Introduction
Business Asset Disposal Relief (‘BADR’) is often associated with trading businesses, entrepreneurial risk, and the eventual sale or winding up of a successful company. However, many otherwise straightforward BADR claims run into difficulty because of a question which, at first sight, appears surprisingly simple. What happens if the company has accumulated a large amount of cash?
The issue frequently arises where a successful owner-managed business has retained profits over many years. Those profits may initially be held in a bank account but, particularly in recent years, many business owners have transferred surplus funds into investment portfolios in order to obtain a better return. When the shareholders subsequently seek to extract those funds through a Members’ Voluntary Liquidation (‘MVL’), an uncomfortable question emerges. Has the company ceased to be a trading company for BADR purposes?
The Trading Company Requirement
One of the conditions for BADR is that the company must be a trading company. Broadly, a trading company is one whose activities do not include, to a substantial extent, activities other than trading activities. The legislation does not define ‘substantial’. HMRC generally applies a 20% benchmark, although this is merely a rule of thumb rather than a statutory test. The difficulty is that holding investments is capable of constituting a non-trading activity.
For many years, advisers often focused on the source of the funds. If the cash had arisen from trading activities and was merely awaiting distribution or future use within the business, there was a tendency to regard the funds as part of the trading operation. The position is now rather more complicated.
The Allam Decision
The leading authority is the Upper Tribunal decision in Allam v HMRC. The case is important because the Tribunal rejected the proposition that an activity requires active management or decision-making. Simply holding investments was capable of constituting an activity in its own right. That conclusion potentially creates difficulties for companies holding substantial cash balances or investment portfolios. At first sight, therefore, Allam appears to create a significant obstacle for many BADR claims. However, that is not the end of the analysis.
What Does HMRC Say?
HMRC’s guidance contains an important qualification. The Capital Gains Manual acknowledges that the temporary investment of surplus funds pending distribution to shareholders may itself be regarded as part of the company’s trading activities. HMRC accepts that the eventual distribution of trading profits is capable of forming part of the trading process. The distinction drawn by HMRC is between the temporary retention of surplus funds and the long-term retention of significant profits. Unfortunately, the guidance does not define where one ends and the other begins. No time limits are specified. No monetary thresholds are provided. The question is left as one of fact and degree. This inevitably creates uncertainty.
When Does Surplus Cash Become an Investment Activity?
There is no universal answer. A company which accumulates cash because it is considering an acquisition, protecting itself against commercial risks, building reserves for future expansion, or preparing for an orderly winding up may have a stronger argument that the funds remain connected with the trade. Similarly, the mere transfer of cash from a bank account into a managed portfolio should not automatically determine the outcome. The underlying question remains whether the company has embarked upon a separate investment activity or is simply managing surplus trading profits in a prudent manner.
Against that, HMRC may reasonably ask how much cash a business genuinely requires. Where retained funds vastly exceed any foreseeable commercial requirement, and particularly where they have been retained for many years, the argument becomes more difficult. At some point, the balance sheet may begin to resemble that of an investment company rather than that of an active trading business. That does not automatically mean BADR is unavailable. It does mean that the factual analysis becomes considerably more important.
The Importance of Context
One of the recurring themes in the authorities is that no single indicator is decisive. The percentage of assets represented by cash and investments may be relevant, but it is not determinative. The amount of management time devoted to investments may be relevant, but it is not determinative. The level of investment income may be relevant, but it is not determinative. Ultimately, the question is whether, viewed in the round, the company’s activities include substantial non-trading activities. That requires a holistic assessment of all the facts.
Conclusion
It would be dangerous to assume that the existence of substantial cash reserves or investment portfolios automatically prevents a BADR claim. Equally, it would be unwise to assume that surplus funds can never present a problem.
The Allam decision has made it clear that passive investments are capable of constituting non-trading activities. At the same time, HMRC continues to recognise that surplus trading profits may, in appropriate circumstances, remain part of a company’s trading activities. The answer will depend upon why the funds were retained, how long they were retained, how they were managed, and the overall context of the business.
For advisers dealing with MVLs and BADR claims, the existence of substantial cash reserves should therefore be regarded neither as fatal nor as irrelevant. It is simply one of the most important issues that needs to be examined before the claim is made.