New tax hit for Northern Ireland SMEs

The first Conservative budget in 20 years may have ostensibly been pro-growth, but one decision will certainly not be greeted with cheer by family-owned or owner-managed businesses in Northern Ireland, writes Maybeth Shaw.

It has become commonplace for economic policy to be discussed through a corporate lens, so that questions of what is positive or not for business are assessed in terms of their impact on the multinational sector. In such a mindset, the role of the SME sector as the real engine of most economies – including Northern Ireland – can often seem to be an afterthought.

July saw the UK’s first wholly Conservative Budget in almost 20 years, styled by Chancellor George Osborne as “a Budget that puts security first” and one that set out to reward hard work. Those who lead SMEs might reasonably have hoped, therefore, that the central role they played in safeguarding the country’s sense of economic security over the last few years would be recognised. A host of changes are certainly in the pipeline for SMEs but one of the most significant, in the area of remuneration planning and the tax efficient extraction of funds, is set to disappoint rather than reward and is likely to prove a costly headache for family-owned businesses in years to come.

The issue arises from a change in the tax treatment of funds extracted by business owners by way of a dividend. Dividends are currently taxed at an effective rate of zero per cent for basic rate band taxpayers, 25 per cent for higher rate taxpayers and 30.56 per cent for additional rate taxpayers. As announced in Budget 2015, from 6th April 2016 the approach will change significantly. Each taxpayer will instead have an annual tax-free dividend allowance of £5,000 and, where additional dividends are withdrawn, they will be taxable at 7.5 per cent for basic rate band taxpayers, 32.5 per cent for higher rate taxpayers and 38.1 per cent for additional rate taxpayers. Table 1 illustrates the different tax treatments that will apply to those extracting funds either as a dividend or as a salary in 2015/16 and 2016/17.

A likely interpretation of these Budget changes is that they were made to address the issue of sole traders and the self-employed incorporating their businesses in a bid to avail of a preferential tax regime. Closing such a loophole is perfectly understandable, but it fails to reflect the reality of genuine SMEs and the vast majority of business owners who wish to invest in and develop their business. The new tax regime can only mean that these business owners must either cut the amount of money they use to fund their personal and family lifestyles, or accept that there will be less money within the business to support its future development. Neither can be viewed as pro-business in either execution or consequence.

The changes, of course, are not specifically targeted at family-owned businesses, so it is worth reflecting on why this group will be the most impacted. For those who run a family or owner-managed business, it is typically the main or only source of existing and future family wealth and sustainability. Therefore, any issue around extracting money from the business in a tax-efficient way is especially pertinent. Family-owned businesses, like all businesses, have benefited from the reduced corporation tax rates of recent years – a policy approach that made extraction by way of dividend more tax-efficient than alternative approaches, which involved awarding the business owners an increased salary or bonuses. For obvious reasons, dividends became the preferred extraction method in family-owned businesses, allowing owners to fund their personal and family lifestyles while still supporting the growth of their business.

The most common business structures set to be impacted by the new rules are companies run by two spouses where both take dividends to help fund their living expenses. Take a husband and wife, for example, each of whom draws £25,000 of net dividends from the business and have £10,000 of other income (typically a salary from the business to maintain their national insurance contributions and future entitlement to state pensions or benefits). In the 2015/16 tax year, there would be no additional tax to pay on extracting the funds by way of a dividend as this is below the basic rate band. In 2016/17, under the new rules, while the first £5,000 of dividends will be covered by the tax-free allowance, the remaining £20,000 will be taxed at the 7.5 per cent rate.

This will result in an additional £1,500 in tax for each spouse. For business owners whose dividend extractions are higher than that shown in this example, the pain points will be correspondingly greater when the new rules apply.

Given that the changes do not come into effect until April 2016, financial advisors can expect a surge of queries from business owners in relation to maximising the dividend yield from their businesses. All steps should be followed to secure the greatest tax advantage, but there remains the question of how best to mitigate future tax charges on dividends in subsequent years.

Pensions remain a tax-efficient means of extraction and, particularly in businesses where owners are close to retirement age, there will be strong arguments to see pensions as an effective medium-term mitigation strategy. In all cases, of course, pensions have a key role to play in effective business planning.

A further consideration for business owners is the possibility of retaining and rolling up profits within the business, where such profits would then be subject to corporation tax rates, and delaying the extraction of money from the business until an eventual exit. This is not a strategy that can be applied universally but where a business exit is under consideration or actively being planned, there is a great deal to gain from taking such a course. An exit from the business will generally be treated under the Capital Gains Tax (CGT) regime and the preferential CGT rate available via Entrepreneurs’ Relief (ER).

ER allows business owners to pay reduced CGT when selling all or part of their business – 10 per cent on qualifying assets as opposed to 28 per cent – so long as they meet certain qualifying conditions. With up to £10 million of lifetime gains potentially qualifying for relief, ER can represent a significant saving for family business owners in exit mode.

For those who are committed to retaining and growing their businesses, there are no simple solutions. Whatever approach is taken to lessen the impact, it will have to be tailored to the specific circumstances of the business and the requirements of the family in question.

As this issue will impact on virtually every family-owned and owner-managed business in Northern Ireland, financial advisors can expect it to be a priority topic as they address their clients’ service needs in the months ahead.