Alan Pink considers the option of winding up a company as tax planning and important points to look out for.
Winding up a company can be by far the most tax-efficient method of extracting value from it. This is what might be termed the central or ‘classic’ problem of owner-managed business tax planning: it’s all very well enjoying the lower rates of tax on profits that operating through a company gives (i.e. 19% corporation tax rather than income tax rates up to 45%) but that leaves unsolved the problem of how you access the funds in the company without paying income tax rates after all.
In fact, there are many situations where putting your profits through a company, and then extracting them as dividends or remuneration, can actually increase the tax over what you would have paid without the company.
It’s not your asset…yet
But firstly, let’s look at the basic mechanics. You can’t just take all of the assets out of a company and claim that you have wound it up. With one exception, the result of doing this would be to tax the asset transfers to you as if they were dividends.
If the reserves of the company are no more than £25,000, you can do this in conjunction with a request to Companies House simply to strike the company off, and in these limited circumstances you will be charged to capital gains tax (CGT) rather than income tax on the value extracted.
If the reserves are more than £25,000 though, and you want CGT treatment, you will need to put the company into formal liquidation. This inevitably involves appointing a qualified and licenced insolvency practitioner (IP), and of course these don’t come cheap. There is a lot of red tape involved, and IPs can’t really be blamed for wanting a fair remuneration for the amount of responsibility and general ‘hassle’ they take on.
Gains or income?
The first and most obvious tax planning point to make, as I’ve implied above, is the fact that you effectively have the choice whether to take the company’s assets out of it as income or as capital gains, in a normal winding up situation.
The top CGT rate on winding up of companies is 20%, whereas income tax on dividends (for example) very soon goes into the 32.5% bracket, or even the 38.1% bracket which applies if your total income for the year, including the dividends, goes over £150,000.
Let’s look at a straightforward example.
Example: Ending the company
John owns all the shares in Apocalypse Limited, which has ceased trading and paid off all its debts. After this process, £100,000 remains in the company’s bank account, and this is the company’s only asset. The company’s share capital is a nominal £1, which we’ll ignore for the purposes of illustration.
The simplest and least formal way that John could bring an end to the company’s life would be simply to pay himself a dividend of £100,000, and then apply to Companies House for the now empty company to be struck off. But assuming John’s other income is £50,000 (including some dividends) for the year in question, this dividend would be chargeable at the 32.5% rate, and the tax bill on winding up this company would therefore be £32,500.
Going down the liquidation route, by contrast, would result in a £20,000 tax charge, assuming that John’s CGT annual exemption has been used elsewhere also.
In that example, another assumption made was that entrepreneurs’ relief (renamed ‘business asset disposal relief’ in the latest Finance Bill) was not available on the winding up. If it had been, John would be facing a tax charge of only £10,000, which is clearly even more advantageous as contrasted with the tax going down the dividend route.
The lion in the path
Whenever you have a big difference in the tax rates applying to different methods of effectively doing the same thing, you’re going to get inventive tax planners seizing on this difference.
At what might be called the sharper end of the tax planning scale, it was even suggested, by some advisers, that business could be run through a series of ‘phoenix’ companies, which made profits, and were wound up on a regular basis. This must have become common enough for HMRC to put their foot down, which they have done in the so-called ‘anti-phoenixism’ rules.
Paraphrased, what these rules say is that, where your winding up is driven by tax planning, and you continue to be involved, in almost any way, in running the same sort of business within the two years following the wind up, income tax will be applied to the liquidation proceeds rather than capital gains tax.
In tax planning terms, of course, this is Armageddon. Very frequently, you will be looking at over three times as much tax falling due.
A lot of attention has been given to these new rules since they were brought in a few years ago; for obvious reasons. If taxpayers were nursing any hopes that very remote involvement in running the same business would get them out of the trap, generally speaking I think these people need to be disabused of that view. The penalty for stepping over the wrong side of the line is so great that you are going to want to keep a million miles away from the accusation of running or being involved in any kind of ‘phoenix’ business after the wind up.
Entrepreneurs’ relief
And this brings us on to another key point of planning for company liquidation. As we’ve already seen, entrepreneurs’ relief, where it is available, will generally result in halving your tax bill. So it’s worthwhile having a good look at your current situation, to see whether all of the shareholders of the company would qualify for the relief if the company were to be wound up.
The conditions are as follows, and they must all be met for two years prior to the effective date of the liquidation:
- The company must be a ‘trading company’;
- The shareholder must have broadly at least 5% of the company; and
- The shareholder must be an employee or officer of the company.
So pre-liquidation planning would clearly involve making sure that all the shareholders have least 5% and work for the company, where the flexibility to bring about this position exists.
For example, somebody who owns 90% of a company, with the other 10% being owned by that person’s four children equally, has not got an ideal shareholding set up. It would be better, purely from the point of view of securing entrepreneurs’ relief on the winding up, if they made sure, in good time before the liquidation, that each of the children had 5% each.
But one of the most problematic conditions is sometimes the ‘trading company’ condition. This is the subject of what is the most notoriously vague definition in the whole of our tax legislation. A company is a ‘trading’ company if its activities do not comprise activities other than trading activities to a ‘substantial’ extent. There is no attempt to define the word ‘substantial’ in the law, but HMRC has interpreted this as ‘20%’. Unfortunately, we don’t know whether this 20% figure relates to assets, income, or management time, or what combination of the three. So it may well be the case that the best planning you can do is to ensure that your company does not undertake investment activities at all.
One way of avoiding this happening, if you have surplus profits that you don’t want to distribute at a high rate of income tax, is to loan the funds, on interest-free inter-company account, to a parallel investment company.
