Taxing of company distributions to individuals: a fundamental change?

Proposed changes to tax legislation concerning distributions to individuals could have a major impact on business owners considering returns of capital or a solvent winding up. Those affected will need to act quickly if they want to ensure that they are best placed before any changes come into effect.

What is being proposed?

From 6 April 2016, the way dividends and certain other company distributions are taxed for individuals could be fundamentally reformed, as new measures are being consulted on to address perceived ‘unfair’ tax advantages being gained from some income-into-capital tax planning.

At the same time, new higher dividend (income) tax rates being introduced from 6 April 2016 will widen the gulf between income and capital tax rates.  For some business owners, this could mean an increase in exit tax rate from 10% (where “entrepreneur’s relief” applies on capital gains) to 38.1% (the new highest dividend rate).

These proposed changes are likely to make tax planning in this area considerably more complicated and provide only a limited window of opportunity for affected individuals to take action before the planned legislation comes into force. 

These developments, and other recent changes concerning the extraction
of funds from companies, show a growing focus by the government on the way funds are paid to shareholders.

What action can those affected take now?

The new proposed changes provide strong incentive for anyone considering
certain returns of capital or a solvent winding up to act sooner rather than
later, as capital distributions will need to be made before the legislation
takes effect on 6 April 2016 to maximise capital gains tax planning.

Existing transactions may also need to be accelerated to ensure they are
taxed within the current tax regime.

What is driving these changes?

Members Voluntary Liquidations (MVLs) are routinely used in order to reduce
tax costs on the winding up of a company, as final distributions on a company
winding up are taxed as a capital gain rather than as income. The dividend tax
rate is significantly higher than the capital rate a recipient would pay upon a
MVL.

The government is concerned that tax planning seeking to benefit from
the lower capital gains tax rate is being abused, particularly in the following
areas:

• ‘moneyboxing’; that is, retaining profits in excess of a company’s commercial needs before eventually taking out the profits as capital when the company is liquidated;
• ‘phoenixism’: this occurs where a company enters an MVL and a new company is set up to carry on substantially the same activities. The shareholder receives all of the value of the liquidated company as capital, while the business continues through the new company; and
• ‘special purpose companies’: where business operations are divided amongst a number of companies for separate projects. As each project concludes, the relevant company is liquidated and its profits realised in a capital rather than income form.  This is often seen in the real estate sector.

The government is also concerned about how certain companies, particularly close companies (those controlled by five or fewer shareholders), seek to return funds to shareholders in the form of capital.

In response, the new measures aim to reduce the incentive to convert income into capital by:

• introducing a new ‘Targeted Anti-Avoidance Rule’ (TAAR); and
• amending the existing legislation currently protecting company distributions.

Effect of the proposed TAAR on a winding-up

Where all of the following criteria apply, a new TAAR will apply to treat a distribution from a winding-up as if it were an income distribution:

• a shareholder in a close company receives a distribution on its winding-up;
• within a period of two years after the winding-up,
  the shareholder is to be involved in a similar trade or activity; and
• the main purpose (or one of the main purposes) of the arrangement is to obtain a tax advantage.

Amendments affecting other returns and distributions

It is not just voluntary liquidations that are caught by the new proposals. Other activities include third party sales of retained profits (which may otherwise have been paid out as a dividend) and certain repayments of share capital.  Amongst other things, the proposed amendments will:

• introduce a “connected parties” rule, to prevent
  tax being avoided by exploiting family or other relationships, including those with trusts and companies;
• focus on the reserves available within a group (rather than a company) to prevent tax avoidance by leaving profits dispersed across a group;
• redefine existing ‘change of ownership’ rules to prevent abuse; and
• redefine the ‘transaction in securities’ rules to capture a return of share capital or share premium and extend the definition to include liquidations.

What will be the practical effect of the proposed changes?

The proposed changes remain subject to the government’s response to a
recent consultation, and there is much uncertainty about how the changes will operate in practice.  Among the questions that remain to be answered include the following:

• how will the TAAR deal with similar companies owned
  by the same person where one closes and the other continues?
• how will “similar trade or activity” be measured?
• how will the mechanism for claw-back operate?

In the short term, a very likely effect will be that the number of MVLs
(which had already almost doubled over the last five years) will increase ahead of any changes coming into effect.

The proposals may also affect many existing and planned arrangements, and
are likely to be particularly relevant to some serial entrepreneurs, such as
property developers using special purpose vehicles over a variety of sites.

A fundamental change?

The changes provide a strong incentive for anyone considering a solvent
winding up or capital distributions to act soon and ensure they take place before 6 April 2016.  Existing transactions may also need to be accelerated to ensure they are taxed within the current regime.

In addition, applying for formal tax clearance before an MVL takes place can take 30 days or more (and clearances obtained before 6 April may not be effective for transactions taking place on or after 6 April), intensifying the urgency for clients who want this assurance.

Furthermore, as the proposed changes follow other recent changes to the
extraction of funds from companies and show an increased focus by the
government, company shareholders should consider whether this trend represents a fundamental shift in the way company distributions will be treated.

Please contact your usual Osborne Clarke contact or a member of our team
below for further advice.