The sale of a subsidiary (Target) will, in practice, mean that it ceases to participate in the pension scheme operated by the Seller. Where the scheme is a UK tax registered group defined benefit scheme, this cessation will often trigger a statutory debt obligation on Target (under section 75 of the Pensions Act 1995).
The amount of the section 75 debt can be substantial (the figure is based on the amount needed to secure liabilities in the scheme on a ‘buy-out’ basis and is dependent on market conditions etc and so is variable).
Any potential purchaser of Target will look to reduce any purchase price payable to reflect this debt. Given the uncertainties over its amount, there is a risk that any reduction is likely to be an overestimate. For this reason it is common for a seller to agree to give an indemnity to the purchaser for any such liability. The payment made by Target will go into the Seller-retained pension scheme and will benefit Seller going forward (and not Target).
Generally payments by employers into registered pension schemes give rise to a tax deduction, even if they are of a capital nature, for the employer. But this only applies if the payment is ‘wholly and exclusively’ for the purposes of the trade of the employer.
Tax authority (HMRC) guidance was issued in February 2007 on this. It indicates that:
- a tax deduction should be available for Target if it makes the section 75 payment (although this would probably be spread over up to four years); it is much less likely that Seller would get a deduction for any amount that it paid to reimburse the purchaser; and
- there may be some circumstances when Seller could get a deduction – eg if Target could not pay the section 75 debt and Seller considered that it needed to in order to preserve its business reputation and the morale of its own employees. Even here the deduction may be limited to any liabilities attributable to ‘orphan’ members of the Seller pension scheme (ie those not attributable to Target).
If correct, this leaves three options.
Target makes the section 75 payment and claims the tax relief. Seller reimburses the Purchaser and adjustments are made by way of payments back to Seller, as Target is able to get the benefit of the tax relief.
This is quite complex to document and police. Payments by the Seller to the Purchaser and adjustment payments the other way risk being taxable on the recipient. To reduce the risks the parties may seek to structure the arrangements as an indemnity by Seller to Purchaser of the after-tax cost of the Target’s payment, payable as an adjustment to the purchase price, with either no payment being made until the after-tax cost is finally established or payments made before then being made as payments on account of the eventual sum due.
Target/Purchaser may not have sufficient taxable profits to be able to utilise the tax relief (eg if the purchaser is a private equity buyer). Seller scheme ends up with extra funding. This may lead the trustees to revisit the investment strategy in a way that Seller does not want. Otherwise this should result in lower funding obligations on Seller in the future.
Seller arranges for it (or another employer) to make the payment instead of Target (this requires an agreement with the Seller scheme trustees and the Pensions Regulator, but this is unlikely to be a concern if Seller is paying in full on the sale).
HMRC guidance indicates Seller may not get tax relief, unless it can show that Target could not pay and it is attributable to orphans). The issue can be tested by seeking formal guidance from HMRC (a COP10 letter). The Seller scheme ends up with extra funding, which may lead the trustees to revisit the investment strategy in a way that Seller does not want. Otherwise, it should result in lower funding obligations on Seller in the future.
No-one pays, but security offered
If the section 75 debt were paid, it would just amount to extra security for the benefits under the Seller scheme. Seller could offer security to the trustees instead of all or part of the full immediate payment – eg a parent guarantee/bank letter of credit/charge over cash or assets. Seller group’s ongoing contributions to the Seller scheme would not be affected (ie not reduced because there is no section 75 payment). Security is gradually released over time as general Seller group contributions are made to the Seller scheme.
This approach requires agreement with the trustees and the Pensions Regulator. They may be concerned at the loss of security (compared to a full payment now), so ask to be offered security with a value of more than the section 75 debt.
There is an improved prospect of tax relief for Seller for its normal funding payments, but this is a new area and is not guaranteed. HMRC may take a view that the Seller contributions are delayed payment of the section 75 debt. But it may be arguable that contributions would have been payable anyway (separately from the sale of Target) so are not being paid to enhance the sale price (instead are wholly and exclusively for the purposes of Seller’s trade). It will obviously be helpful if the contributions are similar in amount and timing as would have been made absent a sale of the Target (with the only change being the provision of security).
This issue can be tested by seeking formal guidance from HMRC (a COP10 letter). If a negative response is received, consider other potential structures.
Tax deductions for pension contributions on the sale of a company
New HMRC guidance was issued on 7 February 2007 as new pages in the Business Income Manual (BIM) – see BIM46000 to 46198. See www.hmrc.gov.uk/manuals/bimmanual/bim46000.htm
The guidance is not legally binding, but it gives a good guide to the likely stance that HMRC will take. A more definitive view, based on the specific current circumstances, can be sought by writing for specific guidance (a COP10 letter).
The tax issue is what tax deduction, if any, is available in relation to the payment of a section 75 debt on a sale by a seller (such as Seller) of the shares in a target company (such as Target) to a third party, where the target participates in a multi-employer defined benefit pension scheme being retained by the Seller Group (such as the Seller pension scheme).
The guidance notes (BIM46030) summarise HMRC’s view of the position
In deciding whether a contribution to a registered pension scheme is allowable, the same rules apply as for any other expense (with the exceptions of whether a payment is capital and the timing of the deduction – see BIM46010).
In particular, any contribution must be paid wholly and exclusively for the purposes of the trade for it to be deductible (ICTA88/S74(1)(a) for corporation tax and ITTOIA05/S34 for income tax).’
The new guidance is as follows.
It is likely that Target will get a deduction (albeit potentially spread over up to four years) for the section 75 debt it may pay (see example 3 in BIM46045).
‘Example 3: trade continues
Company A decided, solely in the interests of its trade, to take part in the group registered pension scheme. Some years later, Company A is the subject of a management buy-out. As a result of this it is decided that Company A will cease to take part in the group registered pension scheme. This results in Company A having to pay additional sums into the pension scheme as its Section 75 debt crystallises. Company A’s liabilities under PA95/S75 include £250,000 in respect of its share of ‘orphan’ liabilities for people who were employed by other companies which have since been wound up (see BIM46055) [Regulations 6(2) and (3) of The Occupational Pension Schemes (Employer Debt) Regulations (SI2005/678)]. Company A can make a deduction for the sum under FA04/S199 as the purpose of making the payment was wholly and exclusively that of its trade. Company A chose to enter the scheme wholly and exclusively for the purposes of its trade. The benefit to the employees of the former group companies is an incidental benefit that arises as a consequence of statute. The cost is an allowable expense of Company A’s trade.’ BIM46045
This appears to allow the potential for Seller to be able to take the benefit of this (if the purchaser does not otherwise use up the benefit of deductions) by only agreeing to indemnify on an after tax basis (ie subject to claw back if a deduction is later used).
If the section 75 debt is reallocated (by agreement with the trustees and the Pensions Regulator through an approved withdrawal arrangement (AWA) or rule allocation following the High Court decision in L v M Ltd) to a retained company (say Seller instead of Target), a deduction for the payment by the Seller-retained company looks more difficult. HMRC looks more likely to say that the payment is not for the purposes of Seller’s business, but instead an adjustment to the sale proceeds (see example 2 in BIM46060).
Company A decided to sell one of its trading subsidiaries to an unconnected party. The subsidiary operated a registered pension scheme for its employees, which was underfunded at the time of sale. Although the subsidiary was in a position to meet its £25m liability under PA95/S75 in relation to its pension scheme deficit, the former parent believed it could secure an increased sale price for its shares in company B and entered into an approved withdrawal arrangement to meet the £25m from the proceeds of the sale.
At the time the agreement was entered into Company A did not do so wholly and exclusively for the purposes of its trade, but rather with a non-trade purpose of securing sale of its shares in the subsidiary at an enhanced value.
This example is in contrast to BIM46045 example 4. In that example the only purpose in a parent company meeting the liability of a subsidiary being sold was to underpin the morale of its remaining scheme members. In that case the subsidiary itself was not in a financial position to meet its PA95/S75 liability. In that case the parent was able to make a deduction as the contribution was wholly and exclusively for the purposes of its trade.’ BIM46060 A deduction may still be available if the payment can be shown to be for the benefit of the Seller business, eg because Target could not pay the section 75 debt and Seller wanted to preserve its business reputation and the morale of its own employees – see example 4 in BIM46065. This appears to be limited to that part of the section 75 debt that relates to ‘orphans’. This looks largely driven by the specific facts. Can Target afford to pay the section 75 debt?
‘Example 4: approved withdrawal arrangement
The entire share capital in Company A was being sold to a previously unconnected company. The financial liquidity of Company A was such that it was unable to meet the liability which would arise under PA95/S75 in relation to its pension scheme deficit. The former parent Company B entered into an approved withdrawal arrangement to guarantee £2m of the pension deficit relating to the orphan employee liability of Company A, as it wanted to secure the morale of the remaining members of its pension scheme.
At the time the agreement was entered into Company B did so wholly and exclusively for the purposes of its trade. If and when Company B is required to make payment in respect of the guarantee, it will make a deduction for the £2m under FA04/S196 during the period in which the contribution was paid.’ BIM46065
There may be scope in seeing if different rules could apply if the retained company making the payment does so as part of its investment business (eg as a holding company). This would need to be considered further.
This still seems to allow the remaining employers to obtain a deduction for later payments after the sale if these are part of normal funding. So if, say, it was possible to agree (by an AWA or rule allocation following L v M Ltd) with the Pensions Regulator and the trustees that:
no (or a nominal) debt would be payable by Target; and
no amount is payable into the scheme now by Seller; but
instead, say, the section 75 amount was put in a blocked account (or some other security given – eg a parent guarantee or a letter of credit), then later funding payments by Seller (and its group) would be normal ongoing funding and so look more likely to get a tax deduction. One variant would be for the security to reduce as these later funding payments are made.
This is not dealt with in the new guidance, but seems to give a better prospect of a deduction for the retained company (compared to a straight contribution to the scheme). Obviously a major issue may be getting the trustees to agree to this (but if full security was offered, would they be more likely to agree?).