Update to the Transactions in Securities rules
With diverging top rates of income and capital gains tax, it is no surprise that taxpayers have looked at ways to convert income returns into capital…
With the increasing divergence of the top rates of income tax and capital gains tax in recent years, it is no surprise that taxpayers have looked at ways in which they can convert income returns into capital returns.
Whilst in the context of rewarding employees the use of approved employees’ shares schemes is, in effect, a Government sanctioned form of such tax alchemy allowing the delivery of an employment reward in capital rather than income form, the Government is not so generous in other contexts. Indeed, it was announced in the Autumn Statement that:
“To reduce opportunities for income to be converted to capital to gain a tax advantage, the government will shortly publish a consultation on the company distributions rules, and will amend the Transactions in Securities rules and introduce a Targeted Anti-Avoidance Rule.”
This has perhaps been precipitated by a rise in the use of liquidations, purchase of own shares, capital reductions and other similar transactions to effectively extract cash/assets from companies as capital (often at a reduced capital gains tax rate of 10% where Entrepreneurs’ Relief applies) rather than as dividends that are subject to income tax at the dividend tax rates.
Given that dividend tax rates will (subject to the £5,000 dividend allowance) be increased with effect from 6 April 2016 so that any dividends received in excess of the £5,000 allowance will be taxed at the following rates:
- Basic rate taxpayer: 7.5%
- Higher rate taxpayer: 32.5%
- Additional rate taxpayer: 38.1%
For most individual taxpayers, particularly those who qualify for Entrepreneurs’ Relief, capital returns will become even more attractive.
The main weapon in HMRC’s armoury to prevent the conversion of income to capital on extraction of funds from companies is the Transactions in Securities rules. These are complex and rather unwieldy anti-avoidance rules that, in certain prescribed circumstances, allow HMRC to serve a counteraction notice on the taxpayer to treat all or part of a capital receipt as an income distribution and therefore tax it as a dividend instead. The stated aim of these rules is to “prevent amounts extracted from companies being treated as capital transactions when their effect is in substance the same as a distribution”. In broad terms, the receipt can however only be re-categorised as income to the extent that there are assets available for distribution as a dividend by the company (i.e. to the extent the company has distributable reserves) and the rules do not apply where the transaction is effected for genuine commercial reasons and not for the avoidance of tax.
To bolster these rules, as announced in the Autumn Statement, draft legislation has been published to:
- Widen the application of the rules;
- Clarify that they can apply to capital reductions and distributions on a winding up (as there was a technical argument that the rules could not apply in these circumstances); and
- Include the distributable reserves of the company’s subsidiaries in determining the amount that can be reclassified as income.
One of the main exclusions to the rules applies where there is a fundamental (75%) change in ownership of the company, intended to permit a return of capital from the proceeds of a bona fide share sale. To avoid abuse of this exemption, the draft legislation will also look behind the strict shareholding test at the underlying economic interest of the original shareholders before and after the transaction, to determine whether a change has occurred.
The changes are intended to come into effect from 6 April 2016.
As noted above these rules do not impact upon transactions that are being carried out for genuine commercial reasons. It will however become increasingly important to review and document the commercial rationale for any share buy-backs, capital reductions or liquidations in order to try to protect against any subsequent HMRC challenge.
A clearance can be sought from HMRC as to whether or not they will seek to apply the Transactions in Securities rules but careful consideration is required as to whether or not to do so.
A new Targeted Anti-Avoidance Rule (TAAR) is also to be introduced to combat “phoenixism”. Phoenixism is a term used to describe a situation where people carry on the same business or trade successively though a series of two or more companies. There is a concern that instead of paying salaries or dividends trading companies are building up cash reserves before being wound up so that director shareholders can claim Entrepreneurs’ Relief on the distributions in the winding up (such distributions being treated as capital distributions). This allows them to extract the cash and assets at a 10% tax rate. The directors then simply start over carrying out the same business in a new company.
The new TAAR will therefore apply where a company is wound up and, within two years, any of the shareholders (or persons connected with them) set up or are involved with a new business that carries on the same or a similar activity to that carried out by the company. It must be reasonable to assume that the winding up forms part of arrangements designed to reduce their income tax liability.
If you have any questions on the changes or the potential impact for any transactions that you are, or are contemplating, undertaking please do not hesitate to contact Haydn Rogan, a Partner in the Corporate department, on 0161 214 0517 or by email to email@example.com.