Tax by Telepathy

By | 9 June 2009

How many people genuinely thought that they would see the day when business taxpayers with cash flow problems could spread or defer tax liabilities simply by picking up the telephone and having a quick chat with a friendly HMRC representative?

If someone had told me a couple of years ago that an HMRC service would exist to make late payments easier and more convenient, I probably would have thought that they were a few pages short of a tax return.

Businesses need all the help and support they can get in the current, very difficult, economic climate.

The number of taxpayers helped by the Business Payment Support Service suggests that HMRC are doing their bit in respect of paying tax bills.

However, what about applications for statutory clearances, such as on a company reconstruction?

Are HMRC taking a more pragmatic approach to clearance applications in these difficult conditions? Unfortunately, it would seem not.

I am not suggesting for one moment that HMRC should be granting clearances just to boost the economy, where they would not otherwise be granted.

Tax avoidance is tax avoidance, whether the economy is booming or in recession.

However, I sometimes wonder whether HMRC could be more understanding of the harsh commercial realities of running a business in the present climate, and also the necessity for some businesses to do (legally) whatever it takes to stay afloat.

Whose choice?

If there are two possible ways to undertake a commercial business transaction, can HMRC require taxpayers to adopt the less attractive route from a tax perspective?

Last year, I reported on a Meeting Point made by Alun James of Temple Tax Chambers about clearances on company reorganisations (Practical tax planning for wealthy individuals and SMEs).

Alun’s observation was that HMRC’s clearance and counteraction team may ask a series of questions when considering clearances, such as the following:

  • Whether the transaction planned would be carried out even if no sale of part of the business were in prospect.
  • What alternative arrangements the company considered which would give the same commercial outcome.

Alun also observed that if a business sale were in prospect, the purchaser may be able to help in terms of securing clearance by insisting on a prior reorganisation.

It would seem both logical and sensible for HMRC to grant clearance in cases where vendor and purchaser are unconnected and there has been no negotiation or consultation between the parties about the manner of the acquisition.

However, the vendor is not necessarily assured of obtaining HMRC clearance even in those circumstances.

Deal or no deal

Suppose, for example, that prospective purchasers engage business agents to find them a target business in a specific part of the country to expand their existing activities. The agent spots a suitable business outlet in the ideal location.

The target business is owned by a company which also operates a second business.

The purchasers instruct the agent that they only wish to acquire one of the company’s businesses. They will not consider an asset purchase, and will therefore only acquire the target business from the vendors on the basis of a share sale.

The agent approaches the company’s shareholders and communicates the purchaser’s offer.

The company owners accept the offer because they need the funds to inject into the second business, having been unable to secure further borrowings. The second business commenced recently and made an initial loss, but shows good potential.

The vendors’ advisers send a statutory clearance application to HMRC for the company’s second business to be transferred to a new company (Newco), in exchange for the issue of shares in that company to the existing company’s shareholders.

The advisers expect the immediate tax treatment for the company and its individual shareholders to proceed as follows:

  • Shareholders: their shares in Newco will ‘stand in the shoes’ of the old shares on the basis that reconstruction relief is available (TCGA 1992, s 136, Sch 5AA). In addition, the advisers expect that the income tax anti-avoidance rules regarding transactions in securities (ITA 2007, s 684) will not apply to the proposed transactions. Any income distribution to the shareholders in respect of the loss-making second business transferred to Newco is considered to be minimal. Clearance for a statutory demerger is not sought, because a sale of the target company is in prospect.
  • The company: the transfer of the existing company’s second business to Newco will be on a no gain, no loss basis as far as corporation tax on chargeable gains is concerned (TCGA 1992, s 139). In addition, any intangible fixed assets will be transferred on a tax neutral basis (CTA 2009, s 818, previously FA 2002, Sch 29, para 84).
    The clearance application is not concerned with whether the various tax relief conditions are satisfied, because that is a question of fact.

The purpose of the clearance is to obtain confirmation that HMRC are satisfied that the proposed transactions are being undertaken for bona fide commercial reasons, and are not part of a scheme or arrangements that have tax avoidance as their only or main purpose.

Each of the above tax provisions effectively has a statutory clearance facility (TCGA 1992, ss 138, 139(5), ITA 2007, s 701, CTA 2009, s 832 (previously FA 2002, Sch 29, para 88)).

The vendors are content with the purchaser’s preference to buy the company’s shares rather than its assets, as they hope that the share sale will result in an effective capital gains tax rate of around 10% on a sale of the target company’s shares, with entrepreneurs’ relief being available in full.

This compares favourably with the position if the company sold the target business, resulting in a corporation tax charge at the company’s marginal rate, with additional tax liabilities as and when the net sale proceeds are extracted by the shareholders as bonuses or dividends.

The clearance application submitted to HMRC by the vendors’ advisers explains the background circumstances in some detail, emphasising that the vendor and purchaser are unconnected, that the purchaser’s approach was unsolicited, and that the purchasers will only consider an acquisition of the target company’s shares.

Who knows?

It had been assumed by the vendors’ advisers that obtaining clearance from HMRC would be something of a formality, so they were rather perplexed when HMRC responded by listing numerous questions, including the following:

  • Why do the potential purchasers prefer to buy the company’s shares rather than the target business?
  • Is there anything to prevent the target business being sold at asset level by the company?
  • What alternative transactions (if any) were considered, and why were they discounted?
  • What are the relative asset values, turnovers, costs and profits of the company’s businesses?

The vendor’s advisers were quite staggered by the first of the above questions in particular. After all, it was made quite clear to HMRC that there had been no negotiations or discussions between the vendors regarding the manner of the proposed transactions.

It was a straightforward case of the purchasers acquiring the shares or nothing. How were the vendors supposed to know the answer to that question?

The advisers questioned whether HMRC could dictate the form that commercial transactions take. Can they refuse clearance on a share sale, but give clearance on an asset sale?

As mentioned, there are generally two requirements to be satisfied before HMRC will grant clearance on a company reconstruction.

The income tax, capital gains tax and intangibles provisions mentioned earlier contain similar requirements, which are broadly as follows:

(a) the transactions are effected for bona fide commercial reasons; and

(b) they do not form part of a scheme or arrangements, of which obtaining a tax advantage is an only or main purpose.

Bona fide

With regard to the ‘bona fide commercial reasons’ test, there is often more than one way to achieve a particular business outcome. If one of those ways is more tax-efficient or beneficial than the other, is it any less commercial?

In CIR v Brebner 43 TC 705, Lord Upjohn in the House of Lords made the following observation:

‘No commercial man in his senses is going to carry out commercial transactions except upon the footing of paying the smallest amount of tax involved.’

Subsequently, in Snell v HMRC [2007] STC 1279, the taxpayer sold company shares for consideration including loan notes, and claimed that TCGA 1992, ss 135 and 127 to 131 applied to treat the loan stock as the same asset as the company shares.

This had the effect of deferring the chargeable gain until the loan notes were redeemed. The taxpayer left the UK to live abroad, and redeemed the loan notes while not resident in the UK.

The Revenue assessed the taxpayer to capital gains tax on the basis that TCGA 1992, s 137 disapplied the share exchange provisions.

The taxpayer’s appeal was dismissed as the exchange of shares for loan notes was held to be part of a scheme or arrangements, of which a main purpose was the avoidance of liability to CGT.

However, the Revenue had cross-appealed against the Special Commissioners’ decision that the exchange was effected for bona fide commercial reasons. The Court of Appeal dismissed the Revenue’s cross-appeal.

Sir Andrew Morritt C held:

‘I can see no reason why Parliament should have been concerned with whether the same result might have been achieved by some other legal form or means.’

He added:

‘The question is whether ‘the exchange in question … is effected for bona fide commercial reasons. If the answer is in the affirmative it is irrelevant to consider the reasons why the parties chose to structure their transactions in that way.’

Tax advantage

The requirement in (b) is independent of (a), and is outside the scope of this article.

However, it is worth noting in the context of the above example that the clearance application is being made by (or on behalf of) the vendor shareholders, and only in respect of the proposed transactions. HMRC are required to base clearances on the facts and circumstances presented to them.

A clearance notification in response to an incorrect or incomplete application cannot be relied upon, and it is surely not within HMRC’s remit to seek evidence that the information presented is true and correct.

In the above example, there is a potential tax advantage for the shareholders as the anticipated capital gains tax rate of around 10% is much lower than, say, the 25% higher rate income tax charge if the net sale proceeds were distributed as a dividend following an asset sale.

On the other hand, how likely is it that an unconnected third party purchaser would direct that the deal be structured as a share purchase with the only or main intention of conferring an income tax advantage on complete strangers?

It is possible that a purchaser could negotiate a lower price for the business in return for agreeing to a share sale.

However, if (as in the above scenario) no negotiations took place between vendor and purchaser about the structure of the deal, one would expect the above requirement to be satisfied.

As indicated in a recent Readers’ Forum (Clearance Clarification), HMRC sometimes place a caveat on statutory clearances, e.g. that the notification ‘does not extend to the sale or liquidation of Newco’.

However, the sale or liquidation of Newco will not normally be contemplated when the clearance application is made for the reorganisation, and is not the subject of the application in any event, so it is probably unsurprising that HMRC’s clearance notification does not extend that far.

Life in the real world

In the case mentioned, HMRC’s clearance adviser said that he would grant clearance if the vendors could produce a letter from the purchasers, confirming that the proposed transactions were at the purchaser’s insistence.

Both sides were slightly bemused by this request. However, the business sale was subject to a tight timescale.

There was no time for the vendor’s advisers to challenge the validity of HMRC’s request.

It was therefore with some trepidation that they contacted the purchaser’s advisers and explained the situation, in the hope of securing the purchaser’s cooperation. Thankfully, the purchasers duly produced a letter for HMRC’s benefit.

The letter effectively verified that what HMRC had been told about the proposed transactions was complete and correct. After a long and unforeseen delay, HMRC finally granted a positive clearance.

Is it right and proper that the vendor should be required to establish the purchaser’s reasons for undertaking a business transaction in a particular way? On the basis that the clearance application relates to the vendor, and that the conditions for clearance must be satisfied by the vendor, the answer must seemingly be no.

If that is wrong, how likely is it that the commerciality test will not be satisfied in an arm’s length transaction with an unconnected third party? As pointed out by the Special Commissioner in Lloyd [2008] SpC 672:

‘The issues for me are first whether the transaction was carried out for bona fide commercial reasons; it is not whether it was a bona fide commercial transaction, which is more objective’.

The above scenario is based on a real case. No doubt many other advisers will have their own stories about clearance applications which have been unduly protracted and difficult. Business sales are often stressful and subject to strict timetables.

The adviser may not have time to argue with HMRC, and there is no formal mechanism to appeal against HMRC’s refusal to give statutory clearance. Some business deals will not be structured as HMRC would prefer.

Doubtless some will be virtually forced into considering deals that would not have been contemplated a year or two ago. HMRC needs to be aware of the changing business climate when considering issues of commerciality in clearance applications.

The above article was first published in Taxation, 7 May 2009.