The recent changes to Corporation Tax, Income Tax and National Insurance mean that now is a good time to look again at the best way to extract profit from your business. Head of Tax, Chris Riley shares his thoughts on the factors to consider now, and how they may change.
As you would likely expect, we plan the topics for TaxTalk some way in advance, and in April this year we sat down and determined the topics for the summer months ahead. Given the various changes to Corporation Tax, Income Tax and National Insurance rates, I eagerly suggested that this would be a good time to look at Profit Extraction mechanisms – particularly the consideration of Bonus vs Dividend.
Little did I know that I’d find myself writing this article not only in the middle of the hottest July on record (not of much relevance to the tax system) but also, in the middle of a Prime Ministerial leadership contest. There is a clear dividing line between the two candidates in respect of taxation – Rishi Sunak proposes that in the near term, there will be no reduction in taxes, whereas Liz Truss proposes reductions – indeed, an Emergency budget to bring forward these reductions should she be elected, largely framed around reversing the recent increases that are the background to this article. Therefore more than ever, events may quickly supercede this article.
Where are we now?
In the current tax year, as in recent years, it is more tax efficient to extract profits from a company by way of dividend rather than salary/bonus. Over the years the balance between the two options has changed with tax rates and policy, but the gap has become more significant in recent years – the reasons for this being:
The increase in National Insurance rates in the current year (to be rebadged as the Health and Social Care Levy from 2023) has made the salary option more unfavourable. Whilst the Employee National Insurance increase of 1.25% was mirrored by an increase in dividend tax rates, a salary route will also bear increased Employers National Insurance which is not factored into the Dividend route.
The historically low level of Corporation Tax of 19% means that although tax relief is available on salary or bonus payments, this relief is less valuable than it used to be.
This means that, even taking account of the significant increase in dividend tax rates, the fact is that 66.25% of cash will be retained by an individual paying higher rate income tax on a dividend, whereas only 60.8% is retained after all taxes are paid in respect of a bonus. The scale of the differential is replicated for those who pay the upper rate (45%) of Income Tax.
How will this potentially change?
In March 2021, as Chancellor, Mr Sunak announced an increase in the rate of Corporation Tax for companies with profits over £50,000. Below that level, the rate of tax stays at the same 19%, whereas where profits exceed £250,000 these will be taxable at 25%. Between £50,000 and £250,000, the effective rate of Corporation Tax will be 26.5%.
These changes are due to take effect from 1 April 2023. Assuming that they do (which, given the statements made in the Leadership campaigns to date – would have to assume Rishi Sunak wins the keys to Number 10) the effect on profit extraction will be to bring bonuses and dividends into virtual parity. The cash retention for a dividend will stay at 66.25% as there are no changes here; however, a bonus paid to a higher rate taxpayer will give cash retention of 65.7% if profits are over £250,000, or 67.1% if they fall between £50,000 and £250,000. Again, those in the upper rate of tax will see a similar analysis.
With the cash outcomes of the two routes so close, tax is unlikely to be a determining factor in respect of profit extraction, should the Corporation Tax rate increase as planned.
Other factors to consider
So what else should you take into account? As ever, the above is a basic analysis that makes several assumptions:
Key to these is the presumption that any person planning to take a bonus already receives a salary of £50,000. If the basic salary is below that level, then Employee National Insurance at 13.25% (rather than 3.25%) will apply on at least part of the income arising and will reduce the efficiency of a bonus compared to a dividend. It also assumes that the recipient is not above state retirement age, as no Employee National Insurance applies in such cases.
Dividends can of course only be paid to shareholders, and in general only pro-rata to their dividend entitlement. Accordingly, using dividends to provide discretionary bonuses is problematic, and may give rise to tax issues.
If an Owner Manager is planning on selling their business in the foreseeable future and has no immediate need for cash, not paying any bonus or dividends to themselves may instead mean they benefit from a higher sale value which is only taxed at 20% Capital Gains Tax. However, if this leads to significant build up of excess funds, this may jeopardise the availably of reliefs which require the Company to be “trading” – such as Business Relief for Inheritance Tax purposes, or Business Asset Disposal Relief (formerly Entrepreneurs’ Relief) for Capital Gains Tax purposes.
No crystal ball
Come the Autumn we may have a clearer idea as to what the future holds and whether this analysis (an unusual example of a tax legislation change actually making life simpler) will come to pass. In addition, regardless of who becomes Prime Minister, and the promises that have been made, the timing of any reversal of the tax increases (and the potential impacts here) are not matters that have been specifically referenced, and so may yet remain valid in the near term.
If you would like advice on any of the issues raised in this article, please contact Chris Riley.