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I have a client who owns two small trading companies. It is anticipated that both companies should just about break even each year.
The sole director/shareholder wants to sell one company to the other and has had it valued at £100,000 (based on its turnover). His idea is to create a loan account in the purchasing company and draw on it when the company has sufficient funds. It seems to me that this is clearly within TA 1988, s 703 territory.
Neither company will have any reserves at the point of sale, so how will HMRC seek to tax it?
I have a client who owns two small trading companies. It is anticipated that both companies should just about break even each year.
The sole director/shareholder wants to sell one company to the other and has had it valued at £100,000 (based on its turnover). His idea is to create a loan account in the purchasing company and draw on it when the company has sufficient funds. It seems to me that this is clearly within TA 1988, s 703 territory.
Neither company will have any reserves at the point of sale, so how will HMRC seek to tax it?
If they decide to tax it as income on the grounds that it relates to future receipts of the company, then will they raise Schedule D, Case VI assessments every year in which money is drawn out of the loan account? Presumably this will be taxed on the director in the same way as a dividend, so he will get the 10% tax credit.
Also, will the company have non-corporate distribution rate issues? Readers' views are welcomed.
Query T16,710 — Joiner.
Reply by Edmund:
Joiner is correct that this is the type of transaction which will interest HMRC's Business Tax Clearance Team. Joiner's client will have obtained a tax advantage as a result of a transaction in securities in one of the set of circumstances set out in TA 1988, s 704. It will be open to him to seek advance clearance of the transaction under the procedure in TA 1988, s 707 if he requires certainty of the tax treatment.
Some practitioners may be under the impression that one of the conditions for s 703 is for the taxpayer to obtain access to a company's distributable reserves. However, case law shows this is not necessary. The sale of shares in one company to another under the taxpayer's control was held to be a transaction in securities in the case of CIR v Cleary 43 TC 399. This is one of the types of situation which local officers are asked to report to HMRC's Section 703 group (see Company Tax Manual, paragraph c in CT3687a).
This query bears a close resemblance to the Cleary case mentioned above. In that case, two sisters owned all the shares in two companies and sold all the shares in one to the other. It was held that the 'tax advantage' mentioned in the legislation was not merely a reduction in the profits available for distribution, but also the reduction of assets available for payment of a dividend in cash. By arranging for the second company to buy the shares in the first, cash had been extracted by the sisters which otherwise could have been available for the payment of a dividend.
Whilst some commentators find this to be a tortuous construction of the legislation (see Bramwell's Taxation of Companies and Company Reconstructions at E6-203), it remains a point that HMRC can be expected to take. The tax advantage arises at the time that the cash is taken, rather than at the time of the sale of the shares. This was established in the case of CIR v Parker 43 TC 396.
Joiner's case appears to fall in the circumstances outlined in TA 1988, s 704, paragraphs D and E. We have unquoted companies and, as a result of the sale of shares, the shareholder will receive a sum of cash by way of capital that would otherwise be available for distribution.
We are left to consider whether the 'escape clause' will operate. Was the transaction undertaken for commercial reasons? On the face of it, no such reason can be ascertained.
TA 1988, s 703(3) requires HMRC to issue an income tax assessment to cancel the tax advantage obtained, in this case the drawing on the loan account. The amount of the assessment will be equal to the highest rate of income tax applicable if he had received the amount as a qualifying distribution. If a higher-rate taxpayer, this will be a Schedule F dividend at 32.5% of the amount received, less a notional tax credit of 10%; i.e. an effective rate of 25% of the amount received. This is not necessarily an assessment under Schedule D, Case VI. The reference in the legislation to Schedule D, Case VI appears to refer to the case where the advantage is nullified by requiring the amount received to be returned to the company; the return is then to be chargeable on the company under Schedule D, Case VI. There is a question of whether any credit should be given for the amount of capital gains tax to which the taxpayer will have been liable as a result of the original sale of the shares in company A. Whilst the legislation contains no direct relieving mechanism, it is understood that — in practice — credit will be given (see the Company Tax Manual at CT3685a and CT3686).
This does not seem to be a 'distribution' by the company to be taken into account for non-corporate distribution purposes. It is merely taxed on the shareholder receiving the tax advantage at an amount calculated by reference to the amount of income tax due if he had received a dividend. I do not think that this makes it a distribution.
Reply by Hodgy:
The facts of this case bear a close resemblance to those in CIR v Cleary 44 TC 399. In that case, two individuals owned two companies one of which was cash rich and had reserves. The cash-rich company acquired the entire share capital of the other company for cash and it was held that this transaction was caught by the transactions in securities legislation at TA 1988, s 703. Therefore, the proceeds for the shares were taxed as dividends.
Consequently, Joiner is concerned that s 703 could apply to the transaction proposed by one of his clients. The difference perceived by Joiner is that neither the company whose shares are to be purchased nor the purchasing company have any distributable reserves and nor are they making a profit at the moment. Thus, the purchasing company could not have paid a dividend to the clients instead of buying the shares, and so the question is raised as to whether s 703 can apply and, if not, what would happen?
The legislation refers to the receipt of an abnormal dividend, but no dividend can be paid as there are no reserves. TA 1988, s 704 sets out various circumstances, one of which must apply for the legislation to bite. I would refer Joiner to HMRC's Company Taxation Manual at reference CT3683a, which deals with circumstance C. That paragraph states that the consideration must represent the value of assets available for distribution by the company apart from one caveat that I will come to shortly. It goes on to say that, in practice, the circumstance is unlikely to apply unless the company has (or recently had) at least some distributable reserves. This wording comes up again throughout this section of HMRC's guidance.
I mentioned a caveat which is that s 703 can apply if there are no reserves if the consideration is received in respect of future receipts of the company or represents the value of trading stock of the company.
Taking a step back, I wondered why this transaction is to take place, as if the companies continue as they are just breaking even, how will the purchasing company be able to repay the director's loan? The transaction only makes sense if the purchasing company will start to make profits as in that case, the loan can be repaid and money that would otherwise have been tied up in share capital is paid out to the client.
As the value of the target company is based on turnover, does this mean that the payment for the shares is out of the future receipts of the company? I would say that this is unlikely, because otherwise why would the manuals say that the legislation is unlikely to apply unless the company has (or recently had) at least some distributable reserves? I would suggest that for such an analysis to make sense, the words 'or may have' would need to be inserted between the words 'recently had' and 'at least'.
The best way to get some clarity on this issue will be to submit a clearance letter under TA 1988, s 707 as to whether the transactions in securities legislation does apply.
If HMRC give clearance that s 703 does not apply, then the sale of the shares will simply be taxed as a capital gain. The potential problem for the client in those circumstances is that he could end up with a fair-sized tax bill, but if the companies have not started to make any profits to allow the director's loan to be repaid in full or in part, how is this tax bill to be met?
Extract from reply by Brumus:
The circumstances of TA 1988, s 704D (as linked to ss 704C and 704B) appear to apply. TA 1988, s 703(3) then states that ' Where this section applies to a person in respect of any transaction or transactions, the tax advantage obtained or obtainable by him in consequence thereof shall be counteracted by such of the following adjustments, that is to say an assessment ...'. As the point of s 703 is the 'cancellation of tax advantage', I cannot see why the non-corporate distribution rate should not apply.
