This is the third article in our series on corporate tax groups where we explore the rules governing intra-group transactions, and how they are taxed. In this article we shall look at the rules relating to capital assets.
(This article is Part One of a two part mini-series on the Capital Gains Degrouping Rules. Both parts can be read in a single article in pdf format which can be downloaded at Academia.edu.)
What are the degrouping rules and why do we have them?
In a nutshell, the degrouping rules are designed to prevent assets from being smuggled out of a group tax free, under the protection of a corporate wrapper.
In the first article on corporate tax groups, we discussed the basic proposition that intra-group transfers should be tax neutral, with any gains or losses being triggered only when the asset leaves the group. Without special rules however, this proposition can be circumvented, as the following example shows.
V has a property, such as a factory or a warehouse – which it intends to sell to P for a price of £10m. The base cost of the property is £6m, which results in a taxable gain of £4m. V would prefer not to pay the tax – so what can it do?
- V establishes a wholly owned subsidiary Newco, subscribing a nominal amount of £1;
- V transfers the property to Newco for a consideration of £10m, satisfied by the latter issuing 10 million shares of £1 each. Since this is an intra-group transfer, no tax is payable, and Newco inherits V’s base cost of £6m 1;
- V sells Newco to P for £10m. Again, no tax is payable, since the base cost for the shares is also £10m. This is because the value of the shares issued, matches the value of the property that Newco acquired from V on the intra-group transfer.
And that’s that.
Well, not quite. This type of transaction – known as an envelope scheme – is prevented by the degrouping rules. These rules apply when a company leaves a group, taking with it an asset acquired from a fellow group member. If the asset was acquired by the exiting company within the previous 6 years, the tax neutral status of the original transaction is revoked and a degrouping charge is triggered. We shall see how this works in a moment.
There are in fact, two sets of rules. One set covers capital assets which is the subject of this, and the next article in the series2. The other set covers intangibles such as IP and goodwill 3, which shall be the subject of a later article. There are similarities between the two regimes, but also important differences.
The legislation for capital assets uses the term “company A” for the company leaving the group. We shall adopt this terminology in the following discussion.
Leaving the group – notional sale and buyback of “intra-group” asset
This is the key concept behind the degrouping rules.
On exiting the group, one needs to ask the following questions:
- Has company A acquired an asset from a fellow group member within the previous 6 years?
- Does A still own the asset?
If the answer to both questions is “Yes”, company A is deemed to have sold and bought back the asset with the following consequences:
- A, as a notional seller will incur a degrouping charge. This is the capital gains calculation, with the sale price fixed at the market value prevailing at the date of the original intra-group transfer, and the base cost inherited from its fellow group member. This can result in a loss as well as a gain;
- A, as a notional buyer, will have a new base cost, replacing the base cost inherited from its fellow group member. This is the notional sale price mentioned above, the market value prevailing at the date of the original intra-group transfer. As we shall see, this is necessary to avoid double taxation.
At first glance, the tax charge (or loss) falls on A, the exiting company 4. However, if A leaves the group by means of a share disposal, such as a company sale, the degrouping charge is borne by the seller. This is achieved by adding the degrouping charge to the purchase price in the capital gains calculation for the shares. Gains are added on, and losses are deducted 5.
Example – why the envelope scheme doesn’t work
Newco leaves V’s group when it is sold to P. So Newco is the “A” that is referred to in the legislation. The degrouping charge arising on a notional sale of the property is £4m.
Because Newco has left by means of a share sale, this degrouping charge is added to the sale price when V calculates its tax liability. Accordingly, there is an adjustment to the original calculation:
So V ends up with a gain of £4m, which it had originally intended to avoid incurring in the first place.
This degrouping adjustment is only relevant to V’s tax position. P’s base cost in Newco remains at £10m, the actual price paid for the shares, and not the £14m that V is deemed to have received for them.
At the same time, Newco’s base cost in the property is re-set from £6m to £10m. This is the acquisition cost that Newco incurs as a buyer on the notional sale and buyback. This adjustment is necessary to avoid double taxation.
Example – Newco leaves the group and sells the property for £13m
Suppose that Newco subsequently sells the property for £13m. It is the re-set base cost that is deducted when calculating the gain, and not the original base cost that was inherited from V.
Accordingly, the gain is £3m, being the subsequent growth in value of the property, and not the higher value of £7m. Note that we can rewrite the gain of £7m:
£13m – £6m = £7m
(sale proceeds less old base cost)
(£10m – £6m) + (£13m – £10m) = £4m + £3m = £7m
degrouping charge subsequent growth in value
We find that the result of taxing the gain of £7m is to include the £4m degrouping charge which has already been captured when Newco was originally sold to P. There is no need to tax it again.
- The notional sale and buyback is deemed to have taken place immediately after A acquired the asset from its fellow group member, and not when it exits the group. These two events do not necessarily coincide as they did in our envelope example – the exit point can be up to 6 years after the intra-group transfer;
- However, the gain or loss is actually recorded in A’s last accounting period as a group member 6.
The first rule concerns quantum – it fixes the amount of the gain or loss by reference to market values prevailing at the (earlier) time when the intra-group transfer took place. The second rule concerns timing – it tells us when this gain or loss is to be incurred for the purpose of collecting the tax.
Example – Newco is sold when the value of the property increases to £13m
As an example, suppose that in our envelope scheme, Newco were to be sold three years after acquiring the property, rather than immediately. Suppose also, that the value of the property – and therefore the value of Newco – has by then increased to £13m.
The degrouping charge is the same £4m as in our previous example. This is because the date of the initial intra-group transfer is fixed in time – and so the market value figure remains at £10m. The figure of £13m which is the value at the point of exit, is not relevant to this part of the calculation.
Note that the correct result is equal to the overall growth in value of the property during the time that it remained within V’s group (£13m – £6m).
But if we use the market value at the point of exit to calculate our degrouping charge, we get a higher figure of £7m. Where does the additional £3m come from?
The (incorrect) degrouping charge is:
£13m – £6m = £7m
(market value at point of exit less inherited base cost)
and this, as we have just seen, is the overall growth in the value of the property during the period that it was held within V’s group.
But this is not what the degrouping charge is intended to do. The function of the degrouping charge is to capture the gain that would have arisen had the relevant asset been sold outside the group, instead of being transferred to a fellow group member. The remainder of the gain is picked up via the sale of the shares when Newco leaves the group.
We can rewrite the calculation for the (incorrect) degrouping charge as:
(£13m – £10m) + (£10m – £6m) = £7m
(gain on Newco shares plus intra-group gain)
Note that the extra £3m happens to be exactly the same as the gain on the Newco shares. But this £3m figure appears again when later on in the calculation, since:
Total tax charge on Newco shares = gain on Newco shares plus degrouping charge
In the incorrect calculation we have included this figure twice. There is no need to include it again.
But why is the degrouping charge brought forward to A’s last accounting period in the group?
This is convenient because it avoids having to reopen the tax return for the earlier year when the original intra-group transaction took place. Consider what would be the case if there were six intra-group transactions for each of the six previous years. This can be dealt with in the latest return, rather than having to make six separate adjustments.
No tax avoidance motive required
The previous example shows why the envelope scheme doesn’t work. However, it should be noted that the degrouping rules are not restricted to this type of scheme. Any intra-group transaction is liable to give rise to future degrouping charges, irrespective of whether a tax avoidance motive is involved.
That’s all for today!
In the next part, we shall round off our discussion of the basic degrouping rules for capital assets, before going on to look at some more complicated situations involving groups.
- Strictly speaking, Newco inherits the indexed base cost – this is the base cost adjusted for inflation. However, we shall ignore indexation in the examples in this and the following articles. ↩
- TCGA 1992 s 179. ↩
- CTA 2009 ss 780-791 ↩
- TCGA 1992 s 179(3) ↩
- TCGA 1992 ss 179(3A), (3D). ↩
- TCGA 1992 s 179(4). ↩
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