Following the hike in dividend tax rates from 6 April 2016, and the surprise cutting of capital gains tax (CGT) rates, HMRC are keen to ensure that money taken out of a company is taxed as income rather than capital as much as possible. New rules, and amendments to existing ones, will go some way toward doing this; however, a darker possibility is also lurking in the background.
Extracting profits as capital
The incentive to extract company profits as capital rather than income is well established. CGT rates, either actual or effective owing to one relief or another, have been lower than the top rates of income tax for some time. The methods used to convert income into capital have been varied, but may include (for example) retaining profits rather than paying them as dividends in anticipation of a sale.
HMRC’s concern about artificial arrangements to convert income into capital led to the development of the ‘transactions in securities’ rules – which have been around since 1960. The current form of these anti-avoidance rules can be found in ITA 2007, Pt 13. The rules broadly cancel a tax advantage where capital extractions from a company are in reality income.
Tightening up
Finance Bill 2016 includes proposed legislation (effective from 6 April 2016) which extends the scope of these rules to include situations where a company repurchases its own share capital, and to payments made during the process of winding up the company, where the main purpose (or one of the main purposes) of structuring the transaction in a particular way is to secure a tax advantage. The changes will likely lead to greater uncertainty, and it will be advisable to seek advance clearance for transactions going forward.
Targeted rule
From 6 April 2016, a new targeted anti-avoidance rule (TAAR) will take specific aim at close companies which are wound up with distributions paid (taxed as capital), only for the recipient (or a connected person) to begin carrying on the same or a similar trade or activity within two years – i.e. a practice commonly called ‘Phoenixism’. Distributions which are caught by this TAAR will be taxed as dividends rather than capital.
More to come?
Make no mistake; the government is hammering small owner managed companies with successive announcements. When announcing the new dividend tax rates, George Osborne stated that this would start to end tax motivated incorporation. It is almost inevitable that more measures will follow.
One such possibility is hinted at in the recently closed consultation document, with mention of the revival of at least some of the old ‘apportionment’ rules – probably for smaller companies.
Accountants who were not in practice before 1990 will not be familiar with this concept. More senior professionals may well have a sinking feeling at the possibility rearing its head!
What is apportionment?
The old rules were complex; but the basic premise was that if the (then) Inland Revenue felt that a close company was not distributing a reasonable amount of its profits to shareholders, the undistributed amounts would be apportioned between the shareholders, who were then taxed on the notional distribution. Arguing with the officer that profits were retained for commercial reasons could become drawn out and frustrating.
A return to such a methodology would obviously render any planning involving retaining profits to smooth peaks and troughs completely ineffective. It would also seriously affect family investment company arrangements, which many have used as an alternative to pension saving, or inheritance tax planning vehicles.
Practical Tip:
If advance clearance was given by HMRC in respect of a transaction in securities prior to 6 April 2016, it cannot be relied upon if the transaction does not take place until after that date. You will need to reapply for clearance if certainty is required and you are in the middle of a transaction.
