So you want to take money out of your limited company?
It’s clear that quite a lot of entrepreneurs knew that they were coming, but anti-avoidance rules that took effect a little over two months ago are still puzzling some one-man band contractor companies, writes Darren Roberts, head of contractor services at online accounting specialist Dynamo Accounts.
The first thing to grasp about these new rules, warned about in March as a way to combat ‘money-boxing’ or ‘phoenixism,’ is that they are part of a wider strategy from the government.
Achieved by a combo of measures that hit from April 6th 2016, the strategy targets individuals who extract funds from their company. It’s become so effective that PSC contractors are now asking if their modus operandi is still the best. A query I’ll clear up later.
Measure number one from HMRC (‘number one’ because it’s the measure that seems to raise the most question marks), is due to the tax authority expanding the transactions it wants to be caught by its anti-avoidance framework. One of those is where profits are retained within a company for the purposes of distributing in the form of capital rather than a dividend, for tax purposes. This is called ‘money-boxing.’
As contractors point out, there are a number of legitimate reasons why capital is retained within companies, owing to, for example, concerns over market trends, availability of bank funds, customer cashflow, business acquisitions or capital purchases. The area which HMRC is trying to address is that which sees the deliberate ‘stock piling’ of cash with the sole objective of gaining a tax advantage.
In order to combat this, HMRC have come up with three conditions that must be met in order to fall foul of the “Phoenixism” scenario:
- The company is a “close company” (or has been so within the previous two years) i.e. a company which is controlled by five or fewer shareholders or is controlled by its directors. In practice, most privately owned companies.
- Within two years after the date of a capital distribution on winding up of the company, the individual receiving the distribution (or someone connected with him or her) is involved in carrying on the trade or other activity carried on by the company. This can involve trading as either a sole trader, partnership, company or LLP.
- It is reasonable to assume that one of the main purposes of the liquidation is the avoidance of income tax.
In addition to you having to consider these April 6th anti-avoidance measures when drawing money out of your company, there is the new dividends tax. Although covered in detail by other tax experts already, this second measure from HMRC and its new rates of 0% (for the first £5,000); 7.5%, 32,5% and 38.1% were April’s other big shower on people extracting funds from their company. These dividend rates represent a dramatic increase in tax and, like the anti-avoidance measures, could put a significant dent in any income extraction strategy that you may have in place.
It’s therefore important for contractors to strongly consider not just taking professional advice but, in light of the anti-avoidance measures, to also fully document it -- should it be required when obtaining clearance from HMRC that the anti-avoidance legislation does not apply.
To veteran contractors, this combo of measures from HMRC has the potential to leave them feeling a bit sore. After all, for successive years gone by, extracting funds through the ‘minimum salary and maximum dividends’ strategy had easily been the most effective method of returning funds to the shareholders and directors of contractor companies.
But as many PSCs are now asking, does that still hold true? The short answer is ‘yes.’ However the cost of doing so has increased due to the measures outlined above, which were brought in by Finance Act 2016.
As to how all this has come about, well it’s down to chancellor George Osborne, whose stance is to align the tax payable by those operating a business through a limited company to those as a sole trader or partnership. So not only has the transparency edge that PSCs had over sole traders long gone, now the financial edge is being eroded too.
But the salary-dividend mix is still definitely the optimal strategy for executing an IR35-friendly contract via a limited company. On top of the numerous advantages this corporate structure still affords, there are additional things contractors can consider to help access their company funds in a tax-efficient manner. For example, look at the use of corporate pension contributions, salary sacrifice arrangements (childcare vouchers and cycle to work schemes) and insurance/protection. These, taken with other steps we can advise on, should form part of an overall strategy to optimise your income. But ideally, only act on it once you have taken professional advice and formulated the best plan based on your individual circumstances.