There are a number of reliefs which shareholders of trading companies are entitled to but these reliefs are dependent on qualifying criteria, one of which is if the company meets a trading test. What is meant by trading is not the same for each of the reliefs and for advisers this can make tax planning perilous. The restructuring of companies and groups can preserve one relief while losing another relief. Therefore understanding the client’s objectives is critical to ensure that any structure meets them.
Advisers will be familiar with the reliefs available to business owners holding shares in trading companies. Each have their own unique set of rules including the key aspect of whether or not the company is actually trading. Where the company or group carries on both trading and non-trading activities, it can be problematic in determining which side of the line it falls. More importantly, there can be a marked difference in the meaning of trading and how this is measured for the different reliefs. Such differences can often lead to difficulties where actions taken to secure one relief can be at the expense of another.
The purpose of this article is to examine the current position, based on HMRC guidance and our experience, on what is meant by a trading company and how this applies to:
For the purposes of this article we will focus on the rules for a single company. In essence the same tests are applied to the group as a whole.
Unless otherwise stated, all statutory references are to TCGA 1992.
Statutory and non-statutory guidance
For individual shareholders wanting to benefit from holdover relief for the gift of business assets and ER the statutory guidance on the definition of a trading company can be found in s 165A.
‘Trading company’ means a company carrying on trading activities whose activities do not include to a substantial extent activities other than trading activities (s 165A(3)).
Activities are interpreted by HMRC to mean what the company does, from selling goods to holding investments. Trading activities are defined in s 165A(4) and include activities carried on in the course of, or for the purposes of, a trade being carried on by the company and preparatory work followed by a commencement of trade. It can be concluded from this that if the activities do not fall within these definitions that they are non-trading activities which is clear cut where investment activity is carried on but advisers are often left in some doubt over the impact of excess cash on the balance sheet. This is discussed below.
As to the meaning of ‘substantial extent’, the legislation is silent and in the absence of any reported cases on the matter we have only HMRC’s non-statutory comments to fall back on. This is set out in HMRC’s Capital Gains Manual at CG64090 and follows earlier guidance published in Tax Bulletin 53 (June 2001) which states that substantial is more than 20% measured in terms of:
Each case should be reviewed on its own merits and the above tests are for guidance. This leaves scope to argue that when looking at a company ‘in the round’ it is a trading company despite the fact that, for example, the company holds substantial cash reserves generated by the trade.
Holdover relief (s 165)
If the company can satisfy the 80/20 test it will be a trading company for s 165 holdover purposes. There is, however, an additional restriction in Sch 7 para 7 which can apply to gains on shares. There is a potential trap where companies hold investment assets and the business has post 2002 goodwill. Such goodwill is not a chargeable asset which can lead to the situation where the holding of £1 of investment can lead to a 100% restriction.
Entrepreneurs’ relief
For ER purposes, ‘trading company’ and ‘trading group’ have the same meanings as in s 165 (s 169S(5)) so the 80/20 test is relevant. In the example below although the excess cash could be considered a non-business asset, as this is less than 20% of the gross assets (£1.47m), this should not prevent shares in the company qualifying for both ER and holdover relief.
Substantial shareholding exemption (SSE)
To qualify for SSE both the company disposing of the shares and the company in which shares are held must be either a trading company or a member of a qualifying trading group (Sch 7AC paras 18 and 19). Once again there is a need to consider what is meant by a ‘trading company’ and ‘trading group’ for these purposes and in this respect the legislation replicates the definition used for both ER and s 165 holdover purposes. The activities of the company and group and whether these satisfy the same ‘substantial’ tests need to be examined.
Where a company holds 10% or more shares in a qualifying trading joint venture (JV) company, defined in Sch 7AC para 23, the holding of shares is ignored, and the company holding the shares is treated as if it was itself carrying on a proportion of the JV company’s activities.
Where the shareholding amounts to less than 10%, the special JV company rules will not apply and the question of whether the shares held represent non-trading activity can arise. We have successfully argued that where a trading company or group acquires small minority interests in companies which are related to the trade these are in fact strategic alliances so should not be treated as non-trading activities. HMRC have now published a brief (HMRC Brief 29/11) to confirm this treatment. Where there is a close degree of integration between the management or activities of both companies and where one is integral to the other the holding of shares would represent part of the trading activity. While this brief is specifically for SSE there is no reason why the same interpretation cannot be applied to the trading company definitions used for ER and s 165 holdover relief.
Business property relief (BPR)
The statutory position for BPR is somewhat different. There is no positive requirement that a company needs to be ‘trading’. Instead the business must not consist wholly or mainly of one or more of the following:
What needs to be established is that the company is not mainly an investment company. For example, in the case of Phillips (Executors of Phillips, decd) v HMRC [2006] STC (SCD) 639 a company whose balance sheet consisted almost entirely of loan creditors qualified for relief because these were not considered to be investments even though, arguably, it might not have been possible to establish that the company was trading.
The other significant difference is that mainly in this context is taken to mean more than 50% so it is easier for shares to qualify for BPR than for holdover relief, ER or SSE where there is an 80% trading hurdle.
How to apply the wholly or mainly test has been at the centre of many cases but the Special Commissioners' decision in Farmer (Executors of Farmer dec'd) v IRC [1999] STC (SCD) 321 consolidated what has become known as the ‘in the round’ approach where the Special Commissioner stated that it was necessary to consider five relevant factors:
and then to take the whole business in the round, ‘…and without giving predominance to any one factor’ consider whether it is mainly one of making or holding investments.
If the wholly or mainly test is passed, the entire value of the business can attract 100% relief. In other words, there is no automatic apportionment of relief in relation to the investment element of the business – as there would be, for example, for s 165 holdover relief.
Relief is however restricted where there are excepted assets on the company’s balance sheet. Excepted assets are assets which are neither used wholly or mainly for the purposes of the business during the previous two years or, if it has not been owned for two years, its entire period of ownership; nor required at the time of the transfer for the future use of the business (IHTA 1984 s 112(2)).
The asset most commonly identified as an excepted asset by HMRC is surplus cash.
The excess cash problem
In the context of ER, SSE and s 165 holdover relief, provided excess cash plus other non-trading activities/assets does not exceed 20% of the total assets, there is no problem. HMRC has always taken the view that the holding of excess cash is itself a non-trading activity but this has never been tested. Where the cash is managed in some way such as the use of money market accounts we can understand this view but is this view sustainable where cash is simply held on current account?
Case law such as the case of Jowett v O’Neil and Brennan Construction Ltd [1998] STC 482 in which cash held on deposit by a company was held not to be a business is useful in defending an excess cash case.
The position for BPR is different. HMRC often uses the case of Barclays Bank Trust Co Ltd v IRC [1998] STC (SCD) 125 as authority for a restriction of BPR on the basis that cash is an excepted asset. In that case, the executors failed in their argument that surplus cash within the business – which had in fact been used some seven years after the date of death to acquire an unrelated business – was at the date of death required for the future use of that business.
As a result, where a company holds more than working cash and where there are no definite future plans for the use of the excess, BPR might be restricted regardless of the relative value of the excess cash to the whole business. The position here can be contrasted with that for ER and s 165 holdover where excess cash of up to 20% of the value of the business would not restrict the relief.
In the Example, the cash held on deposit would be treated as an excepted asset and would lead to a BPR restriction. If the cash were, however, used to buy stocks and shares, BPR is may not be restricted assuming they represent part of the company's business which meets the wholly/mainly test. However the holding of stocks and shares as investments would lead to a restriction for s 165 holdover in the event of a further gift of shares.
It is only the excess cash that should be measured, not the total cash in the business. HMRC will normally accept that, for example, reasonable holdings of cash as part of working capital, or against contingencies, or to build up a reserve of cash to fund the future expansion of the trade, should be treated as part of the company’s trading activities. Periodically high levels of cash are also acceptable where the company’s business is seasonal in nature.
The difficulties can arise where cash is at a level that significantly exceeds the company’s reasonable requirements. There is a balance to be struck between the attraction of accumulating cash to benefit from a 10% tax rate on eventual exit and the risk that the cash could be treated as non-trading so could prevent ER from applying. It is important to build up a file of evidence to back up the reasons for holding cash and to document the plans for the cash. This includes copies of board minutes as it is known that HMRC places great reliance on board minutes, even for the smallest of family-run companies.
Careful planning
When embarking on any planning for shareholders aimed at utilising the reliefs referred to above the starting point is to understand the shareholder’s objectives. If the shareholder has no intention of disposing of their shares but is seeking the best possible structure to minimise IHT on death then keeping investment assets within the company, assuming this does not breach the wholly or mainly test for BPR, may be the ideal structure. Conversely where a clear exit strategy is in point, the attraction of a 10% tax rate will focus advisers on considering the best structure to help preserve ER. For example, where investment and trading activity is carried on within the company a separation of the activities by way of a non-statutory demerger which would improve the ER position could be considered. However, this may have adverse consequences from an IHT perspective where as a result shares are held in a pure investment company. A loss of BPR may not be attractive but in terms of the overall aims of the shareholder it may be worth preserving one relief at the expense of another.
In carrying out any structuring work on private companies all the reliefs should be considered to ensure that there are no unintended results.
Martin Mann is a Director at Gabelle LLP and Ian Maston is a Partner at Gabelle LLP.
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