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Wednesday, 24th April 2024 |
| Indigenous Irish business is largely owner managed. When such a business passes to a new generation it may become necessary to split it amongst family members. The taxation treatment of such a split is confused in an unnecessary way and needs reform. A clear-cut policy on the treatment of demergers needs to be worked out. |
All coalition governments must sooner or later demerge. Likewise a business which does not transform itself into a quoted company, with ownership and management separated, is likely sooner or later to be split up over a number of family members.
Some businesses may be broken up once inherited by the children or first generation. Others may survive to be passed on to a second or third generation. The tax costs of demerging a business in the second or third generation are higher than they are in the first generation. It is not clear that this problem is due to any logically thought out policy but seems rather to be the product of the patchwork nature of the reliefs and taxes that apply to the situation.
Where is the problem?
The tax problems which arise when it becomes necessary to break up a family company are best illustrated by an example.
John Brown founded Brown Trading Limited in the 1930s. Over the years it expanded into a number of businesses, including a bakery, a pub and an undertaking business. On John Brown’s death the business was inherited by his son John Jr and his daughter Ann in equal shares. Ann worked actively in the business, mainly running the bakery. John Jr largely ran the pub and undertaking business.
Over the years tensions had built up as John Jr felt that the bakery operation was not pulling its weight. There were also disagreements as to whether John Jr’s children, who will soon be leaving school, should be allowed to come into the business.
One solution, which commercially seems quite obvious, is that Ann should take the bakery business and go her own way, leaving John Jr with the pub and undertaking business.
One way to achieve this would be to liquidate Brown Trading Limited and pass the various businesses out to the shareholders in specie. That would involve a double charge to capital gains tax, once in respect of the businesses (charged on the company) and once in respect of the shares in the company (charged on Ann and John Jr). Even at the current 20 per cent CGT rate, that could lead to substantial tax liability to bring about a transaction that in itself makes nobody better off and generates no cash.
There are several other methods by which the result can be achieved. These include a ‘share for undertaking three party swap’. This buzz phrase simply means that Brown Trading Limited would transfer the bakery business to a new company for no consideration other than the new company issuing shares to the existing shareholders in Brown Trading Limited, and a similar step being taken in relation to the other businesses of the company.
John Jr and Ann would then be joint owners of a company owning the bakery business, and joint owners of a company owning the pub and undertaking business. They could then swap each other’s shareholdings so as to leave each the sole owner of their respective companies. This transaction potentially gives rise to a plethora of taxes, - income tax, capital gains tax on a multiple basis, stamp duty, capital duty, but most of these disappear due to the application of a variety of reliefs specially designed to cover this situation.
One charge to tax in particular would not disappear – the capital gains tax on the share swap. But at least this approach gives rise to only single capital gains tax and not double capital gains tax as in the case of a liquidation. In the ‘share for undertaking three party swap’ described above, the reliefs from capital duty, stamp duty, and capital gains tax are dependent on the new companies being owned in the same way as the shareholders owned Brown Trading Limited.
That necessity involved creating cross holdings of shares which then had to be swapped, giving rise to the capital gains tax charge.
The concession
The Revenue Commissioners have a published concession ‘Partition of family trading companies’ to relieve the tax in a demerger. In limited circumstances they permit the share for undertaking three party swap to be carried out without preserving the identity of ownership of the new companies compared to the old company. Thus under the Revenue concession the bakery business could go to a company owned solely by Ann, and the other businesses to a company owned solely by John Jr and no necessity for cross share swapping would arise as a result. This concession removes the capital gains tax charge that would otherwise arise on the swap. Unfortunately the concession does not extend to the stamp duty or capital duty and the approach outlined would lose the stamp duty and capital duty reliefs.
Notwithstanding the disadvantages in the Revenue concession, it is widely used. But the concession is not satisfactory in many respects.
It applies only to 100 per cent family companies. In other words, if the long serving financial controller holds a 10 per cent interest in the company, it is no longer a 100 per cent family company and the concession will not apply to a break up, even if the break up is entirely to facilitate the children of the original founder.
It applies only to the break up of a trading group. Where non-trade assets exceed 10 per cent of the value of the trading assets, the concession will not apply.
One of the most unsatisfactory aspects is that it is confined to the demerger or break up of a company or group owned entirely by brothers or sisters or parents and their children. In other words, the demerger relief is available only when the company is owned by the children of the original founder, and possibly also by the original founder and his spouse. Once the company has passed to a third generation, so that shareholders now include people related as cousins rather than as brothers and sisters or parents and children, the concession is not applied.
Why the concession?
It is difficult to see why the concession is applied where a company controlled by brothers and sisters is being broken up, but not where a company which is being controlled by cousins is being broken up. It raises the question of why the concession exists in the first place.
The logic for it would be that it benefits a business, and therefore the economy, if those owning it are not at loggerheads, and when they are at loggerheads, if they can separate. The actual act of separation generates no gain or income in any true economic sense for anyone. The imposition of tax is not therefore on the occasion of anybody coming into new wealth they did not already have, generating new cash resources or otherwise doing anything that rationally might be expected to attract taxation.
That explains why the concession exists. The logic of that extends to any demerger. There is nothing in principle different between warring brothers and sisters paralysing the business of a commonly owned company, and warring cousins doing the same. Nor indeed is there any grounds for distinguishing, in terms of benefit to the economy, between allowing warring family shareholders to separate, and allowing warring unrelated shareholders to go their own way.
Policy needed
As explained above there are reliefs from stamp duty and capital duty where the manner in which businesses are carried on and owned is reorganised, with the business being placed inside new companies owned exactly as the original company was owned. These reliefs do not extend to a situation where a demerger is involved. If the State considers that a demerger should be facilitated by an effective relief from capital gains tax provided through a Revenue concession, why does the same thinking not carry through to stamp duty and to capital duty?
One possible explanation is that capital gains tax is administered by a different area of the Revenue Commissioners than that which administers stamp duty and capital duty.
There is a need to take an overall look at this area and to formulate policy afresh. Should demergers be taxed? If not, is that true of all demergers or merely demergers in companies owned by brothers/sisters? If demergers should not be taxed, should not the same relief from taxation be available for all forms of taxes, whether they be capital gains tax, stamp duty, or capital duty, on the same conditions and terms? This may be a fruitful area for the Department of Finance to coordinate a review of policy. |
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| Article appeared in the May 2002 issue.
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