THOROGOOD PROFESSIONAL INSIGHTS
A SPECIALLY COMMISSIONED REPORT
TAX PLANNING OPPORTUNITIES FOR FAMILY BUSINESSES IN THE NEW REGIME
Christopher Jones
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A Thorogood Report
TAX PLANNING OPPORTUNITIES FOR FAMILY BUSINESSES IN THE NEW REGIME
Christopher Jones
Other Thorogood Reports: Practical Techniques for Effective Project Investment Appraisal
Published by Thorogood 10-12 Rivington Street London EC2A 3DU t: 020 7749 4748 f: 020 7729 6110 e:
[email protected] w: www.thorogood.ws
Ralph Tiffin
© BPP Professional Development 2000 Maximising Value on the Sale of a Business Peter Gray
Techniques for Successful Management Buy-outs Ian Smith
Dynamic Budgetary Control David Allen
Techniques for Minimising the Risks of Acquisitions – Commercial Due Diligence
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Ian Smith and Kevin Jewell
Ian Smith
No responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication can be accepted by BPP Professional Development the author or publisher.
Unlocking Shareholder Value
A CIP catalogue record for this Report is available from the British Library.
Financial Techniques for Business Acquisitions and Disposals
Paul Nichols
ISBN 1 85418 154 8 Printed in Great Britain by Printflow Limited.
The author
Christopher Jones BA (Hons) ATII ATT After graduating in Industrial Economics from Nottingham University in 1989 Chris took up a mixed tax role with Pannell Kerr Forster. His work involved dealing with a whole range of tax compliance and planning issues for owner managed businesses enterprises, wealthy individuals and larger corporate groups. Chris qualified in 1994 and joined BPP Taxation Courses the following year where he trained students qualifying for the Institute of Taxation examinations as well as preparing students sitting the tax papers for the ICAEW and ACCA exams. He was also the ATT Courses Manager responsible for the content,material and structure of all oral and correspondence courses. Chris joined the BPP Professional Development team in January 1997 presenting monthly and quarterly general tax updates as well as public courses on business and personal tax topics. On 1 July 1998 Chris became a freelance lecturer to enable him to develop his career in training and to expand his specialist tax practice on the south coast. As a result Chris became a consultant for Clark Hutchinson, chartered accountants in Seaford in August 1999. Chris continues to lecture extensively for many divisions of BPP as well as providing specialist courses for other organisations,including CCH seminars and local societies throughout the UK.
Contents Introduction ..................................................................................................1
1
INCORPORATION OF THE FAMILY BUSINESS
Income tax implications ...............................................................................3 Capital gains tax implications .......................................................................5 Enterprise Investment Scheme (EIS) Relief ..................................................9 National insurance implications .................................................................13 Corporation tax implications .....................................................................14 VAT implications .........................................................................................16 Inheritance tax implications ......................................................................17 Non tax considerations ..............................................................................17 Stamp duty ..................................................................................................18
2
EXTRACTION OF PROFITS FROM THE FAMILY COMPANY
Introduction ...............................................................................................20 Remuneration issues ...................................................................................24 Dividends ....................................................................................................30 Loans ..........................................................................................................30 Rental income ............................................................................................33 Pension provision .......................................................................................34
CONTENTS
3
ONE MAN SERVICE COMPANY
Introduction ...............................................................................................43 Engineerjob.com ........................................................................................43 Illustrative examples ...................................................................................45 The current position ..................................................................................47 Husband and wife arrangements ................................................................49 Action now .................................................................................................50
4
EXPANDING AND STRUCTURING THE BUSINESS
Introduction ...............................................................................................53 Corporate structures ..................................................................................53 Capital gains planning ................................................................................56
5
EXIT ROUTES
Introduction ...............................................................................................59 Capital gains tax planning ..........................................................................59 Inheritance tax planning ............................................................................73 Pre-sale transactions ...................................................................................77
Introduction Following recent legislative and case law changes the whole area of tax planning for family businesses requires very careful and thorough attention in order to avoid many of the pitfalls.This Report not only draws attention to these pitfalls but also provides practical advice and solutions to overcome them. The Report deals with the most important planning opportunities relevant to the family business and will bring readers up-to-date with the latest tax issues relevant to businesses and companies alike.In particular it deals in detail with the following recent developments: •
Finance Act 1998 rules on the taxation of capital gains together with the latest Inland Revenue guidance in this area;
•
The latest issues raised by IR35 dealing with personal service companies including positive action that may be taken to avoid the problem;
•
Recent case law and Revenue ‘attacks’particularly relevant to the ownermanaged business;
•
Family companies and the national minimum wage.
1
Incorporation of the family business I N C O M E TA X I M P L I C AT I O N S C A P I TA L G A I N S TA X I M P L I C AT I O N S ENTERPRISE INVESTMENT SCHEME (EIS) RELIEF N AT I O N A L I N S U R A N C E I M P L I C AT I O N S C O R P O R AT I O N TA X I M P L I C AT I O N S VAT I M P L I C AT I O N S I N H E R I TA N C E TA X I M P L I C AT I O N S N O N TA X C O N S I D E R AT I O N S S TA M P D U T Y
chapter
1
Chapter 1: Incorporation of the family business
Income tax implications Impact on individuals •
Prior to incorporation the individual will either be self-employed or a partner assessed to tax under Schedule D Case I and paying tax biannually under self assessment.
•
After incorporation the individual will be a director of a close company facing the problem of extraction of profits from the company. He will need to get used to a new way of settling his tax liabilities and appreciate the numerous pitfalls laid by the tax legislation.This is dealt with in chapter two.
Cessation of trade Incorporation will result in the cessation of the unincorporated business. Cessation accounts must therefore be prepared and the CYB closing year adjustments made. Remember relief for real or transitional overlap profits.
Example Abbey is considering incorporating her business on either 1 April or 1 May 2000. Her tax adjusted results are as follows: y/e 30 April 1997
£72,000
y/e 30 April 1998
£60,000
y/e 30 April 1999
£80,000
y/e 30 April 2000
£90,000
3
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INCORPORATION
OF
THE
FAMILY
BUSINESS
Solution a)
Incorporation on 1 April 2000: Her Schedule D Case I assessments will be as follows: 1997/98:
CYB: y/e 30 April 1997
£72,000
1998/99:
CYB: y/e 30 April 1998
£60,000
1999/00:
1.5.98 to 31.3.00 £80,000 + (£90,000 x 11/12) = Less transitional overlap relief: 1.5.96 to 5.4.97: £72,000 x 11/12
£162,500 £(66,000) £96,500
b)
Incorporation on 1 May 2000: Her Schedule D Case I assessments will be as follows: 1997/98:
CYB y/e 30 April 1997
£72,000
1998/99:
CYB y/e 30 April 1998
£60,000
1999/00:
CYB y/e 30 April 1999
£80,000
2000/01:
1.5.99 to 30.4.00 Less transitional overlap
£90,000 (£66,000) £24,000
Capital allowances Incorporation potentially gives rise to balancing adjustments on plant and machinery,and industrial buildings at market value,as the two parties are connected (S.839(6)). However,an election to transfer the assets at Tax Written Down Value is available to avoid this.The joint election must be submitted within two years of the transfer of assets (S.77 CAA 1990). A similar election is available for industrial buildings (S.158 CAA 1990).
Stock adjustments Stock will be transferred to the new company at its market value as both the sole tradership and the company are under common control.However,an election is available to transfer the stock at cost to shift the profit from the unincorporated business to the company.This would be worthwhile where the company would only pay tax on the profit at 21% but the sole trader has a marginal tax rate of 40% (S.100).
4
CHAPTER
1:
INCORPORATION
OF
THE
FAMILY
BUSINESS
Loss relief Where the trade has incurred losses up to the date of incorporation,various reliefs are available: •
The loss may be set against the trader’s statutory total income of the current and/or preceding fiscal year (S.380).
•
The loss of the last twelve months of trading may be carried back and set against net trading income of the final and preceding three fiscal years relieving later years in priority to earlier years.‘Net Trading Assessments’are essentially DI profits less trading charges on income (S.388).
•
The loss may be carried forward and set against future income from the company provided at least 80% of the consideration is in the form of share capital.The losses will first be set against Schedule E income, then interest and finally dividends (S.386).
Capital gains tax implications Introduction A gain will arise at market value given that the parties are connected.The value of self-generated goodwill is usually the most common problem as this rarely has any base cost attached (S.162 TCGA 1992).
Incorporation relief This is available where all assets of the business, with the possible exception of cash, are transferred to the new company in return for shares.The relief is given automatically, (i.e. no claim is required) provided the business is transferred as a going concern and the consideration is wholly or partly in shares.Where the consideration received from the company is in the form of cash, the maximum relief claimable is given by the following fraction: Indexed gain x Value of shares received Total consideration The relief is given by deducting the gains on the chargeable business assets transferred from the base cost of the shares. A subsequent sale of the shares may therefore be expensive for capital gains tax (CGT) purposes (S.165 TCGA 1992).
5
CHAPTER
1:
INCORPORATION
OF
THE
FAMILY
BUSINESS
Gifts relief The gift or sale at undervalue,of business assets to the new company,will qualify for relief by deducting the gains from the base cost of the assets to the company. The future sale of the assets will therefore trigger a higher gain in the company. A joint claim must be submitted.The company, may of course, be able to rollover these gains in the future. S.165 relief is more flexible than S.162 relief as the trader may choose which assets to transfer rather than being required to transfer everything. As the transfer of assets to the company must be a gift (rather than in return for shares) it is common under a S.165 incorporation to issue only a small number of shares (e.g. £100 worth) in exchange for cash.At a later date the goodwill of the business is sold to the company at a nominal value (e.g. £1) and relief is claimed by deducting any gain from the base cost to the company. Other assets are transferred at consideration equal to the lower of their CGT base cost or market value. This therefore limits the consideration to amounts which will not give rise to a capital gain in the hands of the transferor(s).
Choice of relief Incorporation relief deducts the gain from the base cost of the shares in the company and thus any future gains will be charged on the individual. Gift relief deducts the gain from the base cost of the assets and therefore any future gain will be assessed on the company.
Example Herbie wishes to incorporate his flower shop business. He has owned and run the business for a number of years and currently has built-up substantial goodwill. The assets of the business are: Current market value
CGT base cost
£000
£000
Goodwill
650
50
Premises
350
500
Herbie wishes to know the quantum of any capital gains and the method(s) by which they could be relieved. He also wishes to know what would become chargeable if he were to sell the company in the future for, for example £2m (ignore tapering relief).
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INCORPORATION
OF
THE
FAMILY
BUSINESS
Solution a)
Incorporation relief
Herbie could elect under s.162 TCGA 1992 to deduct the gains from the base cost of the shares he will obtain from the company: Goodwill £
Premises £
Current market value
650
350
Cost plus indexation
(50)
(500)
600
(150)
Net gain on incorporation = £450,000 Base cost of shares Market value Gain rolled over Base cost
£ 1,000 (450) 550
Gain on sale of shares in future for £2m £ Proceeds Cost
(550)
Gain before taper relief b)
2,000 1,450
Gift relief
Herbie could elect under s.165 TCGA 1992 to deduct the gains from the base cost of the assets to the company. The company would thus take over the assets at market value, less the rolled over gains: Goodwill
Premises
£
£
650
350
Less: gains held over
(600)
nil
Base cost to company
50
350
Market value on incorporation
7
CHAPTER
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INCORPORATION
OF
THE
FAMILY
BUSINESS
The loss of £150,000 on the premises could only be used by Herbie against future gains on assets transferred to the company, as Herbie will be connected with the new company assuming he acquires control. The gains on the sale of the shares will be: £ Proceeds Base cost
2,000 Nil 2,000
The gain is much higher given that the shares will have a negligible base cost. However, a S.165 incorporation may be the best option in order to save stamp duty by keeping the business premises outside the company. This is considered further in section 9 of this chapter.
The choice between gift relief and incorporation relief will be determined by the circumstances of each situation.The savings in stamp duty available using a S.165 incorporation must be weighed against the increased gain on the eventual sale of the shares resulting from their negligible base cost.
Interaction with taper relief The amount of the gain eligible for either incorporation or gifts relief is the untapered gain.Consequently,the ownership period of the business assets post 5 April 1998 will be lost as a result of a holdover claim. Where S.162 relief is concerned,the qualifying period for taper relief will commence once the shares in the new company have been issued. However, it may be argued that where every asset of the trade is transferred into the company the shares themselves have been derived from the underlying assets and taper relief therefore continues uninterrupted.This,although untested at present is a tenable interpretation of paragraph 14 to Schedule 20 of the Finance Act 1998. Under a S.165 incorporation taper relief due on the business assets transferred will be lost (including the ‘bonus’ year for assets owned on 17 March 1998).The base cost of the asset to the company will be reduced by the untapered gain.
8
CHAPTER
1:
INCORPORATION
OF
THE
FAMILY
BUSINESS
Enterprise Investment Scheme (EIS) Relief Finance Act 1998 rules Following the Finance Act 1998 the provisions of sections 164A to 164N of the TCGA 1992 have been repealed and replaced with an amended Schedule 5B. With effect from the 6 April 1998,reinvestment relief may only be claimed where the shares qualify under the Enterprise Investment Scheme (EIS).The gain on the sale of any asset is not deducted from the base cost of shares but is deferred until the earlier of: •
the EIS shares are sold; or
•
the EIS conditions are breached.
As the gain on the original asset is technically chargeable at the time of disposal but is eligible for deferral, tapering relief may be deducted.This will mean that the ownership period, post 6 April 1998, of the asset is not lost unlike incorporation or gift relief rules. The main changes to the reinvestment relief rules are as follows: •
The investor must subscribe for the shares wholly in cash and the shares must be issued and fully paid within one year before and three years after the disposal(s) giving rise to the relief (Sch 5B TCGA 1992).
•
The shares must be new shares, they cannot be acquired from existing shareholders.
•
The shares must not be redeemable within five years of issue.
•
The definition of ‘qualifying trades’has been tightened to also exclude: –
property development;
–
woodlands or forestry;
–
farming or market gardening;
–
hotel management; or
–
management of nursing or residential homes in addition to the previous excluded activities such as accountancy,solicitors and financial services.
•
The shares must be issued for bona fide commercial reasons and must not be part of a scheme to avoid tax;
•
All the money raised from share issues must be used for qualifying business activities within a specified period (usually within twelve months) (S.289(3)).
9
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INCORPORATION
OF
THE
FAMILY
BUSINESS
However,unlike reinvestment relief into EIS qualifying shares prior to 6 April 1998, there is no longer an upper investment limit for CGT purposes. Any amount of reinvestment qualifies for relief up to the amount of the gain on the disposal/transfer of the previous assets(s).To qualify for income tax relief as a 20% tax reducer the maximum amount of the investment is currently £150,000 (was £100,000 up to 5 April 1998 ). There is no limit for CGT purposes on the size of the shareholding that the investor may subscribe for.However,EIS income tax relief will be denied where the investor is either entitled to more than 30% of the share or loan capital, or is a full-time paid director of the company. The reinvestment relief scheme still allows a taxpayer to choose the amount of relief claimed in order to protect their CGT annual exemption or to utilise capital losses brought forward.
EIS anti-avoidance Suppose that a sole trader client has realised a capital gain on the sale of land. An obvious tax planning strategy is to subscribe for shares in a new company which would purchase the business.The gain on the land (and on the sale of the business) is deferred on a £1 for £1 basis under the Enterprise Investment Scheme. In order for the plan to succeed,the client must negotiate a large number of antiavoidance provisions.For example,the company should not take over any creditors of the existing business,in case the Revenue might argue that the company could be discharging a liability of the investor owed to a third party (para 13(2)(d) of Sch 5B TCGA 1992). Para 11(1)(b),introduced by FA 1998,also looks threatening.It states that deferral relief will be denied if there are arrangements ‘with a view to the cessation of any trade,which is being,or is to be,or may be carried on by the company,or a person connected with the company’.The problem here is that there is a cessation of trade when the business is incorporated and this is all part of the arrangements by which the shares are acquired. Luckily, the Revenue do not interpret para 11 in this way because the trade does not cease as such,but continues under different ownership. However,the Revenue is more likely to employ another anti-avoidance rule introduced in FA 1998.Para 1(2)(d) requires the shares to be subscribed for,and issued for bona fide commercial purposes and not as part of arrangements, the main purpose of which is the avoidance of tax.This rule was not included in the reinvestment relief provisions. It seems that the Revenue might take the view that the plan fails the bona fide commercial test,in that the incorporation of the business
10
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INCORPORATION
OF
THE
FAMILY
BUSINESS
is being carried out not for proper commercial reasons but simply to achieve tax relief.The counter argument,of course,is that the plan is a commercial idea,with generous tax relief. Clearly, the existence of the new anti-avoidance rule should be factored into any planning along these lines.
EIS and management buy-outs There is a trap in the new EIS rules which may deny income tax relief and future CGT advantages to a participant in a management buy-out (MBO). EIS relief is denied to an individual who was an employee of a company or a subsidiary within the relevant period,and before he subscribes for shares (s.291(2) ICTA 1988). A similar exclusion applies to an individual who has been a paid director. Assume that Mr A is an investor in Newco,having subscribed for 10% of the ordinary shares on 1 August 1998. Newco was incorporated on 15 July 1998 in order to acquire 100% of Target,a company of which Mr A was a paid director until 14 July 1998. Once it has acquired Target, Newco will arrange for it to hive-up its trade immediately under s.343.The Inland Revenue confirms that the money put into Newco as ordinary share capital will be regarded as being used for a qualifying business activity. But will Mr A qualify for relief? Until 17 March 1998,his having been a past director of Target would not have mattered as it came to an end before the ‘relevant period’ started (the period beginning from the later of two years prior to his making his investment or the date that Newco was incorporated – s.291(6), before amendment). However, as a result of changes in FA 1998, the relevant period is now a seven year period which commences two years before the date that Newco issues its shares to Mr A,even if that extends back before the date that Newco was incorporated (para 6, Sch. 13, FA 1998). Faced with the above scenario it will be necessary to find alternative ways of structuring the MBO in order to ensure that relief is given.
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INCORPORATION
OF
THE
FAMILY
BUSINESS
EIS deferral pitfall Example On 6 May 1998, eligible shares in Q Ltd were acquired by subscription by Henry, at a cost of £500,000. He claimed EIS deferral relief in respect of gains of the same amount. Assume that on 30 April 2003, unbeknown to Henry, Q Ltd completes the buy-back of a holding of 100 ordinary shares for £500 from Gladys, the widow of a former employee. When Henry becomes aware of the transactions he accepts that £500 of his deferral will be clawed back. Is this correct?
Solution Para 14, Schedule 5B, FA 1998 – Value received by other persons – states that if a purchase of own shares takes place in the two year period prior to a shares subscription, the shares subscribed for will never be eligible shares. If it takes place during the period of five years following the subscription date, the shares cease to be eligible shares at that point. This is the case whether or not the investor has any connection with the shareholder selling his/her own shares to the company. Henry loses all of his relief. It must therefore become a routine task to ask wherever a company purchase of own shares is being contemplated, whether any shareholder has claimed enterprise investment relief during the previous five years. It may also become standard practice to amend the Memorandum and Articles of Association to prohibit the purchase of own shares within five years of a share issue.
12
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1:
INCORPORATION
OF
THE
FAMILY
BUSINESS
National insurance implications Classes 2 and 4 These are payable by the unincorporated sole trader or partnership.The maximum NIC cost in 1999/00 and 2000/01 under both classes amounts to: 1999/00
2000/01
£
£
Class 2 £6.55 x 52 weeks =
£340.60
£2.00 x 52 weeks =
104.00
Class 4 £ (26,000 - 7,530) x 6% =
£1,108.20
£ (27,820 - 4,385) x 7% Total
1,640.45 £1,448.80
1,744.45
Class 1 These are payable by the director/employee post incorporation. Given that the class 1 rates are much higher,the maximum national insurance payable,assuming that the salary to be drawn post incorporation exceeds the upper Class 1 limit is: 1999/00: £ (26,000 - 3,432) x 10% =
2,256.80
2000/01: £ (27,820 - 3,952) x 10% =
2,386.80
The NIC cost to the individual is therefore much higher as an employee and, in addition the company will be required to pay 12.2% as a secondary contribution on earnings exceeding £83 per week in 1999/00 and £84 per week in 2000/01. Further implications of NIC planning are discussed in chapter two.
13
CHAPTER
1:
INCORPORATION
OF
THE
FAMILY
BUSINESS
Corporation tax implications Introduction Generally,owner managed companies tend to be close companies.Broadly,a close company is one which is controlled by either: •
any number of directors (including their associates); or
•
five or fewer participators (including their associates).
Close company status leads to specific tax implications,particularly regarding loans and payments to participators or their associates (S.414).
Loans to participators Where either a participator or his associate incurs a debt to a close company,the company will be required to pay notional ACT at a rate of 20/80ths on the lower of (S.419): •
the amount outstanding at the end of the company’s accounting period; or
•
the amount outstanding nine months following the end of the accounting period.
The notional ACT is due for payment nine months and one day following the end of the accounting period.Therefore, if the loan is repaid back to the company before the tax is due, no notional ACT will become payable. Where a tax liability is due on or after 6 April 1999 it will not be called ‘notional ACT’but will be renamed S.419 tax.The amount will be 25% of the loan outstanding. Where a company waives any loan due by a participator (or associate) the individual will be treated as receiving a dividend equal to the amount of the loan waived. This will be taxable in the fiscal year of the waiver and up to 5 April 1999 will have a 20% non-repayable tax credit attached. Where the loan is waived any time before 6 April 1999 the company will not be able to obtain a repayment of any notional ACT. However, loans waived after this date will mean the company may receive a repayment of the tax.The individual will be treated as receiving a dividend equal to the amount of the loan waived which will be taxed at the appropriate Schedule F rates applicable from 1999/00 onwards.
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OF
THE
FAMILY
BUSINESS
Example Crawley Limited advanced £9,000 to its sole shareholder and director Michael Crawley in January 1997. On 1 May 1999 the company agreed to waive the amount owed. Crawley Limited has a 31 December year end. Michael Crawley is a higher rate taxpayer. What are the tax implications?
Solution Crawley Limited will be required to pay ‘notional ACT’ on 1 October 1998 of £2,250 (£9,000 x 20/80), nine months and one day following the end of the accounting period in which the loan is advanced. This will be refunded to the company on 1 October 2000, nine months and one day following the end of the accounting period in which the loan is waived. Michael Crawley will be assessed to tax in 1999/00 under Schedule F in respect of £9,000 as follows: £ Dividend received: £9,000 x 100/90 = Higher rate tax thereon: £10,000 x 32.5% = Less notional tax credit: £10,000 x 10% = Higher rate tax due
10,000 3,250 (1,000) 2,250
Michael will also have a Schedule E benefit in kind from 1 January 1997 to 30 April 1999 based on the difference between the official rate of interest and any interest he pays to the company.
The new rules effectively shift the liability for the tax from the company to the participator.It is not clear at present as to whether provisions will be introduced whereby the Revenue will be able to claw back or withhold the S.419 refund from the company where the participator fails to pay any higher rate tax liability.
15
CHAPTER
1:
INCORPORATION
OF
THE
FAMILY
BUSINESS
Payments to participators If a close company provides any benefits or facilities for a participator (or associate) the company is treated as making a distribution.The following consequences will arise (S.418): •
the expense is disallowed for corporation tax purposes;
•
ACT will be payable by the company for payments or benefits provided before 6 April 1999;
•
the ACT is available for offset against the company’s corporation tax liability in the normal way;
•
the benefit will be treated as dividend income in the hands of the recipient and any higher rate tax will be payable. Up until the 5 April 1999 the higher rate tax was 20% of the gross equivalent value of the benefit/payment.With effect from 6 April 1999 the rate is 22.5%.
The ACT is payable under normal quarterly accounting on form CT61.
Interest on loans to acquire shares in or make loans to a close trading company An individual may claim relief from income tax if he pays interest on money borrowed to acquire ordinary shares in a close trading company, or to lend to such a company to fund trading activities provided that (S.360): •
the individual owns at least 5% of the ordinary share capital (i.e. the company is the individual’s ‘personal company’); or
•
the individual owns any part of the share capital,and works for a greater part of his time in a managerial or technical capacity for the company.
VAT implications Transfer as a going concern Where the assets of a business are transferred with the business as a going concern this is beyond the scope of VAT and therefore no output tax needs to be accounted for.Each circumstance will be different,especially if some assets are retained outside the new company. The company must carry on the same kind of business as the sole trader or partnership and use the same assets in that business.
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INCORPORATION
OF
THE
FAMILY
BUSINESS
Registration The sole trader or partnership must deregister for VAT (if appropriate) and the company must start a new registration where taxable supplies exceed the registration threshold (currently £50,000). Alternatively, an election may be made to transfer the current VAT registration to the company. Effectively, this will mean that the company stands in the stead of the unincorporated business as far as returns, accounting for tax, penalties and repayments are concerned.
Inheritance tax implications Transfer of value Transfer of assets to a limited company is not a transfer of value for inheritance tax purposes.
Business property relief Non-business assets transferred to the company will restrict the availability of business property relief on a future gift or bequest of the shares.This could arise where the business premises are transferred, and part of which are sublet. Note that for inheritance tax (IHT) purposes surplus cash held by a company will also restrict business property relief (BPR). In a recent case (Barclays Bank Trust Co Ltd v IRC [1998] ),it was held that £300,000 cash retained by a company, to enable it to buy much needed new premises was ‘surplus’,as it was not actually used for that purpose until seven years after the death of the donor.
Non tax considerations Various non tax considerations also require attention.These include: •
Limited liability enjoyed by companies. However, this may be eroded by lenders demanding personal guarantees from shareholders and/or directors.
•
It is often easier to obtain loan finance by trading through a limited company, by enabling floating charges to be registered over the company’s assets and by allowing minority or non-voting shareholders to subscribe for shares.
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OF
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FAMILY
BUSINESS
•
Exit routes – it is easier to sell shares in a company than to sell an interest in partnership,due largely to the attraction of limited liability of shares.
•
Costs and formalities of a company are onerous,such as the maintaining of books and records, audit requirements (depending on size of company) and Companies Act requirements.
•
Competitors can gain knowledge of the business results and activities through published accounts.
•
Companies generally have more generous pension arrangements available to them.
Stamp duty The stamp duty costs of incorporation cannot be overlooked. Any asset that must be transferred by deed will be subject to stamp duty.As an incorporation deals with the simultaneous transfer of assets,then the stamp duty must be based on the composite value of all assets transferred. The most common assets on which stamp duty will be payable include land and buildings,and goodwill.Debtors are also likely to be transferred by deed.However, if an agency arrangement is set up to enable the company to collect the debts on behalf of the sole trader then no stamp duty will be due.This does unfortunately prevent the reliance on s.162 TCGA 1992 as not all of the assets will be transferred in the incorporation. Stamp duty can be a very significant cost and may put the brakes on incorporation even after taking account of other tax benefits. Rates of stamp duty at the time of writing are as follows: Up to £60,000
Nil
£60,001 to £250,000
1%
Over £250,000
2.5%
Over £500,000
3.5%
18
Extraction of profits from the family company INTRODUCTION R E M U N E R AT I O N I S S U E S DIVIDENDS LOANS R E N TA L I N C O M E PENSION PROVISION
chapter
2
Chapter 2: Extraction of profits from the family company
Introduction Where trading activities are carried on through a limited company careful thought needs to be given as to the level and method of extraction of profits generated.
How much should be extracted? This decision should take into account both the needs of the individual shareholders and directors,as well as the needs of the company itself.For instance,the company may need to retain a certain level of profit in order to reduce its bank overdraft or to fund a proposed expansion project. The methods compared Method of extraction
Company
Individual
Salary
Deductible Class 1 (S)
Taxable Class 1 (P)
Benefits in kind
Deductible Class 1A
Taxable
Tax free benefits in kind
Deductible No Class 1A
Tax/NI free
Dividends
Not deductible
Higher rate tax
Loan interest
Deductible
Taxable
Rental income
Deductible
Taxable
Pension contributions: –
approved
Deductible
Tax free
–
unapproved
Deductible Class 1 (S)
Taxable Class 1 (P)
20
CHAPTER
2:
EXTRACTION
OF
PROFITS
FROM
THE
FAMILY
COMPANY
The relative tax (and national insurance) costs a)
Bonus % Gross Secondary class 1NIC Gross salary
100.00
[ ] 12.2 112.2
(10.87) 89.13
Income tax at 40%
(35.65)
Retained
53.48
Total tax and NI cost b)
Dividends Marginal corporation tax (CT) rate
20%
30%
32.5%
Gross
100.00
100.00
100.00
Corporation tax
(20.00)
(30.00)
(32.50)
80.00
70.00
(20.00)
(17.50)
(16.88)
60.00
52.50
50.62
40%
47.50%
49.38%
20%
30%
32.5%
Gross
100.00
100.00
100.00
Corporation tax
(20.00)
(30.00)
(32.50)
80.00
70.00
67.50
Chargeable gain 85%
68.00
59.50
57.38
Capital gains tax (CGT) @ 40%
27.20
23.80
22.95
47.20%
53.80%
55.45%
20.00
17.50
16.88
CGT @ 40%
8.00
7.00
6.75
Total tax cost
28%
37%
39.25%
Net dividend Higher rate tax (at 1/4) Retained Total tax cost c)
46.52%
67.50
Profit retention Marginal corporation tax (CT) rate
Capital gain Taper relief: 99/00
Total tax cost (CT + CGT) Maximum taper relief: 2007/08 Chargeable gain 25%
21
CHAPTER
d)
2:
EXTRACTION
OF
PROFITS
FROM
THE
FAMILY
COMPANY
Conclusion The most tax efficient method of profit withdrawal hinges very much upon the marginal rate of corporation tax the company pays. For a small company,dividends are the cheapest form of profit withdrawal. For a medium-sized or large company a bonus would seem the preferable option on the assumption that the director/shareholder is already paying maximum Class I Primary national insurance contributions. Retaining profits within the company in order to receive higher proceeds on eventual sale of the shares is worthwhile, provided a ten year business taper relief period has been built. However, if the succession of the company is likely to be achieved by passing the shares down the family, profit retention will only increase the gain to be rolled over by way of a gift relief claim.As the gain rolled over is before taper relief the base cost of the shares to the next generation will be substantially reduced. A careful review is required at the end of each year to determine the optimum profit to be extracted.
22
CHAPTER
2:
EXTRACTION
OF
PROFITS
FROM
THE
FAMILY
COMPANY
Example The accountants of Winton Limited have recently calculated the company’s taxable profit to be £310,000 for the year-ended 31 March 2000. The sole owner and director, James Winton, has extracted profit from the company in the form of interim dividends only. Winton Limited has no associated companies.
Solution Bonus paid
£
Profit to extract
10,000
Secondary class 1 NIC: £10,000 x 12.2/112.2
(1,087) 8,913
Personal allowance
(4,335) 4,578
Tax thereon: £1,500 x 10%
150
£3,078 x 23%
708 858
Primary NIC:
£3,432 x 0% £5,481 x 10%
0 548 548
Cash retained: £ (8,913 - 858 - 548) =
7,507
Dividend paid Profit Corporation tax at 32.5% Net dividend received
10,000 (3,250) 6,750
As £10,000 of the profit will be taxed at the marginal rate of 32.5% it would more tax (and NI) efficient to accrue a bonus of this amount in the accounts. Provided it is paid by 31 December 2000 deduction will be allowed in the 2000 corporation tax computation.
23
CHAPTER
2:
EXTRACTION
OF
PROFITS
FROM
THE
FAMILY
COMPANY
Remuneration issues Salary ‘package’ There are a number of ways to remunerate both staff and directors of the company. The aim of the company is to be able to maximise the tax deduction available for the expenditure, whilst creating employee incentives to increase efficiency and maximise profits. A remuneration package often includes a combination of the following: •
Flat rate salary
•
Commissions
•
Bonuses
•
Benefits in kind.
The advantage of bonuses and commissions,as far as the employer is concerned, is that they are only paid where the company actually has received value from the employee.It is important to ensure that employees understand how commissions and bonuses are calculated in order that they know how to ensure they earn them, and at the same time, earn profit for the company. Remuneration in this form is the least tax and national insurance efficient as the employees are required to pay tax and primary national insurance and the employer has to pay up to 12.2% secondary national insurance on all earnings. However, Schedule E remuneration is a necessary ‘evil’ for most employees and directors in order to provide them with relevant income for personal or occupational pension contributions.
24
CHAPTER
2:
EXTRACTION
OF
PROFITS
FROM
THE
FAMILY
COMPANY
Spouse’s wages Last year a salary of £63 a week could have been paid to a working spouse without liability to tax or national insurance contributions. For a higher rate employer, the overall tax saving was: £3,276 x 40% = £1,310 An increase in salary to,for example,£112 a week,would have resulted in an increase in overall savings of just £203, computed as follows: £ Tax relief for additional salary and employer’s national insurance contributions (NIC) [£2,548 + £291] x 40%
1,136
Employee’s tax
(326)
Employee’s NIC
(316)
Employer’s NIC
(291)
Saving
203
This year, a salary of £65 a week could be paid free of tax and NIC resulting in a tax saving of £3,380 x 40% = £1,352. An increase to £83 a week would result in employee NIC of £88.40,with an increase in overall saving of £286: £ Tax relief for additional salary £936 x 40%
374
Employee’s NIC
(88)
Saving
286
An increase to £112 a week (the 10% band) would provide savings of £478 compared to a salary of £65 a week.
25
CHAPTER
2:
EXTRACTION
OF
PROFITS
FROM
THE
FAMILY
COMPANY
£ Tax relief for additional salary and employer’s NIC [£2,444 + £184] x 40%
1,051
Employee’s tax
(150)
Employee’s NIC
(239)
Employer’s NIC
(184) 478
After that level, an increase in salary produces no further savings. £ Tax relief for additional salary (for example £100) and employer’s NIC [£100+£12.20] x 40%
45
Employee’s tax
(23)
Employee’s NIC
(10)
Employer’s NIC
(12) –––
Family companies and the minimum wage The National Minimum Wage Enquiries Office has issued a general letter to assist companies in deciding whether or not they need to pay the national minimum wage to their directors. The letter confirms that the Minimum Wage Act 1998 only applies to individuals with some sort of employment contract. If a director is also an employee then he or she is treated as any other worker. In particular, this means that they must receive the appropriate hourly rate averaged over the relevant pay reference period, which may not be longer than one month.The employer is required to keep sufficient records to show that this is the case.There are no exemptions for companies under family control. Being an office holder does not necessarily make someone an employee. Some directors will also be employees with a contract of employment,express or implied. The letter points out that in the past it has been argued in court that directors who own a sole or controlling shareholding totally in the employing company could not be regarded as employees.The letter adds that ‘this will still be the case
26
CHAPTER
2:
EXTRACTION
OF
PROFITS
FROM
THE
FAMILY
COMPANY
in many instances’. However, it points out that the Court of Appeal held, on 12 February 1999,that ‘whether an employer/employee relationship exists can only be decided by having regard to all the relevant facts.If an individual has a controlling shareholding,that is likely to be significant in all situations and in some cases might prove decisive, but it is only one of the factors which are relevant and is not to be taken as determinative’. James Kessler of counsel suggests that if a director and the company agree specifically that there is no contract between them, then: •
there is no contract;
•
the director is not a worker for the purposes of the Minimum Wage Act; and
•
the director has no right to the minimum wage.
Such an agreement would not stop the company from paying ex gratia remuneration to the director.In the absence of express agreement that there is no contract, Kessler’s view is that an informal contract will usually exist.
Termination payments Planning from the outset can ensure that termination payments fall to be taxed under section 148 rather than under Schedule E.This will enable the first £30,000 to be tax free. Where the termination payment is built into the employment contract or there is a ‘reasonable expectation’ of receiving it, the amount will be treated as arising as a reward for services and thus taxable under s.19 ICTA 1988. In a recent case (EMI Group Electronics Ltd v Coldicott [1997] ) it was held that payments in lieu of notice were taxable on two employees who were dismissed without notice.The emoluments were ‘from’ the employment. Care also needs to be taken to ensure that the termination payment is not treated as a payment into an unapproved retirement benefits scheme where the director or employee is close to retirement age SP13/91.
27
CHAPTER
2:
EXTRACTION
OF
PROFITS
FROM
THE
FAMILY
COMPANY
Example Alan, who is aged 55, is the Managing Director of Aston Limited, a UK subsidiary of a Danish holding company. Your firm acts as auditor and tax adviser to the company and is also responsible for their payroll. Alan telephones you one Thursday afternoon and advises you he will be leaving the company the next day and the company has authorised payment of a £40,000 termination payment together with a maximum top up to his company pension scheme. After taking advice from his own accountant Alan has asked you to pay the £40,000 after his P45 has been prepared, thus enabling tax at only 23% to be deducted from the £10,000 taxable amount. What should you do?
Solution As Alan is close to retirement age it is likely that the Revenue will look closely at the payment and view it as a payment to an unapproved pension scheme and therefore the full £40,000 would be taxable. We would need to establish from Alan whether he intends to work again and, if not, suggest that at least he tries to find some consultancy work. We would also need to see evidence that his termination is a compensation payment rather than a golden handshake: •
Is there any evidence that he is being made redundant?
•
Has anyone taken over his role as Managing Director and if so when did they join the company?
•
Have any significant changes been made to the running of the company since then?
•
What do the board minutes say?
Share options The advantage of an approved share option scheme is the fact that no Schedule charge will arise on the grant,exercise or growth in value of the shares concerned. The only tax charge is a capital gain on the eventual disposal of the shares. The main condition for approval is the restriction on the value of options to no more than £30,000 per employee/director at any one time and the option price
28
CHAPTER
2:
EXTRACTION
OF
PROFITS
FROM
THE
FAMILY
COMPANY
must not be ‘manifestly less’ than the current market price.‘Not be manifestly less’ means at no discount whatsoever. In addition,the scheme must prohibit options being exercised within three years and later than ten years of grant and at least three years must elapse between any two exercises. Where the conditions for approval are not satisfied a Schedule E charge to tax will arise on grant, based on the difference between the current market price and the option price.From 6 April 1998 this charge does not arise where the option is exercisable within ten years,up to 5 April 1998 the period was only seven years. An unapproved share option will be taxable on exercise, based on the current market price,less the price paid for the shares.This is chargeable under Schedule E which means that no capital gains tax reliefs, annual exemption, indexation allowance or tapering relief may be claimed. Following the introduction of taper relief the capital gains tax treatment is now considerably more favourable than the Schedule E treatment.
Example John is granted a ten year unapproved share option on 6 April 1998 to acquire 50,000 shares in Abbotswood Limited, representing 5% of the shares in issue, at their market value of £1 each. The shares are expected to be sold for £11 each ten years later.
Solution If the option is exercised shortly before sale, there will be a Schedule E charge on the increase in value of £10 per share producing a notional profit of £500,000 and an income tax charge of 40%. There would be no capital gain as the capital gains tax base cost would become £11 per share. If the option is exercised immediately after grant there would be no Schedule E charge and the entire growth in value would be within the capital gains tax regime. The capital gain of £500,000 would be reduced to just 25% with a ten year business taper period, creating a taxable gain of £125,000 and a capital gains tax charge of £50,000. Note that John would need to remain a full-time working officer or employee of the company in order for the disposal to qualify for business taper relief. In addition, John would need to outlay £50,000 immediately in order to exercise the option.
29
CHAPTER
2:
EXTRACTION
OF
PROFITS
FROM
THE
FAMILY
COMPANY
Dividends Advantages The main advantages of extracting profits in the form of dividends are: •
They are taxed at only 10% in the basic rate band in the hands of the recipient.
•
No national insurance is payable by the shareholders or the company.
•
They allow flexibility, i.e. family members need not work for the company in order to receive a dividend.
•
From 1999/00 the higher rate of tax applicable to dividends is only 32.5%.
Disadvantages The disadvantages of dividends are: •
The 10% tax credit is non-repayable.Therefore,other forms of remuneration are preferable for income up to the level of the personal allowance.
•
Dividends are not an allowable Schedule D Case I deduction.
•
Dividend income does not form relevant earnings for pension purposes.
•
The company must have generated sufficient distributable profit in order to pay the dividend.
Loans A director/shareholder may choose to lend money to the company and receive interest income in return.
Treatment of interest Under the loan relationship rules introduced in the Finance Act 1996,interest paid by a company will be relievable on an accruals basis provided it is paid within twelve months of the year-end if due to a connected party. Where the money is advanced to fund trading activities, the deduction will be given against Schedule D Case I income. Where the loan is advanced to fund non-trading activities (e.g.to fund the purchase of a subsidiary company or an investment property) it will be relieved firstly against
30
CHAPTER
2:
EXTRACTION
OF
PROFITS
FROM
THE
FAMILY
COMPANY
Schedule D Case III non-trading loan interest receivable and any excess (known as a non-trading loan deficit) may be set against (S.86 FA 1996): •
Other income of the same accounting period (in priority to S.393A relief).
•
Surrendered as group relief.
•
Carried back and set against Schedule D Case III income in the preceding twelve months.
•
Carried forward against future income of any description.
The above options must be claimed in writing within two years of the end of the accounting period.To the extent that the deficit is not relieved by such a claim it may be carried forward as an opening Schedule D Case III debit. The interest paid by the company is likely to be treated as annual.The recipient will be taxed on the interest as savings income and therefore a 20% rate of tax will apply for interest falling in the basic rate band.The 10% and 32.5% tax rates applicable to dividends from 1999/00 will not apply to interest. Interest income is not subject to national insurance but does not count as relevant earnings for pension purposes.
Overdrawn loan accounts When,on incorporation,cash is retained outside the company and subsequently injected in the form of a loan, the shareholder/director can be under the impression that he can then use his company as an extension of his own private banking facilities! This can cause a number of problems where the loan account is allowed to go overdrawn: •
Under company law a note must be made in the accounts to indicate the maximum level overdrawn.
•
Notional ACT/S.419 tax may become payable where the loan is not repaid within nine months of the end of the company’s accounting period.
•
NIC may be due on advancement of the loan where it is historically cleared by a salary or bonus.
•
Where the director took out a loan to make the advance to the company, any overdrawn current or loan account with the company will restrict the interest relief available under section 360.
•
A beneficial loan will arise, subject to tax under Schedule E.
31
CHAPTER
2:
EXTRACTION
OF
PROFITS
FROM
THE
FAMILY
COMPANY
Example Richard is sole owner of Zender Limited, a close trading company. In 1996, when the company was incorporated, he took out a loan from his bank to inject £50,000 to provide the company with initial start-up capital. In 1999 he took out a credit card in the company’s name which he used very freely. Up to 31 March 1999 he managed to spend £15,000 on private purchases, which the company settled. Zender Limited has a 31 March year-end. What are the tax implications?
Solution Richard will only be able to claim relief for interest on the loan taken out to fund the company’s trade on £35,000 from for example, January 1999, or the date the purchases were made. The computation of allowable interest can become unnecessarily complicated.
In addition, the individual is treated as recovering capital if he receives consideration for the sale, exchange or assignment of any part of the shares. Where there is a gift of shares, the deemed consideration is equal to the market value of the asset.This presents a nasty trap as shown by the following example: Mr A borrows £100,000 and uses the loan to buy 10,000 shares for £10 each.The interest on the loan qualifies for income tax relief at the marginal rate of tax. Assume that the shares increase in value and the individual decides to make a gift into trust of 2,000 shares and the market value of those shares is £25 each. He is then deemed to receive a repayment of capital of £50,000 and his interest relief is reduced by half. Therefore, if a client is considering making a gift of shares to a trust, it is important to check whether he acquired the shares with the benefit of a loan and is claiming interest relief.
32
CHAPTER
2:
EXTRACTION
OF
PROFITS
FROM
THE
FAMILY
COMPANY
Rental income On incorporation the owner(s) may decide to retain the business premises outside the company and charge rent for its use.
Advantages The advantages of this method of extraction of profit are: •
The company will obtain a Schedule D Case I deduction for rent charged up to a commercial rate.
•
No national insurance is payable.
Disadvantages The disadvantages of rental income are: •
The charging of rent denies retirement relief on the eventual sale of the building.
•
Schedule A income does not qualify as pensionable income.
However, under the new tapering relief rules introduced with effect from the 6 April 1998, rental income will not restrict the availability of the business rate of taper, provided the building is used for trading purposes by the individual’s personal company.
Lease of the family home For many small companies the directors’own homes are often used for company business. It is possible to claim a DI deduction in the company for reasonable rent paid by the company. Care should be taken so as not to deny principal private residence relief on a proportion of the home.To do this, it must be shown that the room(s) are not used exclusively for company business,i.e.the occasional guest stays in the ‘study’. The rent-a room relief legislation does not stipulate that the rooms that are sublet need to be used for residential purposes.Therefore, if the company paid rent of up to £4,250 it might be treated as tax free. However, the Revenue have stated categorically that they will always challenge such a claim.
33
CHAPTER
2:
EXTRACTION
OF
PROFITS
FROM
THE
FAMILY
COMPANY
Pension provision Introduction Providing for an adequate income on retirement is always at the centre of personal financial planning.Given that the benefit provided by the state system will progressively decrease over the years it is becoming increasingly important to save for one’s own retirement.Fortunately,it is also something the government recognises as important and, as a result, pension provision has become the most efficient way of extracting funds from a family company. There are a large number of different pension schemes on the market. It is not intended that these notes should provide a detailed explanation of all the various schemes, but the major areas and planning opportunities will be examined. It must be noted that the Financial Services Act 1986 governs the advice that accountants and others may give. It is therefore important that advisers who are not registered under this Act restrict their advice to the commercial and taxation consequences of the various schemes and do not advise on the merits of particular individual packages.
Approved occupational pension schemes There are two types of scheme available: 1.
Final salary scheme – defined benefit The pension is based on the employee’s length of service and final salary. The pension is provided out of one central fund and is calculated as,usually, 1/60 or 1/80 of the final pensionable salary.For example,a 1/60 scheme and 30 years of service would result in a pension of one half of final salary.To ensure that there will be sufficient funds to provide for the future pension the level of contributions may be adjusted from time-to-time based on actuarial advice.
2.
Money purchased scheme – defined contributions This is similar to a final salary scheme but there is no employer guarantee of a right to a stated final pension.The fund accrued for each employee is used to purchase an annuity to pay the pension on retirement. The maximum permitted final pension cannot exceed two-thirds of the final salary.
34
CHAPTER
2:
EXTRACTION
OF
PROFITS
FROM
THE
FAMILY
COMPANY
There are a number of tax breaks given to companies and individuals investing in occupational schemes which are summarised below: •
No Schedule E benefit in kind for employer contributions.
•
The employee receives tax relief on contributions under the net pay arrangement.
•
No NIC is due on employer contributions.
•
Additional Voluntary Contributions (AVCs) paid by employees up to 15% of emoluments are tax deductible.
•
Fund grows tax free (NB tax credits on dividends not repayable with effect from the 1 July 1997).
•
Tax free lump sum available up to 1.5 times final salary subject to earnings cap restriction (or max £150,000 for post 17 March 1987 schemes).
•
The employer obtains tax relief for normal contributions actually paid during its accounting period. Relief for special contributions below £500,000 is given in full in the year of payment. Special contributions in excess of this are subject to the ‘spreading’ provisions as follows: Level of contribution
Period of ‘spreading’
£500,000 to £1m
Two years
£1m to £2m
Three years
£2m and above
Four years
Funded unapproved retirement benefit schemes (FURBS) Robert Argles of tax counsel concluded his review of FURBS by stating that they still enjoy a number of clear-cut advantages: •
The benefits payable and the nature of those benefits can be made substantially to exceed those payable under an approved scheme.
•
The nature of the investments in which the trustees reinvest their funds is unrestricted.
•
Chargeable gains accruing to the non-resident trustees of the scheme will escape UK capital gains tax. In his opinion, neither s.86 nor s.87 TCGA 1992 applies to such gains.
•
The income accruing to the trustee of the scheme will in most cases be limited to the lower rate of tax.The trust rate in s.686 ICTA 1988 will not apply.
35
CHAPTER
2:
EXTRACTION
OF
PROFITS
FROM
THE
FAMILY
COMPANY
•
Except in the case of lump sums which become payable under the scheme to a member,or to the estate of a deceased member,the benefits under the scheme,or the potential for such benefits,escape any charge to IHT or any aggregation with the member’s estate for the purpose of computing the rate of such tax.The property in the scheme will not be charged in the hands of the scheme trustees.
•
Lump sums will escape the charge imposed by s.596A if, and so long as, the contributions to the scheme have been charged to tax as the Schedule E income of the scheme members and all income and gains have been charged to UK tax in the hands of the scheme trustees.
•
Any ordinary annual payments to the scheme trustees,whilst attracting a Schedule E charge in the hands of the employee, will in most cases be deductible in computing the profits of the trade or management expenses of the employer.
•
For periods up to the starting date of the new regulations, employers contributing to the scheme, and the members of the scheme, have a strongly arguable case that contributions to it by an employer,whether in respect of the individual employee or in respect of all the employees who are members of the firm, are not ‘earnings’ for NIC purposes.
Small self-administered pension schemes (SSAS) These schemes may be used for a small number of members.Trustees of the scheme are responsible for the management of the scheme investments subject to strict statutory requirements to prevent abuse of the funds. Scheme investments cannot include personal chattels such as yachts,vintage cars and gold bullion but can include shares, traded options and deposit accounts. Shareholdings however,cannot carry more than 30% of the voting power or entitlement to income in any one company.This applies to any unlisted company and not just the employer company. The trustees are prohibited from lending money to scheme members or selling/ leasing any asset to members or persons connected with them. The maximum loan back from a pension scheme to the employer cannot exceed 25% of the market value of the scheme’s assets in the first two years,or 50% thereafter. Loans must be made to fund the business activities of the employer and a commercial rate of interest must be charged.
36
CHAPTER
2:
EXTRACTION
OF
PROFITS
FROM
THE
FAMILY
COMPANY
Example Bodytones Limited is a family-owned company which runs two fitness studios on the South Coast. Their anticipated profit for the year-ended 31 March 2000 is £280,000. The company wishes to expand its operations and open a third site in Hove. The directors are considering using the company’s existing SSAS to purchase the building. The new site will cost approximately £150,000. What advice could be offered?
Solution a)
Company purchases the new premises £
Estimated profit
280,000
Less: corporation tax thereon at 20%
(56,000)
Retained profit
224,000
Less: cost of new premises Net cash surplus b)
(150,000) 74,000
SSAS purchases the new premises: £
Estimated profit Pension contribution – for example
280,000 (200,000)*
Taxable profit
80,000
Corporation tax at 20%
16,000
Retained profit: £(280,000 - 16,000) Less cost of new premises
264,000 (150,000) ––––––––––
Net cash surplus
114,000
It would be preferable for the SSAS to purchase the building due to the beneficial tax relief given to pension contributions. In addition the company would also benefit from a DI deduction for the rent paid on the premises which would not be taxable in the SSAS. * The SSAS would invest £50,000 in addition, in insurance policies in order to remain within the maximum self-investment funding limits.
37
CHAPTER
2:
EXTRACTION
OF
PROFITS
FROM
THE
FAMILY
COMPANY
Personal pension schemes (PPS) Personal pension schemes were introduced in July 1988 to replace the old retirement annuity plans. Personal pensions are available to the self-employed and any employee who is in an occupational scheme.It is possible to have a PPS as well as being a member of an occupational scheme if someone is employed and self-employed,or has two employments and is not in a company scheme in respect of one of them. The key tax advantages of a personal pension scheme are as follows: •
Contributions paid into the scheme by the policyholder are tax deductible.
•
Employed contributors may pay their contributions net of basic rate income tax.
•
An employer may also contribute into the scheme free of tax on the employee.
•
The fund rolls up tax free.
•
A tax free lump sum may be taken on retirement not exceeding 25% of the fund.
There are limits on the maximum contributions based on percentage of net relevant earnings (subject to an upper earnings cap).The percentages increase for older contributors.These overall limits apply to employer and employee contributions combined. Unused relief of the preceding six years may be utilised in the current year and it is also possible to elect to relate a premium back and treat it as though paid in the previous tax year.The election must be made by 31 January following the end of the tax year in which the premium is paid. The benefits on retirement will be dependent on the level of the fund which is used to purchase an annuity. Benefits can be taken between the ages of 50 and 75 and provision allow the phasing of the pension (e.g. to allow an employee to go into semi-retirement).
38
CHAPTER
2:
EXTRACTION
OF
PROFITS
FROM
THE
FAMILY
COMPANY
Retirement annuity schemes These are the predecessor of personal pension schemes. No new RAPs can be taken out after 1 July 1988 but persons holding an RAP can continue to make contributions. The main differences between an RAP and a PPS are as follows: •
RAPs do not have an earnings cap imposed when calculating maximum contributions.
•
The earnings percentages are lower for RAPs in respect of older contributors.
•
All contributions must be paid gross, i.e. employees cannot pay net of basic rate tax.
•
Employers cannot pay into an RAP.
•
Pension benefits can be drawn between ages 60 and 75;
•
The maximum tax free lump sum is restricted to three times the pension payable.
Planning points The recurring theme of this chapter is that the advantages offered by extraction of funds via dividends, interest and rent is the saving of national insurance by both the owner(s) and the company. However, this is, to a large extent, outweighed by the disadvantage that these sources of income do not enable pension contributions to be paid in respect of them. With regard to personal pension provision the amount that can be contributed is directly related to ‘net relevant earnings’ which effectively only includes nonpensionable Schedule E for the owners of a family company.With regard to company pension provision the amount of the final pension is directly related to final salary. This is usually calculated by taking an average of the three highest years salary (including bonuses) in the ten years leading up to retirement. Therefore, owners are in effect forced to pay themselves Schedule E income in order to allow them to save for their retirement. Many directors of small private companies often pay themselves larger bonuses in the three years leading up to retirement in order to maximise their pension and contributions. It is important to discuss proprietor’s pension provision with them where they are approaching retirement, in order to establish whether further bonuses are required and/or the need for a special contribution to top up the company scheme. It is also important to review their previous years salary and bonuses to see whether
39
CHAPTER
2:
EXTRACTION
OF
PROFITS
FROM
THE
FAMILY
COMPANY
they have already established a suitable level of emoluments to provide them with the pension they desire.Where this is the case it may then be better to switch from bonuses to dividends in order to save NIC in the future. Equally,on a business or company start-up it is also important to review previous earnings patterns.
Example Daniel is aged 30 and has worked for a computer software house for the last ten years. His net emoluments in recent years have been approaching £45,000. He is not a member of his employer’s pension scheme. In July 1999 he decides to ‘take the plunge’ and sets up a limited company and trades as a computer consultant. His anticipated earnings are likely to exceed £60,000 per annum. Daniel has paid modest pension contributions of £200 per month (gross) in recent years into a personal pension plan. Daniel wishes to increase his pension contributions to £500 per month (gross), but at the same time withdraw as much income from the company as possible without paying NIC. Can he achieve his aims?
Solution Assuming Daniel has earned on average £40,000 p.a. for the last six years his current unused personal pension relief is as follows: £ £40,000 x 17.5% x 6 = Premiums paid: £(200 x 12) x 6 =
42,000 (14,400) 27,600
He could therefore pay contributions of £500 per month using up his brought forward relief, provided he withdraws a salary from the company of £6,000, as the maximum relief an individual may claim in any tax year for pension premiums paid cannot exceed the year’s net relevant earnings. This pattern could continue for more than seven years. By which time he is likely to wish to review his pension arrangements again. Note that the company is allowed to pay into Daniel’s personal scheme but only up to the level of his relief for the current year, i.e. the company could contribute £1,050 (£6,000 x 17.5%).
40
CHAPTER
2:
EXTRACTION
OF
PROFITS
FROM
THE
FAMILY
COMPANY
Most banks and building societies will recognise regular dividends from an owner managed company as income for mortgage or other loan purposes.This takes away another potential drawback of extraction of funds in the form of investment income.
41
One man service company INTRODUCTION ENGINEERJOB.COM I L L U S T R AT I V E E X A M P L E S THE CURRENT POSITION HUSBAND AND WIFE ARRANGEMENTS ACTION NOW
chapter
3
Chapter 3: One man service company
Introduction In its budget day press release,IR35,the Inland Revenue announced plans to counter the use of service companies and partnerships in order to save tax and national insurance.It is intended that the new provisions will be aimed specifically at ‘consultants’who provide services to one contractor where in normal circumstances they would be on the payroll. Consultants who were previously employees of their main contractor will be particularly exposed. The aim of the proposed legislation is to ensure that such individuals pay the same amount of tax and national insurance as they would if they were an employee. IR35 states that the Inland Revenue will be discussing the matter with representative bodies with a view to legislation being introduced to take effect from 6 April 2000.
Engineerjob.com On 23 April 1999 the Inland Revenue issued their first discussion document. The Revenue have issued a discussion document to representative bodies on the proposed new rules on the use of personal service companies. The document states that the purpose of the new rules is to remove opportunities for the avoidance of tax and Class 1 NICs,which can arise where an engagement is routed through an intermediary. The new rules will apply where: •
a worker holds an office with, or performs services for, a client who has a right of supervision, direction or control as to the tasks undertaken, or the manner in which they are performed; and
•
the worker or the services are provided under a contract between the client and an intermediary (e.g. a service company, or a partnership of which the worker is a member).
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SERVICE
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They will not apply where: •
the worker’s services are supplied incidentally to the supply of materials and/or equipment (e.g.where a lorry and driver are supplied together); or
•
where the client is an individual not in business (e.g.services for a household); or
•
an engagement is ‘exempt’ i.e. any remuneration paid by the intermediary to the worker will be in a form that is subject to tax and NICs, and the intermediary accounts fully for PAYE and NICs.
An intermediary will be able to obtain an exemption certificate from the Revenue, in return for an undertaking to pay workers only in a form chargeable under Schedule E and to NICs. A self-certification procedure could apply, with a public register of certified intermediaries. Where a particular engagement is not covered by an exemption certificate, the worker will (for the purposes of tax and NICs only) be deemed to be an employee of the client.The client will account for PAYE/NIC.The gross amount will be included in the service company’s taxable receipts; income tax and NICs deducted will be treated as an allowable expense.Where the intermediary is a partnership and the worker is a partner, the partnership will exclude amounts received net of tax/NICs when calculating profits. The worker will be subject to tax and NIC on remuneration from the deemed employment and will be able to deduct expenses allowable under the general Schedule E rules.The worker will then be able to receive a salary free of tax/NIC from the intermediary (within a fixed time limit) up to the amount of net payments received by the intermediary. The document, which the Revenue insist is for discussion rather than consultation, contains twelve examples illustrating the effect of the proposed new rules.
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3:
ONE
MAN
SERVICE
COMPANY
Illustrative examples The following illustrations are included in the Revenue’s document.They are not designed to represent the facts of existing relationships and are not intended to serve as guidance. A draughtsman has for some years been employed by an engineering firm.To reduce his tax/NICs liability and to reduce his employer’s costs,the draughtsman’s contract of employment is terminated on 28 February and he is re-engaged on 1 March to do the same work on similar terms via a personal service company. The draughtsman is subject to ongoing control as to what tasks he undertakes and how they are carried out.This arrangement should be caught by the new rules. A doctor comes to work in the UK for two years.She is engaged by a private hospital through a UK service company. The consultant in charge directs the doctor as to what work she should do, has ultimate clinical responsibility for the patients and can supervise the doctor in the performance of her duties.This arrangement should be caught by the new rules. A rugby club engages a player through his own service company. If the engagement had been direct the player would have been an employee.The club can control what the player does e.g.they can say in which matches he plays and tell him what training sessions to attend.This arrangement should be caught by the new rules. A local council engages a firm of architects to design a new civic centre.Within the terms of the contract the architects must provide three different designs within an overall budget.There is a minimum requirement for office space, amenities, public areas etc.The designs must be completed within a fixed timescale.The contract details the work to be carried out,timing,specification etc.These issues are agreed at the outset and the council do not subsequently have the right to tell the firm what tasks are to be undertaken e.g. they cannot tell them to design something different without amending the contract. Beyond the contract specification, the council has no control over how the firm carries out the work.The new rules should not apply here. A jeweller’s shop engages a window cleaner to clean the shop windows twice a week before opening time on a Wednesday and a Saturday morning.The window cleaner operates through his own company. Here the initial agreement would specify exactly what was required. Although payment would not be made for unsatisfactory work,there would be no question of the shop owner telling the window cleaner how to clean the windows or telling him, for example, to go and clean the windows at his home address instead.The new rules should not apply here. A large insurance company has set up a call centre to deal with its car insurance business.It engages a health consultant to give talks to all the call centre operates
45
CHAPTER
3:
ONE
MAN
SERVICE
COMPANY
about back care and ergonomics.The consultant,who operates through her own company, is engaged to give ten, three hour workshops.The insurance company is relying on the consultant’s expertise and cannot tell the consultant how to do the work.The contract specifies exactly what is to be done (i.e. ten workshops) and the insurance company cannot tell the consultant to do something else instead (e.g. to provide treatment for those with existing back problems).The new rules should not apply here. A school hires a coach with driver from a local coach firm to take a class on a two week field trip.The provision of the driver is incidental to the hire of the coach.The new rules should not apply here. An IT engineer employed by a medium sized manufacturing company decides to ‘go it alone’ – leaving employment to set up his own IT consultancy. A few weeks later the former employer engages the consultant to undertake a millennium bug health check on all the company’s computer systems.The consultant negotiates a fixed fee for providing a specific service to a pre-determined deadline. The company has no ongoing right of direction or control over what is done or how it is done.The new rules should not apply here. A travel company has had a new computer system installed.The company hires an IT consultant to supply additional technical support and training for staff in the use of the new system.The consultant is taken on for a period of three months to undertake tasks as directed on a day-to-day basis by the IT manager.The new rules apply here. The ‘head chef’ at a small hotel is engaged through her own personal service company.The hotel cannot tell the chef ‘how’ to cook the food but it is able to veto menus suggested by the chef and can,for example,tell her to lay on a special buffet on a particular day, arrange a special themed menu for a particular night or produce special children’s meals for a particular group of guests.The arrangement should be caught by the new rules. A vet in partnership spends every Monday working at the local zoo attending various animals as required by their keepers and undertaking other duties (e.g. performing postmortems,preparing animals for transit,supervising inseminations and providing training on various animal health matters) as directed by the headkeeper.The zoo pays the partnership an annual fee for the vets attendance each Monday.This engagement should be caught by the new rules.However,members of the partnership are sometimes requested to attend animals at other times – for example, when one injures itself in the middle of the night. Such visits are outside the terms of the annual contract and a fee is charged appropriate to the work done. On these occasions the zoo has no right of direction or control over what is done or how it is done.The zoo may reject advice given or refuse treat-
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CHAPTER
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SERVICE
COMPANY
ment recommended but this would not amount to a right or direction or control. In these cases the new rules should not apply.
The current position The Government has announced that it will press ahead with measures to prevent avoidance of PAYE and NIC using personal service companies.However,a number of changes have been made to the original proposals. Under the revised proposals, the existing tests will be used to determine the boundary between employment and self-employment – the alternative test has been dropped. Also, responsibility for applying PAYE and NICs will rest with the intermediaries rather than with the ‘client’. The detailed proposals, to take effect from April 2000, are that: •
the new rules will apply to ‘relevant engagements’ where a worker provides services under a contract between a client and an intermediary in circumstances where the income would have been taxed under Schedule E, were it not for the presence of the intermediary;
•
the client will not be responsible for the operation of PAYE and will not need to check whether the new rules apply; there will be no certification scheme;
•
the intermediary company will operate PAYE and pay NICs on payments of salary to the worker in the usual way;
•
if,at the end of the tax year,the company’s income from relevant engagements exceeds the amount paid out as salary,the excess,net of expenses, will be deemed to have been paid on 5 April and the company will be required to account for tax/NICs;
•
where the intermediary is a partnership,the income of the partnership from relevant engagements, net of expenses, will be deemed to have been paid to the worker on 5 April as salary from a deemed employment; it will be excluded when computing the worker’s share of the partnership profits;
•
expenses which will be allowable in computing any deemed payment will be those which would otherwise qualify under s.198,any employer pension contributions which are allowable under normal rules, any employer NICs and a further flat rate of 5% of the gross payment from a relevant contract to cover miscellaneous expenses such as the running costs of the intermediary.
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The Revenue has produced draft guidance on the application of employment status rules in typical service company situations in the IT and engineering industry. The objective of the guidance is to allow as many people as possible to determine whether they are likely to be affected by the new legislation without having to ask for a formal ruling. The guidance emphasises that the status rules will apply to people working through service companies in exactly the same way as they are currently applied to people working directly for clients. One of the central questions in deciding whether the new rules apply to an engagement is whether the worker would have been an employee of the client if engaged directly. The guidance reviews the factors identified by the Courts which help to determine whether a particular contract is a ‘contract of service’ (employment) or a ‘contract for services’ (self-employment). Relevant factors considered are: •
control;
•
the right to get a substitute or helper to do the job;
•
provision of equipment;
•
financial risk;
•
basis of payment;
•
opportunity to profit from sound management;
•
part and parcel of the organisation;
•
right of dismissal;
•
employee benefits;
•
length of engagement;
•
personal factors;
•
intention.
The approach is then to evaluate the overall effect. ‘In order to decide whether a person carries on a business on his own account it is necessary to consider many different aspects of the person’s work activity. This is not a mechanical exercise of running through a checklist to see whether they are present in, or absent from, a given situation...It is a matter of evaluation of the overall effect, which is not necessarily the same as the sum total of all the individual details. Not all details are of equal weight or importance in any given situation.The details may also vary in importance from one situation to another’. (Mummery J in Hall v Lorimer)
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CHAPTER
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ONE
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SERVICE
COMPANY
The guidance states that,when the detailed facts have been established,the right approach is to stand back and look at the picture as a whole. If the evidence is evenly balanced the intention of the parties may then decide the issue.
Husband and wife arrangements The Revenue have provided detailed guidance on the scope of the new rules on personal service companies which take effect from 6 April 2000.The information is in the form of a series of questions and answers available on the Revenue’s web site. One of the answers gives a numerical illustration: Mr A and Mrs A work through a service company, B Ltd, in which they own all the shares. B Ltd receives £20,000 in respect of relevant engagements for Mr A and £40,000 in respect of relevant engagements for Mrs A. A further £40,000 income is received from other business activities which do not fall within the new rules. Both Mr A and Mrs A are paid salaries of £20,000 during the year on which PAYE and NICs are accounted for under the normal rules.Employer’s NICs are 2 x £1,913. Travel costs related to relevant engagements, which would be deductible under Schedule E,are £2,000 for Mr A and £500 for Mrs A. B Ltd incurs £10,000 business expenses and makes a contribution to a pension scheme of £4,000 in respect of Mr A and £4,000 in respect of Mrs A. PAYE and NICs will be payable on a deemed payment on the last day of the tax year, as follows: Mr A Mrs A Income from relevant contracts
£
£
20,000
40,000
Less: Expenses
(2,000)
(500)
Employer NICs paid in year
(1,913)
(1,913)
Pension contributions
(4,000)
(4,000)
5% of relevant contract income
(1,000)
(2,000)
11,087
31,587
(20,000)
(20,000)
Deduct: Salary paid in year
No deemed payment
11,587
Employer’s NIC on deemed payment
(1,260)
Deemed payment to Mrs A
10,327
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CHAPTER
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ONE
MAN
SERVICE
COMPANY
B Ltd – Corporation tax computation Turnover
100,000
Less: Salaries, including deemed payment
(50,327)
Employer’s NICs including deemed payment
(5,086)
Pension contributions
(8,000)
Expenses
(12,500)
PCTCT
£24,087
(www.inlandrevenue.gov.uk/ir35/faqs6.htm)
Action now The budget day press release,IR35,made it clear that the new rules will not seek to redefine the current boundaries between employment and self-employment. Therefore,each situation must be carefully reviewed to determine possible genuine self-employed status. Action that such consultants can take to demonstrate this includes: •
Seeking new contracts with other parties
•
Entering into new contracts which allows the consultant to send a substitute in their place.
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CHAPTER
3:
ONE
MAN
SERVICE
COMPANY
Express and Echo Publications Ltd V Tanton (1999)
Background Mr Tanton (T) was an employee of EP Ltd when he was made redundant in 1995. He was subsequently taken on as a driver under an ‘agreement for services’ which provided in clause 3.3 that: ‘in the event that the contractor is unable or unwilling to perform the services personally he shall arrange at his own expense entirely for another suitable person to perform the services’. An industrial tribunal decided that T was an employee within the meaning of s.230 of the Employment Rights Act 1996 and this was upheld by the Employment Appeal Tribunal. EP Ltd appealed to the Court of Appeal.
Decision Peter Gibson LJ referred to Clark v Oxfordshire Health Authority where it was held that an irreducible minimum of obligation was necessary to create a contract of employment. The law recognised that a contract of employment involved mutual trust and confidence. It was established that where a person who worked for another was not required to provide those services personally, it could not be right as a matter of law that the relationship between the worker and the person for whom he worked, was that of employee and employer. Clause 3.3, in not requiring T to perform any services personally, was a provision wholly inconsistent with the contract being a contract of service. The only conclusion which could properly be reached was that the contract was one for services. EP Ltd’s appeal was allowed.
51
Expanding and structuring the business INTRODUCTION C O R P O R AT E S T R U C T U R E S C A P I TA L G A I N S P L A N N I N G
chapter
4
Chapter 4: Expanding and structuring the business
Introduction Once a successful business has been established and expansion is being considered, it is important to plan carefully the method by which expansion will take place and to determine the most appropriate structure. Each individual situation needs to be considered on the basis of the requirements at that time. This chapter aims to highlight the key aspects of each of the main business/corporate structures and to also identify the need for careful capital gains tax planning following the Finance Act 1998.
Corporate structures Group structure Expanding operations by trading through a group of companies can be done by either: •
retain the assets in the parent company and hive down the trade to a subsidiary company under the provisions of section 343 of ICTA 1988 or,
•
keep assets and the trades within different subsidiaries.
The setting up of a trading group can have a number of advantages, namely: •
it is easier to give status to a key employee by appointing him director of a subsidiary company;
•
group relief of losses is available;
•
assets may be transferred between the group without giving rise to a charge to tax;
•
group wide rollover relief may be claimed;
•
group income and charges elections may be made.
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CHAPTER
4:
EXPANDING
AND
STRUCTURING
THE
BUSINESS
However,there are also a number of disadvantages that must be considered,particularly where the parent company or subsidiaries are to be sold. Where the parent company is sold then the group could either: •
sell the group and then buy back the required subsidiaries;
•
reconstruct the group which would need tax clearances and would cause delays, or
•
sell assets
Where a subsidiary is sold this could give rise to a capital gain.Therefore,no reliefs are available.
Parallel companies The main advantage of a parallel structure is that it allows the proprietor(s) to spread the value of their assets for capital gains tax and IHT purposes.Consequently, they may sell or gift particular companies over a period,thus utilising various capital gains tax reliefs (annual exemption, capital losses brought forward or Enterprise Investment Scheme reinvestment relief etc.).The entrepreneur would be free to choose which companies to sell and when, providing much greater flexibility. In addition,a parallel structure does have the benefit over a group structure,that proceeds received on the sale of a particular company go directly to the owners as capital,rather than being received by a group holding company creating problems of tax efficient extraction of any gains.
Divisions The main advantage of a divisional structure is the fact that the full amount of the small companies tax bands will be available,rather than being divided among all companies under common control. The other advantages are: •
automatic set-off of losses in respect of the various divisions;
•
automatic set-off of capital gains and losses;
•
administration is simplified.
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EXPANDING
AND
STRUCTURING
THE
BUSINESS
On the other hand, the disadvantages include: •
lack of incentive for divisional directors;
•
difficulty in giving equity interest in a venture (but may consider profitrelated bonuses);
•
it may be difficult to find a prospective purchaser for the whole company;
•
grouped profits can decrease the possibility of making optimum use of the small company’s rate of tax.
Example Sumner Limited carries on two trades through two separate divisions. The furniture production division makes profits of £1.35m in the year to 31 March 2000. The antique furniture restoration division makes profits of £150,000 in the same year.
Solution Sumner Limited will pay tax of £450,000 (i.e. £1,500,000 x 30%). If the company were to operate the trades through two separate companies the tax payable would be: £1,350,000 x 30% = £150,000 x 20% = Total
£405,000 £30,000 £435,000
This creates a tax saving of £15,000 (i.e. £150,000 x 10%) as part of the profit utilises the small company’s rate.
It may be worthwhile setting up a subsidiary company where it is possible to channel £150,000 profit into it.
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CHAPTER
4:
EXPANDING
AND
STRUCTURING
THE
BUSINESS
Capital gains planning When a trader or a company wishes to expand its operations by moving into bigger premises,it is possible to rollover the gain on the sale of the old building by deducting from the base cost of the new (S.152 TCGA 1992). Following the abolition of indexation allowance as at 5 April 1998 and the introduction of the new tapering relief rules applicable to individuals it may be preferable for a sole trader or partnership to expand by extending existing premises rather than moving to a new site.The reason for this is because it is the untapered gain that is rolled over and therefore the ownership period of the old asset after 5 April 1998 (and the bonus tapering relief year) is effectively lost.
Example Silas bought the freehold of an office block on 14 October 1992 for £170,000. He sold it on 29 January 1999 for £550,000 and purchased new larger premises for £650,000 around the corner. Assuming that Silas expects to sell the new premises in August 2003 for £1m what is the expected chargeable gain?
Solution With rollover claim: £ Old premises Proceeds Cost
550,000 (170,000) 380,000
Indexation to 5 April 1998 at 0.162
(27,540)
Gain rolled over
352,460
New premises Sales proceeds Cost: £(650,000 - 352,460)
1,000,000 (297,540) 702,460
Taper relief - 30%* Chargeable gain - 70%
(210,738) 491,722
* Four complete years of ownership from 29 January 1999 to 8 August 2003
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EXPANDING
AND
STRUCTURING
THE
BUSINESS
Under the tapering relief rules the enhancement expenditure on an asset is deemed to have taken place when the asset was originally acquired and therefore the whole gain will be eligible for tapering relief, including the ‘bonus year’ for assets held on 17 March 1998.
Example Assume in the last example that Silas was able to expand his existing office block by spending £100,000. The premises will still be sold in August 2003 for £1m.
Solution £ Proceeds Cost: £ (170,000 + 100,000)
1,000,000 (270,000) 730,000
Indexation on cost up to 5 April 1998
(27,540) 702,460
Taper relief on full gain - 45%* Chargeable gain - 55%
(316,107) 386,353
* Five complete years of ownership from 6 April 1998 plus the bonus year.
A trader that moves premises to expand and makes successive rollover relief claims could end up with no taper relief whereas a trader that expands by extending his site can ensure a taper relief of up to 75% of gains, making his effective tax rate only 10% (i.e. 25% x 40%).
57
Exit routes INTRODUCTION C A P I TA L G A I N S TA X P L A N N I N G I N H E R I TA N C E TA X P L A N N I N G PRE-SALE TRANSACTIONS
chapter
5
Chapter 5: Exit routes
Introduction This is probably the biggest area that a professional adviser is asked to deal with in tax planning for an owner managed business. In many family run enterprises it is difficult to decide how the future running of the business should be governed,particularly where the older generation are reluctant to relinquish control and/or the younger generation are battling among themselves as to the best person to be in charge.This is where the adviser should keep in the background until the various parties have come to a decision. Once this has been done it is then down to us to ensure the proposals are actioned in the most tax efficient manner. Modification of the original plans may be necessary and it is therefore paramount that all interested parties are kept informed at all times to ensure continuing good relations with the new personalties. This chapter will explore the key tax implications of passing on and selling the family business or company and suggest useful planning tips to help structure the business in the most efficient manner from the outset.The planning issues arising from the changes to capital gains tax contained in Finance Act 1998 will also be examined.
Capital gains tax planning Regardless as to whether the business or company is to be sold or passed down to the next generation, a capital gain is likely to arise. It is therefore essential to maximise the reliefs available to either permanently reduce or defer the gain.
Retirement relief Retirement relief is the most valuable of all the reliefs available as it exempts the gain rather than simply deferring it by a rollover into the base cost of assets. To claim retirement relief the claimant must be aged at least 50, or if younger, retiring on grounds of ill health.This definition is very strict in that the individual must be permanently incapable of carrying on his job due to the illness.
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EXIT
ROUTES
To obtain maximum relief the claimant must have a qualifying period of at least ten years: •
For a sole trader or partner the period refers to the length of time they have owned the business or partnership.
•
For shares in a family company the period is measured as the length of time the company has been the claimant’s personal trading company (the claimant must own at least 5% of the share capital for it to be his personal company); and the claimant has been a full-time working officer or employee of the company devoting substantially the whole of his time to the service of the company.
A problem has been highlighted in a recent case. A taxpayer had operated his business through both a limited company and a sole tradership.He spent on average 37.5 hours of his week working for the company and an additional 7.5 hours per week as a sole trader. It was held by the High Court that ‘substantially’ the whole of the time means at least 90% of total working time and 83% was not sufficient. Retirement relief was denied on the sale of the shares.However,this was overturned by the Court of Appeal who felt that 37.5 hours per week on its own was sufficient as a full time employee.The fact that he also had another business did not deny retirement relief. The gain eligible for retirement relief on the disposal of shares is restricted where the company owns chargeable assets that are not used for trading purposes,such as an investment property or shares in another company.The qualifying gain is calculated as follows: Chargeable gain x
Value of chargeable business assets Value of all chargeable assets
The values are taken at the date the shares are sold. Agreements may need to be reached with the district valuer. For the sale of a business the qualifying gain is calculated by adding the gains together on all chargeable assets used in the business. The maximum retirement relief claimable for disposals up to 5 April 1999 is 100% on the first £250,000 of qualifying gains and 50% on gains between £250,001 and £1,000,000.
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However, retirement relief is being phased out over the next five years and the limits will be reduced as follows: Tax year of disposal
100% band £
50% band £
Maximum relief £
1998/99
250,000
1,000,000
625,000
1999/00
200,000
800,000
500,000
2000/01
150,000
600,000
375,000
2001/02
100,000
400,000
250,000
2002/03
50,000
200,000
125,000
Where the claimant’s qualifying period is below the ten years these limits are time apportioned accordingly.
Example Frank has been in in business since 1 April 1993. He will be retiring on 31 December 2000. His anticipated gain is £300,000. How much retirement relief will he be entitled to?
Solution Limits for 2000/01:
£150,000 x 7 9/12 = £116,250 10 £600,000 x 7 9/12 = £465,000 10 £
Retirement relief: £116,250 x 100% =
116,250
£(300,000 - 116,250) x 50% = 91,875 208,125
Given that the relief is being phased out, individuals who are over the age of 50 may consider taking action in 1998/99 in order to crystalise gains eligible for retirement relief.This may be achieved by: •
sale of the business or shares to a third party;
•
passing the business or company onto the next generation;
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•
settling the shares in a personal trading company into a life interest trust for the benefit of the settlor and family.Note that any gains not covered by retirement relief will be eligible for gift relief;
•
incorporating the business or partnership.The Revenue accept that retirement relief is given in priority to incorporation relief.
ROUTES
Retirement relief planning Example Jeremy who is a higher rate taxpayer plans to sell all the shares in his trading company, Willoughby Limited, for £600,000 in 1999/00. He set the company up approximately 15 years ago and the shares have a negligible base cost for capital gains tax purposes. Jeremy is eligible for full retirement relief. The first £200,000 of the gain is covered by 100% retirement relief and the balance of £400,000 is reduced to £200,000 before taper relief. Taper relief for two years is applicable as the shares qualify as business assets. This reduces the gain to 85% resulting in a taxable gain of £170,000 and tax payable of £68,000. Is there a way of reducing the tax liability still further?
Solution Jeremy can save a substantial amount of tax if, before the sale, he gifts the shares into an ‘interest in possession’ trust and is a potential beneficiary of capital. The gain not covered by retirement relief is £200,000, this can be held over under s.165 TCGA 1992. The base cost of the shares to the trustees therefore becomes £(600,000 - 200,000) i.e. £400,000. The trustees then sell the shares for £600,000, realising a further gain of £200,000. This too is eligible for retirement relief by virtue of s.164(3) and para 15, Sch 6 as Jeremy has only used up £600,000 of his retirement relief. The trustees’ gain is therefore eligible for 50% retirement relief reducing the gain to £100,000 and a tax charge of £40,000 will apply. This would be payable by Jeremy as settlor with a right of recovery from the trustees. The end result is a tax saving of £28,000. There would, of course, need to be a respectable gap between the setting up of the trust and the sale of the shares in order to avoid an attack by the Revenue under the Ramsay principle.
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Business taper relief From 6 April 1998 indexation allowance has been replaced with the new tapering relief rules.The rate of taper on business assets is higher than that for non-business assets as can be shown from the chart given below: No. of whole years in qualifying period
Tapering relief Business
Non-business
1
7.5%
Nil
2
15%
Nil
3
22.5%
5%
4
30%
10%
5
37.5%
15%
6
45%
20%
7
52.5%
25%
8
60%
30%
9
67.5%
35%
75%
40%
10
Tapering relief applies to the gain after indexation allowance has been deducted up to 5 April 1998. Consequently, the new rules may be good news for businesses that have a high level of self-generated goodwill, as indexation allowance is often not very useful in reducing the gain as it is applied to the cost, which is often negligible. The definition of business assets for tapering relief purposes is not as strict as the definition required for retirement relief.The main differences are given below: •
For business taper relief on shares the individual must either: –
own at least 25% of the voting rights, or,
–
hold at least 5% and be a full-time working officer or employee.
•
Retirement relief is restricted where rent is charged to the company for assets held personally. Provided the assets are used for business purposes by the individual’s personal company or partnership,business tapering relief may be claimed.
•
To claim retirement relief on assets held personally the disposal of the asset must be associated with the disposal of the business interest (i.e. be roughly at the same time).This does not apply to business taper relief.
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•
Retirement relief is only given for the material disposal of business assets. In other words the individual must be disposing of substantially all of his business interest.Business taper simply applies to individual business assets.
•
Retirement relief can only be claimed by persons aged over 50.This does not apply to business taper relief.
ROUTES
The length of the qualifying period for tapering relief purposes is determined by the use of the asset by the claimant.This has a number of implications for assets transferred between husband and wife. Transfers between spouses Where an asset,other than shares,has been transferred at no gain/no loss between spouses it can qualify at any time for business assets taper,depending on the extent to which the asset satisfies the business use tests during the combined period of ownership. It is necessary to review both the period during which the asset was held by the transferee spouse and the period during which it was held by the transferring spouse.For the period following the no gain/no loss transfer the asset will be a business asset at any time if one of the business asset tests is satisfied by the transferee spouse. For the period before the transfer, the asset will be a business asset at any time if one of the tests can be satisfied by either of the spouses.
Example An asset other than shares is used in a trade carried on by Mr A, but is owned by Mrs A. Mrs A transfers the asset to Mr A at no gain/no loss. If he makes a disposal of the asset it will be a business asset throughout the relevant period of ownership, both before and after the no gain/no loss transfer, because of the business use by Mr A.
Different rules apply if the asset disposed of by the transferee spouse consists of shares.For shares to qualify as a business asset it is necessary to determine whether the company was the qualifying company of the transferee spouse throughout the whole of the period of ownership falling after 5 April 1998. If the company was not the qualifying company of the transferee spouse throughout the whole period of ownership, the gain should be apportioned.
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Example Mr and Mrs T are both full-time working employees of a trading company where Mr T can exercise 3% and Mrs T 6% of the voting rights in the company. Mr T transfers his 3% interest in the company to Mrs T. Business assets status is secured for all of the shares from the time at which Mrs T, as a full-time working employee, held more than 5% of the voting rights in the company. This is because the company was already a qualifying company for Mrs T due to her existing 6% holding. Therefore, any disposal of shares in the company by her will be a disposal of a business asset from the time she had the necessary holding. If Mrs T were to transfer her 6% interest to Mr T, the benefit of Mrs T’s pre-transfer holding of greater than 5% would be lost. For the period prior to transfer, Mr T would only qualify for the non-business taper, even though he would be assessed on the whole gain arising on a holding of 9% for the entire period.
Under the retirement relief rules it was common practice to transfer the shareholding of a non-working spouse to the working spouse prior to retirement in order to maximise the gain covered by the relief. Provided the working spouse owned at least 5% of the shares for ten years prior to the inter-spouse transfer, full relief was given on his total holding on retirement as he has a qualifying period. However, under the taper relief rules as long as the non-working spouse owns at least 25% of the share capital, the shares will qualify for business taper.There, would therefore,be no need to transfer the shares prior to retirement of the working spouse. The business taper regime requires us to look at, not just the ownership period of each spouse, but also the nature of each spouses’ ownership.
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Example Walter owns 90% of Rooke Limited, an unquoted trading company. The remaining 10% are owned by his wife Margaret. Margaret does not work for the company and has no intention of so doing. Walter is considering transferring a further 15% of the shares to Margaret. What effect will this have on the availability of business taper relief?
Solution As matters currently stand Margaret’s shares do not qualify for business taper relief as she is non-working and owns below 25%. However, if Walter were to transfer 15% to her this would increase her holding to 25%. The 15% holding transferred would clearly qualify for business taper from the date they were acquired by Walter. Margaret’s original 10% holding would qualify for business taper from the date of the inter-spouse transfer. The legislation is not clear as to whether the 10% would also qualify for business taper from the date she acquired them, as she now owns a ‘business asset.’ The logic of tapering relief rules would imply not, but we await the Revenue’s interpretation in due course.
The Revenue’s 80-page guide ‘Capital Gains Tax Reform:The Finance Act 1998’ contains a number of useful examples on the application of taper relief. Investments The mere existence of investments does not necessarily mean that there is a business of making investments for the purposes of the anti-avoidance rules in para 11. The Revenue would not, for example, regard the following in themselves as amounting to a business of making investments where they are carried out by a trading company: •
using surplus profits to invest in listed shares or securities where there is a reasonable possibility that those funds may be needed to meet trading requirements, including major expansion;
•
letting part of the trading premises;
•
letting properties that are no longer required for the purposes of the trade, where the long-term objective is to sell those properties;
•
subletting property where it would be impractical to assign or surrender the lease.
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Taper relief planning Para 11 Sch 20 Finance Act 1998 contains a nasty trap in the application of taper relief.In certain circumstances,the period of ownership of shares may be deemed to have begun at a later date for taper relief purposes, than the acquisition date used in computing the gain.The problem arises where a ‘relevant change’ takes place, which means that the period of ownership for taper relief is dated from the change.
Example Mark owns all the shares in Nicholls Limited and has done so since 1981. Assume that the trade ceases on 6 April 2003. The gain Mark is likely to realise on sale of the shares is expected to be £800,000. What will be the taxable gain if: a)
He sells the shares on 6 April 2003?
b)
The shares are retained until 6 April 2005 and the company is then liquidated?
Solution If he sells the shares on 6 April 2003, the whole gain will be eligible for business taper based on an ownership period post 5 April 1998, plus the ‘bonus’ year i.e. a total of six years. The chargeable gain will therefore be £800,000 x 55% = £440,000. If the company is liquidated on 6 April 2005 the disposal is treated as two separate assets, a business asset held for five years (post 5 April 1998) and a non-business asset held for two years as the company was dormant. The taper relief rates applying would be for an eight year ownership period as the bonus year will still be given. The gain would become: £ Business assets £800,000 x 5/7 = £571,429 x 40% =
228,572
Non-business asset £800,000 x 2/7 = £228,571 x 70%
160,000
Chargeable gain
388,572
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There is therefore some advantage in retaining the shares in order to build up more years of business taper relief,even though some of the gain will only qualify for non-business taper. However,care needs to be taken.If Nicholls Limited did not become dormant after ceasing to trade on 6 April 2003 but instead let out surplus properties and invested its surplus cash it would become an investment company. The move from trading company to investment company is a ‘relevant change’ within para 11 and the business period from 6 April 1998 to 6 April 2003 will be lost.
Example What would be Mark’s gain if Nicholls Limited did become an investment company on 6 April 2003?
Solution The asset will be deemed to be acquired for taper relief purposes on 6 April 2003. A non-business asset held for less than three years does not qualify for any relief.
Care also needs to be taken where a company ceases to trade and a new trade is started some time later.This again will be treated as a para 11 ‘relevant change’ and business taper relief will start again on commencement of the second trading period.
Example Alice has a company which operates a nursing home between 1994 and 2000. The company then sells the nursing home and the original trade comes to an end. In May 2001 a new opportunity is identified and the company buys another nursing home and starts to trade again.
Solution Unfortunately, business taper relief will be lost from 6 April 1998 to 2000 (including the bonus year for assets held on 17 March 1998). A new business taper period will begin in May 2001. If Alice is likely to retain the new home for at least ten years this will not present a problem. However, if this is not the position she ought to consider purchasing the second home through a new limited company in order to preserve business taper in the old company.
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Interaction of retirement relief and business taper relief Retirement relief is claimed before tapering relief.Over the next ten years taxable gains will increase as retirement relief is phased out and will then gradually decrease as higher amounts of business taper relief are available. A person currently making a modest gain will be worse off under the new regime,whereas a person making higher gains will benefit as illustrated by the following table: Year of disposal
Gain of £250K
Gain of £1m
1998/99
Nil
346,875
1999/00
21,250
425,000
2000/01
38,750
484,375
2001/02
52,500
525,000
2002/03
78,125
546,875
2003/04
137,500
550,000
2004/05
118,750
475,000
2005/06
100,000
400,000
2006/07
81,250
325,000
2007/08
62,500
250,000
Consequently,individuals who are currently over the age of 50 ought to consider ways in which they can crystallise gains now in order to ensure entitlement to as much retirement relief as possible.Ways that this can be done include: •
Selling the business/company to a third party.
•
Transferring shares in a family trading company to a life interest trust for the benefit of the settlor and/or his family. Any gains remaining chargeable after retirement relief will be eligible for gift relief.
•
Incorporating a sole trade or partnership.Retirement relief takes priority to incorporation relief.
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Gift relief Where an asset is transferred by way of a bargain other than at arm’s length (such as by gift or sale at an undervalue) the disposal is deemed to have taken place at current market value. Gift relief is available to shelter a gain on the disposal of business assets transferred by way of gift or sale at an undervalue. In order to claim the relief the transferee must be either (S.165 TCGA 1992): •
a UK resident or ordinarily resident individual; or
•
trustees of a UK resident settlement; or
•
a UK resident company not controlled by non resident or ordinarily resident persons connected with the transferor.
A joint claim must be made by the transferor and transferee by 31 January in the sixth year of assessment, following the year in which the gift was made. To qualify for relief the assets transferred must be business assets as defined for retirement relief.In addition,gift relief is available on shares or securities of a trading company or the holding company of a trading group, provided the shares are unquoted (and not USM) or the company is the transferor’s personal company (S.260 TCGA 1992). Gift relief is also available where non-business assets are transferred by way of a chargeable lifetime transfer for inheritance tax purposes (e.g.a gift to a discretionary trust). Gift relief is restricted where a sale takes place at an undervalue.The amount of proceeds that exceed original cost (or 31.3.82 market value) are charged to tax immediately,with only the balance being eligible for rollover against the base cost of the asset to the transferee. It is the untapered gain that is rolled over and the transferee takes over the asset at its current market value less the gain held-over.
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Example Christine is the managing director of Perry Limited. She purchased her 90% holding in the company in February 1985 at a cost of £140,000. In December 1993 she gave all of her shares to her son, Nicholas and both elected that any eligible gains be held-over. The market value of the company’s assets in December 1993 and December 1999 were: 12/93 12/99 £
£
Goodwill
200
250
Freehold building*
320
400
Listed investments
50
70
Net current assets
40
80
610
800
80% of the building is used for the purposes of the company’s trade and 20% of it is let to an unconnected trader. Nicholas sells his shares for their market value in December 1999.
Solution The gains arising are as follows: December 1993 £000 Market value of shares 12/93 £610,000 x 90% Cost 2/85
549 (140)
Indexation at 0.543
(76)
Indexed gain
333
Gain eligible for gift relief: 200 + (80% x 320) x £333,000 200 + 320 +50
Gain chargeable on Christine
(266)
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December 1999 Proceeds: £800,000 x 90%
720
Cost: £(549,000 - 266,000)
(283)
Indexation to April 1998 at 0.146
(41)
Untapered gain
396
Tapering relief: This will apply to the whole asset as the Revenue’s guidance booklet makes it clear that the leasing of surplus business premises does not restrict business taper relief.
Chargeable gain: £396,000 x 85%
£336,600
Capital gains tax and non residence Prior to the Finance Act 1998,an individual could avoid a chargeable gain by going abroad for a period spanning at least a complete tax year and disposing of the asset after the following 5 April of departure from the UK. Individuals who leave the UK on or after 17 March 1998 and who were resident in the UK in four out of the last seven tax years will be required to remain non resident for at least the following five tax years in order to avoid a charge to tax on gains.Where an individual returns within five tax years he will be assessed to capital gains tax as follows: •
gains arising in the tax year of departure will be assessed in that tax year; and
•
gains arising in subsequent years will be assessed in the tax year of return to the UK.
Consequently, an individual may only defer a gain by going abroad for a short period rather than exempting it. An individual is still advised to sell assets following the next 5th April of their departure from the UK. However, the new legislation introduced in Finance Act 1998 does not override the terms of double tax treaties.
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Therefore,it is still possible to escape capital gains tax by ceasing to be a UK resident and ordinarily resident and becoming resident in a country with which the double tax treaty either exempts the gain or taxes it at a much lower rate than in the UK.Sadly,not many treaties prevent a s.10A charge on the disposal of UK situated immoveable property which often extends to unquoted shares in companies whose assets comprise UK situated property.One treaty that is worth considering is that between the UK and Belgium.
Inheritance tax planning Inheritance tax is only a consideration where the family business or company is to be passed on to the next generation. An outright sale of the business to a third party does not have a donative intent and therefore does not constitute a transfer of value for inheritance tax purposes.
Business property relief (BPR) Business property relief is currently available at 100% on: •
Sole trader or partnership assets
•
Unquoted shares in trading companies.
Business property relief at 50% is available on: •
Controlling shareholdings in quoted companies
•
Business assets used by the owner’s personal company or partnership.
There is a two year minimum ownership requirement for the above assets to be eligible for BPR. BPR is given in priority to other reliefs (e.g. annual IHT exemption) and is therefore a very valuable relief. Where a trading company also owns ‘excepted assets’BPR may be restricted accordingly. Excepted assets are assets that are not used by the company for trading purposes, for example, an investment property. In many situations the value of the shares that are eligible for BPR may be calculated by using the fraction CBA/CA used for retirement and gift relief purposes.However,for inheritance tax we must also look for ‘excess cash’. In a recent case (Barclays Bank Trust Co Ltd v IRC ) it was held that a 50% holding in a company with surplus cash not immediately required for trading purposes, only qualified for BPR to the extent that the share value comprised trading assets.
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In this case,the company successfully argued that £150,000 cash was held for trading purposes to settle amounts owed to suppliers to take advantage of prompt payment discounts.The remaining £300,000,the company argued,was required to purchase much needed new premises. However, because no suitable premises were found until seven years later it was held that at the time of the shareholder’s death the cash was surplus and thus an ‘excepted asset’. BPR was restricted accordingly.
Timing of the transfer IHT is a ‘voluntary’ tax and can generally be avoided by making a lifetime gift of assets to an individual (or into a life interest trust for him) as the gift will be a ‘potentially exempt transfer’or PET.Provided the donor survives for at least seven years following the gift,no tax will be due.Even where the donor does not survive for at least seven years the value chargeable is ‘frozen’ at the time of the gift and tapering relief reduces the tax due on death for survival of between three and seven years. The timing of the transfer can be crucial to effective inheritance tax planning. If the transfer takes place during lifetime the client and/or his or her spouse may be reluctant to relinquish control at an age where he is very likely to survive for at least seven years.Where the family company is of a reasonable size it may be appropriate to reorganise the share capital into ‘A’ and ‘B’ shares.The ‘A’ shares would give current voting and distribution rights, whereas the ‘B’ shares would carry future rights that the ‘A’ shares enjoy.The ‘B’ shares could be gifted at their comparatively low value without the current owners giving away control of the company. The ‘B’ shares would increase in value as the company (hopefully) continues to grow. In some situations the timing of the transfer can be dictated by non tax events, for example, on a major illness of the client. In this situation the shares/business could be passed to the wife (or husband) who stands a greater chance of surviving seven years and then on to the children.The danger of this, of course, is loss of BPR if the transfer to the children takes place within two years and the loss of retirement relief where the healthier spouse does not work full-time for the company.
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Planning points With the current level of BPR of 100% and retirement and gifts relief for CGT on business property, a major question exists as to whether to gift the assets now or wait until death. If the assets are given during lifetime there may never be an IHT liability either because the PET does not become chargeable or because the gift is covered by BPR provided the transferee still owns it (or other relevant business property) at the time of the transferor’s death. A lifetime gift not covered by retirement relief (or business taper relief) will be chargeable at some point, either on transfer or on sale of the assets by the transferee assuming a rollover claim is made. In addition, where gifts relief is claimed the period of ownership by the transferor is effectively ‘lost’as it is the untapered gain that is rolled over. However, a transfer of assets on death receives a free uplift in the CGT base cost to current market value and any business property is passed on with the benefit of 100% BPR. There are strong arguments in favour of the approach to hold business property until death but other points are worthy of serious consideration: •
If a business is hit by a recession the gain itself may be fairly low in any case, compared with for example, a relatively high March 1982 value.
•
The gain may be sheltered in full by retirement relief or deferred through EIS reinvestment relief.
•
Structuring a disposal by interspouse transfer prior to passing on, to maximise retirement, may be possible.
•
BPR at 100% may not be around forever?
•
Free CGT uplift on assets covered by BPR may be abolished?
Pitfalls Some of the main IHT pitfalls can be avoided provided they are identified and acted upon.The main areas to consider include: •
Holding assets such as business premises,outside the company or partnership restricts BPR to a rate of only 50%. Additionally, the charging of rent restricts the availability of retirement relief.
•
Where a lifetime gift is made it is important that the property remains ‘business property’for the next seven years and that the transferee retains ownership of it (or owns alternative business property).This will prevent
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a charge to IHT on a sudden death. NB. Consider surplus cash held by a company. •
Care should be taken not to change the nature of the company, i.e. a property development company becoming a property holding company.
•
Beware of buy and sell arrangements included in the Articles of Association,or partnership or shareholder agreements,as BPR may be denied. ‘Keyman’ policy documents should also be reviewed.
Reservation of benefit on shares Assume that a shareholder intends to give away shares in his company, but will continue to act as a remunerated director of the company. Robert Venables QC advises that it is important that the arrangements are such as to exclude the possibility of a reservation of benefit. He advises that the director should enter into a long-term service agreement before the gift is made (after taking account of s.319 CA 1985 which deals with directors’contracts of employment for more than five years).The agreement must be binding on the company and must therefore be viewed by the company as being in its interests. Ideally, the decision should be taken by an independent board which does not include the donor or his spouse. It could be crucial to prove,many years later,that the directors did actually address their minds to the question whether the agreement was for the benefit of the company, as opposed to the benefit of the donor and so full contemporaneous evidence is desirable. Any entitlement to benefits in kind and pension contributions should be written into the agreement. It will often be desirable for a donor to take a service agreement through to his retirement, with the option for the director to terminate it on, say, six months notice, with provision for the company to terminate it only on grounds of gross breach of duty or persistent ill health.
BPR pitfall Where business property is the subject of a lifetime gift, the retention rules in s.113A IHTA 1984 must be borne in mind. It is generally well-known that the property needs to be retained by the donee and that, if the subject matter of the gift is shares in an unquoted company,the company should remain unquoted for the shortest of the normal seven year period of exposure for a PET, the donor’s lifetime, or the donee’s lifetime. However, additional care is required if the subject matter of the gift is any land or building,machinery or plant qualifying for 50% relief within s.105(1)(d),as being used wholly or mainly for the purpose of the business carried on by a company
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controlled by the transferor, or by a partnership of which he is a partner.This is because s.113A(3) requires such property to be relevant business property in relation to a notional transfer of value made by the transferee immediately before the donor’s death. If the donor dies within seven years of the gift, the relief will only be available if the donee has control of the company, or is a partner in the partnership. A lifetime gift, even if of the entirety of an unquoted trading company, together with land etc. used in the company, equally between two or more children will expose the entire value of the land to IHT on the donor’s death within seven years. Provided the land is not worth more than £462,000, the preferred solution may be to gift the shares and the land to a discretionary trust. For these purposes, the transferees will then be the trustees who will control the company, so that on a notional transfer of the land it would be relevant business property. A further advantage of using a discretionary trust is that if the assets gifted are subsequently denied relief for any reason on the transferor’s death,s.113A(2) affects only the additional tax chargeable and does not increase the transferor’s cumulative total which is the effect of s.113A(1) where the original transfer is potentially exempt rather than immediately chargeable.
Pre-sale transactions Capital gain v dividend On a sale of shares, tax may be reduced on the retained profit element by paying out as a dividend rather than leaving it in the company to increase the capital gain.
Example Bill has recently received an offer of £3m for his 100% holding in Clinton’s Clothing Limited which he has run for the last thirty years following the retirement of his father. The March 1982 value of the shares is £400,000. The revenue reserves of the company are currently £2m. Bill is a higher rate taxpayer and has used his capital gains tax annual exemption for the current year, 1999/00.
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Solution a)
Straight offer of £3m £000
Proceeds
3,000
March 1982 value
(400)
Indexation to April 1998 at 1.047
(419)
Chargeable gain CGT: £2,181,000 x 85% at 40% Net proceeds £(3,000 - 742)
b)
2,181 742 2,258
Pre-sale dividend with reduced proceeds £000
Proceeds £ (3m - 2m) Indexed cost (above) Chargeable gain
1,000 (819) 181
CGT: £181,000 x 85% at 40%
62
Gross dividend: £2m x 100/90
2,222
HRT at 32.5%
722
Less 10% tax credit
(222)
Higher rate liability
500
Net proceeds £(3,000 - 62 - 500) Difference
2,438 £180,000
Taking a ‘dividend strip’out of distributable reserves creates a tax saving of approximately £180,000.This will not increase the tax charge for the company and there will be no ACT payable by the company. The decision to extract profits by way of a pre-sale dividend must also take account of other factors such as: •
Availability of CGT retirement relief.
•
The purchaser may offer consideration in the form of shares or loan notes which will be eligible as a ‘paper for paper’ transaction where
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the conditions of sections 135 and 137 TCGA 1992 are satisfied.The vendor could choose to realise small amounts of the gain each year thereby utilising his annual exemption. •
The purchaser might require the vendor to remain with the company for a certain period and offer ‘earn-out’ consideration.This would be taxed using the Marren v Ingles principle.
•
The Revenue may assess the capital as income under s.703 ICTA 1988 with a non-repayable notional tax credit. Advance clearance may be obtained where it can be shown that the pre-sale dividend is being made for bona fide commercial reasons and not with the intention of securing a tax advantage.
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