Most owner-managers continually seek to re-appraise whether they are adopting the most tax efficient methods of extracting their 'share' of the company's profits. In recent years, the tax regime has generally favoured taking surplus profits out in the form of dividends, largely due to the recent hikes in the level of National Insurance Contributions (NICs).
This may not always be the case. Many fear that a chancellor hungry for more tax revenue may still seek to raise additional tax from dividend income.
Bonus - main tax and NIC issues
Having broadly determined the appropriate level of profits that can be 'extracted' by the owner-manager(s), attention usually shifts to deciding whether the amount should be taken out as a bonus and/or dividend.
For the current year to 5 April 2005, a bonus will attract employers' NIC at 12.8%. No employees' NIC is payable on earnings up to 4,745; earnings between 4,745 and 26,975 attract employees' NIC of 11%. Following the effective removal of the employee's NIC cap on 6 April 2003, additional employee's NIC of 1% now arises on any bonus where the recipient's normal annual salary and P11D benefits exceed 31,720 (for 2004/05). The income tax on the bonus (or additional salary) is suffered by deduction under the PAYE system. The company must account for the PAYE and total NIC within 14 days after the tax month of payment.
The bonus and NIC is fully deductible for corporation tax purposes for the period in which it is charged in the accounts (provided it is actually paid within nine months following the end of the accounting period). This offers considerable flexibility. For example, it means that if the company's year-end has just passed, the relevant bonus can be provided in the accounts.
Corporation tax relief can still be obtained for the bonus provision in that period where it is 'paid' in the nine-months following the year end (s43, FA 1989).
Taxation of dividends
For the vast majority of owner-managed companies, dividends have proved to be a popular way of extracting 'surplus' profits. Many owner-managers will be higher-rate taxpayers, which means that their 'grossed-up' dividend would be taxed at 32.5% with a deduction for the tax credit of 10% (ie, a net rate of 22.5%). This works out to an effective tax rate of 25% on the cash dividend received (see Panel 1).
The collection of the income tax on dividends (22.50 in the Panel 1 example) also offers a cash flow advantage since it is collected under the self-assessment payment profile. Thus, where the dividend represents 'new' income for the owner-manager, the tax would not be paid until the balancing payment is due, being the 31 January following the tax year of receipt. Where the dividend is paid early in the tax year, this can give rise to a considerable delay in the payment of the tax.
Where shareholders only pay tax at the basic rate, their dividend income would be subject to income tax at 10% in their hands. However, because the tax liability is fully offset by the 10% tax credit, no additional tax liability arises. This particularly favourable position also shows why many owner-managers seek to route further dividend income to their spouses, an option considered later.
The Finance Act 2004 introduces a special 19% non-corporate distribution rate (NCDR) on post-31 March 2004 dividends paid by 'very small' companies.
However, it is only likely to affect the 'smaller' owner-managed companies with annual taxable profits below 50,000 (assuming there are no associated companies). (See Accountancy, August 2004, pp112-114.)
Bonus v dividend comparison
For the owner-managed company, the comparison between extracting profits via a bonus or a dividend must take both the company's and owner-manager's tax costs into account. Many owner-managers typically pay tax at the higher rate. The tax comparison for them is best explained through a worked case study. (See Panel 2). Because the company obtains tax relief for the bonus, the effective combined tax rate is always 47.7%, irrespective of the relevant corporation tax rate.
Where the company pays corporation tax at the marginal rate of 32.75% (eg, where profits fall between 300,000 and 1.5m (assuming no associated companies)), the effective overall tax rate on a dividend becomes relatively expensive. Dividends paid from profits within the marginal rate band attract a corporation tax cost of 32.5%, giving an overall tax rate of 49.6%.
However, even at this marginal level of profits, the choice may be fairly neutral, given that a bonus suffers its tax and NIC immediately under the PAYE system.
Shareholders paying tax at the lower/basic rate
Where the shareholder(s) pay income tax at the basic rate, the effective tax rates for bonuses and dividends are as given in Panel 3, which shows that 'basic rate' shareholders would generally prefer dividends (irrespective of the corporate tax rate). They do not suffer any income tax on the dividend income - the only 'indirect' tax suffered is the corporate tax on the profits from which the dividend is paid.
Remuneration and dividend payments to spouses
Spouses may be paid a commensurate wage or salary for administrative or secretarial duties. There will usually be a tax advantage in bringing the wife (or husband) in as director/employee and paying a salary or wage, provided:
• the remuneration attracts a lower tax liability in the spouse's hands than if it had been paid to the owner-manager; and
• the company is able to deduct the payment against its profits for tax purposes.
Every opportunity should be taken to ensure that the owner-manager's spouse makes full use of personal tax allowances and lower/basic rate bands. In practice, the remuneration that can be paid tends to be limited to the amount that the tax inspector would accept as tax deductible. Inspectors will apply Copeland v William Flood & Sons Ltd ((1940) 24 TC 53) to challenge the tax deduction for remuneration that is considered 'excessive' in relation to the commercial value of the work performed.
If the inspector disallows all or part of the wife's remuneration, her employment income tax liability will still remain. However, this can be avoided provided the wife formally waives her remuneration and pays the relevant amount back to the company. (ICAEW, Tax Faculty Guidance Note, TAX 11/93).
If the wife does little or no work for the company, it is unlikely to obtain a material corporation tax deduction. In such cases, it is generally better to structure the shareholdings so that the wife receives dividend income instead. If the spouse has no other (taxable) income, a dividend of up to (say) 32,000 could be paid without any tax liability (in the year to 5 April 2005), as shown in Panel 4.
Application of the 'settlements' legislation
A wife can only receive dividend income if she owns some shares in the company. The tax considerations involved in securing a tax effective dividend to the wife have been complicated by the Revenue's recent challenges in this area. The Revenue's main 'weapon' has been the 'settlements' legislation, as illustrated in the case of Young v Pearce ((1996) STC 743) and the views expressed in Inland Revenue Tax Bulletins.
An individual (the settlor) is treated as creating a 'settlement' for income tax purposes if he makes any disposition, trust, covenant, agreement or arrangement or transfer of assets. For these purposes, a series of transactions taken together may constitute a 'settlement' (s660G ICTA 1988). This definition would therefore catch any gift or 'under-value' transfer made to a wife. Broadly speaking, the settlement rules treat the income arising from the purported transfer as still belonging to the settlor for tax purposes (s660A(1)(2), ICTA 1988).
The payment of dividends to the wife may be generated by the creation of a new class of shares or by the husband transferring some of his existing shareholding. Depending on the precise facts of each case, the Revenue may contend that such arrangements constitute a settlement. This would negate the tax advantage, since the dividends paid on the wife's shares would be taxed on her husband at his highest tax rate.
Inter-spousal settlement exemption
The settlements rules will apply, inter alia, where the settlor or his spouse retains an interest in the property transferred. However, following amendments to the settlements rules in FA 1989, an outright gift made by a husband to his wife (or vice versa), would only be caught by the settlement rules if:
• the property gifted was wholly or substantially a right to income (s 660A (6) ICTA 1988), or
• the property gifted carried a right to the whole of the income.
Thus, an outright gift (ie, with no strings attached) of property from husband to wife should not be caught by the settlements rules, except where the gift was purely a right to income (without the underlying capital).
Whether 'bounty' is conferred
It is well established that a settlement can only exist if the transaction is not a commercial one and an element of 'bounty' has been conferred on the recipient. The Revenue takes the view that the dividend income is generally created by the husband's efforts and he can decide how the company can allot its shares etc. On this basis, a dividend received by a spouse on shares previously gifted from her husband would represent sufficient bounty to create a settlement, particularly if the dividend represented an exceptional return (CIR v Plummer (1979) STC 793).
On the other hand, if a spouse pays full market value for the shares (out of their own resources), the dividends subsequently paid out on those shares may be considered a normal commercial return on a proper business transaction with no element of bounty. The Revenue also seems to accept that the issue of founder shares at par may also be commercial, particularly if both members of the couple are fully involved in the company.
In its April 2003 Tax Bulletin, the Revenue provided a series of examples to illustrate where they would (and would not) seek to apply the 'settlements' legislation to dividends received by a spouse. In the Revenue's view, potentially vulnerable situations include dividends paid to a 'wife' in the following cases:
• On shares gifted or issued with restricted rights (eg, no voting rights and very restricted capital rights, as in Young v Pearce).
• On ordinary shares in an effective 'one-man' band or 'consultancy-type' company with minimal underlying capital assets. In this case, the company's income stream arises from the husband's efforts and the dividend paid to the wife is considered disproportionate.
• On a separate class of ordinary shares, where different classes of 'ordinary share' capital have been 'used' to enable a 'high' proportion of the company's profits to be paid out to the wife. (The decision to vote dividends on one class of shares is considered to be a 'bounteous' arrangement).
In summary, the tax treatment of the provision of dividend income to spouses through share transfers/issues is far from being 'clear-cut'.
Each case must be judged on its own facts, although it seems that arrangements involving consultancy companies in which the wife has little involvement are particularly susceptible to attack. In contrast, the Revenue is unlikely to challenge situations where:
• the wife receives ordinary shares (with substantive rights)
• in an established trading company (with tangible asset backing) and
• works for and plays a 'meaningful' role in the company's day-to-day activities.
Hopefully, the hitherto hazy dividing line between 'acceptable' and 'unacceptable' arrangements involving spouses' shares will be clarified when the special commissioner's decision in Arctic Systems (a small information technology company run by a husband and wife) is announced.
This article is based on material from Peter Rayney's chapter, 'Cash extraction Strategies for Owner-Managers in 2004/05', from TAXline TAX PLANNING 2004/05, published by the ICAEW's Tax Faculty.