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MALCOLM GUNN FTII, TEP offers a refresher course on securities and corporate bonds. ARE YOU ONE of the country's greatest experts on deep gain securities, qualifying indexed securities, deep discount securities and qualifying convertible securities? If you are, jolly bad luck because all these terms are now as relevant to modern life as Egyptian mummies. They were filed under WPB when the Finance Act 1996 introduced the loan relationships régime with a whole raft of new terms. That régime had some tinkering in 1999 and some more in 2002.
MALCOLM GUNN FTII, TEP offers a refresher course on securities and corporate bonds. ARE YOU ONE of the country's greatest experts on deep gain securities, qualifying indexed securities, deep discount securities and qualifying convertible securities? If you are, jolly bad luck because all these terms are now as relevant to modern life as Egyptian mummies. They were filed under WPB when the Finance Act 1996 introduced the loan relationships régime with a whole raft of new terms. That régime had some tinkering in 1999 and some more in 2002. Being the fool that rushes in where angels would keep well clear, I decided that it was time for me to sort out where we are now with corporate bonds and tax. This project, like most tax themes, proved not to be straightforward and I found that some of the major books and articles written on the subject had some differences of interpretation. Since 1997 the Revenue has adopted an angelic stance and has kept well clear of the topic, not having updated its guidance in the Inspector's Manual for the significant changes since that time, six years ago.
Basic concepts
Before we plunge much further into the murky depths of this topic, the first step is to identify what is a security. Unfortunately, even in this age of self assessment when the taxpayer is supposed to work out his tax for himself, there is simply a gaping black hole in the legislation in the places where there should be a definition of what is a 'security'. This problem goes back before capital gains tax; for example the anti-avoidance legislation on transactions in securities fails to explain exactly what is a security, but simply indicates what the term includes. Two section 703 cases have held that interest free loans by companies repayable on demand were securities, as they were coupled with the deposit of Government stocks to guarantee repayment. Various capital gains tax decisions before the Ramsay case suggested that a prerequisite for a security is a document held by a creditor as evidence or guarantee of his right to repayment. Then of course along came the Ramsay case when the Courts were itching to clamp down on tax avoidance, and in that case, the strenuous efforts to avoid creating a debt on a security by having an offer of a loan orally accepted were held nevertheless to have created the very thing which the parties thought they were not creating. If a debt on a security includes instruments of that type, then a common or garden security must equally include things which are informally drawn up. For the purposes of this article, and in the context of ordinary transactions, I am going to suggest that a security for tax purposes will normally require a deed as evidence that a loan has been made, and often there will be some form of charge or guarantee for repayment. As is now well settled, the hallmark of a debt on a security (a sub-category of securities) is marketability. Since judges tend to come from the closeted background of chambers, they have fastened on the strange idea that something is marketable only if there is a chance of the purchaser making a profit out of it. In the real world, this is not the case and income streams, whether fixed or variable, are equally purchased and sold by financial institutions. However, the law on debts on a security is now well settled, and so it matters not what is going on in the real world. This oddity at one time gave rise to considerable tax avoidance opportunities. If debentures issued by companies were not marketable, according to the ideas of the courts about what represents marketability, then they were not debts on a security but simple debts outside the scope of capital gains tax. So shares could be converted into debentures which were not debts on a security, and gains vanished into thin air. Section 84, Finance Act 1993 therefore introduced legislation to treat debentures issued on most company reorganisations as securities within section 132, Taxation of Chargeable Gains Act 1992; section 251(1) already states that a security within that section is a debt on a security, and so must be a chargeable asset.
Loan stocks
A key point is that any qualifying corporate bond must, in the first place, fall within the definition of security in section 132(3)(b), Taxation of Chargeable Gains Act 1992. Apart from government, public and local authority securities (whether in the United Kingdom or overseas), this section states that security includes any loan stock or similar security of any company, whether secured or unsecured. How helpful is that? 'A security is a security!' What we do know is that in a statement issued by the Revenue in 1970 it was said that the Revenue regards this definition as exhaustive, notwithstanding the use of the word 'includes'. So the first point to notice is that, under the basic definition of corporate bond, any such qualifying bond must be issued by a company, or a public or local authority. Various other types of asset have been added into the qualifying corporate bond exemption over the years. Not all of them are company securities and so in a sense they are gatecrashers into the qualifying corporate bond festivities.
Relevant discounted securities
Schedule 13 to the Finance Act 1996 brought two new creatures into being; these were relevant discounted securities and excluded indexed securities. Both broadly relate to securities which are likely to be redeemed at a premium in due course. The key point is that they do not have to be issued by companies; they simply have to be securities. So they could be issued by you or me, so long as what we are talking about is something within the definition of security. As already mentioned, there is in fact no definition and so the net result is a chunk of legislation with no one really knowing for certain what it applies to. Try telling that to your clients and see what the reaction is! However, perhaps we can assume that the legislation wants some formal paperwork to be in existence for the loan.
Qualifying corporate bonds
As will be seen in a moment, relevant discounted securities are one of the gatecrashers into the qualifying corporate bond régime, and so they are something to look at in more detail after examining the exact parameters of qualifying bonds.
Companies
Not much time need be wasted on discussing what is a qualifying corporate bond in the hands of a company. Section 117(A1), Taxation of Chargeable Gains Act 1992 says that any asset representing a loan relationship of a company is a bond of this type for the purposes of corporation tax. The rest of section 117 is only applicable for other tax purposes and so that is the end of the story for corporate bondholders. Of course, not all instruments which appear to be loan relationships of a company are within the Finance Act 1996 régime. The two main examples which are excluded are convertible debt and asset linked securities. For companies, these remain within the capital gains tax régime so that gains are taxable as capital gains.
Individuals
Private investors holding corporate bonds have to flog through the rest of section 117, Taxation of Chargeable Gains Act 1992 in order to decide whether or not their investment falls within the definition. Any reader of the section, particularly one from the Tax Law Rewrite project, is quickly likely to reach screaming pitch. The section first requires the investor to identify whether or not he or she has a 'corporate bond'. Once the investor has jumped through that hoop, it is possible to identify whether it is qualifying or not. The requirements for a corporate bond are that:
(a) it is a normal commercial loan
(b) it is expressed in sterling, and the sterling amount is not determined by reference to the value of any other currency or asset at any time
(c) there is no provision made for conversion into, or redemption in, a currency other than sterling, save that redemption in a foreign currency is permitted at the rate of exchange prevailing on the redemption date (or under Revenue practice within 10 days before the redemption date).
The test for a normal commercial loan is obviously one of the crucial features of a corporate bond and the requirements here are:
(i) it must be a loan which includes new consideration, this being consideration not provided directly or indirectly out of the assets of the company, but it can include the giving up of rights to shares;
(ii) there must be no conversion rights into shares; only conversion into other qualifying corporate bonds is permitted;
(iii) interest on the debt must not be in excess of a reasonable commercial return;
(iv) the interest must not be dependent on the results of the company or the value of its assets;
(v) there must not be any rights to acquire additional shares or securities;
(vi) the amount payable on redemption must not exceed the 'new consideration' on loan, or else must be reasonably comparable with the terms of issue of quoted securities.
Other types of corporate bond
The original concept of corporate bond was in the Finance Act 1984 and over the years there have been progressive additions to the types of security which fall within the definition. These are, in date order:
(1) 24 July 1991: permanent interest bearing shares of building societies so long as satisfying the sterling tests already mentioned.
(2) From 16 March 1993, debentures issued in exchange for shares or debentures on a company reorganisation or takeover, deemed to be a security by section 251(6), Taxation of Chargeable Gains Act 1992 and satisfying the other tests for corporate bonds (for example having no prohibited non-sterling attributes). However, this exemption does not extend to any third party purchasing the debenture, unless it is a no gain, no loss disposal (to spouse, to group companies or to a legatee, for example).
(3) From 6 April 1996, all securities falling within the definition of 'relevant discounted security'. This is no doubt because all the return on such securities is brought into charge to income tax.
The above three categories of securities are specifically brought within the scope of the term 'corporate bond', but on the other hand excluded indexed securities issued after 5 April 1996 are never corporate bonds. Ones issued before that date as qualifying corporate bonds in exchange for shares and carrying suspended gains within section 116, Taxation of Chargeable Gains Act 1992 do, however, continue to be qualifying corporate bonds.
Those bonds which qualify
Having struggled through all the tangle of provisions which are designed to tell the taxpayer exactly what a corporate bond is, one has still not reached the finishing point with the topic, but at least the home straight is in sight! It then remains to be determined whether the particular corporate bond under consideration is 'qualifying' or not. As regards relevant discounted securities, the position is quite straightforward. Any security which is within the definition of them is a qualifying corporate bond whenever it was issued. Also any corporate bond issued after 13 March 1984 is also automatically qualifying. Bonds issued before 13 March 1984 become qualifying corporate bonds in all cases where they are purchased by an unconnected third party and there is no claim for capital gains tax holdover relief. Bonds issued before that date remain non-qualifying if the only disposals of them are no gain, no loss disposals.
Revenue manuals
The Inland Revenue's Capital Gains Tax Manual gives three helpful examples on the topic of qualifying corporate bonds and these are set out in the three boxes with this article.
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Example: convertible stocks and normal commercial loan |
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In August 1990 a company issues securities that can be converted into the shares of its quoted parent company as long as the quoted parent is not in liquidation. The parent company goes into liquidation in May 1991 and the securities therefore lose their convertibility. The securities are disposed of when they are redeemed in July 1991. All the other conditions in section 117, Taxation of Chargeable Gains Act 1992 are satisfied. At the date of disposal the securities are not convertible into shares. However, there was a time when they were convertible into shares and therefore they cannot be corporate bonds as they have not at all times represented a normal commercial loan within the meaning of section 117(1), Taxation of Chargeable Gains Act 1992. It is not relevant that the securities might have satisfied the different definition of normal commercial loan which was in force when they were issued. |
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Example: acquisition of security issued intra group |
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A Ltd, B Ltd and C Ltd are in the same section 170, Taxation of Chargeable Gains Act 1992 group. A Ltd issues a security to B Ltd which sells it on to Mr Smith. Mr Smith later sells the security to C Ltd which redeems it. The sale by B Ltd and the redemption by C Ltd cannot be of a qualifying corporate bond - because both B Ltd and C Ltd are grouped with A Ltd, the issuing company. The indexation allowance on these disposals is subject to the restrictions of section 183, Taxation of Chargeable Gains Act 1992. But assuming the security satisfies the remaining provisions of section 117, Taxation of Chargeable Gains Act 1992, the disposal by Mr Smith will be exempt. |
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Example: pre 1984 corporate debt acquired by gift |
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Extel includes the debenture in the list of qualifying corporate bonds. |
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The £10,000 worth loan stock acquired in June 1983 will not become a qualifying corporate bond in Miss Wright's hands because although she acquired the securities after 14 March 1984 they were issued before that date and her acquisition was subject to a gifts holdover relief claim. |
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The £7,000 worth debenture stock acquired by Mr Wright in March 1985 would be a qualifying corporate bond in Miss Wright's hands. Although the debenture stock was issued before 14 March 1984, it was acquired by Mr Wright after that date and had, therefore, become a qualifying corporate bond in his hands. The fact that Miss Wright's acquisition was subject to a gifts holdover relief claim is not relevant. |
Discounted and indexed securities
In the interests of not being sued by countless readers for putting their mental health and safety at risk by continuing with this topic in this issue of Taxation, I will leave examination of the terms 'relevant discounted security' and 'excluded indexed security' for next week's issue of Taxation. However, be warned - you have only one week to recover.
