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Tolley's Practical Tax by Nichola Ross Martin

Nichola Ross Martin director of Ross Martin Tax Consultancy Ltd takes an in-depth look at what are associated companies and the effect of the relationshipAssociated companies affect the tax payable when companies are falling into the starting rate and lower rate bands. They can create complexities in tax computations, and tax planning when advising on optimal business structures and minimising corporation tax.

This article looks at the main tax planning points and common stumbling blocks surrounding associated companies by:

- Defining and determining associated companies and looking at issues of ‘control’.

- Looking at the effects on marginal tax rates, and clarifying treatment, when accounting periods span corporation tax financial years.

What is an associated company?

The biggest problem with associated company definitions is that they are entombed in ICTA 1988 s416, and this is ‘Close Company’ legislation - a blind spot for many practitioners.

‘A company is to be treated as an associated company of another at a given time if at that time, or at any other time within one year previously, one of the two has control of the other or both are under the control of the same person or persons.’

In other words, companies are associated where a person or group of persons can control both, either personally, or via their interests in other corporate shareholders.

Control does not mean what you think it might…

In s416, control is primarily direct/ indirect control over the company’s affairs.

In Steele v EVC International NV [1996] STC 785 it was held that control over the
company’s affairs as defined in s416 means control at the level of general meetings to make the ultimate decisions as to the business of the company.

The main tests for control will normally depend upon:

- Share ownership - excluding fixed rate preference share, but including future rights.

- Voting power.

- Any rights conferred in the Memorandum and Articles, or other rights.

- Attributable rights – of associates, of nominees, or beneficial entitlement.

- Entitlement to assets on winding up, with particular reference to loan creditors.

In a group with a holding company and x number of wholly owned subsidiaries, the subsidiaries are all under common control, and you would then look to see who controlled the holding company. To work out further associates, you would then see whether any other non-group companies would also fall to be under control of that individual or group of individuals.

In practice, there is a sting in control’s tail; the Revenue will look at the minimum controlling combination, but there is no hierarchy in the control tests, the Revenue can take any combination that it needs.

Where a number of factors will give a different result, then it becomes possible for a number of persons to be in control. One person might have all the voting rights, another the rights on winding up, and one gets some interesting results when ‘loan creditors’ (see below) are brought into play, and this element is quite possibly going to generate the most confusion when you are attempting to attribute controlling rights in practice.

Attributable rights

These are rights of other people or companies, which are added or attributed to your person, in order to gauge, whether that person can control the company. You will include the rights of:

- associates;

- nominees;

- beneficial entitlements; and

- companies over which the individual is able to exert control.

You do not attribute the rights of your associates’ associates, but you must attribute the rights of associates’ nominees.

Associates are:

- husband and wife, including separated spouses, but NOT divorced spouses;

- parents, grandparents and remoter forebear;

- child or grandchild or remoter issue;

- brother or sister, including half siblings, but not step’. Blood is what matters;

- partner;

- settlements and will trust associates;

- trustees are associates where the individual, or any living or dead relative (brother, sister, ancestor or lineal descendant) is or was the settlor;

- where the individual is interested in a settlement, then beneficiaries, remainder men and trustees are associates. In R v IRC, ex parte Newfields Development Ltd [2001] STC 901, HL, it was held that the Revenue correctly attributed to an individual beneficiary, and wife of the late settlor, all the rights and powers of trustees in respect of two companies, so that she was treated as controlling both companies;

- for attributed company associates, one can also be attributed rights by reason of control of another company.

Example

The issued share capital of Cat Ltd comprises of 100 £1 Ordinary shares, held as follows:

	%
Share holding
A Director	25
B Wife of A	10
C Uncle of A	35
Dog Ltd	30

Dog Ltd is owned 60% by C and 40% by an unrelated individual.

C has control of Cat Ltd, because the rights in the shares of Dog Ltd are attributed to him. You do not calculate his control here as being 60% of 30%, you attribute the entire 30%, so C is deemed to control 65% of Cat Ltd. A & B are associates, being husband and wife, although they cannot achieve control with 35% of the shares.

Aunts, uncles, cousins, nieces and nephews are not associates.

Entitlement to assets on winding up

This is best illustrated by example:

Company has a balance sheet as follows:

Current assets - cash		£100,000
Current liability - loan creditor		£50,000
Net assets		£50,000
Shares ownership is as follows:
A	25%
B	25%
C	50%
On notional winding up, £50,000 would be paid to the loan creditor, and the balance split between the shareholders:
A	£12,500
B	£12,500
C	£25,000

In the absence of other companies, and other control issues, the loan creditor is deemed to be controlling the company, as he receives the biggest share of assets on a fictional winding up of the company. So that this does not produce totally irrational results in control tests, ESC 9 provides a concession for this scenario (see below).

Loan creditors

A loan creditor in terms of close company control means a creditor in respect of any redeemable loan capital issued by the company, or in respect of any of the following by the company:

- for money borrowed or capital assets acquired, or
- any right to receive income created in favour of the company, or
- for consideration, the value of which to the company was, when the debt was incurred, substantially less than the amount of the debt, and any premium attaching.

Any of the following will not be classed as loan creditor:

- Normal trade creditors.

- Hire purchase creditors.

- A person who carries on the normal business of banking.

Extra-Statutory Concession 9 provides an important concession for loan creditors under the following circumstances:
If there is no past or present connection between the company and the loan creditor, other than the loan or loans which cause it to be a loan creditor, and the loan is made on a bona fide commercial basis, then that loan creditor will not be treated as having control of the company.

This ensures that venture capitalists, amongst others, are not deemed as being in control of their investee companies.

Attribution and participators

Any discussion concerning close companies cannot ignore the term ‘participator’. Before you turn over and find a more interesting article, I have found by far the best and most comprehensible definition of a participator: ‘a person who has any sort of financial interest in a company’, You can exclude persons whose interest is bona fide commercial and deals at arms length. You can therefore exclude all normal trade creditors and debtors, and you will find practically that most participators are directors, their shareholding families and sometimes loan creditors.

A person will be classed as a participator if:

- he possesses or is entitled to acquire share capital or voting rights in the company, or

- he is a loan creditor, or,

- he possesses or is entitled to acquire a right to receive or participate in distributions of the company (as defined in ICTA 1988 s.209) or in amounts payable by the company (in cash or kind) to loan creditors by way of premium or redemption.

- any person who entitled to secure that income or assets of the company, whether present or future of the company will be applied directly or indirectly for their benefit.

- a participator may have rights attributed to him, such as those of his nominees, his associates, and the nominees of his associates, but not the associates of the associates.

So to work out if someone is a participator, you must recognise his or her associates. This is fundamental to Close Company legislation (ICTA 1988 s414). A close company being a company is controlled by five or fewer participators, or by participators who are directors.

Controlling combinations and ‘irreducible groups’

Once you have worked out who is in control of what, then you must address ‘controlling combinations’. You must look at all other parties to see if it can be said that the group of individuals who control the company can also control another company in an identical combination. This group of persons are termed the ‘irreducible group’, although you may call one person an irreducible group on their own.

Two or more persons may control a company, if those two or more persons control another company; the two are associated, as under the control of the same irreducible group.

Example

Shareholders	Co X	Co Y	Co Z
A	15%	33%	40%
B	55%	33%	30%
C	30%	33%	30%

A+B+C, or A + B or B + C acting together control company X, but B can control it on his own. B is the irreducible group of company X.

Company Y has three irreducible groups:
A + B, A + C, B + C
Company Z has the same irreducible groups as Y.
Company X is treated as having no associated companies. Y & Z are associates.

Which companies make up associates?

Upon making a decision as to who controls what, and whether there are any controlling combinations of individuals and irreducible groups, it is necessary to look at the companies themselves to see whether they should form part of the equation. You include all UK companies which carry on a business, but:

- Non-resident companies are also counted as associates.
- A company is included even if only associated for a fraction of the accounting period, but this will depend on whether there is a change in the marginal rates from one financial year to the next (see below).
- Dormant companies are disregarded.
- Investment companies may or may not be disregarded, depending upon whether they are engaged in a business or not.

Investment companies and close investment holding companies

An investment company is a company carrying on a business of making investments, and so is not dormant.

Holding companies might be investment companies, or they could be dormant. IR SP 5/94 considers that holding companies will be deemed dormant if they only hold subsidiary shares, and receive dividend income. The presence of a bank account might indicate that a company is in business, and the Revenue like to say that this is prima facie evidence of being in business. The circumstances and facts could indicate that it is actually dormant (say because trade has ceased, and it really is doing nothing other than owning a bank account, with a small amount of funds). In these cases the courts take a different view to the Revenue. Each case must be decided on its merits.

A close investment holding company will be counted as an associate, although, in its own taxation, it need not worry about associates, because it is paying tax at full rates.

Concessionary practice

ESC C9 is for companies under common control, the following are not treated as associated:

- Companies controlled by a common loan creditor.
- Companies controlled by common fixed rate preference shareholders.
- Companies controlled by a common trustee, such as a trustee of a clearing bank.

In addition, where there is no substantial commercial trading interdependence between the companies, the attribution of a relative’s rights is limited to those of husbands, wives and minor children. Practically this means that brothers and sisters business interests may be excluded under this concession.

Partnerships and LLPs

A partnership or a limited liability partnership is not an associated company.

Marginal tax rates and what to do if the accounting period spans the corporation tax financial year

Associated companies can reduce the amounts of relief due for marginal small companies relief under ICTA 1988 s13, which contains bands called the ‘upper and lower amounts’ and the marginal starting rate relief under ICTA 1988 s13AA, whose bands are called the ‘first and second relevant amounts’.

Companies with taxable profits falling within these bands are paying tax at marginal rates. The presence of an associated company will, in these cases increase the amount of corporation tax payable.

See Example

It goes without saying, that in cases where corporation tax is paid at marginal rates, it can be quite undesirable to have associated companies. It can also be quite undesirable to have so many companies if you are also making low profits – the administration time and the accountancy fees may prove excessive.

The effects of a change in the bands

When the Starting rate or Small Company rate bands change between financial years and the accounting period overlaps the financial year, there will be provision given in the relevant Finance Act to apportion the profits and the number of associated companies into the two notional accounting periods.

This last happened in FY 2000, when the Starting rate came in, and so companies with profits falling into FY 1999 and FY 2000 accounted for associated companies in each separate notional accounting period. The last time this happened to the Small Companies rate was between 1993 and 1994.

Practically, until the rates change again, just include the number of associates that the company has had during its accounting period, and use this number for the computation for each financial year.

Planning points

- Marginal rates should be avoided where possible. A group of companies with total profits of less than the upper relevant amounts will pay less tax if the profits are evenly distributed around the group, than if one company retains the bulk of the profits. Small and medium sized companies are exempt from FA 2004 transfer pricing provisions; however, the Revenue will look at intra-group transactions, particularly where profits are artificially manipulated. One angle of attack in this area is s74 'General rules as to deductions not allowable', further ‘hot spots’ could involve excessive remuneration.

- FA 2004 requires distributions to be taxed at the small companies rate of 19%, and this will simplify calculations in some cases, but also make it extraordinarily difficult to adequately explain to clients the significance of marginal rates and associates.

Practical points

1. Disclosure - Associated companies must be shown on the CT600 return, as small companies relief and starting rate relief are subject to a claim (IR SPP 1/91).

2. Determining partners’ business interests - A business partner is classed as an associate, and so if you are looking at attributing rights of associates, you will need to know the full details of an individual’s business partner’s interests in other companies. This might be nigh on impossible, as it is sensitive information for some. This point has been made to
the Revenue - with the hope of some sort of extension to ESC 9, and we wait to see whether this problem will be properly addressed. It is something to point out to members of large partnerships, and with the advent of LLPs, we are seeing more and more of these.

3. ‘Actual’ control and control under ICTA 1988 s416 are not the same.

Control under s416 defies normal logic. If you are debating this with the IR, then recommended reading is the case of R v IRC, ex parte Newfields Development Ltd [2001] STC 901 HL, where it was agreed that attribution of rights was not discretionary on the part
of the Revenue.

NICHOLA ROSS MARTIN FCA BA (Hons)

Nichola is director of Ross Martin Tax
Consultancy Ltd, and provides tax troubleshooting services for professional firms. Email: Nicki@rossmartin.co.uk

Originally published in Tolley’s Practical Tax, 8th October 2004 and reproduced with the kind permission of Lexis Nexis.