Article on the provisions of ICTA 1988 s703, by Lindsay Pentelow of Mazars Neville Russell
Published in the March 2001 issue of "Tax Adviser"
It is reasonably common knowledge that the provisions of ICTA 1988, s. 703 – 709 operate to cancel tax advantages arising from certain transactions in securities. The most typical circumstances in which the provisions may apply are set out in IM 4510 as it presently stands as being:
- the receipt of artificially high income by an exempt body or of inflated franked investment income by a company in a position to exploit that income; and
· the extraction by an individual of funds from a company in the form of capital .
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Most of the cases heard or arising during the 1990’s were in the first category (for example Sheppard & Another v CIR Ch D 1993, 65 TC 724; CIR v Universities Superannuation Scheme Ltd, Ch D 1996, 70 TC 193; Marwood Homes Ltd v CIR (No 3), Tribunal 1998,[1999] SSCD 44; and The Laird Group plc v CIR , Tribunal [2000] SSCD 75). The number of these cases should of course decline as a result of the changes over the last few years relating to the abolition of both ACT and the repayment of tax credits to exempt bodies. There have been few cases in the second category partly for the reason that treating a capital sum as a distribution has been an object of much tax planning (presale dividend strips and scrip dividends for example). In recent years the effect of distribution treatment in the hands of a shareholder has in most usual cases been benign when compared with capital treatment. IM 4520 confirms that in circumstances C-E (which we will return to below but which broadly re-categorise a capital sum as a distribution) s. 703 will only be invoked if the tax on a potential assessment exceeds the capital gains tax liability on the same consideration. It then goes on to give the examples of the gain being wholly covered by retirement relief or substantially reduced by rebasing, indexation or the availability of capital losses.
However, with the advent of taper relief, from 2002-03 the effective rate of capital gains tax on many, if not most, capital transactions relating to securities will be ten per cent. Much present tax planning is geared to deferring the disposal for tax purposes until then. The effective rate of 25 per cent on a distribution clearly compares favourably (from the Revenue’s perspective) and so we can expect more transactions to satisfy the criteria in IM 4520 and therefore should expect more challenges.
So it is opportune to revisit s. 703 and the object of this article is to ring as many bells as possible for practitioners involved in transactions which may create these exposures.
Triggering circumstances
Rather than plunging immediately into the technicalities of the provisions it is worth looking at the types of transaction which IM 4524 says ought to be reported to the Section 703 Group;
(a) the receipt of a dividend (or interest) which represents an excessive return on the cost of the shares or securities on which it is paid and which is taken into account for any of the purposes listed at IM4514 [these purposes are those referred to below in the discussion on Sec 704A].
(b) the payment of a substantial dividend by a company prior to the sale of shares in that company combined with an agreement whereby some or all of the shareholders waive all or part of their dividend rights in return for a greater share of the sale proceeds.
(c) the sale of shares or other securities to a company in which the vendor has a substantial interest
(d) the sale of shares or other securities to the Trustees of a Pension Scheme of which the vendor is a member.
(e) the transfer or sale by a company of its assets or business to another company having some or all of the same shareholders followed by the liquidation of the company whose assets etc have been acquired or the sale of shares in either company.
(f) a company reconstruction in which some or all of the shareholders in the original company retain an interest in the second company.
(g) the sale of shares under any agreement whereby the shares themselves or the underlying assets are capable of being subsequently reacquired by the vendor.
(h) the acquisition by an individual or a company under his control of shares in a company with accumulated losses at the same time as the assignment to him at a substantial discount of debts due by the loss-making company followed by repayments of the assigned debts (within six years of the end of the year of assessment in which the debts were assigned).
(i) the merger of two (or more) companies in which shares or securities form all or part of the consideration and where all the companies concerned are within Section 704(D)(2), ICTA 1988.’
It is worth pointing out that some of these are fairly usual types of situations for any practitioner involved with OMB clients.
The technical conditions
The basic conditions triggering ss. 703-9 are
1 there are one of the five sets of circumstances prescribed at ICTA 1988, s. 704 A-E (for which see below); and
2 there has been one or more transactions in securities or a transaction in securities combined with a liquidation; and
3 in consequence of the transaction(s) concerned the person in question has obtained a tax advantage (s. 703(1))
Where these conditions exist the Board has a broad power to counteract any tax advantage.
1 There is, however, an escape clause for bona fide commercial transactions (see below).
Defining a transaction in securities
‘Securities’ includes not only shares and stock but any interest in a company not limited by shares (for example a company limited by guarantee).
‘Transactions in securities’ includes transactions of whatever description relating to securities and in particular
- the purchase, sale, or exchange of securities;
· the issuing or securing the issue of, or applying or subscribing for, new securities
· the altering, or securing the alteration of, the rights attached to securities. It should be noted that the transactions specified above are not exhaustive but merely examples and a transaction in securities would also include, say, the redemption of a security. A liquidation alone is not a transaction in securities but a combination of a transaction in securities and a liquidation will be within the legislation.
The Inland Revenue Manual at IM 4512 states that a payment of a dividend is also a transaction in securities on the authority of Greenberg v CIR 47 TC 272. This has not been followed in The Laird Group plc v CIR (No 2), Tribunal [2000] SSCD 75 which reversed the Special Commissioners decision on the issue, although the Revenue have appealed to the Court of Appeal against this decision.
Defining a tax advantage
A ‘tax advantage’ means —
(i) relief (or increased relief) from,
(ii) or repayment (or increased repayment) of tax
(ii) or the avoidance (or reduction) of a charge (or assessment) to tax
whether the avoidance or reduction arises by receipts not being taxable or by a deduction in computing profits or gains (s. 709(1)). ‘Tax’ is not defined and accordingly means both income and corporation tax. So it does not include any other tax including it seems corporation tax on chargeable gains.
The 704 A – E circumstances
Circumstances D and E are the ones which presently have the widest potential application but each of the circumstances will be covered for completeness drawing from the examples given in the Revenue Manual at IM 4514-4519.
S. 704A
704A applies when in connection with the distribution of profits of a company, or the sale or purchase of securities followed by the purchase or sale of the same securities, the person in question receives an abnormal dividend (dividend being extended to include any other qualifying distributions and interest) which is then taken into account for any of the following purposes —
(a) any exemption from tax (for example most commonly in the past in a claim to payment of tax credit by a charity or a pension fund)
(b) the relief of losses against profits or income
(c) group relief (abnormal interest only)
(d) the application of franked investment income for the purposes of the regulations for unrelieved surplus ACT
(f) to cover charges
(g) to relieve interest paid.
Clearly with the abolition of ACT, of the set off of losses against FII and the repayment of tax credit to exempt bodies, these provisions are likely to have little impact in the future.
S. 704B
704B is obsolete for practical purposes, originally being to catch the dealer who does not receive the abnormal dividend but claims an income loss as a result of the fall in value following a dividend strip.
It should be noted that because s. 703 does not apply to capital losses it is possible for individuals to create capital losses by dividend stripping - though not companies.
S. 704C
ICTA 1988, s. 704C applies when a person receives an Income Tax free consideration in consequence of a transaction in which some other person receives an abnormal dividend
(704A) or obtains a deduction in computing his profits (704B).
The income tax free consideration must generally represent the value of assets available for distribution by the company. The only exceptions are where it represents future receipts of the company or the value of trading stock of the company. This means in practice that Section 704C, ICTA 1988 is unlikely to apply unless the company has (or has recently had) at least some distributable reserves.
Given that s. 704A has a reduced impact now and s. 704B even less it is difficult to think of many circumstances in which 704C may apply. However the example at IM 4516 and flagged to Inspectors as a type of case to look out for above still would be caught. That is where shareholders with differing tax positions try to achieve an optimal mix of consideration by waiving pre-sale dividends in return for a greater share of sale proceeds.
S. 704D
It is easy to think of this circumstance applying when a shareholder receives in a form not liable to income tax a consideration he might otherwise have received in the form of a dividend or other distribution. The Inspectors Manual speaks in these terms. However the provision is more restricted requiring that:
(a) the shareholder receives a capital sum (not subject to income tax);
(b) that is in connection with the distribution of profits of a company (the definition of which is extended to include the transfer of assets); and
(c) the sum received represents distributable reserves, trading stock, or future receipts of the company.
In addition under s. 704D(2) it cannot apply to:
(a) any company listed on the Stock exchange unless controlled by five or fewer persons; or
(b) any company controlled by one or more companies in (a).
So broadly the provision can apply to all unquoted companies unless they are subsidiaries or otherwise controlled by a quoted company (‘D(2)’ companies).
The provision also only applies where the consideration is received in the form of cash or its equivalent. Where shares are received in a second D(2) company it appears 704E applies to the exclusion of 704D.
Examples given by the Revenue in IM4517 include:
A is the sole shareholder in company X. He inherits company Y on the death of his father. X has reserves of £250,000 but instead of paying a dividend it purchases his shares in Y at the probate value of £100,000. A still owns the shares in Y (indirectly through his shareholding in X) but has received £100,000 in cash. A has no CGT liability and as the sale was at market value the distribution legislation cannot be invoked. Under ICTA 1988, s. 703 he may be assessed to income tax at his highest rate on the whole £100,000 consideration.
Company X has made a transfer of assets (the purchase price) representing assets which would otherwise have been available for distribution by X.
S. 704E
Whilst generally it can be said that 703D covers cash and cash equivalent proceeds, and 703E covers proceeds of shares and securities, more precisely the 703E circumstances are:
(a) the transfer directly or indirectly of assets from one para.. D(2) company to another (i.e. reconstruction); or
(b) a transaction in securities between para.. D(2) companies (i.e. acquisition, takeover, reorganisation)
(c) a person receives a capital amount;
(d) that amount represents assets available for distribution.
Like D, E only applies to transactions in the shares or assets of companies which are D(2) companies. If the consideration takes the form of non-redeemable shares, s. 703 applies when the share capital is repaid.
Example (from IM 4518)
A and B hold equally the whole of the issued share capital in company X (reserves £80,000) and in company Y (reserves £10,000). They each exchange their shares in Y for 10,000 £1 Ordinary shares and 40,000 £1 redeemable preference shares issued by X. Under ICTA 1988, s. 703 A and B may each be assessed to Income Tax at his top rate on £40,000. If any of the 20,000 ordinary shares are subsequently repaid, they may also be liable to assessment (for the year of repayment) on the amount repaid.
The escape clause
It needs to be recognised that there are two criteria needing to be satisfied in relation to the escape clause and that they are cumulative:
1 that the transactions were carried out for bona fide commercial reasons or in the ordinary course of making or managing investments; and
2 that the obtaining of a tax advantage was not one of the main objects of any of the transactions.
There are a number of cases which turn on the availability of the escape clause including two recent Special Commissioners/Tribunal cases where the issue is dealt with in some detail: Clark v CIR, Ch D 1978, 52 TC 482; Marwood Homes Ltd v CIR (No 3), Tribunal 1998,[1999] SSCD 44 reversing the Special Commissioners earlier decision on rehearing; and Lewis v CIR, Sp C [1999] SSCD 349 (Sp C 218).
The main principles, which as always are easier stated than applied appear to be:
1. Whether transactions have been carried out for bona fide commercial reasons is a subjective matter of intention to be ascertained by looking at the transactions as a whole and in their proper context. The commercial reasons may include non-financial ones, such as retaining family control of the company (IRC v Goodwin [1976] STC 28) and reasons unconnected with the company involved in the transaction (Clark as above).
2. This may involve looking at the intentions of the directors, or of the shareholders or, sometimes, the professional advisers.
3. On the second limb, it is once again a matter of ascertaining the object as a subjective matter of intention to be ascertained by looking at the transactions as a whole.
4. So far as this is concerned if the obtaining of the ‘tax advantage’ is only an ancillary, albeit valuable, benefit arising from the transaction then the escape clause should still be satisfied. Following Lord Upjohn in CIR v Brebner [1967] 43 TC 705 ‘No commercial man in his senses is going to carry out commercial transactions except upon the footing of paying the smallest amount of tax involved’.
Clearances
The major saving grace of these provisions which are both obscure and carry significant penalties if they can be invoked against the taxpayer is the very comprehensive clearance facility given by s. 707.
This is subject to the normal requirement of full and accurate disclosure of all material facts and considerations. Further if a clearance is refused the Board will usually give the reasons for its objection with the taxpayer able then to make a fresh application having modified the proposal to take account of the objections.
The important practical point is to spot the circumstances where the provisions could be invoked (erring on the side of caution) and to submit a clearance application in all circumstances bearing in mind the implications of Matrix Securities [1994] STC 272 for the content of the application. Equally important is to be aware of the greater likelihood of s. 703 being invoked when discussing transactions with clients since in practice clearances are often applied for at a late stage. A clearance refusal junking a transaction which has been worked on for several months will be an especially unwelcome one.
Technical Department
020 7235 9381
March 2001 by
