Change to the financial, commercial, tax and/or legal context in which we work is the lifeblood of effective communication from IFAs to their clients. What a cornucopia of communication subjects the pre-Budget report has given us, from reforms of trusts, inheritance tax anti-avoidance measures, Isas and corporate tax to a worrying attack on small companies.
The latter comes in the form of an expressed concern about dividend strategies typically adopted. The mischief is to be found in paragraph 5.91 of the report, which will bring a chill to the spines of many owner-managers of private limited companies who draw remuneration by way of dividends.
It states: “The Government is concerned that the long-standing differences in tax treatment between earned income and dividend income should not distort business strategies or enable reductions by tax planning of individuals' tax liability and that support should continue to be focused on growth. The Government will therefore bring forward specific proposals for action in Budget 2004 to ensure that the right amount of tax is paid by owner-managers of small incorporated businesses on the profits extracted from their company and so protect the benefits of low tax rates for the majority of small businesses.”
The Government has been very cagey about releasing details but it seems likely that the plans under consideration involve equating the tax treatment of certain dividends from close companies – those controlled by, broadly, five or fewer shareholders – with remuneration drawn by the owner-managers. The implication is that pay-as-you-earn and National Insurance contributions will be applied to the extraction of certain profits, whether by means of dividend or salary.
It is important to set this official disquiet against a backdrop of reducing rates of corporation tax. In April 2000, the starting rate fell to 10 per cent. In April 2002, it was reduced to nil. The Government said this was designed to encourage owner-managers to invest more profits back into the business but many small businesses saw it as offering an advantage to incorporation purely for tax reasons. Trading via a company offered the proprietor the chance of paying no or little corporation tax while drawing “remuneration” of up to £14,615 (the £10,000 starting rate – nil – and the personal allowance) with no tax liability.
It is apparent that the Government knew of the tax planning opportunities its changes would present yet still proceeded with the measures. Suddenly, it seems to have changed its attitude. The corporate tax regime that has been built since April 2000 “to reinforce the advantages of producing in the UK” now “distorts business strategies” and “enables reductions by tax planning of individuals' tax liability”.
It may be that a key factor behind the latest initiative is a desire to place the attack on small companies' pay practices on a more stable and wide-ranging legislative footing. Many believe that new legislation on dividends could make the IR35 legislation redundant.
The problem is that there are very few tax reliefs available for companies which wish to disincorporate, so a number of small businesses which chose to trade as a corporate entity because of the tax advantages may feel trapped and face the significantly higher costs of operating through a company.
A new regime may also cause hardship to many business owners on relatively low incomes in that, if there are to be PAYE liabilities on the extraction of profits, these will be additional to the next corporation tax payment, due at some stage in the year following the introduction of the new regime and based on the last profits under the old regime.
There is likely to be a range of reasons for proposing these changes to dividend tax:
The Government can gather more information about companies than self-employed businesses because of the greater need for disclosure and reports.
It is easier to regulate companies than self-employed businesses so the Government can exercise more control over such businesses in future.
Introducing more effective measures aimed at taxing dividends may reduce the need to enforce the IR35 provisions and reduce the need to apply the settlement provisions in section 660A ICTA 1988 on dividends paid to spouses who play only a small role in the business.
IFAs need to be familiar with the fact that dividends may become less attractive from an income tax and NIC standpoint, which may encourage a switch to salary/bonus. It is also important to remember that payment by dividends is not pensionable although this may be less relevant if pension simplification is implemented. Meanwhile, owner-managers may be keen to extract as much as possible from their private limited company by way of dividend before April 6 while the favourable tax regime on dividends still applies.
Apart from lack of clarity on the true reasons for the proposed changes, there is complete uncertainty about the extent to which any changes might impact on dividend strategies for owner-managers of private companies. It may be that any new provisions are targeted solely at close companies. After all, there is no realistic expectation that all dividends from private companies will be caught by any new rules, only those that are perceived as substituting for remuneration. It may also be only dividends paid from the nil corporation tax band that would be affected.
If the line is not drawn at dividends paid from the nil corporation tax band, where will it be drawn, if at all? We have not got long to wait until the provisions are due to be introduced.