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ROGER JONES comments on loans to participators and the new non-corporate distribution rate
No one in his right mind could have devised the tax system, if one could be so charitable as to call it a system, which currently applies to small companies and their owner managers. It is an accident of fate, as a number of changes have been made piecemeal over recent years.
No single Parliamentary draftsman can have looked at the overall situation to establish how various issues might dovetail, or not as the case may be.
Thus the comments in Mike Truman's article 19% nonsense will have struck a chord with many practitioners who advise the owner managers of small family companies.
The legislation in FA 2004, s 28, which brings us the non-corporate distribution rate, is just another patch on an already ailing system. The whole thing is becoming very difficult for professionals to understand, let alone the man in the street. Having read Mike's article, I dared to suggest that he had missed something.
The owner manager of a small company broadly has a choice between salary and dividends in setting up the balance of his remuneration package. Though there are many peripheral issues, the fundamentals are perhaps best demonstrated by an example.
Basic proposition
Gordon is the director/shareholder of Blue Moon Ltd. In its accounting period ended 31 March 2004, the company has profits of £10,000 and Gordon wants to draw out the full amount. He is a basic rate taxpayer and his earnings are below the National Insurance upper earnings limit. Gordon's first choice is to take a bonus (or additional salary), as illustrated in Example 1 below.
Example 1: Bonus
Company profits to be withdrawn £10,000
Less:
Bonus (100/112.8 x 10,000) (8,865)
Employer's NI (12.8/112.8 x 10,000) (1,135)
nil
Corporation tax nil
Gordon's bonus 8,865
Less:
Income tax @ 22% (1,950)
NIC @ 11% (975)
Net retained £5,940
Example 2: Dividend 2003-04
Company profits to be withdrawn £10,000
Less:
Corporation tax @ 0% (nil)
10,000
Dividend paid (10,000)
nil
Gordon's dividend 10,000
Add: Tax credit at 1/9 1,111
11,111
Less: Income tax @ 10% (1,111)
Net retained £10,000
The total effective rate of tax and NIC on the amount withdrawn is 40.6%. Gordon's alternative is to take a dividend. For 2003-04, the position would have been as in Example 2 above. The total effective tax rate on the amount withdrawn has been reduced to nil. In this case, it represents a useful saving of £4,060. Who can blame Gordon for taking the dividend in preference to further salary? The Government can, so it seems.
Applying the non-corporate distribution rules in FA 2004, the company must pay corporation tax at a minimum rate of 19% on profits withdrawn. So, all other things being equal, the dividend calculation in 2004-05 is as shown in Example 3 below. The effective rate of tax on the profits used to pay Gordon's dividend is now 15.97%, but he still has a substantial saving of £2,463 by taking a dividend rather than salary. The tax advantage in 2004-05 is less than in 2003-04, but it still exists and it is significant.
Example 3: Dividend 2004-05
Company profits to be withdrawn £10,000
Less:
Corporation tax @ 19% on dividend paid (1,597) @ 0% on balance
(nil)
8,403
Dividend paid (8,403)
nil
Gordon's dividend 8,403
Add: Tax credit at 1/9 934
9,337
Less: Income tax @ 10% (934)
Net retained £8,403
Loans written off
In his article, Mike sought to restore the 2003-04 dividend position by taking a rather different route. Where a close company makes a loan to a participator, the tax effects are well rehearsed. The company must pay tax at 25% of the amount advanced under TA 1988, s 419. If the participator is also an employee or director, he will have an income tax charge under ITEPA 2003, s 175.
When the loan is written off, there are two alternative heads of charge:
* ITEPA 2003, s 188 might treat it as employment earnings;
* TA 1988, s 421 might treat it as if it were a distribution.
The impasse is resolved by ITEPA 2003, s 189(1)(a), which prohibits the application of s 188 where the amount written off is treated as income of the employee under some other provision of the Taxes Acts. So, the charge under s 421 takes precedence. But the wording of s 421 is indeed convoluted and, while the loan written off is taxed as if it were a distribution, it is not actually a distribution. Mike concluded that the non-corporate distribution rate provisions of FA 2004, s 28 could not apply and, therefore, Gordon's tax liability on a loan write off in 2004-05 should be calculated as in Example 2 and not Example 3. I agree with his reasoning thus far, but not the conclusion.
I should stress that the loan must be formally written off; these consequences do not follow if the company decides not to collect the debt.
As an aside, there is a timing advantage in a loan write off where income tax is due at the higher rate; see Example 4.
Example 4
Humpty Dumpty Ltd makes a loan of £10,000 to Dawn, its shareholder, on 1 April 2002 (within its accounting period ended 31 December 2002). The loan is written off on 10 April 2003. No s 419 tax is due as the loan was cleared before the due date. Dawn is treated as if she received a dividend on 10 April 2003, to be included in her tax return for 2003-04. Any higher rate income tax is due on 31 January 2005. If Humpty Dumpty had simply declared and paid a dividend on 1 April 2002, Dawn would pay the higher rate tax on 31 January 2003.
National Insurance
What Mike did not deal with was the impact of National Insurance. The tax legislation is slightly ambiguous in giving two possible heads of charge for the loan written off, though there is the means to resolve it. The National Insurance legislation is much more single minded.
As a director of Blue Moon Ltd, Gordon is an employed earner within the meaning of Social Security Contributions and Benefits Act (SSCBA 1992), s 3. This means that he must suffer primary Class 1 NIC on all earnings and, likewise, the company is responsible for secondary Class 1 contributions. In SSCBA 1992, s 3(1)(b) 'earnings' are defined to include 'any remuneration or profit derived from an employment'. As long ago as 21 November 2001, a querist to the 'Any answers' section of the Accountingweb took the view that regulations under SSCBA 1992, s 1 always treated the write-off of a loan to a participator as earnings if the loan was made to an employee. I can find nothing so specific in the National Insurance legislation, but it is difficult to demur from this point of view. Schedule 3 of the Social Security Contributions Regulations SI 2001 No 1004 lists out payments to be disregarded in the calculation of earnings-related contributions, but nowhere does this mention loans written off.
One cannot accept the Revenue's view as definitive, but:
* its guidance to employers, booklet CWG2(2004) at page 75 indicates that a loan to an employee should be included on form P11 for NI purposes at the time of write off; and
* para 12020 of the National Insurance Manual (following earlier Contributions Agency practice) sets out the view that loans to participators which are written off do attract Class 1 NIC. This is reinforced in paragraph 6663 of the Company Taxation Manual reminding Inspectors of the National Insurance liability.
In Tolley's Incorporating a Business, I covered the possible use of loans written off as an alternative way of getting remuneration to the owner manager of a small company. While I mentioned the possibility of a NIC liability there, I have not personally seen this applied. However, one reader of the book approached me specifically asking if I knew a defence to the National Insurance charge (which had been applied to one of his clients).
This leaves me with something of a dichotomy. The participator, who receives the loan subsequently written off, does not have to be a director. Many will be, but that is not always the case. If the participator is neither a director nor employee there cannot be a National Insurance liability. The income tax charge flows from TA 1988, s 421. The participator who is a director gets the same tax charge for the same reason. If this tax charge takes precedence, surely the role as participator is primary in these circumstances? If faced with this situation, I might argue against the National Insurance liability on these grounds, but I am not convinced that I would win. If that is the case, the overall liability becomes as in Example 5.
Example 5: Loan written off
Company profits to be withdrawn 10,000
Less: NI @ 12.8% on loan written off (1,135)
Loan written off (8,865)
nil
Gordon's income 8,865
Add: Tax credit at 1/9 985
9,850
Less:
Income tax @ 10% (985)
National Insurance @ 11% on loan written off (975)
Net retained £7,890
The overall effective rate of tax is therefore 21.1% and, while representing a useful saving as against a bonus, Gordon is worse off than had he taken a dividend.
Additionally, Mike refers in his original example to a debit balance having built up on the director's loan account with the company. This is because the proprietor has yet to accept that the company's money is not his money. If personal expenditure and drawings are debited to the loan account in this fashion in anticipation that the overdrawn balance might later be cleared by declaration of a bonus, there is an argument that Class 1 National Insurance is due at the point of overdrawing, as this amounts to an advance of earnings. In such circumstances a loan write off will not help.
Finally, there is the problem of accounting for the National Insurance due. Presumably one adds it to the figures on form P11 as an NIC only item, as one would with, for example, a company payment of a personal bill.
The company's position
On the write off of the loan, the company can recover any tax which has been paid under TA 1988, s 419, though the timing and mechanism for dealing with this should be carefully examined.
Although the write-off of the loan is not a true distribution of profits, the company cannot claim any tax deduction for it. This is because it seems, almost certainly, to fall foul of the unallowable purpose rules in FA 1996, Sch 9 para 13 since the loan write off cannot be argued to be for the benefit of the company's business.
The future
Mike supposed that the 19% nonsense of FA 2004, s 28 would not last. Indeed the more that one looks at it, the more anomalies it is possible to find. The infamous paragraph 5.91 of the 2003 Pre-Budget Report actually said that the Government would seek to ensure that the right amount of tax is paid by owner managers of small incorporated businesses on the profits extracted from their company. The FA 2004 legislation does not actually do this.
We are on notice that the Government will have another go and we can expect a discussion paper to be issued at the time of the 2004 Pre-Budget Report. So, we may yet see National Insurance on dividends or the return of investment income surcharge, but at least we may get to comment next time.
More significantly in the current context, 2004 Budget press notice REV PN5 also says: 'The Government will also consider measures to strengthen anti-avoidance legislation on loans made to shareholder directors of close companies.'
At this point my crystal ball gets hazy … but I do not expect the present régime to last.
Roger Jones is senior tax manager at Larking Gowen in Norwich, but the views expressed are personal and do not necessarily represent the opinion of the firm. He also has written a Tax Digest 'Extracting Profit from the Family Company' which is due to be published shortly.
