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your tax by R. H. Grimsley BCom, FIAC
3. Disposing of the company's profit
THE COMPANY has made a profit for the year. The Corporation tax liability has been calculated and the necessary funds have been earmarked for paying it after the customary, authorized delay. Or at least plans have been made for finding the money when it is needed and meanwhile this portion of the profit which will later be going out to the tax collector is available as a temporary supply of funds to put to some other use in the business.
There are two possibilities for the remainder of the profit: 1. It may be kept within the company to cover the growing needs of the business for extra funds. Unless the business is actually shrinking it always needs more funds merely to stand still because of inflation. More ,;ommonly, extra funds are also needed to match an actual increase in the amount of turnover and the value of assets.
If three extra trucks are to be added to the fleet £X000 will be needed to pay for them. This cost could be met by way of a lease agreement or a loan, but the company is far safer and stronger if it can find the money from its own resources. There is no better way of doing this than out of the stored up profits.
Tax rules The tax rules actively encourage this approach because no further tax is payable on retained profits, whereas profits paid out as dividend to the shareholders are taxed again and perhaps even a third time by way of surtax. In 1973 or 1974 this tax distinction between dividend and retained profits will be changed but even then the equivalent of surtax will still he in force so this subject will not become entirely out of date.
2. When a dividend is paid to shareholders, the company must deduct income tax at the standard rate (at present 38.75 per cent) and hand this to the collector of taxes under the rules of Schedule F, sending only the net amount to the shareholdeis. It is not possible to get round this by declaring a net dividend because the net figure has to be grossed up to find the amount of tax.
The Schedule F income tax is really the shareholder's personal income tax liability but the company acts as unpaid tax collector. In circumstances where a shareholder's total income is quite small so that he should not really be liable to pay standard rate income tax, he is entitled to recover the excess amount he has suffered. He obtains his refund from the tax office, not from the company.
The example shows the dramatic difference between paying out all, some or none of the net after-corporation tax profit as dividend. However, some restraints must be recognized as the directors do not have quite a free hand in deciding the dividend policy.
A If the company is a close company it will only be allowed to retain 40 per cent of its net trading profit unless it has some genuine need for keeping the funds in the business to finance expansion. modernization or improvement. If it lacks these reasons and fails to pay out the required standard of dividend there is a stiff tax penalty known as shortfall.
B For the few road haulage companies which are public companies, the shareholders and the stock exchange exert some persuasive pressure on directors who authorize only very low dividends. This pressure is usually effective although thert is no legal compulsion behind it.
C Not all shareholders can afford to live without dividends, even though they do see their company growing in
prosperity and the shares increasing in value. Short of the ridiculously extreme step of sacking their directors and replacing them with a more cooperative set, they cannot force the directors to declare larger dividends, but mostly directors will fall in with the wishes of their shareholders.
D Many shareholders like to see the dividends keep fairly steady from year to year and not bound up and down wildly. So if the company has an unusually profitable year it may decide on a smaller proportion of the net profit being used for dividend than average and balance this out against another year when profit happens to be lower than normal.
The upshot of these points is that the directors in most companies steer a sensible middle course, using between four-tenths and sixtenths of the net profit as dividend and retaining the remainder with the company.
Different case However, in the young business which is pushing hard for r,_,pid growth, the situation is somewhat different, particularly where the directors are themselves the only or chief shareholders of the company. In these circumstances a policy of paying no dividend is correct and well justified. The directors will have taken out the earnings they require to meet their own living expenses and they will be most happy to see the funds of the company growing in line with their own ambitions.
Another even more useful way of getting round the profit disposal problem for the growing company is to buy new assets, such as trucks, just before the end of the financial year. Tax relief by way of capital allowances on these items makes a substantial reduction from profit. For assets bought between July 20 1971 and August 1 1973 the allowances in the year of purchase are equal to 80 per cent of the cost of commercial vehicles and of most other machinery except private cars. In development areas the allowances on many kinds of immobile equipment are 100 per cent. This reduces the amount of corporation tax, leaving a bigger net amount in the company and, as it is not proposed to pay out any dividend, there is no further liability to tax on this amount.
Next week: Expenses that are allowable for tax purposes.