Exchequer Weblog

This was billed as a ‘no-surprises’ budget by Treasury insiders, which it almost was. Most of the tax changes due to come into force in April 2008 were announced by Gordon Brown in the Spring 2007 Budget, or by Alistair Darling in the 2007 Pre-Budget Report. However, the big and welcome surprise for small businesses is the postponement of the Income Shifting proposals.

There are also a number of small changes made to the new capital allowance rules, as well as to corporation tax, and in VAT administration which may make life easier for small businesses. This budget summary concentrates on the main tax issues affecting our business clients.

Small Business Tax

Income Shifting
When the Taxman lost the Arctic Systems case back in July 2007 the Government immediately said they would change the law to prevent individuals drawing profits from a business in a way that minimised the total tax payable. The Government referred to this behaviour as ‘income shifting’.
Income shifting is said to apply where an individual makes larger contribution to the business than his co-owners, but receives a smaller or similar share of the profits. Some of the profits generated by the main worker are paid to individuals who play a less active role in the business. Crucially, the total tax paid by sharing the profits in this way is less than would be paid if the main worker had received his fair share of the profits. Many small companies and partnerships share profits on a basis that does not strictly reflect work each person put into business, and thus would be caught by the income shifting law making the main earner taxed on their ‘fair’ share of the profits.
The draft income shifting proposals were released for consultation in December 2007 and were roundly criticised as completely unworkable. Fortunately someone in the Treasury has listened and more consultation will now take place to see if a more reasonable solution can be found. The income shifting law will not be brought into effect until at least 6 April 2009.

Capital Allowances
The system of capital allowances is radically changed from 1 April 2008 for companies, and from 6 April 2008 for unincorporated businesses. Under the new rules all businesses of whatever size can claim a 100% deduction for the cost of plant and machinery up to a total of £50,000 per year, known as the annual investment allowance (AIA). The cost of assets not covered by the AIA is set against profits by way of a so-called writing down allowance given at 20% per year (down from 25%), or at 10% for equipment that is an integral feature in a building.
Most small businesses won’t have to worry about claiming the writing down allowance on new equipment as the full cost will be covered by the £50,000 AIA. However, you will need to continue to claim writing down allowances for equipment purchased before April 2008, which has not yet been given full tax relief. This could be annoying as the amounts of unrelieved costs get progressively smaller each year. For accounting periods starting on or after 1 or 6 April 2008 (depending on the structure of your business) you will be able to write off the full cost of old assets, where the total unrelieved cost is £1,000 or less.
It may therefore pay to delay the purchase of plant and machinery until after 1 or 6 April.

Company Cars

The Employee
The increase in the taxable benefit for using a company car was announced in the 2007 Budget. The scale of CO2 emissions that sets the taxable amount of the vehicle’s list price is ratcheted up by 1% for each 5g/km, and now starts at 15% for cars with CO2 emissions of 121-139g/km. Although cars with CO2 emissions of 120g/km or less are taxed at 10% of their list price. The list price scale will remain the same for 2008/09 to 2009/10 but will move up again by 1% for each 5g/km from 6 April 2010.

Where fuel is given for private use, the taxable benefit is based on the same percentage that is used to calculate the car benefit, multiplied by the fuel constant. This fuel constant figure increases from £14,400 to £16,900 on 6 April 2008, which will increase up the taxable benefit of private fuel by about 21%. This fuel constant will also be increased by the rate of inflation in 2009 and 2010.

The tax free allowances for using your own car for business journeys will not increase in spite of the huge rise in fuel costs. Currently up to 40p per mile can be paid for the first 10,000 business miles driven per year, and 25p per mile for any additional miles.

The Employer
The capital allowances system for company cars is to be reformed from April 2009, not from April 2008 as we had expected. From 1 April 2009 for companies, (6 April 2009 for unincorporated businesses) all cars will be categorised on the basis of their CO2 emissions.

Low emissions cars will qualify for a 100% first year allowance, but the definition of low emissions will be changed from CO2 of 120g/km or less to 110g/km or less from 1 April 2008 (note the earlier year). High emissions cars are those with CO2 emissions of 160g/km or more. These only qualify for a 10% writing down allowance per year. All other cars will qualify for a 20% writing down allowance. This new system will lengthen the period over which tax relief for the full cost of the cars will be given, particularly for higher polluting cars. It is not yet clear whether the new system will only apply to cars purchased after 1 April 2009 or for all cars owned at that date.

Income Tax

New Rates
Gordon Brown told us last March last the basic rate of tax was being cut from 22% to 20%, with effect from 6 April 2008. What he didn’t make clear was that the starting rate of tax at 10% is also removed for most types of income, but not for savings income. This is confusing, but we’ll try to explain.

The 10% tax band has been abolished for most types of income, so you will pay 20% tax on all of your taxable income up to £36,000 in 2008/09, and 40% tax on income above that threshold. However, dividends are still taxed at 10% up to £36,000 and at 32.5% above £36,000. The 10% dividend tax credit attached to dividends means that you pay no additional income tax on dividends as a basic rate taxpayer.

Savings income is basically interest paid by banks and building societies. It is taxed as a slice on top of your other earned income but before your dividend income. The £2,230 of savings income is taxed at 10%, if your other earned income hasn’t already pushed you into the 20% rate.

Example
In 2008/09 you take a salary of £5,435 from your company, and gross dividends of £33,000. You also receive £2,000 in gross interest from a savings account. Your personal allowance of £5,435 for 2008/09 covers your salary leaving nothing taxable. The next slice of your taxable income is the savings interest of £2,000. This falls within the savings income band of up to £2,230, so is taxed at 10%. Your total taxable income amounts to £35,000 (£33,000 + £2,000) and is within the £36,000 limit for higher rate tax, so all of your dividend income is also taxed at 10% and is covered by the 10% dividend tax credit.

Pensions and Charities
There are two problems with the reduction in the basic rate of income tax, which concern pension contributions and gift aid donations.
The pension problem is solved easily. If you make a pension contribution of £2,000 before 6 April 2008, the pension fund can reclaim £564 of basic rate tax (22% x £2,564) to add to the fund on your behalf. If you pay £2,000 to the pension fund on or after 6 April 2008 the fund can only reclaim £500 (20% x £2,500). Your gross pension contribution has been reduced by £64 due to the drop in the basic rate of tax from 22% to 20%.
To maintain the same level of gross contributions into your pension fund in 2008/09 and beyond you will have to increase your net pension contributions by 2.56%.

The same problem applies to charities that receive donations under the gift aid scheme. The charity can reclaim the basic rate tax on any gift made under gift aid. So in 2007/08 the charity can reclaim £564 on a gift of £2,000, but in 2008/09 the charity’s income will be cut by £64 to £500. This problem will be solved temporarily in the tax years 2008/09 to 2010/11. The Government is to repay the charities the extra income they will lose by the reduction in the basic rate of tax in those years. This will not affect the individuals who made the original donations under gift aid.

Enterprise Investment Scheme (EIS)
When an individual subscribes for EIS shares, they can claim income tax relief of 20% of the amount invested, up to a limit of £400,000. This caps the income tax relief at £80,000 (20% x £400,000) for each tax year. Where EIS shares are issued on and after 6 April 2008 the maximum investment that will qualify for income tax relief is increased to £500,000, giving income tax relief of £100,000, (20% x £500,000).
In addition to this income tax relief, the investor can also defer any amount of capital gains tax by claiming deferral relief on his EIS shares. There is no limit on the amount that can be invested in EIS shares to claim deferral relief in one tax year.

Corporation Tax

Tax Rates
The changes to corporation tax rates were announced in the 2007 Budget. The rate for small companies increases to 21% on 1 April 2008, and then to 22% on 1 April 2009. The main rate of corporation tax reduces to 28% on 1 April 2008. This is charged where taxable profits exceed the £1.5 million large company threshold.

Associated Companies
When you control a company any other companies you also control are all treated as associated companies. The large company threshold is divided by the number of associated companies to determine when the main rate of corporation tax is payable. Three associated companies means the 28% rate is charged where profits exceed £500,000 (£1.5 million /3).

All the companies controlled by your business partners, spouse or civil partner are also treated as your associated companies, even where there are no commercial links with your company. This problem is partly solved from 1 April 2008 by ignoring the interests of the business partners of the controlling shareholder who otherwise have no connection to the company. However, it does not remove the problem of your spouse’s company being associated with your company.

Enterprise Management Incentives (EMI)
This is a useful share option scheme that is designed to be used by smaller companies to help attract and retain employees. If the scheme is operated correctly the employees can acquire shares and not be charged income tax or NI on the value of those shares. However, there is a £100,000 cap on the value of the share options each employee can be granted in a three year period. This cap will be raised to £120,000 per employee for EMI share options granted on and after 6 April 2008.

Only companies with gross assets of no more than £30 million can issue EMI options. It can also have no more than £3 million of its shares under option at any one time. In addition a new restriction will be imposed by the Finance Act 2008 that the company must have no more than 250 full time equivalent employees.

Value Added Tax

Registration Limit
The compulsory VAT registration threshold has been increased to £67,000 from 1 April 2008. This is a generous increase of £3,000, which maintains the VAT registration threshold at one of the highest in Europe. You must register for VAT when the total value of your vatable sales for the last 12 months exceeds the compulsory registration limit. You can of-course register voluntarily for VAT at any time once you intend to trade.
If the level of your sales drops below the de-registration threshold you can ask to be de-registered for VAT. This de-registration threshold is also increased by £3,000 to £64,000 from 1 April 2008.

Errors on VAT Returns
This is good news for all VAT registered businesses. At present if you make an error in your VAT calculations you can work the under or over payment into your next VAT return if the total net error amounts to no more than £2,000, which is not a lot. Where the error produces an under or overpayment of more than £2,000 you should write to the VAT office and confess. This wakes up the VAT Inspector and they hit you with interest on the late paid VAT.

This error reporting limit is being raised to the greater of £10,000 or 1% of the reported turnover for the VAT quarter, subject to a cap of £50,000. The new limit will apply for accounting periods beginning on and after 1 July 2008. The same error reporting limit will also apply for other indirect tax returns such as air passenger duty, landfill tax and the climate change levy.

Stamp Duty

In spite of rumours that Stamp Duty Land Tax (SDLT) would be increased for higher value properties there have been no changes in the rates or thresholds for freehold properties. There are some changes for leases of residential property which may reduce the SDLT payable in some circumstances.

Purchasers of some very high value residential properties have used tax avoidance schemes to avoid paying the SDLT due on the purchase. From now on the use of any tax avoidance scheme in conjunction with a residential property costing over £1 million will have to be reported to HMRC.

Non-Domicile UK Residents

There has been a considerable amount of fuss about the changes proposed to the tax residence and non-domicile rules.
Your tax residence depends largely on the number of days for which you are actually present in the UK during a tax year. From 6 April 2008 every day in which you are present in the UK at midnight will count as a day of residence. Days spent in transit travelling through the country are not counted.

Individuals who are UK resident but not domiciled (non-dom) in the UK, generally only pay UK tax on their foreign income and gains if they bring those funds into the UK, on the so-called remittance basis. This generous tax treatment will be blocked once the individual has been resident in the UK for more than seven out of the previous nine tax years.

The non-dom individual can retain the remittance basis if he pays an annual fee of £30,000, or if his overseas income and gains amount to less than £2,000 per year. This de-minimis amount is increased from the level previously suggested level of £1,000. However, all non-dom individuals will lose the use of their UK personal allowances if they wish to use the remittance basis, even if they are only resident in the UK for less than seven years. Although those with foreign income of less than £2,000 per year can retain the use of their personal allowances.

If you are like Bruce Forsyth and have deferred taking your state pension as you are happy working, you need to carefully consider the timing of when you do take up that pension. You have two choices when taking your deferred state pension:

• Draw an enhanced weekly pension; or
• Take a lump sum plus the normal weekly amount.

The enhanced weekly pension is taxable just like the normal pension. If you defer taking your pension until after 6 April 2008 you will have an increased tax free personal allowance of £9,030 (if aged under 75) to set against that income. However you need to estimate your total income for the tax year, as if it exceed £21,800 your age allowance will be reduced.

The lump sum pension payment is taxable at the top rate of tax you pay in the year you become entitled to receive your deferred pension, not necessarily the date when you actually receive the lump sum. So the date you claim your deferred pension could be crucial.

The lump sum is not added to your total income to work out your marginal rate. If the top tax rate you pay on other income is 20% (for 2008/09), then the full lump sum will be taxed at 20%. Similarly if your personal allowance fully covers all your other income so you pay no tax, the lump sum is taxed at a nil rate.

If you are planning to stop work and take your state pension, cease your earnings in 2007/08 then take your pension lump sum in 2008/09, and possibly defer your personal pension until 2009/10. In this way you will minimise the marginal tax rate in the year the lump sum falls into.

Taper relief reduces the taxable gain made on business assets by up to 75% and by up to 40% if the assets don’t qualify as business assets. However, taper relief will also be withdrawn on 5 April 2008, which has annoyed those who are about to sell their businesses. The new Entrepreneurs’ relief will partially restore the taper relief position where you are selling all or part of your business but this does not apply to everyone.

To qualify for entrepreneurs’ relief on the sale of shares you have to own at least 5% of the company and be an employee or director of that company for at least a year. If you acquired your shares as part of an employee share scheme, or you don’t work for the company, you will lose your taper relief (possibly at 75%) and won’t get the entrepreneurs’ relief. In order to bank your taper relief you need to sell your shares by 5 April 2008, but you may want to hang on to them, as they are a good investment.
In which case you could sell the shares but use one of the following strategies to reacquire a similar number and value of the same shares:

• After 30 days you can acquire the same number of shares. You need to delay the repurchase by at least 30 days as otherwise your sale and purchase are matched for tax purposes and you can’t take advantage of the taper relief. This is a risky strategy as you may have to pay more for the replacement shares if the share price has increased in that 30 day period.
• Ask your spouse to immediately acquire the same shares. They can then give those shares to you in a no-gain, no loss transfer.
• Ask the trustees of your Self Invested Pension Plan (SIPP) to the same shares as soon as you sell them.
• Ask the fund manager of your ISA to acquire the same shares.

In the last two options (SIPP and ISA) you do not have direct control of the shares but you still benefit from their growth in value in the future.

Several important capital gains tax reliefs are being withdrawn at the end of this tax year on 5 April 2008, including indexation allowance which compensates for the effect of inflation on the value of your assets. In return for this simplification, capital gains made from 6 April 2008 will be taxed at a flat rate of 18% instead of your marginal tax rate of 20% or 40%. In spite of this tax rate reduction those who have held assets for ten years or more could pay more tax on a disposal after 6 April 2008, but it does depend on how much the asset originally cost.
Example:
You are about to sell some land you’ve held since April 1982. It has not been used for a business purpose, so the taper relief is 40% for a non-business asset. You also get indexation allowance to compensate for the effect of inflation from April 1982 to April 1998. We assume you have already used your annual exemption for 2007/08, so all the gain you make is taxed at your highest margin rate.

By delaying the sale you save tax of £11,712 (£191,712 - £180,000), but you lose the benefit of both the indexation allowance and the taper relief.
You can bank the indexation allowance by transferring the land to your spouse before 6 April 2008, who then sells it in the new tax year to take advantage of the lower tax rate. A transfer to a spouse or civil partner is treated as a no gain/ no loss transaction for capital gains tax purposes, so no tax is due on the inter-spouse transaction. The deemed cost of the land for your spouse includes the indexation allowance.

Example:

By making the inter-spouse transfer and selling in the later tax year you and your spouse pay tax of £143,784 on the gain rather than £180,000, a further saving of £36,216.

Points to note:

• This indexation saving trick only works when transferring the asset to a spouse or civil partner, a transfer to a sibling or unmarried partner will not work.
• The spousal transfer must be legal and complete. Land must be transferred by a deed, and shares must be recorded against the new owner’s name on the company’s share register.
• Complete the transfer to your spouse well before the asset is advertised for sale. If the sale negotiations start before the spousal transfer is done, the Taxman will say the transfer is an inserted step to reduce the tax payable, and will ignore the spouse transfer for tax purposes.
• Check whether the tax saving is worthwhile before making the transfer. An asset with a low cost, or low base value in March 1982, will not attract much indexation.

When you run your own company you have a certain amount of control over how much income you are personally taxed on in each tax year. The company is taxed on the profits it makes in each accounting year, but you don’t have to draw those profits out in the same period. You may well take a basic salary from your own company and top-up your income needs with a series of dividends.
Just before the end of the tax year is a good time to assess how much you have taken out of the company, and what your total taxable income will be for 2007/08. The threshold at which higher rate tax kicks in is £34,600, so assuming you are aged under 65 and have a personal allowance of £5,225, you can receive gross income of £39,825 in 2007/08 before you start paying tax at 40%.
To work out your gross income you need to ‘gross-up’ the dividends you receive from your company. Each dividend voucher should show the gross and net amount, but in case you have mislaid those vouchers, £1,000 of net dividend is equivalent to £1,111 gross. Your pay-slips should show the gross pay you have received and all the tax and NI deducted. You also need to take into account the value of any benefits in kind and interest you have received in this tax year. Interest from bank accounts is normally paid net of 20% tax, so for each £100 net you receive the gross equivalent is £125. Tot up all your different sources of gross income and benefits for the year, to see how much headroom you have before reaching the higher rate tax threshold of £39,825.
If you are about to exceed the 40% threshold, you could postpone issuing that next dividend so it falls after 5 April 2008 and in a new tax year. If you need the funds you could arrange for your own company to lend you up to £5,000 until after 5 April 2008, when it can be repaid with the issue of a dividend. As long as the total amount you borrow from the company at any one time is less than £5000, and you repay the amount borrowed within nine months of the company’s year end, there should be no tax implications.
On the other hand if you have a good deal of headroom before hitting the 40% threshold, and the company has the available funds, it makes sense to withdraw dividends up to that threshold. If you don’t need the income straight away you can invest it in your own name or lend it back to your company.