Small profit rate tax trap

The Corporation Tax rate leaps from 20% to 27.5% where company profits exceed £300,000. But the higher tax rate can kick in on lower profits if you own shares in more than one company. What is this trap and how can you avoid it?

The rules of association

There's no doubt about it, tax planning isn't easy, and when it comes to the Corporation Tax (CT) small profits rate (SPR) band, things can get downright tricky. The Taxman's anti-avoidance rules say that if two or more companies are controlled by the same persons, they are “associated” and therefore must share the SPR rate band. This increases the CT payable even where, overall, the companies' combined profits are less than the SPR band. Example. Tom and his friend Gerry own all the shares in Acom Ltd equally between them. They also own all the shares in Bcom Ltd. As they own more than 50% of the shares in each company between them they control both. This makes the companies associated. Each is therefore entitled to only half of the £300,000 SPR band. Where either makes profits above £150,000 in a year, the excess will be taxed not at the SPR of 20% but at the higher CT rate of up to 27.5%. So if Acom has profits of £200,000 and Bcom £10,000, Acom will pay the higher CT rate on £50,000 of its profit.

Alternative business structure

Tom and Gerry could have avoided this trap by running one of the businesses through a partnership rather than a company. They could even keep their limited liability protection by making a Limited Liability Partnership. But the downside to this is that Tom and Gerry would have to pay income tax at rates of up to 50% on the profits made by the partnership. The shelter offered by limited companies from high income tax rates will be lost. What's needed is a company business structure which dodges the associated company rules, but still allows you to shelter profits from income tax.

Tip. Instead of Tom and Gerry owning 50% of the shares in each company, they could have owned 100% of the shares in two companies - we'll call them company A and B. Tom would own all the shares in company A and Gerry all the shares in company B. These companies could then form a partnership which would run the business and generate the profits. This arrangement wouldn't automatically trigger the associated company trap.

Never the twain shall meet

The profit made by a partnership can be given out to the partners, in our example companies A and B, in whatever sums Tom and Gerry agree. Because the partners are companies, their share of the income is charged to CT meaning Tom and Gerry get the advantage of sheltering profits from the higher income tax rates. And as company A and B are not associated they each have a full £300,000 SPR band.

A word of caution

The company partnership structure needs to be set up carefully, as other factors can cause the associated company rule to be triggered anyway, for example if Tom or Gerry owned shares in further companies. Plus, the structure requires more tax administration, which means more costs, so it's only worth doing where you're sure tax will be saved. In any case, it will only save tax where profits are high enough that the SPR band is exceeded. The bottom line is that if you're thinking of using this type of arrangement, you should speak to a tax expert before going ahead.

Where you and a fellow shareholder together control more than one company, the £300,000 small profit rate band must be shared between you. An alternative company structure where each of you owns 100% of the shares in companies that operate in partnership can avoid this trap.

If you need more information on corportation tax or feel like you need someone to talk to about this issue, dont hesitate to contact us for a free initial meeting on 0191 386 4786

Small profit rate tax trap

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