Article by Felicity Cullen, Gray's Inn Chambers, published in the July 2001 issue of Tax Adviser. Since the introduction of taper relief in 1998, practitioners have raised concerns as to the way in which the term 'security' would would be interpreted for the purposes of the relief.
The Revenue has acknowledged these concerns and some months agao announced that it would issue guidance as to the meaning of 'security' for taper relief purposes in Summer 2001. The June 2001 issue of the Tax Bulletin contains the promised guidance.
In summary, the guidance states that:
a) a security within the meaning of TCGA 1992 s132 is a security for the purposes of taper relief;
b) a debenture possessing the characteristics of a 'debt on a security' will be a security for taper relief purposes;
c) a debenture which is only deemed to be a security by TCGA 1992 s251(6) is not a security for taper relief purposes.
The issues that arise in determining whether a debt instrument is a 'security', in the broader capital gains tax (CGT) context, are well known and will not be discussed at length in this article. In the context of the meaning of 'debt on a security', the most recent authority is in Taylor Clark International v Lewis [1998] STC 1259 where, in short, it was held that in order to be a 'security' a debt had to be a marketable investment.
The courts have not produced any definitive statement as to what is meant by a 'marketable investment' but, inevitably, there are debt instruments in issue which, though intended to be securities for taper relief purposes, will not be regarded as 'marketable investments' and will not fall on the right side of the line.
It is, for example, not infrequently the case that, for various commercial reasons, securities are not freely transferable; and this may, depending on the terms of the instruments as a whole, cause them to fall outside the definition of securities for taper relief purposes.
The context in which securities (as opposed to shares) and issues concerning them most frequently occur for taper relief purposes is takeovers, ie where loan notes (whether or not together with shares) are issued in exchange for shares on the occasion of company acquisitions, and it is this context in which this article is set. In this context, the loan notes will often have substantial gains (deriving from the former shareholdings) inherent in them and the holders will want to maximise their taper relief by ensuring, first, that the loan notes are indeed 'securities' which are eligible for taper relief and, secondly, that the crystallisation of the gains is deferred as long as necessary or desirable.
This article addresses the question of whether in the light of the guidance on the meaning of 'security' for taper relief purposes the terms of debt instruments issued or to be issued on exchanges (and which do not or may not constitute securities as that term is now to be interpreted by the Inland Revenue can be amended or varied so as to fall, or fall more clearly, within the Revenue's interpretation of 'security'.
Existing loan notes
It may be possible to amend an existing loan note so as to improve (where necessary) its status as a 'security'. For example, a loan note which does not include a provision permitting assignment could, in the light of the Inland Revenue's interpretation of security, be amended so as to include such a provision.
There are, however, at least two problem areas in the context of amending existing loan notes.
First, an amendment which is regarded as essential so as to convert a loan note which is not a 'security' into a security in future cannot retrospectively improve the position.
If the loan note under consideration does not (in accordance with the Revenue's interpretation) constitute a 'security' (and, as such, an asset eligible for taper relief at the business assets rate) and it is converted into a security which is eligible, the apportionment rules will apply to attribute different rates of taper relief to different periods of ownership (see TCGA 1992 Sch A1 para 3).
Accordingly, although the taper relief position would be improved for the future, amendment or variation would not be a complete solution (unless the unamended loan note can, contrary to the Revenue's published position, be successfully argued to be a security).
Secondly, the sort of amendments which may be necessary to ensure that a given loan note is treated as a 'security' for taper relief purposes may be alleged by the Revenue to be so fundamental as to constitute a disposal of the original loan note in consideration of a new one. If the effect of any amendment is indeed to convert a debt instrument which is not a security into a security - an instrument of a different nature - it may be difficult to resist an argument that the amendment is fundamental.
If the argument for such a disposal were to be sustained, the gains inherent in the loan note would be realised; the disposal would not fall within TCGA 1992 s126 (reorganisation of share capital) or TCGA 1992 s135 (exchanges) and would, in my view, be difficult to bring withing TCGA 1992 s132 (equation of converted securities and new holding) so as to avoid the crystallisation of gains on it.
In conclusion, it is not possible to improve the status of loan notes for the past and it is likely to be difficult to 'improve' existing loan notes so as to ensure that they fall within the Revenue's interpretation of 'security' for the future without creating undesirable side effects.
Earn-out loan notes
The position concerning earn-outs giving rights to future issues of loan notes is more promising.
Section 138A of TCGA 1992 is essentially designed to give rollover treatment to earn-out rights and their satisfaction (where rolloever would not otherwise apply), but is of interest in the present context as described below.
Where, under TCGA 1992 s138A (the statutory successor to Extra-statutory Concession D27), an earn-out right given on a share exchange 'consists in a right to be issued with share sin or debentures of another company' and the conditions of TCGA 1992 s138A are otherwise satisfied, the earn-out right is assumed to be a security of the issuing company for the purposes of TCGA 1992.
More particularly, where an earn-out right is granted in the prescribed circumstances 'this Act shall have effect, in the case of the seller and every other person who from time to time has the earn-out right, in accordance with the assumptions specified in subsection (3) below': TCGA 1992 s138A(2). Subsection (3) provides as follows:
"(3) Those assumptions are -
a) that the earn-out right is a security within the definition in section 132;
b) that the security consisting in the earn-out right is a security of the new [purchasing] company and is incapable of being a qualifying corporate bond for the purposes of this Act".
The effect of subsection (3) read in combination with subsection (1) of TCGA 1992 2124A is that an earn-out right to 'debentures' (subsection (1)) which may not, on their terms, constitute 'securities' in accordance with the Revenue interpretation will constitute a 'security' of a purchasing company for the purposes of TCGA 1992, which must include the taper relief provisions of TCGA 1992 Sch A1. (Almost all loan notes will constitute debentures - a term of wide meaning - even if they do not constitute 'securities'.)
Accordingly, during the earn-out period, the earn-out right should accrue taper relief at the business assets rate. (This assumes, of course, that the purchasing company is either a trading company or the holding company of a trading group and that the individual eligibility conditions for taper relief are met.)
Eligibility for taper relief at the business assets rate at the end of the earn-out period will be governed by (amongst other conditions) whether or not the loan notes issued pursuant to earn-out rights are 'securities'.
If, because the loan notes to be issued pursuant to the earn-out rights are not (in the light of the Revenue's interpretation) themselves considered to be 'securities' for taper relief purposes, arrangements are made for the terms of the loan notes to be 'improved', it is possible that the Revenue would allege that the existing earn-out right has bene extinguished and replaced by a new earn-out right. Subsection (4) of s138A TCGA 1992 provides for the rollover of one earn-out right into a replacement one, so an argument from the Revenue that there has been a disposal of an earn-out right and the acquisition of another is not necessarily problematic.
In the case of an earn-out right which is maturing shortly, however, there may be a problem in achiving the s138A(4) TCGA 1992 rollover in that one of the conditions of s138A(4) is that:
"(c) the new right is such that the value or quantity of the shares or debentures to be issued in pursuance of the right ('the replacement securities') is unascertainable at the time when the old right is extinguished."
The value or quantity of loan notes to be issued under a maturing right may be ascertainable so that the s138A(4) rollover could not, if necessary, be relied upon. I have added the words 'if necessary' because it is just possible that the variation of the terms of loan notes to be issued pursuant to an earn-out right may not necessarily involve a disposal of that right, but I would not recommend reliance on this point.
It may be that the 'unascertainable' point can be dealt with by, for example, deferring the maturity of the earn-out right and ensuring that the value or quantity of the debentures to be issued in pursuance of it (albeit ascertainable by reference to the old right) is unascertainable by reference to the new right.
In conclusion, it may be possible to amend the terms of loan notes to be issued under earn-out rights so as to salvage the status of the loan notes as 'securities' and rely on s138A(4) TCGA 1002 to prevent premature crystallisation of gains. As a final point, subsection (4) of s138A is clearly intended to provide for the rolloever of earn-out rights, and the Revenue ought not, in practice, to suggest otherwise. The drafting is, however, somewhat imperfect, and this will need to be drawn to the attention of the client.
Technical Department
020 7235 9381
June 2001 by Felicity Cullen
