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Tolley's Practical Tax by Roger Jones BSc FTII TEP

Roger Jones BSc FTII TEP examines the effect of recent changes in the taxation of small companies.In "A Painless Extraction" (TPT 29 March 2002), I explored the various ways of extracting profits from a company with especial reference to the owner manager of a family company. Most readers will be aware of the Chancellor's comments in the pre-Budget report of 10 December 2003 and the new legislation which has followed. The question is - does this really make a difference?

Back to basics. Just how can the proprietor get the money out? There are four main options:

- salary (or bonus);

- dividend;

- benefits-in-kind; and

- capital transactions.

There can never be a single right answer and, in a given situation, it may be necessary to strike an appropriate balance between the factors. I will concentrate here on the first two.

Salary/Bonus vs Dividend Comparisons

The starting point for any discussion of profit extraction in the family company will, almost invariably, centre on a comparison of salaries and dividends. There are other ways, many of which will have their place in the overall package but there is little point in addressing these in detail until the fundamental salary vs dividend balance has been struck.

The business proprietor will usually prefer to take a dividend as the rate of income tax to be suffered is quite simply less. With the underlying proposition that we are considering a family company, there is the other side of the equation to consider. What is the effect on the company; indeed looking at the business and its proprietors in the round what is the total liability and how do we keep it to a minimum?

The system under which we now operate seems to have come about largely by accident. The free use of dividends has already caused the Inland Revenue to take rearguard action in one significant circumstance. That is the IR35 legislation to inhibit personal service companies from taking the balance too far one way. Maybe application of the settlements legislation is a further example of similar thinking.

Given a free choice, dividends are to be preferred. It may be that future changes will tip the balance the other way. If and when change comes, we as professional advisers must be ready to meet the challenge and adapt our strategies.

Potter Ltd has had a successful trading year and has profits available for distribution in excess of £50,000. Harry, who is the director/shareholder, wants to draw out £10,000. He is a higher rate taxpayer and the company pays corporation tax @ 19%. All tax and NIC rates are those applicable to 2003/04 and 2004/05.

The first choice is that he might take a bonus (or additional salary) thus:

Example 1: Bonus
Company profits to be withdrawn		10,000
Less:	Bonus (100 / 112.8 x 10,000)	(8,865)
	Employer's NIC (12.8 / 112.8 x 10,000)	(1,135)
		NIL
Corporation tax		NIL
Harry's bonus		8,865
Less:	Income tax @ 40%	(3,546)
	*NIC @ 1%	(89)
Net retained		£5,230
* Assume Harry's other salary already exceeds upper earnings limit.

If Harry chooses this option, the total effective rate of tax and national insurance on the amount withdrawn totals 47.7%.

The alternative is to take a dividend thus:

Example 2: Dividend
Company profits to be withdrawn		10,000
Less:	Corporation tax @ 19%	(1,900)
Dividend paid		8,100
		(8,100)
		NIL
Harry's dividend		8,100
Add:	Tax credit at 1 / 9	900
		9,000
Less:	Income tax @ 32.5%	(2,925)
Net retained		£6,075

The total effective tax rate on the amount withdrawn has been reduced to 39.25%. In this case, it represents a useful saving of £845. This is the result for 2003/04 and it holds good for 2004/05 providing that the profits of Potter Ltd are at least £50,000 ie it pays corporation tax at 19%. So far, nothing has changed.

If Harry takes his drawings by way of a bonus, the overall tax rate remains the same whatever the size of the company since there is no corporation tax liability (the whole of the profit being deducted from its profits). If he takes a dividend, the effective rate varies since the amount of corporation tax changes. This is where the new rules may take effect.

Let's now take similar examples for Weasley Ltd which has profits available for distribution of £10,000 only. Ron, who is the director/shareholder, wants to draw out the full £10,000. He is a basic rate taxpayer and, in FY 2003 the company pays corporation tax @ nil%. Otherwise, tax and NIC rates are those applicable to 2003/04 and 2004/05.

Again, the first choice is that he might take a bonus:

Example 1: Bonus
Company profits to be withdrawn		10,000
Less:	Bonus (100 / 112.8 x 10,000)	(8,865)
	Employer's NIC (12.8 / 112.8 x 10,000)	(1,135)
		NIL
Corporation tax		NIL
Ron's bonus		8,865
Less:	Income tax @ 22%	(1,950)
	*NIC @ 11%	(975)
Net retained		£5,940

If Ron takes this option, the total effective rate of tax and national insurance on the amount withdrawn totals 40.6%.

Once more, the alternative is to take a dividend. For 2003/04 the position would have been as follows:

Example 4: Dividend
Company profits to be withdrawn		10,000
Less:	Corporation tax @ nil%	(nil)
Dividend paid		10,000
		(10,000)
		NIL
Ron's dividend		10,000
Add:	Tax credit at 1 / 9	1,111
		11,111
Less:	Income tax @ 10%	(1,111)
Net retained		£10,000

The total effective tax rate on the amount withdrawn has been reduced to nil. In this case, it represents a useful saving of £4,060. Who can blame Ron for taking the dividend in preference to further salary? The Chancellor, so it seems. Applying the "right amount of tax" rules (see below) in FY 2004, the company must pay corporation tax at a minimum rate of 19% on profits withdrawn. So the dividend calculation now becomes:

Example 5: Dividend
Company profits to be withdrawn		10,000
Less:	Corporation tax @ 19%	(1,900)
Dividend paid		8,100
		(8,100)
		NIL
Ron's dividend		8,100
Add:	Tax credit at 1 / 9	900
		9,000
Less:	Income tax @ 10%	(900)
Net retained		£8,100

The effective rate of tax on Ron's dividend is now 19% but he still saves £2,160 by taking a dividend rather than salary. The advantage has been reduced in 2004/05 as compared to 2003/04 but it is still there and it is significant. As with Harry, the overall rate of tax on profits withdrawn by way of bonus remains the same. For a dividend, the rate of tax changes according to the company's rate of tax. In 2004/05, the rate of corporation tax on profits withdrawn by way of dividend cannot be less than 19%. The comparisons of rate are thus:

Table 1: Overall rate of tax (and NIC) on profits withdrawn – higher rate taxpayer
Company CT rate	Salary	Dividend
19%	47.7%	39.25%
32.75%	47.7%	49.6%
30%	47.7%	47.5%
Table 2: Overall rate of tax (and NIC) on profits withdrawn – basic rate taxpayer
Company CT rate	Salary	Dividend
19%	40.6%	19%
32.75%	40.6%	32.75%
30%	40.6%	30%

Some business proprietors have seen this advantage as one of the main influences in deciding whether to incorporate. This is, no doubt, what the Chancellor perceives as a "loophole". Anyone who thought that such a bonanza could last would have been ill-advised. A move to restrict this advantage of incorporation had to be on the cards, though it was unlikely that any counter-measure would destroy the advantage altogether. By way of illustration only the following table demonstrates the possible savings as between a sole trader and an incorporated business where the proprietor takes a minimal salary and the balance as dividend.

Table 3: Possible direct tax savings through incorporation
Profit	Saving 2003/04	Saving 2004/05	Difference
£10,000	£1,484	£ 602	£ (882)
20,000	3,205	1,826	(1,379)
30,000	3,830	2,856	(974)
40,000	4,224	3,880	(344)
50,000	4,042	3,989	(53)

These are extreme examples which few are likely to pursue to the ultimate. What the figures do show is that there is still a tax saving to be enjoyed from incorporation at all profit levels. Whilst the "£10,000 business" has lost about £900 of its former advantage, it is still there. The saving now may not be enough to prompt a business of this size to incorporate. However, if it has already done so, there is no reason to disincorporate as some, more hysterical, elements of the professional press are suggesting. On the other hand, the "£40,000 or £50,000 business" has lost very little: if tax savings can be viewed in isolation there is still a great advantage to be derived from incorporation.

The Right Amount of Tax

In his Pre-Budget Report speech on 10 December 2003, the Chancellor made an aside reference to the taxation of small company proprietors. What he actually said was contained in one sentence:

"Also published today are measures ... closing loopholes involving ... tax paid on the personal income of owner managers of small companies."

There is no reference to this in any of the PBR press notices from the Treasury or the Inland Revenue. It is necessary to trawl through the full text of the Pre-Budget Report itself. On page 117 you will find para 5.91 which includes:

" ... the Government is concerned that the longstanding differences in tax treatment between earned income and dividend income should not distort business strategies, or enable reductions by tax planning of individuals' tax liability, and that support should continue to be focussed on growth. The Government will therefore bring forward specific proposals for action in Budget 2004, to ensure that the right amount of tax is paid by owner managers of small incorporated businesses on the profits extracted from their company, and so protect the benefits of low tax rates for the majority of small businesses."

One cannot say that this was unexpected. There followed a period of pure speculation as to what the Chancellor might actually have meant. Favourite ideas were a return to some form of close company apportionment, National Insurance on close company dividends or a return to investment income surcharge for close company dividends.

In the end, the proposed solution was something that none of us seemed to have thought of and was simple in concept. There is little doubt that various nuances will be detected for some time to come though. The essence of it is that dividends (payable to non-corporate shareholders) should be paid out of profits which have borne a minimum corporation tax rate of 19%. In other words, the much vaunted nil rate band of corporation tax is reversed where the profits are distributed. What short memories those in Government seem to have. It is only two years since the nil rate band was introduced as an incentive to small and growing businesses. Now it has become a "loophole" that too many have exploited and must be reversed.

The reimposition of a minimum rate of corporation tax of 19%, but only in respect of profits distributed to non-corporate shareholders, was announced in the 2004 Budget. Press release REV BN34 was very short on detail. Catching some people, who were intending to pay large dividends out of small companies before 6 April, unawares the change took effect from the beginning of Financial Year 2004 ie 1 April 2004.

In its now usual style, the Revenue posted more information on the operation of the new charge on its website in question and answer format. One of the major complaints was that the new charge took effect on 1 April, 7 days before the Finance Bill was even published. Company proprietors were therefore forced to make major financial decisions on no better information than the Revenue's view of how the new charge would operate. The draft legislation is now available in Cl 28 and Sch 3 FB 2004.

The fundamentals of its operation are as follows:

Basic Example:

Company has taxable profits of £40,000 in its accounting period ending on 31 March 2005. During the period it pays dividends of £10,000.

Step 1:

Calculate the company's underlying rate of tax, ignoring the dividend:
Starting rate nil on first £10,000 = nil
Marginal rate1 23.75% on next £30,000 = £7,125
Total tax = £7,125
Underlying rate of tax 7,125/40,000 = 17.81%
Note: The Revenue examples do this the "correct" way by calculating corporation tax at the small companies rate of 19% and applying the marginal relief fraction.

Step 2:

Calculate the company's liability using the non-corporate distribution rate (NCDR) on the distributions and the underlying rate on the balance:
NDR 19% on dividends paid £10,000 = £1,900
Underlying rate on balance 17.81% on £30,000 = £5,343
Corporation tax payable = £7,243

The shareholder's position is unaffected. He has a net dividend of £10,000 (which attracts a notional tax credit of 1/9). This is taxed at 10% if he is a basic rate taxpayer (franked in full by the notional tax credit) or 32.5% (less the tax credit) if he is a higher rate taxpayer.

It has to be stressed that this is a very basic example. There are provisions to deal with accounting periods which span 1 April 2004 (NCDR only applies to profits earned after that date), distributions paid in a different year to that in which the profits were earned, companies with losses, part of the dividend paid to a corporate shareholder etc.

As far as remuneration strategy is concerned, we ought to look more closely at the mismatch of distributions and profit earning:

Example:

The new charge operates on a "cash basis". It looks at dividends paid in an accounting period, not the dividends declared. Few companies will necessarily pay out all of the dividends referable to the profits of an accounting period within that period.

Company has taxable profits, ape 31/03/04 £50,000, ape 31/03/05 £10,000. Dividend is declared out of 2004 profits and paid in August 2004.

Ape 31/03/04
£50,000 x 19% = CT payable £9,500

Ape 31/03/05
(step1)
... £10,000 x nil% = nil
... underlying rate = nil
(step 2)
... NCDR 19% on dividends = £1,900

Corporation tax payable = £1,900

There are some who might regard this as meaning that the amount distributed has suffered corporation tax of 38% (19% on profits in the year that it was earned and 19% NCDR in the year in which it was paid out). This is arguable. If dividends are paid in a different period to that in which they are earned, the NCDR is applied to different profits; nothing has actually been taxed twice. There could be anomalies if profits fluctuate and dividends are paid from reserves of a high profit year in a year where earnings are lower. There is no mechanism for carrying back the distributions to be "franked" by profits earned and taxed in an earlier year. Rather unused non-corporate distributions are carried forward until the company next has profits.

The legislation does not define the size of company affected. It is merely necessary that it should have an underlying rate of corporation tax (ie that which it would pay if there were no distributions) below 19%. Watch out therefore not only for companies with profits below £50,000 but temporary loss makers, groups where one member has tiny profits etc.

Where businesses trade through "micro companies", the proprietors may wish to extract all of the company's profits. For maximum tax advantage, most of the withdrawal should still be by way of dividend. Bearing in mind that the NCDR is applied to dividends actually paid in an accounting period (not dividends declared) there might be a certain incentive to maximise the dividends paid before the end of the period in which the profits were earned. Calculating the greatest dividend that can be declared is a whole lot more difficult and, at this point, you may wish that you had a degree in mathematics. The process is also likely to put a strain on the client company's management accounting.

The maximum dividend that can be paid will be given by the formula:
D = P x (100 - ULR%) / (119 - ULR%)

where:
D - is the maximum possible dividend
P - is the distributable profit
ULR - is the underlying rate of corporation tax

In most cases this will be impossible. The profit will not be known before the year end. Until the profit is known, the underlying rate of tax cannot be calculated. Also bear in mind that the "profit" in this case is the taxable profit which may be a statutory fiction after adjustments have been made eg for capital allowances, disallowance of entertaining expenditure etc. The maximum dividend which may be paid is actually derived from the distributable profits determined according to the Companies Act and GAAP.

The Future

Anyone still interested in incorporating, must understand that the perceived tax advantages could be restricted in future. The Chancellor, Gordon Brown, is not going to want to stop incorporation altogether; because companies must be registered they are much easier to police than unincorporated businesses. The saving of tax ought not, in any case, to be the overriding factor in incorporating a business.

Lastly, a word of warning. What we have got has been described as "the least worst solution" (Mark Lee - chairman of the ICAEW Tax Faculty). It does not actually do what the Chancellor said he was going to do. He promised action to ensure that "owner managers pay the right amount of tax". This measure does absolutely nothing for their personal liabilities. Budget press notice REV PN5 says:

"To ensure that targeted tax incentives support the Government's objectives for growth, enterprise and productivity, the Government proposes to consider the issues raised by the interaction with the tax system of definitions of income of self employment, and the remuneration paid to owner-managers, in a discussion paper which will be issued at the time of the 2004 Pre-Budget Report".

So, we may yet see NIC on dividends or the return of investment income surcharge but at least we get to comment next time!

For the time being, I would counsel against panicking to disincorporate existing small companies. Whilst there may be specific tax reliefs to mitigate tax liabilities (especially CGT) on transfer of a business to a company, there are none for transactions going the other way. Just because there may be a period of uncertainty for small company owners, it would be wrong to rush into closing the company down with the risk of even greater tax charges.

Roger Jones

Roger Jones BSc FTII TEP is senior tax manager at Larking Gowen in Norwich though the views expressed are personal and do not necessarily reflect the opinion of the firm. Roger's book "Incorporating a Business" ISBN 0406 965293 is available from LexisNexis UK price £54.95.

This article was first published in 'Tolley's Practical Tax' on 2 July 2004, and is reproduced with the kind permission of Lexis Nexis.