Run For Cover? Winding Up Companies – New Anti-Avoidance Rules

To judge from the hue and cry from insolvency practitioners and others, you would have thought that capital gains tax (CGT) entrepreneurs’ relief was being abolished from 6 April 2016. The company liquidation industry has obviously seen this as a big opportunity to drum up business, by circulating everybody to say that, unless you put your company into member’s voluntary liquidation (MVL) before 6 April, you will be paying a lot more tax. We’ve heard that many insolvency practitioners are surprised at the lack of take up.

Looking at the way the rules are actually written, though, perhaps makes this lack of take up less surprising. First, let’s put the hue and cry in context. 

Probably ever since the invention of income tax, wily tax planners have been trying to work out ways of turning income into capital. Before CGT came on the scene in 1965, it was a simple question of: if it’s income, it’s taxed; if it’s capital, it’s untaxed. So it’s hardly surprising that people who objected to paying the sometimes substantial rates of income tax found ways of rolling up value in their capital assets, including shares in companies, so that they could take the value out tax-free rather than paying through the nose in income tax (on dividends, director’s remuneration, and so on).

This was modified a bit by the advent of CGT, but even then there was an incentive to roll up profits inside your company, because CGT was at 30%, as against income tax rates of 60% or more.

The income/capital divide is still very much with us, as far as tax planning is concerned. If your company is trading and ER is due, you’re eligible for 10% tax on winding up the company, and taking out all of its reserves, as against up to 38% from taking it as income (once the new dividend tax comes in next year).

We’ve actually seen some fairly aggressive strategies suggested to businesses, to take advantage of this income/capital divide. One firm of city solicitors were subjected to a presentation, not that long ago, seriously suggesting that they incorporate their practice and wind it up, transferring the practice to a new company, every twelve months. This way, you had the advantage of paying the low corporation tax rate on your profits, with a minimal (comparatively speaking) further tax on getting the money into your personal bank accounts. Broadly speaking, using current rates, the overall tax, if you can do this, is 28%: being 20% corporation tax, followed by 10% CGT on the 80% you have left – that is, another 8%.

Compared with income tax at 45% and National Insurance contributions on top of that of another, at least 2%, 28% isn’t looking like too bad a rate. 

We would suggest that what this rather naive suggestion missed out was any consideration of the ‘Transactions in Securities’ anti-avoidance rules. The rules have actually been with us since 1960, so you might say that any tax adviser who disregards them is not really doing his job properly. 

Under the Transactions in Securities rules, it was highly arguable that winding up a company just to take out its assets on a capital gains basis, rather than as dividends, was already squarely within the anti-avoidance rules. The effect of Transactions in Securities applying was that the reserves of the company could be taxed after all as if they were paid out as a dividend; that is, to income tax at the recipient’s marginal rate.

So HMRC already had weaponry at its disposal to counteract the more ‘abusive’ attempts to convert income into capital. Whilst ‘ordinary, commercial liquidations’ were specifically not caught by these rules, in HMRC’s published opinion, any attempt to use them systematically to take money out as quasi-dividends, which were actually taxed as capital gains, was, at least in theory, liable to be counteracted under these provisions.

The new rules are included in the draft Finance Bill 2016 clauses published in December 2015. These are basically doing two things: 

If anyone can see more than a general tightening up, and making explicit of the application of these rules to liquidations, please let us know. Interestingly, although the proposed legislation is introduced in the context of a perceived (by HMRC) need to bring the counteraction rules under Transactions in Securities up to date following self-assessment, there’s still no requirement on taxpayers to self-assess where they think that the rules bite in their situation. It still depends on HMRC issuing a ‘counteraction notice’.

Unless there’s anything in these rules, or underlying them, that isn’t obvious, we would describe this as very much ‘the mixture as before’, but with a new and perhaps more specific interest being taken in windings up by the tax authorities.

It’s probably the proposed new legislation countering the practice of setting up ‘phoenix companies’ that is likely to cause the most difficulty to tax planners, and, indeed, the wider business community. If a close company is wound up, and an individual or connected person is a participator in that company, who carries on a similar trade or activity either directly or as participator in another company in the following two years, then, subject to an important condition, the proceeds of winding up of the original company can be taxed as income. 

The important condition is that it is reasonable to assume, having regard to all the circumstances, that the main purpose, or one of the main purposes, of the winding up is the avoidance or reduction of a charge to income tax.

In response to a specific question from us, HMRC confirmed that it doesn’t matter how small the individual’s interest is in the ‘phoenix’ company. In principle, if a builder winds up his building company when he retires, but retains ten shares in Balfour Beatty, these conditions are met. HMRC’s answer to being challenged on this obvious absurdity was to say that the ‘tax avoidance condition’ (condition C in the proposed new rules) would be unlikely to be met in these circumstances.

Our response to HMRC’s consultation on these clauses was to ask whether an official clearance procedure would be included in the new rules. The answer was ‘we hear what you say, but there are no plans for clearance’.

So we have a possibly substantial increased tax charge based on the extremely vague and difficult area of interpretation introduced by this tax avoidance motive test. 

To take an example, many property development companies set up a special purpose vehicle (SPV) for each development, and one of the benefits of this is that it ring-fences liabilities. If one development goes badly wrong, this doesn’t bring down the rest of the business. However, where one SPV is wound up, it is likely that the individuals who own it will be developing other sites through other SPV’s. Will HMRC accept that the SPV’s are set up for commercial purposes or not? 

No doubt if you ask the taxman, he will give you his usual highly unhelpful answer: ‘it depends on the facts and circumstances of each case.’ Certainly, in this situation, you would need to explain why, if tax wasn’t on your mind at all, you held all of the shares in the SPV’s separately rather than them forming part of a group with an overall holding company, which would be equally effective in ring fencing liabilities.

Realistically, we think that the strategic purpose of the rules is to frighten everybody. The more gung-ho of the tax planning fraternity might be tempted to call their bluff, and rely on the difficulty which a depleted HMRC would have in policing such a difficult system, depending on fine shades of interpretation. Only time will tell.