1.Your manager has had a meeting with Gordon, the Group Finance Director of the Flame plc group of companies. Flame plc is quoted on the UK Stock Exchange. An extract from the memorandum prepared by your manager after the meeting, together with an email from him detailing the tasks for you to perform, is set out below.
Extract from the memorandum prepared by your manager
Flame plc is a UK resident company, which has annual taxable profits of more than £200,000. It owns the whole of the ordinary share capital of Inferno Ltd, Bon Ltd and six other companies. All of the companies in the Flame plc group are UK resident companies with a 31 March year end.
Flame plc – sale of Inferno Ltd
Flame plc purchased the whole of the ordinary share capital of Inferno Ltd on 1 March 2008 for £600,000. The value of Inferno Ltd has increased and Gordon has decided to sell the company. For the purposes of our work, we are to assume that the sale will take place on 1 January 2013. The budgeted taxable profits of Inferno Ltd for the nine months ending 31 December 2012 are £160,000.
The sale will be carried out in one of two ways:
(i) a sale by Flame plc of the whole of the ordinary share capital of Inferno Ltd for £1 million; or
(ii) a sale by Inferno Ltd of its trade and assets for their market value.
Gordon needs to know the tax cost for the Flame plc group of each of these options to help him in his negotiations. Inferno Ltd owns the following assets.
Note Cost Current market value
Equipment 1,3 100,000 60,000
Milling machine 2,3 95,000 80,000
Goodwill 4 Nil 530,000
Building-business premises 5 300,000 490,000
1. No item of equipment will be sold for more than cost.
2. The milling machine is an item of fixed plant and machinery that was purchased on 1 June 2009. Inferno Ltd claimed rollover relief in respect of the purchase of this machine to defer a chargeable gain of £8,500 made on 1 May 2008.
3. Capital allowances have been claimed in respect of the equipment and the milling machine. The tax written down value of the main pool of Inferno Ltd as at 1 April 2012 was zero. There have been no additions or disposals since that date.
4. The goodwill has been generated internally by Inferno Ltd since it began trading on 1 May 2003.
5. Inferno Ltd purchased the building from Flame plc on 15 March 2008 for its market value at that time of £300,000. Flame plc had purchased the building on 1 January 2004 for £240,000.
Flame plc – employee share scheme
Gordon is planning to introduce a share option scheme in order to reward the senior managers of Flame plc.
Bon Ltd – the grant of a lease
Part of the trading premises of Bon Ltd, a subsidiary of Flame plc, is surplus to requirements. Bon Ltd intends to grant a lease to an independent third-party company in respect of that part of its premises.
Bon Ltd – refund of corporation tax
Bon Ltd received a refund of corporation tax from HM Revenue and Customs on 1 June 2012. The company has not been able to identify any reason for this refund.
Email from your manager
(a) Draft the report to the Group Finance Director requested in the email from your manager. The following marks are available.
(i) Flame plc – sale of Inferno Ltd;
Notes for part (a)(i):
1 For guidance, approximately equal marks are available for calculations and explanations.
2 The following indexation factors should be used, where necessary.
January 2004 to March 2008 0·158
January 2004 to January 2013 0·338 (assumed)
March 2008 to January 2013 0·155 (assumed)
(ii) Flame plc – employee share scheme;
(iii) Bon Ltd – the grant of a lease.
Professional marks will be awarded in part (a) for the overall presentation of the report, the provision of relevant advice and the effectiveness with which the information is communicated.
(b) Prepare the summary requested in the email from your manager.
1 Flame plc group
(a) Report to the Group Finance Director of Flame plc
(i) Flame plc – sale of Inferno Ltd
Sale by Flame plc of the whole of the ordinary share capital of Inferno Ltd for £1 million
A sale of the share capital will result in a liability to corporation tax calculated as follows:
Market value of the premises as at 1 March 2008 300,000
Less: cost (240,000)
indexation allowance (IA) (£240,000 x 0·158) (37,920)
Less: cost (600,000)
IA (£600,000 x 0·155) (93,000)
Corporation tax (£329,080 x 26%) 85,561
Due to the unavailability of the substantial shareholding exemption, the sale of Inferno Ltd will result in a gain chargeable to corporation tax.
A degrouping charge will arise in respect of the building because it was transferred at no gain, no loss (Flame plc and Inferno Ltd are members of a capital gains group) within the six years prior to the sale of Inferno Ltd. Inferno Ltd will be regarded as having sold the building at the time of the no gain, no loss transfer for its market value at that time. Inferno Ltd’s base cost in the building, resulting from the no gain, no loss transfer, is the original cost to Flame plc plus indexation allowance up to 15 March 2008, the date Inferno Ltd purchased the building. The degrouping charge will increase the sales proceeds on the disposal of Inferno Ltd.
The corporation tax limits of Flame plc for the year ending 31 March 2013 will be divided by nine (Flame plc and eight subsidiaries), such that the upper limit will be £166,667 (£1,500,000 ÷ 9). Accordingly, because the annual taxable profits of Flame plc exceed £200,000, the chargeable gain will be taxed at the main rate of corporation tax.
Sale by Inferno Ltd of its trade and assets for their market value
A sale of the trade and assets will result in a liability to corporation tax calculated as follows:
Balancing charge on the sale of equipment and milling machine
((£60,000 + £80,000) – £0) 140,000
Profit on the sale of goodwill 530,000
Additional trading profits 670,000
Crystallisation of gain deferred on the purchase of milling machine 8,500
Chargeable gain on the sale of the premises
IA up to March 2008 (£240,000 x 0·158) 37,920
IA up to January 2013 (£277,920 x 0·155) (43,078)
Taxable profits 847,502
Corporation tax (£847,502 x 26%) 220,351
The excess of the sales proceeds (market value) of the equipment and the milling machine over the balance on the main pool will result in a taxable balancing charge.
The goodwill is a trading asset such that the profit on its sale will be additional trading income.
When a rollover relief claim has been made in respect of the purchase of a depreciating asset, as in the case of the milling machine, the deferred gain crystallises on the sale of that replacement asset.
The equipment and the milling machine are to be sold for less than cost. However, no capital loss will arise because capital allowances have been claimed.
As noted above, Inferno Ltd’s base cost in the building is the original price paid by Flame plc plus indexation allowance up to March 2008.
Inferno Ltd will cease trading when it sells its business on 1 January 2013. This will bring about the end of an accounting period. The corporation tax limits will be divided by nine (in respect of the number of associates) and multiplied by 9/12 in respect of the nine-month accounting period, such that the upper limit will be £125,000 (£1,500,000 ÷ 9 x 9/12). Accordingly, because the taxable profits of Inferno Ltd for the nine-month period are expected to be £160,000, the trading income and chargeable gains arising on the sale of the business will be taxed at the main rate of corporation tax.
(ii) Flame plc – employee share scheme
The tax advantages of an approved company share option plan (CSOP) over an unapproved scheme
1. With a CSOP, there would be no income tax or national insurance contributions liability on the grant or exercise of the option, provided it is exercised between three and ten years after it is granted. Whereas with an unapproved scheme, there would be a liability when the option is exercised.
2. With a CSOP, the whole of the employee’s profit on the shares will be subject to capital gains tax when the shares are sold. Whereas with an unapproved scheme, the excess of the market value of the shares at the time the option is exercised over the amount paid by the employee for the shares will be subject to income tax and national insurance contributions in the year the option is exercised; any subsequent increase in the value of the shares will be subject to capital gains tax when the shares are sold.
The advantages of capital gains tax over income tax and national insurance contributions are the availability of the annual exempt amount and the lower tax rates.
Suitability of a CSOP
Gordon wants to use the scheme to reward the company’s senior managers as opposed to all of the company’s staff. Accordingly, he needs to use a scheme that allows him to choose which employees are able to join. The two approved schemes that allow this are the CSOP and the enterprise management incentive scheme.
– The value of shares in respect of which an employee holds options cannot exceed £30,000.
– The exercise price of the shares must not be manifestly less than the value of the shares at the time of the grant of the option.
(iii) Bon Ltd – the grant of a lease
If Bon Ltd were to opt to tax the building, the proposed granting of the lease would be a standard rated supply rather than an exempt supply, such that Bon Ltd would have to charge value added tax (VAT) on the rent. A lessee that was registered for VAT and making wholly taxable supplies would be able to recover all of the VAT charged. However, some or all of the VAT would be a cost for a lessee that was not registered or one that was partially exempt and not within the de minimis limits.
(b) Refund of corporation tax
We should review the tax affairs of Bon Ltd in order to identify the reason for the tax refund.
If, as would appear likely, it is an error on the part of HM Revenue and Customs (HMRC), we should inform Bon Ltd that it should be repaid immediately. Failure to return the money in these circumstances may well be a civil and/or a criminal offence.
We should advise Bon Ltd to disclose the matter to HMRC immediately in order to minimise any interest and penalties that may otherwise become payable.
In addition, unless the money is returned, we would have to consider ceasing to act as advisers to Bon Ltd. In these circumstances, we are required to notify the tax authorities that we no longer act for the company, although we would not provide them with any reason for our action. We should also consider whether or not we are required to make a report under the money laundering rules.