It is time to bring the exempt distribution rules into line with the CGT rules.
There are three main mechanisms for carrying out corporate demergers: liquidation, reduction of capital and distribution. All of these are subject only to the rules for relief from capital gains in the reorganisations legislation (TCGA 1992 s 127, applied by virtue of s 136). But the distribution route also carries a charge to income tax, as the transaction is a distribution by a company in favour of some or all of its shareholders. To alleviate this there are the special rules for ‘exempt distributions’ in CTA 2010 Part 23 Chapter 5 (ss 1073–1099).
The capital gains tax rules simply require that the transactions be carried out for bona fide commercial purposes and not be part of a scheme of arrangements to avoid capital gains tax, corporation tax and, in some cases, income tax (TCGA 1992 ss 137(1) and 139(5)).
However, the rules for exempt distributions are much more detailed and prescriptive. Some of this is because the exempt distribution regime was enacted at a time when companies were subject to advance corporation tax (ACT) on distributions, so the rules may have been required to prevent abuse of the ACT regime.
Having been one of the Inland Revenue’s in-house experts on that regime, however, it was never clear why some of the conditions were considered necessary and, in any case, ACT was abolished in 1998. My view is that there are no longer any policy reasons why the exempt distribution rules should not be brought into line with the capital gains tax rules. I have a number of observations on specific rules to illustrate this.
The main distinguishing feature of the exempt distribution rules is that they can only be used to divide trading activities, not to separate trading activities from investment activities or to divide investment activities (CTA 2010 ss 1081(2), 1082(2) and 1083(5)). There is no obvious reason why the exempt distribution rules discriminate against investment activities or why the exempt distribution mechanism should not be available to all types of demerger.
It is often possible to get clearance from HMRC under the capital gains tax provisions for demergers by one of the other mechanisms prior to a sale of part of the business to a third party, if there are strong commercial reasons. The restriction against a change of control in the exempt distributions rules (CTA 2010 s 1081(5)(d)) means that we are forced to go down one of the other routes in such cases, even though using a distribution might be mechanically simpler and therefore cheaper for taxpayers.
The commercial purpose test for the purpose of the exempt distributions rules is that the demerger must be intended to benefit one or more of the trades that are being separated (CTA 2010 s 1081(3)). This is subtly different from the capital gains requirement to have a commercial purpose. Why does Parliament consider that a demerger by distribution must specifically benefit the trade?
Why does the tax anti-avoidance rule (CTA 2010 s 1081(5)(a), (7)) include stamp duty and stamp duty land tax when the anti-avoidance rule for capital gains purposes does not?
Why are there rules about ‘chargeable payments’ (CTA 2010 ss 1086–1089)? I have never seen a chargeable payment in 24 years of working with exempt distributions!
A major practical issue is the requirement about future activities. Where a trade is distributed to a transferee company in a demerger, a condition for exempt distribution treatment is that the only or main activity of the transferee company after the demerger must be the carrying on of that trade (CTA 2010 s 1083(3)(a)). This means that the transferee company cannot grow by acquisition: if it acquires other trades or subsidiaries, its main activities may no longer be the carrying on of the trade that was transferred to it. So we would have to go through some contortions to allow for anything other than organic growth of that trade, such as inserting a new holding company to acquire the further trades, either directly or through sister subsidiaries.
Similarly, where a subsidiary trading company is hived out in a demerger, the transferee holding company is restricted to the holding of those shares as its only or main activity (CTA 2010 s 1083(3)(b)). So that company cannot, itself, acquire trades or other subsidiaries. Instead, any trades would need to be acquired by the trading subsidiary, which isn’t necessarily particularly restrictive. But that trading subsidiary would also have to be the acquisition vehicle for any new trading companies that were being bought, because they cannot be bought by the holding company.
These examples show that there is no reason for the more restrictive rules for exempt distributions compared to other mechanisms for demerger. Demergers by distribution are often easier to carry out and cheaper for taxpayers, and the logical conclusion is that the exempt distribution rules should only be subject to the main anti-avoidance rules for schemes of reconstruction at TCGA 1992 ss 137(1) and 139(5).
Home >Articles > Miller’s tales: demergers by distribution
Miller’s tales: demergers by distribution
It is time to bring the exempt distribution rules into line with the CGT rules.
There are three main mechanisms for carrying out corporate demergers: liquidation, reduction of capital and distribution. All of these are subject only to the rules for relief from capital gains in the reorganisations legislation (TCGA 1992 s 127, applied by virtue of s 136). But the distribution route also carries a charge to income tax, as the transaction is a distribution by a company in favour of some or all of its shareholders. To alleviate this there are the special rules for ‘exempt distributions’ in CTA 2010 Part 23 Chapter 5 (ss 1073–1099).
The capital gains tax rules simply require that the transactions be carried out for bona fide commercial purposes and not be part of a scheme of arrangements to avoid capital gains tax, corporation tax and, in some cases, income tax (TCGA 1992 ss 137(1) and 139(5)).
However, the rules for exempt distributions are much more detailed and prescriptive. Some of this is because the exempt distribution regime was enacted at a time when companies were subject to advance corporation tax (ACT) on distributions, so the rules may have been required to prevent abuse of the ACT regime.
Having been one of the Inland Revenue’s in-house experts on that regime, however, it was never clear why some of the conditions were considered necessary and, in any case, ACT was abolished in 1998. My view is that there are no longer any policy reasons why the exempt distribution rules should not be brought into line with the capital gains tax rules. I have a number of observations on specific rules to illustrate this.
The main distinguishing feature of the exempt distribution rules is that they can only be used to divide trading activities, not to separate trading activities from investment activities or to divide investment activities (CTA 2010 ss 1081(2), 1082(2) and 1083(5)). There is no obvious reason why the exempt distribution rules discriminate against investment activities or why the exempt distribution mechanism should not be available to all types of demerger.
It is often possible to get clearance from HMRC under the capital gains tax provisions for demergers by one of the other mechanisms prior to a sale of part of the business to a third party, if there are strong commercial reasons. The restriction against a change of control in the exempt distributions rules (CTA 2010 s 1081(5)(d)) means that we are forced to go down one of the other routes in such cases, even though using a distribution might be mechanically simpler and therefore cheaper for taxpayers.
The commercial purpose test for the purpose of the exempt distributions rules is that the demerger must be intended to benefit one or more of the trades that are being separated (CTA 2010 s 1081(3)). This is subtly different from the capital gains requirement to have a commercial purpose. Why does Parliament consider that a demerger by distribution must specifically benefit the trade?
Why does the tax anti-avoidance rule (CTA 2010 s 1081(5)(a), (7)) include stamp duty and stamp duty land tax when the anti-avoidance rule for capital gains purposes does not?
Why are there rules about ‘chargeable payments’ (CTA 2010 ss 1086–1089)? I have never seen a chargeable payment in 24 years of working with exempt distributions!
A major practical issue is the requirement about future activities. Where a trade is distributed to a transferee company in a demerger, a condition for exempt distribution treatment is that the only or main activity of the transferee company after the demerger must be the carrying on of that trade (CTA 2010 s 1083(3)(a)). This means that the transferee company cannot grow by acquisition: if it acquires other trades or subsidiaries, its main activities may no longer be the carrying on of the trade that was transferred to it. So we would have to go through some contortions to allow for anything other than organic growth of that trade, such as inserting a new holding company to acquire the further trades, either directly or through sister subsidiaries.
Similarly, where a subsidiary trading company is hived out in a demerger, the transferee holding company is restricted to the holding of those shares as its only or main activity (CTA 2010 s 1083(3)(b)). So that company cannot, itself, acquire trades or other subsidiaries. Instead, any trades would need to be acquired by the trading subsidiary, which isn’t necessarily particularly restrictive. But that trading subsidiary would also have to be the acquisition vehicle for any new trading companies that were being bought, because they cannot be bought by the holding company.
These examples show that there is no reason for the more restrictive rules for exempt distributions compared to other mechanisms for demerger. Demergers by distribution are often easier to carry out and cheaper for taxpayers, and the logical conclusion is that the exempt distribution rules should only be subject to the main anti-avoidance rules for schemes of reconstruction at TCGA 1992 ss 137(1) and 139(5).
