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BLC Tax Print E-mail

Internet Marketing

Any entity has a lifespan from starting up, growing, peaking and declining to eventually dissolving.

To ensure the correct tax vehicle has been chosen entails detailed and ongoing comprehensive tax planning. Tax planning should be conducted before and not after transactions have occurred as it is often too late to implement tax saving measures once transactions have occurred.

As the business changes, the new tax structures will be required to ensure money is not wasted, because as taxable income grows, the percentage of tax charged on that income grows. Simple tax structures are the best to use because they are easy to manage and adapt in changing circumstances.

A tax strategy involves planning the type of entity used to conduct trade, the nature of the shareholders, the structure of the contracts under which trade is conducted, deciding whether the entity is likely to make initial losses, the manner in which the entity will grow and the way in which investors plan to withdraw a return from their investment. Getting it wrong can be costly.

This is an introduction to the types of vehicles available. We will continue to add detailed discussions to flesh out the implications of using various vehicles in the coming months. Keeping it simple allows one to focus on other strategic matters but it is good to know about complex rules should the opportunity arise to use them.

The following is a table of the main types of entities available for trade. Each has a unique set of rules that apply to it.

Sole trader

Person trades without separate company

Pays tax as individual

Company

Shareholder and company are separate legal entities

Company and individual pay tax separately

Group

One company owns the shares of another company

Companies pay tax separately but can choose to pay some taxes as a single unit

Consortium

More than 75% shares are owned by companies who each own more than 5%

Companies take their share of profits or losses and pay tax on it in their own separate entities

Corporate partnership

Joint project for which no shares are issued

Companies pay corporation tax on joint project calculated using CT rules

Limited liability partnership

A partnership with limited liability

Individuals to the partnership pay tax individually as with sole traders

Joint venture

Jointly controlled operations, assets or entities

Corporation tax, corporate partnership rules, consortium or group rules

 

Bank payments and receipt in the first year of trade

Regardless of the type of entity used, receipts and payments to and from UK company bank accounts need to be carefully recorded and controlled. 

Receipts and payments must be supported by the appropriate invoices.  Payments will be tax deductible if they are wholly and necessarily incurred for the business. In other words, expenses that are reasonably incurred to allow the business to trade. There are many detailed rules set out in the tax Acts on what types of expenses are disallowed. Examples are depreciation on assets, entertaining clients and certain donations to charities.

A few general rules about making payments in the first years of trade are:

  • Pay business expenses out of the business bank account and personal expenses out of personal bank account, keeping them seperate as far as possible
  • Keep transfers from the business bank account to the personal bank account to a minimum, but do transfer any amounts needed to cover personal expenses when required (this action of transferring money is called 'taking a loan from the business' because the shareholder or director and the company are two seperate legal entities) 
  • If there are other sources of income, such as salary from spouse or rental income, use this money to pay for personal expenses as far as possible, supplementing it where necessary by transferring from the business bank account to the personal bank account
  • Transfers to the business account from the personal account or payments made directly to suppliers on behalf of the business out of the personal bank account is making a loan to the business, and repayment of this type of loan has no consequences for persoanl or corporation tax
  • Make all payments by card, cheque, direct debit or bacs to ensure they can be easily identified
  • Avoid making payments by cash as far as possible, as they are harder to identify and record
  • Keep detailed notes on cheque stubs, paying in books and instruction sheets to the bank, signing and marking each invoice with the cheque number or other reference and date of payment when payments are made
  • If trading out of a home office, pay the mortgage and buildings insurance out of your personal account and allocated running costs of the company out of the company account
  • Make a choice between taking a loan or a salary and paying the necessary PAYE and National Insurance contributions every month
  • If not drawing a salary, pay voluntary national insurance by direct debit to protect state pension

Receipts and payments must be recorded in a cashbook, preferably daily or weekly. The preparation of accounts section of this site contains a downloadable spreadsheet in the format used by most accountants in UK who do not use expensive software for very small companies. Use the export button to download your own private record to Microsoft Excel and insert the information as described in the notes contained in the spreadsheet.

Perform a draft tax computation after six months to indicate how much tax is likely to be paid and put this money aside for when it is due.

Drawings for personal use in the first year of trade

Drawing funds out of the business for personal use can be done via salary, dividend or loans to directors.  Usually a salary is the most expensive way to withdraw funds, as PAYE (20% - 40%), employees national insurance (11%) and Employers national insurance (12.8%) will be due on the gross monthly payments. It is calculated as a percentage of the monthly payment made and is due 22 days after the end of the month in which the payment was made.

The detailed rules can be found on HMRC guides such as A General Guide to Corporation Tax Self Assessment issued by HMRC. On page 24 of the guide, loans to participators are discussed.  A loan to a participator out of a close company (very small company) can be a very tax efficient way to draw funds, as no tax is due on the loan until the final corporation tax liability is calculated for the first year of trade. The payment of tax is only due 9 months and one day after the year end. If the loan is repaid within 9 months of the end of the accounting period of the company, no tax will be due. If it is not repaid, the company pays 25% corporation tax on the loan which is refundable when the loan is repaid. The loan must be declared on form CT600A. If the loan is eventually written off, it is taxed as a dividend in the hand of the recipient.

A loan is recorded by recording a debit in the balance sheet account called 'director's loan' and a credit in the bank control account.   At the end of the year, credits can be introduced to reduce the amount of the loan owed to the company. 

For instance, a dividend can be introduced that is taxed in the hand of the director.  A dividend is not tax deductible for the company, so the company pays corporation tax on the dividend.  However, the company rate is 21% on small profits.  Depending on the income of the recipient, the dividend is potentially tax free for the recipient.  If the recipient is a higher rate tax payer, the dividend is taxed at an effective rate of 25%.

A salary can be introduced to cover the annual tax free portion of salaries given to all taxpayers in UK, called the personal allowance. The amount is adjusted each year by the government when the new budget is introduced in April. The salary is a tax deductible expense for the company when calculating corporation tax.

The director can introduce expenses paid out of pocket for running the business. The credit reduces the director's loan and the debit becomes an expense for calculating taxable profits of the company. For instance, if a director pays a mobile phone, motor vehicle expenses or use of a home office out of personal funds, a business portion can be introduced as a company expense.  The business portion must be allocated on a reasonable basis, by reference to the area of the home office as a portion of the whole house, or number of hours spent working.  Personal use of mobile phones of 25% to 50% is usually considered a reasonable allocation.

Before incorporating, it may be useful to trade as a self employed individual for a few years. There are tax benefits available if arrangments are put into place to ensure that the conditions of self employment status are met, such as having more than one customer or several sources of income.

Losses made in first years of trade

If losses are made in the first few years, they can be 'carried back' against employment income of the last four years spent in employment before becoming self empoyed.  This is done by ticking box 77 in the supplementary self employment pages of the individual tax return and putting a note in box 101 stating that you wish to make a S381 claim for losses againts general income from previous years.  If a person earned £30,000 in the last year of employment, and paid £10,000 PAYE, a loss of £30,000 in the first year of self employment can be carried back against the income earned in the last year of employement, resulting in a tax refund of £10,000. This can be done for the last four years of employment and the first four years of self employement.  The refunds can then be used to help the start up, and reduce loans to directors as described above.

Losses made by companies can only be used for relief against profits of the previous twelve months of the same trade or future profits made by the same trade, provided that the owners and nature of the trade do not change over time. They cannot be directly relieved against the personal income of the owner/manager of the business. It is possible to pass losses to members of the same group of companies if the share structures are correct in a 75% group, where beneficial holding by the parent company in its subsidiaries is more than or equal to 75%.

The most beneficial rule available to group companies is the substantial shareholding exemption rule, where the sale of the shares from one company to another can be exempt from capital gains tax if they have been held for longer than two years.  An individual shareholder will pay 40% on the taxable gain from the sale of the shares.

For this reason, it is useful to plan the exit route from the start.

Limited Liability Partnerships (LLP'S)

The profits of LLP's are taxed in the hands of the members who have contributed funds or assets to the LLP. Members are defined by the Limited Liability Partnerships Act 2000. The tax treatment of the LLP is governed by the accounting treatment set out in the SORP and there is HMRC guidance available on the tax treatment of LLP's but no specific tax legislation covering the tax treatment of profit in UK. Therefore, any tax schemes involving the use of LLP's would benefit from pre-arranged HMRC approval prior to implementation.  HMRC have actively challenged unapproved schemes involving LLP's.

Ownership of the LLP, and therefore its assets and profits, is dependent on the partnership agreement and usually defined by virtue of relative contributions to the LLP. For example, if Investor A has contributed 50% of the Members' capital to the LLP, then Investor A will receive a 50% allocation of profit at the end of the financial year and 50% of the proceeds on any sale of the assets.

The key concept to notice is that in order to change the ownership of any particular assets help in an LLP, the LLP does not need to make a taxable sale of the asset, but the members can simply withdraw one contribution and inject a contribution from a different owner.  For example, if Investor A wants to pass its 50% ownership to Investor C, it simply withdraws its contribution (in cash) from the LLP which is then replaced by a contribution from Investor A. The injection and withdrawel of contributions are not taxable transactions, whereas the sale of shares in Limited Companies would carry capital gains tax and stamp duty fees. 

Tax on the sale of assets

Companies in UK benefit from tax relief when transferring assets between Companies in collectively owned groups.  This is known in the profession as the Nil Gain Nil Loss transfer of assets.  The tax base value which is used to calculate the profit on sale remains unchanged and the asset simply disappears from one balance sheet and appears on another. If a company transfers a property outside its own group, capital gains tax of 40% comes into play on the market value of the asset.  A company that regularly buys and sells properties as its main trade will be treated differently for tax from investment holding companies that simply hold the assets on their balance sheets for capital growth. This is where HMRC can challenge revenue versus capital treatment of profits. Capital gains tax is far more stringent with fewer deductions available to reduce the full charge of 40% and the rate of revenue tax is lower at 30% (the Corporation Tax rate).

On the other hand, individuals trading in properties are heavily taxed. Properties owned by individuals are subject to capital gains tax and inheritance tax. If assets are transferred to family members within seven years of death, the assets are taxed at 40%  which is the same rate of tax paid when selling second homes via the vehicle of capital gains tax.  There are various annual and other exemptions in the capital gains tax rules that can make this burden lighter, and assets transferring to a spouse are not taxed if the spouse is UK domiciled for tax. 

First homes can benefit from principal private residence relief, but that will not necesarily apply to situations involving inheritance tax. Problems arise when estates contain valuable assets and little cash, as inheritance tax is applied to the entire value of the estate after certain exemptions and reliefs have been applied. 

Comments
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Yasir  - Nice to see some knowledge base   |124.29.216.xxx |2010-08-09 02:17:15
It is wounder full to see such knowledge base for professionals.
I really found
it usefull and have some suggestions which if incorporated will be of great help
for me and others.

1-please do incorporate the IAS-12 along with some practical
examples so that it would be able to clarify to professionals in the field of
tax planning the overall flow of tax
nfowler  - IAS 12   |SAdministrator |2012-09-24 14:41:31
Please visit the IAS pages on this site to view a presentation on IAS 12. To see
real life examples of more complicated tax notes, I suggest reviewing the Annual
Reports of Banks and PLC's. These can be downloaded from Companies House or from
the individual corporate websites.

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