EXPLANATORY NOTE

1. Clause and Schedule close a loophole in existing anti-avoidance legislation which counters schemes by groups of companies to avoid tax on capital gains on the sales of shares in subsidiary companies and other assets. The existing legislation adjusts the capital gain arising to a company on a sale of a subsidiary company if value has been stripped out of that subsidiary in a non-taxable form before the sale. The loophole which is now being exploited involves the sale of the subsidiary to a non-resident company within the world-wide group prior to its onward sale outside the group. The anti-avoidance legislation will be extended to cover this situation.

2. The clause and schedule focus on the underlying assets of a company which have been used in the scheme to strip value out of the subsidiary. A charge will be incurred if a company holding such assets leaves the group of companies within 6 years of the transfer to the non resident company.

3. The provisions will apply to groups where the transfer to the non-resident company takes place on or after 9 March 1999.

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4. Clause 67 provides that Schedule 9 will have effect.

5. Paragraph 1 is introductory.

6. Paragraph 2 inserts a new section 31A into the Taxation of Chargeable Gains Act 1992 (TCGA).

New section 31A

7. Subsection (1) sets out the circumstances in which the new section is to apply: that the profits of a company would be profits arising on a transaction caught by section 31 TCGA, except the condition in the existing section 31(8) is not met. That condition is that immediately after the disposal of shares (‘the section 30 disposal’) which have been materially reduced in value by the payment of a dividend, the asset which was used to generate the profit out of which the dividend was paid (the ‘asset with enhanced value’) was no longer owned by the company disposing of the shares, or a company associated with that company.

8. Subsection (2) provides that profits shall be treated as profits falling within the existing section 31 TCGA if conditions specified in subsections (4) or (5), and subsection (6) of the new section 31A are met. This widens the scope of the transactions caught by section 31.

9. Subsection (3) defines various phrases used in the section.

10. Subsection (4) provides that this subsection is satisfied if at any time within six years of the section 30 disposal, the company holding the asset with enhanced value leaves the group of which it was a member when the section 30 disposal was made. This subsection is not satisfied however if a company leaves that group only because the principal company of that group becomes a member of another group i.e. the first group is taken over by another group.

11. Subsection (5) sets out the rules if the company holding the asset with enhanced value does leave the group because that original group is taken over by another group. If at any time during the six year period after the section 30 disposal, the company holding the asset with enhanced value ceases to be a 75% subsidiary, or an effective 51% subsidiary, of any member of the disposal group, the subsection is satisfied. This means that a charge is not triggered on a straightforward takeover of the original group, but a charge is triggered if the company holding the asset with enhanced value is disposed of outside the original group which was taken over.

12. Subsection (6) is satisfied only if there has not been a prior charge under the provisions that apply where a company leaves a group. It prevents a double charge under these provisions and those other provisions.

13. Subsections (7) and (8) determine the amount of the gain arising, and the time when it is chargeable . The amount that is brought into charge is the difference between the amount that was chargeable on the section 30 disposal, and the amount that would have been chargeable if a just and reasonable adjustment had been made by reference to the dividend paid. The gain representing that difference comes into charge immediately before the company holding the asset with enhanced value leaves the group.

14. Subsection (9) sets out which company is charged on the increased gain. It is either the company which made the section 30 disposal or, if that company is no longer a member of the group, the principal company of that group.

15. Subsection (10) allows unused losses arising on the earlier disposal, which may otherwise be barred from set off by the rules applying to connected persons, to be set off against the charge calculated in accordance with this section.

16. Paragraph 3 contains amendments to the existing section 33 TCGA consequent on the introduction of the new section 31A. The purpose of section 33 is to secure an appropriate charge where there has been a part disposal of an asset or an asset has been sub-divided prior to the anti-avoidance provisions being triggered.

17. Subparagraph (2) inserts new section 33(1A) which provides for the equivalent treatment in section 33 in respect of an asset with enhanced value referred to in section 31A. Subparagraph (3) extends the existing section 33(2) to include the relevant part of the new section 31A. Subparagraphs (4), (5) and (6) insert new subsections (3A) to (3C) to provide equivalent treatment for part-disposals where new section 31A applies and make consequential adjustments to the existing section 33(3) and (4). Sub-paragraph (7) inserts a new subsection (8A) into section 33 to mirror the existing section 33(8) so that any adjustment by virtue of new section 31A is appropriate where there has been a prior part disposal.

18. Paragraph 4 provides for amendments to be made to the existing section 34 TCGA. Section 34 deals with cases where shares are transferred to the ownership of another company in exchange for shares. In certain circumstances, such a transfer would not be treated as a disposal for capital gains purposes (the ‘no disposal fiction’). Where the anti-avoidance provisions would apply, were it not for the no disposal fiction, section 34 sets aside that statutory fiction. By inserting new subsections (1A) to (1C) in the existing section 34, and making some consequential amendments to section 34(2), subparagraphs (2) and (3) provide that the anti-avoidance provisions can apply by virtue of section 31A, even where the no disposal fiction would otherwise prevent this.

19. Paragraph 5 provides the commencement provision for the Schedule 9. It is to have effect to transactions where the section 30 disposal of an asset takes place on or after 9 March 1999.

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20. Existing anti-avoidance legislation at sections 30 to 34 TCGA provides protection against schemes, commonly known as drain-out dividend schemes, which can be used to reduce the gain chargeable to corporation tax on a company on the sale of a UK subsidiary company.

21. Typically, these schemes involve the stripping out of value from the company to be sold by the payment of a dividend out of profits that have not been subject to tax prior to the sale outside the group of companies. A dividend is not normally subject to corporation tax and without the anti-avoidance legislation no charge would be levied on the commercial gain realised. The anti-avoidance legislation allows the gain to be computed as if the value had not been stripped out.

22. This legislation is being side-stepped by a series of transactions which involve the payment of the dividend by the UK subsidiary company, but then instead of selling the subsidiary directly to the third party purchaser, the subsidiary is first transferred to a non-resident subsidiary within the same world-wide group, prior to its onward sale to the third party purchaser. Safeguards built into the existing legislation mean that the anti-avoidance legislation cannot apply on the sale to the non-resident subsidiary or on the onward sale outside the group.

23. The anti-avoidance legislation will be extended so that it applies where at some time within 6 years of the disposal to the non-resident subsidiary, the company owning the assets which were used to generate the profit out of which the dividend was paid, is sold outside the group. The effect will be to permit adjustment of the gain that would have arisen on the transfer to the non-resident subsidiary. Any increase in the gain will come into charge at the time of the sale of the UK subsidiary company outside the group. It will be chargeable on the company which made the transfer to the non-resident company, or the parent company of the group if that company no longer exists or has left the group.

24. An example of the type of scheme to which the legislation will apply is illustrated below.

i. The group, headed by Parent, wishes to sell to a third party, part of its business owned by a subsidiary company "Target".

ii. Target sells its business at market value to a newly formed subsidiary of Target, Newco (there is no capital gain on this transfer because Target and Newco are in the same capital gains group and the transfer is on a no gain/no loss basis).

iii. Newco typically funds the purchase of the business by a loan (which it may receive from another group member or a third party).

iv. Target uses the cash it has received to pay a dividend to the parent company of the group "Parent".

v. Parent sells Target to an offshore company within the same world-wide group (this is the section 30 disposal). This is designed so that no capital gain is likely to arise on this sale because of the much reduced value of Target. The profit on the sale has effectively already been received by Parent by way of the dividend it received at step iv.

vi. The offshore company then sells Target to the third party. As part of the sale agreement the third party purchaser will arrange for the repayment of the loan incurred by Newco at step iii. This means that the group no longer has the loan outstanding which had funded the dividend, and the purchaser has paid what was the full value of Target before the dividend was paid.

vii. Although there has been a disposal for the purposes of the anti-avoidance legislation (the sale to the offshore company) Target actually stays within the same capital gains group at step v and the anti-avoidance legislation is not triggered.

viii. The scheme effectively changes a potential charge to Corporation Tax on the capital gain to a dividend which is tax free under the normal rules. The purchaser pays the same as it would have done had the contrived transactions not taken place, but the bulk of the payment will be the payment to Newco so that it can repay the loan. The group gets full economic value for the Target and suffers no tax.