Time for plcs to put their house in order

The Budget provides impetus for restructuring major UK plcs, reports Richard Collier-Keywood

The Budget, together with the changes introduced by the Chancellor of the Exchequer last year, is likely to prompt a radical reform of the capital structures of major UK plcs.

Traditionally, UK companies have opted for modest levels of financial gearing; a study last summer by Union Bank of Switzerland indicated that the average net debt as a proportion of equity of UK companies is only 30 per cent, compared with more than 60 per cent in the US and Continental Europe.

A key reason for the low level of gearing in UK companies has been the imputation tax system, which has been in place since 1973 and has historically provided for a repayment of tax credits on dividend payments to investors with enhanced tax status, most notably UK pension funds.

Last year the Chancellor announced that where a dividend is paid on or after 2 July 1997, pension funds and most UK corporate shareholders would no longer be entitled to repayment of the associated tax credit, though certain other investors (for example, charities and PEP holders) would still be entitled to a repayment of tax credits on dividends until 6 April 1999. He also announced that the imputation tax credit for all shareholders would be reduced from 20 per cent to 10 per cent on that date.

These changes have fundamentally reduced the significance of the UK's imputation tax system and may encourage foreign jurisdictions to renegotiate double taxation treaties with this country, in view of the reduction in tax credits repayable to their residents.

In corporate finance terms, the changes have removed the tax subsidy available to institutional investors on dividend returns, with a resulting increase in the cost of equity. In contrast, the tax shield on debt (in the form of tax-deductible interest payments) remains unchanged.

Removing the in-built tax subsidy for equity will inevitably lead to increased levels of financial re-engineering as UK companies strive to increase the level of debt in their capital structures. Companies that fail to respond face an increased risk of being taken over by predators.

Share buy-backs are a widely recognised technique for gearing up companies, or increasing debt ratios, and have become more common in the UK in recent years. If, as a result of the recent Budget changes, UK companies decide to move to the gearing levels typical of US and Continental European companies, it would imply the need for pounds 100bn of share buy-backs, according to the Union Bank of Switzerland study. On this basis, the recent spate of share buy-backs in the UK is likely to be a drop in the ocean in comparison with what can be expected in future.

The abolition of advance corporation tax (from 6 April 1999), which was first announced in last year's Green Budget and confirmed in last month's Budget, will give further impetus to this. Following the abolition of refundable tax credits on share buy backs in October 1996, there was understandably a general reluctance on the part of companies to fund the Advance Corporation Tax (ACT) arising on the distribution element of a share buy-back. The abolition of ACT will remove this obstacle.

It was also announced in the Green Budget that the utilisation of surplus ACT carried forward to 1999 will be subject to a system of "Shadow ACT" designed to restrict the utilisation of surplus ACT carried forward to the post-ACT era in order to protect the cash flow of the Exchequer.

The new regime may encourage surplus ACT companies to structure their share buy-backs as a return of capital. This will help to preserve their capacity to utilise their real surplus ACT.

The UK's company law rules governing share repurchases are unduly complex and include a requirement to cancel any shares repurchased. This has led to increased lobbying recently for the UK government to introduce US-style buy backs. Companies in the US can buy back their own shares without cancellation, enabling these shares to be held in "treasury". These treasury shares can then be re-issued at a later stage when the need for additional equity arises.

The Budget changes to imputation tax credits and ACT are being introduced at time of increasing global competition and if UK companies are to sustain their ability to compete internationally, they will need to take stock quickly of their capital structures with a view to minimising their cost of capital.

The writer is a corporate and international tax partner at Coopers & Lybrand.