The Revenue's Licence to Bill

IAN CONTING, a corporate tax manager in industry, looks at section 707, Taxes Act 1988.

INVESTORS IN MARKS and Spencer plc who recently received a circular detailing the company's proposed return of £2 billion to shareholders might have been intrigued by the following paragraph towards the end of the (relatively user-friendly) taxation section:

At the same time taxation practitioners will be pondering the implications of the recent High Court decision in Commissioners of Inland Revenue v Trustees of the Sema Group Pension Scheme [2002] SWTI 170 where the Revenue successfully sought to apply section 703 to deny the repayment of tax credit to a pension fund on the deemed distribution element of a share buyback (sic) by Powergen.

So what is this section all about?

What section 703 says

Section 703 is in the section of the Taxes Act headed 'tax avoidance'. What it says is:

• where there is a 'transaction in securities',
• and one or more of five specific circumstances are present, and
• a tax advantage is obtained, and obtaining that tax advantage is the main object or one of the main objects of the transaction,
• then the Revenue can nullify that tax advantage.

The five circumstances are listed in section 704. Circumstances D and E are specific to close companies and circumstance B relates to obtaining a trading deduction for a fall in value of securities following a transaction in them. For the purposes of this article they are not considered further. Those that may be relevant to publicly quoted companies are as follows:

A: the taxpayer receives an abnormal amount by way of dividend which is taken into account for various tax purposes, e.g. exemption from tax, use against advance corporation tax. Thus if as part of a corporate reorganisation a dividend is paid to shareholders, one tax advantage would be the ability of certain shareholders (charities, personal equity plan or individual savings account holders, theoretically non-resident shareholders) to reclaim in cash some or all of the tax credit that will attach to the dividend. This was the issue in Sema under the then law allowing pension funds to reclaim tax credits on dividends.

C: an abnormal dividend is paid (not necessarily to the person involved in the transaction in securities), and in consequence thereof the taxpayer receives a sum in such a way that it is not taxed as income. This would catch, for example, a dividend paid from a subsidiary to a holding company which is then used to buy in shares, thus turning something that would otherwise be taxed as income into a capital gain.

An historic perspective

The legislation dates back to the 1960s, and was meant to catch attempts to turn income into capital and vice versa. For example, a shareholder could dividend strip a company and, under the old rules, reclaim withholding tax on the dividends. Alternatively, before the introduction of capital gains tax in 1965, a shareholder could manipulate his holding so as to turn otherwise taxable income into tax-free capital gains. This was still attractive in the 1970s and 1980s when capital gains tax was levied at a flat 30 per cent, whereas investment income could be taxed at rates up to 98 per cent.

The taxpayer can apply to the Revenue under section 707 for clearance for a particular transaction that section 703 should not apply, and that the Revenue will not seek to take action under it.

Section 703 is policed by the Special Investigations Section of the Business Tax Division within Revenue Policy Division. Its members view themselves very much as an investigation and anti-avoidance section rather than a clearance section like the capital gains tax team in Solihull. Special Investigations Section receives in excess of 5,000 applications a year of which 75 per cent are cleared automatically. It adopts a risk-based approach, assesses applications on merit, and is particularly interested in dividend-stripping structures. It is suspicious of loan note components in a transaction. Clearance may be refused either because of individual elements within the transaction or the transaction as a whole. Any refusal for clearance will be followed by counter-action, although it will always assess the benefits of taking such action.

There has been a recent change in personnel in Special Investigations Section, and there is very much a feeling of a new broom sweeping through the section 703 unit. Practitioners report an increasingly hard line being taken as regards clearances under section 707 for some of the more high profile corporate reorganisations, contrasting with a more user-friendly response from the capital gains tax clearance section. Interestingly, Recommendation 12 of the Hartnett Review suggests trialling a 'one-stop shop' approach to clearance applications, i.e. bringing together the capital gains tax, section 707, demergers and purchase of own shares sections in one actual (or virtual) office.

The Revenue's position

From discussions with the personnel involved, the Revenue's position seems easier to understand if one imagines a world without capital gains tax. Accordingly, for the purposes of section 703, any amount received that is not itself subject to income tax is received in a tax-free form. The general scheme of taxation is that a shareholder's return in his investment should be an income receipt unless he realises his shares by sale or in a liquidation. Capital treatment only follows where the payment out of the company represents a return of capital invested.

It is not difficult to see where a tax practitioner may take issue with this proposition. Case law has clearly established that, in assessing the capital or income nature of a receipt, one should apply the analogy of a tree (capital) and its fruit (income). If the payment clearly represents solely the fruit of the tree, it should properly be characterised as income whereas, if the payment represents part of the tree, it should properly be characterised as capital. A distinction must be made in the case of a corporate reconstruction between Newco as a different tree from Oldco, as opposed to being the same tree with less fruit; compare the partial liquidation which occurred in Rae v Lazard Investment Co Ltd 41 TC 1.

Like all provisions with a motive test, it may be difficult to prove to the Revenue's satisfaction that the obtaining of a tax advantage was not a main object. Indeed, it is understood that the Revenue takes the view that the motives of the shareholders receiving, or potentially receiving, the tax advantage are not determinative, and where the promoter of the transaction, usually the company itself, intends that tax advantages are obtained, then the escape clause is not satisfied.

It is interesting to consider how, in practice, the Inland Revenue would police the section in the era of self assessment. A shareholder receiving what he believes to be a capital return will enter it as such on his tax return, if he gets one, and if his net gains exceeds the annual exemption, but there is no requirement at this stage to detail the investments giving rise to the gains. The Revenue has in the past written to the relevant companies requesting details of all payments made to shareholders as a result of the transaction and it would then have to take a view as to whether it was worth pursuing individual shareholders further. As will be seen later, an unofficial de minimis policy is used. It would then have to dispute the taxpayer's chosen treatment, e.g. recharacterise capital as income, or deny use of tax credit on a dividend, and be prepared to argue the matter before the Commissioners.

Recent corporate reorganisations

Recent transactions include the following:

• Reuters (£1.5 billion) - February 1998. For every 15 shares in Reuters Holdings investors received 13 shares in a new holding company Reuters Group and £13.60 in cash. The return was not linked to any specific transaction. A similar structure was used by Vickers (£282 million) to return the proceeds realised from the sale of Rolls Royce.
• Dalgety (£675 million) - May 1998. For each share in Dalgety investors received one share in a new holding company (PIC International Group), a loan note redeemable for up to 138p, and 94.5p in cash. The return was linked to the proceeds realised from the sale of Spillers Petfoods. A similar structure was used by Elementis (£400 million) where loan notes were an alternative to some or all of the cash element.
• United Business Media (£1.25 billion) - April 2001. For every 44 shares in United Business Media, investors received 29 new shares and 44 B shares in United Business Media. Shareholders elected on their B shares to redeem them or receive a special dividend (of the same amount - 245 pence a share) - or elect or default to receiving a sub-LIBOR dividend on the B shares with redemption rights every six months. The return was linked to the proceeds realised from the sale of United Business Media's television interests. A similar structure was used by British Energy (£432 million).

All of the above companies (except United Business Media and British Energy) and Marks and Spencer plc interposed a new holding company into their existing corporate structure. This would appear to be on the basis of a desire to preserve distributable reserves in the old top company, either a dividend or share buy in its retained earnings - a new holding company with a court approved reduction of capital of the new redeemable shares allows distributable profits to be created.

For tax purposes, any cash element of the package is treated as a part disposal of the original shareholding. Where shares are exchanged for a bundle of securities (new ordinary shares, loan notes and A and B shares) the capital gains tax base cost in the existing shareholding transfers across to the new securities pro rata to their respective market values on the first day of trading (section 130, Taxation of Chargeable Gains Act 1992). The inclusion of the loan note and A and B shares, both with redemption rights, would clearly help individuals manage their capital gains tax position in terms of phasing disposals in different tax years.

Shareholder tax treatment

In the United Business Media and British Energy transactions, shareholders had a choice of income or capital treatment. Intuitively an individual holding shares in a personal equity plan or individual savings account would elect for income treatment, because of the ability to reclaim the tax credit on the dividend, and United Kingdom corporates would follow suit so as to receive tax-free franked investment income rather than taxable capital gain (and companies within the shadow advance corporation tax régime would welcome additional franked investment income).

Higher rate taxpaying individuals would prefer capital treatment because of the ability to offset gains against losses on other investments and phase redemptions so as to maximise use of the annual exemption. However, starter, lower and basic rate taxpayers will be indifferent. In addition, for many major investors such as tax exempts and investment funds, the capital versus income issue, at least since 2 July 1997, has been largely irrelevant. Paradoxically, it is this group of shareholders that will be the main shareholders in the type of company liable to undertake the 'big ticket' type of transaction likely to attract most Revenue scrutiny.

Clearance experience

Reuters, United Business Media and Elementis received clearance (despite Elementis containing a loan note element). Dalgety and Vickers were refused clearance, but were able to obtain Revenue confirmation that action would probably not be taken in respect of shareholdings below 10,000 shares, and when Dalgety was ultimately approached to give details, a de minimis limit of 20,000 was used. British Energy did not apply for clearance, and neither did Marks and Spencer.

The United Business Media clearance was the most surprising in that shareholders could choose on their B shares whether to receive a dividend or a capital redemption. The writer understands that if a company submitted a similar structure to the Revenue today, it would be refused clearance.

One could defend a United Business Media-type structure against a Revenue attack on two bases. Firstly, although there is undoubtedly the possibility of an abnormal dividend (circumstance A), since it is the Revenue's belief that income treatment is appropriate it should not object to the fact that certain groups of investors are gaining a tax advantage, principally the personal equity plan and individual savings account population where the tax breaks have been specifically sanctioned by successive Governments.

Secondly, circumstance C (turning income into capital) requires that this occurs 'in consequence' of an 'abnormal dividend'. Since the United Business Media abnormal dividend is occurring in parallel with the capital option rather than leading to it, it would be straining the section too far to argue that it is in point. Circumstance C may be triggered in a new group holding company structure where the return to shareholders was being financed by a large upstream dividend from the old top company. Presumably this is why the new Marks and Spencer holding company is being financed by a loan from 'old' Marks and Spencer.

It is understood that current Revenue thinking is very much against the provision of choice on the basis that this will be solely motivated by tax considerations. This, however, is not always the case: a fund manager may prefer capital treatment to enhance investment return for bonus purposes. Furthermore, even a plain vanilla special dividend can be turned into capital by selling the shares cum div, so why should the shareholder be penalised for the company's using an explicit mechanism to obtain the same economic result?

The future

It will be interesting to see how the one-stop shop initiative works, particularly considering the clash of culture between the enabling capital gains tax clearance section and the investigating section 707 section. An Inspector may have to 'think capital gains tax' for the purposes of section 138, Taxation of Chargeable Gains Act 1992 and then presume its non-existence for the purposes of section 707.

It may be argued that some of the Revenue's current thinking on section 703 is at least questionable, but until it takes action under the section which the taxpayer (not the originating company) successfully challenges, it is likely that the volume of refusals for clearance, or at least the structuring of corporate reorganisations to circumvent the section, will increase.

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