An end to 10% tax for serial property development?
Will entrepreneurs’ relief be restricted through proposed changes to the treatment of distributions on liquidation?
The Chancellor’s recent Autumn Statement included a rather cryptic reference to proposed changes to entrepreneurs’ relief to target “contrived schemes” whilst ensuring that the relief remained available for genuine commercial transactions.
The release of the draft clauses, on 9 December, for inclusion in next year’s Finance Act, provides detail to these proposals and reveals how the ability to claim entrepreneurs’ relief will be affected in many common situations. It is likely that these changes will be effective from 6 April 2016.
Strictly speaking, what is proposed is not a change to entrepreneurs’ relief but, as outlined below, to the treatment of distributions on a winding up. Nevertheless, conventional structures for property transactions may need re-assessing.
The proposed change
The proposed change targets the tax treatment of distributions made in the course of liquidating a company. At present, these are generally treated as capital distributions and taxed as capital gains. Where the conditions for entrepreneurs’ relief were met, such gains benefitted from a 10% rate of capital gains tax. This general rule is now “switched off” in defined circumstances with the distribution being taxed as dividend income; potentially at rates as high as 38.1%.
What is the intended target?
The “contrived schemes” referred to in the Autumn Statement appear to be “phoenix operations”: the tax-effective extraction of profits of one company by liquidation, without paying a revenue dividend, followed by re-commencing the same trade in a new company (the phoenix company).
What distributions are caught?
The new rules will apply where three conditions, called conditions A, B and C, are met. These conditions reflect a “capture and discard” approach.
Condition A is very widely drafted and applies to all “close companies” or companies that were close at any time in the two years prior to the start of the winding up. This will cover the vast majority of private companies.
Condition B refines those captured to individuals who receive the distribution and, within two years after the date of the distribution, carry on any trade or other similar activity previously carried on by the company. This applies whether this involvement is as a sole trader, in partnership or in a new company.
The final discard condition, condition C, requires that it is reasonable in all the circumstances to assume that one of the main purposes of the liquidation, or arrangements of which the liquidation formed part, is the avoidance of an income tax liability.
The issues for property
As with much anti-avoidance legislation based upon a “capture and discard” approach, the subjective nature of these proposals is unsatisfactory. In particular, it remains to be seen how HMRC will interpret condition C.
Many single property, or single site, developments are conducted through a Special Purpose Vehicle which is then liquidated at the conclusion of the development for bona fide commercial reasons, such as ring fencing liabilities and individual parties going their own separate ways. There may be a tax advantage in liquidating, but is it reasonable to conclude it is the main, or one of the main, purposes of the winding up?
If an individual is involved in the liquidation and party to a similar development within two years of the distribution then, on the face of it, there is a risk that the capital distribution will need to be treated as a dividend in the future. However, this is dependent upon the “main purpose” found, something that may not be agreed with HMRC until after the subsequent development has been completed.
With many property ventures being conducted as joint ventures between different parties, there is a real risk that participants will have different track records such that some will be able to enjoy capital treatment whilst others will be subject to revenue treatment. Again the “main purpose” of the liquidation will be critical in determining the tax treatment.
Although attracting little attention at the time of the Autumn Statement, the release of the Finance Bill 2016 has brought into the open what is meant by “contrived structures” for entrepreneurs’ relief. These rules have the potential to impact significantly many commonly encountered situations, but will give rise to inevitable uncertainty over the tax treatment of the resulting distributions.
No prior clearance procedure appears to be contemplated leaving us with inherent uncertainty in many liquidations until some measure of experience is achieved with respect as to how HMRC are going to interpret these new rules.