Out-Law Guide 12 min. read
25 Feb 2022, 4:47 pm
The tax treatment of businesses operating in the UK through alternative business structures such as partnerships, sole traders or joint venture arrangements is not covered in this guide.
The guide covers general issues of taxation of profit, payroll taxes and VAT that may arise for a business as well as some tax issues that investors in the business may need to consider.
UK tax is administered by HM Revenue & Customs (HMRC).
A UK company will be subject to UK corporation tax on its income profits and capital profits. The rate of corporation tax for all companies is currently 19%. This rate is due to be increased to 25% in April 2023 for companies with profits above £50,000. Marginal relief will be available for companies with profits between £50,000 and £250,000.
Corporation tax is paid nine months after the end of the accounting period or, for companies with profits of more than £1.5 million, in four equal instalments, due in the seventh and tenth months of the current accounting period and the first and fourth months after the end of the accounting period. Companies with annual taxable profits of £20m or more are required to make payments in the third, sixth, ninth and twelfth months of their accounting period. Where a company is a member of a group, the threshold will be divided by the number of companies in the group.
For tax purposes, trading profits are calculated by deducting certain reliefs/allowances together with any expenses incurred wholly and exclusively for the purposes of the trade from the sum of all trading receipts. Trading profits are taxed on an accruals basis and generally in accordance with the accounting treatment. Capital gains are generally taxed on realisation.
Losses: Trading losses can be set off against other profits and gains, including capital gains, arising in the same, or previous accounting period, or carried forward and set off against future profits arising in the same trade. Capital losses can only be set off against capital gains arising in the same period, or in subsequent periods.
Companies are able to deduct carried forward trading losses against profits from different income streams and groups can deduct the losses from one company from the profits of another group company. However, companies with profits in excess of £5m are only be able to offset 50% of their profits against losses carried forward in a single tax year.
Interest: Subject to certain anti-avoidance rules, interest paid by a UK company is deductible in calculating its profits. Deductions are available broadly on an accruals basis.
A fixed ratio rule restricts the ability of companies to deduct interest payments from their taxable profits. Broadly, the rule limits corporate tax deductions for net interest expense to 30% of a group's UK earnings before interest, tax, depreciation and amortisation (EBITDA). The rule only applies to groups with more than £2 million of net UK interest expenses. For more detail see our Out-Law Guide: UK restriction on corporate interest relief.
R&D expenditure: Additional tax relief is available for qualifying research and development (R&D) expenditure. The rate of tax relief available, and the way in which relief is given, depends upon whether the company is a small or medium sized company (SME) or a large company, and in each case a number of conditions have to be fulfilled. SMEs are entitled to relief (in aggregate) at 230%. If loss-making they can claim a payable tax credit of 14.5% of the enhanced deduction.
Large companies undertaking qualifying R&D expenditure can claim an 'above the line' credit known as the R&D expenditure credit (RDEC). The RDEC is calculated directly as a percentage of the company’s R&D spend. The credit can be recorded in companies’ accounts as a reduction in the cost of R&D – that is ‘above’ the tax line. The RDEC is first brought into account as a receipt of the trade, increasing profits or decreasing losses. From 1 April 2020, the expenditure credit is 13%. It is then credited to the company and can be offset against corporation tax liabilities, surrendered to another group company or repaid. At a corporation tax rate of 19% the RDEC is equivalent to 9.5% of qualifying R&D expenditure.
Goodwill and intellectual property (IP) rights: The tax treatment of intangibles, such as goodwill and intellectual property, broadly follows their accounting treatment. It is therefore possible in some circumstances to obtain tax relief for the amortisation of intangible assets. However, only limited relief is available for goodwill and customer related intangibles acquired on an asset acquisition.
The 'patent box' allows companies to elect to apply a lower rate of corporation tax to all profits attributable to qualifying patents. See our Out-Law Guide: Patent box regime (entrants on or after 1 July 2016).
Royalties: Royalty payments made by a UK company are usually deductible for corporation tax purposes provided that they do not exceed a market rate. Diverted profits tax could restrict or prevent the deduction (see below). UK companies may be required to deduct tax at the basic rate (20%) from certain royalty payments that are made to non-UK residents. UK companies are required to deduct tax on payments made in respect of trademarks and brand names in addition to copyright, design rights and patent royalties.
From 6 April 2019 income tax is charged directly on a non-UK resident person that is also not resident in a jurisdiction with which the UK has a double tax treaty that contains a non-discrimination provision on gross income from intangible property held in low-tax jurisdictions to the extent that the income is referable to UK sales.
Depreciation: Depreciation on fixed assets is disallowed for corporation tax purposes. Companies are instead allowed a fixed writing down capital allowance on certain capital expenditure such as expenditure on plant and machinery. An annual investment allowance (AIA) is available to each company allowing full tax relief for expenditure on qualifying plant and machinery. The AIA is £1m until 31 March 2023. Where a company is a member of a group, only one AIA is available for the group.
From 1 April 2021 to 31 March 2023 a 130% ‘super-deduction’ is available for new plant and machinery that would otherwise have qualified for the 18% ‘main rate’ of capital allowances. Expenditure on ‘special rate’ assets that would otherwise have qualified for allowances at the lower rate of 6% qualifies for a 50% first-year allowance. Assets on which the super-deduction or the 50% allowance for special rate expenditure have been claimed are subject to an immediate balancing charge on disposal.
A structures and buildings allowance is available for capital expenditure incurred on certain buildings and structures. The 2% annual allowance is available over a 50-year period.
Transfer pricing: The UK transfer pricing legislation enables HMRC to adjust a UK company’s profits for corporation tax purposes if it pays more or less than the market rate for goods or services provided by or to non-arm’s length enterprises.
Distributions: Dividends are paid out of after tax profits. A company does not have to account for any tax when it pays dividends. Individuals are entiled to an annual dividend tax allowance. It is currently set at £2,000 and dividend income up to that amount will be tax free. Income tax will be payable on dividend income above that allowance at 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers.
Diverted profits tax (DPT): DPT is designed to increase the tax take from multinationals operating in the UK. In certain circumstances, DPT could restrict or prevent a tax deduction for royalties or other sums paid to a foreign affiliated company. For more information see our Out-Law Guide: Diverted profits tax regime.
Tax avoidance: A general anti-abuse rule (GAAR) was introduced in 2013. This enables HMRC to counteract 'abusive' tax planning.
Every company which has directors and employees must operate the Pay As You Earn (PAYE) scheme. This is the mechanism used for the collection of income tax and National Insurance contributions (NICs) for remuneration payable to employees and directors. Companies are under an obligation to correctly operate PAYE and to make monthly returns to HMRC of the PAYE deducted from employees.
Income tax is payable at three rates: the basic rate (20%), higher rate (40%) and additional rate (45%). There are thresholds for each rate. Employee NICs are paid at the rate of 12% on earnings between the primary threshold and the upper earnings limit and 2% above the upper earnings limit. Employer NICs are payable at 13.8% above the secondary earnings threshold. There are thresholds for each of these rates.
There will be a temporary 1.25% increase to both employer and employee NICs for the 2022-23 tax year. From April 2023 onwards, NIC rates will decrease back to 2021-22 tax year levels and a new 1.25% health and social care levy will be introduced.
It is essential that the correct tax treatment is given to payments of expenses to employees and directors and that any benefits in kind provided to employees or directors are notified to HMRC. Benefits in kind include the provision of accommodation, private medical insurance and cars.
Income tax and NICs arising in respect of certain employment related securities and the exercise of unapproved share options may also be collected through PAYE.
VAT is payable on the supply of most goods and services in the UK by a taxable person (a person who is registered, or should be registered, for VAT purposes). In the UK, the standard rate of VAT is currently 20%.
Certain supplies are exempt from VAT, the most important of which relate to finance, insurance, education, health and some supplies of land. A business which has made taxable supplies in excess of £85,000 in the last 12 months, or anticipates making taxable supplies in excess of £85,000 in the next 30 days, is required to register for VAT and account to HMRC for it. A business which is registered for VAT must charge VAT on taxable supplies made by it ('output tax') but can recover the VAT charged on supplies made to it ('input tax') to the extent that the VAT was incurred for the purposes of making taxable supplies. VAT will, however, be a real cost for businesses that are making exempt supplies.
Where employees or directors of the business, including those intending to become employees or directors in the future, acquire shares in the company at less than their actual market value, they may be charged to income tax on the difference between the price paid and market value. NICs for both the business as the employer and the employee may also be due on the difference between the price paid and the market value. If the shares carry certain types of restrictions, then further income tax charges (and NICs) may arise on disposal of the shares, or on any change in or lifting of the restrictions. This can be avoided by making an election within two weeks of acquisition. The decision to complete an election needs to be considered carefully, since the election could also trigger, or indeed increase, an initial tax charge.
Convertible shares and shares which may have an artificially manipulated value may also give rise to income tax and NIC charges.
Where possible, planning should be undertaken prior to acquisition of the shares so as to minimise the risk of any such income tax charges arising, either upfront (when there is unlikely to be cash to meet the tax charge) or on disposal (when capital gains tax treatment is likely to be preferred to an income tax charge plus).
Granting options to acquire shares in the future may be a useful way to incentivise employees. The company would grant individuals a right to acquire shares in the future upon payment of a fixed sum, and often conditional upon achieving certain performance targets. Although income tax charges may arise if the shares are in fact acquired at an undervalue, there are certain types of option which receive beneficial tax treatment. The Enterprise Management Incentive scheme is particularly aimed at smaller start-up businesses.
Where income tax treatment mentioned above does not apply, any gain on disposal of the shares will be subject to capital gains tax. Every individual benefits from an annual exemption, currently £12,300.
With the exception of gains made on residential property (see below), all gains on the disposal of assets are subject to capital gains tax at a fixed rate regardless of the type of asset or how long they have been owned. The rate is 10% for basic rate income tax payers (unless the gains, when added to taxable income, take the individual over the threshold for higher rate tax) and 20% for higher rate and additional rate income tax payers.
For gains made on the sale of residential property, the rate is 18% for basic rate income tax payers and 28% for higher and additional rate income tax payers. Individuals are exempt from capital gains tax on any gains made on the sale of their own home.
Business asset disposal relief: This relief, formerly known as entrepreneurs’ relief, can reduce the rate of capital gains tax to 10% on the disposal of shares or assets used in a business if detailed conditions are fulfilled. The conditions of the relief need to be considered in detail in relation to each individual, but in the case of shares the main conditions to be fulfilled for the period of at least two years prior to the disposal are that:
The amount of an individual's gains that can qualify for business asset disposal relief is subject to a lifetime limit of £1m. Any gains in excess of the limit are subject to the main rates of capital gains tax highlighted above.
Investors' relief: External investors are entitled to capital gains tax relief on share sales provided certain conditions are met, including that the shares are newly issued in an unlisted trading company, or an unlisted holding company of a trading group, after 16 March 2016 and are held for a continuous period of at least three years before their disposal, starting from 6 April 2016. The relief is only available if neither the investor nor any person connected with them is an employee of the company or of a company connected with it. Investors' relief has a rate of 10% and has a £10m limit which is separate to the £1m business asset disposal relief limit.
Interest relief: Shareholders who borrow to invest in shares in the company may be able to get relief from income tax in relation to the interest on that borrowing. There are a number of conditions to be fulfilled, including in relation to the company’s ownership structure, but the relief may be available where the company is a trading company and the shareholder is either an employee/director or owns more than 5% of the share capital.
Enterprise Investment Scheme (EIS) relief: This relief was devised to encourage investment into small start-up companies. The conditions for EIS relief are complex, but in outline, income tax relief at 30% will be given to individuals investing in qualifying companies on the amount invested up to £1m in any tax year. The limit is £2m for an investment in a 'knowledge intensive company'.
Gains on any increase in value of those shares are exempt provided the individual holds the shares for in excess of three years. Investors therefore have an immediate income tax relief and the prospect of tax free growth in their investment.
This is a particularly attractive scheme for start-up companies wishing to attract venture capital. However, the relief will only be available to companies which meet certain criteria (such as in relation to size). In addition, companies carrying on certain trades such as dealing in land, shares, securities or other financial instruments are excluded from the relief. See our Out-law Guide for further details of the EIS.
For smaller companies Seed Enterprise Investment Scheme (SEIS) is available. The qualifying conditions for SEIS are based very closely on EIS.
Although the amount of investment qualifying for SEIS relief is quite low - only £100,000 a year - in certain circumstances, qualifying investors will be able to claim income tax relief worth 50% of the cost of buying shares in the company.
Qualifying SEIS investors will also be exempt from paying capital gains tax on gains on shares within the scope of the SEIS and benefit from a 50% exemption from capital gains tax on gains reinvested into SEIS shares.