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Participation Exemption on Dividends
Our practice has had some interesting recent experience in dealings with HM Revenue & Customs ("HMRC") relating to the relatively new participation exemption on dividends. Prior to 1 July 2009 the position with dividends paid between UK companies was fairly simple. Legislation operated to exempt any payments of dividends paid by a UK company to a UK shareholding company. It was widely recognised that this treatment was discriminatory given that dividends paid from overseas companies, and in particular EU companies, were subject to tax at the UK level (albeit sometimes with the availability of a tax credit for foreign tax suffered).
In response to this problem HMRC fundamentally changed the way dividends are taxed in the UK and introduced the UK participation exemption on dividends. Under this regime the receipt of dividends by a UK company after 1 July 2009 can be exempt. You should note though that any dividends that are not exempt will be charged to tax under the new regime and it is not a blanket exemption. Our client was preparing to pay a very large dividend (several billion dollars) to its UK holding company from a UK subsidiary and wanted certainty of tax treatment before proceeding. If the exemption applied then they would be happy to go ahead but if there was any even remote chance that the exemption would not apply then the transaction would not be performed. The client wanted absolute certainty.
The participation exemption regime is designed such that most dividends received by UK companies will be exempt. However, there are several conditions that need to be satisfied for the receipt of a dividend to be exempt. In particular the dividend must be received by a company that is not small, fall within an exempt class, not be in respect of non-commercial securities or special securities and be such that no deduction is allowed in an overseas territory in respect of the payment.
The question as to whether the company receiving the dividend is small is settled by looking at the European Commission's definition. In our case the company itself was not small due to the presence of a large number of linked enterprises (other group companies) for which financial information relating to turnover, number of employees and gross assets must be shared under the rules set out in the Commission Recommendation.
There are several exempt classes of dividends. There are exempt classes for dividends from controlled companies, dividends in respect of non-redeemable shares, dividends in respect of portfolio holdings, dividends derived from transactions not designed to reduce taxation, and dividends in respect of shares accounted for as liabilities. In our case, the exempt class that seemed to apply most readily to the facts was the exempt class for controlled companies. Note though that we believe that the dividend payment to the company would also have fallen within the exempt class available to dividends paid on non-redeemable shares.
Under the exemption for controlled companies the conditions for the dividend to be exempt are satisfied if the recipient of the dividend controls the payer of the dividend. This was the case in respect of our client as the recipient of the dividend owned 100% of the ordinary share capital of the company making the payment.
There is anti-avoidance that applies to the controlled company exemption such that a dividend which would be exempt under first principles may still be charged to tax. The anti-avoidance bites if the dividend is paid as part of a scheme of which the main purpose, or one of the main purposes, is to secure that the payment of the dividend from the payer to the recipient falls within an exempt class. In addition the dividend needs to be paid out of pre-control profits (broadly profits of the payer prior to the payer being controlled by the recipient) for the anti-avoidance to apply to the transaction.
In our case we made the point to HMRC through the clearance application that we had no avoidance motive. The main purpose of the transactions was to facilitate repayment of an intercompany balance and the dividend payment was just one of a number of transactions designed to simplify the intercompany accounts within the worldwide group. HMRC agreed with this and also stated that they considered that the dividend was fully paid out of profits that had arisen after the payer had become controlled by the recipient. As such HMRC agreed that this anti-avoidance should not apply.
Securities of a company are non-commercial securities if the consideration given by the company under the securities for the use of the principal secured by them represents more than a reasonable commercial return for the use of that principal. As we were dealing with ordinary share capital of the paying company we did not consider that this would be in point. The definition of special securities covers a number of situations including those relating to convertibles, equity notes and securities the return upon which depend upon the profits of the company. Note of these situations were considered to be in point.
As the dividend was being paid between two UK tax resident companies it was obvious that the final condition would be satisfied and that no tax deductions in respect of the payment were going to be available in an overseas jurisdiction.
We applied for a non-statutory clearance from HMRC that on the basis that the proposed dividend payment would be an income distribution, that it would be treated as received by a company that was not small, would fall within the controlled company exemption, would not be subject to anti-avoidance, would not be paid on non-commercial securities or special securities, was not such that a tax deduction was taken overseas and would therefore be exempt from taxation.
HMRC gave us a very clear indication in writing that they agreed with all of the above analysis. In addition they were able to respond to our request within two days of us writing to them even although they had a time limit of 28 days for a first response. This acceleration of the timings was possible due to a good relationship that we had built with the Inspector that was in charge of our client from HMRC's perspective.
We were able to use the non-statutory clearance process to obtain a very strong clearance from HMRC that the dividend contemplated by our client would not be taxable and that the participation exemption should apply. This allowed our client to proceed confident in the knowledge that they had obtained agreement from HMRC in advance as to what the tax treatment would be. We obtained the clearance in a sufficiently short timeframe for it to be useful to our client even though HMRC had a much longer time limit in which to respond.
This is not the end of our story. There are some further areas of uncertainty that arise in relation to capital dividends. Broadly speaking the participation exemption above only applies to income dividends not capital dividends. This means that a taxpayer may be concerned that HMRC would try to treat their dividend as a capital dividend (subject to tax under other provisions) rather than an income dividend. There is also some well known analysis that works on the literal rule of statutory interpretation that can be taken to mean that any payment of a dividend by a UK company is capital rather than income in nature. In practice HMRC (and indeed most UK tax advisers, ourselves included) do not take this point as it is understood that it was never the intention of Parliament for all dividends to be taxed as capital dividends.
As our client wanted absolute certainty on the tax treatment of their dividend payment we addressed these concerns in a second round of correspondence with HMRC. In the next edition of Taxand's Take we will explain how we worked with HMRC to obtain certainty on these points for our client.
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