Reform of the UK’s substantial shareholdings exemption

Update

For changes introduced in the Finance Bill, see The UK’s substantial shareholdings exemption: Finance Bill provisions.

For further details of the Finance Bill provisions, see “Reform of the UK’s substantial shareholdings exemption: Finance Bill provisions”.

The Government has released a consultation response document setting out its plans to reform the substantial shareholdings exemption (SSE). Whilst the Government has rejected calls for the introduction a broader participation exemption regime, it will introduce a number of reforms to enhance the current regime and make it simpler to apply. These include removing the need for the investing company to be trading at all, removing the need for the investee company to be trading immediately after acquisition, and extending the time allowed for piecemeal disposals of substantial shareholdings.

In addition, the Government will introduce a new and wider exemption for the direct or indirect holdings of qualifying institutional investors. This exemption will not require the investee company to meet the trading condition and will also apply to investment exceeding £50m even if the normal 10% shareholding condition is not met.

Taken together, these changes will address a number of practical restrictions on the operation of the SSE as well as simplifying and widening its application. The removal of the need for the investing company to be a trading company will be especially welcome and it is hoped that the broader exemption for qualifying institutional investors should help promote the UK a place where global investors can establish and manage their investments in trading businesses, infrastructure and real estate.

Background

In May 2016, the Government released a consultation document considering options for making the substantial shareholdings exemption (SSE) “simpler, more coherent and more internationally competitive”. The consultation document, “Reform of the Substantial Shareholdings Exemption”, put forward a number of options for reform ranging from technical changes to the existing rules to a more comprehensive exemption for gains akin to other participation exemption regimes. In particular, it was clear that the Government was keen to, at the very least, address a number of issues with the SSE against the background of the competitiveness of the UK’s tax system.

The existing SSE rules

The current SSE is essentially designed to allow trading groups to make rational decisions concerning restructurings or the disposal of trading companies without being discouraged by potential corporation tax charges. The current rules allow the gains on the disposal of a substantial (10%+) interest in a trading subsidiary (or holding company of a trading group or sub-group) to be exempted from corporation tax provided that the necessary qualifying holding period is met and the investing company also qualifies as a trading company or member of a trading group.

The Government’s driver behind the May 2016 consultation was the competitiveness of the UK tax system. The UK system benefits from a number of features which make it highly attractive from a holding company perspective, including exemption for UK and non-UK inbound corporate distributions, an extensive tax treaty network, no withholding taxes on outbound dividends and a largely territorial basis of tax. However, concerns had been expressed that the limited scope of the SSE, and the complexity of the rules for groups of any meaningful size, was impacting on this competitiveness.

In particular, the existing SSE is not available in a number of circumstances, including where:

• companies within groups have substantial investment assets, irrespective of the nature of the shareholding being sold
• companies within trading groups are disposing of shares in a non-trading company or sub-group
• companies within trading groups are disposing of sizeable investments in trading companies but which represents less than a 10% interest, and
• funds that make investments in trading and non-trading companies hold those investments via intermediate UK corporate vehicles.

Against this background, the Government’s consultation looked at a number of options for reform, ranging from the introduction of a comprehensive exemption akin to participation exemptions in certain other jurisdictions to restricted technical changes to address particular issues with the application of the SSE. The response document announces that the Government’s changes will fall short of a full exemption, but will include substantive changes to extend and simplify the application of the SSE.

Removing the investing company trading condition

The Government has announced that it will remove the requirement that the investing company be a trading company or part of a trading group. This will provide that all companies which have substantial shareholdings in trading companies or sub-groups will be exempt on their gains and losses on those disposals, simplifying the regime and reducing the administrative burden on businesses and the tax authorities.

While many respondents were in favour of a comprehensive exemption which would remove the trading requirements at both investing and investee company levels, the Government considered that the additional benefit of removing the investee trading condition was not proportionate to the avoidance risk and cost that this would entail.

Removing the post-disposal investee trading condition

Although the Government has rejected calls to remove the investee company trading condition completely, it will remove the requirement that the investee company be trading immediately after the disposal where the disposal is to an unconnected party. The Government accepted that the current requirement could act as an administrative hindrance to the operation of the SSE. The investing company has no influence over the trading status of the investee company after the disposal and so should not affect the availability of the SSE for the investing company.

Piecemeal sales of substantial shareholdings

A further issue raised by respondents was the difficulties of meeting the SSE condition where a substantial shareholding is sold piecemeal or where there is an additional issue of shares to outside investors reducing the level of the investing company’s shareholding. In these cases, respondents argued that there was no apparent policy reason for the current requirement that a substantial shareholding must be held for 12 months within the two years prior to disposal. To address this issue, the Government has agreed to extend this period to 12 months within the six years prior to the disposal.

Introducing a broader exemption for qualifying institutional investors

The original consultation noted that the existing application of the SSE tends to dissuade funds, such as sovereign wealth and pension funds, from locating their holding platforms in the UK. This is because the SSE does not extend to holding companies where there is a substantial non-trading activity in the group of which they form part.

In its response document the Government recognises the case for aligning the tax treatment, through SSE, for investors who are exempt or immune from tax on gains and losses on investments which they make directly, but are currently subject to tax on gains and losses made on investments held through UK resident companies. The Government has therefore announced that it will introduce a broader exemption for companies that are owned by certain defined institutional investors.

Under this exemption UK companies owned by qualifying institutional investors will be exempt from gains and losses on disposals of substantial shareholdings without regard to the trading status of the investing or the investee companies or sub-groups. In addition, under the extended exemption, the substantial shareholding condition may be met if the investing company’s shareholding is below 10% but the cost of which on acquisition was at least £50m. This will allow large investments which do not meet the 10% threshold to nevertheless qualify for the SSE due to the scale of the investment project.

Qualifying institutional investors

This broader exemption is intended to align the tax treatment of direct and indirect gains and losses on disposals of investments.

As such, the investors being targeted by this definition fall into two categories. The first category is investors that are exempt from tax on gains or are immune from taxation as a result of their status i.e. pension funds, charities and persons immune from UK tax on their gains by reason of sovereign immunity. The second category is UK funds that are exempt from tax on gains in order to pass the incidence of tax onto the investors in the fund, which in some cases is achieved through a withholding tax on distributions.

The investors which the Government, therefore, intends to include in the definition of qualifying institutional investors are:

• pension scheme trustees and managers
• companies carrying on “life assurance business”, as defined by section 56 of the Finance Act 2012
• persons immune from UK tax on their gains by reason of sovereign immunity
• charities
• investment trusts, and
• widely marketed UK investment schemes, including authorised investment funds and the trustees of exempt unauthorised unit trusts.

Notably, the exemption does not cover overseas equivalent funds which are not exempt from UK tax on gains due to status, but instead fall outside of the scope of UK tax due to their residence. The consultation response document does not mention the issue, but there would appear to be concerns that this approach may result in illegal discrimination with regard to EU funds.

In addition, the exemption does not include every type of UK fund, notably excluding real estate investment trusts (REITs). The Government explains that this is due to a number of factors including the fact that their exemption from tax on gains is limited to gains on assets used in property rental business, which distinguishes them from other UK funds. However, the Government will continue to consider whether there is a case for including REITs within this definition.

Shareholding covered by the broader exemption

A company will be considered to be owned by qualifying institutional investors if such investors own the ordinary share capital of that company either directly or indirectly through one or more other companies. The ownership condition will be considered immediately before the disposal of the company’s shareholding. However, the response document explains that where qualifying investors invest in large trading companies which have autonomy in their decision making, the policy objective is not to allow those trading companies to benefit from SSE on disposal of non-trading companies. For this reason companies will not be considered owned by qualifying institutional investors if the share capital is held indirectly through a company which is listed on a recognised stock exchange.

To accommodate joint venture situations, where the qualifying institutional investors might be exempt but other investors subject to tax, the Government will implement a system of proportionate exemption for disposals of non-trading companies or sub-groups by companies which are at least 25% owned by one or more qualifying institutional investors, by reference to ordinary share capital. Where 80% or more of a company’s ordinary share capital is owned by one or more qualifying institutional investors the gains and losses of a disposal of a substantial shareholding will be exempt in full.

If ownership of the company or any intermediary companies is held through a partnership then the response document states that, for the purposes of the broader exemption, ownership will be attributed to the partners. However, it does not appear that the current drafting of the legislation achieves this aim. More generally, the original consultation noted that in determining the members of a group to which the trading conditions apply, the legislation does not take into account interests held through a partnership. The original consultation sought comments on whether such interests should be taken into account. Unfortunately, the consultation response document does not address this issue, which remains relevant to determining the trading status of the investee company.

Another issue on which the consultation is silent is whether the legislation should take into account other relationships where a company does not issue ordinary share capital. The Government sought comments on the case for including such interests in determining whether the trading conditions apply but has not addressed the issue in the response document.

Comment

Draft legislation has been released for inclusion in the Finance Bill 2017 to give effect to the changes from 01 April 2017. The draft clauses are open for comments until Wednesday 01 February 2017. Comments on the SSE changes should be sent to corey.herbertson@hmrc.gsi.gov.uk.

The relaxation of the current conditions of the SSE and the introduction of a broader new exemption for qualifying institutional investors are very welcome. However, technical concerns remain around the determination of the trading nature of the investee group and it is to be hoped that these are addressed as part of the consultation on the draft legislation.