Section 396B of the Income Tax (Trading and Other Income) Act 2005 (ITTOIA) is a targeted anti-avoidance rule (TAAR) that affects many owner-managed companies, landlords operating through corporate vehicles, and high-net-worth individuals planning solvent liquidations. It allows HMRC to reclassify certain winding-up distributions as income, rather than capital, where the taxpayer goes on to carry out the same or a similar trade.
This can dramatically increase the tax payable, particularly where shareholders expected capital gains treatment or Business Asset Disposal Relief, and instead face higher dividend rates. Unsurprisingly, Section 396B issues now feature regularly in HMRC enquiries, compliance checks, and correspondence with accountants or insolvency practitioners.
This article explains how the provision works, the tests HMRC applies, common risk scenarios, and what practical steps clients and advisers should take. Our expert solicitors are regularly instructed by individuals, directors, shareholders, and professional firms in contentious tax matters, including disputes involving Section 396B and allegations of phoenixing.
What Is Section 396B ITTOIA?
Section 396B is designed to counter “phoenixing”, a behaviour HMRC views as abusive. Phoenixing occurs where an individual winds up a close company, extracts the accumulated profits as a capital distribution in a Members’ Voluntary Liquidation (MVL), and then continues the same business through a new company or structure.
Without this rule, an owner could repeatedly convert what HMRC considers to be income into capital taxed at lower rates. Section 396B prevents this by treating the winding-up distribution as if it were an income distribution where certain legal conditions are met.
The rule does not apply to every liquidation. It only applies where four statutory tests, Conditions A to D, are all satisfied. The legislation is purposely broad, and HMRC often applies it assertively. Understanding the triggers and obtaining structured legal advice is therefore critical for anyone planning a corporate exit or restructuring.
When Section 396B Applies: Key Conditions
Section 396B applies only if all four statutory conditions are satisfied. If any condition fails, capital treatment is preserved.
Condition A: 5% Interest Before Winding-Up
The individual must hold at least 5% of:
- the ordinary share capital, and
- the voting rights.
This typically captures owner-managers but excludes small minority shareholders.
Condition B: The Company Is or Was a Close Company
A close company is broadly one controlled by five or fewer participators or by its directors. Most family-owned companies and SMEs meet this condition by default.
Condition C: Carrying On the Same or a Similar Trade
Within two years of the distribution, the individual (or a connected person) must:
- carry on the same or similar trade, or
- be involved in the carrying on of that trade.
This is often the most contentious condition. HMRC interprets “similar trade” widely. Changes in branding, location, or scale rarely prevent similarity; the focus is on the underlying business activity. It is important to be guided by legal experts who can negotiate when HMRC applies this condition broadly.
“Connected persons” includes spouses, civil partners, certain relatives, partners, trustees, and companies controlled by the individual or those connected with them. However, the connected person’s trade only counts if the taxpayer is involved with it.
Condition D: Main-Purpose (or One of the Main Purposes) Is Tax Avoidance
HMRC must reasonably conclude that avoiding or reducing Income Tax was a main purpose of the winding-up. Relevant factors may include:
- whether the new business closely resembles the old trade;
- the speed of restarting activity;
- whether past behaviour shows a pattern of similar liquidations;
- genuine commercial events (retirement, ill health, sale of premises, change of career).
This is an objective test. Tax planning alone is not prohibited, but the reasoning behind the liquidation must be clearly evidenced with proper legal guidance.
How HMRC Approaches Section 396B in Practice
HMRC’s interest in Section 396B has increased significantly in recent years, and several patterns are emerging in how enquiries typically begin. Many cases start with routine self-assessment enquiries focused on the year of the liquidation distribution, where HMRC asks for details about the taxpayer’s post-liquidation activities. Others arise through discovery assessments, particularly where HMRC believes that the taxpayer did not sufficiently disclose the circumstances of the liquidation or subsequent trade in the “white space.” HMRC also frequently gathers information from liquidators and accountants, comparing the taxpayer’s explanation with Companies House filings and other public records.
Compliance checks often broaden into questions about the taxpayer’s involvement with new businesses, related companies, or connected persons. In situations involving multiple liquidations or rapid restarts of trading activity, HMRC tends to scrutinise the case closely and may assume phoenixing unless convincing evidence is provided. In more complex scenarios, especially where HMRC suspects wider tax irregularities, other anti-avoidance regimes may be considered alongside Section 396B, even though the TAAR itself is not part of the COP9 process. The cumulative result is that taxpayers often experience sustained, detailed questioning that can be difficult to manage without strong contemporaneous evidence and specialist legal advice.
Risks of Getting It Wrong
If HMRC successfully applies Section 396B, the consequences can be significant.
Financial exposure
- Distribution reclassified as income
- Higher dividend tax rates
- Potential loss of Business Asset Disposal Relief
- Interest on underpaid tax
Penalty risk
Penalties depend on behaviour. Where HMRC considers that the taxpayer took reasonable care, penalties may be reduced or eliminated. However, if HMRC believes the taxpayer failed to disclose relevant information, penalties can escalate.
Extended time limits
In some cases, HMRC may rely on extended assessment periods if they suspect careless or deliberate behaviour.
Practical stress and cost
Disputes can last months or even years, consuming substantial time and professional fees.
Practical Steps to Take Now
Anyone contemplating a liquidation should begin by clearly recording the commercial reasons behind the decision. Rather than relying on memory later, it is far more effective to seek specialist advice now and maintain detailed board minutes, email trails and professional advice notes showing why the business closed, for example, the sale or loss of trading premises, strategic restructuring, health issues or a genuine change of direction. HMRC places significant weight on contemporaneous evidence, and well-documented reasons help demonstrate that tax avoidance was not a main purpose.
It is also sensible to reflect on whether the planned liquidation resembles a pattern of repeated closures followed by similar new businesses. Where this pattern exists, HMRC scrutiny becomes more likely, and taxpayers should ensure they can point to strong commercial circumstances that independently justified each winding-up. Careful explanation in the self-assessment return can also help. A clear and accurate “white space” disclosure outlining why Section 396B is or is not thought to apply may prevent HMRC from arguing that the taxpayer failed to take reasonable care or from raising discovery assessments in later years.
Close communication with accountants and insolvency practitioners is equally important. Early alignment helps to ensure that all explanations given to HMRC, Companies House and professional advisers are consistent and properly supported. Above all, taxpayers should avoid ignoring or delaying responses to HMRC. Prompt, complete and accurate interaction usually leads to smoother progress, whereas incomplete or late replies often create unnecessary suspicion. For any liquidation involving significant retained profits or any situation where a post-closure business could resemble the previous trade, taking specialist advice is strongly recommended.
Instruct Expert London Tax Dispute Solicitors
Section 396B issues often escalate quickly and require a blend of tax technical knowledge, litigation experience, and an understanding of how HMRC conducts enquiries. LEXLAW’s specialist tax disputes team advises company directors, shareholders, professional advisers, and insolvency practitioners on all aspects of Section 396B risk and HMRC’s phoenixing challenges.
We assist with reviewing proposed liquidations, preparing risk assessments, drafting white-space disclosures, handling HMRC investigations, responding to information notices, negotiating settlements, and conducting appeals before the Tax Tribunal. We also coordinate with accountants and insolvency professionals, ensuring a consistent and protected strategy, including the use of legal privilege where appropriate. Where the stakes are high, particularly with significant retained profits or complex group structures, expert input is absolutely necessary. Contact now for expert legal guidance!
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FAQs on Section 396B ITTOIA
When does Section 396B apply to a winding-up distribution?
Section 396B applies only when all four statutory conditions (A–D) are satisfied. These include having a 5% interest in the company immediately before winding-up, the company being a close company, the individual (or a connected person) carrying on or being involved in the same or a similar trade within two years, and the winding-up having a main purpose of obtaining an Income Tax advantage. If any condition fails, the distribution remains taxed as capital.
How does HMRC decide whether a new business is a “same or similar” trade?
HMRC looks at what the old company actually did and compares it to what the individual or connected person does after liquidation. Minor differences—such as a new brand, different premises or changes in scale—generally do not prevent similarity. HMRC focuses on the substance of the activities, the nature of services or products offered, and whether the customers or market are materially the same.
What evidence helps show that tax avoidance was not a main purpose of the liquidation?
Contemporaneous documents carry the greatest weight. This includes board minutes explaining commercial reasons for closure, emails with accountants or insolvency practitioners, evidence of genuine business pressures, and any documentation showing changes in strategy, health, premises or personal circumstances. Detailed “white space” disclosures in the tax return can also help demonstrate transparency.
What happens if HMRC successfully applies Section 396B?
If Section 396B is triggered, the liquidation distribution is reclassified as an income distribution and taxed at dividend rates rather than Capital Gains Tax rates. This can result in much higher tax liabilities, along with interest and potentially penalties depending on HMRC’s view of the taxpayer’s behaviour. Business Asset Disposal Relief normally becomes unavailable.
Can HMRC open a Section 396B enquiry after the liquidation has completed?
Yes. HMRC can raise enquiries into the tax year in which the distribution was made, or issue a discovery assessment if it believes the taxpayer did not fully disclose relevant facts. Full and accurate disclosure in the tax return helps reduce this risk and may limit HMRC’s ability to rely on extended time limits.
Does Section 396B affect every Members’ Voluntary Liquidation (MVL)?
No. Many MVLs fall entirely outside Section 396B. Genuine retirements, career changes, cessation of trade due to commercial pressures, and liquidations linked to restructuring that does not involve continuing a similar trade typically do not meet Conditions C or D. The provision is targeted at situations HMRC considers to be phoenixing behaviour.