Why distributions on winding-up never looked so taxing
Last week’s Finance Bill 2016 gave more detail of the changes to the taxation of company distributions -- an area which was ominously foreshadowed for reform in the 2015 Autumn Statement, writes David Whiscombe, partner at tax advisory BKL.
Although the following analysis is based on the only limited HMRC guidance available so far and the bill’s proposals (which may be changed before passing into law), it is clear that these changes will impact the way in which the proceeds received by a shareholder on the liquidation of a company will be taxed.
Who is potentially affected?
Any individual receiving a distribution on a winding-up of a company. This includes a contractor who is the sole employee and company director winding up their PSC.
What is changing?
At present, the general rule is that (unless certain anti-avoidance legislation is invoked by HMRC) any distribution in a winding-up is charged to Capital Gains Tax (CGT) in the hands of an individual. The rate of tax may be as low as 10% (if Entrepreneurs’ Relief is available) and will be a maximum of 28%.
Under the new proposals, distributions will in some common circumstances be chargeable instead to Income Tax, at rates ranging up to 38.1%.
When will the changes come into force?
The rules will apply to distributions made after 5th April 2016 (regardless of whether the liquidation commences before or after that date).
What distributions will be caught by the new rules?
The rules will apply if three conditions are all met. The conditions are broadly as follows.
Condition One
The company is a "close company" (or has been such a company within the previous two years). This will include most privately-owned companies.
Condition Two
Within two years after the date of the distribution, the individual receiving the distribution (or someone connected with him or her) is involved in carrying on any trade or other activity previously carried on by the company (or any similar trade or activity); this could for example be as sole trader or via a partnership LLP or new company.
Condition Three
It is reasonable in all the circumstances to assume that one of the main purposes of the liquidation (or arrangements of which the liquidation forms part) is the avoidance of Income Tax. For this purpose the fact that Condition B is met is regarded as a relevant circumstance.
Are there any exclusions?
There is no charge to Income Tax to the extent that the amount distributed
- does not exceed the amount originally subscribed for the shares or
- is itself a shareholding in a subsidiary company.
In either case there may, as under the current rules, be a charge to CGT.
Examples
Contractor Joe has carried on business through his company for many years. On reaching retirement he sells the shares in the company.
Joe is not affected by the new rules: they apply only in a liquidation.
Contractor Ben has carried on business through his company for many years. On retirement the company sells the business and is wound up with cash being distributed to Ben.
Ben is not affected by the new rules: he is not involved in any trade or activity previously carried on by the company or any similar trade or activity.
Contractor Ian has carried on business through his company for many years. The company sells the business and is wound up with cash being distributed to Ian. He uses the cash to start a sole trade in the same line of business.
Ian may be affected by the new rules such that the cash distributed in the winding-up is charged to Income Tax.
Former contractor Jon owns a family property investment company. He winds up the company and distributes the investment portfolio to the shareholders who continue to operate the property investment business as a partnership.
Jon may be affected by the new rules such that the value of the properties distributed in the winding-up is charged to Income Tax.
Final thought
If the pressures of paying the mortgage, the food bill, the ex-spouse or whatever means that in practice you end up paying out more or less all the company’s earnings as you go, these changes are not going to affect you. If you’re in the minority of contractors able to accumulate substantial amounts within your company, you may need to re-think your end game, with the help of your accountant or financial adviser.
Editor’s Note: Related Reading –
Contractors, don’t be outlaws like the Robin Hood directors