Welcome to the spring edition of the Financial services and markets group bulletin.
Despite numerous newspaper headlines regarding the gloomy economic outlook, nearly half of the businesses that took part in our annual survey are predicting growth. Perhaps we are finally starting to see real signs of much needed confidence returning to the sector.
Our survey also highlighted that many are considering the possibility of changing their business structure. Ultimately, of course, the most suitable option for you will be distinct to your individual business' circumstances but we outline the main advantages and disadvantages of a limited company and a limited liability partnership.
Regulation and tax continue to be the main concerns for the industry. Tim Lyford explains how the reporting fund regime allows offshore funds to avoid the potential pitfall for their investors of gains being subject to high rates of income tax.
Finally, Laurence Bard, a member of the joint HMRC/taxpayer R&D Committee, explains how those in financial services could be able to take advantage of the generous tax relief on software development.
STRUCTURE – COMPANY OR LLP
By Colin Aylott
A summary of the main advantages and disadvantages of both structures
Each structure has advantages, the choice is ultimately driven by your objectives such as profitability, tax and future strategy
In our survey, nearly half of respondents said that they were considering changing their business structure. We therefore thought it would be helpful to set out a few advantages and disadvantages about two widely used structures for financial services businesses: a company and a limited liability partnership (LLP). The choice between the two structures depends on numerous factors such as commercial convenience, tax and future succession/exit.
Below is a summary of the main advantages and disadvantages of both structures:
As companies have distinct shareholders and employees, each may have different interests. These can be aligned by giving employees a share either as options or by using different categories of shares, with each category having varying rights. The share classes might, for example, prevent the owners giving up more of their value than they might wish, while still keeping management incentivised.
However, issuing shares in companies is complicated compared to using an LLP. For example, the Articles of Association may need to be amended as well as possible tax/NIC costs. A shareholders' agreement may be also be required. With an LLP, there are fewer formalities to bringing in new members. In order to maintain a similar distinction, LLPs have the option to issue income and full capital shares; with new members enjoying just a share of the profits. Company share options can, in some cases, be replicated in an LLP. With both entities, incentive arrangements need to be structured correctly in order to avoid future problems.
From a taxation perspective, there are several considerations; a key one is whether you need to draw all income earned. If you are interested in rolling up retained profits, thus building value, then a company may be the best choice as, from 1 April 2012, you are taxed on profits at an average rate of between 20% and 25%. If you want to draw all or most of the income from the business then an LLP may be better as there is likely to be less taxation overall, even with an effective rate of tax/NIC of 52%. The key point is that LLP profits allocated to individuals are taxed at high personal tax rates, even if the profits are not drawn down. One solution might be to have an LLP with a corporate member. The rationale is that you can take what income is needed from the LLP and roll up the remaining profits in the corporate entity.
From an individual perspective, directors and employees of a company must pay PAYE and national insurance each month on their salaries. For those individuals who are also shareholders, it is often possible to reduce tax costs by extracting profits as dividends, though these are non-deductible to the company. A member of an LLP does not suffer PAYE but income tax will be due in January and July each year. The LLP should have lower NIC costs overall compared to a company.
Each structure has advantages, some of which are covered in this article. The choice is ultimately driven by your objectives such as profitability, tax and future strategy but we can assist you in making the right choice for your situation.
OUR SURVEY SAYS - A SUMMARY OF OUR 14TH ANNUAL FSMG SURVEY
By Colin Aylott
46% of businesses predict growth despite gloom about the overall economic outlook and concern over regulation and tax.
Firms in the financial services sector are generally confident about the state of their business and about growth prospects, both in terms of turnover and recruitment.
According to our 14th annual financial services and markets group (FSMG) survey 2011/12, nearly 50% of respondents expect recruitment in the next 12 months to increase or strongly increase. This is up by 6% on the previous year. "The belief that companies will grow shows they are resilient and have confidence in their own ability," says Colin Aylott, corporate tax director. Further, in 2011/12, 52% of businesses said their turnover had actually increased over the last 12 months, compared to 44% in the previous year.
Those surveyed are considering important changes to their business, with nearly half the respondents (45%) considering changing their business structure and 29% stating they would consider merging with another business over the coming year. A further 60% of respondents are looking to expand the range of their products and/or services. "These are significant numbers and are reflective of the dynamic nature of the sector and its ability to respond to threats," says Colin. "The financial sector is innovative and fast moving," he adds, "businesses are therefore capable of making and implementing decisions quickly."
There is a marked change in the foreign financial centre perceived as the biggest threat to the City of London. Last year it was resoundingly New York, with 41% of respondents citing it as the biggest threat. However, this is now seen as the Far East, evenly split between Singapore (21%) and Hong Kong (19%). "These markets are also areas financial sector businesses are looking to expand into to take advantage of Asian markets," explains Colin.
What is happening in the US that is affecting how New York is perceived and so making people more wary of the Far East? "It is difficult to pinpoint one specific reason but probably a combination of factors, many perceived as attacks by authorities on the sector. The proposed introduction of the Dodd-Frank law, the Foreign Account Tax Compliant Act (FATCA) rules, coupled with existing Sarbanes Oxley complexities and general hostility to the financial sector on the streets of New York with ongoing street protests and business occupations, are having a significant impact," Colin comments.
He adds: "Compliance with the myriad of rules and regulations will be a complex and costly process for many financial institutions both ahead of the new rules and after their introduction, even though, for example, some of the FATCA changes are not due to come into force until 2017. The legacy of all this new legislation will be felt for many years."
The UK is far from immune to these issues. In our survey, the biggest perceived threats to UK financial sector businesses, and the two subjects painted most negatively, are tax and regulation.
- 76% of businesses expect spending to be increased or strongly increased on regulatory compliance.
- 61% feel tax authorities are placing individuals under greater scrutiny than a year or two ago, with a feeling that tax authorities are going after everyone – from plumbers to RBS employees.
- 54% believe tax authorities are planning to place businesses under more scrutiny with the financial sector, and its employees, under the greatest scrutiny.
Colin comments, "While there is pressure on the Government to act in connection with perceived financial sector excess, it needs to be very careful to ensure it doesn't drive businesses away with negative comment or excess regulation/HMRC scrutiny. The Far East is clearly trying to attract good entrepreneurial business with their low tax and lower regulation regimes and the Government needs to take this into account."
One tax that was almost wholly regarded as bad news by respondents, unsurprisingly, was the much mooted financial transactions tax. 94% of businesses thought it would be bad or very bad for London as a financial sector. One respondent pointed out that the UK already has a transaction tax, namely, stamp duty. Colin agrees, stating that, "The Government needs to firmly shut the door on this unpopular and potentially damaging tax. The resulting uncertainty is not helping financial sector businesses at all."
There is a clear view on deterioration of the economy, a view borne out by Moody's comments on 14 February 2012 about possibly downgrading the UK's credit rating. This is a clear change from 2010, when 81% of respondents felt at that time that the economic recovery was stable or had improved. In the latest results, 71% of respondents have little confidence about the broader economy, and believe it is likely to restrict the growth of their business over the next 12 months.
REPORTING FUNDS REGIME -INCREASING THE RETURN ON OFFSHORE INVESTMENTS
By Tim Lyford
The reporting fund regime allows UK investors to obtain capital gains tax treatment when disposing of investments in offshore funds.
For top rate income tax payers, this can lead to a reduction in tax rates on disposals from 50% to 28%. This preferential tax treatment may improve the marketability of offshore investments to UK investors.
UK offshore fund rules
UK offshore fund rules are designed to prevent UK investors avoiding income tax by accumulating income tax-free offshore. Without these rules, investors would pay tax at the more favourable CGT rates when the income is realised on disposal of their investment.
When do they apply?
The rules will typically apply to non-UK open-ended arrangements or collective investment vehicles that allow investors to redeem their interest by reference to NAV.
Benefits of reporting fund status
Gains made by individuals on disposal of investments in offshore funds that have reporting fund status are subject to CGT rather than income tax.
For those that pay tax at the top rate, this can mean a headline tax rate on disposal of 28% (or 0% if covered by the CGT annual exemption) rather than 50%, significantly improving an investor's overall return. It was announced in the March 2012 Budget that the top rate of income tax will fall to 45% (30.6% for dividend income) from 6 April 2013. The table below shows the comparison for a top rate taxpayer making a disposal prior to 6 April 2013.
In exchange for providing the preferential CGT treatment on disposal, HMRC requires that investors pay income tax annually on their share of the income earned by the fund, whether or not physically paid out by the fund. This means both distributing and accumulation funds may apply for reporting fund status.
Applying for reporting fund status
An application for reporting fund status is made by the fund itself.
Having made an initial application to join the regime, the fund is required to make annual filings with HMRC. This annual filing principally comprises a calculation of the income earned by the fund during the period, calculated in accordance with relevant tax legislation.
The results of this calculation must also be made available to UK investors, in a format prescribed by HMRC. UK investors then use this information when preparing their personal tax returns.
ARE YOU CLAIMING R&D TAX RELIEF ON SOFTWARE DEVELOPMENT?
By Laurence Bard
Many companies continue to miss out on the very generous tax reliefs given for R&D expenditure, particularly those developing software for use in their financial services activities.
Software is specifically recognised as a technology; its development is often difficult and uncertain, and the resolution of technological uncertainty is just what R&D relief is about. If your staff are competent professionals working in the field, and they consider their development assignments to be uncertain as to whether or how results can be achieved, then HMRC is almost bound to accept the principle of a claim. Nor does it matter if competitors have already found a solution – as long as they have not made their discoveries public.
We have considerable experience of financial services companies making successful claims in such fields as:
- securities trading
- asset management
- internet security
- interaction between systems (this is accepted as a possible technological uncertainty even where individual systems themselves have been fully developed)
- building functionality for clients' own adaptation
- migration to the internet.
What are the benefits?
A small or medium sized enterprise (SME) (with up to 500 employees) currently obtains a tax deduction of 200% (soon to be 225%) of qualifying R&D cost. So a taxpaying SME may derive a 34% cash benefit from categorising cost as qualifying R&D. A loss making SME may be able to claim a payment of 25% of cost, even where no corporation tax has ever been paid, and for some current periods, where no PAYE nor NIC has been paid. Larger companies may obtain a tax deduction on 130% of cost.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.