Windfalls and Gains

MIKE THEXTON MA, FCA, ATII explains the capital gains tax treatment of windfalls from the demutualisation of Scottish Widows.

THOSE LUCKY ENOUGH to hold the right sort of policy in Scottish Widows received a number of substantial documents leading up to the takeover by Lloyds TSB, and a 28-page booklet explaining 'Compensation Options for Qualifying Members' in June 2000. Those who opted for cash received their money in late August, and the tax consequences have to be entered on a 2000-01 tax return. As with most capital gains tax share transactions, the treatment is quite technical, and almost certainly not understood by many of those who received compensation.

The transaction

The way in which the transaction was arranged was as follows:

• On 14 August 2000, a Lloyds TSB group company issued redeemable shares to the account of those entitled to compensation.
• Those who had not opted to receive qualifying corporate bonds had their shares redeemed very shortly afterwards, and the cash proceeds of redemption were paid to them.
• Those who opted for loan notes received 99.5 per cent of the value of their shares, because this represented a disposal of the shares (chargeable to stamp duty) rather than a redemption of the shares (not chargeable).
• Those holding loan notes are entitled to cash them in (including partial encashments) at six-monthly intervals thereafter, at the end of March or September, until 31 March 2008.

Capital gains analysis

The acquisition of the shares is treated by the Revenue as a 'share-for-share exchange' within section 136, Taxation of Chargeable Gains Act 1992. (It will be recalled that this is the standard capital gains tax provision which deals with shares issued under a scheme of reconstruction of a company or the amalgamation of two companies, and it avoids any immediate capital gains tax liability.) At first sight, this is surprising because the policyholder may not seem to have exchanged two similar assets. However, the rights of a mutual company member are regarded by the Revenue as being within section 136, and this means that no gain is triggered on that part of the transaction.

It also means that the shares acquire the base cost and history of what has been exchanged for them, i.e. the member's rights. The Revenue believes that these have no base cost. They are connected with insurance policies that have cost money (mainly with profits endowments and pensions), but the Revenue believes that all the money paid by the member has gone into the policy and is still there, so the member's rights effectively 'came free' with the policy. No-one seems keen to challenge this idea (in spite of the successful challenge on the question of building society share accounts in relation to the Cheltenham & Gloucester takeover; also by Lloyds TSB, see Foster v Williams, Horan v Williams SpC 113).

Taper relief

Next, there is a specific and unwelcome rule in paragraph 18 of Schedule A1 to the Taxation of Chargeable Gains Act 1992. This provides that the shares acquired on a demutualisation count for taper relief only from the day they are issued, even though section 136 applies to the transaction. This means that a member may have owned the member's rights for several years, and expects at worst five per cent taper on the disposal of those rights in August 2000, but will find that no taper relief is available, because:

• the disposal of the member's rights (owned for many years) does not trigger a gain, because of section 136;
• the disposal of the shares (for cash or for loan notes) happened very shortly after they were issued, and only that short period counts for taper relief under paragraph 18.

If the compensation had been effected by making a straight 'payment of cash for members' rights', there would have been an immediate gain, but there would have been five per cent taper relief (at least for anyone with a worthwhile amount of money, because it was necessary to have started the policy before 17 March 1998 to qualify for a significant amount).

As it is, there was no straight payment of cash but instead an issue of shares which could be redeemed shortly thereafter.

Those taking the cash option therefore have a chargeable gain in 2000-01 of the whole amount of money received, with no base cost, no indexation and no taper.

Joint policies

The Revenue has recently published a small note about joint policies in Working Together Issue 6. This comments on the fact that payments were only made to the first named policyholder, who therefore appears to have the whole of the gain. However, the Revenue will accept a declaration that the amount was received on behalf of both of the owners, and the gain will then be divided between them.

Loan notes

The gain could be deferred by taking loan notes instead of cash. The disposal of the redeemable shares for loan notes was within section 116, Taxation of Chargeable Gains Act 1992: the gain is chargeable, but deferred until the loan notes are disposed of. The taper relief (of nil) is also frozen at the time of the disposal.

The Scottish Widows document explains that the full amount of the gain is deferred into the loan notes, disregarding the 0.5 per cent stamp duty cost. This means that cashing in £9,950 of loan notes will generate a gain of £10,000. This seems a little unfair, but the stamp duty is really part of the acquisition cost of the loan stock (which is exempt from capital gains tax) rather than a true disposal cost of the shares (which would bring it within the calculation of the frozen gain). Normally, stamp duty on a share sale is borne by the purchaser, but Lloyds TSB was unwilling to bear the cost of its policyholders' tax planning, so the policyholders suffered it. It might be argued that the stamp duty is a disposal cost, but that was not the line taken by Scottish Widows.

The planning idea within the loan notes is to allow policyholders to realise their capital gain in annual tranches so that several annual exemptions can be set against it. As with most other aspects of the transaction, this may not be fully understood by some holders, who only know that 'holding the loan notes means I do not pay capital gains tax'. Holding them until 31 March 2008 would miss the whole point, if the total gain is above the annual exemption for 2007-08. It is important to cash them in on a regular basis, probably on the second redemption date in each fiscal year (31 March), when the owner can assess how much of the annual exemption for the year remains unused.

The position

In summary, then, anyone taking the cash option has a gain equal to the full amount of cash received in 2000-01. Anyone taking the loan notes can cash them in year by year, and will have a gain equal to 100/99.5 times the cash received in each year.

Mike Thexton is a director of Thexton Training. He can be contacted on 020 8715 4434, or by e-mail: thexton@enterprise.net.

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