Commercial Tax Planning

In the second of a series of four articles by Burges Salmon [see first] relating to the sale of shares in private companies, ANDREW EVANS ATII, solicitor considers pre-sale tax planning for corporates.

A decision to sell shares in the company or the business of the company including its assets will (whatever tax advisers may think) primarily be driven by commercial issues including whether or not the purchaser is prepared to take on the company 'warts and all'. However, it is important not to forget the taxation implications of the sale of shares or the sale of assets and the various schemes that may be used to reduce the corporation tax liability which may arise, particularly when selling a subsidiary out of a group of companies.

All references are to Taxation of Chargeable Gains Act 1992 unless otherwise stated.

Sale of assets

The acquisition of assets from the purchaser's point of view would generally be the most preferable result, as the purchaser will be able to cherry pick the particular assets it wants and leave the others, including any liabilities, for the vendor to sort out. The purchaser will wish to ensure that there is a proper apportionment of the purchase price for capital allowances purposes, in order to claim full capital allowances on the purchase price paid for plant and machinery. This assumes that the purchaser was not acquiring assets from a connected company, in which case the capital allowances claim will be based on the original cost of the assets rather than the price paid by the purchaser (if higher). The vendor will be faced with either a balancing charge or balancing allowance depending on the relative values of the tax written down value and the purchase price.

The purchaser may also wish to claim rollover relief on replacement of business assets, having disposed of previous business assets in the three years prior to the acquisition of the current asset or plans to sell business assets in the next 12 months. It is not possible (at present) to claim rollover of business assets on the acquisition of shares. The only assets that qualify as only business assets are set out in section 155.

The purchase of assets is not all good news for the purchaser. Any amount paid for goodwill has to be amortised over a maximum of 20 years or its useful economic life if shorter due to Financial Reporting Standard 10. The purchaser is also faced with an additional stamp duty liability on the acquisition of assets of up to four per cent compared with 0.5 per cent on the acquisition of shares. Unless the purchase is a transfer of business as a going concern, the purchaser will have to pay VAT on VATable goods acquired which will include most types of assets acquired as part of a business acquisition (the only exception being land which may have been covered by an option to tax in any event). If the acquisition of the assets can be classified as a transfer of a going concern, then VAT will not be payable.

However, purchasers are required to sign an undertaking to the Stamp Office that if a transfer which is first thought to be a transfer of a going concern is subsequently not a transfer of a going concern and therefore becomes subject to VAT, the business acquisition documents will be submitted for readjudication so that stamp duty may be payable on the VAT element of the consideration.

The Inland Revenue published a technical note on the taxation of intellectual property, goodwill and other intangible assets on 7 March. One of the aims of the legislation which will follow the note is to provide some form of revenue depreciation for capital sums spent on goodwill. Whether this is done through accounting treatment or amended capital allowance treatment is as yet unknown. However, it might mean that purchasing goodwill in an asset sale (rather than purchasing the underlying goodwill when buying shares) will become more attractive for a purchaser who, hitherto, has had to wait until that goodwill is sold to benefit from that expenditure.

Acquisition of shares

The sale of shares in the company is generally favoured by the vendor, as it allows the vendor to wash its hands of the company and all its liabilities. The purchaser will generally require a full tax indemnity to protect itself against unknown tax liabilities. Issues that may arise in the tax indemnity are considered in the next article in this series. The vendor has traditionally been interested in reducing its capital gains tax exposure on disposal of the shares, particularly when the base cost of the shares has been minimal. Traditionally this has involved use of pre-sale dividends or other methods of turning the consideration from capital into income. The introduction of taper relief and the recent changes to ownership periods set out in the press release of 18 June 2001 (particularly where the shares have been held for more than two years by individuals) has lessened the interest in this type of pre-sale tax planning, although it is still very important for individuals who have not achieved more than two years ownership of the shares, and the corporates for whom business asset taper relief is not applicable.

A common problem is that the target company, Target, does not have sufficient distributable reserves to pay a pre-sale dividend equal to the purchase price. There are techniques (see below) for creating such reserves, but they commonly involve transferring assets within a group prior to the sale. If so, then it is important to realise the impact that section 179 might have.

Section 179

Transfers of assets within a 75 per cent group of companies can be undertaken on a no gain/no loss basis.

If section 179 did not exist, it would be easy for a company which wished to sell assets to securitise them within a subsidiary company, the new company's shares being issued for the market value of the asset transferred. The selling company then sells the shares at market value and there is no gain since they have a market value base.

Section 179 prevents this by deeming the asset to be disposed of and re-acquired at market value when a company leaves a capital gains tax group within six years of having had a chargeable asset transferred to it. Since that asset will have been transferred on a no gain/no loss basis (i.e. at historical base), there will usually be a tax charge within the de-grouping company. The gain is calculated as the difference between the original base at which the de-grouping company acquired the asset, and the market value of that asset immediately after it was acquired (and not, as is commonly thought, the market value at the date the company de-groups).

There is an associated company exemption. If A owns B which owns C, B transfers an asset to C, and then within six years B and C leave the group together, there is no de-grouping charge. Although C has left the A group, it has done so with the company (B) which transferred the asset. See Figure 1.

Figure 1

If subsequently, after B and C have joined, say, P's group, B sells C, is there then a de-grouping charge in C? The answer is (surprisingly) no. Although C has now left the P group, the section 179 charge only applies to an asset acquired while the recipient was a member of the group that it is leaving. Here it is leaving the P group, but it did not acquire the asset whilst it was a member of the P group. It acquired it whilst it was a member of the A group. See Figure 2.

Figure 2

Dividend stripping and value shifting

Unlike a higher rate tax-paying individual, who will have an effective tax rate of 25 per cent on a pre-sale dividend, a corporate shareholder will not be taxed on a pre-sale dividend by virtue of section 208, Taxes Act 1988. The rationale for this is that the profits from which the dividend is paid have already been taxed in the paying company.

Thus, stripping cash out of a subsidiary before selling it is an extremely tax efficient way of getting a capital tax free receipt for the parent.

The Revenue has always accepted that a dividend paid out of taxed profits is fine. It is not at all happy, however, where profits are artificially generated. A technique which could be used (in the absence of the anti-avoidance legislation which now exists, and provided that the Institute of Chartered Accountants in England & Wales technical note 25/00 is complied with) is illustrated in Figure 3 below.

Figure 3

A owns B, which it is intending to sell for £10 million. It has a nil base in these shares. If it sells for £10 million it will suffer a huge gain. If, on the other hand, it strips £10 million out of B prior to the sale and sells for £1, it will suffer no tax at all. To achieve this, it could set up new subsidiary C, which borrows £10 million (perhaps backed by a parent company guarantee by A) which cash it uses to buy the assets of B. This generates distributable reserves in B which are used to frank a dividend which is paid up to A, of £10 million. A thus has the money it wants. A then sells B to a purchaser for £1. The purchaser capitalises B by injecting £10 million into it in consideration for the issue of shares. This gives the purchaser a £10 million base cost going forward. B then moves the money down to C which uses it to pay off the debt to the bank. There is no section 179 charge when A sells B and C, since B and C leave the group together and the associated company exemption applies.

Anti avoidance

To prevent these sort of schemes, anti-avoidance legislation has been introduced (sections 29 to 34 and 176 to 177) which allows the Revenue to adjust the amount of gain (or loss) which arises on A in these circumstances by 'such amount as is just and reasonable having regard to the scheme or arrangements of the tax-free benefit in question'. In the above example they would clearly adjust the consideration received by A up to £10 million.

However, the circumstances in which these value shifting provisions apply are limited, and it is possible to get outside them.

Swamping

One technique which (theoretically) achieves this is 'swamping'. This would be achieved if, instead of the purchaser buying shares from A, it subscribed directly, £10 million, for the shares in B in respect of which B would issue sufficient shares so that the purchaser would own 99.9 per cent of the share capital. That subscription money would be used by B to transfer to C, which would then repay the third party debt. In these circumstances, there would be no disposal of A's shares to the purchaser, and the value shifting provisions require a disposal. However, it means that A still has a very small proportion of shareholding in B, and that might be unsatisfactory to vendor and purchaser.

Hiving up

Hiving up might be considered when a buyer wants to acquire specific assets or subsidiary company shares but leave others behind, in circumstances where a straight hive-down would result in a de-grouping charge. It may, however, increase the tax for the selling company, and thus may only be appropriate if that company is in a jurisdiction where the participation exemption applies (in other words there are no gains on a sale of shares in a subsidiary), or it is a United Kingdom selling company which has losses (capital losses, current year trading losses or losses which can be group relieved into it), which can be used to mitigate the gain.

The scheme can best be illustrated by an example (see Figure 4). Assume that all companies are United Kingdom resident. A owns B which owns C. Purchaser wants to buy £10 million worth of assets in C, but does not want the rest. If they were hived down to a new company below C which was then sold by C, there would be a de-grouping charge which the purchaser would normally pick up via the tax covenant in the acquisition paperwork. Instead, the following steps might be adopted.

Figure 4

Step 1

NewCo 1 (N1) is inserted between A and B on a share for share exchange. This means that N1 has a market value base cost of its shares in B, but A has an historic (and presumably low) basis for its shares in N1. Thus if (which is what is going to happen) it sells N1, it will realise a substantial gain. It is here therefore that you need losses, etc. The shareholding between A and N1 is structured so that A ceases to be the principal company of the capital gains tax group, N1 becoming that principal company. This means that A cannot have ordinary shares in N1, and the type of shares that must be issued by N1 to A needs considerable thought and is highly technical. This makes N1 the principal company of the N1/B/C group.

Step 2

C forms NewCo 2 (N2) into which it transfers the assets or shares in other subsidiaries which are to be sold. They are transferred at book value in return for the issue of the new shares.

Step 3

The shares in N2 are sold by C to N1. The purchase price will be the price that the purchaser will be ultimately paying. The consideration is left outstanding as a debt.

Step 4

N1 then sells its shares in B to A. There is a market value base cost so no gain to N1. The price is the same, i.e. what the purchaser will pay, and again is left outstanding as a debt.

Step 5

A sells N1 to the purchaser. The funds are used by A to repay the debt it owes to N1 incurred at step 4 and then by N1 to repay the debt to C incurred at step 3.

Observations

There will be stamp duty considerations, but these might be alleviated by the use of bearer shares at various stages. There is no de-grouping charge when N1 and N2 are sold by A because when the assets/shares were hived down by C, N2 was in the N1 capital gains tax group and, since it leaves with N1, it effectively never leaves the N1 group.

Treasury consent

It is all very well getting a complicated scheme correct but it is important not to forget other tax issues which may trip up the tax adviser. One of these is the need to obtain Treasury consent under section 765, Taxes Act 1988 when companies migrate offshore. Treasury consent is required when a United Kingdom corporate transfers any shares in a non-United Kingdom corporate to any other person resident outside the United Kingdom. This provision even applies where the transfer may take place within the same corporate group. For example a United States holding company may own a United Kingdom intermediate holding company, which in turn may hold a United States subsidiary. The United States parent company may have been put in place to facilitate a listing on NASDAQ rather than trying to obtain a listing of shares in the United Kingdom company. From a business point of view, the corporate group may wish to rationalise its structure by transferring the United States subsidiary into the direct ownership of the United States holding company. This type of transfer will require Treasury consent.

Certain transfers do not require Treasury consent including transfers between companies within the European community. The penalties for breaching section 765 can be harsh, including two years imprisonment and/or a fine which can be the greater of £10,000 or three times the tax liability of the company in the previous three years prior to the offence.

Gains on substantial shareholdings

The Revenue published technical notes on 23 June and 8 November 2000, and announced a further period of consultation in the 2001 Budget, with a view to introducing relief on gains arising to companies when they dispose of substantial shareholdings. Unlike some other European countries (for example, the Netherlands) there is no participation exemption for United Kingdom companies selling shares for the subsidiary companies. Nor is there any form of rollover relief since shares are not qualifying assets for the purposes of section 155, and the relief available to individuals (enterprise investment scheme deferral relief) is denied to companies.

Simply stated, the Government proposed to introduce a deferral relief which will allow chargeable gains to be deferred where a qualifying company which has held a substantial shareholding in a qualifying company (a trading company or the holding company of a trading group) throughout a 12-month period, realises a gain on the disposal of shares in that company. The shareholding company must reinvest the proceeds of that sale in shares in another qualifying company in which it holds a substantial shareholding, and must also hold those shares for 12 months. Alternatively, the shareholding company could reinvest the disposal proceeds in qualifying business assets within the categories set out in section 155.

The relief will also be available where a qualifying shareholding company disposes of section 155 assets and then reinvests in shares of the qualifying company in which it has, although comes to hold, a substantial shareholding, and holds those shares for 12 months.

Originally a substantial shareholding was 30 per cent of ordinary share capital but the proposals are that it should now be 20 per cent. (The provisions in Schedule 18 to the Taxes Act 1988 apply.) The press release dealing with this further consultation period (REV BN23) identified a number of key features which suggest that although the principles of the relief are simple, the legislation to govern it could be littered with anti-avoidance provisions. This is in contrast with the announcement in the Treasury press release of 18 June 2001 (Enterprise for all – the challenge for the next Parliament) which says that 'the Government will also consult on whether there are worthwhile or good value for money options to simplify capital gains tax within the existing policy framework …'.

In that context an even better possibility was put forward in the consultative document issued on 19 July 2001 and entitled 'Large business taxation: The Government's Strategy and Corporate Tax Reforms'. This finally conceded the possibility of an exemption being introduced for the disposal by trading groups of substantial (a 20 per cent test again) shareholdings in trading companies or groups.

A change would also be made to section 179, Taxation of Chargeable Gains Act 1992 to allow appropriate gains within that section to be rolled over. The downside was in the form of comments about a review being required in relation to the company tax residence.

Andrew Evans is an associate at Burges Salmon; he can be contacted on 0117 902 2730.

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