Goodbye ESC C16; Hello ESC C16
When individuals die, their affairs are “tidied up” by executors. The executors ingather the deceased’s assets, pay the outstanding liabilities and distribute the surplus to the beneficiaries in accordance with the terms of the will.
Companies have executors too
A similar procedure exists with companies, writes Gerry Brown, technical manager of Tax and Trusts at Prudential. A liquidator fulfils a similar role to the executor, except that the liquidator acts immediately before death rather than after death. When trading permanently ceases and the company is no longer needed, a liquidator can be appointed. The liquidator ingathers assets, converts them to cash, pays liabilities and distributes the surplus to shareholders.
The reality, and often the problem, is that liquidators need to be paid. The liquidation (winding up) process involves a number of time-consuming formalities and these can result in significant fees, thus reducing the amount available for shareholders. HMRC has suggested a cost of £7,500 to wind up “a small business with straightforward affairs”.
Fortunately, a simplified procedure has for a long time existed for winding up companies where there is a surplus of assets. Here, the company can be “struck off” on application to the Registrar of Companies. Legally this procedure does not amount to liquidation (winding up).
The current tax consequences for shareholders
Payments to shareholders during the course of a liquidation are capital and subject to capital gains tax. Shareholders like this treatment; the annual exemption (currently £10,600) may be available and the maximum rate of tax is an attractive 28 per cent.
Payments to shareholders outside the framework of a formal liquidation are dividends and subject to income tax at the dividend rates (10 per cent, 32.5 per cent or 42.5 per cent, with an associated tax credit and depending on the recipient’s other income).
So from a tax viewpoint, capital treatment is clearly going to be preferred. But the problem is that, legally, a “striking off” does not amount to a liquidation and so capital treatment wouldn’t be available in such situations.
ESC C16 - Background
This is where extra statutory concession ESC C16 came to the rescue. This concession allowed distributions prior to a “striking off” to be treated as capital. This approach worked satisfactorily for many years. There were no significant objections from the parties involved: shareholders, accountants, HM Revenue & Customs and the Registrar of Companies.
The hidden fly in the ointment is that ESC C16 is – as the name implies – a concession. In 2005, the House of Lords held that HMRC’s function was to administer the existing law and not make a new law by implementing concessions. While this analysis is, no doubt, constitutionally correct, it does impose additional costs on the owners of small and micro businesses wishing to bring them to an end. Arguably these costs are wasted; it is difficult to see a corresponding benefit.
New legislation from March 1st 2012
The taxman’s solution to this self-inflicted problem is to bring what was ESC C16 into the UK tax code. The concession has been ‘transmogrified into legislation’, to use advisor parlance.
So we will soon have a legislated ESC C16, albeit with a distribution limit of £25,000. This means that if a company’s distributions in the winding up are £25,000 or less, “capital treatment” will apply – whereas distributions in excess of £25,000 will be treated as income in the shareholders’ hands.
Planning should start now
Those company owners wishing to take advantage of “capital treatment” will need to ensure that the amount to be distributed in the striking off process does not exceed £25,000. One way of achieving this, without incurring a tax charge, would be to make pension contributions on behalf of employee-shareholders. Such contributions would need to be made before trading ceased, to ensure that they were deductible in arriving at the company’s taxable profits. Specialist advice is essential.