Over recent years in this economic climate, it has been increasingly common for distressed companies to be sold in an effort to rescue the entity. On first blush, this seems a relatively simple exercise although care is required to ensure that no unexpected tax charges arise, especially if there is restructuring of the debt. The taxation rules governing the end of business life are varied and complex and the sooner that thought is given to taxation in respect of the insolvent company the better this will be for the seller, the remaining group and for any buyer.
Types of Corporate Insolvency Proceeding
The different forms of insolvency are as follows:
Administration: When a company goes into administration, the administrators will run the company and they will often sell the assets and business as a going concern, free from any historic debt. The aim of the administrators is to rescue the company, and if this is not achievable, they would look to achieve the best result possible for the creditors (on the basis that this result would be better than having the company wound up).
Liquidation: When a company goes into liquidation, a liquidator is appointed to realise the company’s property, and the liquidator will aim to distribute the proceeds to the creditors and shareholders. Liquidation has a much greater impact on a company (and other group members) than administration. Once the company has gone into liquidation, the scope for tax planning becomes limited as the company loses beneficial ownership of its assets. It would not be possible, therefore, for a company in liquidation to protect assets by funnelling them to its subsidiaries in a tax efficient manner.
Receivership: Receivers are usually appointed by creditors. The goal for the receivers is to realise any assets held as security in order to repay debts due. The appointment of a receiver does not have any direct corporate tax effects. The company retains beneficial ownership of its assets, although careful thought needs to be given as to whether “arrangements” are in place to break the group, which could prevent the surrender of group relief losses.
Company voluntary arrangement: A company voluntary agreement is a procedure for agreement between a company and its creditors for a compromise in satisfaction of its debts.
Legal Consequences of Insolvency
Where a company is insolvent, it can produce a number of headaches for the tax advisor. The insolvent company will continue to retain legal ownership of the assets, although beneficial ownership will vest in the insolvency practitioner. The role of the liquidator can also change the ownership of a company and it can mean that a group structure is broken for tax purposes. As a consequence, group relief for trading losses can become lost, and this can result in serious adverse implications for the rest of the group that remains solvent. It is not only group relief for trading losses that can become compromised, there may be implications for some other taxes, including corporation tax, stamp duty and Stamp Duty Land Tax (“SDLT”).
It is worth noting that the beneficial ownership of the assets of the company is vested in the insolvency practitioner upon commencement of the liquidation, although special rules exist to prevent liquidation from breaking up a group for the purposes of tax on chargeable gains.
It would be usual for the seller to provide warranties and indemnities if the target is in financial difficulty. It would be less common for an administrator to provide warranties and indemnities.
If we assume for current purposes that warranties and indemnities will be provided, thought needs to be given as to what the limit of liability for any such claims will be. Let us assume that the consideration for the shares is £1, with a further £5 million being contributed to repay some of the existing debt in the company. The first commercial issue to be resolved is what limit to set the liability for any warranty or indemnity claims. In the UK (as is the case in the US), a successful warranty or indemnity claim is normally treated as an adjustment to the purchase price. If, after completion, the seller makes a warranty payment to the purchaser, the purchaser’s base cost in target is reduced by the sum received, and the sale proceeds of the seller are correspondingly adjusted.1
Where there is a low level of cash consideration payable for the shares in a company, the sellers would be right to be concerned that any claim under the warranties or the indemnities would give rise to negative consideration. In the event that there is negative consideration, there is a risk that the receipt of the warranty/indemnity payments could be taxable in the hands of the purchaser. A gross-up provision in the agreement could therefore be very expensive for the seller. In similar situations, sellers often agree to subscribe for shares (which are economically worthless). To the extent that any warranty/indemnity payments exceed the cash consideration, the sellers will have the option to subscribe for a “non-participating share” in the company rather than making a payment under the warranty/indemnity. The “non-participating share” would have a nominal value of £1 and the subscription price would be an amount equal to the warranty/indemnity payment. Accordingly, most of the subscription price would be allocated towards share premium account. The “non-participating share” would have the following rights:
- no voting rights;
- no rights to dividends; and
- on a return of capital, a right to the nominal value of the share, but no right to be repaid any share premium.
There would be irrevocable put and call options over any “non-participating share” issued to the seller entitling/requiring the purchaser to acquire such share for £1. To square the circle, the gross-up clause in the sale and purchase agreement would be amended such that the seller would take the risk of the above structure proving ineffective and the amount subscribed for the “non-participating share” being treated as a taxable receipt in the hands of the Company.
Restructuring the Debt
Selling a Distressed Business: Hive Downs
A distressed business may be able to solve its financial issues by selling part of its business. This could either be an asset sale or the sale of a target business, often by an administrator. The first issue is whether the sale of the target business should be by way of share sale of the company or by way of the assets of the business. In an insolvency situation, the company is likely to have valuable trading losses and these are likely to be attractive to the purchaser. One way to preserve the tax losses, whilst ensuring that the purchaser is shielded from the historic liabilities of the company, is to drop down the trade to a newly incorporated company (ensuring that the purchaser is able to acquire a "clean" company owning just the target business). It is possible, in certain circumstances, to ensure that the accrued tax losses of the business will also transfer into the new hive down company (“drop down” company).2
The trading losses and capital allowances of a business can be transferred with the business when a trade or part of a trade is transferred between companies in the same 75% common ownership (either direct or indirect traced through parent companies in a group). The legislation provides that there is no discontinuance of the trade and the successor company succeeds to the losses of the trade.3
Other Tax Implications of a Hive Down
The drop down will need to be effected before any liquidation of the transferor because the loss of beneficial ownership of the drop down company resulting from a liquidation prevents the application of Chapter 1 of Part 22 of CTA 2010. The drop down could be effected in the course of an administration of the transferor, however, as beneficial ownership of the drop down company would not be automatically lost.
There are a few risks with this sort of transfer: one is that there should be no major change in the nature or conduct of the trade within three years of the change of ownership, otherwise the trading losses will be lost. The second is that there should be no contract for the on-sale of the drop down company at the time of the drop down.4 However, the existence of an option does not affect the beneficial ownership of the relevant company’s shares unless and until exercised and should not cause beneficial ownership in the drop down company to be lost, provided the vendor retains more than a mere shell of ownership.5
If there is a VAT group, the assets can be transferred intra-group without any VAT issues (the transfer will be disregarded for VAT); the alternative would be to ensure that the transfer of the drop down assets must be a transfer of a business or part of a business as a going concern (and it is then outside the scope of VAT).
SDLT will be payable on any interest in land involved in the drop down if, at the time of the drop down, there are arrangements for the drop down company to leave the group or the drop down company leaves the vendor's group within three years or pursuant to arrangements entered into during those three years.