There has been a welcome amendment to the rules that prevent the carry forward of corporate tax losses where there have been significant changes to the underlying business activities. The rules apply when a company undergoes a change of ownership, and they make perfect sense in the context of a company takeover.
However, one would not expect tax losses to be restricted when the corporate group has undergone an internal restructuring. There is less justification for this, given that a restructuring doesn’t usually result in a change in the underlying economic ownership of the assets involved.
And indeed, as we shall see, the rules don’t apply when the target is a subsidiary that is being transferred from one group company to another. Unfortunately, the exception doesn’t extend to the introduction of a new holding company.
This situation is to be remedied in the next Finance Act. The changes will take effect from 1 April 2014.
In the following article, we shall for convenience, refer to trading companies that have incurred trading losses that are intended to set against future profits. However, the “major change” rules are also relevant to other losses of a revenue nature such as losses sustained in a property or investment business. The amendments apply equally to these types of businesses.
A recap on the “major change rules”
Recall that when a company undergoes a change in ownership, it is not permitted to carry forward its past tax losses in either of the following two situations1:
- A major change in the nature or conduct of the trade occurs within any 3 year period that includes the date on which the company was transferred to its new owner2; or
- The scale of the company’s activities had become small or negligible prior to being sold, with no significant revival in the interim3.
The reasoning behind all this is that when a company changes hands, the new owners will inevitably want to make alterations to the way the business is run. If the changes are too radical, this begs the question whether the underlying trade is really the same, or has been transformed into a totally new one. If the latter, then past trading losses shouldn’t be available for future profits, as the set off is only permitted against profits from the same trade4.
What constitutes a change in ownership?
The starting point is that there is a change of ownership if any of the following hold5:
- A single person has acquired more than half of the company’s ordinary share capital – this is the situation we have looked at in previous articles6;
- Two or more people hold more than half the share capital between them, as a result of acquiring shares in the company, with each person having a holding of at least 5% when the acquisition is completed7.
There are other tests to determine whether a change in ownership has occurred, which look at factors other than the company’s share capital. For example, a person may have extraordinary or special powers controlling the company without necessarily having the requisite number of shares or even being a shareholder at all8. However, in this article we shall keep it simple and focus on a single company taking over a target by acquiring all of the latter company’s shares.
What happens when the target company has subsidiaries? Are they also affected by the major change rules?
Yes they are9 – buying the target company means buying the target’s assets, including the latter’s own subsidiaries. Accordingly, in the diagram, there is a change in ownership not only of Tradeco 1, but also of Tradeco 2 and any other company that may be further down the group chain. These companies are also subject to the restrictions on carrying forward past trading losses.
What about intra-group transfers?
What is the position when all the companies involved – target, seller and buyer – all happen to be in the same group? Given that there is no change in the underlying economic ownership of the target, one would not expect the rules to apply. And indeed this is the case.
Although technically, there has been a change of ownership, this is disregarded when the target has a 75% parent and remains a subsidiary of this parent company, both before and after the transaction10. In order for the target company to be a 75% subsidiary, the following conditions must hold:
- The parent must be the beneficial owner of at least 75% of the target’s ordinary share capital – and the shares can be held indirectly as is the case with V and B following the intra-group transfer11;
- The parent holds the requisite 75% of the economic rights, being the rights to profits available on a distribution and assets on a winding up12.
So in this case, B clearly falls within the exception, as one would expect. Furthermore, since A is not regarded as having acquired B, it cannot be regarded as having acquired any of B’s assets, including B’s subsidiary C13.
What about inserting a holding company?
This involves replacing the principal company at the very top of the group. There are no corporate shareholders with a 75% stake above this level. One wouldn’t expect the rules to apply in this situation, as again, the ultimate owners of the group structure remain the same. However, this is not the case at the moment, and this is why the rules are being amended.
Let us first see why it doesn’t work, before discussing how this situation is to be put right.
Let us look at the top company V. V has clearly undergone a change in ownership because Holdco has acquired all of its share capital. So this is a real change rather than a notional one. Do the disregard provisions apply in this situation?
The answer is “no”. Although the ultimate shareholders of V are the same, V needs to have a 75% parent both before and after the insertion of Holdco. But V had no parent before the transaction because V was the principal company of the group. Accordingly, V now faces restrictions on the carry forward of any tax losses should there be a major change in the nature and conduct of its business14.
It is worth noting however that V’s subsidiaries are still protected by the disregard provisions. Tradeco has the same 75% parent V both before and after the introduction of Holdco. It is instructive to see how the legislation achieves this result.
The two main provisions are in CTA 2010 s 723 and s 724:
- CTA 2010 s 723 states that if there is a change of ownership, the new owner is also deemed to have acquired the target company’s assets, including its subsidiaries. At first, this would mean that Holdco is deemed to have acquired Tradeco as well as V;
- But if we now go to the disregard provisions in CTA 2010 s 724, we see that Tradeco is not deemed to have changed ownership after all – it is a 75% subsidiary of V both before and after Holdco became the top company;
- Returning to CTA 2010 s 723, we see that since the Tradeco acquisition is to be disregarded, Holdco cannot be deemed to have acquired any of Tradeco’s assets either – so any company lower down the chain is also safe15.
In short, the disruption caused to the group’s tax losses is limited to the top level, to the former principal company V. All other subsidiaries have the freedom to arrange their business activities without falling foul of the “major change” rules.
It will now be possible to insert a top holding company
These changes will take effect from 1 April 201416. Like the disregard provisions in CTA 2010 s 724, this new provision focuses on the people who own the top company, both before and after the change in ownership. It is slightly more complicated in that the ownership conditions are more stringent.
In particular, the following continuity requirements must be satisfied17:
- The consideration for Holdco acquiring the share capital of V must consist solely of the shares that Holdco issues to V’s shareholders. Shares and nothing else;
- All the shareholders must be included in the deal – it is not an option for some of the shareholders to keep their V shares – everyone must be involved in the share exchange;
- Holdco’s share structure, in particular the classes of shares making up its share capital, must match exactly the share structure of V. So if V has three classes A, B and C, Holdco must also have classes A, B and C;
- The way in which Holdco’s share classes are distributed over the company’s share capital must be in exactly the same proportion as the corresponding share classes in V are distributed. So if V has share classes A, B and C, with 50 A shares 100 B shares and 50 C shares, then Holdco’s share classes must keep the same ratio of 1:2:1. This is obviously satisfied if Holdco has the shares in the proportion 50 A, 100 B and 50 C, but it is also satisfied if the numbers are 100 A, 200 B and 100 C;
- Each shareholder in V must receive his Holdco shares in the same classes and proportions as he held his shares in V;
- Finally, we must make sure that each shareholder holds the same economic rights in Holdco as he did in V – in other words, it isn’t possible to keep exactly the same share classes in the same proportions but then rearrange the actual rights attaching to the securities. The economic rights referred to are our familiar friends, rights to profits on distribution and assets on a winding up.
There are also restrictions on Holdco. Holdco needs to be a brand new company that either has no shares to begin with, except subscriber shares (as an off-the shelf company), or, it has not begun to carry out any business of its own – in short, it must be empty18. Holdco must also acquire all the V shares, hold all the voting power and all the economic rights in the latter company19.
This is a welcome amendment to the rules – it is easy to see why losses should not be restricted in circumstances where the economic unit is substantially unchanged. You can find a link to the relevant HMRC document at the GOV.UK website here.
- CTA 2010 s 674(2). ↩
- CTA 2010 s 673(2). ↩
- CTA 2010 s 673(3). ↩
- CTA 2010 s 45. ↩
- CTA 2010 ss 672(7)(a), 719. ↩
- CTA 2010 s 719(2). ↩
- CTA 2010 ss 719(3), (4) – these two provisions look complicated but the idea is that the new owners must each have more than 5% individually, which they can acquire in a single go (CTA 2010 s 719(3)) or in stages (CTA 2010 s 719(4)). ↩
- CTA 2010 ss 721, 722. ↩
- CTA 2010 s 723. ↩
- CTA 2010 s 724. ↩
- CTA 2010 ss 724(3), 1119, 1154(3), 1155. ↩
- CTA 2010 ss 724(4), (5). ↩
- CTA 2010 s 723(1) specifically states that the rule on acquiring the target company’s assets doesn’t apply where the target company has been saved by the disregard provisions of CTA 2010 s 724 . ↩
- It could be argued that the risk is slight if V is a “pure” holding company whose main business is simply the holding of the other subsidiaries lower down the group. ↩
- We have actually applied CTA 2010 s 723 twice. Firstly to V, where we find that Tradeco is also affected by the major change rules. We then have to go to CTA 2010 s 724 to save Tradeco and then back to CTA 2010 s 723 to save Tradeco’s subsidiaries. ↩
- Autumn Statement 2013 paper: Corporation Tax – amending loss relief provisions. ↩
- New CTA 2010 s 724A(4). These mirror provisions are similar to the rules on stamp duty relief for share reconstructions under FA 1986 s 77. ↩
- New CTA 2010 s 724A(3). ↩
- New CTA 2010 s 724A(1). ↩
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