A Close Relationship

ANDREW HIRST of Denton Wilde Sapte explains and illustrates the stamp duty problems of transactions carried out between closely associated companies.

Section 42, Finance Act 1930 allows two bodies corporate to transfer property between each other free of ad valorem stamp duty in circumstances where the two bodies corporate are so closely associated that the effect of the transfer is that the property conveyed remains under the same underlying economic ownership. Despite both (i) numerous amendments made to section 42; and (ii) the introduction of various anti-avoidance provisions to buttress section 42, in the years since 1930, the basic intent behind the section is the same today as it was in 1930. References to section 42 in this article are to section 42, Finance Act 1930 as amended.

The basic legislation

In very basic terms, section 42 provides that an instrument will be exempt from ad valorem stamp duty if the effect of the instrument is:

• to transfer a beneficial interest in property;
• from one body corporate to another; and
• at the time of the transfer the two bodies corporate are associated (essentially, one body corporate is the beneficial owner of the other or both bodies corporate are beneficially owned by a third body corporate).

Two issues which are fundamental to the operation of section 42 relief are:

(1) what constitutes the transfer of a 'beneficial interest' in property; and

(2) when does 'beneficial ownership' exist for the purposes of establishing the necessary group relationship at the time of the transfer of the property?

Unfortunately, neither the term 'beneficial interest' nor 'beneficial ownership' are precise terms defined in the legislation. Rather, the meaning of both terms has evolved over a number of years through decisions of the courts and the practice of the Stamp Office. This article will consider both these terms as they stand today following various judicial decisions before going on to consider the application of section 42 to a set of facts.

Transfer of a beneficial interest

Stamp duty is payable on instruments which transfer certain forms of property. Although section 42 relief applies to the instrument which transfers property, its operation is triggered by the transfer of a 'beneficial interest' from one body corporate (A) to another (B). In most cases there will not be any divergence between the transfer of the legal estate and the beneficial interest in property as A will own and will transfer both the legal estate and the beneficial interest to B at the same time, pursuant to a single instrument of transfer.

However, the transfer of both the legal estate and the beneficial interest in property will not always occur contemporaneously; an example of this is seen when A enters into an agreement to transfer property to B and then subsequently actually transfers that property to B pursuant to an instrument of transfer. In these circumstances, the beneficial interest in the property is likely to have passed from A to B pursuant to the original agreement between them with legal title passing under the subsequent instrument of transfer. As described above, although stamp duty is payable on the instrument which transfers title, section 42 relief is driven purely off the transfer of the beneficial interest in property which, in our example, occurred pursuant to the original agreement between A and B.

Despite this divergence, it appears that the instrument of transfer will be granted relief under section 42 as it will be 'stamped in respect of the value and transfer of the equitable interest, although that has previously passed' (per Lord Somervell in Escoigne Properties Ltd v Commissioners of Inland Revenue [1958] AC 549 at p564). This position is also accepted by the Stamp Office (see paragraph 6.94 of the Inland Revenue Stamp Duty Manual).

The Escoigne Properties case also confirms that section 42 relief is available in circumstances where A agrees to sell property to B who in turn agrees to sell that property to C when that property is transferred directly from A to C (where A and C are associated for the purposes of section 42). In Escoigne the instrument transferring the property directly from A to C was held to be exempt under section 42 despite the fact it related to two transfers of beneficial ownership from A to B and then from B to C.

A company will only be able to transfer a 'beneficial interest' in property if it is the 'beneficial owner' of the property. Accordingly, care must always be taken when considering whether section 42 relief is available to ensure that A is the beneficial owner of property when it transfers that property to B. This issue will be considered further below.

Beneficial ownership

Two bodies corporate (A and B) will be associated for the purposes of section 42 if either:

Company A:

(i) beneficially owns not less than 75 per cent of the ordinary share capital of B (or vice-versa);
(ii) is entitled to not less than 75 per cent of the profits available for distribution to equity holders of B (or vice-versa); and
(iii) is entitled to not less than 75 per cent of the assets available for distribution to equity holders of B on a winding up of B (or vice-versa); or

• if A and B are not in such a direct relationship then a third body corporate (C) satisfies the three tests set out at (i) to (iii) above in respect of both A and B.

In applying the criteria set out at (ii) and (iii), the tests set out in Schedule 18 to the Taxes Act 1988 apply.

The question what constitutes 'beneficial ownership' (both for the purposes of the group relationship required by section 42 and also in relation to whether a company is the beneficial owner of the property transferred) has a particular meaning which is set out in a number of decisions of the courts. A number of principles can be taken from these cases, including the following.

Unconditional contracts

A company which has entered into an unconditional contract for the sale of property will no longer be the beneficial owner of that property. Accordingly, a company (A) which has entered into an unconditional contract to sell one of its subsidiaries to an unassociated third party will no longer be the beneficial owner of that subsidiary and so any transfer of property from that subsidiary to another of A's subsidiaries will not qualify for section 42 relief.

Conditional contracts

A company which has entered into a conditional contract for the sale of property will usually remain the beneficial owner of that property until the conditions precedent to the sale of that property have been performed. However, this will not always be the case and the conditional contract may in some circumstances operate to divest the transferor of beneficial ownership of that property. The circumstances in which this is likely to occur are:

• if satisfaction of the conditions is within the control of the transferee who has the ability to waive the conditions;
• if the transferee is able to enforce the contract by way of specific performance; and
• if the transferor has as a result of the contract divested itself of its fundamental rights over the property (for instance, in the case of shares, its ability to receive dividends, vote, or otherwise dispose of the shares).

Whether a contract is a conditional or unconditional contract can be extremely difficult to determine. By way of example, in the case of Parway Estates Ltd v Commissioners of Inland Revenue 45 TC 135 a contract for the sale of shares was held to be unconditional despite the fact that the transferor was required to perform various obligations prior to the sale.

Options

The granting of an option to a prospective transferee to purchase property may operate to divest the transferor of beneficial ownership of that property if the effect of the option is to limit severely the transferor's rights over the property (again, for instance, in the case of shares, the transferor loses the right to receive dividends, vote or otherwise dispose of the shares).

Liquidations

A company ceases to be the beneficial owner of its property when it goes into liquidation.

Relevant case law

Although a number of these principles appear clear and straightforward, they can in practice be difficult to apply to everything but the most clear-cut examples. This difficulty is reinforced by the conflict which exists between a number of the leading cases on beneficial ownership. This conflict is seen in the different approaches advocated by the Court of Appeal in the cases of Wood Preservation Ltd v Prior (Inspector of Taxes) 45 TC 112 and J Sainsbury plc v O'Connor [1991] STC 318.

The facts of the Wood Preservation case are relatively straightforward. S Ltd, a German company, entered into an agreement with BR Ltd to sell its subsidiary (Wood Preservation Ltd) to BR Ltd. The sale was subject to a condition that S Ltd would obtain for BR Ltd an assurance from a German company that it would continue granting certain rights to Wood Preservation Ltd. This condition was ultimately waived by BR Ltd (BR Ltd got the assurance directly from the German company). The Court of Appeal held that by virtue of the fact that S Ltd had divested itself of its rights of ownership (as a result of the contract with BR Ltd it was unable to sell the shares, it was unable to pay any bonus or dividend on the shares and it was bound to transfer the shares to BR Ltd if BR Ltd waived the condition), it was no longer the beneficial owner of the shares. To quote the words of Lord Donovan – 'The shares were like a tree which the owner could not sell and could not cut down and of which he could enjoy none of the fruit'.

In the J Sainsbury case, the Court of Appeal expressed reservations on the approach adopted by the Court of Appeal in Wood Preservation. Mr Justice Lloyd attempted to draw a link between the concepts of beneficial and equitable ownership. He thought the proper test in determining the question of who has beneficial ownership of property should be to look at whether equitable ownership had passed to the transferee; that test turning, in his view, on whether the transferee could call for specific performance of the contract. Despite advocating a different approach, the Court of Appeal in the J Sainsbury case found itself bound to follow the decision in Wood Preservation v Prior and so ultimately looked, not at where equitable ownership of the shares actually rested but, simply at whether the transferor had so restricted its rights over the shares that it had lost beneficial ownership of them.

When considering whether an intending transferor of property is still the beneficial owner of that property, Wood Preservation directs us to look at whether the effect of the contract is so severely to restrict the transferor's rights over the property that it has lost beneficial ownership of that property. Although this test can be operated with some certainty when considering the transferor's position, it is not so easy to apply in the reverse position when one is concerned with whether beneficial ownership has passed to the transferee.

In the Wood Preservation case, the Court of Appeal went on to state that although S Ltd had lost beneficial ownership of the shares in Wood Preservation Ltd, it did not necessarily follow that beneficial ownership of those shares had passed to BR Ltd; the Court accepted that it was possible for beneficial ownership of the shares to be held in abeyance and not rest with either the transferor or transferee. Both Lord Widgery in the Wood Preservation case and the Court of Appeal in Sainsbury v O'Connor expressed doubts over the concept that beneficial ownership of property can be held in limbo lying with neither the transferor nor the transferee.

Unfortunately, until this issue is resolved before the courts, tremendous difficulties will remain for a transferee who wishes to show that beneficial ownership of property has passed to it in circumstances where the instrument of transfer has not been executed. Some of these issues are evident in the case study considered below.

Case Study

(1) A and X enter into a Share Purchase Agreement (the 'Agreement') on 1 January under which:

(i) X agrees to buy from A 100 per cent of the share capital of B by 1 February; and
(ii) X agrees to procure that its subsidiary Y will purchase from B 100 per cent of the share capital of C.

For commercial reasons, the sale of C to Y must take place prior to the sale of B to X. The sale of B to X is subject to a number of conditions precedent. As part of the Agreement, in the period 1 January to 1 February, A does not have any rights to receive dividends from B nor to dispose of its shares in B (otherwise than to X).

(2) By 29 January, the conditions precedent are satisfied.

(3) On 30 January, B executes a stock transfer form and transfers its shares in C to Y.

(4) On 1 February, A executes a stock transfer form and transfers its shares in B to X.

B and Y apply to the Stamp Office for relief under section 42 in respect of the transfer of shares in C to Y on 30 January. The basis of this application is that at the time of the transfer on 30 January, X was the beneficial owner of 100 per cent of the ordinary share capital of both B and Y who were therefore associated for the purposes of section 42. Clearly, X is the 100 per cent legal and beneficial owner of Y. However, has beneficial ownership of B passed to X by virtue of the agreement?

Following Wood Preservation v Prior, A has unquestionably divested itself of beneficial ownership of B by virtue of the restrictions imposed on it under the agreement (it no longer having a right to receive dividends from B or otherwise dispose of B). However, it does not necessarily follow that by virtue of A losing beneficial ownership of B, X has gained it.

On the facts, as the conditions precedent are satisfied on 29 January then from that time the agreement will be unconditional and beneficial ownership of B will have vested with X. Accordingly, on 30 January when C is transferred to Y, B and Y will have been associated for the purposes of section 42.

Significantly, if the conditions precedent had not been fulfilled until 31 January then at the time of the transfer of the shares in C on 30 January it would have been considerably more difficult to demonstrate that X was the beneficial owner of B. In these circumstances, whether or not beneficial ownership of B had passed to X would probably be determined by the nature of the conditions precedent. Two different types of conditions precedent can be distinguished:

(i) Conditions precedent which are under the control of third parties (for instance, regulatory consents). If the conditions precedent were of this type then beneficial ownership of B will almost certainly not have passed from A to X;
(ii) Conditions precedent which are under the control of the transferee. In these circumstances if the transferee X was able to waive the conditions precedent and get specific performance of the agreement then it is likely that beneficial ownership of B will have passed to X.

The practice of the Stamp Office

Unfortunately, the practice adopted by the Stamp Office in this area frequently leads to even further confusion. In essence, the approach of the Stamp Office appears to be to ignore the Sainsbury v O'Connor judgment and to follow the line of cases culminating in the Wood Preservation case. Accordingly, the Stamp Office contends that:

(i) where parties enter into a non-contractually binding arrangement which involves the sale of property, then once the first step is taken which commercially binds the parties to proceed to completion then beneficial ownership of the property will be lost; and
(ii) when parties are negotiating the sale of property, then the vendor may lose beneficial ownership of that property once the parties have reached a serious stage in their negotiations.

Due to the tremendous revenue generating potential that stamp duty now has, it is the writer's experience that the Stamp Office is actively trying to restrict the scope of section 42 relief. In this climate, the boundaries of this area are likely to come before the courts in the near future. We await developments.

Andrew Hirst is an assistant solicitor in the tax department at Denton Wilde Sapte.

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