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What needs to be included on the tax return to avoid giving yourself a headache.

There are many reasons why a company is dissolved, ranging from insolvency to simply having come to the end of its useful life. Whatever the reason, it is essential that the correct advice is given by the company’s advisers and the correct decisions are taken by the directors. Get it wrong and it could mean the directors/shareholders lose money, incur unlimited fines and might need to restore the company.

In addition, the correct advice and planning is important from a tax efficiency point of view.

Tax efficiency and the different disclosures in the tax return

Good tax advice is important where the company is solvent and the directors are looking for the most tax efficient way out. The default position is that a distribution by a company is, strictly speaking, an income distribution. Even where a distribution is capital for other purposes, it is treated as income for income tax purposes

So how can the distribution be treated more efficiently?

Since 2012, where the assets of the company are below £25,000 a pre-dissolution distribution can be treated as a capital gain. Entrepreneurs’ relief (ER) may also therefore be available which in many cases would create a tax saving.

Where the assets are above this figure then the distribution will normally be treated as a dividend with no ER available.  This could make the extraction of the final shareholders’ funds far less tax efficient depending on the shareholders’ personal tax situation.

If a liquidator is appointed on behalf of members or creditors, then the distributions made by the liquidator to the shareholders may still be subject to capital gains tax (and possibly benefit from ER) in the hands of the shareholders. This is because of s829 of the Companies Act 2006 which states that:

The following are not distributions for the purposes of this Part:

  • an issue of shares as fully or partly paid bonus shares;
  • the reduction of share capital:
    – by extinguishing or reducing the liability of any of the members on any of the company’s shares in respect of share capital not paid up, or
    – by repaying paid-up share capital
  • the redemption or purchase of any of the company’s own shares out of capital (including the proceeds of any fresh issue of shares) or out of unrealised profits in accordance with Chapter 3, 4 or 5 of Part 18
  • a distribution of assets to members of the company on its winding up.

So the correct use (and expense of) a liquidator could save the shareholders a considerable amount of money as entrepreneurs’ relief may be available. If a formal close down was not performed then the default is that the final distribution may well be income subject to income tax.

To illustrate the tax savings consider the following example (courtesy of LexisNexis):

Example of capital treatment on winding up

Mr and Mrs Brown own equal shares in Brown Ltd, a trading company they set up in 1996. During 2018, Mr and Mrs Brown decided to retire and wanted to distribute the company’s post tax cash reserves of £1m in the most tax efficient manner.

Mr and Mrs Brown are additional rate taxpayers and utilise their annual capital gains tax exempt amount every year. They are entitled to entrepreneurs’ relief and have utilised their dividend allowance.

Without CTA 2010, s1030A, the entire £500,000 each paid to Mr and Mrs Brown would be treated as a dividend. Mr and Mrs Brown would both have additional rate tax liabilities as follows:

£

Dividend

500,000

Additional rate tax due at 38.1%

190,500

 

Applying CTA 2010, s1030A, £25,000 of the distribution may be treated as capital proceeds on the sale of their shares. This is on the assumption that a dividend may be paid in advance of winding up and does not constitute ‘a distribution in respect of share capital in anticipation of its dissolution’ under CA 2006, s1003.

In this situation it may be difficult to argue that such a dividend is not with a view to winding up, but it may depend on the timing of payments.

The £25,000 cap is per company, not per shareholder, so initially a dividend would need to be paid that left only £25,000 in the company. This would be a dividend of:

£1,000,000 – £25,000 = £975,000

This means that Mr and Mrs Brown would each receive a dividend of £487,500. This is subject to income tax as usual and produces a tax liability as follows:

£

Dividend

487,500

Additional rate tax due at 38.1%

185,737

Then, at a later point in time, the remaining capital would be distributed on an informal winding up. This provides Mr and Mrs Brown with a capital distribution of £12,500 each.

£

Capital distribution

12,500

Cost

Nil

Gain

12,500

Entrepreneurs’ relief applies
Tax at 10%

1,250

Because of the large amount of profits retained in the company it would certainly be more beneficial to incur the cost of a formal liquidation to secure a capital treatment.

(Note that ER (qualifying capital gains) for each individual are subject to various lifetime limits.)

Therefore directors will need to undertake some careful tax/operational planning if they are considering winding up the company especially where distributable reserves are more than £25,000.

For instance, contrast the following example (courtesy of LexisNexis) where savings are more marginal under an expensive formal liquidation and so other ways of reducing the reserves might be considered:

Example 2 ― marginal situations

The situation in Example 1 illustrates that where there are significant profits retained in the company, it will be far more beneficial to pay for a formal liquidation. Where the company has profits closer to the £25k threshold, the case for a formal liquidation diminishes.

Mr and Mrs Gray own equal shares in Gray Ltd, a trading company they set up in 1996. During 2018, Mr and Mrs Gray decided to retire and wanted to distribute the company’s post tax cash reserves of £54,000 in the most tax efficient manner.

Mr and Mrs Gray are higher rate taxpayers and have not utilised their annual capital gains tax exemption for 2018/19. They are entitled to entrepreneurs’ relief and have utilised their dividend allowance.

There are essentially three options available to Mr and Mrs Gray:

  • use an informal winding up procedure and distribute all profits of the company as dividends
  • distribute excess profits and use an informal winding up procedure to distribute no more than £25,000
  • use a formal liquidation procedure.

These produce net proceeds for Mr and Mrs Gray as follows:

Net position (each)
Income distribution £18,225
Income distribution with £25k as capital £22,208
Formal liquidation £22,770

The workings are shown below.

It can be seen that at this level of retained profits, the results are very close to each other. Utilising an informal winding up may secure a good position if the dividend paid in advance of winding up is not caught by CTA 2010, s1030A(2)(b).

However, if the dividend paid before the informal winding up is considered to be a ‘distribution in respect of share capital in anticipation of its dissolution’, the position may be adjusted, following an HMRC enquiry, to give the worst outcome. Furthermore there may be penalties due if it is considered that reasonable care has not been taken.

The formal liquidation produces the best outcome and it is also the safest.

It may be that the liquidator fees are less than the £6,000 estimated below. If the fees were dropped to £4,500, the formal liquidation would actually provide a much more efficient outcome too.

Informal winding up ― all income

Mr and Mrs Gray receive a dividend of £27,000 each. This gives them liabilities as follows:

£

Dividend

27,000

Higher rate tax due at 32.5%

8,775

This means that Mr and Mrs Gray each receive proceeds net of tax of £18,225.

Informal winding up ― utilising s1030A

Mr and Mrs Gray distribute £29,000 of the profits as a dividend. They receive £14,500 each.

£

Dividend

14,500

Higher rate tax due at 32.5%

4,712

Then, at a later point in time, the remaining capital is distributed on an informal winding up. This provides Mr and Mrs Gray with a capital distribution of £12,500 each under CTA 2010, s1030A. After utilising their annual exempt amount of £11,700, this produces capital gains as follows:

£

Capital distribution

800

Cost

Nil

Gain

800

Entrepreneurs’ relief applies
Tax at 10%

80

This leaves Mr and Mrs Gray with net proceeds each after tax of £22,208.

Formal liquidation

Mr and Mrs Gray pay £6,000 for a formal liquidation, leaving £48,000 of profit to distribute. This gives them each a capital distribution of £24,000. After utilising their annual exempt amount of £11,700, they each have liabilities as follows:

£

Capital distribution

12,300

Cost

Nil

Gain

12,300

Entrepreneurs’ relief applies
Tax at 10%

1,230

This leaves Mr and Mrs Gray with net proceeds each after tax of £22,770.

Treatment of distributions on the tax return

As discussed above, the treatment of receipts needs to follow the legal form and so the entries on the 2017/18 self-assessment are crucial. If not properly planned the winding up of the company it can have severe consequences on the personal tax paid by the shareholders.

Article from ACCA In Practice