In this article, we shall discuss the degrouping rules as they apply to intangible assets such as IP and goodwill (collectively referred to as IP). The tax treatment is similar to that applying to capital assets, but with important differences.
(This article can be downloaded in pdf format at Academia.edu.)
We shall see that:
- There is an extra stage in the degrouping calculation, involving an adjustment to the exiting company’s tax deductions;
- The degrouping charge is ALWAYS borne in the first instance, by the company leaving the group. This is the case even when the degrouping event involves a share disposal. In contrast to the capital gains rules, there is no mechanism for transferring liability from assets to shares;
- Accordingly, when a company leaves a group by means of an exempt share disposal, the degrouping charge for the capital assets is extinguished, but the charge for the IP remains.
A recap on why we have degrouping rules
Recall that the degrouping rules are designed to prevent assets from being smuggled out of a group tax free, under the protection of a corporate wrapper.
The idea is exactly the same as for capital assets. The patent transfer between V and Newco is tax neutral1, with the value of the issued shares being the same as that of the IP. Consequently, V incurs no liability when Newco is sold (see below for further details).
But before we begin…a word about IP taxation
Under the intangibles legislation, IP acquired or created by a company after 1 April 2002 is given tax relief in accordance with the accounting treatment. When IP is sold, the gain or loss is calculated not by reference to the acquisition cost (if any), but by the tax written down value.2 This is the residual amount recorded in the company’s balance sheet, after all tax debits and credits have been taken into account.
For example, assume that V has acquired a patent for a price of £15m. Assume also that the acquisition cost is amortised over the patent’s useful life on a straight line basis – if this is 15 years, tax deductions are given at £1m per annum.
After 5 years, the amount written off is £5m, so the tax written down value is £10m. If the market value of the patent is £12m, a sale to a party outside V’s group results in a taxable gain of £2m. We deduct from the purchase price the tax written down value of £10m, not the original acquisition cost of £15m.
We shall use these figures in the example below.
On to the degrouping rules – what are they in a nutshell?
As with capital assets, the degrouping rules apply when a company leaves a group, taking with it IP acquired from a fellow group member. If the relevant intra-group transaction occurred within the previous 6 years, the tax neutral status is revoked and the two group members are placed on the same footing as if they had been independent parties.
The legislation uses the terms “transferor” and “transferee” for the two group companies involved. However, we shall use the same terminology applying to capital assets, and refer to “company A” as the company leaving the group.
Notional sale and buyback
When company A leaves a group, it is deemed to have sold and bought back at market value, those assets acquired from fellow group members within the previous 6 years, and which it still holds3. This is the same principle as for capital assets, but the position is slightly complicated:
- As a notional seller, A, incurs a degrouping charge, being the difference between the asset’s market value and tax written down value at the time of the intra-group transfer – this can result in a loss as well as a gain;
- As a notional buyer, A’s original acquisition cost is re-set to market value. So far so good – however;
- As a consequence of pretending that it has reacquired the asset, A must revisit its previous tax computations. So far, A has obtained tax relief at the rate inherited from its fellow group member. On degrouping, A’s writedowns must be adjusted to reflect the fact that the tax neutral status of this intra-group transaction is being revoked;
- This will involve a new writing down rate based on the revised acquisition cost and economic life of the asset. This results in a tax credit or debit to be added to the degrouping charge incurred by A as a notional seller.
Example 1 – why the envelope scheme doesn’t work
In the envelope scheme:
- V establishes a wholly owned subsidiary Newco, subscribing a nominal amount of £1;
- V transfers the patent to Newco for a market value consideration of £12m. In return, Newco issues shares worth £12m. This is a tax neutral transaction, and Newco inherits V’s tax written down value of £10m;
- V immediately sells Newco to P for £12m. Since V’s base cost in Newco matches the purchase price, there is no capital gain on the shares.
This doesn’t work because when Newco leaves V’s group, it is deemed to have sold and re-acquired the patent at market value. Newco therefore bears a tax charge of:
£12m – £10m = £2m
(Market Value of patent less Tax Written Down Value at intra-group transfer)
The liability is borne directly by Newco, the company leaving the group. Unlike the case for capital assets, this is not included in V’s capital gains calculation for the shares.
Example 2 – adjustments to the tax writedowns
In our last example, Newco was sold immediately after having acquired the patent from V. Accordingly, there was no time for Newco to write down its acquisition cost. What is the position if V were to sell Newco after 3 years?
We shall assume that at this time, the market value of the patent – and therefore of Newco – is now £8m. During this three year period, Newco has written down a further £3m, so that the tax written down value is now £7m.
On leaving the group, the same degrouping charge of £2m is incurred. The calculation is:
£12m – £10m = £2m
(Market Value of patent less Tax Written Down Value at intra-group transfer)
£8m – £7m = £1m
(Market Value of patent less Tax Written Down Value at exit)
As with capital assets, the notional sale and buyback is deemed to take place immediately after the relevant intra-group transaction, and NOT at the exit point. The idea is to revoke the tax neutral status of this transaction and to capture the gain (or loss) that would have arisen had the asset been sold to an outsider. It is this gain or loss that has been left untaxed as a result of the buyer and seller being fellow group members.
That’s the first calculation. But there’s more to follow.
On the initial intra-group transaction, Newco inherited V’s tax written down value of £10m and continued to obtain writedowns at the same rate of £1m per year. But Newco has now left the group – it is deemed not only to have sold the patent, but also to have bought it back for the market value of £12m. Accordingly, the tax writedeowns of the previous 3 years must be adjusted to reflect this new acquisition cost.
So how much should Newco have been writing down?
Recall that when V bought the patent, it had a useful economic life of 15 years. It was acquired by Newco after 5 years, when it had a useful life of 10 years. Had the parties been independent, Newco would have written down the cost of £12m at the rate of £1.2m per annum.
Accordingly, the following adjustments need to be made.
We see that Newco has written down too little – there is an extra £0.6m in tax deductions that it is entitled to. If we net this off with our degrouping charge of £2m, this gives rise to an overall taxable gain of £1.4m4.
A tax charge on assets remains a tax charge on assets
Note that the degrouping charge is not added to Newco’s purchase price in the above examples.
This is one of the most important differences between the capital and IP regimes. If the sale of Newco is tax exempt, the degrouping charge for any capital assets in the company is extinguished because it is included in the capital gains computation for the shares. But the charge for IP does not benefit from this treatment and therefore the liability remains. We shall look at this in more detail in a later article.
We have already seen from the examples that the notional transaction is deemed to take place immediately after the relevant intra-group transaction and not when the company actually leaves the group.
However, the actual gains or losses are recorded in the last accounting period for which A was a group member5. One can see clearly from the table why this is so convenient – instead of having to revisit each of the previous years’ tax computations, the company only needs to include the net figure in the latest return.
No tax avoidance motive required
As with capital assets, the degrouping rules are not restricted to cases where a tax avoidance element is involved.
Allocation of degrouping charge to other group members
As with capital assets, degrouping gains or losses can be surrendered to other group members6.
- The object of the degrouping rules is to prevent assets from being smuggled out of a group tax free, under the protection of a corporate wrapper;
- Degrouping charges – which can include a loss – arise when a company leaves a group, taking with it IP acquired from fellow group members within the previous 6 years;
- On exit, there is a notional sale and buyback of the asset for market value, deemed to have taken place immediately before the relevant intra-group transaction, but recorded in the last accounting period;
- As a notional seller, the company incurs a gain or loss calculated by the difference between the market value and tax written down value;
- This is set off against adjustments to the company’s writedowns previously based on the tax written down value inherited on the initial intra-group transaction. The new writedowns are based on a market value acquisition cost and economic life of the asset at the time of the intra-group transaction – this reflects the fact that the tax neutral status of this transaction is being revoked;
- The net degrouping charge can be surrendered to fellow group members.
This completes the basic articles on how the degrouping rules work. In the next articles we shall look more closely at some of the detail, starting with a discussion on the differences between capital and IP assets.
- CTA 2009 ss 775, 776. ↩
- CTA 2009 s 735. It is possible that there is no tax written down value, in which case it is the cost that is deducted – see CTA 2009 ss 736, 738. For example, internally generated goodwill is not recognised on the balance sheet and is not written down – in which case the cost is nil. However, for simplicity, we shall assume in this and later articles, that the IP has been bought from outside the group and subsequently written down in the accounts. ↩
- CTA 2009 s 780(2). ↩
- Note that there is also a capital loss of £4m on the Newco shares, being the £12m base cost less the purchase price of £8m. We do not include this loss in the degrouping calculation as corporate gains and losses on IP are charged to income, not capital. Furthermore, it is V, not Newco who bears this loss. ↩
- CTA 2009 s 780(3). ↩
- CTA 2009 s 792. ↩
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