The government has confirmed that it will push ahead with a series of proposals which would fundamentally reshape the rules governing how payments from companies to their shareholders are taxed. This is despite advisers and businesses warning during a consultation launched in June this year that the proposals could stifle genuine commercial transactions, damage the UK's competitiveness, slow inward investment, and lead to capital flight.
It does at least appear that the government is making some changes to the policy design based on the feedback received as part of the consultation process. In particular, in a welcome acknowledgment of concerns raised during the consultation process that the proposals in relation to distributions from non-UK resident companies could have a distortive effect on the UK's private capital industry, the government has confirmed that it is committed to supporting the industry, and that it does not intend for these reforms to impact the tax treatment of returns received by investors in private capital funds or by investment managers who have co-invested. The government has confirmed that it will work with industry stakeholders on how to achieve this outcome.
A further technical consultation on the draft legislation will be carried out during 2027. The government intends for the new rules to apply from April 2028.
Why is the government pushing ahead with these reforms?
The government's perspective is that the current rules on distributions and repayments of capital from companies have not kept pace with the commercial and legal environment and now produce inconsistencies in terms of the treatment of substantively similar payments from companies in different scenarios. However, as identified at various points below, there are real concerns that these proposals will entrench an approach to the taxation of capital returns from companies which already makes the UK an outlier amongst comparable jurisdictions and will inhibit genuine commercial transactions.
A more cynical take is that this is about bringing more types of returns of value within the scope of income tax, thereby increasing tax revenues. The proposed reforms are expected to raise more than £800m in additional tax revenue each year once they are fully enacted.
Summary of proposals and commentary on potential impacts
1. Reductions of capital.
In most cases where companies carry out a reduction or repayment of share capital, such as a share buyback, the amount received by shareholders is subject to income tax as a distribution unless it represents a return of share capital which they originally invested.
Under current law, one of the effects of interposing a new holding company on top of a company via a share-for-share exchange can be that it is possible to extract additional amounts from the new holding company by way of repayment of capital (as compared to what would have been possible from the original company).
The reforms which the government has confirmed will be carried forward would "freeze" the amount of share capital, which is recognised for these purposes, limiting it to the amount originally subscribed for the shares in the original company. The effect of this would be that share buybacks or capital reductions through a new holding company would produce substantially the same income tax result as a direct extraction from the original company.
In a welcome development, the government has confirmed, in response to concerns raised during the consultation, that it agrees that:
- Listed companies should not be within the scope of these proposals, and
- The changes should not apply to transactions undertaken before the legislation comes into force, so companies will not be required to analyse their historical share capital and share premium.
However, the introduction of the concept of 'frozen' capital could still impact a range of legitimate commercial structures. For example, when management shareholders exchange interests in an existing business for shares in a new holding company as part of a private equity acquisition, they are contributing the genuine economic value of the business they have built. The holding company structure in those circumstances is generally a requirement of the third-party lenders, for commercial and finance reasons, and not a mechanism designed to achieve a UK tax advantage.
The 'frozen' capital approach would limit the capital that those management shareholders could extract free of income tax by reference to the original subscription price of the shares in the target company, disregarding entirely the real economic value that they contributed to the new holding company.
It is hoped that there will be scope through the forthcoming technical consultation to mitigate such impacts.
2. Demergers
The above proposals in relation to the "freezing" of share capital would remove the capital reduction route for demergers in most cases. Acknowledging this, the government is proposing to 'liberalise' the conditions for statutory demerger relief.
These 'liberalisations' will be the subject of the forthcoming technical consultation, but the proposals currently include:
- Removing the UK residence requirement;
- Extending the relief to investment companies, and
- Introducing fixed time-based restrictions (generally five years) in place of the current open-ended anti-avoidance conditions.
Capital reduction demergers are currently the standard, market-accepted, method for commercially separating businesses in the UK. There are serious question marks over whether a reformed statutory demerger regime can compensate for the loss of access to the capital reduction route or whether these changes will inhibit commercially driven demergers from taking place in the market.
3. Distributions from non-UK resident companies
The proposal here is to align the income tax treatment of distributions from non-UK resident companies with that which already applies to UK companies.
Under the current rules, when a non-UK resident company makes a payment to a UK-resident shareholder, it is charged to income tax as a distribution if it is a dividend which is not capital in nature.
The government's proposals would extend the charge to income tax to the much broader categories of distributions which currently apply in relation to UK-resident companies.
Private capital
- Serious concerns were raised during the consultation that, if these changes were applied to private capital fund structures, they would jeopardise the ability of funds to repatriate capital returns generated from the disposal of underlying investments in a way which retained their character as capital for tax purposes in the hands of UK investors. This would undermine one of the core principles of structuring investment funds, which is that investors should be no worse off from a tax perspective through investing via the fund than if they invested directly in the underlying assets.
- It is therefore welcome that the government has confirmed in the Budget that it will work with stakeholders in the private capital sector to ensure that these changes do not impact the tax treatment of investment returns realised by investors or by investment managers with co-investments in the relevant fund. The government has not confirmed how it envisages achieving this position and so it will be important for stakeholders to engage closely with the forthcoming technical consultation.
4. Interaction between distributions and loans to participators
The proposals which the government is carrying forward include a proposal to introduce a priority rule to clarify whether an extraction of value should be taxed as a distribution (charged on the shareholder) or whether it should be taxed under the loans to participators regime (charged on the company).
The options covered in the consultation included:
- Legislating for the practice of unwinding inadvertent distributions (which is currently discretionary), and
- Allowing income tax which has been paid on an unlawful distribution to be set off against liabilities arising when the position is rectified.
The government has confirmed that it will take a final decision on which option to proceed with during the forthcoming technical consultation.
5. Loans from non-UK resident companies
One of the proposals which the government is pushing forward is the extension of the existing "loans to participators" regime so that it will apply to loans from non-UK companies which are closely controlled.
Under the existing regime, when a UK-resident company which is closely controlled (by a small number of participators) makes a loan to one of its participators which is not repaid within a prescribed time period, a charge to corporation tax arises on the UK-resident company which can be recovered if and when the loan is ultimately repaid.
Under the proposed reforms, these rules will be extended to loans from non-UK resident companies as well. However, because the relevant non-UK resident company is likely to fall outside the scope of UK corporation tax, the charge to tax will fall on relevant UK-resident individual participators. It will be possible for the individual participator to recover the charge if the loan is ultimately repaid, as with the charge which applies to UK companies, but this nonetheless represents a burdensome charge to apply to an individual and a significant misalignment with the regime for UK-resident companies.
This proposal also creates a range of technical challenges, including the application of the close company definition in a non-UK context. The existing definition captures a very wide range of commercial structures, and the rules are hard to navigate in practice, with extensive information being required to reach a firm conclusion. It will be burdensome (and in some cases may not be possible) for UK individuals to make inquiries of non-UK lender entities to ascertain whether that entity would have been a close company if it were resident in the UK, particularly given it may never have been required to carry out any equivalent or similar analysis.
In a more welcome development, the government has confirmed that it is considering excluding from the new rules:
- Participators with immaterial interests;
- Loans which are made for the commercial purposes of the relevant company's business; and
- Interests in companies which are held through partnerships.
These exclusions remain subject to development through the forthcoming technical consultation.
6. Purchase of own shares (POS)
The government is proceeding with the proposal to amend the conditions for obtaining capital treatment when a company purchases its own shares, by replacing the subjective 'trade benefit test' with more mechanical conditions.
The proposed new conditions include:
- A minimum 5% shareholding;
- Full exit from the company within two years;
- A five-year claw-back period, and
- Extended holding periods where family connections remain.
The government has confirmed that it intends to relax the requirement which was initially proposed in the consultation for the relevant shareholder to have been an employee for the two years prior to the sale.
7. New anti-avoidance regime
The government has also confirmed that it intends to push ahead with plans to amend or replace the existing 'transactions in securities' (TiS) rules with a modernised, principles-based anti-avoidance regime. The TiS rules are anti-avoidance rules which are designed to prevent individuals from avoiding income tax by extracting profits from companies in the form of capital when the relevant amounts could have been paid as a dividend.
HMRC's concerns regarding the difficulty of deploying the TIS regime in practice are not without merit. Indeed, a modernised TiS regime could address a significant number of the issues which are raised in the consultation without the need for the broader structural changes.
Our view is that any new regime, should retain clear legislative carve-outs for genuine commercial transactions and genuine changes of ownership, especially if, as is proposed, it is brought within self-assessment.
The government has not provided any details on its preferred approach for the reform of TiS and has confirmed that it will lay out more detailed proposals as part of the forthcoming technical consultation. It will be important for stakeholders to utilize the chance to provide robust scrutiny and critical analysis of the proposals.
Corporate law consultation on the distributions regime
Alongside these proposed tax reforms, the government is also separately consulting on plans to simplify financial and non-financial reporting obligations, including a proposal to replace the existing rules on distributable profits and maintenance of capital with a solvency-based regime for determining the legality of dividends.
This separate, non-tax, consultation does not seem to dovetail neatly with the proposed tax reforms; whilst HMRC's focus is on treating foreign company distributions in the same way as for UK companies, the government at the same time seems to be trying to bring UK company distributions more into line with what is seen in other jurisdictions.
The company law reforms will need to be equally closely monitored alongside the tax reforms.
Next steps
The Government is expected to publish draft legislation in relation to these proposals, for technical consultation with stakeholders, during the course of 2027. The Government's intention is for the new rules to take effect from April 2028.
