What are capital contributions
If you fund a company in the UK, there are two common mechanisms you could use. You could issue new shares in the company or you could lend funds to the company. However, there is a third option, a “capital contribution”, and the tax treatment of these can be problematic. A capital contribution is an injection of funds into a company where the funder does not receive a new asset in return.
By way of an example, let’s assume that a company has a single shareholder who owns 100 shares. The shares were issued for £1 each, meaning the initial capital of the company was £100. If the shareholder wished to fund the company with a further £10,000, they could:
- Issue more shares in exchange for the funds;
- Loan the funds to the company; or
- Make a gratuitous transfer of the money to the company.
The shareholder decides to sell the company in future. The company’s value at the time is £10,500.
What happens on a future sale?
If the shareholder funded the company by issuing more shares, the tax treatment is simple. The shareholder acquired their shares for £10,100 and sold them for £10,500. They have therefore made a £400 gain which will be subject to Capital Gains Tax. A similar result arises the shareholder instead lent the funds to the company. After repayment of the outstanding loan, the shareholder’s 100 shares would now be worth £500, and again they will therefore have made a £400 gain.
Logically, you might think the same result will apply to capital contributions. The shareholder has spent £10,100 on a company now worth £10,500. What other result could there possibly be?
Unfortunately, the law disagrees. When calculating the gain on an asset sale, you are able to deduct your acquisition costs from your sale proceeds (s.38 TCGA 1992). However, case law has decided that a capital contribution is not usually considered to be a deductible cost. To quote HMRC’s manual:
“Although a capital contribution will typically affect the value of the shares in the company to which the contribution is made, it does not represent either expenditure on the shares, or expenditure reflected in the state or nature of the shares at the time of their disposal.“
So what does this mean for our shareholder? It means that on the sale of their shares, they will generate a gain of £10,400 rather than £400. Tax law in this instance entirely ignores the economic reality of the situation, with potentially costly consequences. This is the most unfair tax law I am aware of in the UK.
How do capital contributions impact international clients?
The rules on capital contributions apply to UK and overseas clients alike. However, if the company is based overseas in a jurisdiction with more rational tax laws, the shareholder may have thought nothing of making a capital contribution to fund their company. On moving to the UK, they could open themselves up to a significant tax charge on a future sale.
