The government announced at Budget 2013 the introduction of a new ‘employment allowance’, with effect from April 2014. This allowance will broadly enable businesses and charities to offset up to £2,000 against their employer’s NIC liabilities over the course of the year’s PAYE and NIC payments.
Unlike most new tax measures these days, there is apparently to be no formal consultation on the introduction of the employment allowance. Instead, HMRC is discussing the design and operation of the allowance with business representatives.
Full details of the allowance are not available and no official announcements have been made by the government or HMRC on what restrictions or anti-avoidance rules might apply to prevent employers claiming the employment allowance at the time of writing (Summer 2013). This article therefore looks at some of the potential considerations arising from the employment allowance, subject to any such restrictions or anti-avoidance rules still to be announced.
The government’s stated aim is that every business and charity will be entitled to the employment allowance. If so, it potentially represents a further factor for small business owners to consider when looking at a strategy for profit extraction from the business.
For example, assuming there are no restrictions in utilising the employment allowance, a sole trader with no employees might consider it attractive to incorporate his or her business. Sole traders (and also most individual partners in a partnership) are self-employed rather than employed, so if there are no employees in the business, there would be no opportunity to claim the employment allowance. However, as a director or employee of the company, the payment of a salary to the business owner could enable the employment allowance to be claimed. Even so, whether it would be better to pay a lower salary plus dividends in that situation would need to be considered (see below).
Another potential benefit of the employment allowance might arise in the situation of a company director in a business with no other employees. He or she may have previously received only a modest salary, but now wishes to receive a higher salary, perhaps to allow personal pension contributions to be paid on up to 100% of his or her earnings. Of course, an increased salary potentially means employee’s primary Class 1 NIC deductions, as well as the employer’s secondary NIC liability. However, if the business owner was going to increase his or her salary anyway to enable higher pension contributions, the employment allowance would no doubt be seen as a welcome ‘bonus’ in the form of a reduction in the overall NIC liability.
A further circumstance in which the employment allowance might be useful is where an individual has previously received a modest salary, plus benefits in kind. Increasing salary to enable the employment allowance to be claimed may be more attractive from the employer’s perspective than providing benefits, where the employer is liable to Class 1A NIC on those benefits at 13.8%. Of course, this assumes that the employer will be unable to deduct the employment allowance from the Class 1A NIC on benefits under the employment allowance system – as mentioned, details are awaited at the time of writing.
Salary v dividends
A popular remuneration strategy for owners of small companies has been the payment of a low salary, with the balance of the business owner’s income being extracted from the company by way of dividends.
Class 1 contribution payments by employees start at the ‘primary threshold’ (i.e. £149 per week or £7,755 per annum for 2013/14). However, contributions are treated as paid for state retirement pension purposes where earnings equal or exceed the ‘lower earnings limit’ (i.e. £109 per week or £5,668 per annum for 2013/14), albeit that no contributions are actually paid (SSCBA 1992, s 6A(2)). On earnings between the lower earnings limit and primary threshold, a credit is available to establish a contribution record for state retirement pension purposes for the individual, even though no contributions are actually due.
So for 2013/14, small business owners might consider paying themselves a salary of between £5,668 and £7,755, such that they pay no income tax or NIC on the salary but still receive an NIC credit for state retirement pension purposes. If the salary is on or below £148 per week or £7,696 per annum, there is no secondary Class 1 NIC liability for the employer either. This is potentially a very useful and attractive planning tool.
However, will the employment allowance affect this strategy in the case of ‘one man band’ companies with no other employees?
Example 1 – Higher salary
Tax and NIC rates for 2014/15 are not known as yet, so this example is based on 2013/14 rates. Widgets Ltd has pre-tax profits of £25,000, before any director’s remuneration.
Widgets Ltd is 100% owned by Fred, who is also the sole director of the company. Widgets has a couple of part-time employees, both of whom are paid below the tax and NIC thresholds. Fred normally extracts all the post-tax profits of Widgets each year. In the past, the company has paid Fred a salary up to the employer’s Class 1 NIC secondary threshold, and Fred has voted himself dividends up to the balance of the company’s profits.
Fred is considering increasing his salary for the tax year 2014/15, so that Widgets Ltd can claim the full £2,000 employment allowance. Suppose that Fred decides to draw a salary of £22,200 from the company, with any balance of the company’s (post-tax) profits being extracted by way of dividend. He has no other income in the tax year.
Fred pays income tax on his salary of £2,552 after his personal allowance, and employee’s NIC of £1,733. So his net pay is £17,915.
The employer’s NIC liability of Widgets Ltd on Fred’s salary of £22,200 (based on 2013/14 rates) is £2,002 (rounded up). The employment allowance of £2,000 is deducted from that NIC liability, leaving a very small employer’s NIC balance of £2. So the employment allowance reduces employment costs, and leaves the company with a pre-tax profit of £2,798. Corporation tax at 20% is £560, leaving a balance available for dividend of £2,238.
So Fred’s net income is his net salary of £17,915 plus the net dividend of £2,238, i.e. £20,153 in total.
Example 2 – Low salary
By contrast, suppose that Fred draws a salary up to the employer’s NIC Class 1 NIC secondary threshold of £7,696, and the balance of the company’s post-tax profit is extracted by way of dividends. Fred’s salary is covered by his personal allowance, so there’s no income tax payable. There are no employee’s or employer’s National Insurance contributions payable either. The company’s pre-tax profit is again £25,000, less Fred’s salary of £7,696, leaving £17,304 taxable. Corporation tax at 20% is £3,461, leaving £13,843 available to extract by way of dividends.
Fred’s net income is therefore his net salary of £7,696 plus the net dividend of £13,843, so £21,539 in total. Compare this to the previous calculation in which the company claimed the full employment allowance of £2,000, where Fred’s net income was £20,153 in total. Overall, Fred’s net income is higher by £1,386 if he continues to withdraw a low salary and the balance by dividends, as opposed to increasing his salary so that the company can claim the full employment allowance.
Of course, circumstances will vary, and as with tax calculations relevant to salary versus dividends generally, there’s really no substitute for ‘doing the sums’ in each case. Nevertheless, it would seem that the employment allowance is probably unlikely to change the behaviour of small business owners generally, in terms of whether to draw a low salary or a higher salary to enable the company to claim the employment allowance.
Restrictions and anti-avoidance
Finally, as mentioned earlier, at the time of writing details of any restrictions and anti-avoidance provisions in respect of the employment allowance are still awaited. The government has said that the employment allowance will be available to every employer. However, will that actually be the case? I have previously asked HMRC whether there would be any restrictions or anti-avoidance provisions to prevent the employment allowance being claimed by all employers. HMRC indicated to me that there will be some restrictions. For example, employers with more than one PAYE scheme will have to choose which scheme the allowance is to be used against, so it will not be possible to split the allowance between PAYE schemes. In addition, the allowance will not be available to individuals who employ nannies or other domestic workers.
HMRC also informed me that they were working on anti-avoidance provisions. These are apparently aimed at preventing those who are not genuine businesses from gaining what HMRC perceives to be an unfair benefit from the employment allowance. What is meant by a ‘genuine business’ remains to be seen, so we will need to wait for the employment allowance legislation in due course. I would not be surprised if there was also an anti-avoidance rule to deal with situations such as where one business is artificially split into two or more separate businesses, so that where the anti-avoidance rule applies, the employment allowance cannot be claimed by each of the smaller businesses. However, we will have to wait and see what restrictions and anti-avoidance rules are introduced when the employment allowance legislation is eventually published.