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Introduction to tax

Note: This guide is based on UK law for the tax year 2008/09.

Overview

This guide assumes setting up in business as a company. However, this is not the only option – alternatives would include a partnership, acting as a sole trader, or setting up another form of joint venture arrangement.

The guide covers (1) general issues of taxation of profit, payroll taxes and VAT for the business and (2) issues to consider for investors in the business.

UK tax is administered by HM Revenue & Customs ("HMRC").

Part 1 – Running the business

Profit: Corporation Tax

A UK company will be subject to UK corporation tax. Income profits and capital profits are charged at the same rate, currently 28%. In certain circumstances, a company may qualify for the “small companies' rate” of 21% for profits between £50,001 and £300,000, then increasing to 28% for profits over £1.5 million.

Corporation tax is paid nine months after the end of the accounting period, or, for companies with profits of more than £1.5 million, in four equal instalments, due in the seventh and tenth months of the current accounting period and the first and fourth months after the end of the accounting period.

For tax purposes, trading profits are calculated by deducting from the trading receipts specified deductions together with any expenses incurred wholly and exclusively for the purposes of the trade. Trading profits are taxed on an accruals basis, generally in accordance with the accounting treatment. Capital gains are generally taxed on realisation.

Losses: Trading losses can be set off against other profits and gains, including capital gains, arising in the same, or previous, accounting period, or carried forward and set off against future profits arising in the same trade. Capital losses can only be set off against capital gains arising in the same period or in subsequent periods.

Interest: Interest paid by a UK company is, subject to certain anti-avoidance provisions, deductible in calculating its profits. Deductions are available broadly on an accruals basis.

R&D expenditure: Additional tax relief is available for qualifying research and development (R&D) expenditure. The rate of tax relief available depends upon whether the company is a small or medium sized company, entitled to relief (in aggregate) at 150% or a large company entitled to relief at 125%. In each case a number of conditions have to be fulfilled.

Goodwill and IPR: The tax treatment of intangibles, such as goodwill and intellectual property, broadly follows their accounting treatment. It is therefore possible in some circumstances to obtain tax relief for the amortisation of intangible assets.

Royalties: Royalty payments made by a UK company are usually deductible for corporation tax purposes provided that they do not exceed a market rate.

Depreciation: Depreciation on fixed assets is disallowed for corporation tax purposes. Companies are instead allowed a fixed writing down allowance on certain capital expenditure such as expenditure on plant and machinery. Allowances are currently available for expenditure incurred on industrial buildings but it has been announced that this relief will be phased out.

Transfer Pricing: The UK transfer pricing legislation enables HMRC to adjust a UK company’s profits for corporation tax purposes, if it pays more or less than the market rate for goods or services provided by or to non-arm’s length enterprises.

Distributions: Dividends are paid out of after tax profits. A company does not have to account for any tax when it pays dividends. A shareholder is entitled to a tax credit attaching to a dividend of 1/9th of the cash dividend.

PAYE

Every company which has directors and employees must operate the PAYE scheme. This is the mechanism used for the collection of income tax and national insurance contributions for remuneration payable to employees and directors. Companies are under an obligation to correctly operate PAYE and to make monthly returns of the PAYE deducted from employees.

HMRC will make periodic visits to companies to check that they have correctly operated their PAYE schemes. Any discrepancies found may involve penalties.

It is essential for the correct tax treatment to be given to the payment of expenses to employees and directors and for any benefits in kind provided to employers or directors to be notified to HMRC on the end of year P11d return. Benefits in kind include the provision of accommodation, private medical insurance and cars.

Income tax and National Insurance contributions arising in respect of certain employment related securities and the exercise of unapproved share options may also be collected through PAYE – see further in Part 2 below.

Value Added Tax

Value added tax (VAT) is payable on the supply of most goods and services in the UK by a taxable person (a person who is registered, or should be registered, for VAT purposes). The standard rate of VAT is currently 17.5%. Certain supplies are exempt from VAT, the most important of which relate to finance, insurance, education, health and some supplies of land.

A business which has made taxable supplies in excess of £67,000 in the last 12 months, or anticipates making taxable supplies in excess of £67,000 in the next 30 days is required to register for VAT and account to HMRC for it. A business which is registered for VAT must charge VAT on taxable supplies made by it (known as output tax) but can recover the VAT charged on supplies made to it (known as input tax) to the extent that the VAT was incurred for the purposes of making taxable supplies. VAT will however be a real cost for businesses that are making exempt supplies.

The basic rule is that supplies are treated as made where the supplier belongs – e.g., in the UK. However, certain services are treated as supplied where received. A VAT liability can therefore arise under the 'reverse charge' provisions where a UK business receives such supplies from abroad. Similarly, certain services supplied from the UK may be treated as supplied abroad, and so fall outside the scope of UK VAT. The types of services affected include transfers of IPR, some consultancy and other professional services, supply of staff, telecommunications services and electronically–supplied services.

Part 2 – Investing in the business

Income tax on employment related shares

Where employees or directors of the business, including those intending in future to become employees or directors, acquire shares in the company at less than their actual market value, they may be charged to income tax on the difference between the price paid and market value.

If the shares carry certain types of restrictions, then further income tax charges may arise on disposal of the shares, or on any change in or lifting of the restrictions. This can be avoided by making an election within two weeks of acquisition, which needs to be considered carefully as the election could also potentially increase any initial tax charge.

Convertible shares, and shares which may have an artificially manipulated value may also give rise to income tax charges.

Where possible, planning should be undertaken prior to acquisition of the shares so as to minimise the risk of any such income tax charges arising, either upfront (when there is unlikely to be cash to meet the tax charge) or on disposal (when capital gains tax treatment is likely to be preferred to a 40% income tax charge plus national insurance contributions).

Share options

Granting options to acquire shares in the future may be a useful way to incentivise employees. The company would grant individuals a right to acquire shares in the future upon payment of a fixed sum, and often conditional upon achieving certain performance targets. Although income tax charges may arise if the shares are in fact acquired at an undervalue, there are certain types of option which receive beneficial tax treatment – the enterprise management incentive is particularly aimed at smaller start-up businesses.

Capital gains tax

Where income tax treatment mentioned above does not apply, any gain on disposal of the shares will be subject to capital gains tax. Every individual benefits from an annual exemption, currently £9,600.

From 6 April 2008 all gains are subject to capital gains tax at a fixed rate of 18%, regardless of the type of asset or how long they have been owned. However entrepreneurs' relief may be available to reduce the rate of tax to 10% in respect of shares or assets used in a business if detailed conditions are fulfilled. The conditions need to be considered in detail in relation to each individual, but in the case of shares the main conditions to be fulfilled for the period of at least 12 months prior to the disposal are that:

the company is a trading company or the holding company of a trading group
the individual is an officeholder or employee of the company (or another member of the group)
the individual holds at least 5% of the ordinary share capital and votes in the company

Interest relief: shareholders who borrow to invest in shares in the company may be able to get relief from income tax in relation to the interest on that borrowing. There are a number of conditions to be fulfilled, including in relation to the company’s ownership structure, but the relief may be available where the company is a trading company and the shareholder is either an employee/director or owns more than 5% of the share capital.

EIS relief: enterprise investment scheme relief was devised to encourage investment into small start-up companies. The conditions for EIS relief are complex, but in outline, income tax relief at 20% is given to individuals investing in qualifying companies on the amount invested up to £500,000 in any tax year. Gains on any increase in value of those shares are exempt provided the individual holds the shares for in excess of three years. Investors therefore have an immediate income tax relief and the prospect of tax free growth in their investment.

This is a particularly attractive scheme for start-up companies wishing to attract venture capital. However the relief will only be available to companies with fewer than 50 full time employees who have raised no more than £2 million in the preceding 12 months under EIS and certain other reliefs. In addition, companies carrying on certain trades such as dealing in land, shares, securities or other financial instruments are excluded from relief.

See: HMRC's information for those setting up in business