Does the partition of a company amount to a "reconstruction"?

United Kingdom
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trust reorganisations may not always fall to be treated as reconstructions there have been concerns that SP5/85 may be withdrawn.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 year.

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.

Implications

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 available.

If you would like any further information, please contact Mark Nichols on 020 7367 2051 (mbn@cms-cmck.com), Simon Meredith on 020 7367 2959 (sim@cms-cmck.com) or Mike Boutell on 020 7367 2218 (mqb@cms-cmck.com).