Introduction »

A change for the worse

When the time comes to dispose of the company business and enjoy a hard earned retirement you will clearly want to do this as tax efficiently as possible. Even where a cash sale to a third party is available, a purchaser may prefer to acquire the ‘assets and trade’ of the company rather than the shares. This would result in cash balances in the company after the sale which would then have to be extracted.

Where there is no third party to buy the business then after ceasing to trade the company will settle any outstanding liabilities, dispose of the assets and again consider the best possible method of extracting the cash available.

Extracting the cash then generally becomes a tax issue about whether income or capital treatment is the preferred option. Over the years the choice between the two has varied depending on the tax rates in force for income tax and capital gains tax (CGT).

Currently income extraction would generally only be preferred to the extent that the taxpayer has not yet used the total of their personal allowance and basic rate band (BRB). This is because dividend extraction for a basic rate taxpayer does not trigger any further personal tax liability (though the company will have paid corporation tax on the profits at some point in the past). For 2012/13 this means than an individual with £22,475 gross income already could receive a cash dividend of £18,000 (treated as £20,000 for gross income purposes) without any tax becoming due on the dividend extracted. Furthermore, national insurance is not due on a dividend.

Once the taxpayer has used up their BRB additional tax will be due on any further income extractions. As a minimum this will equate to 25% of any dividend received. So will you fare better with CGT?

Capital extraction

CGT is levied on individuals at three rates:

• 18% if the individual has any BRB remaining after using it for income
• 28% once the BRB is used
• 10% where Entrepreneurs’ Relief (ER) applies.

ER will apply to a qualifying capital extraction or sale of shares where the company is an eligible trading company, the shares have been held for at least one year prior to disposal and where the individual owns at least 5% of the ordinary voting shares of the company. This will clearly be the favoured route, where it is available, once the BRB is exhausted but it relies on achieving a capital ‘distribution’.

For many years when a capital outcome was desired family owned companies were able to take advantage of an extra statutory concession commonly known as ESC C16, to obtain such a capital distribution.

It enabled a company, once it had ceased business and paid off its creditors, to close down a company informally, but without the necessity to have a formal liquidation for tax purposes. This saved both the administration and the costs involved in going through a formal liquidation (known as winding up procedures) under the Companies Act.

The significance for tax purposes is that any distribution of profit is primarily treated as an income payment unless made as part of a liquidation. However, ESC C16 used to allow a distribution in these informal circumstances to be treated as the equivalent of a distribution in a liquidation.

Change of law

Unfortunately, this well used concession has now been abolished. From 1 March 2012 a new law still permits a company to shut down under the Companies Act without a formal liquidation but it will not be possible to get capital extraction treatment for the profits distributed where they exceed £25,000. The restriction does not include the repayment of the original share capital itself.

In addition, it will be necessary, within two years of making the qualifying capital distribution, to ensure that the company:

• has been dissolved during that time and
• that it has collected in all sums due to the company and
• that it has settled all of its debts and liabilities.

Otherwise, the distribution will be classed as income and adjustments will be retrospectively made to correct the position.

Who does the change really affect?

The cost of a formal liquidation will vary depending on the size of the company and the complexities involved but can involve several thousand pounds. Clearly, where distributable profits are substantial, the overall cost effect is not damaging. However, for the smaller owner managed business company looking to close down or sell the business of the company (rather than sell the shares), where profits are not substantially in excess of £25,000, this is truly an extra cost burden. A plan for extracting dividends up to BRB capacity over a reasonable time period could be considered to reduce profits to the £25,000 limit before the business is sold or closed down.

Please contact us to assess the right course and timing of action for you and your business if you have short to medium term plans for making a disposal of your company business or its shares, so that the best outcome for your circumstances can be determined.

Introduction »