Changing Tack

A transaction did not amount to a reconstruction, ruled the High Court in Fallon and another (executors of Morgan, deceased) v Fellows.

A limited company, F&M, carried on a locks and pressing business through several divisions. Two groups of shareholders owned the shares in the company, and they wanted to divide the company, so that the group of shareholders headed by Norman Morgan took the locks division, and the other group, headed by Barrie Morgan, took the pressings business. So in April 1980, two shell companies were acquired and named Locks and RH Morgan. The shares in F&M were reorganised so that the Norman Morgan group's shares became A shares, and the Barrie Norman group's shares became B shares, with respective rights streaming through to the underlying business of the locks and pressings divisions.

F&M was put into liquidation, and the liquidator transferred the undertakings and assets of the locks division to Locks in consideration of shares in Locks which were issued directly to the A shareholders, and the undertakings and assets of the pressings division to R H Morgan in consideration of shares in R H Morgan issued directly to B shareholders.

In 1987, Norman Morgan and his wife disposed of their shares in Locks for some £1.5 million. The Revenue assessed Norman Morgan to capital gains tax on the basis that the base value of the shares in Locks was the base value of the shares in F&M, since the shares in Locks had been acquired under an arrangement within section 86, Capital Gains Tax Act 1979 (now section 136, Taxation of Chargeable Gains Act 1992).

Section 86 applied where an arrangement was entered into between a company and the shareholders for the purposes of or in connection with a scheme of reconstruction, and under the arrangement another company issued shares to those persons in respect of and in proportion to their holdings of shares in the first company.

In 1994, Mr Morgan died. His executors appealed against the 1988 capital gains tax assessment, on the ground that section 86 did not apply, as there had been no reconstruction. F&M had been partitioned between the two new companies, and although the Revenue had by concession not charged capital gains tax on the 1980 disposal of F&M shares, the concession had not altered the legal position with regard to the base value of the shares in Locks, which was their market value in 1980.

The Special Commissioners held that there had been a reconstruction, so the executors appealed to the High Court.

(William Massey QC for the executors; Michael Furness QC for the Revenue.)

Mr Justice Park, in another of his beautifully lucid judgments, started by explaining that although the events under appeal happened some time ago, it was a principle at stake, and neither the Revenue nor the executors were blaming each other for the seeming delay. He summed up the question of principle as:

He said further that the taxpayer's claim that the capital gains tax analysis of the 1980 transaction was strictly that Mr and Mrs Morgan made a disposal of their F&M shares at market value, and acquired the Locks shares. The base value of the Locks shares was an uplifted figure derived from current 1980 values. Technically, there was a chargeable gain but, by concession, the Revenue did not charge the tax on that disposal. This, however, did not affect the legal position as to the base value of the Locks shares. They had their own uplifted 1980 base value, and the original base value of the F&M shares was not carried over to the Locks shares to be the deductible base value on a subsequent disposal.

The Revenue argued that in 1980, it probably did think that it was applying an extra-statutory concession by not charging capital gains tax on the Morgans' disposal of shares in F&M, and the concession was not made on condition that the Morgans accepted that the base value of the Locks shares was that carried over from the F&M shares. Thus if the Revenue still thought as it had in 1980, there would be no argument with the taxpayers. However, the Revenue now thought that what it did in 1980 was wrong. The treatment was not concessionary at all, but rather according to the law. So if the Revenue were correct, the strict law said that there was no taxable disposal of the F&M shares, but that the original base value of those shares was carried over to the Locks shares.

The judge said that, in essence, he had to decide whether the 1980 treatment of the shares was concessionary, as both sides then thought, or whether it was in accordance with the law, as the Revenue now believes, but did not in 1980. This all depended on whether section 86 applied to the corporate restructuring which took place in 1980.

Mr Justice Park explained the mechanics of section 86 and said that it only applied if there had been a scheme of reconstruction, so the question was whether transactions of 1980 amounted to a reconstruction.

F&M was, according to the judge, 'a classic subject matter for a press release reconstruction'. This refers to a press release issued by the Revenue on 16 October 1975, which described a procedure whereby a company could be partitioned, but that it would in practice be treated as a scheme of reconstruction, and subject to section 86. Clearance from the Revenue was obtained before the F&M scheme was arranged, although it was a year before it was actually carried out.

Mr Justice Park did not find the Special Commissioners' findings particularly helpful, so said that he would have to form his own conclusions. He disagreed with the taxpayer's first argument that a reconstruction could only involve a single company becoming another single company. However, he agreed with the taxpayer's argument that the transactions were a partition, and could not therefore be a reconstruction. This position was, according to the taxpayer, supported by Brooklands Selangor Holdings Ltd v Commissioners of Inland Revenue [1970] 1 WLR 429. The judge said that while the mechanics of the F&M scheme were different from those in Brooklands, the fundamental point was that both involved a partition.

The Revenue argued that the reclassification of F&M shares into A and B class shares meant that only the A shareholders held shares in the locks business, and only the B shareholders held shares in the pressings business. However, the judge said that this reorganisation was simply part of the scheme, and had not existed before the scheme was adopted. Before the scheme, the shares related to the whole of F&M's business, not just to sections of it.

The judge concluded that the 1980 transaction was not a scheme of reconstruction, and that as a matter of law, section 86 did not apply to it. The Morgans' shares therefore had a capital gains tax base value derived from 1980 values.

Finally, the judge commented on the fact that the taxpayers appeared to be having their cake and eating it, in that they accepted the concessionary treatment meted out to them by the Revenue in 1980, and did not pay capital gains tax on the rise in value of their F&M shares from their original value to their 1980 value, but later decided to insist on their legal rights. The judge said that the Revenue 'probably' accepted, as the judge did himself, that the taxpayers should not be criticised for this.

(Reported at [2001] STC 1409.)

This case could easily be called 'the perils of tax by concession'. It was certainly accepted for many years that 'press release reconstructions' were matters of Revenue extra-statutory practice and it appears that only in more recent times has any debate arisen to suggest that they could actually be within the legal definition of a 'reconstruction'. The solution provided by Mr Justice Park is that if the dividing of a company's share capital, together with the division of its business between the new groups of shareholders, takes place as part of the scheme to transfer those assets out to new separate companies, then that cannot be a reconstruction for tax purposes. If, however, the company has been running in separate divisions for some time, with separate groups of shareholders allocated the results of the separate divisions, there is a much stronger argument that splitting the company into separate new companies is a reconstruction. Of course questions would still arise as to how long the company must be run first with an internal division, but the basic test for this would be whether or not the division is all part of an intended press release reconstruction.

Under the 2002 Budget proposals, we now expect the position to be regulated by new legislation, to replace the Revenue practice. It will be interesting to see how the legislation squares up with Mr Justice Park's analysis.

Taxpayers can of course no longer achieve what the executors here have done, namely taking the benefit of a concession in relation to capital gains at one stage, and having the strict legal basis applied at a later time. Section 76, Finance Act 1999 was introduced to ensure that any benefit from such tactics is removed.

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