Hastings-Bass was the solvent that unstuck a sticky IHT situation

Mon 22 May 2017

Power Adhesives Ltd. almost came unstuck when, under the guidance of their advisers, the Company adopted an inappropriate arrangement to remove the possible problem of having to repay a director’s loan account on death. The arrangement made, for non-tax reasons, would have created an IHT liability on an amount far greater than the loan itself. The case of Power Adhesives Ltd v Sweeney & Ors. concerned a director/shareholder (Peter) who owned 6,600 of the company’s issued share capital of £10,000, and was owed £490,000 by the company on his director’s loan account.

The facts

The Company was buoyant, with a balance sheet value of some £15m but the directors and shareholders had concerns about the possible detrimental effects to the Company should Peter die and the executors call in the loan: although the Company was prospering the directors considered that it might have difficulty funding repayment of the loan. Matters were brought to a head when Peter was diagnosed with cancer in December 2014 and as terminally ill in Spring 2015. Therefore, having taken advice, in April 2015 the directors arranged that the Company would issue to Peter new shares of a different class (“B” shares) from his existing shares with a nominal value of £490k, thereby cancelling the debt and removing the possibility of repayment being demanded on Peter’s death.
Peter died in July 2015 and only then was it realised that the effect of the debt to equity swap had been to:
• create a very substantial IHT liability on Peter’s estate;
• change substantially the relative interests of the Company’s shareholders (including two family trusts); and
• make a value-shift from the other shareholders to Peter.

IHT liability

No valuation was made of the market value of the Company’s shares when the B shares were issued and it was not until probate was obtained that the likely scale of the impact was became apparent. The amounts involved are not given in the case report but the proportionate shift in value can be appreciated because before the B shares were issued Peter owned 66% of the issued share capital: after, he owned a nominal £496,600 of the issued share capital of £500,000, i.e. 99.32%. On a balance sheet value for the whole company of £15m, the value of Peter’s shareholding would have been increased by around £5m, for a cost to him of £490,000. If the Company’s market value was higher than that ‘balance sheet value’ then so, proportionately, was the value of the B shares.

No business property relief on the new shares

Although the Company was a trading company for business property relief (BPR) purposes, Peter’s new B shares did not qualify for BPR at the time of his death because of the way in which the issue had been arranged. His estate could not take advantage of the fact that he was already a shareholder So the B shares were all taxable in full on Peter’s death and their value was market value, not their nominal value.
Potentially exempt and chargeable transfers by the other shareholders
To the extent that the other shareholders’ interests in the Company were reduced they made IHT dispositions:
• potentially exempt transfers (PETs) in the case of individuals;
• possibly chargeable transfers by the trusts.
The PETs may have been considered unlikely to fail and produce a liability, since the individuals concerned were much younger than Peter and in good health, while the transfers out of trust were covered by BPR.

Changes in interests of shareholders

The way in which the “B” share reorganisation was made significantly prejudiced the interests of the other shareholders; a serious company law issue. As majority shareholder Peter was exercising his power to diminish the interests of the other shareholders. The evidence presented to the Court was that this was not the intention of the directors, Peter included: the only purpose of the exercise was to replace the Company’s debt to Peter with a security of equal value that could not be compulsorily redeemed on his death.

CGT Value-shifting

Under the Taxation of Chargeable Gains Act 1992 (TCGA) where a person who controls a company exercises his control so that value is passed out of shares that he or a connected person owns, there is a CGT disposal to the extent that value has passed out of those shares. The other shareholders were connected with Peter, so they all made CGT disposals when the B shares were allotted because they did not receive new shares pro rata.
In this case the disposal, being of trading company shares could probably have been covered by gift hold-over relief (TCGA s 165) claim and so no liability was likely to arise.

The solution

The legalities of the arrangement were all formally correct and there was no dispute about the transactions being what the Company directors and shareholders wanted, based on the advice given by their advisers. Therefore the share issue was legally valid and they could not argue that it was void ab initio.
Therefore the Company had to apply to the court for a legal declaration that the transaction was voidable because the directors (Peter and others), had not taken proper steps to uphold the interests of the minority shareholders, a situation similar to that seen in the joined cases of Futter v Holt and Pitt v Holt.
The nub of these cases is that the Court has a discretionary power to set aside arrangements made by trustees or others who exercise a fiduciary duty where:
• they have failed to take proper care in exercising their fiduciary powers;
• the objects of those powers (e.g. beneficiaries or shareholders) would be unfairly disadvantaged; and
• it would be unconscionable for others who may have benefited from the transactions to retain their benefits.
Failure of fiduciary duty
The Judge had to think carefully about whether the Company’s directors had failed in their fiduciary duty as custodians of the Company for the benefit of its shareholders because, if they had taken all reasonable care he might have been obliged to deny them relief from the consequences of their actions. In this case the Judge concluded that, although the directors had taken professional guidance and were aware that their advisers had taken some trouble in advising them, they were responsible for taking more care, perhaps in the form of second opinions, before acting in reliance on the advice given (possibly a reasonable view, given that the advice contained errors at least as to the effects of the arrangements).
Disadvantage to the objects of fiduciary powers
That the objects of the powers suffered loss was relatively easy to see, since Peter’s estate would have been severely diminished by additional IHT liabilities had the share issue been allowed to stand and the other shareholders had lost out by the diminution of their stakes in the Company.
Denying the benefits of the transaction to other interested parties
The other interested parties in this case were Peter’s heirs and HMRC (who were required to be notified of the Company’s application to the court and might have objected to the B shares issue being made voidable on the basis that it would give rise to a tax advantage, i.e. a considerable reduction in the IHT payable out of Peter’s estate). HMRC did not oppose the application, which they would have been likely to do had they regarded the arrangement as avoidance and the court would not have granted relief if the only purpose had been to further a tax avoidance scheme.
What might have worked?
The problem stemmed mainly from the way in which the B shares were structured and issued. There were other possibilities that might have avoided creating additional IHT liabilities over and above that arising on the debt, and possibly even enabled the debt itself to be shielded from IHT. If the Company had issued fixed value securities or shares of equal nominal value to the debt Peter’s interest in the capital assets of the Company would not have increased and there would have been no value-shift for either IHT or CGT purposes. Preference shares would have been preferable because they could have qualified for BPR after two years had Peter survived.
An issue to all shareholders based on their shareholdings would, if taken up, have resulted in there being no value-shift for any purpose and might have been acceptable to HMRC as effectively converting the debt into share capital which represented a continuation of existing holdings: if so there would have been no two-year waiting time for BPR. We have to say “might” here because this is an area that depends on HMRC’s interpretation and their published view is that they may not regard shares or securities acquired under a rights issue as representing the same assets where take-up of a rights issue is selective and can create a tax advantage.  In the case of Vinton and others v Fladgate Fielder (a firm) and another shares were issued to an existing shareholder in a rights issue that was accepted as enabling the newly acquired shares to meet the conditions for BPR.