Section 42 Rip - The latest legislative changes to section 42, Finance Act 1930 have ripped it in pieces, says R S Nock.

Section 42 RIP
The latest legislative changes to section 42, Finance Act 1930 have ripped it in pieces, says R S Nock.
The Stamp Office continues its strange and unique fiscal policy of record levels of tax with diminishing reliefs, including reducing the exemptions which were regarded by its predecessors as essential, even in the days of lower rates. While the requirement for a statutory declaration has been replaced by the use of a formal letter, this year's Finance Act, inter alia, cuts back (spelt 'mutilates') the exemptions from conveyance on sale and lease duties pursuant to section 42, Finance Act 1930 and section 151, Finance Act 1995 respectively (transactions between associated companies). At present, no guidance has been given on the contents of the letter applying for the relief. It will need to include the same information as the old form declarations which can form the basis of the precedents, but the difficulty will be discovering what information the Stamp Office will require therein to meet the terms of the new restrictive conditions.
Snapshot or video?
The important practical problem of the current changes is that the Stamp Office has forgotten its own argument in Combined Technologies v Commissioners of Inland Revenue [1985] STC 348 and Canada Safeway v Commissioners of Inland Revenue [1972] 1 All ER 666 that stamp duty is a transaction tax that is linked to a precise time, i.e. when the document becomes effective and there is no wait and see. In relation to the reliefs under consideration, it is not appropriate that a company should move in or out of a stamp duty group by reference to commercial factors such as profit or interest levels which fluctuate from day to day.
Comparison with corporation tax
Unfortunately Schedule 18 to the Taxes Act 1988 (corporation tax group relief and equity holders) works by reference to the end result of an accounting period. The writer has been puzzled for some time as to how the test for capital gains tax groups can operate properly since whether there is a group at the time of the transfer can only be determined after the end of the current accounting period. Fortunately this has rarely been a problem, but only because of the vary narrow definitions in Schedule 18, and because capital structures can be modified if necessary.
Nevertheless, there have been cases where, at the time of the intra-group transfer, it was uncertain whether the companies would be grouped at the year end depending upon interest rate movements affecting the overall profit level. The planning is however on risk that profits or assets may turn down before the end of the accounting period.
On a straightforward reading of the revised stamp duty legislation, it cannot be determined until after the year end whether or not a transfer or lease is exempt, since although there may not be any offending loan arrangements at the time of the transfer, subsequent fund-raising may bring them into play. This may not matter for capital gains tax which is an aggregate of the year's disposals and there is a reasonable time for the payment of the tax after that date, but it is totally unreasonable for stamp duty given the new compliance régime and the fact that unstamped documents of title cannot be registered which is likely to delay land transactions and the perfecting of security. The Stamp Office response that it does not matter reflects its lack of understanding of the technical issues of stamp duty and the changes, and is clearly not a proper basis for administering what is now an expensive tax and deal breaker.
Some help
The new corporation tax provisions permitting the surrender of capital losses between group members mean that there is, in situations where the relief applies, no need for a pre-disposal intra-group transfer which should avoid much complicated stamp duty planning.
Increased importance
Bearing in mind that there are now anti-avoidance provisions which impose a charge to four per cent duty upon market value upon any transfer or lease of land where the transferee/lessee is a company 'connected' with the transferor/lessor, and that every company within a group is connected with every other member, then every land transaction within a group is potentially caught by these provisions which are in sections 119 and 121, Finance Act 2000. The exemptions for distributions in section 120 whether in a liquidation or as a dividend in specie do not cover many situations. Fortunately, it appears to be the current Stamp Office view that the reliefs under sections 42 and 151 override the provisions of 119 and 121. It is, therefore, vital that the new conditions are fully understood and carefully planned around on every intra-group transfer.
Group relationship
The pre-existing anti-avoidance arrangements (section 27(3), Finance Act 1967 and section 151(3), Finance Act 1995) were restricted by Statement of Practice 3/98 (but the fact that even after 32 years the Stamp Office can in practice still invert the transferor/transferee relationship is not encouraging for the application of the far more complicated new legislation!). The current attack is upon the group structure itself. It is concerned with narrowing down the circumstances when companies are associated with each other for the purposes of the reliefs in section 42, Finance Act 1930 and section 151, Finance Act 1995.
As a result of the changes, the conditions for the existence of a stamp duty group are:
? one company (the parent), whether transferor or transferee, must be the beneficial owner of not less than 75 per cent of the ordinary share capital of the other – a linear relationship; or
? a third company must be a 75 per cent beneficial shareholder, whether direct or indirect, of both transferor and transferee – a triangular relationship;
? the parent must hold shares carrying the right to:
? 75 per cent of the dividends
? 75 per cent of the assets on a winding up
These tests are in addition to the 75 per cent shareholding requirement:
? The parent must have control (defined in section 840, Taxes Act 1988) of the transferor and/or transferee; and
? There must be no arrangements whereby some person could obtain control of the transferee but not of the transferor.
Economic interest condition
The tests for determining the level of entitlement are those in Schedule 18 to the Taxes Act 1988 as adapted for capital gains tax, and section 170, Taxation of Chargeable Gains Act 1992; it should be noted that in Schedule 18, paragraphs 5(3) and 5B to 5E are not applicable. However, there is no indication that the Stamp Office will adopt the rulings and practices of the Inland Revenue as contained in its Corporation Tax Manual at paragraph CT2730 where appropriate.
The timing issue for the application of these rules has been outlined above. It is to be hoped, that companies' tax advisers or accountants will have these types of issue under review for other taxes such as capital gains tax so that should there be a risk, it can be taken into the planning.
The rules are concerned with whether the parent in either form of stamp duty group has the right to 75 per cent of the dividends or assets. This is tested not merely by reference to the rights of shareholders other than holders of fixed rate preference shares; it is necessary to include the rights of certain 'loan creditors' whose participation reduces the share of the 'adjusted profits and assets' of the members.
The participation is linked to equity holders. This is not just ordinary share capital but also certain preference shares where these were not issued for new consideration such as bonus issues. Equity holders include various categories of member and certain creditors.
Debts and loans
The structure is that a loan creditor is defined for these purposes in terms of section 417(7), Taxes Act 1988 which applies to:
'a creditor in respect of any debt incurred by the company
'(a) for any money borrowed or capital assets acquired by the company; or
'(b) for any right to receive income created in favour of the company; or
'(c) for consideration the value of which to the company was (at the time when the debt was incurred) substantially less than the amount of the debt (including any premium thereon);
or in respect of any redeemable loan capital issued by the company.'
This applies also to a person who has a beneficial interest in such a debt. This takes matters beyond loans, i.e. advances of cash to be repaid in cash, to debts, such as the unpaid purchase price for assets. The above definition refers to debts; however, loan creditors in Schedule 18 to the Taxes Act 1988 are defined in terms of loans. This drafting is important.
There is a fundamental distinction between a loan and a debt; the former usually requires a cash advance, whereas the latter arises where there is no cash advance but a payment obligation exists, such as an unpaid purchase price. For example, a question may arise where land or other assets have been acquired upon the basis of an earnout or overage payment (i.e. a property term for earn-outs) and whether this profit participation could produce a non-commercial loan. The unpaid purchase price is prima facie, a debt and the issue is whether, as it is not a loan in the strict sense which might exclude it from the review of the group structure, the rights of the seller, i.e. creditor, in respect of a debt for the acquisition of capital assets automatically make him an equity holder. Much will depend upon whether, as is likely, the Stamp Office will accept the technical point that only loans are involved in the testing and that debts are excluded from equity holdings.
The position may depend upon the structure and the drafting of the documents. Thus, if instead of dealing upon the basis of an unpaid purchase price (which may raise questions of beneficial ownership, see Michaels v Harley House [1999] 3 WLR 229), it is decided to lend the money which is then used to pay for the asset, there will be a loan and a potential problem. Moreover the drafting of the document by carrying implications of set-off rather than an unpaid price may produce the legal relationship of payment and loan for these purposes (see Coren v Keighley 48 TC 370). However, it is not inconceivable that the Stamp Office may wish to investigate these issues, especially where there has been the granting of security for the unpaid price or earnout or overage payment, so as to destroy the stamp duty group. But even if the unpaid purchase price is treated by the Stamp Office as a loan, there is still the question of whether the rights of the seller to participate mean that it is not a normal commercial loan because the loan creditor is entitled, on repayment, to an amount which either exceeds the new consideration lent or is not reasonably comparable with the amount generally repayable (in respect of an equal amount of new consideration) under the terms of issue of securities listed on a recognised stock exchange.
Summary
There are, therefore, included in the participation calculation of the parent the rights of items such as such as:
? convertible preference shares;
? most forms of convertible loan stocks;
? participating preference and preferred ordinary shares;
? participating and non-commercial interest rate loan stocks;
? without recourse finance unless raised for purchasing investment land; and
? other non-commercial loans, including certain sale and leaseback capital allowance arrangements with banks (paragraph 1(6) and (7) of Schedule 18).
Non-commercial loans also include excessive or profit related interest or repayments and loans which entitle the creditor to an amount of interest or principal upon repayment that is linked to the value of the business or assets or profits. This is likely to give rise to problems with the Stamp Office since it has taken the totally bizarre and unsustainable view that a stock linked to a stock exchange index is linked to the profits and asset values of the companies within the index and so is asset backed. Not only will it seek to treat such stock as excluded from the exemption contained is section 79, Finance Act 1986, but also as affecting the stamp duty group structure if the loan stock has been issued by a financing subsidiary.
Single asset and similar companies
More importantly in practice, the problems arising may be particularly acute in relation to land companies which are especially vulnerable to the new rules on land transfers. There is a limited safeguard for such companies in relation to without recourse finance raised for certain land acquisitions; but, for example, where there is a group established on the basis of single asset property subsidiaries, or where there may have been some financing operations with banks and other lenders, the terms of the lending may lead to problems for these purposes. The provision relating to without recourse funding could become a significant issue in relation to stamp duty for property groups where this type of financing is relatively frequent, particularly given the need to deal with the group implications of the new connected company legislation for property groups.
However, for most purposes the same economic result can be achieved by a single asset company giving a charge over its sole asset. Notwithstanding the alleged relaxation of the anti-avoidance rules in relation to refinancing in Statement of Practice 3/98, problems may now arise for example where some years ago there were rescue packages under which banks took some form of equity kicker or participation rights in relation to the various property companies including their subsidiaries. These profit-related or asset backed loans raise issues for such groups but companies involved in many of the more sophisticated forms of real property financing arrangements, which are themselves beset with stamp duty costs, may now have other problems in relation to stamp duty costs.
Variable rights
There are also complex provisions concerned with variable rights in those parts of Schedule 18 which do apply for stamp duty. If the participation rights could vary in the future these variations have to be applied in determining the relevant 75 per cent (paragraphs 5(1) and 5A)). The possible exercise of conversion rights by preference shares with a fixed coupon so as to acquire full participation in ordinary dividends may matter.
Having and keeping control
Overriding the economic interest test, it is provided that the stamp duty group does not exist if there are arrangements in place at the time of the relevant instrument whereby some person has or could acquire the control of the transferee company but not of the transferor. Control is defined in terms of section 840, Taxes Act 1988. This is not limited to the Articles of Association, but includes other arrangements whereby any person can secure that the company's affairs are carried out in accordance with his wishes. This will raise interesting questions where there is some proposed joint venture or shareholders' agreement. However, the extent of the provision is interesting because of the use of the word 'could'. This differs from section 27(3), Finance Act 1967 (as amended) which uses the word 'were' which carries with it the suggestion of 'necessity' required by Times Newspapers v Commissioners of Inland Revenue [1971] 3 All ER 98. 'Could' seems a little more speculative but it is itself limited by the implication which it carries of some existing power to bring about the result rather than there is an 'expectation'. Third party involvement at the time is essential and it may be that such involvement may require a contract enabling it to act, such as powers in the articles of association.
Preference shares are generally ignored in the context, but it is not unusual for such shares to be given the right to vote should their dividends be in arrears, so this may require investigation. The position of shares with limited weighted voting such a power to appoint an 'A' director or to veto transactions above a certain limit is not expressly dealt with and 50/50 voting provisions for joint venture companies on certain issues clearly present a problem notwithstanding a 75 per cent interest in one of the parties. It seems that as control relates to the 'affairs' of the company the provision will apply only where there is a general right to vote and limited weighted voting rights should not necessarily represent a problem but this may turn upon just how limited they are!
Arrangements to degroup control
The basic anti-avoidance legislation, which remains in place, applies only where there are arrangements, whereby the transferee company is to leave the stamp duty group (section 27(3), Finance Act 1967); it does not apply where the party leaving the group was the transferor, such as on an extraction of assets prior to a sale of a subsidiary company. Since the asset remained within the group, stamp duty relief was generally available, provided that the negotiations for the disposal of the transferor's shares had not reached a stage where beneficial ownership had been lost. The new provision applies where there are arrangements where there is to be a change of control of the transferee but not of the transferor. This is intended to catch situations where the asset leaves the group, as demonstrated in the Example below.
Example
A owns B which owns C
C owns an asset
C transfers the asset to B
B sells the shares in C to A
A sells the shares in B to TP.
The relief is not available if there are arrangements concerning the sale of B's shares. There will be a change of control of the transferee but not of the transferor. The transfer of the shares in C should qualify for relief notwithstanding the new provisions; there is a change of control of B, the transferor, but not of the transferee and the asset remains within the stamp duty group under A, provided that the negotiations for the sale of B's shares have not deprived A of its beneficial ownership of the shares (see Wood Preservation v Prior [1969] 1 All ER 364; Sainsbury v O'Connor [1991] STC 318). Some time ago the Stamp Office attempted to argue that serious negotiations for sale caused a loss of beneficial ownership, but this is clearly wrong in the light of the latter case. The Stamp Office's views on shareholders' agreements to reconstruct and clearance letters as deprivation of beneficial ownership as put forward in Swithland Investments v Commissioners of Inland Revenue [1990] STC 448 should be noted. The fate of the transferor's shares may, therefore, be relevant in certain cases; fortunately these may be rare cases but the problem will require investigation.
The provision requires a change of control. The loss of control by itself is not sufficient and this could be important in relation to many types of pre-sale reconstructions. For example, suppose it is intended to sell part of the assets of A involving several steps:
Holdco takes over A (section 77, Finance Act 1986)
A sells up assets to Holdco
Holdco is liquidated and assets divided between Newco 1 and Newco 2 in consideration of the issue of shares to the members in Holdco (section 75, Finance Act 1986).
The hive up to Holdco should qualify for section 42 relief since although there is a loss of control of the transferee, Holdco, there is no change in that no other person could acquire control. The other conditions of section 42 have to be satisfied, especially the question of beneficial ownership of the shares in A (see Swithland).
This will have significant implications for transactions involving de-mergers, management buy-outs, sale of non-core businesses, and so on. There were always difficulties about putting assets into the vehicle that was to be divested from the group, since this would be the transferee or lessee departing. However, now the fate of the transferor is called into question. In the situation of a de-merger or similar transaction there may be arrangements in place under which the outside party, such as the management buy-out team, will be acquiring the control of the transferor company, but will not be acquiring control of the transferee which will remain owning the assets within the group. This seems to run counter to the whole purpose of section 42 relief on looking through to the economic ownership of the asset and seeing whether that was unchanged by reason of the arrangements.
Liquidations, etc.
It can be seen that where a company is liquidating a subsidiary and passing its assets up to the parent company, there are likely to be considerable problems in relation to a charge to stamp duty. While the new provisions of sections 119 and 120, Finance Act 2000 contain a specific exemption for distributions out of the company, whether in the course of a winding up or as a dividend in specie, these are not likely to assist in the problems that arise in connection with stamp duty on a liquidation. These are situations under which the normal stamp duty charge would be a fixed charge or an exemption as a gift. A dividend in specie is a voluntary disposition and can be made free of stamp duty provided the appropriate certificate is included in the instrument of transfer. Similarly, a distribution by liquidated members in satisfaction of their rights in the winding up is a transfer under which no beneficial interest passes and is subject to a fixed duty of unless certified under the Stamp Duty Exempt Instrument Regulations 1987 (SI 1987 No 516).
However, the position is complicated, particularly in relation to winding up, by the fact that there may be liabilities such as a charge on the land being transferred to the shareholders. In such situations, section 57, Stamp Act 1891 will apply to convert that from being a distribution and winding up to a sale by the liquidators of the parent company. This raises an acute problem since exemption under section 42, Finance Act 1930 is not available in respect of distributions in a winding up. It is a requirement of the section that beneficial ownership passes from the transferor to the transferee. Upon going into liquidation the transferor company ceases to be the beneficial owner of its assets (Ayerst v C&K Construction [1975] STC 345) and the basic conditions for exemption under section 42 are not capable of being satisfied.
In this situation, the normal procedure hitherto has been for the subsidiary company to contract to sell the assets to the parent company prior to commencing liquidation leaving the consideration outstanding as an inter-company debt which would be satisfied in the winding up. This procedure would require relief under section 42 which it seems should still be available. In this situation, although the parent/transferee company is losing control of the transferor some other person is not acquiring control of it, so that the new anti-avoidance rules do not apply.
Retrospective legislation
The new group provision is effectively retrospective in that it applies even where the convertible loan was entered into prior to the new legislation. It will therefore be necessary to consider not merely new fundraising, but as a matter of urgency to review existing structures. It is to be hoped that these issues will come under review because of other taxes.
R S Nock LLM, FTII, barrister is in chambers at 24 Old Buildings, London WC2.

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