Companies cease for a variety of reasons, some closing for the personal reasons of its directors or shareholders, rather than being forced to close by creditors. Many companies will have accumulated monies or assets that need to be distributed to shareholders on cessation. The method of distribution needs careful planning to ensure that the minimum amount of tax is paid.
Different methods of withdrawal:
· Dividends
Distributions are usually in the form of dividends, but income dividends can only be made ‘out of profits available for the purpose' (CA 2006, s 830); a company’s profits being the “accumulated, realised profits, so far as not previously utilised by distribution or capitalisation, less its accumulated, realised losses....".
Thus the company needs to have set aside sufficient profits to cover the amount of dividend as at the date of payment. Having a credit balance in the bank account is not enough - profits must have been earned which have not been withdrawn. If there are sufficient accumulated profits then the monies can be withdrawn over a period before cessation, but this may mean having to take a tax ‘hit’ at higher rates, depending on the shareholders’ marginal tax rates.
· Repayment of share capital
A capital repayment is paid out of shareholders' equity, rather than from the company's earnings. This type of payment will not generally be taxable on the shareholder as it is return of the share capital original paid into the company by the investor shareholder.
· ‘Capital Distribution’
On cessation, whether via the ’strike off’ route or the liquidation method, income dividends may have been made to the fullest extent possible from realised profits but there may still be capital to distribute. This type of distribution is defined (in TCGA 1992, s 122(5)(b)) as ‘any distribution from a company, including a distribution in the course of dissolving or winding up the company, in money or money's worth except a distribution which in the hands of the recipient constitutes income for the purposes of Income Tax'.
Tax Treatment of distributions on cessation
When a company ceases trading it can either:
- Apply to be ‘struck off’ from the Register of Companies; or
- Be wound-up under liquidation; or
- Become dormant.
Distributions made on ‘striking off’
‘Striking off’ is not a formal winding up procedure, and as such any distribution of surplus assets (including the repayment of its share capital represented by those assets) is legally an income distribution. However, if certain conditions are met, such distributions are treated as capital and will possibly attract entrepreneurs’ relief for capital gains tax purposes (CGT).
The tax conditions are to be found in CTA 2010, s 1030A, being the formal enactment of what was extra statutory concession C16’. ESC C16 was first introduced in 1985 to provide a simple and straightforward method by which companies could be ‘struck off’ with the company assets (usually cash) being returned to shareholders without the cost of a formal liquidation. Under this provision, CGT is generally charged, rather than income tax being payable on the transaction. The main advantage of this section is that should entrepreneurs’ relief be possible, the tax cost of dissolution will often be significantly lower than a charge to income tax. As the treatment is no longer a concession, HMRC authority is not required.
A problem with this approach is that two conditions must be present for a claim under the section to apply. First, there is a requirement that at the time of distribution the company has collected, or intends to collect, its debts and has paid off or intends to pay off its creditors. Secondly, there is a limit to the amount that can be withdrawn. This statutory limit is £25,000, whether as a single distribution or in separate amounts.
If the distribution exceeds this amount then the whole sum is taxed as income, unless the company goes down the route of formal liquidation.
Should the shareholder be a basic rate taxpayer, consideration may be given to extracting the excess over £25,000 as a dividend chargeable to income tax, leaving an amount equal to £25,000 to be extracted as capital. However, should the company then apply for dissolution, HMRC could argue that the intention was always to apply CTA 2010, s 1030A in striking off the company, and tax the whole amount as income. Therefore any dividend payment pre-dating the actual application should be taken into account when determining whether the £25,000 limit has been breached. Intent is likely to be inferred should the company dispose of remaining assets, leaving only cash at bank prior to the application.
No tribunal cases have been heard regarding CTA 2010, s 1030A to test its application, but some commentators believe that HMRC could use the above argument, so care should be taken.
What happens if the company is not dissolved?
If a company has applied to be ‘struck off’ but within two years of making a distribution the company has not been dissolved, or the company has either failed to collect all its debts or pay all its creditors, the distribution is treated as if CTA 2010, s 1030A had never applied, i.e. it is automatically treated as an income dividend (s 1030B).
Distributions on liquidation
Any company needing to make a distribution in excess of the £25,000 will effectively be forced to incur the additional costs of a formal liquidation (usually approximately £3,000-£4,000 for a small company in straightforward circumstances), if the shareholders would prefer CGT to income tax treatment. Where the distribution is of assets other than cash, the valuation of those assets could assume significance in determining whether the £25,000 threshold is breached.
Once a liquidator is appointed, all distributions made during the winding up process are normally treated as capital subject to CGT. Entrepreneur’s relief may be available if the relevant conditions are satisfied plus, if timed right, distribution payments can attract the individual’s CGT annual exemption for more than one tax year. A liquidator usually distributes 75% of the available amount as soon as funds are received, retaining the balance as a ‘buffer’ payable after HMRC clearance has been obtained and the period for any creditors to object has passed.
An application to ‘strike off’ can only be made if the company has not traded or carried on business, changed its name, or sold business assets, rights or property in the previous three months. In comparison, a liquidation can be instituted immediately on cessation of trade, and is generally an efficient way to wind up the affairs of a solvent entity.
Practical Tip:
Planning as far in advance as possible is key to saving tax on cessation. Should the shareholders wish to use the ‘strike off’ method, the appropriate board resolutions must be in place confirming the decision. The minutes of meetings may well be needed as evidence of intention.
