In Greek mythology, a phoenix is an immortal bird that rises from the ashes of its predecessor. I imagine such a sight would be spectacular and graceful. A symbol of new starts and fresh chances. Phoenix companies, however, are often not looked at in the same light.
What is it?
‘Phoenixism’ is a term used to describe the method by which directors carry on the same business or trade successively through a series of companies, partnerships, or sole trades (in this article we will refer to all as companies).
The actual process itself involves a company that ceases trading (for whatever reason). The assets of the company are passed on to a new entity (the phoenix company) with which the director is connected. The debts, however, are not passed on and die with the company.
There are a variety of reasons why a company might fail and it is often not as a result of misconduct. Yet it is a reality that sometimes a company was never intended to succeed. In these cases, the plan has always been to avoid paying what is owed – the phoenix looks a whole lot less graceful now.
Regardless, it is crucial to acknowledge that not all phoenix companies are the product of illegitimate planning and many are genuine attempts to continue business with real commercial goals. The government knows this and hence the law allows the set-up of new companies to continue the business – the anti-avoidance rules apply to prevent a charge from the distribution of assets being applied to capital gains tax as opposed to income tax.
Distributions on striking off
When a company goes into liquidation, the director(s) may seek that its assets are passed to them. This is what is known as a distribution. Distributions are subject to tax as dividends unless, on the event of its winding up, the total assets of the company are less than £25,000. For smaller companies with low asset value this can be a low-cost way of extracting the profits of the company. For larger companies the director may be subject to the less beneficial income tax rates.
A members’ voluntary liquidation (MVL) is an ideal way of extracting value from the liquidating company where assets exceed £25,000. This is a formal procedure, requiring the appointment of an insolvency practitioner, whereby the distributions can be received and instead charged as capital despite assets exceeding £25,000. Further, business asset disposal relief may be available if the company was a qualifying trading company.
The charge to income tax is done at the dividend tax rates which can be as high as 39.35% (as of 06 April 2022). Capital rates are charged at 10% for those in the basic rate band and 20% for any amount exceeding the basic rate threshold. If the recipient of the distributions qualifies for business asset disposal relief, they could stand to pay almost four times less than if it were charged to income – a significant difference. It’s clear to see why this regime has been historically abused.
Prior to anti-avoidance measures, the director could make use of the capital distributions rate and then continue the business via some other entity. However, new legislation was introduced to prevent this. For the phoenix rules to trigger and thus class distributions as a charge to income tax, all four of the following must be satisfied:
- Condition A – immediately before the winding up, the individual has at least a 5% interest in the company;
- Condition B – the distributing company was a close company when it was wound up or a close company within the two year period before the winding up began;
- Condition C – within two years in which the distribution was made, the recipient of the distribution carries on a trade or activity which is the same or similar to the previous company.;
- Condition D – 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 income tax.
The legislation states that condition D is particularly reliant on condition C being met. In other words, the government is aware that condition C may occur frequently for various reasons and as such we must be certain that C was only triggered due to the reasoning of condition D.
Like previously mentioned, it is important that we remember that phoenixing is not inherently wrong. HMRC may lean heavily on what constitutes as a similar trade or where the motive for tax avoidance lies when they challenge claims for capital treatment.
Whilst the phoenixing rules apply to all transactions meeting the above conditions, we see a number of HMRC Enquiries where there has been substantive abuse where a company might rack up significant debts to HMRC (PAYE, VAT etc) and then proceed to go into liquidation. A director might do this so they can extract as much profit from the company as possible charged at the lower capital gains tax rates. Where the behaviour is deliberate, it amounts to fraud and the repercussions from HMRC are much more severe and can include prosecution. A director has a fiduciary responsibility to act in the best interest of the company and its shareholders, failure to do so can result in disqualification a s director).
An MVL can be a genuine exit strategy for individuals wishing to continue the business as an unincorporated entity. Care should be taken to ensure that the strategy of the MVL is clearly identified and the participator should be acutely aware of the tax consequences that are likely to arise – after all they could fall victim to anti-avoidance up to two years after the fact, or, if the behaviour is deliberate, 20 years!