The emergency Budget of 2015 introduced rates of tax for dividends which had repercussions for contractors trading via a company and other owner-managed businesses.
Prior to 2016-17 there was often a clear tax benefit to forming a company compared with invoicing as a sole trader. This is because, unlike a sole trader, a company owner could take profits as dividend and thereby avoid national insurance.
The example below takes a company with profits after deduction of director’s salary of £90,000. Using the corporation tax rate for 2015-16 and 2016-17 which is 20%, profits available as dividend would be £72,000. In this case, the director receives a salary up to the national insurance threshold of £8,060 and withdraws all remaining profit as dividend.
Limited company calculation
2015-16 @ 10% basic rate
2016-17 @ 7.5% basic rate
2015-16 @ 32.5% higher rate
2016-17 @ 32.5% higher rate
Note in 2015/16 the dividend is grossed up by 100/90. Grossing up does not occur under the new rules.
Adding the corporation tax payable of £18,000, the overall tax burden increases from £28,276.88, to £30,819.50. This tax is calculated on a profit, before salary of £98,060.
Sole trader illustration
The following table illustrates the tax implications of the same individual trading as an unincorporated business
Income tax @ 20% basic rate
Income tax @ 40% higher rate
National insurance @ 0%
National insurance @ 9%
National insurance @ 2%
It can therefore be noted form the above that while a sole trader tax liability has not changed considerably in 2016-17, a company contractor now has a burden about the same as that of a sole trader.
Personal allowance abatement
Income over £100,000 would normally result in abatement of personal allowance. A sole traderdreach this abatementold with lower income than a contractor company. This is because corporation tax is deducted from income subject to income tax.
The tax benefit of a company compared with a sole trader will be significant if the profits in the above example were increased by say £10,000.
Benefits a limited company
Where the shareholder pays another person from their income a shareholder could be added so as to effectively double the £5,000 dividend allowance. A typical situation would be where household costs are shared with a spouse, who has no other dividend income.
The rate of corporation tax drops to 19% on March 2017 and again to 17% in March 2019. Therefore, the tax benefit of company compared with sole trader will become clearer.
It is not necessary to withdraw all remaining profit as dividend. Alternative could be to accumulate profits in the company and extract these as capital gains on eventual disposal of the company.
In the approach to the 2016-17 Budget the government entered a consultation on the abolition of entrepreneur’s relief for contractor companies. However this capital gains tax relief has remained intact.
The protection of limited liability which derives from using a separate entity through which to contract often suits both sides of the arrangement for non-tax benefits.
On account of the above, it can be maintained that a company pulls more credibility.
Mr Osborne delivered his eighth Budget as Chancellor at round 12.30pm today. The Budget was announced against a backdrop of slowing global growth, recent interest rate cuts by central banks into negative territory and the forthcoming EU referendum in Britain. The first two Budgets of our current government have been far reaching and full of surprises. This contrasts with the Budgets of the preceding coalition government which tended to alter very little.
The overviews below follow the chronological order in which the announcements were made, with some supporting explanation.
From 6 April 2016, the charge for a loan to a participator will increase from its current rate of 25% to a new rate of 32.5%. A participator is typically a shareholder or director of a company with five or fewer owners. Directors of a one-person or ‘contractor company’ and family owned business will usually be participators.
A full summary of the rules can be read here in the article about overdrawn director’s loan accounts. In brief, where a contractor has not retained sufficient funds in the company at the year end to cover corporation tax, it will be a requirement to lend money as a director. This loan gives rise to a tax charge.
Company funds are usually represented by the company bank account, however amounts owed from clients and equipment and other assets brought into the business can also be used as a buffer.
If the bank account is brought back into balance in future years, the charge can be repaid by HMRC. However there is a cash flow drawback and an administrative burden of borrowing money from the company.
Payments on termination of an employment contract receive preferential tax treatment, provided the payments are not an entitlement under the employment contract. Under current legislation a termination payment is not subject to employer’s national insurance and the first £30,000 will not be subject to income tax in the hands of the employee.
This measure has the purpose of an anti-avoidance provision.
Diverted Profits Tax (Large companies)
A series of new rules are scheduled to be introduced to bring profits derived from the UK into the charge of UK corporation tax. The measures are aimed at companies with profits of over £5 million.
The rules will have most impact on multi-national organisations with that particular scope to structure finances so group profits are taxed in jurisdictions with lower than average rates.
For most companies, the deduction from profits chargeable to corporation tax for interest payments will be restricted to 30% of UK income.
Only 50% of current year profits can be reduced by losses brought forward from previous years.
The tightening of rules on withholding tax for royalty payments and other measures will also be presented.
Corporation tax fall
Following previous announcements, the corporation tax, which is currently 20%, was due to fall to 19% in April 2017 and to 18% in April 2020. The Chancellor announced that the rate will now be reduced further to 16% in 2020.
Tax relief for ‘micro-entrepreneurs’
Traders and landlords with less than £1,000 will not need to declare this income on a Tax Return. The income will be tax free. This will particularly benefit vendors with a side-line on websites such as E-Bay and AirBnB. Traders bringing in more than £1,000 income can deduct the allowance from their income profits, instead of actual expenses. A total of £2,000 can be exempted from tax, one allowance for property income and the other for trading.
Business rates drop
From April 2017, small business rate relief will be increase. The relief currently exempts businesses with a rateable value of £6,000, however this is set to increase to £12,000 from next year. The higher rate threshold will also increase at the same time from £18,000 to £51,000.
Stamp duty on commercial property
With effect from midnight, the chancellor has brought the stamp duty system for commercial property in line with that for residential property. The tiered system will mean that no stamp duty is payable on a property worth £150,000 or less, 2% is paid on consideration between £150,000 and £250,000 and 5% is levied on the value of the property which exceeds £250,000.
With the stated aim of helping “small firms”, the new duty will benefit all but purchasers of the highest value property.
Indirect taxes mixed
Levy on sugary drinks
Fuel duty freeze (despite lower petrol prices on account of the recent oil glut.)
Tobacco duty rise.
Freeze on beer, cider, whisky and other spirits duty with other alcohol taxes rising.
Class 2 NICs
Class 2 is a flat rate of national insurance which is payable by sole traders and partners. The contribution secures a year towards the number required to qualify for a basic state pension. This tax will now be abolished in 2018. A social security and state pension entitlement will accrue to self-employed people via the Class 4 National Insurance. This is payable at the same time as income tax.
Capital gains tax cut
With effect from 6 April 2016, the basic rate of capital gains tax will be cut from 18% to 10% and the higher rate of capital gains tax will be cut from 28% to 20%.
The rate at which an individual pays capital gains tax depends on their total income. Gains below the annual allowance are not taxable. Taxable gains are added to an individual’s yearly income. To the extent that total income and gains are above the higher rate tax threshold, gains are taxed at the higher rate. Otherwise gains are taxed at the basic rate.
Gains made on residential property will continue to be charged at the existing rate of 18% basic and 28% higher rate tax.
Entrepreneur’s relief for investment in small companies
Entrepreneur’s relief will reduce capital gains tax for the subscription of shares in an unlisted company and held for the longer term. The new rules will apply to any purchase in new shares made from tomorrow. The requirement will be for the shares to be held for at least three years from 6 April 2016 or date of purchase, whichever date is the later.
In effect the rate of tax will be 10% and subject to a life time limit of £10 million. The new rules extend relief currently available for shares purchased under the enterprise investment scheme.
Chancellor silent on entrepreneur’s relief restriction for contractor companies
The government had consulted on the abolition of entrepreneur’s relief on disposal of a business. However, there were no announcements in the Budget about this relief being withdrawn.
There remains an opportunity for company owners to accumulate profits in the company and withdraw this on eventual disposal. The accumulated funds in the business, usually represented by monies in the bank account, can be withdrawn as capital on eventual disposal. The implication is that the funds will be taxed at just 10%, rather than the much higher rates for dividends or salary.
Nonetheless, holding funds in a company in order to save tax carries the risk that the rules about entrepreneur’s relief will be scrapped.
Lifetime ISA of £4,000 a year for the under 40s
From April 2017, the government will introduce a new ISA. Savers who are under 40 on 5 April 2017, will be able to contribute up to £4,000 a year into an ISA. For every £4 contributed by the taxpayer, the government will add £1 to the ISA account. The government contributions will continue until the ISA holder reaches 50.
Some or all of the capital can be invested in an ISA for purchasing a property after just one year. However the property must be the first home owned by the taxpayer and have a value of £450,000 or less.
Alternatively, savers can wait until 60 to use the capital as pension income. Unlike pensions however there is no tax to pay on withdrawing the funds. The tax relief on investment is equal to the current basic rate of tax. To this extent the new ISAs will be more attractive to basic rate taxpayers.
If the ISA fund is not used to buy a home or for a pension on reaching 60, any withdrawals would be subject to a 5% charge and loss of the government bonus. The measure is intended to assist young people saving towards a deposit on their first property.
From 6 April 2017, all savers will be able to contribute up to £20,000 a year into their ISA.
The Budget introduced some expensive tax breaks, with a particular focus on easing the burden for small business. However, with a stated policy of national deficit reduction, it remains to be seen whether this trend of fiscal policy can be upheld.
A new dividend tax rate was announced on 8 July 2015 in the Chancellor’s Budget. The implication is that no tax will be payable on the first £5,000 of dividends. Thereafter, income tax will be charged on dividends at a rate of 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional tax payers.
The implications for Contractors have been summarised in the article on 2016-17 Contractor companies. The introduction of the new dividend tax will significantly reduce any tax savings currently enjoyed by operating via a company. From 6 April 2016, contractors will probably pay more income tax on dividends (in addition to the corporation tax.)
The saving in national insurance (NI) will remain. However the NI saving of being a company may marginally outweigh the extra income tax (when compared with being a sole trader.) As a broad measure, once profits exceed £65,000, if all profits are withdrawn as dividends there will no longer be an overall tax benefit to being a company.
Advantages of continuing via a company
Unlike employees, businesses can register for VAT. Particularly for flat rate scheme users, VAT registration is a considerable tax benefit, and unchanged by the Budget.
The paymaster will save in employer’s national insurance compared with hiring a contractor as an employee. This is a considerable saving equal to 13.8% on earnings (above about £8,000 a year.) There may be other non-tax benefits to the contract arrangement.
Paying a shareholder on a lower rate of tax (such as a spouse) will continue to have a tax benefit.
Outlook over the next five years
Corporation tax is reducing to 19% in 2017 and to 18% in 2020. This will reduce the overall tax payable by company owners compared with employees and sole traders.
Tax rules change frequently. This guidance applies to the 2016-17 tax year.
The new rules take effect on 6 April 2016. Therefore, the tax benefit of having a company up to this point will remain.
Consider taking as much dividend as possible before 6 April 2016.
Consider dissolving the company and withdrawing accumulated profits as capital gain on disposal of the business.
Dissolving the company
It is possible to extend an accounting period up to 18 months. Accounting costs could be saved by extending the final period of account.
There is also the option of extracting some accumulated profit as capital on dissolving the company. Up to £25,000 can be withdrawn without a requirement to involve an insolvency practitioner.
Yesterday’s Budget announcement Budget on the taxation of dividends has significant tax implications for company owners.
The current system for contractors
Currently, contractors providing their services via a company are liable to corporation tax on profits. To the extent that dividends increase total income into higher rates of tax there is additional tax to pay.
In a typical scenario where a person has little or no income from outside the company, it is tax efficient to pay a salary up to the national insurance threshold. This is £8,060 for 2015/16. Provided the director has no other income, the salary results in no income tax and is deducted from corporation tax profits. The taxpayer is effectively in the same position as an employee or sole trader who can also have income up to the personal allowance (of £10,600 for 2014/15) tax free.
The remainder of profits are treated as dividends. The basic rate tax threshold is £31,785 for 2015/16. Given the first £8,060 is paid in salary, the most net dividend that can be paid to an individual without making that person a higher rate taxpayer is £30,892 in 2015/16.
In a typical scenario a company owner will receive a salary, so that the first £8,000 of profits are effectively tax free, provided there is no other income, the next £30,000 or so of profits taken out of the company also result in no income tax. To the extent that dividends increase total income into higher rate of tax an effective rate of 25% is payable. Since dividends are paid out of after tax profits, for a higher rate taxpayer, the combined effect of corporation tax (20%) and income tax (80% of 25%) is 40%.
The new regime
From April 2016, the tax payable by a contractor will likely increase. Profits will be calculated after deduction of director’s salary and corporation tax will be applied to profits.
Any contractor, with personal allowance fully used and, with a dividend of more than £5,000 will be paying more tax than before.
In total, transfers from the company bank account to the director’s personal bank account of more than £13,060 (in salary and dividend) will result in more tax. In 2016/17 a person can receive total income of £43,000 before being a higher rate taxpayer. Therefore, a contractor will be taxed at 7.5% on income between £13,060 and £43,000.
In 2016/17, a shareholder with dividends of £34,940 (and salary of £8,060) will be taxed at 7.5% on £29,940 of dividends. An increase in tax of approximately £2,246, compared with the same situation in 2015/16.
The national insurance rates are scheduled to alter in line with the income tax rates. For the purposes of example, I will base 2016/17 rates on the 2015/16 levels. An employee with earnings of £43,000 a year would pay approximately £4,200 a year in national insurance. A self-employed person with £43,000 profit, would pay approximately £3,150 a year in national insurance.
There will still be a tax benefit for a basic rate taxpayer from using a company, although significantly reduced from April 2016.
For self-employed individuals, the increase in accounting costs only justify the saving in national insurance when income reaches about £15,000 to £20,000. For a person self-employed, with profits between £15,000 and £43,000 there is still tax efficiency achieved by operating via a company.
For a higher rate taxpayer, the new dividend rate is 32.5% compared with 25% previously. If all company profits are taken as dividend, the combined income tax and corporation tax rate for a higher rate taxpayer is 20% plus (80% of 32.5%), or 46%. This is higher than the income tax and national insurance paid by higher rate taxpayers who are either employed, sole traders or partners, where the marginal rate is effectively 42%, i.e. 40% income tax and 2% national insurance.
In the example above an employee on £43,000 would save £1,954 (i.e. £4,200 less £2,246) by providing services via a company. A sole trader would save £904 providing services through a company. The extra 4% payable by higher rate taxpayers will gradually erode this tax advantage. A sole trader would be no better off using a company when total income reaches £65,600, and thereafter worse off. This calculation compares saving in national insurance with increase in income tax only.
The comparison with an employee is less relevant since an individual who would be employed ‘but for’ the company should be taxed under the old ‘IR35’ rules. However, for illustration purposes only, an employee may need to earn as much as £91,850 a year to be no worse off than if operating via a company.
Notwithstanding, there are other tax benefits to the corporate structure. An employer saves considerable national insurance by using contactor. Employer’s national insurance is currently 13.8% on earnings over the primary threshold of approximately £8,000 a year. The flat rate scheme will remain available to sole traders and company owners with total turnover of less than £150,000. A considerable potential tax advantage over employees who cannot be VAT registered.
Moreover, there is some respite for contractors in the form of a drop in corporation tax, falling to 19% in 2017 and 18% in 2020. This saving in corporation tax from 2017/18 and thereafter will help to mitigate the tax increase explained above.