Corporate formula
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Should profits be reinvested or handed to shareholders? Labour's corporation tax proposals could be a powerful incentive to investment.
Hauliers running limited companies pd}. cm poration tax at 33% on its taxable profits, but these are not necessarily the same as its accounting profits. The profits shown in the account are the starting point but a number of adjustments need to be made.
The tax is payable nine months after the end of the company's accounting period, which is normally the date to which it prepares its accounts. However, if these cover a period of more than 12 months it will he split into two accounting periods; the first 12 months and the rest. If the company is not carrying on business for the full period for which it prepares accounts, the accounting period will start from the date it begins or ceases its business.
Formula
A lower rate of 24% (23% from April 1997) applies where profits are below £300,000. Eletween £300,000 and £1.5m of profit the tax is calculated under a formula designed to produce an average tax rate of 33% for a company that earns exactly .E1.5m. Profit in that hand attracts tax at 35.25% (35.5% from April 1997). This exceeds the basic corporation tax rate as it claws back some of the relief given on the first £300,000.
Clearly, if a business has profits in this band it is worth considering whether anything can be done to create expenses against them. For example, it may be sensible to pay a bonus to shareholder directors. This will save tax at 35.5% instead of the normal 23%, so the extra tax payable to put the money into the hands of the individuals is significantly reduced.
In practice, the marginal rate applies at far lower levels than £300,000. This is because where a company has associated companies the sums of £300,000 and f.1.5m have to be divided equally between all of them. Broadly speaking, companies within a group are associated: so are companies under common control and those con . — trolled by close relations of the pro prietor.
1A company with five associated 6 companies will pay the 24% rate on only the first £50,000 of its profits Ps> (a sixth of f300,000), the 35.25% rate on the next £200,000, and the full 33% rate after that. When dividends are paid to shareholders the company must account for advance corporation tax (ACT). This is normally payable 19 days after the end of the calendar quarter to which it relates, The ACT is 25% of the dividend, which represents 20% of the dividend plus the ACT.
As the name suggests, the ACT is a payment on account of the company's corporation tax liability.
Suppose a company with profits of £200,000 (and no associated companies) pays a dividend of 150,000 during its accounting year to 31 December 1996. It must pay ACT of 1:12,500. When it pays its corporation tax on 30 September 1997, it needs to pay a further .05,500, that is 24% of £200,000, a total of 148,000 less the ACT of £12,500 already paid.
The shareholder is entitled to a tax credit equal to the ACT: a 50% shareholder in the above company will receive a £25,000 dividend and a £6,250 tax credit. He is taxable on both of these amounts (X3 l ,250) but can set the tax credit against his bill.
This effectively eliminates the tax on the dividend where the shareholder is a basic rate taxpayer, but leaves a further 25% of the dividend to pay if he is taxable at 40%, (there would be a further ,C.6,250 to pay on the above dividend). In effect, the benefit of having paid tax at 20% on the profits out of which the dividend (and ACT) is paid is passed through to the shareholder. The other 4%, 25.25% or 9% (the balance of the corporation tax rate) therefore remains as an additional burden on the company What changes would a Labour government make? Labour believes that capital allowances should he higher to encourage investment. For most of the last Labour government corporation tax was 52% and the small companies rate 42%, but 100% of the cost of plant and machinery could be set against profits in the year the expenditure was incurred.
Incentive
This was a powerful investment incentive. If a similar scheme of first-year allowances were to be introduced the corporation tax rate would probably need to go up again to around 50% to pay for the relief. This is unlikely to happen, but a 50% first-year allowance and, say, a 42% corporation tax rate looks a good bet Another possible way to pay for investment incentives would be to reduce or abolish the part of the corporation tax that passes to the shareholders. Germany imposes corporation tax at a lower rate on profits that are distributed than those that are not and taxes the shareholder in full on the dividend, so that the benefit of the reduced tax bill on distributed profits remains in the company rather than being passed to the shareholders.
Labour could introduce a similar system here combined with a small increase in the corporation tax rate. Such a system could be used to encourage the retention of profits and their reinvestment within the company if the differential between the corporation tax rate on distributed and undistributed profits is small.
While Gordon Brown has pledged not to increase the income tax rates he has said nothing about corporation tax. It is possible that the rate could be increased not only to pay increased investment incentives but to produce an overall increase in tax yield as well.
L Robert W Maas
Robert W Maas is a Tax Partner of Blackstone Franks & Co, a leading City _firm of Chartered Accountants.