The rules concerning the way company shareholders can and should extract funds from their companies have become rather a grey area.
In the past, shareholders would often seek ways to extract funds as capital rather than income if that was possible because the rates of capital gains tax are lower than the rates of income tax. However, new legislation brought in from 6 April 2016 has created a lot of uncertainty for shareholders, not just when considering how to extract funds, but when considering whether to retain profits within the company and what HMRC may do in the future about this practice.
As a result of a recent consultation, new anti-avoidance rules were brought into play from 6 April 2016, which prevent shareholders extracting funds from a company as capital when they could extract them as dividends. These rules also prevent shareholders from restructuring companies and extracting capital whilst retaining control of the company.
New rules counter tax planning over dividends tax increase
The motivation for making these changes seems to have been triggered by the increase in the rates of income tax payable on dividends (and the subsequent reduction in the rates of capital gains tax), which HMRC consider will increase the incentive for company owners to extract capital rather than dividends from their companies where possible.
HMRC is also concerned about the retention of profits within a company for a period of time until they can be paid out in the form of capital, rather than being paid out in the form of dividends as they are earned, where they are not needed by the company.
There will be clear instances where excess funds are retained for periods of time in order to reduce tax, but these pale into insignificance alongside the number of instances where companies retain profits for many other reasons, such as concerns over market trends or customer payment terms, the unreliability of bank funds, or the possibility of making business acquisitions which may or may not come to fruition. In this situation, who decides on the subjective issue of whether the company 'needs' the funds?
Having retained funds over a period of time, for whatever reason, a company may then be the subject of a trade sale or a members' voluntary liquidation. This new legislation will entitle HMRC to take the view that the shareholders have retained excess profits within the company with a view to extracting them as capital at the time of the sale or liquidation rather than taking dividends as the profits were earned; therefore leading to the conclusion that the main objective was to gain a tax advantage.
Companies need to be aware of this and fully document the commercial reasons for the retention of funds over the period they are retained. To demonstrate at some point in the future that the funds were not retained in order to create a tax advantage. While it is possible to approach HMRC in advance of a transaction in order to request clearance that the anti-avoidance legislation will not apply, recent experience suggests very little clarification has been provided to date.
They will apply if the following three conditions are all met:
The situation is less clear in other instances, and until the legislation has been in existence for longer and we have a better idea of HMRC's approach, companies will need to be meticulous in documenting the commercial reasons for retaining funds, which on the face of it appear to be surplus to requirements.
In the past, shareholders would often seek ways to extract funds as capital rather than income if that was possible because the rates of capital gains tax are lower than the rates of income tax. However, new legislation brought in from 6 April 2016 has created a lot of uncertainty for shareholders, not just when considering how to extract funds, but when considering whether to retain profits within the company and what HMRC may do in the future about this practice.
As a result of a recent consultation, new anti-avoidance rules were brought into play from 6 April 2016, which prevent shareholders extracting funds from a company as capital when they could extract them as dividends. These rules also prevent shareholders from restructuring companies and extracting capital whilst retaining control of the company.
New rules counter tax planning over dividends tax increase
The motivation for making these changes seems to have been triggered by the increase in the rates of income tax payable on dividends (and the subsequent reduction in the rates of capital gains tax), which HMRC consider will increase the incentive for company owners to extract capital rather than dividends from their companies where possible.
HMRC is also concerned about the retention of profits within a company for a period of time until they can be paid out in the form of capital, rather than being paid out in the form of dividends as they are earned, where they are not needed by the company.
Does a company 'need' to retain profits?
This point has major implications for shareholders and directors who may have a variety of reasons for retaining profits within the company because the question of whether a company 'needs' the profits it retains is subjective.There will be clear instances where excess funds are retained for periods of time in order to reduce tax, but these pale into insignificance alongside the number of instances where companies retain profits for many other reasons, such as concerns over market trends or customer payment terms, the unreliability of bank funds, or the possibility of making business acquisitions which may or may not come to fruition. In this situation, who decides on the subjective issue of whether the company 'needs' the funds?
Having retained funds over a period of time, for whatever reason, a company may then be the subject of a trade sale or a members' voluntary liquidation. This new legislation will entitle HMRC to take the view that the shareholders have retained excess profits within the company with a view to extracting them as capital at the time of the sale or liquidation rather than taking dividends as the profits were earned; therefore leading to the conclusion that the main objective was to gain a tax advantage.
Companies need to be aware of this and fully document the commercial reasons for the retention of funds over the period they are retained. To demonstrate at some point in the future that the funds were not retained in order to create a tax advantage. While it is possible to approach HMRC in advance of a transaction in order to request clearance that the anti-avoidance legislation will not apply, recent experience suggests very little clarification has been provided to date.
What are the new rules?
The following practices were highlighted as unacceptable in HMRC's consultation document on this issue:- Phoenixism - where a company enters into a members' voluntary liquidation, but one or all of the shareholders move on to carry on substantially the same activities in another trading vehicle
- Use of special purpose companies - where business operations or projects are divided amongst separate companies and as each project comes to an end the company is liquidated
- Company sales where the purchaser includes the purchase of accrued profits in the purchase price for the shares
- The creation of new capital in a reconstruction which does not require shareholders to invest new capital and which is subsequently the subject of a repayment of share capital
How can company owners overcome these restrictions?
The situation surrounding 'phoenixism' is relatively clear; the new rules tax distributions received by individuals in some circumstances to income tax rather than capital gains tax.They will apply if the following three conditions are all met:
- Condition A - the company is a 'close company' (or has been so within the previous two years). This is a company which is controlled by five or fewer shareholders or is controlled by its directors. In practice, most privately owned companies are close companies
- Condition B - within two years after the date of the distribution, the individual receiving the distribution (or someone connected with him or her) is involved in carrying on any trade or other activity previously carried on by the company (or any similar trade or activity). This can involve trading either as a company, partnership, LLP or sole trader
- Condition C - it is reasonable in all the circumstances to assume that one of the main purposes of the liquidation is the avoidance of income tax (if Condition B is met this will be a relevant circumstance)
The situation is less clear in other instances, and until the legislation has been in existence for longer and we have a better idea of HMRC's approach, companies will need to be meticulous in documenting the commercial reasons for retaining funds, which on the face of it appear to be surplus to requirements.
