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20 December 2000
Warranty and Indemnity Payments
Tim Sanders LLB(Hons), FTII looks at the status of warranty and indemnity payments on notional disposals.
Tim Sanders LLB(Hons), FTII looks at the status of warranty and indemnity payments on notional disposals.
Warranty and Indemnity Payments
Tim Sanders LLB(Hons), FTII looks at the status of warranty and indemnity payments on notional disposals.
The introduction of section 171A, Taxation of Chargeable Gains Act 1992 (notional transfers within a group) by Finance Act 2000 was a welcome simplification of the law. Before section 171A, tax advisers had to devise ways of moving capital assets pregnant with uncrystallised chargeable gains from one company within a group to another with capital loss shelter prior to an onward sale. Such pre-sale intra group movements frequently gave rise to more substantial issues.
For example, if shares in a subsidiary had to be moved at market value, one could not move such shares by way of sub-sale (an intra group agreement between A and B to sell with a conveyance direct from A to the purchaser) without incurring stamp duty reserve tax. However, because in practice such intra group movements often take place after negotiations with a potential purchaser have started, the alternative, namely an intra group transfer relying on stamp duty relief under section 42, Finance Act 1930, may be unavailable. The concern would be whether there were 'arrangements' within section 27(3), Finance Act 1967 which could prejudice the availability of that relief.
Conversely, if such shares were sold at less than market value, corporate issues could arise, such as distribution issues under Aveling Barford Ltd v Pevion Ltd and others [1989] BCLC 626 (tax issues caused by intra group transfers at undervalue were not usually a problem due, inter alia, to section 171, Taxation of Chargeable Gains Act 1992 and section 209(4) and (5), Taxes Act 1988).
Section 171A to the rescue
Section 171A solves these issues by allowing members of a chargeable gains tax group to enter into a joint election to deem an intra group transfer under section 171, Taxation of Chargeable Gains Act 1992 to have taken place immediately before a sale to an outside third party, such a sale being treated as having been made by the notional transferee of such deemed intra group transfer. However, issues may arise if section 171A is relied upon and payments are made under the warranties and indemnities in the sale documentation. These are illustrated in Example 1.
Example 1
A plc has a large pool of capital losses and is the parent of a group comprising, inter alia, its 100 per cent subsidiary B Ltd which in turn owns 100 per cent of C Ltd. The shares in C Ltd have a base cost of £1 million and are to be sold at their market value of £11 million.
Prior to 1 April 2000, to ensure that A plc's capital losses could be used to shelter the gain arising on the sale of C Ltd's shares, B Ltd would first need to transfer the shares in C Ltd to A plc. Following the introduction of section 171A the sale can be made by B Ltd, but A plc and B Ltd can enter into an election at any time within two years of the end of the accounting period of B Ltd in which the sale takes place. The effect of such an election is to deem a section 171 disposal of C Ltd's shares from B Ltd to A plc and then a sale of those shares by A plc, with the result that A plc is deemed to realise the chargeable gain of £10 million and (subject to any applicable restrictions) can offset its capital losses.
The problem arises in reconciling the tax fiction of the disposal by A plc with the fact that it is B Ltd which has made the disposal and entered into the sale documentation giving the tax indemnities and warranties.
Reconciliation issue
Section 49, Taxation of Chargeable Gains Act 1992 allows payments under a warranty to be treated as an adjustment of the purchase price. By virtue of Extra-statutory Concession D33 this treatment is also extended to indemnity payments made by a seller to a purchaser, which apart from allowing an adjustment to the price, ensures that the payment is not taxable in the hands of the recipient under the doctrine in Zim Properties Ltd v Proctor [1985] STC 90.
Taking the facts in the example: traditionally B Ltd would enter into sale documentation including certain warranties and would also provide the tax deed. If a payment were subsequently made by B Ltd its receipt of the purchase monies on the sale of the shares of C Ltd would be adjusted downwards for chargeable gains tax purposes. However, if an election has been made under section 171A this does not appear to be possible. It is A plc which is treated for the purposes of chargeable gains as having made the disposal so B Ltd has no taxable receipt to adjust. The potential exposure is that the tax position of the group is based on the gross receipt of purchase money with no reduction to reflect the economic loss caused by a payment under the tax deed or warranties. The net effect would be that more losses than are necessary to cover the real economic gain of the transaction would be used by A plc.
A solution
One potential solution would be for A plc to join in the sale documentation and provide the warranties and the indemnity to the purchaser. This would only be practical if the group had decided to make the section 171A election at the time of the sale. Furthermore, while in the example the purchaser is unlikely to object to receiving indemnities and warranties from X plc as head of the group, the position may be different if the losses were in and indemnities and warranties were provided by a small sister company of B Ltd, where the purchaser may feel there is a greater credit risk. (This could probably be resolved by guarantees from the parent.) Practical hurdles can be overcome but the questions is: will this solution work technically?
Subsection 49(1)(c), Taxation of Chargeable Gains Act 1992 talks about 'contingent liability in respect of a warranty or representation made on a disposal'. Subsection 49(2) talks about adjustments in consequence of a claim under such warranties or representation. Nowhere in subsection 49(1)(c) (unlike subsections (a) and (b) which refer to the 'liability of the person making the disposal') is there specific mention made of the party making the representations and warranties. Consequently, since for chargeable gains purposes A plc is treated as the seller and taxable entity and since it is A plc that gives the warranties and representations in respect of such a disposal, there would seem to be no technical objection to A plc making an adjustment in respect of payments made under the warranties it gives, notwithstanding that it is B Ltd that makes the sale. However, the position in respect of the indemnities is not as clear.
Section 49 is de facto extended to catch tax indemnities by Extra-statutory Concession D33 which in paragraph 13 extends the application of section 49 (and provides the exclusion from the Zim Properties Ltd doctrine) where a payment is made by a seller to a purchaser. The legal seller in Example 1 is B Ltd so on a strict reading of the concession, it is arguable that it would not apply to payments made by A plc. This not only raises the potential spectre of A plc being unable to adjust its calculation of sale proceeds downwards in respect of satisfied indemnity claims but also raises the possibility that a payment under the tax deed may be taxable in the hands of the purchaser.
Illogical result
Such a result would be illogical and certainly not in keeping with the spirit of the concession. For chargeable gains purposes A plc is treated as the seller. One would expect that a concession which deals specifically with the chargeable gains tax consequences of a sale would respect the treatment given by the Taxation of Chargeable Gains Act 1992. It is understood that the Inland Revenue is indeed prepared to apply the concession. In other words, provided A plc enters into the tax deed and warranties at the date of the sale, if it subsequently makes payment there can be an adjustment in the purchase price.
This analysis leaves one remaining issue: if A plc makes an actual payment under the tax deed or warranties, one ends up in the right tax position but economically A plc would be disadvantaged because it has to make a cash payment to satisfy a claim when it has not actually received any consideration (which is received by B Ltd). Thus, to ensure that the economic position matches the tax position, one would need to have a reimbursement arrangement under which B Ltd agrees to reimburse A Ltd. Section 171(A)(5) would appear to confirm that any such internal arrangement should be tax neutral (subject to it not exceeding the capital gain or allowable loss) and thus a payment from B Ltd to A plc would effectively be ignored.
This would appear to ensure the right result: namely, the economic cost is borne by B Ltd which also obtains the economic benefit of the cash sale proceeds and the associated tax consequences are all treated as arising in A plc.
Post sale election
This is fine when A plc and B Ltd have decided at the time of the transaction with the third party that they wish to enter into a section 171A election. However, in practice, a section 171A election may be implemented only after the sale takes place. Thus, if in our example one assumes that B Ltd entered into the sale documentation, received the consideration and subsequently enters into a joint section 171A election with A plc: what is the position when B Ltd makes a payment under the tax deed and/or warranties? B Ltd would have received the cash proceeds and made the warranty/indemnity payment, so incurring real economic cost for the group, but for tax purposes it is A plc which will be treated as having received the proceeds which, prima facie, cannot be adjusted as A plc has not incurred the cost of a warranty/indemnity claim.
The initial reaction is that the solution is to assign the sale and purchase contract from B Ltd to A plc at the time of making the election with B Ltd agreeing to make tax neutral reimbursements of any costs incurred by A plc as a result of the election and associated payments under the assigned indemnities and warranties under section 171A(5). However, under English law it is not possible to assign the burden of a contract and therefore a novation would be necessary (under which the original contractual obligations are extinguished and recreated with a new obligation direct from A plc to X plc).
In practice, this is likely to be very difficult if not impossible to achieve as there is no incentive for a third party purchaser such as X plc to enter into such an arrangement particularly if, unlike the case in the example, a novation is in favour of a smaller company within the group. If a novation can be achieved then it would seem to offer a solution to concerns if coupled with a reimbursement pursuant to the election in section 171A(5).
If a novation route cannot be adopted it would seem that there is a potential issue for which there is no obvious immediate solution. Essentially the problem lies in the fact that although changes in the law such as section 171A have moved tax law further and further towards looking at groups of companies on a consolidated basis, the fundamental law is still based on taxation on an entity by entity basis. This seems to be an example where a relatively common situation is likely to arise which falls down one of the gaps between the two approaches.
Logical move
The quick solution would be for the Revenue to accept that where A plc agrees to discharge B Ltd's obligations under the tax warranties and indemnities entered into by B Ltd at the time of a sale, this should be regarded as an adjustment of purchase price on the basis that A plc is the seller for the purposes of chargeable gains (and therefore for section 49, Taxation of Chargeable Gains Act 1992 and Extra-statutory Concession 33 purposes). Any reimbursement by B Ltd to A plc in consideration of it discharging these obligations and making the election would need to be treated as a tax neutral payment under section 171A(5).
This would produce a logical and equitable result and is arguably the correct interpretation. However, a degree of uncertainty remains particularly as a concession is involved.
Tim Sanders LLB(Hons), FTII looks at the status of warranty and indemnity payments on notional disposals.
The introduction of section 171A, Taxation of Chargeable Gains Act 1992 (notional transfers within a group) by Finance Act 2000 was a welcome simplification of the law. Before section 171A, tax advisers had to devise ways of moving capital assets pregnant with uncrystallised chargeable gains from one company within a group to another with capital loss shelter prior to an onward sale. Such pre-sale intra group movements frequently gave rise to more substantial issues.
For example, if shares in a subsidiary had to be moved at market value, one could not move such shares by way of sub-sale (an intra group agreement between A and B to sell with a conveyance direct from A to the purchaser) without incurring stamp duty reserve tax. However, because in practice such intra group movements often take place after negotiations with a potential purchaser have started, the alternative, namely an intra group transfer relying on stamp duty relief under section 42, Finance Act 1930, may be unavailable. The concern would be whether there were 'arrangements' within section 27(3), Finance Act 1967 which could prejudice the availability of that relief.
Conversely, if such shares were sold at less than market value, corporate issues could arise, such as distribution issues under Aveling Barford Ltd v Pevion Ltd and others [1989] BCLC 626 (tax issues caused by intra group transfers at undervalue were not usually a problem due, inter alia, to section 171, Taxation of Chargeable Gains Act 1992 and section 209(4) and (5), Taxes Act 1988).
Section 171A to the rescue
Section 171A solves these issues by allowing members of a chargeable gains tax group to enter into a joint election to deem an intra group transfer under section 171, Taxation of Chargeable Gains Act 1992 to have taken place immediately before a sale to an outside third party, such a sale being treated as having been made by the notional transferee of such deemed intra group transfer. However, issues may arise if section 171A is relied upon and payments are made under the warranties and indemnities in the sale documentation. These are illustrated in Example 1.
Example 1
A plc has a large pool of capital losses and is the parent of a group comprising, inter alia, its 100 per cent subsidiary B Ltd which in turn owns 100 per cent of C Ltd. The shares in C Ltd have a base cost of £1 million and are to be sold at their market value of £11 million.
Prior to 1 April 2000, to ensure that A plc's capital losses could be used to shelter the gain arising on the sale of C Ltd's shares, B Ltd would first need to transfer the shares in C Ltd to A plc. Following the introduction of section 171A the sale can be made by B Ltd, but A plc and B Ltd can enter into an election at any time within two years of the end of the accounting period of B Ltd in which the sale takes place. The effect of such an election is to deem a section 171 disposal of C Ltd's shares from B Ltd to A plc and then a sale of those shares by A plc, with the result that A plc is deemed to realise the chargeable gain of £10 million and (subject to any applicable restrictions) can offset its capital losses.
The problem arises in reconciling the tax fiction of the disposal by A plc with the fact that it is B Ltd which has made the disposal and entered into the sale documentation giving the tax indemnities and warranties.
Reconciliation issue
Section 49, Taxation of Chargeable Gains Act 1992 allows payments under a warranty to be treated as an adjustment of the purchase price. By virtue of Extra-statutory Concession D33 this treatment is also extended to indemnity payments made by a seller to a purchaser, which apart from allowing an adjustment to the price, ensures that the payment is not taxable in the hands of the recipient under the doctrine in Zim Properties Ltd v Proctor [1985] STC 90.
Taking the facts in the example: traditionally B Ltd would enter into sale documentation including certain warranties and would also provide the tax deed. If a payment were subsequently made by B Ltd its receipt of the purchase monies on the sale of the shares of C Ltd would be adjusted downwards for chargeable gains tax purposes. However, if an election has been made under section 171A this does not appear to be possible. It is A plc which is treated for the purposes of chargeable gains as having made the disposal so B Ltd has no taxable receipt to adjust. The potential exposure is that the tax position of the group is based on the gross receipt of purchase money with no reduction to reflect the economic loss caused by a payment under the tax deed or warranties. The net effect would be that more losses than are necessary to cover the real economic gain of the transaction would be used by A plc.
A solution
One potential solution would be for A plc to join in the sale documentation and provide the warranties and the indemnity to the purchaser. This would only be practical if the group had decided to make the section 171A election at the time of the sale. Furthermore, while in the example the purchaser is unlikely to object to receiving indemnities and warranties from X plc as head of the group, the position may be different if the losses were in and indemnities and warranties were provided by a small sister company of B Ltd, where the purchaser may feel there is a greater credit risk. (This could probably be resolved by guarantees from the parent.) Practical hurdles can be overcome but the questions is: will this solution work technically?
Subsection 49(1)(c), Taxation of Chargeable Gains Act 1992 talks about 'contingent liability in respect of a warranty or representation made on a disposal'. Subsection 49(2) talks about adjustments in consequence of a claim under such warranties or representation. Nowhere in subsection 49(1)(c) (unlike subsections (a) and (b) which refer to the 'liability of the person making the disposal') is there specific mention made of the party making the representations and warranties. Consequently, since for chargeable gains purposes A plc is treated as the seller and taxable entity and since it is A plc that gives the warranties and representations in respect of such a disposal, there would seem to be no technical objection to A plc making an adjustment in respect of payments made under the warranties it gives, notwithstanding that it is B Ltd that makes the sale. However, the position in respect of the indemnities is not as clear.
Section 49 is de facto extended to catch tax indemnities by Extra-statutory Concession D33 which in paragraph 13 extends the application of section 49 (and provides the exclusion from the Zim Properties Ltd doctrine) where a payment is made by a seller to a purchaser. The legal seller in Example 1 is B Ltd so on a strict reading of the concession, it is arguable that it would not apply to payments made by A plc. This not only raises the potential spectre of A plc being unable to adjust its calculation of sale proceeds downwards in respect of satisfied indemnity claims but also raises the possibility that a payment under the tax deed may be taxable in the hands of the purchaser.
Illogical result
Such a result would be illogical and certainly not in keeping with the spirit of the concession. For chargeable gains purposes A plc is treated as the seller. One would expect that a concession which deals specifically with the chargeable gains tax consequences of a sale would respect the treatment given by the Taxation of Chargeable Gains Act 1992. It is understood that the Inland Revenue is indeed prepared to apply the concession. In other words, provided A plc enters into the tax deed and warranties at the date of the sale, if it subsequently makes payment there can be an adjustment in the purchase price.
This analysis leaves one remaining issue: if A plc makes an actual payment under the tax deed or warranties, one ends up in the right tax position but economically A plc would be disadvantaged because it has to make a cash payment to satisfy a claim when it has not actually received any consideration (which is received by B Ltd). Thus, to ensure that the economic position matches the tax position, one would need to have a reimbursement arrangement under which B Ltd agrees to reimburse A Ltd. Section 171(A)(5) would appear to confirm that any such internal arrangement should be tax neutral (subject to it not exceeding the capital gain or allowable loss) and thus a payment from B Ltd to A plc would effectively be ignored.
This would appear to ensure the right result: namely, the economic cost is borne by B Ltd which also obtains the economic benefit of the cash sale proceeds and the associated tax consequences are all treated as arising in A plc.
Post sale election
This is fine when A plc and B Ltd have decided at the time of the transaction with the third party that they wish to enter into a section 171A election. However, in practice, a section 171A election may be implemented only after the sale takes place. Thus, if in our example one assumes that B Ltd entered into the sale documentation, received the consideration and subsequently enters into a joint section 171A election with A plc: what is the position when B Ltd makes a payment under the tax deed and/or warranties? B Ltd would have received the cash proceeds and made the warranty/indemnity payment, so incurring real economic cost for the group, but for tax purposes it is A plc which will be treated as having received the proceeds which, prima facie, cannot be adjusted as A plc has not incurred the cost of a warranty/indemnity claim.
The initial reaction is that the solution is to assign the sale and purchase contract from B Ltd to A plc at the time of making the election with B Ltd agreeing to make tax neutral reimbursements of any costs incurred by A plc as a result of the election and associated payments under the assigned indemnities and warranties under section 171A(5). However, under English law it is not possible to assign the burden of a contract and therefore a novation would be necessary (under which the original contractual obligations are extinguished and recreated with a new obligation direct from A plc to X plc).
In practice, this is likely to be very difficult if not impossible to achieve as there is no incentive for a third party purchaser such as X plc to enter into such an arrangement particularly if, unlike the case in the example, a novation is in favour of a smaller company within the group. If a novation can be achieved then it would seem to offer a solution to concerns if coupled with a reimbursement pursuant to the election in section 171A(5).
If a novation route cannot be adopted it would seem that there is a potential issue for which there is no obvious immediate solution. Essentially the problem lies in the fact that although changes in the law such as section 171A have moved tax law further and further towards looking at groups of companies on a consolidated basis, the fundamental law is still based on taxation on an entity by entity basis. This seems to be an example where a relatively common situation is likely to arise which falls down one of the gaps between the two approaches.
Logical move
The quick solution would be for the Revenue to accept that where A plc agrees to discharge B Ltd's obligations under the tax warranties and indemnities entered into by B Ltd at the time of a sale, this should be regarded as an adjustment of purchase price on the basis that A plc is the seller for the purposes of chargeable gains (and therefore for section 49, Taxation of Chargeable Gains Act 1992 and Extra-statutory Concession 33 purposes). Any reimbursement by B Ltd to A plc in consideration of it discharging these obligations and making the election would need to be treated as a tax neutral payment under section 171A(5).
This would produce a logical and equitable result and is arguably the correct interpretation. However, a degree of uncertainty remains particularly as a concession is involved.
