Implications for Small to Medium Size Companies
George Osborne’s Budget on 8 July was one of the most significant for several years with a number of key announcements covering:
- Reducing corporation tax rates;
- Tax relief on plant and machinery;
- Stopping tax relief on goodwill acquired by companies;
- Increasing tax rates on dividends;
- Restricting pension tax relief for the higher paid;
- Limiting interest tax relief on personal rental income from residential properties. Click here for full details.
- Major changes to the Non-Domicile tax regime.
This article explains the changes in a little more detail for those who operate small to medium size companies and how the playing field has become a bit tougher. Although the reduction in the corporation tax rate is welcomed, the Budget signalled a more aggressive approach by HMRC to business tax planning generally.
The Budget should not be seen as a one off attack on tax planning, the current Chancellor’s approach to Budgets is not a direct big hit on raising taxes, but a case of returning to certain areas again and again over a number of Budgets – as highlighted by changes to Non-Domicile taxation and pensions. The key themes for this Budget are an ongoing attack on “tax motivated incorporation” and raising taxes on higher earners. The lower rate of corporation tax encourages reinvestment of profits and with high taxes on those with incomes in excess of £150k profit extraction is bad but re-investing for the future is good. For businesses that look to pay out all or most of their profits, then the Budget has probably boosted Limited Liability Partnership as a trading structure.
We have summarised the main points from the Budget for small and medium size companies below
Reduction in Corporation Tax
With the flat rate of corporation tax of 20% applying to all limited companies from 1 April 2015, further reductions were announced in the Budget. From 1 April 2017 the rate will reduce to 19% and from 1 April 2020 to 18%. On reaching 18% this will be well below the current European Union average of 22%. As with the UK, other countries have also tended to reduce their corporate tax rates in recent years.
Annual Investment Allowance (“AIA”)
The AIA provides a 100% deduction for the cost of most capital items purchased by a business. The AIA is currently £500,000 but this was due to reduce after 31 December 2015 to only £25,000. This will still reduce, but now to £200,000 instead and this will be a permanent limit.
Transitional rules apply where periods straddle the change, so care is required over the timing of investment.
National Insurance Employer Allowance Increase
This allowance, currently £2,000, is to encourage employers to take on employees, providing a saving for the employer of national insurance contributions. The allowance will be increased to £3,000 from April 2016. This measure is to help offset the additional cost to employers from the introduction of the living wage (all employees over 25 to be paid £7.20 by April 2016). All employers are required to pay the new wage, which is to reach £9 per hour by 2020.
The point not highlighted and hidden in the detail is that from 6 April 2016, the Employment Allowance will no longer be available for companies where the sole director is the only employee. Employers pay National Insurance at 13.8% on salaries above around £8,000 pa. Most employers can currently reclaim the first £2,000 of this National Insurance. It does not apply to the National Insurance paid by employees.
Currently, a sole director-shareholder could pay themselves £22,553 and reclaim the entire employer’s National Insurance of £2,000 i.e. (£22,553 - £8,060) x 13.8%.
Taxation of Dividends
The Chancellor has proposed a radical change to the way that dividends are taxed.
Early 2000s tax changes encouraged the use of companies, resulting in traditional self-employed tradesmen incorporating their businesses, taking salaries equal to the income tax personal allowance or lower national insurance threshold and withdrawing other remuneration as dividends. Generally, goodwill was sold on incorporation to create a loan account that was drawn down having suffered only 10% tax. This approach has been challenged at times by HMRC (using the IR35 provisions and the taking of the Arctic Systems case through the Tax Tribunal system) and there has been much noise within the Treasury and HMRC, such as reviews of IR35, but no substantive policy change. However, in December last year, changes were made to remove the tax advantages of recognising goodwill on incorporation and this has now been followed up with a very simple dividend change that removes much of the income tax and national insurance advantages of incorporation.
In essence, the notional 10% tax credit that was deemed to have been “paid at source” on dividends will disappear and a special rate of tax will be applied to the dividends received in excess of £5,000 (the first £5,000 of dividend income is to be tax-free and this is additional to an individual’s personal allowance).
The 2016/17 rates of tax on the dividend income will depend upon the individual’s top rate of income tax as follows:
- Basic rate payer (taxable income under £32k) 7.5%
- Higher rate payer (taxable income between £32k and £150k) 32.5%
- Additional rate payer (taxable income over £150k) 38.1%
To put this into context for you we have done the calculations for an individual owner/manager who generates profit before tax in their company at three different levels - £40,000, £100,000 or £200,000 and all of the available cash after corporation tax is to be extracted either by way of bonus or dividends. The following table illustrates the overall tax loss (corporation tax, income tax and NIC) under each alternative and compares this to the current year’s position.
Bonus Dividend Bonus Dividend
£40,000 profits – tax paid 39.5% 22.1% 39.4% 25.1%
£100,000 profits – tax paid 45.9% 34.1% 46.0% 36.4%
£200,000 profits – tax paid 48.1% 38.7% 48.1% 40.5%
It is clear that at any significant profit level the tax burden on profits extracted via dividends will increase next year but that there still remains a large benefit from extracting profits via dividends compared to paying bonuses.
A limited company therefore still provides a tax shelter for those partners who do not wish to extract all the profits from their company so as to protect child benefit, personal allowances and enable profit extraction via other methods such as pension contributions. For those who aim to extract all profits then the news is not so good.
The dividend measure was not included in the Finance Bill published after the Budget and so there are many unanswered questions. Further consultation and policy details are however expected in the near future and we have already seen a consultation released re IR35 proposing that a limited company will not protect the business engaging the contractor’s services from having to operate PAYE, if the contractor should be treated as an employee.
With the changes, if implemented as announced, other methods of profit extraction will have to be considered:
- Introducing Family Members as Shareholders – In many cases there is a now a clear tax incentive to ensure that shareholdings are held by both husbands and wives, as well as perhaps, adult children. However legal as well as other tax issues, such as Entrepreneurs’ Relief need to be considered, but a review of the current ownership position should be considered.
- Charging Interest on Loans to the Company – This has never been popular due to the extra administration burden that has to be undertaken, together with the requirement to withhold 20% basic rate income tax by the company to be paid to HMRC quarterly. However, changes announced in the March Budget, which may make this route more attractive – especially if the new interest tax allowance (£1,000 tax free for basic rate taxpayers) can be used against it. Consideration could be given to receiving a large dividend prior to 5 April 2016 which is then loaned back wholly or in part to the Company with an interest rate charged at a commercial rate. Commercially, the loan could in turn replace more expensive bank borrowing.
- Where property is provided rent free or at a low rent to a company by the shareholders, then receiving rental income instead of dividends should also be considered. However, care is required, as Entrepreneurs’ Relief can only be claimed in full on the gain arising on the sale of the property held outside the company if no rent has been charged.
- Company Pension Contributions – Although there have been many changes to pensions (including some in this Budget) and more changes are expected following the release of a recent consultation, pension contributions should still be considered, see below.
- Tax Efficient Investments – Using income tax saving investments such as EIS or VCTs, however this bring risk and ties up cash for specific periods of time.
Restriction of Tax Relief for Amortisation of Goodwill
This was the surprise of the day and hidden in the detail. We have already seen tax relief for goodwill being restricted in recent Budgets when an existing unincorporated business is transferred into a limited company owned by the same person(s).
New rules introduced in the summer Budget will further restrict the corporation tax relief a company may obtain for the cost of goodwill (the excess value of a business over and above its tangible net assets) when a company buys a business from an unrelated third party. The Budget notice stated this was to make it a “fairer playing field” when a business was sold between a share sale and a trade & asset sale.
Purchases of goodwill made before 8 July 2015 will continue to be eligible for tax relief on the annual amortisation of the cost of the goodwill.
Goodwill sold by a limited company after 8 July 2015 at a profit will be taxed as a trading receipt but if a loss arises it will be treated as a non-trading debit which may not be so readily relievable.
A “knock on” impact of this change, is that under accounting rules goodwill has to be written down in the accounts impacting the profit & loss and therefore directly reducing the profits the company can pay out as dividends since the accounting deduction can no longer be taken in to account when working out the profits chargeable to corporation tax. (The Chancellor probably feels this is not an issue as he keeps reducing corporation tax).
Pensions – Restriction on Tax Relief
The new Government, as part of their election manifesto, announced that pension tax relief for additional rate tax payers was to be restricted. The increase in dividend tax rates and the more flexible pension drawdown rules that are now in place may make the extraction of profits from companies in the form of pension contributions look an attractive option. However there are traps to consider; there is both the annual allowance (currently £40k maximum) and the lifetime allowance (£1 million). For high earning, self-employed individuals (sole traders and partners) then there is still some opportunity to mitigate significant income tax by maximising pension contributions over the next few years.
The annual allowance provides an annual limit on tax relieved pension savings. It is measured by reference to pension input periods and is currently £40,000 but with the ability to carry forward unused relief from the last three years as long as a pension plan was in place. Indeed the annual allowance was £50,000 as recently as 2013/14. (Pension input periods are not necessarily in line with the tax year).
From April 2016 a taper to the annual allowance is being proposed for those with adjusted annual incomes, including their own and employer pension contributions, of over £150,000. For every £2 of adjusted income over £150,000, an individual’s annual allowance will be reduced by £1, down to a minimum of £10,000 for those earning more than £210,000. The key point is that the adjusted income will include earned income and personal and employer pension contributions. The impact of the adjusted income definition is that potentially anyone earning over £110,000 could be impacted by the reduced annual allowance. However, where an individual has income of £110,000 or less, they cannot be subject to the restriction, regardless of the level of their adjusted income.
The draft legislation provides that carry forward relief from 2015/16 and prior is still available, so contributions in excess of £10,000 may be possible even for those individuals with incomes in excess of £210,000 in 2016/17 and the following two years. A further opportunity arises from the fact that in order to facilitate the tapering of the annual allowance, it is necessary to bring pension input periods into line with the tax year. Depending upon an individual scheme’s annual period, the annual allowance in 2015/16 is potentially £80,000 and therefore much higher pension contributions are possible prior to 5 April 2016.
Pension planning should not be dismissed, particularly if you can make your pension plan work for your business by using pension lending.
If you wish to benefit from the opportunity to make a potential £80,000 contribution (or more if prior year unused relief is available) before April 2016, speak to your financial advisor. Alternatively, Harbour Key will be holding a joint Autumn seminar Wednesday 14th October at the Gloucester Guildhall Cinema titled – Is the Private Pension Dead?
Should you wish to discuss any topic covered in this article or the Budget generally, please do not hesitate to contact us at Harbour Key.
Harbour Key Limited
4 August 2015
Always take professional advice when deciding your tax planning or investment strategy. The contents of this article are intended for general information purposes only and shall not be deemed to be, or constitute advice. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of this article. Harbour Key Limited © All rights reserved