Consultation on Company Distributions – Prepare for Change
The recently published consultation and draft legislation on company distributions closes on 3rd February 2016, and has the potential to have significant implications for owner-managed businesses (“OMBs”) and their advisors.
It is a well-established cornerstone of tax planning that extraction by way of capital, rather than income, is usually advantageous for OMBs. Not only is the “top” tax rate for capital significantly less than that for income, but where trading businesses are concerned, Entrepreneur’s Relief will typically be available to reduce the tax rate to only 10% on extraction. This compares very favorably to income treatment in almost all instances.
However, the Government now intends to significantly restrict the tax advantages in this area – a savvy move by the Chancellor in light of the impending increase in dividend tax rates. These changes were set to make tax planning in this area much more attractive, though Mr Osborne seems committed to taking pre-emptive action.
The Consultation is titled “Company Distribution”, which is exceptionally broad, but in effect it is aimed solely at three main types of arrangements:
- Distributions on Winding Up
- Company Purchases of Own Shares
- Repayments of Share Capital
It is useful to look at each in turn to understand precisely what the Government is seeking to counter, the legislative changes that have been proposed, and the likely implications.
Distributions on Winding Up
Where a company has expended its commercial usefulness, the directors and shareholders may elect to enter it into formal liquidation. On liquidation, assets distributed to the shareholders are treated as capital. Where a company has significant cash on the balance sheet, this can permit tax-efficient extraction of cash.
Whilst the Government does not appear to want to change this tax treatment for genuine commercial transactions, it does highlight a number of types of behavior that it is seeking to counter:
- Moneyboxing – the retention of profits, in excess of commercial need, with a view to a future winding up.
- Phoenixing – where the company is liquidated, only for a the trade to effectively continue via a new entity
- Special Purpose Companies – where business operations are separated across multiple companies to allow a winding up to take place after each project comes to an end.
Although the Government have highlighted the above three areas as potential targets, the specific measures that have been proposed in the draft legislation thus far appear to only target “phoenixism”. A targeted anti-avoidance rule (“TAAR”) has been recommended which will, in broad terms, seek to tax distributions retrospectively as income where, within a period of two years, the shareholder is involved in a “similar” trade or activity.
However, in addition to this specific TAAR, a number of broader solutions are currently being consulted upon, with the potential of much broader effect. Few details are provided in the Consultation document itself, as submissions are requested from stakeholders. However, one particular idea that is mooted is a re-introduction of some form of the close company apportionment legislation – which were abolished in 1989 and taxed shareholders of close companies on retained (not only extracted) profits – which could have significant implications.
Company Purchase of Own Shares (CPOS)
The second area that the Government is consulting on is the CPOS rules. Where this takes place, the company purchases shares from a shareholder at market value and, in the correct circumstances, it can allow a substantial cash balance to be extracted from the balance sheet of the company as capital.
Capital treatment will not always be available. Rather, a number of statutory conditions must be met (as found in CTA 2010, s.1033), which include that the purchase must be wholly or mainly for the purpose of the trade, and that the purchaser’s interest in the company (including that of their associates) has been reduced by 75%.
The Revenue has expressed some concern over the ability for shareholders to continue to hold 30% shareholding while still qualifying for this relief, suggesting that this may not fit with the intention behind the rules (primarily to facilitate the retirement of shareholders where no external purchaser is on the cards), given the continued influence of the shareholder. This indicates that the Government may seek to lower this threshold in future, though the consultation considers this in only broad terms.
Reduction of Share Capital (ROSC)
Finally we look at ROSC, an area that has seen a lot of publicity in the tax planning press of late. On appearance, ROSCs are similar to CPOS – they both involve the company buying back shares and can result in distributions being taxed as capital. However, the relevant statutory conditions for ROSCs are very different, and where not met, the tax treatment is not altered – rather the transaction cannot legally take place.
For a ROSC to be implemented, the company must have sufficient share capital. The directors must also undertake a statement of solvency to prove that the company is left with sufficient capital post-reduction. Sufficient share capital can often be a limiting factor, as it typically relates to the capital invested by the shareholders themselves. However, share capital can also arise from a suitably implemented commercial reconstruction of the business, providing much broader application for this type of transaction.
Where the relevant conditions are met capital treatment will be obtained. This is regardless of the commercial circumstances surrounding the transaction (for example, the shareholder can continue to maintain a significant interest in the company). This flexibility makes capital reductions an attractive way to distribute excess cash on the balance sheet tax efficiently.
The Government has sought to prevent shareholders from being able to benefit from this treatment by amending the Transactions in Securities (TiS) rules. The TiS rules seek to counteract an income tax advantage resulting from transactions made between close companies and their owners. The changes are to ensure that reductions of share capital are more likely to be caught, by amending the definitions and closing some of the potential loopholes. The TiS rules will also face a procedural change, to make counteraction assessable under self-assessment, which marks a major change in this area.
The consultation on company distributions is currently still underway. The implications for owner-managed business may have pronounced repercussions for years to come.
If you would like to discuss any of the above further, please get in touch.