The Taper Caper
Nothing is ever that simple … especially when it concerns taper relief, warns KEVIN SLEVIN.
One of the biggest problems with the taper relief régime is one of client expectation. Many clients think that they know what taper relief is all about. Hardly a week goes by without someone telling me that he or his client is planning to sell a business shortly after April 2002 when 'there is only ten per cent tax to pay'. Little does he know of the hurdles that he must jump! Many who make disposals long before April 2002 are in for a shock, too.
Salutory tale
The Taper Caper
Nothing is ever that simple … especially when it concerns taper relief, warns KEVIN SLEVIN.
One of the biggest problems with the taper relief régime is one of client expectation. Many clients think that they know what taper relief is all about. Hardly a week goes by without someone telling me that he or his client is planning to sell a business shortly after April 2002 when 'there is only ten per cent tax to pay'. Little does he know of the hurdles that he must jump! Many who make disposals long before April 2002 are in for a shock, too.
Salutory tale
Take the following example: Wayne and Sharon have just agreed to sell their business. Contracts have been signed so the die has been cast.
They were blissfully happy after doing the 'mother of all deals' with George's help. George had only acted as tax adviser to Wayne and Sharon for a matter of months. His first action on taking over the case was to convince them to incorporate their business. After many years of hard work and long hours trading in partnership, things had begun to look really good about four years ago when their taxable profits first exceeded £100,000. Profits had risen rapidly and reached £350,000 in the year to cessation of trade as a partnership, but Wayne and Sharon's drawings were limited to £45,000 because of the seemingly ever increasing need for working capital. Incorporation seemed the logical answer to George and the only question was why it had not been done before he was appointed to act for them. Cutting the tax rate on retained profits by half from the top rate of 40 per cent would soon have a positive impact on cash flow.
George was careful to document his advice and sent his clients a list of the downsides to running a business through a company, as well as his calculations of the reduction in taxes on income achievable. His advice looked solid and was clearly stated. Alas, all that is history now. Yes, they had incorporated the business on his advice and, yes, they had continued to expand their business and their profits, but less than a year after incorporation they sold 100 per cent of their shares to an American company following an unsolicited offer.
The buyer would not wait until after 5 April 2001, but that did not seem to worry Wayne and Sharon as neither could believe the amount of cash offered to them. They were staggered by the terms of the unsolicited offer. Even if taper relief would amount to only 25 per cent, having to pay 40 per cent capital gains tax on just 75 per cent of their gain was an acceptable burden of taxation. Furthermore, they did not want to go to Belgium or anywhere else for tax reasons, they simply wanted to take the money before the purchaser changed his mind. They wanted to set up another business in a totally different field, and yes, they were interested in deferring some of the capital gains tax under the enterprise investment scheme deferral relief (Schedule 5B to the Taxation of Chargeable Gains Act 1992), but only if the conditions were not going to prove to be too complex.
Bombshell
It was when George was attending a lecture that he learned to his dismay that, because Wayne and Sharon had acted on his advice to incorporate the business, taper relief would only arise on the sale of shares if it took place more than 12 months after the incorporation. This was because the 'taper clock' had to be reset on the date of incorporation. Consequently, the savings achieved by the decision to incorporate paled into insignificance when compared to the extra capital gains tax payable as a direct result of the decision to incorporate the business.
Put simply, the extra gain that would be taxed amounted to nearly £2.5 million more than Wayne and Sharon were anticipating – a little matter of £1 million extra tax, tax that did not feature anywhere in George's list of downsides to incorporation mentioned above. Of course, this series of events will never happen again in practice, or will it? But it is not all bad news – at least George knows where he stands, as do his two ex-clients....
Holding on?
If shares or securities in a company are to qualify as business assets for taper relief purposes under Finance Act 2000, one of the conditions to be satisfied is that the company must either be a 'trading company' or the 'holding company' of a 'trading group'. Much has been written about the meaning of trading company and in my article 'Taste for Taper' in Taxation, 27 April 2000 at pages 85 to 86, I highlighted a problem with the practical impact of the meaning of holding company. Readers will recall that the definition of holding company taper relief purposes is as follows:
A company whose business (disregarding any trade carried on by it) consists wholly or mainly of the holding of shares in one or more companies which are its 51 per cent subsidiaries. (There is a special rule for companies that have invested in certain joint venture companies but, despite the importance thereof to the scheme of things, this provision is to be ignored in this article.)
The first step that one must take when carrying out an analysis of the position is to ignore the trading activities carried on by the holding company in question. Many readers have sought to question the rationale behind this step. There is no known rationale behind it, so the advice has to be 'just do it'. If your client is upset, urge him to write to his MP asking why, when deciding whether a company is the holding company of a trading group, it is necessary to ignore all trading activities carried on by the holding company in question.
The next step is the statutory equivalent to being told to compare elephants with sea water. It is necessary to establish whether the business of the company, having removed all traces of the company's trading activities from one's mind, can properly be described as mainly that of holding shares in one or more companies which fall within the definition of a 51 per cent subsidiary. 'Mainly' is accepted by the Revenue as meaning more than 50 per cent.
This provision works particularly well where the holding company of a trading group does nothing other than hold shares in subsidiaries, all of which are within the definition of '51 per cent subsidiary' found in section 170(7), (this states, broadly, that a company is a 51 per cent subsidiary of the holding company when the holding company is entitled to (i) more than 50 per cent of any distributable profits and (ii) more than 50 per cent of the assets of the subsidiary on a winding-up thereof). But what happens if matters are not that straightforward? For instance, in the following example is Noteasy Ltd a holding company for taper relief purposes?
Example
Noteasy Ltd owns four 100 per cent subsidiaries. Each subsidiary does nothing other than trade. Each subsidiary has an issued share capital of £100. However, Noteasy Ltd has loaned monies to all four of its subsidiaries, amounting to £300,000, and it is in receipt of interest therefrom. Noteasy Ltd also owns a freehold building which it bought as an investment and which is let to a third party on an arm's length basis. It generates £10,000 rental profit assessed under Schedule A. Noteasy Ltd carries on a trade in its own right, the turnover of which is £2 million and the net profit after directors' fees of £300,000 is £200,000. This trade is thought to be worth ten times the value of the property investment referred to above.
Noteasy Ltd's advisers explain to the board of directors that in deciding whether or not Noteasy Ltd is a holding company, they must first disregard the trade carried on by it (and by implication disregard the net assets thereof) and then compare the activity of holding shares in four subsidiaries with the activity of:
(a) owning a freehold property and renting it out; and
(b) lending money in return for interest.
Should it be found that the business activity of owning shares in four subsidiaries (measured in accordance with any reasonable measurement) fails to exceed the business activity referred to as (a) and (b) above (when these two activities are measured in the same manner), Noteasy Ltd will not be regarded as a holding company.
How does one compare the activity of owning shares with Noteasy Ltd's other activities? The company's letting business (plus the other non trade activities not being that of holding shares in subsidiaries) must be compared to and contrasted with its share ownership activities, i.e. its business of holding shares in subsidiaries. Quite how, no one seems certain. Only time will tell how these comparisons are to be made in practice.
Second chance?
So what happens in these circumstances if the holding company test fails? It is simple (by that I mean it is not quite so complex). If a company is not within the definition of 'holding company', the only way in which its shares qualify as business assets for taper relief is if it falls within the definition of 'trading company'. Yes, a company that has failed the holding company test may, nevertheless, satisfy the 'trading company' test.
Before concluding that shares in the holding company of a group are not business assets because they fail the 'holding company' test described above, it is essential to look again at the holding company. It is then necessary to ask the question whether, apart from any non-trade purposes which have not had, and are not capable of having, a substantial effect on the extent of the company's activities, the company in question exists wholly for the purpose of carrying on one or more trades. Before one can answer this question it is necessary to understand the meaning of 'substantial' in these circumstances.
Substantial issue
It is not possible to have any grasp of what the Parliamentary draftsman meant by the phrase 'substantial effect'. Some say it means all things to all people. It is only with the help of the Revenue's guidance that any conclusion can be reached, but perhaps it is worth repeating the precise (or perhaps I should say 'imprecise') wording of the legislation in order to make one particular point. Paragraph 22 of Schedule A1 states:
'"trading company" means a company which is either –
'(a) a company existing wholly for the purpose of carrying on one or more trades; or
'(b) a company that would fall within paragraph (a) above apart from any purposes capable of having no substantial effect on the extent of the company's activities.'
As yet, the Revenue has not formally pronounced the Board's understanding of the legislation in this area. In the context of the anti-avoidance provisions found in paragraph 10 of Schedule A1, the Revenue's Capital Gains Tax Manual at paragraph 17916 states:
'Substantial should, in general terms, be taken to mean greater than 20 per cent,...'
It is seems to be generally accepted within the Revenue that the '80:20 test' referred to above is also the same test which must be applied when striving to determine whether a particular company is a trading company or not, as all too often the case may be. We must ask whether the non-trading activities of a company are so small that we can properly regard them as being such that they are capable of having no substantial effect on the extent of the company's activities. Therefore, when examining a holding company for this purpose, i.e. assuming that it has failed to fall within the definition of holding company as discussed earlier in this article, it is necessary to see if its non-trading activities breach the 80:20 test having regard to the fact that its investments in its subsidiaries must be treated like any other arm's length investment outside the group. But how will this work in practice?
There is an inference in the definition of trading company that the reason for the company's being is a factor in deciding whether the company under the microscope is a trading company or not. While looking at a so-called singleton company, i.e. a company that is not part of a group, it may well be possible to put forward arguments as to why a company that was formed with the main purpose of carrying on a trade or trades continues to be a trading company, even though it now has significant investment assets acquired by investing surplus profits, the converse must apply where a company has been set up to be a holding company. Does it not exist to be a holding company? How can it exist 'wholly for the purpose of carrying on one or more trades' or that 'it so exists apart from purposes capable of having no substantial effect on the extent of the company's activities'? On the other hand, a company that was formed to carry on a trade 20 years ago and, say, ten years ago decided to transfer its trading activities to a wholly owned subsidiary and from that day forward become a holding company, would appear to have at least some potential for meeting the test.
Some Inspectors may argue that the proper way of construing the trading company definition is to ask not why the company existed 20 years ago but, instead, why does it still exist? The short answer is that even with guidance from past cases we cannot be certain how this provision will be interpreted by the courts or, indeed, by the Revenue.
A little help from a friend?
All is not doom and gloom, however. The Revenue is always keen to help (well, nearly always) these days, so any company that is concerned about its trading status can approach its tax office and get confirmation of its status from the local Inspector. Nevertheless, surely when introducing a measure which is going to affect so many shareholders in unlisted companies, it could be structured in a manner that gives the shareholder a greater degree of certainty than that which is on offer at present.
Kevin S Slevin, FTII TEP is a tax partner with chartered accountants Francis Clark and is the author of the Institute of Chartered Accountants in England & Wales' Tax Digest on Taper Relief available in March 2001 from ABG Publishing Ltd. Kevin can be contacted on 01752 301010 or kss@francisclark.co.uk.
