The rules surrounding reorganisations of share capital and the transactions that are treated as reorganisations of share capital were part of the very earliest legislation charging tax on capital gains, the short-term gains rules introduced by Finance Act 1962. The majority of those rules are replicated in the latest legislation, TCGA 1992, in a virtually unchanged form. Obviously, the rules as a whole have evolved, but it is clear that these rules have been an important part of the capital gains legislation since its earliest inception.
This Tax Digest aims to be a practical guide to the way in which the rules work, from the simplest reorganisations of a company's share capital through to more complex transactions, such as mergers and demergers. Most provisions are illustrated by examples that should make clear both how the transactions proceed and what the tax consequences are. All the examples are based on real-life experiences from 25 years of being involved in these transactions, and the Digest includes practical advice on such areas as applying for clearance from HMRC and computing the capital gains in complex cases.
A few notes on company law
It is not possible to practice tax in the area of corporate transactions without having some working knowledge of corporate law in order to determine what transactions are lawful. Indeed, there is nothing more embarrassing than designing a complex sequence of steps to achieve what a client wants, only to be told by the corporate lawyers that one or more of the steps cannot lawfully be carried out.
A second reason for understanding some basic company law is to ensure that responsibility for the consequences of transactions is firmly placed with the people who are competent to advise on those elements. For example, if we want to carry out a transaction in respect of only one class of shares of the company, the tax legislation tells us where that is allowable from a tax perspective, and what the tax consequences will be. But it does not tell us whether the shares concerned are, in fact, shares of different classes or whether the proposed transaction is lawful under company law. Therefore, when designing or implementing these transactions, we must get advice from the corporate lawyers that the shares are properly shares of different classes and that the transaction is lawful.
The obvious corollary to this is that we, the tax advisers, should make sure that we do not inadvertently accept or take on responsibility for aspects of the transaction that are, properly, the domain of corporate lawyers (or, indeed, of any other advisers in a transaction). Even if a tax adviser is qualified as a lawyer, unless they are actually acting in that capacity, they should stick to advising on the tax issues and ensure that responsibility for the company law issues is taken on by the lawyers.
Given that there are a number of areas of corporate law which tax advisers in this area should be aware of, I have included some separate text boxes about company law – including what constitutes different classes of share – which should be taken by readers as guidance but not advice in these areas. If you want chapter and verse, ask a corporate lawyer or read a textbook on the relevant areas of corporate law. But if you are advising on a transaction, make sure that the corporate lawyers take responsibility for advising on these issues.
'Original shares' and 'new holding'
Let us start off with a simple scenario, Example 1, where Alex and Bella set up Apple Ltd in March 1999 and each subscribed £50 for 50 £1 shares (see Example 1 Diagram). In September 2019, when the company was worth £1 million, Alex and Bella decided that the share capital should be reorganised into shares of a different class, 'A ordinary shares'. (For the moment, let's not worry about the technical question as to what makes shares a different class, as this is just an example.)
The core piece of legislation that is relevant here is TCGA 1992, s 127 'Equation of original shares and new holding':
'Subject to sections 128 to 130, a reorganisation shall not be treated as involving any disposal of the original shares or any acquisition of the new holding or any part of it, but the original shares (taken as a single asset) and the new holding (taken as a single asset) shall be treated as the same asset acquired as the original shares were acquired.'
For the moment, let us accept that the 50 £1 shares each held by Alex and Bella originally are the 'original shares' and the A ordinary shares they hold afterwards are the 'new holding'. The impact of section 127 is, therefore, that neither of them is treated as selling their ordinary shares or as acquiring the new shares. Instead, the new shares are treated as having cost £50 each and as having been acquired in March 1999. This achieves a dual aim:
Alex and Bella do not suffer a chargeable gain in a scenario where they have not received any cash consideration out of which a tax bill could be paid; and
the shares are not rebased for capital gains tax purposes, so that HMRC will get the appropriate amount of capital gains tax when the shares are eventually sold. A helpful corollary of the operation of section 127 is that, since the new shares are deemed to have been held for as long as the old shares were held, ie since March 1999 in the example, the holding periods required for tax purposes, such as business asset disposal relief (previously entrepreneurs' relief), business property relief for inheritance tax purposes or for capital treatment for a company purchase of own shares, are all unaffected by the reorganisation.
Company law comment – what is a class of share?
Section 629(1) of Companies Act 2006, 'Classes of shares', says that, 'For the purposes of the Companies Acts shares are of one class if the rights attached to them are in all respects uniform'.
There are a number of provisions in tax legislation that refer to different classes of shares, including several provisions relevant to the subject matter of this Tax Digest. However, there is no definition of a class of shares in the tax legislation, so we have to look at corporate law to see what this means. As is clear from the legislation, if shares have exactly the same rights, then they are shares of the same class for company law purposes and, therefore, for tax law purposes.
Examples of shares where the rights between different classes are not in all respects uniform might be ordinary shares, carrying a normal rate of dividend, compared with preferred shares with a preferred dividend that is often at a fixed rate, or deferred shares, that may not have any dividend rights at all. Similarly, ordinary shares with one vote per share would be of a different class to shares that did not carry any voting rights.
If, however, a company decides to designate some of its shares as 'A shares' and some of its shares as 'B shares', this does not automatically mean that they are shares of a different class. If the only difference is the name, then one must assume that all the actual rights associated with the shares are in all respects uniform. This is a noteworthy change from the previous rules, in Companies Act 1985, which provided that shares with different names were to be treated as shares of a different class.
Of more indeterminate status are so called 'alphabet shares'. One of the most common planning strategies is for companies to arrange that one shareholder's shares are called A shares and another shareholder's shares are called B shares, with the intention that a different rate of dividend can be declared by the directors on each type of share. However, the description of each type of share in the articles of the company is likely to be identical, ie something along the lines of 'the shares carry a rate of dividend to be decided by the directors in general meeting'. As a result, we have shares that are identically described in the articles of the company, and yet they can carry a different rate of dividend. Are they shares of the same class, on the basis that the rights attaching to those shares are defined exhaustively in the articles, and are identical? Alternatively, notwithstanding the description in the articles, are they shares of a different class because they can, potentially, carry different rates of dividend each year? The jury appears to be out on this point in that corporate lawyers with whom I have discussed this seemed to divide roughly 50:50 between the two possibilities.
What is a reorganisation?
We are starting to get a feel for the tax effect of a reorganisation of a company's share capital, but we haven't said what a reorganisation actually is. Our starting point is, as always, the tax legislation itself and, specifically, TCGA 1992, s 126(1), which states that, 'for the purposes of this section … “reorganisation” means a reorganisation or reduction of a company's share capital'. This is not particularly helpful; it tells us that a reorganisation for the purposes of the capital gains legislation should include a reduction of capital, but it does not tell us what a reorganisation is, in the sense intended by its second appearance in TCGA 1992, s 127, ie the thing that the draftsman assumed was a reorganisation before the addition of reductions of capital to extend the meaning for the purposes of the capital gains legislation.
Given that the first version of this legislation came into force with Finance Act 1962, it may seem slightly odd that a final decision as to what constitutes a reorganisation was not formally handed down until the 1989 judgement in the Court of Appeal in the case of Dunstan v Young, Austin and Young Ltd 61 TC 448.
This case revolved around the recapitalisation of a member of the Trafalgar House group, Jones Refrigeration Ltd (Jones), by its immediate parent company, Young, Austen and Young Ltd (YAY). Jones Refrigeration owed its parent company something over £200,000 and trading had not been particularly successful. However, the company was still thought to have some value if the group were to sell it having cleaned up the balance sheet. As a result, YAY subscribed for 200,000 £1 shares at par in Jones, which was then able to repay all or most of its indebtedness to YAY. On the same day, Jones was sold for £38,000.
The reason for the structure shown in the diagram is that, in those days, a company had to have more than one shareholder, so most groups of companies would have a nominee company, in this case called THIGS, which would have legal ownership of one share of every group company. As this was only a legal holding, the beneficial ownership of all the shares was with YAY throughout.
The Inland Revenue contended that the investment of £200,000 immediately before the sale was not a reorganisation and, therefore, that the transaction, not being at arm's length, gave rise to no new base cost for the shares. YAY contended that the transaction was a reorganisation within the terms of what is now TCGA 1992, s 126(1), so that the total base cost was £216,100, ie the aggregate of the amount originally paid for the shares and the further investment (under the rules then applicable, now at TCGA 1992, s 128(1) – see below).
The Inland Revenue's arguments against the transaction being a reorganisation had two limbs. Firstly, they highlighted the fact that THIGS was not part of the transaction, ie it did not subscribe for new share capital, and this was contrary to the general approach to reorganisations, whereby the identity and proportionate ownership of shareholders had to be maintained. The second leg was that, since a reduction of a company's share capital was explicitly treated as if it were a reorganisation of a company's share capital, the fact that the legislation was silent about an increase in share capital must mean that an increase in share capital could not be a reorganisation (except in the limited circumstances described at what is now TCGA 1992, s 126(2)).
While the Special Commissioner and the High Court seemed to think that the first argument caused the company some difficulty, the Court of Appeal agreed with the company that the rules for nominee holdings (now at TCGA 1992, s 60(1)) meant that the nominee shareholding should be ignored and the transaction effectively looked at as if all 1,000 shares of Jones were held by YAY. The court also agreed with the company that the examples of increases in share capital given in what is now section 126(2) were not exhaustive, and that there was no reason why an increase in share capital of a company, as such, should not be a reorganisation of share capital on first principles. As Balcombe LJ put it:
'We are left with the clear impression that the policy behind [the legislation] is that, for the purposes of capital gains taxation, there shall not be a disposal of the original holding, or the acquisition of the new holding … where the shareholders remain the same and they hold their shares in the same proportions, notwithstanding that the number of shares increases (a reorganisation or conversion) or decreases (a reduction) within the same company'.
So, the first mantra for a reorganisation of share capital on first principles is 'same shareholders, same proportions'.
'Original shares' and 'new holding' [3.3] The other part of the definition of reorganisation in TCGA 1992, s 126(1) gives us more of an understanding of the meaning to be given to the phrases 'original shares' and 'new holding', as follows:
'in relation to the reorganisation—
(a) “original shares” means shares held before and concerned in the reorganisation,
(b) “new holding” means, in relation to any original shares, the shares in and debentures of the company which as a result of the reorganisation represent the original shares (including such, if any, of the original shares as remain)'
One important point that leaps out of the description of a new holding is that there is no requirement for all, or indeed any, of the new holding to consist of shares. It can, instead, consist of debentures of the company. Thus, we understand that a reorganisation of a company's share capital can reorganise some of that capital into a completely different type of instrument, a debenture. This is not something we see very often in simple reorganisations but, as we will see, it has important consequences for certain transactions that are treated as being reorganisations, such as share exchanges or schemes of reconstruction.
Company law comment – debentures
Much of the tax legislation dealing with reorganisations of capital, and with other transactions that are treated as such, refers to 'debentures', although tax practitioners usually use the phrase 'loan notes'. For our purposes we usually assume that they are the same thing. However, since the tax legislation requires the instrument concerned to be a debenture, we should ensure that the corporate lawyers working on the transaction are instructed to ensure that the loan instrument used in the transaction is a debenture. Alternatively, there are times when we want to ensure that a debt is a simple debt (or 'debt simpliciter' in legal parlance), in which case we will need the lawyers to confirm that the terms of that debt do not tip it into being a debenture.
There is no universally accepted definition of a debenture but some general features of a debenture are:
- it is a registered participation in debt issued by a company;
- it will typically be secured by a floating charge over the company's assets and undertaking;
- it will often carry interest and have fixed payment and repayment dates;
- it is a piece of property, ie something that you can buy or sell; and
- its terms of issue will be described in the company's Articles of Association.
In the wider commercial context, a debt secured by a debenture often ranks ahead of simple debts, so if the issuing company becomes insolvent, the holders of debentures should be repaid ahead of unsecured creditors.
In contrast, a simple debt would simply rank alongside all the other unsecured creditors if anything went wrong. There is no barrier to a simple debt carrying interest or even having agreed terms of repayment, but it is not a creature of the company's Articles of Association, so a simple debt cannot, for example, carry any special rights of veto.
It is obvious that, if there is going to be a reorganisation of the company's share capital, somebody must hold that capital, so there isn't much to say about the requirement for the original shares to be held before a reorganisation. But it is important that the shares we are looking at be concerned in the reorganisation, that is, something must happen to them for the transaction to potentially qualify as a reorganisation. Similarly, the new holding must be in some way related to the original shares and must arise as a result of the reorganisation of those original shares. Following Young, Austen and Young, we know that an increase in share capital can also be a reorganisation, and it will also clearly be one where the original shares still exist. Conversely, looking back at Example 1, this was a reorganisation where all the shares were converted into something else, and the original shares no longer exist.
Many of these points were brought out in the case of Unilever (UK) Holdings v Smith 76 TC 300.
The subsidiary, BOHC, had a class of shareholders entitled to a preferred dividend and Unilever wanted to be rid of them. This was done by an agreement between BOHC and those shareholders that the class of shares be cancelled. Payment to the preference shareholders came directly from Unilever itself, as part of the tripartite arrangement. When BOHC was subsequently sold, many years later, the company claimed a capital loss on the ground that the payment made to buy out the preference shareholders constituted new consideration paid for the new holding in a reorganisation.
The decision was that the transaction did not amount to a reorganisation. The nub of the main judgment, by Jonathan Parker LJ in the Court of Appeal, is that 'a “new holding” must, “as a result of the reorganisation”, “represent the original shares”'. If that requirement is not met, the transaction cannot constitute a reorganisation. The only shares remaining after the preference shares had been cancelled were the ordinary shares, which were not changed, disposed of or acquired in any way. It was accepted that their value would increase as a result of the elimination of the preference shares, but this was an extraneous element that had no impact on the ordinary shares themselves. Furthermore, since the preference shares were completely eliminated, there was no holding of shares or debentures afterwards which could be said to represent those preference shares, following the cancellation. Hence, there was no reorganisation in this case and Unilever was not able to claim the £6.9 million consideration as base cost for the later disposal.
As the judge put it: 'there was no “reorganisation” in the instant case unless the effect of the cancellation of the preference shares was to alter the rights attaching either to the ordinary shares or to the preference shares'.
Thus, a transaction which cancelled the preference shares and left the ordinary shares unchanged could not be a reorganisation for tax purposes.
In my view, the two important takeaway points from this case are:
- shares cannot be 'concerned in' a reorganisation unless there is some element of disposal or acquisition or alteration of the rights to give that effect; and
- for a reorganisation to exist, there has to be a new holding that in some way represents the original shares.