Peter Rayney explores how to shield investment assets away from trading risks.
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Many family and owner-managed companies grow to a stage where surplus funds retained from healthy trading profits are invested in significant income-producing investments. Typically, these range from residential or commercial properties to listed share portfolios.
For a while, these investment activities tend to be operated alongside the company’s trading activities. However, there often comes a point where the owner-manager starts to ‘worry’ that these valuable investments are exposed to trading risk. If the company experiences an insolvency event, these investments may well be ‘swallowed up’ by an administrator or liquidator for the benefit of creditors and lenders.
What can be done?
Professional advisers are often asked whether there is anything that can be done to separate the company’s valuable investments from the financial and commercial risks attaching to the trade. It is, of course, often possible to implement a suitable demerger arrangement to hive-off the investment activities to a separate new company with little or no tax cost. Such arrangements may also be effective for inheritance tax (IHT) purposes, since this will ensure that 100% business property relief (BPR) is available on the trading operations.
However, demergers are often relatively complex and costly operations and will inevitably result in two or more separate trading and investment companies or groups.
A number of owner-managers may seek a simpler, perhaps interim solution to prevent the investment assets from being exposed to the financial and commercial hazards inherent in the trade. A useful strategy might be to create a new holding company (‘Newholdco’), with the investment activities being transferred to it. The trading activities would be retained in the original company, which now becomes the wholly-owned subsidiary of Newholdco.
A detailed analysis of this technique is shown in the worked example below.
Example: Protecting an investment business
Vera Fashions Ltd (VFL) is wholly owned by Vera Stanhope (VS). VFL has operated a very successful clothing and fashion business for many years. It has tended to plough back its profits in buy-to-let properties in Birmingham, which are now worth some £2.8m. Based on recent profitability, its fashion trade is worth some £3m (applying an EBITDA multiple of 5). The company currently has no debt.
VS now wishes to insulate the company’s buy-to-let investment business from the fashion operations since she is concerned that increased competition in the fashion sector may put pressure on margins and the company’s profits.
Her financial adviser, Mr Kenny, has suggested that she forms a new holding company (Vera Holdings Ltd) (‘Holdings’) and moves the residential property business to it. This would involve the following steps.
Step 1 - Insert Holdings ‘above’ VFL
Holdings would be inserted above VFL by means of a share-for-share exchange. Thus, Holdings would purchase the entire share capital of VFL for around £5.8m (being £3m for the fashion trade and £2.8m for the residential property business), which would be satisfied entirely by an issue of new Holdings shares to VS.
This share exchange transaction is illustrated below:
VS’s sale of her VFL shares should be ‘tax-neutral’ for capital gains tax (CGT) purposes since the share exchange falls within TCGA 1992, s 135. Advance tax clearance under TCGA 1992, s 138 (and ITA 2007, s 701) is highly recommended to confirm in advance that HMRC accepts that the transaction is driven by commercial reasons and not tax avoidance. The CGT reorganisation rules should apply so that VS is treated as making no CGT disposal of her VFL shares, and the new Holdings shares issued to VS would ‘step into the shoes’ of her old VFL shares.
Stamp duty share exchange relief under FA 1986, s 77 should also be available on Holdings’ acquisition of shares in VFL. This requires (amongst other things) that the shares issued by Holdings satisfy the ‘mirror-image’ requirements of FA 1986, s 77 (f)-(h). That would not be a problem in this case, since VS holds 100% of the ordinary share capital of VFL before the exchange, and she also holds 100% of Holdings ordinary share capital after it.
Further, there are no arrangements in place for a subsequent change of control in Holdings (FA 1986, s 77A). This means that the share exchange exemption would not be jeopardised.
The share exchange relief is claimed after the share exchange transaction and must be applied for in writing to the Stamp Taxes Office in Birmingham. The application must contain sufficient information for HMRC to consider whether the conditions for relief have been met. Applications by email are encouraged, which can be sent to stampdutymailbox@hmrc.gov.uk (e-signatures are accepted).
Step 2 – VFL distributes its property investment business to Holdings
Given the commercial rationale, VS would prefer VFL to distribute the investment properties to Holdings. This would result in a transfer of some £2.8m from VFL to Holdings.
The distribution must be lawful under the Companies Act 2006 (CA 2006). For legal and accounting purposes, the distribution is measured by the carrying value in the accounts (CA 2006, s 845). This may not necessarily be market value. The distributing company (in this case, VFL) would therefore require sufficient distributable reserves to ‘frank’ the carrying value of the relevant investment properties. However, for these purposes, any ‘revaluation reserve’ would be treated as distributable to the extent that it relates to the property or properties being distributed (CA 2006, s 846).
The in-specie distribution is illustrated below:
The transfer of the properties to Holdings would be treated as a ‘no gain, no loss’ transfer under TCGA 1992, s 171. Thus, for tax purposes, Holdings would acquire the relevant properties at their original cost (plus any accrued indexation to December 2017) (TCGA 1992, s 171).
Provided VFL distributes the properties in specie, there should be no stamp duty land tax (SDLT) liability. This is because no purchase consideration is passing and the deemed ‘market value’ rule for connected company transfers is ‘switched off’ (see FA 2003, Sch 3, para 1 and FA 2003, s 54). However, SDLT ‘intra-group’ transfer relief should be claimed if any actual consideration is given, such as the novation of property-related debt or mortgages to the acquirer (FA 2003, Sch 7, paras 1 and 2).
Provided the group structure remains intact for at least six years, there would be no chargeable gains degrouping issues. Similarly, if SDLT intra-group transfer relief was claimed, there should be no SDLT degrouping issues if the group structure remains in place for at least three years.
VAT would also need to be considered where ‘opted’ or new commercial properties are involved.
Insulation from claims and liabilities
Distributions of investment assets to a new holding company are treated as transactions at an undervalue under the Insolvency Act 1986. Therefore, if the trading company subsequently went into administration or liquidation, it may be vulnerable to challenge by an administrator or liquidator.
If a distribution in specie is made with the intention to place assets out of reach of the subsidiary’s creditors or if the company is already struggling to pay its debts, the transaction could be reversed by a liquidator so that the investments etc., would be available to meet creditors’ claims.
The risks of such challenges reduce if the distribution transfers take place more than two years before an insolvency event. Consequently, owner-managers that wish to ‘protect’ their company’s investment assets from future claims etc., should implement these arrangements as soon as possible.
Furthermore, directors that have behaved in an irresponsible, reckless or fraudulent manner potentially face a number of serious sanctions. These can include disqualification from being a director, personal liability to contribute to the payment of the company’s debts, and significant fines.
Practical tip
Where the company is financially healthy when the in-specie distribution takes place and it is made from distributable profits for genuine business reasons, there is little risk of it subsequently being set aside by an insolvency practitioner.
