KEVIN SLEVIN FTII, ATT illustrates the conflicts of interests that can arise when tax advisers advise both individual and corporate shareholders of a company. TO GET TO grips with the main point of this article, readers must imagine the following scenario. The article raises issues for the tax practitioner which have not received the attention they deserve. Potentially, the points arising from the example have far-reaching implications for all those advising individual and corporate shareholders of the same company.
KEVIN SLEVIN FTII, ATT illustrates the conflicts of interests that can arise when tax advisers advise both individual and corporate shareholders of a company. TO GET TO grips with the main point of this article, readers must imagine the following scenario. The article raises issues for the tax practitioner which have not received the attention they deserve. Potentially, the points arising from the example have far-reaching implications for all those advising individual and corporate shareholders of the same company.
Scenario
The decision has been made by the shareholders of Tax Example Ltd (TEL) to explore the possibility of finding a 'trade buyer' to acquire the entire share capital of TEL. The plan is to sell the entire share capital of this unlisted company. The shares in TEL are held as follows:
(1) Mr A holds 35 per cent. He formed TEL and has worked in the business for more years than he cares to remember. The base cost of his shares is £500. Mr A is looking forward to a substantial capital gain.
(2) JJJ Ltd holds 30 per cent. JJJ Ltd is a trading company (no doubt about it). JJJ Ltd acquired its shares in TEL by purchase from the individual who co-founded the company with Mr A. JJJ Ltd is anticipating a substantial capital gain and plans to use the cash generated by the sale to expand its main trading activity, it will, therefore, remain a trading company.
(3) SSS Ltd holds 15 per cent. SSS Ltd is a trading company (no doubt about it). SSS Ltd acquired its shares for £1 million four years ago but now realises that it made a duff investment and wants to cut its losses. SSS Ltd's directors anticipate a substantial capital loss if the transaction goes through. The company has other taxable capital gains against which any allowable loss can be set.
(4) Mr T holds 9 per cent. Mr T inherited his shares on 6 April 2000 and has worked for TEL ever since. He has no connection with any other shareholder.
(5) Mrs G holds 11 per cent. Mrs G, aged 45, has worked on a full-time basis in the company since 1997 and has held her shares for even longer. She hopes to realise a substantial gain when her shares are sold.
The activities conducted by TEL are such that the status of TEL as a trading company has been called into question. The irony is that it is often the companies which have traded most successfully which find they have problems in demonstrating that they are trading companies for the purposes of tax legislation. The problem cases are usually successful companies which have thought it desirable to retain profits for one good reason or another, and have built up a series of assets that are held as investments. Often the same attention to detail that has resulted in the successful trading history has also been applied to good effect to the investment activity. Possibly between five and ten per cent of successful trading companies fall into this category, i.e. they operate on the margins when it comes to being regarded as trading companies for the purposes addressed in this article. The respective position of the shareholders in TEL follows.
Mr A
Mr A believes that TEL has been a trading company throughout the period from 6 April 1998. Accordingly, Mr A expects to pay a ten per cent effective rate of capital gains tax on his capital gain.
Mr A's chartered tax adviser has explained to him that for the period from 6 April 1998 to 16 April 2002, trading company is defined by paragraph 22(1) of Schedule A1 to the Taxation of Chargeable Gains Act 1992 as being a company that 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) apart from any purposes capable of having no substantial effect on the extent of the company's activities.
Furthermore, following Finance Act 2002, a new definition of trading company has been inserted into Schedule A1. With effect from 17 April 2002, under paragraph 22A, 'trading company' means a company carrying on trading activities whose activities do not include to a substantial extent activities other than trading activities. Having reviewed the position, Mr A is cautiously optimistic about TEL's status as a trading company, but his chartered tax adviser is not so sure.
JJJ Ltd
The directors of JJJ Ltd also believe that TEL has been a trading company, or that at least it will be shown to have been so during the relevant period specified in paragraphs 19 and 7 of Schedule 7AC to the Taxation of Chargeable Gains Act 1992. In this example, the relevant period is assumed to be the 12 months ending with the anticipated disposal.
The directors are interested in this because they have been told that, following Finance Act 2002, gains on disposals of 'substantial shareholdings' in 'trading companies' are exempt from corporation tax, providing that it can be shown that TEL was a trading company as defined in paragraph 20 of Schedule 7AC. For this purpose, 'trading company' means a company carrying on trading activities whose activities do not include to a substantial extent activity other than trading activities. The directors of JJJ Ltd are cautiously optimistic about TEL's status as a trading company, and it is no coincidence that their chartered tax adviser also advises Mr A.
SSS Ltd
However, the directors of SSS Ltd are cautiously optimistic that TEL is not a trading company. SSS Ltd is about to make a substantial loss when it realises its investment in TEL, and if the provision relating to substantial shareholdings provisions of Schedule 7AC would apply to exempt any gain (had there been a gain), any loss arising will not be an allowable loss for corporation tax purposes. The directors of SSS Ltd have formed the view that the investment activities of TEL are 'substantial' and will be claiming loss relief accordingly for the capital loss in the accounting period in which it arises.
Mr T
Mr T has been an employee of the company since acquiring his shares on 6 April 2000. His holding is not a material interest in the company (see paragraph 6A of Schedule A1) and therefore he is confidently looking forward to paying a ten per cent effective rate of tax on his capital gain. He knows that either paragraph 6(1A) of Schedule 1A will apply if the company is not a trading company, or that paragraph 6(1) will apply if it is a trading company. How does he know this? He is a chartered tax adviser!
Mrs G
Mrs G does not have the flexibility possessed by Mr T because her holding is a material interest, i.e. greater than ten per cent (see above). Therefore, only if the company has been a trading company throughout the period since 5 April 1998 will she achieve the ten per cent effective rate of tax she is expecting to pay. Mrs G was confident that TEL was within the definition of trading company throughout the period since April 1998 - until she talked to her chartered tax adviser (who knew a lot about the company due to the fact that he also acts for SSS Ltd). It will be difficult for the adviser to continue acting for both SSS Ltd and Mrs G or indeed for SSS Ltd and any other shareholder in TEL, other than Mr T who has no interest in whether or not TEL is a trading company. But there is more to think about.
Contingent problems!
The good news is that an offer is already in the pipeline but, as usual, there is a complication. The interested party is prepared to offer cash plus a wholly unquantifiable earnout to all the shareholders in TEL. The deal looks good but the directors of JJJ Ltd are particularly unhappy. They realise that:
- while any capital gain in respect of the cash element of the consideration (plus the value of the right to receive the contingent consideration) will be exempt from corporation tax,
- they are actually realising a loss which will not be allowable as a result of Schedule 7AC if TEL is a trading company, yet,
- irrespective of TEL's trading status, there will be corporation tax to pay on the amount of contingent consideration actually received.
Although the chose in action will come about as a result of a share transaction which is itself an exempt transaction under the Marren v Ingles [1980] STC 500 principle, it is a separate asset which, alas, cannot be regarded as exempt under Schedule 7AC.
It is hoped that the absurdity of this consideration, which also applies to taper relief, will not continue for much longer. It creates distortions in the marketplace with different shareholders being treated in different ways. Tax will drive a vendor to sacrifice earnout potential for immediate cash consideration, while only the former of the two is exempt.
Complexity
The purpose of this article was to highlight the complexity of the matters under consideration and the clear conflicts of interest where advisers act for more than one shareholder in the same company.
Kevin S Slevin is a tax partner with Solomon Hare LLP, the Bristol based chartered accountants and taxation consultants. Kevin can be contacted on 0117 933 3191, e-mail: kevin_slevin@solomonhare.co.uk.
