Taxing times for liquidation proceeds

Introduced in April 2016, the changes are designed to combat tax advantages associated with so-called ‘phoenixing’. This occurs when a close company (broadly a company controlled by five or fewer shareholders) is liquidated, the profit distributed as capital and within a period of two years, the same or a similar trade is being carried on by one or more of the shareholders in another company or any other form.

If HMRC discovers a situation where this has occurred and concludes that the main purpose or one of the main purposes of the arrangements was to obtain a tax advantage, it could seek to reclassify the capital distribution as a dividend, which is taxed at a much higher rate.

When the legislative changes took effect, property developers were concerned that they could undermine their business model. It is relatively common practice for SME developers to undertake different developments in separate companies, commonly called Special Purpose Vehicles (SPVs). When the development is complete, the SPV is liquidated and the profit is extracted as capital, often benefitting from a 10% tax rate if Entrepreneur’s Relief applies. The next development is then carried on in a new SPV and the process is repeated.

On the face of it, this arrangement would appear to fall foul of the anti-phoenixing rules. However, developers usually have commercial reasons for carrying out different projects in SPVs. The most common reason is to ring fence risk, which is usually a condition for obtaining third-party financing for each project. Whilst obtaining capital treatment on distributed profits is a clear advantage of the SPV model, it is not the main reason for structuring in this way and therefore, the anti-phoenixing rules should not apply.

HMRC published its guidance on the legislation towards the end of last year but there is still a lack of clarity about how it might be applied to developers who use SPV structures. To minimise the risk of disputes arising, developers should take simple precautions, such as carefully documenting the commercial rationale for undertaking each development in a separate company. This may include keeping records of discussions with lenders, particularly if this demonstrates a requirement to ring fence risk.

Whilst there is no immediate cause for concern, property developers must take care if frequently extracting profit via liquidations, particularly as HMRC guidance lacks clarity. With the Spring Statement just around the corner, the chancellor could do more to put developers minds at rest, particularly as they are helping to address the housing shortage.