Limited company contractors could be negatively impacted by potential Government measures to tackle money boxing. This warning comes after HMRC’s acknowledgement of the problem within a recent consultation heightened concerns that new measures to tackle money boxing are imminent.
“HMRC has always been aware that contractors have been able to take advantage of the fact that capital is taxed at a lower rate than income,” explains James Abbott, owner of contractor accountant Abbott Moore.
“Though they are in a minority, some contractors look to hold money within their companies to maximise tax efficiencies. The recent increase in dividend taxation has intensified HMRC’s concerns about money boxing, which in turn makes new legislation all the more likely.”
What is money boxing?
Money boxing is where the shareholders of a company retain profits in excess of the company’s commercial needs, receiving the money as capital once the company is liquidated, as opposed to distributing it via dividends.
This is a popular option amongst some contractors, who may claim entrepreneur’s relief (ER) where applicable to minimise their tax liability to 10%. The implementation of the recent dividend tax hikes has meant the differential between the tax liability for distributing funds via dividends and for money boxing is at an all-time high.
Following the dividend tax hikes, contractors who are additional rate taxpayers will now be taxed at a rate of 38.1% on dividend distributions, compared with a potential 10% via Capital Gains Tax (CGT) with ER.
Anti-phoenixing rules throw money boxing into the spotlight
A HMRC consultation into company distributions, published in December 2015, proposed changes to the transactions in securities (TIS) rules. These included plans to introduce a new Targeted Anti-Avoidance Rule (TAAR) to prevent ‘phoenixing’, whereby an individual closes down a company to extract cash without paying income tax, before starting up a new company immediately afterwards.
The new TAAR stipulates that a contractor’s distributions will be subject to income tax if they continue to be involved in a similar trade or activity within two years of closing down their company – effectively ruling it out as a possibility.
As a result, tax advisers were inundated with requests from companies looking to take advantage of tax efficiencies before the new TAAR came into force on 6 April 2016. Abbott adds that other contractors sought to close down their companies and claim ER, for fear that the tax break would be made unavailable in the near future.
Money boxing well on HMRC’s radar
“The two-year rule included in the TAAR effectively shuts the door on phoenixing,” notes Abbott. “But there is still little in the way of rules preventing companies from money boxing.”
HMRC is seemingly well aware of this. Within the same consultation document, it highlights money boxing as one of the main areas where it is concerned that aggressive tax planning is most likely to occur.
Although HMRC insists it has no plans to introduce any new rules beyond those recently enacted, the fact that it has identified money boxing as a problem has fuelled concern within the contracting sector that stricter regulations may be just around the corner.
“A lot of people expect HMRC to assess the impact of the changes to the TAAR and decide its next course of action based on how effective they have been,” comments Abbott. “If the updated TAAR wipes out the majority of tax savings, there’s less inclination on behalf of HMRC to make further changes, but nobody can predict what will happen.”
What would a money boxing clampdown look like?
With the understanding that money boxing remains an option for limited company owners, HMRC is considering encouraging contractors to wash out the money left in their company that exceeds their working capital requirements, so that it can be taxed as either dividends or income.
The suggestion is that HMRC may look to make this a compulsory requirement, with very few – if any – non-compliant contractors likely to adhere unless it is written in law. For Abbott, this proposal poses numerous problems, notably concerning what constitutes working capital requirements:
“It’s very difficult to define what constitutes excessive funds. There’s no formula for deciding what a fair amount of working capital is. I know contractors who will say that the right amount is one or two months-worth of sales invoices, whereas others would feel uncomfortable if they didn’t have six months of income in their account.
“This is probably the biggest hurdle to the ideas coming in, because it’s too hard to come up with something that’s relatively straightforward whereby a contractor can determine that they’re not keeping excessive funds behind.”
How might compliant contractors be affected?
Abbott admits that the proposed measures would likely prove effective in clamping down on money boxing, but warns of multiple ways in which compliant contractors could also be negatively affected.
“The difficulty is the rules would likely be very ambiguous, and subsequently very difficult to define and apply for a compliant contractor. As a result, they could easily fall foul of the rules by mistake for the simple fact that there’s no definition of fair working capital.”
Whilst Abbott concedes that some contractors do build up funds within a company to claim tax advantages, he notes that for others it simply makes good business sense. The difficulties that many contractors face getting paid on time by larger clients is well documented. As a result, some contractors like to hold money within their company as a reserve, a safety net that the new proposals would eliminate.
“Other companies might want to expand,” Abbott adds. “You need money to do that, and so it could well stifle entrepreneurship if contractors with growth plans are deemed to be in excess of what HMRC considers a reasonable amount to hold within a company.”
Analysing the matter from a broader perspective, Abbott also highlights the uncertainty that any implementation of further red tape is bound to cause within the sector.
In addition to the potential widening of travel and subsistence (T&S) rules, the proposed public sector IR35 reform and the demands placed on small businesses by the Government’s digital tax regime, a clampdown on money boxing would add further red tape and cause more uncertainty within the contracting sector.
Money boxing harder to tackle than phoenixing
Abbott says he hopes any measures taken by the Government will be preceded by a consultation where more consideration can be granted, as tackling money boxing poses a different challenge to phoenixing.
“The updated TAAR rules surrounding phoenixing are very straightforward and easy to apply in practice. For example, there’s not really any way of misconstruing the two-year rule. Money boxing – on the other hand – is a lot harder to get right due to its ambiguity, and so you would hope for a consultation.”
Abbott concludes by encouraging limited company contractors to stay on the lookout for consultations and be wary of potential changes that may be implemented in the Autumn Statement.
“Finally, contractors have to be aware that tax breaks that are currently available may not be there several years down the line. Therefore, it’s a calculation of risk as to whether or not they decide to bring that income forward.”