In the second of a two-part article, Peter Rayney examines how to access the beneficial 10% entrepreneurs’ relief rate on winding-up a ‘personal service’ company tax.
Provided various ‘anti-avoidance’ rules can be surmounted (see Part 1 of my article), liquidation distributions received by a personal service company (PSC) owner should fall within the capital gains regime (CTA 2010, s 1030). They are treated as ‘capital distributions’ and taxed under TCGA 1992, s 122. Broadly, the receipt of a capital distribution is treated as a disposal of an interest in shares for capital gains tax (CGT) purposes. Where several capital distributions are made, these effectively represent part disposals of the shares.
In some cases, the liquidator may make an in-specie capital distribution of an asset. This will generally involve a deemed market value disposal of the relevant asset by the company. Furthermore, the recipient shareholder is also deemed to receive a taxable capital distribution equal to the market value of the asset (TCGA 1992, s 122(5)(b)).
Obtaining entrepreneurs’ relief on capital distributions
The entrepreneurs’ relief (ER) legislation contains special rules for capital distributions. In such cases, ER is available provided that the recipient shareholder satisfies the relevant ER conditions in the 12 months before the PSC ceases to trade (TCGA 1992, s 169I(7)). In the context of a PSC, these are:
- the PSC must be a trading company;
- the recipient shareholder must have held at least 5% of the PSC’s voting and ordinary share capital in their own right; and
- the recipient shareholder was an employee or director of the PSC.
Furthermore, the relevant capital distribution must be made within three years of the cessation.
Large cash balances and ‘trading company’ status
The ER rules are quite stringent in that they require the company to be wholly trading; although non-trading activities are ignored provided they are not substantial (TCGA 1992, s 165A(3)).
Many PSCs tend to accumulate considerable cash balances over their working life. In my experience, the PSC owners (and their accountants) are often concerned that large cash balances could prejudice the ER entitlement. Whilst care must be exercised with substantial cash balances, HMRC appear to adopt a pragmatic approach.
HMRC tends to accept that cash generated from a company’s trading activities should not necessarily prejudice its ‘trading’ status. There are many factors to be considered – for example, the extent to which surplus cash has been actively ‘managed’. If cash balances are applied and managed as ‘investment’ assets, HMRC would treat them as ‘non-trading’ items, which would, therefore, be subject to the 20% ‘safe harbour’ rule. However, case law and HMRC guidance has shown that gross assets, turnover/income, expenses, management/employee time must all be considered in the analysis.
If ER cannot be successfully accessed, the main 20% CGT rate would probably apply.
Example: Capital distribution paid on a winding-up
Apollo 11 Consulting Ltd (A11C) is 100% owned by Neil, who subscribed for its entire 100 £1 ordinary shares at par on 21 July 2009. A11C has provided public relations consultancy services with Neil and various sub-contractors providing advice and support to a number of high-profile clients.
In December 2017, Neil retired and the company’s trade ceased. A liquidator was appointed on 1 March 2018. On 10 April 2018, the liquidator paid out £876,000 – representing all the company’s reserves and share capital (after deducting liquidation and other professional costs) to Neil as a single capital distribution.
Neil’s CGT liability (in 2018/19) would be £86,420 (with an ER claim), which is calculated as follows:
£
Capital distribution 876,000
Less: Base cost (100)
Capital gain 875,900
Less: Annual exemption (11,700)
Taxable gain 864,200
Practical Tip:
Given the importance in obtaining HMRC’s acceptance that the PSC is a ‘trading company’ for ER purposes in the 12 months to cessation, PSC owners and their advisers should consider making an advance application to HMRC under the ‘non-statutory’ business clearance procedure to confirm this.
