Corporation tax - Tax treatment of company distributions to shareholders

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Overview

Understanding how company distributions to shareholders are taxed is essential for the SQE1 FLK1 exam. This area covers dividends, share buybacks, and loans to shareholders. Each method influences tax outcomes for both companies and their shareholders, shaped by legal frameworks and accounting rules. This article breaks down these concepts, helping candidates tackle complex scenarios and showcase the analytical skills needed for the exam.

Dividends: Tax Considerations and Legal Factors

Dividends are a primary way for companies to share profits with shareholders. Their tax treatment is a key aspect of corporate finance.

Tax Treatment for Companies

  • Dividends come from post-tax profits; corporation tax is paid before distribution.
  • Dividend payments are not deductible for corporation tax.
  • This distinguishes dividends from other payments like salaries.

Exemptions for Recipient Companies

  • In the UK, dividends received by one UK company from another are typically exempt from corporation tax.
  • This prevents double taxation as profits move through corporate groups.
  • It's an important factor in tax planning and corporate structures.

Capital Maintenance Principles

Dividend distributions must follow strict capital maintenance rules per the Companies Act 2006:

  1. Dividends must originate from profits calculated using accepted accounting standards.
  2. These rules safeguard creditors by preventing excessive distributions.
  3. They ensure the company's financial stability and legality in capital reduction.

Example: Dividend Distribution

Imagine TechInnovate Ltd makes £1,000,000 in profits for the year. The board proposes a £300,000 dividend, retaining £700,000 for growth.

  1. Corporation Tax:

    • With a 19% tax rate, its liability is £190,000.
    • Available profit for distribution: £810,000.

  2. Dividend:

    • The £300,000 dividend is compliant with capital rules.
    • This distribution doesn't alter corporation tax liability.

  3. Shareholder Impact:

    • Individual shareholders face personal tax on dividends.
    • Corporate shareholders might enjoy tax exemptions.

This example illustrates the link between profit, corporation tax, and dividend distribution, highlighting tax details for both entities.

Share Buybacks: Tax Classification

Share buybacks offer another way to return value to shareholders, impacting tax for both parties.

Corporate Tax Impacts

  • A buyback isn't typically deductible for corporation tax.
  • It affects the company's capital structure and reserves.

Shareholder Tax Handling

How buyback proceeds are taxed for shareholders depends on whether treated as capital or income.

Capital Treatment

Conditions for capital treatment include:

  1. The company must be actively trading.
  2. The buyback should mainly benefit the company's trade.
  3. The shareholder needs to be UK-based and not trading the stock.
  4. The shareholder's stake should decrease substantially (by about 25%).
  5. The shareholder must have held the shares for at least five years prior.

Meeting these, shareholders could be eligible for capital gains tax, possibly benefiting from lower rates and reliefs like Business Asset Disposal Relief.

Income Handling

If capital conditions aren't met, proceeds (minus original share cost) are typically treated as income, leading to potentially higher tax rates.

Example: Share Buyback Tax Implications

Scenario: InnovTech plc plans to buy back 30% of its shares from Dr. Smith for £500,000. Dr. Smith's initial investment was £100,000.

Analysis:

  1. Company View:

    • No deductible expense for InnovTech.
    • Must ensure enough distributable reserves.

  2. Shareholder View:

    • Likely qualifies for capital treatment as it significantly reduces Dr. Smith's stake.
    • Capital Gain: £400,000 (£500,000 - £100,000).
    • With Business Asset Disposal Relief, Dr. Smith may pay a 10% tax rate on gains, within limits.

This scenario shows the tax benefits when buybacks meet capital treatment criteria.

Loans to Shareholders: Tax Rules and Measures

Loans to shareholders, especially in close companies, face specific tax regulations to prevent avoidance through disguised distributions.

Defining Close Companies

A close company is generally controlled by five or fewer shareholders or by directors who are also shareholders.

Section 455 Tax Charge

When a close company loans to a shareholder or associate, a temporary tax charge might apply under Section 455 of the Corporation Tax Act 2010:

  • A 33.75% tax charge on the loan amount is payable to HMRC.
  • This is temporary and refundable upon loan repayment or write-off.

Timing and Repayment of Section 455 Tax

  • The tax is due nine months and one day post accounting period of the loan.
  • If repaid by this time, no tax is due.
  • If repaid later, the tax is paid but can be reclaimed nine months and a day after the repayment period ends.

Example: Applying Section 455 Tax

Scenario: CloseInnovate Ltd, a close company, loans £100,000 to Ms. Johnson, its majority shareholder, on 1 June 2022. The company's year ends on 31 December.

Analysis:

  1. Initial Tax Matter:

    • £33,750 tax is due by 1 October 2023, unless repaid by then.

  2. Repayment Options: a) By 1 October 2023: No tax due. b) By 1 March 2024:

    • Pay £33,750 by 1 October 2023.
    • Reclaim this tax on 1 October 2025.

This example highlights the temporary nature of Section 455 and the strategic importance of timing in managing loans.

Conclusion

The taxation of company distributions to shareholders covers several areas of corporate law, tax rules, and financial management. For SQE1 FLK1 exam success, candidates must grasp:

  1. The non-deductibility of dividends and their effects on companies and shareholders.
  2. The rules overseeing share buybacks and the criteria for capital vs. income classification.
  3. Anti-avoidance strategies for loans to shareholders in close companies, like the Section 455 tax.
  4. Capital maintenance principles in all distribution types.
  5. Applying theoretical knowledge to practical scenarios, assessing tax outcomes for companies and shareholders.

By mastering these topics, candidates will be ready to tackle complex corporate situations, showcasing the analytical and problem-solving skills vital for the SQE1 FLK1 exam and future legal practice.