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Thursday, 28th March 2024
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It has become common to use a company to carry on business, or to make an investment. The use of a company has tax advantages. But the private shareholder often has not reckoned with the legal difficulties of subsequently attempting to take advantage of the company’s cash and assets. Extracting cash can have high tax costs writes Brian Daly of KPMG.
Why a company?
Brian Daly, Editor, Tax Monitor


Many companies have been created and used for no better reason than that it is what is commonly done. The lure of limited liability can be a factor in a decision to incorporate. But the protection offered by incorporation is often diluted by personal guarantees given by shareholders to financial institutions and landlords. The use of a company can provide a structure to a business and help an entrepreneur to distinguish between his personal affairs and his business affairs. Some financial institutions and businesses have a preference for dealing with a company rather than directly with an individual in that it can remove the ‘personal element’ from enforcement of obligations, should that arise. There are many reasons for incorporation, but traditionally tax was not the major motivation.

The low tax rates now available for companies - 121⁄2p.c. on trading income, 25p.c. on other income (subject to a surcharge if undistributed in a closely owned company) – mean that tax is now an important consideration. The exemption from capital gains tax on the disposal of certain shareholdings by a company has increased the tax advantages of conducting business through a group of companies.

However incorporation has at least one major disadvantage. The assets of the company, including its cash, are not the property of the shareholders. There are legal restrictions on the ability of shareholders to make use of the company assets. There can also be significant tax costs involved in making use of the assets, or taking cash from the company. In a publicly quoted company the distinction between the company’s assets and the shareholders is easily understood. In a family company it can be difficult for a 100p.c. owner of a company to appreciate that what is the company’s, is not necessarily his.

Tax costs
There are four basic methods by which a shareholder in a family company can get effective benefit from the company’s cash and other assets.

• He can liquidate the company and have its assets distributed to him after payment of creditors.
• He can sell his shares and obtain the value of the shares in cash from a purchaser.
• He can take a dividend or a salary from the company.
• He can borrow from the company or otherwise make use of its assets.

All of these approaches are likely to involve tax costs.
Liquidation will typically involve a double charge to capital gains tax (CGT). CGT will arise on any gain that has accrued on the shares (ie increase in value since acquired). It will also arise in any gain accrued on the company’s assets since they were acquired by the company.

The sale of the shares will involve only a single charge to capital gains tax, in respect of the gain accrued on the shares. It is not easy to find a purchaser for shares in a private company and especially if only a minority share is being sold. It is possible to have the company buy back its shares provided it has sufficient distributable reserves. However such a buy-back of shares will usually give rise to an income tax charge on the excess of the proceeds of sale of the shares over the sum originally subscribed to the company for them.
There is an exception where the buy-back is for the benefit of the trade of the company, in which case CGT will apply. But for that exception to be available, it is usually necessary for the shareholder to dispose of their entire shareholding and cease their connection with the company.

Where the company is involved in arrangements relating to the sale of the shares to a third party, for example where it indirectly provides financial assistance for that purpose, an income tax charge may arise also, rather than a CGT charge. Typically the income tax charge would be at the rate of 42p.c. on the excess of the proceeds over the sum originally subscribed for the shares, rather than the CGT rate of 20p.c. applied to the increase in values since the shares were acquired.

A dividend or a salary or fees will all attract income tax in the hands of an individual shareholder. In most cases income tax at 42p.c. will apply, and additionally PRSI will arise in both the company and in the hands of the individual.

There are legal restrictions on the ability to make a loan as noted above. But where a loan is made to a shareholder in a closely held company, a payment must be made to the Revenue equal to 25p.c. of the sum advanced. The Revenue will refund this when the loan is repaid. That is not the only tax consequence. In a closely held company the shareholder will typically be a director or connected with a director. In such a case an income tax charge will arises calculated on the shortfall between the interest (if any) charged on the loan and its statutorily determined rate (currently 11p.c.).

The broad scheme of tax legislation could be summarised as saying that where a shareholder is not disposing of all of his shareholding; or is not disposing of at least 25p.c. of his shareholding in a transaction not in any way assisted by the company, an extraction of cash from the company, or a realisation of the value of the company, is likely to involve income tax. The use by a shareholder of non-cash assets of the company eg a house, motor car, aircraft etc, will also attract income tax where the shareholder is a director or connected with a director, to the extent that a full market value is not paid for the use of the asset.

What is described above is what might be thought of as the broad thrust of legislation. Depending on the facts of a particular situation it can be possible to arrange matters so as to provide access to a company’s surplus cash without attracting the tax consequences outlined above. However it is not easy and not always possible in every case. Tax planning always involves a certain amount of risk of challenge by the Revenue.

Conclusion
The frustration felt by shareholders in family companies at their inability to obtain access to the surplus cash within companies which they own without attracting an income tax charge is one of the most frequent and difficult problems presented to tax advisers. There are solutions but they don’t suit everybody as they necessarily involve an element of risk that the tax liabilities may prove greater than hoped for.

The background to the problem is the substantial difference in tax rates on trading income between that applied to an individual (42p.c. typically) and that applied to a company (121⁄2p.c.). The advantage of the use of a company is obvious, and it is usually only after the company has been successful that the shareholder comes to appreciate the cost involved, in terms of being unable to get access to the money.

This dilemma is lessened in one situation only – development of residential land. In that case the rate applied to an individual is only 20p.c. and in consequence many developers of residential land choose to acquire and develop the land personally, and without the use of a company. But in all other areas of business life, the company is dominant and the corporate cash can be expensive to get hold of.

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