Beating the taxman

This case was all about the taxman trying to use one company in Sussex which it claimed owed it £42,000 in back taxes, in order to be able to collect and estimated £1 billion in “unpaid” tax from other small companies.

The circumstances were simple, the company is jointly owned by husband and wife, but the husband was the sole director and principal fee earner. Minimal salaries were paid and dividends used to pay the profits equally to both parties.

As a result, instead of the husband’s income attracting higher rate tax on a large chunk, much of the income was paid to the wife, who is not a higher rate taxpayer. HMRC wanted to tax her income as if it was his. Fortunately, the Law Lords disagreed; which caused thousands of small businesses to heave a sigh of relief.

However, there is every chance that having spent an estimated £1 million on legal costs, the taxman will be unwilling to let this go and we can expect to see legislation at an early stage to outlaw this method of remuneration for family businesses. Alistair Darling’s boss (and predecessor) is a past master at introducing stealth taxes and closing loopholes, and it is too much to hope that this government can leave small business – long the powerhouse of economic growth in the UK – alone.

There is, however, an underused way of protecting money against the taxman, which could well come into its own, should this option be closed down (possibly as early as the Pre Budget Report in December, if Darling cannot wait for his first Budget). This is the rather unattractively named “Salary Sacrifice”.

It works very simply. Salaries are subject to tax and National Insurance contributions. This affects both employers and employees because while employees only pay 1% NI contributions on earnings above £34,840 (as well as 11% up to this level, once the earnings threshold of £5,200 a year is exceeded), employers pay 12.8% on every penny above the earnings threshold.

However, pension contributions do not attract NI contributions for either party. So if the employee and employer agree to cut the salary, the employee saves up to 40% in income tax and anything from 1% to 11% in NI contributions. But the employer will also save 12.8% on the entire contribution, making it highly cost effective.

Of course, pensions are about future income, salaries are for today. But since it is now possible for a person over age 50 (rising to 55 in three years’ time) to draw pension benefits at the same time as working, this need not be a problem. Especially as it is possible to draw just the tax free cash and leave the balance of the money to roll up in a highly tax efficient environment. So a taxed income of £10,000 sacrificed by a higher rate taxpayer would save £4,100 for the employee, £1,280 for the employer, generate an immediate tax free lump sum of £2,500 and a residual pension fund worth £7,500 (ignoring charges in this case).

It is important to be aware, however, that the total benefits package must be justifiable. So paying a part time worker £6,000 a year and topping this up with a pension contribution of £100,000 is unlikely to get past the taxman.

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