Enviroco Ltd - Tax implications of Supreme Court decision
02 August 2011
A recent judgment of Farstad Supply A/S v Enviroco Limited  handed down by the Supreme Court has confirmed that a subsidiary ceases to be a "subsidiary" of its holding company when its shares are "pledged" as security.
The pledge of security has tax implications under Extra- statutory concession C10 ("ESC C10"). Outlined in this concession, in para 7, a "pledge" such as a mortgage of shares or securities, can be considered to be an "arrangement" for tax purposes, and therefore special rules will apply to group and consortium relief. However, a pledge of shares does not automatically mean that an "arrangement" is in existence, unless a default or other triggering event has occurred.
It should be noted that Enviroco Ltd is a commercial decision, not a tax one, but there are important tax implications arising from the judgment that should be highlighted.
The case centred on whether Enviroco Limited ("Enviroco") had the benefit of an English law indemnity given in favour of companies within its group and considered the definition of "subsidiary".
Farstad Supply A/S (“Farstad”) chartered a vessel to Asco UK Ltd (“Asco”). Enviroco was subsequently appointed to clean the oil tanks in the vessel. Both Asco and Enviroco were subsidiaries of Asco plc (“Parent Company”).
A fire broke out causing considerable damage during the cleaning operation. Farstad therefore brought legal proceedings against Enviroco for the damage caused. Enviroco sought to rely on the benefit of an indemnity clause in the charterparty (between Farstad and Asco) as the indemnity benefitted Asco’s affiliates. The definition of affiliate in the indemnity provision referred to the definition of subsidiary in s.736 Companies Act 1985.
Enviroco claimed that it was an affiliate and was therefore a "subsidiary" under s.736. However, subsequent to the charterparty, the Parent Company had granted a security by way of a legal mortgage of its shares in Enviroco in favour of a Scottish bank.
Farstad therefore argued that because the shares were registered in the name of the bank’s nominee, Enviroco was no longer a "subsidiary" of the Parent Company and, consequently, could not rely on the indemnity clause.
Supreme Court Decision
The Justices decided that it is very likely that the parties to the contract would not have envisaged that a subsidiary would cease to be so, merely because the shares in it were charged to a Scottish bank.
They also decided that there was no basis for construing the definition of "subsidiary" differently because it is incorporated in a contract. If terms of a statute were incorporated into a contract by reference, the contract had to be read as if the words were written out in the contract and construed, as a matter of contract, in their contractual context. The Justices ruled that they were in no position to re-write the contract as stated.
Therefore Enviroco was deemed to no longer be a "subsidiary" of the Parent Company.
Main Tax implications
The definition of "subsidiary" under s.736 Companies Act 1985 is only relevant in relation to VAT groups (s.43A VATA 1994). Accordingly, if a company ceases to be a subsidiary of a group, it will cease to be eligible to be treated as a member of a group for VAT purposes. The subsidiary will therefore have to account for VAT on its intra-group supplies. This will have particularly serious consequences for groups that are not able to recover all of their input tax such as banks and insurance groups.
In relation to capital gains tax, stamp duty land tax and corporation tax, a different definition of subsidiary is used for grouping rules. Therefore, the fact that a company is no longer considered to be a subsidiary under s.736 does not automatically mean that a group has been broken for tax purposes.
The judgment in Farstad Supply A/S v Enviroco Limited  goes beyond this position laid out in ESC C10, in that there were no "arrangements" in place which involved a future change in the ownership of the shares in Enviroco: there was simply a change in ownership when the legal charge in favour of the lender was given by the Parent Company to the bank.
As there was also no trigger event within the meaning of ESC C10, it is difficult to predict the extent of the tax implications arising from the judgment. However, the pledging of shares clearly has implications for the integrity of a group for tax purposes.
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