Extraction of profits for owner-managed businesses

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The guidance on Extraction of profits in the Owner-managed business module of TolleyGuidance has been updated to take into account the changes to the taxation of dividends from 6 April 2016 to make it easier for tax advisers of owner-managed companies to understand the implications of the changes. This section provides detailed guidance on not only the tax implications of dividends but the legal, administrative and other important aspects. A sample of the extensive guidance on this topic is included below:

For owner-managers, most ongoing remuneration requirements will usually be met in the form of a combination of regular salary, bonuses or dividends.

The composition of a proprietor's remuneration package should be considered carefully to try to achieve the most tax efficient result possible. Tax is, as usual, not the only consideration; the following must be taken into account in tax planning for a proprietor's remuneration:

  • ensure sufficient distributable reserves for payment of dividends, not only to satisfy immediate requirements but also taking into account future plans
  • requirement for shareholder / external investor approval under terms of Company's Articles of Association / Shareholder's agreements, etc.
  • regulatory / industry requirements and guidelines relating to director's remuneration
  • Companies' Act requirements regarding declaration and documentation of dividends
  • timing and mechanics of payment of tax (see further guidance below)
  • the application of the National Minimum Wage Act (see further guidance below)
  • maintaining credit record for eligibility to receive the state pension (see further guidance on this below)
  • whether there are any mortgage or insurance products which the proprietor purchases which are affected by the form of remuneration

All of this remains true notwithstanding the changes to the taxation of dividend income from 6 April 2016. With effect from that date, the way in which dividends received by individuals has changed fundamentally. In most cases this will result in higher effective tax rates for owner-managers extracting profits by way of dividends. The taxation of dividends is discussed further below.

The tax gap between salary and dividends has narrowed as a result of these changes. However, it is important to remember that there are many aspects to consider when deciding how to extract profits and to keep sight of the overall picture. Legal, commercial and administrative factors are important in designing a profit extraction strategy. In terms of tax, there remain other aspects to consider other than overall effective tax rates, for instance timing of payment of tax, which are considered further below. The same considerations apply as previously in terms of ensuring sufficient levels of working capital and reserves for any future capital transactions.

For general guidance on extraction of profits, including longer term, non-cash and capital methods of profit extraction, see the Effective extraction strategies guidance note.

Summary of taxation of salary and dividends - 2016/17

This table summarises the main differences between the tax treatment of bonuses and dividends in simple terms for 2016/17:

   

Salary

Dividends

Taxed as

 

Earned income

Unearned income

Income tax rate band

     

Dividend nil rate

£0-£5,000

 

0% (NB dividend income within the nil rate band is included within total income)

Basic rate

£0-£32,000

20%

7.5%

Higher rate

£32,001-£150,000

40%

32.5%

Additional rate

Over £150,000

45%

38.1%

NICs - employee's Class 1

     

Primary threshold to Upper earnings limit

£155-£827 per week

12%

None

In excess of Upper earnings limit

Over £827 per week

2%

None

NICs - employer's Class 1

Over £156 per week

13.8%

None

Timing of payment

 

Tax and NIC paid via PAYE system

Via self assessment

Income tax reporting

 

Employer's annual return and (for those in self assessment) annual self assessment tax return

Self assessment tax return

Tax relief for company?

 

Yes, provided paid 'wholly and exclusively' for the purposes of the trade

No

Timing of tax relief for company

 

Relief in accounting period in which paid or accrued, as long as accrued amount paid within nine months of period end

No relief

Qualifying remuneration for pension purposes?

 

Yes

No

Taxation of dividends - from 6 April 2016

From 6 April 2016, there is a dividend nil rate band which applies to the first £5,000 of dividends received by an individual. The rates of tax on dividend income are increased to 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers.

The notional 10% tax credit on dividends is repealed and therefore there will be no 'grossing up' required of the amount of dividend income received.

Dividend income falling within the nil rate band is included within the individual's total income, so existence of dividend income within the band may push other income into higher tax bands even if the dividend income itself is taxed at 0%.

Summary of taxation of salary and dividends - 2015/16

This table summarises the main differences between the tax treatment of bonuses and dividends in simple terms for 2015/16:

   

Salary

Dividends

Taxed as

 

Earned income

Unearned income

Income tax rate

     

Basic rate

£0-£31,785

20%

10% (effective rate 0%)

Higher rate

£31,786-£150,000

40%

32.5% (effective rate 25%)

Additional rate

Over £150,000

45%

37.5% (effective rate 30.56%)

(See further guidance below for more on taxation of dividends)

NICs - employee's Class 1

     

Primary threshold to Upper earnings limit

£155-£815 per week

12%

None

In excess of Upper earnings limit

Over £815 per week

2%

None

NICs - employer's Class 1

Over £156 per week

13.8%

None

Timing of payment

 

Tax and NIC paid via PAYE system

Via self assessment

Income tax reporting

 

Employer's annual return and (for those in self assessment) annual self assessment tax return

Self assessment tax return

Tax relief for company?

 

Yes, provided paid 'wholly and exclusively' for the purposes of the trade

No

Timing of tax relief for company

 

Relief in accounting period in which paid or accrued, as long as accrued amount paid within nine months of period end

No relief

Qualifying remuneration for pension purposes?

 

Yes

No

Taxation of dividends - prior to 6 April 2016

Dividends paid prior to 6 April 2016 carry a deemed tax credit of 10% which is available to offset in the individual's income tax computation. Any unused tax credit is wasted.

For individuals who are basic rate taxpayers there is no further liability to income tax on dividends.

For taxpayers with income in excess of the higher rate band (£31,785 in 2015/16), additional tax will be due at 32.5% up to the additional rate band limit of £150,000 and 37.5% for income in excess of the limit. The deemed 10% tax credit is available for offset against the tax liability on the dividend, which gives effective tax rates of 25% for higher rate taxpayers, and 30.56% for additional rate taxpayers.

Timing of payment of tax on dividends

Generally, where additional tax is due on dividends for higher / additional rate taxpayers, this is collected via the self assessment system. The tax is due for payment by 31 January following the tax year of the dividend.

Where the amount of tax not satisfied at source represents more than 80% of the total tax liability, or is more than £1,000, then payments on account will be due for the following year. Payments on account are due on 31 January in the tax year and 31 July following the tax year. So in most cases, the tax payment due on 31 January each year will be for the full amount of the tax liability for the previous tax year plus a payment on account in respect of the following tax year.

It is possible for the taxpayer to claim reduced payments on account if the level of dividends varies from year to year.

The Personal Tax Module contains detailed guidance on the taxation of dividend income, self assessment and payment of income tax.

Timing of taxation of salary

Generally, salary is treated as received by individuals when received or, if earlier, when the person becomes entitled to receive it. There are some additional dates which need to be considered for directors. For directors, remuneration is treated as received on the earliest of all the following dates:

  • when received
  • when the director is entitled to receive it
  • when amounts on account of the earnings are credited in the company's accounts or books
  • at the end of the accounting period, if the amount of earnings for that period are determined by the end of it
  • when the amount of earnings is determined, if that is after the end of the period

Tax relief for remuneration for the employing company

Remuneration is generally deductible from trading profits as long as it is paid wholly and exclusively for the purpose of the trade. Whilst it is almost unheard of for HMRC to challenge the level of director's salary, there may be more focus on remuneration paid to family members. For more information on this see Husband and wife / civil partners and Employing the children guidance notes.

Tax relief for remuneration is generally given when it is accrued in the accounts, as long as the amounts accrued are paid within 9 months of the year end. For more information on this see the Employee related guidance note.

In order for amounts accrued at the year end to be allowable, as a general rule they must be in accordance with FRS 12/FRS 102. For more information on this see the and Tax relief for provisions guidance notes.

Impact on company's taxable profits

The impact of the payment of salary on the company's taxable profits should not be ignored. For periods prior to 1 April 2015, where a company is paying tax at the marginal rate, it may be appropriate to pay sufficient salary to bring the level of profits down to the small profits' rate. For periods post 1 April 2015, this mechanism could also be used to avoid falling within the quarterly instalments regime by reducing augmented profits to below the £1.5m limit.

Due regard should also be given to utilising losses generated by payment of salary. In particular, it may be desirable to generate a repayment of corporation tax by carrying back losses to the previous 12 months, or for three years under the extended carry back provisions. For more information on this see the Current year relief and carry back losses guidance note.

National Minimum Wage

Guidance published by the Tax Faculty of ICAEW, and approved by both the DTI and HMRC, indicates that there is no need to pay the National Minimum wage to directors, provided they do not have a specific written contract of employment with the company. Should there be a contract of employment in place when a director is appointed, this should be terminated on appointment if it is desired to exclude the provisions of the National Minimum Wage.

Note that employment of the spouse, when not a director or other officer of the company, is affected by National Minimum Wage. A record of hours worked and wages paid is advisable.

Balancing remuneration between salary and dividends - optimum tax position

Generally, prior to 6 April 2016, the most tax-efficient way of extracting profits is to extract a salary to the level of the NICs earnings threshold and take the remainder of distributable profits as a dividend. Remuneration in the form of salary is taxed as earned income and so has the advantage of dividends of being qualifying remuneration for pensions purposes. Similarly, an adequate level of salary can fulfil the requirements of the National Minimum Wage Act 1999 (more on this below) as opposed to dividends.

From 6 April 2016, the tax advantage of taking dividends as opposed to salary is reduced or even eliminated. However, there remain differences between dividends and salary in terms of timing of payment of tax, statutory framework, impact on company reserves and many other factors. It is important when advising clients not to lose sight of the overall picture.

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