Business Asset Disposal Relief
Navigating the intricate landscape of self-employment is no easy feat, especially for contractors. Amidst the myriad of regulations, one term stands out prominently: Limited Companies. But what is Business Asset Disposal Relief? How does it work?
In this comprehensive guide, we delve deep into the heart of limited companies. Whether you’re an aspiring contractor or a seasoned veteran seeking clarity, this guide aims to empower you with the knowledge to make informed decisions.
What Is Business Asset Disposal Relief?
Business Asset Disposal Relief (‘BADR’), formerly Entrepreneur’s Relief, is a capital gains tax relief available to eligible individuals when they dispose of (close, sell etc) their business. It reduces the capital gains tax rate on disposals of certain business assets from 20% to 10%.
To qualify for BADR:
- The business must have been a trading company for at least two years leading up to the date of disposal;
- When the disposal takes place, you must own at least 5% of the company and have at least 5% of the voting rights; and
- You must have been an employee/director of the company for at least two years leading up to the disposal.
You can claim BADR through your self-assessment tax return or by filling in Section A of the Business Asset Disposal Relief helpsheet. It must be claimed by the second 31 January following the end of the tax year in which the qualifying gain arose.
There’s no limit to how many times you can claim BADR, although there is a lifetime limit of £1m.
What Counts As A ‘Trading’ Company?
As point 1 mentions above, BADR is only available for trading companies. It is not available for companies that have substantial non-trading activities. Most businesses will have some non-trading activity, so it is essential to determine precisely what ‘substantial’ means in this context.?
HMRC has long advised that ‘substantial’ for BADR means 20%, and must consider:
- Income from non-trading activities;
- The asset base of the company; and
- Expenses incurred and time spent by officers and employees of the company in trading and non-trading activities
However, in Assem Allam vs HMRC, the Upper Tribunal found that HMRC’s 20% guidance did not always produce the correct answer when deciding if BADR should be available. That concluded that the legislation does not provide for a strict numeric test. The test of whether non-trading activities are substantial is a holistic one that is not confined to physical human activity but requires an overall consideration of what the company does.
HMRC has now revised its manual, placing less emphasis on a 20% test, which it suggests is only likely to be relevant when considering turnover and the company’s asset base. If neither exceeds 20%, HMRC will generally accept that the relief is available without further enquiry.
In practice, this means that if your limited company holds investment property or invests its business profits directly in the stock market, you could be precluded from claiming BADR. However, a bit more leeway is now given to a large cash balance as it can be argued it is required for trading purposes.
How Does BADR Impact Contractors?
Most contractors working through their limited company qualify for BADR as they are the business’s sole director/employee. Even if your shareholdings are split (such as with your spouse), you likely have more than 5% of shares and voting rights.
This means that when a contractor decides to close their business, they will likely be eligible to pay 10% tax on the disposal of their business assets, including ‘retained earnings’. Retained earnings are the profit left within the business at the end of a financial year.
In other words, if a contractor leaves money in their limited company (instead of paying it all out as a dividend), it could be subject to a reduced capital gains tax rather than the dividend tax rate. Considering that the higher and additional tax rates for dividends are 33.75% and 39.35%, respectively, you can see how this results in significant savings.
What is ‘Phoenixing’?
When you consider that BADR is only available upon the disposal of a business, and it only costs £12 to open another, you can see how there is an incentive to close your company to claim the relief and then immediately start another to carry on trading.
This is known as ‘phoenixing’. Owners of a limited company put the business into liquidation, seeking to extract the value of the business as capital, paying the lower capital gains rates of tax rather than as income. They then create a new company doing something of a similar nature and repeat the cycle.
The Targeted Anti-Avoidance Rules
HMRC introduced the Targeted Anti-Avoidance Rules (TAAR) in 2016 to combat phoenixing. The rules are designed to prevent individuals from converting what would otherwise be a dividend into a capital repayment, thereby reducing their overall tax liability.
If you decide to close your business and claim BADR, you can’t be involved with the same trade or trade similar to that of the wound-up company at any time within two years from the date of the distribution.
If you do, HMRC will treat the disposal as an income distribution instead of a capital gain, meaning you will be subject to higher income tax rates rather than the lower capital gains tax rate paid already.
To be caught by the TAAR rules, all of the following conditions need to 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 trade similar to 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 primary purpose, or one of the primary purposes of the winding up, is avoiding or reducing a charge to Income Tax.
If all of the above apply, the higher dividend rate of tax will be applied to the value of the assets received from the company closure. Depending on the value of the assets, the additional tax burden can be substantial.
Problems With The TAAR Rules
While conditions A and B are clear-cut, conditions C and D are less so. There are no legislative definitions of ‘to be involved with’ or ‘same trade or similar trade’, and determining whether the primary purpose of the winding up was to avoid tax is incredibly subjective.
HMRC provides some guidance on the definitions; however, it is limited and only covers extreme examples. See here and here.
For example, upon retirement, it is not unusual for a previous business owner to continue in some capacity to provide services of a similar nature, perhaps to supplement pension income. HMRC provides the example of a landscape gardener who winds up their landscape gardening company and becomes a general gardener. This would be ‘of a similar nature’ and would be caught by condition C.
While condition C is ambiguous, condition D is far trickier to evaluate accurately. It is a highly subjective motive test, and HMRC considers it to be narrowly framed. It relates to your intentions when closing your company, not two years later, when/if you decide to open a similar business.
A significant amount of judgment needs to be applied to every case individually. Providing an exhaustive list is impossible, 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 that would otherwise have been paid out as income.
When providing context as to how to assess condition D, HMRC has said:
- It is up to you, the business owner, to decide whether it’s ‘reasonable to assume’ that one of the primary purposes of closing your business was tax avoidance, and
- If you decide it wasn’t, it is up to HMRC to demonstrate that your assessment of the event is unreasonable.
Once you decide that condition D doesn’t apply, the onus is on HMRC to prove otherwise, and they can only displace your decision if it is ‘not reasonable’. If you have a genuine reason to close your business other than tax avoidance, HMRC will struggle to argue that condition D applies.
Continuing the example above, the primary purpose of the landscape gardener closing their business was to retire rather than avoid tax. Although the individual may be caught by condition C, they are not caught by condition D. Therefore, not all conditions have been met, and the TAAR rules do not apply.
TAAR and Contractors
For those contractors that have closed their limited company and claimed Business Asset Disposal Relief, if the decision was driven purely by a desire to minimise tax, you cannot work in a similar industry for two years. If you do, you must pay additional tax on the disposal proceeds.
If your decision wasn’t motivated by a desire to reduce tax, and you can describe your actual motive fairly, then it’s unlikely the TAAR’ll catch you.
What about contractors that move from outside IR35 to inside IR35, closing their limited company to start working through an umbrella? Or what about contractors who want to move into a permanent role?
In 2018, HMRC made several updates to its guidance on the TAAR legislation, most of which relate to condition D. They clarified that:
- A decision not to pay an income distribution before the winding-up does not mean that condition D is automatically met;
- Condition D must be assessed by reference to intentions at the time the decision was made to wind up the company, but HMRC will treat events occurring after the winding up as evidence of those intentions and want to look at all available evidence when assessing the primary purpose; and
- Condition D is less likely to be met where an individual remains ‘involved with the carrying on’ of a trade solely as an employee with no decision-making power or influence.
This means that contractors who close their limited company and start working as employees (either directly or via an umbrella company) are unlikely to be caught by TAAR.
While condition C may be met, condition D won’t be. It is unlikely the primary purpose of closing your business is tax avoidance if you’re moving from being a business owner to an employee, as employees pay more tax.