New rules were introduced from April 2016, to tax certain distributions on a wind up as income rather than capital. This legislation was introduced following a consultation on company distributions published in December 2015.
Income distributions on a wind up
Under the new rules, a distribution on wind up will be treated as income rather than capital where all of the following are met:
- immediately before the winding up, the individual has a share holding of 5% or more;
- the company being wound up is a close company (e.g. owned by five or less participators or controlled by any number of participators who are directors);
- the individual receiving the distribution, or a connected person, carries on a trade or activity similar to that of the company being wound up within two years following the distribution; and
- the main purpose or one of the main purposes of the winding up is the avoidance or reduction of a charge to income tax.
For companies with significant reserves, a tax rate of 32.5% or 38.1% could be due on a liquidation distribution taxed as a dividend under the income tax rules. This is assuming that the new £5,000 dividend allowance has been used against real dividends and that the individual receiving the dividend is a higher rate taxpayer.
Compared to the tax rates if treated as a capital gain of 10% (where Entrepreneurs’ Relief is available) or otherwise 20%, this could result in a significantly higher tax bill.
The taxpayer will be required to self assess whether the new rules apply and there are currently no procedures in place to apply to HMRC for clearance to obtain certainty.
Will HMRC stop there?
As part of the consultation on the new legislation highlighted above, HMRC also asked for comments on other company distributions on a wind up that are currently treated as capital. This included where either the company has retained profits in excess of the company’s commercial needs or a ‘special purpose company’ is set up for separate projects of the same trade.
It would appear difficult to see how HMRC could determine what constitutes excess profits in order to be able to tax these as income, however, there has been talk of reintroducing close company apportionment rules which were repealed in the late 80’s. Effectively this operated by notionally distributing undistributed reserves to the shareholders of a close company and subjecting them to an income tax charge.
Using separate companies for joint ventures on different projects with different partners is a common operating structure. The new rules introduced as highlighted above could prevent such commercial arrangements from being treated as a capital distribution on liquidations going forward.
What's next?
As part of the consultation HMRC also explored other distributions taxed as capital including:
- repayment of share capital which has been increased by way of a share reconstruction; and
Although HMRC said within the consultation document that they have “no current plans to introduce any further changes to the distribution legislation” we would not be surprised if they do look to introduce further restrictions in the future.
If you think you might be affected by the new rules or would like to discuss your operating structure based on the potential changes ahead, please get in touch with your usual tax contact.