Originally written for Contractor UK https://www.contractoruk.com/limited_companies/contractors_factor_taar_when_winding_your_limited_company.html
As we established last week on ContractorUK, generally-speaking, if the limited company is solvent and is able to meet its financial obligations, it would be closed by way of a Members’ Voluntary Liquidation. An MVL is a formal process that winds up a company and allows the directors to realise the assets in the company.
MVLs: the appeal
MVLs are attractive because distributions that are made following an MVL will be taxed as a capital gains disposal, rather than income. Crucially, CGT tax rates are significantly lower than the current income tax rates. Specifically, CGT’s higher rate is 20% for these circumstances, whereas the higher income tax rate for dividends is 32.5% and the additional rate is 38.1%.
Additionally, should you meet the qualifying conditions, Business Asset Disposal Relief (BADR) is available, in which the distributions are taxed at 10% up to the lifetime limit, which is £1million.
Sense, complexity and preparation
Contractors must remember that in general, they should have a genuine commercial reason for liquidating their own limited company and therefore, where a limited company is no longer required, BADR can clearly be sensible planning.
However, it is complex. And failure to prepare properly may result in being caught by the targeted ‘anti-phoenix’ rules, also known as the company winding-up Targeted Anti-Avoidance Rules. These were introduced because the issue that caught HMRC’s attention was directors liquidating their limited companies and opening new businesses to benefit from the lower CGT rates while they were still trading.
So TAAR was implemented to ensure that directors would no longer gain a tax advantage while they are carrying out the same trade/activity. The purpose of these anti-avoidance rules is to prevent individuals converting what would otherwise be a dividend into a capital payment. Note, TAAR applies to distributions made on or after April 6th 2016.
What are the anti-phoenix (or TAAR) rules?
The rules apply only to distributions on winding up a company and not to the sale of a company. An individual will be caught by TAAR if they meet all the following conditions:
- Condition A: The individual receiving the distribution had at least a 5% interest in the company immediately before the winding up
- Condition B: the company was a ‘close company’ at any point in the two years ending with the start of the winding up
- Condition C: the individual receiving the distribution continues to carry on, or be involved with, the same trade or a trade similar to that of the wound-up company at any time within two years from the date of the distribution, and;
- Condition D: it is reasonable to assume that the main purpose, or one of the main purposes of the winding up is the avoidance or reduction of a charge to income tax.
Looking at the conditions in depth
Condition A, above, is a similar condition you would need to meet to qualify for BADR. It requires that immediately before the start of the winding up of the company, the individual had at least a 5% interest in the company.
This means that the individual would need to have 5% or more of the ordinary share capital and 5% the voting power exercisable by that individual. Importantly, for contractors operating a limited company, this condition is likely to be met as generally, they would have a 100% as sole director, or perhaps at least a 50 % interest in the company.
Condition B is straightforward. A ‘close company’ is broadly a company which:
- is under the control of five or fewer participators, or any number of participators if those participators are a director, or
- more than half the assets of which would be distributed to five or fewer participators, or to participators who are directors, in the event of the winding up of the company.
Again, most contractors with limited companies will likely be caught under this condition (Condition B), as they would have fewer than five participators.
Subject to interpretation
Next, Condition C will be applicable in most circumstances in which you carry on a trade or activity which is similar to that carried on by the company, including whether you start a new limited company, partnership, self-employed business or even in circumstances where a connected person carries on such trade or activity.
It is deliberately widely drafted to catch most circumstances. “Similar trade or activity” is also not defined and again, is wide-ranging and subject to interpretation, which is one of the difficulties when analysing the rules to determine if they apply!
Finally, Condition D is probably the vaguest condition and the most likely to be relied upon to avoid being caught by the TAAR provisions. If it is evidential that the main reason for winding up the company was not to avoid or reduce tax, but there was a genuine commercial reason for the winding up for the company, then condition D will not apply. And as mentioned earlier, all conditions must be met and therefore if condition D fails, then TAAR will not apply.
As even the most casual reader can hopefully see, these rules are complex. More than that, though, Conditions C and D are subject to interpretation, and any outcome is uncertain due to the lack of case law in this area. Therefore, an individual exploring the liquidation of their company will need to consider these rules, especially where they intend to carry on the same or similar trade or activity within two years.
In the current climate, a final consideration that has been on HMRC’s radar are attempts to avoid an income tax charge when a company is wound up. In particular, HMRC published Spotlight 47 which states that some scheme promotors have claimed to have an arrangement to avoid income tax charge due if an individual is caught by TAAR. This is because the rules do not apply to limited companies being sold to third parties, and the promoters are able to make such a claim by making an artificial modification of the arrangements to avoid the income tax charge. HMRC insists however, that such arrangements will be caught — by the General Anti-Abuse Rule (GAAR).
So with not just one, but two anti-avoidance frameworks in place to catch anyone from the unwitting or unprepared and upwards, we recommend contractors should strongly consider their options if planning to wind up and make distributions. This complex, interpretative area may result in serious financial implications for you if skimped over, possibly even criminal proceedings for those contractors who are not careful.