Corporation Tax: Chargeable Gains: Deferral Relief For Substantial Shareholdings

Summary

S.1 The world's economy is changing rapidly. In particular, developments in technology are fast opening up new markets and increasing international competition. The Government's aims are to ensure that in the new global economy:

• the UK is seen as an attractive place in which to do business; and
• UK businesses can compete successfully.

S.2 To achieve these aims, the Government is promoting innovation and modernisation in UK business, as well as working to make the UK a more competitive environment for businesses generally.

S.3 Certain aspects of the current tax code for capital gains can hinder businesses' international competitive position and distort their commercial decisions, forcing them to adopt structures that they would not have needed otherwise. It may also act as a disincentive to companies that are investing to innovate and modernise. In particular, it can result in a charge to tax where a company sells a shareholding in a successful business that it has developed in order to invest in further developing the business or in developing another business.

S.4 To address these problems, the Government is considering introducing a substantial relaxation in the taxation of corporate capital gains by introducing a new tax relief for companies alongside the existing rollover relief so that the charge to tax is deferred where a company

• realises a gain on the sale of a shareholding in a business or assets of that business; and
• invests the proceeds in developing that business or another business or acquires shares in another business.

S.5 Broadly, the Government envisages that the relief would apply to:

• defer the charge on a gain arising where
• any qualifying shareholder company, regardless of its activities (Chapter 2)
  sells
  • a shareholding in a trading company (Chapter 3), or
  • a shareholding in the holding company of a trading group (including a sub-holding company) (Chapter 3), or
  • a business asset within the existing business asset rollover relief
• and reinvests the proceeds in such an asset or shareholding
• provided that the shareholding company holds a substantial holding for a minimum period (Chapter 4).

S.6 A possible way of defining a trading company and a holding company of a trading group would be to follow the approach in the capital gains tax taper for individuals, subject to modification to include shareholdings in sub-holding companies (Chapter 3).

S.7 Broadly, a substantial holding would be one where the shareholder holds in excess of a specified percentage, say 30%, of the issued ordinary share capital conferring a genuine economic interest in the company or group. In order to qualify a substantial holding would have to be held for a minimum period of, say, 2 years (Chapter 4).

S.8 Assuming the funds released are reinvested in an asset currently qualifying for business asset rollover relief or in a qualifying shareholding (see Chapter 5), the charge to tax on the gain would then be deferred. Deferral would be until the replacement asset or shareholding is sold, or one of a number of other defined events occurs (the possible events are discussed in Chapter 5). Further deferral relief might be available at that time.

S.9 Special considerations relating to capital gains groups are likewise discussed in chapter 5.

S.10 Chapter 6 focuses on the mechanics of the new relief. It considers what needs to be reinvested; the time limits for reinvestment; the mechanism for achieving deferral and the interaction with the existing business asset rollover relief.

S.11 Chapter 7 discusses the measures which might be necessary to protect against exploitation of the relief.

S.12 The Government is interested in hearing views generally and on a number of particular points for consideration which are summarised at Annex A.

S.13 The Government's current intention is to publish draft legislation at the time of the Pre-Budget Report. It would then invite comments on the draft legislation before incorporating it in the 2001 Finance Bill.

S.14 A draft Regulatory Impact Assessment would also be published at the same time as draft legislation. In the meantime, the Government would welcome comments on how the compliance costs of a new relief might be minimised.

Chapter One - Introduction

1.1 In the March 2000 Budget the Government announced that it was considering introducing a new deferral relief for substantial shareholdings held by companies. This technical note invites views on how such a relief should work.

The overall picture

1.2 The Government is very conscious that the world economy is changing rapidly. Developments in technology and communications are opening up new markets and increasing international competition. The Government's aim is that in the new global market place

• the UK should be an attractive environment in which to do business; and
• UK businesses can compete effectively.

1.3 The Government's Budget 2000 thus proposed a wide-ranging package of tax measures to help UK enterprises meet the new challenges. In particular some of these are designed to give businesses, including multi-national groups of companies, more flexibility over how they choose to structure and to operate. The specific measures range over:

• changes to the group relief rules to give companies more freedom to structure themselves internationally in ways that suit their business rather than in ways driven by the tax system;
• changes in the capital gains rules for groups to allow them to match their gains and losses more easily;
• a stamp duty exemption for sales of intellectual property to boost R&D and foster an environment in which invention and innovation are encouraged;
• improvements in the tax treatment of companies which draw up their accounts in a foreign currency; and
• changes in the tax treatment of "ratchet loans" to give companies easier access to the finance they need to compete effectively in the international market.

1.4 Both to complement the various measures now contained in the Finance Bill and to increase the UK's attractiveness as a first-rate place in which to do business, the Government is considering two further proposals. The first is to provide relief to companies when they make a gain on a substantial holding of shares and then look to enhance corporate profitability by reinvesting the funds released. Second, the Government proposes to overhaul the tax regime for companies' intellectual property and other intangibles, including consultation on the introduction of a tax relief for the costs of purchasing goodwill and other intangibles.

A relief for companies' gains on substantial shareholdings?

1.5 At present an immediate corporation tax charge may be due on the chargeable gain arising when a company disposes of a shareholding at a gain. This applies whether the shares are held simply as a temporary investment or the investor company has a sufficiently substantial stake in the investee company both to influence the results of the investee company's underlying business and for that stake to be considered a structural part of its own business. The immediate tax charge arises irrespective of how the investor company utilises the consideration from the disposal.

1.6 The existence of an immediate charge on disposals by companies of substantial holdings differentiates the UK from many other countries whose tax system provide various reliefs. This is true of a number of European countries: for example the Netherlands has a participation exemption for capital gains and Germany is in the process of widening its relief for shareholdings in foreign companies to embrace domestic shareholdings as well. Likewise the US has a limited rollover relief for certain incorporation, liquidation and reorganisation transactions. To that extent the current chargeable gains rules impair the UK's international competitive position. They deter UK groups and foreign companies with UK subsidiaries from retaining immediate ownership of their subsidiaries and other substantial holdings in this country. Instead they might set up a holding company in a jurisdiction where they can effectively defer or eliminate tax on any gains from disposing of their shares in the underlying businesses.

1.7 For those who cannot, or do not wish to incur the trouble and expense of setting up an overseas holding company, the present tax charge on disposals of substantial shareholdings may deter companies or groups from deploying their resources so as best to enhance their overall profitability. As such it can inhibit business enterprise and companies investing to innovate and modernise are perhaps most at risk.

1.8 The prospect of an immediate charge can also lead to companies being 'locked in' to their existing investments. They may hold on to poor investments for too long and fail to make new investments that are strategically better. Such locking in, by inhibiting normal market decisions to sell shareholdings can also inhibit good corporate governance, giving some managements a degree of protection from normal market pressures.

1.9 It can also distort commercial decisions within a company or group. In contrast to the position for shareholdings, where a company disposes of any one of a range of business assets used in the course of its trade - land and buildings; fixed plant and machinery; goodwill etc - the tax on any gain arising can be deferred by reinvesting in another such business asset. There is thus an inbuilt incentive, particularly with wholly owned subsidiaries, to sell at the asset tier, rather than the share tier. That applies even where, the chargeable gains rules apart, the commercially sensible decision would be to do the opposite.

The way forward

1.10 The Government wishes to consult on both its two further proposals to help UK enterprises meet the challenges of the new global economy. A Technical Note on the proposed reform of intangible property is being published in parallel with this Note on the proposed relief for substantial shareholdings. In both cases, the Government's current intention is to publish draft clauses on the possible changes at the time of the pre-Budget Report on which comments would be invited before the legislation is incorporated in Finance Bill 2001.

1.11 In any new relief the Government would aim to keep compliance costs to a minimum. The Government would aim to publish a draft Regulatory Impact Assessment when it publishes draft legislation. In the meantime, this Note asks for views on how the compliance costs of any new relief might be minimised.

Chapter Two - The Shareholding Company

2.1 With its reforms to capital gains tax (CGT) in Finance Act 1998 and Budget 2000, the Government has already introduced incentives for individuals and others to boost productivity, encourage entrepreneurial activity, increase the provision of risk capital and encourage wider share ownership amongst employees. The proposal here relates to companies. The intention is that this relief should apply to all companies, including the UK branches of non-resident companies, when the shareholding being disposed of and the reinvested shareholding or other business asset are within the charge to corporation tax on chargeable gains.

2.2 As will be seen later (chapters 3 to 5), the proposal is that the relief should apply to a gain arising on a substantial shareholding in a trading company or the holding company of a trading group on the qualifying reinvestment of certain gains into such a holding or other business asset.

2.3 However, so far as the shareholder company claiming the relief is concerned, it is not proposed that access to the relief should be determined by what activities that company carries on.

Should the deferral relief apply to close companies?

2.4 There is however, a substantive point as to whether the relief should be applied to close companies.

2.5 The concern is that it would be possible for substantial holdings in trading companies, presently held directly by individuals, to be held through an investment company which in turn is wholly owned by the individual. By arranging that any sale of the holding in the trading company is made by the investment company, the gain could be deferred if a qualifying reinvestment is made in another trading company. Serial entrepreneurs could therefore achieve a more favourable result than if the sale had been made by them directly.

2.6 This is contrary to the thrust of recent changes to CGT which has been to reduce the effective tax on sales of assets that have been held for a sufficiently long time, but to ensure that some tax is paid, even when a serial entrepreneur chooses to sell one business and reinvest in another. This would argue for restricting the relief to non-close company investors.

2.7 But there are arguments the other way. In particular it is clear that there are some very large close companies and groups who contribute substantially towards productivity. It is recognised that barring them from the benefit of this relief might be a significant step. It might be possible to find some workable way of carving out such companies from any restriction - assets, turnover etc. exceeding a certain size. But this does not look attractive as a practical possibility and may have the unintended consequence of large investment companies held by certain individual entrepreneurs benefiting from the relief. It therefore seems likely that all close companies will need to be excluded from the benefit of this relief.

How should the new relief apply to life insurance companies?

2.8 It is an essential feature of the life tax regime that the income and gains backing basic life policies are fully taxed in the hands of the company so that the policyholder can be relieved of any basic or lower rate income tax liability on policy gains and can be given credit for basic rate tax against any higher rate liability. It is therefore important that the new relief cannot be used to avoid such liability. So special rules may be needed in respect of those shareholdings of life companies which are backing life policies.

2.9 Achieving the right balance might not be straightforward. For proprietary life companies, relief might be denied where the shares are held in the long-term fund and allowed where the shares are held outside the long term fund. However, mutual companies have to keep all their assets in the long-term fund. So for mutual companies, it would be necessary to differentiate those shareholdings which can qualify for the relief from those which cannot.

2.10 A friendly society might be treated in the same way as a mutual company.

2.11 Alternatively, it may be possible to target the general relief sufficiently accurately to exclude any shareholdings that back long term business. However, it would be difficult to frame these general rules to exclude relief on trading subsidiaries held to back long term business.

How should the new relief apply to North Sea companies?

2.12 Special rules - known as the 'ring fence' rules - prevent profits and gains from UK oil extraction activities from being reduced by losses from other activities. As part of the 'ring fence' rules, rollover relief is currently restricted where, in connection with the transfer of an interest in an oil field, a company disposes of its interest in an oil licence or an asset used in connection with a field. In these circumstances, rollover relief can only be claimed on any gain resulting from the disposal if the replacement asset is used solely for the purpose of the ring fence (i.e. UK oil extraction) trade. The asset into which the gain is rolled over is deemed to be a depreciating asset and holdover treatment applies.

2.13 In applying the relief to gains made by North Sea companies, the Government will want to preserve the principle underlying the current North Sea rollover rules to ensure that the 'ring-fence' is not breached. This means that the new deferral relief will only be available if the gain from the disposal of a shareholding that derives its value, or the greater part of its value, from North Sea exploration or exploitation assets is 'rolled over' into another North Sea shareholding or other North Sea assets. Whatever the form of the relief generally (see Chapter 6), the 'new' North Sea assets acquired by the company would likewise deemed to be depreciating assets subject to holdover treatment.

Chapter Three - The company in which the shares are held

3.1 This chapter looks at what kind of companies should be qualifying companies for the purposes of the deferral relief so that a shareholding would be the subject of a qualifying disposal or - subject to the further points in chapter 5 - a qualifying reinvestment.

Trading companies

3.2 The Government's objective is to promote innovation and modernisation in productive business. So it follows that the relief should be targeted at disposals and acquisitions of shareholdings in companies that exist for the purpose of carrying on a trade (trading companies).

3.3 It is not the purpose of the relief to facilitate the rationalisation of investment holdings, such as interests in companies that exist merely for the purpose of making and holding a portfolio of investments. Targeting the relief on disposals and acquisitions of shareholdings in trading companies would exclude interests in such investment holdings.

3.4 Likewise it would be a cause for concern if the relief were to benefit disposals of shares in a company which, albeit theoretically trading, was effectively being used as a 'moneybox' for another connected company. If it were felt necessary to exclude such companies specifically, one possibility might be to follow the approach in the Controlled Foreign Company provisions and use a definition based on paragraph 9, Schedule 25 ICTA 1988 to exclude companies thereby treated as carrying on investment business.

3.5 The proposal is to include within the scope of the relief shareholdings in companies that carry on a property-based trade, such as property dealing or providing property management services. However, holding property by way of investment, such as holding to let, would not amount to carrying on a trade for the purposes of qualifying as a trading company.

Holding companies of trading groups

3.6 A company may hold shares in the holding company of a group of companies carrying on one or more trades or it may be a holding company of other sub-holding companies within such a group. Where there are holding companies or sub-holding companies the aim is to provide maximum flexibility so that the relief could operate at any of the shareholding tiers.

3.7 Thus, in addition to trading companies, it is proposed to treat holding companies of trading groups and sub-holding companies of trading sub-groups as qualifying companies, so that the relief could apply where:

• a company disposed of or acquired a shareholding in the holding company of a trading group, or
• the holding company disposed of or acquired a shareholding in an underlying trading company, or
• the holding company disposed of or acquired a shareholding in a sub-holding company of a trading sub-group.

(In the rest of this technical note, references to a "holding company of a trading group" include references to a "sub-holding company of a trading sub-group".)

3.8 The application of the trading test to any particular shareholding would be by reference to the entire activity of the company, group, or sub-group represented by that shareholding. So that where a holding company had a trading arm and an investment arm the disposal of the investment arm would not qualify for relief, but the trading arm disposal would. Whether the shares in the holding company would qualify (if held by another company) would depend on the contribution of the different arms to the overall activities of the group.

Defining trading companies and holding companies of trading groups

3.9 A company or group may have a mix of trading and non-trading activities and assets. It is therefore necessary to consider how any relief would deal with disposals and acquisitions of shareholdings in such companies and groups. There are two main options.

3.10 The first option would be to follow the approach in the business asset taper and:

• exclude companies and groups with substantial non-trading activities, but
• disregard insubstantial non-trading activities, so that disposals and acquisitions of shareholdings in companies and groups with such activities came within the relief.

3.11 This approach would use concepts that are already present in existing legislation (Schedule A1 TCGA 1992). However, it would exclude shareholdings in some companies and groups from the scope of the relief, notwithstanding that they may have limited trading activities. Conversely, it would give relief in respect of disposals and acquisitions notwithstanding that there may be a limited amount of underlying non-trade assets.

3.12 A second option would be to follow the approach that has been used elsewhere and:

• bring shareholdings in any company or group that is wholly or mainly carrying on a trade within the scope of the relief, but
• apply an apportionment test to look through to the underlying assets of the company or group to determine the proportion that are held for trade purposes.

3.13 An equivalent proportion of the gain or reinvestment could then qualify for the purposes of the relief.

3.14 This approach would be more precise in the targeting of the relief than the business asset taper approach. However, it would still not ensure precise targeting, in that apportionment would necessarily have to operate by reference to a snapshot of the underlying assets at the time of the disposal or acquisition. Also, apportionment could be difficult to operate in practice in the case of a large group, particularly one with multiple tiers of companies. It would also involve significant compliance costs; for example, because of the need to value the underlying trade and non-trade assets.

3.15 The approach in business asset taper (the first option above) would be considerably more flexible and simpler to operate in practice than apportionment (the second option above). These benefits might be felt to outweigh the disadvantage arising from any imprecision in the targeting of the relief.

3.16 The definition of a holding company of a trading group in the business asset taper does not include sub-holding companies. The intention is to bring shareholdings in or by sub-holding companies within the scope of the deferral relief. Therefore, it would be necessary to modify the definition.

Chapter Four - The Shareholding on which the Gain arises

4.1 This chapter looks at what kind of shareholding could be the subject of a qualifying disposal or - subject to the further points in chapter 5 - a qualifying reinvestment for the purposes of the deferral relief.

4.2 The relief is intended to encourage shareholdings by companies that are large enough for the companies holding the shares to have a significant stake in the trade of the company in which the shares are held, and an ability to influence the results of that trade. It will be geared to the active shareholder, rather than the passive investor. On this basis, it is clearly right that the relief should apply to substantial shareholdings held by companies. The meaning of 'substantial' will need to be defined in the legislation.

4.3 It is considered that the relief should be focussed on shareholdings which are not just substantial in terms of size, but also 'structural'. A structural holding might be defined as one of sufficient size (as provided by the definition of 'substantial') and duration (by setting a minimum time throughout which a substantial shareholding must be held) so that the holding can be said to be part of the shareholder company's structural business, as opposed to being a temporary investment.

What interest should be used for defining 'substantial'?

4.4 There are a number of possibilities:

• many present tax rules rely on the percentage of ordinary share capital held in a company e.g. the definitions of 51%, 75% and 90% subsidiaries; the test of whether a 'material interest' is held in a company. 'Ordinary share capital' is defined in section 832(1) ICTA 1988 as meaning all the issued share capital (by whatever name called) of the company, other than capital the holders of which have a right to a dividend at a fixed rate but have no other right to share in the profits of the company;
• an alternative approach is to focus on voting rights exercisable by the investor company e.g. paragraph 6 Schedule A1 TCGA 1992 defines a qualifying company for the purposes of business assets taper relief by reference to voting rights;
• other provisions test either the level of ordinary share capital or the voting power of the investor company. It is proposed that the new corporate venturing relief should work in this way (paragraph 7 Schedule 15 Finance Bill 2000 (as introduced)) though there the test operates to deny relief where the threshold is exceeded, rather than as here to allow relief where the threshold is exceeded.

4.5 The objective is to target those companies that have a substantial interest in the sense of participating in the success of the investee company. That suggests that focusing solely on voting rights is too narrow and might point to a test based on ordinary share capital.

4.6 However, the history of defining a group of companies for capital gains purposes has shown that it is relatively easy to achieve the result that economic ownership is not aligned with the holding of ordinary share capital and that it is easy to manipulate a definition based solely on ordinary share capital.

4.7 That might suggest that a company's interest should be defined, as for capital gains groups, by reference to:

• ordinary share capital, and
• beneficial entitlement to profits of the company available for distribution, and
• beneficial entitlement to assets of the company in a winding up.

4.8 This would bring in the approach of Schedule 18 ICTA 1988. It would essentially focus on shares in which the shareholder has a true economic interest i.e. shares where the shareholder has the right to share in the appropriate proportion of profits and assets of the underlying company.

4.9 It is acknowledged that this approach is not without its disadvantages in that it can be quite complicated to apply the provisions of Schedule 18, particularly as the relative importance of the interests conferred by the second and third elements will fluctuate over time, depending on the results of the company's business and the financing of the company. The Schedule 18 test, as modified by Section 170 TCGA 1992 for the purposes of capital gains, would not however present additional hurdles for groups of companies and is a familiar concept.

4.10 A simpler, but in principle less satisfactory, alternative may be to take an approach similar to that used in the US for certain purposes where a key factor is whether an investor has the right to appoint directors in proportion to the investment in the ordinary share capital. Using this test, the shares that could be taken into account for the purposes of a substantial shareholding would be those that form part, or the whole, of the ordinary share capital and carry rights to appoint directors to the company board.

4.11 A test based on ordinary share capital would be very easy to exploit. But suggestions will be welcomed on how a test could be bolstered particularly with regard to a Schedule 18 ICTA 1988 type test. What changes, if any, should be made to that Schedule in the way that it would apply to the relief?

The treatment of indirect interests in establishing whether the threshold is exceeded

4.12 There will be different circumstances where companies may hold shareholdings in companies through direct and indirect holdings. One will be where the holdings are all held by companies within the same capital gains group, so that the shares in the subsidiary could be passed from one company to another under the no gain/no loss provisions of section 171. Another could be where there is no group relationship (as defined by section 170), but a company has an interest in a subsidiary through direct and indirect holdings.

4.13 Outside a capital gains group, if an interest is held via more than one company in this way, the influence of one company over another company is likely to be diluted, so that the combined interest is not in the nature of a substantial holding. Additionally, accommodating mixed direct and indirect holdings could make the relief complicated to operate. So the case for allowing the inclusion of indirect interests outside capital gains groups looks weak. But there may be a stronger case for allowing this within capital gains groups, not least because all the interests could be brought together in a single holding on a tax neutral basis.

At what level should the threshold be set?

4.14 The news release of 21 March 2000 suggested a threshold of shareholdings in excess of 30%. But cases can be advanced for both higher and lower figures, including

• 10%, being the figure at which a shareholding is regarded as substantial for the purposes of double taxation relief;
• 15%, being the figure at which (particularly in combination with other factors) an investor may be considered to hold a material influence for the purposes of UK merger control;
• 20%, being the figure at which a company is normally treated as an associated company for the purposes of accounting for an interest in such a company (paragraphs 20 to 22 Schedule 4A Companies Act 1985);
• 30%, allowing an investor blocking powers under Company Law over key resolutions proposed by other shareholders, and the same holding also triggers a mandatory offer under Stock Exchange Rules in respect of listed companies;
• 51%, giving the investor effective control;

and, of course, there is the figure of 75% as the test of whether a company is part of a capital gains group.

4.15 The objective is that this valuable relief should be available only where the shareholder has a substantial interest in the economic success of the investee company and the holding can be said to be part of the shareholder company's structural business. That suggests that the level of the threshold should be set at a reasonably high level.

4.16 Another consideration is the interaction with other tax reliefs operating in this area. In particular, 30% is the maximum investment possible for corporate venturing relief to be available. Allowing a deferral relief in a wider range of circumstances than the deferral relief under corporate venturing might be seen as undermining the effectiveness of that scheme. This would point to a threshold exceeding 30% for the new capital gains deferral relief, thereby ensuring no overlap.

4.17 The likely size of holdings in joint ventures and consortia is also a factor. In this context, too, a holding of more than 30% may be needed before an interest can be said to be truly 'substantial'.

4.18 The Government's objectives, both for the new deferral relief for substantial shareholdings and for a coherent tax system generally, seem to point to a threshold of at least 30%, so that only shareholdings in excess of that level would qualify.

Should there be a minimum period throughout which a substantial holding must be held?

4.19 At paragraph 4.3 above, the idea was introduced that not only should a shareholding be of sufficient size, but it should also be of sufficient duration before it can be considered structural.

4.20 In determining how long the percentage holding should be held in order to qualify as a structural holding, a balance needs to be struck. A short term investment is unlikely to have resulted in the exercise of sufficient influence etc. to have become part of the structure of the shareholder's business, so relief should not be given in such a case. On the other hand, a long qualifying period may unnecessarily constrain the development of business in rapidly moving sectors.

4.21 If the relief is to be targeted at substantial holdings in companies which have been part of the shareholder's business there are clearly strong arguments for a minimum holding period. Only disposals out of substantial shareholdings made after this minimum period would qualify for the relief.

Would two years strike the right balance between commitment and flexibility?

How should part-disposals out of a substantial holding be dealt with?

4.22 Assuming the introduction of a minimum holding period, the relief could operate by testing whether a substantial holding is held immediately before the disposal, or part-disposal. But that approach might be seen as over-restrictive. It would exclude part-disposals out of a holding which was substantial at some point in the past but had ceased to be because past part-disposals had reduced the holding below the threshold. There would be a marked cliff-edge effect at the point when the size of the holding fell below the threshold.

4.23 An apportionment approach could provide an answer to this. It might work in a similar way to the current rollover rules where part of a gain can be relieved where the old asset has not been used for a trade during the total period of ownership. So apportionment would provide that a proportion of the gains on a disposal or part-disposal would qualify to the extent that a substantial shareholding had been held during the period whilst shares of that class had been held. The approach would have to cater for shares held in a pool and an example of how this might work is set out in the annex to this chapter. Such an approach would deal with the 'cliff edge' effect, but at the expense of greater complexity. If this approach were adopted it might be necessary to address devices to maximise relief such as shifts of value between different classes.

4.24 If a minimum holding period were not introduced there would be a number of options, none wholly satisfactory. The requirement could be that the threshold must have been exceeded:

• throughout the whole period when shares of the class being disposed of have been held. However, this would prevent relief on the sale of a shareholding that had been built up by way of smaller acquisitions over a period and would therefore seem over restrictive;
• immediately prior to the sale of the whole, or part of, a holding of the class of shares. That might seem the least restrictive approach. But it would have a cliff edge effect. The gains on part-disposals out of a holding would qualify if the holding exceeded the threshold immediately prior to that part disposal. But once the holding fell below the threshold, the gains on any further part disposals would not qualify. Further, this approach might give rise to concerns about short-term acquisitions made just prior to the disposal designed to ensure that the threshold is exceeded at that time, even though the substance of the situation is that the threshold has not been exceeded through the period that the shares have been held. In essence the gain would arise from a shareholding below the threshold and should not qualify for deferral;
• at any time during the holding of the shares and an apportionment approach adopted as described above.

On which shares can gains be deferred?

4.25 Once a qualifying substantial shareholding is established, what shares should give rise to gains on disposal for which a claim to deferral relief can be made? The answer to this question may well depend upon the approach taken as to the test of whether a company holds a substantial shareholding.

4.26 If the decision is that the shares that can qualify towards a substantial shareholding will be those in which there is a true economic interest (i.e. that part of the ordinary share capital that satisfies Schedule 18 ICTA 1988), it seems right that the shares that can comprise a qualifying disposal should go no wider. These shares are the ones on which the vast majority of the gains are likely to arise; they are the shares that impart true value to the shareholder company.

4.27 If, however, a different test is adopted for those shares that qualify in a substantial shareholding, there might be a case for going wider in defining the shares that can qualify for deferral relief. For example if a substantial shareholding comprised ordinary share capital that carried rights to appoint directors to the Board, restricting deferral relief to such shares would exclude shares that are non-voting and carry no rights to appoint directors. But such shares may still be a valuable economic interest in the investee company.

4.28 However, there does not seem to be a strong case for going wider than shares constituting ordinary share capital to include preference shares and securities, particularly as the gains likely to arise on such capital are generally small or zero.

Annex 4A Apportionment: an Example

4A.1 Suppose company Y has been a trading company at all times. It has 'A' shares and 'B' shares, both classes forming ordinary share capital of the company which satisfies Schedule 18 ICTA 1988. 4A.2 Company X has the following transactions in the shares in company Y:

4A.3 Assume for the purposes of this example that the threshold is set at 30%.

4A.4 Part-disposal of 'A' shares on 1.6.2002; chargeable gain computed in normal way; the threshold has been exceeded for 8 out of the 11 years the pool of 'A' shares has been held by company X; so 8/11ths of the chargeable gain qualifies for relief.

4A.5 Disposal of remainder of 'A' shares on 1.6.2003; chargeable gain computed in the normal way; the threshold has been exceeded for 8 out of the 12 years the pool of 'A' shares has been held by company X; so 8/12ths of the chargeable gain qualifies for relief.

4A.6 Disposal of 'B' shares on 1.6.2004; chargeable gain computed in the normal way; the threshold has been exceeded for 8 out of the 10 years the pool of 'B' shares has been held by company X; so 8/10ths of the chargeable gain qualifies for relief.

Chapter Five - The Shareholding as a Qualifying Reinvestment

5.1 Chapters 3 and 4 discussed the conditions that need to be satisfied for a gain on the disposal of a shareholding to be capable of being deferred under this new relief. Chapter 6 sets out the Government's intention that it should be possible for gains on other assets to be deferred against reinvestment in substantial shareholdings and for gains on qualifying substantial shareholdings to be deferred against reinvestment into other assets. This Chapter discusses the conditions that the purchase of a shareholding would need to meet in order to be a qualifying reinvestment for the deferral relief.

5.2 In general, the conditions discussed in Chapters 3 and 4 that apply to determine whether a gain may be subject to a claim to deferral relief should apply to the shareholdings that are a qualifying reinvestment. Thus, for example, the shareholding has to be in a trading company, or the holding company of a trading group, or sub-group. However, there are a number of specific issues which arise in respect of a shareholding which is a qualifying reinvestment:

• should the same types of shares qualify as in a qualifying disposal?
• what size shareholdings should qualify and how should any threshold operate?
• over what period of time should the shareholding continue to be a qualifying reinvestment?
• what special rules are needed in the case of groups that might modify some of the general rules discussed in this chapter?

What types of shares should qualify?

5.3 The obvious answer to this question is that the shares which should qualify for reinvestment should be the same as those on which a gain can be deferred. There would be symmetry between the types of shares which can be a qualifying disposal and those which can be a qualifying reinvestment for the purposes of this deferral relief.

5.4 Chapter 4 suggested that ordinary share capital that satisfies a test based on Schedule 18 ICTA 1988 should inform the decision of what constitutes a substantial shareholding and those shares should have an entitlement to deferral relief. On the basis of the symmetry arguments set out in the previous paragraph, the acquisition of that type of share capital would also be a qualifying reinvestment for deferral relief. It would also follow that ordinary share capital that does not satisfy such a test, and preference shares and securities which are not part of the ordinary share capital, would not be qualifying reinvestments.

What size shareholdings should qualify?

5.5 It seems reasonable that the shareholding size criterion should be treated as met if:

• the shares already held by the shareholder company or group in that company exceeded the threshold for it to be a substantial holding at the time of the reinvestment, or
• the shares already held by the shareholder company or group, together with those acquired in the reinvestment, constituted a substantial shareholding immediately after the reinvestment.

5.6 The rule set out above would be simple to understand and operate. It would mean, however, that for a company buying a number of packets of shares on different days it would only be the acquisition of sufficient shares to take the investment over the qualifying threshold (and subsequent acquisitions) which would constitute a qualifying reinvestment for the purposes of this relief. That said, in normal commercial practice substantial shareholdings would typically be acquired in a single transaction, and it is unlikely that a substantial shareholding would be acquired in multiple smaller transactions. In the case of a take-over of a listed company some shares might be acquired before a bid for the rest; but the later acquisition would typically be of a substantial shareholding.

Over what period of time should the shareholding continue to be a qualifying reinvestment?

5.7 A number of deferral reliefs recover the deferred gain in a wider range of circumstances than just the disposal of the qualifying reinvestment. For example:

• in the case of business asset rollover relief (Sections 152-158 TCGA 1992) where the gain is held over against the cost of a depreciating asset, the held-over gain is brought back into charge on the earliest of the disposal of the depreciating asset, the asset ceasing to be used for the purposes of the trade into which it was taken into use, or 10 years from acquisition of the depreciating asset;
• reinvestment relief (Sections 164A-164N TCGA 1992, repealed for investments on or after 6 April 1998) applied to persons and certain trustees disposing of assets and acquiring certain shareholdings in unlisted trading companies. Broadly, where any of the qualifying conditions ceased to be met within three years of acquisition of the shares, the whole of the rolled over gain would be brought back into charge. Qualifying conditions included the company being a trading company and employing the funds raised for trading purposes within a specific time; and
• for the Enterprise Investment Scheme (EIS - Schedule 5B TCGA 1992) the deferred gain is brought back into charge in a number of circumstances, including the company ceasing to be a qualifying company by ceasing to carry on a qualifying trade.

5.8 The circumstances leading to a clawback of the gain deferred under this new relief might include cases where -

• the company in which the replacement shares were held ceased to trade or meet any other qualifying conditions;
• the shareholding ceased to be a substantial shareholding, for example it fell below the minimum percentage - whether due to a disposal, a share exchange, a dilution caused by a decision not to take up a rights issue, or any other cause; or the shareholding ceased to meet the test based on Schedule 18;
• the investing company received a return of the value of its investment, for example, the investment is immediately returned to the investing company by way of loan.

5.9 The possibility of incurring a tax charge in the circumstances indicated in the preceding paragraph might be an onerous burden on the investing company. For example, a cessation of trading some 10 years after the qualifying reinvestment was acquired might be regarded as too far removed from the earlier investment to be an appropriate occasion of recovering the relief. The record-keeping and monitoring involved might also involve significant compliance costs for companies. So a tax charge under the preceding paragraph could be limited to cases where the relevant event occurred only within a specified time limit. The appropriate limit is a matter for discussion, but three years after the later of the disposal and acquisition of the relevant assets might be a reasonable compromise.

What special rules are needed in the case of groups of companies?

5.10 If the relief is to be properly targeted and applied, a number of special rules would seem to be necessary in its application to groups of companies

Intra-group share issues

5.11 Where a company acquires further shares in a company and both companies are already members of the same group, there is no difficulty when the shares are acquired from a person outside the group, as the shareholder is increasing its economic interest.

5.12 But there could be scope for manipulation when one company in a group acquires shares in another by a subscription for new shares. For example, there could be multiple shareholding tiers, where an amount of money is invested in a company and that same sum is used to reinvest in successive tiers of subsidiaries and sub-subsidiaries. Each investment could form a qualifying reinvestment for relief. And double relief could be available to a group where the subsidiary business uses the money to invest in assets that themselves qualify for rollover relief on disposal.

5.13 The obvious way of countering such manipulation would be to restrict the availability of deferral relief so that it is not available for subscriptions to a new issue of shares in a company that is already part of the same capital gains group as the shareholder company. It may also be necessary to address the use of artificial de-grouping to circumvent such a limitation.

5.14 However, it would be a cause for concern if such a restriction were to hinder bona fide situations where a group is expanding its own business. In this context, it should be noted that the commercial use of rollover relief to acquire business assets within the group would not be affected. The normal provisions of section 175 TCGA 1992 will allow a claim to be made for rollover relief on the disposal of a qualifying shareholding when any group company acquires a business asset.

Special clawback provisions

5.15 It is also considered that special clawback provisions may be needed for groups because it will be possible for

• a gain to be eliminated or indefinitely deferred via a shift of value into other assets owned by the same company (or group); or
• a gain to be eliminated or indefinitely deferred via an intra-group depreciatory transaction within the meaning of section 176 TCGA 1992.

5.16 It is not the intention that this relief should enable groups effectively to wash out gains by marooning deferred gains in shares that will not be disposed of while the underlying value has been separated from those shares.

5.17 However, it has to be recognised that there will be circumstances where a company acquires the shares in a company with a view to amalgamating the trade of that company with its existing trade or the trade of a company elsewhere within the group. The usefulness of this relief would be undermined if a clawback was triggered on a genuine intra group consolidation of businesses.

5.18 In a simple case where the whole of the acquired company's trade was transferred to a group company, it may be possible to have a rule to allow the transfer of the deferred gain so that it attached to the shares in the transferee company.

5.19 But if only part of the acquired company's trade was transferred in this way, or if it was transferred to a number of companies, there would be significant compliance problems in allowing a further deferral of the gain. These might be too substantial to make a deferral operable.

5.20 The Government would be interested in any proposals for allowing a further deferral on a reorganisation that were simple for companies and the Inland Revenue to operate, but continue to provide the necessary protection against exploitation.

Chapter Six - How should the new relief work?

6.1 This chapter looks at the form that any new relief should take and how it should interact with the existing business assets rollover relief.

The interaction of the new deferral relief with the existing business assets rollover relief

6.2 The existing business asset rollover relief applies to a range of qualifying assets that are used for the purposes of a trade. It defers a gain where the proceeds of disposal of a qualifying asset are reinvested in one or more other qualifying assets. While both the old and the new asset must be qualifying, they do not have to be of the same type.

6.3 For the new deferral relief, the options are:

• to develop a stand-alone relief that applies only to disposals and acquisitions of qualifying shares, or
• to link the new relief with the existing business asset relief, so that the proceeds of disposal of a qualifying asset may be reinvested in qualifying shares, and vice versa.

6.4 The second option would provide a much broader relief, which would maximise flexibility for companies. In the light of its overall objectives as set out in Chapter 1, the Government proposes this more generous option.

The time limit for reinvestment

6.5 Business asset rollover relief requires a replacement asset to be acquired within one year before and three years after the date of disposal of the original asset (the Inland Revenue has power to extend that period in appropriate circumstances). There are time limits also for making a claim and, under self-assessment, for temporary relief on a provisional basis.

6.6 To avoid awkward mismatches between the existing relief and the new deferral relief for companies' substantial shareholdings, it would seem to be sensible to utilise the same time limits.

Reinvestment of disposal proceeds

6.7 Certain deferral reliefs such as that within the Enterprise Investment Scheme and for reinvestment in Venture Capital Trusts require merely the reinvestment of the gain. The present relief for the replacement of business assets requires that the whole of the disposal proceeds should be reinvested if the gain is to be entirely relieved. If only part is reinvested none or only a part of the gain may be deferred.

6.8 As with the time limits for reinvestment, the broader relief the Government favours would probably work best if the rules for companies' disposals of substantial shareholdings were aligned with those for the existing relief. That points to giving the new relief by reference to the application of disposal proceeds.

Mechanism for achieving deferral

6.9 There are several ways of reducing the gain arising on the disposal of the original asset:

• a rollover - this works by reducing the base cost of the replacement asset by a similar amount, so that the previous gain is effectively taken into account on a later disposal of that asset;
• a holdover - this simply postpones the time at which the gain is brought into charge, without affecting the base cost of the replacement asset. The commonest occasion of charge is when the replacement asset is disposed of, but it may occur by reference to other specified events, depending on the terms of the particular relief;
• a mix-and-match approach using rollover in some circumstances and holdover in others.

6.10 Business asset rollover relief uses both rollover and holdover mechanisms. In most cases rollover is employed. But where a replacement asset is a "depreciating asset" a holdover is used.

6.11 In the case of gains made by North Sea companies, it has been noted in paragraph 2.13 above that for the purposes of this relief North Sea assets into which a gain could be rolled over would be deemed to be depreciating assets, resulting in a holdover relief.

6.12 In other cases, for the new deferral relief, where the replacement asset is one of the assets to which the existing business asset rollover relief applies, the relief could simply take the form of either a rollover or a holdover depending on the nature of the replacement asset, in the same way as it does under the existing relief.

6.13 Where the replacement asset is a holding of shares, the relief could be cast as either a rollover or a holdover.

6.14 A holdover would probably involve taking the replacement shares out of the normal share pooling arrangements and introducing identification rules to determine when the gain should be brought back into charge on a subsequent disposal. Similar identification rules would probably be needed in the rules for share reorganisations. The shareholding company would have to keep separate records for the purposes of administering the holdover.

6.15 A holdover would also require some mechanism to give further deferral relief where a deferred gain crystallises and there is a further reinvestment.

6.16 A rollover could probably work in the context of the pooling arrangements. The replacement shares would be pooled in the normal way with others not subject to the new relief and their reduced base cost could simply spread over the pool. Any subsequent disposal would be out of the pool. However, as there could be clawback triggers other than disposal, there would have to be some mechanism for adjusting the base cost of the pool in these circumstances. Records would thus need to be retained until the end of any clawback period.

6.17 Under a rollover, it should be fairly straightforward to give further deferral relief where a deferred gain crystallises and there is a further reinvestment.

6.18 The Government is not looking to put extra burdens on companies where these can be avoided. Its aim is to structure the new relief to maximise the ease of compliance.

Chapter Seven - Provisions to safeguard the relief against exploitation.

7.1 This chapter examines what further measures, beyond the targeting already mentioned in the preceding chapters, might be appropriate to guard against the relief being exploited.

7.2 In the main, potential exploitation by groups of companies will be dealt with by the rules suggested in Chapter 5. Without rules to deal with subscriptions to new issues of shares by group members, additional protection could be required to deal with schemes to exploit multiple shareholding tiers, and double relief at the shareholding and asset tier within groups. Three further issues have been identified where protection may be needed: value returned and value shifting; certain share exchanges; and connected company acquisitions and disposals.

Value Returned and Value Shifting

7.3 It is no part of the Government's objectives for this relief to enable money invested on an issue of new shares by a company outside a group relationship to be returned to the shareholder in a different form, but with the deferral relief being retained. The present Enterprise Investment Scheme contains such provisions as did the old CGT reinvestment relief (Section 164L TCGA 1992). It is likely that a provision on these lines will be necessary for the new relief also. (Treating the return of the value as a chargeable event has already been mentioned in chapter 5.)

7.5 In addition, there may need to be provisions to prevent the use of value shifting to obtain or to maximise the availability of deferral relief in circumstances not intended by the Government (specific examples where this could occur are referred to at 4.23 and 5.15 above).

Share Exchange Involving Qualifying Reinvestment

7.6 The shareholding which forms the qualifying reinvestment may itself be the subject of a subsequent share exchange. Under Section 135 TCGA 1992 this might not be a disposal for capital gains purposes, but the new holding received as consideration in the share exchange "stands in the shoes" of the original shares.

7.7 It will be necessary to ensure that any deferred gain attaching to the original shares can still be recovered in appropriate circumstances. One way of doing this might be to disapply the provisions of Section 135. Disapplication would allow the share exchange to give rise to a disposal. Then any gain arising could be subject to a claim to deferral relief, although further consideration will have to be given to this in the context of intra-group share exchanges. However there would be difficult detail on the share identification rules to work through. An alternative would be to ensure that the deferred gain continues to attach to the consideration shares so that it is recoverable in appropriate circumstances.

Connected Company Acquisitions and Disposals

7.8 Transfers of shareholdings within a worldwide group take place on a no gain/no loss basis if the shares remain within the UK tax net (assuming the provisions in the current Finance Bill are enacted). However, it is possible for a company to make an acquisition or a disposal of a qualifying shareholding from or to a connected company that was not on a no gain/no loss basis (because the connected company is not within the UK tax net, or has no branch or agency here). Such an acquisition could be a qualifying reinvestment and the gain on such a disposal could qualify for relief.

7.9 There is also the possibility of acquisitions of a qualifying shareholding from a connected company which was not within the same capital gains group but was under common ownership, possibly of an individual or a trust. Such an acquisition could constitute a qualifying reinvestment and, similarly, the gain on a qualifying disposal to such a connected company could also qualify for relief.

7.10 It is arguable that deferral relief should not be available in these circumstances since the shareholding has not passed into or out of the ownership of the worldwide group or the common owners. This would point to barring an acquisition from a connected company from being a qualifying reinvestment and a disposal to a connected company from being a qualifying disposal for the purposes of this relief.

Wider Ranging Protection

7.11 Introducing a deferral relief for qualifying substantial shareholdings would widen the gap between the taxation of gains and that of income. That might give rise to further tax avoidance schemes to turn accumulated income into capital. As part of drafting this relief, consideration might have to be given to the scope for minimising exploitation in this way.

7.12 Further, some companies might be quite active in attempting to extract value from a qualifying reinvestment while not triggering recovery of the deferred gain. It is impossible to anticipate the form of all such schemes.

7.13 It might therefore be appropriate to introduce a more general rule along the lines that where any series of transactions are designed to realise the value in a shareholding, directly or indirectly, without triggering the recovery of any deferred gain, the deferred gain should be recovered at that time.

Annex A: Summary list of questions

Comments are invited on the proposal outlined in this Technical Note and should be sent to :

Richard J. Thomas
Capital and Savings Division
Room 121, New Wing
Somerset House
Strand
LONDON WC2R 1LB
Fax Number: 020 7438 6380
E-Mail Address: Mal.Thomas@ir.gsi.gov.uk

to arrive no later than 11 August 2000

In accordance with the Inland Revenue's Code of Practice on Consultation, once the outcome of the consultation is announced, we will make available, on request, responses to consultative documents, unless any respondent has asked for her or his comments to be treated as confidential. If you wish the whole of your comments, or your name and address, to be treated as confidential, please say so when you return your comments.