Tax break for shareholders of dissolved companies to be made less favourable

The current concessionary treatment will often result in beneficiaries paying less tax. However from March the favourable tax treatment will only be available if the total amount to be distributed is less than £25,000 after deducting the amount subscribed for the shares, HMRC has said.

The change will affect shareholders in companies that do not go through formal winding-up procedures under the Companies Act.  

As a matter of strict law if assets are distributed to shareholders other than in the course of a formal winding up the shareholder will be treated as receiving an income distribution, whereas if assets are distributed as part of a winding up, it will be a capital receipt.

As a concession, if the shareholder notifies HMRC and provides certain assurances HMRC currently treats returns of assets where there is no winding up as a capital distribution rather than a dividend for tax purposes.

The current rule is contained in extra-statutory concession (ESC) C16.  To take advantage of this provision the company must not intend to trade or carry on business in the future, and must collect its debts and pay off its creditors. It must also be struck off the Companies Register. There is no limit in the ESC on the amount that can be treated as an income distribution.

When the practice is put on a statutory basis income tax treatment will only apply where the amount to be distributed by the company is £25,000 or less once the original amount subscribed is deducted.

In its explanatory note (2-page / 31KB PDF) on the change, HMRC said that the provision enabled smaller companies to avoid the administration and cost requirements of going through a formal winding-up procedure. About 325,000 companies were dissolved in this way in 2010 according to HMRC figures.

The £25,000 restriction on total distributions was increased from HMRC's original proposed limit of £4,000 following a technical consultation. Tax advisors argued that the limit was set at "too low a level to be of practical benefit to those affected", as well as creating a "significant limitation... where one did not previously apply". However HMRC has argued that the limit is necessary to prevent tax avoidance, saying that it would otherwise have to introduce "complex anti-avoidance legislation which would require careful monitoring and be disproportionate to any revenue risk in the great majority of cases".

HMRC said that companies making large distributions on the cessation of their business had the option of being formally wound up "in order to protect the tax position of their shareholders".

Smaller companies, in particular, with straightforward affairs which have ceased business altogether and paid off their creditors may not wish to undertake the administration and incur the costs involved in going through the formal winding up procedures. In such a situation the company may simply distribute its remaining assets to shareholders and then either wait or seek to be struck off and dissolved.

Income treatment means that if the amount returned is greater than the shareholder's original investment then any excess will be subject to income tax. Capital treatment can result in a lower tax bill as entrepreneurs' relief may be available to reduce the tax liability to 10% or the distribution may be within the capital gains tax annual exemption.

ESCs allow HMRC to depart from the strict legal position and to give tax relief in specific sets of circumstances. They are introduced when the strict application of the law would create a disadvantage or the effect would not be that which was intended.

A 2005 House of Lords decision known as the Wilkinson case decided that HMRC's administrative discretion to create ESCs was not as wide as had previously been thought. HMRC is therefore currently involved in a legislative process to give statutory effect to existing ESCs that may exceed the scope of that discretion.

In its explanatory note it added that although the cost of a winding up would vary according to the size or complexity of the business, hiring a liquidator for a small business with straightforward affairs would cost in the region of £7,500.