TAAR, do your conditions apply?

Liquidation and phoenixism

Budget 2016 introduced measures to counter phoenixism, the practice of carrying on the same business or trade successively through a series of companies where each becomes insolvent in turn. Each time this happens, the insolvent company’s business, but not its debts, is transferred to a new, similar ‘phoenix’ company. The insolvent company then ceases to trade and might enter into formal insolvency proceedings (liquidation, administration or administrative receivership) or be dissolved.

Following the consultation on ‘Company distributions’, this year’s Budget announced that legislation would introduce a set of income tax avoidance rules; aimed to stop shareholders of close companies turning income into capital, so as to pay Capital Gains Tax (CGT) rather than Income Tax and thereby make a substantial saving of tax.

It is because the income/capital divide is still very much an issue that tax planning in this area thrives. A contractor whose company is a trading company and qualifies for Entrepreneurs’ Relief, will pay CGT at a rate of 10% on winding up of their company and extracting all of its reserves, as opposed to 7.5%, 32.5% or even 38.1% – the ordinary, upper and additional dividend tax rates effective from 6th April 2016.

Now that Finance Act 2016 has received Royal Assent, new sections 396B and 404A ITTOIA (Income Tax (Trading and Other Income) Act) 2005 introduced via section 35 of the Finance Act 2016, will impose a Targeted Anti-Avoidance Rule (TAAR). The TAAR will treat a distribution from a winding up as if were an income distribution, ie a dividend, where four conditions are met:

Condition A

Immediately before the start of the winding up, the individual has at least a 5% interest in the company, ie they must hold at least 5% of the ordinary share capital and 5% of the voting power by virtue of the shareholding.

Condition B

The company is a close company or was close at any time within two years before the start of the winding up. For small companies ‘close’ is likely to mean five or fewer shareholders.

Condition D

• It is reasonable to assume, having regard to all the circumstances, 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’ or
• It is reasonable to assume, having regard to all the circumstances, that the winding up forms part of the arrangements the main purpose or one of the main purposes of which is the avoidance or reduction of a charge to income tax.
• The circumstances include the fact that Condition C is satisfied.

Condition C

Within two years after the distribution:

• The individual carries on a trade or activity which is the same as, or similar to, that carried on by the company
• The individual is a partner in a partnership which carries on such a trade or activity
• The individual, or a person connected with him or her, is at least a 5% participator in a company which at that time carries on such a trade or activity, or is connected with a company which carries on such a trade or activity; or
• The individual is involved with the carrying on of such a trade or activity by a person connected with the individual

For those of you who think I have forgotten my alphabet, condition D has been deliberately placed between ‘B’ and ‘C’ to emphasise the point that if there is a genuine non-tax motive for winding up the company then we do not have to consider condition C as it becomes irrelevant.  For instance, retirement would be a perfect example of an initial motive that is not inspired by avoiding tax. The fact that the person gains a tax advantage from the closing down of the company is secondary to the main driver of retirement.

Evidence should be retained of the reason(s) for winding up the company, in the event that the individual unwittingly becomes involved in a similar trade or activity within the two-year period following the final distribution and is challenged by HMRC.

It is important to note that it is not the date that the company is put into liquidation but rather the date the distribution is made that will determine whether the TAAR is relevant. Proceedings to wind up a company could therefore begin before 5th April 2016 but if the final distribution is not made until after that date, then the legislation has to be considered.

Whilst HMRC will not provide clearance for the TAARs they have added distributions on the winding up of a close company to the list of transactions in securities in section 684 Income Tax Act (ITA) 2007 for which clearance is available. Every time a distribution is imminent therefore, it would be prudent to seek advance clearance under section 701 ITA 2007 for peace of mind.

We are still awaiting HMRC guidance which is must needed as there are still many unanswered questions.