What A Big Relief

What A Big Relief

PHILIP VICKERY, solicitor, delves into the new substantial shareholdings legislation.

THE GOVERNMENT FIRST announced its intention to introduce a new corporation tax relief for disposals of substantial shareholdings some considerable time ago. As proposed in a Technical Note of 23 June 2000, the new relief would take the form of a deferral of tax on chargeable gains reinvested in qualifying assets.

This approach was followed in the draft legislation published in November 2000. However, by the time of the consultation document of July 2001 (see 'Large Business Taxation: The Government's strategy and corporate tax reforms' at www.inlandrevenue.gov.uk/consult/index.htm), the Inland Revenue was putting forward an alternative proposal based on an exemption system. In line with the general reaction to that document, this approach was followed in the draft legislation published in November 2001.

However, it was only following the publication of this year's Finance Bill that we had confirmation of the full details of the proposed new legislation, which has progressed through Parliament without substantial amendment (see the reports of the Standing Committee in Taxation 13 June 2002, page 301), other than in relation to the anti-avoidance provisions.

There has already been considerable comment on the terms of the proposed legislation over the course of the consultation progress and the main features of the new relief were outlined in 'A New Landscape' by Paul Eagland and Zigurds Kronbergs (Taxation, 14 March 2002, page 574). Rather than carrying out a comprehensive review of the draft provisions, the purpose of this article, therefore, is to examine in more detail the practical effects of some of those provisions. It will focus on certain particular features of the drafting in the light of the stated aims of the new legislation (being principally 'to enable United Kingdom-based companies and groups to restructure flexibly and rapidly … without facing the prospect of a large tax charge'). I will also highlight some of the remaining uncertainties in the legislation, some of which, it is hoped, should be clarified by Inland Revenue guidance in the form of a promised statement of practice.

(N.B. Paragraph references in this article are to Schedule 7AC to the Taxation of Chargeable Gains Act 1992, introduced by Schedule 8 to the Finance Act 2002, unless otherwise specified.)

In examining the effect of the draft provisions in the light of the Government's stated aims, it is instructive to review the progress of the draft legislation to date. In addition to the adoption of an exemption, rather than a deferral system, some of the principal changes in the course of consultation include the following.

The 10 per cent threshold

Originally, it was proposed to set the qualifying threshold at 30 per cent, although the Revenue, in its Technical Note of November 2001, had suggested that it would 'see whether it is possible to formulate a practical test, which will better identify structural holdings to which the relief should apply'. However, the Revenue came to the view that it was not possible to formulate such a test, which would be sufficiently 'accurate and robust', whilst not being subject to manipulation by the taxpayer according to whether a holding is showing a gain or a loss. Accordingly, the legislation retains a simple numerical approach, albeit at the reduced level of 10 per cent, save in relation to disposals by insurance companies of assets comprised in long term insurance funds, where the 30 per cent threshold is retained. The reduction in the qualifying threshold can only be welcomed; however, the numerical approach is an imprecise means of achieving the Government's avowed aim of distinguishing between structural and portfolio holdings. It may be noted that the threshold for the superficially comparable European participation exemption régimes may be as little as 5 per cent. In fact, in Germany there is currently no threshold at all for a corporate shareholder, so that any holding, however small, will qualify for exemption from tax on any gain arising on a disposal.

'Trading activities'

While the latest draft legislation continues to restrict the new relief to trading companies and groups, the definition of trading activities has been extended to a certain extent to include preparatory activities. However, the precise scope of the definition remains unclear in several respects (see below).

Anti-avoidance

The anti-avoidance measures previously took the form of a widely drawn provision to the effect that certain 'financial and investment activities' would only be treated as qualifying activities if they constituted trading activities of a finance company. There was widespread concern at the apparent width of this provision, which would have denied the benefit of the proposed exemption in many cases. It is to be welcomed, therefore, that the provision was rewritten prior to publication in the Finance Bill. However, the scope of the rewritten provision remained unclear and was the subject of further adverse comment. The provision has accordingly been revised yet again and, in what would appear to be its final form, the anti-avoidance provision (paragraph 5) will now apply where there are in place arrangements giving rise to a gain on a disposal of shares or an interest in shares, where the 'sole or main benefit' which could be expected to arise from those arrangements is that the gain on that disposal is not chargeable (and where the gain, or all of it but a part that is not 'substantial', is 'untaxed profits'). This will be the case to the extent that the gain represents profits which have not been brought into account for tax purposes in the United Kingdom 'or elsewhere' (or imputed to a United Kingdom resident company under the United Kingdom's controlled foreign company provisions) for a period ending on or before the date of the relevant disposal in respect of which substantial shareholdings relief is sought.

Notwithstanding the various revisions of this provision, certain questions remain unanswered. For example, what is the meaning of 'substantial' for the purpose of determining whether a gain, 'or all of it but a part that is not substantial' is untaxed? This has not been made clear, although it has been suggested that a 20 per cent test will apply.

One must also ask in what circumstances will a gain be treated as 'representing' untaxed profits? It is also not clear whether the provision could potentially be applied in some situations; for example, where profits are ultimately derived from a foreign company held through a chain of companies, the profits of some, but not all of which, bear tax.

As is borne out by reports of the Standing Committee proceedings, the Revenue is maintaining the approach that has been adopted in relation to certain other reliefs; this is to the effect that anti-avoidance provisions should be widely drafted, but extra-statutory reassurances will be given that the provisions will not be unreasonably applied by the Revenue. In accordance with this approach, it is understood that the scope of the anti-avoidance provision should be further clarified by the expected statement of practice.

Grey areas

Notwithstanding the refinements to the draft legislation that have arisen out of the consultation process, various uncertainties remain in relation to the effect of the new provisions in certain areas. In particular are the following.

The 'substantial' test

A 'trading company' is defined negatively, by reference to the requirement that such a company must not be involved to a 'substantial extent' in activities other than trading activities (paragraph 20). Although the Revenue has confirmed that the draft legislation is intended to put on a statutory footing the guidance in relation to taper relief, contained at Tax Bulletin 53, it would be helpful to have specific confirmation that the '20% test' of substantiality referred to in the Tax Bulletin is also to be adopted for current purposes, if this is indeed the Government's intention.

It appears, from the reports of proceedings in Standing Committee, that the '20 per cent test' is also intended to apply in the context of the anti-avoidance provision at paragraph 5.

The purpose of this provision is in determining whether a gain, 'or all of it but a part that is not substantial', represents untaxed profits. It is understood that this is to be confirmed in the awaited Revenue guidance and one can only hope that this will also confirm the position in relation to the above 'substantiality' test for the purposes of the trading company definition. However, one would have hoped that, given the extent of the consultation process, it would have been possible to avoid both the unnecessary confusion caused by incorporating references to different tests of substantiality within the same set of provisions, and the residual uncertainty that remains whenever one is obliged to rely on extra-statutory Revenue guidance in order to interpret legislation.

Continuing to trade

There is still considerable uncertainty in relation to the requirement that an investing company must be a trading company or a member of a qualifying group both before and 'immediately after' the relevant disposal. (A similar requirement also applies to the company invested in.) This is perhaps one of the more significant remaining grey areas and an obvious issue arises in relation to liquidations as, without specific provision, a disposal in the course of a liquidation may not qualify for relief.

There are now specific provisions to the effect that where the required trading status is not present in relation to either the investing company or the company invested in, as a result of the winding-up of the relevant company, this will generally be disregarded (paragraph 3). The position in relation to an investing company in liquidation is also strengthened by the provision (at paragraph 16) to the effect that the acts of a liquidator will effectively be treated as acts of the relevant company in liquidation and assets vested in a liquidator will be treated as if vested in the company. Any transfer of assets from an investing company in liquidation to a liquidator will therefore be disregarded.

Re-investment problems

The position on a liquidation has therefore been clarified in the taxpayer's favour. However, the revised draft provisions do little to clarify the position where an investing company or group makes a disposal but, rather than being dissolved, the investing entity is temporarily involved in non-trading activities to a 'substantial extent'; for example, as a result of holding the sales proceeds, with no immediate plans for re-investment.

It seems inequitable that the favourable treatment which may be obtained on a liquidation could be forfeited where the investing structure remains in place, but there is a period of uncertainty with regard to re-investment strategy.

As has been pointed out in Standing Committee, this aspect of the new relief seems more akin to the 'deferral' approach which was originally taken and seems inconsistent with the intention that the new relief should operate as an exemption. Clearly there is considerable scope for uncertainty in this area.

It would appear, from the Revenue's responses to replies received from interested parties during the consultation process, that where there is a demonstrable intention on the part of the investing company to reinvest sale proceeds for the purposes of trading activities, the temporary holding of those proceeds prior to reinvestment may be disregarded. However, it is stated that this will be a question of 'fact and degree' in every case. This approach is consistent with the 'trading company' definition at paragraph 20. This is to the effect that 'trading activities' will be deemed to include activities carried on with a view to acquiring or starting to carry on a trade or with a view to acquiring a significant interest in, broadly, another trading company. However, this is expressly subject to the caveat that the relevant company must make an acquisition, or start to carry on a trade 'as soon as is reasonably practicable in the circumstances'. No clarification of this phrase is provided in the Revenue's explanatory notes on the draft provisions, or elsewhere. It is also questionable whether the legislative provision fully supports the Revenue's expressed intention, given the deliberate choice of an 'activity' (rather than 'purpose') based definition of a trading company for these purposes. There must be some concern that the mere holding of sale proceeds prior to an intended reinvestment does not constitute an 'activity carried on …', so as to fall within the extended definition of trading activities. Yet again, this is an area which would benefit from further clarification in the expected Revenue guidance, but it is regrettable that the issue could not be dealt with more definitively in the underlying legislation.

The international aspect

The new legislation is undoubtedly of great significance, both with regard to the United Kingdom's position as a location for an international holding company and in relation to domestic restructurings. In relation to the international position, it is widely perceived as increasing the attractiveness of this country as a holding company jurisdiction and the absence of a general exemption from United Kingdom tax on foreign dividends in this context will not be of great significance in many cases, given the low rates of corporation tax now applicable here and the availability of double tax relief for withholding tax and underlying tax. However, as already noted, the Government is, on the face of it at least, focusing on the position of existing United Kingdom-based groups and the expressed intention behind the new provisions is to give greater flexibility in the restructuring of such groups.

Domestic issues

In relation to domestic restructurings, it will be important in practice to ascertain the way in which the new substantial shareholdings relief interacts with various other existing corporation tax reliefs.

This is not always immediately apparent and the draft legislation repays close study in this area. Inevitably, it will take some time for all of the practical implications to surface. However, some of the main points to note at this early stage are as follows.

Prior reconstructions

Where the shares in the company invested in have been the subject of a reconstruction or demerger prior to the disposal which potentially qualifies for substantial shareholdings relief, it would seem inequitable if, in determining whether the 'substantial shareholding requirement' (paragraph 7) is satisfied by the investing company, ownership of shares in the relevant pre-reconstruction or demerger entities were to be disregarded. It is welcome therefore that it is specifically provided (paragraphs 14 and 15) that, in such circumstances, the original shares and the new holding will, very largely, be treated as the same asset for these purposes, with a view to achieving transparency. However, it is worth noting that the Law Society's proposed amendment to the effect that the new holding should inherit the ownership history of the original holding in such circumstances was withdrawn at the committee stage, so that the usual twelve months ownership requirement will apply to the new holding. In other words, although the old and new shares will for some purposes effectively be treated as the 'same asset', where a share exchange in principle gives rise to a chargeable gain, i.e., broadly, where this is not an intra-group transaction, and that gain qualifies for exemption under the substantial shareholdings provisions, a new holding period commences on that share exchange and the investing company must hold the new shares for at least twelve months before it will qualify for relief on a disposal of those shares.

The Inland Revenue published technical guidance on 28 June 2002 on certain aspects of the interaction of the substantial shareholdings provisions and the provisions relating to share reorganisations which repays close study.

The provisions at paragraphs 14 and 15, promoting 'transparency', are also applied (see paragraph 25) when determining whether the company invested in satisfies the requirement that it is a qualifying company (i.e. a trading company or the holding company of a trading group or subgroup) throughout the prescribed period (i.e., broadly, the twelve months period for which the 'substantial shareholding' requirement is satisfied). Accordingly, relief may be obtained if this requirement may be met by reference both to the post reconstruction/demerger entity and, in relation to previous periods, by the original company.

Intra-group transfers

Similarly, where shares (or 'assets related to shares') are transferred intra-group by way of a no gain/no loss transfer with the benefit of section 171, Taxation of Chargeable Gains Act 1992, if this has the effect that the company making a subsequent disposal does not satisfy the requirement that it must have been a sole trading company or a member of a qualifying group throughout the 'qualifying period', then the intra-group transfer will effectively be disregarded (paragraph 18(4)) in determining whether that requirement has been met. Accordingly, if the requirements relating to the 'investing company' would have been met, in the absence of the section 171 transfer, this should be sufficient.

De-grouping charges

Conversely, where a charge would arise under section 179, Taxation of Chargeable Gains Act 1992 under normal principles on a de-grouping, but if the underlying asset, comprising shares or an interest in shares, had been disposed of by the owning company immediately before the de-grouping, substantial shareholdings relief would have been available, then - in broad terms - it is provided that the substantial shareholdings provisions will take priority.

The mechanism by which this is achieved is that the timing of the deemed disposal and reacquisition of the underlying asset, under section 179, is varied so that this occurs immediately prior to the relevant degrouping, see paragraph 38.

Conclusion

In summary, the new relief for disposals of substantial shareholdings is definitely to be welcomed. However, in several areas (despite, or perhaps as a result of, the consultation process) the drafting of the legislation could be described as tortuous. There are, perhaps inevitably, several aspects of the relief which are not dealt with definitively in the legislation and which will therefore benefit from further Revenue guidance. Nevertheless, it seems that, in relation to many proposed United Kingdom restructurings, it will not be immediately apparent whether the new relief will apply. It will then be vital, when considering the potential application of the new relief in relation to a restructuring of a United Kingdom group, to consider the history of the group structure closely.

Philip Vickery is with Stephenson Harwood and can be contacted on 020 7329 4422.

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