As comforting as it may be to see the fruits of your labour generating large cash reserves in your company, is this a wise move? Do you have a plan as to what you want to do with the funds? Are your savings actually costing you money?
In the short term, you may need to access cash reserves to cover known liabilities, but we will assume for the purposes of this piece that your company has surplus reserves. If these reserves are sitting in a high street deposit bank account they are almost certainly not giving you a great return. Despite the very recent move by the Bank of England to increase the base rate, interest rates on short term cash deposit accounts remain very low. With the right Investment advice you could make your money work much harder for you and even assist in reducing your own personal tax liability along the way.
Long term there are potential dangers to “stock piling” cash in your company. For years, advisors actively suggested that taking a small salary and dividends in the basic rate tax bracket was the most tax efficient way to work, this way you could build up large cash reserves that could be withdrawn from the company as capital at closure, benefiting from Entrepreneurs Relief at 10%, therefore not suffering the higher rate dividend tax rate.
BUT beware this may not be as available as you think!
There are three qualifying criteria for Entrepreneurs Relief and whilst the first two are a matter of fact the third is open to interpretation by HMRC.
You must have been a director or employee of the company for a minimum of at least 12months prior to the sale
You must have owned a minimum of 5% ordinary shares carrying at least 5% of the voting rights
Your company must be defined as a trading company
The question of whether your company is trading has long been a moot point. A trading company is defined in TCGA 1992, s 165A(3) as a “company carrying on trading activities whose activities do not include to a substantial extent activities other than trading activities”. It has always been understood that HMRC will regard any activity as not being substantial if it comprises less than 20% of the company’s activities.
It will be abundantly clear if your company has diversified substantially into non-trading activities such as the purchasing of investment property or quoted shares but it will be less easy to determine if you meet the criteria when substantial levels of cash have built up. Cash rich trading companies can struggle to meet the trading company requirements and therefore can be denied Entrepreneurs Relief.
The general view taken by HMRC is that cash built up should be extracted as a dividend. For most tax payers the rate of tax applicable to dividends is greater than 10%. It may be easier to justify that your cash surplus is needed for trading operations in the case of a longer established or growing business. The need for the retention of cash for future business use can then be more easily justified than in, for example, a service company where perhaps the only income is your consultancy fees with expenses at a minimal level. If you do seek to rely on being a trading company it is well worth retaining director’s minutes and reports documenting the business need for the surplus funds.
Further complications arise from the New Targeted Anti- Avoidance Rule (TAAR), introduced in April 2016. With the introduction of the new dividend tax rates from April 2016, HMRC were concerned that there would be further incentive for a shareholder to divert income to a capital distribution by way of saving cash in the company until such time as the company is liquidated.
Under TAAR, a distribution from the winding up of your company will therefore be treated as if it were an income distribution where all of the following conditions are met:-
Where you as an individual shareholder in a close company and you receive from the company a distribution in respect of shares in a winding-up situation
Where within a period of two years after the distribution, you continue to be involved in a similar trade or activity.
Where the circumstances surrounding the winding-up have the main purpose, or one of the main purposes, of obtaining a tax advantage
The first two conditions will be relatively easy to prove and valid commercial reasons for closing your company such as retirement or moving to a permanent PAYE position, for example, remain unaffected with regards to the Targeted Anti-Avoidance rules. Issues may arise under the third provision if you struggle to persuade HMRC that the cash funds built up were for any reason other than continuing the trade of the business.
Don’t despair! All is not lost. There are things you can do that will mean your money works harder for you and with the right tax planning you can continue to maximise your return over the lifetime of your company.
Considering a plan for the future and taking proper advice now can save you £’000s. Talk to your accountant today who can work with you and Financial Advisors, Contractor Wealth, to balance your short term needs and long term goals.