Using a company to avoid paying income tax? Not for much longer you won’t be

I wrote here earlier in the week about how tricky it is getting for the government to collect corporation tax from big companies. But there is another group of people who are just thrilled at paying corporation tax – individuals and families who run their income or their  investments through companies to save tax.

You may have read about ‘personal service companies’. These are set up by individuals who work as freelancers or independent contractors. They have everything paid into the company and then pay themselves a basic income from it, up to the personal allowance. The rest comes as dividends.

The chancellor has thrown a slight spanner in the works of the tax savings you can make from this with his new dividend tax, but it still comes with huge advantages, not least that un-needed income can sit inside the company indefinitely. The company can then be liquidated and the contractor can claim it as a capital gain (tax rates on gains are lower than those on income). It has also been possible for them to claim entrepreneur’s relief on shutting the firm down.

The same elements of the tax system works for families and other small groups of shareholders with companies. Trading profits of any kind that aren’t needed for the business or the shareholders can be held inside the firm and paid out as capital gains on liquidation.

Doing this kind of thing made little sense back when the top rates of income tax and corporation tax were roughly the same (in 1989 they were 40% and 35% respectively) but now that the former is 45% and the latter is set to fall to 18%, while capital gains tax ranges from a mere 10% up to 28%, it clearly makes a whole lot of sense.

Unfortunately, it seems there is disappointment ahead. According to tax consultant RSM, next year’s Finance Bill is likely to make some changes. The first is to withdraw entrepreneur’s relief from those who are too obviously taking advantage: if you close down a business and set up a similar one within two years you will lose the entrepreneur’s relief. But that isn’t to be the end of it.

HMRC is also unimpressed by those who hold cash not needed for trading inside companies so as to pay only 20% (the current rate of corporation tax) on the income on it (rather than 40%/45% outside). So they are considering new rules on close companies (those controlled by five or fewer shareholders). They might tax all unneeded profits at the shareholder’s marginal rate of income tax regardless of whether they are distributed or not, or they might tax those profits as dividends whether they are distributed or not.

Either way, it looks like HMRC, as RSM puts it, is committed to “policing the boundary” between income tax and corporation tax. That’s no bad thing in theory. But as with all these things, it’s going to be tough in practice.

There is, you see, nothing new under the sun. The UK had a system of “apportionment” (which effectively taxed close company profits as dividends) back in the 1970s (when corporation tax and income tax rates were also far apart). We know that was an administration nightmare. And we can make a reasonable stab at guessing that whatever system HMRC comes up with this time will be one too.