Posted on 6th Jan 2011 - Share this blog/article
Those who operate their business through a private company will normally have had advice at the outset on structuring the company and on the minimisation of tax liabilities for withdrawal of profits. However, with tax rates and the applicable tax rules for private companies constantly changing, this update may be helpful to summarise the current possibilities for tax efficient management of net realised profits in the company.
Reinvestment within the Company
Unless funds within a company are required for personal expenditure, it is not of course necessary for them to be withdrawn in order for them to be invested for the long term. The company itself could invest the funds in any way that the shareholder could personally.
However, it can be dangerous for trading companies to retain profits for long term investment. This is because usually one or more of the shareholders in the company will in the course of time wish to dispose of their shares either by sale or gift, and at that stage they may wish to take advantage of capital gains tax entrepreneur’s relief on the disposal. This relief is only available for trading companies whose activities do not include investment activity amounting to more than 20% of total activities.
Contributions to Pension Schemes
The annual allowance for pension contributions in 2010/11 is £50,000 and this includes an individual’s own contributions and also any employer’s contributions. However, the individual’s own contributions must be covered by earnings in order to achieve tax relief – there will be no tax relief against dividends drawn. Although the pension premium paid will shelter the earnings paid from income tax liability, it will not shelter it from national insurance contributions liability. It may therefore be more appropriate for contributions to a personal pension scheme to be made direct by the company which are exempt from National Insurance, rather than by the director or employee of it.
Salary and Directors Fees
These are fully liable to income tax and national insurance contributions. In the current tax year, the basic tax rate band covers the first £35,000 of income; the rate of 40% then applies up to a threshold of £150,000 and a higher rate of 50% applies for remuneration in excess of £150,000. However, there is also a heavy burden of national insurance contributions on remuneration. For the current tax year the employee’s primary rate (not contracted out) is 12% and a 2% rate applies for remuneration in excess of £42,484. In addition, there is the employer’s contributions to be paid on all remuneration above £136 per week and the rate is 13.8%.
It usually therefore makes sense for remuneration to be maintained at a low level, although where there is a contract of employment in force, remuneration should not be below the national minimum wage which is currently £5.93 per hour. Where there is no employment contract, the authorities will normally accept that the national minimum wage does not apply, although directors should be sure that there is no implied contract, as there are penalties for non-compliance with the national minimum wage rules.
A company cannot legally pay a dividend unless it has sufficient distributable profits to cover the amount paid. Distributable profits will be those brought forward from the latest accounts. Alternatively, reliable up-to-date management accounts drawn up in the course of the company’s financial year can be used as a basis to establish any further distributable profits.
Dividends should be properly recorded and a tax notification issued showing the credit. Owner/directors of private companies should not just pay private expenses and shopping bills from the company on a routine basis and call the drawings “dividends”. HMRC may allege that such payments are further remuneration and not distributions; any remuneration cannot subsequently be relabelled as a dividend.
Dividends have two tax advantages. The first is that they are not liable to any form of national insurance contributions and the second is that they are tax free where they fall within the basic rate band of the shareholder. Where dividends fall within the higher rate band (to which the 40% rate of income tax would apply in the case of other income) the tax liability is one quarter of the actual dividend paid. Where dividends fall in the additional higher rate band (to which the 50% rate applies for other income) the tax rate is 36.11% of the dividend paid.
Fragmentation of Shares
There is currently no tax rule which counteracts any tax advantage to be gained by fragmentation of ordinary shares around adult members of the family. Accordingly, it can often be tax efficient to transfer some shares to the spouse of the main shareholder to enable some dividends to be paid to the spouse within his or her basic rate band. The appropriate number of shares to be transferred can be fine tuned to produce the best anticipated tax position. It may be necessary to declare a bonus issue of shares on the existing shareholding in order to provide a suitable number of shares for subsequent division by gift.
Equally, there is nothing to prevent some shares being given to an adult child who is in need of income, for example to meet the costs of university education.
Note however caution is necessary for special classes of shares with limited rights to be issued to other family members. HMRC have a published statement which clearly indicates that they will seek to counteract the intended tax advantages from such gifts under legislation which relates to “gifts and settlements”. Their statement deals with shares which have rights to income alone, but the principles behind the statement can be applied to shares which have more extensive but still limited rights.
A dividend must be paid at the same rate per share on all issued share capital of the same class; it is not possible to pay a dividend to one or more shareholders to the exclusion of others.
However, one shareholder could waive his or her right to a forthcoming dividend, so that the rate per share is then payable only to the others. However, a dividend waiver should not be made so as to enable a larger dividend to be paid to the other shareholders than would otherwise be the case if the dividend waiver had not been made. HMRC will once again apply the “gifts and settlements” legislation in such circumstances. There are formalities for dividend waivers and we can advise you on the details.
If there is a possibility of the director/shareholder becoming non-resident in the United Kingdom in the foreseeable future, a tax advantage can be obtained by leaving profits in the company, for withdrawal after non-resident status has been acquired. A dividend paid to a non-resident shareholder is not liable to income tax in the United Kingdom. It may of course be liable to tax in the country of residence overseas, in which case, it may be advisable to structure the timing of the dividend payment more carefully and we can advise you in this regard.
Renting premises to a private company
If the premises used by a business are held by a director or shareholder personally, this will enable a rental charge to be made to the company for the use of those premises. The rents will be tax deductible from company profits, but fully liable to income tax in the hands of the lessor less any expenses attributable to the letting. Rents are not however liable to national insurance contributions and there is therefore that advantage for tax purposes. Furthermore, the liability for payment of the rents is not subject to the restrictions in relation to distributable profits as applies to dividends.
However on granting a tenancy the net present value of the rental stream is liable to stamp duty land tax, normally at a rate of 1%. For owner managed companies, it is generally not possible to limit liability to stamp duty land tax by reducing rent because the company will be within the “connected persons” provisions and so an open market rent rule will apply for stamp duty land tax purposes.
It may therefore be preferable for a licence given to the company to use premises, rather than a lease or tenancy, as a licence is not liable to stamp duty land tax. However if a company effectively has exclusive use of the premises by virtue of the licence HMRC may contend that the arrangement is in reality a tenancy.
Unapproved pension schemes
These are known as EFRBs and although they appeared to have very significant tax advantages in relation to the withdrawal of profits from a private company, those benefits were largely withdrawn with effect from 9 December 2010. The new rules for them now have a somewhat draconian impact such that the previous tax advantages have been swept away. It is thought that the funds in an EFRB are still mostly free of inheritance tax, but HMRC have put out a statement disputing this, although their reasoning looks open to contrary arguments.
In a nutshell EFRBs should now be considered off the agenda except for those of a very courageous disposition.
Benefits in kind
In general, it is not a good idea to purchase assets such as private yachts or works of art within a company to be provided as a benefit in kind to a director. The income tax benefit in kind charge for most types of assets is 20% of the market value of the asset when it is first provided and this continues at the same rate for all the subsequent years whilst the asset continues to be made available in this way.
Separate rules apply to living accommodation, such as a holiday home where the benefit in kind charge is based on a complex formula, but most of the value can be expected to be taxed according to the official rate of interest (currently 4 per cent) applied to the value of the property.
For the current tax year, the taxable benefits from company cars (for directors and those earning £8,500 or over including benefits) continues to be calculated as a percentage of the car’s UK list price, the percentage being governed by the CO2 emissions of the car. The maximum rate for all cars is 35% so that expensive cars with high CO2 emissions are not normally a tax efficient proposition as a benefit in kind. If a car is a qualifying low emissions car (broadly one with emissions of 120g/km or less) the appropriate benefit in kind percentage is 10% of the list price of the car. There are special discounted rates for electric cars and hybrid electric cars.
Buying a car through the company does not enable the VAT on purchase to be recovered but it does enable all the VAT on repairs and maintenance costs to be treated as input tax and recovered provided the work done is paid for by the company. (There are special VAT rules which apply to the purchase of cars for special purposes, such as for hire to the public or where there is categorically no usage other than business use.)
Where a car is owned in a personal capacity outside the company but is used on company business, the recoverable mileage rate for the current tax year is 45 pence for the first 10,000 business miles in the year, up from 40 pence previously. However it is generally thought that this rate does not normally cover the full costs of running a car although claiming the fixed mileage rate has the advantage of simplicity.
It can be possible to achieve a favourable tax rate on the extraction of profits from a company by accumulating the net profits each year and then receiving the funds in capital form on dissolution or winding up of the company. In those circumstances, the sums received by the shareholder are not treated as income distributions, but instead represent the disposal proceeds of the shares.
Although this is a topic which requires careful forward planning and advice, in principle for a trading company the profit on the shares should benefit from entrepreneur’s relief for capital gains tax purposes. This provides for a 10% tax rate on gains up to £10,000,000.
Once all debtors and creditors of a company have been paid, it is currently possible to distribute the funds informally with a benefit of a concession operated by HMRC to treat those funds as the proceeds of disposal of the shares, rather than an income distribution. After withdrawal of the funds in this way, the company can be struck off at Companies House. However this concession is set to be withdrawn and replaced by legislation which will not be so favourable. The legislation as so far proposed will require that there is a formal winding-up if the funds in the company exceed £4,000.
Buy backs of company shares are normally subject to income tax as distributions.
It can be possible for the shares of a retiring director of a trading company to be bought back by the company with the sale proceeds attracting capital gains tax treatment, and thus within the capital gains tax charge rather than income tax charge. There are very detailed rules which apply to this process and we can offer advice in any particular case.
If it is anticipated that a company will be sold in due course as a going concern, shareholders should expect the buyer to request that excess cash funds are withdrawn before the purchase goes ahead. Buyers will not want the purchase price of the company unnecessarily inflated by surplus cash held within the company. It is therefore necessary to plan ahead for the withdrawal of these funds before placing the company on the market for sale.
FOR GENERAL INFORMATION ONLY
Please note that this Memorandum is not intended to give specific technical advice and it should not be construed as doing so. It is designed to alert clients to some of the issues. It is not intended to give exhaustive coverage of the topic.
Professional advice should always be sought before action is either taken or refrained from as a result of information contained herein.