The financial crisis and changes to the Tax Grouping Rules
22 April 2009
The government 'bail-out' of the banking industry has led to a number of banks seeking to increase their capital base by the issue of preference shares. For regulatory reasons, these preference shares must be 'non-cumulative' to qualify as Tier 1 capital on the banks' balance sheets. That is, the shares do not carry a right to a dividend where paying it would risk breaching the banks' capital adequacy requirements.
In light of this, HM Treasury has announced a prospective change to the tax grouping rules to deal with the following problem.
With banks issuing significant amounts of preference shares, the non-cumulative nature of the dividend rights attaching to the shares could in some cases 'degroup' the issuing bank from the rest of its group for tax purposes. This could result both in tax degrouping charges arising, and an inability to surrender tax losses vis à vis the company issuing the preference shares.
Technically it works like this. Companies are treated as members of the same group for corporation tax purposes where one is a 75% subsidiary of the other or both are 75% subsidiaries of a third company. In broad terms the parent must have a 75% equity stake in the subsidiary, and 'equity holder' is defined in paragraph 1 of Schedule 18 ICTA 1988 as a person who:
- holds 'ordinary shares' in the company or
- is a loan creditor of the company where the loan is not on normal commercial terms.
'Ordinary shares' are defined as shares that are not 'fixed rate preference shares'. To qualify as the latter the shares must carry a right to a dividend of a fixed amount or at a fixed percentage rate of the nominal value of the shares. Non-cumulative preference shares do not qualify as 'fixed rate preference shares', and would therefore constitute ordinary share capital.
The upshot is that issuing them in significant amounts to persons outside the group could result in the parents' equity stake dropping below 75%, with the consequences outlined above.
The solution proposed by the government is to amend the existing legislation (in particular paragraph 1(3) of Schedule 18 ICTA 1988), effective for accounting periods beginning on or after 1 January 2008, to ensure that preference shares which would qualify as 'fixed rate preference shares' but for the issuer being able to pay a lower or no dividend in certain defined circumstances (such as where doing so would violate capital adequacy requirements) shall be treated in the same way as fixed
rate preference shares for tax grouping purposes.
In other words, the preference shares will not count as ordinary share capital and so the degrouping issues will not arise.
Companies will be permitted to elect for the new regime to apply only to new share issues and not retrospectively.
This change will be welcomed by banks looking to strengthen the Tier 1 capital on their balance sheets. It should be noted, however, that though this issue has emerged with regard to the bail-out of the financial sector, the changes will apply to all companies issuing non-cumulative preference shares, and which could therefore have an impact on their tax grouping arrangements.