Corporate Tax Groups the Capital Gains Degrouping Rules

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1 Corporate Tax Groups the Capital Gains Degrouping Rules 18 September 2015 This is the third article in our series on corporate tax groups where we explore the rules governing intra-group transactions, and how they are taxed. In this article we shall look at the rules relating to capital assets. What are the degrouping rules and why do we have them? In a nutshell, the degrouping rules are designed to prevent assets from being smuggled out of a group tax free, under the protection of a corporate wrapper. In the first article on corporate tax groups, we discussed the basic proposition that intra-group transfers should be tax neutral, with any gains or losses being triggered only when the asset leaves the group. Without special rules however, this proposition can be circumvented, as the following example shows. V has a property, such as a factory or a warehouse which it intends to sell to P for a price of 10m. The base cost of the property is 6m, which results in a taxable gain of 4m. V would prefer not to pay the tax so what can it do? This is what V does: V establishes a wholly owned subsidiary Newco, subscribing a nominal amount of 1; 1

2 V transfers the property to Newco for a consideration of 10m, satisfied by the latter issuing 10 million shares of 1 each. Since this is an intra-group transfer, no tax is payable, and Newco inherits V s base cost of 6m 1 ; V sells Newco to P for 10m. Again, no tax is payable, since the base cost for the shares is also 10m. This is because the value of the shares issued, matches the value of the property that Newco acquired from V on the intra-group transfer. And that s that. Well, not quite. This type of transaction known as an envelope scheme is prevented by the degrouping rules. These rules apply when a company leaves a group, taking with it an asset acquired from a fellow group member. If the asset was acquired by the exiting company within the previous 6 years, the tax neutral status of the original transaction is revoked and a degrouping charge is triggered. We shall see how this works in a moment. There are in fact, two sets of rules. One set covers capital assets, being the subject of the present article 2, and the other set covers intangibles such as IP and goodwill 3, which shall be the subject of a later article. There are similarities between the two regimes, but also important differences. The legislation for capital assets uses the term company A for the company leaving the group. We shall adopt this terminology in the following discussion. Company leaves the group notional sale and buyback of intra-group asset This is the key concept behind the degrouping rules. On exiting the group, one needs to ask the following questions: Has company A acquired an asset from a fellow group member within the previous 6 years? Does A still own the asset? If the answer to both questions is Yes, company A is deemed to have sold and bought back the asset with the following consequences: A, as a notional seller will incur a degrouping charge. This is the capital gains calculation, with the sale price fixed at the market value prevailing at the date of the original intra-group transfer, and the base cost inherited from its fellow group member. This can result in a loss as well as a gain; A, as a notional buyer, will have a new base cost, replacing the base cost inherited from its fellow group member. This is the notional sale price mentioned above, the market value prevailing at the date of the original intra-group transfer. As we shall see, this is necessary to avoid double taxation. At first glance, the tax charge (or loss) falls on A, the exiting company 4. However, if A leaves the group by means of a share disposal, such as a company sale, the degrouping charge is borne by the seller. This is achieved by adding the degrouping charge to the purchase price in the capital gains calculation for the shares. Gains are added on, and losses are deducted 5. We shall deal with this in further detail below. 2

3 Example why the envelope scheme doesn t work Newco leaves V s group when it is sold to P. So Newco is the A that is referred to in the legislation. The degrouping charge arising on a notional sale of the property is 4m. Calculation of degrouping charge Market value on V-Newco property transfer 10m Base cost of property inherited from V ( 6m) Degrouping charge 4m Because Newco has left the group by means of a share sale, this degrouping charge is added to the sale price when V calculates its tax liability. Accordingly, there is an adjustment to the original calculation: Gain on sale of Newco shares No degrouping rules Degrouping rules Sale proceeds of Newco shares 10m 10m Degrouping charge on Newco sale 4m Adjusted sale proceeds 14m Base cost of Newco shares ( 10m) ( 10m) Gain nil 4m So V ends up with a gain of 4m, which it had originally intended to avoid incurring in the first place. This degrouping adjustment is only relevant to V s tax position. P s base cost in Newco remains at 10m, the actual price paid for the shares, and not the 14m that V is deemed to have received for them. At the same time, Newco s base cost in the property is re-set from 6m to 10m. This is the acquisition cost that Newco incurs as a buyer on the notional sale and buyback. This adjustment is necessary to avoid double taxation. Example Newco leaves the group and sells the property after for 13m Suppose that Newco subsequently sells the property for 13m. It is the re-set base cost that is deducted when calculating the gain, and not the original base cost that was inherited from V. 3

4 Gain on sale of property Original base cost Re-set base cost Sale proceeds of property 13m 13m Base cost ( 6m) ( 10m) Gain 7m 3m Accordingly, the gain is 3m, being the subsequent growth in value of the property, and not the higher value of 7m. Note that we can rewrite the gain of 7m: as: 13m 6m = 7m (sale proceeds less old base cost) ( 10m 6m) + ( 13m 10m) = 4m + 3m = 7m degrouping charge subsequent growth in value We find that the result of taxing the gain of 7m is to include the 4m degrouping charge which has already been captured when Newco was originally sold to P. There is no need to tax it again. Timing issues The notional sale and buyback is deemed to have taken place immediately after A acquired the asset from its fellow group member, and not when it exits the group. These two events do not necessarily coincide as they did in our envelope example the exit point can be up to 6 years after the intra-group transfer; However, the gain or loss is actually recorded in A s last accounting period as a group member 6. The first rule concerns quantum it fixes the amount of the gain or loss by reference to market values prevailing at the (earlier) time when the intra-group transfer took place. The second rule concerns timing it tells us when this gain or loss is to be incurred for the purpose of collecting the tax. Example Newco is sold when the value of the property increases to 13m As an example, suppose that in our envelope scheme, Newco were to be sold three years after acquiring the property, rather than immediately. Suppose also, that the value of the property and therefore the value of Newco has by then increased to 13m. The degrouping charge is the same 4m as in our previous example. This is because the date of the initial intra-group transfer is fixed in time and so the market value figure remains 4

5 at 10m. The figure of 13m which is the value at the point of exit, is not relevant to this part of the calculation. Gain on sale of Newco shares Property valued at Newco exit Market valued at V-Newco transfer Sale proceeds of Newco shares 13m 13m Degrouping charge on Newco sale 7m 4m ( 13m/ 10m market value less inherited base cost of 6m) Adjusted sale proceeds 20m 17m Base cost of Newco shares ( 10m) ( 10m) Gain 10m 7m Note that the correct result is equal to the overall growth in value of the property during the time that it remained within V s group ( 13m 6m). But if we use the market value at the point of exit to calculate our degrouping charge, we get a higher figure of 7m. Where does the additional 3m come from? The (incorrect) degrouping charge is: 13m 6m = 7m (market value at point of exit less inherited base cost) and this, as we have just seen, is the overall growth in the value of the property during the period that it was held within V s group. But this is not what the degrouping charge is intended to do. The function of the degrouping charge is to capture the gain that would have arisen had the relevant asset been sold outside the group, instead of being transferred to a fellow group member. The remainder of the gain is picked up via the sale of the shares when Newco leaves the group. We can rewrite the calculation for the (incorrect) degrouping charge as: ( 13m 10m) + ( 10m - 6m) = 7m (gain on Newco shares plus intra-group gain) Note that the extra 3m happens to be exactly the same as the gain on the Newco shares. But this 3m figure appears again when later on in the calculation, since: Total tax charge on Newco shares = gain on Newco shares plus degrouping charge In the incorrect calculation we have included this figure twice. There is no need to include it again. 5

6 But why is the degrouping charge brought forward to A s last accounting period in the group? This is convenient because it avoids having to reopen the tax return for the earlier year when the original intra-group transaction took place. Consider what would be the case if there were six intra-group transactions for each of the six previous years. This can be dealt with in the latest return, rather than having to make six separate adjustments. No tax avoidance motive required The previous example shows why the envelope scheme doesn t work. However, it should be noted that the degrouping rules are not restricted to this type of scheme. Any intra-group transaction is liable to give rise to future degrouping charges, irrespective of whether a tax avoidance motive is involved. Further point on degrouping a tax charge on assets becomes a tax charge on shares This is actually quite a powerful statement. When the degrouping takes place as a result of a share sale, the degrouping charge is transferred from the company leaving the group, to the group member selling the shares. However, it is not simply a case of transferring liability from one company to another. In the envelope scheme, Newco is deemed to have sold the property on leaving the group, but V s liability is deemed to arise on its shareholding in Newco itself. This is a direct consequence of adding the degrouping charge to the purchase price in V s capital gains computation. What would be the position if the Newco shares qualify for a tax exemption? In these circumstances the degrouping charge on the property is actually extinguished. This is the result of transferring the taxable gain on the property to the exempt gain on the shares. And yet a direct property sale would have been fully taxed! We shall discuss this concept in more detail in a later article. How can a company leave the group? This transformation is only possible when the company leaves the group by means of a share disposal for example, when the company is sold. But an exit is also possible by the sale of a company further up the group chain. For example in the diagram (next page), A has left the group on the sale of its immediate parent C. 6

7 This time, the degrouping charge is added on to the sale price for C, not A A is not being sold. Note that C doesn t actually own the asset itself. Furthermore, one doesn t need to sell the entire company. For example, a holding of 100% can be diluted by selling more than 25% of the share capital. The next diagram shows how a company can leave a group without a share disposal. 7

8 Company A, is a wholly owned subsidiary of V holding 100 shares. It is intended that P will obtain a 90% stake in this company. This can be achieved in two ways: V can simply sell 90 A shares to P; or A can issue 900 shares to P. In either case, A leaves the group, as V s stake is diluted to 10%. We have seen that on a share sale, it is V, the seller who bears the degrouping charge. But if there is no share sale as is the case where the shares are issued the degrouping charge remains with the asset, and is primarily borne by A. There is however, a caveat. If the value shifting rules apply when A issues the shares, the dilution of V s shareholding is deemed to be a partial sale 7. According to HMRC, this would mean that A has left the group by means of a share disposal after all 8. It is not entirely clear why this should be the case. The words of the legislation state that the purchase price adjustment is made if company A ceases to be a member of the group in consequence of 9 a share disposal(s.). This phrase gives the impression of cause and effect company A leaves the group because shares have been disposed of. But in the above situation, this is not what has happened. It is the issuing of the shares to P that has caused A to leave the group, not the deemed share sale from V to P 10. Allocation of degrouping charge to other group members So far, we have shown that the degrouping charge falls either on the company leaving the group, or the company that sells the shares resulting in the degrouping. However, it is possible to allocate the degrouping charge to other group members 11. This is a useful option if these other members have losses or gains of their own, that can be set off against the degrouping charge, and therefore lower the group s overall tax burden. Summary The object of the degrouping rules is to prevent assets from being smuggled out of a group tax free, under the protection of a corporate wrapper; Degrouping charges which can include a loss arise when a company leaves a group, taking with it assets acquired from fellow group members within the previous 6 years; On exit, there is a notional sale and buyback of the asset at market value, deemed to have taken place immediately before the relevant intra-group transaction, but recorded in the last accounting period; When a company leaves a group by means of a share disposal, the degrouping charge is included in the capital gains computation for the shares; In other cases, it is the exiting company that bears the tax charge; 8

9 However, in both cases, the degrouping charge can be surrendered to fellow group members; In both cases, the company s base cost in the asset is re-set to market value at the date of the relevant intra-group transaction (NOT at the point of exit). In our next article we shall discuss the IP degrouping rules. We shall see the treatment of IP is similar to that applying to capital assets, but with some important differences. Satwaki Chanda Barrister at Law This article was first published on the author s website Tax Notes (taxnotes.co.uk) in two parts and can be viewed at the following links: Strictly speaking, Newco inherits the indexed base cost this is the base cost adjusted for inflation. However, we shall ignore indexation in the examples in this and the following articles. 2 TCGA 1992 s CTA 2009 ss TCGA 1992 s 179(3). 5 TCGA 1992 ss 179(3A), (3D). 6 TCGA 1992 s 179(4). 7 TCGA 1992 s 29. Value shifting is a complicated form of tax avoidance, which includes the case where a company issues shares, as shown in the diagram. We say that value has passed from V s shares to P s. Although V has done nothing with its shareholding, the economic effect is the same as an actual sale. The tax legislation deems there to have been a sale if V exercised its control over A to issue the shares to P. 8 HMRC Manual CG TCGA 1992 s 179(3A)(a). 10 Note that A s issuing shares to P doesn t constitute a share disposal either. 11 TCGA 1992 s 171A. 9