HMRC has launched a wide ranging consultation on how distributions and returns of capital are taxed for individuals and trusts.
Although framed as “modernisation”, the proposals could significantly affect how companies and their advisers approach a wide range of transactions including:
- Purchases of own shares (share buybacks)
- Share exchanges (e.g. inserting holding companies)
- M&A transactions and corporate restructuring
- Corporate demergers.
The proposals represent a potentially significant tightening of the boundary between income and capital.
In practice, this is the line that often determines whether value extracted from a company is taxed at dividend rates or at capital gains rates.
Many established planning techniques sit along that boundary.
HMRC’s stated concern is that the current rules allow income to be converted into capital in ways it considers inappropriate.
There are specific proposals in a number of areas but those most likely to affect our Scottish SME clients are summarised below.
Reductions of capital
Generally, a reduction or return of capital to non-corporate shareholders is subject to Income Tax but relief is often available when a company purchases its own shares (a share buyback) from a departing director to ‘benefit the trade’ so that the distribution can be taxed as capital.
The consultation document (condoc) provides an example of how HMRC thinks existing rules are being exploited by close companies that insert a holding company with a share exchange and then distribute capital in the holding company which might be taxed partly or wholly as capital, rather than as income.
The proposal looks at ‘freezing’ the amount of capital on any shares in the newly inserted holding company at the amount subscribed in the original investment but acknowledges this has the potential to create issues and unfairness in certain situations.
Demergers
Companies undertake demergers for a variety of legitimate commercial reasons. The condoc acknowledges that the exact approach will vary depending on the circumstances.
Though there is a statutory demerger route, companies are often unable to meet the necessary conditions in which case they must look to other approaches that can achieve the same (or a similar) commercial outcome, including the ‘capital reduction demerger’.
The statutory demerger route, HMRC acknowledges, is currently ‘not well used’.
Capital reduction demergers rely on the operation of the share exchange rules referred to earlier.
The condoc states that by changing those rules, it may no longer be possible to undertake capital reduction demergers and, consequently, there may be increased reliance on the statutory route.
The proposals include changing the statutory demerger provisions so that the conditions are clearer, more reflective of commercial practice, introduce more ‘certainty’, and are able to be met by companies in a wider range of situations than is currently the case.
Worryingly, it is also proposed that the right to automatic appeal by Tribunal should a tax clearance request be denied will be removed.
Interaction between debt, loans and the distributions rules
As the condoc acknowledges, value extracted from companies may be taxed as a distribution even in circumstances where the payment is not properly made under company law.*
The Government considers that taxpayers are exploiting the rules in this area, particularly where the company is ‘close’ (broadly, under the control of five or fewer participators or directors who are also participators), to avoid a charge to Income Tax or a charge to tax on the company.
Several options are set out in the condoc to address the issue, including establishing a priority rule that will determine the tax treatment and legislating to allow ‘gratuitous transfers’ to be unwound.
*(The fact such distributions are ‘illegal’ may only come to light some time after the event).
Purchase of own shares
Where a company makes a purchase of its own shares, any excess paid over the amount of capital originally subscribed for the shares is generally a distribution subject to Income Tax.
However, there are special provisions that can enable a company to undertake a purchase of its own shares without making a taxable distribution.
If the requirements are met, such payments are taxed as capital rather than as a distribution.
The relief is intended to facilitate the departure of a shareholder from a company for the benefit of the company’s trade.
The current rules relate largely to satisfying a subjective ‘trade benefit test’ which is explained in HMRC’s Statement of Practice 1982 but the condoc says that this is a significant source of dispute between taxpayers and HMRC.
The Government intends to replace the trade benefit test with a more mechanical set of requirements, as set out in the document.
Anti-avoidance
The Government has said it intends to overhaul the existing anti-avoidance rules governing “Transactions in Securities” (TIS).
Broadly speaking these rules are designed to counter situations involving close companies where a transaction (or series of transactions) in share capital is undertaken and a main purpose of the transaction is “to secure an Income Tax advantage”.
The proposal is to replace the TIS rules “with an updated anti-avoidance regime” that is “clearer and more principles based”.
The full consultation document can be viewed at Modernising the taxation of distributions and repayments of capital from companies - GOV.UK.
Our view
Changes to existing tax legislation that deliver better certainty for taxpayers and their advisers, without imposing excessive compliance costs, are to be welcomed provided they do not distort or curtail transactions that have genuine commercial motives.
Whilst certain proposals in the condoc have some merit, others have the potential to make matters worse, introducing more uncertainty and additional costs for business. Other commentators have already remarked that many reorganisations could actually become more difficult and expensive as a result of the new proposals.
It is really critical that HMRC fully engages with the tax advisory community about the proposals, and that the consultation provides sufficient time and opportunity to respond.
(The closing date for responses is 14 September. Bearing in mind the consultation period spans the summer holidays is this really long enough, given the expected impacts of the proposals?)
HMRC must genuinely listen to the comments and concerns of the profession and the Government must be careful to avoid ‘unintended consequences’ that could negatively affect how businesses and their shareholders operate.
If you’d like to discuss this issue with our team, please get in touch with your local Scholes office.
