This guide provides a brief overview of the UK tax system for a business operating in the UK through a company. The tax treatment of businesses operating in the UK through alternative business structures, such as partnerships, sole traders, or joint venture arrangements is not covered in this guide.
The guide covers general issues of taxation of profit, payroll taxes and VAT that may arise for a business as well as some tax issues that investors in the business may need to consider.
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 on its income profits and capital profits. The rate of corporation tax for all companies is currently 20%. This rate will be reduced to 19% in April 2017 and then 17% in April 2020.
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. The government will introduce new payment dates for accounting periods starting on or after 1 April 2017 for companies with annual taxable profits of £20 million or more. Where a company is a member of a group, the threshold will be divided by the number of companies in the group. Affected companies will need to pay corporation tax in quarterly instalments in the third, sixth, ninth and twelfth months of their accounting period.
For tax purposes, trading profits are calculated by deducting certain reliefs/allowances together with any expenses incurred wholly and exclusively for the purposes of the trade from the sum of all trading receipts. Trading profits are taxed on an accruals basis and 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.
At the 2016 Budget, the government announced that it is proposing to change the rules regarding the use of losses by companies. From 1 April 2017, companies will be able to deduct carried forward losses (both trading and capital losses) against profits from different income streams. The changes will also enable groups to deduct the losses from one company from the profits of another group company.
However, the government also intends to limit the amount of profits that can be reduced by carried forward losses. From 1 April 2017, companies with profits in excess of £5 million will only be able to offset 50% of their profits against losses carried forward in a single tax year.
Interest: Subject to certain anti-avoidance rules, interest paid by a UK company is deductible in calculating its profits. Deductions are available broadly on an accruals basis.
From 1 April 2017, the government intends to introduce a fixed ratio rule restricting the ability of companies to deduct interest payments from their taxable profits. Broadly, the rule will limit corporate tax deductions for net interest expense to 30% of a group's UK earnings before interest, tax, depreciation and amortisation (EBITDA). The rule will only apply to groups with more than £2 million of net UK interest expenses. R&D expenditure: Additional tax relief is available for qualifying research and development (R&D) expenditure. The rate of tax relief available (and the way in which relief is given) depends upon whether the company is a small or medium sized company (SME) or a large company and in each case a number of conditions have to be fulfilled. SMEs are entitled to relief (in aggregate) at 230%.
From 1 April 2016, the only tax relief available for large companies for qualifying R&D expenditure is an "above the line" credit known as the R&D Expenditure Credit (RDEC). The RDEC is calculated directly as a percentage of the company’s R&D spend. The credit can be recorded in companies’ accounts as a reduction in the cost of R&D – that is ‘above’ the tax line. The RDEC is payable at 11%.
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. However, no tax relief is available for goodwill and customer related intangibles acquired on an asset acquisition on or after 8 July 2015.
A new regime, the "Patent Box", was introduced from 1 April 2013. This allows companies to elect to apply a lower rate of corporation tax to all profits attributable to qualifying patents, whether paid separately as royalties or embedded in the price of products. The relief was phased in over 5 years and by 1 April 2017 will provide an effective corporation tax rate of 10% on worldwide profits attributable to qualifying patents and similar intellectual property (IP) rights. .However, the patent box will be closed to new entrants from 30 June 2016 and will be abolished for existing claimants by 30 June 2021. In December 2015, the government published drafted legislation to change the design of the patent box to comply with recommendations from the Organisation for Economic Co-operation and Development (OECD). From 1 July 2016, a new UK "Patent box" will be available that will be based on the "modified nexus" approach. This approach looks more closely at where R&D expenditure incurred in developing the patent or product actually takes place. It seeks to ensure that substantial economic activities be undertaken in the jurisdiction in which a preferential IP regime exists, by requiring tax benefits to be connected directly to R&D expenditure.
Royalties: Royalty payments made by a UK company are usually deductible for corporation tax purposes provided that they do not exceed a market rate. Diverted profits tax could restrict or prevent the deduction (see below). UK companies may be required to deduct tax at the basic rate (20%) from certain royalty payments that are made to non-UK residents. From summer 2016, the government intends to extend the categories of royalty payments that may be subject to withholding tax. Under the proposals, UK companies may be required to deduct tax on payments made in respect of trademarks and brandnames in addition to copyright, design rights and patent royalties. Depreciation: Depreciation on fixed assets is disallowed for corporation tax purposes. Companies are instead allowed a fixed writing down capital allowance on certain capital expenditure such as expenditure on plant and machinery. An Annual Investment Allowance (AIA) is available to each company allowing full tax relief for expenditure on qualifying plant and machinery. The AIA is £200,000 for expenditure incurred on or after 1 January 2016. Where a company is a member of a group, only one AIA is available for the group.
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. Prior to 6 April 2016, a shareholder was entitled to a tax credit attaching to a dividend of 1/9th of the cash dividend. This satisfied the tax liability for a basic rate taxpayer but resulted in no tax repayment for a non-taxpayer. Cash dividends received by higher rate taxpayers were taxed at an effective rate of 32.%. From April 2016, a new dividend tax allowance has replaced the dividend tax credit. The dividend tax allowance is currently set at £5,000 and dividend income up to that amount will be tax free. Income tax will be payable on dividend income above that allowance at 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers.
Diverted Profits Tax (DPT): DPT is a new tax that was introduced with effect from 1 April 2015. DPT is designed to increase the tax take from multinationals operating in the UK. In certain circumstances, DPT could restrict or prevent a tax deduction for royalties or other sums paid to a foreign affiliated company.
Tax avoidance: A General Anti-Abuse Rule (GAAR) was introduced in 2013. This enables HMRC to counteract "abusive" tax planning.
Every company which has directors and employees must operate the Pay As You Earn (PAYE) scheme. This is the mechanism used for the collection of income tax and National Insurance Contributions (NICs) for remuneration payable to employees and directors. Companies are under an obligation to correctly operate PAYE and to make monthly returns to HMRC of the PAYE deducted from employees.
Income tax is payable at three rates: the basic rate (20%), higher rate (40%) and the additional rate (45%). There are thresholds for each rate. Employee NICs are paid at the rate of 12% on earnings between the primary threshold and the upper earnings limit and 2% above the upper earnings limit. Employer NICs are payable at 13.8% above the secondary earnings threshold. There are thresholds for each of these rates.
The government has introduced a 'tax lock' by legislation. The lock sets a ceiling for the main rates of income tax and employer and employee (Class 1) NIC rates, ensuring that they cannot rise above the levels set in 2015-16. The tax lock also ensures that the NICs Upper Earnings Limit cannot rise above the income tax higher rate threshold. The tax lock is limited to the duration of this Parliament.
It is essential that the correct tax treatment is given to payments of expenses to employees and directors and that any benefits in kind provided to employees or directors are notified to HMRC. Benefits in kind include the provision of accommodation, private medical insurance and cars.
Income tax and NICs 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 (VAT)
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). In the UK, the standard rate of VAT is currently 20%. A 'tax lock' setting a ceiling for the standard and reduced rates of VAT has been introduced by the government through legislation. The tax lock also prevents the relevant statutory provisions being used to remove any items from the zero and reduced rates of VAT for the duration of the current Parliament.
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 £83,000 in the last 12 months, or anticipates making taxable supplies in excess of £83,000 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.
VAT is a European tax, where there is an international element to the business it is important to work out the place of supply for VAT purposes, since UK VAT will only apply where the place of supply is in the UK. However, if the place of supply is another EU country, there may be an obligation to register for VAT there. The rules are complicated and depend upon the precise nature of the supplies made so the following paragraphs should only be regarded as a general guide.
The basic rule is that most supplies of services from one business to another business are treated as made where the recipient belongs. A VAT liability can arise under the 'reverse charge' provisions where a UK business receives supplies from abroad. Where the reverse charge applies, the UK business acts as if it is both the supplier and the customer - it charges itself the VAT and then, assuming that the service relates to VAT taxable supplies that it makes, it also claims the VAT back. Similarly, services supplied from the UK may be treated as supplied abroad, and so fall outside the scope of UK VAT. For services supplied by a business to a non-business customer, the place of supply is where the supplier belongs.
If goods are supplied to an EU business which is VAT registered in the EU, the supply is zero rated (which means that the supplier does not charge VAT but can recover input tax attributable to that supply). The recipient of the goods must account for VAT at the rate applying in its home jurisdiction. If the goods are supplied to a non-business customer located elsewhere in the EU, the UK supplier should apply UK VAT. Supplies of goods are zero rated if they are exported outside the EU to non-UK customers.
Part 2 – Investing in the business
Income tax on employment related shares
Where employees or directors of the business, including those intending to become employees or directors in the future, 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. National insurance contributions (NICs) for both the business as the employer and the employee may also be due on the difference between the price paid and the market value. If the shares carry certain types of restrictions, then further income tax charges (and NICs) 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. The decision to complete an election needs to be considered carefully, since the election could also trigger or indeed, increase an initial tax charge.
Convertible shares and shares which may have an artificially manipulated value may also give rise to income tax and NIC 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 an income tax charge plus).
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 scheme 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 £11,100.
With the exception of gains made on residential property (see below), all gains on the disposal of assets are subject to capital gains tax at a fixed rate regardless of the type of asset or how long they have been owned. From April 2016, the rate is 10% for basic rate income tax payers (unless the gains, when added to taxable income, take the individual over the threshold for higher rate tax) and 20% for higher rate and additional rate income tax payers.
From April 2016, for gains made on the sale of residential property, the rate is 18% for basic rate income tax payers and 28% for higher and additional rate income tax payers. Individuals are exempt from capital gains tax on any gains made on the sale of their own home. Entrepreneurs' Relief: this relief can reduce the rate of capital gains tax to 10% on the disposal of shares or assets used in a business if detailed conditions are fulfilled. The conditions of the relief 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.
The amount of an individual's gains that can qualify for Entrepreneurs' Relief is subject to a lifetime limit of £10 million. Any gains in excess of the limit are subject to the main rates of capital gains tax highlighted above.
At the 2016 Budget, Entrepreneurs' Relief was extended to external investors. External investors will now be able to claim Entrepreneurs' Relief provided certain conditions are met, including that the shares are newly issued in an unlisted trading company, or an unlisted holding company of a trading group, after 16 March 2016 and are held for a continuous period of at least three years before their disposal, starting from 6 April 2016.The Entrepreneurs' Relief for external investors also has a rate of 10% and has a £10 million limit which is separate to the normal £10 million Entrepreneurs' Relief limit.
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.
Enterprise Investment Scheme (EIS) relief: this 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 30% will be given to individuals investing in qualifying companies on the amount invested up to £1 million 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 which meet certain criteria (such as in relation to size). In addition, companies carrying on certain trades such as dealing in land, shares, securities or other financial instruments are excluded from the relief.
See our Out-law tax guide for further details of the EIS.
For smaller companies Seed Enterprise Investment Scheme (SEIS) is available. The qualifying conditions for SEIS are based very closely on EIS.
Although the amount of investment qualifying for SEIS relief is quite low - only £150,000 in total for the company, in certain circumstances, qualifying investors will be able to claim income tax relief worth 50% of the cost of buying shares in the company.
Qualifying SEIS investors will also be exempt from paying capital gains tax on gains on shares within the scope of the SEIS and benefit from a 50% exemption from CGT on gains reinvested into SEIS shares.
For further details see our guide to Seed Enterprise Investment Scheme.