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A More Balanced Footing?
REBECCA BENNEYWORTH considers the new tax rate for non-corporate distributions.
A More Balanced Footing?
REBECCA BENNEYWORTH considers the new tax rate for non-corporate distributions.
THE INLAND REVENUE has become used to Budget press releases being used as a stick to beat it with and this year is no exception. Take, for example, the new measures to tax the profits of companies which distribute their profits by way of dividends to individual shareholders. The press release making this announcement (REV BN 34 at paragraph 3) states that 'This measure puts matters on a more balanced footing by ensuring that when profits are distributed to non-company shareholders by a company or group, profits are charged at a minimum rate of corporation tax of 19 per cent'.
Most readers of the press release thought that they understood what this meant, but with the publication of early guidance on the Revenue website within days, followed by the Finance Bill shortly after the new financial year started, we found that the legislators had other ideas! We had supposed that distributed profits would be subject to 19 per cent corporation tax — a reasonable assumption, but this is not quite the case. It leaves those wishing to distribute 100 per cent of their post-tax profits with an interesting conundrum.
Calculations using the new rules
The rules for the calculation of corporation tax under the new non-corporate distribution régime are set out very clearly in section 28, Finance Act 2004 . Schedule 3 to the Finance Act 2004 provides us with a wealth of additional information that the legislator believed that we would need, but the basic calculation for a single company with private shareholders is quite straightforward.
The new rules apply where, in an accounting period, a company makes (or is treated as making) a distribution to non-corporate shareholders and the company's underlying rate of corporation tax is less than the non-corporate distribution rate, which has been set at 19 per cent for the present.
The computation proceeds in two steps:
- Step 1. Calculate the tax ignoring the non-corporate distribution rules, but using the current rates of corporation tax and appropriate company divisor for limits to starting rate. This arrives at what the legislation describes as the 'underlying rate' for the period. If this effective rate is less than 19 per cent, continue with step 2.
- Step 2. Calculate the tax on profits chargeable to corporation tax (PCTCT) as follows. Match the profits chargeable to corporation tax (known as the basic profits) with non-corporate distributions paid in the period. Tax the amount matched to non-corporate distributions at 19 per cent and the balance of the basic profits at the underlying rate as shown in Example 1 below.
Example 1. Partial distribution — tax calculation
| Profit after salary | £20,000 | ||
| Step1 . 'Normal' tax computation — underlying rate | |||
| £ | |||
| Tax at 0% on £10,000 | 0.00 | ||
| Tax at 23.75% on £10,000 | 2,375.00 | ||
| Corporation tax | £2,375.00 | ||
| Effective ('underlying') rate on £20,000 | 11.875% | ||
| Step 2 . 'New' tax computation | £ | ||
| Non-corporate distributions (say) | 10,000 | ||
| £10,000 at 19% = | 1,900 | ||
| Balance of profits taxed at underlying rate | |||
| £10,000 at 11.875% | 1,188 | ||
| Total tax due | £3,088 | ||
As illustrated in Example 1 , the non-corporate distribution rules produced an increase in corporation tax for the company of £713 (£3,088 - £2,375). However, if we now consider the dividends paid to individual shareholders out of post-tax profits, we can see that the legislator has not done what we expected him to do. The dividend of £10,000 must be paid out of the post-tax profit of £16,912, which has arisen as follows:
£ Taxed at 19 per cent — profit after tax 8,100 Taxed at 11.875 per cent — profit after tax 8,812 Total profit after tax £ 16,912
Clearly, there are insufficient profits which have been taxed at 19 per cent for the dividend to be paid out of these, and the resulting distribution of £10,000 is made out of profits which have borne an effective rate of 17.64 per cent and not 19 per cent. While this is of course welcome news for the company and its shareholders, it does also pose an interesting puzzle. How does one calculate the corporation tax charge when 100 per cent of the post-tax profits are to be paid as a dividend? In order to calculate the tax, one needs to know the dividends, but in order to set the dividend, one needs to know the tax on the profits ...!
Those with a memory of 'O' level mathematics will hear the distant ring of the words 'solve using simultaneous equations' and they would, of course, be correct. In reality, the dividends paid in a period are a question of fact, and thus would not normally be calculated at the stage of doing the corporation tax computation — unless of course your director/shareholders are planning well in advance of the year end. Those fazed by simultaneous equations will find the modern solution in a spreadsheet, with appropriate formulae, and an iterative approach (known by most of us as 'trial and error'). We are bound to wonder whether this failure to implement what the press release said was a slip-up or happened by design. The explanation that this approach is simpler (avoiding a gross-up of dividends at 81 per cent) is dubious when considering the outcome for 100 per cent distribution.
More complications
Leaving such academic niceties aside, we have a number of other complications to consider when we depart from the very simple example outlined above. The legislation (section 28(5)) requires that periods spanning 1 April 2004 are to be split into two separate accounting periods, with profits to be apportioned on a time basis unless this provides an unjust result. This may apply to very few companies as, in practice, many distributed all available profits between Budget day and 31 March 2004, so very few will have paid distributions in the period 1 April until their next year end! However, a consideration of this in Example 2 gives a useful insight into a critical aspect of the new rules — the matching procedure.
Example 2. Period spanning 1 April 2004
| The profits chargeable are to be split on a time-apportioned basis. In this example, the underlying rate is not calculated, but the split is done to match the non-corporate distributions with basic profits. | ||||||||
| X Limited has profits for the year ended 30 June 2004 of £30,000. The dividends paid in the year were £10,000 on 31 December 2003 and £10,000 on 5 April 2004. | ||||||||
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In Example 2 , we have non-corporate distributions paid in excess of the basic profits. For a single company with individual shareholders, the treatment of 'excess non-corporate distributions' is given by paragraph 13 of Schedule 3 to the Finance Act 2004. These are carried forward and treated as a non-corporate distribution of the next accounting period. Thus, X Limited in Example 2 will begin the year ended 30 June 2005 with non-corporate distributions of £2,500. If the underlying rate of tax in the next period is at least 19 per cent, this will have no effect, but, clearly, significant excess non-corporate distributions carried forward could have an impact on the company's tax computations for years to come. Do the words 'deferred tax' now spring to mind? Rest easy, dear reader, surplus non-corporate distributions do not satisfy the definition of a timing difference in Financial Reporting Standard 19, so no deferred tax provision would be necessary. However, it may be necessary to disclose the existence of excess non-corporate distributions in the current tax note under Financial Reporting Standard 16, as this may have a material effect on the company's tax liability in the future. Quantifying that effect will be very difficult indeed! It remains the case that all companies which could be affected by these rules at any time should match non-corporate distributions with basic profits for each accounting period after 1 April 2004, to identify surplus non-corporate distributions on an annual basis.
For a single company, we near the end of the effect of the new rules. Non-corporate distributions will, however, affect a number of corporation tax situations. Consider the decision of whether to carry a trading loss back to the preceding period or carry forward to set against future profits. This decision can no longer be taken without considering the impact of the non-corporate distribution rules, which may be quite complex.
For companies that cease trading with significant undistributed profits, the distribution of those profits by way of a dividend to individual shareholders provides a scenario where one can still benefit from the nil rate band of corporation tax and draw the profits by way of dividends. However, this is not really a case of having the cake and eating it, but more of remaining hungry for an extended period before eating as much cake as one desires! The reverse is also true. Companies which have borne significant corporation tax rates of 30 per cent and more on their past profits and which are now in decline will still bear the brunt of the new tax on dividends they pay out to shareholders — inequitable indeed!
Groups of companies
Most groups have probably ignored the potential impact of these non-corporate distribution rules on their corporation tax liabilities, and rightly so in practice. However, the Revenue was clearly concerned that small groups could be formed to manipulate their way around the non-corporate distribution rules and it thus developed some fearsome additional rules to counter that perceived threat.
Returning to the basic rules, much of the content of the previous paragraphs is unchanged for companies which are members of groups, but where the non-corporate distributions in a period exceed the basic profits, a different route is taken to resolve this issue. Non-corporate distributions are allocated to a company within the group at the election of the distributing company and with the agreement of the recipient company (paragraph 10(1) of Schedule 3). If this is not done within the permitted time period, then the Revenue may impose an allocation. Groups for this purpose are those with 51 per cent subsidiaries, using the normal test.
The amount allocated must not exceed the recipient company's available profits (that is, profits after its own non-corporate distributions). However, the amount of the non-corporate distributions allocated in this way is restricted by the fraction of non-corporate distributions out of total distributions made by the distributing company, applied to the available profits of the recipient company. Here is where the complexity of the rules accelerates significantly! First, I offer a simple example (involving only a non-corporate distribution) — see Example 3 below — of how the rules are designed to operate.
Example 3. Non-corporate distributions in group situations
| Where a group company distributes profits in excess of its taxable profits, the surplus dividends are allocated to group companies. This will prevent the formation of a holding company to avoid the impact of the legislation thus: | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Fred Bloggs | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| | | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Holding company | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| | | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Bloggs and Co Limited | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Bloggs and Co Limited has made profits affected by the new rules — say £30,000, all of which it wishes to distribute to the ultimate shareholder, Fred. These are paid as a dividend to the holding company. The holding company is dormant, apart from receiving dividends from Bloggs and Co Limited and paying them to Fred, so it is not counted for associated company purposes. | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Bloggs and Co Limited pays a dividend to a corporate shareholder, so the new rules would not affect the tax position. The holding company does then pay a dividend to a personal shareholder, but has no taxable profits, so the rules will work as follows. | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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The deficit of £799, shown in Example 3 , represents the additional tax charge as a result of the new rules. Where there are a number of subsidiaries, there will be a choice in allocating non-corporate distributions. In such a case, the distributing company can choose the most appropriate solution. This would permit the allocation of excess non-corporate distributions against profits taxed at 19 per cent or more if they are available.
More complex situations
However, where the holding company is owned, say, 60 per cent by Fred and 40 per cent by another company and is paying the same dividends as shown in Example 3 , the amount allocated is restricted, as mentioned above, by the formula:
Non-corporate distributions
Dividendx available profits
This gives the following:
Non-corporate distributions = 60 per cent x £25,250 = £15,150 Dividend = £25,250 Available profits = Basic profits — non-corporate distributions = £30,000
The maximum amount that can be surrendered is thus limited to 60 per cent of the available profits, which here equals £18,000 and so, in this case, the whole of the non-corporate distribution of £15,150 can be allocated to the subsidiary. However, there may be situations where this limiting amount is less than the non-corporate distribution made by the parent company; for example, where the subsidiary has made a distribution in excess of its profits (say by distributing reserves). In such cases, the balance is carried forward by the holding company as excess non-corporate distributions.
These grouping rules then lead to other complexities which are not dealt with in detail here. Readers who expect that these rules will apply in practice should make a study of Schedule 3 to the Finance Act 2004. The rules are:
- the identification of corresponding accounting period for the purpose of allocation of excess non-corporate distributions;
- the treatment of excess non-corporate distributions where a group breaks up, but remains under the control of the same person or persons; anthe amendment of allocated amounts following an enquiry into the tax affairs of a company.
Summary
Most practitioners advising smaller companies have now appreciated the limited effect of these new rules and for those companies making profits in excess of £25,000 per annum the impact is noticeable, but not significant. However, a close study of these rules is bound to put some readers in mind of a possible version of a famous quote: 'never in the field of taxation has so much complex legislation been written for such little real effect' — and that is a difficult contest to win!
Rebecca Benneyworth is a sole practitioner and freelance lecturer.
