Having previously looked at the impact of the changes to dividend tax announced in the summer Budget 2015 on incorporation and dividends v remuneration issues, this article looks at getting money out of private companies and into the shareholders’ hands through sales/leases of assets.
There is no such thing as a free lunch as they say, and getting money out of companies tax-efficiently is not dissimilar. Basically the government does not want shareholders taking value out of their companies without paying income tax on that value (other than on liquidation or, exceptionally, as a return of capital).
Transfers of assets on incorporation
Until Finance Act 2015, the incorporation of a business by selling to ’Newco’ for full market value and claiming capital gains tax (CGT) entrepreneurs’ relief (ER) had been highly popular, especially with professional practices such as dentists and solicitors. Finance Act 2015, s 42 denies ER on disposals of goodwill to a related company, for disposals on or after 3 December 2014.
With CGT at only 10% with the benefit of ER, the great attraction was that this created a substantial credit balance on directors’ loan account, which could be drawn down over a period in preference to dividends or remuneration. Coupled with the possibility of amortisation of the goodwill for corporation tax purposes (now also denied) the strategy was highly tax-efficient. Little wonder then that the cost of ER (alone) to the Treasury for 2013/14 was some £2 billion more than expected.
This brings back into play a couple of reliefs that had been made somewhat redundant with the advent of ER, i.e. incorporation relief (under TCGA 1992, s 162) and relief for gifts of business assets (under TCGA 1992, s 165).
For incorporation relief, the business needs to be transferred ‘lock, stock and barrel’ (apart from cash) wholly or partly in exchange for shares in the company. This has meant that if it were decided to keep the business premises outside the company, incorporation relief would usually not be available, but s 165 relief enables other chargeable assets to be gifted to the company and for the gain (by reference to market value) to be ‘held over’ under a joint election between the transferor and the company.
Section 165 election
The effect of a s 165 election is that the company inherits the transferor’s CGT base cost, assuming that no consideration is given. If consideration is given which exceeds the base cost, the excess is liable to CGT and only part of the gain is held over.
Example: Sale of goodwill at undervalue
Trevor paid £50,000 for the goodwill of his dental practice in 2009. He decides to incorporate and sells the goodwill to Newco for £75,000 in 2015 when it is worth £100,000.
As he and Newco are connected persons (Trevor owns the only share in issue) the disposal is deemed to be at market value. The excess of the proceeds over base cost (£25,000) is liable to CGT (less the annual exemption £11,100, at 18%/28%), and the gift element of £25,000 is held over under s 165. The company’s base cost is £75,000.
However, it is often the case that goodwill is internally generated and therefore there is no base cost while plant and machinery will usually have depreciated and there will be no gain anyway. It should be noted that the transfer to a company of shares in another company (even a trading company) is specifically excluded from relief by s 165(3)(ba).
The business premises
The major asset of a business apart from goodwill is often the business premises. It may be preferable to retain the business premises in personal ownership, partly for commercial reasons. A substantial tax drawback of transferring to the company is stamp duty land tax (SDLT). The SDLT legislation (FA 2003, s 53) applies a market value rule where land is transferred to a company connected with the transferor, and so even if the actual consideration is nil there may still be a SDLT liability (depending on the value).
If, alternatively, the property is let to the company this will of course extract funds from the company, albeit that the income will be liable to income tax.
In terms of tax-efficiency, receipt of rental income from a company was on a par with extraction in the form of dividends for a higher rate (40%) or additional rate (45%) taxpayer. The comparative overall rates for dividends start with the company’s corporation tax liability of 20% for 2015/16 and 2016/17. Net of tax profit per £100 is therefore £80 paid out as dividend.
|
|
2015/16 |
2016/17 |
||
|
Dividend tax rate |
25%* |
30.55%** |
32.5% |
38.1% |
|
Dividend |
80.00 |
80.00 |
80.00 |
80.00 |
|
Dividend tax |
(20.00) |
(24.44) |
(26.00) |
(30.48) |
|
Funds retained |
60.00 |
55.56 |
54.00 |
49.52 |
|
Effective overall tax rate |
40% |
44.44% |
46% |
50.48% |
|
*80 x 10/9 = 88.89 x 32.5% = 28.89 – TC
8.89 = 20 /80 = 25% **88.89 x 37.5% = 33.33 – TC 8.89 =
24.44 / 80 = 30.55% |
||||
For 2016/17, there is therefore a clear income tax advantage in charging a full market rent for property (and other assets) let to a company.
However, as is nearly always the case with tax, where there is a plus there is usually one or two minuses:
- On a ‘material disposal’ of shares in a company, ER is not available for an ‘associated disposal’ of property used by the company where the property has (since April 2008) been let to the company at a full market rent (TCGA 1992, s 169P).
- Inheritance tax (IHT) business property relief for property used by a company or partnership is only 50% compared to 100% if owned by the company or an asset of the partnership.
For example, the sole shareholder of a trading company sells the shares in the company and the purchaser also buys the business premises which are in personal ownership. ER would normally be available for the material disposal of the shares in the company but if a full market rent has been charged no relief is, in effect, available for the associated disposal of the property.
Up to 2014/15, in order to avoid the ER downside, the property could be leased to the company at a peppercorn rent and increased dividends taken instead, as the overall tax rates are similar. From 2016/17 many company owners may prefer the ‘bird in the hand’ of paying less tax on rental income than dividends.
There is also another reason why it may be preferable to charge rent (even if not at a full market rate to preserve some ER). If there is a mortgage on the property the interest payable can only be offset against rental income.
The future
At this stage it is impossible to know how the proposed changes to dividend taxation announced in summer Budget 2015 will impact on profit extraction strategies, especially as the aim is to ‘start to reduce the incentive to incorporate and remunerate through dividends rather than through wages’ (my emphasis). So we don’t know what further increases might be in the offing. However, what we do know is that an overall rate of tax on dividends of 46% or 50% (or more) is somewhat worse than a CGT rate of 28%, so might we still see sales of goodwill at market value on incorporation?
In Re Sofra Bakery Limited (in liquidation) [2013] EWCH 1499 (Ch), a non-tax case, a court held that a business owner retained his baker's goodwill personally when he incorporated the business. So (accepting the ER/IHT downsides) might we see the goodwill retained personally on incorporation and leased to the company? Or perhaps sold in tranches to minimise the effect of the up-front CGT ‘hit’?
Practical Tip:
Where property owned personally is leased to a company a formal lease may be advisable, especially since any tenant’s alterations or improvements may become in law part of the building and therefore property of the landlord. The cost of such improvements might be regarded as distributions out of the assets of the company (dividends in effect) or even as benefits-in-kind.
A formal business tenancy would give rights to compensation for tenant’s improvements which might assist from a tax point of view and in terms of accounting for leasehold improvements.
