19% nonsense

MIKE TRUMAN asks how long the non-corporate dividend rate will last

'The Government will therefore bring forward specific proposals for action in Budget 2004, to ensure that the right amount of tax is paid by owner managers of small incorporated businesses on the profits extracted from their company.'

So read the infamous paragraph 5.91 from the Pre-Budget Report in 2003. For the next three months, speculation was rife about the Chancellor's intentions. The more I look at what was eventually produced, the more I wonder whether he actually had any.

The most plausible explanation I can find of the mess that is section 28 Finance Act 2004, is that the Chancellor made the announcement in the Pre-Budget Report and then told his civil servants to find some way of implementing it. A couple of months later, they came back and told him it couldn't be done, but that as a stop-gap he should reverse the decision to introduce a nil rate band on the first £10,000 of profits.

That, however, would have meant admitting that the decision was wrong in the first place, and politicians who admit to being wrong are as rare as shy retiring introverts in the Big Brother house.

So instead we end up with a system that tries to tax profits that are distributed, but not to tax those that are accumulated; because obviously distributing profits from close companies is unacceptable tax avoidance, whilst accumulating profits is acceptable tax planning.

Those of us who can still remember close company apportionment will never be able to persuade our younger colleagues that it used to be the other way around...

The above is, of course, pure speculation on my part, but I really hope that I am right. I would hate to think that what we have got was how it was planned to be.

The basics of the 19 per cent rate were examined by Janet Paterson in her article Through the Maze, and some of the anomalies and complications are analysed in Rebecca Benneyworth's article A More Balanced Footing?

In particular, Rebecca's article highlights that, even when it is working as it should, the 19 per cent rate is not really 19 per cent at all. What I want to illustrate is that sometimes the new régime simply does not work, and the tax rate on distributed profits under £10,000 is still nil.

Deferred dividend

Let's look at an example. Widget Ltd starts trading on 1 April 2004, and has no associated companies. For the year to 31 March 2005, Widget Ltd makes profits of £9,500.

For the year to 31 March 2006, it makes profits of £50,000. For both years its accounting profits are the same as its taxable profits, and in both years it pays out a dividend on 31 March which distributes all of the profits after the tax which will be due for the current year.

The tax calculation is given in Example 1 .

As Rebecca's article explains, calculating the tax can involve simultaneous equations, but when the profits are below £10,000 the underlying rate is nil, and the distributable profit is therefore 100/119 x taxable profit. The dividend is £7,983, leaving £1,517 to pay the tax — an effective rate of 15.97 per cent.

In the second year, the profits hit the £50,000 ceiling over which the new rules have no effect. Regardless of the amount distributed, the tax liability is £9,500, so £40,500 can be distributed as a dividend.

So far, so good. The new régime has at least charged the dividend in the first year to tax at 15.97 per cent when it would otherwise have escaped tax entirely. The system is working. But make one small change, and it all falls apart.

In Example 2 , the only thing that has changed is the timing of the first dividend. Instead of paying the dividend on 31 March, it is paid on 1 April. This means that for the year ended 31 March 2005 there is no distribution and therefore no tax liability. From a company law point of view, the company carries forward £9,500 of distributable profits.

In the year to 31 March 2006 the tax liability does not change; it is still £9,500. But, because we have £9,500 of distributable reserves brought forward, the maximum dividend payable is £50,000.

For the purposes of paragraph 5 of Schedule 3 to the Finance Act 2004, this £50,000 has to be compared with the profits for the year to see if there are any excess non-corporate dividends.

Logically there should be, because £9,500 of the profits for the year has been used to pay tax. But the legislation takes no account of this — net dividends are compared with gross profits. £50,000 of dividends is covered by £50,000 of profits, and there are no excess non-corporate dividends carried forward.

The distribution of the £9,500 in the year to 31 March 2005, by virtue of being made in the following year, has escaped tax entirely.

Example 1

Example 2

Write off loans?

Of course, that requires a certain amount of sophisticated management accounting, so that the profits for the year can be identified in time to decide what the dividends should be.

Most small corporate clients, particularly those micro-businesses incorporated in the past couple of years in response to the generous tax incentives the Chancellor was offering, would not have the information to do that. But for them there is a different way out — one which involves doing little more than telling the truth about how they operate.

In theory, the micro-company is entirely separate from its shareholders and directors. A board meeting sets the level of remuneration the directors are to receive, and may declare interim dividends for the shareholders. The final dividend is recommended by the board and approved by the company in a general meeting.

In practice, Joe Bloggs is the sole director and shareholder of Widget Ltd. He used to be a sole trader, as Bloggs' Widgets, and he's never quite understood the implications of incorporation, try though you might to explain them in words of one syllable.

Each month his personal credit card bill comes in, with a mixture of personal and company expenditure, and each month it is paid off by direct debit from the company's bank account.

When he was Bloggs' Widgets he had a standing order paying drawings from the business account to his personal account each month, and he saw no reason to alter that practice just because of some nonsense about being a limited company.

What is the true construction of these transactions? There was no agreement for these non-business payments to be made as benefits in kind, so they would appear to be loans made by the company to its director-shareholder.

The normal approach would be to clear the debit balance off the director's loan account by any combination of salary and dividends. But what if, instead, the loans are written off?

There are potentially two ways that loans written off can be taxed. The first is under section 188, Income Tax (Earnings and Pensions) Act 2003, which would tax it as earnings from the employment. The second is section 421, Taxes Act 1988, which taxes loans to participators that are subsequently written off. Clearly there cannot be a double charge, but which takes precedence?

The answer is in section 189(1)( a ), Income Tax (Earnings and Pensions) Act 2003. Where the amount written off would be treated as the income of the employee under some other provision of the Taxes Acts, otherwise than as employment income, then section 188 does not apply.

So the charge is under section 421, which is convoluted in its wording, but has the effect of taxing the amount written off as if it was a dividend. It does so, however, precisely because writing the loan off is not considered to be the payment of a dividend or other distribution by the company; see for example Collins v Addies [1992] STC 746.

It therefore would appear to follow that the section 28 rate cannot apply. Mr Bloggs will be taxed in the same way as he would have been if a dividend was declared, but Widget Ltd will not be within section 28.

All change?

It is, in short, a nonsense. But in all probability, it will be a short-lived one. The specific issue of writing off loans was picked up in the Budget Report, at paragraph 5.94, where the promise made by the Chancellor to the directors of small companies was that:

'the Government will consider measures to strengthen anti-avoidance legislation on loans made to shareholder directors of close companies, reinforcing existing legal obligations under Company Law.'

Nothing has happened yet, but the implication seems to be that the potential problem will be attacked by beefing up the legal prohibition on loans to participators, which are currently of no practical effect for companies controlled by one or two shareholder-directors because of the lack of criminal sanctions.

More generally, paragraph 5.95 merits more attention than it has attracted so far:

'the growth in small owner-managed businesses … is creating challenges for the definitions and boundaries in the tax and National Insurance systems between income from self-employment and the remuneration of owner-managers. The Government therefore proposes to consider the strategic issues raised by these developments ... A discussion paper will be issued at the time of the 2004 Pre-Budget Report.'

Translation: make the most of the anomalies in the 19 per cent rate. It's not going to last.

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