Solving the Taper Trap - II

MARTIN DAWSON and SANDRA MacMILLAN examine the corporate problems that can arise in relation to the availability of business asset taper relief.

SOME OF THE day to day issues likely to arise at shareholder level to disrupt the recipient's business asset taper relief clock were considered in the authors' previous article, 'Solving the Taper Trap', in Taxation, 10 January 2002 at pages 332 to 333. Practical solutions were offered to side-step these, and keep the shareholder on track to achieve a headline rate of capital gains tax of ten per cent.

In this second article, we will cover some of the events and circumstances where it is the corporate structure/profile that corrupts the shareholder's taper clock, showing how these can be tackled, to ensure continuity at the business asset rate.

Shareholders should appreciate the impact that a tainted corporate structure has on their shareholding. If, during the holding period of their shares (or during the last ten years once April 2008 is reached) the company (or group) fails the 'trading test', then any ultimate gains realised on a disposal of their shareholding will be apportioned accordingly between business and non business rates.

A minority of shareholders are likely to escape this rule, namely those that fall within the provisions of Schedule 26 to the Finance Act 2001. Broadly, this Schedule applies to officers and employees whose shareholding amounts to less than a material interest, i.e. ten per cent, when business asset taper relief is given, whether or not the company is a trading company.

A tainted corporate structure will be imputed through to shareholders, and hence affect their own profile, either immediately or sometime in the future, where commonly the corporate structure falls outside the trading definition ascribed by the taper relief legislation in accordance with paragraph 22 of Schedule A1 to the Taxation of Chargeable Gains Act 1992. What is often not appreciated at an early stage is that, while an existing corporate structure may not be (initially) broken, it could eventually lead to a loss of taper relief if it is not groomed towards a client's ultimate business destination.

Qualifying companies

Before highlighting the practical issues, we will recap the definition of a qualifying company, since this is pivotal to recognising certain issues. The 2001 Budget introduced a welcome 'let out' for some employees of non-trading companies, but the general rule for a stand-alone company to be a qualifying company is that it has to be a trading company.

A trading company is defined as:

• a company existing wholly for the purposes of carrying on one or more trades; or
• a company that would fall within the above definition, apart from any purposes capable of having no substantial effect on the extent of the company's activities.

While the Revenue has confirmed that 'substantial' should be read as meaning more than 20 per cent (in line with the definition found within the enterprise investment scheme legislation), this does, however, beg the question, 20 per cent of what?

Tax Bulletin 53 offers further guidance on the likely indicators that the Revenue will look at to establish if the 20 per cent test has been 'passed'. These could include:

• percentage of turnover receivable from non-trading activities;
• the assets of the balance sheet of the company;
• expenses incurred; and/or
• time spent by employees on the non-trading activity.

In essence, the Revenue is likely to apply the test that it believes is most appropriate to the company's (past and present) circumstances. It is therefore important that a detailed review of the company and its accounts should be carried out on a regular basis, perhaps as part of the normal pre year-end tax planning procedures, and the company profile is groomed accordingly.

While the trading status of the company could well be subjective where a situation is open to interpretation, the guidance in Tax Bulletin 53 should be followed and a request made to the Revenue for a view on the status of the company.

Unsuitable balance sheets/ surplus trading assets

A company's balance sheet can become tainted by the holding of 'substantial' non-trading assets. These can be represented in a variety of forms including:

• significant cash reserves;
• surplus trading property;
• shareholdings in non trading companies.

This article will not explore in detail whether persuasive technical arguments exist to counter whether the holding of these assets are indeed substantial. Tax Bulletin 53 offers 'let-outs' in the case of surplus trading property (re-iterated by the Revenue's Capital Gains Manual at paragraph 17919) and offers illustrations of when surplus funds may be treated as being a part of the trade of the company.

Small or medium-sized enterprises

If there is no likelihood of the cash being used for the benefit of the company's trade, consideration may be given to removing it from the balance sheet. Various methods of doing this exist, such as the payment of bonuses or dividends to the directors/shareholders or, if appropriate, a personal pension or funded unapproved retirement benefit scheme contribution.

Should the company have an employee benefit trust, certain commentators argue that any contributions made for the future benefit of company employees may offer a 'cleansing' solution to the problem. In the light of recent pronouncements, we would respectfully suggest that care should be exercised bearing in mind the application of Urgent Issues Task Force 13 and 32 and Financial Reporting Standard 5 regarding the inclusion of assets held in an employee benefit trust within the balance sheet of the settlor company.

Equally, if the company held a quoted share portfolio, it may well be possible to remove this from the balance sheet to the shareholders as a 'dividend in specie'.

In the case of shareholders with a foreign 'element', who intend to realise a gain offshore, for instance, those non domiciled, non resident already or those who intend to become genuinely non resident before a sale, it may be sensible to leave the surplus cash within the company and ultimately sell the shareholding for a higher value.

The writers have seen similar strategies being adopted by shareholders planning to become non resident, but only after sale (and hence they would need the benefit of a paper exchange by virtue of section 135, Taxation of Chargeable Gains Act 1992). Care will be needed to ensure that full disclosure is made of the relevant facts when seeking the appropriate clearance applications under section 707, Taxes Act 1988 or section 138, Taxation of Chargeable Gains Act 1992.

An alternative strategy is to undertake a corporate reconstruction, thus creating a new company (Newco) into which the surplus cash can be transferred by dividend. Providing that careful thought is given to the shareholding structure and hence the relationship between Newco and Tradeco, it should be possible to side-step the 'corporate taper test' and create a business asset.

Multiple trades

The business which operates more than one trade can often generate practical problems. Common scenarios with the potential for a taper relief disaster include:

• multiple trades being operated through a singleton company; or
• multiple trades being operated through a corporate group, perhaps with each trade operated by individual group members.

The very attractive rates of business asset taper relief provide a clear incentive for vendor shareholders to structure a company sale as a share sale rather than an asset disposal.

Advisers need to be comfortable with the simple concept that taper relief does not apply to corporates, and hence, where a business 'destination' will ultimately be achieved through a sale (as opposed to, say, a family succession), it is absolutely vital that the business is groomed to achieve maximum taper relief.

Many existing corporate structures have been historically established for a sound commercial rationale, but all such structures should be revisited as part of the business sale grooming process.

Unless a company (or indeed a group) can be sold as a 'job lot', this will generally lead to an extra tier of (unnecessary) tax that could have been avoided with a little foresight, as illustrated in the following CaseStudy.

Case study

ABC Cars Ltd operates two different motor vehicle dealerships through separate limited companies, both 'grouped' underneath a dormant holding company. The tax base cost of each subsidiary is the base cost of its shareholding, which in most cases will be minimal.

In the event of receiving an offer to sell either, not both, of the dealerships, taper relief will not feature since a sale would generally be achieved by either:

• the parent selling the appropriate subsidiary company; or
• the subsidiary selling its trade and assets to the intended purchaser.

Either scenario is likely to generate a significant capital gain within the corporate structure. Various tax planning techniques exist to mitigate this liability, but neither route is likely to offer a tax charge equivalent to that arising on a disposal made by the shareholders personally.

Post disposal, there is likely to be a corporate group with significant cash reserves which in turn could taint the remaining balance sheet, giving the shareholders a holding in a 'non trading' group for taper relief purposes. Additionally, depending on the relative sizes of the 'before' and 'after' trades, the enveloping provisions of paragraph 11 of Schedule A1 to the Taxation of Chargeable Gains Act 1992 could also bite deeming there to be a change of activity (assuming ABC Cars Ltd to be close).

Last November's pre Budget report included future proposals to exempt from corporation tax any gains made on the disposal of 'substantial corporate shareholdings'. This may provide some assistance, but it is unlikely to be of a real taper benefit unless most of any sale proceeds are reinvested back into the trading group and the complete group is subsequently sold by the shareholders.

One possible technique available that may provide a preservation of the shareholder's taper relief would be a demerger of the two companies into two 'mini' trading groups, each of which could be sold separately. The various clearances are unlikely to be forthcoming, however, without there being a sound commercial rationale to the demerger, in addition to no imminent likelihood of a sale.

Retaining assets

Consideration also needs to be given where the shareholders are likely to retain significant assets of the company (usually the trading premises of the company). On the face of it, this could provide an obstacle to them disposing of their shares, and hence an additional tier of tax could be incurred in extracting the asset from the company prior to a subsequent sale thereof.

One solution may be to sell the company (in order to secure the shareholder's taper relief) and buy back the property. However, this will often not be viable due to the increased stamp duty costs and the triggering of otherwise unnecessary capital gains both on the company (by the saleback of the property) and the shareholders (by the increased initial sale price of their shares).

With sufficient foresight and a sound commercial rationale, a corporate reconstruction involving section 110, Insolvency Act 1986 may provide a useful alternative. Care will be needed in side-stepping the likely tax charges, e.g. stamp duty and section 179, Taxation of Chargeable Gains Act 1992.

Quality of ownership

It is not a forgone conclusion that business taper relief will be available, just because someone has shares in a trading company, or a trading group. Since taper relief is a function of past ownership, it is vital that advisers monitor the 'quality' of this ownership and, if appropriate, make the necessary modifications to ensure relief at the business asset rate is continually secured.

Martin Dawson is a tax partner and Sandra MacMillan is a tax manager in the Manchester office of HLB Kidsons, and can be contacted at: mdawson@kimanch.hlbkidsons.co.uk or smacmillan@kimanch.hlbkidsons.co.uk. The views expressed in this article are those of the authors alone.

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