Section 42 Finance Act 1998

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Section 42 of the Finance Act 1998 in the United Kingdom introduced a significant change to the taxation of company distributions, specifically targeting what were perceived as tax avoidance schemes involving the conversion of income into capital gains. Prior to Section 42, it was possible for individuals to extract profits from companies in a way that attracted lower capital gains tax rates instead of the higher income tax rates that would have been applicable if the profits were distributed as dividends.

The core problem Section 42 addressed was the manipulation of company share structures and transactions to effectively turn revenue income into capital. Common techniques included the sale of a company or its assets to a related party (often another company owned by the same individual), followed by the eventual extraction of the sales proceeds as capital gains. This allowed individuals to sidestep income tax and National Insurance contributions, resulting in a significant tax advantage.

To combat this, Section 42 introduced provisions that re-characterized certain capital distributions as income in specific circumstances. It targeted situations where there was a close connection between the individual receiving the capital distribution and the company making the distribution. The legislation focused on arrangements where the primary purpose, or one of the main purposes, was to obtain a tax advantage. This subjective element – the intention behind the transaction – was a crucial aspect of the legislation.

Specifically, Section 42 applies where:

A person receives a capital distribution from a company.
The person has a material interest in the company (typically defined as owning more than 5% of the share capital or voting power).
A chargeable payment (the capital distribution) is received in connection with the company being wound up, dissolved, or ceasing to trade.
The avoidance of income tax is a main purpose of the arrangements.

If these conditions are met, the capital distribution is treated as income and taxed accordingly. This effectively claws back the tax advantage previously gained by converting income into capital. The onus is on the tax authorities (HMRC) to demonstrate that the conditions for Section 42 application are satisfied, particularly the ‘main purpose’ test. This often involves a detailed examination of the transactions and the surrounding circumstances.

The impact of Section 42 was substantial. It acted as a deterrent to tax avoidance schemes involving the conversion of income into capital gains via company distributions. While proving the “main purpose” of tax avoidance could be challenging, the threat of Section 42 often discouraged individuals from engaging in such arrangements. It forced individuals and their advisors to carefully consider the tax implications of extracting profits from companies, ensuring that distributions were structured in a way that reflected their true economic substance rather than solely for tax advantages.

It’s important to note that Section 42 has been amended and updated over time and is now primarily encompassed within the broader anti-avoidance legislation concerning distributions. While the specific provisions of the 1998 Act may have been superseded or incorporated into later legislation, the underlying principle – preventing the artificial conversion of income into capital to avoid tax – remains a cornerstone of UK tax law.