Depreciatory transactions: distributions out of post acquistion profits
HMRC does not interpret the rule as applying where a distribution is paid out of profits that accrue during the time the company making the distribution is owned by the group: “post acquisition profits”.
This was made clear in a letter dated 20 September 1985 from the Board to the Institute of Chartered Accountants in England and Wales. The letter dealt with the application of the Ramsay principle to a wide range of commercial situations. It includes the following statement in relation to dividends paid before the sale of a company.
`We would not normally expect the new approach to apply here. There is, of course, nothing objectionable about a parent taking out profits of a subsidiary as a dividend. And, as regards ICTA70/S280 which you specifically mention, we would not regard there being a depreciatory transaction under that provision where dividends are paid out of post-acquisition profits.’
However, a distribution made out of pre-acquisition profits will be depreciatory as those profits will effectively have been paid for as part of the cost of acquiring shares; a capital loss on a subsequent disposal of the shares should not be allowable to the extent that it results from stripping the pre-acquisition profits.
In year 1, company A acquires company B for £8M. Company B has pre-acquisition profits £1M. In year 2, B pays a dividend £1M to A. This is an exempt distribution. In year 3, A sells B for £7M and claims a capital loss.
In year 1, B’s net assets are worth £8M. Of this amount £1M represents assets generated by B’s pre-acquisition profits. The £1M dividend paid by B to A is effectively a recovery by A of part of the cost of acquiring B. It is therefore appropriate to restrict A’s capital loss on the shares, since this is computed by reference to an acquisition cost £8M.
In year 1, company A acquires company B for £10M. Company B has pre-acquisition profits £1M. In years 2 - 4, B has trading profits £2M which increase B’s assets to £12M. This assumes no change in the aggregate value of B’s capital assets. In year 5, B pays a dividend to A £3M. Because of a decline in the value of B’s capital assets, B is now worth only £5M. A sells B and claims a capital loss.
A loss restriction should be made in respect of that part (£1M) of the dividend which is paid out of pre-acquisition profits.
The distinction between pre-acquisition and post-acquisition profits should be applied whether or not those profits are realised at the time the company is acquired. In practical terms this is unlikely to be material in relation to profits of a revenue nature. It may however make a significant difference in relation to capital profits. This is because a capital profit realised by a subsidiary after acquisition by its new parent may have accrued (in the general sense) to a substantial extent before the company was acquired. In these circumstances the price paid by the parent for the shares in the subsidiary will reflect the accrued profit at the time of the parent’s acquisition.
To the extent that any part of a capital profit realised after acquisition of the shares had accrued at the time of acquisition, the cost of the shares will reflect the accrued profit. If the cost of the shares reflects an accrued capital profit which the parent strips out by a dividend when the profit is realised, a loss restriction is appropriate under the depreciatory transactions rules.
In year 1, company A acquires the shares in company B for £8M. Company B’s assets include a property with book value £1M which is worth £3M. In year 4, company B sells the property for £6M and realises a commercial profit £5M. Company B pays a dividend £5M to A. Company A sells B for £6M and claims a capital loss.
B paid the dividend out of a profit realised after A’s acquisition of B, but £2M of the dividend was paid out of a profit which had accrued at the time of A’s acquisition. A’s acquisition cost £8M effectively included £2M in respect of the accrued profit. For the purposes of the depreciatory transactions rules the dividend £5M should be treated as paid £2M out of pre-acquisition profits and £3M out of post-acquisition profits.
Tracing the source of dividends
Where a company acquires shares in another company which itself has subsidiaries, the distinction between pre-acquisition and post-acquisition profits will need to take account of all of the companies taken over. In broad terms, a dividend is paid out of pre-acquisition profits if the immediate source of those profits was a dividend paid from a pre-acquisition profit of a subsidiary; even if the subsidiary paid the dividend after the companies were acquired by the group in question.
Company A acquires company B which has subsidiary C. At the time A acquires B, company C has an accrued capital profit £2M on one of its assets. C subsequently sells the asset and realises a commercial profit £5M. C pays a dividend £5M to B which pays a dividend £5M to A. Company A subsequently sells company B at a loss. Neither B nor C has any other profits in the relevant periods.
The cost to A of the shares in B will have reflected the accrued profit £2M in the hands of C. The dividend paid by B to A should accordingly be identified to the extent of £2M with pre-acquisition profits, and to the extent of £3M with post-acquisition profits. The relevant acquisition is A’s acquisition of B, and the relevant profits are those of C. A loss restriction is appropriate in respect of the £2M which derives from C’s pre-acquisition profits.
Group transfer following payment of dividend
Another special case is where a company pays a dividend out of profits accrued after its acquisition by the group and before its acquisition at no gain/no loss within the group by the company making the ultimate disposal.
In 2008 company A acquires company B. In 2009 company B acquires company C. In 2010 B disposes of C at no gain/no loss to A. C pays a dividend to A equal to the whole of C’s distributable reserves £5M. These comprise pre-2009 trading profits £2M and 2009 trading profits £3M. A sells C at a loss.
The whole of the dividend £5M is out of pre-acquisition profits in relation to A’s 2010 acquisition of C. But the effect of the no gain/no loss rule is that A’s loss is by reference to the 2009 cost of C to B. And that cost will have reflected C’s pre-2009 profits £2M but not the subsequent 2009 profits of £3M. In this situation the appropriate loss restriction is by reference to the pre-acquisition profits £2M when the group acquired C, rather than the pre-acquisition profits on the acquisition at no gain/no loss by A, which is the company making the ultimate disposal of the shares in C.
Post-acquisition profit identification
Where a depreciatory distribution is made out of a pool of profits which contains both pre-acquisition and post-acquisition profits, the distribution should be identified in the first instance with post-acquisition profits. The distribution accordingly drains out the post-acquisition profits in priority. It is only when the distribution exceeds the available post-acquisition profits that a loss restriction becomes appropriate in respect of the excess, which represents a distribution out of pre-acquisition profits.