How is HMRC examining capital distributions?
As a brief reminder, HM Revenue & Customs have set out four conditions under which they may reclassify a capital distribution as income. In order to take this action, all four of the below conditions must be met:
- The company must be a close company.
- Your interest in the company is at least 5%, generally meaning you are eligible for entrepreneurs relief.
- You carry out a similar trade or activity within 2 years of the date of distribution.
- The main purpose of the winding up is to achieve a tax advantage.
If all of the above conditions are met, HMRC will reclassify any capital distributions as income subject to dividend tax. This will also leave you unable to claim entrepreneurs relief following the members voluntary liquidation. HMRC have clarified that they expect the majority of distributions following winding up will remain capital distributions. Only a minority will be reclassified as income.
HMRC response for clearance prior to members voluntary liquidation
Unfortunately, if you request tax clearance on capital distribution prior to commencing the members voluntary liquidation process, HM Revenue & Customs have confirmed that they have no procedures in place to grant this. Instead, the response from HMRC to the tax clearance request is to provide further guidance. Essentially, this leaves you to make your own decision. HMRC have also now published additional guidance in their tax manual and our assessment of this can be found here.
Commenting specifically on the provisions, HMRC are clear that there is no ambiguity over the first two conditions. These are that the company is a close company, ie where all shareholders are directors or where there are less than 5 shareholders, and the shareholders’ interest is 5% or more. The ambiguity comes for the final conditions, relating to carry on trading and whether the main purpose is to obtain a tax advantage.
Carrying on a similar trade
The clearance letter sets out what HMRC would view as carrying on a similar trade or activity. It is important to note that the provision of the 2 year period starts from the date of each distribution, rather than the date of winding up. It may, therefore, be that if there are multiple distributions and you are clear of the first distribution, if starting up again, later distributions may be treated as income.
When actually reviewing the similar trade position, the HMRC clearance letter makes a very clear statement that the condition will not be met, “where the individual is employed by an unconnected third party.” The letter does state, however, that HMRC will form the view an individual is carrying on the trade or activity, “as a sole trader, through a partnership, through another company, and through connection to the company of an associate.” This includes, “working as an employee for a spouse in a similar trade.”
The term trade or activity carries a wide definition. When considering whether HMRC will take action, the clearance letter states this should be, “interpreted widely as anything done by the company.” If you continue to trade in a business that bares any similarities, or a connected similar business, this condition is likely to apply. This doesn’t just apply to new businesses, but also to concurrent businesses in a similar trade or activity.
Main purpose for tax advantage
The pre liquidation tax clearance letter stipulates that the conditions will be considered in order. Therefore, if the first three conditions are met, HMRC will then consider whether the main purpose of the winding up is to obtain a tax advantage. The default position with HMRC is that the assumption will be made that the purpose is to obtain a tax advantage and it is for the taxpayer to prove otherwise.
The clearance letter from HMRC provides several examples of circumstances under which condition D will not apply. The examples effectively suggest that if separate companies are set up to manage separate contracts, it is likely that the purpose is to obtain a tax advantage. Some examples of circumstances which may not meet the final condition include:
- Emigrating on a permanent basis.
- Sale of business to an unconnected party.
- Winding up for commercial reasons.
Obviously the circumstances surrounding the above will apply and should be prepared for a submission to HMRC. Again, the letter suggests that clearance will not be given before commencing the members voluntary liquidation procedure.
If all four conditions apply HMRC may reclassify the capital distribution as income, also preventing claims for entrepreneurs relief. If you are considering making an entrepreneurs relief claim, our business rescue experts can consider the circumstances as to whether you should proceed with the liquidation.