Article by Jan Ellis, tax partner, Baker Tilly Birmingham. She specialises in practical tax planning and tax valuations, for owner-managed companies and larger groups. The views expressed here are her own and not necessarily those of her firm.
Published in October 2001 issue of Tax Adviser. The original idea was simple enough: you have a manager in part of your organisation who does his job very well. Why not give him some shares in the subsidiary where he works, and, when he retires in a few years time, buy them off him at a huge premium? He gets retirement relief so the gain is effectively tax free; you get a highly motivated employee; and by clever accounting and transactions at a very full value with the parent company, you can “help” the value of the subsidiary increase to the required level. Why, you might not even need to pay him a bonus if the growth in the value of his shares is enough.
Put like that, the anti-avoidance provisions of Finance Act 1988 s77ff are all too easy to understand. The shares are a thinly-disguised bonus and the taxman wants the profit charged to income tax and not as exempt gains. Sadly, as with many anti-avoidance rules, the legislation hits much more widely than this. It can result in hefty tax charges, which may bite before the shares are realised, and the unfortunate taxpayer all too often is not aware of what is happening and does not realise he needs advice.
Scope of the charge
The legislation for dependent subsidiaries is in ss77 - 87 FA 1988. The basic provision (s87) charges Schedule E income tax (under Case I only - ie UK residents working in the UK) on the increase in value of shares acquired by an employee or director of the company in which the shares are acquired, or any company associated with it, where the company in which shares are issued is a dependent subsidiary at the time of the acquisition or becomes so subsequently but before any disposal of the shares. A similar Schedule E charge will also arise (s88) if the owner of shares in a dependent subsidiary receives “special benefits” by virtue of his shareholding.
The increase in value charge will arise on the earliest of three occasions:
- the sale of the shares (so that there is no scope for CGT planning by way of intra-spouse transfers or EIS deferral and no entitlement to taper relief or retirement relief);
- the company ceasing to be a dependent subsidiary (eg because new shares are issued so as to stop the company being a 51% subsidiary or potentially because a dependent subsidiary certificate - see below - is issued late);
- seven years after the company first becomes a dependent subsidiary.
Note that in the last two instances, the shareholder will not have received any money for his shares. Paying the tax on a significant increase in value may well be very difficult.
Any taxable increase in value must be returned in the individual’s self assessment tax return. It will be submitted by the individual’s local tax inspector for agreement with Shares Valuation Division in the normal way.
These draconian provisions do not apply for “innocent” share issues, where all of the following conditions are satisfied (s86 FA 1988).
- all or substantially all of the subsidiary’s business in a tax accounting period is not carried on with other group members;
- during the tax accounting period there is a maximum 5% increase in value in the shares which is attributable to group transactions;
- the directors of the overall parent (the principal company of the chargeable gains group) certify that these two conditions are satisfied for a specific tax accounting period; and
- the auditors of the subsidiary certify both that they have looked into the affairs of the company with regard to the conditions above, and that they consider the opinion given in the directors’ certificate is not unreasonable.
These certificates must be issued within two years within the end of the tax accounting period, for each and every tax accounting period. The Revenue have no jurisdiction to accept a late dependent subsidiary certificate, although the writer has experience of less alert Inspectors doing just that, and of a zealous Inspector fighting another case for six and a half years (where the increase in value was negligible and took a very long time to agree) and the tax in point totalled only £10,000.
Two overwhelming practical problems: first if the principal company is a large plc (perhaps one which has recently bought a sub-group with a messy structure) or, following FA2000, a non-UK company, the practicalities of arranging a board meeting to discuss and certify what to them is relative trivia is not straight-forward to arrange; second: who is commissioning and paying for the certificates, which may require a conscientious group or auditor to undertake specific research.
The second problem above highlights a further very significant issue for many “innocent” dependent subsidiary shareholders: not being tax experts they do not realise they are about to fall victim to anti-avoidance law. Few ordinary employees have a personal tax advisor to advise them, while the corporate tax advisor and auditors to the dependent subsidiary itself or the principal company of its chargeable gains group owe no duty of care to these shareholders.
Structures which are caught
A company is prima facie a dependent subsidiary if it is the 51% subsidiary of another company (s86 and s87 FA 1988), unless the dependent subsidiary certificate process is followed. This will therefore apply to the “classic” shares-to-a-deserving-employee situation described in the introduction, but may also apply in the following cases:
- a management buy-out where a venture capitalist obtains shares as well as providing debt giving it more than 50% of the ordinary share capital;
- the exercise of a pre-emption right not taken up evenly by all the members or a share buy-back which increases the percentage holdings of the remaining shareholders and gives a company which previously had a minority shareholding a 51% interest;
- the collapse of a joint venture arrangement, where a corporate partner buys the shares of parties wanting an exit, thereby bringing its interest above the 50% level.
- the sale to a company of more than 50% of a previously management-owned business, where management originally got shares as employees not founders.
Ironically, given the potentially very wide scope of the dependent subsidiary rules, they are reasonably easy to avoid. One of the easiest ways is through “alphabet stock”: ie a key employee in A Limited, Mr A, is given A shares in Holdco; his counterpart, Mr B, who works for a sister subsidiary B Limited gets B shares in Holdco, etc. The rights of the A and B shares are carefully restricted so that they entitle Mr A to benefit only from the growth in value of A Limited, by tracking dividends through to the underlying profits in A Limited and giving capital rights based on the underlying asset value of A Limited; because, however, the shares are in the parent, the dependent subsidiary rules do not bite and disposals will be subject to capital gains tax (and hopefully business taper). There is a small degree of risk if Holdco is anything other than a pure holding company that the rights of the A shares will be restricted by adverse trading performance in Holdco, eg if retained losses in Holdco limit the legally distributable amounts payable to Mr A, but these can often be managed.
There are other alternatives to motivate key employees and restrict their enfranchisement to the part of the group in which they are involved, but avoid the risk of a dependent subsidiary tax charge crystallising pre-disposal. These generally involve share options (eg where the option is exercisable immediately pre-disposal) including tax-favoured EMI options, or phantom shares, to give a cash payment to the employee pre-sale or after a specified time lapse, based on the increase in the value of his part of the business, effectively as a “normal” bonus.
Two issues need addressing for existing dependent subsidiaries for which certificates have not been filed on time. First: has a tax charge arisen and not been returned; second: is a tax charge imminent?
If the former, the complexities of the tax system are such that Inspectors, too, are most unlikely to spot that there is a problem. However, a “head in the sand” approach by the taxpayer is not an option under self-assessment and an incomplete tax return must be corrected forthwith. The trick now is to try and minimise the tax due by successfully arguing that any increase in the value of the shares is negligible.
By definition we are looking at a minority shareholding, and a minority interest in an unquoted company is often unattractive to other investors because of the lack of an appropriate exit and an unreliable (or non-existent) dividend stream. As ever with tax valuations, it is essential to prepare your case. Look at the rights of the shares in question and any restrictive pre-emption clauses. What is the size of the shareholding in question and how are the other shares held? - It will generally be the case that the smaller the shareholding the lower the value per share, but a small interest the purchase of which would give another shareholder control, or 75% (ie sufficient to pass a special resolution), or 90% (sufficient to expropriate the minority) may have more value than its stand-alone percentage interest might suggest.
Against this, it is sometimes the case with dependent subsidiary situations that the shareholders are very limited in number and may be seen almost as members of a club: they may choose to get dividends rather than bonuses now, but if the “hypothetical purchaser” deemed under valuation law were to be one of their number, they would stop dividing the cake to give him a share at once. Each case depends on its facts but a careful consideration of the pertinent facts may allow a modest increase in value to be successfully argued.
It can also be possible to eliminate an imminent dependent subsidiary charge, by reducing the value of the shares held by the individual (to the benefit of the majority shareholder) and compensating the employee with share options. The steps to follow to achieve the desired technical position here can be cumbersome, but well worth it if the tax charge that would otherwise arise is large and the shares remain unsold, so that the taxpayer has no liquid resource with which to fund the tax due.
The rationale for the dependent subsidiary legislation is easy to follow but its application in practice can be unfair, particularly for those caught “innocently” who could in theory submit certificates but fail to do so. The burden in obtaining and filing the certificates is inappropriate for taxpayers who are not aware of the position they are in. It would be fairer for the legislation to be disapplied if a certificate could be submitted rather than to require its submission.
The payment of tax without proceeds being realised - eg the seven year charge - can also be very difficult in practice. In many situations, it is not possible for the taxpayer to sell the shares to pay the tax: there is usually no effective market in small minority interests in unquoted companies if the majority shareholder cannot or will not buy the shares, and a buy-back is not possible. It would be fairer if the tax due at this time could be rolled over until the date of sale.
Given the generosity of EMI options, which can achieve much the same aim of giving a bonus taxed as capital, in the current climate, the dependent subsidiary rules now look harsh. At the height of the “dot-com” market, with fancy remuneration packages met largely in shares, envy may well have played its part in keeping the status quo. But following the collapse of dot-coms and with the first signs of recession in the air, it would seem a good time now to remove some of the inequity of the dependent subsidiary legislation.
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October 2001 by