Extracting cash from a privately-owned company as tax efficiently as possible is an important consideration for any shareholder. However, over recent years the government has been concerned about an increase in shareholders seeking to exploit the differential in income tax and capital gains tax (CGT) rates by liquidating their company only to, shortly thereafter, incorporate a new company carrying on similar activities.
This process, known as ‘phoenixism’, was being used to minimise the tax paid by shareholders and was potentially capable of being used many times over for the same business. Ordinarily, any distribution of income (ie a dividend) is subject to income tax rates at up to 38.1 per cent. However, if the shareholders instead undertake a solvent liquidation of the company, thus receiving a capital distribution subject to CGT, the tax liability can be as low as 10 per cent if entrepreneurs relief applies.
To counter this perceived abuse of the tax rules , since 6 April 2016 new rules require distributions in liquidation to be taxed as income if:
- the company is controlled by five of fewer individual share (or debt) holders, or is wholly controlled by directors;
- the shareholder concerned holds at least 5 per cent of the ordinary share capital and voting rights of the company;
- within two years of the distribution, the individual shareholder carries on the same or a similar activity to that of the company or its subsidiary, whether individually, in partnership or through a connected person or company; and
- it is reasonable to assume, having regard to all the circumstances, that the main purpose, or one of the main purposes, of the liquidation is to obtain a tax advantage.
Whilst on the face of it the legislation resolves the issue at hand, as usual in tax, common commercial situations may be caught, such as where the commercial rationale to liquidate is strong, but it is difficult to establish that tax considerations are not a main purpose. Where this is the case, higher rates of income tax will be paid.
Consider a consultant who receives a distribution on the liquidation of their personal company and then goes into partnership with another individual, engaged in similar activities. The third condition is very wide in its application and doesn’t require the same or similar activities to be in a company for the distribution to be caught, and accordingly, the consultant will be liable to income tax at up to 38.1 per cent unless it can be established that any tax advantage arising is merely incidental to the main purpose(s) of the liquidation. It should also be noted that the third condition does not require that the activities concerned qualify as a trade or business and thus, investment activities such as property ownership are also within the scope of this legislation.
Significant tax motivation
As alluded to above, the fourth condition does reduce the scope of the legislation to apply by considering whether a reasonable person would conclude that the liquidation was tax motived to a sufficiently significant degree. In all cases, it will therefore be necessary to ascertain the facts. However, one may consider that it will be harder to convince HMRC that distributions in liquidation to a property developer who incorporates a new company for each project should be treated as capital for tax purposes, when compared with distributions made as part of a reorganisation resulting in changes to both the ownership and organisational structure of a business.