As in most years, but particularly so in this, the rules governing the tax efficient extraction of profits for owners of corporate SMEs has seen material change as a result of measures included in what is now the Finance Act 2016.
For director/employee shareholders, a choice remains to access the profits of the business by way of either dividends or salary or a combination of each. While there is an undoubted desire on HMRC’s part to remove this flexibility and tax “working shareholders” as for other employees (that is as employment income together with national insurance) the means of achieving this remains in the “too difficult” tray.
Accordingly for many corporate SMEs run on quasi partnership lines (and many that are not), the shareholder/directors may still prefer to receive a small director’s fee below the national insurance threshold (in order to access social benefits) with the balance of their reward taken by way of dividends. With the personal allowance now set at £11,000, a director’s fee of up to £8,000 carries no income tax or national insurance charge. Assuming no other sources of income the balance of the personal allowance, £3,000, together with the new dividends allowance of £5,000 may be taken free of tax: that is income of £16,000. Dividends of a further £27,000 taxed at the new 7.5 per cent dividend rate may be paid to exhaust the basic rate band and thereafter at 32.5 per cent (or 38.1 per cent once total income exceeds £150k). Structured in this way the aggregate of the personal allowance and basic rate band allows income of £43,000 to be extracted at a cost of £2,025, an effective rate of 4.7 per cent.
Notwithstanding the changes to the taxation of dividends, which have removed the tax credit and imposed the rates as detailed earlier, the national insurance costs, and particularly the employers national insurance costs of 13.8 per cent, means that profits taken as salary remain unattractive (in the absence of wider pension planning or other tax shelter with respect to the resulting employment income). The personal allowance and basic rate band of £43,000 taken entirely as salary or bonus gives a tax and national insurance cost of £10,240, an effective rate of 23.8 per cent!.
The stark differential in effective tax rates is not quite as it seems: it ignores the fact that the payment of a salary or bonus will give corporation tax relief (at a current rate of 20%) whereas the dividend, as a distribution of profit, will give none. Notwithstanding, it remains the case that dividends will generally give a more favourable result in overall tax costs at the corporate and individual level, although the differential is narrowing.
Although dividends are relatively more attractive there remains the difficulty of targeting dividends to individual shareholders. Many SMEs have adopted different classes of share (so called “alphabet” share arrangements) to allow specific levels of dividend to be targeted to individual shareholders holding specific “classes” of share according to their alphabetical designation. In economic terms the dividend clearly represents a reward for the director/employee’s services and such targeting remains vulnerable to HMRC challenge on the basis that the dividend is de facto employment income. This is an area ripe for HMRC challenge but one they seem reluctant to take up, save in those cases where the dividend is documented as a bonus or reward for services (for example, a directors’ minute awarding a bonus of £x to be delivered as a dividend!). In the absence of such evidentiary “gifts” HMRC appear to acknowledge that it will require explicit legislative change to enable them to re-characterise a dividend properly declared as something else (that is employment income). Documenting the dividend as a dividend and meeting the necessary companies act formalities for the payment of dividends therefore remains key to defending this strategy. Other techniques for targeting dividends include appropriate dividend waivers as between the shareholders. Individual circumstances will dictate which is the more robust planning in any given situation.
Other changes impacting on profit extraction include an increase to 32.5% (from 25%) in the rate of corporation tax payable where a shareholder takes a loan from the company. The corporation tax is repayable once the loan is repaid or where the loan is waived. However, the waiver of the loan gives a deemed dividend to the shareholder in the year it is released (in addition to the benefit in kind charges taxed as employment income during the period the loan was outstanding and not subject to an arm’s length rate of interest). The intention here is clear enough: to impose a significant cash flow disadvantage on any company engaged in delivering “dividends” as soft loans.
Overall the effect of Finance Act 2016 has been to squeeze the differential in effective tax rates as between profits taken as dividends and employment income. Although the changes to the taxation of dividends are in themselves significant, the real significance for SMEs is that the rules of the game have not been fundamentally altered. It remains the case that there is a tax arbitrage between profits taken as dividends and salary and an assessment needs to be made in each case. HMRC’s longer term ambition of placing employee shareholders and employees on the same tax base would seem to have been “kicked down the road”. How far remains anybody’s guess.