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Taxation by Mark McLaughlin CTA (Fellow) ATT TEP

Mark McLaughlin CTA (Fellow) ATT TEP considers some alternative methods of extracting value from family and owner-managed trading companies.Family and owner-managed trading companies come in all shapes and sizes. The same applies to their owners; not only in a physical sense, but also in terms of their financial aspirations and their needs and attitudes towards extracting value from the company. The challenge faced by many advisers is in convincing director shareholders that the company’s money is not their own! So here are ten ways of extracting profits or value from the family company. This article does not cover share option schemes, nor does it seek to contrast the relative merits of one extraction method over another, although it does highlight some practical issues relating to them. I expect that the intellectual and innovative minds of Taxation readers will be able to come up with additional strategies! However, this article considers ten important methods. (All references are to Taxes Act 1988, unless otherwise stated.)

1. Remuneration

A director’s salary or bonus is normally an allowable expense of a family trading company if the amount is justifiable in relation to the duties performed. Otherwise, any excess is disallowable ( Copeman v William Flood & Sons Ltd [1941] 24 TC 53). This may be a consideration with husband and wife companies in which one spouse works part-time. To the extent that disallowed remuneration is negotiated with the Inland Revenue, the director’s earnings can be correspondingly reduced if the ‘excess’ is formally waived and repaid to the company ( Employment Income Manual , paragraph 42730). Payments to employees such as the couple’s children or other close relatives which are not commercial can also fall outside the ‘wholly and exclusively’ rule in s 74 ( Dollar & Dollar v Lyon [1981] STC 333 ).

Whilst this article is not primarily concerned with issues of relative tax-efficiency, many advisers of family trading companies will instinctively compare overall effective tax rates (i.e. for company and individual) resulting from the payment of remuneration versus dividends. In recent years, dividends have usually been more tax-efficient where the company is liable to corporation tax at the starting or small companies rates; however, it is unsafe to generalise. There is really no substitute for a ‘number crunching’ exercise based on the client’s particular circumstances, or possibly acquiring suitable software to do the exercise for you!

2. Dividends

Before dividends can be considered as a strategy for extracting profits from the family trading company, the Companies Act requirements for lawful dividends must be addressed. Andrew Hubbard’s useful article ‘ When is a dividend not a dividend? ’ ( Taxation , 28 October 2004, p102) considered company law issues relating to family company dividends, including checking whether the company’s articles of association permit directors to declare dividends, and also the necessity for the company to have sufficient distributable profits for dividends to be paid (Companies Act 1985, s 263).

These days, company articles usually allow directors to declare interim dividends from time to time. Interim dividends are legally due and payable when actually paid. Final dividends must be recommended by the directors and approved by the shareholders in a general meeting, and are legally due when declared unless a later date for payment is specified, in which case they are due on that payment date (Companies Regulations 1985, Table A, Articles 102, 103). The payment date can be significant in small family companies; for example, if the owners have withdrawn funds ‘on account’ of dividends being paid, resulting in an overdrawn director’s loan account. In the case of interim dividends being credited to the loan account, the Inland Revenue considers that payment is not made until an entry is made in the company’s books, which may be in a later accounting period than the directors’ resolution to pay the interim dividend ( Company Taxation Manual , paragraph 2007b). Physical payment of dividends to shareholders immediately after their declaration, followed by the re-introduction of those funds to the company with a corresponding credit to the loan account, should (although an inconvenient chore, perhaps!) prevent such issues arising in the first place.

A detailed consideration of differences in the tax consequences of dividend payments and remuneration is beyond the scope of this article. However, the factors potentially influencing their payment include the fact that dividends are not allowable deductions for the company and do not constitute pensionable earnings of the shareholder. But nor do they attract National Insurance contributions. The perils of dividend arrangements containing an element of bounty sufficient to constitute a settlement for the purposes of s 660A have been well documented over the past year or two (e.g. Tax Bulletin 64 (April 2003) and Tax Bulletin 69 (February 2004)) and – in the context of husband and wife shareholders – the issue was highlighted in Jones v Garnett [2005] STC (SCD) 9 (SpC 432), which has recently been heard by the High Court.

3. Benefits and expenses

Family or owner-managed companies are likely to be ‘closely controlled’, perhaps with friends or acquaintances holding shares. In certain circumstances, expenses incurred by close trading companies on the provision of benefits to individual shareholders (or associates) are not allowable corporation tax deductions for the company and are treated as taxable distributions for the shareholder (s 418). This treatment can apply, for example, to shareholders who are not directors or employees earning at a rate of £8,500 a year or more (see Tolley’s Corporation Tax 2004-05 , at paragraphs 20.19 to 20.20).

The natural tendency of many director shareholders is to favour benefits and expenses which are ‘cheap’ or ‘efficient’ from a tax (and/or National Insurance) perspective, such as car parking facilities, mobile phones provided by the company and approved mileage allowance payments for business travel in the individual’s own vehicle. The importance of correctly establishing the value of a benefit was illustrated in Langham v Veltema [2004] STC 544 .

It may be tempting to replace an element of salary with tax-free benefits. However, the Inland Revenue only considers ‘salary sacrifice’ arrangements to be effective if two conditions are met:

• the right to the future remuneration has been given up before it is treated as received for tax purposes (see ITEPA 2003, ss 18 , 31 ); and

• the revised contractual arrangement between employer and employee is that the employee is entitled to lower cash remuneration and a benefit.

The second condition may be difficult to prove, as written contracts may not exist in many family or owner-managed companies, although the Revenue does acknowledge that contractual arrangements between employer and employee may be wholly or partly verbal ( Employment Income Manual at paragraph 42769).

4. Pension contributions

The term ‘pension contributions’ is wide ranging, encompassing company payments to an approved occupational pension scheme, small self-administered scheme, funded unapproved retirement benefit scheme and the individual’s personal pension plan. However, a single pensions regime applies from 6 April 2006. A tax privileged annual limit (£215,000 for 2006-07) normally applies to contributions by both individual and employer. Contributions in excess of that limit will be taxable on the individual at 40% (FA 2004, s 227).

The existing pensions rules allow the company tax relief for ‘ordinary’ contributions to an approved occupational pension schemes in the accounting period of payment, with tax relief for ‘special’ contributions being subject to potential spreading over more than one accounting period ( s 592(4), (6) ). Under the new regime, ordinary contributions by the company to a registered pension scheme will normally be eligible for tax relief in accordance with Schedule D principles, and are similarly deductible from profits for the period of payment. Tax relief for exceptionally high contributions is spread over two, three or four periods of account including the current one. However, spreading of contributions only applies if they represent 210% of contributions paid in the previous period and the excess is £500,000 or more ( FA 2004, ss 196, 197 ). This level of contribution is beyond the scope of most family and owner-managed companies, so spreading of relief is unlikely to be an issue.

5. Loans

Advances to director shareholders of owner-managed or family companies often take the form of overdrawn directors’ current or loan accounts. The potential s 419 implications for the company (and beneficial loan implications for the individual) are generally well known. The exceptions from a charge on loans to participators (in s 420 ) are quite limited in scope. An income tax charge (at Schedule F rates) arises on the shareholder (or associate) if the company writes off the loan ( s 421 ), which takes precedence over an income tax charge on employment income (s 189(1)(b)). The company can recover any tax paid under s 419, but a corporation tax deduction for the loan written off may be difficult to obtain under the ‘unallowable purpose’ rule in FA 1996, Sch 9 para 13. (See ’ article ‘ The ‘NIC’eties of a Loan Write Off ’, Taxation , 7 October 2004, p22).

Conversely, owner managers who make loans to the company or who have a credit balance on their current account may wish to charge a commercial rate of interest on their advances to the company. The company normally obtains tax relief for interest charged if its accounts are prepared in accordance with UK generally accepted accounting practice or international accounting standards for periods of account beginning from 1 January 2005, or previously on an accruals basis (FA 1996, s 85A). However, in the case of loans from shareholders (or associates) to close companies, tax relief for any interest unpaid more than twelve months following the accounting period is deferred until the interest is actually paid (FA 1996, Sch 9 para 2).

6. Assets

The owner manager could sell personally-owned assets to the company. This might seem attractive from a tax (and National Insurance) perspective if, for example, gift relief can be claimed on a sale at undervalue ( TCGA 1992, s 165 ), or if the asset is standing at a low or no capital gain, or if full business asset taper relief is available, such as on a disposal of the company’s trading premises. However, sales at undervalue are deemed to take place at market value for capital gains tax, and also for stamp duty land tax purposes, if applicable. Sales at overvalue can give rise to a tax charge on employment earnings on the excess over market value (see Employment Income Manual at paragraph 21660), or as a shareholder distribution by virtue of s 209(4) . There are also potential tax charges when the asset is eventually sold and the proceeds are distributed by the company.

Whilst this article is concerned with extracting value from the company and not gifting to it, in some cases a sale of investment assets at undervalue (e.g. a portfolio of quoted shares) could achieve an inheritance tax saving. Assuming that the owner manager’s shares are in an unquoted trading company and qualify for 100 per cent business property relief, if the assets constitute an active investment business, entitlement to unrestricted business property relief potentially applies to the shares so long as the company’s activities remain mainly trading ( IHTA 1984, s 105(3) ). (See ‘A Business Proposal’ by Malcolm Gunn, Taxation 1 July 2004, p358).

7. Shares

The proceeds from the purchase of own shares by an unquoted trading company (e.g. upon the retirement of a director shareholder) are ordinarily taxable as an income distribution, unless the conditions for mandatory capital gains tax treatment are satisfied ( s 219(1) ). The share buyback must wholly or mainly benefit the company’s trade. Providing a shareholder with a convenient and/or tax-efficient exit route is unlikely to satisfy this condition! The Revenue’s Statement of Practice 2/82 offers guidance on the ‘trade benefit test’ in s 219(1)(a), and includes a pro forma application to the Inland Revenue for advance clearance under s 225 that capital gains tax treatment does, or does not, apply.

Owner managers with entitlement to business asset taper relief in respect of their shares will invariably prefer capital gains tax treatment. However, if the qualifying conditions in ss 220 to 224 are not satisfied, the resulting income distribution is the amount by which sale proceeds exceed the original subscription price of the repurchased shares ( s 209(2)(b) ). If the shareholder is not the original subscriber, it is therefore necessary to determine the initial subscription price. There is also a separate disposal for capital gains tax purposes, although the distribution element is excluded from the repurchase consideration ( TCGA 1992, s 37(1) ), which usually makes the disposal neutral in practical terms, but nevertheless subject to the normal reporting requirements ( TCGA 1992, s 3A ). The 0.5% stamp duty charge on the purchase consideration paid by the company should not be forgotten (FA 1986, s 66).

8. Rent

An alternative to selling assets to the company is for the owner manager to rent them. Letting property (e.g. trading premises) is a further means of extracting income, with no liability to National Insurance contributions arising on Schedule A business profits. Premises used by an unquoted trading company qualify as a business asset for capital gains tax taper relief purposes, irrespective of whether rent is charged. If appropriate, 50% business property relief is available to the controlling shareholder if the premises have been owned for at least two years and used wholly or mainly for business purposes ( IHTA 1984, s 105(1)(d) ).

However, there are certain potential drawbacks, including a possible capital gains tax part disposal for leases to the company below a market rent, and a stamp duty land tax charge (see Query T16,524 ‘Property Advantages’ in Taxation , 9 December 2004, p272). A licence can alleviate some of these difficulties. For example, a licence to use or occupy land is an exempt interest for stamp duty land tax purposes (FA 2003, s 48(2)(b)). For the company, rent in excess of market value can result in a disallowance in its Schedule D, Case I computation, so a professional rental valuation could be worthwhile.

9. Liquidation

The members of a family or owner-managed solvent private company may decide to wind up the company voluntarily through a formal liquidation, or possibly by means of an informal winding up. The Inland Revenue may be prepared to treat dissolution of the company under Companies Act 1985, ss 652 or 652A (or comparable provisions) as a formal winding up for tax purposes under Extra-statutory Concession C16 (see my article ‘ Ending the Family Company ’, Taxation , 23 September 2004, p654).

There is an automatic inclination in many cases towards informally winding up the company and applying – under Concession C16 – for distributions to be treated as capital receipts within TCGA 1992, s 122(1) , rather than Schedule F income. However, capital distribution treatment will not always be beneficial. For example, in the case of an investment company, comparison should be drawn between the individual shareholder’s effective income tax rate for a pre-liquidation dividend (25% for higher rate taxpayers) and the capital gains tax rate after taking into account any available taper relief (for example, 30% for capital distributions to higher-rate taxpayers during 2004-05, assuming that maximum non-business asset taper relief is available, but that the capital gains tax annual exemption is used elsewhere). In practice, the tax position and planning opportunities for shareholders often differs, such as by reason of share ownership periods, availability of taper relief and annual exemptions, marital status and liability to tax at different rates. Diplomacy, as well as computational, skills may therefore be required!

10. Termination payments

A director shareholder of a family company may receive a payment upon termination of employment. That individual may also sell their shares upon withdrawing from the company. It is generally unsafe to assume that the £30,000 exemption from employment income for termination payments or benefits ( ITEPA 2003, s 403 ) will automatically apply. For example, the Inland Revenue could argue that a lump sum termination payment to a major shareholder is disguised proceeds from the shares. The importance of being able to demonstrate that the termination payment and share sale are unconnected was illustrated in James Snook & Co Ltd v Blasdale [1952] 33 TC 244, albeit in the context of a Schedule D deduction for compensation payments. The Revenue may also consider whether the termination payment constitutes general earnings within ITEPA 2003, s 62 .

However, it is accepted that genuine redundancy payments (statutory or otherwise) are within the employment termination provisions of ITEPA 2003, s 401 (see Employment Income Manual at paragraph 12810), and are therefore subject to the £30,000 exemption. Certain termination payments are exempt without limit, including contributions to a tax-exempt or approved personal pension scheme, or on account of the employee’s injury or disability ( ITEPA 2003, ss 406(b), 408 ), with the result that the £30,000 exemption remains available, if required (see Tolley’s Income Tax 2004-05 , at paragraph 18.6).

Hands off!

By presenting owner managers and family company director shareholders with a host of possible extraction methods, it should be possible to persuade clients not to simply help themselves!

Mark McLaughlin CTA (Fellow), ATT, TEP
April 2005

This article first appeared in Taxation on 7 April 2005, and is reproduced with the kind permission of Lexis Nexis UK.