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Sad to say, the problems of associated companies often come to my mind as a potentially 'unfair' aspect of our tax system. I usually push them away while intoning my previously published mantra about 'unfair' being a word that should not figure in the tax practitioner's mind (well at least not while at work unless taking time out to watch the World Cup!). Having recently managed to expunge those thoughts from my mind, I have to thank Mr Philip Needham of Hornbeam Accountancy Services Ltd for bringing them back to mind (thanks, Phil!).
On the other hand, perhaps it is a relief to find that I am not the only lost soul wandering around the dark recesses of the associated companies legislation in TA 1988, s 416.
Section 416(1) explains that 'a company is to be treated as another's “associated company” at a given time if, at that time or at any other time within one year previously, one of the two has control of the other, or both are under the control of the same person or persons'. Section 416(2) goes on to explain that 'a person shall be taken to have control of a company if he exercises, or is able to exercise or is entitled to acquire, direct or indirect control over the company's affairs'. The rest of the section expands upon this.
Perhaps the important principle enshrined in s 416(1) and which is important for the purposes of this article is — as set out by the Inland Revenue as it then was in a press release on 21 October 1983 — that two companies are under the control of the same person or persons only if 'an irreducible group of persons' having control of one company is identical to an irreducible group of persons having control of the second company. An irreducible group of persons is one which has control, but which would not have control if any one of them were excluded.
An associated problem
Mottly Electronics Ltd (not their real name) supply a variety of businesses with control systems. Financing deals can be difficult to arrange for some customers without much of a track record and finance deals incorporating varying levels of service support can also be quite difficult to put together. With their own more intimate knowledge of their client base, and with a second-hand market for their products, Mottly Electronics Ltd decided to set up their own financing subsidiary as a fairly low risk way of improving the package offered to their clients.
Phil's firm were asked to set up the new company, Mottly Finance Ltd, but pointed out that the subsidiary would be an associated company and the halving of the 19% corporation tax band would potentially cost Mottly Electronics Ltd £20,625 in extra corporation tax per year as shown in the Example below.
Example: Tax effect of an associated company |
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| The £300,000 19% corporation tax band is halved to £150,000 when a company in common control is created. If we assume that the taxable profits of Mottly Electronics Ltd are £300,000 p.a. and that Mottly Finance Ltd will not make a profit in its initial years, the 'before and after' tax computations of Mottly Electronics Ltd would be as follows. | |||
| Before — with no associated company | After — with an associated company | ||
| £ | £ | ||
| Profit | 300,000 | Profit | 300,000 |
| Taxable | Taxable | ||
| 300,000 x 19% = | 57,000 | 300,000 x 30% * = | 90,000 |
| Less: marginal relief | |||
| 11/400 x 450,000 ** = | 12,375 | ||
| Tax payable | 57,000 | Tax payable | 77,625 |
| £150,000 is thus taxed at the 32.75% marginal rate instead of at 19%. £150,000 x 13.75% = £20,625 (i.e. £77,625 — 57,000). | |||
| *Note. The taxable profit of £300,000 exceeds the small companies' limit which is now £150,000 (i.e £300,000/2 because of the associated company) and is therefore taxable at the full rate of 30%. | |||
| ** Note. Marginal relief is calculated by reference to the revised upper limit of £750,000 (£1,500,000/2 because of the associated company) less profit of £300,000. | |||
Because the main point of Mottly Finance Ltd was to support and facilitate the business of Mottly Electronics Ltd, the consequent £20,625 of extra tax would be considerably more than the expected profits from the new venture for the first couple of years, perhaps ever, and therefore was enough to put the whole venture on hold. Phil considered a number of possible solutions, but these all had drawbacks:
- different ownership was simply not acceptable;
- partnership would involve higher levels of risk; and
- a limited liability partnership would result in 40% income tax for the owners.
As a result, the whole 'Mottly' project was put back, possibly strangled at birth.
In a second and similar case, a construction materials company wanted to set up a subsidiary to develop an innovative new product, only to find the tax cost so penal that it tipped the scales and caused the project to be abandoned. These instances set Phil thinking about the inequities of the associated companies' rules for corporation tax. He wrote to HM Treasury on this subject, but their reply (see below) intimated that, although his calculations were correct, this has not been identified as a 'large-scale' problem. Unless of course you, dear reader, know differently.
HM Treasury reply |
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'You are right that the associated companies rules can, in certain specific circumstances, lead to the type of outcome that you describe. While I accept that this is not ideal, we have not been made aware of evidence that this happens on a large scale. 'The associated company rules are necessary to prevent high-profit companies from fragmenting so as to pay lower rates of corporation tax. In this way, the current rules play an effective revenue protection role. Another highly significant strength of the rules as they stand is that they are simple, and well understood by business. Alternative rules have to be considered in this context. While Ministers are very keen to support enterprise, they have to balance this with the need to keep the corporate tax regime as simple as possible for small companies. 'As you'll recognise, this year's Budget and Finance Bill process is at an advanced stage. Potential enterprise and simplification measures for next year's Finance Bill will be considered as part of the normal Budget process.' |
Risk and reward
It is usually accepted that a limited liability company is the right vehicle for an innovative, but high-risk venture and, in general, one would not want to put a high-risk business in the same company as an established and low-risk business. But the option of setting up a new company can mean that it is so heavily penalised by an additional tax charge as to be virtually unavailable to a reasonably successful family company.
We are always hearing that the stated aim of the Government is to make the UK 'the best place in the world to start and grow a business', but are the associated company rules completely contrary to that stated aim?
Suggested reforms
Where an individual (as opposed to a company) has more than one source of income, allowances and tax rates are split between the sources in the most beneficial manner and those income sources are treated as though they were 'slices' of one cake, rather than being separate 'cakes'.
Phil has given some thought to these issues and has considered the various options to make the rules on associated companies more equitable, and concluded that allowing management to allocate bands in any proportion would be unworkably complex. Instead, his suggestion is that a simple form should allow the directors of a company to opt to pay tax at 30% on all income, whilst not having to be counted as an associate by any business. He suggests that this would solve the penal tax charge problem very simply.
Fringe benefits
Presumably, HM Treasury would not want to see tax receipts haemorrhaging from the Exchequer as a result of changes to the associated companies' rules. But perhaps the fact that the Treasury indicate in their letter that they are not aware of evidence indicating that the problems highlighted are happening on a large scale means that substantial amounts of tax are not at issue on a national scale.
The Explanatory Notes to Finance (No 2) Bill 2005 include a paragraph (which is not reproduced or updated in the 2006 Notes) stating that 'around 45,000 companies are expected to pay corporation tax at the main rate in 2005-06. They are estimated to make up around 3.6% of all active companies, but contribute around 84% of the total corporation tax yield'.
This leaves the 16% balance to be paid by the 170,000 companies which (at 2005 levels) paid tax at the small companies rate and the further 25,000 that — in the words of the Notes — 'benefited' from marginal relief. (Although, and perhaps this is the crux of this article, exactly how one 'benefits' from paying tax on a slice of profits at a rate higher than the 'top' rate seems a somewhat ingenious use of the word.)
Time for a change?
If the Government is serious in its stated aims of encouraging and assisting entrepreneurship, a change that would encourage, rather than hinder, the formation of additional companies and businesses would be a useful step forward. Phil suggests that there are other scenarios that could benefit from a rule change and which would facilitate business.
One valuable spin off of this option would be to allow many semi-dormant holding companies to sort themselves out without fear of triggering extra tax for the trading subsidiary or subsidiaries. For example, a company that has inter-company loans left over from a 'whitewash' (under Companies Act 1985, s 155) supporting an old management buy-out (MBO). These loans distort the individual company balance sheets, but with the trading subsidiary making over £300,000 profits, transactions put through the holding company would risk £20,625 of extra tax.
Similarly, a holding company that would like to repay family loans has been held back for fear of triggering the associated companies' tax rules.
Finally, the trading subsidiaries of a 'dormant' holding company pay the holding company's annual return fees and accountancy fees to protect the parent's dormant status. If these holding companies could opt to pay tax at 30% and fall outside of any group of associated companies, they could then take responsibility for their own costs, without fear of tax penalty.
Once one starts to consider the various scenarios that can arise in groups of companies that have grown over the years, the suspicion also grows that there must be tens of thousands of small/medium-sized enterprises across the country that are unable to sort out their group structures because of the fear of disproportionate tax penalties.
The next step
Limited companies were invented to protect entrepreneurs making risk investments. Perhaps inadvertently, the associated companies' tax rules have made this option prohibitively expensive for one of the most important groups of potential innovators. One wonders whether Parliament ever really intended this outcome. Was it foreseen that small trading companies with an associated company would be so heavily penalised by the rules that were designed to prevent investors abusing the lower rate bands by spawning multiple limited companies?
The existing situation may suit the short-term interests of the Treasury by depriving small businesses of lower rate bands; but is this at the cost of stifling innovation and creating inefficiency in many smaller companies?
As mentioned above, Phil wrote to HM Treasury on this subject and received the reply below.
The 'fragmentation' issue and the need for simplicity were mentioned in the minutes of an HMRC Corporate Tax Operational Consultative Committee meeting on 26 January 2005, which also stated that 'any changes are likely to affect nearly 100 other pieces of legislation. Consequently changes would be difficult and costly to make'.
One cannot of course stop wondering what were the costs of introducing and abolishing a corporation tax
nil-rate band and its associated 'non-corporate distribution rate' (measures which the tax profession, unlike the Government, seems to have almost universally foreseen would lead to an incorporation 'stampede') and how that might compare with the cost of amendments to the associated companies' rules that might actually encourage real entrepreneurship.
An alternative suggestion
Having considered Phil's suggestion, it seems to me that it might need some refinement to remove the possibility that opting out of treatment as an associated company could lead to tax avoidance. For example, the rules should prevent, say, a parent company that was already liable to the 30% full rate from 'opting out' of the associated company rules and freeing up another tranche of the lower rate for its associates.
One tends to forget that treatment as a 'small company' requires a claim under TA 1988, s 13. Perhaps this claim should have two 'arms'; either the company elects for treatment as a small company and thus has its profits taxed at the lower rate; or, and subject to it otherwise being eligible for the small companies' rate, it could elect not to be treated as an associated company and be taxed at the full 30% rate. In that way it could be seen as almost 'group relieving' its lower rate entitlement to another associated company.
Being subject to these conditions should mean that, in a group of associated companies, there is not an entitlement to more than £300,000 worth of profits being charged to tax at the small companies' rate of 19%.
Get associated
As seen, HM Treasury are of the view that the problems of associated companies and the loss of the small companies' tax rate are not an issue. Perhaps readers would like to respond to their assertion that such problems are not happening on a large scale by e-mailing Taxation magazine (taxation@lexisnexis.co.uk) with their own experiences, which we can forward to HM Treasury for a response.
Finally, many thanks to Phil Needham BA, ACA for raising this issue. If they wish, readers can contact him at phil@hornbeam-accountancy.co.uk.
