The substantial shareholdings exemption (SSE) enacted in the Finance Act 2002 provides an extremely valuable tax relief for corporate disposals of subsidiaries and certain other equity investments.
Previously, UK-based groups usually suffered a tax charge when they sold off their subsidiary companies. This put them at a major competitive disadvantage when compared to the tax exemptions granted by most other jurisdictions. Since 1 April 2002, capital gains realised by UK groups on the sale of their subsidiaries, etc, are exempt from tax provided the detailed conditions laid down in Sch 7AC of the Taxation of Chargeable Gains Act (TCGA) 1992 are satisfied. On the other hand, if the disposal satisfies all the SSE conditions but produces a capital loss, that loss no longer counts as an allowable loss for reducing the company's/group's capital gains (s16(2) TCGA 1992).
I will review the key aspects of the valuable new SSE, which is probably one of the most important in a series of measures that have been introduced in recent years to increase the UK's attractiveness as a location for multinationals. Unless stated otherwise, all statutory references are to Sch 7AC, TCGA 1992.Key SSE conditions
Groups that are now planning to sell their subsidiaries must clearly ensure (as far as commercially possible) that all the relevant preconditions for the SSE would be satisfied. For the main SSE, the key requirements are: 1) The investing company must be a sole trading company or a member of a trading group throughout the 'qualifying period', which begins at the start of the relevant 12-month 'substantial shareholding' period (see (2) below) and ends when the substantial shareholding is sold. It must also be a sole trading company or trading group member immediately after the disposal (para 18). 2) The relevant shareholding investment must qualify as a 'substantial shareholding' held throughout a 12-month period starting not more than two years before the shares are disposed of (para 7). 3) The company in which the shares are held (ie, the investee company) must be a qualifying trading company or qualifying holding company of a trading group throughout the qualifying period defined in (1) above and immediately after the disposal too (para 19). It should be noted that the SSE exemption is not restricted to eligible shareholdings in UK resident companies - it also applies to exempt gains arising on the sale of non-resident subsidiaries, etc.
The SSE is underpinned by an anti-avoidance rule, which is primarily aimed at denying relief on rolled-up income from investments that are treated as a trading activity (such as derivatives). This provision applies where the transaction has been solely or mainly motivated by the SSE and produces a gain entirely or almost entirely relating to untaxed profits. However, the rule in para 5 is widely drafted and potentially catches the sale of any controlling shareholdings, such as shares in a subsidiary. Happily, the Inland Revenue has indicated that this rule would only be used to attack blatant cases - genuine commercial disposals should not be affected.Earn-out deals
Care should be taken on earn-out transactions since the capital gains arising on earn-out payments would not qualify for the SSE. (This is because the actual payments derive from the earn-out right as opposed to the sale of the original shares, following the dicta in Marren v Ingles (1980) STC 500.) In some cases, it may be possible to alleviate this problem by making the deferred consideration ascertainable. The maximum amount payable would then be included in the consideration for the original SSE sale (under s48, TCGA 1992), although this may increase the purchaser's stamp duty liability on the share purchase. If the relevant post-acquisition profits fell short of the required targets, there would be a retrospective reduction in the initial consideration, but the entire transaction would have been tax exempt.Secondary SSEs
There are also two secondary SSEs that provide exemption for the disposal of
• assets relating to shares (ie, options over shares or securities convertible/exchangeable into shares) provided the vendor also qualifies for the SSE (para 2);
• shares that do not qualify for the main SSE at that time if they would have done so on a hypothetical disposal at any time in the previous two years. This relief can only be used if the investing company controls the investee company or a fellow group member (para 3). Hence relief can be claimed where, for example, a (postliquidation) capital distribution is received by the investee company. The capital distribution would trigger a capital gains disposal in the investing company's hands, but clearly the investee company would no longer qualify for the exemption (as it has ceased trading). Consequently, provided the investing company meets the substantial shareholding requirement at the disposal date, para 3 exempts the gain.Investing company conditions
In the two-year period before the sale of the substantial shareholding, the investing company must have been a trading company or trading group member for at least a 12-month period. Furthermore, the investing company must also be a sole trading company or trading group member immediately after the sale (para 18).
The requirement for the investing company to be a trading company (or member of a trading group) immediately after the disposal is likely to deny relief where, for example, a holding company sells its only (trading) subsidiary company. In this case, the holding company would normally be left with the sale proceeds. The Revenue has acknowledged that this may not satisfy the trading company requirement unless the holding company planned to acquire another trade or a significant equity interest in a trading company or group within the near future (see below).Trading company or group
For these purposes, a trading company is a company carrying on trading activities that do not to any substantial extent include non-trading activities (para 20). A company is treated as carrying on trading activities where they are carried on in the course of or for the purposes of its trade. Activities carried out for the purposes of preparing to trade also count. A very helpful extension to the meaning of 'trading activities' embraces activities carried on with a view to:
• acquiring or starting to carry on a trade, or
• purchasing a significant (ie, 51% or eligible joint venture) shareholding in another trading company or trading group.
In such cases, the acquisition must be made 'as soon as reasonably practicable in the circumstances'. This means that a holding company may still qualify for SSE relief if it sells its only trading subsidiary and reinvests the sale proceeds in buying a 51% stake in another trading company.
The 'trading company' definition is based on the one used for CGT business asset taper relief purposes, where the Revenue applies a 20% de minimis limit for non-trading activities. Where a company has non-trading activities or investments, the Revenue may look at a range of possible measures, depending on the facts of the particular case. These are:
• the value of 'non-trade' assets, such as investments
• time spent by management and staff.
All these measures are used to build up the relevant picture, but they are necessarily subjective. The Revenue has indicated that temporary/short-term investment of surplus funds in equities and cash deposit accounts should not prejudice the company's trading status provided such amounts are required for future business purposes, typically where they are earmarked for anticipated working capital or capital investment requirements.
In its Tax Bulletin, June 2001, issue 53, the Revenue indicated (in the context of the identical-taper relief definition) that it may be necessary to build up the correct picture over time and this might involve striking a balance between the above factors. My experience has been that the Revenue has tended to argue that a company does not qualify if it has substantial non-trading assets, even though all the other measures listed above relate completely to trading activities. Although the commissioners may ultimately settle difficult marginal cases, the uncertainty inherent in the trading company test is clearly undesirable. For example, there is a risk that the valuable SSE could be denied where a company has amassed substantial cash balances that do not appear to be necessary for current or future trading purposes.Member of a trading group
A 'trading group' is defined in much the same way as a sole trading company. For these purposes, a group broadly consists of a principal or parent company and its 51% subsidiaries on a worldwide basis.
A trading group is one where, taking all the activities of the group together, it carries on trading activities, ignoring any non-substantial (ie, no more than 20%) non-trading activities (para 21). The legislative requirement to take all the activities of the group together ensures that any intra-group transactions are effectively ignored. For example, making loans or leasing property to another 51% group member is not regarded as an investment/non-trading activity.
It is understood that the Revenue has helpfullyindicated that where the net sale proceeds generated from an SSE sale of a subsidiary are paid out to the parent company's shareholders by way of a dividend within a 'reasonable' period, such amounts would not be treated as nontrading funds. This should usually enable the vendor group to satisfy the trading group test immediately after the disposal as required by para 18(1)(b).Joint venture holdings
Most types of joint venture investments should benefit from the transparency rule in para 23. Without this special rule, a minority shareholding in a joint venture company (JVC) would be regarded as an investment activity, thus potentially prejudicing the shareholder's trading status. Provided the company or group holds at least 10% of a trading JVC's ordinary shares, it is treated as carrying on an appropriate part of the JVC's trade. This would therefore be part of the trading activities carried on by the investee company or group. However, this treatment only applies where five or fewer individual or corporate shareholders hold 75% or more of the JVC's ordinary shares.The 'substantial shareholding' requirement
The SSE is also dependent on the investing company having a substantial shareholding in the relevant investee company throughout a 12-month period within the two years before the shares are disposed of (para 7). It is possible to look through any no gain/no loss transfer (such as an intra-group transfer under s171, TCGA 1992) and include the transferor's period of ownership for the purpose of satisfying the above condition.
The investing company satisfies the substantial shareholding requirement provided it is beneficially entitled to at least 10% of the:
• investee company's ordinary share capital,
• profits available for distribution to the investee company's equity holders (see Sch 18, ICTA 1988), and
• assets that would be distributed on a winding up of the investee company.
If a group's shareholding in the investee company is split among various group members, each members' shareholding can simply be aggregated in order to determine whether the 10% substantial shareholding requirement is satisfied (para 9).Investee company requirements
The investee company in which the shares are held must be:
• a sole trading company or
• a holding company of a trading group (or trading subgroup)
throughout the qualifying period, which runs from the start of the relevant 12-month substantial shareholding period until the disposal date, as well as immediately after the disposal (para 19).
It is clearly important that any non-trading activities carried on by the investee company or group fall below the de minimis 20% threshold, otherwise the disposal would not be protected by the SSE and thus would potentially be exposed to a tax charge.Intra-group or reconstruction transfers
Where shares are transferred to another 75% group company, the normal s171, TCGA 1992 no gain/no loss rule takes precedence and the SSE does not apply (para 6).
Similarly, the corporate gains reconstruction provisions of s139, TCGA 1992 also override the SSE. This means that shares in a (75%) subsidiary distributed under a s110, Insolvency Act 1986 reconstruction scheme or a statutory demerger within s213, ICTA 1988, are transferred to the new successor company on a no gain/no loss basis. However, where a corporate reconstruction falls outside the s139, TCGA 1992 provisions, the transfer of the subsidiary may be relieved under the SSE.Share for share exchanges
The SSE does, however, override the corporate capital gains reorganisation reliefs (para 4). This would typically arise where the investing company sells its subsidiary ( to a non-group company) in exchange for shares. Here, the sale of the subsidiary is tax-free under the SSE, which trumps the share exchange relief in s135, TCGA 1992. The vendor company acquires the new shares at their market value. (The SSE is beneficial, since otherwise under s127, TCGA 1992 there would have been deemed to be no disposal for tax purposes, with the 'new' consideration shares having been acquired at the same time and cost as the old shares. Hence, if a subsequent sale of the new shares did not attract the SSE, the gain on the old shares would be taxed as part of the overall gain.)
A different analysis applies where shares in a group company are transferred to a fellow group member in exchange for a fresh issue of shares. Although the transaction potentially qualifies for share exchange relief under s135, TCGA 1992, para 4(1)(b) deems the transaction to be a disposal for SSE purposes. As the shares are transferred intra-group, this means that the s171, TCGA 1992 no gain/no loss treatment takes precedence over the SSE (see above). The shares would therefore effectively be disposed of at their indexed base cost for tax purposes and the SSE would not apply.Case study
In most cases, considerable work will be required to determine whether the valuable SSE relief can be competently claimed on a particular disposal. An illustrative case study example involving the sale of a subsidiary company is given in Panel 1. Panel 2 summarises the key considerations that would be involved in concluding whether the SSE is available.
Peter Rayney FCA FTII TEP is a tax partner with BDO Stoy Hayward Midlands RBC. He recently received the 'Tax Writer of the Year' award at the Butterworths Tolleys Tax Awards 2002.
1: Case study - example
The Hogwarts Group develops, manufactures and sells pharmaceutical products and potential drugs, making up accounts to 31 December each year. The corporate structure of the Hogwarts Group shown below (indicating the relevant percentage of ordinary share capital and voting rights held for each holding) has remained the same for many years.
All the above companies carry on pharmaceutical trades except Harry Ltd, which specialises in the development of herbal remedies. Leviosa Spa, an Italian resident company, holds the remaining 85% of Broomstick Ltd's ordinary share capital. 20% of Quidditch Ltd is owned by Nimbus Two Thousand plc.
The group is currently considering an offer to sell the entire share capital of Harry Ltd to Wizard plc. The group incorporated Harry Ltd with 100,000 £1 ordinary shares (issued at par) in 1975. It is estimated that Harry Ltd's shares were worth about £500,000 at 31 March 1982. Harry Ltd has never acquired capital assets from other members of the group.
The sale of Harry Ltd is likely to take place on 31 December 2002 and legal heads of agreement for a share sale were finalised some weeks ago. The expected sale consideration is £4m, of which £3m is to be satisfied in cash and £1m in shares in Wizard plc.2: Case study - analysis
The sale of the entire share capital of Harry Ltd should qualify for the SSE. Based on the facts provided, the relevant preconditions for relief appear to be satisfied as follows.
• The investing company, Hogwarts (Holdings) Ltd, qualifies as a member of a trading group for at least a 12-month period in the two years to 31 December 2002 (the disposal date). As all the group members are engaged in trading activities, the group should have little difficulty in satisfying the 'trading group' definition in para 21. Although the 15% shareholding in Broomstick Ltd might appear to be treated as an investment activity, Hogwarts (Holdings) Ltd is deemed to carry on 15% of Broomstick Ltd's trading activities under the special rules for joint venture companies referred to above.
• The entire share capital of Harry Ltd clearly represents a 'substantial shareholding' held throughout the same relevant period.
• Harry Ltd has been a trading company during the relevant period.
Clearly the SSE provides a valuable relief in this case as it avoids an immediate tax liability of around £647,000 on the sale, calculated as follows:
|Sale proceeds - cash element||3,000|
|Less: 31 March 1982 value|
|£500,000 x £3m/(£3m + £1m)||(375)|
|Indexation (March 1982 to date) £375,000 x (say) 125%||(469)|
|Corporation tax thereon at 30%||647|
As the SSE applies to the entire £4m sale consideration, including the part satisfied by the shares issued by Wizard plc, Hogwarts (Holdings) Ltd will acquire the Wizard plc shares at a capital gains base cost of £1m (rather than at a pro rata proportion of its base cost in Harry Ltd's shares).
There are no other tax charges to consider as Harry Ltd has not received any chargeable assets by way of intra-group transfer within the previous six years.