Summer 2010 Newsletter

Entrepreneurs' Relief - More 10% Capital Gains Tax

The Budget has improved Entrepreneurs’ Relief by increasing the amount of gain to which it applies. This is now an even more valuable relief for tax mitigation and it is important to ensure that you satisfy the criteria to qualify for 10% tax. Failure to qualify increases your tax from 10% to 18%.

The key features are:

  • effective 10% rate of tax on the first £2 million of lifetime gains on business assets arising in connection with the sale of business after 5 April 2010. This year’s Budget has proposed increasing this from £1 million.
  • the £2 million is a lifetime limit per individual and may be spread over more than one business.
  • gains in excess of this will be taxed at 18%.
  • assets must be held for a minimum period of 1 year.
  • for shares, you must hold more than 5% of the ordinary shares, the company must be a trading company and you must be an officer or employee of the company.

Planning in advance is essential for you to maximise your ability to pay 10% tax and the right time to start planning is now.

New Ventures and Company Structure

As the economy picks up, there are opportunities for expanding trade into new areas. Such expansion will involve new investment and can include new business partners. A number of factors should be considered in choosing the structure of such new ventures.

Limited liability. Assuming no laws are breached, this is limited to the value of share capital. If a business fails, loans from owners are repaid only after all other creditors.

Security of assets invested. If a new venture is part of an existing business, then both parts of the business cross guarantee each other. This can be a problem if the new venture is risky and may endanger the accumulated assets of an existing business. In such cases, a separate company should be considered.

Shares. These determine rights to voting, dividends and capital on sale or winding up. Such rights should be handed out only after careful consideration.

Exit strategy. If the new venture has a finite life or is intended for sale, a new company, rather than a division of an established business, will allow the value of the business to be realised without impacting upon existing trades.

Reporting as a division, rather than a separate limited company should be easier. A division saves the extra expenses of statutory accounts, corporation tax return, payroll and VAT registration, to name but a few.

A separate entity may make it easier to price discriminate, allowing the customers to be treated differently from the existing trade. It is worth noting that any trade name (except those prescribed by law) may be used by a limited company, as long as the business is not trying to pass itself off as an existing business.

Tax. This includes such issues as the marginal rate of corporation tax, annual investment allowances and VAT groups.

It is well worth seeking advice on new projects in advance, so that the benefits can be maximised.

100% Capital Allowances

The recent Budget has enhanced the tax relief on fixed assets. The previous 100% rate of tax relief is unchanged, but, from 1 April 2010, the annual investment allowance is increased from £50,000 to £100,000. This is clearly beneficial and, for many companies, this will mean they obtain 100% tax relief on all expenditure on plant and machinery.

The timing of expenditure can be important and do not assume you will receive 100% relief.

Having enhanced the capital allowances regime, the Chancellor of the Exchequer also reduced allowances elsewhere. For any expenditure not qualifying for 100% relief, it qualifies for 20% relief. So, for any company that invests more than £250,000 in plant and machinery, the benefit of the 100% relief on £100,000 is taken away by the reduction of writing down allowances from 40% to 20%. Another example, if we needed one, of a Chancellor giving with one hand and taking with the other.

BASEL II - Why The Cost of Bank Borrowing May Increase

Basel II was implemented in the UK in January 2008. Following the financial crisis in 2008, the Basel committee pushed for improved controls. Currently, we are operating in a pre-financial crisis regulatory world. The regulations are likely to be tightened up, although this will take some time. Many banks are looking to justify alterations in their commercial dealings with customers, but one suspects this process would not have been so open if we had not seen the bank crisis of 2008.

Basel II identified 3 ‘pillars’ for a secure banking sector: Capital Adequacy - the holding of capital relative to exposure; Supervisory; Market Discipline - obligations to publish details of risks, capital and risk management.

Banks are using this as a reason to review capital adequacy and pricing. From a customer’s perspective, capital adequacy is likely to have the most immediate impact, as this requires banks to hold a set level of capital and the bank will want to charge this to the customer. Capital adequacy is not simply linked to potential exposure, but is weighted to reflect the profile of the risk taken by the bank. This risk is made up of product type, general nature of the customer and individual customer risk profile. Customers will be assigned a risk category. It will cost the bank more to provide financial products to higher risk customers. The difficulty from a customer’s perspective is determining how this will impact a transaction and long term relationship with the bank.

The UK banking sector is governed by HM Treasury, Bank of England and Financial Services Authority working together or following the collapse, blaming each other. Banks are able to adopt either their own procedures (approved by the FSA) or one of the authorised credit rating bodies’ rating system. The credit rating agencies authorised by the FSA are Fitch, Moody, Standard and Poors, and DBRS. Credit ratings fall within 3 bands, namely A, B or C. ‘A’ being the rating issued for the most financially robust companies. Each rating will impact on capital requirements. ‘B’ rating doubles the amount of capital of the lending bank. ‘C’ rating triples the amount of capital. This is only a formulated version of what we all know, namely the higher the risk the higher the price, but it does impose a real cost on the bank of taking greater risk, which will, no doubt, temper their enthusiasm for such risk.

No company will set out to achieve a poor credit rating, but there may be commercial reasons to conduct business in a manner that leads to a poor rating. Larger businesses often use their market dominance to extend payment terms, and keep assets off the balance sheet. These factors may increase their cost of borrowing and may force businesses to alter their trading model.

Transfer Pricing

Whilst most business transactions are with unconnected third parties and the price is agreed by negotiation, transactions between entities that are connected may not arrive at a “price” by independent negotiation. Factors other than the bare commercial desire to make the maximum profit from a transaction may come into play when setting a “price” between connected parties. This could include minimising tax – by, for example, maximising profits in a low tax country and minimising profits in a higher tax country.

Tax authorities around the world address this risk by imposing “transfer pricing” rules to such transactions that require the actual price agreed to be replaced for tax purposes with an “arms-length price”. This is a theoretical price that the taxpayer must calculate and is what would have been agreed if there were no connection.

Sometimes this process can be straightforward – for example a business in India may sell widgets to an unconnecteddistributor in  France for £1 each and to its UK subsidiary distributor for £1.50 each – assuming all other contractual terms are the same the UK’s transfer pricing rules would require the £1 price charged to the unconnected French distributor to be used by the UK subsidiary of the Indian manufacturer for UK tax purposes rather than £1.50. The result would be £0.50 profit per widget sold being taxed in the UK rather than in India. In most cases, calculating the “transfer price” is more complicated.

The UK’s transfer pricing rules broadly apply to transactions or arrangements made between parties under common control even if both parties are in the UK, but there is an exemption for most transactions of small or medium-sized entities. The rules fall into the “selfassessment” system meaning that a failure to apply them in your tax return could lead to penalties being imposed. This is a complex area - you should contact us for specialist advice.