Since 2016 the use of a solvent liquidation (a so-called Members’ Voluntary Liquidation, or MVL), as a means to extract value from a company in a highly tax efficient way, has become a controversial and risky option, in some circumstances. This is a consequence of the Finance Act 2016 together with the fact that the scope of the anti-avoidance law introduced in that Act is, at this early stage in its life, less than clear.

Company owners are advised to understand (i) the potential benefits of a liquidation; and (ii) the potential impact of the new tax law, in case it might apply to their plans.

As outlined below, the new provisions, referred to as the “TAAR” (targeted anti-avoidance rule), add to the list of grey, subjective, unclear and controversial parts of the UK Tax Code. We await the first cases and Court judgements to provide us all with greater clarity (hopefully). In the meantime, we have to do our best to anticipate the risks.

Liquidation – the tax consequences

Before we outline the TAAR and what it might mean for company owners potentially contemplating a liquidation of their company, we should explain why this course of action can have very positive tax implications (and why it can continue to be a very positive option where it is not caught by the new law).

When cash (and other assets) are distributed to shareholders during the liquidation of a company, the tax rules provide that these sums of money (or money’s worth) represent capital proceeds for the disposal of the shares in the company which will cease to exist. As a result, the distribution gives rise to Capital Gains Tax (CGT) rather than Income Tax.

CGT on shares involves tax rates of 10% or 20% on the amount of gain arising from a distribution of capital (and, furthermore, that gain is calculated after deduction of the shareholder’s tax base cost of their shares).

Income Tax, meanwhile, involves tax rates of 32.5% or 38.1% (where the sums extracted exceed the shareholder’s basic rate band) and there is no reduction for the shareholder’s cost of those shares.

The CGT outcome provided by distributions on liquidation is therefore typically much more tax efficient than a corresponding Income Tax outcome deriving from dividends or other income distribution. It is not uncommon for capital to yield tax which is nearly only a quarter the tax cost of income. So, the word “significant” can be an appropriate description to attach to the positive tax implications of a liquidation.

Liquidation is not an appropriate course of action in all circumstances, of course, but it does become potentially appropriate where, for example;

  • the company’s business has been sold out of the company previously;
  • the company’s business has run its course and come to an end; and
  • the company was an investment-holding vehicle and it has realised all of its assets.

Even in these circumstances, planning discussions will always be desirable to assess the merits of preserving the company. It may, for example be retained and used to pay out income to all shareholders over a long period perhaps (like a quasi pension fund). It may be used as a form of Family Investment Company in which the value in its shares is passed down to the next generation, while voting control is retained in the senior family members’ hands (like a quasi family trust). It may even be the launchpad for a brand new business venture of course.

However, it will often be appropriate for the company to be wound up and for the monies to be taken out. In these cases, a liquidation can be a highly suitable way by which to achieve that, at low tax cost. It should be noted by owners of trading companies that, where a previous trading business was sold or ceased, the tax rules allow the shareholders to liquidate the company up to three years after the date of the business sale/cessation, and still benefit from Entrepreneur’s Relief (ER).

So, it is not difficult to see why, in the right circumstances, a liquidation can prove to be very tax efficient for a shareholder.

Not surprisingly, it is probably fair to say that some business owners have, over time, organised their affairs in such a way as they have avoided taking income from their company. They may have, instead, operated their company for a relatively short period (nb. until recently, owners became eligible for ER after only one year of ownership), liquidated the company to extract the profits, and then started up again in a new company. This is what is referred to as “phoenixism” and, above all else, is what the new TAAR is intended to catch – serial capital gains, at very low rates of tax, in circumstances, which the government would argue, do not constitute a genuine “exit” from the business, long-term.

As usual, however, when new tax law is introduced to tackle something specific, it has the very real potential to impact “innocent” transactions; and so it is with the new TAAR.

The Targeted Anti-Avoidance Rule (“TAAR”)

We should begin by making clear that the so-called “TAAR” is just one targeted anti-avoidance rule (and not the only such rule in the Tax Code).

The rule seeks to ensure that distributions of monies (and other assets) on a liquidation are subject to Income Tax and not CGT, in specific circumstances, despite the normally expected capital treatment. The law prescribes that this will be the case where all of 4 conditions (A to D) apply, duly summarised by the following:

Condition A

The individual has at least a 5% stake in the company which is liquidated.

Condition B

The company which is liquidated is (or was) a “close” company [nb. 99% of our client companies are “close”].

Condition C

Within two years of a distribution in a liquidation, the individual carries on a “trade or activity which is similar to” that of the company which was liquidated.

Condition D

It is reasonable to assume that the main purpose (or one of the main purposes) of the liquidation is the avoidance, or reduction, of Income Tax.

So, to paraphrase further, the rule seeks to treat funds extracted from a company liquidation as income where;

  • the 5% (or more) shareholder is involved in a similar trade or activity;
  • within 2 years from the date of the distribution;
  • and it has been reasonable to assume that the liquidation had a tax avoidance motive.

Conditions C and D look likely to pose a potentially significant challenge to our confidence in the tax implications of liquidation in certain circumstances, therefore As readers might imagine, a considerable volume of commentary has already been written on what the words in the text of this untested law actually mean. Our purpose here is not to reproduce that extensive dialogue but rather only to provide an awareness of the risks and uncertainties involved, so that potentially affected future parties are forewarned. Consider these few questions:

Condition CWhat does “similar” (re trading or other activity) mean? After the closure of one business the taxpayer might take up a new venture in a related industry but where and when does business No.2 become “similar”?
What does “activity” mean? This is a potentially very wide concept, currently without legal definition.
Condition C can be expected to pose taxpayers, HMRC and the Courts some headaches in the coming months and years.
Condition DWho decides what the motives for a course of action might be? Who decides what it is reasonable to assume or not to assume? Looking into the mind of the decision-maker is a challenging proposition.
We acknowledge that there are times when tax planning might stand behind a decision to liquate but, at the same time, there may be no practicable course of action other than to wind up a company which the shareholders no longer need or want, having no further use for it. Those shareholders might nevertheless be faced with a risk of (expensive) Income Tax arising from their commercial decision, depending upon the circumstances.

Overall, the liquidation of companies can be expected to continue as an efficient and effective means of closing down a company, in many situations. At the same time, awareness of the conditions that could cause HMRC to consider if the TAAR might apply will be very important, before that course of action is adopted.

As with everything else in tax, early advice and discussion will be highly desirable, to manage the considerable risks involved.

If you would like to discuss what the above might mean for you, now or in the future, please contact your relationship principal here at Harold Sharp or contact Tax Partner, Chris Barrington by email.

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