TAX RATE SHOPPING
You may think, at least if you are not a regular reader of these pages, that tax is fundamentally a pretty straightforward matter. You do something, you make a certain amount of money and you feed this into the tax machine. With a whirring noise and the flashing of lights, out comes the tax you’ve got to pay.
If anyone has this feeling of delightful (or not so delightful) certainty, allow me to sow some seeds of doubt!
In fact, the situation is a long way from this nice straightforward scenario of the automatic tax liability. Personally, I would change the metaphor completely, in order to describe the system we have in this country. What it’s actually more like is going to the supermarket and having a look at the different range of goods on offer. In fact, what I have christened ‘tax rate shopping’ is a reality in a lot of situations. You, the taxpayer, have the choice of how much tax you pay.
Bizarre? Well, I suppose one way of looking at it would be to say that there wouldn’t be much point having tax advisers or a magazine like Schmidt Tax Report if we were all completely deprived of choice. But let’s get down to some examples.
Capital gains tax
For me, this was the most striking point in George Osborne’s 22nd June Budget. There is more on this Budget elsewhere in this month’s offering, but to sum up briefly, we were all surprised, I think, by the decision to charge 28% capital gains tax (CGT) on assets that don’t qualify for entrepreneurs’ relief, where those gains are made by higher-rate taxpayers.
The 18% rate announced as continuing for lower-rate taxpayers seems pretty much of an irrelevance to me. Anybody making any kind of sizeable gain is likely to be in the higher rate simply by reason of the amount of the gain. So we can take the effective rate of CGT on non-trading assets as 28% for all practical tax-planning purposes.
Now, I could go on at great length (indeed, write a book) about all the different reliefs and ways of avoiding CGT that there are. But my point here is about tax rate shopping, and I’ll give an example of the issues which CGT planners now face.
It won’t have escaped the notice of most people who have any interest at all in tax, on looking at the Budget announcements, that the corporation tax top rate, currently 28%, is coming down by stages to 24% over the next four years. At the same time, CGT is jumping up to 28%.
So, what rate would you rather pay on your capital gains: 28% or 24%? I confidently expect a number of people will start acquiring investment assets in limited companies rather than in their personal names.
But this is, potentially, a bit of a minefield. It’s true that, if you buy that investment property, for example, through a limited company, and sell it at a gain in five years’ time, that gain will only be subject to 24% tax (assuming the Budget proposals go through). But what if you actually want to spend the money you’ve made?
The problem with gains made in limited companies is that, if you are going to spend them personally, you need to take the post-tax proceeds out of the company. That can be highly expensive in terms of tax: if you are a 50% taxpayer, for example, a dividend of the net-of-tax proceeds will land you in with a whopping further 36% of the net. I make that a total tax charge of over 51% on the gain. I’d rather leave that counter completely and move over to the personal ownership aisle, where there is a 28% rate of tax on offer!
Generally speaking, I would sum up the idea of putting capital gains into companies to reduce the tax as a bit of a minority interest. While the rate of tax on the immediate gain is cheaper in a company than in an individual’s hands, it’s not that much cheaper, and the reduction may be no more than a deferral of a much higher overall tax charge.
You might want to use a limited company as your asset-holding vehicle if you never envisage taking the money out of your investment portfolio (i.e. the capital) to spend it. If you regard your portfolio as being in the nature of a pension scheme, whose capital you will leave alone while living off the income, a company could just be the answer, because, unless you take the capital out, you’ll never suffer this second layer of tax that I have illustrated at 36%. In fact, if you still have the shares in the company when you die, your beneficiaries can, at least in theory, wind up the company, take the money out and never pay the higher rate of tax at all. This is because the company shares are rebased up to their market value on the date you die. A more cheerful and positive thought is that your beneficiaries, or even you, may cease to be UK-resident at some point in the future. If this is the case, you will be able to take out the net-of-tax proceeds from making capital gains in the company without another layer of personal tax: non-UK residents don’t pay either CGT or tax on dividends.
So, there are some very long-term planning issues here, but personally, if I were at all in doubt as to what I wanted to do in the future, I would stick to personal ownership and look to reduce the 28% rate that now applies in other ways.
Inheritance tax
You can choose what rate of inheritance tax (IHT) you pay, in lots of cases, starting from the rather expensive, and you might say not particularly good value for money, 40% rate that applies to a person’s estate on death. I don’t know whether you might prefer, instead, to pay 20%?
You can do this, at the same time as retaining complete control over your assets, by putting them into a trust for your beneficiaries. You have to exclude yourself from benefiting, so this only applies to assets that you don’t need yourself. However, there is an unlimited ability to avail yourself of the 20% rate, which is what applies to lifetime gifts into trust that you survive by seven years.
The drawbacks to a trust, which you may or may not care about, are, first, that there is a (relatively low) ten-year charge to IHT on its value, and, second, the fact that you yourself have to be excluded from any chance of benefiting, if it is to be effective as IHT planning.
The massive upside of a trust, in comparison with making an absolute gift of the same asset to your children or grandchildren, is that you can be one of the trustees and can control, effectively, exactly what is done with the assets. They are protected from any misfortune that may strike your beneficiaries.
A sensible view may be that it’s better to suffer a loss of 20% of the value of the assets concerned rather than the family losing them completely.
And then, of course, there’s the bargain basement, where a 0% rate of IHT is freely available to all. This is the rate that applies to all gifts other than to trusts that the donor survives by seven years. If you don’t want to be bothered with a trust, or if the idea of voluntarily paying HM Revenue & Customs 20% of the value of the gift just sticks in your throat, then this could be the product for you.
Of course, bear in mind that gifts of up to £325,000 (£650,000 for a couple) can be made into a trust at the same time as taking advantage of the 0% rate, and this can be repeated every seven years.
VAT
Come on, I can hear you saying, you can’t be telling us that we’ve got any choice on what rate of VAT we pay? Value-added tax, surely, is the one classic example of where the tax rate follows on automatically from the goods or services you are buying?
Generally speaking, yes, but have a look at the ‘Property Column’ elsewhere in this month’s articles!
International shopping
In some ways, this is the most obvious way of shopping to reduce your tax rate. The UK, to take corporation tax as an example, once one of the cheapest jurisdictions to run a company, is now amongst the ranks of the most expensive. Even though George Osborne is doing something about this with his reduction in rates to a top 24% corporation tax, he’s still hard put to rival the 12.5% that applies in the Republic of Ireland, just to take one example. Some Eastern European countries still boast a 0% rate of tax for locally incorporated companies.
So the moral seems quite simple: set up elsewhere, having done a little preliminary research on the local rules.
More than just a word of warning, though: if you continue to be personally UK-resident, too blatant a tax rate shopping trip can unleash the anti-avoidance dogs at HMRC. Where the purpose of setting up an offshore arrangement is avoiding tax to any great extent, rather than being driven by commercial considerations, you can end up with an assessment on yourself, charging income tax on the non-UK-company’s profits. So it’s essential to be able to show a commercial justification.
The other word of warning that you need to bear in mind is the fact that income from the offshore company, paid to you as a dividend or remuneration, will end up getting taxed in this country if you are resident here. So it’s a fat lot of good saving corporation tax by setting up in Ireland, for example, if you’re then just going to have to pay 50% tax when you take all the money out.
Longer-term projects, though, could well benefit hugely from the lower rates applying, as companies like Diageo and Microsoft have found.
Business income
If you’re going to be keeping profits within the business, perhaps rolling them back into capital expenditure, or perhaps to meet the business’ working-capital requirements, how does the difference between 50% and 21% sound to you?
Might you be inclined to select the 21% rate?
Most people would, and this is the single-most-compelling reason for operating your business through a limited company.
As far as I am aware, almost any business can now be operated through a company, including the professions to whom it was, at one time, strictly verboten. Not only lawyers and accountants but also doctors and dentists can now operate through companies.
The basic principle behind the taxation of companies is very simple (although the Labour administration managed to introduce a lot of nonsensical complications in its period of rule between 1997 and 2010). If you keep the profits within the company, you’ll pay the relatively benign rates of corporation tax, a maximum of 28%, but currently 21% for profits, up to £300,000. If, on the other hand, you pay out the company’s income to yourself, so that it becomes dividends or remuneration for you, you pay income tax which, of course, can be as high as 50%.
Well, that’s simple enough, and you can even see the political policy behind it. It’s good for businesses to have the profits ploughed back into them rather than blown by the proprietors, on wine, women and song.
But this doesn’t really help in those cases where there is no need to retain profits within the business. I mentioned doctors and dentists just now. Most of these are not going to need to keep back a lot for working capital. Once they’ve bought their appropriate medical equipment, they can’t do much else with retained profits in a company.
For profits that you extract from a company, in fact, the use of a limited company vehicle can actually increase your overall tax significantly, and this, to me, is one of the many examples of policy-free stupidity that has been introduced into our tax system.
Let’s stick with the example of the doctor who makes enough income to put him in the marginal rate of corporation tax (on profits over £300,000 divided by the number of companies he has) but wants to pay out all the fruits of his labours to himself personally. This may not, in fact, be for the purposes of wine, women and song, but may be, for example, to pay off a home mortgage, improve the home or build up an investment property portfolio.
The problem is, if you have a company, you are not only paying the marginal rate of corporation tax of just under 30%, you also have a further tax charge of 36.1% on top of that, if you then pay the post-tax profits out as a dividend. Paying yourself remuneration instead of dividends is likely to be even worse, because then you’re letting yourself in for employers’ and employees’ National Insurance contributions (NIC).
The effect of the income tax on the dividends combined with the corporation tax that the company’s already paid makes a total effective rate of over 55%.
It would have been better for our hypothetical doctor simply to practise as himself, and not try to do clever things with a limited company.
On a much lower level, a basic-rate taxpayer can actually save quite a significant proportion of his tax by operating through a company. If you would otherwise have been a sole trader, or a partner in a business, you would have been facing a total tax and NI hit of 28%, which is made up of 20% income tax and 8% NI. By setting up a company, which, shortly will also be at a 20% rate, you are saving the 8% NI and reducing your overall rate from 28% to 20%, assuming that you take the income out of the company by way of dividend.
Of course, what a lot of people would really love would be a method by which they could enjoy the company rates of tax on their profits or other income at the same time as taking the money out of the business personally.
Funny you should mention that...
Alan Pink FCA ATII is a specialist tax consultant who operates a bespoke tax practice, Alan Pink Tax, from offices situated in Tunbridge Wells. Alan advises on a wide range of tax issues and regularly writes for the professional press. Alan has experience in both major international plcs and small local businesses and is recognised for his proactive approach to taxation and solving tax problems. Alan can be contacted on (01892) 539000 or email: alan.pink@alanpinktax.com.