Government consults on wide-ranging reform of the UK distributions framework

HMRC has published a wide-ranging consultation seeking to modernise the distributions rules, which have remained largely unchanged since 1965, so that "economically similar" payments to a shareholder are taxed consistently. 

The reform is targeted at shareholders within the charge to income tax, being individuals and trusts. While it is not intended to affect corporate shareholders directly, the practical implications for a range of common restructurings are significant.

Reductions of capital 

The government intends to reduce the scope for shareholders to use "holdco" structures, whereby a new holding company is inserted above a company making a distribution, to uplift the "good capital" that may later be extracted in capital form.

Under the proposals, share buybacks and other returns of capital using holdco structures would instead reflect a "frozen" amount of capital on the shares in the new holding company, fixed at the amount subscribed on the original investment (with any amount returned to a shareholder in excess of this to be treated as a distribution).  This would produce the same outcome as if the shareholder had sold back shares in the original company without any holdco involvement. 

The consultation recognises that this may cause issues for share-for-share exchanges within corporate groups or where the substantial shareholder exemption may apply and invites ideas for mitigation.

Demergers

The proposed freezing rule on capital contributions would directly affect demergers structured by interposing a new holding company followed by a capital reduction, which is currently a widely used route. The statutory demerger regime, in chapter 5, part 23, Corporation Tax Act 2010, provides an alternative, but its conditions are currently strict and the consultation highlights that this route is little used.

The proposal is to loosen the strict conditions for statutory demergers. These include, among others, removing condition A which currently requires all relevant companies to be resident in the UK resident or a member state, widening condition B to include investment companies and loosening condition D's restriction on onwards sales, changes of control and voluntary dissolutions or winding-ups, to a five-year period from the demerger. 

Alongside the relaxation of the conditions, the consultation proposes to remove the right to apply for automatic appeal to the tribunal should clearance be denied. 

Liquidation demergers appear to be left as another alternative, albeit more complex, route. 

Distributions from non-UK resident companies

Different rules currently apply depending on whether a distribution is made by a UK-resident or a non-UK resident company. The result is that certain returns of capital, share repurchases and stock dividends may be taxed partly as income when received from a UK company but as capital when received from a non-UK company. 

The proposal is to apply the existing distribution rules to distributions from non-UK resident companies so that they are taxed in the same way as those from UK-resident companies. 

Close company transactions

The reform aims to bring the distributions code and the loans to participators rules for close companies into closer alignment, as practical difficulties can arise where a distribution is found to be unlawful and has to be unwound.

The objective is greater clarity, so that extractions of value in favour of shareholders are clearly charged under one set of rules. Possible reforms include: a priority rule determining whether the distribution charge or the section 455 charge takes precedence; codification of HMRC's existing discretionary practice for inadvertent distributions; and provision allowing income tax on a value extraction to be set off against income tax arising when the position is subsequently rectified, to prevent double taxation.

The consultation also proposes extending the loans to participators regime to non-UK resident companies (which would be close if they were UK resident), with a new regime proposed for any resulting charge to fall on the individual borrower (as the company would be outside the net of UK corporation tax). 

Purchase of own shares relief

Where a company buys back its own shares, any amount paid above the capital originally subscribed is generally treated as a distribution for the shareholder, but the purchase of own shares relief can allow capital treatment where a shareholder departs for the benefit of the company's trade. The trade benefit test has proved a significant source of dispute between taxpayers and HMRC.

The proposal is to replace it with a more mechanical set of requirements including a minimum holding and working requirement under which the departing shareholder must have held at least 5% of the company's equity for a minimum of two years before departure and worked for the company throughout that period. The consultation proposes that the holding and working period requirements are extended to five years in cases where the departing shareholder retains family connections with remaining shareholders and directors. A clawback of the relief is also proposed if the departing shareholder becomes a director or shareholder again within five years.

Anti-avoidance and transactions in securities

The transactions in securities rules have remained generally unchanged since 1960 and are designed to counter avoidance and ensure that extractions of value are taxed as income. The consultation aims to modernise the regime and replace it with an updated anti-avoidance framework, with the proposal being a principles-based approach operating as a backstop, with existing legislation taking priority where relevant. The specific design remains unsettled and will be informed by responses to the consultation, with no detail currently available.

Osborne Clarke comment

A key theme of the proposals is to target structures that have enabled shareholders to extract value as capital (and so subject to a lower rate of tax than income). However, the wide remit will impact many commercial restructurings in particular owner-managed businesses. 

With the government highlighting that the proposals will only be taken forward after ensuring that "commercial activity is not adversely affected",  further consultation with stakeholders is expected. Those with an interest in the outcome – whether individuals or businesses – may wish to consider responding to the consultation, which runs until 14 September. 

If you would like to discuss any aspect of the proposals further, please get in touch with one of the contacts below.