Phoenixing Rules – Rising from the Ashes
By Qdos Vantage
A topic that is frequently asked about on our helpline relates to the Phoenixing Rules. “Phoenixing” which was introduced by Finance Bill 2016 and is in the legislation at ITTOIA05 S396B.
The purpose of ITTOIA05 S396B is to prevent individuals converting what would otherwise be a dividend into a capital payment, and so reducing their overall tax liability. This provision applies to distributions in a winding-up made on or after 6 April 2016, regardless of when the winding-up commenced.
Mr J is a dance instructor who runs his business through his own company. At the end of each year, instead of paying himself a dividend (which would be liable to Income Tax), Mr J winds up his company and receives the profits as a distribution in a winding up, liable to Capital Gains Tax. He then immediately creates a new company and continues his dance instruction business
This practice is often known as ‘phoenixism’ (because the new company rises from the ashes of the old).
The Targeted Anti-Avoidance Rule (TAAR)
A distribution in a winding up made to an individual on or after 6 April 2016 will be treated as if it were a distribution where certain conditions are met. For the rule to apply, all the following conditions must be met:
- Condition A: The individual receiving the distribution had at least a 5% interest in the company immediately before the winding up
- Condition B: the company was a close company at any point in the two years ending with the start of the winding up
- Condition C: the individual receiving the distribution continues to carry on, or be involved with, the same trade or a trade like that of the wound-up company at any time within two years from the date of the distribution
- Condition D: it is reasonable to assume that the main purpose, or one of the main purposes of the winding up is the avoidance or reduction of a charge to Income Tax.
Condition A – ITTOIA05/S396B
For the purpose of ITTOIA05/S396B, a person has a 5% interest in a company if:
- The individual holds at least 5% of the ordinary share capital of the company, and
- The individual can exercise at least 5% of the voting rights in the company by that holding.
Ordinary share capital is defined at ITA07/S989
Condition B – ITTOIA05/S396B
ITTOIA05/S396B only applies where the company being wound up was a close company at any time in the two years immediately preceding the start of the winding up.
Company A starts winding up proceedings on 1 May 2016. If it was a close company at any point during the period 2 May 2014 to 1 May 2016, section 396Bcan apply where the other conditions are met.
Condition C – Introduction – ITTOIA05/S396B
Condition C is met where the individual receiving the distribution in the winding up continues to be directly or indirectly involved with the same or similar trade or activity as the company being wound up at any time within two years from the date of the distribution.
The condition is widely drafted to prevent the rule being easily avoided by subtly changing the type of trade or activity of the company, or by changing the structure in which that trade or activity is carried out (for example by transferring the company’s trade to a partnership).
Condition C is met not only where a new company is created after the winding up of the company in question – it will apply wherever the individual receiving the distribution continues to carry on, directly or indirectly, the same or a similar activity.
Meeting Condition C does not, on its own, mean that the legislation will apply. All four of the conditions must apply, and while Condition C is deliberately wide, Condition D (the purpose test) will narrow the application of the legislation.
‘Similar trade or activity’ Definition
ITTOIA05/S396B/404A applies not only to distributions from companies carrying on a trade but also to companies carrying on an investment business and to a holding company of a trading group, for example.
‘Similar trade or activity’ is not further defined and is a deliberately wide-ranging term designed to prevent arguments that a new company is not carrying on “the same” trade as the wound-up company because of changes to the business model.
HMRC Example 1
Mr G is the sole shareholder in a company that provides a car-washing service. Mr G winds up that company but continues to provide car-washing services through a partnership with his wife, but now also sells air-fresheners.
Clearly Mr G is carrying on the same trade, or at least a trade very similar to that carried out by the company, and so Condition C is satisfied.
HMRC Example 2
Mrs F is a landscape garden designer and runs her business through a company. Mrs F decides she would like to retire, and so winds up the company. In order to supplement her pension, and because she enjoys it, Mrs F continues to provide routine gardening services to a small group of clients in her local village as a sole-trader.
It is unlikely that Mrs F is carrying on “the same trade” after the winding up as that carried on by the company. However, the provision of gardening services is “similar to” the provision of landscape gardening, and so Condition C is met. (But that does not mean that ITTOIA05/S396Bwill apply to the distribution, because all the conditions must be met, and it is not likely on these facts that Condition D – the purpose test – will be satisfied.)
HMRC Example 3
Mr E is a builder who runs his business through two companies – Company 1 specialises in loft conversions, and Company 2 specialises in extensions. Mr E winds up Company 1, but the trade of Company 2 continues.
As with Example 2, Mr E continues to be involved with a trade that is similar to that of the company that is wound up, and so Condition C is satisfied.
HMRC Example 4
Mrs D is a recruitment consultant who runs her business through a company. After three years of training part time, she winds up her company and starts a new company that offers her services as an IT consultant. Some of her new clients are businesses she dealt with in her previous company.
Although Mrs D is still a consultant, the trade has changed significantly, and it is unlikely that it would be viewed as the same or similar to that carried on by the wound-up company. It does not matter that she continues to deal with some of the same clients because the nature of the service she is providing is different. Even if it were argued that the work was similar consultancy support, it is unlikely that Condition D would be met in any event.
Condition C is met where “the individual [who receives the distribution in a winding up] is involved with the carrying on of such a trade or activity by a person connected with the individual”.
“Involved with” Definition
Like “similar trade or activity”, “involved with” is not a defined term and is potentially wide in scope. It is designed to prevent the TAAR being avoided by connected parties working together to circumvent the other conditions.
HMRC Example 1
Mrs C is an accountant who runs her business through a company. Her husband is a self-employed lion tamer. Mrs C winds up her company and starts work for a newly-formed company owned by her husband, providing accountancy services.
Mrs C continues to be involved with the carrying on of the same trade or activity as the wound-up company was involved with (the provision of accountancy services), even though she is now an employee rather than business owner. She is connected to her husband and so Condition C is met (and so are Conditions A and B). Condition D will still need to be satisfied.
HMRC Example 2
Instead of going to work for a newly-formed company, Mrs C, from Example 1, goes to work for her sister’s pre-existing accountancy practice, which the sister operates as a sole trader.
Mrs C is connected with her sister, and she is continuing to be “involved with the carrying on of” the same or a similar activity, and so Condition C is met. Condition D will still need to be satisfied.
HMRC Example 3
Mr B is a fitness instructor who provides his services through a company. After suffering an injury, he winds up his company and starts work as a journalist. Mr B’s wife is also a fitness instructor and she offers her services as a sole trader, before and after the winding up of her husband’s company. Mr B provides no services to his wife’s business at all.
Mr B is not “involved with the carrying on of” a similar trade or activity after the winding up of the first company, even though his wife is.
“Connected with” Definition – ITTOIA05/S396B
Paragraphs (c) and (d) of Condition C apply where there is a connected person. “Connected” is defined in ITA07/S989 (read in accordance with ITA07/S993 and S994), in the same terms as CAA01/S575.
Condition D – ITTOIA05/S396B
Where conditions A, B and C are satisfied S396B/404A will still not apply unless Condition D is also met. S396B/404A (5) applies Condition D where:
“it is reasonable to assume, having regard to all the circumstances, that –
- The main purpose, or one of the main purposes of the winding up is the avoidance or reduction of a charge to income tax, or
- The winding up forms part of arrangements the main purpose or one of the main purposes of which is the avoidance or reduction of a charge to income tax”.
S396Bprovides further guidance on the purpose test:
“The circumstances referred to in subsection (5) include the fact that Condition C is met.”
S396Brequires that regard is given “to all the circumstances”, whereas S396B states that the circumstances should be specifically considered in relation to the fact that Condition C is met. Consideration will therefore be given in particular to whether the tax advantage is a consequence of the winding-up and the continuing involvement with the carrying on of the same or a similar trade or activity.
Ultimately, the legislation is asking whether the recipient of the distribution is continuing what amounts to the same business having extracted the accumulated profits in a capital form. This is inevitably a question of judgment to be made based on facts in individual cases. The following issues are likely to be relevant:
- Is there a tax advantage, and if so, is its size consistent with a decision to wind-up a company to obtain it?
- To what extent does the trade or activity carried on after the winding-up resemble the trade or activity carried on by the wound-up company?
- What is the involvement in that trade or activity by the individual who received the distribution? To what extent have their working practices changed?
- Are there any special circumstances? For example, is the individual merely supplying short-term consultancy to the new owners of the trade?
- How much influence did the person that received the tax advantage have over the arrangements? Is it a reasonable inference that arrangements were entered to secure this advantage?
- Is there a pattern, for instance have previous companies with similar activities been wound-up?
- What other factors might be present to lead to a decision to wind-up? Are these commercial and independent of tax benefits?
- Are there any events apparently linked with the winding-up that might reasonably be considered? For example, was the only trade sold to a third party, leaving just the proceeds of the sale?
HMRC say that it is impossible to give an exhaustive list
HMRC say that it is impossible to give an exhaustive list or comprehensive examples as individual facts and circumstances will be paramount. The aim is to establish whether it is reasonable to assume that the company was wound-up as a way of converting into a capital transaction what would otherwise have been paid out as income. The essential question is whether an individual may reasonably be regarded as carrying on or continuing to be involved in the carrying on of the same business as before, having extracted the profits in a capital form.
A decision by a company and its shareholders not to make an income distribution prior to the company’s being wound up does not, by itself, mean that the main purpose test is met.
The individual will know their purpose and, if fairly described, can be confident that there will be enough supporting evidence (“having regard to all the circumstances”) for an officer to arrive at a sound conclusion when applying the test of whether it is ‘reasonable to assume’ that a main purpose of the winding up or the wider arrangements was the avoidance or reduction of a charge to income tax. The individual should self-assess on that basis. HMRC can only displace this self-assessment where the individual’s decision is not reasonable.
The purpose test is subjective, but the purpose may be inferred from objective characteristics having regard to all the circumstances surrounding the winding-up to which the test is being applied, much as Lord Brightman was able to draw an inference in a different context. In Mallalieu v Drummond (1983) 57 TC 330 he was able to distinguish between the motive the barrister asserted of maintaining a wardrobe of a certain type and standard, and the object or purpose of the purchase of it.
The main purpose test is applied by reference to intentions known at the time the decision was made to wind up the company. However, this will be evidenced by what happens after the winding up occurs and it is likely that, to test assertions in relation to the main purpose, officers will review all available evidence.
Where a company is wound-up as part of a series of transactions designed to refine or restructure the commercial architecture Condition D is unlikely to be met.
Subject to the facts of the case, where Condition C is met due to an individual remaining ‘involved with the carrying on of’ a trade as an employee, rather than as an owner, shareholder or partner, and has no involvement in or influence over the direction or decision-making of the entity carrying on the activities, it is less likely that Condition D will be met.
Requests for clearance
ITTOIA05/S396B provides no statutory clearance procedure. Although there is a non-statutory clearance procedure, the applicant would not be uncertain about purpose, which is a subjective matter. It follows that a clearance application would not be appropriate unless it is limited to the application of specific rules in the legislation where there is genuine uncertainty about their application to a specific proposed transaction.
Note that similar legislation is in place for overseas companies under ITTOIA 2005 S404
At present there are no Tax Cases to clarify to what extent HMRC will use the rules.