Tax efficient extraction of surplus cash

If your company is fortunate enough to have surplus cash, you may consider releasing some of this to shareholders. How will you be taxed if you do so?                                            

Dividends

Dividend income is currently taxed at the following rates:

Basic rate taxpayer:                   10%

Higher rate taxpayer:                32%

Additional rate taxpayer:           37.5%.

Most dividends also carry a notional tax credit (which is 1/9th of the net dividend i.e. the amount actually received, being 10% of the dividend plus the tax credit). This is intended to reflect that the dividend is paid out of the company’s post-tax profits. After taking into account the dividend tax credit, the real (or effective) tax rates payable on the dividend actually received are:

Basic rate taxpayer:                   nil

Higher rate taxpayer:                25%

Additional rate taxpayer:           30.6%.

Proposed changes

With effect from 6 April 2016, the dividend tax credit is to be abolished and replaced with a £5,000 dividend allowance. 

This operates so that the first £5,000 of dividends received by an individual in any tax year will be tax-free (but such dividends will still be taken into account in determining the individual’s overall taxable income when calculating how much of their basic rate band or higher rate band has been used). 

Any dividends received in excess of this £5,000 allowance will be taxed at the following rates:

Basic rate taxpayer:                   7.5%

Higher rate taxpayer:                32.5%

Additional rate taxpayer:           38.1%. 

For any dividends received in excess of the £5,000 allowance, this represents a 7.5% tax increase for all individual taxpayers. 

Capital extraction

For higher and additional rate taxpayers, capital gains are taxed at 28%, subject to any applicable exemption and reliefs (including Entrepreneurs’ Relief which reduces the tax rate to 10%). Where possible, it will therefore be more efficient to extract funds as capital rather than dividends. 

So how can company funds be extracted as capital? 

The two main ways in which this can be achieved are:

• A sale of the company
• By a capital reduction. 

Sale of the company

Selling the company will realise a capital gain for the shareholders on the sale of their shares and, provided the conditions are met, Entrepreneurs’ Relief will mean that the tax rate applied to any gain on the sale is only 10%. 

This is however only a viable option where the intention is to build the business to sell. Care is also required to ensure that retaining surplus cash/profits within the company rather than extracting as dividends does not prejudice the qualifying status of the company for Entrepreneurs’ Relief purposes. HMRC may contend that where cash represents more than 20% of its assets the company no longer qualifies as a trading company (one of the requirements for Entrepreneur’s Relief). Provided, however, that the cash is not invested or actively managed and is simply held on deposit, it should be possible to rebut any such challenge. If Entrepreneurs’ Relief is not available, on a sale to an unconnected third party capital gains tax will be due at 28% - which still compares favourably to the increased dividend tax rates for higher/additional rate taxpayers. 

Capital reductions

For companies with sufficient share capital or premium, a more attractive option could potentially be to extract cash by way of a capital reduction instead. 

This does not require any sale of the company and is totally within the control of the existing shareholders/directors. There is no longer a requirement to obtain court approval but the directors will have to provide a statutory declaration of solvency (essentially confirming that following the capital reduction the company will remain solvent and able to pay its creditors). 

A capital reduction, as the name suggests simply involves reducing the share capital of the company by a specified amount and paying that amount back to the relevant shareholders. This is treated as a disposal/part disposal of the shares for tax purposes so, for individual shareholders, should be subject to capital gains tax rather than treated as a dividend. For those shareholders who meet the relevant requirements, any such capital gain can also potentially qualify for Entrepreneurs’ Relief, subject to tax at 10%. 

It does however require the company to have sufficient share capital to reduce so will not, for example, be viable for a company which only has £100 share capital. 

The circumstances where it is perhaps most likely to be a viable option is where an established trading company has, at any point, put in place a holding company by way of a share for share exchange. In this case, the holding company will generally have an issued share capital (and premium) account equivalent to the market value of the trading company at the time the holding company was put in place. 

Simply putting in place a holding company to create the share capital with a view to then carrying out a capital reduction will fall foul of the anti-avoidance legislation and not deliver the desired tax treatment. However, putting in place a holding company or group structure could leave open the possibility of returning value to shareholders by way of a tax-efficient capital reduction in the future, if:

• There are other legitimate commercial reasons for creating a holding company; and
• There is at the time of creation no current intention that there will be a capital reduction. 

HMRC could potentially seek to apply anti-avoidance legislation to any capital reduction (even where no holding company has been put in place). If they were successful, the amounts received would be treated and taxed as dividends – in which case the shareholders are in no worse position. Provided, however, that there is no artificiality (such as the insertion of a holding company with the primary purpose being to then carry out a capital reduction), it is unlikely that the anti-avoidance rules would apply or that HMRC would seek to invoke them.

Summary

For companies that do have a significant share capital, the use of a capital reduction to return surplus cash to shareholders could deliver significant tax savings (of up to 28.1%). 

Much will of course depend upon the capital structure, shareholder profile and other commercial considerations but with the relaxation in the capital reduction procedures for private companies a capital reduction is potentially a very tax-efficient option for extracting surplus cash.