Finance Bill 2016 includes provisions designed to prevent taxpayers converting profits generated in a company into a capital receipt in the hands of the shareholder(s). Taxpayers may want to consider winding-up their companies or making substantial dividend distributions ahead of 6 April 2016 as a result of these measures and the changes to the taxation of dividends.
Broadly, the intention is that a capital distribution made in the winding-up of a company will be taxed as income if:
- within two years of the winding-up the shareholder (or someone connected with the shareholder) continues to be involved in the same (or a similar) trade as that carried out by the company that has been wound-up; or
- 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.
In particular, these measures are likely to have a significant impact on property developers and serial entrepreneurs.
These new measures only apply to individual shareholders and close companies (broadly, companies controlled by five or fewer people).
When rates of capital gains tax (CGT) are significantly lower than rates of income tax taxpayers will always be drawn to planning that extracts profit as a capital receipt. The increase in the dividend tax rates from April 2016 will make it even more tempting to arrange for returns from a company to be taxed as capital (at rates as low as 10% and no more than 28%) rather than income.
Profits extracted from a company as dividends are taxed as income. From 6 April 2016 the first £5,000 of a taxpayer’s dividend income will be taxed at 0%; thereafter, dividend income will be subject to tax at 7.5% for dividend income within the basic rate band; 32.5% for dividend income within the higher rate band and 38.1% for dividend income within the additional rate band (up from a current effective rate of 30.56% on the amount of the dividend received).
Where a shareholder receives a capital return, for example, on a sale, or a distribution made in a winding-up, that receipt is subject to CGT. The top rate of CGT is currently 28% but the rate of CGT may be as low as 10% if entrepreneurs’ relief is available.
The government thinks it is unfair that where a single shareholder, or a small group of shareholders, controls a company they can arrange their affairs to take advantage of lower tax rates where others can’t, and has included draft legislation in Finance Bill 2016 to address this issue.
Impact of proposed changes
Finance Bill 2016 provisions target a number of perceived abuses.
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 very 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; and is likely to result in a rash of liquidations before the end of the current tax year.
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%.