Please do not DIY your tax affairs. Just ask Mr Khan…

May 25, 2021 | Tax Tuesday, Taxation

Today’s Tax Tuesday deals with the very, very, unfortunate recent case, in the Court of Appeal, of Bostan Khan.

In the words of Lady Justice Andrews, one of the three justices who presided over Mr Khan’s unhappy appeal case:

“This is a cautionary tale which illustrates all too graphically, the importance of seeking specialist tax advice before entering into commercial arrangements that might have adverse tax consequences, however remote that risk might appear”.

Mr Khan was an accountant who had a client company called Computer Aided Design Ltd. That company was engaged as an employment bureau for consultants but, by June 2013, the company had seen a significant decline in its business and the three shareholders had reached a decision that they wanted to “call it a day”. There was £1.95m of reserves in the company and, needless to say, the shareholders wanted to extract that value and walk away.

Mr Khan, meanwhile, was willing to facilitate their exit and saw an opportunity to keep the business going for a short period of time, during which he could earn some profit from the ongoing work in the business, while also mitigating some of the redundancy costs which would otherwise accrue upon an early cessation of operations. Mr Khan was willing to assist his client with the taxation management of their exit.

As a consequence of these facts, Mr Khan entered into an arrangement with the shareholders of the company which would leave him with 100% of the company and a balance of about £19,000 of working capital therein to move forward with. Unfortunately, the way that composite transaction was structured left Mr Khan with a £600,000 tax bill and zero monies with which to pay it. The tax position was recently confirmed by the Court of Appeal.

Originally, the plan had been for 96 of the 99 company shares in issue to be bought back by the company direct from the three shareholders for a sum of £1.95m, whereupon Mr Khan would then acquire the three remaining shares for £19,000, representing the value of the company’s working capital, as noted above.

It appears that the detailed step plan changed late in the day. By implication this might have been because the shareholders could not obtain comfort that Plan A would have yielded for them their desired CGT outcome. They were almost certainly right! In any event, whether that was the trigger for a revised plan or not, Mr Khan and the shareholders did revise the steps – with catastrophic consequences for Khan:

Instead of proceeding with a buyback of shares by the company, direct from the three shareholders, Mr. Khan, himself, acquired the whole of the share capital (the 99 shares) from the three shareholders for a sum of £1.95m plus £19,000 and then immediately had 98 of those shares bought back (by the company) from himself for £1.95m, which value was duly and immediately passed on to the shareholders (in satisfaction of almost all of Mr Khan’s debt to them under their acquisition agreement).

Mr Khan was left, as he was always intended to be left, with 100% of the company (worth £19,000) and a residual debt of £19,000 to the shareholders, which was duly paid a short time later.

But the tax analysis had changed dramatically.

Firstly, the three shareholders achieved the capital gain they had wanted (by reference to the proceeds they received from Mr Khan for their sale of the company to him). They were no doubt very happy about their tax efficient outcome.

Secondly, however, Mr. Khan had received a taxable distribution of income, in the sum of £1.95m, when he executed the buy-back of 98 shares from himself. This was (i) a sum of money to which he (and no one else) was “entitled” in law, arising from the buy-back (notwithstanding the fact that he had to then hand all of that value straight over to the shareholders in settlement of his acquisition debt to them); and (ii) it was income, not capital gain, under the tax code. As income, Mr Khan could not then offset any of his corresponding cost of purchasing those shares. There was a total mismatch of taxation character between his cost of the shares and his receipt from their realisation.

Mr Khan suffered a £600,000 Income Tax liability on zero net “proceeds”. This was confirmed by the court.

Even if the shareholders feel any kind of sympathy for Mr Khan’s plight (who knows if they do, or they don’t) they will have paid CGT on their own receipt and are unlikely, I suggest, to be minded to help Mr Khan with his major financial problem.

A complete personal disaster. Clearly illustrating the point that specialist tax advice needs to be taken at every step of the way.

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