Contractors with large sums of cash in their limited companies should consider a Members Voluntary Liquidation (MVL) before changes to tax rules on distributions made to shareholders from winding-up companies come into effect in April 2016.
This is according to Mike Simister, director at specialist contractor licensed insolvency practitioners Lines Henry, who warns that HMRC may investigate any contractor attempting an MVL once the new rules are enforced:
“Following the dividend tax changes coming into force in April 2016, HMRC’s concern is that limited company contractor’s will see MVL’s as a loophole to minimise tax liabilities. As such, HMRC is set to enforce new rules that contractors need to be aware of.”
HMRC announced a new Targeted Anti-Avoidance Rule (TAAR) in a Policy Paper titled Corporation Tax, Income Tax and Capital Gains Tax: company distributions, published in December 2015, designed to prevent ‘phoenixing MVL’s’, where a contractor uses the process to close down their company and extract the cash without paying income tax, before starting up a new company immediately afterwards.
Securing an MVL before new regulations take effect on 6 April 2016 could be the last opportunity for limited company contractors to withdraw profits tax-efficiently before retirement, with upcoming dividend tax hikes set to compound matters.
Why MVL’s have become popular with contractors
Contractors with significant cash reserves in their limited companies are currently able to distribute profits tax-efficiently with an MVL. By winding-up the company in this fashion, contractors can avoid income tax whilst distributing cash reserves as capital, potentially attracting a tax rate as low as 10%.
Licensed insolvency practitioners can perform MVL’s at competitive fees, sometimes for as little as £2,500. However, there must be a substantial amount of cash within the company for it to be a financially viable move - usually in excess of £50,000.
To benefit from the minimal capital gains tax rate of 10%, contractors can apply for Entrepreneur’s Relief (ER). In order to qualify, the company must have been trading for 12 months up to the date it ceases to trade, whilst the contractor is also required to have been at least a 5% shareholder and an employee of the company for at least one year before ceasing to trade.
What are the new MVL regulations?
In its Policy Paper, HMRC outlines a new TAAR aimed specifically at MVL’s, which states that distribution from a liquidated company will be treated as income distribution in the instance that three conditions are met. These conditions are:
- An individual (S) who is a shareholder in a close company (C) receives from C a distribution in respect of shares in a winding-up
- Within a period of two years after the distribution, S continues to be involved in a similar trade or activity
- The circumstances surrounding the winding-up have the main purpose, or one of the main purposes, of obtaining a tax advantage.
Contractors automatically fall foul of two criteria
The conditions make it clear that the taxman is determined to put a halt to phoenixing, but Simister raises concerns that the new rules leave contractors with very little in terms of leeway: “If you look at the conditions within the TAAR, any contractor is automatically likely to fall foul of two of them.
“A contractor meets the first condition simply by engaging in an MVL. Also, whilst tax is rarely the main motive when it comes to winding-up, it is almost always a factor. Indeed, many of the accountants I’ve spoken to believe tax is always going to be considered ‘one of the main purposes’.
“Until we find out how tightly HMRC is going to define ‘main purpose’, we won’t know for sure. As it stands, it appears as though the only condition a contractor has any control over is the two-year rule.”
Contractor TAAR compliance dependent on the two-year rule
If a contractor wishes to take advantage of the MVL process beyond 5 April 2016, the easiest way to comply with the TAAR would be to stop contracting and secure PAYE employment. Or a contractor could work via an umbrella company for two years following the final dividend being paid through the MVL. This should ensure that the second condition isn’t breached.
“For high earning limited company contractors with large amounts of cash in their business, working via an umbrella company for a couple of years obviously won’t be as tax-efficient as their current arrangement. But it may leave them better off than if they were to remain with their company beyond 5 April 2016, when you also take into account the dividend tax changes,” Simister notes.
One possible outcome of the new regulations is that some contractors will be encouraged to take a break from contracting, living off the taxes they have saved. This would reduce the contractor workforce during a time of particularly acute skills shortages and actually cut HMRC’s tax yield in the process.
“There are many contractors who contract for a few years before utilising MVL’s and using the money received to travel,” highlights Simister. “The problem for contractors considering this is they will now have to take a two-year break from contracting via a limited company. But yes, that very much could be one of the impacts of the regulations.”
Lack of transitional provisions places contractors at risk
Due to the current lack of transitional provisions – special arrangements that apply to relevant parties when changes to the law are implemented - surrounding the new MVL rules, contractors who are currently within the process of liquidating their company could have their distribution treated as income, should it occur on or after 6 April 2016.
When MVL claims are dragged out, it is often due to delays caused by HMRC. A final distribution can be made once HMRC has confirmed the tax position of a company, but it can often take up to six months to do so.
“There are instances where we can complete a job - from the shareholder’s point of view - within a month, but it’s all a matter of how promptly HMRC responds to claims and requests for confirmation, because that is necessary to complete the process.
“We have suggested to HMRC that it would be more appropriate to apply the new rules to any liquidation which commences on or after 6 April 2016, rather than should the date of the distribution happen to fall beyond this date.”
New regulations won’t significantly impact on the number of MVL requests
Simister highlights that - whilst there will be the inevitable rush of MVL requests over the coming six weeks – over the long-term the new rules aren’t likely to have a great impact upon the number of MVL requests received.
“The vast majority of MVL’s we’ve carried out over the past couple of years have been either due to genuine retirements or from contractors who have accepted a paid position and no longer require their limited company,” he explains.
“As such, I wouldn’t expect a significant decrease in terms of MVL requests after April, despite HMRC’s apparent perception that contractors are primarily motivated by the tax advantages that accompany incorporation.”
Contractors still have time – just not very much
Due to the administrative procedures involved – including a 21-day notice period - contractors don’t have a great deal of time left to secure an MVL. However, for contractors whose tax affairs are up-to-date, it remains a possibility.
Simister points out that the latest possible date for applications is 1 March 2016, and encourages contractors to talk to their accountants or tax advisers to see if they’re in a position to apply for an MVL, but warns that many won’t be:
“Many contractors will be in the middle of a contract and so won’t be in a position to set up a new company prior to 6 April 2016. Also, contractor accounts need to be completely up-to-date.
“It doesn’t help that, for most accountants, we’re halfway through the busiest month of the year. However, if you can, and there is a significant tax saving available, why not? But beware, time is ticking.”