Tax treatment of the final distribution of assets
For contractors contemplating winding up their company, the tax treatment of the final distribution of assets will either be income, ie a dividend or capital, subject to capital gains tax (CGT). The decision on how to treat the final distribution will depend on the contractors’ level of income and the value of the assets to be distributed, normally cash in the case of PSCs.
Where there are substantial assets to be distributed that, which if taken as a dividend, would plunge the contractor’s income into the higher rates, then capital treatment will be a preferred option where the gain qualifies for Entrepreneurs’ Relief. In this case the gain, after deducting the annual exemption (tax free allowance) of £11,100, will only be subject to 10% rather than the higher rate on dividends of 32.5%.
Where a company’s assets exceed £25,000, then a formal liquidation has to take place which will involve engaging the services of an insolvency practitioner and come at a cost.
Entrepreneurs Relief (ER)
To qualify for ER a number of conditions must be satisfied, namely that throughout the year ending with the disposal:
- the company is the individual’s PSC;
- the company is a trading company; and
- the individual is an officer or employee of the company.
Company distributions legislation
Budget 2016 announced measures to introduce a set of income tax avoidance rules aimed to stop shareholders of close companies turning income into capital so as to pay CGT rather than income tax and thereby make a substantial saving of tax.
Finance Act 2016 introduced sections 396B and 404A ITTOIA (Income Tax (Trading and Other Income) Act) 2005 which imposes a Targeted Anti-Avoidance Rule (TAAR). The TAAR will treat a distribution from a winding up as if were an income distribution, ie a dividend, where four conditions are met:
- Immediately before the start of the winding up, the individual has at least a 5% interest in the company, ie they must hold at least 5% of the ordinary share capital and 5% of the voting power by virtue of the shareholding.
- The company is a close company or was close at any time within 2 years before the start of the winding up. For small companies ‘close’ is likely to mean 5 or fewer shareholders.
- It is reasonable to assume, having regard to all the circumstances, that the main purpose or one of the main purposes of the winding up is the avoidance or reduction of a charge to income tax’ or
- It is reasonable to assume, having regard to all the circumstances, that the winding up forms part of the arrangements the main purpose or one of the main purposes of which is the avoidance or reduction of a charge to income tax.
- The circumstances include the fact that Condition C is satisfied.
Within 2 years after the distribution:
- the individual carries on a trade or activity which is the same as, or similar to, that carried on by the company;
- the individual is a partner in a partnership which carries on such a trade or activity.;
- the individual, or a person connected with him or her, is at least a 5% participator in a company which at that time carries on such a trade or activity, or is connected with a company which carries on such a trade or activity; or
- the individual is involved with the carrying on of such a trade or activity by a person connected with the individual
Condition D has been deliberately placed between ‘B’ and ‘C’ to emphasise the point that if there is a genuine non-tax motive for winding up the company then we do not have to consider condition C as it becomes irrelevant. For instance, retirement would be a perfect example of an initial motive that is not inspired by avoiding tax. The fact that the person gains a tax advantage from the closing down of the company is secondary to the main driver of retirement.
Martin is an IT contractor. Whenever he receives a new contract, he sets up a limited company to carry out that contract, as part of his strategy to escape IR35. When the work is completed and the client has paid, Martin winds up the company and receive the profits as capital.
Conditions A – C are met because Martin has a new company which carries on the same or a similar trade to the previously wound up company. It appears that there is a main purpose of obtaining a tax advantage. All of the contracts could have been operated through the same company, and apart from the tax savings it would seem that would have been the most practical option. Where the distribution from the winding up is made on or after 6th April 2016 it will be treated as a dividend and subject to income tax.
Evidence should be retained of the reason(s) for winding up the company, in the event that the individual unwittingly becomes involved in a similar trade or activity within the 2 year period following the final distribution and is challenged by HMRC.
It is important to note that it is not the date that the company is put into liquidation but rather the date the distribution is made that will determine whether the TAAR is relevant. Proceedings to wind up a company could therefore begin before 5th April 2016 but if the final distribution is not made until after that date, then the legislation has to be considered.
Whilst HMRC will not provide clearance for the TAARs they have added distributions on the winding up of a close company to the list of transactions in securities in section 684 Income Tax Act (ITA) 2007 for which clearance is available. Every time a distribution is imminent therefore, it would be prudent to seek advance clearance under section 701 ITA 2007 for peace of mind.
We are still awaiting HMRC guidance which is much needed as there are still many unanswered questions.
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