As has been stated in previous articles, the degrouping rules are designed to prevent assets from being smuggled out of a group tax free under the protection of a corporate wrapper. This is achieved by imposing a tax liability when a company acquires an asset from a fellow group member and subsequently leaves the group within the next 6 years.
But for every rule, there is an exception.
The exception applies when the asset transfer takes place between two companies that are part of a subgroup within the main group. No degrouping charge is incurred in respect of this transaction, provided the parties leave together as members of a subgroup.
This article is intended as an overview of the rules for subgroups. We shall not look too closely into the legislation at this point – the aim is to look at the big picture before going into the detail. The examples are based on the rules for capital assets, but the rules for intangibles are similar.
Why is there an exception?
It is not hard to see why this should be the case.
Recall that a group is an economic unit, so when assets are transferred between the members, there is no underlying change in ownership. Accordingly, no tax is charged, but is deferred until such time that the asset leaves the group. This can be either by way of direct sale, or under the cover of a corporate wrapper.
The same principle applies to asset transfers that take place within a smaller subgroup. When this subgroup is detached from the main group, it is arguable that there is still no underlying change in ownership, provided that the two companies leave together as members of this subgroup. In these circumstances no tax is charged.
The subgroup exception is also necessary to prevent double taxation.
The idea is that when the two companies leave the group together, the gain is already captured in the tax computation for the shares that have been disposed of. In this case, a separate degrouping charge is not required. This is best explained by an example.
Example 1 – back to the envelope scheme
Let us suppose that V has a 100% subsidiary B, whose business involves property investment. We shall assume that there is no company A to begin with, and that V’s shareholding in B is worth £50m. The following events take place:
- B buys a property worth £6m. This doesn’t change the value of V’s holding as one asset (cash) is being replaced for another of the same value (property);
- A few years later, the value of this property increases to £10m. We shall assume that all of B’s other properties remain the same value;
- B transfers the property to a newly incorporated subsidiary A in return for shares.
The following table shows what is happening to the value of the various assets involved.
We already know that B cannot sell A without triggering a degrouping charge. This is also explained by the fact that the value of A doesn’t reflect the gain in the property. B’s gain on selling A is precisely nil, while the property has appreciated by £4m. So there needs to be an appropriate degrouping adjustment when A is sold.
What would be the position if V sells B? The degrouping rules are activated, because the consequence of selling B is that A also leaves the group, taking the property with it.
However, as the previous table shows, the value of V’s shareholding in B has increased by £4m, which is precisely the amount by which the property has appreciated. The shares already reflect the gain – there is no need for an additional tax charge.
Example 2 – departing companies must leave as part of a subgroup
It is important to note that for the subgroup exception to apply, both companies must leave together as part of a subgroup.
Let us suppose the same facts as in Example 1, but this time, the new company A is incorporated as a subsidiary of V for £1. B sells the property to A for £10m funded on intercompany loan account.
V sells A and B simultaneously.
- V is paid £54m for B;
- V is paid £1 for A. However, the total cost to A’s buyer will not in fact be £1, but £10m in order to discharge A’s liability to B.
A and B have left the group at the same time, but they haven’t left together. They aren’t “joined at the hip” when they leave. The subgroup exception doesn’t apply, and so the degrouping charge is added to V’s corporation tax bill.
It is harder to see the justification when looking at the numbers, as the amount V is paid still reflects the gain on the property.
However, on a conceptual basis, it is easier to see what is going on.
V, A and B together form a group, but A and B do not. By selling off the two subsidiaries, the V-A-B group has been broken up. One would expect degrouping charges in this situation. The same rationale applies if V-A-B were to form a subgroup of a larger group
Example 3 – companies leaving as a subgroup can trigger a degrouping charge
In this example, we see that W and A make up a subgroup on their own. We shall again assume that B has bought an investment property for £6m, whose value rises to £10m.
- B sells the property to A for its market value of £10m. This is a tax neutral transaction;
- B pays a tax free dividend to V of £4m, being the profit on the sale;
- V sells B to W in another tax neutral transaction1.
At this point, B is now part of the subgroup headed by W. However, a sale of W would still trigger a degrouping charge in respect of the B-A property transfer. Although the two companies have left together as part of W’s subgroup, they weren’t members of this subgroup at the time of the intra-group transfer.
What about the numbers?2 Let us assume that W’s only asset is its shareholding in A, which has a value of £15m.
Overall, the value of W remains the same throughout. Consequently if V were to sell W, the tax computation should be exactly the same as if B hadn’t been transferred into W’s subgroup.
And yet, the property stands at a gain of £4m. Where has this gain disappeared to? The answer is that the gain is captured by the usual degrouping rules – the subgroup exception does not apply in this situation3.
Another way of understanding why the subgroup exception doesn’t apply is a visual one. We shall redraw the previous diagram but with V blotted out:
Without the top company V, B and A would not be in the same group. B, an outsider, would have sold the property to A and have paid tax on the transaction. The fact that it subsequently joins W’s group would have made no difference to this prior liability.
So why is no tax actually paid when B sells to A? Because in reality there is a group relationship. V is the thread that ties B to A, ensuring that the transaction is tax neutral. However, this thread is cut when W is subsequently sold – it is at this point that the tax is recovered.
There is another visual explanation.
Imagine that we could take the companies W and A and put them in an opaque box. We label this box X, and pretend that X is a separate corporate entity. We also introduce a rule that we cannot see what is happening inside the box, we can only see what goes in and what comes out.
Suppose A were to transfer one of its properties to W. This takes place inside the box, so we can’t see it. This explains why no degrouping charge is incurred when W is sold. As far as the outside world is concerned, V has simply sold its single subsidiary X.
Now consider the previous transaction where B joins the W-A subgroup after first transferring the property over to A. In “box language”:
B transfers a property to fellow group member X:
V then transfers subsidiary B to fellow group member X – after which B mysteriously disappears into the box:
V then sells X. What does the outside world see?
The outside world sees two intra-group transactions followed by the departure of the recipient company from the group. X is a classic corporate wrapper – one would expect a degrouping charge in this situation.
Example 5 – the subgroup exception doesn’t apply, but still no degrouping charge
Let us return to the last example, but this time, B sells the property to A at the book cost of £6m instead of market value. Since B doesn’t make a profit on the transaction, there is no dividend payment to V.
The subgroup exception still doesn’t apply when W is sold, for the same reason as last time – B and A weren’t part of the same subgroup at the time of the property transfer. But what does our table of values look like now?
Overall, the value of W increases by the same £4m gain on the property. If a degrouping charge is imposed when W is sold, V will be taxed twice.
In these circumstances, V can apply to have the additional liability waived4. This is a new feature of the degrouping rules for capital assets, but unfortunately doesn’t apply to IP. Note that this is a discretionary measure – the legislation doesn’t automatically disapply the degrouping charge in a case of double taxation.
This concludes our overview of the subgroup exception. We shall revisit this topic in another article, where we shall look more closely at how the legislation works.
- The sequence of events follows that in Johnston Publishing (North) Ltd & Ors v Revenue & Customs (2006) UKSPC SPC00564, appealed at (2007) EWHC 512 (Ch). This is the case which decided that this type of transaction didn’t work. ↩
- Note that the values of the various companies involved do not change when they engage in market-value transactions, which they are doing in this, and the previous examples. For example, when B sells property worth £10m, one asset is being replaced with another. B can be paid £10m in cash, or the amount left outstanding on intercompany loan account. In the last case, B has parted with a £10m property in exchange for being a creditor for the same amount. ↩
- Note that on a sale of W, there is also a degrouping charge in respect of W’s acquisition of B. However, this has been mitigated by the payment of the £4m dividend (though it raises the issue of whether the rules on depreciatory transactions apply). ↩
- TCGA 1992 s 179ZA. ↩
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