In certain overseas jurisdictions there are commonly used mechanisms in which subsidiaries hold shares in their parent companies as an intermediary step in a wider transaction. For example, in the US, “hook stock” (i.e. stock issued by a parent company and held by its subsidiary) is often utilised in various triangular merger structures.
Where the subsidiaries in question are incorporated in the UK, we are often asked to consider these structures from a UK tax and legal perspective. A common question is whether such structures are prohibited by Section 136 of the Companies Act 2006 (the “CA 2006”), which prevents a subsidiary from being a member of its holding company in certain circumstances. This article examines whether this section applies to overseas holding companies, and notes some of the wider issues.
Section 136 of the CA 2006 provides that “a body corporate cannot be a member of a company that is its holding company” and states that “any allotment or transfer of shares in a company to its subsidiary is void”, subject to various narrow exceptions (for example in relation to pension schemes or employees’ share schemes). The relevant definitions of “holding company” and “body corporate” expressly include entities incorporated outside of the UK. Therefore, at first blush, it appears that Section 136 prohibits UK subsidiaries from holding shares in their overseas parent companies.
However, Section 1(1) of the CA 2006 provides that “unless the context otherwise requires” the word “company” means a company formed and registered under the Companies Acts (i.e. the CA 2006 and its predecessors), that is to say: a UK company. Therefore, since Section 136 only prohibits a body corporate from being a member of “a company that is its holding company” and only voids an allotment or transfer of shares “in a company to its subsidiary” this section will only prohibit UK companies from holding shares in their overseas holding companies if it can be shown that the context of Section 136 requires the normal definition of “company” to be expanded: in other words, if the context of Section 136 does “require otherwise” in these situations, as Section 1(1) contemplates that it may.
There is a strong argument that Parliament’s inclusion of the word “company” in these provisions evidences a clear intention to exclude situations in which the relevant holding company is an overseas entity. We are aware of clients who have been challenged on this point in the past, including by revenue authorities, on the basis that the words “unless the context otherwise requires” in Section 1(1) allow the context of Section 136 to be taken into account, and that this Section is intended to apply in relation to all holding companies, whether or not incorporated in the UK. It is therefore important to consider the history of these provisions, relevant case law and the consultations that led to the provisions being adopted.
The provisions of Section 136 originate from the Cohen Committee Report of 1945. This recommended amendments which were eventually adopted by the Companies Act 1989, and carried over without any substantive changes into the CA 2006.
It is clear from this report that the amendments had two purposes:
1. to prevent directors of a holding company from maintaining themselves in office using the voting rights attached to shares held by a subsidiary, and...
2. to prevent the capital of the holding company from being indirectly depleted by the purchase of its shares by a subsidiary.
The second purpose, the maintenance of capital, was considered by Millett J in Arab Bank Ltd v. Mercantile Credit Plc . In this case the Court was considering the meaning of the same terms (i.e. “company” and “subsidiary”) in a similar formulation, although the case addressed a different issue, namely the scope of financial assistance under the Companies Act 1985. However, Millet J made several observations which apply to the interpretation of Section 136. In particular, he noted that “the capacity of a corporation, the regulation of its conduct, the maintenance of its capital and the protection of its creditors and shareholders are all matters for the law of the place of its incorporation” and that there is a presumption (unless a contrary intention can be shown) that UK legislation does not apply to foreign corporations whose acts are performed outside of the UK.
The CA 2006 was enacted following a consultation by the Department of Trade and Industry (“DTI”). The consultation document was published in 2000 and specifically considered the prohibition on a subsidiary holding shares in its parent company.
It noted that the prohibition “only applies to parent/subsidiary relationships. It does not prevent more complex reciprocal relationships which may disguise the fact that there is little or no “external” capital in any of the companies involved… We also suspect that attempts to close off all the potential scope for abuse would result in an overly complex set of provisions…and that reliance on disclosure is a better solution”.
In addition when Section 136 was discussed at the Commons Committee it was noted that although the clause had a long history there had been no lobbying of which the Committee was aware for any changes to the existing provisions. The Committee noted “It is probably true to say that this is one of those things that are best left alone unless there is another reason for consideration”. Accordingly the old provisions were adopted into the CA 2006 without any substantive amendments.
The above analysis suggests that, in general, Section 136 should not prohibit a UK company from holding shares in its overseas holding company, unless it can be shown that the context of Section 136 requires the normal definition of “company” to be expanded.
However, there are several strong arguments that the context of Section 136 does not require this:
The above analysis suggests that in general Section 136 of the CA 2006 should not prevent a UK company from holding the shares of an overseas holding company. However, the effect of Section 136 should always be considered in the light of the full facts. For example, if a UK subsidiary receives enough shares in an overseas parent to become that parent’s holding company, Section 136 may be breached, since the parent/subsidiary relationship will have in effect been inverted. In addition, it will always be necessary to consider the applicable law of the overseas parent company whose shares are being purchased by the UK subsidiary, as well as the laws applicable to the wider transaction and group.
Finally, it should be emphasised that even where Section 136 does not apply, it is still necessary to consider UK company law more generally (for example, in relation to corporate benefit, the maintenance of capital or financial assistance), as well as any other relevant regimes, for example applicable regulatory requirements or investment exchange rules. In addition, structures which entail circular ownership ownership may have adverse accounting, tax and governance implications, which will also need to be considered carefully before they are implemented.