Tolley's Practical Tax by Mark McLaughlin ATII TEPThe family company or group of companies is a commonly used business vehicle. But why can such close relationships matter for tax purposes? What is a 'close' company and what are the exceptions from close company status?
In practice, a high proportion of corporate clients will generally tend to consist of close companies. But what is a 'close' company? What are 'associates' and 'participators', and what role do they play in the determination of close company status? (all statutory references in this article are to the Income and Corporation Taxes Act 1988, unless otherwise stated).
Why does being 'close' matter?
There are a number of consequences flowing from close company status, most notably the following-
a) Loans to participators or associates can result in the requirement to make tax payments to the Inland Revenue equal to 25 per cent of the loan, subject to certain exceptions (s 419(1));
b) Where a close company incurs an expense in the provision of benefits or services to a participator who is not a director or employee earning £8,500 or more, that expense is treated as a distribution rather than an allowable expense of the company (s 418(2));
c) For income tax purposes, relief is available for the interest paid on loans to an individual to acquire ordinary shares or make loans to a close company (which is not a 'close investment-holding company' (CIHC)), where certain conditions are satisfied (s 360);
d) The 'small companies'' rate of corporation tax (and, with effect from 1 April 2000 the 'starting rate') can be utilised by a close company, other than CIHCs. Such CIHCs therefore pay corporation tax at the full rate, regardless of profit levels (ss 13(1)(b) and 13AA(8)(b)). The statutory definition is such that every close company is a CIHC, unless falling within certain exceptions (see s 13A(2)). For example, a company existing throughout an accounting period wholly or mainly for the purposes of carrying on a commercial trade is specifically excluded from CIHC status.
With regard to the final point, the recent case R v IRC, ex parte Newfields Developments Ltd ( STC 52 (see below)) concerned a claim to small companies' corporation tax relief. The relief is reduced through equal division between active, associated companies. For these purposes, companies are 'associated' if one company controls another, or both companies are under common control. The Newfields case primarily involved the issue of 'control' of close companies.
What is a 'close' company?
A 'close company' (as defined by s 414) is one which is-
a) Under the 'control' of five or fewer 'participators' (including their 'associates');
'Control' is defined (s 416) as the ability to exercise or entitlement to acquire control over the company's affairs. This includes the ownership of, or entitlement to acquire-
- over 50 per cent of the company's share capital; or
- over 50 per cent of the company's voting rights; or
- the right to receive over 50 per cent of the company's distributable income; or
- the right to receive over 50 per cent of the company's distributable assets.
b) Under the control of any number of 'directors' (including their associates).
A 'director' includes any person (s 417(5))-
- who acts in that capacity (whatever title is given); or
- who gives directions upon which the directors are accustomed to acting; or
- who is concerned in the management of the company's business and controls, or is able to control (with or without associates) 20 per cent or more of the company's ordinary share capital.
c) A further test of close company status is broadly satisfied where five or fewer participators, or participators who are directors, together possess or are entitled to acquire rights to receive the greater part of the assets (with or without taking the rights of any loan creditors into account), based upon a notional winding up of the company (s 414(2)).
The definition of 'participator' (s 417(1)) includes a person with a financial interest in the company, such as a shareholder or loan creditor, but excludes a bank operating in the ordinary course of its business (s 417(9)), and normal trade creditors of the company (CT 6113).
An 'associate' of a participator is defined as (s 417(3))-
a) Any 'relative'-spouses, parents or remoter forebear, children or remoter issue, or brothers or sisters are included (but note that more distant relatives, such as aunts and uncles, nephews and nieces, are excluded from the definition). Separated spouses and half-brothers are regarded as associated, but divorced spouses and step-brothers are not;
b) any business partner;
c) the trustee(s) of any settlement in which the participator (or any living or dead persons in (a) above) is or was the settlor; and
d) the trustee(s) of a settlement or personal representatives of an estate holding company shares in which the participator has an interest (nb. where the participator is a company, any other company interested in those shares is also an associate).
Attribution of associates' rights and powers
For the purposes of the control test, in determining control there may be attributed to any person the rights and powers of nominees, 'associates' or of any companies controlled by him (or jointly with his associates). Such attributions should be made as would result in a company being treated as under the control of five or fewer 'participators', if it could be so treated (s 416(6)).
The Newfields case
In Newfields, the share capital of that company was held by W's will trust, in which W's widow had a life interest. The trustees of the will trust and W's widow were associated, due to her interest in the will trust (see above). A second company (L Ltd) was controlled by a discretionary trust, of which W was the settlor. The trustees of the discretionary trust were also associated with W's widow, because her husband was the settlor. The Revenue considered that corporation tax small companies' relief should be divided between Newfields and L Ltd due to common control, on the basis that the rights and powers of both trusts should be attributed to W's widow. The taxpayer applied for judicial review, contending that the attribution of rights and powers (under s 416(6)) was subject to the Revenue's discretion. It argued that the Revenue had to consider on the facts whether it was appropriate to attribute the rights of the discretionary trust to W's widow, because she was not a beneficiary under the trust and could not derive any benefit from L Ltd.
The High Court dismissed the taxpayer's application and the case proceeded to the Court of Appeal, where Lord Justice Peter Gibson said that the phrase in the legislation 'may-be attributed' did not create a Revenue discretion. However, a further test in s 416(6) required the attribution of rights to participators. Since W's wife was not a participator, attribution of the rights and powers of her associates was not required. Newfields and L Ltd were therefore not associated companies. The taxpayer's appeal was allowed.
Close company exceptions
There are a number of exemptions from close company status, even where the conditions outlined would otherwise be satisfied-
- Non-resident companies are specifically excluded, together with registered industrial and provident societies, building societies and companies controlled by the crown (and not otherwise close companies) (s 414(1));
- A UK-resident company controlled by a non-resident company is not treated as a close company, unless the non-resident company would itself be close if resident in the UK;
- A company controlled by a non-close company or companies is similarly excluded, where it cannot be treated as a close company except by including a non-close company as one of its five or fewer participators;
- A quoted company is not a close company (s 415)-
a) where 35 per cent or more of the company's voting power is held by the public (excluding shares entitled to a fixed rate of dividend); and
b) within the preceding 12 months those voting shares have been the subject of dealings on a recognised stock exchange,
unless the total voting power of the company's principal members exceeds 85 per cent (including shares entitled to a fixed rate of dividend).
The definition of 'public' above excludes the following:
- directors and their associates;
- any company controlled by them;
- any associated company;
- any fund for the benefit past or present employees, directors or dependants of the company or associated companies; and
- the principal members.
A 'principal member' is a person who, as one of five or fewer others, each holds more than five per cent of the company's voting power. Where more than five persons each hold more than five per cent, the principal members are the five holders of the greatest percentages. Where two or more persons hold equal percentages, so that the greatest percentages are held by more than five persons, the principal members may number six or more (s 415(6)).
Associated companies: points to note
The 'associated companies' rule restricting claims to small companies' or starting rate corporation tax relief applies where there is common control at any other time within the previous twelve months (s 416(1));
- Foreign companies are taken into account in determining the number of associated companies;
- Active companies associated at any time during the company's accounting period should be included. Two or more companies are counted even if associated for different parts of the accounting period.
- However, where the corporation tax accounting period straddles 31 March and different small companies' relief limits apply in each financial year, those parts are treated separately when taking into account the number of associated companies in each period. The authority to apportion associated companies in this way is given by the Finance Act for the year in which the amounts change (CT 3064).
'Active' companiesAn associated company that has not carried on a trade or business at any time in the accounting period may be disregarded (s 13(4)). A detailed consideration of what constitutes a "trade or business" is outside the scope of this article. However, in Jowett (Insp of Taxes) v O'Neill and Brennan Construction Ltd  STC 482, the receipt of bank interest by an associated company following the cessation of its trade was held not to constitute an investment "business".
Statement of Practice 5/94A non-trading holding company which holds no assets other than shares in its 51 per cent subsidiaries is treated as dormant where it is not entitled to any deduction for its outgoings, and has no income or gains other than group dividends which are fully distributed to its shareholders.
Extra Statutory Concession C9In certain circumstances, the Revenue will not treat as associated companies that are under common control only by virtue of fixed rate preference shares, loan creditors or trustee companies. This concession broadly applies where the relevant connection is on an arm's length, commercial basis.
'Substantial commercial interdependence'For the purposes of determining control for associated company purposes, Concession C9 allows the rights and powers of 'relatives' (see above) except spouses or minor children to be disregarded, provided that there is no substantial trading interdependence between the companies. A broad view is required as to whether 'substantial trading interdependence' exists, although this will generally be the case if the companies rely on each other to any extent (ie purchasing and selling arrangements, inter-company loans and guarantees, etc).
Control by an 'irreducible group'Another factor determining whether companies are under common control is the Revenue practice of ascertaining whether an irreducible group of persons controlling one company is identical with an irreducible group of persons controlling another. An 'irreducible group' is defined as a group of persons which has control of a company but which would not have control of the company if any one of them were excluded from that group.
Example: An 'irreducible group'The shareholdings in Gary Ltd and Des Ltd are held by the following individuals (none of whom are otherwise connected)-
|Gary Ltd||Des Ltd|
Messrs Hansen and Brooking together control both Gary Ltd and Des Ltd. However, Mr Brooking singularly controls Gary Ltd, and is therefore an 'irreducible group' in respect of that company. Since Mr Brooking does not also control Des Ltd on his own, the two companies are not treated as associated.
Other points to note
- An added complication to the 'control' tests mentioned earlier is the requirement to take into account "...anything which he is entitled to acquire at a future date, or will at a future date be entitled to acquire", ie future rights such as share options (s 416(4)). There are also "look through" provisions to attribute the rights and powers of nominees to the beneficial owners (s 416(5)). Therefore a nominee cannot be considered to control a company in that capacity. However, a nominee shareholder may nevertheless be regarded as a participator in the company (CT 3074);
- Benefits to participators (within s 418 - see above), including associates, are broadly valued using Schedule E rules to determine the 'cash equivalent' of the benefit, and hence the amount of the distribution (see CT 6609);
- In addition to corporation tax and income tax, close company status can also have a bearing on capital taxes issues. For example, where a close company makes a transfer of value for inheritance tax purposes, that value is broadly apportioned among its participators and treated as if each had made a chargeable transfer of the apportioned part (IHTA 1984 s 94). For capital gains tax purposes, the transfer of an asset at undervalue by a close company can result in a proportionate reduction in the shareholders' base cost of their shares, to the extent that it has not already been taken into account for income tax purposes (TCGA 1992 s 125 and ESC D51).