New tax rules could strike death knell for B share schemes

At face value owning shares in a company should be fairly straightforward. An investors buys stock at the prevailing market value, handing them rights to a portion of future earnings and dividends (if any) proportional to the size of the individual’s stake. But unique circumstances can leave some companies with surplus funds, such as life insurer Standard Life’s (SL.) September 2014 £2.2 billion sale of its Canadian division to rival firm Manulife (MFC:TO), or Vodafone’s (VOD) £84 billion sale of its stake in US mobile operator Verizon Wireless to Verizon Communications (VZ:NYSE), agreed in September 2013.

Both of these deals sparked massive cash returns to shareholders, £1.75 billion for Standard Life, a staggering £51 billion in Vodafone’s case, equating to 29p per share. With other hefty cash returns looking likely among UK quoted companies, we are going to look at one of the more quirky ways that companies facilitate cash returns – special purpose share arrangements, often referred to as B and C share schemes. For simplicity’s sake, in this feature we’ll just call them B shares. We will clarify how they work, why companies choose to issue them, and how their mechanics have recently changed, potentially torpedoing the usefulness of such schemes in future.

The first thing to say is that investors should not confuse B shares, or any form of ordinary shares, with preferred stock. Preferred shares are an entirely different type of security that gives their owners greater claims over dividend payments and places them higher up the priority ladder in the event of a company’s liquidation or bankruptcy.

B shares are one method used by UK companies to return excess capital to shareholders, spare cash in other words. According to Ian Lopez, a partner at corporate law firm Norton Rose Fulbright in London, there are three main ways to implement a B share scheme: an bonus issue of B shares, a share split, and the holding company route.

Three routes to B

A bonus issue of new B shares to holders of ordinary stock is made in proportion to their existing stake size and, says Lopez, is ‘the most usual B share scheme structure.’ No payment is required from shareholders as the new stock is paid-up using the company’s reserves.

Alternatively, B shares can be created by splitting the existing ordinary shares into two intermediate unclassified new shares, one becoming a new ordinary share, the other being reclassified as a B share.

‘If this method is adopted the B shares issued are not redeemable shares as a company cannot create redeemable shares from existing unredeemable share capital,’ points out Lopez.

Lastly, a new holding company can be used. This route involves a corporate reorganisation under which a new listed holding company (NewCo) is introduced as a holding company of the existing listed company (OldCo). The reorganisation is generally effected by way of a scheme of arrangement under the Companies Act 2006.

‘Under the scheme shareholders receive new ordinary and B shares in NewCo, with their shares in OldCo cancelled. Once the scheme is effective there is a reduction of capital by NewCo to create distributive reserves that can be used for the return of value,’ the lawyer explains. ‘The return is made via the B shares issued by NewCo and shareholders were given the option over the form of payment they will receive from their B shares, effectively boiling down as either as income or as capital.

But not any more. ‘Unfortunately, the complexity of the UK tax system makes it impossible to point to one route that offers the best outcome for all types of shareholder,’ says Jane Haxby, a partner and tax expert at corporate lawyer Squire Patton Boggs. ‘There has been a general perception that income is bad and capital is good but this is a gross over-simplification.’

Fundamentally, the value to shareholders of cash paid out by companies depends on the tax treatment of the payment. Private investors have in the past generally preferred capital treatment thanks to capital gains tax (CGT)-free allowances, whereas institutional shareholders will often be indifferent, or in some cases may prefer income treatment because of the different method for calculating charges by separate tax rates and rules.

How dividends are taxed

New rules

This, in the view of Her Majesty’s Revenue & Customs (HMRC), created an uneven playing field, and with government keen to clamp down on tax avoidance, HMRC has finally acted.

In December 2014, the government finally called time on the income/capital option for B share schemes when draft legislation was published. This was followed up with the introduction of the Finance Bill 2015 which has changed the law to tax all returns to shareholders through B share schemes as income. The new rules were put into effect from 6 April 2015, despite complaints from many tax experts that the Finance Bill was rushed through without enough parliamentary scrutiny due to the general election.

Although not specifically aimed at changes to B share schemes, concerns remain about the wider Finance Bill 2015. ‘Although draft Finance Bill clauses were published in December 2014 for most measures, it is highly unusual for them to be enacted in a pre-election period without proper debate,’ complained tax expert Heather Self of Pinsent Masons, the law firm behind the Out-Law.com website. Self’s concerns largely surround changes to a new diverted profits tax (DPT) designed to prevent avoidance by multinational companies and a new anti-avoidance measure on corporate tax losses.

End of B shares?

In the past, investors had three options in how they received returned cash, says Norton Rose Fulbright’s Lopez, ‘an income option, a immediate capital option and a deferred capital option.’

The lawyer believes this system offered two advantages. First, it keeps to a minimum the amount of the reserve the company needs to capitalise to create the bonus shares. ‘The B shares will have a nominal value equivalent to the amount to be returned but the C shares have a low nominal value,’ says Lopez. The other main benefit was a stamp duty saving. ‘As the B shares issued to satisfy capital elections are issued as redeemable shares they can be redeemed by the company saving stamp duty that will otherwise be payable on them if the shares were non-redeemable and were instead repurchased.’

What all investors are now left with is a straightforward income option regardless of professional or private investor status. In the past, where shareholders elect for an income receipt a dividend is usually declared on the B shares equal to the amount of value to be returned.

‘After the dividend has been paid the B shares automatically convert into deferred shares with limited rights and negligible value which can be repurchased by the company, or redeemed provided the B shares were not created from non redeemable shares, ‘says Lopez. ‘The dividend has to be paid from the company’s distributable reserves and under the Companies Act 2006, the company may only make a distribution out of profits available for that purpose.’

Whether companies follow the B shares route in future given the changes in the tax legislation remains to be seen. ‘There may still be occasions when these structures make sense from a company law perspective, says Squire Patton Boggs’ Jane Haxby, ‘but it is likely that this route for returning cash to shareholders will largely cease to be relevant.’

Steven Frazer Online Editor, Shares