Using a company to avoid the new 50% rate of income tax from April 2010?

Note that dividends are excluded from this list. They'll still be caught but will be taxed at a new 42.5% rate of income tax. This equates to an effective income tax rate of 36.1%.

Many of the people on the list above would have the choice whether to trade or hold assets in their own name or alternatively to use a company.

When you you look at the position of a company, it looks very favourable when compared to individuals.

The key issue is that the small company rate of corporation tax is currently 21%. When compared to a 40% or 50% rate of income tax this looks very attractive. Trading income would also be subject to NIC within the basic rate band, whereas company income wouldn't.

Of course this assumes that no profits are extracted from the company. If profits are extracted from the company there would then be an income tax charge. Many company users though would look to extract minimal cash from the company and benefit from the lower rate of corporation tax in the company.

Using a company would therefore be a simple option to avoiding the 50% income tax charge.

For any traders or investors this can prove invaluable as halving their tax bill allows more cash for reinvestment, and hopefully maximizing returns in the long run.

Of course cash does need to be extracted at some point. Fortunately there are a number of options. They could of course extract cash as a dividend. If this was substantial the downside to this is that it would then be subject to the new 'super tax rate' (as its called in the press) of 42.5%.

Better options to extract the cash include:

A capital distribution is subject to CGT as opposed to income tax. In order to extract cash as capital rather than income the company would need to be wound up. If this applied, the cash received would be treated as disposal proceeds for a disposal of the shares. The gain would then be taxed at 18% (ie CGT) as opposed to income tax (at rates up to 50%).

Of course the profits would have already suffered corporation tax (eg at 21%) however in many cases it's still substantially less than income tax and national insurance (for traders).

Who can benefit from using a company

Using a company to avoid the 50% rate of income tax can be beneficial for property traders, financial traders as well as anyone else running a trading business. It could also be useful for investors who generate substantial investment income returns.

Entrepreneurs Relief

In principle if the extraction is from a trading company Entrepreneurs Relief could reduce the rate of CGT from 18% to 10% on gains within the £1,000,000 allowance. However in practice if you built up significant cash reserves in the business any disposal or transfer of shares in the company could be 'penalised' as the shares may not qualify for Entrepreneurs Relief.

This is because the Entrepreneurs Relief provisions don't count a company as a trading company if it has substantial non - trading assets or income.

Substantial in this context is taken to mean at least 20% of net assets or income. The Revenue will consider any form of non trading asset for this purposes including property held in a company which is let (eg old business premises) as well as surplus cash not required for the purposes of the trade.

Therefore anyone looking to maximise the benefit of the companies retained profits may have suffered a tax penalty in the future.

As such if a large amount of cash was generated in a company the best way to extract it if you were a UK resident would be to liquidate and pay a capital distribution. As above though the Revenue could then consider whether the company truly is a trading company for the purposes of Entrepreneurs Relief.

Even if Entrepreneurs Relief wasn't due, the rate of CGT at 18% is still substantially less than the income tax rate.

Downsides of using money box companies

There are a couple of points that you would need to watch out for:

Pre liquidation dividend?

It's worthwhile bearing in mind that if there is no other income in the tax year of liquidation it makes sense to extract cash up to the basic rate band as a dividend. This will be free of income tax for the shareholders and reduce the future capital gain on the shares.

About the Author

He worked in Ernst & Youngs Entrepreneurial Services department for a number of years before setting up his own tax planning practice. He is now a full time tax author.

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