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- KEY POINTS
- The consultation on associated companies is helpful.
- HMRC should look at companies as a whole.
- Interdependence can be financial, economic or organisational.
- Associated companies should review their position.
- Beware of creating a tax advantage.
Anyone who advises owner-managed businesses is likely to have found that one of the most frequently asked questions is whether two companies are associated.
One of the traps in this respect is how separately owned businesses can still be associated, especially where family is involved. It can mean surprisingly large tax costs through the loss of the small companies rate (SCR), which are widely seen as unfair, especially where the firms have little in common.
HMRC recently issued a consultation document ‘Simplification review: the associated company rules as they apply to the small companies’ rate of corporation tax’ proposing further measures to try to improve this.
They estimate, on a rough basis, that some 3,000 businesses may see benefits, climbing to 5,000 after the recession. Consultation ends on 22 January 2010, so enactment in the next Finance Act is a possibility.
Businesses need to look at how they operate to see whether they may be able to save tax and what pitfalls they need to avoid in achieving that. The effect of the proposed changes on a business could depend on the way it plans now, for example on how loans are secured.
There may be 3,000 winners in prospect but some frustrated losers, so it is worth seeing how your clients may stand and looking at the available options.
This article looks at some of the issues raised in the document.
What does association cost?
Where two companies are associated there can be a drastic effect on the rate of tax which they both pay. A company with no associates currently pays corporation tax at 21% on profits up to £300,000.
It will only pay the main rate of 28% when profits exceed £1.5 million, with the profits between taxed at a 29.75% marginal rate. The £300,000 and £1.5 million thresholds are divided by the number of associates.
Example 1 shows that having two companies associated can be expensive where both have £300,000 profits.
There would be an increase in tax of £26,250 each year split equally between the two companies. Over five years this is equivalent to tax on an extra £625,000 of profits for those hoping to pay tax at 21%. The extra sales and hard work these fictitious profits represent hardly bear thinking about.
The result in Example 1 is not as extreme as it may seem. Businesses may legitimately want to plan commercially and structure reward for the owners/executives around maximising the use of the SCR bands.
Companies could find themselves associated in unexpected ways that may escape common sense. This includes activities by relatives beyond their knowledge or control, perhaps in estranged families.
Incorrect counting?
The number of companies deemed to be associated is based upon control which for the SCR purposes of TA 1988, s 13 is by reference to s 416. It will probably not be surprising that where a company controls another company, or a single person (or a nominee) controls two companies directly, those companies are associated. This remains unaltered through the planned changes.
Complications start when you have to look at the associates of that person as defined in s 417. Crucially, s 416(6) provides that the rights of a person’s associates may be attributed to that person even if the person in question is not himself a participator in the company in question.
Association can be created by fixed preference share ownership, loan creditor rights, trusteeship or by being related. Most cases involve relatives which s 417(4) defines, for association purposes, as being ‘[spouse or civil partner], parent or remoter forebear, child or remoter issue, or brother or sister’.
The current statutory rules mean that if two spouses run quite independent companies, association for SCR purposes could result in a considerable amount of extra tax payable.
It is important to recognise that the legislation, while it applies to deliberate fragmentation ploys to gain access to the lower rate of tax, is not based on testing tax for an avoidance purpose. It applies by effect, not intent.
Commercial arrangements demonstrably set up with without regard to the tax effect are equally caught.
Is help already at hand?
Extra-statutory concession C9 ‘Associated companies’ reduces the impact for associates and, in the case of relatives, restricts those associated to just spouses (and, since 2005, civil partners) and children who are minors, provided the companies in question have no substantial commercial interdependence.
In testing this, HMRC officers are instructed to look at the overall picture, not isolated factors.
However, the list of things is so extensive that companies which are taking almost any commercially sensible steps to support each other are likely to face challenge. The list includes administration, staff, equipment, premises, buying and selling arrangements, joint ventures, loan and guarantees.
A further relaxation was made in FA 2008, s 35 effective from 1 April 2008 such that business partners are not taken into account unless there are planning arrangements (as specifically defined) involved to obtain a reduction in corporation tax.
Count me out
The present consultation builds upon ESC C9 and the 2008 changes. The overall stated intent is that the associated company rules should relate to whether companies are part of a wider economic unit rather than being potentially associated by ‘accident of circumstance’.
While a single person and his nominees are not affected, the proposals in the consultation have two main effects:
- to make it sometimes possible to disregard the association of spouses/civil partners and minors, as well as providing a potential disregard for all associates who control other companies;
- to provide criteria and examples to appraise the level of economic, financial and organisational interdependence between companies.
The change to statute is by amending TA 1988, s 13(4) and also s 13(4A) to (4C), as introduced in 2008 potentially to exclude partners, in effect to exclude all associates.
This disregard is subject to a ‘relevant tax planning arrangements’ override as defined in s 13(4A) to (4C). There are three significant aspects to this.
First, the arrangements have effect at any time in relation to the company, in connection with its formation or otherwise. This suggests that past or future arrangements may need to be taken into account.
The HMRC notes make clear that the effect must extend to the period concerned which would be appropriate as the associated company position is tested on a period by period basis. Section 13 needs to be read as a whole to be able to construct this meaning.
It is quite possible, however, to envisage that some past events could be argued as having a continuing effect and so impact on the SCR in later periods.
Second, arrangements are said to include ‘any agreement, understanding, scheme, transaction or series of transactions (whether or not legally enforceable), other than any guarantee, security or charge given to or taken by a bank’.
This is very wide ranging and the guidance notes provided are intended to clarify how HMRC propose to apply this.
Finally, the relevant tax arrangement means an increase in the amount of the SCR is obtained. This operates by cause rather than intent, in other words by effect of the arrangements.
HMRC do not need to impute an avoidance purpose, for example that fragmentation to save tax is a main purpose of using multiple companies.
Be my guide
HMRC’s intended practice in the guidance notes is to look at three types of interdependences, namely financial, economic, and organisational. HMRC say each case is to be looked at on its facts, and that not all three types of interdependence need to be present where one type is present to a sufficient extent.
Financial interdependences involve:
- Financial support by one company or its owners to another without which it would not be viable. This extends to indirect support, such as guarantees.
- Companies with common financial interest in the affairs of a business.
Economic indicators include:
- Seeking to realise the same economic objective.
- One company benefiting from another’s activities.
- Companies supplying the same circle of customers.
An organisational interdependence would apply where direct and immediate organisational links mean that the businesses could not reasonably be run at arm’s length without sharing, for example, common management, employees, premises and equipment.
Examples and questions
The consultation document gives four examples of each of these three categories with HMRC’s views as to whether the companies are associated or not.
The positive news is that some taxpayers will find support in the guidance that they are not associated, but the sheer diversity of business scenarios means that some taxpayers, while they believe they are acting commercially, are likely to find uncertainty and dispute with HMRC were they to press their case.
In the impact assessment HMRC estimate business will have a one-off time cost of 20 minutes to see how the new rules apply to them. This seems optimistic in more complex or marginal cases, even with advisers who know the rules to help. Also circumstances could change over time, meriting periodic reappraisal.
What pointers can be drawn from the examples? What anomalies and uncertainties may exist which perhaps the consultation process may help to improve? Some points from the examples follow.
However, those examining cases should read through the examples in the guidance and, it is to be hoped, find food for thought from the extra questions below while doing so.
Separation in the past
Companies separately run by spouses or civil partners are no longer automatically associated. The consultation document makes clear that this can only be the case if the companies were so run before the persons met.
Loans and guarantees
A loan to another family member’s company guaranteed personally by the owner of another company for family reasons will not be seen as associated. If the guarantee extends to the second company’s assets that would cause association. Care with how guarantees are made could save tax should bank requirements permit this.
Shared premises and resource
Sharing premises, staff and overheads without cross charge will be seen as association. Making a cross charge or bearing costs separately will not change this where premises are shared, the businesses are not independently viable and they share a common economic goal.
Here HMRC give the example of separation of ‘wet’ and catering parts in a pub. Shared or linked premises are seen generally as causing association where one underpins the viability of another (even if they operate at arm’s length) and organisational and economic links exist.
The example is given of a father and son with wholesale and retail building materials companies operating on the same site.
The issue here is the range of circumstance in which premises and services may be shared, and when any safe harbour may exist for family companies at the same site.
Take a business which has surplus floor capacity in a retail space and so wishes to sublet a part. What level of separation is needed before deciding to let it to a family member rather than a third party? The wrong decision could risk a serious loss of the SCR.
How will factors such as shared common services or the need, for image-related or regulatory reasons, for the businesses to be compatible?
Does it make any difference whether the sublet follows the void of a third party tenant? Could creating greater barriers or separation in legal ownership by lease help at all?
If HMRC could show that, at least in a recession, the sublet was contributory to the viability of the main business, does that raise issues on whether the sublet to an associate effects SCR or would it be wise to stick out for a third party tenant with possibly lower rent yield or a longer void period on the sublet part?
Services and customers
A company providing a service to another run by relatives may cause problems. An example is given of two laundrettes, some distance apart, owned and run separately by husband and wife.
The wife’s business specialises in cleaning evening and wedding clothes, as well as offering a normal dry-cleaning service. The husband’s company acts as agent for the specialist services, but does not have the ability to supply them itself.
Although both do their own mainstream work, HMRC’s draft guidance on the example sees the agency as resulting in association.
HMRC seem to imply that without the agency there is no association, e.g. if the agency shop refused to take in speciality work or used an independent business.
The questions arise as to whether it would make any difference if the speciality work were a trivial part of the business (as is often the case with high street dry cleaners) or if it had to pay far more send it elsewhere. Are HMRC therefore saying that even small levels of cross-referral in sales fulfilment are generally a fundamental issue?
If so, that would leave the second business in the example needing to calculate whether lower profits by refusing speciality work, or informally redirecting customers, should be considered if calculations show that may yield a better post-tax profit?
It could be argued that some of these counter-examples can be judged in the light of the general principles, but this raises questions as to how to obtain certainty.
The examples are hypothetical and will inevitably not be an accurate reflection of real-life situations. It may be natural for family businesses to support each other more in a recession in ways not needed before or afterwards. What extra level of risk with the SCR does this cause?
It can be sensible to share premises and working practices. If this were not done there could be an adverse effect on profits but that may be far from making either business really interdependent.
Applying commercial commonsense may mean the exchequer gets the double benefit of more profits to tax and a higher tax rate on those profits.
Practical help for business
If HMRC’s conjecture that 3,000 businesses may see benefits is correct, it is possible that quite a number of others could be better off by altering how they work, especially as profits improve.
But would HMRC provide advance rulings to help give clarity, and how could they ensure consistency and expertise at reasonable cost?
Action plan
HMRC await responses to their proposals. In the meantime, taxpayers, especially those with associated companies, should review matters to see if they stand to win.
Potential winners will want to seek as much benefit as they can obtain, as the following circumstances show.
A husband and wife have separate businesses with profits expected of £250,000 each in the year to 31 March 2010 and a cash surplus in each of £100,000 or more.
There could be a potential double benefit of considering a £100,000 bonus paid by the year end rather than later to:
- obtain a tax deduction at the 28% rather than 21% margin;
- pay income tax at a top rate of 40% rather than 50%.
With this size of payments it will be important to do the usual bonus/dividend comparisons based on actual figures and combine it with the overall wealth creation plans of the owners in terms of pensions, growth or sale of the business.
Where companies consider they may benefit from the rule changes, they should review the extent to which profit recognition can be legitimately deferred until the new rules come in.
Were they to do so, or in certain cases adapt business practice to improve the position, the question could arise whether such tactics may themselves represent arrangements securing a tax advantage, creating issues with s 13(4)(A) to (C) and so prevent the hoped for benefits.
Iain Robertson is a freelance writer on business tax issues, an area in which he has specialised for many years.
