Disincorporation part 2: Get the details right
Mark McLaughlin, co-author of ‘Incorporating and Disincorporating a Business’ looks at further important considerations for company owners when disincorporating their business.
Disincorporating a business has tax implications for the company and its shareholders. In part one of this series, I looked at tax implications for the company. In this article, I examine the tax implications for individual shareholders.
The story so far
Continuing the example of Crumbs Ltd and Bill, it was decided by Bill (as the sole director and shareholder) to have the company wound up. The liquidator will distribute the catering business to Bill so that he can operate the same business as a sole trader.
Distributions on winding up
The distribution of assets to shareholders under a formal winding-up generally falls to be treated as a capital distribution, in consideration of the disposal (or part disposal) of the shareholders’ shares (TCGA 1992, s 122(1)).
Entrepreneurs’ relief may be available on capital distributions if the relevant conditions are satisfied. Otherwise, the capital distributions will attract CGT at either 10% or 20%, depending on the shareholder’s income and other gains in the tax year of distribution. In our example, Bill will need to ensure that the entrepreneurs’ relief conditions are satisfied when the distributions are received in the winding-up.
However, this tax treatment is subject to anti-avoidance provisions, which could result in the company’s shareholders being treated as receiving income for tax purposes instead of capital gains.
The anti-phoenix TAAR
A targeted anti-avoidance rule (TAAR) is designed to prevent ‘phoenixism’. This is broadly when company owners wind up their ‘old’ companies, extract profit reserves as capital and shortly thereafter engage in a similar business.
A distribution is caught by the TAAR if four conditions: A to D (summarised below) are all satisfied, (ITTOIA 2005, s 396B):
A. The individual receiving the distribution had at least a 5% interest in the company immediately before the winding up;
B. The company is a close company when it is wound up or at any point in the two years ending with the start of the winding up;
C. The individual continues to carry on, or be involved with, the same trade or a trade similar to that of the wound-up company at any time within two years from the date of the distribution; and
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 an income tax charge, or that the winding up forms part of such arrangements.
Tax avoidance motive?
In our example, conditions A, B and C are all met. But what about condition D; is it ‘reasonable to assume’ that income tax avoidance or reduction was a main purpose of the disincorporation?
The disincorporation is taking place because Bill was forced to downsize the business following the COVID-19 outbreak. On the face of it, avoiding or reducing an income tax charge was seemingly not the main purpose of winding up Crumbs Ltd. However, the test is a subjective one, and HMRC may well take a different view.
Unfortunately, HMRC does not offer a clearance procedure on whether the TAAR applies. However, HMRC guidance in its company taxation manual (CTM36340) lists several matters that are likely to be relevant when considering whether the TAAR applies.
Transactions in securities
The transaction in securities (TIS) provisions for income tax purposes (ITA 2007, Pt 13, Ch 1) must also be considered in relation to transactions involving the company’s individual shareholders.
Where (as in Bill’s case) the company’s business is being transferred into the personal ownership of its shareholders, there is a risk HMRC may seek to counteract the ‘tax advantage’ from the liquidation/dissolution (i.e. extracting the reserves of Crumbs Ltd in an income tax-free form as a capital receipt) under ITA 2007, s 684.
The practical application of the TIS rules depends on HMRC’s interpretation of the facts in each case. For example, HMRC is likely to challenge cases where it suspects the shareholders have only disincorporated to extract the company’s reserves at a beneficial CGT rate (possibly assisted by entrepreneurs’ relief).
On the other hand, where all (or substantially all) of the company’s funds need to be re-invested in the successor sole trade/partnership business, HMRC might be inclined to take a more benign approach. The overall tax costs of the disincorporation may also be a significant factor in HMRC’s deliberations.
Shareholders requiring certainty for TIS purposes on the tax treatment of the capital distribution could consider applying for advance clearance under ITA 2007, s 701 to confirm HMRC’s agreement that no counteraction notice ought to be given in respect of the disincorporation.
Unfortunately, HMRC’s position is that if clearance is given under ITA 2007, s 701, it does not also cover the ‘anti-phoenix’ TAAR. However, some tax advisers take the view that a section 701 clearance is a strong indicator that it would not be reasonable to assume avoiding or reducing an income tax charge was a main purpose of the distribution.
In our example, Bill owned 100% of Crumbs Ltd. After disincorporation he still owns 100% of the same business, so there should be no change for IHT purposes, but that is not necessarily the case.
To qualify for business property relief (BPR) Bill needs to have owned the business for a continuous period of at least two years (IHTA 1984, s 106).
The replacement property rules (IHTA 1984 s 107) should allow Bill to aggregate his period of ownership of the shares with that of the disincorporated business. However, if the business was transferred to Bill after the company ceased to trade, the conditions for the replacement property rules would not strictly be satisfied in respect of the company’s shares.
In such cases, Bill might consider a non-statutory clearance application for BPR purposes, and if necessary, taking out short-term insurance cover if the potential IHT risk was significant.
The circumstances in the example of Crumbs Ltd and Bill were relatively straightforward. In practice, there may be complicating factors to disincorporating a business (e.g. multiple shareholders, overdrawn director’s loan accounts, interest relief on borrowings, losses, etc.), not to mention non-tax legal and practical implications.
There is more than one possible way to deal with the disincorporation, and every case is different. Careful planning will help reduce the possibility of unwelcome tax surprises.
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Mark is a Consultant Editor with Bloomsbury Professional, and co-author of ‘Incorporating and Disincorporating a Business’. This content is available as part of a number of Bloomsbury Professional's online modules.
Mark is also the editor of many...