Disincorporation Relief

By | 26 September 2012

‘Disincorporation’ is broadly the process of a business changing its legal form from a limited company to a sole trader or partnership. This process generally involves a transfer of the business as a going concern, including assets and liabilities, from the company to its shareholders, who then carry on the business on a self-employed basis.

It is generally easier for a sole trader or partnership to incorporate than for a company to disincorporate its business. For example, there is a specific form of capital gains tax relief in respect of incorporation (TCGA 1992, s 162). However, there is presently no specific tax relief on disincorporation.

The Office of Tax Simplification (OTS) published a report in February 2012, which considered whether disincorporation relief should be introduced. This was part of an overall review of small business taxation. The OTS report looked at the possible introduction of disincorporation relief for those companies at the smallest end of the business sector, which no longer wished to operate as limited companies, and had no commercial need to do so.

Will it happen?

The Treasury then published a consultation document on disincorporation relief on 7th June 2012. The first point to note about this consultation is that the government still appears to be undecided about whether to introduce disincorporation relief at all. A final decision will only be made after the consultation. The government seems to have some reservations about introducing the relief. For example, it is generally trying to make tax simpler for small businesses, and therefore does not want to create pages and pages of further legislation, or make the rules so complex that expensive professional advice is needed. In addition, the government is obviously keen to ensure that disincorporation relief is not open to abuse, i.e. that the relief does not provide opportunities to artificially reduce tax liabilities.

There are also some non-tax reasons why the government seems unsure about disincorporation relief. For example, if a company transfers its business and assets, the government is keen to ensure that any creditors of the company are paid, rather than being left high and dry because the company no longer has any assets from which to pay them.

However, assuming that disincorporation relief is introduced, its availability is likely to be restricted to small businesses. The OTS document reported that those businesses most likely to be interested in disincorporation have a turnover in the region of £20,000 to £30,000. However, the consultation document suggests that the relief might apply to businesses with a turnover up to the VAT registration threshold, which is currently £77,000.

What will it cover?

The big question is: what tax charges would the disincorporation relief provisions cover? The OTS report points out that under current law the main tax consequence of a disincorporation is a potential ‘double tax charge’ on any assets transferred in the process. The first tax charge can arise when the company disposes of its assets to the sole trader or partnership, such as goodwill or land and buildings. The second potential tax charge is on the shareholders when they dispose of their shares. A distribution of assets to shareholders generally falls to be treated as an income distribution, but if the company is being wound up the transfer of assets can be treated as a capital distribution which would be chargeable to CGT on the shareholder.

The OTS report also identified various other potential tax issues arising on disincorporation:

– Stock and WIP;
– Capital allowances;
– Losses;
– General (e.g. capital losses, excess management expenses, non-trading loan relationship deficits);
– Stamp duty land tax; and

The OTS put forward two possible options for disincorporation relief. The first option would allow the goodwill of a small business to be transferred at a value which would not give rise to a tax charge on the company. It would also relieve the shareholders from a distribution tax charge on the transfer. An important simplification here is that there would be no need to value the goodwill upon disincorporation, because any gain would arise on the later disposal of the sole trade or partnership business. The OTS calls this option the ‘narrow’ form of relief.

The second option put forward by the OTS was a ‘wider’ form of relief. This relief would allow other chargeable assets to be transferred as well, with the asset value giving rise to no gain on the company. There would also be a deferral of at least part of the tax charge on the shareholders, with any gain crystallising when the assets were finally sold to a third party.

In a similar way to the OTS relief options, the government is looking at either a simple form of disincorporation relief, or a more comprehensive relief. The simple relief would remove any corporation tax charge to the company on a transfer of goodwill. The government said that with additional legislation, it may be possible to extend the relief to any company tax charges relating to the disposal of land and also plant and machinery. However, as the government appears anxious to keep additional legislation to a minimum, it is by no means certain that the simple form of disincorporation relief would be extended to include assets other than goodwill.

The more comprehensive relief would additionally cover tax charges that might otherwise arise on the shareholders in respect of the assets distributed to them. However, the government seems keen to prevent this relief being abused and is looking at possible measures, including a targeted anti-avoidance rule. Once again, additional measures means additional legislation, so a more comprehensive relief may well depend on whether the legislation can be drafted in a relatively simple and straightforward way.

Key decisions

There are two more key decisions for the government to consider before deciding whether to introduce disincorporation relief. As mentioned, the first is the size of business that might be eligible for disincorporation relief. Even with a turnover limit of £77,000, the scope for using disincorporation relief is fairly restricted, and in fact it is quite possible that the turnover limit may be set at less than half that amount, for example £30,000.

The second key decision for the government is whether disincorporation relief should apply for a limited period only. The OTS recommended that the relief should be introduced for an initial period of five years, after which it would be reviewed as to whether the relief should be made permanent. No decision has been made at the time of writing, but I expect that there will be a review period, as the government will probably want to ensure that the relief is being used in the right circumstances, and is not being abused. If so, the length of this review period could be more or less than five years.

The good news about the consultation (if one could call it that) is that the government seems fairly open-minded about which tax charges the disincorporation relief should cover, and about what form the relief should take. Clearly, from the business owner’s perspective, the wider the relief, the more useful and flexible it is likely to be. The disincorporation relief consultation ended on 30 August 2012, and further developments are awaited at the time of writing, so watch this space.

The above article is reproduced from ‘Practice Update’ (September / October 2012), a tax Newsletter produced by Mark McLaughlin Associates Ltd. To download current and past editions of Practice Update, see the Newsletters section.