UK: The Abolition of ACT

Last Updated: 16 March 1999
The Abolition of ACT

INTRODUCTION

Advance Corporation Tax (ACT) is being abolished for dividends and other distributions paid on or after 6 April 1999. This major change forms part of a package of measures designed to "modernize" the corporation tax system.

The principal changes are:

  • the abolition of ACT (accompanied by the introduction of a new "shadow ACT" system - see below);
  • the abolition of repayable tax credits on dividends and other distributions (other than pursuant to double taxation treaties);
  • reduced rates of income tax on dividends and other distributions, together with reduced tax credits;
  • for "large companies", a payment on account system for corporation tax liabilities;
  • reduced rates of corporation tax.

This note considers the implications for UK companies of the abolition of ACT.

CARRIED FORWARD ACT AND THE NEW SHADOW ACT SYSTEM

Companies with carried forward surplus ACT as at 6 April 1999 do not automatically lose the surplus when ACT is abolished. In principle, the surplus ACT which is carried forward at 6 April 1999 can continue to be set against corporation tax liabilities arising after that date. However, the limit on the amount of ACT which can be used for such offset (which remains unchanged, at 20% of taxable profits) has to be calculated in the light of the new shadow ACT system.

The aim of the shadow ACT system is to ensure that companies which pay dividends cannot use their ACT surplus any more quickly after 6 April 1999 than they could have done under the abolished ACT regime.

Under the new system a company is treated as paying shadow ACT (at 25%) on all dividends and other distributions after 6 April. No actual payment of shadow ACT is made. Shadow ACT does not reduce subsequent corporation tax liabilities. It is simply a means of determining how much carried forward ACT can be used to set against corporation tax liabilities for periods after 6 April 1999. When the limit on the offset of ACT against corporation tax is applied, shadow ACT takes priority over carried forward ACT. Offset of carried forward ACT is only available to the extent that the shadow ACT does not use up the set-off limit.

The Shadow ACT Regulations were laid before Parliament in February 1999 and came into effect on 9 March.

The shadow ACT system only applies to companies or groups with carried forward surplus ACT. Companies without surplus ACT are not affected by the regime.

It is open to companies (and groups) to opt out of the system, either from the outset or at a future date. Generally, opting out is irrevocable. However, if a group which has opted out subsequently acquires a company with carried forward ACT, then the group comes back within the system but only to use the newcomer's ACT.

The grouping test is basically more than 50 per cent of ordinary share capital and more than 50 per cent of economic ownership. Companies which satisfy the test are automatically treated as members of a group for the purposes of the system.

A company is not treated as paying shadow ACT to the extent that it has sufficient franked investment income (UK dividend income) (FII) to frank the liability. Franked investment income from before 6 April 1999 can be carried forward.

Shadow ACT does not generally arise when a company pays a dividend or other distribution to another group member. (This is like a compulsory group income election, though applying to all types of distribution and not just to dividends.) Intra-group dividends do not usually constitute FII. However, if the company paying the dividend has FII it can make an election for its intra-group dividend to attract shadow ACT, and the intra-group dividend will constitute FII. In effect, such an election moves the benefit of FII up the group, so that the parent company is not treated as paying shadow ACT on its dividend to shareholders.

If a company is treated as paying shadow ACT in an accounting period in excess of the amount of the offset limit, the excess is treated as surplus shadow ACT.

The company is required to carry back its surplus shadow ACT for up to 6 years (but not into a period ending prior to 6 April 1999). Any remaining surplus has to be allocated to other group members for their current accounting period or, broadly, their previous accounting period.

Both the company's own carry back and its group allocation may displace carried forward ACT which has offset a post-6 April 1999 mainstream corporation tax liability. This means that the carry-back or allocation can result in additional corporation tax being payable.

Any further surplus shadow ACT is carried forward in the company whose dividend gave rise to it.

ACT PLANNING

Companies and groups outside the shadow ACT system need not worry about ACT planning.

Companies and groups with surplus ACT will want to use their carried forward ACT as soon as possible.

Such companies may have taken steps before 6 April to minimize their surplus ACT. After 6 April they will want to minimize their shadow ACT in much the same way.

Steps they should consider include:

i) Paying scrip dividends (which are not treated as distributions for tax purposes and will not give rise to shadow ACT).

ii) Increasing UK taxable profits by acquiring UK source income or increasing an existing source (perhaps by disclaiming capital allowances). This will increase the ability to absorb both shadow ACT and carried forward ACT.

iii) Deferring the payment of cash dividends until after the group has ceased to be within the shadow ACT system. An anti-avoidance provision puts companies back into the system if they pay a dividend in an accounting period which begins in the 12 months following their "final" accounting period so, a dividend would have to be deferred until a subsequent accounting period.

iv) Acquiring sources of FII (so that FII offsets the shadow ACT liability). A company might, for example, fund a UK joint venture vehicle with preference shares rather than debt. The preference dividends will not be taxable and will frank the company's own shadow ACT liability on paying dividends. If the joint venture vehicle is loss-making (for example, in a start up period) the non-availability of a tax deduction for the dividend (as compared to an interest payment) may be acceptable. The Shadow ACT Regulations contain anti-avoidance provisions designed to counter artificial arrangements to increase a company's FII.

Groups with surplus ACT should allocate any surplus shadow ACT to companies in the group which do not have surplus ACT.

The shadow ACT system does not include an equivalent of the foreign income dividend (FID) regime. Many multi-national groups built up ACT surpluses because foreign tax credits reduced the effective rate of corporation tax below the ACT rate. As a result, ACT could not be used and had to be carried forward. Under the FID regime, ACT could be reclaimed if the relevant dividend was matched with relevant foreign income.

Under the new shadow ACT system companies with foreign tax credits will be worse-off than they were under the repealed ACT regime (they will be in much the same position as they were before the introduction of FIDs). Shadow ACT will be treated as paid even when dividends or distributions are paid out of the foreign income. Affected companies may come to the conclusion that they have virtually no chance of ever using their carried forward ACT to offset against a future corporation tax liability. In such a case, a group may decide to opt out of the system.

GROUP STRUCTURING

Over recent years the UK has become more attractive as a holding company jurisdiction. The abolition of ACT is a further improvement.

The reduction in the tax credits attaching to dividends means, however, that the benefit of incorporating a UK branch to reduce the effective UK tax rate becomes illusory. For the same reason, debt financing is likely to be a more attractive way of financing a UK subsidiary (deduction in the UK for the interest), subject to thin capitalization issues.

CORPORATE TRANSACTIONS

Buying a company with carried forward ACT

If the target company has carried forward ACT and has not opted out of the shadow ACT system, the carried forward ACT will continue to be available for offset in the target company after its change of ownership. Further carry forward will be subject to anti-avoidance rules equivalent to those which applied before 6 April 1999. Thus, the ACT will not be usable where, in any period of three years, there is both (i) a change in ownership and (ii) a major change in the nature or conduct of the company's trade or business or the scale of activities becomes negligible.

The target company's ability to use its carried forward ACT once it is in the purchaser's group will depend on the operation of the shadow ACT system within that group (including the target). Thus, if surplus shadow ACT arises in another member of the purchaser group after acquisition of the target, this may potentially be allocated to the target to defer its use of carried forward ACT.

If the purchaser's group has not been, or is no longer, within the shadow ACT system, its acquisition of a target company with carried forward ACT will bring the group into the system. However, this will not enable existing group members to use their own carried forward ACT.

If the target company was a member of a group within the shadow ACT system, it may have been the recipient of amounts of surplus shadow ACT allocated from other group members. Conversely, it may itself have paid dividends giving rise to surplus shadow ACT which has been allocated to other companies within the vendor group. Such group allocation may relate to the accounting period in which the target company leaves the vendor's group.

Furthermore, group allocations once made can be reallocated.

Therefore, on an acquisition of a target company with carried forward ACT, a purchaser should seek warranties as to the past operation of the rules relating to group allocation of surplus shadow ACT, and assurances that previous group allocations within the vendor group of surplus shadow ACT will not be reallocated to impact on the target company. The purchaser will also want an indemnity from the vendor to cover any possible secondary liability which arises in the target company (under the Regulations) as a result of a failure of one of the vendor group companies to satisfy a corporation tax liability triggered by the operation of the shadow ACT system.

Buying a company which does not have carried forward ACT

If the existing purchaser group has carried forward ACT and has not opted out of the shadow ACT system, acquisition of a target company will enlarge the group for the purposes of future allocations of surplus shadow ACT. Thus, if the target does not have its own carried forward ACT, its corporation tax capacity will be available to absorb amounts of surplus shadow ACT arising elsewhere in the purchaser group.

Company sales

Pre-sale dividend strips are fairly standard, and will remain an effective tax planning technique.

Before 6 April 1999 a pre-sale dividend would usually be paid under a group income election so that the target company did not have to pay ACT. The dividend would need to be paid whilst the vendor and target were still members of the same group: it was crucial that, at the time of the dividend, the vendor continued to be the beneficial owner of the shares in the target.

Similar issues will arise after 6 April 1999 for groups with carried forward ACT as they will want to ensure that the pre-sale dividend is treated as made between members of a group so that shadow ACT does not arise. The grouping tests in the shadow ACT system include an anti-avoidance "arrangements" rule which is likely (assuming that the rule is applied consistently with the equivalent rule for group-relief grouping) to mean it will actually be more difficult to ensure that the dividend is intra-group for shadow ACT purposes than it previously was for group income purposes.

If the pre-sale dividend takes place in the accounting period of target which straddles the sale, the possibility of a shadow ACT charge is potentially a point of concern to both the purchaser group and the vendor group if they have carried forward ACT. Shadow ACT which arises in the target as a result of the pre-sale dividend will impact on the target's capacity, for the accounting period in which the change in ownership takes place, to receive surplus shadow ACT from members of both the vendor and purchaser groups. Furthermore, the group allocation rules potentially operate to require surplus shadow ACT relating to the target's pre-sale dividend to be allocated to companies in both groups.

Planning for pre-sale dividends became more complex when Schedule 7 to the Finance Act 1997 imposed FID treatment on certain distributions as part of a package of anti-avoidance measures. FID treatment denied the shareholder the right to repayment of the tax credit (in advance of the general removal of the right from 6 April 1999). Pre-sale dividends had to be structured to benefit from an exemption from this treatment.

Along with the abolition of ACT and the repeal of the FID regime, Schedule 7 is repealed for distributions on or after 6 April 1999. Pre-sale dividends after that date can be made without consideration of the timing constraints that have applied in recent years.

RETURNING CASH TO SHAREHOLDERS

After 6 April 1999 there will be a major distinction between groups with carried forward ACT and those without. Those with carried forward ACT will be within the shadow ACT system and will want to return cash in a way that does not give rise to distribution treatment (and thereby to shadow ACT). Groups without carried forward ACT will be outside the shadow ACT system and will be able to make distributions without additional cost to the company.

Groups without carried forward ACT

For many public companies, the removal of the right to repayable tax credits will mean that most shareholders will not have a marked preference for a return which constitutes a distribution as opposed to one which is treated as a return of capital.

The distinction is still relevant for UK corporate shareholders (who receive a distribution free of tax) and tax paying individuals (who get the benefit of a tax credit on receipt of a distribution). Few public companies have sufficient information about such shareholders' tax affairs to be able to structure to suit them. More closely held companies may be able to do so.

The abolition of ACT increases the choices available to groups without carried forward ACT in structuring a return of cash to shareholders. For example:

i) Special dividends on flotations will have no cost to the company.

ii) Share buy-backs may be attractive in order to turn equity into debt.

iii) There will be no benefit to the company in scrip dividends rather than cash dividends.

Groups with carried forward ACT

Companies with carried forward ACT will want to return cash to shareholders in a way that does not give rise to shadow ACT. Techniques were employed by companies before 6 April 1999 to return cash to shareholders without incurring an ACT liability. A number of these should be effective to avoid a shadow ACT charge after 6 April.

It may be possible to structure a share buy-back so that the entire payment from the company is treated as a return of capital for tax purposes. A number of companies have done this by reorganising their capital first (by splitting existing shares, or issuing bonus shares with the appropriate nominal value). An alternative approach (which requires Inland Revenue clearance) has entailed shareholders exchanging their shares for shares in a new company by way of rollover. The shares in the new company are subsequently bought back.

Share cancellations, redemptions and reductions can all potentially produce return of capital treatment, though generally giving rise to more difficult company law and procedural issues. As compared with a buy-back, these mechanisms have the benefit of being free of stamp duty (a buy-back attracts a 1/2% charge). A prior share capital reorganisation may be needed to ensure that the entire payment to shareholders is treated as return of capital.

DEMERGERS

Many tax issues arise when structuring a demerger. One crucial issue before 6 April 1999 was whether the arrangements would give rise to an ACT liability for any of the companies involved. After 6 April, ACT will no longer be an issue for companies without carried forward ACT. Companies with carried forward ACT will need to consider whether a demerger gives rise to shadow ACT.

This note is intended to provide a general summary of the main implications for UK companies of the abolition of ACT and is believed to be correct at the time of publication. It is, however, not intended to be exhaustive, nor to provide legal advice in relation to any particular situation and should not be acted or relied upon without taking specific advice.

If you would like further information or specific advice, please contact Nigel Doran at Macfarlanes London Office.

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