Tax Doctor:
Mark McLaughlin
ATII ATT TEP

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April 2003

Q:

I understand that it can be beneficial for tax purposes to start a new business venture through a limited company, run the business profitably for two years and then sell it. Is this correct?

A:

Setting up successive businesses as trading companies to run for a couple of years or so has potential benefits for Capital Gains Tax (CGT) purposes. However, this approach may not be commercially practical in every case, and the benefits will depend to some extent on individual circumstances. In particular, it is only really suitable for people who can afford to withdraw relatively little from the company, and who are higher rate taxpayers.

Taper relief

There is a particular relief from CGT, known as 'taper relief'. This relief reduces chargeable gains according to the length of time an asset has been held (since 5 April 1998), with more generous reductions for disposals of 'business assets' than 'non-business assets'. The maximum rate of business asset taper relief for disposals after 2 complete years of ownership is 75%, leaving 25% chargeable to CGT. For non business assets, the maximum rate of taper relief is 40%, leaving 60% chargeable. There are specific categories of 'business asset' in the capital gains tax legislation. A 'non-business asset' is any asset which is not a business asset.

Shares in an unquoted trading company are a 'business asset', and an individual shareholder can therefore qualify for maximum taper relief after only 2 years. The 75% reduction in chargeable gains broadly means that the effective rate of CGT for a higher rate taxpayer is only 10% (i.e. 25% of the gain x 40% higher rate tax), or 5.5% for a basic rate taxpayer.

How does the plan work?

Most company owners need to extract substantial income from the company, normally by salary or dividend. This income is taxable at rates of up to 40%, and the company is left with less 'retained profits', i.e. lower funds remaining within the company. However, if the owner can afford to take little (or nothing!) out of the company (those funds being available for the trade) upon completion of the business venture in a couple of years' time, there will be accumulated surplus profits within the company.

What can then happen is that the owner arranges for the trading company to be 'wound up'. This can usually be done by the business owner on an informal basis (i.e. without appointing a liquidator). This broadly means that assets are realised (potentially at a taxable profit, although perhaps not after a two year period) and creditors are paid, so that remaining surplus funds are payable to the business owners. Normally, such payments to shareholders are treated in the same way as dividends, and higher rate taxpayers are liable at 25% of the net distribution. However, by obtaining special permission from the Inland Revenue, payments to shareholders can be treated as capital (not income) distributions, which are liable to CGT, not income tax.

Having obtained this Inland Revenue approval, retained profits can be paid to shareholders as capital, which is liable to CGT after deducting the cost of the shares, taper relief at the 'business asset' rate, and the individual's annual CGT exemption (if not used elsewhere). The taxpayer may possibly also have capital losses from the disposal of other assets to offset against the gain. With these proceeds, the individual may wish to set up another trading company to operate a different business venture, for a further two years.

Points to note

As with all things tax-related, things are never straightforward! There are other points to bear in mind, including the following:

• There are tax avoidance rules preventing certain planning in order to obtain a tax advantage. If the Inland Revenue successfully challenged this planning, the 10% tax rate would be lost in favour of a higher rate. There are other tax avoidance rules as well, with land developers potentially at risk. So always bear in mind that there is a risk of attack from the tax man!
  
  
• The company is liable to corporation tax on its profits. There is a 0% tax rate on profits of up to £10,000, but many companies are liable at the 'small companies' rate' of 19% on profits up to £300,000. If this is the case, the overall tax rate becomes just over 27% (i.e. 19% corporation tax, plus (10% CGT on the remaining 81%) 8.1%). However, this is still attractive compared with the maximum 40% tax rate (plus national insurance contributions) for sole traders and partners.

In conclusion, there are certainly tax savings to be gained in the right set of circumstances. But to take a leaf from the health warnings given in certain television programmes - "don't try this at home without the aid of a tax adviser"!

Mark McLaughlin

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