A couple of updates on the Budget released in July 2015
Please see a couple of articles with links to the website below.
The other major property-related changes in the Budget statement will affect “buy-to-let” investors in residential property (whether in the UK or overseas). Investors in commercial property are unaffected; as are investors in properties which meet the criteria to be treated as furnished holiday lettings. There are two separate changes.
Wear and Tear
The first change relates to the “Wear and Tear” allowance for furnished lettings. It applies to companies as well as to individual landlords (but not to furnished holiday lettings). At present, the costs of replacing furniture and fittings are not tax-deductible. Instead, a notional deduction is given for tax purposes equal to 10% of rents. HMRC seem to consider that in many cases this is over-generous and from April 2016, it is intended that the 10% deduction will be abolished and instead tax relief will be given for the actual costs of replacements. Note that this change does not affect tax relief for expenditure on routine repairs to the property, including furniture and fittings in it, which will continue, as now, to be tax-deductible in full.
The second change is in relation to “finance costs” such as mortgage interest, interest on loans to buy furnishings and fees incurred when taking out or repaying mortgages or loans. Starting from 6 April 2017 (and phased in over 4 years from then) tax relief for these costs will be restricted the basic rate of Income Tax. This restriction will apply to individuals (presumably including individual members of partnerships or LLPs) only. It will not affect companies, but the position of trusts is not yet clear. No Income Tax relief is of course in any event available for capital repayments of a mortgage or loan.
Instead of deducting finance costs from rents to arrive at taxable profits, landlords will instead receive relief in terms of tax by deducting an amount equal to tax at the basic rate on the finance costs from the tax otherwise chargeable on the profits. If the tax deduction for finance costs exceeds the tax otherwise payable on the profits the excess can be carried forward and used in subsequent years.
The change will be phased in so that for 2017/18 the new rule will apply to 25% of the finance costs (with the other 75% being deducted in computing taxable profits as now); for 2018/19 the restriction will apply to 50% of the finance costs; for 2019/20 to 75%; and from 6 April 2020, 100% of the finance costs will “disallowed” and dealt with under the new rule.
Although its impact is ameliorated by the delayed and phased introduction, this change will significantly change the economics of some buy-to-let portfolios. Since the change does not affect companies, one response may be to consider adopting a limited company structure. But there are many factors to consider in choosing the right structure, summarised in our recent briefing note and the position is further affected by the change from April 2016 of the way in which dividends are taxed, also announced in the Summer Budget. The tax credit attaching to a dividend will be abolished and dividends will be taxed as normal income albeit at special rates of tax (with exemption for the first £5,000 of dividends). Broadly, this will increase the effective rates of tax on
Small firms face another taxation shake-up
Evasion, avoidance and aggressive tax planning, we understand – but imbalances? What are they? It is now clear that one of those imbalances that he seeks to address is the taxation of small companies.
- The changes to dividend tax are the start of a process to reduce the tax advantages of incorporation.
- For existing companies dividends are still generally more tax efficient that salary, though the advantage are reducing.
IR 35 and personal service companies are back on the government’s agenda.
- The OTS has been asked to look again at the alignment of tax and NIC and at small company taxation generally.
- There will be much to talk about with clients – many of them could face significantly higher tax bills next year.
We are in for considerable changes over the next few years.
We have been here before – indeed I seem to have spent considerable parts of my career grappling with these imbalances.
There are, in essence, three separate tensions within the system which make rational policy making so difficult.
Any change in part of this triangle has knock-on effects elsewhere – does anybody remember the ill-fated non-corporate distribution rate?
- Employed versus self-employed.
- Incorporated versus unincorporated.
- Dividend versus salary
The result is that the taxation of small business in this county is far too complex and creates distortions and sometimes produces arbitrary results. Let’s be honest, some of those results are in our client’s favour and so removing distortions will create losers and well as winners.
But I’ve yet to meet anyone who really believes that what we have at the moment is a sensible and coherent system: change is necessary.
Seeing the bigger picture
So what is happening? After a couple of days reflecting on the Budget announcements I am starting to see what I think are the overall themes, although many of the details need to be firmed up. I’m writing this in advance of the publication of the Finance Bill so what follows will need to be reviewed against the small print.
The most obvious change is in the taxation of dividends. From next year dividends will have no tax credit attached (thus removing the often confusing distinction between “gross” dividends and “net” dividends) and the amount received will be all that matters.
Dividends will be taxable at 7.5%, 32.5% and 38.1% respectively, depending on the marginal rate. As we will no longer have to take into account the grossed-up amount of the dividend in determining which rate band somebody falls into there are likely to be some odd results close to the rate band changes.
Those rates represent real increases in tax. The blow is, however, softened by the introduction of a £5,000 dividend allowance for all taxpayers. The assumption is that this will mean that an individual who receives total dividends in a year of £6,000 will be taxable on £1,000.
I did see some commentators suggest that it meant something different: that if the dividends were less than £5,000 no tax was paid, but once they got to £5,001 tax was paid on the whole amount.
I don’t think that that can be right but, until we see the legislation, we can’t be certain. I will assume in the rest of this article that the former reading is the right one.
What’s the objective?
Why has he done things this way? First, I believe that the £5,000 limit is all linked with digital tax accounts. Just as we saw earlier in the year with savings income, taking out small amounts from tax should reduce the compliance burden considerably.
A typical self-assessment taxpayer whose dividend and interest income are small should have little to enter onto his digital account (I say should because we don’t yet know the mechanics of all this).
Second, the changes will raise more tax from those few extremely wealthy people with massive dividend portfolios. But third, and this is the key change, it will directly affect small businesses.
The Budget Red Book is clear on this. It says at 1.189:
“These changes will also start to reduce the incentive to incorporate and remunerate through dividends rather than through wages to reduce tax liabilities. This will reduce the cost to the Exchequer of future tax motivated incorporation (TMI) by £500 million a year from 2019-20. The tax system will continue to encourage entrepreneurship and investment, including through lower rates of corporation tax.”
There are two limbs to this: incorporation and dividend versus salary. Let’s take them in reverse order. A low-salary, high-dividend route still looks to be more tax-efficient even after these changes. Everybody has a different way of doing the comparison.
I like to keep it simple and look at a basic rate taxpayer who has used up his personal allowance against salary and is looking to take another £10,000 out of his company.
This confirms that the dividend route is still more efficient. This is consistent with what is said in the Red Book with its reference to “start to reduce the incentive”. I can only read that as a very strong hint that dividend tax rates will eventually be ratcheted up to align salary and dividends.
The chancellor hasn’t done it by putting National Insurance on dividends – with all of the problems that would have caused elsewhere in the tax system – but the new dividend tax is in some ways a back door way of doing the same thing.
So, the message to clients is: expect to pay more tax next year. If, as a result, they question the chancellor’s triple-lock announcement about no increases in tax rates, this query might be passed to 11 Downing Street.
What about the other element – the tax-motivated incorporation? Many people incorporated their businesses at the time of the 0% corporation tax band and, to an extent, all actions taken since have been trying to close the stable door after the horse has bolted. But these new changes are intended to discourage individuals from incorporating purely to obtain a tax advantage.
The computations here are trickier because we do not yet know the National Insurance bands for next year and therefore complete precision is not yet possible.
But the tipping point at which incorporation starts to deliver significant tax systems has clearly gone up. It looks as if incorporation at earnings even as high as £30,000 will now deliver a very marginal benefit.
I think of it this in the following broad terms. The advantage of incorporation has been that much of the income could be received as a tax-free dividend. Of that £30,000, something like £20,000 could be taken as dividend (using the personal allowance to cover salary).
Next year that £20,000 will create additional tax of £1,125 (£15,000 x 7.5%). That is a significant increase whereas, broadly speaking, the self-employed will see little change. Additional tax at that level would make incorporation much less attractive.
In our heart of hearts we all know some taxpayers who could not cope with operating through a company. The additional hassle of dealing with benefits in kind, loans to participators and company returns is often a nightmare for them, and hence for advisers.
With the tax benefits of incorporating being reduced (and I expect them to be further reduced in the coming years) there is a lot to be said for them to remain as self-employed.
The dividend tax was not the only small business measure. Personal service companies are back on the agenda.
There is not only the decision to withdraw the employment allowance for one-person companies, but yet another review of the IR35 provisions to “find a solution which protects the Exchequer and improves fairness in the system”.
So where does this leave us? As I have said many times over the years the system for taxing small businesses lacks any coherence.
What we have is the result of various strands of the tax system designed for different purposes all crashing together on the small businesses that are the lifeblood of the economy.
This creates complexity and administrative burdens. We need a system designed specifically for small businesses and which addresses the triangle of tensions outlined above.