Time running out to respond to HMRC’s latest proposals on company distribution anti-avoidance rules

Two weeks remain to influence draft legislation which reduces the ability for individuals to convert income distributions from a company into capital gains by way of winding-up that company, an expert has warned.19 Jan 2016.

Proposals amending the Transactions in Securities (TIS) rules were published by HMRC on 9 December 2015, and are subject to a public consultation until 3 February 2016. Broadly, the TIS rules operate to prevent a disposal of shares and other securities producing a capital gain, where the main purpose of the transaction is to obtain a tax advantage by avoiding an income distribution.

The draft legislation proposes to widen the scope of the TIS rules to apply to distributions on a winding-up. Consequently, when a company is liquidated, excess profits would not be taxed as capital if the profits had been retained to avoid income tax on a dividend distribution.

The government has become concerned that impending increases to the dividend tax rate will incentivise individuals to attempt to convert dividend distributions into capital gains. From April 2016, significant changes are being introduced to the tax treatment of dividends, resulting in an effective tax rate of up to 38.1% for higher rate taxpayers. In contrast, the top rate of tax for capital gains is 28%. On disposals of shares, individuals may also be eligible for entrepreneurs’ relief which could reduce the tax rate to as little as 10%.

HMRC has become aware that some individuals are retaining profits in a company for the sole purpose of receiving those profits as capital when the company is eventually liquidated. This behaviour is known as “money-boxing”, since the company is essentially being used as a money-box to accumulate profits until the company is wound-up. Generally, distributions to shareholders on a winding-up are treated as capital distributions and therefore, taxed as capital gains.

“Rolling up distributable profits into capital gains on shares has been standard planning for a while – so much so, it is barely considered ‘tax planning’ at all – and why HMRC suddenly has a problem with it now can only be a reflection of the increasing difference in tax rates between income and capital and the popularity of entrepreneurs’ relief,” said tax expert Eloise Walker of Pinsent Masons, the law firm behind Out-Law.com.

“There will be a practical difficulty here in determining why profits have been retained, and whether tax avoidance – as opposed to commercial reasons such as bank covenants, or just plain good working capital considerations – is the primary motivation,” she said.

The draft legislation also introduces a specific anti-avoidance rule (TAAR) to prevent “phoenixism”. This refers to a company entering into a members’ voluntary liquidation, retained profits being distributed to the shareholders as capital and then the company’s trade is continued in the form of a new company.

The new TAAR will apply where a shareholder enters into a similar trading activity of the wound-up company within 2 years of the original company being liquidated. The TAAR will only apply where the winding-up is being effected to reduce or avoid income tax. Where the TAAR applies the distribution from the winding-up will be taxed as income rather than capital. It should be noted that the draft TAAR includes an exemption to prevent certain liquidation demergers being affected by the changes.

“This aspect of the proposed changes is easier to understand, because it is harder to see how a phoenix would arise without pointing to tax motivations – but, that said, there must even here be innocent scenarios where commercial instead of tax drivers dictate a ‘re-set and try again’,” Walker said. “After all, the whole point of having limited companies, in part, is that if a venture fails you should be able to have another go without fear of personal liability – and imposing a tax penalty on a phoenix venture might adversely impact start-ups, for example.”

HMRC is also proposing to amend certain procedural aspects of the TIS rules to modernise and clarify the way in which the rules operate.

“It remains to be seen whether ‘modernise and clarify’ will actually mean that or whether it will actually ‘overcomplicate and stifle’, as has been the case in several recent consultations on anti-avoidance matters,” Walker said.