Individuals who operate their businesses as sole traders or partnerships may sometimes wish that they operated through a company instead.
For example, following changes to dividend taxation from April 2016, an income tax rate of 0% applies to the first £5,000 of dividend income (for 2016/17 and 2017/18). This has obvious potential attractions. Furthermore, if some of the company’s shares are held (for example) by spouses and possibly other family members, the benefit of this dividend ‘nil rate’ can be multiplied.
However, there may be commercial and/or other reasons why the unincorporated business owner may not wish to incorporate and operate through a company. The same applies to introducing a company into a partnership of individuals (i.e. a ‘mixed partnership’). The tax implications of both operations can also be complex and difficult. For example, anti-avoidance legislation relating to mixed partnerships (ITTOIA 2005, ss 850C-850E) is broadly aimed at counteracting tax-motivated partnership profit-sharing arrangements.
Why use a service company?
As a possible alternative to incorporating the business (or operating a mixed partnership), a service company might be considered to operate alongside the existing unincorporated business. For example, some professional partnerships have traditionally used service companies. The trade of the service company might include providing accommodation, office and/or other ancillary services to the main partnership. The service company may possibly also deal with the partnership’s suppliers, engage staff, etc., and sell its services to the partnership with a suitable mark-up on its costs.
For tax purposes, the service company’s charges in the above example could effectively move some partnership profits away from immediate (and often higher) rates of income tax (and National Insurance contributions) otherwise chargeable on the individual partners, and into the service company (on which corporation tax is charged at 20% (for financial year 2016)). This could also potentially allow the partners to take dividends (in their capacity as the company’s shareholders), and possibly to transfer shares to their spouses to enable them to do so.
Plenty to consider
This may sound fairly straightforward. However, there are numerous tax implications to consider, and some possible traps.
For example, the service company’s charges must be commercially established. The level of charges will generally depend on the nature and extent of the services provided. HMRC guidance (on partnerships and service companies) has changed on several occasions. Prior to a change in late 2013, it stated that where a service company provides office accommodation and clerical services, the charges to the partnership ‘should not be at more than their cost plus a modest uplift’. But what is a ‘modest uplift’? HMRC’s guidance also changed in early 2011. Before that change, it stated that, as a broad rule of thumb, a modest uplift would be in the region of 5%.
This reference to 5% does not appear in HMRC’s present guidance. Instead, HMRC’s Business Income manual (at BIM82070) states that relevant factors to consider are: what services the company provides to the partnership; the basis on which the company is remunerated for the services it provides; and whether the company and partnership are connected persons. Care is needed. If the service company’s charges are excessive, this could result in a ‘double whammy’; corporation tax for the company on its profits, but with no (or a restricted) tax deduction for the partnership for the service charges incurred.
The trading transactions between the service company and partnership in the above example should also be on arm’s length terms including any credit afforded by the company to the partnership. Otherwise, a tax charge could arise for the company under the ‘loan to participator’ provisions (see CTA 2010, ss 455, 456(2); Grant v Watton Ch D 1999, 71 TC 333). There may also be beneficial loan implications to consider (under ITEPA 2003, Pt 3, Ch 7) for the partners in their capacity as directors or employees of the service company, in respect of monies owed to the company by the partnership.
There are various other potential tax issues of service company structures to consider (e.g. VAT, the ‘settlements’ anti-avoidance provisions if service company shares are transferred to family members, etc.). The decision to use a service company should be a commercial one; it should not be tax motivated. Business owners should seek professional advice when considering such structures.
The above article was first published by Tax Insider (June 2016) (www.taxinsider.co.uk).