Insights

Tax efficient extraction of funds from a company is always a big issue for director shareholders of limited companies. They will typically prefer to withdraw company funds as capital rather than income, in order to benefit from the lower rates of tax that apply. These can be as low as 10% where entrepreneurs’ relief can be utilised.

Now, due to the increased tax on shareholder dividends and the continued economic unpredictability, some company owners are opting to retain higher levels of profits in their company, if they can feasibly do so, rather than seek ways to extract additional funds. Ordinarily there is nothing wrong with this strategy and it can be very prudent. However, when the time for exit approaches, complexity can arise if significant profits have been retained over a period of time. This is because HMRC can argue that the profits should already have been taken as dividends and therefore should be taxed as income rather than capital, or that the level of cash investment prejudices the availability of entrepreneurs’ relief to the shareholders.

Current position on a trade sale

In their December 2015 consultation document, HMRC mentioned that they did not like the practice of companies retaining large amounts of cash leading up to a trade sale, and then effectively ‘selling’ that cash to a purchaser. This caused a lot of concern and uncertainty for companies heading towards a trade sale. Since then, legislation has been introduced which specifically targets companies in members’ voluntary liquidation, but not those undertaking a trade sale where at least 75% of the ordinary share capital of the company is sold to an unconnected party. So what is the current position?

Clearance applications made to HMRC that a trade sale would not attract a counteraction notice; i.e. that it was not undertaken for the purpose of achieving an income tax advantage, were, at the time of the consultation document, met by clearances from HMRC which included a caveat that the transaction may be affected by proposed changes in the legislation. Since that time, provided clearance applications clearly set out the reasons for cash retentions, that caveat has fallen away.

In summary therefore, our advice remains that provided cash retentions are clearly supported by business reasons, an unconnected trade sale in which at least 75% of the share capital is sold should not cause any problems in this context.

Pros and cons of retaining profits

There are multiple reasons why shareholders and directors of a company may wish to retain profits, and the argument as to whether a company ‘needs’ to retain its profits is subjective. Whilst excess funds may be retained to be taken out at a later date at a lower rate of tax, there are many other reasons why companies retain profits. These can include concerns over market trends or customer payment terms, the unreliability of bank funds, fluctuating stock levels, or the possibility of making business acquisitions that may or may not come to fruition.

Whatever the business rationale, it is always prudent to carefully document the reasons for retaining profits in a company and if necessary, to obtain clearance from HMRC well in advance of an exit transaction. This can help to protect future entitlements to capital gains tax treatment and any associated tax relief opportunities such as entrepreneurs’ relief.

Members’ Voluntary Liquidations

The situation where director shareholders are seeking a members’ voluntary liquidation (MVL), the position is treated quite differently by HMRC; they will counteract an income tax advantage (i.e. charge the transaction to income tax rather than capital gains tax) if they believe the company has accumulated excess cash which could have been paid out as a dividend.

HMRC have targeted anti-avoidance rules (‘Phoenixism’ rules) to attack situations where, within two years of the distribution, any shareholder carries on a similar trade, either alone or with others, or by persons connected to him. In this case, they will charge the consideration to income tax.

This will impact shareholders involved in multiple ways as follows:

• Funds extracted are typically treated as income rather than capital and taxed accordingly at the taxpayer’s marginal rate;
• Even where HMRC agrees that funds can legitimately be extracted as capital, there may be no entitlement to entrepreneurs’ relief;
• In this case, any capital gains tax will be payable at the standard rates - either the 20% higher rate or 10% basic rate, depending on the individual’s total levels of income and gains;
• Where the MVL also includes the disposal of a company-owned residential property, capital gains tax may be payable at 28%, the current standard rate for gains made through residential investment property transactions.

Given the restrictions created by the Phoenixism rules, it may be worthwhile for shareholders of companies with significant retained profits to consider other tax efficient ways to access company funds. For instance, it may be appropriate to make pension contributions through your company, or to invest in tax efficient employee training, which is still available using salary sacrifice.

To learn more about the Phoenixism rules, you can read our earlier blog on this subject.

For help with any aspect of corporate taxation including exit strategy, or to find out more, please email partners@rjp.co.uk.