In the exam you may have to deal with a number of different aspects relating to the disposal of shares and securities. These can include the following:
- Matching rules for disposals
- Treatment of bonus and rights issues
- Takeovers
- Qualifying Corporate Bonds
- Entrepreneurs' Relief
This article will deal with each of these issues in turn.
Matching rules for disposals
It is very common for individuals who are investing in quoted shares to have acquired them at different times. When some of the shares are being disposed of it is necessary to understand how the shares being sold are matched with the purchases made in order to calculate the gain or loss on the disposal. The matching order for individuals is:
- Shares acquired on the same day
- Shares acquired in the following 30 days
- Shares acquired before the disposal date which are treated as being a single asset or pooled together, effectively losing their individual identity.
Example 1 deals with the approach required where the matching rules need to be applied.
Example 1
Jess currently owns 6,000 shares in X plc. She has had the following transactions:
- 25 August 2013 Purchased 7,000 shares for £7,500
- 19 May 2014 Purchased 3,000 shares for £4,500
- 16 October 2017 Sold 8,000 shares for £15,000
- 31 October 2017 Purchased 4,000 shares for £8,000
Calculate the net chargeable gain on Jess’s disposal.
Solution
Jess makes the disposal on 16 October 2017 but also made a purchase within the following 30 days on 31 October 2017, so the first 4,000 shares sold will be matched with the subsequent purchase and the remaining 4,000 shares of the disposal will be matched with the shares held in the “Pool”. Therefore, 2 separate calculations are required to be prepared and the results aggregated together to calculate the net chargeable gain.
Disposal matched with the purchase made on 31 October 2017 (4,000 shares)
Proceeds 4,000/8,000 x £15,000 7,500
Less: Cost (8,000)
Loss (500)
Disposal matched with the “pooled” shares (4,000 shares)
Proceeds 4,000/8,000 x £15,000 7,500
Less: Cost – see Pool working (W1) (4,800)
Gain 2,700
Net chargeable gain on disposal: (500) + 2,700 = £2,200
W1 Pool Number Cost
25 August 2013 7,000 7,500
19 May 2014 3,000 4,500
10,000 12,000
Disposal (4,000) (4,800) 4,000/10,000 x £12,000
Carried forward 6,000 £7,200
Bonus and rights issues
A bonus issue is a free issue of shares by a company to its shareholders. A rights issue is where a company offers existing shareholders the right to buy additional shares. Both a bonus issue and a rights issue must be offered to shareholders in proportion to their existing shareholding. Since the bonus issue is a free issue there is no associated cost, whereas there is a cost with a rights issue as the shareholders are purchasing additional shares.
Both a bonus issue and a rights issue are treated as having been acquired at the same time as the original shares which gave the entitlement to receive/purchase the additional shares. From a computational point of view they are both treated as being additions to the Pool, the only difference being that there is no cost associated with the bonus issue.
Example 2
Fiona has the following transactions in X plc shares:
- 25 August 2013 Purchased 7,000 shares for £7,500
- 19 May 2014 1 for 2 bonus issue
- 16 October 2017 1 for 3 rights issue at £2.00 per share
- 31 January 2018 Sells 4,000 shares for £13,000
Calculate the chargeable gain on Fiona’s disposal
Solution
Applying the matching rules the disposal will be matched solely with purchases made in the Pool as there are no acquisitions made on the same day, nor in the following 30 days.
The Pool working will be as follows:
Number Cost
25 August 2013 7,000 7,500
19 May 2014 3,500 Nil 1 share for every 2 held at no cost
10,500 7,500
16 October 2017 3,500 7,000 1 share for every 3 held at £2.00 per share
14,000 14,500
Disposal (4,000) (4,143) 4,000/14,000 x £14,500
Carried forward 10,000 £10,357
The chargeable gain will be calculated as follows:
Proceeds 13,000
Less: Cost – see Pool working (4,143)
Gain £8,857
Takeovers
In a takeover situation, a company (Co A) is buying the entire shareholding of another company (Co B). The takeover can be made in a number of ways:
- Cash – Co A purchases all the shares of the Co B shareholders for cash giving rise to a complete disposal of the individual shareholder’s holding. This will be a chargeable disposal for CGT.
- Shares – Co A gives new shares to the Co B shareholders. This “share for share exchange“ is not a disposal for CGT and the new Co A shares take over the cost and history of the old Co B shares.
- Combination of cash and shares – the mixture of cash and shares will be a part disposal for CGT where there is a chargeable disposal relating to the cash element of the consideration but no disposal relating to the share element.
It is more common in the exam to have a takeover where the consideration is a combination of cash and shares.
Example 3
Charles purchased 2,000 shares in Castle Ltd in September 2010 for £6,000. Castle Ltd was taken over by X plc in January 2018. For every share Charles held in Castle Ltd he received the following:
- 1 share in X plc valued at £5.00
- Cash of £7.50
Calculate Charles’s gain in 2017/18.
Solution
As Charles has received a mix of shares and cash there will be a chargeable disposal relating to the cash consideration but no disposal relating to the share consideration. Where we have a part disposal the allowable cost is determined by using the formula:
A/(A + B) x original cost
A = cash received on the takeover
B = market value of the new shares received
In the exam it is always best to adopt a columnar approach to a computational takeover question as follows:
Consideration Original cost
Shares: 2,000 x 1 x £5.00 10,000 2,400
Cash: 2,000 x £7.50 15,000 3,600
£25,000 £6,000
In the first column enter the total market value of what Charles receives for his old shares as a result of the takeover. In the second column allocate the original cost of the old shares between the consideration elements in proportion to their market values. For the cash element of the consideration the original cost allocated will be:
15,000/25,000 x 6,000 = 3,600
which is exactly the same calculation as if we had applied the part disposal fraction of A/(A+B) to determine the allowable cost.
The chargeable gain on the cash consideration will then be calculated as follows:
£
Proceeds (first column) 15,000
Less: Cost (second column) (3,600)
Gain £11,400
There is no chargeable disposal at the date of the takeover on the receipt of the shares since the new shares take over the cost and the history of the old shares. The cost of the new X plc shares to carry forward will therefore be £2,400 (the figure in the second column allocated to the new shares).
Qualifying Corporate Bonds (QCB)
A QCB is where an individual is lending money to a company and will receive interest on the loan as opposed to purchasing shares and receiving dividends. The QCB will often be referred to as “loan stock” or “debentures”.
In order to be a QCB the loan stock must be:
- Issued after March 1984 (which is likely to be so in an exam question)
- Expressed in Sterling and cannot be converted into any other currency
From a CGT point of view a QCB is an exempt asset so that no gain is chargeable and no loss allowable on its disposal. If the loan stock does not satisfy the QCB conditions it will remain a chargeable asset and be treated in exactly the same way as a share.
QCB are frequently examined in the context of a takeover where part of the consideration offered is in the form of QCB as well as cash and shares.
On the receipt of a QCB on a takeover the gain arising relating to the QCB element of the consideration is calculated (as if cash had been received) but is not chargeable to CGT at the date of the takeover. The gain is “frozen” and becomes chargeable to CGT on the eventual disposal of the QCB (or part of the “frozen gain” if only part of the QCB is disposed of).
Example 4
Harry owns 1,000 £1 ordinary shares in Windsor Ltd which he had acquired May 2008 when he subscribed for them at par.
On 17 July 2017 X plc made an offer to the shareholders of Windsor Ltd and bought all of the share capital. The consideration for each Windsor Ltd share was as follows:
- 20 £1 ordinary shares valued at £7.50 each
- 10 £1 preference shares valued at £5.00 each
- £600 £1 5% loan notes valued at par
- £400 cash
Explain the CGT consequences to Harry of the takeover.
Solution
Applying the columnar approach adopted in Example 3 we will end up with the following:
Consideration Original cost
Ordinary shares: 1,000 x 20 x £7.50 150,000 125
Preference shares: 1,000 x 10 x £5.00 50,000 42
QCB: 1,000 x £600 x £1.00 600,000 500
Cash: 1,000 x £400.00 400,000 333
£1,200,000 £1,000
At the date of the takeover there is no disposal relating to the receipt of either the ordinary or preference shares. They will have costs to carry forward to be used in a subsequent disposal of the X plc shares of £125 and £42 respectively.
There is no indication that the loan note is not a QCB so we make the assumption that it fully satisfies the relevant criteria. At the date of the takeover we calculate the amount of the gain relating to the receipt of the QCB. The gain is not chargeable and is “frozen” and only becomes chargeable when the QCB is subsequently disposed of.
The “frozen gain” is: £(600,000 – 500) = £599,500
As the QCB is an exempt asset for CGT any movement in its value between the date of the takeover and its subsequent disposal is ignored.
The only gain chargeable immediately as a result of the takeover relates to the cash consideration received.
The chargeable gain is: £(400,000 – 333) = £399,667
The columnar approach adopted in Examples 3 and 4 is the best way of attempting takeover questions and will apply irrespective of the number of different types of consideration received.
Entrepreneurs' Relief (ER)
In order to be a material disposal in the context of shares and securities, and therefore be entitled to claim ER, 3 conditions need to be satisfied in the 12 month period up to the date of disposal:
- The individual making the disposal must be an officer or employee of the company
- The individual must have at least 5% of the ordinary shares and be able to exercise at least 5% of the voting rights in the company
- The company must be a trading company
Where ER is available the rate of CGT will be at a flat rate of 10% (subject to the lifetime gain limit of £10 million) irrespective of whether the individual is a basic, higher or additional rate taxpayer.
One of the trickier aspects of ER is where you have to deal with a takeover scenario. Where shares and/or QCB are received as part of the consideration we have seen there is no chargeable disposal at the date of the takeover. Shares will take the cost and history of the old shares whereas with QCB the gain is calculated at the date of the takeover but does not become chargeable until the QCB is subsequently disposed of.
At the date of the takeover there is a chargeable gain if any of the consideration received is in the form of cash. ER will be available on that gain if the 3 conditions noted above are satisfied in the 12 month period up to the date of the takeover. The entitlement to ER is therefore based on the original shares that were held by the individual.
In Example 3 above Charles had a chargeable gain of £11,400 relating to the cash consideration he received at the date of the takeover in January 2018. If he satisfied the 3 conditions in the 12 month period up to January 2018 the gain would qualify for ER and therefore be subject to CGT at 10%.
On the other hand the “share for share exchange” provisions mean that there is no chargeable gain relating to the share consideration received. The gain on a subsequent disposal of the X plc shares received on the takeover will only qualify for ER if Charles satisfies the 3 conditions in the 12 month period to the date of the disposal of those shares. It is unlikely that Charles will qualify for ER at that date if X plc is a quoted company as his holding is either less than 5% or he is neither an officer nor an employee of X plc.
There is an election available to disapply the “share for share exchange” provisions in order for the individual to take full benefit of the ER at the date of the takeover.
In Example 3 above if Charles would not satisfy the 3 conditions for ER on a subsequent disposal of the X plc shares the impact of the election would be to treat the receipt of the shares, as well as the cash, as a chargeable disposal at the date of the takeover. The chargeable gain would then become £19,000 (total consideration received of £25,000 less the original cost of the Castle Ltd shares of £6,000). The election would also have the impact of increasing the base cost of the X plc shares to their market value at the date of the takeover (£10,000) thereby decreasing the gain chargeable on their eventual disposal.
There is also a similar election available when QCB are received as part of the takeover. The impact of the election is similar to that for shares in that the calculated gain at the date of the takeover becomes chargeable at that date instead of being deferred until the QCB are subsequently disposed of.
The impact in Example 4 if the election for both the shares and the QCB was beneficial is that a chargeable gain of £1,199,000 (£1,200,000 - £1,000) would be subject to CGT in July 2017 and have an entitlement to the ER rate of 10% if the lifetime gain limit of £10 million is not exceeded.
When preparing for your exam ensure that have looked through the above topics in your study manuals and question banks and will therefore be able to answer any question that the examiner may set.
Good luck with your studies.
Hywel Jones
Tax Tutor
Kaplan Financial