Alan Pink looks at the potential impact of allowing reserves to build up in limited companies.
Many businesses are sitting on a kind of ticking time bomb in relation to tax. This is in the situation where profit and loss reserves build up because they are not being regularly cleared out by way of dividends paid to the shareholders.
The reason this is such a big issue is basically because of the big difference between the tax rates that apply to profits that are distributed from a company on the one hand, and the profits that are kept within the company on the other.
Even with the changes promised us from 2023, the top rate of corporation tax will be 25%, with profits of less than £250,000 being taxed at rates down to a minimum of 19%. So, it seems to make obvious sense to run a business activity through a limited company, when you compare the rates of tax that you would be facing if the same income were received by individuals; 40% over approximately £50,000 total income in the year, and a current top rate of 45% on income of over £150,000.
Delaying the inevitable?
But it is all very well just looking at these ‘headline’ rates; you’ve got to consider the fact that, if you arrange for income to be received by a company rather than by you as the individual, there’s likely to be a price to pay eventually, in the form of income tax when the profits are finally paid out to you as dividends. Nevertheless, it is common practice to leave profits within a company, sometimes for a long period.
One reason this is done is a commercial reason. By ploughing the profits of the company back into the trade, you may be able to increase the scale of the company’s operations by a kind of organic internal reinvestment. Sometimes, this happens almost accidentally because the working capital of the business increases massively in the form of things like stock and debtors, and there simply isn’t the cash available to pay the dividends anyway. But another common reason for ‘warehousing’ company profits is purely tax-driven. Often, companies build up large inert cash balances simply because the shareholders do not want to face a big personal tax charge that would be the result of paying dividends.
But are the people in this position just guilty of sticking their heads in the sand, and is the building up of reserves in a company no more than a deferral of tax? I don’t think so. But before coming on to my reasons for saying that, is ‘mere’ deferral such a bad thing after all?
Example 1: Making use of cash reserves
Chaotic Software Ltd is a service providing business, which doesn’t need to plough any money back into the business. The main shareholder is wary about paying dividends because he doesn’t like the thought of the massive personal tax bills that will result. So, cash builds up in the company because the profits exceed what the shareholder needs to take out to live on.
After a few years of this, the company buys an investment property for £300,000, which ten years later has increased in value to £600,000. If the shareholder had taken the money out himself to buy the property, he would have had an income tax bill of about £114,000 on the dividend, and so it wouldn’t have been possible to buy the £300,000 property. A cheaper property could have been bought, but that could have sacrificed over £100,000 of capital growth.
So, in summary, even if keeping profits in a company were no more than a tax deferral, this can still be a very good thing in some circumstances. But is it, in fact, no more than a deferral of the inevitable? It depends on your end game.
Sale or winding-up?
The first possible end game is a situation where the ultimate effective tax rate on the retained profits is much lower than it would have been if dividends had been paid in the first place.
Here is another simple example to illustrate the principle.
Example 2: Property development company
Susan sees an opportunity to buy a piece of land, get planning permission, and develop it by building five houses on the land. Rather than doing this as a sole trader, though, she sets up Development Co Ltd. The profits from the development are £1 million, and Susan would have paid 45% tax (plus 2% National Insurance contributions) on nearly all of this if she’d been a sole trader. Development Co Ltd instead pays 25% tax, leaving £750,000 in the company bank account after the houses have all been sold and the tax paid.
Because this is very much a one-off (and therefore the ‘anti-phoenixism’ rules won’t apply), Susan is able to put the company into voluntary solvent liquidation, and she receives the £750,000 as a distribution in that liquidation. As a distribution in liquidation, it is chargeable to capital gains tax (CGT) rather than income tax, and therefore Susan pays 20% of the £750,000 (i.e. £150,000), which is the applicable rate of CGT at the time. If she had taken the profits by way of dividend, the rate of tax would have been somewhere on average between 32.5% and 38.1%.
The same basic principle applies where the company is not wound up but sold up to someone else.
Example 3: Sale of company with cash reserves
Jane Eyre Ltd trades successfully for many years, building up reserves of cash of about £1 million. The shareholder, Charlotte, agrees to sell the company to Wildfell PLC in a deal which values the business (purely as a business) at £1 million, but the stated sale consideration in the share purchase agreement is £2 million because of the ‘surplus’ £1 million cash that is sitting in the company’s bank account.
So, Charlotte realises a capital gain of £2 million, half of which is taxable at 10% due to business asset disposal relief, and the other half at 20%. An average of 15% tax, at some long-deferred date, is obviously better than the 32.5% that Charlotte would have been paying on dividends over the years.
Emigration
Emigration (that is, becoming non-UK resident for tax purposes) isn’t quite the ultimate form of tax planning (that comes next), but it might be seen as a similarly radical approach to avoiding the deferred tax timebomb on retained company reserves.
A payment of a dividend out of the reserves can be made free of UK tax, on one important condition, which is that the shareholder concerned remains non-UK resident for a period of at least five years. If the shareholder returns less than five years after emigration, the rules against temporary non-residence kick in, and the dividend is charged to tax on their return. And, of course, you need to be mindful of the tax rules in any other country where you might have become resident.
‘Till death us do part
Then there’s what you might refer to as really the ultimate form of tax planning in this particular regard, which is keeping the profits within the company until they get passed on to your beneficiaries in your will.
There are clearly significant inheritance tax issues to address if this situation applies, but these are too complex to include within the scope of this article.
From a CGT perspective though, the effect of leaving the shares in the company (complete with its accumulated reserves) to your beneficiaries is to wipe out entirely the tax charge that was deferred over the years by accumulating profits in the company. This is because the treatment for CGT of a legacy is that the beneficiary receiving the shares from the deceased’s estate is treated as if the shares had been acquired for the market value on the date of death.
In the simple example of a 100% shareholding in a company, this therefore means that the value of all the reserves will have been reflected in a new uplifted CGT base cost. So, in theory, the beneficiary could wind up the company or sell it immediately afterwards, and there would be no tax to pay at all.
