UK authorities reconsider approach to the taxation of sales of leasing companies.
UK lessors are currently contemplating HM Revenue & Customs’ (HMRC) proposals to amend the UK ‘sale of lessor’ tax provisions in order to reduce their impact on genuine commercial transactions.
In response to industry concerns that the legislation, introduced as an anti-avoidance measure in Schedule 10 to the Finance Act 2006, is hindering sales of lessor businesses in non-avoidance contexts, HMRC published on July 29 a discussion paper setting out a number of possible options that they hope would alleviate the issues.
The paper explains that Schedule 10 was enacted to counter well-established avoidance schemes involving the sale of a lessor company to a loss-making group. The opportunity for avoidance arises because the effect of capital allowances is to defer the recognition of profits for tax purposes. However, where a purchaser can use its losses to shelter those profits, this temporary deferral becomes, in effect, a permanent deferral of tax.
In broad terms, Schedule 10 seeks to counter such planning by requiring the lessor to bring into account a tax charge at the point of sale, effectively accelerating the deferred tax at that time. A corresponding tax relief is then available to the lessor going forward and, subject to restrictions, can be used to shelter profits in the wider purchaser group.
However, while the legislation has been effective at closing down the tax schemes at which it was directed, the lack of a let-out for non-avoidance transactions can cause it to have unintended consequences in the context of genuine commercial activity.
Even if the purchaser intends the lessor company to carry on its business as before, and to pay the same amount of tax, the deferred tax is accelerated. And Schedule 10 applies just as much to ordinary operating lessors as it does to traditional tax-based lessors. Furthermore, selling the lessor’s business is no alternative to selling the lessor company itself: under general principles, a sale of the business assets would also, in broad terms, trigger the deferred tax.
The fundamental problem here is that, although the corresponding tax relief available under Schedule 10 produces, in principle, a form of tax symmetry, the purchaser may well have insufficient UK tax capacity to absorb fully the relief and so will be unable to attribute material value to it (for example, where it has little or no other UK business or is not currently profitable).
Issues may also arise in the context of lender security in leveraged transactions since the normal approach of taking security over the shares in the lessor would risk Schedule 10 tax charges on enforcement. Although some restructuring strategies have been conceived to mitigate the impact of Schedule 10, in extreme cases the charge may render businesses effectively unsellable. It can also deter future investment in and expansion of the business.
In its discussion paper, HMRC describes four options to mitigate the impact of the legislation on commercial transactions. Its preferred approach is to focus on maximising the value of the Schedule 10 relief to a purchaser group. In its view, this could be achieved either by extending the period in which the relief is available for offset against profits elsewhere in the purchaser’s group (currently up to two years) and/or by applying a form of indexation each year to the unutilised portion of the relief in order to negate the timing cost that arises from paying tax upfront but only realising the benefit of the relief over time.
The alternative approaches suggested are either to spread the charge and the relief over time or to introduce, at the parties’ election, a ring fence of the lessor’s trade, with losses arising outside the ring fence being incapable of sheltering profits within it.
While HMRC’s acknowledgement that Schedule 10 needs to be revisited is welcome, the initial reaction from some market participants is that (at least outside smaller ticket businesses) its preferred proposals do not address the real problems.
In particular, the focus on maximising the value of the Schedule 10 relief, rather than, for example, introducing a motive test, fails to address the issues faced by non-UK purchasers or purchasers with no UK tax capacity – with such purchasers likely to remain unable to attribute material value to the relief.
An example is private equity or infrastructure fund purchasers, which typically have no other business under common ownership and, therefore ,would not benefit from an extension to the period in which the relief can be offset against profits elsewhere in the purchaser’s group.
The spreading and ring fencing proposals are, in principle, more promising (although spreading as explained by HMRC would appear to be cumbersome and rigid in nature). Ring fencing, in particular, would deal elegantly with the concerns that led to the introduction of Schedule 10.
However, the concept is very narrowly formulated in the discussion paper, which contemplates that profits arising from leases entered into before the change of ownership could not be sheltered by “losses of the wider group, losses arising within the company from separate activities [or] new losses generated by new investment in the same trade”.
An exclusion of group relief and sideways relief in respect of losses arising in the new ownership is understandable in view of the purpose of Schedule 10. But it seems unnecessarily restrictive to exclude losses referable to new investment where the business is simply carried on as it was before. It is to be hoped that progress can be made in this area.
HMRC has invited comments from interested parties on its proposals by the end of September.