Closing a company -- due to IR35 or not
It’s quite some time since contractors last felt the need to ask about liquidation, but the ContractorUK Forum shows that closing a company is once again on the minds of some PSCs, writes Gareth Wilcox, director at Opus Restructuring & Insolvency.
In the same short, sharp style that contractors are asking these questions, which are potentially motivated by the prospect of private sector IR35 reform leaving the limited company as a less viable contracting vehicle, we will raise and resolve them in this two-part guide exclusively for ContractorUK.
1. What is Liquidation?
Liquidation is a process whereby the affairs of a company are wound up by a liquidator, appointed by a resolution of shareholders, to deal with a company’s assets and distribute them, firstly to pay any liabilities and thereafter to a company’s shareholders.
Liquidation can be carried out on either a solvent or insolvent company, depending on whether it is capable of paying its liabilities. Our focus in this piece is on solvent liquidations, known as Members Voluntary Liquidations since it is the members (shareholders) who have the primary interest in the matter, as the persons who will receive the monies when any liabilities have been paid.
2. What is a Members’ Voluntary Liquidation?
A Members’ Voluntary Liquidation (‘MVL’) is a process used to wind up the affairs of a solvent company. Despite this, the process is defined by the Insolvency Act 1986 (‘IA86’) and can only be conducted by a Licensed Insolvency Practitioner.
An MVL is typically used where a company has come to the end of its useful life. For example, where an owner-manager or contractor has retired or entered full-time employment, or a business and/or its assets have been sold leaving only ‘a shell,’ or where a reorganisation has occurred.
The procedure is not appropriate where a company will be unable to pay its debts in full, (together with interest) within 12 months, which is the test of solvency. If the company cannot meet this requirement, then an insolvent liquidation would be required.
Likewise, if it is determined during a members voluntary liquidation that a company is, in fact, unable to pay its debts, then the liquidation would be converted into an insolvent one, and there are potential civil and criminal implications for the directors who swore the declaration of solvency which has proven to be false.
3. Why a Members’ Voluntary Liquidation?
The MVL process facilitates a controlled exit allowing the shareholders to realise their investment in a tax effective manner. There are often substantial tax advantages in conducting an MVL as the monies that will be distributed to shareholders represent a return of capital, on which capital gains tax is payable by the shareholder.
Where the assets of a company exceed £25,000, a distribution of capital can only be made by a liquidator, following the withdrawal of Extra-Statutory Concession 16 (ESC16) in 2012.
4. What is the alternative for my dormant company?
For a solvent, dormant company, the principal alternative is that the assets and/or cash held is transferred the shareholder(s) by way of dividends, and an application for dissolution is made when all assets are dealt with.
In order for dissolution to be appropriate, the following criteria must also be met:
- That it has not traded or sold off any stock in the last 3 months;
- That is has not changed names in the last 3 months;
- That it is not threatened with liquidation;
- That it has no agreements with creditors, e.g. a Company Voluntary Arrangement (CVA).
What are the drawbacks to applying for dissolution/strike-off?
As stated above, there are strict criteria to be met prior to an application, including dealing with all assets. If cash is extracted by way of dividend, this is often taxed at a higher rate than a capital distribution.
Whilst a UK taxpayer benefits from a level of dividend income being exempt from tax, the allowance has been reduced to £2,000 for the current tax year (2018-19) and there have been suggestions that it may be removed altogether in future. If a company has a substantial amount of cash, to withdraw tax-free income will take many years, during which accountancy fees and any other running costs will continue to be incurred.
The actual tax payable on dividend income on income over the £2,000 allowance is dependent on an individual’s income tax band, current rates are as follows:
- Basic rate (currently £11,851 to £46,350): 7.5%
- Higher rate (currently £46,351 to £150,000): 32.5%
- Additional rate (currently earnings over £150,000): 38.1%
In a situation where a contractor has entered full time employment, it is likely that they will fall into one of the higher bands and, therefore, the rate will be at one of the higher ones shown above.
In the unlikely event that there is no other taxable income received, an individual would be entitled to their tax-free personal allowance (currently £11,850) on dividend income.
For a full breakdown of tax consequences of an MVL, it is prudent for a shareholder to speak to their accountant prior to embarking on the process. For this reason, Insolvency Practitioners work closely with accountants and tax advisers, in order that all circumstances can be considered.
6. What are the tax advantages of MVL and what is Entrepreneurs’ Relief?
Distributions declared by a Liquidator are taxed as a capital distribution, which is tax on the capital gain, being the gain in the value of the shares compared with the amount which the shareholder initially paid for them. For example, if a shareholder were to receive a distribution of £1,000 on a share which they purchased for £1, that would represent a notional gain of £999.
The primary advantage for contractors is that, if the circumstances are correct, monies received as a capital distribution may qualify for Entrepreneurs’ Relief.
Entrepreneurs’ Relief is a tax benefit seeking to reward individuals who have invested in companies, allowing them to pay a tax rate of 10% on qualifying disposals. It is claimed as part of a personal tax submission for the period in which a capital distribution is received, and the following criteria must apply:
- The shareholder must own at least 5% of the shares;
- They must have been owned for at least one year prior to disposal (in this case liquidation);
- The assets must be distributed within three years of cessation.
7. What are the ‘anti-phoenix rules’ (Targeted Anti-Avoidance)?
The Targeted Anti-Avoidance Rules (TAARs) were introduced by The Finance Act 2016. They apply to distributions made to individuals on or after April 6th 2016 if all of the following conditions are met:
Condition A: The individual receiving the distribution had at least a 5% interest in the company immediately before the winding up
Condition B: the company was a close company at any point in the two years ending with the start of the winding up (that is to say it is a limited company with five or fewer shareholders, or a limited company of which all the 'participators' are also directors).
Condition C: at any time within the period of two years beginning with the date on which the distribution is made—
- the individual carries on a trade or activity which is the same as, or similar to, that carried on by the company or an effective 51% subsidiary of 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 a participator in a company in which he or she has at least a 5% interest and 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: it is reasonable to assume 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.
The TAAR rules were designed to prevent a shareholder from forming and liquidating a succession of companies in order to gain a 10% tax rate on each of them.
Essentially, this means that in order for Entrepreneurs’ Relief to be available, there must be a genuine reason for cessation, and no intention that a shareholder submitting a claim will carry on in the same, or a similar trade within the prescribed period of two years from the date that monies or assets are to be distributed. This includes as a sole trader, in partnership, or as the (5% or more) owner of a limited company.
As such, whilst a contractor entering into full-time employment with a limited company should qualify for Entrepreneurs’ Relief providing the criteria are met, this would not be the case if they were to become a shareholder of 5% or more of the shares in their new employer within two years of the capital distribution being made to them.
The rules also include a restriction that a person ‘connected’ to the individual cannot be participator in a company which carries on a similar trade or activity. The definition of a connected party is in accordance with s.989 of the Income Tax Act 2007, and broadly includes spouses, civil partners, relatives, and relatives of spouses/civil partners, but could also include business partners of a spouse/civil partner.
Whilst Conditions A and B are not difficult to prove (or disprove), the remaining conditions are wider and therefore subject to interpretation. It is important to note that all of the conditions must be met for the TAARs to apply.
HMRC has provided guidance and examples of how the TAARs are to be applied here: https://www.gov.uk/hmrc-internal-manuals/company-taxation-manual/ctm36300 although there is little legal guidance available since the first deadline for tax returns to include distributions made since 6th April 2016 (i.e. in the tax year 16-17) only passed in January 2018. As such, while the rules have been in place for two years, there is little clarity to date as to how HMRC will implement them in practice, apart from the rules themselves and taxation manual above.
8. What if I do not qualify for Entrepreneurs’ Relief?
Where Entrepreneurs’ Relief is not available, a UK individual will typically pay a rate of 20% on capital gains, so an MVL may still offer a substantial tax saving over taking dividend income.
It is important to note that if you engage an insolvency practitioner to assist with the liquidation of your company, they act for that company only and will not be in a position to provide the director/shareholder with advice on their personal tax position. Any specific queries regarding a director/shareholder’s personal tax position should be dealt with by their personal accountant or tax adviser.
Editor’s Note: This is part one of a two-part guide, by Opus Restructuring & Insolvency's director Gareth Wilcox, addressing the top questions contractors have about the process of shutting down a limited company. Part 2 will explore appointing a liquidator, MVL costs and director loan accounts, among other areas.