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Taxation by Mark McLaughlin ATII TEP

Mark McLaughlin ATII, ATT, TEP, outlines some key considerations relating to the liquidation or winding up of family companies.‘All good things must come to an end’ so the saying goes. Family companies (good or otherwise) also reach the end of their useful lives on occasion, for various reasons. Here are ten important points to bear in mind when that time arrives (all references are to the Income and Corporation Taxes Act 1988 unless otherwise stated).

1. Cessation of trade

The cessation of the company’s trade will trigger the end of the company’s accounting period (s 12(3)). If the company is not ‘large’ for the purposes of paying corporation tax by quarterly instalments, any liability for the final trading period will be due within nine months and one day following the end of that period (TMA 1970, s 59D(1)). Provision for trading expenses should be made as far as possible in the cessation accounts and/or tax computation, as expenses following cessation can only be set off against any post-cessation receipts (s 105(1)). Expenses incurred in connection with the cessation of trade are generally not allowable, because they are not incurred ‘wholly and exclusively’ for the purposes of the trade (IRC v Anglo Brewing Co Ltd (1925) 12 TC 803). However, statutory redundancy payments are specifically allowable, together with additional redundancy payments within certain defined limits (ss 90, 579). The Inland Revenue may also allow tax relief for contractual severance payments, following the decision in Hong Kong Commissioner of Inland Revenue v Cosmotron Manufacturing Co Ltd [1997] STC 1134 (see Revenue Interpretation 200).

2. Liquidation

The members of a solvent company can wind up the company voluntarily through a licensed insolvency practitioner. The commencement of liquidation (or a winding up) signals the end of an accounting period, and the start of a new one, with each accounting period lasting twelve months and the final accounting period ending when the winding up is completed (s 12(7)). Distributions to shareholders during this time are treated as capital distributions in part or full repayment of share capital, i.e. there is no tax credit, as there is no income distribution (s 209(1)). An interim distribution is therefore treated as a part disposal of the shares (TCGA 1992, s 122(1)).

3. Winding up & ESC C16

A possible alternative to the potential expense of a formal liquidation is for the business owners to undertake an informal winding up, and to seek the application of Extra Statutory Concession C16. This concession allows a company’s dissolution under Companies Act 1985, sections 652 and 652A (or comparative provisions) to be treated as a formal winding up for tax purposes. The company secretary and its shareholders must give the Inland Revenue certain assurances regarding:

- the company – i.e. that it does not intend trading or carrying on a business in future, intends collecting its debts, paying off its creditors and distributing any balance of its assets to its shareholders, and intends to seek or accept striking off and dissolution; and

- the company and its shareholders – i.e. that company tax returns, accounts etc will be submitted to determine any tax liabilities, any corporation tax liability on income or chargeable gains will be paid, and the shareholders will pay any capital gains tax liability (or corporation tax if a company shareholder) in respect of any amounts distributed to them as if the distributions had been made during a winding up.

If ESC C16 is applied, the value of the distribution is treated as a capital receipt as opposed to an income distribution. Payments to shareholders during an informal winding up are taken into account when calculating any chargeable gains arising to them on the disposal of their shares in the company. However, it should be remembered that this treatment is concessionary. A concession can be refused or withdrawn if the Inland Revenue considers that it is being used for tax avoidance purposes. Shareholders can therefore only achieve certainty that a distribution will be treated as a capital receipt if the company is formally liquidated, subject to the anti-avoidance rule concerning transactions in securities (s 703).

4. Striking off (England & Wales)

As mentioned, an alternative to formal proceedings under a members’ voluntary liquidation is for a solvent private company to be dissolved through a striking off by the Registrar of Companies under Companies Act 1985, s 652. The striking off process may be undertaken by the company owners or their advisers, and does not require a licensed insolvency practitioner. However, certain conditions must be satisfied. An application (on form 652a) must be made to the Registrar of Companies by a majority of the company’s directors. Companies Act 1985, s 652A broadly requires that the company must have been dormant for at least three months before an application for striking off can be made, i.e. ‘no significant accounting transaction occurs’ (Companies Act 1985, s 250). The Registrar publishes a notice in the London Gazette. If no-one objects within three months of the notice being published, the company can be struck off the company register and dissolved.

5. Bona vacantia (England & Wales)

It is important to ensure that the business owners extract the company’s assets before dissolution and striking off. When a company is dissolved, any remaining assets pass to the Crown (Companies Act 1985, s 654). This rule is known as bona vacantia. A company cannot normally make a distribution except out of profits available for distribution (Companies Act 1985, s 263), and therefore cannot distribute its share capital when it is struck off under Companies Act 1985, s 652. For companies with substantial share capital (or non-distributable reserves), a formal liquidation may therefore need to be considered, although the Crown can disclaim its right to bona vacantia assets (Companies Act 1985, s 656). However, this right of disclaimer should not be relied upon, as it is only applied in limited circumstances. Further information on bona vacantia can be obtained from the Treasury Solicitor’s Department website (www.bonavacantia.gov.uk). A further alternative to a formal liquidation or an informal winding up could be to re-register the company as an unlimited company (Companies Act 1985, s 49). An unlimited private company can usually repay its share capital, although the protection of limited liability is then lost.

6. Capital distributions

Company payments to shareholders during a liquidation or winding up under ESC C16 are not treated as income distributions, but as full or part disposals for the purposes of capital gains tax or corporation tax on chargeable gains. The timing of capital distributions to individual shareholders can be an important consideration in terms of capital gains tax, for example if shares in a family trading company are standing at a potential gain and maximum business asset taper relief entitlement has accrued prior to the liquidation or winding up. In some cases, an income distribution may be preferable to capital treatment. A pre-liquidation dividend followed by capital distributions to shareholders during liquidation can achieve a balance between income and capital treatment, although the anti-avoidance provisions in TA 1988, s 703 may need to be addressed.

7. Taper relief

In most cases, the liquidation or winding up of the company follows the cessation is trading. For shares that were a ‘business asset’ for taper relief purposes before the company ceased trading, following cessation the shares become a non-business asset. However, the effect of business asset taper relief ‘dilution’ should be considered. It will often be beneficial to make capital payments as soon as possible after commencement of the winding up. Alternatively, consideration could be given to transferring the shares to a settlor-interested life interest trust prior to the cessation of trading and commencement of the winding up. Calculations should ideally be prepared to quantify the effect for taper relief purposes and the timing of tax payments under each option. Alternatively, it is possible that the company may not be ‘active’ for taper relief purposes during the post-trading period (TCGA 1992, Sch A1 para 11A). Periods of inactivity are not taken into account for taper relief purposes. A company being liquidated or having its business affairs wound up is considered active. However, if a company is in liquidation and where there are no winding up or other activities, it is unlikely to be active. (see Tax Bulletin Issue 61 (October 2002)).

8. Close investment holding company

When a close company ceases trading, it will normally be treated as a close investment holding company (CIHC) (s 13A). The profits of a CIHC are subject to corporation tax at the main rate of 30 per cent, irrespective of income levels. If the company is not a CIHC in the accounting period immediately before the liquidation commenced, it will not be treated as a CIHC in the following accounting period (s 13A(4)). However, if the company ceases trading some time before it is wound up, this exception from CIHC status is unlikely to apply, as usually the company will already have become a CIHC before going into liquidation (see Revenue Interpretation 21). The Inland Revenue’s Company Taxation Manual (at paragraph CT6708) indicates that a short gap between cessation of business and commencement of winding up will be ignored if it is unavoidable and the company would ‘suffer significantly’ if the treatment afforded by s 13A(4) is not given. Nevertheless, if possible it may be sensible to appoint a liquidator immediately following cessation of trade to put the issue beyond doubt.

9. Transactions In Securities

The Inland Revenue does not regard the ‘ordinary liquidation’ of a company as constituting a ‘transaction in securities’ within TA 1988, s 703, if it involves the genuine winding-up of a company where the business ceases or is taken over by new owners. However, if the business is transferred to substantially the same owners as before, the Revenue is likely to challenge the winding up as involving a transaction in securities, unless the business is transferred as part of a genuine company reconstruction within TCGA 1992, ss 136 and 139 by applying Insolvency Act 1986, s 110. There is case law to support the Revenue’s challenge in such cases (see IRC v Joiner [1975] STC 657 and Addy v IRC [1975] STC 601). This anti-avoidance rule makes taper relief planning through ‘phoenix companies’ (i.e. operating through successive ‘two year trading companies’) difficult to achieve. An application to the Revenue for an informal winding up under ESC C16 does not cover transactions in securities. For cases in which section 703 could apply, an application for clearance in advance under TA 1988, s 707 should be made to the Inland Revenue’s Business Tax Clearance Team.

10. Disincorporation Problems

‘Disincorporation’ broadly involves the transfer of the company’s trade and assets to the business owners. The tax implications of disincorporation should be considered carefully beforehand. For example, a transfer of chargeable assets (e.g. land and buildings) by the company upon disincorporation will probably involve disposals at market value between connected persons for tax purposes. Asset valuations are therefore likely to be required. In addition to potential tax liabilities for the company, a transfer of trade and assets could also result in significant tax liabilities for the recipient shareholder. The company’s goodwill could be an important issue for many family (and other) business owners, including those who incorporated their businesses in recent years to take advantage of lower corporation tax rates, possibly selling goodwill to the company to take advantage of capital gains tax taper relief and the annual exemption. The value of goodwill could be significantly higher within the company by the time the trade is transferred back to the business owners and continued, with consequent tax implications. Following the transfer of the trade, any surplus profits remaining within the company will need to be distributed to the shareholders, with the tax implications for the recipient shareholder depending on whether the payments are dividends or capital distributions.

Bearing in mind the varied potential tax implications of ending the family company, and to end this article with another well-known saying, remember that ‘it isn’t over until it’s over’!

The above article was published in ‘Taxation’ on 23 September 2004, and is reproduced with kind acknowledgement to LexisNexis UK.