Anti-Phoenixing
In the run up to Budget Day 30 October 2024 we are seeing many clients trying to get transactions across the line to lock into the current capital gains tax regime rather than risk potential tax changes in Labour’s first fiscal event of this parliament.
Individuals with value trapped in their own company may be looking towards a solvent liquidation – a Members Voluntary Liquidation (“MVL”) – to extract value in either the form of cash or as assets in specie, perhaps with a view to continuing their business themselves or via a new company.
One area of increasing focus for HMRC involves the alleged misuse of the MVL process to avoid tax – a practice known as “phoenixing”. Legislation was introduced in 2016 – the Targeted Anti-Avoidance Rule (“TAAR”) – to clamp down on tax avoidance associated with these activities but the widely drawn legislation can catch genuine entrepreneurial activity.
What is Phoenixing?
Phoenixing occurs when a company is wound up, but the same or a similar business is resurrected shortly thereafter in a new company or in another capacity. This process is sometimes used to extract profits in a tax-efficient manner. For example, directors may liquidate a company, distribute the remaining assets as capital (attracting capital gains tax (“CGT”)), and then start a new business, repeating this process multiple times. Since CGT is usually lower than income tax, this practice can significantly reduce a director-shareholder’s tax liability on the extracted funds.
The Anti-Phoenixing TAAR
The TAAR on phoenixing aims to prevent individuals from artificially obtaining capital treatment (which benefits from lower CGT rates) on distributions received when a company is liquidated, instead of paying income tax on the same funds. The rule is designed to stop serial liquidators who extract company profits through liquidation, avoiding higher income tax charges, but its effect can be much wider. The key conditions of the TAAR are as follows:
1. Distribution on Winding Up: The rule applies when a company makes a distribution during liquidation or dissolution.
2. Close Company: The rule targets close companies, where five or fewer shareholders, or directors, control the business.
3. Size of Shareholding: immediately before the winding up, an individual has at least 5% of the shares in, and voting rights of, the company.
4. Involvement in a Similar Trade: Within two years of receiving the distribution, the individual involved in the liquidation must start up or continue to be involved in a similar trade or activity. This includes forming or becoming a director of a new company or being involved in a similar trade as a sole trader or partner or being connected to someone else who carries on a similar trade.
5. Main Purpose Test: The rule also includes a purpose test. If one of the main purposes of the liquidation is to avoid income tax by obtaining capital treatment for the distributions, the TAAR may apply. This test focuses on the intention behind the liquidation.
If these conditions are met, the distribution could be reclassified as income instead of capital, resulting in income tax being charged at rates of up to 39.35% (as opposed to CGT, which can be as low as 10% if Business Asset Disposal Relief is available). It is worth commenting that distributions on a winding up are also specifically defined as “transactions in securities” (TiS), a set of overarching anti avoidance rules to prevent transactions involving shares or securities which should be taxed as income being taxed as capital gain. The TAAR takes priority over TiS.
Key Implications
The legislation is drawn very widely such that it could be triggered even if a tax reduction were not the main or only motivation behind the winding up of a company. Moreover, the two year “tail” considering activities of the individual in this period post liquidation means lack of certainty on the tax position and again could catch a whole spectrum of scenarios. The subjective nature of the purpose test creates grey areas, particularly where individuals genuinely plan to exit a business but subsequently re-enter the same or similar trade due to unforeseen circumstances.
HMRC have provided some guidance in respect of the application of the main purpose test though this guidance is cursory and skirts around the more complex issues that are encountered in practice. HMRC is silent, for example, on the application of the TAAR where it is considered commercially essential to conduct a project within a company and then wind that company up at the end of the project; common practice in the construction or property development industry. HMRC does not specifically address this point in its guidance. It could perhaps be assumed that such transactions would not be within the TAAR because of the primary motive exclusion but this is not explicitly stated.
The guidance states that it is for the individual to determine whether tax avoidance was a main purpose of the winding up and to self-assess the tax treatment of a distribution on a liquidation via their tax return. HMRC can displace this approach only where the individual’s decision is not reasonable, and it is for HMRC to demonstrate that point i.e. the onus is on HMRC. The test in relation to the taxpayer’s intentions considers what they were at the time of the winding up of the company, rather than two years later. It will, of course, be open to HMRC to review the facts considering subsequent events and to draw conclusions therefrom.
Practical Considerations and possible protections
In practice, it can be sensible for any person that is expecting a distribution in the winding-up of a close company to apply for pre-transaction clearance from HMRC that the TiS rules do not apply. Although any TiS clearance does not prevent HMRC applying the TAAR, it may provide some reassurance. There is no separate advance clearance process for the TAAR and therefore it is critical for individuals considering an MVL to keep detailed records of intentions at the time of the liquidation, any relevant market conditions or personal factors that influenced their decisions. Consideration should be given to longer term plans – could there be a return to a similar trade or industry following the liquidation? Practical steps should be taken which can support the disclosures made to HMRC via self-assessment.
- Before the Liquidation: Consider long term plans. Is the plan to exit the business entirely, or could you end up in a similar trade or industry in the near future?
- Document motivations: Keep clear, detailed records of the reasons for liquidation, particularly if you are retiring or exiting the industry for genuine commercial reasons.
Chris Peverley
- Monitor involvement in similar trades: After liquidation, consider your ongoing activities in the two-year period following to ensure you are not unintentionally triggering the TAAR by becoming involved in a similar trade too soon.
- Consider alternative tax planning: Explore other options for extracting funds from the company, such as dividend payments or selling the business, to avoid the complications associated with liquidation and potential TAAR breaches.
Given the complexities which can arise, it is important if you are considering an MVL that you seek professional advice from your usual member of the RG team.