Ken Moody looks closely into the ongoing debate over dividends versus remuneration, and also the alternative of retaining cash in the company following anti-avoidance rules in Finance Bill 2016.
It remains to be seen whether the increase in dividend tax rates from 6 April 2016 will deter private company owner-managers from rewarding themselves in the form of dividends rather than remuneration.
The comparative percentage overall tax rates are given in the following table, which factors in the proposed reductions in the corporation tax rate to 19% for the financial years 2017, 2018 and 2019, and to 17% from 1 April 2020. The rate for remuneration (including employers’ and employees’ National Insurance contributions (NIC)) remain the same, as these are unaffected by changes in the corporation tax rate, but will fluctuate with changes in NIC rates/limits.
2016/17 2017/20 2020/21
D R D D
Basic rate taxpayer 26 40.2 25 23
Higher rate taxpayer 46 49 45.3 44
Additional rate taxpayer 50.5 53.4 50 48.6
Admittedly, at higher levels of reward the choice becomes more marginal. For a taxpayer who is an additional rate taxpayer, for example, the difference in tax payable on a bonus of £100,000 compared to a dividend of the same amount is only £2,900 (i.e. 53.4% - 50.5% = 2.9%), rising to £4,800 (53.4% - 48.6% = 4.8%) after 5 April 2020.
Be that as it may, there is still a clear saving for a basic rate taxpayer in receipt of dividends of up to about £7,000. Take a slice of company profit of £60,000 and tax it in both ways and this is what happens (assuming no other income):
Dividend Remuneration
£ £ £ £
Profit 60,000 60,000
CT (12,000) -
Dividend 48,000 48,000 -
Employers’ NIC (6,292)1
Salary 53,708 53,708
Employees’ NIC (4,401)
Personal allowance (11,000) (11,000)
Taxable 37,000 42,708
Dividend tax @ 0% 5,000 -
Dividend tax @ 7.5% 32,000 (2,400)
Income tax @ 20% 32,000 (6,400)
Income tax @ 40% 10,708 (4,283)
Funds retained 45,600 38,624
Tax % 24% 35.6%
Notes:
1. £53,706 – £8,112 (£156 x 52) = £45,594 @ 13.8%
2. £34,892 (£827 – £156 x 52) @ 12% = £4,187 + £10,702 @ 2% = £214
A saving of just under £7,000 still seems worth having to me.
A small salary of up to about £8,000 is commonly drawn to protect future state pension entitlement, and some NIC exposure could be offset by the £3,000 employment allowance if the director-shareholder is not the only person on the payroll. Paradoxically, drawing salary increases exposure to the dividend higher rate, but there are various permutations which need be worked through in the particular circumstances.
Don’t forget that dividends are treated as the top slice of income, and so while you can top up remuneration with dividends it doesn’t work the other way round, because remuneration will displace dividends and there goes your tax saving. So to my mind it’s still broadly either one or the other.
Retaining profits in the company
Of course, retained profits are ‘sheltered’ at only 20% and falling, even though this may only be a deferral. However, the build-up of cash reserves in a company may cause problems of its own.
To the extent that the cash surplus is invested or exceeds the amount reasonably required for the purposes of the company’s business, this may be regarded as an ‘excepted asset’ for the purposes of inheritance tax business property relief. Secondly, capital gains tax (CGT) entrepreneurs’ relief may not be available where a company’s activities ’to a substantial extent’ include non-trading activities (TCGA 1992, s 165A). Although HMRC’s guidance is unclear on this point (see CG64060), the better view seems to be that mere retention of cash surpluses on a bank deposit account does not amount to an ‘activity’ at all – see Jowett v O’Neill & Brennan Construction Ltd [1998] STC 482.
It would be a nice idea therefore to retain cash surpluses and receive the money as capital distributions on the eventual winding up of the company. With the benefit of entrepreneurs’ relief the rate of CGT is only 10% (up to the £10 million ‘lifetime’ limit).
Anti-avoidance rules
However, as they say ‘all that glitters is not gold’, and further proposed changes in the Finance Bill 2016 may take the shine off any such notions.
The changes are two-fold:
1. new legislation (sections 396B and 404A inserted into ITTOIA 2005) - whereby distributions on winding up may be treated as income distributions where certain conditions are met; and
2. the ‘gateway’ provisions in the transactions in securities (TiS) rules (ITA 2007, ss 684-s 687) are amended to widen their scope.
Section 396B applies where a ‘close’ (broadly private) company is wound up and within two years an individual receiving a capital distribution is involved with carrying on a similar trade or activity as was carried on by the company. This could be by carrying on a similar business directly, in partnership, via a company in which the individual has a 5% interest, or via a connected person. In those circumstances, the distribution may be treated as an income distribution provided it is reasonable to assume that a main purpose of the arrangement was the avoidance of income tax.
The provisions are designed of course to deter ‘Phoenixism’, whereby a company is wound up and one or more shareholders form a new company carrying on a similar business, or perhaps via a connected person. However, the test of what it is reasonable to assume introduces considerable uncertainty. It may happen for a variety of reasons that a person may decide to wind up their company with no intention of carrying on a similar business, but circumstances may change and either for commercial or personal reasons they become involved with carrying on a similar business to that carried on by the old company. Moreover, there may be commercial reasons for ring fencing (e.g. building projects within a succession of companies). And of course what HMRC consider it is ‘reasonable to assume’ may not seem reasonable to the taxpayer.
Turning now to the proposed amendments to the TiS rules, it was held by the House of Lords in Laird Group plc v CIR [2003] STC 1349 that a company distribution, whether as a dividend or in winding up, is not a TiS but merely gives effect to the rights attaching to the shares. In CIR v Joiner [1975] STC 657 the Lords held that the distribution of assets in a private company was a TiS because of an arrangement entered into prior to the liquidation for the transfer of the assets to a new company owned by the controlling shareholder. Absent any such arrangement it may be debateable whether winding up a company, distributing its assets and then commencing a similar business through a new company is necessarily a TiS.
The TiS ‘gateway’ provisions at ITA2007, ss 684687 are amended in various ways, but of particular note in this context is the amendment of section 684(2), which lists a number of transactions which are specifically considered to be TiS, to include the winding up of a company.
The above changes apply from 6 April 2016, but it may be some time before it becomes at all clear as to how the rules will apply in practice.
Practical Tip:
If a company is wound up which has built up substantial cash surpluses, for the purpose of ensuring that CGT entrepreneurs’ relief is available, it may be advisable to request informal clearance from HM Revenue and Customs that either the holding of such surpluses is not considered to be an ‘activity’ for the purposes of TCGA 1992, s 165A(4) or that if it is an activity it is not ‘substantial’ (having regard to the factors set out at CG64090).
Given the amendment to the TiS rules to specifically include a winding up among the transactions which are TiS, it would logically follow that a request for statutory clearance (under ITA 2007, s 701) might also be appropriate in future.
