Winding up your company? Beware of potential tax pitfalls….

Date posted: 1st Oct 2018

In recent years, HMRC have taken a magnifying glass to situations involving the winding up of owner managed limited companies, particularly as the winding up could lead to the extraction of the funds within the company at an attractively low 10% rate of tax.

Phoenix from the flames?
One particular practice that they wished to counter was ‘phoenixing.’

Essentially what was happening was that a business owner would operate his business via a limited company and then instead of drawing dividends (taxable as income – potentially up to a 38.1% tax rate), the director would take monies (needed to live on) as loans from the company. These loans would carry tax charges themselves, but at a much lower rate of income tax for the individual. These would be repaid, by the director-shareholder, to the company, on the eventual wind up of the company.

Simultaneously, the limited company would begin to be wound up (by a licenced insolvency practitioner / liquidator) and the loans would deem to have been repaid as part of the wind up. This transaction was usually undertaken to allow the shareholders (usually the business owner!) to take the undrawn profits built up in the company as a ‘capital’ payment and therefore subject to capital gains tax. If entrepreneurs relief applied, this would mean that the monies within the company could be effectively drawn by the shareholder/owner at a 10% capital gains tax rate, rather than a 38.1% income tax rate on any dividends.

The business owner would then start up a new company shortly after, carrying on the same trade, and repeat the same ‘trick’ as above in a few years’ time.

In April 2016, to counter such ‘phoenixing’, HMRC introduced some new rules to cancel out the tax advantage of the above practice. Essentially, HMRC now seek to tax the monies drawn on a wind up as income (therefore taxable up to 38.1%) if a number of conditions were met. These are that:

  • The person receiving the distribution had at least a 5% interest in the company prior to winding up
  • The company was a close company at end point in the two years prior to the wind up
  • The individual receiving the distribution of funds continues to carry on, or be involved with, the same trade, or similar, to that of the wound up company in the next two years
  • It would be reasonable to assume that the main purposes or one of the main purposes of the winding up was the avoidance or reduction of tax

So what’s new?
As we discussed above, HMRC have dealt with phoenixing. However, there is still a tax advantage for those businesses genuinely winding up after the cessation of trade.

Where the director-shareholder has an outstanding loan (overdrawn loan account) with the company at the time of the wind up, HMRC could deem that the amount of loan is taxed as income, leading to a higher tax bill. This would be regardless of the fact that there was no intended ‘phoenixing’ as above.

As we stated above, it is common practice for a liquidator to clear the overdrawn loan account balance as part of the wind up procedure, without the actual repayment of funds to the company by the director. It has always been understood that the deemed repayment of the loan account would be then taxed upon the director-shareholder under the capital gains tax rules rather than then more punitive income tax rules.

Robert Limited has ceased trading and Bob (the sole director-shareholder) wishes to retire. Robert Limited has net assets of £300,000 being £100,000 cash in the company bank account and a £200,000 loan owed by Bob himself.

The previous advice would have been for Robert Limited to appoint a liquidator and for Bob to draw the £300,000 assets as a capital sum, thus paying potentially 10% (£30,000) tax. In essence, Bob would not actually pay back the £200,000 he owes to the company and would receive £100,000 from the liquidator (less their fees) from which he would pay the £30,000 tax bill.
HMRC is not happy about this and is intending to take a test case to tribunal to challenge that the loan account monies not repaid should be taxed as income and therefore at a tax rate of up to 38.1%.

If that were the case, Bob would pay say 38.1% tax on the £200,000 and say 10% tax on the £100,000 – total £86,200. Clearly a significantly higher tax liability than the £30,000 Bob had anticipated!

What can be done?
Given the uncertainty whilst we await the outcome of the case, the most obvious route would appear to be for the loan account to be repaid before the wind up commences. Bob could consider using personal savings to repay the loan or a short term bank loan, if he is able to raise the monies and this is commercially viable.

Once the loan had been repaid to the company, the liquidator could make an interim distribution to Bob to allow him to repay the bank loan or top back up his savings.

Of course, HMRC may lose the test case at the tribunal as there case would be based upon the tax law as it stands today. However, HMRC could then bring in some new tax rules to counter this perceived tax advantage in the future, so this may not go away lightly.

Such liquidations should be pre-planned and controlled carefully so that the business owners are aware of the pitfalls and potential challenges by HMRC.

Our tax team are highly experienced in such matters and are here to help, so contact us today at your closest office.

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