8 February 2010
The forthcoming tax regime will certainly have a lightening effect on partners’ pockets. David Furst examines the various ways to mitigate the impact
Many partners believe and hope their firms’ financial years to spring 2009 will have been the year that really hurt their back pockets. Most firms were hit in some respects by the financial crisis that impacted on the whole economy in the second half of 2008. Swift action was taken by many of them, largely concentrating on cost and headcount reductions, with much of the restructuring costs incurred in the 2009 accounting period. Nevertheless, even for those firms that took appropriate action, it is unlikely that their partners can look forward to a restoration of drawings to a more normal level, let alone the levels enjoyed in the boom years.
HM Revenue & Customs is looking for a larger share of firms’ gross profits. For the tax year 2010-11 there are three new provisions that will impact on many firms and partners. Indeed, one has already impacted on 2009-10.
First, a partner with an income in excess of £100,000 will have their personal allowance abated by £1 for every £2. Based on the current personal allowance of £6,475, this will mean an additional £2,590 of tax for those whose income exceeds £112,950. Effectively there is a 60 per cent tax band on income between £100,000 and £112,950.
Second, a 50 per cent tax band is to be levied on taxable income of more than £150,000. For example, a partner earning £450,000 would therefore have to pay an additional 10 per cent on an income of more than £150,000. This results in an additional £30,000 in tax, to which the loss of their personal allowance at 50 per cent (ie £3,238) must be added. This means a total increase in the tax liability of £33,238. Taking into account the effects of Class 4 NI contributions and the partner will need to have an additional profit share of £67,832 just to stand still in terms of profit after tax (ie an increase of 15 per cent).
But for many it does not end there. From 6 April 2011 higher rate tax relief will no longer be available on pension contributions.
For those who do not make regular contributions the amount of premiums attracting higher rate relief may well already be much reduced. Many take the view that conventional pension arrangements are no longer a sensible option for high earners. What is the attraction of investing in a pension scheme and getting 20 per cent tax relief on premiums paid and being taxed at 40 or possibly 50 per cent when the pension is drawn?
While some are turning to enterprise investment schemes or venture capital trust investments as alternatives, these are high-risk investments and their attractiveness depends on an individual’s risk profile.
Accordingly, reverting to the example of the partner earning £450,000 per annum, if in recent years a pension contribution of £100,000 has been made and then this is discontinued, the partner’s tax hit will go up by a further £40,000. The total increase in tax liability would then be £73,238. The partner would need to earn a further £149,465 to stand still in respect of profit after tax (ie an increase of 33 per cent).
Realistically in the light of the state of the public finances, higher rate taxes, and in particular the 50 per cent rate, are here to stay in the medium term, whichever party wins the election. While it is likely to be impossible to reverse fully the taxation effect in the example given above, there are a number of ways to mitigate the impact during the transitional period.
Ways and means
Any partner planning to retire or leave their present firm on 30 April 2010 (or any date early in the tax year 2010-11) should bring forward their retirement date to 31 March 2010. As a result their overlap profit (ie the increase in their profit share between the time they first became a partner, or the time the present system came in during the late 1990s, and current profitability will be taxed at 40 rather than 50 per cent). Partners planning to retire on 30 April 2011 may also seek to retire by 31 March 2010 and then enter into a consultancy arrangement for the ensuing period.
A number of firms are changing their year-ends from 30 April to 31 March in 2010. The effect will be to crystallise the overlap profits for all of the partners at 40 rather than 50 per cent.
ssuming the 50 per cent rate is here for some time to come, this will result in an absolute tax saving of 10 per cent of the overlap profit, but a cash outflow. If for example £1m of overlap profit was crystallised, the tax saving would be £100,000. The cost of funding the accelerated tax of £400,000, assuming an interest rate of 5 per cent, would be £20,000 per annum; but on the basis of 50 per cent tax relief it would thereon amount to £10,000 per annum. After five years a firm could revert to a 30 April year-end. A saving should be achieved even if interest rates do rise in the meantime, but the benefit may be reduced if profit is expected to increase significantly in real terms.
The 50 per cent tax rate has highlighted the benefits of the utilisation of service companies and the ability to divert a modicum of profit to be taxed at corporation tax rates at a maximum of 28 per cent rather than marginal income tax rates. Arrangements can be put in place so that profit is not locked in the service company but remains available for the partners to enjoy.
Regarding pensions, all partners should try to ensure they pay the maximum premium on which they can gain higher rate relief, both prior to 5 April 2010 when 40 per cent will be available and in 2010-11 when 50 per cent relief will be obtained.
David Furst is chairman of Horwath Clark Whitehill and immediate past president of the Institute of Chartered Accountants in England and Wales