Disincorporation and downsizing (Part 2)

By | 19 May 2020

Disincorporating a business has potential tax implications for the company and its shareholders. The first part of this article looked at tax implications for the company. In part two, tax implications for individual shareholders are considered. 

Business owner(s) may well perceive there to be a ‘double tax charge’ on the basis that the company is taxable on any chargeable gains or credits when it transfers assets to the shareholders, and the shareholders will be taxable on the value of the company’s assets through any distribution made on disincorporation.

The story so far…

Continuing the example of Crumbs Ltd and Bill, it was decided by Bill (as the sole director shareholder) to have the company wound up.

The winding-up process is nearing completion, and the liquidator is in a position to distribute the catering business to Bill, so that he can operate 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 (soon to be renamed ‘business asset disposal relief’ in FA 2020) may be available on the capital distributions if the relevant conditions are satisfied. Otherwise, the capital distributions will attract CGT at either 10% or 20% (for 2020/21), 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.

(a) The ‘anti-phoenix’ TAAR

A targeted anti-avoidance rule (TAAR) is designed to prevent ‘phoenixism’ (i.e. broadly company owners winding up their ‘old’ companies, extracting profit reserves as capital and shortly thereafter engaging in a similar business).

A distribution is ‘caught’ by the TAAR if four conditions (i.e. A to D) are all satisfied, which are paraphrased below (ITTOIA 2005, s 396B; similar provisions apply for non-UK resident companies in s 404A):

  • 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 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;
  • Condition 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
  • 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 an income tax charge, or that the winding up forms part of such arrangements.

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 a main purpose of winding up Crumbs Ltd. However, the test is a subjective one, and HMRC may well take a different view.

Unfortunately, no clearance application procedure is offered by HMRC on whether the TAAR applies. However, HMRC guidance in the Company Taxation manual (at CTM36340) lists several matters that are likely to be relevant when considering whether the TAAR applies.

(b) Transactions in securities

The ‘transaction in securities’ (TIS) provisions for income tax purposes (in ITA 2007, Pt 13, Ch 1) must also be considered in relation to transactions involving the company’s individual shareholders.

The scope of the TIS provisions was widened (in FA 2016) to include a distribution on liquidation. However, HMRC confirmed (in a meeting with the ICAEW Tax Faculty on 26 January 2016) that ‘there would be no counteraction under the TIS as long as it was a simple liquidation with no successor company or other ancillary issues.’

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 ITA 2007, Pt 13, Ch 1 clearly depends on HMRC’s interpretation of the facts in each case. For example, HMRC are likely to challenge cases where they suspect 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 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.

Inheritance tax

In our example, Bill owned 100% of Crumbs Ltd. The transfer of his interest from a shareholding in a company which owns the business to direct ownership of the business should not have an IHT impact, as there should be no significant reduction in the value of Bill’s estate.

However, the post-disincorporation impact on the availability of business property relief (BPR) needs to be considered, due to the two-year ownership requirement (in IHTA 1984, s 106). The question arises whether the replacement property provisions would have the effect of aggregating Bill’s period of ownership of the shares with that of the disincorporated business. One of the conditions for replacement property treatment is that, had the replaced property been transferred immediately before it was replaced, it would have qualified for BPR but for the two-year minimum ownership requirement (s 107(1)(b)). If the business was transferred to Bill after the company ceased to trade, this ‘immediately before’ requirement would not strictly be satisfied in respect of the company’s shares, as it would not then be carrying on a business.

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.

Other factors

The circumstances in the example of Crumbs Ltd and Bill in this article 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.

As mentioned, there is more than one possible way to deal with the disincorporation. Every case is different. Careful planning will help reduce the possibility of unwelcome tax surprises.

The above article was first published on AccountingWeb on 7 May 2020: www.accountingweb.co.uk/tax/business-tax/disincorporation-part-2-get-the-details-right