Why Dan Neidle is wrong about tax relief for finance costs and capital extraction

We still await a defence from DN on the articles on whether the Substantial Incorporation Structure (SIS) is tax avoidance, and on incorporation relief. All we have had so far is social media comments to say the rest of the tax profession agrees with him, including the author of the leading text on CGT. No analysis of the contents, just bare assertions and claims to speak for an entire profession.

I now continue with the next article on the topics above.

Tax on the business sellers

As explained in my previous articles, part of the consideration given for the transfer of the business is often an indemnity against business liabilities. This indemnity would be taxable in the hands of the sellers but for the concession ESC/D32. There is no statutory definition of ‘consideration’ for these purposes, but CG14500 states that HMRC will consider the following as being consideration.

• the capitalised value of relief from liability, for example to pay maintenance or rent or to repay a loan

This is another way of expressing the ‘indemnity’ that the company gives the sellers against business debts. To the extent that the indemnity covers business debts the sellers will not be taxed due to the concession. To be fair to DN he agrees that this is a correct interpretation.

The company may fulfil the indemnity by taking new finance in its own name to complete the transfer of the legal estate to the company post-incorporation (which is of course an essential element of the SIS) and may service the debts in the meantime as follows.

Tax on the company

The company is entitled to tax relief against the payments it makes pursuant to this indemnity, so long as the payments are made for the purposes of the company business and are not tax avoidance. S.330A(4) CTA 2009 provides that where the company is not a legal party to the relevant loan relationship

the amounts recognised as mentioned in subsection (1)(a) (ie deductible from profits under the loan relationship rules) are recognised as a result of a transaction which has the effect of transferring to the company all or part of the risk or reward relating to the qualifying relationship without a corresponding transfer of rights or obligations under the relationship.

This is amplified in CFM33275 where an example of applicability given is:

Condition B – transfers of risk and reward

Parties may enter into contractual arrangements that transfer all or part of the risk and reward for being party to a debt, without a legal transfer of the debt itself. Where this happens, the debt may for accounting purposes be wholly or partially derecognised (or not recognised) by one party and wholly or partly recognised by another…

An example might be a defeasance transaction where one company agreed to take over the obligation to service a debt, but without a novation of the debt. In that event S330A would enable the party to whom the obligation was transferred to take into account amounts arising from serving (sic) the debt.

This describes with exactitude what happens when the company services the debt pursuant to its contractual indemnity. It has taken on the risk, which it must fulfil from its income from the business.

Again, we remind the reader that our interpretation of these principles, and application of them by the hundreds of accountants we work with, has never been challenged by HMRC.

Capital Extraction

A business may take out substitute funding by loan for the purpose of enabling the withdrawal of owners’ capital (as outlined in BIM45700) as long as the owner’s capital account remains in a positive balance (ie the owner does not take out more than they put in), and that the purpose of the loan is to provide working capital for the business. This loan would become a liability of the business, as it has been introduced to provide working capital for the business. It is not personal borrowing, as the interest payable on it is an allowable deduction (subject of course to s.24) under s.34 so it is wholly and exclusively incurred for the purposes of the business. The servicing of the liability is indemnified against by the company on incorporation under the provisions of ESC/D32. The funds withdrawn may be retained by the business owner or subsequently be lent to the company as a director’s loan to optimise working capital efficiency. This is not a tax avoidance matter. It is properly justified commercially.

The desirability of doing this as a commercial step prior to incorporation is set out in Simon’s Taxes and Tolley’s Tax Planning.

DN misstates the HMRC guidance on the extraction of capital contributed by the proprietor of a business-

This is wrong. BIM45700 has no relevance to funding a capital distribution from a company.

This loan can be taken out in any form, and used for any purpose by the business owner-so long as it does not exceed capital introduced by the owner. The liability for that loan in this situation is on the business. The business owner would be fully entitled to retain the funds and not lend them back to the company post-incorporation. If the business owner chooses to loan the proceeds of the loan to the company post-incorporation that is evidence of the intention to use it for the capitalisation of the business as required by BIM45700. That is what invariably happens where the method of extraction is by short-term lending.

It is correct that the funds flow goes via client accounts held in the names of the business holders and the company. This does not change the legal effect of the transaction. Consider the situation where a borrower has a mortgage of £100,000 with an interest rate of 8% and wants to refinance to a mortgage of £100,000 at 5%. The new funds are drawn down into the solicitors’ client account against undertakings, used to discharge the original loan, and the charges register updated. The funds are never in the hands of the borrowers, but the legal consequences are that a liability has been discharged and a new one created.

What happens if the business owner does not take this opportunity?

It is worth considering the position if the business owners had not financed the extraction of capital before incorporation.

What would happen is that on incorporation the share premium account would have been inflated by the value of the capital account left unextracted, which would sit on the share premium account. This value would have been left embedded in the properties, not in cash. This value could only be extracted in cash following a cash input of some kind into the company to fund a capital reduction, and this would be taxed again in the hands of the shareholders (either capital or income tax). If the shareholder wanted to reinvest the money in the company as a directors loan only the post-tax amount would be left, thus reducing the working capital available.

This process created an unsecured directors loan subordinate to preferential and secured creditors, thus giving the company greater and more flexible capital to work with. It also preserves the position of the directors in having access to the (post-tax) funds introduced in the first place on either side of the incorporation and prevents double taxation on extraction of capital from the company from free funds. When the capital extraction by bridging loan is examined as one composite transaction its business purposes are clear.

Links

https://www.gov.uk/hmrc-internal-manuals/capital-gains-manual/cg14500

https://www.legislation.gov.uk/ukpga/2009/4/section/330A

https://www.gov.uk/hmrc-internal-manuals/corporate-finance-manual/cfm33275

https://www.gov.uk/hmrc-internal-manuals/business-income-manual/bim45700

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