Thousands of family businesses could face being priced out of passing their business down to their offspring should Chancellor John Healey to use his maiden Budget to clamp down on a little-known rule making it easier for firms to transfer ownership.

Treasury officials have been mulling an overhaul of so-called company distribution rules that would make it more attractive for founders to offload their business to private equity than hand it down to the next generation.

One of the options under consideration – making the transfer of a business from one generation to another liable to income tax as opposed to capital gains – has already sparked uproar from entrepreneurs and business owners.

But Chris Etherington, tax partner at RSM, told that the consultation also includes a suite of other proposals that are “much more troubling” than the capital gains tax clampdown. 

One possibility buried in the HMRC plans published in the summer, could see officials dismantle a buyout structure favoured by many retiring entrepreneurs.

Upon retiring, founders’ families rarely have the cash needed to buy their parents out, leading many companies to issue retiring business owners  ‘redeemable preference shares’. 

The share class acts as a bridge, allowing retirees to freeze their financial stake and slowly withdraw capital from the business over time as the firm makes profit. It also allows children to take immediate control of the company.

These deferred repayments are typically treated as parents selling an investment, meaning it is charged as capital gains tax (CGT), between 10 per cent and 24 per cent.

Shifting to dividend tax

But the consultation looked at scrapping this arrangement for staged handovers by no longer recognising the current, real value of the shares being bought back.

Instead, HMRC has proposed capping the returns at the level originally invested by founders when shares were first issued, meaning anything above that baseline will be recognised as an income dividend.

In the majority of cases, the move would cause retirees’ tax bill to nearly double, as higher and additional rate taxpayers will be slapped with dividend taxes of between 35.75 per cent and 39.35 per cent.

On those handing over £1m, the tax bill can swell from £200,000 to roughly £393,00 making it financially unviable for the next generation to pay off their parents without running out of capital or selling the business.

In a response to the consultation, Mark Goddard, tax partner at KPMG, warned that this overhaul could put families at a “disadvantage” to third-parties and ultimately discourage generational ownership.

RSM’s Etherington said that the government is “trying to clamp down” on people who may be trying to take “advantage of the rules to try and get capital gains tax treatment” when it should be income tax, but warned them to be cautious.

“As a government, don’t… throw such a large net over it that you capture innocent scenarios that fundamentally stop businesses from being passed down to the next generation or to third parties in the right way.”

“It could impact management buyouts, it could impact family buyouts, people just wanting to retire. We don’t want to do that. That’s bad for the economy.”

The two-year trap

HMRC is also considering changes to the conditions under which companies can buyback shares from retiring founders.

Under current legislation, businesses can buy back shares through accumulated profit over several years to protect everyday capital, ensuring enough is set aside to pay taxes, suppliers and wages.

But HMRC is debating ending this by introducing a strict two year-cut off time to qualify for capital gains treatment. If a departing founder still holds shares beyond the 24-month window, companies lose the tax break and payments are instead subject to income tax. 

Advisers have warned this leaves businesses highly exposed to supply chain shocks or other problems if they are forced to purchase all shares over the two year window, as it is a much shorter time frame.

HMRC did not respond to a request for comment