Introduction

Dividend rate changes were announced as part of the Summer Budget 2015 yet since then not much thought has been given to reviewing how owner managed businesses extract funds or manage their overall remuneration package. These changes are part of the Finance Bill 2016 and are intended to take effect from 6 April 2016. However the Finance Bill 2016 is not expected to receive Royal Assent until after the summer parliamentary recess.

As we move into the second quarter of the 2016/17 tax year, this article looks at how these changes, combined with the previously announced restrictions on tax relief for goodwill, impact on decisions to trade via a limited company. The article also considers the options for cash extraction of funds within owner managed businesses.

Cash extraction

We are now four months into the 2016/17 tax year. Many owner managed businesses continue to extract funds as they have done in the past, without giving any consideration to the dividend rate changes which are intended to apply from 6 April 2016.

A summary of the proposed changes are as follows:-

• The introduction of a new £5,000 tax free dividend allowance for dividend income for all tax payers – this means that any individual can receive up to £5,000 of dividends without incurring a tax liability
• As dividends are treated as the top slice of income, the dividend allowance is taken into account as income for both the basic rate and higher rate bands
• Dividend income will be included in an individual’s total income for the purposes of the high income child benefit charge and the calculation of the personal allowances restrictions for those with incomes over £100,000
• The 10% dividend tax credit is being abolished – the amount received from the company will now match the amount subject to tax
• The effective rate of tax on dividend income not covered by the £5,000 dividend allowance will be 7.5% within the basic rate band (up to £32,000 in 2016/17 after deducting personal allowance), 32.5% for higher rate tax payers and 38.1% for additional rate taxpayers whose income exceeds £150,000

The effective rates for dividends prior to 6 April 2016 were 0% for basic rate taxpayers, 25% for higher rate taxpayers and 30.56% for additional rate taxpayers. So at first glance, it doesn’t sound good. But like everything in the tax world, you need to work the numbers to see the true impact.

The changes will of course impact any taxpayers with significant dividend income. However it will probably be more painful for basic rate taxpayers who historically have had no personal tax liability on their dividends.

For some, it will still remain significantly more tax efficient to take a combination of small salary and dividends rather than a larger salary. This is demonstrated by the examples below which assume that bands, rates and allowances for both years remain the same. This clearly shows the difference between a low salary/high dividend scenario vis a vis. a high salary/low dividend position.

Example 1

Mr Clemintine runs a small fruit & veg company. He has historically taken a combination of low salary up to the national insurance threshold and dividends up to the basic rate limit and has had no tax liability. The table below highlights how his position will now change, with taxable income of £32,000 under the new rules after deducting the 2016/17 £11,000 personal allowance.

		2015/16 £	2016/17 £
Low salary/high dividend	Tax	0	2,025
	Net cash	39,800	40,975
High salary/ low dividend	Tax	8,014	8,243
	Net cash	34,180	34,757

It is clear from the above example that a higher salary would not be desirable. Sticking with the low salary/high dividend option, in 2015/16 Mr Clementine had no tax liability. His tax bill in 2016/17 will be £2,025, however his net cash in 2016/17 will be £40,975 compared to £39,800 in 2015/16, a saving of over £1,000 under the new rules. Essentially, Mr Clemintine can extract more cash from the company due to the removal of the 10% tax credit, and still remain under the basic rate limit.

So will a higher earner be better off under the new rules?

Example 2

Mrs Star runs a successful PR company and has no children. She has historically taken a combination of low salary and dividends up to £100,000 to preserve her personal allowance. The table below highlights how her position will now change, with taxable income of £89,000 under the new rules after deducting the £11,000 personal allowance.

		2015/16 £	2016/17 £
Low salary/high dividend	Tax	12,530	20,550
	Net cash	78,275	79,450
High salary/ low dividend	Tax	32,961	32,142
	Net cash	66,233	67,858

Again, it is evident that a higher salary would not be tax efficient. Under the low salary/ high dividend option, in 2015/16 her tax liability would have been £12,530 but under the new rules this will increase to £20,550. Her net cash position in 2015/16 would have been £78,275 compared to £79,450 in 2016/17, over £1,000 better off under the new rules. Essentially, Mrs Star can take additional cash from the company without breaching the £100,000 threshold due to the removal of the 10% dividend tax credit. In this example, Mrs Star has no children however the loss of child benefit would also need to be considered for any individuals with children.

The above examples highlight that dividends should still play a part in any tax efficient remuneration package for a company owner due to the removal of the 10% dividend tax credit. Not many like the idea of paying tax but if the end result is more money in your pocket; it can’t be a bad thing. The tax payment due on a dividend can also be advantageous from a cash flow perspective. Tax and national insurance on salaries and bonuses are payable pretty much immediately, whereas the tax due on a dividend can be payable up to 21 months later.

The optimum level of salary may vary depending on whether or not the company is able to fully claim the employment allowance for employer’s national insurance which increases to £3,000 in 2016/17. For example, for companies who have a small number of employees and where the employers national insurance bill does not exceed the allowance, it may be more tax efficient for the director to take a higher salary up to the level of their personal allowance and not just up to the national insurance primary threshold.

Note that in Budget 2016, it was announced that the employment allowance will not be available to single director employee limited companies. So in order to avail of the allowance the business must have ‘real’ employees.

Is incorporation still an option?

The benefits of incorporation have been greatly reduced in recent years with the clampdown on corporate partners and the removal of both entrepreneurs’ relief and tax relief for goodwill on incorporation.

The latest measure impacting on the decision to incorporate is the change in the dividend rates.

However, the benefit of trading via a limited company remains for many. The tax saved by incorporating compared to being in an unincorporated structure may have narrowed but often there will still be an overall tax saving if the remuneration structure is carefully planned.

So at what level of profits is it worth incorporating and paying dividends? The answer is that it depends. With any potential incorporation, the lifestyle and income requirements of the new shareholders need to be addressed in addition to issues such as whether or not property, cars etc. are transferred into the new company.

If drawings are high as a sole trader, incorporation may not always be beneficial. One year cannot be looked at in isolation, and it is always useful to do forward calculations to determine the tax and cash position over say a 10 year period.

Other tax factors should also be addressed, such as the potential for R&D tax relief or the patent box regime via the limited company option, as these favourable incentives are not available to sole traders or partnerships. As always, there are non-tax considerations to be factored in, such as personal liability, financing arrangements etc.

Thought should also now be given to whether residential landlords should incorporate. From 6 April 2017, interest relief for landlords is to be restricted to basic rate relief with the change being phased in over a four year period. From 6 April 2016, the 10% wear & tear allowance is replaced with replacement furniture relief.

However, through a company structure, a full corporation tax deduction can currently still be obtained for any interest paid to finance the property and the company will benefit from the current lower corporation tax rate of 20% which is planned to fall to 19% from 1 April 2017 with a further reduction to 17% planned from 1 April 2020. That rate may possibly be even lower given the Chancellor’s recent interview with the Financial Times.

On sale of a residential property, the rate of CGT paid by an individual is a maximum of 28%. If held in a company, corporation tax is paid instead though there may be a further tax cost if it is desired to extract the sales proceeds from the company. Other factors need to be considered including various taxes such as income tax, capital gains tax, inheritance tax and stamp duty land tax on incorporation.

No single solution fits all is the message when it comes to incorporation, but with careful forward planning, it can work.

Other options for extraction

Every individual will have individual needs and therefore each case must be addressed independently – no one remuneration package suits all circumstances. For many, immediate access to cash is a priority to fund current lifestyle.

But for others, putting cash away for the future may be the driver. If immediate access to all available funds is not a priority then in many cases it may be more tax efficient to leave the money in the business and benefit from entrepreneurs’ relief later on the sale of the company shares. Subject to certain conditions being met, the retained profits on a sale will be reflected in the price paid for the shares which may be taxed on the individual at the favourable 10% rate of capital gains tax which applies to qualifying business disposals for entrepreneurs’ relief. However an element of risk lies with treating your business as your ‘pension’. It may be at risk from creditors or it may not be saleable when you want it to be.

Pensions

Pensions still remain a useful tool not only when saving for retirement but they continue to offer attractive tax benefits. Any contributions made by a company on behalf of its director are fully deductible for corporation tax (with some restrictions) and national insurance is not payable on contributions.

Any contributions which exceed the annual allowance limit of £40,000 will be subject to a punitive tax charge so it is important to establish if the director has any other pension pots so that this annual limit, in addition to the lifetime limit of £1million, is not exceeded. From 6 April 2016 those with income above £150,000 will see their annual allowance reduced by £1 for every £2 of income above £150,000. The maximum reduction is £30,000 – reached with income of at least £210,000 – resulting in a much reduced annual allowance of £10,000 for additional rate taxpayers.

Some pension funds can also invest in commercial premises. The company then pays market rent to the pension scheme for use of the premises, which constitutes tax free income for the pension fund helping the pension pot to grow.

Pension pots can usually be accessed from age 55 and a 25% tax free lump sum can be taken. Any further drawdowns are generally subject to tax at the individual’s marginal rate.

Spouse

If a spouse is not already a shareholder in the company, it may be worthwhile considering giving him/her a shareholding to avail of the new £5,000 dividend allowance, their personal allowance and basic rate band, if these are not already being used. Pension contributions could also be made on his/her behalf, if they are an employee. However the “wholly and exclusively for the purposes of the trade” test will need to be met.

Conclusion

We are in a new era when it comes to cash extraction and examining the incorporation decision. Making the decision to incorporate can save tax in a variety of ways. However, the decision should be accompanied by a review of cash extraction, the individual and business’s long-term objectives, and an assessment of the one-off costs, taxes, reliefs and ongoing savings and costs.

Una McKearney is a Senior Tax Associate with Cavanagh Kelly specialising in Tax compliance.

Email: Una.McKearney@cavanaghkelly.com