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Tolley's Practical Tax by Roger Jones BSc FTII TEP

Roger Jones considers some issues relating to disincorporation of a businessTo be asked if I would like to write an article on disincorporation came as something of a culture shock. Over the last few years, I have spent so much time advising businesses on use of the corporate medium. This in turn led to a book on incorporation. Although there are many reasons why a business proprietor might wish to trade through a company, recently one factor seems to have outranked all others. That is the impact of taxation.

When considering the reasons to incorporate, one ought to look at taxation last. Of course, minimisation of tax liabilities is an important factor in any commercial decision but it should not be the overriding one. Developments over the last few years though have tipped the balance so far in favour of the company that one cannot really blame so many small businessmen for wanting to go in that direction. I remain to be convinced that, if taxation implications could be ignored, trading through a company is right for the majority of small businesses. For simplicity alone, sole trader or partnership has to be the better option.

However, the proprietor of the incorporating business should have been advised at the outset that he was heading down a one-way street. A number of reliefs assist the sole trader or partnership to move to the corporate medium. There is nothing that helps a move in the opposite direction. As long ago as July 1987, a joint consultative document issued by the (then) Inland Revenue and Department of Trade and Industry considered removal of barriers to the disincorporation of UK companies.

None of the proposals discussed has ever been implemented.

Is now the time to do it?

If the owner managers of a small company feel that the corporate medium is no longer right for them, should they make haste to take steps now?

Remember that there remain significant tax advantages from using a company. This is not just the lower corporation tax rates and oddities of dividend taxation as against salaries or even business profits. There are some reliefs which are available only to companies such as those for intangible fixed assets in FA 2002, Sch 29, research and development tax credits first introduced in FA 2000, Sch 20 for small and medium companies and possibly also the substantial shareholdings exemption in TCGA 1992 s192A & Sch 7AC. Whenever the Chancellor has announced a new incentive for small businesses in recent years, it has turned out in almost all cases to be applicable to companies only.

At the time of the 2003 pre-Budget Report, the Chancellor made comments about small company proprietors paying ‘the right amount of tax’. The non-corporate distribution rate of corporation tax that came and went so quickly did not address this point. It simply reversed the much vaunted 0% rate of corporation tax in certain circumstances. It certainly did not satisfy Government comments to the effect that ‘the right amount of tax is paid by owner managers of small incorporated businesses on the profits extracted from their company …’. It did nothing to their personal liabilities. More importantly, a document entitled ‘Small companies, the self employed and the tax system; a discussion paper’ was issued at the time of the 2004 pre-Budget Report.

This highlighted some of the anomalies in the treatment of small companies and their owner managers as against the self-employed. There are several references to ‘structural tensions at the interface between the personal and corporate tax regimes’. The suggestion is that these have been exploited unfairly but it ended with a completely open question as to what should be done to improve the situation.

Almost two years on, nothing has come as a result of it.

One must not lose sight of the Arctic Systems case. This is due to progress to the House of Lords though, at the time of writing, no date had been set for the hearing. Perhaps it is the outstanding decision in this case that is holding up resolution of so many issues.

One cannot blame many small business proprietors for being in so much confusion. They want to get on with life, earn profits and pay the tax. When it is impossible to predict with any certainty just how much tax that will be, something has to be wrong. For the moment, I would be inclined to advise small company proprietors to maintain the status quo in the hope of a more stable regime in the not too distant future.

However, for those who want to give up and turn their back on the company now (and I suspect these are the very smallest who are struggling with the administrative burden) what must they do?

Getting rid of the company

In principle, all the considerations for incorporation, such as the cessation of trade, capital gains, VAT, inheritance tax etc. apply to disincorporation. The problem is that, whilst there are reliefs to ease the way into the company, there is precious little to help on the way out. Perhaps the biggest single problem is capital gains tax. TCGA 1992, s 162 and s 165 are there to defer capital gains arising on the incorporation of a business.

There is no equivalent to deal with such liabilities on the way out. Bear in mind that these could be enormous with inflation, development of the business inside the company and understanding that the underlying assets may have a low base cost because of deferred gains when the company was incorporated.

To leave the company behind and start (or resume) business as a sole trader or partnership, one must follow very similar steps to those which were involved in incorporation in the first place. It is therefore necessary to consider the issues set out in the preceding paragraph. Moving in this direction, one also has to think about:

• extracting retained profits from the company;

• disposing of the company itself.

How extensive these processes might be depends on the size of the company and the complexity of the business. It may be that some very small companies could simply cease trading and the proprietor recommences a sole trade. However, in most instances the company will have at least some assets and it becomes necessary to extract these.

Cessation of trade

The cessation of trade in a company will bring about the end of its current corporation tax accounting period [ICTA 1988, s 12(3)(c)]. This means an advance in the date for payment of any corporation tax due for the last period.

Computational adjustments will include consideration of the price at which stock should be sold. There will be a deemed disposal of plant and machinery leading to a balancing adjustment for capital allowance purposes though this may be deferred in certain circumstances.

Disposal of the company’s chargeable assets may produce capital gains. As suggested above, this can often lead to significant liabilities. The disposal will usually take place after cessation of the trade. This precludes the offset of any trading losses which will have accrued in an earlier corporation tax accounting period.

If the company was loss making at the cessation of trade, this may give rise to an additional problem. Losses for the final corporation tax accounting period of trade may be offset against the profits of the period [ICTA 1988, s 393A(1)(a)]. Any surplus can be carried back and set against the total profits of the previous three years [s 393A(1)(b), (2A), (2B)]. That is all that is available. The losses cannot go forward, especially against any gains in a later corporation tax accounting period as noted above. They certainly cannot be transferred with the trade to a successor.

Extraction of the business from the company

If the proprietor(s) want to take the trade out of the company as a going concern, it is still necessary to consider all the influences of the cessation of trade in the company. Pay especial attention here to the capital gains arising. This will be a connected party transaction, requiring the use of market value in calculating the gain. However, in the absence of a third party sale, there will not be any cash proceeds to pay the tax. This may influence the manner of extraction.

If the company is needing funds with which to pay any capital gains tax due, this almost certainly forces the proprietor to buy the assets of the business from the company. This is quite probably a situation that he will not have envisaged. The payment does not need to be the full market value (even though that will be imposed in order to calculate the gain) but simply sufficient to leave the company with adequate funds to pay the tax.

Alternatively, if the company has adequate cash reserves to ensure that it can pay its own tax liabilities consequent on the transfer, the business may be paid to the shareholders as a dividend in specie. This is a distribution within ICTA 1988, s 209(4) with the consequence that the shareholders suffer higher rate income tax on the grossed up value of the business transferred.

Remember: there is a double charge. The company has a liability on any realised or deemed gains (or trading profit on cessation of trade) and the individual has a liability on his receipt.

Where the proprietor buys the business at under value to provide the company with funds to meet its tax liability, the excess of market value over the actual consideration given should again be treated as a distribution under ICTA 1988, s 209(4).

Extracting cash from the company

If the company was adequately funded then, after extraction of the trade (or perhaps its sale to a third party), there remains the problem of getting any remaining cash out of the company.

The choice is probably a straight decision between:

• dividend;

• a capital distribution on liquidation.

A dividend may be useful if the amounts are small and the shareholders are not higher rate taxpayers.

Otherwise, tax will be due at an effective rate of 25%.

The capital distribution may enjoy the benefits of business asset taper relief (watch whether the company is still a trading company; its status may have changed on the cessation of trade and apportionment of the gain may be necessary). See also the comments in HMRC Tax Bulletin 61, October 2002 as regards whether the company is active or inactive for the purposes of TCGA 1992,Sch A1 para 11A during the course of winding up. The capital distribution may be effected during liquidation and specifically gives rise to a capital gain under TCGA 1992, s 122. Any personal capital losses and the annual exemption may also be offset.

I have seen suggestion that the directors of the company might declare themselves redundant and conveniently be paid a lump sum award which would be exempt from income tax in the hands of the individual under ITEPA 2003, s 403. If this were truly a redundancy payment, the calculation of the statutory amount is likely to fall well short of the suggested £30,000 income tax exemption.
Further, if trading has ceased the company is unlikely to achieve a tax deduction.

Attempts to take a larger ex gratia payment are so incestuous as to attract the attentions of HMRC and, it is considered, a less than sympathetic ear.

Liquidation

Formal liquidation of the company may prove to be a long and costly process. The members of a solvent company can proceed to wind it up, but this must be dealt with by a licensed insolvency practitioner.

The commencement of winding up proceedings terminates the company’s current corporation tax accounting period and a new one begins. Any corporation tax liabilities which arise in the course of winding up are an expense or disbursement of the liquidation.

The liquidator must also take account of any preliquidation tax liabilities.

Some of these, including outstanding tax under PAYE and NIC for the twelve months prior to the liquidator’s appointment, are preferential.

Striking off

The expense and complexity of a formal liquidation may seem excessive when dealing with a close company which is no longer required and which has only modest reserves. Strictly, capital distributions are only seen after the appointment of a liquidator. Otherwise, the distribution of funds to the members of a company, even prior to its dissolution, is strictly an income distribution under ICTA 1988, s 209.

There is a far simpler procedure for disposing of an unwanted company. The company may apply to the Registrar under Companies Act 1985, s 652, to be struck off the register. The directors must meet the stringent requirements in s 652A to notify all shareholders, employees, creditors etc. of the intention to invoke this process. Additionally, the application cannot be made until at least three months after the company has ceased trading. The first move in this process, assuming that the company’s business has not been sold, is to deal with its extraction as above. A solvent company may be dissolved as a result of its name being struck off the register.

Under ESC C16, HMRC are prepared to accept that distributions made prior to such dissolution have been made under a formal winding up. In other words, they should be treated as capital and not income distributions. Application of the concession requires that the company and its members give certain assurances to HMRC. These include that:

• the company does not intend to trade or carry on business in future;

• the company intends to collect its debts, pay off its creditors and distribute any balance of assets to its shareholders (or has already done so);

• the company intends to seek or accept striking off and dissolution;

• the company and its shareholders will supply such information as is necessary to determine, and will pay, any corporation tax liability on income or capital gains;

• the shareholders will pay any capital gains tax liability in respect of any amount distributed to them in cash or otherwise as if the distributions have been made during the winding up.

An interesting exchange took place in the Tax Faculty Newsletter TAXline. One correspondent pointed out that technically under ESC C16 the company is not actually in liquidation. Notwithstanding HMRC acceptance for tax purposes, company law actually forbids distributions of anything in excess of the company’s distributable reserves. This leaves the share capital (including any share premium) to pass to the Crown bona vacantia under Companies Act 1985, s 654. A respondent took the view that, HMRC having given clearance under the extra statutory concession, this point is not pursued. Others were not so sure. In most cases, the share capital will be minimal and this seems a point which is not normally worth arguing about. If the share capital is large, the solution would seem to be to go for a formal liquidation.

Failed companies

The processes of disincorporation, liquidation and striking off assume that there is something in the company worthy of sale or recovery. What is the position, though, if the company has simply ceased to trade and has no significant assets or is insolvent?

Bear in mind that, if a sole trader business fails, then bankruptcy is the only obstacle to the proprietor picking himself up and starting again. There is no statutory bar to trading.

By contrast, an incompetent director can be banned from acting in such capacity in other companies and future options may be limited to sole trader without the advantages of a company.

In the case of insolvency, enforced liquidation is still a possibility. This presumes, though, that the creditors perceive prospects of recovery to invoke the formal procedure. This does not always happen; some companies just die.

It should be noted that the company cannot just be abandoned if no longer required. Companies Act filing requirements must still be met even if the company has no transactions and no activities.

The shareholders are left with what, to all intents and purposes, is an empty shell. This may have cost them money in terms of purchase of the share capital or loans to the company.

In these circumstances, a members’ voluntary liquidation to effect disposal of the shares and crystallise a capital loss seems unlikely. However, a capital loss may still be created by a negligible value claim under TCGA 1992, s 24(2). The shareholders must demonstrate to the Inspector of Taxes that the shares are of negligible value, which should not be difficult if the company has ceased to trade and has no assets. A claim is then made, the effect of which is to treat the shares as disposed of and immediately reacquired. The disposal value will be nil, with the cost being the original subscription price or purchase price. The loss arising may then be set against any other capital gains realised by the shareholder. The claim may specify an earlier date for negligible value treatment, though it cannot be more than two years before the claim.

Where the shares were originally acquired by subscription, ICTA 1988, s 574 provides a useful extension to give relief for the loss against income. The shares must be in a qualifying trading company as defined in s 576. This invokes many of the provisions of the Enterprise Investment Scheme legislation, thus prohibiting the relief where the company had any significant activity other than a trade. The loss must be computed in accordance with capital gains principles (which can include a negligible value claim under TCGA 1992, s 24(2)). A claim may then be made that the capital loss arising is set against income of either the same tax year as that in which the loss arose, or the preceding year.

Lastly, the company may not have been financed entirely by share capital. There may also have been loans. Where a person lends money to a UK trader (which includes a company) and the funds are used in the borrower’s trade then, if the loan becomes irrecoverable, a claim may be made that the amount lost should be treated as a capital loss [TCGA 1992, s 253]. There are connected party provisions limiting relief but, curiously, these do not include a company and its shareholders/directors. So a participator who has loaned money to a trading company may claim relief for the capital loss if the company fails. Note that HMRC interprets the provision in s 253(3) that the loan has become irrecoverable very strictly. If funds were put into an ailing company to ‘prop it up’ so to speak, then there is an argument that there was never any realistic prospect of recovery and relief would be denied.

Roger H Jones BSc FTII TEP
November 2006

Roger Jones is Senior Tax Manager at Larking Gowen in Norwich but the views expressed are personal and do not necessarilyrepresent the opinion of the firm. The second edition of his book “Incorporating a Business” is published by Tottel Publishing and available directfrom Marston Book Services 01235 465500.

The above article was first published in Tolleys Practical Tax in November 2006, and is reproduced with the kind permission of LexisNexis UK.