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HMRC's guidance on the SSE trading tests

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To qualify for the substantial shareholdings exemption (SSE), a company disposing of shares has to be a sole trading company or a member of a trading group and the target has to be a trading company or the holding company of a trading group. Where trading groups have significant investments in companies which are not within the group there can be uncertainty as to whether the SSE applies. HMRC Brief 29/11 helpfully indicates HMRC’s view that some such investments may not cause the trading tests to be failed. However, the technical basis for this seems open to question in light of the recent Dawsongroup case.

Lydia ChallenAndrew HowardOne of the main weaknesses of the substantial shareholdings exemption (SSE), when compared with participation exemptions in other jurisdictions, is the uncertainty caused by the trading requirements for both the selling company and the target.

The publication of HMRC Brief 29/11 (the Brief) goes some way to reducing this uncertainty, although in the authors’ view it has not completely hit its target.

The trading requirements

To qualify for the exemption from corporation tax on chargeable gains under the SSE, a company disposing of shares has to be a sole trading company or a member of a trading group and the target has to be a trading company or the holding company of a trading group or sub-group.

It is helpful and timely that HMRC have stepped in to address one of the more difficult aspects of the tests but unfortunate that the Brief leaves some technical uncertainties

Activities within a group are ignored. The question is then whether the group’s other activities include ‘to a substantial extent’ non-trading activities.

There are detailed rules in the context of certain joint venture companies that attribute to shareholders a proportionate part of the joint venture company’s activities.

In determining whether non-trading activities are substantial, HMRC use a number of indicators (set out in HMRC’s Capital Gains Manual at CG53116), such as the level of turnover, proportion of asset value and amount of management time attributable to non-trading activities.

HMRC’s guidance is clear that these are not to be used as definitive tests, and one of the other indicators – the company’s history – in itself supports a wider approach to the interpretation of whether non-trading activities are substantial.

Nonetheless, it can be difficult for a group, or its advisers, to take a robust view that the trading test is satisfied where one of the indicators points in the wrong direction. As a result there are groups that, in layman’s terms, are manifestly ‘trading’ where the SSE analysis is by no means clear.

The issue

Particular problems arise where groups have non-UK subsidiaries without ordinary share capital, or hold sub-50% interests in companies, which are therefore not within the group for SSE purposes.

The problems are exacerbated because the joint venture rules are – seemingly unintentionally – more narrowly drawn than might be expected.

The trading activities of those companies would therefore not, under a strict reading of the rules, be attributed to the group, and the usual view taken is that the group’s holding in the relevant company would have to be treated as an investment, potentially altering the balance between the group’s trading and investment activity.

HMRC Brief 29/11

The Brief applies across all the trading tests within the SSE (as written it does not seem to cover whether a company is a member of a trading group, but HMRC have confirmed informally that this omission is not intentional.)

It challenges the view that, if a company does not fall within the joint venture rules, or if it does not have ordinary share capital, the holding of that company is necessarily an investment activity.

HMRC say that this will be a question of fact:

‘Where, for example, the effective management of the company is closely integrated with that of the group, and it conducts a trade that is similar to or complements that of the wider group, the group’s involvement in the enterprise does not represent a separate non-trading activity.’

This is a helpful indication that HMRC will not take an overly formalistic view of what constitutes a trading group, and should go some way to removing some significant uncertainties with the application of the SSE that detract from the UK’s attractiveness as a holding company jurisdiction.

However, the apparent requirement for close integration of effective management may limit the situations in which it will assist as this may well not be satisfied for junior partners in joint enterprises.

In the remainder of this article, we consider whether the Brief is based on a sound technical analysis.

It is well established that, as the Brief suggests, the question as to whether an activity is a trading activity is a question of fact.

It is clear, for example, that there is a line to be drawn between the bare holding of shares (investment) and loosely associated activities such as the provision of services to group companies (trading).

However, where the Brief seems on uncertain technical ground is suggesting that a decision about which side of the line a case falls can be made by looking at facts that are relevant to the activities of the subsidiary rather than the holding company.

When is a holding of shares as an investment a trading activity?

This question was addressed in Dawsongroup Plc v HMRC [2010] STC 1906.

The context was whether Dawsongroup was an investment company for the purposes of what was then ICTA 1988 s 130 (and therefore entitled to deductions for expenses of management).

At the relevant time an investment company was defined as ‘a company whose business consists wholly or mainly in the making of investments and the principal part of whose income is derived therefrom’.

Dawsongroup did in fact have some trading activities (the provision of services to its subsidiaries).

The question was whether its investment activities were sufficient to make it an investment company.

At first instance, the tribunal reached ‘a clear conclusion that Dawsongroup is a trading company which carries out its business by means of subsidiaries which it controls’.

This is essentially the same conclusion as is drawn in the Brief: a holding of shares or another interest in a company is not necessarily an independent activity by the holder, but can be effectively ignored in favour of looking at the underlying activity of the company concerned.

However, this conclusion was firmly overruled by the Upper Tribunal.

One of the errors identified by the Upper Tribunal was that the first instance judge:

‘thought that the trading activities of the holding company involved, or included, its control over its trading subsidiaries, or its control over those subsidiaries. He mischaracterises the holding company attributes of Dawsongroup, or some of them, as being trading activities. This is incorrect.’

In the case, HMRC also argued that decisions taken at the holding company level about the actual trading activities of subsidiaries were not investment type activities. The Upper Tribunal rejected this.

This case seems to us to present two difficulties for the Brief.

The first is that it appears to reject the contention that it is in some way possible to look through the holding company and characterise its activities by reference to those of the subsidiary.

The second is that, even at first instance, it was common ground that Dawsongroup was to some extent carrying on investment activities; whereas the Brief appears to indicate, where it applies, that a group's interest in a company can be a trading activity exclusively.

Is there a better analysis?

The SSE exempts losses as well as gains so there may be situations where it will suit a group to argue that it is not a trading group.

As a result it is possible to envisage a situation where the Brief could come under challenge from taxpayers.

In view of the difficulties identified above, it might have been more robust for HMRC to provide comfort that their view is that although the activities are investment activities, they are not ‘substantial’ compared to the trading activities.

The application of this concept is already determined by HMRC guidance to a large extent and it would be difficult to argue against such a view by reference to precedent.

A purposive approach to the trading test?

While the Brief does not say as much, perhaps HMRC's approach can be explained as encouraging a purposive view of the SSE trading tests.

At one point the Brief suggests that the relevant question is whether the underlying venture is ‘part and parcel’ of the general trading activity.

It is not easy to discern the policy reason for the investing company trading test and this makes it difficult to apply a purposive approach.

HMRC’s understanding of its purpose can perhaps be derived from comments made during the Corporation Tax Reform consultation in August 2003, in which abolition of the trading test for the investing company was considered.

HMRC were concerned that this could be used for avoidance purposes, for example for ‘companies which exist solely for the purpose of ‘wrapping up’ personal stakes in trading companies to get the benefit of the exemption’.

So, can the conclusions in the Brief be supported by a purposive reading of the actual legislation?

The primary difficulty is that the Brief effectively creates some new conditions which do not seem to reflect this purpose, for example by drawing an apparently arbitrary line between a joint enterprise conducting a trade which complements or is similar to the trade of existing members of the group and a new adventure.

We cannot see any way of supporting this by reference to the legislation.

Uncertainties remain

As already noted in this journal (see ‘Cross-border M&As: the current landscape’ (James Wilson) Tax Journal dated 29 July 2011), overhaul of the trading tests in the SSE should be a priority in the drive to make the UK a competitive jurisdiction.

It is helpful and timely that HMRC have stepped in to address one of the more difficult aspects of the tests but unfortunate that the Brief leaves some technical uncertainties.  

Lydia Challen, Partner, Allen & Overy LLP

Andrew Howard, Senior Tax Associate, Allen & Overy LLP