Tax Bite – How HMRC taxes capital receipts as income and additional points you may not know

It is often preferable for a company’s shareholder to receive funds from the company as capital rather than as a dividend. This is because capital gains can be taxed at rates as low as 10% while dividends are taxable at rates as high as 30.56%. However, HMRC use legislation (known as transactions in securities legislation) to tax capital receipts as dividends in certain circumstances where there would otherwise be a tax advantage.

The classic example where this legislation could bite is as follows:

1. Individual sells trading company to a newly setup company (Newco).

2. Newco pays for its acquisition with dividends received from the trading company.

Here it is clear that the trading company’s reserves have been paid out in a capital form without any significant change to the commercial ownership position (no sale to third parties etc). As a broad rule of thumb HMRC may try to tax capital gains as dividends in cases where the original shareholders retain a significant commercial stake in a company.

Facts you may not know

Because this legislation is outside the scope of self-assessment HMRC has 6 years from the end of a tax year to issue a ‘counteraction notice’ to eliminate the tax advantage through the collection of further tax (however the onus is fully on HMRC to apply the legislation and therefore penalties should not be applicable).

Usefully there is a fundamental change of ownership exemption which prevents the legislation from applying when as a result of a transaction a person not connected with the vendor acquires at least 75% of a company. Therefore on the face of it this exemption should apply in many venture capital transactions where a new company is used as a vehicle to allow the venture capital company to invest. It remains to be seen whether this will apply in more ‘aggressive’ transactions where shareholders do not relinquish any commercial control. For example a simple sale to a new company (above) is just the kind of transaction that the legislation is supposed to attack, however prima facie the exemption can sometimes protect them from just this kind of transaction!

 

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