Is The Tax Deed Dead?

No, it is not dead, says NIGEL POPPLEWELL FTII. Buyers of companies should still take a tax covenant as an indemnity against various liabilities.

TWO CRUCIALLY IMPORTANT pieces of legislation came into effect on 1 April 2002. The first relates to the exemption for substantial shareholdings, the second to the taxation of intangibles. Draft clauses for both were published in November 2001 on which comments were invited by 31 January 2002 and further draft clauses were published on 26 March 2002.

As part of the substantial shareholding legislation, it is proposed to introduce a new section 179A, Taxation of Chargeable Gains Act 1992 which will enable companies to make an election pursuant to which gains accruing under section 179 will be deemed to have accrued to a different company from the degrouping company.

Furthermore, as part of the intangibles legislation, an equivalent régime to that in section 179 will be introduced where intangibles are moved from one member of a capital gains tax group to another. This is not necessarily on a tax neutral basis. The group provisions are found in Part I of the draft intangibles legislation, and paragraph references in this article are references to that draft legislation.

A question which arises, following implementation of this legislation as presently drafted, is whether there will be any need for a buyer to take a tax deed/covenant when buying shares, if an election under either provision has been made (degrouping election(s)). The answer is yes, and the purpose of this article is to consider the basics of the degrouping elections, and explain why tax covenants will still be industry standard.

The article is based on the draft legislation as available at the time of going to press.

Why have a tax deed?

A tax deed is a document which is usually executed on the completion of a share purchase, and which indemnifies the buyer or the target company against certain liabilities. The operative part (a tax covenant) is frequently included in the share sale agreement itself (in the main body of the agreement or as a schedule), to circumvent issues raised in Zim Properties Ltd v Proctor [1985] STC 90.

The purpose of the tax covenant is to indemnify the buyer against undisclosed pre-completion tax liabilities for which no provision has been made, secondary liabilities, and tax which arises on the sale itself.

The main tax charge falling within the latter category is under section 179 or paragraph I5 (together referred to here as the degrouping charge). Thus, if it is possible to visit this degrouping charge on another member of the seller's group using a degrouping election, is there any continuing need to have a tax covenant?

The rest of this article is devoted to looking at the degrouping elections. The main focus is on section 179A. There are differences between the basic degrouping charge under section 179 and that under paragraph I5. Similarly, there are differences between the degrouping election under new section 179A and the parallel provision under the intangibles legislation (paragraph I12). While the principles are largely similar, there is devil in the detail. However, there are three instances where there are specific provisions made in the intangibles legislation which have no parallel in the section 179A legislation. These relate to non book value transfers, secondary liabilities, and rollover.

Section 179A

Section 179A provides a possibility of the target company and another member of the seller's group making a joint election, pursuant to which any de-grouping charge is treated as accruing not to the target company but to the elected company within the seller's group. Brief details follow.

The gain

The section applies where company A (which is defined in terms consistent with section 179) suffers a degrouping charge under section 179(3) which results in a chargeable gain or an allowable loss, accruing to that company.

Time of accrual

This is of fundamental importance. Although under section 179(3) the market value is that immediately after acquisition of the asset, the time the gain/loss accrues is set out in section 179(4). This specifies it is the later of:

• the beginning of the accounting period in which the de-grouping takes place; or
• the time when company A is treated as having sold and reacquired the asset.

The company

Although the substantial shareholding exemption only applies to trading companies, the de-grouping election can be made by non trading companies.

Company A and another member of the capital gains tax group, say company C, make the election jointly. Companies A and C must be members of the same group at the time of accrual.

Notwithstanding the provisions of Finance Act 2000, in particular sections 102 and paragraph 1(1) of Schedule 29, company C must either be United Kingdom resident or own assets that are within the charge to United Kingdom corporation tax. Thus, provided that company C is a member of the same capital gains tax group as company A either at the beginning of the accounting period in which the de-grouping takes place, or, if later, the date on which the asset is transferred inter group, it can be party to the election.

One election?

The draft legislation suggests that only a single election can be made. Clause 2(b) talks about making 'a joint election'. Subsequently there is talk about the gain which is 'specified in the election'. However, the legislation then mentions 'two or more elections', and the explanatory notes clearly admit the possibility of more than one election being made.

Note A26 in the explanatory notes states that 'Subsection (2) of [section 179A] also provides that where two or more elections are made (companies C and A, D and A, etc.) in respect of parts of the same gain or loss, the total amount of gain or loss reallocated does not exceed the gain or loss that would have accrued to company A'.

It is possible to make a number of elections between company A and other members of the vendor capital gains tax group specifying different proportions of the gains/losses which can be allocated to the various group companies.

Non qualifying companies

An election is only possible if:

• company C is a group company;
• neither A nor C is a qualifying friendly society; and
• C is not an investment trust, a venture capital trust or a dual resident investing company at the time of accrual.

Effect of election

The effect of the election is that the gain/loss specified in the election is deemed to accrue to company C instead of company A.

Timing

An election must be submitted in writing to an officer of the Board no later than two years after the end of the accounting period of company A in which the time of accrual falls.

This seems to be pretty limited, and I have put this point to the Revenue. Consider a company with a 31 December year end. In the year to 31 December 2002 there is a de-grouping charge. This is deemed to have accrued under section 179(4) at the beginning of that accounting period, i.e. 1 January 2002.

That company will then have 12 months to submit its corporation tax self-assessment return, and the Revenue will have a further 12 months in which to enquire into that return. 31 December 2004, i.e. that deadline date, is also the deadline date for submission of a section 179A election. Company A might have happily self assessed on the basis of values provided by the seller but which, on enquiry (and subsequent agreement with the district valuer), might be incorrect. The result of any revaluation might be to impose a section 179 charge and in such circumstances the parties will be out of time to make an election.

For all practical purposes therefore it is important that a buyer takes a section 179A election signed by the relevant company C at completion of the acquisition.

It is to be hoped that the legislation will be amended to extend the deadline for making the election (and perhaps adopt provisions similar to those in paragraph 74(1) of Schedule 18 to the Finance Act 1998).

Intangibles

Under section 179, an intergroup transfer takes place on a no gain/no loss basis irrespective of any price paid by the transferee. This is not the case for an intergroup transfer of intangibles. The basic provision is that the transfer takes place on a tax neutral basis (the equivalent to no gain/no loss) (paragraph I1).

However, if the transferee gives consideration which is different from the book value of the asset (paragraph I2), then the transferor is treated as having revalued the asset for accounting purposes immediately before the transfer, and has to recognise the resulting gain or loss.

This will have an impact on the level of any degrouping gain/loss arising under paragraph I5, since the deemed sale and acquisition under paragraph I5 is deemed to take place immediately after the transfer.

The degrouping election for intangibles is at paragraph I12. As currently drafted the legislation uses company X (rather than company A), and company Y (rather than company C). There does not appear to be any equivalent to company B. Company Y must be a member of the same group at the relevant time, as opposed to the time when the charge accrues. In the case of a sale of a subsidiary, this will be the time immediately before the target company ceases to be a member of the group.

The effect of the election is that the gain (or part specified in it) is treated as having accrued to company Y at that time as a non-trading credit. Although not specified, any loss will presumably be a non-trading debit.

Buyer comfort

As mentioned above, a buyer will want to ensure that if there is a degrouping charge, this is visited on the seller, through the election, rather than staying with the target company (company A). It is common place for a seller to accept this risk through a tax covenant, and the purchaser, in seeking a degrouping election, is doing no more than seeking additional statutory protection.

The company joining in the election

The seller might be prepared to give the election if it knows that company C is a worthless company. The buyer will therefore need to conduct its own due diligence on the substance of company C (or indeed companies D, E, F and G where the election is to be made with several members of the seller's group) to ensure they are good for the money. I suspect that parent company guarantees will be sought in the same way they are when there is concern over the substance of the entity giving a traditional tax covenant.

The same applies to company Y in the case of an intangibles election.

Secondary liability

Section 179B itself does not provide for any residual liability in company A. This is in contrast to intangibles legislation where a specific provision is made for secondary liability at paragraph I14 (entitled 'Recovery of degrouping charge from other companies').

What happens if company C does not pay it? Could liability be visited back on company A? As readers will be aware, there are a number of statutory provisions which enable the Revenue to assess companies other than the primarily liable company for unpaid corporation tax which include section 190, Taxation of Chargeable Gains Act 1992, and Schedule 28 to the Finance Act 2000.

Section 190 was revamped by Finance Act 2000 and can render a group company liable for company C's failure to pay, if company C was the principal company in the capital gains tax group, or it was the company which owned the asset which gave rise to the degrouping charge.

If, however, company C is neither of these, it is difficult to see how section 190 could bounce liability for unpaid tax under the election, to company A. Schedule 28 can only apply where company C is non-resident, but is competent to make the election because it owns assets are within the charge to corporation tax. Thus if company C is United Kingdom resident, secondary liability under this Schedule cannot be visited on company A.

Thus although there will be purchaser concerns about the position of company C, which should be covered off by a tax covenant, a properly made election under section 179A in favour of a worthless company C might disadvantage the Revenue.

Paragraph I14 is drafted along very similar lines to section 190, Taxation of Chargeable Gains Act 1992, a fact recognised by the Revenue in the explanatory notes. The companies from which the tax can be recovered are defined in broadly similar terms to those set out in section 190. Thus in connection with intangibles, the Revenue has clearly thought about company Y defaulting. Secondary liability could clearly therefore be bounced back onto target co (company X), and a properly drafted tax covenant should be taken to cover this. The procedures and time limits for making a claim under paragraph I14 are in paragraphs I15 and I16.

Rollover

As a part of the legislative charges, the Revenue has also proposed that a degrouping charge can be rolled over. This will be enacted by the introduction of section 179B of, and Schedule 7AB to, the Taxation of Chargeable Gains Act 1992 (and the equivalent for intangibles in paragraph I11).

It is not the purpose of this article to examine the rollover provisions in detail. However, what is clear is that if company A degroups and suffers a degrouping charge, it will be possible, with effect from 1 April 2002, to roll over the degrouping charge by reinvestment into qualifying assets, under section 155, Taxation of Chargeable Gains Act 1992, within three years.

What has not been clear (at least to me) is whether a gain which is deemed to accrue to company C because A and C have made a section 179A election, is capable of being rolled over by company C. My conclusion was that it could not, for the following reasons:

• Firstly, rollover relief is only available (under section 179B) where 'a company is treated by virtue of section 179(3) or (6) as having sold and immediately re-acquired an asset at market value'. The effect of a section 179A election is not to deem company C to have made that disposal and reacquisition. On the contrary, it accepts that company A has made the disposal and reacquisition; it simply treats the gain itself as accruing to company C. Since company C has not made the disposal and reacquisition, it is difficult to see how the rollover provisions bite.
• Secondly, provision is made in the draft intangibles legislation (paragraph I13) which specifically deals with rollover relief in relation to the reallocated degrouping charge, i.e. where an election has been made under paragraph I12. Provided the statutory criteria are met, company Y can make a claim for rollover relief on reinvestment, albeit on the more limited basis for intangibles.

However, the Revenue's press release issued on 26 March 2002 contained a statement that a gain surrendered under section 179A will be capable of rollover under the new provisions. Hence it appears that this point has now been dealt with.

Practicalities

Because of the timing difficulties in connection with section 179A, a buyer should make it a condition of completion that the seller will produce degrouping elections signed by company C/Y and give them to the buyer at completion. The buyer can then procure that they are executed by target co (company A/X) and submit them so that the two-year deadline is met.

It is more difficult where the seller insists that the liability is to be distributed among various companies in its retained group. In that situation it is not possible to put in a protective degrouping election, according to the Revenue. Even if the proportions are known, the actual amounts are not. In those circumstances the bargaining position of the parties is going to be an issue. However, a buyer should insist that, since the seller will be giving a tax covenant and warranties anyway, then it should also be party to the relevant degrouping elections. Buyers should take a robust line on this.

A wait-and-see approach might be dangerous. The Revenue has indicated that the final legislation may allow a longer time to submit an election where the gain is to be allocated among various seller group companies. Even then, the buyer should still take an election signed by those companies, without the proportions completed, at completion, and should reserve the right to fill them in at such time as it sees fit, in the absence of any contrary directions from the seller. It can then submit the elections prior to the relevant deadline.

The seller might also be concerned to ensure that losses arising as a result of a degrouping charge could be transferred back into its group. The interaction between a section 179A election and a section 171A notional transfer brings tears to the eyes.

Death of the tax covenant?

Hence my conclusion from all this is that the tax covenant is not dead. This is mainly because:

• Corporate finance lawyers feel comfortable with the tax covenant and it will take more than a change in tax law to persuade them to give up several pages of drafting.
• Less flippantly, a tax covenant goes far further than simply protecting against degrouping changes. It also protects a buyer from secondary liabilities, statutory and contractual, and any pre completion tax, subject to certain exclusions.
• Mechanical provisions relating to conduct of claims, overprovisions, corresponding benefits, surrender of losses, and now degrouping election issues, have to go somewhere, and are part and parcel of the usual tax covenant provisions.
• It is a forum for the seller indemnities against sections 703 to 707 and 767A to 767C, Taxes Act 1988 liabilities, and VAT group secondary liabilities.
• The tax covenant is a convenient provision to cover off secondary liabilities from previous transactions, for example degrouping elections under which target co is company C. This is usually the reason that tax covenants are drafted so they cover tax and also amounts relating to tax, thus covering off secondary liabilities under, say, tax covenants given on previous deals. If you are buying company C, you will want an indemnity from someone that if company C is called upon to pay that deemed gain, that liability will be reimbursed to you.
• Finally, secondary liabilities under degrouping elections can still remain with target co (company A) under, for example, section 190, Taxation of Chargeable Gains Act 1992 or the intangibles equivalent. An indemnity against these secondary liabilities should be in a tax covenant.

The future

The opportunities and problems relating to the degrouping elections will only become apparent over the next year or so, once the final legislation has been published, and practitioners become familiar with it. However, it should be a matter of best practice for those advising buyers of company shares that, to bolster contractual protection under a tax covenant, degrouping elections signed by the sellers and retained group companies should be taken at completion.

Nigel Popplewell is a partner at Burges Salmon, and can be contacted on 0117 902 2782.

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