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Mark McLaughlin CTA (Fellow) ATT TEP looks at the legislation to supersede ESC C16 and asks why the concession's scope is being restricted.

Introduction

HMRC are never short of surprises. Unfortunately, few of them are of the pleasant variety. The consultation document ‘Extra-Statutory Concessions – Fourth Technical Consultation on Draft Legislation’ was issued on 13 December 2010. The consultation period ended on 7 March 2011. One of the concessions dealt with in this document was Extra-Statutory Concession (ESC) C16.

Why do We Need ESC C16?

The purpose of ESC C16 and the reason why it is being replaced by legislation were explained in the previous articles Concession C16 - HMRC Not Keen? and No ESCape.

In broad terms, it allows distributions to shareholders by a company that has ceased business and is awaiting dissolution to be treated as made in a formal winding up, if certain conditions are satisfied and assurances given to HMRC.

For tax purposes, the distributions are treated as capital distributions within TCGA 1992 s 122, as opposed to income distributions under CTA 2010 s 1000(1). so the distributions are subject to Capital Gains Tax, rather than Income Tax.

According to HMRC, the purpose of the concession was originally to save company owners the professional costs of having companies formally wound up. However, in practice HMRC treated distributions well in excess of such costs as falling within ESC C16.

In fact, in all the many applications I have previously submitted to HMRC for concessionary treatment to apply, not one of them was rejected on the basis that distributable reserves were too high. There was seemingly no upper limit on the level of distributions under ESC C16.

Change Ahead

Things are about to change, based on the draft legislation published in HMRC’s consultation document.

The effect of the legislation in new CTA 2010 s 1030A, if enacted, is that company distributions made in the course of its dissolution under Companies Act 2006 s 1000 or s 1003 (or comparable foreign provisions) will still be treated as capital payments in the shareholders’ hands, if the statutory conditions are satisfied. The definition of ‘capital distribution’ in TCGA 1992 s 122 is amended to include distributions prior to dissolving the company within new s 1030A(3).

However, capital treatment is reversed if, within two years of making a distribution, the company has not been dissolved, or the company has broadly either failed to collect all its debts or pay all its creditors (proposed new CTA 2010 s 1030B).

The real surprise for me was that the total amount of distributions which can be treated as capital payments under the proposed new legislation is restricted to £4,000.

The Official Reason

This £4,000 limit is a severe restriction on the application of ESC C16. Why has it been introduced? The explanatory note to the draft legislation states:

‘A company which has ceased business altogether and paid off its creditors may not wish to undertake the administration and incur the costs, etc., involved in going through the formal winding up procedures under the Companies Acts.’

It goes on:

‘Informal consultation with accountancy practitioners confirmed a continuing need for the concession in relation to micro and small businesses. The draft legislation is therefore subject to a £4,000 ceiling on distributions, which is broadly equivalent to the cost of winding up a small company.’

Many readers will recognise that £4,000 is also the amount of share capital that the bona vacantia (ownerless property) division of the Treasury Solicitor’s Department will allow by concession to be repaid without seeking recovery as an unauthorised distribution. Note that the bona vacantia concession refers to repayments of share capital.

The ESC C16 replacement legislation applies to distributions in respect of share capital. A distribution out of assets in respect of the company’s shares is not a distribution to the extent that it represents repayment of capital on the shares (CTA 2010 s 1000(1)B(a)).

A repayment of share capital would therefore appear to fall outside the proposed £4,000 limit. HMRC have confirmed to me that this is the case.

On that basis, a company could make distributions of £4,000 and also repay share capital of £4,000, i.e., up to £8,000 in total, while remaining within the monetary limits set by the proposed legislation and the Treasury Solicitor’s Office.

The Real Reason

There is more to the £4,000 limit than meets the eye. I asked HMRC’s Central Policy Unit why an upper limit had been introduced. The response was that the department had concerns about abuse of the concession in practice. The £4,000 limit was considered to obviate the requirement for ‘complex anti-avoidance provisions’.

HMRC had alluded to these concerns (among other perceived difficulties in legislating for ESC C16) in a letter to the Corporation Tax Operational Consultative Committee as far back as 3 March 2009.

Those issues were addressed in my article No ESCape. One of the possibilities mentioned at the time was the introduction of an avoidance rule to prevent the new legislation being used to gain a tax advantage.

It therefore seems that the £4,000 limit has mainly been introduced to put HMRC minds at rest, and as a quick and easy alternative to drafting anti-avoidance legislation.

If there is any significant abuse of ESC C16 (although it is not clear what the ‘abuse’ is in this context, and where the evidence is), a £4,000 distribution limit is certainly effective in terms of restricting its scope.

In any event, there are other compelling arguments for an upper limit. For example, why should company owners benefit from capital treatment on substantial distributions without having the company formally wound up? Furthermore, as mentioned in Concession C16 - HMRC Not Keen?, there are company law difficulties caused by such actions.

The problem with including such a limit in statute is that it introduces a restriction which did not exist in the practical operation of ESC C16. There is no dispute that HMRC have the power to modify an existing concession before giving statutory effect to it (FA 2008 s 160(5)(a)).

However, in its document ‘Extra Statutory Concessions – Technical Consultation on Draft Legislation’, it was stated (in November 2008):

‘The purpose of this consultation is to expose for comment draft legislation which is intended to maintain the existing tax treatment under the ESCs concerned. This consultation, which is of a technical nature, is designed to ensure that the legislation as drafted will successfully maintain the purposes and effects of the existing ESC.’

The consultation responses document in February 2009 subsequently said:

‘The process of drafting legislation inevitably requires wording to be as free from ambiguity as possible, and this has sometimes led to a change of wording from the ESC to the draft legislation. The enabling power of s 160 of the Finance Act 2008 does not allow us to address potential ambiguities by extending the scope of the concession, so there are some occasions where there has been a marginal tightening of meaning. However, it is important to stress that in such cases we have been careful to ensure that the draft legislation reflects the way that the original ESC was applied.’

It is arguable that the draft legislation to replace ESC C16 does not maintain its existing treatment, and that the £4,000 limit amounts to something rather more than a marginal tightening of its meaning.

Practical Effects

What will happen in practice if the draft legislation is enacted? Circumstances differ from one company and its owners to the next. For example, individual shareholders with a potential entitlement to Entrepreneurs’ Relief in respect of capital payments will need to have the company formally wound up to access the 10% Capital Gains Tax rate, subject to the £4,000 limit.

This will normally be an attractive proposition where substantial amounts of distributable cash are involved.

However, in other cases it may be much less clear whether capital or income distribution treatment is more beneficial. It will therefore be prudent to ‘do the numbers’ and compare carefully the tax cost of income and capital treatment, taking into account the relative professional costs as well.

Planning in this area could possibly include making a combination of capital and income distributions. The permutations are many and varied.

I have no idea whether £4,000 represents a realistic average professional cost of winding up a company for which ESC C16 treatment might previously have applied. A liquidator’s perspective on the cost, timescale and other implications of winding up such companies if the proposed legislation is enacted would perhaps make an interesting future article here.

It is certain, however, that the legislation in its current form will add a further layer of professional involvement which does not presently exist in many cases.

Better Alternatives?

Applying an upper limit is probably the right thing to do, but unfortunately it is being done for the wrong reasons. If the government is unwilling to dispense with an upper limit altogether (and possibly introduce an anti-avoidance rule, as previously intimated), is there a better way to restrict the scope of ESC C16?

HMRC have identified a continuing need for the concession in relation to small and micro businesses. However, it is not known what is meant by ‘small’ and ‘micro’ in this context.

A company’s size can be defined in different terms, depending on the tax rules under consideration.

Definitions of ‘small’ and ‘micro’ business could be introduced for these specific purposes, perhaps by reference to the number of employees, turnover and/or net assets when the company was last in business, prior to the commencement of dissolution and striking off.

Those levels could be regulated to control the level of distributions treated as capital payments under the new legislation.

Alternatively, the upper distribution limit could be increased to a higher, more workable and realistic limit. But what should that level be? I have seen companies with eye-watering cash reserves being distributed under ESC C16 in the past.

At one extreme, it is perhaps difficult to justify the new legislation applying to a company with reserves in excess of, say, £1 million. On the other hand, distributions up to, say, £50,000 would probably not give rise to significant avoidance risk or lost tax revenues.

The third alternative is to dispense with an upper limit completely, and replace it with an anti-avoidance rule and a statutory clearance procedure. Complex anti-avoidance legislation would be unwelcome, and I expect that HMRC would also point to a lack of resources to deal with a significant volume of clearance applications.

However, too difficult and inconvenient are not sufficient reasons by themselves to justify introducing a £4,000 upper distribution limit instead.

Good While it Lasted

An upper distribution limit for capital treatment in the new legislation will be an unwelcome change for professional advisers, unless you happen to be a liquidator. There does seem to be a certain unfairness about introducing into legislation a major restriction that was absent from the concession it replaces.

However, we know that tax and fairness are often incompatible, and it would also be disingenuous to argue for fairness when ESC C16 discriminated against liquidators for many years.

Nevertheless, difficulties in giving full legislative effect to ESC C16 as it now applies is a poor excuse for introducing an upper limit. If the perceived abuse is that taxpayers are using the concession just because it is there, surely HMRC only have themselves to blame?

If the £4,000 threshold were increased to a more practical level, it would certainly be useful in administrative and cost terms. How many liquidators would object to a £50,000 upper limit? I don’t know.

What I do know is that ESC C16 will be sadly missed, and not necessarily for the reasons that HMRC apparently perceive.

Appendix 1 - ESC C16

ESC C16 Dissolution of Companies under s 652 and s 652A Companies Act 1985: Distributions to Shareholders

A distribution of assets to its shareholders by a company which is then dissolved under the Companies Act 1985, s 652 [7] or s 652A (or any comparable provisions) is strictly an income distribution within TA 1988 s 209 [8].

In most circumstances and providing that certain assurances are given to the inspector before the event, the Revenue is prepared for tax purposes to regard the distribution as having been made under a formal winding-up so that the proviso to s 209(1) applies.

The value of the distribution is then treated as capital receipts of the shareholders for the purpose of calculating any chargeable gains arising to them on the disposal of their shares in the company.

The assurances include:

The company:

• does not intend to trade or carry on business in future; and
• intends to collect its debts, pay off its creditors and distribute any balance of its assets to its shareholders (or has already done so); and
• intends to seek or accept striking off and dissolution.
• The company and its shareholders agree that:
• they will supply such information as is necessary to determine, and will pay, any Corporation Tax liability on income or capital gains; and
• the shareholders will pay any Capital Gains tax liability (or Corporation Tax in the case of a corporate shareholder) in respect of any amount distributed to them in cash or otherwise as if the distributions had been made during a winding-up.

Notes

(1) References to CA 1985 s 652 and s 652A have been superseded by CA 2006 s 1000 [9] to s 1003 (the latter section dealing with voluntary striking off).

(2) HMRC guidance indicates two further conditions, i.e., that if the distributions were made in a winding up, the company would not be reported under the 'Transactions in Securities' anti-avoidance rules, and that the company is not under investigation (either on its own or as part of an enquiry involving individuals or other companies (CTM36220).

Appendix 2

Draft legislation - Section 1030A

Distributions in respect of share capital prior to dissolution of company

(1) This section applies where—

(a) the procedure in section 1000 of the Companies Act 2006 (power to strike off company not carrying on business or in operation) has been commenced in relation to a company, and

(b) the company makes a distribution in respect of share capital in anticipation of its dissolution under that section.

(2) This section also applies where—

(a) a company intends to make, or has made, an application under section 1003 of that Act (striking off on application by company), and

(b) the company makes a distribution in respect of share capital in anticipation of its dissolution under that section.

(3) The distribution is not a distribution of a company for the purposes of the Corporation Tax Acts if conditions A and B are met (but see section 1030B).

(4) Condition A is that, at the time of the distribution, the company—

(a) intends to secure, or has secured, the payment of any sums due to the company, and

(b) intends to satisfy, or has satisfied, any debts or liabilities of the company.

(5) Condition B is that—

(a) the amount of the distribution, or

(b) in a case where the company makes more than one distribution falling within subsection (1)(b) or (2)(b), the total amount of the distributions,

does not exceed £4,000.

(6) In the case of a company incorporated in a territory outside the United Kingdom, any reference in subsection (1) or (2) to a section of the Companies Act 2006 is to be read as a reference to any provision of the law of that territory corresponding to that section.

The above article was first published in Taxation on 17 March 2011.