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SME update for October 2016

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The extraction of profits by way of dividends and salaries is a familiar concept to advisers to SMEs. This month we consider cases where the companies did not have sufficient reserves to pay dividends and instead paid salaries without accounting for the tax under PAYE. Two cases with similar facts but conflicting decisions. In a negligible value claim case, the lack of contracts for services and IP meant a loss of the relief. The requirements for a change of accounting date were considered in the case of R Grint. Sideways loss relief was denied because of lack of involvement in the trade by the taxpayer. All these cases highlight problems encountered by SMEs. 

West and Marsh: tax on salaries and companies in financial difficulties

The responsibility to deduct income tax on behalf of employees via the PAYE system rests with the employer. However, under reg 72 of the Income Tax (PAYE) Regulations, SI 2003/2682, HMRC can recover the tax from the employee in cases where HMRC is of the opinion that the employee received the payments knowing that the employer had ‘wilfully failed to deduct the amount of tax which should have been deducted from those payments’. This is where directors of OMBs are exposed as they ought to know whether tax has been deducted.

This issue was considered in two recent unconnected cases brought before the First-tier Tribunal: West v HMRC [2016] UKFTT 536 and Marsh v HMRC [2016] UKFTT 539. Although the facts of the two cases were broadly similar, they both had surprisingly different outcomes.

In both cases, the individuals were directors and shareholders of private companies and both withdrew funds from their companies during the year. In common with many OMBs the amounts withdrawn during the year were debited to a director’s loan account and the loan accounts were reviewed on preparation of the annual accounts. At that point the directors’ loan accounts were substantially reduced or in some instances reduced to zero by a combination of a small salary and large dividends.

Both companies ran into financial difficulty so had insufficient reserves to pay dividends. In the case of West the director instructed his accountant to prepare a set of accounts making sure that any payments to him were recorded as salary. In the Marsh case, the directors increased their salaries to £102,000 and maintained that the decision to do that was made during an AGM although no documentary evidence was produced to substantiate this. In both cases the necessary accounting entries were made to show the tax and NICs owing to HMRC. In neither case did the companies account to HMRC for that tax and NICs.

In West, the taxpayer’s appeal was allowed although the two-person tribunal could not reach agreement so it is the decision of the tribunal judge. The tribunal judge concluded that the entry of the liability owed to HMRC into the management accounts satisfied the ‘deduction of tax’ within reg 72. This meant that tax had been properly deducted so the employer had not ‘failed to deduct the amount of tax which should have been deducted’. Therefore, the first precondition to the operation of reg 72 was not fulfilled, so there was no basis to transfer the company’s liability to the director.

The dissenting member’s view was that the book-keeping entries were ‘entirely notional’ and that the director knew that the company had no means of paying the sums due to HMRC.

In Marsh, the tribunal rejected the appellants’ argument that tax and NICs had been deducted from the payments. It was found that book entries recording the tax and NICs on the P35 were not sufficient to demonstrate a deduction. The company was already in financial difficulties when the decision was taken to pay increased salaries and the tribunal’s opinion was that the directors knew that the company did not have sufficient profits and that they would not be able to pay the tax and NICs to HMRC. The taxpayers’ appeal was dismissed.

Points to watch

There seems to be little difference between the facts in these two cases, but the tribunal decisions were very different. In both, the directors relied on accounting entries and form P35 to prove deduction of tax under PAYE. While West may give hope to the directors of failing businesses that they can simply walk away from their obligations, it seems probable that HMRC will appeal the decision.

These cases highlight how small companies deal with accounting matters, and the question is how these types of issues will be dealt with under the ‘making tax digital’ proposals.

Dyer: negligible value claims

A negligible value claim under TCGA 1992 s 24 can be a valuable relief for taxpayers who have invested in a venture that subsequently fails. Under s 24 a capital loss arises that can be offset against other capital gains. However, in certain circumstances where the shares are in an unquoted trading company the loss can be offset against the taxpayer’s income under ITA 2007 s 131.

However, care should be taken when making a negligible value claim as there may be aspects to a case which can prevent relief being available as was the case in Dyer v HMRC [2016] UKUT 381.

The case was an appeal from the First-tier Tribunal which had found that the taxpayers were not entitled to make a claim as the shares were of negligible value when they were acquired. In 2007 the appellants had made loans to their daughter’s (JD) fashion business. In 2007 the loans were partly capitalised. In 2008, JD went to the US and the company ceased trading. It was subsequently wound up in 2009. The taxpayers claimed their shares had become of negligible value under TCGA 1992 s 24 but HMRC denied relief.

In order to make a negligible value claim TCGA 1992, s 24(1B) states that ‘the asset has become of negligible value while owned by P’ (condition A). This means that the asset must have had a value attributed to it and that value has at some point (after acquisition) diminished. HMRC agreed in the Dyer case that the shares were of negligible value in 2009 at the time the company was wound up but they did not agree that they had ‘become’ of negligible vale. Their view was that the shares were of negligible value when the taxpayers acquired them two years earlier. The trade names and brands were owned personally by JD and there were no contracts in place between JD and the company. Furthermore, there was no contract between JD and the company for her services. In valuing the shares a hypothetical purchaser would value them on the basis that no contract existed. My Dyer argued that JD would have entered into contracts for both her services and the IP rights if a purchaser were to acquire the business. HMRC argued that the shares should be valued without the benefit of the contracts.

The Upper Tribunal found that the company had no contractual rights over JD’s services, her trademarks or her designs. Instead it had an unsuccessful trading history and a high level of indebtedness so the shares had no value when issued. The appeal was dismissed.

 Points to watch

This case is relevant for shareholders in private companies. Where loans are made to a company and they are subsequently converted into share capital the parties need to be able to prove that the shares had a value at the time of issue. This can be supported by cashflow projections, a copy of the order book or the sale pipeline or, as in the above case, ensuring that key people have contracts with the company and that the company has some rights over the IP.

Grint: change of accounting date

The rules applicable to changes of accounting date were recently examined in the case of Grint v HMRC [2016] UKFTT 0537. The Harry Potter actor, Rupert Grint, changed his accounting date in order for his profits from self-employment to be brought within the charge to income tax in an earlier tax year so that profits for the eight months to 5 April 2010 could be taxed at 40% rather than at the 50% rate that was introduced on 6 April 2010.

His accountants prepared accounts for the 20 month period from 1 August 2008 to 5 April 2010, and these were signed by Mr Grint and were used to discuss the financial and commercial performance of the business. However, because ITTOIA 2005 s 217 stipulates a maximum 18 month period of account on a change of accounting date, the accountants split those accounts into two periods on a time apportionment basis for the purpose of preparing the 2009/10 tax return.

HMRC accepted that Mr Grint was able to change his accounting date in order to shelter profits from the 50% rate, but challenged the efficacy of the change on the basis that the business accounts were prepared for a 20 month period (which they obtained as a result of a VAT visit).

The First-tier Tribunal considered detailed expert opinion as to the criteria for recognising figures drawn up by a business as accounts, and accepted that a business could prepare different accounts covering the same period.

However, the tribunal concluded that although the ‘new accounts’ were accounts as understood by the accountancy profession, they were not in existence at the time the change in accounting date was notified. Moreover, the original accounts were the commercial accounts for the business, and these accounts were prepared for a 20 month period.

Points to watch

Although there must be some doubt as to whether the tribunal is correct in stating that the accounts must exist at the time the change of accounting date is notified, practitioners should take care that the ‘correct’ accounts are approved and used by the proprietors.

Anderson: sideways loss relief

The case of J Anderson v HMRC [2016] UKFTT 565 (TC) considered the availability of sideways loss relief under ITA 2007 s 64 or losses for early years of trading under s 72, and whether HMRC were able to raise a discovery assessment under TMA 1970 s 29.

Mr Anderson is a football agent, who was introduced to a South African soccer academy run by Bafana, a Jersey company. Although the structure not a notifiable scheme, HMRC took the view that it had many of the attributes of a tax loss scheme, in that there were a number of participants, it was financed by a non-recourse loan, and a large initial loss arose.

Although Mr Anderson had relevant expertise, and had identified and promoted some players from the academy, he did not have any substantive involvement with the academy. The tribunal concluded that his involvement was as an investor rather than as a participator in any trade carried on by the academy.

Mr Anderson had not carried on a trade on a commercial basis and with a view to profit. He was, therefore, not entitled to sideways loss relief in relation to the claimed losses of more than £3m, and the tribunal confirmed HMRC’s discovery assessment denying those losses.

Points to watch

The key question in this case was whether Mr Anderson carried on a trade or had acted as an investor in the business. In order to claim sideways loss relief an individual must be involved in the trade.

What to look out for

Agents representing businesses and landlords should consider responding to the six ‘making tax digital’ consultations before the deadline closes on 7 November 2016. The consultations cover a significant amount of issues, and raise more than 100 questions. The changes being brought about by the consultations are substantial, and it is important that as many people as possible in the profession canvass the opinions of their clients and respond to the consultations.

It is worth noting that although the six consultations relate to the same subject, each consultation has a different email and postal address. Read page two of each consultation carefully before submitting responses.