August Tax Tips & News

Welcome to the Benedicts Tax Tips & News monthly newsletter, bringing you the latest news to keep you one step ahead of the taxman.

If you need further assistance just let us know or send us a question for our Question and Answer Section.

We’re committed to ensuring none of our clients pay a penny more in tax than is necessary and they receive useful tax and business advice and support throughout the year.

Please contact us for advice on your own specific circumstances. We’re here to help!

Newsletter issue - August 07.

The long-running tax case known as Arctic Systems has finally reached its conclusion with a decision by the House of Lords in favour of the taxpayer: Mr Jones. This means that Mr Jones will not have to pay higher rate tax on the dividends paid out of his company (Arctic Systems Ltd) to his wife. More importantly, thousands of other couples who set up their companies in a similar fashion to Mr and Mrs Jones should no longer be pursued by the Taxman for additional tax on their dividend income.

Mr Jones set up Arctic Systems in 1992 through which to offer his services as an IT contractor. He was the only director and held one of the two ordinary shares issued by the company. Mrs Jones purchased the other ordinary share from the company formation agents, and also became the company secretary.

They acted on advice from their accountant to take minimal salaries from the company, and pay out most of excess profits as dividends. As Mr and Mrs Jones held the shares equally, the dividends were paid to them equally and were mostly covered by their basic rate tax bands, meaning little higher rate tax was paid. If Mr Jones had paid himself a higher salary, or had been the only person receiving a dividend, he would have paid far more tax as much of his income would then have been taxed at the higher tax rate of 40%.

This type of arrangement has been standard tax planning for many husband and wife companies since the introduction of independent taxation for spouses in 1990. It was even recommended on the Business Link website! However, the Taxman decided to attack the arrangement, saying Mrs Jones only received her share, and the dividends paid on that share, because of Mr Jones work and the decisions he took as a director. The argument was that Mr Jones had effectively made a gift of half the earning capacity of the company to Mrs Jones, and because she is his spouse, the tax law says he automatically benefits from the gift, and thus Mr Jones should be taxed on all of the dividends.

The House of Lords actually agreed with the Taxman that the shareholdings in the company had been set up to minimise the tax paid by Mr and Mrs Jones. However, because the gift by Mr Jones had been made to his wife, and the gift was not restricted to the earning capacity of the company, but included future rights to capital on liquidation, and the voting rights associated with the ordinary share, there was a get-out clause. This get-out clause only applies to married couples and civil partnerships, and says that if you make a gift to your spouse/civil partner (which comprises more than just income), and there are no strings attached, you should not be taxed on the income arising from that gift.

Mr Jones had allowed Mrs Jones to buy half of the company (the other ordinary share) for a very small sum. This did amount to a gift, but the gift was covered by what is known as the "spouse exemption", so Mr Jones could not be taxed on the dividends arising from Mrs Jones' share. The Taxman went away red-faced, and the taxpayer was victorious!

Newsletter issue - August 07.

The Taxman is a bad loser, and after a big defeat like Arctic Systems it is quite likely the tax law will be changed. In fact the Treasury has already announced that they will be looking to change the law to prevent people splitting income between themselves in an unfair way. However, the Treasury spokesperson has also said that they do not want to disturb commercial arrangements.

What should you do now?

1. Don't Panic. The House of Lords decision stands until the law is changed, and if any change is made it probably won't come into effect until April 2008. Anyway you have little to worry about if you and your spouse/civil partner are both actively involved in running the business, in other words the ownership split of the business is a commercial arrangement.
2. If you and your spouse/civil partner own all the shares in your limited company, examples of precautions to take to help ensure that your arrangements are water tight and commercial include...
   • You should both be appointed as directors of the company. This means you are both responsible for the running of the company so collectively make important decisions, such as how much dividend to pay, or which contracts to take on. Record all these decisions so you can prove to the Taxman that you are both actively involved in the key business decisions.
   • Make sure you and your spouse/civil partner both hold ordinary shares in the company whose rights are not restricted in any way.
   • Follow the correct procedure when paying dividends to ensure they can't be reclassified as loans. The directors need to check there are enough profits in the company to pay the dividend, suggest an amount to pay, then the shareholders can vote on whether to pay it out. Dividend vouchers should be prepared and given to the shareholders when the dividend is paid.
3. If you want to bring your spouse/civil partner into the business as a shareholder, so you can divide profits between you, come and discuss the matter with us first. However we recommend you should think through the following points...
   • Will giving away some of the dividend income actually save tax? If your spouse/ civil partner already has enough income to cover most of their basic rate tax band, there is unlikely to be much tax saving.
   • Think about what may happen to the business should you divorce or separate.

Newsletter issue - August 07.

When you transfer your existing unincorporated business into your own limited company you could sell the goodwill that has built up in the business to the company for a tidy sum, then draw that amount out of the company tax-free over a number of years. It works like this:

Say your business has built up a loyal bunch of customers who generate around £100,000 of income after expenses for the business each year. After deducting your salary of £40,000, you have £60,000 of net profits. The goodwill created by these customers could be valued at a multiple of say 2.5 giving a value of £150,000. You sell the details of the customers to the new company for £150,000, but it leaves the amount owing as a loan to you in the company books.

The sale of the goodwill is a capital gain in your hands, but if your business has been running for at least two years the gain should qualify for full business asset taper relief, leaving only 25% taxable. After deducting your annual exemption of £9,200 (for 2007/08), you have a taxable gain of £28,300, on which you pay tax on this at 40%: £11,320.

The company can pay you £11,320 out of the loan account when you need to pay the tax due, then you can gradually withdraw the balance of £138,680 as you need the cash, with no further tax to pay. With a lower valuation you could actually avoid any tax bill at all on the gain.

The goodwill you sell to the company must be genuine free goodwill, and not tied to you or a particular location. Goodwill associated with the premises you operate out of can't be transferred, unless you also transfer those premises to the company. The goodwill in most one-man businesses is tied to the skills and personality of the business owner and can't be transferred to a company.

Newsletter issue - August 07.

Q. I am about to sign a lease for a new shop, but the landlord wants to charge VAT on the lease rental payments. The solicitor has grossed up the lease payments including VAT for the full lease term, to calculate the Stamp Duty Land Tax due. This means I am paying Stamp Duty on the VAT on the rents. Is that right?

A. Unfortunately the solicitor is correct. If the landlord has opted to tax the building for VAT purposes he must also charge VAT on the rents due under the lease. Stamp Duty Land Tax is calculated on the net present value of the gross amount of the rents, including the VAT charged, whether or not you can reclaim that VAT.

Q. I applied for a VAT number for my new business months ago, but it still hasn't arrived. I now need to invoice clients, or I will run of cash. What should I do?

A. Ringing the VAT office to chase up your registration application is probably a waste of time. You probably won't get through, and if you do, it won't speed up the process. You can send invoices to your clients but you can't technically charge the VAT due until you have your VAT number. You can do this by either:

• issuing an invoice for the net amount, then when you VAT number comes through send a VAT-only invoice to collect the VAT due; or
• sending a 'request for payment' for the full amount including VAT , but do not separate out the VAT and make it clear the request for payment is not a VAT invoice. When you VAT number arrives send a correct VAT invoice, showing any amounts that have already been paid.

In either case you need the co-operation of your clients and you will need to go through the invoicing process twice.

Benedicts Accountants are based in London, offering local business owners and individuals a wide range of services.

All clients are entitled to fixed fees, work delivered on time and unlimited phone support. Visit our website jbenedict.co.uk for more information.