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Contracting company profits - tax issues when investing cash surpluses

Contractors with a cash surplus in their contractor business may be considering investments using their company to get their money working harder, particularly when corporate deposit interest rates are very low or inflation is eating away at cash deposits.

But, as James Abbott of contractor accountant Abbott Moore explains, expert financial advice is essential before taking any decisions. “From a Capital Gains Tax (CGT) perspective, contractors could well be better off choosing to extract the cash from the business and invest personally, rather than maintaining a high cash balance and using this money for company investments,” Abbott says. “For example, there are tax efficient investment vehicles, such as Individual Savings Accounts (ISAs), which are only available to individuals and not to companies.

“But each contractor and their business will have a unique risk and investment profile, so they would be well advised to speak to a Financial Services Authority authorised Independent Financial Adviser (IFA) before making any decisions. Better still, they should consult an IFA who is an expert at dealing with contractor clients.”

Companies can invest in assets, just as individuals can, but there are pitfalls

According to Abbott, a contractor can choose to invest their limited company’s surplus cash in the same types of assets and investments as an individual, with the exception of specific personal investments, such as ISAs.

“A contractor could invest their limited company cash in assets such as shares, bonds and real estate property,” continues Abbott. “They could even buy precious metals such as gold or art and antiques.”

But Abbott warns contractors that HMRC’s rules mean that when a company’s income from non-property investments exceeds a certain level, the company becomes a Close Investment Company (CIC) and a higher rate of corporation tax [28% at the time of writing] kicks in.

How does capital gains tax work with limited companies?

When assets owned by a business increase in value and the company makes a profit from the sale of the asset, capital gains tax is applied to that profit. In practice, at the end of the financial year, the business must treat the capital gain as a company profit and charge corporation tax [21% at the time of writing] on it.

If the company owns an asset that has appreciated in value, such as an equity investment or precious metal, but the asset is not sold during the financial year, the company’s accounts will reflect that increase in value, but there is no corporation tax charge until the company sells the asset and the profit is realised.

Capital gains tax: indexation versus personal allowance

“The major difference between the CGT calculation for companies versus that for individuals is that companies benefit from an indexation allowance, whereas individuals don’t,” explains Abbott. “Conversely, individuals have a CGT allowance [£10,100 at the time of writing], whereas companies have no allowance.”

A company’s indexation allowance means that the values of any company assets are pegged to the Retail Price Index (RPI), so when calculating a company asset for sale, the elevated book value after indexation becomes the effective purchase price when calculating CGT.

“For contractors who want to hang onto their limited company over the longer term and invest in assets with relatively stable prices held over a long time, indexation can reduce CGT liability,” continues Abbott. “However, contractors with assets owned personally can generate up to their CGT allowance in capital gains before incurring any CGT liability.”

The indexation allowance for individuals was abolished in April 2008.

Companies can use capital losses to offset gains and reduce tax

Although an asset’s indexation allowance cannot be used to generate a loss on the sale of a capital asset, if some of a company’s investments have been sold at a loss during the financial year, the company can use the loss on one asset to offset the gain on another, thus reducing CGT liability.

Abbot explains: “If there is a net loss for the financial year, the loss can be carried forward to offset against future capital gains. Although trading losses can sometimes be used to reduce corporation tax on a company’s capital gains, unfortunately capital losses cannot normally be used to reduce corporation tax payable on trading profits.”

And to prevent companies benefiting from manipulating CGT liabilities by selling assets in the same class bought at different times and with varying capital gain values, a similar set of ‘bed and breakfasting’ rules apply.

Even with indexation and the ability to carry forward losses, most contractors may well pay less tax by extracting their cash via a dividend and making personal investments in more tax efficient ways

James Abbott, Abbott Moore LLP

Abbott stresses that capital gains is a particularly complex area of taxation, with a large number of reliefs for different asset classes, and contractors should seek professional advice before taking any decisions.

Calculating the tax implications of investing personally versus via a company

“Even with indexation and the ability to carry forward losses, most contractors may well pay less tax by extracting their cash via a dividend and making personal investments in more tax efficient ways,” says Abbott. “This is particularly apparent when you consider the range of tax-free investments available to individuals, but not companies.”

By way of example, let’s say a contractor decides not to take a dividend, because they are a higher rate taxpayer. She invests £50,000 of the company’s money in assets, such as shares, making a 25% gain (option 1 below). A capital gain of £12,500 (25% of £50,000 invested), with company capital gains tax and then income tax on the dividend leaves the contractor with £44,906.

Conversely, in option 2, if the contractor immediately extracts the cash as a dividend and takes the higher rate income tax on the chin, and then personally invests her remaining £37,500 after tax, with a similar return of 25% she is left with £46,875.

Option 1 Option 2
Amount 50,000 Amount 50,000
 
Gain % 25% Dividend Tax% 25%
Gain (£) 12,500 Dividend tax (£) 12500
 
CGT Tax % 21% Amount invested 37,500
CGT (£) 2,625
 
Remaining amount 59,875 Gain % 25%
Dividend tax % 25% Gain (£) 9,375
Dividend tax (£) 14,969 CGT (£) Zero
 
In pocket 44,906 In pocket 46,875

There are always exceptions, and some contractors have, for example, created property empires by reinvesting contracting earnings into their business. Others have built software businesses or other types of trading entities. The wide range of variables is why Abbott urges high earning contractors and those with low living costs who are building up cash surpluses to seek professional advice.

Abbott concludes: “Although there is no absolute right or wrong answer to making surplus cash in the company work harder by making company investments, most contractors, including higher rate taxpayers, may well find that they pay less tax by taking dividends and investing personally.”

Published: 21 February 2011

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