New clampdown on capital treatment of distributions

Starting April 6th next month, a new targeted anti-avoidance rule (TAAR) will make it more difficult to convert profits generated in a company into a capital receipt in the hands of the shareholders. Indeed, a capital distribution made in the winding-up of a company will be taxed as income if either within two years of the winding-up the shareholder continues to be involved in the same trade as that carried out by the company that has been wound-up or if profits, in excess of those required by the company, were retained in the company so that they could be received as capital on a later liquidation.

These new measures only apply to individual shareholders and close companies (broadly, companies controlled by five or fewer people) but it represents a significant tax increase where the shareholder was able to claim Entrepreneur's Relief on the gain (a jump from 10% to 38.1% if dividends are falling within the additional rate band).

More specifically, the anti-avoidance is targeted after the following behaviours:

Phoenixism

This is where a company is liquidated, and a new company is set up to replace it and carry on the same (or similar) activities. In the winding up of the company the shareholder receives the retained profits as capital on which he is subject to CGT. For some businesses, such as consultancies, there is little disruption in liquidating a company and setting up another company to carry on the business. Under a new anti-avoidance rule, a shareholder will be subject to income tax (at the dividend tax rates) on a distribution in a winding-up if he is a shareholder of a close company and receives a distribution from that company in respect of his shares in a winding-up of the company;

• within two years after the winding-up he continues to be involved in a similar trade or activity (this includes where someone connected with the shareholder carries on the trade or activity, either directly or through a company); and
• the main purpose, or one of the main purposes of the arrangements is to obtain an income tax advantage.

The new rule will not apply where what the shareholder receives in the winding-up is a repayment of the share capital originally subscribed for the shares or consists only of irredeemable shares in a subsidiary of the company being wound-up.

The measure will apply to distributions made in the winding-up of UK and non-UK companies on or after 6 April 2016.

Moneyboxing

This is where profits in excess of those required by the company for its commercial needs are retained in the company and shareholders receive the retained profits as capital (on which the shareholders are subject to CGT) when the company is liquidated, rather than paying them out as dividends on which the shareholders would be subject to income tax. Where the shareholders don't need the cash, many small companies will retain profits rather than paying them out as dividends which would result in an income tax charge on the shareholders. With the increased dividend tax rates this retention becomes more attractive.

The government's intention is that, where profits over and above those that are needed by the company are retained so that those profits are received as capital on a later liquidation, shareholders will be subject to income tax on the retained profits on the liquidation of the company.

This measure does not address directly the benefit of deferring an income tax charge by accumulating profit within the company. The consultation document asks whether consideration should be given to re-introducing a rule under which the profits of close companies are apportioned to their participators and taxed as income (similar rules existed until 1989).

Special purpose companies

In some industries, for example, property development, it is common for each project to be undertaken by a separate special purpose vehicle (SPV) which is liquidated at the end of the project, with the profits of the SPV being realised as a capital receipt subject to CGT. From April 2016, those profits could be taxed as income at the new dividend tax rates of up to 38.1%.