Tax efficient remuneration for shareholders – Don’t forget capital reductions!

Traditional remuneration planning for shareholders has typically involved the comparison of the cost of a salary or dividend.  In the current environment dividends are very much the winner – salaries are subject to NI as well as PAYE, and the benefit of corporation tax relief is now much reduced as the corporate rate approaches 20%.

Although the dividend v bonus debate remains an important subject, the point of this article is to focus on a much newer and more exciting third option – The potential to use a capital reduction.  From 1 October 2008, CA 2006 section 641 gives private limited companies the power to reduce share capital by passing a special resolution supported by a directors’ statement of solvency.  This is a much simpler process than under the old legislation where capital could only be reduced through an application to the Court.

The reason that capital reductions are exciting from a remuneration planning point of view is that they are taxed under the capital gains tax regime.  This means that  any return of capital would be taxed on the shareholder at a “worse case” rate of 28% but with the possibility of enjoying the 10% entrepreneurs’ relief rate in appropriate cases.  To add to their attractiveness, certain individuals may have capital losses and annual exemptions (currently £10,600) available to reduce any tax charge still further.

Are Capital Reductions Viable?

We were recently discussing the benefits of capital reductions at a client seminar and various clients asked how it applied to them if their companies only had small levels of share capital.  The quick answer to this is that a capital reduction would not be relevant for such a company because there must be a sufficient level of capital to effect a reduction.  However, a capital reduction is probably more widely applicable than you would think.  For example share premiums can be reduced and not just the nominal value of the share capital.

There can also be instances where sizeable share capital is created through corporate reorganisations.  In the very simple example where a new holding company acquires a subsidiary via a share for share exchange, the value of the capital subscribed should equate to the value of Newco’s subsidiary.  Similar results can occur in more complicated reorganisations such as liquidation demergers where trade and assets are distributed to various new companies in exchange for those companies issuing shares to the shareholders.  In these cases there may be significant opportunities to extract cash or other assets through capital reductions.

Whenever a share for share exchange is undertaken HMRC clearance will need to be obtained to avoid the share for share exchange itself from triggering a capital gain.

Transactions in Securities Legislation

Some readers may at this point be thinking about the implications of transactions in securities legislation.  This legislation broadly acts to empower HMRC to deem that capital received by a shareholder should be treated as income in certain circumstances where they have received a tax advantage.  Although this legislation can apply, it may not be practically relevant for various of the reasons below:

  1. Transactions in securities legislation is only effective to the extent that there are distributable reserves in a company to start with.  Therefore it should not be in point in cases where the share capital “created” on a reorganisation is not derived from distributable reserves. For example the capital could be “created” from goodwill calculated by reference to the value of future profits.
  2. It seems clear that transactions in securities legislation cannot be applied to the beneficiary of a trust where it is the trustees (and not the beneficiary) that have been ‘a party to’ the transaction in question.
  3. The transactions in securities legislation is not covered by self assessment.  Therefore the taxpayer would have to assess themselves to capital gains tax in the first instance with the onus being on HMRC to “counteract” the capital nature of the transaction.  Therefore in practical terms there may often be no downside in opting for a capital reduction route as opposed to declaring a dividend.

Of course there is always the option of applying to HMRC for clearance that the transactions and securities legislation will not be invoked for a specific transaction.  However it may be difficult to obtain HMRC clearance in cases where there is a clear tax motive for taking the capital reduction in preference to a dividend.

We have had informal discussions with leading tax counsel who think that it is unlikely that HMRC will issue a counteraction notice for capital reductions which have been made some years after reconstructions. They believe that this is the case even if there were distributable reserves prior to the reconstruction.

Cases where Dividends are not viable

We have seen cases where companies have been unable to pay dividends due to a lack of distributable reserves but the shareholders still wish to extract value. Normally they would simply take salary with all the undesirable associated tax consequence. In certain cases however it may be possible to undertake a corporate reorganisation which will open the door for a potential capital reduction (at more favourable capital rates). As well as achieving the tax objective this has the advantage that the transactions in securities legislation should not apply due to the absence of distributable reserves.

This route will not always be advisable, and the wider consequences must be considered. In particular legal advice should be taken in relation to the need for a director’s statement of solvency. Furthermore, any reorganisation should be driven by other commercial considerations and not just by the objective of making a future capital reduction. This is important so as to benefit from various tax reconstruction reliefs that may be available (eg. no tax liability arising on a share for share exchange).

Conclusion

Our key message is that share capital and other capital reserves, can now be distributed to shareholders and this should be seriously considered as an option in remuneration planning. Although the transactions in securities legislation is a hurdle to overcome, in most cases even if a counteraction notice is served by HMRC, the tax payer should not be in a worse position than if they had taken dividends. Furthermore, a capital reduction may be attractive in certain cases where dividends are not viable.

 

 

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