Against a background of income tax rates varying from 20% to 50% (on taxable income over £150,000), many UK businesses owners are looking for relatively straightforward methods of reducing their annual tax bill.

In carrying out such planning, the prevailing trend of current government policy and public outcry against perceived tax “loopholes” must be borne in mind.

Incorporation

Incorporating an existing business has long been a method of tax planning. The headline corporation tax rate in the UK is to be reduced to 25% from 1 April 2012, with further 1% reductions over the next two years resulting in a 23% rate expected from 1 April 2014. Furthermore a “small profits rate” of 20% on profits below £300,000 is already in place. A substantial number of UK businesses will pay corporation tax at this rate. At first look this compares very favourably with the 50% income tax rate noted above.

The incorporation method favoured at present is a “sale for debt”. Essentially the newly incorporated company's opening balance sheet will consist of goodwill on the asset side with a corresponding directors/shareholders loan on the other with nominal issued share capital.

The sale of the goodwill to the company is a disposal for capital gains purposes. Providing all qualifying conditions are met, this disposal should qualify for entrepreneurs relief and be taxed at a rate of 10%.

Extraction

The shareholder will then extract monies from the company. In the early years this will typically be by way of a small salary to utilise the individual's personal allowance, further extractions by way of dividends to the basic rate band (thus keeping below the 40% threshold). There is no additional tax payable by the UK shareholder on the receipt of the dividend provided their tax able income remains below the basic rate tax threshold (£35,000 for 2011/12 fiscal year). Additional monies may be drawn from the loan account as required.

The advisor should be aware of the case of “HMRC v PA Holdings Limited” in that, in certain circumstances, dividends may be subject to national insurance contributions. It is believed that HMRC would not try to apply this principle to the above strategy on the basis that it is not part of an artificial tax avoidance scheme.

The primary downside of incorporation is the loss of reliefs that were in place for the individual. These include Business Property Relief for Inheritance Tax Purposes – it will be two years before the shares in the company qualify; also it will take one year before the shares qualify for capital gains tax reliefs available to trading companies.

Associated Companies

The 20% “small profits rate” applies to the first £300,000 of taxable profits within the company. However, this limit is reduced if there are associated companies during the accounting period. Associated companies are broadly defined as companies under common control. Falling corporation tax rates make this less of an issue than in previous years; however it is still contentious for many companies. Recent legislative changes (Finance Act 2011) to the “attribution” rules should benefit most companies that are operated independently of each other.

Plant and Machinery

Tax allowances available to businesses for expenditure on plant and machinery has undergone several changes in recent years. The most notable of these is the Annual Investment Allowance. Eligible expenditure of up to £100,000 is given a 100% allowance in the year the expenditure is incurred. However, the £100,000 limit ends on 31 March 2012 for corporates and 5 April 2012 for unincorporated businesses. The limit will be reduced to £25,000 for expenditure incurred after these dates. Businesses that have not fully utilised their allowance would be advised to consider accelerating their capital expenditure plans.

Further legislative changes to come into force on 1 April 2012 for companies (6 April for individuals and partnerships) relate to the mandatory pooling within a specified period of capital allowances for fixtures (items that are fixed to and become part of a building such as electrical systems, heating installations and air conditioning). Currently, and subject to claims by previous owners, a business may claim allowances in relation to the fixtures as long as they own the property at the time of the claim. This would apply even if the property was acquired several years previously.

Rates at which writing down allowances are given are also decreasing; the main rate of 20% will decrease to 18% with the special rate (certain items of plant and motor cars with CO2 emissions greater than 160g/km) will decrease from 10% to 8%.

The legislation does however, present several planning opportunities. A 100% allowance remains in place (for expenditure incurred prior to 1 April 2013/6 April 2013 respectively) on the acquisition of a qualifying low emission car. The main requirements are the timing of the expenditure, the car must be new and unused and the CO2 emissions do not exceed 110g/km. Although many company directors and business owners may not wish to benefit directly from this, it may be a tax efficient way of providing a car to another family member with the benefit assessed on the owner/director.

Research and Development (“R&D”)

Research and development tax relief is a tax incentive designed to encourage businesses to invest in innovation. It is only available to corporates and is claimed on the company tax return. The rate of relief under the SME element of the scheme has increased over the years from 150% (from 1 April 2000 to 31st July 2008), to 175% (1 August 2008 to 31st March 2011), 200% (from 1 April 2011 to 31 March 2012) and will increase to 225% from 1st April 2012.

Claims by companies have also increased due to the growing awareness of the type of activities that may qualify. Sectors that may qualify include software design, food and drink, electronics, and manufacturing. Any company that engages in a process or product that aims to resolve technological or scientific uncertainty may potentially qualify.

The claims for R&D relief are required to be submitted to HMRC within two years of the accounting period in which the relevant expenditure is incurred. Planning should be centred on identifying and capturing the expenditure associated with the eligible project.

Patent Box

After a period of consultation by HMRC, the concept of a Patent Box is to be legislated for and come into force on 1 April 2013. The main thrust of the legislation will be to allow companies to elect to have a 10% rate of corporation tax on profits attributable to qualifying intellectual property. The legislation will apply to existing intellectual property as well as new intellectual property. With a lead in time of one year, companies should commence their planning now to avail of this relief.

Entrepreneurs’ Relief

Capital gains tax rates for individuals in the UK are dependent on the personal tax circumstances of the individual and the type of disposal. The two main rates are 28% (for individuals whose taxable income in the year of disposal is taxed at either the 40% higher rate or 50% additional rate) and 18% for basic rate taxpayers. An annual allowance of £10,600 applies for 2011/12. Indexation relief is no longer available for individuals (although it is still available for companies).

However, the main concern for business owners, whether it is their shareholding in their private company or an unincorporated business, is the availability of entrepreneurs’ relief. If the conditions for relief are applicable, any gains on the disposal of the shares or business will be taxed at a rate of 10%. This rate applies on lifetime gains up to a limit of £10 million. The maximum benefit of the relief is therefore £1.8 million.

There are a number of tests to be passed in order to avail of the relief. The tests must be maintained for a period of one year prior to any disposal. Where the asset is the holding of shares by the individual in that individual's private company, there is a “company activities” test. The company must carry on trading activities. The activities of the company overall must not include substantial non-trading activities. Non-trading activities would include deriving rental income from a commercial property portfolio owned by the company. The relief is all or nothing.

Where the relief is endangered it may be possible to restructure the company and extract the trade to a new company and thereby separate the trading and investment aspects of the business. This should be carried out well in advance of any potential sale of the shareholding.

Another test that should not be overlooked is the shareholding requirement of the individual. The shareholder must have at least 5% of the ordinary shares and the entitlement to 5% of the votes by virtue of the shareholding and be an employee or officer (director or company secretary) of the company. For capital gains tax purposes, all shares count as ordinary shares except for fixed rate preference shares.

Proper planning should ensure that the shareholder does not fall below the 5% threshold and the other conditions are maintained. The advisor should also be aware of unexercised options held by, for example, senior employees that would be exercised on a disposal and the impact that this may have on any existing shareholders who are currently slightly over the 5% threshold.

Joseph Brown is a Corporate Tax Director with Goldblatt McGuigan

Email:brownj@goldmac.com