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Disincorporation and downsizing: Get the details right

Mark McLaughlin, co-author of ‘Incorporating and Disincorporating a Business’ (Bloomsbury Professional), looks at some important considerations for company owners when disincorporating their business.

1st May 2020
Tax writer Bloomsbury Professional
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These are difficult and worrying times, including for business owners. It was reported in the Financial Times last week that an extra 21,000 companies were dissolved in March 2020, compared to March 2019.

Sadly, the Covid-19 pandemic will cause the failure of many businesses. Some companies will cease trading, never to recommence. However, other companies will survive, although their owners may be forced to operate on a much smaller scale.

Crumbs Ltd and Bill

By way of illustration, Bill is the sole director and shareholder of Crumbs Ltd, a small catering business, which has traded in London since 2016. COVID-19 has forced the company to release its only two employees.

Bill is hopeful he can still earn a living for himself but would prefer the simplicity of owning and running the business personally.

This article looks at some important tax implications for Bill’s accountant to consider when advising him on disincorporating the company and operating the business as a sole trader.

Dispensing with the company

Disincorporation generally involves the transfer of the assets and liabilities of a business (ie including any goodwill, property, plant and machinery, stock and creditors) as a going concern to the shareholder(s), who then continue the business in an unincorporated form.

A distribution may arise through a formal or informal winding up, or it can be made by way of a ‘normal’ sale or distribution to the shareholders.

A members’ voluntary liquidation (MVL) is common in practice. An MVL is largely controlled by the company’s shareholders and can be used only where the company being liquidated is solvent (Insolvency Act 1986, Pt IV).

An MVL broadly involves the liquidator winding up the company, which (under a disincorporation) would entail the transfer of the business and assets to the shareholder(s), after paying off creditors. In our illustration, Bill decides that the company should be wound up.

Tax issues for the company

Until recently, a temporary disincorporation relief was available for small companies. The effect of this relief was that when a qualifying business disincorporated and its assets were transferred to individual company owners, there was no immediate corporation tax on chargeable gains that arose (on qualifying assets) within the company. However, for businesses to qualify the transfer had to take place between 1 April 2013 and 31 March 2018 inclusive.

The potential tax issues of disincorporation for Bill’s company include those outlined below.

  • Transfer of closing trading stock

As Crumbs Ltd is ‘connected’ with Bill (see CTA 2009, s 168), and Bill will continue to carry on the trade, the deemed ‘market value’ rule (in CTA 2009, s 166) will apply to the transfer of closing stock. However, in Bill’s case, it should be possible for the parties to make a joint election (under CTA 2009, s 167) to transfer the stock at its actual transfer value (or, if higher, the book value).

  • Capital allowances

No writing down allowances are given on plant and machinery in the final basis period, and a balancing adjustment is calculated. This is generally computed by reference to the actual transfer value of the plant and machinery, but market value is applied where the parties are ‘connected’, as in Bill’s case (CAA 2001, s 575). However, Crumbs Ltd and Bill may make an election (under CAA 2001, s 266) for the plant to be transferred at its tax written-down value instead (CAA 2001, s 267).

The industrial unit is being distributed to Bill in specie as part of the winding-up. In the case of fixtures, as no consideration is given (see CAA 2001, s 196, table item 3), the ‘disposal value statement’ requirement would need to be satisfied. A ‘pooling’ requirement also applies in relation to fixtures, whereby the availability of capital allowances to a purchaser of fixtures is generally conditional on the pooling of relevant expenditure prior to transfer. Otherwise, Bill’s qualifying expenditure for the fixtures would be deemed to be nil (CAA 2001, ss 187A–187B).

A joint election under CAA 2001, s 198 (‘Election to apportion sale price on sale of qualifying interest’) would neither be possible nor necessary for the fixtures because it is not a sale (at or above market value), nor the permanent discontinuance of the qualifying activity followed by a sale (CAA 2001, s 198(1)).

  • VAT

As a general rule, where a trade ceases the VAT-registered person is deemed to make a taxable supply of all the goods then held by the business. However, since the business of Crumbs Ltd will be transferred to Bill who will continue to carry it on as a sole trader, there should be no VAT on the transfer by virtue of the ‘transfer of going concern’ provisions (SI 1995/1268, art 5).

However, where land or buildings are being transferred in respect of which the transferor has made an election to waive exemption (ie has exercised the option to tax), the transferor is required to charge VAT at the standard rate unless the transferee has made a valid option to tax the relevant property before the transfer takes place.

To avoid any delays obtaining a new VAT registration, consideration could be given to electing to continue using the business’s existing VAT registration number (on form VAT 68), as the history of the business will be well known to Bill.

  • Capital gains on transfer of chargeable assets

Capital gains can arise when chargeable assets are transferred to the shareholder(s). The chargeable assets of the company are deemed to be disposed of at market value for tax purposes (TCGA 1992, s 17). Crumbs Ltd owned a small industrial unit. The property might be distributed to Bill in specie during the winding-up to avoid SDLT (see below). This would still trigger a chargeable gain, by reference to the property’s market value.

  • Stamp duty land tax

An SDLT charge may arise on Bill when the industrial unit is transferred to him on disincorporation. SDLT is generally charged on the consideration provided for the transfer; so if Bill bought the property from Crumbs Ltd, SDLT would be chargeable on the purchase price paid. However, consideration could be given to ‘distributing’ the property to the shareholder (Bill) in specie during the winding-up.

This will normally avoid any SDLT charge (see FA 2003, Sch 3, para 1), and generally ranks as a capital distribution in the shareholder’s hands. However, the assumption of any property loan/mortgage by Bill would represent ‘consideration’ for the transfer with a consequent SDLT charge, unless the debt is owed to Bill (see SDLTM04042). If the property is situated in Scotland or Wales, the equivalent taxes will need to be considered.

  • Intangible fixed assets

A corporation tax charge will apply to any gain arising on the transfer of business goodwill, on the chargeable gain arising on the disposal of any pre-1 April 2002 goodwill and on the profit (or ‘credit’) arising in relation to any post-31 March 2002 goodwill. However, in our example, the goodwill of Crumbs Ltd was internally generated post-31 March 2002 and does not feature on the company’s balance sheet.

The profit arising on the disposal of post-31 March 2002 goodwill is generally calculated as the excess of the disposal proceeds over the tax written down value (if any) of the goodwill. Disincorporation will normally result in a transfer of assets between ‘related parties’ (within CTA 2009, s 835), which is deemed to take place at market value for the purposes of the intangible fixed assets regime (CTA 2009, s 845).

However, in the case of Crumbs Ltd, the value of goodwill to be deducted from the deemed proceeds for the purposes of calculating the profit on disposal is nil, as the goodwill was internally generated and was not shown in a company’s balance sheet (CTA 2009, s 738).

Intangible assets other than goodwill (eg copyright and customer lists) also falling within the regime could give rise to a tax charge on disincorporation.

…and there’s more

The above list of tax implications is not exhaustive; there are other possible issues to address (e.g. closure of PAYE scheme). Each case needs to be considered on its particular facts. Of course, the non-tax legal and other considerations of disincorporation (e.g. company and commercial law) will also need to be scrutinised.

Replies (4)

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By Trethi Teg
02nd May 2020 07:32

I am not sure why Bill would want to do this. No benefit to being a sole trader - except a little, stress little - work with accounts, corp tax return etc. However, if this pandemic has taught us anything is how things can go horribly wrong. Therefore the concept of limited liability is more valuable today than 3 months ago. Why go through the above for little or no gain?

That said this is a good article and where disincorporation is required for non financial reasons e.g. some regulatory circumstances.

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Replying to Trethi Teg:
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By philaccountant
04th May 2020 10:16

Indeed, interesting reading but sounds like a total minefield for very little gain.

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By cfield
04th May 2020 14:23

Yes it would be more useful to have an article summarising the tax implications of winding up a company without a transfer of trade. This is going to be far more common, and is already in point for contractors shafted by the new IR35 rules. I know they've just closed the stable door for another year on this, but the horse has already bolted for many contractors.

A lot of these issues are still relevant, such as valuing the fixed assets and any remaining stock, both for tax and VAT purposes. It is worth noting, however, that VAT is waived on stock and assets if it comes to less than £1,000 (so valuations up to £6k are exempt) but there will be a claw-back of capital allowances on fixed assets, whatever their market value, if the AIA was claimed on them.

The stock and fixed assets should either be debited to the director's loan account at market value (typically whatever they would fetch on eBay) or paid on invoice, but if the company does invoice them, remember to deregister from VAT first.

There is no depreciation in the year of disposal. Just write the net book value down to nil, deduct the sale proceeds (or deemed market value) and debit the loss on disposal to P&L. It's not tax deductible but it will help to get retained profits down. Gains are unlikely when writing off fixed assets.

If there are savings accounts with fixed notice periods, call them in before you begin the wind-up. No point in paying early withdrawal penalties. P2P loans are quite common now. These are more problematical as the platforms have suspended their secondary loan markets. There might be a way of putting them in your own name and treating them as a sale of assets. The platform helpline may be able to answer this point. Hopefully they won't need a letter from the liquidator.

Directors who have legitimately furloughed themselves might wish to claim 80% of their average monthly salary up to 30/6/20 (or longer if the CJRS is extended) before they fold their companies. This can be claimed even if they have started a new job, so long as they remain on their own payroll and are still paying themselves the 80%.

They might even claim statutory redundancy pay based on age and length of service. This is tax free for the director but tax deductible for the company. You don't need a written employment contract for this. HMRC say in their manuals that they will accept redundancy pay for owner-directors up to the statutory amounts. Best to write a letter giving yourself the required notice though, and email it to your accountant. Maybe a board minute too. Otherwise, it might look a bit dodgy!

Terminal loss relief will be available if there were losses in the last 12 months of trading. These can include the aforesaid redundancy pay. You can go back 3 years with this so if losses are high they might get a substantial corporation tax rebate. So long as they can prove they were trading that year, of course! These claims should go through without a hitch if there was some turnover in the final year.

They might wish to take a last ditch dividend before they finally decide to cease trading in order to get retained profits below £25k and thus avoid the cost of a liquidator. You need to be careful with this as the £25k is before dividends taken in anticipation of a winding up. There need to be strong grounds for believing the business was still trading at the time, even if it wasn't generating any income. The director might well have been looking, or least hoping, for further contracts.

It's also worth taking at least £2k in dividends for 2020/21 to use up their tax free limit, plus any interest owed on their loan account up to the tax free limit. You can use an old CT61 form for this if you have one. A photocopy or print from a PDF will do. Otherwise, you can now order a CT61 online.

It might even be worth doing a last-ditch transfer of shares between husband and wife in order to utilise both their £12k CGT exemptions. Always document this on a Stock Transfer form.

Section 455 tax on overdrawn loan accounts is always a thorny issue on liquidations. HMRC insist on taking the full 9 months to repay this so it is bound to hold up the final dissolution. Always make sure the old loan is repaid by the year end (or at least by cessation of trading) and no new loans arise that cannot be repaid by salary or dividend within 9 months.

Of course, the only reason for having an MVL rather than filing Form DS01 yourself is to qualify for CGT treatment if your retained profits exceed £25k. Be very careful with this if you think you might end up contracting again in the next 2 years, or even doing the same line of work as a sole trader or in a partnership. Otherwise, HMRC could re-classify your final distribution as a dividend and hit you with a massive tax bill, plus interest and penalties. Even if you wait more than 2 years, there are anti-avoidance rules that might trip you up if they can prove your motives were less than pure.

Lastly, always pay off any taxes owed to HMRC, file the final CT600, deregister from VAT, close the PAYE scheme and get your loan account down to zero before handing over to a liquidator. I was told by a local ISP that overdrawn loan accounts can no longer be netted off final distributions. You have to repay them first, preferably before the liquidator takes over. He should be given a Balance Sheet with nothing on it except cash at the bank and retained profits.

All of this is worth a decent final fee if you're an accountant acting for an MVL client, or even a DS01 one. I ought to get a commission really. PM me if this post is really helpful and you think I deserve one!

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JPS Bookkeeping
By JPS-2004
11th May 2020 10:36

very interesting and extremely helpful - thanks

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