Many contractors operating out of Personal Service Companies (PSC) find that a significant amount of cash reserves build up in their company bank account over time. They are often advised by their accountants to leave as much money in the business as possible, as these funds can be accessed at a heavily reduced rate of tax upon liquidation of the company following a successful application for Entrepreneur’s Relief, which can bring the Capital Gains Tax rate down to just 10%.
Whilst this is an extremely tax efficient way of getting funds out of the business, it is not always the most tax efficient strategy and the alternatives should be considered carefully and as early as possible in order to plan accordingly.
Recent changes to pension legislation, including improved flexibility and increased tax efficiency have made them a very attractive investment vehicle. As such, using pensions to extract money from the business rather than leavings funds to languish in low interest bearing deposit accounts can be appropriate in many scenarios.
Tax on extraction
First, let’s address the tax issue. Consider the following:
Corporation tax of 20% is due on gross profits. Assuming these funds are not drawn as dividends but left as retained profits, a further 10% of Capital Gains Tax would apply if Entrepreneur’s Relief is awarded. Total tax is therefore 30%.
Alternatively, an employer pension contribution could be made. Pension contributions are a deductible expense for Corporation Tax purposes, and so the 20% Corporation Tax would not apply. When it comes to withdrawing funds from the pension the marginal rate of Income Tax would apply to the withdrawal, but only on 75% of the fund as 25% is tax-free. Assuming the individual is a higher-rate taxpayer post-retirement the applicable rate would therefore be 30%, (75% of the 40% higher rate tax rate).
So to summarise, whether you (a) leave the cash in the business, liquidate the company, and extract the funds following the successful application of Entrepreneur’s Relief, or (b) make a company pension contribution, the rate of tax paid is broadly the same.
So, what are the other considerations?
It’s possible that Entrepreneur’s Relief will not be granted at all, and the tax rate due will remain at 28% rather than reduce to a rate of 10%.
You need to demonstrate that the company is a ‘trading company’ rather than an ‘investment company’, and the relief only applies to ‘relevant assets’.
The HMRC definition of a ‘trading company’ (which seems to be purposely vague to prevent abuse) for these purposes is a company, which is carrying on trading activities, whose activities to not include to a substantial extent activities other than trading activities, such as surplus cash placed on deposit or invested.
HMRC could therefore contend that cash is not a relevant asset and holding significant amounts of it on the balance sheet indicates the company is an investment company rather than a trading company, and therefore reject an application for Entrepreneur’s Relief, which is granted “all or nothing”.
The days of “cash is king” are long gone. At present, interest rates are so low your cash savings are unlikely to generate more than 1% interest per year, and most business banking accounts pay no interest at all. When you factor in the current rate of inflation, a non-interest bearing deposit account is in fact losing value in real terms.
Modern, flexible pension contracts can invest in a huge variety of assets including fixed interest, commercial property, UK and international shares. Investing £100,000 in a low-cost FTSE 100 index tracker today would be expected to grow to £234,573 net of charges after 10 years, whereas the equivalent sum left in a deposit account paying 0.5% interest would be worth only £105,114.
It is also worth pointing out that Corporation Tax is due on bank interest, but pension will grow virtually tax-free.
‘eValue Efficient Portfolio Update, July 2015’. These assumptions will change over time and the figures stated are based on forward-looking assumptions and not be guaranteed.
Company owners can extract the cash from the business via Entrepreneurs Relief at any time. However, once the company has been liquidated you cannot setup another company which carries on a similar type of business without risk of breaching HMRC rules relating to the ‘Transfer in Securities’, sometimes referred to as ‘the phoenix rules’ which are in place to prevent an abuse of the tax system.
For this reason most contractors only wind-up the company when they plan to retire, take a long break or choose a different career, or take up an employed role.
Pension assets can be accessed without at anytime form age fifty-five. So, if you expect to need access to the cash within your business before this time, transferring assets into a pension may not be the best idea and you should consider other options. If, however you do not expect to need the funds before fifty-five, pension contributions could be an extremely sensible route.
Pension assets are usually held in trust and therefore outside of your estate for Inheritance purposes. Upon death it is possible for any remaining pension assets to pass to your nominated beneficiary (which can now be anyone regardless of age, as long as you are under 75) completely free of taxes (including inheritance tax). Recent changes to pension legislation have made these contracts an extremely useful mechanism to pass wealth down the generations tax efficiently.
Compare this to the tax treatment if the company was wound-up and cash reserves extracted via Entrepreneurs Relief: once the business is liquidated and the cash extracted, this cash becomes part of your estate and could be subject to a 40% tax charge on death if the value of your total estate is over the prevailing Nil Rate Band (currently £325,000 per person).
For contractors operating out of public service companies in a very unique set of circumstances, leaving cash to build in the business with the intention of extracting it at a reduced rate of Capital Gains Tax following the successful application of Entrepreneurs Relief is an appropriate course of action.
However, I expect that in the majority of cases this is neither the most appropriate nor the most tax-efficient way to get cash reserves out of the business, and it is very likely that making use of pension contracts would play a large role in a bespoke financial plan put in place to meet this objective.
A good financial adviser will make a detailed assessment of your situation, consider all the potential options, and advice accordingly.