How HMRC is examining entrepreneurs relief in members voluntary liquidations
What is entrepreneur’s relief in members voluntary liquidation?
If a business owner liquidates a profitable business using member’s voluntary liquidation (MVL), shareholders may be entitled to pay, for example, 10% Capital Gains Tax via entrepreneur’s relief on the distribution that they receive. This is much more favourable than dividend taxation rates which, after an initial £2,000 allowance, are (as of April 2018) calculated at:
- 7.5% for basic rate taxpayers
- 32.5% for higher rate taxpayers
- 38.1% additional rate taxpayers
Why has HMRC made changes to entrepreneur’s relief in members voluntary liquidations?
Under the new rules known as the targeted anti-avoidance rule (TAAR), HMRC has additional powers to reclassify capital payments as income payments if it thinks that the distribution has been set up for the purposes of gaining a tax advantage.
If, for example, a business owner uses an MVL to close a business and distributes its assets at the lower rate of 10% CGT using entrepreneur’s relief, but then starts a new business doing the same or a similar activity within 2 years of receiving the distribution from the first business, HMRC would view the closure of the first business as activity set up for the purposes of gaining a tax advantage. Under the TAAR, it would then retrospectively reclassify the capital payment received as an income payment subject to dividend tax rates, rather than friendlier capital gains rates.
Essentially, the new rules are designed to target business owners who use the closure of a business as a tax efficient way to release funds, and continue to carry on the same, or substantially the same activity with a new business soon after (within 2 years) of the closure of the first business.
Who will the changes affect?
For those business owners who seek to shut down a business for the purposes of retirement or to do something completely different, they will still be entitled to benefit from paying capital tax rates rather than income tax rates. Such business owners will still be able to benefit from entrepreneurs relief in members voluntary liquidation, and the TAAR will not apply.
How will HMRC decide?
However, where HMRC thinks that a business owner is trying to gain a tax advantage through entrepreneurs relief in members voluntary liquidation, it will intervene and apply the TAAR. In order to judge individual cases, there are three conditions – all of which must be met – for HMRC to consider activity as set up for the purposes of tax avoidance.
- Condition A – an individual (S) who is a shareholder (owns more than 5% shares) in a close company (broadly speaking, a company that is under the control of 5 or fewer participants) receives from the company a distribution in respect of shares in a winding-up.
- Condition B – within a period of two years after the date of distribution S continues to be involved in a similar trade or activity; and
- Condition C – the arrangements have a main purpose, or one of the main purposes, of obtaining a tax advantage.
HMRC have recently provided additional clarity on conditions B and C and how they will be applied. Under condition B, they have added additional definitions that this must meet both the “Similar trade or activity” and the “”Involved in” category. They have expanded that to be involved in the company you or a connected party, such as a friend or family member, are running the new business.
Under condition C, HMRC have confirmed they will assume the main purpose is to obtain a tax advantage. They will apply the TAAR as standard. They have confirmed, however, they will consider representations from the beneficiary and will consider the following to when considering whether to disapply the TAAR:
- The size of the tax advantage in proportion to the company.
- The extent to which the trade or activity is similar along with work practices.
- Is the continuation a transitional consultancy to help to new owners get set up?
- Was the shareholder party to the decision to enter liquidation?
- Is there a history of entering liquidation for a tax advantage?
- Any other commercial factors in the decision to wind up.
- Was the business sold to an independent third party before the decision to wind up?
Some working examples
In order to better understand its guidelines, HMRC gives the following helpful examples:
Mr A has been the sole shareholder of a landscape gardening company for 10 years. He decides to wind up the business and retire. Because he no longer needs a company he liquidates the company and receives a distribution in the winding up. To subsidise his pension Mr A continues to do a small amount of gardening in his local village. These arrangements do not appear to have gaining a tax advantage as a main purpose. It does not seem that Mr A setup the company, wound it up and then continued to trade as a sole trader with the view to receive the profits as capital rather than income.
Mrs B is an IT contractor. When she receives a new contract she sets up a limited company to carry out that contract. When the contract is completed and the money paid, Mrs winds up the company and receives the profits as capital. In this example, it looks the main purpose of this setup is to receive a tax advantage. All of the contracts could have been operated through the same company, and this would seem the most sensible setup, were it not for receiving a tax advantage.
Mrs C is an accountant who has operated through a limited company for 3 years. She has decided that the risk involved with running her own company is too much effort and decides to accept a job at another accountancy firm as an employee. It is not reasonable to assume in this example that Mrs C’s company was incorporated and wound up for tax reasons, rather than commercial reasons.
Mr D is a builder who runs his business through two companies – Company 1 specialises in loft conversions, and Company 2 specialises in extensions. Mr D winds up Company 1, but the trade of Company 2 continues. Mr D continues to be involved with a trade that is similar to that of the company that is wound up, and so Condition B is satisfied.
Mr E is a fitness instructor who provides his services through a company. After suffering an injury, he winds up his company and starts work as a journalist. Mr E’s wife is also a fitness instructor and she offers her services as a sole trader, before and after the winding up of her husband’s company. Mr E provides no services to his wife’s business at all. Mr E is not “involved with the carrying on of” a similar trade or activity after the winding up of the first company, even though his wife is.
The new rules will not affect the vast majority of business owners who seek to use entrepreneurs relief in members voluntary liquidation to close their businesses for reasons other than the explicit purpose of avoiding tax.
If you are thinking about using an MVL to liquidate your business, contact us for free initial advice. Moving forward, if an MVL is the best option for your business, we charge as little as £1,150 plus VAT to implement the liquidation.
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