Liquidations and entrepreneur’s relief – proposed new rules
Today is the closing date for responses to a Government consultation on the tax treatment of company distributions. You can read the consultation document here.
The direction of travel, per the consultation, is clear. Anyone thinking of liquidating their company should consider these new rules carefully.
As with many recent changes to tax law, there is a fundamental point that under current rules capital returns to individuals generally receive a significantly preferential tax treatment from income returns. The top rate of CGT is 28%, but this reduces to 10% where entrepreneur’s relief applies (and can be reduced to 0% where certain other more bespoke reliefs apply). The top rate of income tax is 45%. Dividends tax is being reformed, but will fall between these two rates, with a top rate of 38.1% from April 2016. So, there is an incentive to structure a capital return where possible.
The Government is concerned that this incentive is “distorting normal commercial decision making and putting those who do not structure their affairs around the tax system at a competitive disadvantage”. The issues raised by this statement, in the context of the current public debate on the tax system, are for another day…
Specifically, the concern behind this consultation is the perceived risk that individuals owning incorporated businesses roll up income within the company (where it is taxed at say 20% corporation tax), and then return that “income” in capital form by for example liquidating the company, rather than declaring a dividend or paying a salary.
The Government takes the following view:
1. Selling out to a third party
Generally, the proceeds should be capital not income (there are already some exceptions here, particularly in certain cases where employment related securities are being sold). That is the case even where there is undistributed profit sat in the company, as long as there is an outright sale: “a fundamental change of ownership” (note that too much cash sat in a company could impact the company’s status as a trading company, which is necessary for entrepreneur’s relief).
2. Winding up/liquidation
This is more controversial for the Government. It points to:
(A) “Moneyboxing” – rolling up income in the company then distributing it in capital form on a liquidation, rather than as an income dividend.
(B) “Phoenixism” – rolling up income, liquidating the company, and then restarting the business in a new company shortly afterwards.
(C) “Special purpose companies” – similar to Phoenixism: where there is an SPV for each project, but where essentially each carries on a similar trade. [A practical difference with an SPV is that it is often necessary for all sorts of non-tax reasons – eg loan finance requirements and commercial risk issues].
3. Repayment of share capital
The repayment of share capital originally subscribed is and should remain capital. The Government is concerned about arrangements which can “create” new capital without actually investing fresh money.
4. Purchase of own shares (buy-backs)
Currently, the excess over the amount originally subscribed is already treated as income, but there is an exception for unquoted companies, provided certain strict conditions are met, in the context of removing a shareholder. The Government appears broadly content with these rules, but is concerned that they may become a new focus for tax planning in the light of the tightening up around the issues above and the increasing dividend tax rate. Watch this space.
So, what is going to change?
There are two sets of changes. The second set tightens up existing anti-avoidance rules, and is hard to argue with in concept, but the first set is potentially more wide-ranging:
1. TAAR
A new Targeted Anti-avoidance Rule (although one may disagree with whether it is sufficiently targeted), chiefly aimed at “phoenixism”.
Broadly, it is proposed that a distribution on a winding up should be taxed as an income distribution where:
(A) an individual is a shareholder in a close company and receives a distribution on a winding up;
(B) within 2 years after the distribution, he/she (or someone connected with him/her) continues to be involved (directly or indirectly) in the same or similar trade or activity (it needn’t be through a new company; it could be individually or through a partnership etc); and
(C) (having regard to (B)), the arrangements have a main purpose, or one of the main purposes of obtaining a tax advantage.
It remains to be seen what is meant by a “similar” trade or activity. It also remains to be seen how sensible a view will be taken on (C), because in the absence of a sensible view, (A) and (B) are very wide-ranging. There is currently no advance clearance process proposed.
If , as an individual, you use SPVs for your projects or are considering liquidating/winding up your business, but are not fully retiring, you should consider the proposed new rules very carefully. They are due to become law with effect from 6 April 2016, but may change between now and then as a result of the consultation process.
2. Tightening up of existing “transactions in securities” rules
There are already anti-avoidance rules aimed at counteracting schemes designed to turn income into capital. These will be “strengthened” and “clarified”. There will be a number of changes here. The more notable are:
(A) the “fundamental change of ownership” get-out will be toughened up. Where there is a sale to a third party of at least 75% of the shares in the target company, the transactions in securities rules do not bite (the logic being that that is a straightforward commercially motivated transaction and unlikely to be motivated by tax avoidance). There has been some debate around what is meant precisely by a change of ownership, in cases where the original seller(s) retain an economic or voting interest in the business by virtue of taking an interest in the buyer group structure, higher up the chain. The rules in this area are proposed to be tightened, so that beneficially ownership, direct or indirect, is the focus. This seems sensible, but will need careful analysis wherever the seller or an associate retains some interest (direct or indirect) in the business post-sale.
(B) a liquidation or a return of capital will be a “transaction in securities”, meaning that the rules can be applied to returns of capital and capital distributions on a liquidation (although the main change on liquidations is at point 1 above).
If you are selling your business, but intend to retain some kind of interest in the business (directly or indirectly) going forward, you should consider these new changes.