Keep the customer satisfied!

Peter Rayney reviews the legal status and tax treatment of capital contributions received by trading companies. 

Tax professionals often come across capital contributions where an overseas company wishes to inject money into its UK subsidiary or UK affiliate by way of a gift. Typically, they are a method of contributing capital into a company without taking an issue of shares or creating a liability.  

Legal status of capital contributions 

Capital contributions are not specifically legislated for under UK company law, although their status was considered in Kellar v Williams [2000] 2 BCLC 390. The court found that:  

‘If the shareholders of a company agree to increase its capital without a formal allocation of shares that capital will become like the share premium part of the owner’s equity and there is nothing [in law]…to render their agreement ineffective’.  

As a general rule, while capital contributions are treated akin to a share premium, they do not fall to be a share premium under company law. This means, for example, that they cannot be repaid or used under the reduction of share capital rules. 

ICAEW’s Technical Release: TECH 02/17BL ‘Guidance on Realised Profits and Distributable Profits under the Companies Act 2006’ states that capital contributions are gifts and not liabilities of the recipient company since they do not create any obligation for the money to be repaid.  

Group companies 

Where the capital contribution is made by a parent company (as will normally be the case), it will be treated as an addition to the cost of its investment in the subsidiary for accounting purposes. However, since it is not a payment for subscribing for shares, it is unlikely to be treated as part of its base cost in the subsidiary’s shares (see HMRC Capital Gains manual at CG43502 and the decision in The Trustees of the FD Fenston Will Trusts v HMRC [2007] STC (SCD) 316). However, where the parent company expects to obtain the substantial shareholding exemption, the lack of base cost is unlikely to be a concern. 

The recipient (normally a subsidiary company) will reflect the capital contribution as a separate item in the shareholders’ equity part of its balance sheet. In the vast majority of cases, the contribution would be given in the form of cash or assets readily convertible into cash. Consequently, it will be treated as a realised profit and form part of the company’s distributable reserves. This means that they could be repaid to shareholders by means of a distribution payment (along with the subsidiary’s other distributable reserves). 

Example 1: Accounting treatment 

In the year ended 30 June 2021, Ludovico S. C. p. A. makes a capital contribution of £1 million to its 100% UK subsidiary, Divenire Ltd. The capital contribution is made to enable Divenire Ltd to purchase its new office premises and is not repayable.  

The capital contribution appears in Divenire Ltd’s 30 June 2021 balance sheet (extract) as follows: 

Tax treatment for the recipient company 

The tax treatment of the capital contribution in the hands of the recipient is based on the individual facts of each case. This will be interpreted according to the jurisprudence governing this area.  

While the payment may be called a ‘capital contribution’, HMRC will examine the circumstances and substance surrounding the payment to determine its true nature and character in the recipient’s hands. Where a trading company receives the contribution, the main tax risk is whether HMRC can successfully tax it as trading income.  

The Falkirk Ice Rink case 

Probably the most important case in this area is CIR v Falkirk Ice Rink [1975] STC 434. In that case, the Falkirk Ice Club (the club) made a donation of £1,500 to Falkirk Ice Rink (the ice rink), which was the owner of the rink. The rink was used by the club for its curling activities. Furthermore, the club was charged preferential rates - the charges made by the ice rink did not cover its costs of providing the high-quality rink. It was found that the club made the voluntary donation towards the club’s trading expenses to enable it to continue enjoying the ice rink facilities. Given these findings, the court had little difficulty in finding that the donation was a trading receipt for the club.  

Similar decisions were made in the earlier cases of Smart v Lincolnshire Sugar Co Ltd [1937] 20 TC 643 and British Commonwealth International Newsfilm Agency Ltd v Mahany 1962] 40 TC 550. These cases are cited as the authority for the following statement in HMRC’s Business Income manual at BIM41810: 

‘If the character in the recipient’s hands is that of a payment made in order that the money be used in the recipient’s business, to supplement trading or other business receipts and to enable the recipient to carry on business or otherwise to preserve and maintain trading stability and solvency, then it will be a taxable trading receipt.’ 

Example 2: Capital contribution as a potential trading receipt  

In 2019, Einaudi Inc. incorporated a 100% trading subsidiary, Ombre UK Ltd, to act as its UK distribution arm.  

In its early years, Ombre UK Ltd made substantial trading losses. The directors of Ombre UK Ltd believe that this may be partly due to the level of charges being made for the stock purchased from Einaudi Inc. Einaudi Inc. agrees to make a voluntary ‘capital contribution’ of £800,000 to its UK subsidiary to subsidise its trading losses and ensure its future viability. 

There is a trading relationship between the parties, and the payment is being made to ensure that Ombre UK Ltd remains in business (Note: HMRC might also raise enquiries about the prices that have been charged by Einaudi Inc. either under the transfer pricing rules, or if not applicable, whether the amounts paid for the purchases were wholly and exclusively incurred for the purposes of Ombre UK Ltd’s trade!). 

Example 3: Capital contribution as a capital receipt  

The £1 million capital contribution received by Divenire Ltd (see Example 1) should be treated as a non-taxable capital receipt. It is not intended to be repaid (therefore, it is not a loan relationship).  

The parties specifically intend that the contribution is being made to assist with the purchase of the company’s new office premises, which is a fixed asset in its accounts.  

Key principles 

Some important principles can be taken from the key tax cases in this area: 

• Trading relationship – Where the contribution payment is made by a customer, the receipt is more likely to be regarded as a trading receipt, particularly where the customer is seeking to ensure the continuity of its services. 
• Purpose of the contribution – If the contribution is intended to be quasi-equity, such as a large one-off payment to finance the start-up or expansion of a subsidiary, then it should normally be treated as a capital receipt. On the other hand, payments that are specifically made to compensate the recipient for its trading losses or to preserve its financial stability would generally be treated as taxable trading receipts. 

• Frequency of payment – If the advances or annual payments are of a recurrent nature, this will be a persuasive factor for them being treated as trading income (see the Lincolnshire Sugar and British Commonwealth cases). 

The tax treatment of a capital contribution receipt is invariably dictated by the application of established case law principles to the facts of each case. It is therefore extremely important that the parties’ intentions for the payment are carefully documented in a letter or capital subscription agreement. 

Furthermore, the accounting treatment adopted for the contribution is persuasive but not necessarily conclusive. Nevertheless, crediting the receipt to a company’s profit and loss account (rather than shareholders’ equity in the balance sheet) increases the risk of HMRC upholding that it is a taxable trading receipt. 

Practical tip 

If there is a high risk of a proposed capital contribution being treated as taxable trading income, it may be preferable to eliminate this problem by arranging for a traditional share subscription instead.