1.12 The Zim principle is not regarded as being applicable by HMRC as payments made under warranty or tax covenant claims are rights under contract. Therefore they need to be taken into account for the purposes of capital gains tax. They either represent taxable proceeds, or they represent a reduction in the base cost of the asset in question.
1.13 Therefore the tax analysis of a payment contractually due to the Company, (rather than the Buyer) under a tax covenant is as follows:
1.13.1 the receipt by the Company relates to a contractual right under the tax covenant. It therefore falls outside ESC D33 and is a taxable capital gains receipt for the Company; and there are no deductions to be offset against the receipt. Therefore the whole of the receipt will be subject to capital gains tax;
1.13.2 the base cost of the shares held by the Buyer is not reduced as the Buyer has not received any sum;
1.13.3 the payment by the Sellers still represents a payment within the terms of Section 49, so that the capital gains tax computation of the Sellers are reopened and recomputed by reference to the lower net proceeds. 1.14 If the tax covenant includes the Company as a party, then any amounts paid to the Company by the Sellers under the covenant will relate to contractual rights and not to Zim style rights. As contractual rights they will therefore fall outside ESC D33: the amounts will be taxable receipts, almost certainly without any base costs. 1.15 The possible benefit to the Buyer of having the Company as a party to the tax covenant (that possible benefit is the protection of the Buyer’s capital gain base cost) is no benefit at all if the company is a trading company and any gain on the disposal is therefore likely to be covered by the Substantial Shareholding Exemption for trading groups. 2.1 As a matter of general practice tax covenants are now normally between the Buyer and those Sellers who are to act as Covenantors. The Company is normally not expected to be a party to the tax covenant. This then avoids the problem set out above. 2.2 It is possible for the buyer to direct that the proceeds of the claim should be paid to the Company rather than him, should he so wish. This does not jeopardise the treatment set out in ESC D33 provided that the Company does not have any contractual entitlement to the claim under the tax covenant. For tax purposes the proceeds relate to the Buyer even if he directs that they are paid elsewhere. In such circumstances the proceeds have been constructively received by the Buyer. 2.3 Tax Covenants normally include a “grossing up” clause. This deals with the idea that the Buyer should be compensated if the amount that he receives under the Tax Covenant is taxable upon him. If the Buyer insists that the Company should be a party to the Tax Covenant with rights to receive amounts under that agreement, it is 2The Current Position
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