Archives for posts with tag: distribution

Bonuses or Dividends?

A not uncommon strategy for small companies is to take a small salary, sometimes one so small that neither tax nor national insurance will be payable and then to distribute the remaining profit as a dividend.  Because the dividend carries a tax credit a basic rate taxpayer will have no liability at all.  Before the late 1990’s there was a link between this tax credit and the corporation tax that the company paid through the medium of ACT, Advance Corporation Tax.  At that time if a company paid a dividend it had to pay this ACT over to the revenue even if it was a loss making company.

 Gordon Brown believed that there was too much abuse by companies and pension funds claiming repayment of the ACT and under some schemes it was artificially inflated. He ended the obligation on the company to pay ACT and substituted, for larger companies, an obligation to pay their CT by instalments.  Tax credits were also no longer to be repayable, for either companies, or pension funds, or even individuals.  This was the source of the allegation that Gordon ‘raided’ the pension funds, he was acting to prevent an abuse, such as that uncovered in the case of the Universities Superannuation Scheme, but pension funds that were not fiddling their tax credit repayments lost out heavily.

However the tax credit survived and is worked out as being 10/90ths of the net dividend paid, equivalent to the basic rate of tax which applies to dividends which is also 10%.

A taxpayer chargeable at 40% will find that the dividend is charged at the lower rate of 32.5% and after deduction of the dividend tax credit is effectively chargeable at 25% of the net dividend received by them.  A taxpayer liable at 50% is charged to tax on their dividends at 42.5% and after the tax credit is deducted is liable to effective tax of 36.1% of the dividend received.

The profits used to pay the dividends are of course taxable in the company’s hands and if it is a small company currently liable at 20% the effective rate for a 40% taxpayer is then 40% of those profits.  For a 50% taxpayer the liability is, of course higher, and the combination of corporation tax at 20% and excess liability at 36.1% is a grand total of 48.88%.

Woe betide a Chancellor like Gordon Brown who lowers the corporation tax rate below 20% because it creates an immediate advantage to dividend payments but…

 Dividends are not chargeable to National Insurance, but salaries and directors’ fees and bonuses can be, which is why this low salary, high dividend strategy is so popular.

Could this all change in the future?  I think the answer is certainly yes, and recent scandals involving government civil servants paying themselves through personal service companies whilst seemingly being immune from the IR35 rules that can deem a person who would have been an employee if the company were not used have not helped.

The simplest weapon would be to take a suggestion that was contained in John Smith’s shadow budget in 1992 – subject close company dividends to National Insurance!  That would put the cat amongst the pigeons and make no mistake and also, of course, it would enable IR35 to be abolished as it would no longer be needed!

This podcast is going to look at a recent case which some commentators have suggested could also be brought to bear against this sort of abuse, the PA Holdings case.  Now PA Holdings is not a low salary, high dividend case, it is a case concerning a National Insurance avoidance scheme marketed by accountants Ernst & Young who employed, at that time, a chap called Jim Yuill who was an acknowledged NIC expert, in fact probably the only one!  The secret behind the scheme which made it feasible was the abolition of ACT.  Companies who wanted to pay dividends before then were obliged to pay ACT, remember, even if they had no profits, but now they didn’t need to!  Jim’s scheme was intended to take a magic wand and wave it over a bonus, turning it into a dividend and hence minimising the income tax liability because of the tax credit and avoiding NIC to boot!

PA Holdings was also a slightly unusual company, a firm of management consultants owned by the employees, today it would be called an example of a ‘John Lewis’ company.  Every employee owned shares and received an average salary for the position that they held.  This policy almost guaranteed a profit at the end of the year which was distributed to all staff by awarding points for the efforts that they put in and distributing the bonus according to the points awarded.  80% of the employees decided to join the new scheme, the remaining 20% opted to continue to receive bonuses directly.

A company was set up in the Channel Islands and the money representing the bonus was used by PA Holdings to purchase shares in this company.  The shares were then awarded to each employee according to the points accrued and then a dividend was paid of the whole of the company’s funds – this would be illegal for a UK company but it was permitted under Channel Island’s laws.  However the Channel Islands company was also for tax purposes controlled and so resident in the United Kingdom so that a tax credit attached to the dividends received.  Then in the following year a new company was established and the process repeated, all over again.

So the employees who joined the scheme received a dividend, and if they were only liable at the basic rate this was effectively tax free, if higher rate taxpayers they had a liability of 25% rather than 40%, then claimed that as a distribution, a dividend, what they received was not liable to NIC either.  Why was this so significant, was it just the abolition of ACT?  No – it was that combined with the decision to lift the upper limit from employer’s NIC – to create what was, in effect, a payroll tax.  Create a tax and somebody will look to see if it can be sidestepped.

The revenue felt that this avoidance of both income tax, because after the tax credit the liability on a dividend was significantly less than the liability on a bonus, and national insurance was unacceptable and so ruled against the workings of the scheme, raising assessments on PA Holdings to recover the tax and national insurance which they thought should have been paid.  PA Holdings appealed and it is believed that there are many other companies who used this scheme or variants of it.

When the case when to the First Tier Tax Tribunal the judge indicated that, in his opinion, there were four questions that needed to be asked:-

 First – was the amount received an emolument, did it represent reward for the work carried out by the recipient?  Earnings within Schedule E as the description of that source was then called from an income tax point of view would be taxable and also be earnings from an NIC perspective.

 Second – was it a distribution, a dividend paid by a company to which the special taxation rules then found in Schedule F, carrying a tax credit to offset against the income tax liability and not chargeable to NIC?

 Thirdly – could it be both?  If so what were the taxation and NIC rules that then applied?

Fourthly, if it was neither, what was it and how should it be taxed, if at all?

The answers to these questions did not require sophisticated analysis or application of anti-avoidance rules such as that evolved in the wake of the Ramsay decision.

Was it remuneration, a reward for work performed?  The answer was clearly yes, and a consequence of that was that the fourth question did not need to be answered.

Was it a dividend, a distribution, and the answer was again yes?  It had been paid in the form of a dividend by the channel islands’ company and to the extent that the distribution exceeded the original capital contributed it was clearly a dividend.

So that brought into play question 3 – how should it be taxed?  It was observed that there was a statutory rule which seemed to govern this situation.  Section 20(2) of the Income and Corporation Tax Act 1988 said ” No distribution which is chargeable under Schedule F shall be chargeable under any other provision of the Income Tax Acts.”  Well that seemed pretty final, from an income tax point of view, as it was a dividend it could only be taxed as a dividend under Schedule F.  However the tribunal pointed out that there was no equivalent rule from an NIC point of view and so NIC was payable.

 It may seem odd that a rule deliberately taxes this income as a dividend and so gives rise to a lower liability but you have to remember that before 1984 there was a tax called investment income surcharge and at that time dividends were taxed more heavily than earned income.  When the surcharge was abolished the legislators seemed to forget to change this rule!

If the decision of the tribunal was allowed to stand PA Holdings would have had an obligation to account for NIC and because of the way it was charged most employees receiving a bonus would already be above the upper limit for NIC contributions or if below it the bonus would take them above their upper limit so that relatively little employees NIC would be payable but, as there was no upper limit for an employer the whole sum would be chargeable to employer’s NIC.  Not surprisingly PA Holdings appealed against this ruling.

From an income tax perspective, however, it meant that employees liable at the basic rate would have no liability on the dividend at all, whereas basic rate tax would have been payable on the bonus, and 40% taxpayers would have a liability of 25% of the bonus received as a dividend rather than a full 40% liability on the bonus.  Not surprising the revenue appealed against this ruling.

The appeal was taken, in the first instance, to the Upper Tier Tax Tribunal who broadly confirmed the decision of the First Tier Tribunal and again both parties appealed to the Court of Appeal who have recently handed down their verdict.  Of the three judges in the Court of Appeal the decision was framed by Lord Justice Moses and the other two judges merely indicated that they agreed with his decision.

Moses has taken a very old-fashioned approach to the problem having stressed that the decision of the first tier determined that in fact this sum represents remuneration.  In his opinion the old case of Salisbury House Estates v Fry in 1930 stresses that the schedules of taxation are mutually exclusive and so if the sum is assessable under Schedule E as remuneration then it cannot be a distribution within Schedule F which was only created in 1965 when corporation tax was created.  He feels that the rule in s20(2) is designed to resolve the situation where a sum which is a distribution is also capable of being taxed in another way as trade profits of a share dealer.

A great result for the revenue but a worrying decision for PA Holdings, but is it also worrying for other taxpayers as well?  I feel it is quite likely that this case will go to the Supreme Court finally and Moses’ decision could well be overturned.  Consider this though, what about the small company where a low salary is taken and the profits which could have been taken as remuneration are taken in the form of a dividend.  Could the arguments in this case apply to create either an NIC liability or possibly both?

From an NIC perspective it is difficult to apply the decision to the situation where a shareholder/director exercises a choice to withdraw profit in dividend form rather than as remuneration and arguably if there could be abuse the IR35 rules limit the scope to avoid liability anyway.

However where a shareholding structure has been designed which gives a shareholding interest to employees which is designed to enable them to take dividends instead of a bonus – sometimes called ‘alphabet’ companies because each employee could hold a different class of shares, and so receive a different bonus there would seem to be a real danger that this would enable the revenue to pursue liability in older cases.

From an income tax point of view it may be much more difficult because of the way in which the law has changed in recent years.  The old-fashioned approach of identifying mutually self-exclusive schedules came to an end in 2005.  The old Schedule E was actually abolished by the Income Tax Earnings and Pension Act of 2003 but initially the old s20(2) survived.  Then in 2005 the Income Tax Trading and Other Income Act completed the process started by the tax law simplification committee of abolishing the remaining old schedules and cases in favour of an approach where the legislation simply describes each type of income.

This 2005 Act inserted a new provision into the 2003 Income Tax Earnings and Pensions Act, section 716A, described in the heading as a ‘Priority Rule for dividends etc of UK companies etc’ says that ‘any income, so far as if falls within Part 2… of this Act and Chapter 3 of Part 4 of the Income Tax Trading and Other Income Act (dividends) is dealt with under Chapter 3 as a dividend.  This seems to suggest two things, the first is that sums are no longer capable of being excluded from charge because they are also potentially taxable in another way, and secondly that the dividend treatment takes priority.   Some commentators have suggested that as dividends fall within Part 7 of the act rather than part 2 a charge could occur but a closer examination of the legislation shows that a sum which is deemed to be income by Part 7 is brought into charge under Part 2 – the dividend would still take priority.

However in 2005 legislation was passed which was designed to attack the alphabet companies referred to above and this provides that a charge can arise in connection with employment related securities where they are issued in connection with tax avoidance.  This suggests that there could be a double liability.  However Dawn Primarolo, then the Paymaster General, made it clear to parliament that this measure was designed to target only “complex, contrived avoidance arrangements that are used, mainly, to disguise cash bonuses“.

For the moment, at least, the dividend extraction strategy of the small company would seem to be unaffected, although the NIC position may still need to be watched carefully.  Attempts to use other methods to disguise bonuses as dividends would seem to effectively counteracted.

But how much longer can or indeed should small companies be permitted by the government to use this strategy of limiting the liability to income tax and avoiding NIC – often totally?


ESC C16 & BVC 17

Hello – I’m Paul Soper and this is an extra edition in the series of Podcasts as usual intended primarily for practitioners – especially small practitioners, but, as ever, if you are a reasonably financially literate taxpayer or an accounting student you should enjoy it too – if enjoy is the right word! You can read the text of this podcast at my website http://www.Taxationpodcasts all one

There has been a considerable amount of confusion in the last couple of weeks over changes to two Extra-statutory Concessions – one, BVC17 being withdrawn, and the other ESC C16 being translated into legislation with significant new restrictions being attached.  The concessions came from different government departments and as they are both concerned with the same basic situation it is probably not surprising that this confusion has occurred.

First of all here are a couple of examples of situations where the concessions might be relevant.

John is a computer consultant and has worked for the last 10 years through a company.  He now wishes to retire.  The Company has two £1 shares in issue, both owned by John.  The company has accumulated reserves amounting to £55,000 and all outstanding debts have now been paid.

Fred has a small technology company which he started 10 years ago with a friend, and he has recently accepted a very well paid offer to work for a multinational, one of the conditions of which is that he works exclusively for them.  He wants, with the consent of his friend, to extract the reserves that he has built up in the company, currently amounting to £140,000 in total.  There are 10,000 £1 shares in issue, 8,000 owned by John and 2,000 by the friend. No claim had been made under the Enterprise Investment scheme.

Both John and Fred could appoint a liquidator to bring their companies to an end, and the sums that they extract will be treated as part-disposals from a Capital Gains Tax perspective, both will be entitled to Entrepreneurs’ Relief and these gains will be chargeable at 10%.  The problem is that liquidation does not come cheap – the liquidator assumes a personal liability in the winding up and so must make quite detailed investigations before distributing what is left.  In recent years government estimates of the cost of a straightforward liquidation have been made in the region of £4,000 to £7,500.

But there is an alternative course of action that John and Fred could have used to get the money out of their companies – it is called ESC C16 and is a revenue concession, at the moment, which recognises the cost of liquidation and allows the taxpayer who applies for the relief, provided they give certain assurances to the revenue, to pay a dividend, which would normally be taxable as income, but treat it instead as though it was a liquidators’ distribution which would only be subject to CGT at the Entrepreneurs’ relief rate of 10%.

They have to assure the revenue, amongst other things, that the company is ceasing to trade and will not carry on a business in future, that all outstanding debts have been or will be paid, that the information required by the revenue to determine the outstanding corporation tax liability will be provided and that the shareholders will accept the CGT liability.  Increasingly HMRC have also been asking for assurances that the trade is not going to continue inside another company or group.  Oh – and one more thing – the company must allow itself or present itself to be struck off by the Registrar of Companies under (in the words of the concession) section 652 or 652A of the Companies Act of 1986.

The most recent company legislation is found in the Companies Act of 2006, this became fully operational in late 2008, and the equivalent provisions are sections 1000 and 1003 of this later Act.  The published revenue concession has not been updated for the change in statutory references.

So both John and Fred could use this mechanism, even though Fred’s company has considerably more to distribute, but there is one fly in the ointment.  For John it is not very important as there are only two shares in issue but for Fred it is more of a problem.  C16 depends on the payment of a dividend, and a dividend cannot legally exceed the distributable reserves of the two companies, in John’s case this will leave £2 inside the company, hardly a concern, but in Fred’s case £10,000 – share capital in a limited company is not distributable.  To get this out would have required a formal liquidation – that is until October of 2011.

First let’s consider what would have happened before October to Fred’s money.  He could have walked away from the company leaving £10,000 inside it and it would then have become the property of the Crown under the Bona Vacantia principle, Bona Vacantia is also the name of a department of the Treasury Solicitor’s Office which deals with ownerless property.

Fred could have paid a dividend of the whole of the company’s reserves including the share capital but the excess of £10,000 would have been an illegal dividend and the same Bona Vacantia department would have the right to pursue Fred and his friend for that money on behalf of the Crown.

A couple of years ago the Bona Vacantia department tried to help out by reaching an agreement with the accounting bodies that an amount not exceeding the cost of a straightforward liquidation, which they estimated at £4,000, could be extracted and they would not pursue the Crown’s rights if the company had permission under ESC C16.  This was contained in an extra statutory concession document called BVC17 and available on their website.

At the time they also pointed out that as a result of the Companies Act 2006 there were other courses of action open which would avoid the problem anyway.

Fred couldn’t use BVC17 because his sum exceeded £4,000 but he could make a declaration of solvency under the 2006 Act and reduce his share capital to a figure of less than £4,000 and then apply for C16 approval.  He could apply to have his company reregistered as an unlimited company in which case all of it’s reserves would become distributable – non-distributability is the price paid for limited liability.

Even if he had, in error, walked away from the company and had allowed it to be struck off the 2006 Act allows a company to be resurrected within 6 years (previously 12 months only) and so put this right and legally extract the money.

Bona Vacantia clearly then thought long and hard about the ease with which a legal distribution could be engineered and in October 2011 announced that they were withdrawing the concession BVC17 with immediate effect because it was no longer necessary – as they made clear in a frequently-asked-questions section of their website they were no longer going to pursue these sums on behalf of the Crown regardless of the amount involved, £4,000 or £4,000,000 it didn’t matter.  So good news for Fred.

However the revenue were also thinking about their concession C16 and the necessity to make it a legislative provision because of a House Of Lords decision in the Wilkinson case suggesting that these concessions were not within the revenue’s power except in cases where they had care or management of the tax system.  Recently the Supreme Court have ameliorated this ruling in the Gaines-Cooper case and indicated that concessions can be made if they increase the potential sums accruing to the exchequer.

In December of 2010 HMRC announced that a number of concessions would be made law including C16, however they designed the legislation so that the amount that could be extracted in this way would be limited to £4,000 – coincidentally the same as the BVC17 limit.

Implementation of this was then postponed because of objections made which required reconsideration but on 6 December 2011, at the same time as they released draft legislation for inclusion in Finance Bill 2012, the revenue announced that the legislation of C16 would go ahead but with a limit of £25,000 rather than £4,000 and this would take effect from 1 March 2012 – it was to be introduced by delegated legislation under powers conferred on them a couple of years ago.  If the distribution exceeded £25,000 the WHOLE amount would now be taxed as income not gain.

Now this will cause problems for both John and Fred.  John’s problem is greater than Fred’s because he has less money locked up inside his company and this is the patently unfair aspect of the proposal, it affects smaller taxpayers proportionately greater than it does taxpayers with greater sums to extract.

If John goes ahead after 1 March and extracts the whole of the amount available as a distribution he will be liable to income tax, not CGT at all.  To the extent that he is a basic rate taxpayer this is an advantage as the dividend will carry a tax credit which will extinguish his basic rate tax liability.  However, to the extent that he is a higher rate taxpayer, he will be liable to income tax at a rate of effectively 25% on the amount extracted – a 15% surcharge on top of the CGT liability which would have been further reduced by his annual CGT exemption of £10,600.  He could pay an initial dividend sufficient to bring his reserves down to £25,000 and then proceed using the new rules, but that would still be a 15% surcharge on £30,000 worth of reserves – a cost of £4,500.

In the document explaining what they proposed to do HMRC comment that they believe the cost of a straightforward liquidation to be £7,500 so John would not have the luxury of using a liquidator to extract his money as capital because it would be even more expensive.  If Bona Vacantia are right and the cost is closer to £4,000 (or even less as some commentators have suggested) he is still being required to incur a cost which before March 2012 he would not be required to bear at all.

Fred on the other hand has a much larger sum to deal with but although he is better placed to afford the services of a liquidator he will still be suffering additional expense which before March 2012 he would also not be required to incur but the effect on him is less.

Normally when HMRC legislate for concessions they undertake that the effect of the legislation is not to change the rules and when the draft legislation was put before parliament a year ago that is exactly what parliament was told – but that is clearly not the case.

 This is a fundamental change, and one that affects less well-off taxpayers to a greater extent than richer ones – this cannot be fair can it?

What’s the rationale behind the change?  HMRC claim that C16 was being used for avoidance or even evasion purposes – but a much greater problem according to Richard Murphy of Tax Research UK is companies being struck off without having made any returns or approaches to HMRC at all, a problem he estimates to be costing the Treasury BILLIONS!

HMRC will have the advantage of making this a self-assessment procedure as they will no longer have to consider applications under C16 but surely this will simply lead to more disgruntled taxpayers presenting empty shell companies for striking off and simply walking off with the cash without having paid either CGT or income tax on the distribution?

It is not too late to affect this proposal, write to the revenue pointing out how unfair this is for less well-off taxpayers, write to your MP who may object to the statutory instrument so that parliament has to debate the proposal, register your disapproval using my online petition at – if you make your voice heard it may do some good, if you do not many of your smaller clients will be adversely affected by this proposal when they retire or cease trading.

Is there a solution?  Surely, other than abandoning the proposal, which is not realistic, raising the limit to a point at which the tax surcharge equated with cost of liquidation would be a first step – if the cost of liquidating is £7,500 then that would equal reserves of £75,000 not £25,000, perhaps increasing it to say £100,000 would allow a little extra advantage.

It cannot be to the revenue’s advantage in the long run to encourage yet more taxpayers to extract money and avoid all liability on it because the alternative is to deny them the benefit of a relief, entrepreneurs’ relief, which parliament has already decided should apply to taxpayers with lifetime gains of up to £10million.

This podcast was presented, written and produced by Paul Soper who asserts copyright therein.  The full text of the podcast can be read at my site For further details of podcast production, particularly if you would like me to create them for you, contact me at Paulsoper, all one word, at mac dot com.

My next podcast, available next week, continues the examination of the Main Residence Exemption available for home-owners and some, I stress some, landlords.