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Tax on winding up a company

Posted: 09/11/2023

Assume that you have a company which has ceased trading and is left with a cash balance. You could extract most of the cash by paying a dividend, but that would be inefficient for tax purposes (resulting in tax rates of up to 39.35%). So, instead, you decide to wind the company up and receive the proceeds as a capital distribution, taking advantage of the lower capital gains tax rates (generally at 10% or 20% depending on the circumstances). Surely that is legitimate?

Until 2016, this would have been perfectly acceptable tax planning. But from 6 April 2016, the law was changed in two ways. Firstly, the ‘transactions in securities’ legislation was widened so that HMRC could issue a counteraction notice to a shareholder who had avoided income tax by virtue of a distribution made in the course of a winding up – more on that later.

Secondly, legislation was introduced specifically to tax shareholders on capital distributions on a winding up as though they have received dividends (at rates of up to 39.35%). This was meant to catch a tax scheme known as ‘phoenixism’ – individuals formed a company to run their business, accumulated income, wound up the company, and started the business again in another new company, repeating the process every couple of years. This resulted in capital gains tax being payable on the accumulated income, often at only 10%.  

It is not immediately obvious that this was unreasonable tax planning. Capital gains have almost always been taxed at lower rates than dividends and there is no obligation on a company to pay a dividend, so the planning simply took advantage of the different tax rates. But the government wanted to end phoenixism and introduced ‘anti-phoenixism’ legislation. The problem, though, is that the legislation is so widely and inaccurately drawn that it could apply in circumstances far removed from phoenixism.    

The tax charge arises if all of the following apply:

(a) you have at least a 5% interest in the company;

(b) the company is ‘close’ – eg it is under the control of five or fewer shareholders – either when it is wound up or at any time in the two years preceding the start of the winding up;

(c) at any time within two years of the capital distribution, you carry on a trade or activity which is the same as, or similar to, that carried on by the company or a subsidiary – this includes if your partnership carries out such a trade or activity, if a company in which you, or someone connected with you, has at least a 5% interest carries out such a trade or activity, and if you are involved with the carrying on of such a trade or activity by a person connected with you; and

(d) it is reasonable to assume, having regard to all the circumstances, that one of the main purposes of the winding up is the avoidance or reduction of a charge to income tax.  

What makes this legislation so widely drawn? Only a 5% interest in a company is needed for the charge to apply. You may know little about the company’s business and have nothing to do with the decision to wind the company up, and still be caught if for example you, or another company in which you hold 5%, carry on a similar trade or activity in the next two years. The tax avoidance test at (d) above can apply even though you have no involvement in the winding up decision provided it is reasonable to assume that the persons who made this decision did so to avoid income tax.

Why is this legislation inaccurately drawn? Firstly, there is no definition of what a similar trade or activity is. There is no definition of what being involved with a trade or activity means. And the legislation applies when ‘it is reasonable to assume’ that income tax avoidance is one of the main purposes of the winding up. On the face of it, this means the legislation can apply even if no-one actually has a tax avoidance motive – just if it is reasonable to assume they did. But since all the circumstances must be taken into account, and one of those circumstances is the actual motives of the parties, this is unclear.

Legislation such as this creates the potential for discretions to be exercised inconsistently by staff at HMRC, leading to unfair outcomes. Neither do the comments by HMRC in its manual fill you with confidence – it misstates the legislation on several occasions and suggests that an important factor is whether the shareholder has control of the trade or activity after the winding up, something which the legislation is silent about.

Shareholders who receive capital distributions on a winding up have to decide whether to include the gains as capital or dividends in their tax returns. As seen previously, there may be great uncertainty as to whether the anti-phoenixism legislation applies. So what to do? HMRC does not operate a clearance procedure for this legislation. So, if you think the legislation probably does not apply, you could return the distributions as capital gains and include full details of the transaction in the white space on the tax return.

Curiously, though, there is an alternative course of action because of the ‘transactions in securities’ legislation mentioned earlier. Since 2016, this legislation allows HMRC to issue a counteraction notice to a shareholder who has avoided income tax by virtue of a distribution made in the course of a winding up. And under this legislation, there is an advance clearance procedure. So you could apply for clearance prior to the winding up that HMRC accepts that the transactions in securities legislation does not apply.

Technically the clearance only applies to the transactions in securities legislation, not to the anti-phoenixism legislation, but in issuing a clearance HMRC would impliedly be accepting that none of the main purposes of the winding up is to obtain an income tax advantage. That would make it hard for it later to argue that the anti-phoenixism legislation applies.

Finally, you may think that the way out of all this is to find a purchaser for your company, rather than wind it up. But HMRC does not agree. It says that the anti-phoenixism legislation, or the general anti-abuse rule, can apply to a sale carried out to avoid the anti-phoenixism legislation. Whether that is right is a whole other story.

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Penningtons Manches Cooper LLP is a limited liability partnership registered in England and Wales with registered number OC311575 and is authorised and regulated by the Solicitors Regulation Authority under number 419867.

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