The In-House Lawyer

It is not surprising that within an economic outlook that seems permanently set to ‘gloomy’ many companies are having to think about restructuring their operations or reorganising their holding structures. This article highlights some of the tax and other considerations that must be borne in mind when planning such changes, with reference to some recent (and less recent) cases, alterations in the law and points that have come to the fore in the current climate.

Recapitalisations

Companies will no doubt be looking at whether they or their subsidiaries need to be recapitalised. In general terms, a fresh injection of equity by a parent into a subsidiary is relatively straightforward for tax purposes. However, in the current conditions, some groups may be considering capitalising loan balances to strengthen the balance sheet of the debtor.¹ There are a few points worth thinking about in these cases:

Recognising income

In group situations, it is unlikely that the debtor would have to recognise any income simply because the loan is converted into share capital of the debtor. On general principles, provided that the nominal value of the share capital issued to the creditor is equal to the amount of the debt capitalised, there should be no profit realised by the debtor. Even if that is not the case, however, the corporate debt regime set out in the Finance Act (FA) 1996 will prevent the debtor from having to recognise taxable income on a transaction of this nature provided that the debtor and creditor are connected for tax purposes (and, correspondingly, the creditor will be prevented from realising a tax loss). Different considerations are relevant when the debtor and creditor are unconnected for tax purposes. There is a real possibility, in these latter cases, that the debtor could recognise income (although in those cases the creditor would also recognise a loss). In some cases it may be important that the transaction is structured to ensure that the creditor realises and is able to use a tax loss on the recapitalisation. In those cases, some measure of protection may be afforded where, before the debt-for-equity swap, the debtor and creditor were unconnected and the connection arises only by virtue of the swap.² However, this relief only applies to the first debt-for-equity swap and any further swaps will not be protected.

Tax base cost

For the creditor, the tax effect of capitalisation will largely depend upon whether the transaction is treated as a reorganisation of share capital. If it is, the amount of the debt is added to the total tax base cost of the shares held by the creditor. However, some care needs to be exercised because the increase in the base cost will normally be restricted to the amount by which the value of the shareholding held by the creditor is increased by the capitalisation. This may not be equal to the amount of the debt, particularly when the company has no net assets. In Fletcher v Revenue & Customs [2008] the Special Commissioner had to consider the meaning of the term ‘reorganisation’. While not all commentators agree that the case was rightly decided, this case is nonetheless useful for taxpayers because of the wide definition of ‘reorganisation’ adopted by the Commissioner and because it supports the view that most capitalisations would constitute reorganisations for these purposes. In some cases it may be necessary to reduce the company’s share capital first (using the Companies Act (CA) 2006 procedures that are referred to later in this article) to ensure that the new shares have sufficient value. The reduction itself should be treated as a reorganisation for tax purposes and will therefore have no impact on the tax base cost of the shares held. Where the creditor did not previously hold shares, it is likely that the base cost of the shares will be the market value of the debt.

Recovery of VAT

After a long period of uncertainty, the position on recovery of VAT on share issues seems to have settled down after the European Court of Justice (ECJ) ruling in Kreztechnik AG v Finanzamt Linz [2005]. Following this ruling, VAT on costs incurred by businesses in issuing shares became recoverable to the extent that the business of the debtor is taxable (ie VATable). Businesses will be told to ensure that advisers’ bills are correctly itemised to maximise VAT recovery.

Group reorganisations: domestic groups

Nothing dramatic has happened in this area for some time. However, the provisions will no doubt be ‘stress-tested’ in the coming months and groups considering reorganisations will have to be careful not to fall foul of some of the more unexpected features of the UK regime.

Transfer of tax losses

Where the reorganisation consists of the transfer of a business, the business transferred may be loss-making or may have historic losses. It will be important, so far as possible, to ensure that the losses are transferred at the same time as the business. In general, the UK tax rules provide that where a business (as opposed to a collection of assets) is transferred and there is continuity of ownership between vendor and purchaser, the losses of the vendor will be transferred to the purchaser.³ The test to be satisfied in relation to continuity of ownership is not onerous, it is only necessary to show that at some time between the transfer and the second anniversary of the transfer the seller owned 75% or more of the purchaser (or vice versa), or both companies were 75% subsidiaries of a third company.⁴ Where the continuity of ownership test is satisfied the losses will be transferred with the business. There are, however, some further points to consider:

1. Following the transfer, the losses are available for set off against profits of the same trade realised by the transferor. The ‘same trade’ requirement causes two types of issues. First, there is a possibility that the transferee will not be carrying on the same trade as the transferor. This will not be an issue if the transferee is a special purpose entity created to carry on the business, but where the transferee has an existing trade some care is needed to ensure that the result of the transfer is not to create a single large trade that is distinct from both the trades carried on by the transferee and the transferor before the transfer. In practice, this is only likely to be an issue when the activities of the transferor are roughly of the same size as the trade of the transferee. Secondly, even if the transferee carries on the same trade as the transferor, it will be necessary to agree against which profits the losses can be used. In certain circumstances, HM Revenue & Customs (HMRC) may require that separate computations are prepared to ensure that the losses are only used against profits of the same trade.
2. Where the transferor retains some of the liabilities associated with the trade, the amount of the losses inherited by the transferor will be restricted. Broadly, this will occur when the liabilities of the transferor exceed its assets after the transfer. In these circumstances the losses will be reduced by the amount of the excess. Some care needs to be taken in identifying what the liabilities of the transferee are: in some cases debt that has been capitalised will be counted in the liabilities of the transferor. As a result, it is not always safe to rely on the balance sheet of the transferor, as this may not reveal all the liabilities of the transferor for these purposes.

Capital gains

In general, the transfer of assets between members of the same group is on a tax-free basis. A full review of the grouping tests to be satisfied in this area is beyond the remit of this article. It is worth remembering, however, that the tests operate not only by reference to the percentage of the share capital owned by group members, but also by reference to entitlement to assets on a winding-up and income distributions. While loans from unconnected parties should not generally cause problems in this area, loans from related parties that are not members of the group may cause a company to cease to be a member of the group.

Johnston Publishing (North) Ltd v HM Revenue & Customs [2008] will have to be considered if the reorganisation is part of a transaction under which the transferee will leave the group. Most readers will be aware that, while transfers between group members are tax free, if the transferee leaves the group within six years of the transfer the original transfer will become taxable. There is a limited exception from this general degrouping charge, where transferor and transferee leave the group as associated companies. For some time, HMRC and advisers had been arguing over whether:

1. it was necessary for the transferor and transferee to be associated both at the time of the initial transfer and when they left the group (HMRC’s view); or
2. whether it was sufficient that the transferor and transferee were associated at the time when they left the group.

For these purposes, companies are associated if, by themselves, they would form a group. For example, if company A owns 100% of company B, company A and B are associated. However, if company A and company B are 100% subsidiaries of company C, they are not associated. At the end of 2008 the Court of Appeal held that HMRC’s view of the associated companies exemption was the correct one. Thus, when a reorganisation is made in contemplation of the sale of the transferee, it will be necessary to consider whether the shareholdings in the group need to be first reorganised to ensure that the transferor and the transferee are associated. This would guarantee that the benefit of the associated companies exemption is not lost. The Johnston case will also have to be considered for previous business transfers where the six-year clawback window is still open. Although there is nothing that can be done to ‘cure’ the position if the companies are not associated at the time of the transfer, taxpayers will need to be aware of any changes that may arise.

Indirect taxes

In general, indirect taxes will not have a great impact on domestic reorganisations. Where the assets transferred amount to a ‘business’ for VAT purposes, it will usually be possible to ensure that the transaction is treated as a transfer of a going concern for VAT purposes and, therefore, no VAT will need to be charged. Where the assets do not constitute a business, VAT can be chargeable but may be recoverable by the transferee. Caution should be taken when the consideration is not paid in cash, as the transferee may not be expecting a VAT charge in those circumstances.

Stamp duty land tax (SDLT), which applies to the transfer of land, and stamp duty (SD), which now only applies on transfers of shares and securities, may cause more difficulties. While transfers between group members are generally exempt from SDLT and SD, the relief may be difficult to obtain when the reorganisation is effected in contemplation of a sale of the transferee. SDLT and SD group relief will not be available when there are ‘arrangements’, at the time of the transfer, for the transferor and transferee to cease to be members of the same group.⁵ The definition of ‘arrangements’ is extremely wide and is not limited to cases where a binding agreement for the sale of the transferee has been entered into. Although each case will have to be looked at on its own facts, it is likely that arrangements will exist where:

1. there exists a plan or a scheme that would result in the group relationship being broken; and
2. the parties to the plan or the scheme have agreed it in principle.

For example, if a group decides to transfer assets having agreed that it will market the transferee for sale, but no purchaser has been identified, it is unlikely that disqualifying arrangements exist. However, if a purchaser has been identified and has entered into heads of terms or a letter of intent, even if non-legally binding, disqualifying arrangements will exist.

SDLT (but not SD) also contains provisions that operate to withdraw any group relief previously granted when, within three years from the initial transfer, the vendor and purchaser cease to be members of the same group. Until recently, the rules relating to the withdrawal would cease to be effective following the vendor leaving the group. However, the Finance Act (FA) 2008 now contains provisions that ensure that when the vendor first leaves the group, relief is not withdrawn. Relief is withdrawn, however, if there is a subsequent change in control of the purchaser within the original three-year period. Some care will have to be taken to ensure that prior reorganisations do not inadvertently fall foul of this rule, although the legislation does contain a ‘grandfathering’ provision that prevents the withdrawal of relief in these circumstances on transfers effected before 13 March 2008. In addition, the definition of ‘control’ for these purposes is that which is used for anti-avoidance purposes in the ‘close companies’ legislation.⁶ This means that control may change, for example, even if shares in the transferee are not transferred because shares have a priority return and the profits of the transferee are such that the preferred return entitles the shareholder to most of the profits available for distribution.

Non-tax considerations

While tax considerations play a vital role in the structure of internal reorganisations there are other considerations that will require careful analysis. To name only two:

1. The current market downturn has brought to the fore issues relating to defined-benefit pension plans. The fact that most of these schemes will be in deficit (sometimes to a very substantial extent), considerably reduces the room for manoeuvre in structuring the transaction. At the very least, it is likely that a reorganisation would require trustee approval that, even if one assumes is obtainable, may take time to obtain. In certain circumstances, Pensions Regulator approval may be required.
2. Until October 2008 the relatively inflexible rules of UK company law regarding the maintenance of capital were a major determinant of the structure of a transaction. However, the introduction of new and easier procedures for capital reductions, together with the fact that financial assistance rules have disappeared for UK private companies, means that reorganisations will be much simpler. While the procedures for capital reductions are much simpler under CA 2006, they are still in their infancy and are subject to constantly evolving ‘best practice’, especially in the current market.⁷ To take only one example, the directors of a company wishing to reduce its capital under the new streamlined process will have to make solvency declarations stating that the company is able to meet its debts as they fall due and will be able to do so for twelve months after the reduction. There is no requirement, in CA 2006, that such a declaration of solvency be supported by the company’s auditors. While this can be seen as a welcome removal of red tape, it will no doubt put some directors in a very difficult position in the current climate. In particular, directors will have to consider what kind of due diligence they want to perform prior to signing off the solvency statements and whether they can get (or should get) any comfort from the auditors. No doubt these provisions, which were largely drafted before the credit crunch, will be severely tested in the next few months and best practice will continue to evolve.

Group reorganisations: the international dimension

Multinational groups, in addition to the UK-centric issues identified above, face several specific issues that domestic groups will be happy to escape (or at least, face to a lesser extent).

Current uncertainties

Tax legislation in both the UK and the US is currently in a state of flux.

In the UK the government is proposing to introduce two major pieces of legislation (the dividend exemption and the so-called worldwide debt cap) that will have a major impact on multinationals. (See IHL168, p54) HMRC, to its credit, has consulted on these proposals and appreciates that some of them are not currently workable or could be improved. However, it is clear that HMRC’s thinking at the moment is that some form of the worldwide debt cap legislation will be introduced and companies should plan accordingly. HMRC has also indicated that some form of grandfathering of existing structures is likely to be a part of the legislation, but the detailed provisions have not been seen.

A major reform of the UK’s controlled foreign companies (CFC) regime was also part of the package containing the dividend exemption and the worldwide debt cap.

The reform of the CFC regime has been pushed back and HMRC has indicated that the new rules will strengthen the current UK regime, which is based on an entity-by-entity approach, rather than the wholesale reform initially indicated that would have sought to distinguish between active and passive income with passive income income viewed unfavourably. While the change in approach is welcome, there will no doubt be some tightening of the exiting rules and this should be borne in mind when restructuring a group.

In both the UK and the US there has been much comment devoted to tax avoidance and tax planning. Ten years ago or so, avoidance was the acceptable face of tax planning, in contrast to tax evasion. The debate has moved on and the emphasis is now on taxpayers paying their fair share; tax avoidance is seen as undesirable. Recent announcements suggest that the UK government, and perhaps to a lesser degree the US government, will come under pressure to put an end to some of the forms of planning (eg locating intellectual property in low-tax jurisdictions such as the Netherlands or Switzerland).

OECD guidelines

Although pricing is an issue in all forms of restructuring, the question of the correct transfer pricing is of much greater concern to companies with offshore operations. Revenue authorities were concerned, in the boom years, that they were losing out when multinational companies restructured their business operations (such restructurings could involve actual transfers of assets but often did not). Although economic conditions are disfferent, these concerns will not disappear in the current climate.

At the end of last year, the Organisation for Economic Co-operation and Development (OECD) published guidelines that address business restructurings specifically. Comments are invited from interested parties and they are in draft form (and are likely to remain this way some time). While some of the guidance is welcome – for example, the acknowledgement that it is possible to carry out a business restructuring for commercial reasons and not just for tax efficiency – the lack of specific guidance suggests that there are disagreements as to how to tax these transactions. Tax authorities who participated in the process seem to have been greatly concerned that if they gave too much away in the guidance they would be forfeiting some of their tax revenues. This is worrying for taxpayers since it hints at the possibility of some serious arguments between tax authorities in the future, something that might lead to double taxation for interested parties.

However, the guidelines are not all bad and there are some welcome aspects. For example, the acknowledgement that in most cases the tax authorities should not seek to adjust tax outcomes by deeming a transaction that did not occur to have occurred, but instead to do so by adjusting the prices paid to reflect an arm’s length outcome for the transaction that actually occurred.

Reversing past transactions

Some multinationals may now be seeking to reverse the effect of past transactions. For example, a group may have set in place structures that are consistent with the retention of profit or income outside their home jurisdiction on the assumption that such profits and income would be re-deployed in the business without being remitted first to their home jurisdiction. The same groups may now be wondering whether their structures will work if they need to remit income or profits home to boost their earnings. In the past, this might have incurred a significant tax cost. It is now possible that a group has losses at home that would ensure the income is not taxable. It may be necessary for those groups to plan for cash extraction from foreign sub-groups in a way that was not contemplated until very recently.

By Blaise Marin-Curtoud, partner, Jones Day.

E-mail: bmarin@jonesday.com.