Peter Mills – Senior Manager
A fundamental question for most corporate Owner Managers is how they can extract profits from their company in a tax effective manner and this continues to be a topic on which we regularly talk to clients about.
From a high level, increases to the rates of tax on dividends introduced last year will likely have meant a higher ongoing tax bill for owner managers and this has revitalised the importance of regularly evaluating ongoing extraction strategies to ensure they remain commercially appropriate and tax effective.
Key commercial factors
Establishing an effective strategy requires a balance between tax efficiency and management of any relevant commercial factors.
What works well for one individual may not work for another and, whilst achieving a tax efficient result is important, commercial as well as tax influences will be highly relevant:
- Dividends can only be paid out of distributable profits whereas other income streams may provide greater flexibility if the company is not profit making.
- Income streams which are not guaranteed may affect personal credit ratings, mortgage or other bank requirements.
- The involvement of external investors, business partners or commercial agreements may limit the options available or provide legal restraints.
- High profits may influence market perceptions which could impact customer and supplier relationships and increase their bargaining power.
- Personal financial requirements may impact the desirability or attractiveness of certain remuneration methods such as pension contributions or reinvestment within the company.
- Certain forms of remuneration negatively influence company profits which may affect corporate credit ratings or bank covenants.
Profit extraction: Tax Aspects
For a time, the optimal position from a tax perspective has usually been to take a modest salary and the remainder as dividends. This strategy historically yielded a significant benefit and in most circumstances this will continue to be a slightly more effective approach. The effective rates of tax for those two methods have however now been broadly aligned and it’s therefore important to ensure all angles are considered to maintain an effective strategy that is tailored and works in the context of all relevant factors:
- Company pension contributions can be attractive, particularly if there is no short term need for cash or for business owners close to retirement, as funds can be transferred into an environment that enables them to grow tax efficiently, outside of an individual’s estate, and with limited short term tax implications;
- Charging interest on shareholder loans or rent on privately held assets can, if applicable and in the right circumstances, be effective ways to extract funds by removing the national insurance obligation;
- Involving spouses or adult children in the company can also yield substantial savings in the right circumstances by utilising all available personal allowances and lower income bands.
An illustration of the effective rates of tax on various remuneration methods are provided in the table below:
|Effective Rate of Tax (2016/17)|
|Basic Rate Taxpayer||Higher Rate Taxpayer||Additional Rate Taxpayer|
|Realisation of capital through sale or liquidation*||27.1%||35.2% or 27.1%||35.2% or 27.1%|
*Subject to anti-avoidance provisions
Profit extraction: Remuneration or value creation?
It is also worth noting that the majority of total tax exposure arises on extraction of profits from the company and therefore leaving profits in a company can often be an effective course of action if there is no short term need or desire for cash to be brought into personal ownership.
The rate of tax applicable to companies better facilitates reinvestment and is conducive to long term business growth. This is likely to increases the prospect of future profits, aid value creation and may facilitate the realisation of value in the form of capital in the future, which is likely to be the most effective mechanism by which profits and business value can be returned to the shareholders.
How to bring business profits into personals hands in a tax efficient manner continues to be a recurrent and critical issue for owner managers and ensuring all opportunities are exploited and commercial influences managed can yield significant tax and commercial benefits.
Working with owner managers to balance their commercial goals with tax efficient implementation is at the heart of ‘Brighter Thinking’ and Menzies work with private business owners and entrepreneurs to find a strategy that works effectively in their personal context.