Contractors who incurred a higher tax liability for previous financial years may be able to reduce their tax bill by adopting a range of common tax-reducing strategies.
“During a financial year, contractors can miscalculate their dividend payments, for example, which takes them into the higher rate tax band,” explains Abbott. “This may not become apparent until final accounts are prepared once the financial year is over.
“However, a contractor can apply different tax planning strategies, such as making charitable donations, additional pension contributions or tax efficient investments that can act retrospectively to cut individual or corporation tax bills.”
According to Abbott, including charitable donations within a tax planning strategy enables contractors to lower their individual tax bills arising from a previous year: “HMRC’s rules specifically allow taxpayers flexibility over the financial term in which the charitable donations are treated.”
For every £80 a basic rate tax-paying contractor pays in charitable donations, the government allows the charity to claim an additional £20 to make up for the tax the contractor paid to be able to pay the £80 net in the first place.
A contractor can apply different tax planning strategies, such as making charitable donations, additional pension contributions or tax efficient investments that can act retrospectively to cut individual or corporation tax bills
James Abbott, Abbott Moore
But higher rate taxpayers can claim 40% tax relief on charitable donations. So, a contractor who overpaid their dividend in one tax year, taking them into the higher rate band, can make charitable donations during the next tax year.
The contractor can choose that their current-year contributions be declared on their individual self-assessment tax return for the previous tax year. The contractor then gains tax relief on income received during the previous tax year from charitable donations made in the current one. The claim must be made on the tax return for the year in which the contractor wants to claim the relief.
“Regular company pension contributions by themselves are a highly tax efficient way for contractors to save for their futures,” continues Abbott. “Contractors who do not make regular pension contributions up to their full allowance can make additional payments, which can be used to incur losses in their business, and those in turn generate corporation tax relief.”
Broadly speaking, the maximum amount of annual pension contributions from a contractor’s company that attract tax relief is currently £50,000 (at the time of writing) and this is reducing to £40,000 for the 2014/15 tax year.
HMRC’s rules also allow a contractor to make use of any unused £50,000 allowance from the previous three years too, if they have been contributing to a pension during those years.
Abbott provides an example: “Take a contractor whose company makes profits each year of £80,000, and made a profit of £80,000 in the year ending March 2013. Circumstances change and the contractor anticipates making only £20,000 profit in the year ending March 2014, whilst still making the full pension contribution of £50,000
“The contractor’s company would then normally show a loss of £30,000 for the tax year ending March 2014. But the contractor can elect to allocate that loss against the profits of the previous year. Taking back a £30,000 loss from 2013/14 against profits of £50,000 in 2012/13 means corporation tax will only be calculated on profits of £20,000.”
Abbott also urges new contractors who have previously been higher rate taxpayers, and higher rate tax paying contractors with one or more individual pension schemes, to review their tax situation, as it is also possible for individuals to secure tax relief and rebates as a result of their pension contributions.
Most limited company contractors will claim legitimate employment expenses via their company on an ongoing basis. But employee expenses rules also apply to any employee, including: umbrella company contractors, contractors employed via the agency payroll and those who might have temporarily stepped out of contracting to work on a fixed-term employment contract.
Abbott explains: “As is the case with all contractor expenses, the definition of employment expenses is narrow and they have to be incurred wholly, exclusively and necessarily and in the performance of the employee’s duties.”
“Employment expenses tend to be the classic ones, such as subsistence and mileage. Professional subscriptions on HMRC’s approved list also qualify, and HMRC provides flat rates for some trades.”
Expenses are claimed via a tax return, although HMRC may deal with the claim outside of the tax return system, and generate a rebate on the previous year’s tax. For contractors and locums not employed by their own limited companies, it can amount to a sizeable sum each year.
Tax efficient investments
“The reason that some investments are tax efficient is that they are risky. And the government’s view is that the only thing more risky than investing in your own business is investing in someone else’s,” notes Abbott. “The Enterprise Investment Scheme (EIS) therefore gives investors tax breaks for investing in small companies.”
Contractors investing in qualifying shares enjoy 30% tax relief (at the time of writing). So, a contractor investing £100,000 in a small company would benefit from a £30,000 saving on their personal tax bill. This could be used to reduce higher rate tax on dividends, for example.
The Seed Enterprise Investment Scheme (SEIS) allows contractors to generate potentially greater returns and tax relief, but is restricted to smaller investments in newer companies, which may be riskier.
The contractor can choose to elect the year in which the investment was made. If a contractor invested £100,000 during the current tax year, but it would have been more beneficial to make the investment during the previous one, they can choose to set it against the previous year instead..
“It is also possible to use EIS to defer capital gains tax payments. This won’t save tax but will allow it to be deferred,” adds Abbott. EIS shares can also be sold free from Capital Gains Tax providing they are held for at least three years enough.
Investing in unlisted shares
Contractors who invest in unquoted shares , such as those listed on the London Stock Exchange’s AIM (formerly known as the Alternative Investment Market), can benefit from tax relief if they lose money on the investments.
“Let’s say a contractor puts £10,000 into a new AIM company share issue and it fails, with the shares becoming worthless,” says Abbott. “Because the company was unquoted, the contractor can choose to write off the losses against their income in the current financial year or the previous tax year.”
The result is tax relief to the value of the loss on the contractor’s previous or current year’s taxable income as an individual.
Loaning money to a company
Although only a current year tax reducer, Abbott has encountered this scenario on numerous occasions, particularly when contractors and freelancers have not been paid because of clients delaying payment.
“I’ve known contractors who are presented with a corporation tax bill, but who don’t have the money to pay, having been drawing on funds set aside for tax because of late payment by clients. They go to the bank and take out a personal loan and pay that into the company to pay the tax bill.”
There is of course an interest cost associated with the loan. Because the contractor is lending to a trading company, they can use the interest cost as tax relief against their personal tax bill based on current financial year earnings.
“All tax-planning strategies involving previous years are subject to HMRC’s rules on time limits,” highlights Abbott. “Contractors can generally have up to four years after the end of the tax year has finished to identify a tax overpayment and make a claim. But other claims and elections require more timely action.”
For more recent changes, a contractor’s accountant can amend a return and file a replacement within 12 months of the normal filing date. Contractors should check with their accountant as some claims, such as the charitable donation carry back, have to be made the first time the return is filed.
“However, these time limits only apply when any changes are in HMRC’s favour,” notes Abbott ruefully. “You don’t get the same four year’s grace if the change to mistake is in HMRC’s favour. And the taxman can go back 20 years if fraud may have been committed!”