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Tax consequences of liquidations and benefiting from capital treatment
Rohan Manro talks about the tax implications of companies entering liquidation/winding up procedures, which could be relevant to a large number of businesses who have been affected by the COVID-19 crisis.
Some business owners might opt to cease trading permanently in the aftermath of the economic downturn. It is not normally possible to cease trading without incurring significant costs. However, provided the company remains solvent (after meeting cessation costs), the owner-manager will be able to control the process of winding-up the business under a members’ voluntary winding-up.
There will often be a surplus available for distribution to the shareholders after the interests of the creditors have been satisfied. It is important to ensure that surplus funds in the company are distributed in a tax-efficient manner. For distributions made as part of a liquidation after 5 April 2016, the shareholders might be subject to high dividend income tax rates in certain cases. It is therefore important that formal tax advice is obtained to reduce the risk of such high tax rates applying to liquidations.
Distributions made in the course of dissolving or winding-up the company are treated as ‘capital’ distributions and are therefore chargeable to capital gains tax, as opposed to the higher income tax rates.
In a large number of cases, capital distributions made as part of a liquidation should be entitled to Business Asset Disposal Relief (previously called Entrepreneurs’ Relief), attracting capital gains tax rate of 10% for gains up to £1 million.
The Demise of the Phoenix
Before April 2016, it was common for the rules to be exploited by building up funds within a company, liquidating, paying tax on the extraction of those funds at 10% / 20% and setting up a new company to repeat the cycle.
Phoenixing is used to describe the act of closing one company and opening another company for a similar, or the same, purpose – i.e., one company rises from the ashes of another.
However, Targeted Anti-Avoidance Rules (“TAAR”) were introduced to level the playing field and remove those tax advantages. These rules are referred to as the ‘Anti-Phoenix’ rules.
Where these rules apply, the distributions are treated as income distributions subject to dividend tax rates of up to 38.1%.
Do the Anti-Phoenix Rules Always Apply?
The short answer is no. The rules only apply where certain conditions are met.
Generally speaking, the provisions will only apply where the business owner carries on a similar trade or activity within two years following the winding up of the company. This can include carrying on a similar activity via a partnership or a company.
However, these provisions do not apply where the purpose of liquidating the company is commercial and not tax motivated.
Due to limited guidance or authority which provides clarity on HMRC view of when these rules apply, business owners should tread with caution and seek professional advice when a liquidation is contemplated. The intention at the time of liquidating will be the most important factor in deciding whether the beneficial treatment can be obtained and ensuring any such intention is properly and legitimately evidenced will help to counter any enquiries or challenges from HMRC.