Companies in administration -- the new tax rules

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1 Page 1 Tolley's Practical Tax Newsletter/2004/Issue 2, January/Articles/Companies in administration -- the new tax rules - 25 PTN 2, 13 Tolley's Practical Tax Newsletter Your Fortnightly Guide To The Latest Tax Developments 25 PTN 2, January 2004 Companies in administration -- the new tax rules Companies In Administration Pete Miller is a director of corporate tax in Ernst & Young's Birmingham Transaction Tax unit. Bridget Walsh is a senior manager in Ernst & Young's London Transaction Tax unit. Both Pete and Budget work extensively with the Corporate Recovery team. Reed Elsevier (UK) Ltd 2004 Pete Miller and Bridget Walsh introduce changes in the tax treatment of companies in administration. The Enterprise Act 2002 (EA) came into force on 15 September 2003, and with it came the new tax rules for companies in administration, introduced by FA 2002 Sch 41. As this article was being written, further changes were announced in the Chancellor's Pre-Budget Report on 10 December This article explains those changes to a wider audience. Tax practitioners should generally welcome these, demonstrating as they do a sensible integration of changes to insolvency law with appropriate changes in tax law. Indeed, the most recent changes appear to be a direct response to representations on the new rules. Why were changes required? The EA introduced new provisions relating to corporate insolvency and, in particular, to company administrations. The changes, so far as we are concerned, relate to: changes to the way a company can enter or leave administration; and changes to the status of tax and social security liabilities. Other changes were made to clarify, for example, the duties of an administrator in respect of a company's tax liabilities in administration.

2 Page 2 Finally, there were some changes to the tax treatment of debt waivers in insolvency proceedings. Entering and leaving administration Previously, a company could only be put into administration by order of a court. Now that the EA is in force, an administrator can be appointed by the holder of a floating charge (EA Sch 16(14)) by the company itself or by the directors of the company. (EA Sch 16(22)) That is, a court order will no longer be required for the appointment of an administrator. It is also now possible for a company to leave liquidation and enter administration, on application by either the holder of a floating charge (EA Sch 16(37)) or by the liquidator. (EA Sch 16(38)) Finally, for our purposes, an administrator now has the power to dissolve a company, on application to the court, so that a formal liquidation is no longer required before dissolution. (EA Sch 16(84)) Tax in administration The EA has affected both the preferential ranking of tax payable by a company in insolvency, and also the responsibility for collection. Both of these are most likely to be matters for the administrator to deal with, but it is as well for tax practitioners to be aware of the changes: Preference Before the EA, when a company entered administration, unpaid tax and social security contributions were subject to Crown preference, effectively giving the Crown first bite at any assets of the company available to unsecured creditors. That Crown preference has now gone, so that debts due to the Revenue (ie all tax due from a company, not just corporation tax but, presumably, unpaid PAYE etc too), debts due to Customs and social security contributions now all rank as ordinary unsecured creditors for the purposes of companies in insolvency (EA s251). Collection The status of tax arising in administration is an area that has caused some confusion in recent years. The Revenue's old view, published by the ICAEW in June 1990, was that tax was not an expense of administration. However, the Revenue's view changed in recent years, although TR799 remains extant, so the position was somewhat ambiguous. The new insolvency rules supporting the EA's administration provisions clarify the responsibilities of administrators to pay corporation tax by bringing the responsibilities of administrators in line with those of liquidators. For liquidations, the case of Kahn and another (liquidators of Toshoku Finance UK Ltd) v IRC [2002] STC 368, amongst others, established that corporation tax is a 'necessary disbursement' of liquidation (SI 1986/1925). The same words are used with regard to administration expenses in the new Insolvency Rules (SI 2003/1730), so that corporation tax should also be a 'necessary disbursement' of administration. Accounting periods If tax arising in administration is to be an expense of administration, there has to be a mechanism for determining the quantum of tax arising in administration. Therefore, the commencement of administration now causes a new accounting period to start for tax purposes. (ICTA 1988 s12(7za)(a)) This permits the tax

3 Page 3 arising in administration to be separately computed. In contrast to the position in liquidation, however, where the corporation tax accounting periods are then annual from the date of appointment of the liquidator (ICTA 1988 s12(7)), there is no requirement to change the accounting reference date of the company. Therefore, future accounting periods in administration can follow the original accounting dates. Example 1 Company A has a normal accounting date of 31 December annually. An administrator is appointed on 17 August As a result, for corporation tax purposes the company's accounting periods will be 1 January to 16 August 2004 before administration and 17 August to 31 December 2004 after the appointment of the administrator. Accounting periods will then be to 31 December annually while the company remains in administration. When an administration ceases, a new accounting period must start for tax purposes (FA 2003 Sch 41(1)(5)), whether the company comes out of administration and recommences to trade normally or goes from administration into winding up. Example 2 Company A remains in administration for 16 months, and a liquidator is appointed on 10 October The accounting period in administration will therefore be 1 January 2005 to 9 October The next accounting period will be the first liquidation accounting period, 10 October 2005 to 9 October Accounting periods will then be annually to 9 October until the company ceases to be in liquidation (either by striking off or returning to administration). Finally, in this context, when a company comes out of liquidation into administration, a new accounting period must start. Again, this permits proper computation of the tax due as an expense of liquidation or of administration. Example 3 Company A remains in liquidation for only three months, and a court order appointing a new administrator is granted on 14 January The accounting periods are therefore 10 October 2005 to 13 January 2006 in liquidation, then 14 January to (presumably) 31 December 2006 in administration. If the company had been in liquidation for some time, so that liquidation accounts had been prepared to 9 October for a number of years, the post-liquidation accounting periods would end on 9 October annually unless the administrator changed the accounting reference date. These changes may have some implications for group relief claims, as tax losses may only be offset against profits arising in other group companies in the same accounting period or in the overlapping parts of non-coterminous accounting periods (ICTA 1988 s403a). The fact that administration crystallises a new accounting period also means there is less flexibility for offsetting trading losses against capital gains. They are also likely to increase the workload of the administrator, as new accounts will be required (at least for tax purposes) at a time when business needs should be paramount. Tax payments

4 Page 4 The tax rules at ICTA 1988 s342 allow companies in liquidation to self-assess early and to make their self-assessment based on the corporation tax rates for the previous financial year. This facilitates the removal of the company from the register at the end of liquidation. These rules now extend to administration, to give the same tax treatment where the administrator exercises the power now given to strike a company off under certain circumstances (ICTA 1988 s342a). Loan relationships: Pre-FA 2003 position If a creditor company is in liquidation or administration, and interest is accruing to it from another group company, the normal rule is that the creditor is taxed on that income, regardless of whether it is actually paid. If, however, both companies are in liquidation or administration, it is obviously anomalous that the creditor company should be taxable on income it will never receive (which principle was established by the Toshoku case). So FA 1996 Sch 9(6A), introduced by FA 2002, over-rode the rules applying to loan relationships between connected companies while creditor (lender) companies are in insolvent liquidation or where an administration order is in force. These rules meant that a lender in insolvent liquidation, or subject to an administration order, were not taxed on any income from connected parties that accrues after the date the liquidation or administration commenced. No relief was available where the income accrued before the commencement of liquidation or administration. FA 2003 changes The FA 2003 changes firstly reflect the new EA provisions, whereby a court order is no longer required for the appointment of an administrator (FA 2003 Sch 41(4)(2)(a) and (3)). Put simply, references to a company being subject to an administration order are replaced by references to a company being in administration. FA 2003 also added a restriction that was not there previously. Originally, paragraph 6A applied to companies subject to an administration order. Post-FA 2003, it only applies to insolvent administrations (FA 2003 Sch 41(4)(2)(b)). This may reflect a policy intention that the relief should only be applicable in insolvency, not in solvent liquidations or solvent administrations. Example 4 Company B enters administration on 24 September 2004, a time 'when its assets are insufficient for the payment of its debts and other liabilities', so that it is in insolvent administration (FA 1996 Sch 9(6A)). Company B is owed 1 million by its parent company, Company C, and would be receiving interest at 5.5%, but for the fact that Company C also cannot afford to pay. Therefore, Company B, as a connected party re Company C, would be taxable as receiving interest of 55,000 annually. However, since Company C is unable to pay any interest, the effect of the amended paragraph 6A is that the relief applies and Company B is not charged to tax in this interest. However, this provision appears to give the result that the relief will cease to be available if a company comes out of insolvent liquidation or insolvent administration into solvent administration or out of administration altogether. Example 5 Company B eventually recovers and the administration ends. The sums due from Company C are still unpaid

5 Page 5 and are not likely to be paid for some time, if ever. However, the accrued interest was not written off or waived. Company B is not taxable on the accrued interest arising in the period of insolvent administration. However, since paragraph 6A no longer applies. Company B is chargeable to corporation tax on future interest accruals, even if Company C continues to be unable to pay. These changes apply to companies in insolvent liquidation or insolvent administration immediately before 9 April 2003, and to companies that go into insolvent liquidation or insolvent administration on or after that date (FA 2003 Sch41(5)). FA 2004 changes The Pre-Budget Report on 10 December 2003 introduced some further amendments in this area, following representations on other anomalies highlighted by the FA 2003 changes. First, a new category has been introduced to paragraph 6A, that of 'insolvent administrative receivership' (FA 1996 Sch 9(6A)). Secondly, there is an extension to the rules preventing debt waivers by creditor companies from generating taxable credits in debtor companies has been extended (FA 1996 Sch 9(5)). Previously, debt waivers generated taxable credits unless the release was part of a 'relevant arrangement or compromise' (broadly, arrangements under either the Insolvency Act 1986 or Companies Act 1985 s425), or the creditor and debtor were connected. The new rules retain these exceptions and add two more: where the creditor becomes subject to insolvency proceedings as mentioned in paragraph 6A (insolvent liquidation, etc.) and, although the creditor and debtor were connected before that event, they are not connected after it, no taxable credit accrues to the debtor on the loan waiver (FA 1996 Sch 9(5)): Example 6 Company A owns Company B, Company B owes Company A 1m, Company B goes into insolvent administration and therefore cannot afford to repay the debt. A third party wants to buy B but wants the debt waived prior to acquisition. Prior to the new rules a waiver by A may have given rise to a taxable credit in B. B, being in administration, would have crystallised a new accounting period and there was a risk that A and B would not have been connected in the accounting period when the waiver took place (i.e. if B being placed in administration resulted in control being broken). Under the new rules the waiver will not result in a taxable credit in B. where the parties are not connected, and the debtor becomes subject to insolvency proceedings as mentioned in paragraph 6A (insolvent liquidation, etc.), no taxable credit accrues to the debtor on the loan waiver (FA 1996 Sch 9(5)). Example 7

6 Page 6 Company A goes into insolvent administrative receivership, owing Company B, an unconnected third party, 5.5m. Company B agrees to waive 4m of the debt. Company A will not be taxed on the waiver of the 4m debt, under the new rules. Company B would presumably still be able to claim bad debt relief under paragraph 5(1). These new rules are introduced with immediate effect, i.e. for all loans released on or after 10 December The 'proper officer' For companies in administration, it has always been unclear whether the administrator is the 'proper officer' for the purposes of TMA 1970 s108. Henceforth, the administrator will be the proper officer. If there are joint administrators, they may give a joint notice to the Revenue specifying which of them is to be the proper officer, and if they do not give such a notice, the Revenue may choose (FA 2003 Sch 41(2)). Conclusions Those of us who work closely with insolvency practitioners have a short while to acquaint them with the new rules. They are mainly likely to be concerned with the changes to their duties as administrators, as they will now have specific legal responsibilities to the Revenue, unlike the previous situation. Given that tax is now clearly an expense of the administrator, the fixed charge holders they represent are also likely to take this into account when evaluating the most appropriate Insolvency procedure given the Revenue's ranking as a creditor. For the rest of us, the changes are probably relatively minor, albeit interesting as an example of tax policy being driven by legislative changes elsewhere. The information in this article is intended to provide only a general outline of the subjects covered. It should neither be regarded as comprehensive nor sufficient for making decisions, nor should it be used in place of professional advice. Ernst & Young LLP accepts no responsibility for loss arising from any action taken or not taken by anyone using this publication.