Is the draft legislation on capital distributions really the key to consistency, asks PETE MILLER

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1 1 of 10 06/07/ :01 Published on Taxation ( Home > Unlocking dividends Unlocking dividends Posted: 15 February 2012 Authors: PETE MILLER [1] Issue: <a href="/taxation/node/35711">vol 169, Issue 4341</a> [2] Categories: Analysis [3], Features [4], CT [5] Related articles: Rules clarify capital distributions treatment [6] Taxing distributions, naturally! [7] Different words [8] Is the draft legislation on capital distributions really the key to consistency, asks PETE MILLER KEY POINTS Definition of capital distributions. Impact of capital gains tax rules. Distributions for purpose of the corporation tax acts. Anomalies within the legislation. Winding up a company. Changes to the distributions legislation were included in the draft Finance Bill issued on 6 December 2011, following consultation over concerns about the rules for so-called capital distributions. This article explains the background to these changes, and explores what they achieve and whether they were necessary. It will also look at how the distributions rules work in some other contexts. It is not intended to analyse every permutation of the distributions legislation and does not, for example, consider distributions to income taxpayers. It will look at a few distributions to corporation taxpayers, specifically distributions in specie, as these are the main subject of the proposed changes, and how, or whether, the legislation works for ordinary cash dividends and distributions on a winding up. The legislation On the payment side, company distributions are defined in CTA 2010, Part 23 [9]. Section 1000 gives the main classes of distribution, while other provisions either refine these

2 2 of 10 06/07/ :01 definitions or state that certain matters are or are not distributions for the purposes of corporation tax. In general, there is no longer a tax charge on a company making a distribution per se, although there is no tax deduction for distributions either (CTA 2009, s 1305 [10]). Furthermore, a distribution in specie might constitute a disposal for capital gains purposes. On the receipts side, any distribution received by a UK company is chargeable to corporation tax as income, under CTA 2009, Part 9A company distributions. The intention, however, is that the various exemptions in Part 9A will ensure that most distributions received will be exempt from corporation tax. Also on the receipts side of distributions is the capital distributions rule, at TCGA 1992, s 122 [11]. This treats certain distributions as if they were a part disposal of the shares held. A capital distribution is defined, in s 122(5), as any distribution from a company, including a distribution in the course of dissolving or winding up the company except a distribution which in the hands of the recipient constitutes income for the purposes of [corporation] tax. (Although s 122(5) refers to income tax, s 8(5) requires us to read this as if it were a reference to corporation tax when looking at the application of the Act to corporation tax.) TCGA 1992, s 122(6) [11], added by F(No 3)A 2010, says that any distribution that is exempt from corporation tax under CTA 2009, Part 9A [12] is also outside the scope of TCGA 1992, s 122 [11]. So a normal income distribution receipt is likely to be exempt under CTA 2009, Part 9A and also cannot be charged to corporation tax on a deemed gain under TCGA 1992, s 122 [11]. CTA 2009, s 931RA [13] effective in respect of distributions made on or after 1 July 2009, says that the other rules for the taxation of chargeable gains can apply to an income distribution that is exempt under Part 9A. Section 931RA is a statutory statement of the principle established in Strand Options & Futures Ltd v Vojak (76 TC 220) [14], so arguably its enactment did not make any difference to the operation of the capital gains legislation. The normal rules apply to a company making a distribution, if the distribution consists of a disposal of a chargeable asset or the realisation of an intangible fixed asset. Distributions in specie Our first example is a distribution in specie of an asset by a company to a shareholder. At face value, this looks like it should be a distribution for corporation tax purposes, which is confirmed by CTA 2010, s 1020 [15]. However, s 1002 and s 1021 say that in certain circumstances a distribution of an asset in specie is not, in fact, a distribution for corporation tax purposes: where both companies are UK resident and the transferor is a 51% subsidiary of the transferee or both are 51% subsidiaries of another UK resident company; where the companies are not under common control, so long as they are both UK resident and are not 51% subsidiaries of a non-uk company.

3 3 of 10 06/07/ :01 This sort of transaction is reasonably common within capital gains groups (75% subsidiaries and effective 51% subsidiaries TCGA 1992, s 170 [16]), particularly if there is a group reorganisation preparatory to a demerger or other form of reconstruction. Any transfers that are not distributions are therefore not chargeable to corporation tax on income under CTA 2009, Part 9A. The enactment of TCGA 1992, s 122(6) [11] is not relevant here, since Part 9A is not in point at all. Capital distribution treatment Historically, the analysis has been that a distribution in specie must therefore be a capital distribution within TCGA 1992, s 122 [11] as a distribution that does not constitute income for the purposes of corporation tax in the hands of the recipient company. The effect of s 122 would be to treat the capital distribution received as the proceeds of a deemed part disposal of the shares of the transferor company. As a result, there might well be a chargeable gain on the recipient company. See Halfco Ltd as an example. HALFCO LTD Halfco Ltd cost its parent company 50,000, and owns an asset worth 100,000, which constitutes half the value of the company. If the asset is distributed in specie to its parent, there is no income distribution but the capital distribution would generate a gain of 75,000. The base cost of 25,000 is half the original cost of the distributing company, as a capital distribution is treated as a part-disposal of the shares (ignoring indexation). This charge will apply to these non-distributions regardless of the relationship between the transferor and transferee companies. Even though the asset transfer might be within a capital gains group, TCGA 1992, s 171 [17] cannot help here as there is no intra-group transfer from the perspective of the recipient company, it is just a deemed disposal without a receipt. This tax charge on a capital distribution is one of the concerns that are being addressed by the draft changes published on 6 December But is there really cause for concern? CTA 2010, s 998 [18] tells us that s 1000 to s 1023 are about the meaning of distribution in the corporation tax acts. The corporation tax acts are defined in Interpretation Act 1985, Sch 1 as the enactments relating to the taxation of the income and chargeable gains of companies and of company distributions (including provisions relating to income tax).

4 4 of 10 06/07/ :01 It is quite clear, therefore, from this definition that the corporation tax acts include not only CTA 2009 and CTA 2010 but also those parts of TCGA 1992 relating to the taxation of the chargeable gains of companies and of company distributions, which will clearly include TCGA 1992, s 122 [11]. So where does this get us? Section 122(5)(b) defines a capital distribution as meaning any distribution from a company.... However, I have just shown that the definition of what is and is not a distribution in CTA 2009 applies to TCGA 1992, s 122 as part of the corporation tax acts. Therefore, if a distribution in specie of an asset from one group company to its parent is not a distribution for the purposes of the corporation tax acts, then that distribution is not a distribution for the purposes of TCGA 1992, s 122 and cannot be caught by the capital distributions legislation. This analysis might be seen as undermined by the words including a distribution in the course of dissolving or winding up the company in s 122(5), despite the fact that such a distribution is also not a distribution for the purposes of the corporation tax acts, as we shall see. my view is that the existence of these words cannot override the clear definition of the scope of the corporation tax acts, without specific provision. I suspect that s 122 has survived largely unchanged through many years and many changes of the distributions legislation, so that the words about distributions in a winding up are now an historical artefact. A heresy? It is my contention, on the basis of this analysis, that the traditional view of the treatment of distributions that are not distributions for the purposes of the corporation tax acts is incorrect. Since such transactions are not distributions for any of the purposes of these acts, they are outside the scope of TCGA 1992, s 122 and cannot be capital distributions. What this means is that a transfer of an asset that is not a distribution for corporation tax purposes should not be chargeable to corporation tax on the recipient company, either as income or as a chargeable gain. Hence one of the major concerns as to the operation of TCGA 1992, s 122 in the context of a distribution in specie is not a problem at all. None of the foregoing has any impact on the capital gains treatment of the company making the distribution. This will depend on whether the asset transfer was between companies that form a capital gains group or not. Within a capital gains group, the transfer is normally treated for corporation tax purposes as taking place on a no gain, no loss basis, i.e. at cost plus indexation for both the transferor and transferee companies (TCGA 1992, s 171). So, in Halfco Ltd, if the asset distributed had cost 10,000, the transfer will be deemed to be at 10,000 (plus indexation). Where the companies concerned are not within a capital gains group, the transferor company

5 5 of 10 06/07/ :01 will have made a disposal for capital gains purposes. Since the disposal is not on arm s length terms, s 17 will operate to impose market value on the computation, so that the transferor company will be treated as making an arm s length disposal of the asset, and be chargeable to corporation tax accordingly. This seems a perfectly acceptable policy result; there is no reason why a disposal of an asset should be exempt from the chargeable gains legislation just because the disposal is by way of distribution. Taking these together, a distribution in specie should be tax free as far as the recipient company is concerned but taxable on the distributing company as a disposal. By the more traditional analysis, it is possible for a transfer of the asset to be taxed as a normal chargeable gain on both the distributing company and on the recipient company as a capital distribution. Continuing Halfco Ltd, Halfco will have made a gain of 90,000 (ignoring indexation) but we have already seen the parent company also having a chargeable gain of 75,000, which feels like economic double taxation of the same transaction. There is no obvious policy consideration here that suggests that the recipient company should be charged on a capital distribution when the income distribution rules are not in point. Note also that the asset transferred might be an intangible fixed asset. If so, the rules for charging corporation tax on the realisation credits will apply to give a similar result. Intra-group transfers will be tax neutral under CTA 2009, s 775 [19]. Non-group transfers are likely to be deemed to be at market value, as a connected party transfer under CTA 2009, s 845 [20] or by virtue of the transfer pricing rules of TIOPA 2010, Part 4 transfer pricing. However, there is no general market value rule for intangible fixed assets equivalent to TCGA 1992, s 17 [21] and there are some specific exceptions to the market value rules for connected parties. Our final category is distributions in specie that are distributions by virtue of CTA 2010, s 1020, and s 1002 and s 1021 do not apply to exclude them. These would include companies under common control or companies that are 51% subsidiaries of a non-uk company. These distributions in specie will be income distributions in the hands of the recipient company. If they are not exempt under CTA 2009, Part 9A, they are charged to corporation tax as income. If they are exempt under Part 9A, they are also not capital distributions under TCGA 1992, s 122 because of s 122(6) which is deemed always to have had effect. Impact of the changes To summarise the current position for distributions in specie: Where the transaction is not a distribution for corporation tax purposes, my analysis is that it also cannot constitute a capital distribution for the recipient company.

6 6 of 10 06/07/ :01 If my analysis is wrong, a transaction that is not a distribution for corporation tax purposes may constitute a capital distribution for the recipient company, which is one of the main concerns with the current legislation. In either case, there is a disposal by the transferor company for the purposes of corporation tax on chargeable gains. Where the companies are not within a TCGA 1992, s 170 group, this means that the distributing company may suffer a chargeable gain on a disposal deemed to be at market value. If the same asset distribution is also taxed on the recipient as a capital distribution (see second bullet point above), there is economic double taxation. Where the transaction is a distribution for corporation tax purposes, it may be taxed as income or exempt under CTA 2009, Part 9A. In either case, it cannot be a capital distribution, although this has only been made clear since the enactment of TCGA 1992, s 122(6). The proposed changes will repeal CTA 2010, s 1021 and s 1002, so that a distribution in specie of an asset by a company to a member will always be a distribution for the purposes of the corporation tax acts. The new rules are intended to apply from the date of royal assent to FA As a result, such a distribution will first of all be inspected under CTA 2009, Part 9A. If the distribution is exempt, either under the small companies exemption or under one of the exemptions for large companies, it cannot then be a capital distribution because of TCGA 1992, s 122(6). So the treatment of all such distributions will now be consistent, regardless of the relationships between the distributing and recipient companies. The distributing company will still have disposed of a chargeable asset or realised an intangible fixed asset, with appropriate tax consequences, as already described. A brief inspection of the new rules suggests that there are a number of advantages: As already noted, there is now a consistent treatment of all distributions in specie, regardless of the relationships between the companies concerned, which is a major simplification of the distributions legislation. This resolves the concerns about capital distribution treatment for intra-group transfers and other non-distributions. The notes accompanying the draft legislation also point out that the treatment of distributions in specie will no longer be partly dependent on the residence of the companies concerned (because, for example, distributions between 51% subsidiaries of a non-uk company are currently distributions within CTA 2009, Part 9A but distributions between 51% subsidiaries of a UK company are not). The current rules probably also contravene EU legislation, given the exception from distribution treatment for distributions only between UK companies, not companies resident in other member states. In my view the simplification effect of a consistent treatment for all distributions is worth all the effort. The international element is merely a useful side-effect. Cash dividends A dividend is at first sight a distribution chargeable to tax under CTA 2009, Part 9A. If so, it is

7 7 of 10 06/07/ :01 either chargeable or, more likely, falls into an exempt class. Either way, that is usually the end of the matter, as a distribution that is exempt under Part 9A is not a capital distribution (TCGA 1992, s 122(6)) and there is no disposal of a chargeable asset (or realisation of an intangible fixed asset) on which the paying company can be taxed. But there is an interesting anomaly. Prior to the enactment of Part 9A a dividend was exempt; not brought into the charge to corporation tax on income by virtue of TA 1988, s 208/CTA 2009, s Both provisions said that distributions received from a UK company were not taken into account in computing income for corporation tax purposes. Does this mean that ordinary dividends were distributions that did not constitute income for the purposes of corporation tax in the hands of the recipient company, so that they should be taxed as capital distributions, instead? HMRC have confirmed that their view is that the phrase constitutes income means has the inherent character of income, so that a dividend that is inherently income in nature should not fall into TCGA1992, s 122. A problem with this analysis is that a distribution of an asset in specie is also income in nature, as a distribution of profits, and they accept the need to change the legislation to ensure that such a distribution is not a capital distribution. And, similarly, a direct demerger by distribution (CTA 2010, s 1076 [22]) is clearly an income distribution, as a matter of company law, but is not a distribution for the purposes of the corporation tax acts, and has a special provision to ensure that it will not be treated as a capital distribution (TCGA 1992, s 192(2) [23]). In essence, HMRC s analysis suggests that a distribution paid in cash has the character of income but a distribution paid in kind does not. Therefore, why wasn t a normal cash dividend always a capital distribution under s 122? Clearly this was never the intention of the legislation, at least as far as cash dividends were concerned and HMRC never took the point. This largely ceased to be a problem for dividends when CTA 2009, Part 9A was enacted, as dividends became income for the purposes of corporation tax, and the later enactment of TCGA 1992, s 122(6) put the matter beyond doubt so the matter is of purely historical interest. The point, however, illustrates the difficulties with the structure of the distributions legislation and the fact that some of the anomalies have been in place for many years and are not just a product of the tax law rewrite. Distributions in a winding up CTA 2010, s 1030 states that a distribution made in respect of share capital in a winding up is not a distribution of a company for the purposes of the corporation tax acts. This is a direct restatement of the rule in the old TA 1988, s 209(2)(a) [24] which itself mirrors the Companies Act provision (or vice versa), that a distribution in a winding up is not a distribution for the purposes of company law, either.

8 8 of 10 06/07/ :01 The most common use of TCGA 1992, s 122 is to charge distributions in a winding up to corporation tax on chargeable gains as capital distributions, relying on the definition of a capital distribution as any distribution from a company, including a distribution in the course of dissolving or winding up the company However, we have already seen that if a distribution in the winding up of a company is not a distribution for the purposes of the corporation tax acts, it is not a distribution for the purposes of s 122, which is part of the corporation tax acts. So there is arguably no proper statutory authority for charging the distributions in a winding up of a company, whether of assets or cash, as capital distributions. HMRC tell me that their view, on normal principles of construction and supported by Interpretation Act 1978, s 5, is that the definition of distribution will apply unless the contrary intention appears. So they say that the word distribution in s 122 is used in a wide and general sense, and that section does apply to a distribution in the course of winding up. I am not convinced that a contrary intention appears in s 122, which looks to me like a catch-all provision, rather than a rule specifically intended to tax distributions in a winding up. Does this mean that distributions on the winding up of a company are not chargeable to corporation tax at all? It seems possible, albeit perhaps a slight stretch, that sums received in the winding up of a company could be caught by TCGA 1992, s 22 capital sums derived from assets. Another alternative is TCGA 1992, s 24 [25], disposal where assets lost or destroyed. But neither of them seem a natural fit. Perhaps a better answer is that the receipt of monies in respect of a shareholding in a company being wound up is a natural disposal of the shares in that company. There is nothing in the legislation to prevent it applying where the consideration, i.e. the distributions in the winding up, is received before the disposal of the asset, i.e. the shares ceasing to exist when the company is eventually struck off. Indeed, this was part of the ratio of the Strand Options & Futures case and well within the scope of CTA 2009, s 931RA [13]. The real problem may well be that TCGA 1992, s 122 has not been amended to keep pace with changes in other legislation (or it was never properly drafted in the first place). The legislation could be amended so that a distribution in a winding up is still a distribution for the purposes of the corporation tax acts but that it is outside the scope of CTA 2009, Part 9A. That way, since it is still a distribution for the purposes of the these acts, it can be the subject of charge under TCGA 1992, s 122. I might also suggest that the change should be made retroactively, to prevent large numbers of repayment claims. What use is TCGA 192, s 122? Apart from distributions on a winding up, as above, I find myself questioning whether s 122

9 9 of 10 06/07/ :01 has any purpose. If there is a distribution for the purposes of the corporation tax acts, as defined by CTA 2010, Part 23 that distribution is either taxable under CTA 2009, Part 9A on the recipient company, or it is exempt. If it is exempt, TCGA 1992, s 122(6) prevents any charge as a capital distribution. If the distribution is not a distribution for the purposes of the corporation tax acts, then the wide scope of the definition of those acts means that s 122 cannot apply to it on first principles, as it is not a distribution for the purposes of that provision either. So I cannot think of anything which would be caught as a capital distribution under s 122. Perhaps the sensible approach is to make it the specific charging provision for distributions in a winding up. Conclusions I have demonstrated a technical analysis that says that the original source of concerns about distributions in specie, that they might be charged as capital distributions, may have been misguided. Nevertheless, the proposed changes to the legislation in this area are welcome, as they give a consistency of treatment to distributions in specie, they resolve the concerns raised, whether or not they were well founded, and they prevent any future challenges under EU legislation or the non-discrimination provisions of any double tax treaties. The analysis also throws up a concern that the current legislation may not be fit for purpose in taxing the chargeable gains on winding up or dissolving a company, although there is a relatively simple fix. Pete Miller is the founding partner at The Miller Partnership and can be contacted on and by [26] FURTHER READING [27] Share this page [28] Halsbury House, 35 Chancery Lane, London WC2A 1EL Customer Services Source URL: Links: [1] [2] [3] [4] [5] [6] [7]

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