Creating your own company could mean dodging tax like US corporations. Here's how this scheme works.
Last week, coffee giant Starbucks got a roasting when a four-month investigation by news agency Reuters revealed that its British division has paid hardly any UK corporation tax.
Starbucks arrived in the UK in May 1998 and, over the next 14 years, racked up sales exceeding £3 billion. However, thanks to some ace accounting, Starbucks UK has paid just £8.6 million in corporation tax.
Normally, such a low tax bill would indicate a struggling business, even one in terminal decline. On the contrary, Starbucks is growing fast, adding 20-30 new outlets each year to its existing portfolio of 735 stores. So what's going on?
Playing 'pass the profits'
Starbucks has huge sales and hefty profit margins, so why isn't it paying UK corporation tax? The simple answer is that its parent company heavily reduces Starbucks' UK tax liability through massive deductions.
For example, Starbucks UK is entirely financed by debt from its US parent, to which it pays millions of pounds a year in tax-deductible interest. Also, 6% of Starbucks' sales are paid to its parent in royalty fees for using its brand, trademarks and intellectual property. In 2011, these royalties came to £26 million, helping to push the UK arm to a loss and completely avoid tax.
Of course, Starbucks is just one of scores of multinational corporations to game the UK tax system. Amazon, Facebook and Google use similar legal loopholes to transfer British profits to low-tax regimes, as we highlighted in Why I'm boycotting Amazon and where I'm going instead.
What if you could do the same? How would such a wheeze work and how low could your tax bill go?
Transform yourself into a company
Perhaps the best way to take total control of your tax affairs is to 'incorporate'. This involves setting yourself up in business as a private limited company and channelling all (or most) of your income through your own 'personal tax haven'.
By starting your own company, you can move away from being taxed as an employee and paying income tax and National Insurance contributions (NICs) through the PAYE (Pay As You Earn) system. Instead, your company get taxed on its profits after legitimate business expenses.
Meanwhile, to avoid income tax and NICs, you take a modest salary from your firm and boost your earnings with tax-efficient share dividends. Here's a practical example of how this works.
Make work less taxing
Let's assume that your company collects, say, £60,000 a year in fees from various clients. Of this, your business pays you a small salary of £107 a week, or £5,564 a year. As this is below the lower threshold for employee NICs, you pay no National Insurance on this wage. In addition, there is no income tax to pay on this mini-salary, as it falls within your personal tax allowance of £8,105.
Next, assume that your company has 1,000 shares, all of which you own. Every six months, you declare a cash dividend on these shares of, say, exactly £1.8455 per share. This gives you an extra £18,455 twice a year, which totals £36,910.
Share dividends are taxed much more lightly than earned income. In fact, thanks to a notional 10% tax credit, basic-rate (20%) taxpayers pay no tax on dividends. For higher-rate (40%) taxpayers, the tax is 32.5%, reduced to 22.5% after the 10% notional tax credit. However, this extra tax is paid only on the slice of dividends in the higher-rate tax threshold, which starts at £34,370 of taxable earnings.
[SPOTLIGHT]In effect, you've received total earnings of £42,474 from the £60,000 paid to your private company. As all of this falls below the threshold for higher-rate tax of £42,475, it is entirely tax-free. In short, the score is: you 100%, HM Revenue & Customers (HMRC) 0%!
Make your company pay
While you pay zero personal taxes on the above earnings, HMRC will get its pound of flesh one way or another. It does this by charging your company corporation tax. In the above example, your company received £60,000 over the course of a year and paid you a salary of £5,564. This sum is offset against corporation tax, reducing the company profit to £54,436.
Although dividends don't reduce this profit any further, all legitimate business expenses do. For the sake of argument, let's say that your company offsets £4,436 in expenses against tax, reducing the final profit to £50,000.
The standard rate of corporation tax for small businesses is 20%, thus generating a tax bill of £10,000. This is the only tax paid by your company (except for VAT on purchases, of course).
What's more, your company is solvent, as it has spare cash remaining of £3,090, as follows:
|
Revenues |
£60,000 |
|
Salary |
-£5,564 |
|
Dividends |
-£36,910 |
|
Expenses |
-£4,436 |
|
Corporation tax |
-£10,000 |
|
Surplus |
£3,090 |
A river of red tape
Of course, not everyone can set up a company and start a business overnight. If you quit your job and return to the same firm as a consultant paid via your own private company, HMRC might take a dim view of this move. It could argue that you are an "employee at arm's length" and, under the provisions of an anti-avoidance rule known as IR35, could order you to pay tax as an employee.
Then again, if you're a genuine consultant or freelancer (as I am), then this sort of tax arrangement should be right up your street. Indeed, I ran my small business along these lines for six years, before overwhelming red tape and a bout of ill-health led me to become self-employed, rather than a company director.
Finally, if you do decide to set up your own company, then be prepared to be washed over by a flood of British bureaucracy. You must keep accurate records for HMRC and Companies House and, if you fail to file your company paperwork and pay its taxes on time, then expect to be fined thousands of pounds. Even so, this entirely legal tax loophole might work for you, as it does for millions of British workers.
More on tax: