Pete Miller of Ernst & Young LLP looks at the recent developments arising from the amended EU Mergers Directive

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1 1 of 5 06/07/ :45 Published on Tax Journal ( Home > EU Mergers Directive EU Mergers Directive EU Mergers Directive Date: Author(s): 10 December 2007 Pete Miller Pete Miller of Ernst & Young LLP looks at the recent developments arising from the amended EU Mergers Directive Pete Miller of Ernst & Young LLP looks at the recent developments arising from the amended EU Mergers Directive FA 2007, s 110 tells us that the Treasury may make regulations amending the Taxes Acts as it considers appropriate in order to make UK tax legislation compliant with the Mergers Directive. Those regulations were trailed in a consultation document dated 10 November 2006 and the regulations were laid on 9 November So why do we have to change UK tax law again and what do the changes mean? Background The main drivers for the recent changes are the 2005 amendments to the European Mergers Tax Directive (90/434/EC amended by Directive 2005/19/EC, referred to here as the EMTD) and the enactment of the 10th Company Law Directive on cross-border mergers of limited liability companies (2005/56/EC, 26 October 2005). The original EMTD, 'on the common system of taxation applicable to mergers, divisions, transfers of assets and exchanges of shares concerning companies of different Member States', was not fully implemented in the UK. While UK companies were able to merge by one company transferring assets to another (a process described in the Directive as 'dissolution without winding up'), under CA 1985, ss 425 to 427, the UK legislation did not permit mergers with non-uk companies. And the European Commission did not require full implementation of the EMTD by Member States whose domestic legislation did not permit cross-border mergers. Following the enactment of the Cross-Border Mergers Directive, it was therefore necessary to amend UK company law to permit cross-border mergers of limited liability companies. UK tax law therefore also required amendment, as the EMTD means that cross-border mergers should carry no greater tax burden than a domestic merger. The 2005 amendments to the EMTD itself included the introduction of the 'partial division', being 'an operation whereby a company transfers, without being dissolved, one or more branches of activity, to one or more existing or new companies, leaving at least one branch of activity in the transferring company, in exchange for the pro rata issue to its shareholders of securities representing the capital of the companies receiving the assets and liabilities '. This looks very like a demerger in UK tax terms. And the EMTD was also amended to cover transfers of registered office of a company between Member States. These amendments were to be brought into domestic law by 1 January 2007, which is the starting date for the new UK tax regulations, notwithstanding their actual introduction in November 2007! The amended EMTD also incorporated the legislation required to cover European companies (Societas Europeae, or SE), which was enacted in UK tax law in FA (No 2) 2005, and the new European Cooperative Societies (SCEs). Amendments to UK tax law to cover SCEs are included in the current regulations and are retrospectively effective from 18 August 2006.

2 2 of 5 06/07/ :45 Finally, the HMRC consultation document tells us that there was an element of uncertainty as to whether 'capital gain', within the meaning of the EMTD, includes a gain on the transfer of an asset representing a loan relationship or derivative contract, in the course of a transfer of assets as defined in the EMTD. That element of uncertainty is resolved by including within the new regulations provisions to apply specifically to EMTD transactions involving transfers of loan relationships or derivative contracts. The Changes Partial Divisions Changes to encompass the new 'partial division' are made to TCGA 1992, ss 140A and 140C, both of which were themselves enacted in 1992 to implement the original EMTD into UK tax law. The first change we see is that ss 140A and 140C are amended to refer to 'business', rather than to 'trade'. This welcome relaxation of the rules arises because 'partial division' is defined by the EMTD as involving the transfer of a 'branch of activity'. Since there is no stipulation in the Directive that the 'branch of activity' be a trade, references to trade are being removed and replaced by references to a business. In order to cover partial divisions, the amendments to s 140A will permit the incorporation of a UK permanent establishment by an EU-resident company. There can be one or more transferee companies, at least one of which must be resident in a Member State other than that of the transferor. The transferor must continue to carry on a business after the incorporation of its UK PE and the business transferred to the transferee must continue to be a UK PE, unless the transferee is a UK company. Finally, the consideration for the transfer must be an issue of shares or debentures of the transferee to the transferor. There is an exception to the rule relating to the consideration where the issue of such shares or debentures would fall foul of company law preventing a company acquiring its own shares or issuing shares to itself (although it is hard to see when this might be an issue). Given that s 140A(1) already applies to the transfer of the whole or part of a UK trade to another company, it is unclear what this change achieves that was not already available. However, HMRC has said on a number of occasions that, while existing tax legislation might already be compliant with EU legislation, it would prefer to enact specific EU-compliant rules to be certain that all situations are properly covered. (Indeed, there is a strong argument that TCGA 1992, s 171 already ensures that transactions of the type described in s 140A would anyway be tax-free and that s 140A itself is otiose). In s 140C the amendments will permit the incorporation of a non-uk permanent establishment by a UK-resident company, so long as at least one transferee is resident in a Member State other than the UK. The aggregate of total gains and losses is then taken and ICTA 1988, s 815A applies to the net gain, to relieve from UK taxation any tax that would have been charged in another Member State but for the implementation of the EMTD in that Member State. The UK transferor must continue to carry on a business after the incorporation of its PE and the consideration for the transfer must be an issue of shares or debentures of the transferee to the transferor (again, subject to the same relaxation where company law prohibits a company acquiring its own shares or issuing shares to itself). As with s 140A, given that s 140C(1) already applies to the transfer of the whole or part of a non-uk trade to another company, it is unclear what this change achieves. By virtue of new s 140DA these partial divisions will be treated as schemes of reconstruction within TCGA 1992, s 136 to the extent that they would not naturally fall to be schemes of reconstruction anyway. Similar provisions are inserted in respect of loan relationships (FA 1996, Sch 9, new paras 12D et seq), derivative contracts (FA 2002, Sch 26, new paras 30D et seq) and intangible fixed assets (FA 2002, Sch 29, amended paras 85 and 87). There are consequential amendments in a number of areas. Where the assets transferred in a business transfer under s 140A or s 140C are shares (that is, where the PE being incorporated itself owned shares in a company) and those shares carried a gain held over under s 140, the transfer of the shares in a partial division will not bring into charge the s 140 heldover gain. Instead, new s 140(6AA) tells us that the gain continues to be held over until there is a disposal by the new transferee company.

3 3 of 5 06/07/ :45 Similarly, where shares are transferred in a business transfer under s 140A or s 140C and a company ceases to be a member of a group as a result, TCGA 1992, new s 179(1AA) ensures that no degrouping charge arises. And if the company becomes a member of another group, the two groups are treated as being the same group. Again, similar provisions are inserted into the legislation covering loan relationships, derivative contracts and intangible fixed assets. TCGA 1992, s 154 is amended to ensure that a transfer of wasting assets with heldover gains does not crystallise those gains in a business transfer under s 140A or s 140C. ICTA 1988, s 213A is inserted into the demergers legislation and provides that partial divisions within ss 140A(1A) and 140C(1A) that are carried out by way of distribution will be exempt distributions. CAA 1992, s 561, which provides for tax-free transfers of assets on incorporation of UK PEs of non-uk companies, is amended to cover partial divisions too and again is amended to refer to a business and not a trade. Mergers Sections 140E to 140G were enacted in 2005 to comply with the European Company Statute. They were specifically designed to permit the formation of SEs by merger. These provisions are now extended to cover general cross-border mergers to form limited companies, SEs and SCEs. Specifically, s 140E is amended to cover: the merger of two or more companies resident in different Member States, one of which is the UK or has a UK PE, to form an SE resident in the UK or with a UK PE; the merger of two or more co-operatives resident in different Member States, one of which is an Industrial and Provident Society, to form an SCE resident in the UK; the merger of two or more companies resident in different Member States, one of which is in the UK or has a UK PE, into a company resident in the UK or with a UK PE, so long as the transferor ceases to exist otherwise than by liquidation; the merger of two or more companies resident in different Member States, one of which is in the UK or has a UK PE, to form a new company resident in the UK or with a UK PE, so long as the transferor ceases to exist otherwise than by liquidation. In each case there must be a transfer of assets by one or more companies in consideration for the issue of shares by the transferee company to the shareholders of the transferee company (subject to any company law that prohibits a company acquiring its own shares or issuing shares to itself). Any transfer of assets is treated as occurring at no gain no loss consideration, unless s 139, which has the same effect, would apply anyway. Similarly, s 140F is amended to cover: PE, to form an SE resident in a Member State other than the UK; the merger of two or more co-operatives resident in different Member States, one of which is an Industrial and Provident Society, to form an SCE resident in a Member State other than the UK; PE, into a company resident in a Member State other than the UK, so long as the transferor ceases to exist otherwise than by liquidation; PE, to form a new company resident in the UK or with a UK PE, so long as the transferor ceases to exist otherwise than by liquidation. In each case there must be a transfer of all the assets and liabilities of the business of the non-uk PE to the transferor company in consideration for the issue of shares by the transferee company to the shareholders of the transferee company

4 4 of 5 06/07/ :45 (subject to any company law that prohibits a company acquiring its own shares or issuing shares to itself). The aggregate of total gains and losses is then taken and ICTA 1988, s 815A applies to the net gain, to relieve from UK taxation any tax that would have been charged in another Member State but for the implementation of the EMTD in that Member State. Section 140G gives the shareholder-level relief for such transactions, which are treated as schemes of reconstruction within TCGA, s 136 if they are not already schemes of reconstruction within that provision. Sections 140E, 140F and 140G are all subject to the tax avoidance and bona fide commercial tests and statutory clearances are available. Similar provisions are inserted in respect of loan relationships (FA 1996, Sch 9, new paras 12B et seq), derivative contracts (FA 2002, Sch 26, new paras 30B et seq) and intangible fixed assets (FA 2002, Sch 29, amended paras 85A and 87A). Again, there are consequential amendments in a number of areas. ICTA 1988, s 209(1), relating to company distributions, is amended so that, where there is a distribution of assets in a cross-border merger transaction and the distributing company then ceases to exist in the course of the merger (without being wound up), the distribution is treated as a distribution in respect of share capital in a winding up, not as an income distribution. Where the assets transferred in a merger under s 140E are shares and those shares carried a gain held over under s 140, the transfer of the shares in a merger will not bring into charge the s 140 heldover gain. Instead, amended s 140(6B) tells us that the gain continues to be held over until there is a disposal by the new transferee company. Similarly, where shares are transferred in a merger under s 140E and a company ceases to exist or ceases to be a member of a group as a result, TCGA 1992, amended s 179(1B) and (1C) ensure that no degrouping charge arises. And if a company becomes a member of another group, the two groups are treated as being the same group. Similar provisions are inserted into the legislation covering loan relationships, derivative contracts and intangible fixed assets. TCGA 1992, s 154 is amended to ensure that a transfer of wasting assets with heldover gains does not crystallise those gains in a merger under s 140E. CAA 1992, s 561A, which provides for tax-free transfers of assets on mergers to form SEs, is amended to cover all mergers within s 140E too and again is amended to refer to a business and not a trade. SCEs Since an SCE is a new type of entity for the UK, the rules for company residence are also amended, from 18 August 2006, to encompass residence of SCEs. Amended FA 1988, s 66A provides that the an SCE that has its registered office in the UK will be tax-resident in the UK and will not cease to be so even if the registered office is moved to another Member State. Under normal principles we would only expect it to cease to be UK-resident for tax purposes if the control and management moved too. General provisions for transparent entities On 21 March 2007 HMRC published a further technical note about the implementation of the EMTD in relation to transparent entities, including SCEs. While certain entities listed in the EMTD are considered transparent for UK tax purposes, the EMTD provides that for EMTD purposes only (that is, where such an entity is involved in a merger, division, partial division, etc) the Member State must treat it as an opaque company. However, an amendment to the EMTD allows Member States not to apply such treatment where it considers either the transferor or transferee as non-resident and transparent. This carve-out must, however, in specific circumstances be accompanied by a notional tax credit for the shareholder or interest holder in the transparent entity. That is, where a UK tax charge would arise on the transaction, a tax credit is given for the tax that would have been paid in the other Member State involved but for the operation of the EMTD in that Member State. The UK has decided to use the carve-out and the regulations introduce the appropriate legislation as new ss 140H to 140L (for chargeable assets), FA 1996, Sch 9, paras 12H to 12J (for loan relationships), FA 2002, Sch 26, paras 30G to 30L (for derivative contracts) and FA 2002, Sch 29, paras 85B to 85D (for intangible fixed assets). The general approach is that the

5 5 of 5 06/07/ :45 new legislation disapplies the relevant EMTD provision but mitigates the UK tax charge by the notional tax credit from the other Member State. Form Of Implementation Both the HMRC discussion papers referred to the 'extremely small number of companies that have made use of the current range of EMTD transactions' and to 'the considerable extent of legislative change involved'. Therefore the Government concluded that it could not justify putting these amendments through the Finance Bill process. This is why the legislation is brought forward through secondary legislation, by the insertion of the enabling provision, FA 2007, s 110. Some people might be concerned that the new provisions have escaped Parliamentary scrutiny. That said, there are those who have seen the process in action who would question whether Parliamentary scrutiny of such technical provisions adds any value to the process. In that context, the provisions have instead been subject to scrutiny by people who understand the provisions and who have a real interest in making them work properly: to wit, taxpayers and advisers as well as HMRC policy-makers. My personal view is that this will have added more value than a Standing Committee debate. That said, now that the regulations have been introduced, perhaps the logical next step would be to introduce the amendments as primary legislation in the next Finance Bill, without further debate. As an aside, the new regulations also include a piece of legislative tidying. TCGA 1992, ss 116(8A) and (8B) are repealed and re-enacted as FA 1996, Sch 9, para 12G on the basis that these are really loan relationship provisions, not capital gains provisions. One or two observers have questioned whether this change, minor though it seems, is within the defined scope of s 110. If these changes are outside that scope, it may be that those parts of the regulations are not valid! Conclusions For the Eurosceptic these changes might represent more creeping Europeanisation of the UK tax code. To most of us working in business, however, the changes are generally welcome. In the non-tax context the ability to carry out cross-border mergers (and, indeed, domestic mergers) may well be a useful tool in an increasingly globalised business environment. And it is vital that domestic tax rules do not stand in the way of commercial cross-border transactions. Furthermore, as a personal view, I welcome the process whereby the rules were subject to consultation and public scrutiny, as this gives greater certainty that the rules are 'fit for purpose'. Issue No: 913 Categories: CGT, Compliance, Corporate taxes, Corporation tax, Groups, OMBs, Partnerships, Private business taxes, Private client taxes, Transactional tax Source URL: