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Corporation Tax: Associated Companies

A COMPANY generally pays Corporation Tax at the ‘small profits rate’ on its first £300,000 of profits each year. Formerly known as the ‘small companies rate’, the small profits rate is currently 21%, but will reduce to just 20% from 1st April 2011.

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For profits in excess of £300,000, a company currently pays Corporation Tax at an effective marginal rate, which is currently 29.75%, until its profits reach £1,500,000. Thereafter, the company pays Corporation Tax at the main rate, currently 28%.

The marginal rate and main rate are both being reduced over the next few years and will ultimately fall to just 25% and 24% respectively from April 2014, but the basic structure of the Corporation Tax system, with three rate bands, will remain.

Associated Companies
Not every company is able to pay Corporation Tax at the small profits rate on its first £300,000 of profit. The £300,000 and £1,500,000 thresholds must be shared equally with any ‘associated’ companies.

The basic rule is that a company is associated with another company if they are both under the control of the same person or persons. In the simplest case this means that, if you own two companies, each of them will have a small profits rate band of just £150,000 and will pay Corporation Tax at the main rate on profits over £750,000. If you owned three companies, each would have a small profits rate band of just £100,000; four would each have a small profits rate band of £75,000; and so on.

In practice, this means that forming extra companies without good reason is generally a bad idea!

Alan has a successful business recruiting apprentices for other local businesses. He runs his own business through a company and makes an annual profit of around £300,000.

In April 2011, Alan opens two new branches and decides to put each of them into a separate company (giving him three companies in total).

In the year to March 2012, Alan’s original company makes its usual profit of £300,000 and his two new companies both break even.

The original company’s Corporation Tax bill for the year is:

£100,000 x 20% =                  £20,000
£200,000 x 28.75% =             £57,500
Total                                        £77,500

If Alan had simply kept all three branches in the same company, his Corporation Tax bill would have been just £60,000. Forming the new companies has therefore cost him an extra £17,500.

There are often good commercial reasons for forming separate companies for different parts of a business, but this example clearly demonstrates that it is generally not something you should do on a whim!

Which Companies Must You Count?
It is important to note that foreign companies must be taken into account in applying the associated companies rules.

Dormant companies may, however, be ignored and this includes companies with ‘passive’ investments, such as cash on deposit, or properties which are never rented out.

Associated People
As well as other companies that you control yourself, the law currently also requires you to take account of companies controlled by your ‘associates’, including your:

On the face of it, this could mean that when your brother in Australia forms a company that you don’t even know about, it could cost you up to £13,125 a year in extra Corporation Tax!

Don’t Panic
Fortunately, it has long been recognised that this would be a plainly absurd result and HM Revenue and Customs operates a concession by which any companies controlled by relatives other than your spouse, civil partner or minor children are not counted as associated companies unless there is ‘substantial commercial interdependence’ between their companies and yours.

‘Substantial commercial interdependence’ would include cases where companies have a significant level of trading between them; other significant transactions, such as renting property to each other; shared facilities like office premises, transport or storage; or a shared brand.

So your brother’s Australian company which you don’t even know about can be ignored, but a company owned by your sister, which you set up to run part of your business through, would need to be counted.

In fact, it is difficult to find someone you could trust enough to control a company which has a significant commercial relationship with your own company without invoking the associated companies rules. With one major exception: an unmarried partner.

Unmarried, or common law, partners have no legal status in tax law (apart from tax credits). This has many potential disadvantages, but one of the few advantages it has is that you can each set up your own company and benefit from a small profits rate band of £300,000.

Rachel owns a small chain of fashion shops in Southern England through her company, BetterthanAnge Ltd. The company is already making an annual profit of £300,000 and Rachel wants to expand the business into the North.

Rachel’s unmarried partner, Ross, forms BTA (North) Ltd to run the Northern operation and, within a couple of years, this is also making an annual profit of £300,000.

As Rachel and Ross are not married, they are not associated persons for tax purposes. This, in turn, means that BetterthanAnge Ltd and BTA (North) Ltd are not associated companies and each of them will pay Corporation Tax at just 20% on its profits.

The same tax result can be achieved when one member of the unmarried couple owns 51% of one company and the other member of the couple owns 51% of the other company (with the remaining 49% held by the other unmarried partner in each case). In this way, an unmarried couple can benefit from a Corporation Tax rate of just 20% on total profits of up to £600,000.

One word of warning though: if the couple were also business partners, the associated companies rules could apply. In 2008, the concessionary relaxation applied to companies controlled by relatives was extended, by law, to companies controlled by business partners, but only where there is no tax planning motive present. A couple like Rachel and Ross who also had a business partnership would therefore be caught by the associated companies rules.

The Current Situation
At present then, the situation is that, in theory, the associated companies rules are very wide ranging but, in practice, the only companies under the control of other individuals which are actually caught are:

i) Companies set up by relatives and business partners for tax planning purposes (in a deliberate, but doomed, attempt to make use of an additional small profits rate band), and
ii) Any companies controlled by spouses, civil partners and minor children

It is difficult to see how a company can be controlled by a minor child and, even if it could, it seems likely that there would be a tax planning motive present.

Hence, the only ‘innocent’ cases where companies controlled by different individuals and running genuinely unconnected businesses must be treated as associated companies are companies controlled by spouses or civil partners. With a potential additional Corporation Tax cost of up to £26,250 a year (£13,125 in each spouse’s company), this is enough to stop some people from getting married!

Light Ahead
Fortunately, there is now some light at the end of the tunnel for those ‘innocent’ cases: in fact many of them may even be out of the tunnel already.

The Government is now proposing to change the law so that companies controlled by any other individual (or group of individuals) will only need to be counted as associated companies where there is ‘substantial commercial interdependence’ between the companies. This change is to apply for any company accounting periods ending after 31st March 2011: so many companies will already be in the clear.

There are still some pitfalls to watch out for though.

For a start, if any couple like Rachel and Ross get married, or enter a civil partnership, their companies will become associated due to their ‘substantial commercial interdependence’.

Secondly, if you form two or more companies with the same shareholdings then these will continue to be associated.

Monica runs a chain of restaurants through her company, CleanFreak Ltd. Some years ago, she transferred 50% of the shares in CleanFreak Ltd to her husband Chandler.

Chandler has his own business, an advertising agency, which he runs through his company, BingHonest Ltd. He also transferred 50% of his company shares to Monica some years ago.

The two businesses are completely unconnected from a commercial perspective but CleanFreak Ltd and BingHonest Ltd are associated companies, even under the new rules, because they are under the control of the same persons.

What Monica and Chandler need to do to take advantage of the new rules is to make some share transfers so that each company is controlled by a different person. If Chandler transfers 1% or more of the shares in CleanFreak Ltd to Monica then she will control that company. Similarly, if Monica transfers 1% or more of the shares in BingHonest Ltd to Chandler then he will control that company. In this way, when the new rules come into effect, the companies will no longer be associated (although they will remain associated until the end of the accounting period in which the share transfers take place).

The Final Hurdle
The next pitfall to watch out for is the risk of accidentally creating ‘substantial commercial interdependence’.

Suppose that Monica and Chandler carry out the share transfers and then, a couple of years later, Monica decides to launch a big advertising campaign for her restaurants. Who does she go to: BingHonest Ltd, of course!

The question then is whether the advertising contract between the companies is significant enough to create ‘substantial commercial interdependence’. This is a tricky question to answer because this point has not yet been dealt with in practice. However, a good rule of thumb would probably be that ‘substantial commercial interdependence’ would arise if the CleanFreak Ltd contract represented 20% or more of BingHonest Ltd’s business.

To be on the safe side, however, Monica could instead appoint Chandler to do the work personally, outside his company.

Alternatively, she could go to another advertising agency, although I would suggest that she explains her reasons to Chandler first: saving a marriage is usually more important than saving tax!

Other Associated Businesses
The associated companies rules only apply to companies: sole traders and partnerships do not need to be counted.

Hence, if you wish to start up a second business without affecting your company’s Corporation Tax bill, you could set up as a sole trader or partnership.

Naturally, there are a great many other issues to consider so, in some cases, you may still want to form that second company, despite the additional tax cost.

But, if limited liability is your only concern, you could form a Limited Liability Partnership and get the necessary protection without paying any extra tax in your original company.