Inland Revenue Statement of Practice 5/85 makes it clear that a
taxpayer may treat a partition of a company as a reconstruction so
that advantage can be taken of s136 Taxation of Chargeable Gains
Act 1992 which treats the shares in the old company (exchanged for
shares in the new company) as the same asset as the shares in the
new company. This means that the taxpayer is not treated as making
a disposal for tax purposes.
Following the recent decision of the High Court in
Fallon and Another v Fellowes together with indications from
the Revenue that investment trust reorganisations may not always
fall to be treated as reconstructions there have been concerns that
SP5/85 may be withdrawn. SP5/85 has been relied upon in several
high profile partitions and demergers eg AA and RAC as well as
reorganisations of investment trusts and therefore this note will
be of general interest.
Fallon v Fellowes
In outline, OldCo carried on two separate
businesses: Business A and Business B. One section of the
shareholders of OldCo was responsible for the management of
Business A (the A shareholders) and another section of shareholders
of OldCo were responsible for the management of Business B (the B
shareholders). It was proposed that OldCo would be partitioned so
that Business A would be transferred to NewCo 1 in exchange for
NewCo 1 issuing shares to the A shareholders and Business B would
be transferred to NewCo 2 in exchange for NewCo 2 issuing shares to
the B shareholders. In accordance with SP5/85 this was treated as a
reconstruction so that neither the A nor B shareholders were
treated as having disposed of their shares in OldCo. Instead, their
shares in NewCo 1 and NewCo 2 inherited the base cost of their
shares in OldCo (in accordance with what is now s136 Taxation of
Chargeable Gains Act 1992).
Subsequently, one of the shareholders in NewCo 1
died and his executors sought to argue that the partition was not,
as a matter of strict law, a reconstruction so that the base cost
of his shares in NewCo 1 was not the low base cost inherited from
the OldCo shares but instead was the market value of the shares as
at the date of the partition (which was somewhat higher).
This left the Revenue in the position of being
bound by their decision to give concessionary reconstruction
treatment at the time of the partition but faced with a taxpayer
seeking to rely on the strict legal position in a subsequent tax
The essence of a reconstruction is that there
should be substantial identity of shareholders as between the old
and the new companies. The reason why a partition is not a
reconstruction is because by its very nature the shareholders in
NewCo 1 would not be substantially the same as the shareholders in
OldCo (since a significant proportion of the shareholders in OldCo
will not be shareholders in NewCo 1 but shareholders in NewCo 2).
The Revenue argued that a reconstruction only needed there to be a
substantial identity as between the A shareholders of OldCo and the
shareholders of NewCo 1 (which would be the case). Park J rejected
this argument upholding the traditional view that a reconstruction
required substantial identity of shareholders as between all the
shareholders of OldCo and the shareholders of NewCo 1.
Why did the Revenue take the case?
It is understood that the Revenue do not intend to
withdraw SP5/85 and that it is unlikely that the Revenue will
appeal against the decision in Fallon. What this means
therefore is that the treatment of a partition as a reconstruction
will remain concessionary.
It is perhaps not difficult to guess why the
Revenue took the case. The taxpayer sought to rely on the
concessionary treatment for the tax year in which the partition
took place thereby avoiding the crystallisation of a tax charge but
also sought to rely on the strict statutory position for the
purposes of calculating the gain arising on a disposal of the
shares in NewCo 1 in a later tax year. In fact, the Revenue
introduced legislation (s284A Taxation of Chargeable Gains Act
1992) in the Finance Act 1999 which prevents a taxpayer from being
able to take advantage of concessionary treatment in one tax year
and his strict legal position in another tax year. This legislation
however did not apply in the Fallon case.
SP5/85 will remain so that reorganisations and
demergers that may not be reconstructions as a matter of strict law
but which have been treated as such by concession will continue to
be treated as reconstructions.
It is understood that there is one area that the
Revenue are currently considering and this is in connection with
schemes of reconstruction of investment trusts normally carried out
to release value from an investment trust that is trading at a
discount to its net asset value. Typically, a shareholder in an
investment trust may be given one of three options: to take shares
in a new investment trust, units in a unit trust, or cash.
The aspect which has lead the Revenue to signal to
investment trusts that a scheme of reconstruction may not qualify
as a reconstruction under SP5/85 is the cash element option. If
more than 10% of the shareholders in the investment trust take the
cash option this will inevitably mean that there will not be
substantial (generally taken to mean 90%) identity of shareholders
as between the investment trust and its successor vehicles.
Taxpayers therefore need to be aware that
reconstruction treatment may not be available in these
circumstances although a Revenue pronouncement on this issue is
expected in due course. Where at least 90% of the shareholders of
an investment trust elect to participate in a successor vehicle
rather than take cash reconstruction treatment should remain
If you would like any further information, please
contact Mark Nichols on 020 7367 2051 (email@example.com), Simon
Meredith on 020 7367 2959 (firstname.lastname@example.org) or Mike Boutell on 020
7367 2218 (email@example.com).