Corporation Tax - A New Landscape?

PAUL EAGLAND ACA,ATII and ZIGURDS KRONBERGS MA, BSc, ARS, ACA, FCCA of BDO Stoy Hayward examine the new substantial shareholdings exemption.

FROM 1 APRIL this year, sales by United Kingdom companies of 'substantial shareholdings' in other companies are to be tax free. This is a completely new avenue for the United Kingdom tax system. For years, governments have resisted calls for the United Kingdom to replicate the 'participation exemption' available in several other European countries, especially the Netherlands. Now, although dividends from foreign subsidiaries will remain fully taxable, disposals of shares in foreign and United Kingdom subsidiaries are to be exempt from corporation tax on capital gains, provided that certain conditions are met.

The significance of this new exemption for United Kingdom-based groups should not be underestimated. Not only will it make restructuring less burdensome, but it calls into question many existing group structures. Many United Kingdom-based groups will have been structured in order to keep gains offshore and tax free. Now that, in many cases, the gain need no longer be realised offshore for it to be tax free, the whole structure of the group should be reviewed.

What is more, since as a quid pro quo, losses on disposals of substantial shareholdings will no longer be recognised, urgent action needs to be taken before 1 April if any accrued losses need to be crystallised in order to reduce other gains.

The aim of this article is, after outlining the main features of the new rules, to indicate what action needs to be taken before and what action should be deferred until after 1 April, and to examine the consequences of the new régime for different types of international group structures. It does not attempt to provide a detailed commentary on the draft legislation.

All the commentary that follows is necessarily based on the draft legislation published on 27 November 2001 (as part of the technical note entitled 'Corporation tax: responses to the July 2001 large business taxation consultation - an exemption for substantial shareholdings').

Given the lateness of this year's Budget speech (17 April), the Finance Bill is unlikely to be published much before the end of April, a good four weeks after the legislation it is to contain is supposed to have come into effect. This is particularly unsatisfactory, and introduces the possibility that the start date of the legislation will be postponed. However, unless and until any announcement is made, we must continue to abide by 1 April.

References are to Schedule 7AC to the Taxation of Chargeable Gains Act 1992, as it appears in the draft legislation and as it would be inserted in Taxation of Chargeable Gains Act 1992 by that legislation.

The new rules in brief

• The relief will be available for disposals by trading companies or members of a trading group (the 'investing' company).
• It applies to gains on the disposal of a substantial shareholding in a trading company or a holding company of a trading group (the 'investee' company).
• A substantial shareholding means, broadly, at least a 20 per cent interest.
• The substantial shareholding must have been held for a continuous period of at least 12 months in the two years immediately before the disposal.

Conditions relating to the investment company

Trading company and trading group

The definitions of 'trading company' and 'trading group' are modelled on the taper relief definitions in Schedule A1 to the Taxation of Chargeable Gains Act 1992. This means that the company, or the group, must not have activities that include non-trading activities to any 'substantial extent' (paragraph 15 of Schedule 7AC). Activities undertaken in preparing to carry on a trade count as trading activities.

The explanatory notes do not elaborate on what substantial extent may mean, but since the definition is explicitly borrowed from taper relief, we must assume that it means more than 20 per cent (see Tax Bulletin Issue 53 dated June 2001, pages 853 to 854), with particular reference to turnover, assets, expenses or management time.

Thus, where there is some possibility of crossing the 20 per cent threshold, and a gain is intended to come within the new rules, action would have to be taken sufficiently in advance of the planned disposal (so as to allow for the minimum 12-month period) to transfer the offending activities or assets elsewhere, for example to shareholders. This may be good practice for other reasons; it is often advisable, for example, to hold passive assets such as land or intellectual property outside the main trading entity.

20 per cent interest

In order to hold a substantial interest, the investing company will need to be beneficially entitled to at least 20 per cent of the investee company's:

• ordinary share capital; and
• profits available for distribution to equity holders; and
• assets available for distribution to equity holders in the event of a winding-up (paragraph 7 of Schedule 7AC).

In determining whether a holding amounts to a substantial shareholding, shares held by other group members are aggregated over the world-wide group (paragraph 8).

The 20 per cent rule may well be subject to change. In the 27 November technical note, the Government indicated that it may still opt for a 'soft test' to eliminate portfolio holdings from the relief without imposing a fixed percentage, although it has yet to identify one that it thinks is sufficiently robust.

Part disposals

The investing company does not have to dispose of its entire shareholding in the investee company to qualify for the exemption. As long as the shareholding is substantial, and the investing and investee companies satisfy the relevant conditions, any gain arising on a disposal of part of that shareholding will be exempt (and, by the same token, a loss will not be allowable).

Nor is it necessary for the investing company to hold a substantial shareholding in the investee company at the time of the disposal. It is only necessary for the 12-month minimum holding period to have begun at some point within the two years preceding the disposal. This means that further disposals from a holding that is no longer a substantial shareholding can still qualify for the exemption for up to 12 months afterwards, provided that the other conditions are satisfied.

Conditions relating to the investee company

Trading company or holding company of trading group

As with the investing company, the investee company must be a qualifying trading company or, in this case, the holding company of a trading group.

A 'qualifying trading company' (paragraph 17 of Schedule 7AC) is a company whose activities do not to any substantial extent include activities that are not qualifying activities. Qualifying activities are trading activities, except that certain activities are excluded unless carried on by a finance company (as defined). These activities are listed in paragraph 19 and include:

• holding shares or securities;
• holding intellectual property;
• leasing; and
• certain types of fund investment.

A finance company is in turn defined as a company mainly engaged in banking and similar activities (paragraph 17(4)).

A holding company for these purposes is one whose activities, taken together with those of its 51 per cent subsidiaries, do not to any substantial extent include activities that are not qualifying activities (paragraph 18).

Again, where the investee company's non-qualifying activities or where the non-qualifying activities of the members of the investee company's group threaten to breach the 20 per cent (substantial) limit, consideration should be given to transferring those activities to another party.

Both the investing company and the investee company must satisfy these conditions throughout the latest 12-month period ending with the disposal and during which the holding is a substantial shareholding. They must also satisfy the conditions immediately after the disposal (paragraphs 14(1) and 16(1)).

Extended exemption

The exemption also extends to disposals of 'assets related to shares', if the disposal of the shares themselves would be exempt (paragraph 2 of Schedule 7AC). A put or call option would be such an asset, as would securities convertible to or exchangeable for the appropriate shares.

Rollover of degrouping charge

The new rules also contain an extension of rollover (and holdover) relief to the degrouping charge under section 179, Taxation of Chargeable Gains Act 1992. Provided that the company leaving the group, i.e., the departing company, with the asset that has been transferred to it on a no gain no loss basis, i.e., the old asset, reinvests in a new trading asset within the normal rollover period it may defer the degrouping gain. Full rollover against the acquisition cost of the new asset will apply where the amount reinvested is at least equal to the deemed sale consideration (market value). The old asset must have been used in the transferor company's trade and both the old asset and the new asset must be assets qualifying for rollover relief under section 155.

It should be noted that with the introduction of the new intellectual property régime (also scheduled for 1 April), intellectual property ceases to qualify, subject to transitional provisions, as an asset class eligible for rollover under the general provisions of sections 152 to 159.

The rollover period is defined by reference to the time of the degrouping charge, not that of the deemed disposal and reacquisition treated as taking place immediately after the departing company acquired the old asset.

There is also the facility for all or part of the degrouping charge to be borne by another member of the vendor group. A joint election to this effect by the departing company and the company assuming all or part of the charge must be made within two years of the end of the accounting period in which the degrouping gain accrues (new section 179B).

Action needed before 1 April 2002

Crystallising losses

Clearly, if there are qualifying substantial shareholdings standing at a loss within a group, and a disposal is intended at some point, it would make sense to realise the losses before 1 April and effectively bank them against future gains. Losses on disposals under the new rules will be disregarded if gains would have been exempt. Such losses could well be present, for example, where an earlier reorganisation has resulted in a step-up of base costs but there has been a subsequent collapse in values, for example, in the technology or dot.com sector.

In relation to disposals at a loss, the extended exemption given under paragraph 3 of Schedule 7AC (see below) must be taken into account. This exempts gains made at a time when not all the necessary conditions are satisfied, but would have been satisfied on the occasion of a hypothetical disposal within the preceding two years. Paragraph 3 is intended primarily to allow capital distributions by a company in liquidation to qualify for the exemption even though it has ceased to trade.

Future chargeable gains could arise on the sale of non-trading companies, especially companies (other than group finance companies) with a substantial involvement in intellectual property or real property.

Postponing sales

On the other side of the coin, where sales pregnant with gain are impending that will be exempt from 1 April, vendor groups may wish to defer those sales.

There is the risk that purchasers may go elsewhere, so some means may have to be found to lock them in now but conclude the sale once the new rules are in place.

The first point to bear in mind is when disposal is considered to take place. Under normal capital gains tax rules, where there is a conditional contract, disposal occurs when the condition is satisfied (section 28(2), Taxation of Chargeable Gains Act 1992). It should therefore be possible to exchange conditional contracts, in relation to which the condition can be satisfied only after 31 March. Alternatively, the vendor could grant an option now under a condition that can only be fulfilled after the new rules come into play.

The new rules do contain an override of section 28(2), but only in the specific circumstances where the exemption is extended to what would otherwise be a non-qualifying disposal occurring within 24 months of a time when a hypothetical disposal would have qualified (paragraph 3(3) of Schedule 7AC).

Where the date of a disposal is deferred under section 28, both the investing and investee companies must comply with the necessary conditions at that later time.

Other techniques that may be considered if a simple conditional contract or option is not feasible include:

• stock-lending techniques;
• a variable forward contract for cash now to the vendor against the shares later.

These techniques are equally applicable once the new rules are in place, in circumstances where the sale needs to be deferred because, say, the holding period is not yet 12 months.

Rethinking group structures

Offshore holding companies: trading groups

Figure 1 shows a typical international group structure under an ultimate United Kingdom parent company.

Figure 1

Hitherto, United Kingdom parent companies would have been advised to hold foreign (and indeed United Kingdom) trading subsidiaries through an offshore holding company primarily in order to defer tax on capital gains arising from disposal of those subsidiaries. Typically, the intermediate holding company (H1) is located in a favourable continental European jurisdiction, such as the Netherlands, Luxembourg or Denmark or in a haven. Before the double taxation relief changes in Finance Acts 2000 and 2001, H1, if located in an appropriate jurisdiction with a good treaty network, e.g. the Netherlands, would also have acted as a dividend mixer to maximise double tax relief.

However, if sales of the trading subsidiaries are now to be exempt, what need is there for H1 at all? The following costs and disadvantages of an intermediate holding company will now become crucial:

• United Kingdom tax on dividends if no underlying tax or eligible unrelieved foreign tax;
• capital duty in most European jurisdictions;
• maintenance costs;
• particularly in the case of havens, withholding tax on dividends from the trading subsidiaries to H1 may be greater than the withholding tax on dividends directly from the trading subsidiaries to the United Kingdom;
• some jurisdictions (e.g. the Netherlands) deny an interest deduction related to the derivation of tax-exempt income and gains.

Groups use offshore holding companies for reasons other than deferral of United Kingdom tax on gains, for instance there may be good non-commercial reasons for their use. Particularly with haven companies, disclosure requirements may be less rigorous, and this may make them attractive to certain classes of investor.

However, at least in the case of wholly trading groups, there seems no compelling United Kingdom tax reason why the trading subsidiaries should not be held directly from the United Kingdom. This could be achieved either by transferring the central management and control of the offshore holding company to the United Kingdom or by selling the shares of the trading subsidiaries to a United Kingdom incorporated holding company. Retaining the offshore holding company, but bringing it into the United Kingdom tax net would have the added advantage of possibly generating a tax-free distribution of its retained profits under section 208, Taxes Act 1988.

Offshore holding companies: mixed groups

The position with groups containing passive or non-trading subsidiaries is not quite so straightforward. Using an offshore holding company to shelter gains from eventual disposal of these companies still appears to be a valid strategy. Alternatively, the companies could be held directly from the United Kingdom. In either case, without careful planning, there would be probable exposure to the controlled foreign companies rules.

Tax on the sale of these passive companies must also come into the picture. Whereas capital gains are outside the controlled foreign companies rules, there is section 13, Taxation of Chargeable Gains Act 1992 to consider if the group is closely owned.

A further strategy would be to flood the passive company with trading activities transferred from other group companies, so that its passive activities become non-substantial and it qualifies for the exemption. This would have to be done in such a way as to avoid chargeable gains on transfers of those assets, and to the extent that United Kingdom-domiciled and ordinarily resident individual shareholders of the ultimate United Kingdom holding company are involved, section 739, Taxes Act 1988 must be considered.

Although the decision in any particular case must depend on the circumstances, an offshore holding company for holding passive activities would still be of merit where the company is to hold assets likely to appreciate in value, and gains remain outside the United Kingdom's controlled foreign companies régime. Under the new régime for intellectual property, most receipts from intellectual property will be classed as revenue and thus potentially subject to controlled foreign companies rules. For closely held groups, an additional condition would be the ability to plan round a section 13, Taxation of Chargeable Gains Act 1992 liability.

Figure 2 illustrates a typical structure for a mixed group with an offshore holding company.

Existing techniques of avoiding the section 13 charge therefore remain valid and necessary.

Figure 2

United Kingdom holding companies

Bringing the focus away from multinational groups to growing businesses and their individual entrepreneur-shareholders, another question to consider is whether trading subsidiaries, wherever located, should be held by a United Kingdom holding company or directly by the shareholders themselves. Diagrammatically, should the structure look like Figure 3 or Figure 4?

Figure 3: Direct ownership by shareholders

Figure 4: ownership via a United Kingdom holding company

Individual shareholders who owned shares in the trading companies directly, as in Figure 3, could benefit from full 75 per cent taper relief, i.e. effectively enjoy a ten per cent rate of capital gains tax, after just two complete years of ownership, under the changes to taper relief proposed for this year's Finance Bill. They would also be spared the expense of maintaining a separate holding company.

The main disadvantage of direct ownership is that the companies, even if all United Kingdom resident, do not constitute a United Kingdom tax group, and hence there is no possibility of group relief, intra-group tax-free asset transfer, capital-loss spotting, etc.

Owning the trading companies through a holding company, as in Figure 4, allows for group relief and the attendant advantages (among the United Kingdom resident companies and any United Kingdom branches of non-resident companies, at least).

Apart from the expense of maintaining a separate holding company, the possible disadvantage lies in the problem of a cash mountain following sale of any one or more of the trading subsidiaries.

Under the new rules, for exemption to apply to a gain from a substantial shareholding, the investing company must remain a sole trading company or a member of a trading group immediately after the disposal (paragraph 14(1)(b) of Schedule 7AC). However, if the holding company held a significant amount of the sale proceeds as cash, there is a danger that it would lose its, or the group's, trading status, by falling foul of the 20 per cent (substantial extent) threshold for passive activities, especially if there are existing passive activities present and it did not have a substantial trade of its own. Clearly, the problem is more acute for a small group than for a large one.

This is one of the areas of uncertainty remaining around the draft legislation. Annex B to the technical note of 27 November 2001 contains semi-contradictory statements. On the one hand, paragraph B6 states:

'… while it will be a question of fact and degree in any particular case, brief periods of non-trading or the temporary holding of significant cash assets will not automatically preclude a company or group from qualifying for the relief.'

Paragraph B3 adds: '… there is no requirement to reinvest the disposal proceeds'. On the other hand, paragraph B3 goes on to state:

'The post-trading condition [i.e. the requirement for the trading condition to be satisfied immediately after the disposal] is necessary to prevent individuals, who may have no intention of applying the proceeds towards trading activities, from taking advantage of the relief by the simple expedient of inserting a holding company between them and their trading company before disposing of the latter.'

Thus while reinvestment into trading assets is not mandatory, reinvestment or application of the cash as working capital would appear advisable, especially after the temporary period, however long that may be, has expired.

If there is any question whether the holding of large amounts of cash is any longer temporary, a distribution to shareholders, in lieu of reinvestment, may also not be wise. Whereas there is nothing in the new rules penalising such distributions, paragraph B3 does remind us that the intention of the relief is to contribute to 'productivity gains'. Distribution of cash is unlikely to enhance this aim.

Revenue guidance on this question would be welcome.

International holding company location

There is no doubt that the new rules will substantially increase the attractiveness of the United Kingdom as a location for international holding companies. Quite apart from any non-fiscal considerations, the United Kingdom's advantages from a tax point of view, even before 1 April 2002, have been:

• no capital duty and no dividend withholding tax;
• no restrictions on interest relief (other than transfer pricing and thin capitalisation rules, which are applied in almost every similar jurisdiction);
• a first class treaty network.

The major drawback has hitherto been the imposition of tax on gains from the disposal of subsidiaries. The new rules remove this obstacle.

It remains true that most jurisdictions offering a participation exemption also exempt dividends from foreign subsidiaries (or, in the case of the Netherlands, from holdings as small as five per cent). The technical note reaffirms that the United Kingdom Government does not intend to introduce a similar dividend exemption in the United Kingdom. If United Kingdom tax on incoming dividends were felt to be a major problem, in circumstances where there was insufficient underlying foreign tax, after pooling, etc., then the use of stapled stock could be considered. This would enable up to 80 per cent of the dividends (at least 20 per cent would have to be retained to maintain a substantial shareholding) to be paid directly to the foreign investors rather than to the United Kingdom holding company.

Summary

The introduction of the exemption for substantial shareholdings represents a significant change in the United Kingdom tax landscape for United Kingdom based groups, and the following summarises action that should be taken:

• Unrealised losses that will cease to be recognised should be crystallised before 1 April 2001 if possible.
• Where gains are likely to arise on an imminent disposal, deferring the sale until 1 April should be considered.
• Existing plans for a new international corporate structure should be reviewed - in particular consider whether there is still a need for an offshore holding company.
• With existing structures, consider whether some offshore companies could be brought back into the United Kingdom tax net.
• Where there is currently no existing group structure, but one is planned, review whether a holding company is still required.

All non-tax considerations must also be taken into account.

The authors would like to acknowledge the assistance of Jeff Bowman in the preparation of this article.

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