and spending an extra day in the UK over the prescribed limit will mean losing non-resident status. It is important to keep a clear record, in diary form if possible, of visits to the UK and where possible this should be supported by passport entries and airline tickets etc.The Inland Revenue could ask to see the appropriate evidence when examining the residence position.

73

APPENDIX

1:

SUMMARY

OF

8.

Provided non-resident status is achieved, earnings from the overseas employment will not be assessable to UK taxation. In addition to this, sources of investment income arising overseas,for instance interest on foreign bank accounts, will also escape UK taxation.

9.

Generally, investment income arising from the UK will still be liable to UK taxation and this will include UK dividends and rental income.Deposit interest arising in the UK is, by concession, exempt from UK tax.The question of the mechanics of the UK taxation of rental income is not dealt with here.

IR20

Becoming not resident when there is no full-time contract of employment The above rules only apply to full-time service under a contract of employment. They do not apply to part-time employment or the self-employed.For these categories it is still possible to become not resident and not ordinarily resident by achieving the following: 1.

Some evidence should be produced to the Inland Revenue that the individual has ceased to be resident and ordinarily resident.The usual situation is the sale of the home in the UK and setting up a permanent home abroad.

2.

The individual will normally be treated as being provisionally not resident and not ordinarily resident from the day after the date of departure.

3.

The provisional ruling is normally confirmed after a complete tax year has been spent abroad.

4.

If insufficient evidence is available the decision will be postponed for three years. It should be noted that anyone wishing to become not resident in this way should be prepared to spend at least three successive tax years abroad,subject to permitted return visits to the UK (see below).

5.

Visits to the UK must average less than 91 days in a tax year.

74

APPENDIX

1:

SUMMARY

OF

IR20

Foreign earnings deduction In the past it was also possible to obtain a 100% deduction for earnings from employment carried out abroad by UK residents during a qualifying period of at least 365 days.This relief has been withdrawn (except for seafarers) from 17 March 1998.

Capital Gains Tax a)

The charging provisions for individuals who make disposals while abroad has been significantly tightened with effect from 17 March 1998.Roughly, Capital Gains Tax will be charged on gains made by individuals during a temporary absence of less than five complete tax years.There is no exit charge or imposition of CGT on the disposals of UK assets on nonresidents.A new Section 10A to the TCGA ensures that gains (and losses) made during what are called tax intervening years are to be treated as the gains of the year of return to the UK where the individual is not resident for five complete tax years.ESC D2 is amended so that any gains in the year of arrival or departure are taxed as gains of that year. These rules do not apply:

R 17 March 1998 ESC D2

b)

•

To gains and losses on assets acquired whilst non-resident

•

Where the individual was not resident for at least four of the preceding seven tax years prior to departure

•

To certain other exemptions.

Amendment to the ESC on non residence for Capital Gains Tax

As a result of the new rules regarding temporary non-residency for Capital Gains Tax,a revised concession has been issued.The concession revised is ESC D2,which allows tax years to be split, in certain circumstances, for the years of departure and arrival.

75

APPENDIX

1:

SUMMARY

OF

IR20

The revised concession applies to individuals who cease to be resident or ordinarily resident on or after 17 March 1998 or become resident or ordinarily resident on or after 6 April 1998.The main changes in the concession are as follows: •

An individual who arrives in the UK and is treated as resident from the date of arrival is only charged on disposals after arrival provided they were neither resident nor non-ordinarily resident during five years immediately preceding the year of assessment of arrival.

•

An individual leaving the UK and treated as not resident and not ordinarily resident from departure is not charged Capital Gains Tax on disposals after departure, provided they were neither resident nor ordinarily resident for at least four out of the seven years of assessment preceding the year of assessment of departure.

R S10 TCGA 1992

Obviously,the concessional treatment would never be available when tax avoidance was a consideration and it also would never cover the gains arising on a business asset where the business continues to be carried on in the UK through a branch or agency.

R ESC A11

It should be noted that the extra statutory concession for split years for income tax remains unchanged,as do the rules for non residence for income tax purposes in general i.e. one year’s absence on a full-time contract of employment or three years (of assessment) absence generally. It was only the 365 day rule to exempt Schedule E income from income tax that was removed for income arising after 17 March 1998.

R S63 TA 1998

Comment Obviously, it is now extremely difficult to shake off residence for Capital Gains Tax purposes,in contrast to income tax,but it should be noted that there are still some opportunities for mitigating tax on disposals.However,all of these are complex and subject to change and further research would be required before any advice in this area is given:

1.

Double Tax Treaty planning

Some countries’Double Tax Treaties with the United Kingdom are not based upon the OECD model,which can allow gains to be taxed in both countries but allowing one country the first bite at the cherry. Treaties sometimes state that where a gain is taxed in one country, it cannot be taxed in the other but further, certain other countries have CGT rules whereby inherent gains are eliminated upon emigration

76

APPENDIX

1:

SUMMARY

OF

IR20

to that country.Effectively,all assets are up lifted to their market value on immigration. By a combination of these two aspects,emigration to a selected country (and Belgium is understood to be one) could eliminate the majority of any gain in any assets which may then be disposed of and subjected to a Capital Gains Tax charge in the country of residence, albeit a small one as it arises on the difference between the market value on entry and the actual disposal proceeds. This prevents the UK authorities, despite the Finance Act 1998 regulations, from collecting any tax, as the disposal is subjected to a tax charge in the other country.It is understood that the Treasury are currently trying to renegotiate the relevant Double Tax Treaties. Quite clearly all the normal anti-avoidance armoury of the Inland Revenue is available to defeat artificial schemes in this area.

2. R Section 128 Finance Act 1995

Dividend planning

Where a person becomes non-resident and receives a dividend their tax liability will be restricted in some situations to the tax credit attached to the dividend – this route may be attractive where a company sells a business and needs to distribute the profits to someone who has not got any retirement relief etc available to them.

77

Stock dividend scheme

appendix

2

APPENDIX

2:

STOCK

DIVIDEND

SCHEME

Appendix 2: Stock dividend scheme As mentioned in chapter two,where a company has limited reserves which restrict its ability to pay a pre-sale dividend, it may consider using an enhanced ‘stock’ dividend. As with pre-sale dividends the previous 15% differential between Capital Gains Tax and income tax is being eroded by business asset taper.When three years business asset taper has been accrued the effective CGT rate falls to 20% and this will apply from 6 April 2001 onwards where the shares have qualified as business assets since 6 April 1998.Thus for many shareholders 2000-01 is the last year that a stock dividend would be beneficial.Note also that shareholders who have capital losses or who are eligible for retirement relief would generally prefer to be assessed on a capital gain rather than taking the stock dividend option. The stock dividend scheme is generally regarded as low risk tax planning and there is even an example in the Inland Revenue manual setting out how the scheme works (see below). It is important that the cash dividend alternative is of sufficient size to ensure that the Revenue does not attack the scheme on the grounds that the shareholders had no option but to take the stock dividend. Where possible the Revenue example should be followed as closely as possible, leaving a reasonable time between the declaration of the dividend and the sale of the company. Ideally the stock dividend will take place before the sale negotiations are finalised but there is then,however,a risk to the shareholder if the sale does not proceed,as they will still be faced with the income tax liability without the cash to pay the tax. Example based on Inland Revenue CGT Manual (58763): Mr Watts subscribes at par for all 1,000, £1 ordinary shares in Purely Paper Ltd. In July 2000 Purely Paper Ltd declares a cash dividend of £10 per share. It also gives Mr Watts the option of taking the dividend in the form of ten £1 ordinary shares for every share held. Mr Watts opts to take the shares. In August 2000 Mr Watts sells all 11,000 shares in Purely Paper Ltd to a public company for £1.2M cash having previously been a full-time director throughout.

79

APPENDIX

2:

STOCK

DIVIDEND

SCHEME

Income tax Compute the value of ‘the appropriate amount in cash’. Section 251(2)(b) ICTA 1988 applies and this is the market value of 10,000, £1 ordinary shares in Purely Paper Ltd in July 2000.Because the shares are unquoted this value must be agreed by SVD. Mr Watts argues the value must be close to the arm’s length sale price in August 2000. SVD accept the value is

10,000 11,000

£1.2M = £1,090,909

This figure is grossed up: £1,090,909 x 100/90 = £1,212,121 Mr Watts has a higher rate liability on this sum. £1,212,121 at 32.5% = less tax deemed paid at 10%

£393,939 £121,212

Income tax due (effective 25%)

£272,727

Capital Gains Tax computation Mr Watts is treated as though he paid the appropriate amount in cash for the shares, £1,090,909. £ Disposal proceeds less Cost

1,200,000 80,000 (31.3.82 value say) 1,090,909 (stock dividend) 1,170,909

Unindexed gain less Indexation No gain/no loss

29,091 80,000 105%

84,000 0

80

APPENDIX

2:

STOCK

DIVIDEND

SCHEME

If the company had not paid the stock dividend the Capital Gains Tax liability would be: £ Disposal proceeds Less March 1982 value Unindexed gain Less indexation Gain before taper Business asset taper 25% Chargeable gain Tax @ 40% = Tax saved by using stock dividend scheme

1,200,000 80,000 1,120,000 84,000 1,036,000 259,000 777,000 £310,800 £38,073

81

Impact of pre-sale dividend

appendix

3

APPENDIX

3:

IMPACT

OF

PRE-SALE

DIVIDEND

Appendix 3: Impact of pre-sale dividend A. No dividend

Share of net proceeds March 1982 MV

A.Aldridge £’000s

B.Aldridge A&M trust £’000s £’000s

Disc.trust £’000s

11,000 1,375

1,000 125

4,000 500

4,000 500

7,000

875

3,500

3,500

1,375

125

500

500

8,250

750

3,000

3,000

7,875

750

3,000

3,000

1,969 –

188 –

150 120

150 120

5,906

562

2,730

2,730

7

7

4

4

Taxable gain

5,899

555

2,726

2,726

CGT @ 40%/34%

2,360

222

927

927

Indexation

Retirement relief: 100% relief 50% relief

Business Asset Taper Relief @ 25% Investment 5% (note)

Annual exemption

Total tax

150 225

£4,436

83

APPENDIX

B. Tax on £10M dividend

3:

IMPACT

OF

PRE-SALE

DIVIDEND

A.Aldridge £’000s

B.Aldridge £’000s

A&M trust £’000s

Disc.trust £’000s

Share of net dividend Tax credit

5,500 611

500 55

2,000 222

2,000 222

Gross dividend

6,111

555

2,222

2,222

Income tax at 32.5%/25% Less tax credit

1,986 611

180 55

555 222

555 222

HRT/ART due

1,375

125

333

333

710

72

308

308

2,085

197

641

641

275

25

286

286

A.Aldridge £’000s

B.Aldridge £’000s

A&M trust £’000s

Disc.trust £’000s

Share of net proceeds March 1982 MV

5,500 1,375

500 125

2,000 500

2,000 500

Indexation

4,125 1,375

375 125

1,500 500

1,500 500

2,750

250

1,000

1,000

2,375

250

1,000

1,000

594

63

50

50

investment 5%

–

–

40

40

Annual exemption

7

7

4

4

Taxable gain

1,774

180

906

906

CGT at 40%/34%

£710

£72

£308

£308

Add CGT on capital gain (see C)

Tax saved through pre-sale dividend Total saved tax with dividend route C. CGT with £10m dividend

Retirement relief: 100% relief 50% relief Taper relief (Note) business 25%

Total tax

£872,000

150 225

£1,398,000

84

APPENDIX

3:

IMPACT

OF

PRE-SALE

DIVIDEND

Note: The gain on the shares held in the trusts must be apportioned, as business asset taper is available from 6 April 2000. 2/2.5 of the gain is eligible for taper relief at the investment rate and 0.5/2.5 of the gain is eligible for business asset taper.

85

Using loan notes

appendix

4

APPENDIX

4:

USING

LOAN

NOTES

Appendix 4: Using loan notes

Capital gain on cash consideration October 2000 Computation for A. Aldridge Alan received £2,750,000 cash and £8,250,000 loan notes with an option to convert into dollar bonds (i.e. non QCB’s) £000’s Share of cash proceeds (55% x £5m) March 1982 £1,375,000

£2,750,000 £2,750,000 + £8,250,000

2,750 344

2,406 Indexation

346 2,060

Retirement relief: 100% relief 50% relief

150 225 1,685

Taper relief 2 years 25% Annual exemption

421 1,264 7

Taxable gain

1,257

CGT at 40%

£503,000

Base cost of £8,250,000 redeemable loan stock c/fwd = £1,375,000 – £344,000

87

Deferred consideration

appendix

5

APPENDIX

5:

DEFERRED

CONSIDERATION

Appendix 5: Deferred consideration A.

A.Aldridge, in addition to a cash consideration of £5.5M may receive a further amount in cash of up to a maximum of £5.5M by reference to earnings over the three years.The right to the deferred consideration is valued at £100,000 as at the date of sale. Gain on initial sale

£000’s

Share of net proceeds

5,500

Value of right to further payment

100 5,600

March 1982 MV

1,375 4,225

Indexation

Less retirement relief 100% relief 50% relief

1,375 2,850

150 225 2,475

Taper relief @ 25% (2 years business)

619 1,856

Gain on deferred consideration assuming £5.5M realised Proceeds from right Cost Gain (no taper relief – not held for three tax years!)

5,500 100 5,400

89

APPENDIX

B.

5:

DEFERRED

CONSIDERATION

If the £5.5M is satisfied in ‘non QCB paper’ the computations would be: Gain on initial sale

£000’s

Share of net proceeds

5,500

March 1982 MV £1,375,000 x 5,500,000 5,500,000 + 100

1,350

Indexation (100% approx)

4,150 1,350 2,800

Retirement relief 100% 50 % Taper relief 25% Gain

150 225 2,425 606 1,819

Gain on receipt of deferred consideration = £Nil Gain on realisation of ‘paper’ consideration at face value Proceeds March 1982 MV (1,375,000 – 1,350,000)

Indexation, say

5,500 25 5,475 25 5,450

Less taper relief (if this security is in an unlisted company) 75% business asset taper

4,088

Total gain after taper relief

£1,362

Total gain now (1,819 + 1,362)

£3,181

Note:If the paper was a QCB,taper would be restricted to just two years at the business rate and a very different result arises.

90

Taxation of the income of discretionary trusts

appendix

6

APPENDIX

6:

TAXATION

OF

THE

INCOME

OF

DISCRETIONARY

TRUSTS

Appendix 6: Taxation of the income of discretionary trusts

Assessing the impact of the changes to dividend income taxation from 6 April 1999 The changes to the rules on tax credits, with effect from 6 April 1999, also have an impact on discretionary trusts.Trustees of discretionary settlements should be considering their investment strategy carefully as the family company advisor may have a potential conflict of interest, as differing shareholders will require very different cash extract methodologies.

Summary of the rules At first sight, the rules appear innocuous: as for individuals, the status quo is maintained.However,the change in the dividend taxation rules to bring into effect the impact of a non-repayable tax credit needs to be appreciated.

Dividends pre and post 6 April 1999 The approach taken in the new dividend rules is not to make a part of the tax credit attaching to a discretionary trust distribution non-refundable but rather to restrict the amount of tax going into the tax pool.This is illustrated in Schedule 1 which compares the taxation of dividends within discretionary trusts up to 5 April 1999 and under the new rules from 6 April 1999. As it stands, where a discretionary trust receives a dividend, the trust accounts for the difference between the trust rate, 34% and the rate of the tax credit, 20% and having paid this tax,the net balance is available to distribute to beneficiaries with a 34% tax credit. The example shows a net dividend of £1,000. Under the old regime, provided that the income distributed did not exceed 66% of the gross income i.e. £825, there was no further tax to pay and,assuming that the beneficiary is a non-taxpayer, they were able to reclaim the difference between £1,250 and the cash received i.e. £425.This is because the total tax liability, £425 was added to the tax pool.

92

APPENDIX

6:

TAXATION

OF

THE

INCOME

OF

DISCRETIONARY

TRUSTS

Under the new regime the trust suffers tax on its dividend income at 25% rather than 34%.This is because of the reduction in the rate of dividend tax credit.The impact is prima facie, that the trust has slightly more income apparently available to distribute i.e. a net tax amount of £833.25 as compared with £825. However, not all of the tax suffered enters the tax pool, but rather only the tax attributable to the difference between the dividend trust rate of 25% and the credit rate of 10%. Because of the restriction to the tax pool,there is insufficient tax credit available to pay out all of the income.The consequence, should a full distribution policy be adopted, is that tax will fall due for payment each year under the provisions of S686.Previously such charges would only accrue where distributions had been made in excess of available net income. The effect of the new rules would appear to be that the benefit accruing to a beneficiary of a discretionary trust will always be the net dividend less tax thereon at their marginal rate.This can mean a marginal tax rate of up to 46% for higher rate tax paying beneficiaries.

Comparison with other forms of income Dividend income is the only form of income which is effected by this rule change. Schedule 2 sets out a comparison of dividend income with rental and interest income post 5 April 1999. It will be seen that the effective rate of tax for dividend income is higher than for any other form.With that in mind,trustees of discretionary settlements should be considering whether they would be better investing in gilts, convertible loan stock etc.

Cash extraction from companies Frequently we will encounter cases of a discretionary trust holding shares in an otherwise owner-managed company. In this type of situation,the trust is frequently in place to make use of grandchildren’s personal allowances and lower/basic rate bands by routing dividends from the company to the trust and out to the beneficiaries. Whilst the commerciality of the situation must be the first consideration, from a taxation viewpoint,it will be most attractive for a trust to receive income in a form other than dividend income.This may be difficult to achieve in some cases,however, interest bearing loan stock/debentures may be appropriate trustee investments in owner managed companies.

93

APPENDIX

6:

TAXATION

OF

THE

INCOME

OF

DISCRETIONARY

TRUSTS

The illustration below sets out how interest,rental and dividend income vary based upon a company suffering corporation tax at the full rate.

Illustration: Discretionary trust taxation Taxation Post 6 April 1999 Comparison of dividend,rental income and interest receipts Profits before tax

£10,000

Underlying CT rate

30%

Savings rate

20%

Dividend notional credit

10%

Trust rate

34%

Trust dividend rate

25%

Tax calculation Dividend £

Rental £

Interest £

7,000

10,000

8,000

778

0

2,000

7,778

10,000

10,000

1,944.50 0.00

0.00 3,400.00

3,400.00 3,400.00

1,944.50

3,400.00

3,400.00

Tax credit

(778.00)

0.00

(2,000.00)

Further tax due

1,166.50

3,400.00

1,400.00

Income available for distribution

5,833.50

6,600.00

6,600.00

0.00

0.00

0.00

Tax for the year

1,166.50

3,400.00

3,400.00

Maximum income distribution without giving rise to S686 charge

2,264.00

6,600.00

6,600.00

Net receipt Tax credit Gross income Income Tax due at trust dividend rate 25% at trust rate 34%

Tax pool calculation Tax pool b/forward

94