Chartered Accountants and Professional Business Advisers

Tax Planning

Tax Planning

At our February 2019 meeting we discussed tax planning opportunities in the following scenario.

Scenario: Mr Victor Green and Highbrow Events Ltd

Victor Green is 60 with two adult children. His wife’s 50th birthday celebration last year went horribly wrong and they are getting divorced. He became reacquainted with his former business partner Bunny whilst Skiing over Christmas, and she is about to move in with him.

He expects to pay his wife over £1m in the divorce settlement. This will leave him with the house worth about £900,000, some £500,000 at the bank earning about 0.25% interest and the shares in his company Highbrow Events Ltd.

The company pays Victor £100,000 p.a. and he still has his Tesla Model S Ludicrous AWD as his company car. The company also provides his iphoneXS max and private medical insurance (about £3,000 per annum). He is always entertaining potential new customers but pays for this personally as he knows it’s not tax deductible. He is considering paying himself a £30,000 bonus to cover the cost for the last year.

Highbrow Events Ltd now turns over about £1.5m and makes a profit of about £300,000 a year. Profits have been allowed to build up in the company so that it has almost £750,000 at the bank. He needs to find a new bookkeeper now that Mrs Green is no longer working for the business, and remains on the lookout for new, larger premises. He would like to relocate before selling the business.

Victor is thinking about purchasing some buy to let flats. He has his eye on a local new development and might buy three 2 bed flats for almost £300,000 each from the developer.

Planning opportunities

The following opportunities were considered.

Rate bands and allowances

Victor’s income is: salary £100,000, car £16,581, medical £3,000, bank interest £1,250 (less the £500 savings allowance) TOTAL: £120,331

This falls in the band between £100,000 and £123,700 in which the personal allowance (£11,850 for 2018/19) is withdrawn, (£1 of allowance is withdrawn for every £2 of income above £100,000). This results in a 60% marginal rate on income within the band.

If a £30,000 bonus is paid, this will mean that the personal allowance is completely withdrawn, and the tax payable on his income in excess of £150,000 will be at the marginal rate of 45%, where taking into account national insurance for he gets to keep 46.6% of what it costs the company.

It makes sense to either bring forward or defer income to avoid these bands. Even if this means you are subject to tax at the 45% additional rate (on income over £150,000) in one year, this is preferable to the 60% marginal rate. Higher rate taxpayers can save tax of up to £5,000 by doing this.

As an additional rate taxpayer the savings allowance is not available.

The ISA allowance remains £20,000.

Company car

Victor’s car cost £127,550, and the benefit in kind (the additional amount on which Victor is being taxed) this year at 13% is £16,581. Last year it was 9% = £11,480. Next year, 2019/20 the rate will be 16%=£20,408, substantially more than it was last year. However, this upward trend is reversed in 2020/21 when the benefit in kind will be 2%=£2,551. The tax on this at the higher rate will amount to about £85 a month. He previously had an old Range Rover (cost when new approximately £75K) which cost him about £1,000 a month in tax!

As the car is 100% electric it will not affected by the changes to the London congestion charge in October 2021 which will mean that all but 100% electric cars will then be subject to the charge. However, from Christmas Day 2025 all cars - including zero-emissions electric ones - will have to pay the £11.50 charge. (Note also the congestion charge exemption for private hire cars will also be removed from April 2019).

At present the company would get tax relief on the installation cost of a car charging point, when incurred, and there is no benefit in kind on the provision by an employer of electricity for a car.

Expenses

Whilst it is correct that the company can’t claim a corporation tax deduction for the cost of entertaining customers which it re-imburses to Victor, he is not taxed personally on the re-imbursement. This would be a much better option; costing the company far less and helping Victor to save tax and avoid the additional 45% tax rate

If the company pays Victor a bonus it has to account for employers NIC and deduct employees NIC and Pay As You Earn (PAYE) tax. At the 40% higher rate, Victor would receive 51% of the cost to the company (bonus + Employers NIC), so if the cost to the company was £30,000 Victor would receive £15,300. The company gets a corporation tax deduction for the bonus which means the net cost is £24,300.

If the company simply re-imburses Victor the business expenses it would cost the company £15,300 with no CT deduction, saving £9,000 and leaving Victor with more of his 40% band available against his other income.

Salary / Dividend mix

It would be worth Victor reviewing the mix of his salary and dividends. The net income that Victor receives is:

 Higher rate (40%) taxpayerAdditional rate (45%) taxpayer
Salary51%46.6%
Dividend54.7%50.1%

Whilst these percentages might appear quite similar, keeping 54.7% represents a 7.25% increase over keeping 51% - a welcome boost to net income. Imagine your own net income increased by 7.25%.

Pension Contributions

Victor could consider making pension contributions which would attract tax relief at his marginal rate. The company may also make contributions for him, which qualify for a corporate tax deduction but do not attract a NIC liability or form part of Victor’s taxable income.
The normal annual allowance for pension contributions is £40,000. But this is reduced by £1 for every £2 by which income exceeds £150,000 up to £210,000, when the allowance is £10,000. The measure of income for these purpose is after deducting gifts of listed securities and land to charity, but not gift aid donations.

It is possible to bring forward unused relief from the previous three years.

Note these limits take into account both employers and employees contributions.

Lower pension contribution limits can apply – notably, those in 'drawdown' are limited to £4,000 a year, and the tax-eligible contributions from individuals are limited to the higher of their earnings from employment or self-employment and £3,600.

IHT

He will need to consider the availability of IHT Business Property Relief (BPR) in relation to his Highbrow events shares which are likely to be worth some £3m. BPR of 100% is given for trading assets meaning that the shares might pass free of Inheritance tax. However, the cash balances might be regarded as beyond those required for the purposes of the trade and be regarded by HMRC as investment assets for which no BPR is available. If Victor is building up cash to fund a change of office premises he should document that fact, and maybe including a note in the accounts, so that he can produce evidence to HMRC if required.

Victor should also note that the additional nil rate band in relation to his is only available if his estate is less than £2m. The estate is valued before reliefs so with the value of Highbrow Events Ltd he will not get the additional allowance meaning that his nil rate band is likely to be the normal £325,000.

Even after his divorce, Victor will need to be mindful of the potential IHT liability on his estate. He may wish to consider marrying Bunny in due course.

Sale of shares in Highbrow Events Ltd

For a higher or additional rate taxpayer the normal rate of capital gains tax (notably not including residential property) is 20%. However, if the shares in Highbrow Events Ltd quality for Entrepreneurs’ Relief (ER) then the applicable tax rate is 10%. There is a lifetime limit of £10m on gains qualifying for ER.

One of the conditions for ER is that the company must be a trading company or substantially a trading company. Substantial in this context means more than 20%. The question to ask is how should a company’s non-trading activities be measured to assess whether they are substantial? There is no simple formula to this but some, or all, of the following are among the measures or indicators that might be taken into account in reviewing a particular company’s status. These indicators are viewed ‘in the round’.

  • Income from non-trading activities
  • The asset base of the company
  • Expenses incurred, or time spent, by officers and employees of the company in undertaking its activities
  • The company’s history

Divorce

By planning a divorce settlement carefully, it should be possible to minimise the tax cost of transfers under the divorce settlement, leaving as much as possible available across the family as a whole for distribution between the divorcing spouses.

There is no immediate tax charge on the transfer of assets under a divorce settlement for either IHT or Income Tax purposes.

There are, however, immediate Capital Gains Tax (CGT) considerations for any transfers of assets (i.e. not cash) between spouses in the tax years following permanent separation

It’s not clear whether the family house is currently in joint names so that his ex-wife will sign over her share as part of the divorce settlement.

Buy to let – Stamp duty surcharge

As the buy to let properties will count as second properties they are subject to a 3% stamp duty surcharge as follows:

                125,000 @ 3%    = 3,750

                125,000 @ 5%    = 6,250

                50,000@ 8%        = 4,000

Making the SDLT £14,000 on each property (rather than £5,000) so £42,000 in total, possibly rather more than Victor was expecting!

Buy to let - Loan interest relief restriction

On the assumption the buy to lets generate a 4.4% yield, if Victor takes out variable rate finance the recent lenders guidelines mean that he may only be able to borrow £150,000 on each property. A higher amount – up to £250,000 might be possible with fixed rate finance but he may find that the more attractive rates are only available for borrowings of around £200,000 per property. With the stamp duty and fees etc. Victor may end up borrowing £600,000 on a total purchase price of £950,000 – using £350,000 from his cash reserves.

This year, only three quarters of the interest paid on the borrowings is allowed as a deduction from his rental income. A basic rate (20% credit) is given against the other quarter. From 6 April 2019 the deduction and credit are both given in relation to half the interest so his position may be as follows:

                                                                                         Taxable  Cash

                                                                                              £            £

Rent (£1,100 / month x 3 properties                                 39,600     39,600

Interest paid deduction £600,000 @ 3.29% (one half/all) (9,870)   (19,740)

Other rental expenses say (assumed all allowable)          (5,940)    (5,940)

                                                                                         _______   _______ 

Taxable rent                                                                      23,790

                                                                                         =======

Tax @ 45% / net of credit                                                (10,706)     (8,732)

Tax credit £9,870 @ 20%                                                   1,974            0

                                                                                         _______________

Tax payable / net rent                                                         8,732        5,188

                                                                                         ==============

The cash generated through lettings is quite modest. If victor has about 3 months of voids across all three properties he would find that the rent does not cover his expenses (as the rent comes down the tax liability also drops).

The interest relief drops over the following two years, so from 2020/21 there is no deduction for interest, only a 20% tax credit on the whole of the interest.

Buy to let - structure

Victor may also wish to consider forming a company through which he purchases his buy to let properties.

Although the company would still be caught by the 3% SDLT surcharge on residential property purchases, it would not be affected by the restriction in relief for interest paid. The rental profit would of course be subject to corporation tax and Victor would be taxed on the dividend.

On first analysis the 40% or 45% marginal rate applicable to Victor if he holds the properties personally looks preferable to the effective rates of 45.3% and 49.9% resulting from corporation tax and then a dividend (calculations are for 2018/19 and assuming higher and additional marginal Rates for Victor).

However, the actual taxable profits are likely to be lower because of the availability of the interest deduction and the profits could be retained in the company to avoid the dividend tax charge. Victor might be able to make use of the £2,000 dividend allowance, or defer extracting profits to a time when his marginal tax rate is lower.

The company structure would also make it easier to introduce other shareholders, who may also benefit from the dividend nil rate band and lower tax rates. This might also form part of a longer term inheritance tax plan for Victor to give away shares in the company to his children.

Other ideas

When we discussed this scenario with our business club members we had a number of other suggestions including:

  • Victor might want to use his ISA allowance of £20,000.
  • He should update his will.
  • Whether Victor might delay his divorce until the next recession when assets values are lower!
  • Entering into some sort of pre-nuptial arrangement with Bunny.
  • If the Children still work for the company should they be paid accordingly?
  • The financing arrangement son the new premises.
  • On the sale of the business
  • Victor should carefully plan his exit strategy
  • The costs associated with relocation of the business will reduce the profit and therefore have an impact on the value of the business when it is sold. Perhaps Victor should instead concentrate on improving profitability and the sales multiple.
  • He might want to relocate to Portugal before selling the business which could mean that he avoids tax on sale.

Victor will need to take specific professional advice on these matters but there is certainly scope for sensible tax and other planning. In relation to his overall finances.