Exploring the end of phoenixism
Kevin Slevin explains the Finance Act 2016 anti-avoidance rules on liquidation distributions – and how they can catch normal commercial arrangements.
Any objective observer of UK taxation will find it difficult to criticise HM Treasury’s decision to stamp out the practice labelled as ‘phoenixism’ – taxpayers deciding to liquidate cash-rich trading companies with a view to claiming entrepreneurs’ relief on the consequent capital gain, effectively extracting profits from a company so as to pay tax at 10% rather than on dividend income at 32.5% or 38.1%.
The legislation introduced by Finance Act 2016, now to be found in s396B, Income Tax (Trading and Other Income) Act 2005 (ITTOIA 2005) and which applies to liquidation distributions made on or after 6 April 2016, certainly gets to the heart of the matter. Tax-driven phoenix operations should now be a thing of the past.
This is good news for tax advisers, for at least two reasons. First, those of us who have always followed HMRC’s view that the simple replacement of one trading company with another did not work because HMRC could successfully apply the ‘transactions in securities’ provisions so as to tax the liquidation distribution as if it were a dividend (s682 et seq, Income Tax Act 2007) will no longer be placing their clients at a disadvantage when compared to clients of other, not so well-informed, firms or firms who simply ignored such a fine point!
Second, HMRC will no longer have the embarrassment of, on the one hand, asserting that phoenix operations on the lines just described failed because of s682, while on the other hand reluctantly admitting it did not have the resources to properly monitor the shifting of trades from one company to another with a view to applying s682 widely. Hearsay leads me to think that the vast majority of those who previously exploited the situation did so with near impunity – a most unsatisfactory feature of the pre-6 April 2016 regime.
Unfortunately, although HMRC has said repeatedly that the new provisions are clear, we appear to have gone from a situation where those practising the ‘art’ of phoenixism were escaping liabilities due to lack of resources within HMRC to properly monitor situations, to a situation where the business proprietors conducting normal commercial arrangements in a business-like manner may find themselves, through no fault of their own, in dispute with HMRC and enmeshed within the s396B targeted anti-avoidance rules (TAARs) – without ever having heard of the term phoenixism.
TAXline readers will know already that s396B makes no reference to the term phoenixism. Instead, the legislation introduces four conditions. If all of Conditions A to D inclusive can be said to apply where a liquidation distribution is received by a shareholder, s396B will operate so as to require the taxpayer to declare a sum as if it were dividend income liable to the income tax on dividends – the sum in question being the amount by which the liquidation distribution exceeds the allowable base cost for capital gains tax (CGT) purposes of the shareholding in question.
The first point to note here is that any liability arising under s396B is to be self-assessed by the shareholder. What is more, HMRC will refuse to give advance clearance as to whether it will argue that the provision will apply so that an otherwise capital gain will fall to be assessed as income.
The second point of note – though hotly disputed by HMRC – is that, in common with many provisions designed to counter perceived tax avoidance, the draftsman of the legislation has adopted terms which, when subject to close scrutiny in a given situation, may well appear vague. This is especially so when it is known that HMRC’s view of the legislation from an interpretation standpoint is that the courts will be expected to adopt a wide interpretation when considering Condition C and Condition D.
Conditions A and B, which effectively define the target companies and target shareholders, are comparatively straightforward.
Condition A requires that, immediately before the winding up is commenced, the taxpayer must possess at least a '5% interest in the company' and goes on to deem this to be the case where the taxpayer:
- possesses at least 5% of the ordinary share capital of the company; and
- can exercise at least 5% of the voting rights therein.
Condition B requires that the company be shown to be a close company when the liquidator is appointed, ie, at the start of its winding-up, or at any time in the period of two years ending with the start of the winding up (incidentally, there is a separate measure which addresses non-resident companies that are deemed to be close companies for this purpose).
It is perhaps worth mentioning here that there is no distinction between trading companies and investment companies; a distribution arising in respect of the winding up of any type of company can fall within the TAARs.
In exceptional cases some issues can arise but for the remainder of this article it is assumed that both Condition A and Condition B are met.
The problem areas
Conditions C and D are far less straightforward. Before exploring aspects of these two conditions it is worth noting that HMRC’s view is that overall the aim is to establish whether it is reasonable to assume that the company was wound up as a way of converting into a capital transaction what would otherwise have been paid out as income. HMRC’s Company Taxation Manual (paragraph CTM36340) goes on to state that 'the essential question is whether an individual may reasonably be regarded as carrying on or continuing to be involved in the same business as before, having extracted the profits in a capital form'.
Condition C (s396B(4)) is met where, at any time within the period of two years beginning with the date on which the liquidation distribution in question is made, any one of the four Condition C ‘trigger events’ occurs. Paraphrased, the trigger events can be broadly summarised as being any one of the following:
- the taxpayer carries on a trade or activity which is the same as, or similar to, that previously carried on by the company in liquidation; or
- he or she is a partner in a partnership which carries on such a trade or activity; or
- the taxpayer, or a person connected with him or her, is a participator in a company (having a 5% interest in the two-year period under review) and that company carries on such a trade or activity (or is connected with a company which carries on such a trade or activity); or
- the taxpayer is involved with the carrying on of such a trade or activity which is conducted by a person connected with the individual.
Here it should be noted that HMRC may well want to label all business in the IT sector as being ‘similar’ – even though the business proprietors may see the different activities as having a chasm between them. It should also be noted that a trading activity can be viewed as being similar to an investment activity, eg, running a hotel as a trade may be regarded as similar to investing in a hotel which is let to a third party.
The key issue: the purpose test
The question to be answered as regards Condition D is this. Is it reasonable to assume that the main purpose or one of the main purposes of the winding-up (or of arrangements of which it is part) is the avoidance of income tax? Three key questions arise here:
- How does one determine what is meant by the phrase 'it is reasonable to assume'?
- What is meant by the phrase 'the main purpose or one of the main purposes'?
- Does the phrase 'the avoidance or reduction of a charge to income tax' extend to include decisions made prior to the winding up not to pay dividends to the shareholders?
Dealing with these points in reverse order, the good news as regards to question 3 above is that HMRC has indicated that the decision not to pay out a pre-winding up dividend will not normally be regarded as tax avoidance for this purpose. HMRC officials have indicated that they see their focus as being on what was done as regards the winding up, rather than what hypothetically could have been done as regards possible declaration of dividends in earlier years.
Turning to (2), above, my understanding of HMRC’s interpretation of the phrase 'the main purpose or one of the main purposes' is that the approach to be taken is, at first sight, surprising. The individual facts of any one case will help shape how one should approach this issue but HMRC holds the view that the focus should not be on the shareholder’s motive in voting in favour of the liquidation resolution but rather it should be on what was achieved by adopting such a course.
Applying this approach to the interpretation of the purpose of a transaction means that one can end up with surprising results. Simply put, the facts of each case will have to be considered carefully and it may be that two situations which appear outwardly to be similar may end up being taxed differently.
HMRC takes the view that the shareholder should know what was to be achieved by what was done. Expect more searching questions to be asked, especially if there appears to be an ongoing similar business activity. Businessmen carrying on a number of similar businesses will find themselves been questioned closely when they liquidate one of the companies they have invested in.
As regards question 3, my reading of the provision is that the first call is on the taxpayer to decide whether it is reasonable to assume that an informed person looking at matters objectively will be highly likely to assume the steps taken were carried out with a view to the shareholder in question avoiding income tax. This simple statement is important because HMRC appears, from my communications with senior officials, to accept that once a shareholder has assessed a liquidation distribution as being a capital receipt and therefore not liable to income tax, arguably it is only if HMRC can show that the taxpayer has been unreasonable in arriving at his conclusion that the treatment adopted may be challenged.
This is important because it means HMRC officials cannot merely argue that they have a view that it is reasonable to assume that the main purpose or one of the main purposes of the winding-up (or of arrangements of which it is part) is the avoidance of income tax, and that it is their view that counts. In effect, HMRC must show that the view of matters taken by the taxpayer in his or her self assessment was unreasonable.
In this article I have sought to flag certain important issues on a topic which has been a considerable cause for concern. Post-liquidation activity which can properly be described as the same as or similar to that carried on the by the liquidated company may well convert a self-assessed CGT liability into a liability to income tax if the two-year rule is broken.
Contrary to HMRC officials’ view that the legislation is clear, I predict that it is only a matter of time before HMRC is pursuing shareholders under s396B. Only as the body of practical experience grows will practitioners be able to find firmer ground on which to base advice.
Of course, the overhanging issue not addressed above is that of penalties. Any taxpayer forced to re-categorise a capital sum as being a dividend can expect HMRC to raise the question of penalties. Accordingly, practitioners should proceed with great caution. Where an egregiously bullish approach is shown to have been adopted it is possible that the tax adviser in question may find himself in the firing line too: knowingly assisting in the completion of an incorrect tax return.
About the author
Kevin Slevin is a taxation consultant and author