Company Distributions – Where To From Here?

Ken Moody looks at the effect of anti-avoidance rules published in Finance Bill 2016 on incorporation and company profit retention.

At the time of writing, Finance Bill 2016 may not receive Royal Assent before the summer parliamentary recess on 21 July, which may defer enactment until the autumn; yet the proposed dividend and other tax changes discussed here are effective since April. This article summarises the effect of those and possible future changes on incorporation and company profit retention.

Thinking of incorporation? Assume a profit of £58,000, which is the point at which an individual taking a salary of £8,000 and drawing the rest in dividends enters the dividend higher rate of 32.5%. The figures are for 2016/17 and Class 2 National Insurance contributions (NICs) are ignored on de minimis grounds.

Now does anyone think it is worth incorporating in order to save £3,445 a year? Running a company is more expensive than continuing as a sole trader due to additional compliance (Companies House annual returns, etc.) and accountancy costs. Tax and Class 1A NICs on benefits–in-kind on running a company car could also easily wipe out any saving. 

Once the profits exceed £58,000 then in the company situation the ‘slice’ of dividend income in excess of £32,000 (up to £150,000) is taxable at 32.5%, but that income has borne corporation tax at 20% and so the overall rate is 46% (i.e. 20% corporation tax + (100 x 80% x 32.5%) 26% dividend tax). This compares with 42% for a sole trader taxable at the higher rate (including the 2% additional NICs).

The chancellor indicated at the time of the 2015 Summer Budget that the dividend tax increases were intended to ‘start to reduce the incentive to incorporate and reward through dividends rather than though wages to reduce tax liabilities’ which could suggest further increases in dividend tax or possibly other measures. Dividend tax is, however, a very blunt instrument since it affects other investors with substantial share portfolios receiving more than £5,000 a year in dividend income, as well as private company owner-managers.

Finance Bill 2016 also includes changes to the transactions in securities (TiS) rules (in ITA 2007, Pt 13, Ch 1) so as to include repayments of share capital and distributions in winding up as TiS. This partially overturns the decision in CIR v Laird Group plc [2003] UKHL 54, where the House of Lords decided unanimously that the payment of a dividend is not a TiS; and, more relevantly here, that the distribution of profits to shareholders in a liquidation is also not a TiS as neither the shares themselves nor their rights are affected by the payment. 

The TiS rules are basically designed to prevent avoidance of tax by conversion of income into capital and apply where, as a result of a TiS, a person receives a payment in connection with the distribution of assets of a close company, which represents assets available for distribution by way of dividend (Condition A at ITA 2007, s 685(1)).

A main purpose of the TiS must be obtaining a tax advantage, and the onus is on HMRC to show that the main purpose test is met. In the consultation document (‘condoc’) on company distributions published in December 2015, HMRC suggest company shareholders might decide to retain profits in the company where the sale or winding up of the company is imminent, and the example given contrasts the relative tax positions where one shareholder receives a dividend and where profits are retained and paid out as distributions in winding-up. 

In both cases, however, the company appears to have traded only for one year and so over a longer period whether a main purpose of retaining cash surpluses was to avoid tax might be difficult to establish. This perhaps begs the question as to whether there is a ‘purpose’ at all. If a company has a post-tax profit of £100,000, but the sole shareholder decides that he only needs £50,000 to live on, the remaining £50,000 left in the company is there for no purpose to my mind.

The retention of profits within a company may pose another problem, i.e. that CGT entrepreneurs’ relief (ER) on a disposal of company shares may be denied if non-trading activities are ‘substantial’ (see CG64090). Mere retention of cash on deposit is arguably not an ‘activity’ at all, but the HMRC guidance is not clear on this point (see HMRC’s Capital Gains manual at CG64060), so there is an element of uncertainty.

HMRC also draw attention to what they call ‘moneyboxing’, ‘phoenixism’ and special purpose companies. The two latter situations are perhaps more within the scope of the proposed targeted anti-avoidance rules (TAAR) referred to shortly, but moneyboxing refers to retention of profits in excess of a company’s commercial needs in order to receive the profits as capital when the company is sold or liquidated. That might be within the revised TiS rules if it can be shown that strategy to have been a main purpose of the TiS. I have my doubts about that, but at any rate there is clearly a danger that long-term retention of profits within a company in excess of commercial requirements may be vulnerable to a counteraction notice when the company is liquidated. However, while the condoc refers to retention of funds within a company prior to sale, which is a TiS by definition, it is unclear how the TiS rules may apply due to the (revised) exception for a ‘fundamental change ownership’ at ITA 2007, s 686. 

The TAAR involves new sections 396B and 404A which will apply, respectively, to resident and non-resident companies, to be inserted into ITTOIA 2005. The rules will broadly apply where:

a) an individual with an interest of at least 5% in the equity of a close company receives a distribution in winding-up; and

b) within two years becomes involved in an identical or similar activity, whether as a sole trader, partner, or (again subject a 5% minimum interest) a shareholder.

However, a further condition is that it is reasonable to assume that the main purpose or one of the main purposes of the winding-up (or arrangements of which the winding-up is part) is the avoidance of income tax. It may be, therefore, that only the most blatant instances of phoenixism or use of special purpose companies which will be caught by these rules.

Older readers will no doubt recall the close company ‘shortfall’ provisions which were abolished in 1989. Section 5 of the condoc considers wider solutions to tax-motivated retention of profits, including amending parts of the distributions rules (CTA 2010, Pt 23) distinguishing between income and capital and the reintroduction of ‘some form’ of close company apportionment regime. 

Under those rules, the ‘relevant income’ of a close company was apportioned between its members and was liable to income tax at a time when income tax rates were very high. For a trading company, however, ‘relevant income’ consisted of so much of its distributable ‘estate’ (i.e. property rental, etc.) and investment income, as could be distributed ‘without prejudice to the requirements of the company’s business’. Obviously, to be effective the reintroduction of such rules would need to include trading income as ‘relevant income’ subject to the requirements of the business, but further comment would be purely speculative at this stage.

In a nutshell, incorporation of a company will not generally be very attractive for tax purposes in future for all the reasons given above and so should, in the main, be considered only for commercial reasons. There may be exceptions. For example, while the favourable rate of CGT of 10% with ER no longer applies to a sale of goodwill, sale of goodwill on incorporation might still be tax efficient following the reduction in the general rate of CGT to only 20%. But a long-term view is still needed.