Article by Robin Godman LLM FTII, who works for a major international oil group as a senior tax adviser. He is also a director of one of their subsidiaries. This article appeared in the January 2003 issue of Tax Adviser.
Chancellors are not noted for their generosity, so it comes as something of a surprise when a generous relief is given. Indeed, we saw a very good one in the form of taper relief, and now, in Finance Act 2002 (FA 2002), Sch. 8 and s. 44 we see another in the form of relief for chargeable gains on substantial shareholdings. So why did he do it, what did he do, and is there anything we should look out for?
Certainly, so far as substantial shareholdings are concerned, its introduction had possibly more to do with bringing the United Kingdom (UK) into line with her major trading competitors than the Chancellor’s charitable nature. Germany, one of Britain’s largest trading partners within the European Union (EU), has enjoyed a similar relief for some time now, and so have a number of others. However, in Germany there is no qualifying threshold, and in many other countries it is five per cent rather than our ten per cent. Also, the idea behind the relief is not new either, because the outline proposals were first aired in a Technical Note issued on 23 June 2000 (Deferral Relief for Substantial Shareholdings), and draft legislation was published in that November.
In what is surely one of the most valuable reliefs currently to be found in UK corporate taxation, substantial shareholdings relief essentially removes from the charge to tax capital gains made by trading companies on the disposal of ‘substantial shareholdings’ owned by them in other trading companies. Of course, something as good as this will not be given away without a few caveats here and there, and as might be expected, there are plenty in the form of the inevitable anti- avoidance provisions.
Schedule 8 and s. 44 introduce the new rules into the Taxation of Chargeable Gains Act 1992 (TCGA 1992) in the form of Sch. 7AC which consists of the main exemption, and two subsidiary exemptions. Therefore, all the references here are to the TCGA 1992 unless otherwise noted. The main exemption, in Sch. 8, para. 1 relates to the main purpose of the new rules in that a company that has bought shares in another company, and makes a gain on their disposal, is exempt from tax as long as the requirements of the act are met:
- Time: the investor must have held a ‘substantial shareholding’ in the other company for twelve months continuously in the preceding two year period.
- This concerns the all important information about what the phrase ‘substantial shareholding’ actually means, and here we find in para. 8 that to qualify, the investor must not only hold at least ten per cent of the shareholding, but must also be able to claim at least ten per cent of the profits and ten per cent of the assets available on liquidation. The fact that the holding level is set at ten per cent goes to show how generous the relief really is. Of course, things in the real world are never simple, and so the legislation works out a scheme of how to apply the rules to changing levels of holding.
Starting with the situation where the investor has held above the ten per cent minimum from acquisition to disposal for the whole of the ownership period, the qualifying time need only be twelve months instead of twenty-four. In cases where the holding has dropped below ten per cent and then gone above that figure, all within a twelve month period, if the holding has not been maintained above ten per cent for twelve months continuously, the exemption will be lost. But what about cases where a holding has been held, disposed of, and then re-acquired? As might be expected, the answer here depends upon how long the two holdings have been owned for, and at what level. If both the first and second periods have been at a level of ten per cent or above for more than twelve months continuously, the exemption will be available for both periods. But if in either period the holding fell below the vital ten per cent for long enough to break the twelve months continuous holding, the exemption will be unavailable for the relevant period, but would be available for the other period, so long as ten per cent or above was maintained for twelve months or longer. In other words, the two periods are not necessarily linked for these purposes.
Groups are catered for in of Sch. 8, para. 9. Apart from the assets of long term insurance funds, a group member can be treated as holding shares held by any other member of the same group. This means that one group company can qualify for the exemption where it has held shares for less than the prescribed time and level so long as other group companies together have held above ten per cent for more than twelve months in the two years before disposal.
In most cases, where shares are passed between members of the same group, the transfer is carried out on the familiar principles of ‘no gain/no loss’ under s. 171. For these circumstances, para. 10 allows the acquirer to inherit the same ‘holding history’ as transferor. This also extends to the reorganisations, reconstructions and amalgamations catered for by s. 127 and s. 135. This is done by regarding the holding periods and levels of ownership applying to the ‘old shares’ as applying equally to the ‘new shares’. But where the arrangements result in a statutory deemed disposal and subsequent re-acquisition, para. 11 prevents the holding applicable before the deemed event from being taken into account. The most likely event where this is of practical effect would be the crystallisation of a gain under s. 179, where the owner of the relevant shares itself leaves the group.
The sale and repurchase of securities covered by s. 263A are catered for by para. 12 where the interim holder is ignored, provided it is a member of the same group as the re-purchaser. Stock lending arrangements covered by s.263B are also catered for by para. 13 on a similar basis. Earlier reconstructions under the aegis of s. 135 and s. 136, and demergers approved under TA 1988, s. 213, are treated by para. 14 and 15 on a broad ‘look through’ basis. These all seem sensible and practicable, but para. 16 is a little curious. Where the shareholder is in liquidation, para. 16 confirms that the shareholding company does not lose beneficial ownership of the relevant shares upon liquidation, but as a number of commentators have observed, since the Inland Revenue does not suggest that the company should be treated in this way, why is this point required?
Having looked at the main exemption, it is now appropriate to examine the two subsidiary exemptions in para. 2 and 3. Both are aimed at gains arising on the disposal of assets related to shares. To find out what these are we must turn to para. 30 where the meaning of an ‘“asset related to shares’ is explained. Broadly, such an asset covers options over shares, securities with rights of conversion into shares, and the right to acquire shares.
First subsidiary exemption
Reverting to para. 2, we find that to qualify for the first subsidiary exemption, (in other words, for any gain arising on the disposal of the asset to be tax free) one of two alternative conditions must be satisfied. The first covers the situation where, just before the asset is disposed of, the shareholding company holds shares or an interest in shares to which the asset relates, and those shares would have qualified for the main exemption if they had been sold, there will be no chargeable gain. The second concerns the circumstances where the shareholding company holds an asset relating to the shares, but does not hold any of the relevant shares itself. If it is a member of a group, and an associated group company holds some of the relevant shares, and those shares would have qualified for the main exemption had they been sold, similarly, there will be no chargeable gain.
Second subsidiary exemption
Going on to para. 3, the second subsidiary exemption is in relation to gains that would have qualified for relief had the disposal taken place earlier, but failed because the required conditions were not met when the disposal actually took place. As before, they cover gains arising on shares, interests in shares, and assets related to shares. However, the conditions that have to be satisfied are more extensive than those encountered in the first subsidiary exemption. It’s also one of the more difficult bits of the legislation and should be handled with care. The requirements are that the continuous twelve-month rule is satisfied; the shareholding company is subject to corporation tax (because of residency or being a branch or agency of a foreign company); and the shareholding company or fellow group member would have qualified for the main exemption within the two years prior to the disposal. This could create difficulty for the first two years in the life of the provision because the main exemption, upon which this exemption depends, was not available until 1 April 2002.
Where the company whose shares are being disposed of is not trading, or is not a holding company whose subsidiaries are trading, relief will still be available as long as the shareholding company (or connected persons) controlled it within the two years preceding the share disposal. Also, it is necessary that a chargeable gain or allowable loss would otherwise arise from the disposal. But remember, if the main exemption cannot be obtained simply because the shareholding company is neither a trading company nor a member of a qualifying group following the disposal, the second subsidiary exemption will not be available either. Because the main exemption is somewhat narrowly drafted, it could be that this exemption comes to be relied upon more frequently than the legislators originally intended. It is also worth noting that although the anti-avoidance provisions are discussed under the next heading, this para. 3 has a distinct anti-avoidance flavour, albeit for very good reasons, giving it something of a dual purpose.
So far so good, but there are a few sharks swimming about in the form of anti-avoidance provisions that practitioners should be aware of. The first crops up in para.3(5). If any assets have been injected into the company (whose shares are being disposed of) in the two preceding years, either by way of a gift or where the gain has been held-over through a s. 165 claim, gains arising in the shareholding company from the sale of relevant shares will get no relief. Similarly, any losses arising on the transaction will not be allowable. Paragraph 3(7) concerns the sale of shares by the shareholding company under a conditional contract. In these cases the date of a conditional disposal for s. 28 purposes is the date the condition is satisfied. But there is a twist, because the date for deciding the two-year period is the date of the contract. Paragraph 5 denies relief for gains where the shareholding company has acquired control of the relevant company, or they have both come under the same control. If there has been any significant change in the trading activities when under such control, relief will be denied. This has the same meaning as in ICTA 1988, s. 768. The familiar phrase ‘sole or main benefit’ appears too: if arrangements are entered into where the sole or main benefit is to obtain an exempt gain, the gain will be taxed. The word ‘arrangements’ is widely defined and includes ‘…any scheme, agreement or understanding, whether or not legally enforceable’. The difficulties inherent in the anti-avoidance provisions is demonstrated by the Revenue having acknowledged the need for clarification so early in the life of the legislation when they issued Statement of Practice 5/2002 (SP5/2002) Exemptions for companies' gains on substantial shareholdings – sole or main benefit test – Paragraph 5 Schedule 7AC Taxation of Chargeable Gains Act 1992. which should always be referred to. The SP attempts to overcome the shortcomings in the drafting by providing two examples of cases where the provisions would apply, but nine examples where they do not. Despite this, the Revenue have said that they expect cases where the provisions apply to be ‘unusual and infrequent’.
In common with most new tax legislation, these provisions are complex and therefore uncertain in practical application. The drafting has been described as ‘tortuous’ in places, which is particularly regrettable in the light of the consultation process that preceded it, and the laudable aims of the Tax Law Rewrite project. Some potential difficulties have been touched on briefly here, and no doubt others will emerge in due course. It is also likely that further Revenue guidance will have to be forthcoming in the form of Concessions and Practices which is yet more ‘soft law’ running alongside the ‘hard law’ of the Statute. The provenance of this is debatable, and calls into question the initial standard of drafting, but maybe it is the intention to give up on making the Statute more understandable, and rely on soft law instead. But we must not complain about the new relief itself because it could be the last big break for a long time to come!
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January 2003 by