HMT: Reform of the substantial shareholdings exemption The Law Society's response August 2016

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1 HMT: Reform of the substantial shareholdings exemption The Law Society's response August 2016 TS4/ /02/SWS/LS XXX :00

2 The Law Society is the professional body for solicitors in England and Wales, representing over 170,000 registered legal practitioners ( the Society ). The Society represents the profession to parliament, government and regulatory bodies and has a public interest in the reform of the law. This response has been prepared by the Society s tax committee who are formed of practitioners with relevant expertise and experience in this field. We welcome the opportunity to respond to HMT s consultation on the reform of the substantial shareholding exemption (the "consultation"), which was published in May A Introduction We agree with the description of the principal motivations behind the SSE and the explanation of the current challenges to its effectiveness. In its current form, the SSE is excessively complex, particularly when compared to other participation exemptions. This complexity damages the attractiveness of the UK as a holding company jurisdiction and does not chime with the UK Government's declaration that the UK is "open for business". The current SSE conditions (especially the investing company condition) mean that businesses are commonly required to undertake a detailed exercise to confirm the applicability of the SSE. This lengthy analysis is required even in what from a policy perspective should be regarded as straight forward circumstances. We are of the view that simplification of the SSE would be greatly appreciated by business. We agree that focussing on key policies underpinning the exemption is the correct starting point. It is critical that the revised exemption is able to stand unaltered for a reasonable period of time revisions to the SSE should be forward looking, rather than just the minimum changes needed to meet the demands of today. This is particularly true given the headwinds currently faced by the UK holding company regime, including the potential loss of the dividend withholding tax exemption under the Parent Subsidiary Directive. Given all of above considerations, our preference is for a move to a simple and comprehensive exemption, which only contains such limitations or conditions as are absolutely critical to policy. B Challenges Presented by Current Rules Detailed analysis is usually required in order to conclude whether the trading group and trading sub-group tests are met. Analysis of groups which are fundamentally trading groups but have cash balances and / or some investment activities (and / or whose most important assets are intangibles not reflected on balance sheet) are often unnecessarily challenging. As a result, a clearance from HMRC that the SSE is applicable is often sought in what ought to be routine cases. This can cause transaction delays and is a waste of HMRC and taxpayer resources. The requirement for the investing company to be a member of a trading group requires an analysis of the worldwide group. This can be a lengthy exercise where the group is particularly large or the group structure is complex. Determining which entities are TS4/ /02/SWS/LS XXX :00

3 members of the group can be a time-consuming task where the group includes vehicles other than conventional companies; advice from local counsel as to the attributes of the foreign entity may be required in order to assess whether that entity has ordinary share capital. It may be administratively burdensome to assess whether the investee company is the holding company of a trading sub-group. This is because consolidated accounts may not have been drawn up at the level of the investee company, meaning that a new set of accounts may need to be generated in order to assess whether the sub-group is trading or not. It is common for there to be a commercial requirement for clearances where there is a lack of certainty, leading to timing implications as well as HMRC and adviser costs. Examples where clearances are frequently sought include the trading status tests and the application of the subsidiary exemption (especially on a liquidation, covered further below). The response from HMRC usually confirms the anticipated position but it is inefficient to be required to do this if instead the SSE could be relaxed, leaving only policy-based conditions. The SSE is a key building block in maintaining an attractive holding company regime for both inbound and outbound investment for instance, the participation exemptions in the Netherlands and Luxembourg are cornerstones of their holding company regimes. The key drivers of the SSE should be simplicity, certainty and consistency of outcome with the widest application that is permitted by policy limitations. C Options for Possible Reform Option 1: Comprehensive Exemption As set out above, our preferred option would be to adopt a more comprehensive exemption. The most internationally competitive option would be for the conditions to be limited to holding period and shareholding requirements, without trading tests at investee or investor level. This option would be consistent with the wider regime for taxation of corporate income. If, however, additional limitations are required as matter of policy, it is less clear that Option 1 would remain preferable over a widened SSE per Option 2 or Option 3. It would not serve the purposes of simplicity or certainty to replace one set of complexities with another set, particularly given the fact that the Option 2/3 complexities arise in the context of familiar UK tax concepts such as the trading test. For example, one useful recent change is to extend SSE to degrouping charges, by way of hive down of assets into a corporate vehicle: any further limitation on enveloping should not prevent what HMRC currently accept is an intended application of the SSE. Both the Netherlands and Luxembourg participation exemptions are considerably broader and easier to apply than the SSE as currently drafted. Neither exemption requires an analysis of the activities of the wider group. Instead, both exemptions safeguard against aggressive tax planning by requiring the investee company to be subject to a minimum level of taxation. A similar test could be adopted as part of a comprehensive exemption. TS4/ /02/SWS/LS XXX :00

4 Options 2 and 3: Exemption subject to Trading Test, or to a Modified Test The removal of the condition that the company making the disposal be part of trading group would improve certainty and simplify the test materially. This would be our preferred approach. We are unconvinced that a wholesale change to the investee company test such that it is not based on trading (other than a change to one based on an extended trading test see below) would provide materially greater simplicity or certainty. The concept of trading is well understood in the UK and provides a clear starting point. We would therefore propose that the investee company test be based on trading but then be extended to include (as proposed in the third bullet of paragraph 4.21) any specified further activities or circumstances alongside trading. This could for example include active investment short of trading as an exempt activity; or could exclude for example cash balances (including but not limited to proceeds of disposals) save where those balances are passive investments. Option 4: Amended and Tests We would see a test limited to the companies involved in the transaction as too arbitrary and capable of manipulation. The alternatives proposed for a modified investor company test do not seem to us to improve materially the position in respect of the challenges presented by the current regime. While these may assist in some circumstances, we would view these as an opportunity to focus on real policy concerns and reduce the burden of the exemption. Option 5: Changing the definition of substantial shareholding We agree there does not appear to be significant merit in lowering the substantial shareholding or augmenting it with a minimum invested capital requirement. D Treatment of Funds Many of the objectives for reform in this context could be achieved by Option 1 (a comprehensive exemption) or Option 3 (investee company test only, but in a modified form). This would also have the benefit of not requiring a specific additional definition in this area. E Detailed Design Modifications 1. Shareholdings Held Within a Partnership The presence of a partnership in a group gives rise to a number of potential issues (and opportunities for avoidance for those seeking artificially to fall outside SSE and so crystallise allowable losses). Some of these issues could be resolved by the removal of the investor company test under Options 2/3. Some other issues relating to the investee company could be resolved by the modification of the investee company test under Option 3. The best way to eliminate these difficulties would be to confirm in legislation that partnerships do not "break" groups or sub-groups (and we can see no policy reasons why they should). TS4/ /02/SWS/LS XXX :00

5 Where a shareholding is held through a partnership, that partnership may, in HMRC's view, break the group. In Example 1, as A's interest in C is held through a partnership rather than an entity with ordinary share capital, there is a risk that C may not be a 51% subsidiary of A. In that case, following the disposal of D, A would no longer be a member of a trading group. This issue would be resolved if Options 2 or 3 were adopted, since A would no longer be required to satisfy the investor company condition. If A itself were the investee company (ie A was being sold by its shareholder), Options 2 and 3 may not resolve this issue. Example 1 90% B LP A Ltd C Ltd D Ltd Secondly, should the partnership be treated as breaking the group, companies held through the partnership would not be group companies. This means that interests held by these companies would not be able to be aggregated for the purpose of meeting the substantial shareholding requirement pursuant to paragraph 9 Schedule 7AC TCGA. In Example 2, if C is not in the same group as A, C's interest in E could not be aggregated with A's interest in E. Likewise, where C is not in the same group as A, a transfer of the 4% shareholding in E by C to A would not be a no-gain no-loss transfer, meaning that C's period of ownership of its interest in E would not be aggregated with that of A under paragraph 10 Schedule 7AC TCGA. There doesn't appear to be a policy reason why shareholdings and holding periods could not be aggregated in this scenario. This issue would not be resolved by the adoption of Options 2 or 3. Example 2 90% B LP C Ltd A Ltd 4% 7% E Ltd 2. Structures without share capital The presence of entities without share capital such as certain US Limited Liability Companies (LLCs) in a group can give rise to a number of issues (and opportunities for avoidance where parties wish to fall outside the SSE and crystallise allowable losses). In our view there is a strong basis for (alongside the ordinary share capital test) the adoption of an equivalent test for entities that do not have ordinary share capital. Again, this would lessen the administration burden on businesses and limit opportunities for avoidance whilst posing limited risk of extending the exemption to unintended areas. TS4/ /02/SWS/LS XXX :00

6 Firstly, the presence of a LLC may break the group for the purposes of the SSE. In Example 3, if O does not have issued share capital, neither O nor P would be 51% subsidiaries of M. This would mean that following the disposal of N, M may no longer be a member of a trading group. We note that the HMRC manuals (CG53116E) provide some comfort on this issue, but its legal basis is unclear). This issue would be resolved if Options 2 or 3 were adopted. These options may not, however, resolve the issue if M were itself the investee company being sold by its shareholder. Example 3 N Ltd M Ltd 99% O LLC P Ltd Secondly, if the LLC does not have share capital, the interest in the LLC would not meet the substantial shareholding requirement, since this condition requires the investing company to hold a 10% interest in the investee company's ordinary share capital. This issue would not be resolved by the adoption of Options 2 or 3 as it goes to the substantial shareholding requirement rather than the investing company condition. Example 4 M Ltd 99% O LLC Finally, where the LLC does not have share capital, it will not be a group company. This means that interests held by subsidiaries of the LLC will not be able to be aggregated for the purpose of meeting the substantial shareholding requirement pursuant to paragraph 9 Schedule 7AC TCGA. In Example 5, if P is not in the same group as M, P's interest in Q cannot be aggregated with M's interest in Q. Likewise, if P is not in the same group as M, a transfer of the 5% shareholding in Q by P to M would not result in the aggregation of P and M's periods of ownership under paragraph 10 Schedule 7AC TCGA. There doesn't appear to be a policy reason why shareholdings and holding periods could not be aggregated in this scenario. This issue would not be resolved by the adoption of Options 2 or Extension of the Qualifying Period Example 5 99% O LLC P Ltd M Ltd 5% 6% Q Ltd We would strongly support this proposal, and would see the alignment of gains and losses as a natural and reasonable consequence of that change. 4. Post-Sale Trading Requirement The issue as identified should be resolved if Option 1 or Option 3 (and probably Option 2) were adopted. The consequences of material cash proceeds are a common issue, albeit TS4/ /02/SWS/LS XXX :00

7 one on which taxpayers generally do manage to get comfortable on bearing the risk (if reluctantly) without seeking further HMRC guidance. The current drafting of the subsidiary exemption is another area of uncertainty. Where a holding company sells its only trading subsidiary, the disposal will not qualify for the main exemption as the holding company will fail the post-sale investor company test. This level of uncertainty is increased where there are multi-tier holding structures, which are often motivated by commercial requirements relating to the subordination of debt finance. Paragraph 3 Schedule 7AC provides for a subsidiary exemption in certain cases where the main exemption is not available. However, paragraph 3(3)(b) requires that the post-sale investor company test is failed as a result of the liquidation of the holding company, which is often not the case. Whilst it is helpful that HMRC guidance states that the subsidiary exemption should be available provided the liquidation of the investor company occurs as soon as reasonably practicable, clearances are often sought to confirm this analysis, which is burdensome for both HMRC and the taxpayer. This issue could be resolved if the investor company conditions were relaxed. If the investor company test is retained, we suggest that the subsidiary exemption is amended more clearly to reflect the position taken in HMRC's guidance. 5. Other Areas of Detailed Design Improvement There is not currently an equivalent in the intangible assets regime to the SSE degrouping charge protection which allows the hive down and sale of a trading business with the benefit of the exemption from any degrouping charge on capital assets. Unfortunately, many businesses have a mix of new and old intangible assets and this creates uncertainty of tax treatment or difficulties in structuring a disposal of a trade with a mix of intangible and chargeable assets, since the latter can rely on the SSE and the former are subject to tax. Another area of uncertainty is the relationship between the SSE, the no-gain no-loss disposal rule at section 171 TCGA and the exchange of securities rule at section 135 TCGA. Whilst it is clear from the wording of paragraph 4 Schedule 7AC that the SSE overrides section 135, and from the wording of paragraph 6 Schedule 7AC that section 171 takes priority over the SSE, the situation is less clear when all three rules are engaged at once. It would be helpful if an election mechanism could be adopted, allowing taxpayers to choose which rule they wish to take priority. We are aware that HMRC can take a narrow view of paragraph 9 Schedule 7AC and consequently resist the aggregate of holdings of group companies where a new UK company (one that has existed for less than a year) has acquired shares from a member of the group which has held those shares for 12 months or more. We believe such narrow reading of paragraph 9 is out of kilter with the policy of SSE and so would support any changes to that paragraph which HMRC consider necessary to make clear that aggregation extends to the period of time when shares in question were held by other members of the group. For more information, please contact Renee Turner (Renee.Turner@LawSociety.org.uk) or Lydia Challen (Lydia.Challen@AllenOvery.com) TS4/ /02/SWS/LS XXX :00

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Our detailed responses to the questions in the consultation document are set out below.

Our detailed responses to the questions in the consultation document are set out below. Corporate Tax Team HM Treasury 1 Horse Guards Road London SW1A 2HQ By email: SSEConsultation@hmtreasury.gsi.gov.uk 18 August 2016 Dear Sirs, Reform of the Substantial Shareholdings Exemption We are writing