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Tolley's Practical Tax by Mark McLaughlin ATII TEP

Is the government deliberately pushing businesses towards incorporating? Has there been a better time to convert sole trader or partnership businesses to limited companies? Tax specialist Mark McLaughlin ATII ATT TEP of Tax Advisers Forbes Dawson considers the proposed legislative changes and some tax planning possibilities.Does anyone sense a subliminal message from the legislation introduced in the Budget, which flashes 'incorporation' at them? This new legislation includes a number of provisions, which seemingly lean towards incorporating businesses above a certain level of profit. The 'break even' point where incorporation becomes attractive will no doubt feature in future articles by other authors, and is not considered further here. Instead, this article considers some of the planning possibilities resulting from the proposed changes which could make incorporation, and also remuneration planning involving family companies, more attractive.

That helps ...

Tax rates

The introduction of a 'zero' starting rate of corporation tax from 1 April 2002, together with a reduction in the small companies' rate from 20% to 19% further widens the gap between corporation tax rates for many family companies, and the 40% tax rate suffered by sole traders and partners whose business profits push them into the higher rate tax bracket (FB 2002, cl. 31, 32).

Salary v Dividend

Of course, sooner or later profits taxed and retained within the company usually need to be extracted. The owners of many family businesses liable to corporation tax at the small companies' rate in particular already receive dividends which form the larger part of their remuneration package. This is likely to become an increasingly popular strategy from 6 April 2003, due to the 1% increase in employees' and employers' National Insurance contributions on salaries and bonuses, coupled with a 1% NIC charge on employees if earnings exceed the upper limit.

The national minimum wage requirements should be considered before embarking on a dividend policy, although family business owners who are directors generally fall outside those provisions if there is no written employment contract or other evidence of an intention to create an employer/worker relationship with the company (see Tax Bulletin 50, December 2000). In addition, bear in mind that an individual's ability to pay personal pension contributions above £3,600 per annum is dependant on earnings. Where this is an issue, the payment of a salary or bonus every 6 years with dividends in the intervening years could enable the payment of personal pension contributions at a higher level than £3,600 per annum based on those earnings for the same and subsequent 5 years, subject to the individual's personal pension contributions 'cap' (ICTA 1988, s 646B).

For companies paying tax at rates above 19%, the salary or dividend choice is less obvious, particularly prior to 6 April 2003. This can involve the practitioner in fairly detailed calculations in order to compare the overall tax rate for each option. Fortunately, there is tax software on the market to 'crunch the numbers', for those (like me) whose spreadsheet expertise leaves something to be desired!

Taper relief

Alternatively, profits could be retained within the company (provided they are used in its trade, to ensure business assets taper relief is preserved) until the company is eventually sold or wound up. Subject to Inland Revenue clearances (e.g. under the 'transactions in securities' legislation in ICTA 1988, s 707), and assurances being satisfactorily given to the Revenue under Extra Statutory Concession C16 (regarding the dissolution of companies) if appropriate, shareholders can extract those profits as capital.

The reduction in the taper relief holding period for business assets to two years for disposals after 5 April 2002 means that the effective rate of capital gains tax on business assets is only 10% for higher rate taxpayers following a relatively short time period (FB 2002, cl. 45). Setting up a trading company to deal with a specific and distinct project of at least two years' duration is therefore one planning possibility. Company profits are taxable at lower rates than the higher rate of personal tax, and the overall effective rate of tax upon 'exit' is 27.1% for a small company and 40% taxpayer (or only 10% for a 'starting rate' company), ignoring the annual CGT exemption. See Example 1.

Example 1

The overall rate of tax on £100 retained profit (assuming maximum business asset taper relief is available to a 40% taxpaying individual, but ignoring the annual exemption) is as follows:

	0% Corporation Tax £	19% Corporation Tax£
Company
Profits chargeable to tax	100.00	100.00
Corporation tax	0.00	(19.00)
Retained profits	100.00	81.00
Individual
Taper relief - 75%	(75.00)	(60.75)
Chargeable to CGT	25.00	20.25
CGT at 40%	10.00	8.10
Post-tax proceeds
£100.00 - £10.00	90.00
£81.00 - £8.10		72.90
Overall tax rate	10%	27.1%

Goodwill

There is an exemption from stamp duty on the sale or transfer of goodwill upon incorporation, in respect of documents executed after 22 April 2002 (FB 2002, cl. 114, Sch 36). This makes the sale of goodwill to a company upon incorporation (as opposed to a gift) potentially more attractive. The sale proceeds could be left outstanding as a loan to the company, and withdrawn without further tax consequences. However, the capital gains tax consequences still need to be considered (see 'planning points' below).

If the business is transferred to the company in exchange for shares (i.e. where rollover relief for capital gains under TCGA 1992, s 162 is in point), stamp duty is payable on the consideration (normally excluding bank current account balances and assets passing on delivery). However, the proportion relating to goodwill is no longer subject to stamp duty, and an apportionment is therefore made between goodwill and chargeable property on a 'just and reasonable' basis. In some cases, the exemption for goodwill will be sufficient to ensure that the consideration on which stamp duty is payable falls below the £60,000 threshold.

Incorporation relief

Business owners can elect that capital gains tax relief under TCGA 1992, s 162 does not apply to the incorporation of their interest in the business, for transfers after 5 April 2002 (FB 2002, cl. 48). Prior to this change, the relief applied on a mandatory basis to roll over gains upon incorporation. It has the effect of resetting the taper relief 'clock', i.e. the taper relief holding period of the chargeable assets (e.g. goodwill and land or buildings) is lost for ever, and a new taper relief holding period commences in respect of the shares. Chargeable gains are broadly rolled over against the base cost of the shares until their subsequent disposal.

An election to disapply section 162 relief may therefore be beneficial if, for example, shortly after a business is incorporated, an offer is received for the shares. An election could be made so that the exchange of chargeable business assets for shares triggers a disposal, but there is potential for 75% business asset taper relief to be available. In this situation, the business owner is potentially faced with an effective capital gains tax liability of up to 10%, but hopefully in the same tax year in which the company is sold, so that he or she is not temporarily out of pocket. The value of the shares will (hopefully!) be close to market value of the company when subsequently sold.

... but that doesn't

Tax relief is available to companies for the cost of goodwill and other intangible fixed assets from 1 April 2002 (FB 2002, cl. 83, Sch 29-30). It was perhaps too much to hope that sole traders and partners would be able to sell goodwill to their company upon incorporation, so that the company could claim tax relief for that goodwill. Regrettably, tax relief will not be available for goodwill transferred between related parties in most situations involving incorporation, e.g. where the sole trader or partnership has built up the goodwill prior to these changes, and where the business owner(s) subsequently control the company (para 118, Sch 29).

Planning Possibilities

Aside from the planning opportunities already mentioned, the incorporation of businesses or the participation of companies in continuing businesses give rise to a number of planning possibilities, including the following:

- A potential sale of goodwill by the business owner upon incorporation was mentioned above, the proceeds being left outstanding as a loan to the company and repaid without income tax or national insurance implications (funds permitting, of course). Stock and fixed assets may be similarly sold. For established businesses, the owner can sell goodwill to the company for £30,800 during 2002/03 without incurring a capital gains tax charge, if the individual's annual exemption is available. See Example 2.

Example 2

Sam and Janet Evening (married, aged 38 and 36 respectively) have run their dating agency for tax practitioners ('Self Assess') as equal partners for over five years. They decide to incorporate the business during 2002/03. The business goodwill is valued at £100,000, but they decide to sell it to the company for £30,800 each, holding over any gain arising (TCGA 1992 s 165(2)). The capital gains tax position is as follows:

		Sam£	Janet£
	Goodwill - market value (TCGA 1992 s 18)	50,000	50,000
Less:	Held over gain (restricted)	(19,200)	(19,200)
	Sale proceeds	30,800	30,800
Less:	Taper relief (75%)	(23,100)	(23,100)
		7,700	7,700
Less:	Annual exemption (2002/03)	(7,700)	(7,700)
	Chargeable gains	Nil	Nil

Proceeds of £61,600 may therefore be withdrawn from the company, with no income tax or national insurance to pay thereon. The held over gain is restricted by the excess of actual proceeds over original cost (TCGA 1992 s 165(7)). However, since the goodwill built up in the business and was not acquired for consideration, the restriction equates to the sale proceeds of £30,800 each. The held over gain is therefore £19,200 (i.e. £50,000 - £30,800).

For sale proceeds above the level in Example 2, the effective tax rate with full business asset taper relief is no more than 10% for higher rate taxpayers, and there is no longer a possible stamp duty liability to consider on the goodwill.

- A business may comprise different products or services. In appropriate circumstances, it can be possible to incorporate those businesses into separate companies with different combinations of shareholders, none of whom can exercise effective control. By ensuring that connected close companies are not 'associated' by common control for tax purposes (TA 1988 s 416), it is not necessary to divide the upper and lower profit limits for starting and small company relief purposes. Such companies can therefore each benefit from unrestricted upper and lower profit limits potentially.

- A service company may be used in conjunction with an unincorporated business, in order to shelter some profits at the starting or small companies' rate as opposed to the higher rate of personal tax. However, the IR35 rules relating to personal service companies must be safely negotiated. In addition, for close companies where the business owners are director/shareholders, credit terms or debt owed to the company by the business can have adverse tax repercussions under TA 1988 s 160 as beneficial loans, and under TA 1988 s 419 as loans to participators (see my article Getting Hitched? in Tolley's Practical Tax Newsletter, 7 November 2001).

- Alternatively, a company can be introduced as a partner in the business. The business owner(s) could sell a proportion of their goodwill to the company, which would acquire an appropriate profit sharing entitlement. A corporate partner would be particularly beneficial in that situation if the business owners paid higher rate tax on profits, the majority of which could otherwise be retained within the company at lower tax rates.

A note of caution

There may now be more good reasons than ever why a business should incorporate or use a company in its tax planning strategy. However, the old adage of not letting the tax tale wag the commercial dog should not be forgotten. Clients should not be 'dragged kicking and screaming' down the incorporation route if commercial factors indicate otherwise…no matter how strong the subliminal message to do so!


Mark McLaughlin ATII ATT TEP is a tax consultant, author and Associate with tax specialists Forbes Dawson, which provides tax consultancy and technical support to professional firms. Mark can be contacted on 0161 - 245 1090. The views expressed by the author are not necessarily those of the firm.