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Taxation of Unincorporated Businesses by Malcolm James

Malcolm James, author of ‘Taxation of Unincorporated Businesses’ considers the tax implications of disincorporating a business.

Chargeable Accounting Periods and Payment of Tax

If a taxpayer, or taxpayers, wishes to disincorporate and operate the business as a sole business or partnership, the first step must be to pass a resolution winding up the company. Under ICTA 198,8 s 12(7) passing this resolution will bring a chargeable accounting period of the company to an end. A new chargeable accounting period will commence immediately after the resolution is passed and the company will remain liable to corporation tax until it has been wound up. Corporation tax on the profits arising up to the date the resolution is passed will therefore be payable nine months after that date.

Capital Allowances

A balancing adjustment will arise on the transfer of plant and machinery to the shareholders, unless an election is made under CAA 2001, s 266 for the transfer to take place at tax written down value. Similarly, an election may be made to transfer industrial buildings at tax written down value under CAA 2001, s 569. In both cases the election must be made within two years of the transfer of the trade. Whilst the value of any assets used in any transfer must reflect their market value, there is some scope for allocating values in a tax‐efficient manner. If any of the assets qualify for allowances under CAA 2001 s.28 (thermal insulation of industrial buildings) or CAA 2001, s 30 (safety at sports grounds) it will be advantageous to allocate as much of any sale proceeds to these as possible, since the disposal value is always deemed to be £NIL. No balancing charge will therefore arise on the disposal of these assets.

Transfer of Trading Stock

Trading stock will normally be transferred at market value, but an election may be made to use the greater of the sale proceeds and book value (ICTA 1988, s 100C). Professional work‐in‐progress may be transferred on a similar basis, provided that the excess of market value or sale proceeds over cost is treated as a post‐cessation receipt (ICTA 1988, s 101). HM Revenue & Customs will normally accept the value attributed to work‐in‐progress, unless it is clearly ‘illusory, colourable or fraudulent’ (ICAEW Guidance note Tax 7/95).

Losses

Trading losses of the company may not be carried forward to be offset against future profits of the unincorporated business. Trading losses may be offset against other income of the same chargeable accounting period or the total profits of the preceding chargeable accounting period (ICTA 1988 s 393A). A trading loss of the final 12 months of trading, which may include part of the penultimate chargeable accounting period, may be carried back and offset against the trading profits of the preceding 36 months. The loss is offset against the profits of the latest period first.

It is not possible to offset trading losses against chargeable gains arising after a company ceases trading, therefore it is advisable, if possible, to sell any assets on which a gain may arise to the shareholders before the cessation of trade.

Chargeable Gains

Disposals of assets to shareholders will take place at market value, which may be the subject of protracted negotiations with HM Revenue & Customs. If any gain has been rolled over or held over the disposal will crystallise this gain. It may be advisable to dispose of assets before the cessation of trade.

The date of transfer for the purpose of chargeable gains is the date of the contract, therefore payment may be deferred until the winding up. If any of the company’s assets have a negligible value, it may be worth considering a negligible value claim under TCGA 1992, s 24, since the date of the deemed disposal may be back‐dated by up to two years. A capital loss may therefore arise in a chargeable accounting period in which it may be possible to obtain relief.

If disincorporartion involves the liquidation of two or more companies and if a capital loss arises in one company and a chargeable gain in another, an election may be made under TCGA 1992, s 171A for a deemed transfer of one of the assets to have been made immediately before sale. In this way the gain and the loss will arise in the same company. The election must be made within two years of the end of the chargeable accounting period in which the deemed transfer is to take place.

Loans to Participators

The company being wound up will almost invariably be a close company. If it has made a loan to a participator and the loan is written off when the company is wound up, the corporation tax charge under ICTA 1988, s 419(1) arising when the loan was made will not be recoverable. In addition, the grossed up value of the loan will be treated as a benefit in kind in the hands of the participator. It is advisable to ensure that such loans are repaid before winding up.

Value Added Tax

The transfer of assets by the company is treated as a supply immediately prior to the cessation of trade unless it is treated as the transfer of a business as a going concern. If the conditions are satisfied, the transfer is treated as being neither a supply of goods nor of services and it is generally possible for the unincorporated business to take over the company’s VAT registration. The unincorporated business will therefore take over the VAT liabilities and obligations of the company, i.e. it must file any outstanding returns on behalf of the company and is liable to any VAT penalties which the company may have incurred.

Pre‐Sale Dividends and Capital Distributions

A pre‐sale dividend will reduce the value of the company on liquidation and will be treated as an income distribution. The consequences to the shareholders will be that there is no income tax liability to the extent that the dividends are taxable at the starting rate or basic rate, but dividends taxable at the higher rate are taxed at an effective rate of 25% of the net dividend declared.

Distributions made in the course of a liquidation are treated as capital and are subject to CGT. Under the current taper relief regime, pre‐sale distributions are therefore unattractive, since the shares will, in practice, invariably be business assets and, provided that they have been held for at least two years, and any gain will be taxable at an effective rate not exceeding 10%. No SDLT will generally arise where land and buildings of the company are distributed to the shareholders on the winding up (FA 2003, s 54).

October 2005

Malcolm James is a Senior Lecturer in Accounting and Taxation at the University of Wales Institute, Cardiff.

The above article is adapted from ‘Taxation of Unincorporated Businesses’ published by Spiramus Press Ltd. To order Taxation of Unincorporated Businesses< click here