'B' Share Schemes

'B' Share Schemes

Shadows, Surpluses and Shares

RICHARD CURTIS considers the implications of 'B' share schemes.

WHATEVER HAPPENED TO the 'paperless office? I seem to recall that this was Bill Gates' aim quite a few years ago; but I also remember reading that, within several years of the ready availability of personal computers and printers, consumption of paper had increased fourfold. I am sure that it's only my imagination, but most of that increase seems to come through the letterbox in my front door at some point in its existence. The dog barks at it and I shout at it, but despite our best efforts a never-ending stream pours on in. Lately, in addition to paper, I am somehow on the receiving end of gifts from Guinness. Not, I hasten to add, free cans of the black stuff, but more interesting items such as a little li-lo that holds four cans while you float alongside in the swimming pool, a magic set, a 'thirstmometer' and my favourite so far — much to the annoyance of my wife, but strangely appreciated by the dog — a harmonica. When 'stuff' like this is coming through your front door it's hardly surprising that the more mundane items, shareholder 'bumpf' from Rolls Royce plc for example, is headed straight for the waste-paper basket. In fact, it was only as I was pouring the basket contents into a black bin liner that the words 'This document is important and requires your immediate attention' caught my eye. A cursory glance at the rest of the contents of the envelope that had contained it yielded no further 'goodies' — I think I was half-expecting a 'cut-out and keep' jet engine or some such — but by then I thought I had better look at it in more detail. I am glad I did, but before I explain why, let's go back in time a little...

Advance corporation tax

No, your trip back in time has not accidentally taken you into another article, all will become clear. Advance corporation tax (ACT) was basically a way that the Government could receive corporation tax during the company's accounting year, rather than having to wait until the normal payment date, which was nine months later. It was paid by reference to the amount of dividends that a company paid and received during the year and this is perhaps easily explained by Example 1.

Now despite the fact that dividends can only be paid out of profits, it could happen — perhaps there was double taxation relief — that the ACT paid by a company during a year exceeded either the corporation tax liability or the allowable limit. In those circumstances, this 'surplus ACT' could be carried back for up to six years, where it would create a repayment of previously paid corporation tax.

Example 1

Advance corporation tax

E Limited, a company with no associated companies, had Sch D, Case I profits for the year ended 31 March 1999 of £1,500,000. During the year, E Limited paid a final dividend of £800,000 in respect of the year ended 31 March 1998, and an interim dividend of £520,000 in respect of the year ending 31 March 1999. ACT on dividends amounted to £200,000 and £130,000 respectively. The dividends were paid on 30 June 1998 and 31 January 1999.

The corporation tax liability was as follows.

£ £

Chargeable profits £1,500,000

Corporation tax at 31% 465,000

Deduct: lesser of

ACT paid 330,000

Maximum set-off

(20% × £1,500,000) 300,000 300,000

Surplus ACT £30,000

'Mainstream' corporation tax liability £165,000

The surplus ACT of £30,000 could be carried back to accounting periods beginning in the six years preceding the accounting period in which the surplus arose or (together with any surplus ACT from previous years) be carried forward and used as shown in Example 2 on the following page.

If there were no profits for it to be set against historically, the surplus was carried forward and used, as and when possible, in a later year.

Then, in Finance Act 1998, as part of a reform to the corporation tax system, the Government decided to abolish ACT from 6 April 1999. (Don't worry, the Government then made companies make payments on account during the year to maintain the 'flow' of tax into the Treasury coffers.) But what if your company still had surplus ACT waiting to be used? To cope with this, a transitional relief, enabling the surplus to be used in future years, was introduced. It was also possible to elect to waive entitlement to relief (Corporation Tax (Treatment of Unrelieved Surplus Advance Corporation Tax), Regulation 4(3 and 4), SI 1999 No 358), which might be beneficial for those businesses that could foresee that the surplus would not be used and who wanted to avoid the record-keeping requirements attached to its use.

Now, the Revenue estimated that there was in the region of £7 billion of surplus ACT as at April 1999 and if companies had been able to use this all in one go against their following profits, this would have had an immediate and detrimental effect on corporation tax receipts. To prevent this, the concept of 'shadow' advance corporation tax was introduced by Regulation 11 of SI 1999 No 358. Basically, these regulations provided that:

Other rules dealt with particular detailed aspects of this transitional relief. Example 2 alongside illustrates the operation of shadow and surplus ACT. It can now be seen that if a company was continuing to distribute its profits as dividends, this would delay the relief of the surplus tax brought forward. A possible answer was therefore to stop paying dividends, increase the ACT set-off and reduce the corporation tax liability. Whilst this might go down well in the boardroom, it would probably not be so well received by the shareholders. Scroll forward a few years and this leads us naturally back to ...

Example 2

Surplus and shadow advance corporation tax

H Limited is a trading company with no associated companies. The company had chargeable profits for the year ended 31 December 2003 of £1,600,000. During that year it paid a dividend of £500,000. At 1 January 2003, H limited had surplus ACT of £300,000.

Calculation of relief for surplus ACT in the year ended 31 December 2003.

£

Maximum ACT limit (£1,600,000 x 20%) 320,000

Less: Shadow ACT (£500,000 x 20/80) 125,000

Surplus ACT set-off £195,000

Corporation tax for the year ended 31 December 2003 is payable as follows.

Mainstream corporation tax (£1,600,000 x 30%) 480,000

Less: Surplus ACT (as above) 195,000

Corporation tax payable £295,000

Surplus ACT memorandum.

Surplus ACT brought forward to the year

ended 31 December 2003 300,000

Less: Used year ended 31 December 2003 195,000

Surplus ACT carried forward at

31 December 2003 £105,000

(b) Surplus shadow ACT is to be carried back and treated as shadow ACT in respect of distributions made in accounting periods beginning in the previous six years (but not before 6 April 1999) with unused balances carried forward. It cannot be carried back so as to displace actual surplus ACT relieved in an earlier period except for the year before the year in which the surplus shadow ACT arose.

The proposed issue of B shares

'Proposed issue of B shares' is what the Rolls Royce document said on the front cover. Just what I need I thought, more pieces of paper; and on closer inspection, it seems that those pieces of paper will yield yet more pieces of paper! Rolls' plan is that, instead of sending you a dividend in cash or more ordinary shares every six months, it will send you 'B' shares; 50 for every one ordinary to be precise, with regards to the first issue. These Rolls Royce B shares will have a nominal value of 0.1 pence each and shareholders will then have the following options.

To its credit, Rolls Royce is trying to keep future paperwork to a minimum. The company is assuming that shareholders — unless they advise it to the contrary — will not want to make and notify it of this decision every six months, so the forms for options 1 and 2 above are 'evergreen' elections, which will remain in force until the company is notified otherwise.

This now all starts to make sense. Previously, shareholders had the option of receiving a cash dividend, which would have created shadow ACT, or of taking a stock dividend, i.e. a number of shares which the cash dividend would have purchased, and which would not have caused a shadow liability (because of TA 1988, s 230). Whilst the latter was more beneficial for the company's tax position, not all shareholders would want stock instead of cash, so by issuing the 'B' shares, the company obtains the tax advantage (no shadow liability), but the shareholder retains the option of converting the B shares into cash. What has happened is that what was previously an income transaction, i.e. the dividend, has been converted into a capital transaction.

What exactly is happening?

To avoid the shadow ACT liability on distributions, what the company has to do (and perhaps I should make it clear that Rolls Royce plc is not alone in using these arrangements, or a version thereof) is to distribute value to shareholders in the form of capital rather than income. Examples of other companies that have used a variation of these arrangements in recent years are Anglian Water, Elementis and GKN.

As explained in the Tolley's Tax Digest, June 2004, which was entitled 'Tax on Company Reorganisations', there are various ways of structuring such arrangements using 'B' share schemes.

Rolls Royce plc seems to have used a version of the third option, creating a new holding company, Rolls Royce Group plc, on 23 June 2003 by way of a 'scheme of arrangement' under section 425, Companies Act 1985 (CA 1985), which issued shares (70p, reduced two days later to 20p) in a one-for-one exchange with the existing Rolls Royce plc shareholders. This created a merger reserve to the extent that the value of the shares exceeded the nominal value.

The issue of shares would normally be capital unless it amounts to a distribution. The B shares are redeemable shares and TA 1988, s 209(2)(c) would make them a distribution, unless issued for 'new consideration'. The merger reserve consists of new consideration (see TA 1988, s 254(1)(6)), and therefore, under s 254(5), any part of it used to pay up share capital is itself treated as new consideration for that share capital. Therefore the B shares are treated as paid up for new consideration and escape s 209(2)(c).

Example 3

Apportionment of cost of original holding

Mr X has 1,000 Rolls Royce shares, which he acquired at privatisation at a cost of £1.70 per share

B shares issued on 25 June 2004.

The market values on first day of trading were:

Ordinary shares 241.875p

B shares 0.113p

Cost of ordinary shares for future capital gains tax purposes

£1,700 x 241.875p x 1,000 £1661.24

(241.875p x 1,000) + (0.113p x 50,000)

Cost of B shares for future capital gains tax purposes

£1,700 x 0.113p x 50,000 £38.76

(241.875p x 1,000) + (0.113p x 50,000)

So the first part of the arrangement for ensuring that the redeemable B share issue is not a distribution has been achieved.

The second part, ensuring that the redemption of those shares by the company is also not a distribution (which would be taken into account in calculating shadow ACT) is then covered by TA 1988, s 209(2)(b), which includes within the meaning of distribution:

According to Rolls' document, £200 million of the company's merger reserve was capitalised and applied to creating 'B' shares with a nominal value of 0.1 pence each and these can be issued to shareholders in proportion to their existing holdings of ordinary shares. Because the shares are fully paid up, there has been a reorganisation of share capital and the redemption or purchase of the B shares by the company is a capital rather than income transaction. This is generally seen as advantageous from many tax angles, particularly for an individual. And because it is not a distribution, there is no shadow ACT and, as confirmed by Patrick Cannon in Tolley's Stamp Taxes (paragraph 76.1), there is no stamp duty liability.

In June 2004, the company issued 50 B shares for every ordinary share held. The B shares will carry a non-cumulative preferential dividend of 75 per cent of the London Interbank Offered Rate ('LIBOR') on their nominal value (0.1 pence each), which will be paid every six months in January and July, so there is not much incentive for holding on to them. In fact, it seems that the company is expecting few shareholders to take this option and has reserved to itself the right to redeem the B shares if less than ten per cent of those issued are not converted or redeemed, although this has not so far happened.

The redeemable B shares have limited voting rights and do not rank pari passu with the existing ordinary shares. This issue is based on the number of shares held (as opposed to a scrip issue based on the alternative cash dividend value) and will be a share reorganisation under TCGA 1992, s 126(2)(a):

The taxpaying client

Where does this leave your Rolls Royce share holding personal tax client? His tax return for the year ended 5 April 2004 will have shown dividend income received at a rate of 5 pence per share in July 2003 and 3.18 pence per share in January 2004.

Depending on the total income from all sources, there would have been a liability at the Schedule F ordinary rate of 10 per cent, i.e. matching the tax credit for those who were not liable to higher rate tax, or the Schedule F upper rate of 32.5%, which — after deduction of the 10% tax credit — equates to an additional tax charge of 25% of the net dividend. However, practitioners must remember that when they see 'dividend' amounts received for the year ended 5 April 2005 — especially if they are taking these from, say, a bank statement and especially, as mentioned above, considering that the first payment for this year will be the same as for the last — these are no longer income payments, but have a capital nature. So, instead of there being a potential higher-rate income tax liability as with a normal dividend, in this case there will be potential capital gains tax implications.

The receipt of the B shares does not constitute a disposal of all or part of the existing shareholding; but, as a share reorganisation, the B shares will be treated as having been acquired at the same time as the existing shareholding and the acquisition cost of that shareholding will then apply to both classes of shares — the 'new holding'.

The treatment after that will then depend upon which of the three options — retention, redemption or conversion — is taken.

Retention or redemption

If the B shares are retained, then on a subsequent disposal of part or all of the new holding, the base cost of the ordinary shares will be apportioned between the ordinary and B shares by reference to market values on the issue date as in Example 3 aside. If the B shares are redeemed for cash by Rolls Royce, the cost apportionment calculation in Example 3 will also be relevant and will feed through into a calculation such as shown in Example 4 below.

Conversion

If the taxpayer opts to convert the B shares into ordinary shares, he is not treated as making a disposal. Instead, this will be a reorganisation of share capital under TCGA 1992, s 126(2)(a), as quoted above. TCGA 1992, s 127 goes on to state that the new (ordinary) shares are treated as the same asset as the previous shareholding. In fact, what we have is two reorganisations: the reorganisation from ordinary shares to ordinary and B shares and the reorganisation from ordinary and B shares to ordinary shares. The taxpayer's original base cost therefore continues to apply to the new increased holding.

Schemes and arrangements

Tucked away at the end of the section dealing with UK taxation, the Rolls Royce document notes:

Such reconstructions are not new and I am not suggesting that Rolls Royce is doing anything wrong by recovering its ACT in this way. Presumably s 703 will not apply, but the company has now rather put me in a dilemma. I am all in favour of increased shareholder returns, but what about the new tax avoidance legislation. Is this 'arrangement', as it is described, a tax avoidance scheme for which a disclosure should be made under the new rules in FA 2004, s 306 et seq? S 318 defines 'advantage' and 'arrangement', and the B share scheme would seem to fall within those definitions.

Example 4

Redemption of B shares

Mr X has been issued with 50,000 B shares in respect of his holding of 1,000 ordinary shares.

These are redeemed at 0.1 pence per share £50.00

Cost of 50,000 B shares as per Example 3 38.76

Unindexed gain before indexation or

taper relief £11.24

Reading the shareholder documentation, it seems to me that a 'step' has been inserted, the issue of B shares, purely to gain a tax advantage. In fact, Rolls Royce, in response to question 4 in its 'Questions and Answers' says: 'You will receive the same amount of cash that you would have received if the company had declared a normal dividend. The cash will be paid on 5 July 2004 in the same manner as dividends have been paid previously'.

In addition, payments can even be made into the same designated bank accounts as before and a similar statement is made for the scrip alternative. And how long will this plan last? Perhaps surprisingly, Rolls Royce answers this at Question 16. 'It is expected that while the company is able to, and there is a benefit in doing so, future payments to shareholders will be made through the issue of further B shares.'

Does the phrase 'while the company is able to' mean while it has B shares to issue and surplus ACT to use, or while the Revenue takes no action to prevent it?

The Tax Avoidance (Prescribed Descriptions of Arrangements) Regulations SI 2004 No 1863 provide for arrangements to be excluded from the avoidance legislation where a 'premium fee' would not be expected to be charged for the 'arrangements' and where a promoter would not be expected to keep the arrangements confidential (other than as regards his normal duty to his client). However, there must surely have been fees in connection with the setting up of this scheme, and from the wording of the company's documentation it seems that the point of it was a tax deferral at least, which is an 'advantage' according to FA 2004, s 318(1)(b). As Mike Truman suggests in 'As I Was Saying ...' (Taxation, 12 August 2004 at page 493), the fact that the Revenue might not expect a commonly used planning device such as this to be declared, does not mean that it does not fall within the regulations.

Don't ignore that mail

We British are well known for saying sorry to all and sundry and, to his credit, Lord Moore of Lower Marsh, the Acting Chairman of Rolls Royce, extols this virtue early on in the document. 'I apologise for the additional paperwork that this change will require, but in view of the tax benefits that will accrue to the group I very much hope that you will agree that it is in the interests of all shareholders to proceed in this way'. Well yes, I can see that now, and the personal tax implications for most shareholders will be minor, but the issue of the B shares does raise other personal and corporate tax issues and hopefully this article will have served as a reminder of some of them. In fact, will the disappearance of the dividend from the tax return of a shareholder with no other such income trigger some kind of 'enabling' letter. Perhaps this change should be mentioned in the 'additional notes' space, although from the recent issue of such letters to the self empoloyed, one understands that such notes were not reviewed in any event.

And I am also assuming at the moment that the paperwork will not be increased by the receipt of a letter advising me of a scheme reference number to be put on my next tax return. But if it does, can I just suggest that some little 'freebie' — a Rolls Royce baseball cap perhaps — could be attached, it might then get my attention rather earlier.

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