If a company sells a capital asset (e.g. commercial land) and derives a non-taxable capital gain, it’s reasonable to expect the shareholders to want access to the cash. However, the problem often arises that in order for a capital gain to be distributed tax-free, the company needs to be wound up. This is a result of the fact that if a capital gain is distributed in the absence of a wind-up, the distribution comprises a taxable dividend.
Winding-up a company is not always desirable or the most practical route because it may own other assets or otherwise serve a purpose that means it needs to stay in existence. This can mean the capital gain becomes ‘trapped’.
Enter the look-through company (LTC) to save the day. An LTC is legally an ordinary company, that elects to be treated as a partnership for tax purposes. As such, the income, expenses, tax credits and losses of the company are attributed to the shareholders based on their ownership percentage.
Just as important in this situation, dividends paid by an LTC to its shareholders are ignored for tax purposes. Hence, electing for a company to be an LTC is an option to enable a capital gain to be extracted tax free. But this gives rise to the question, is this tax avoidance? This exact question was recently covered by Inland Revenue in Technical Decision Summary 24/16 (TDS) issued in August 2024. The TDS notes:
The Applicant’s decision to elect into the LTC regime was to allow the shareholders to retain administrative and financial reporting simplicity, while also allowing tax-free capital gains (e.g., from the sale of assets) to be paid out to the family without requiring the liquidation of the Applicant.
It was acknowledged that the LTC rules clearly provide for a company to be treated as transparent as intended by Parliament. Therefore, Parliament would consider that the tax treatment of the arrangement is consistent with Parliament’s purpose and is therefore not tax avoidance.
It is important to note that the TDS did state that it is a summary only, and does not include various facts or assumptions and hence cannot be relied upon. However, it would be unusual for Inland Revenue to release the TDS without a stronger comment to the contrary if the LTC option was not acceptable for this purpose.
However, the LTC option is not perfect. A tax cost to enter the regime can apply, calculated based on the company’s retained earnings. There are also a number of criteria that need to be satisfied, such as it needing to have five or fewer ‘look-though counted owners’; which itself can be complex to confirm.
That being said, it is an option to have ‘in the back pocket’ if the need arises.
