Chapter 10Close Companies
The aim of this chapter is to teach you what a close company is, why the close company legislation was introduced and the numerous disadvantages of being classified as a close company.
On completion of this chapter, you will be able to:
Personal Taxes Manual
■ Chapter 32 Anti-Avoidance
MAIN LEGISLATIVE PROVISIONS
Corporation Tax, Finance Act 2010, Irish Tax Institute
■ Chapter 8 Close companies
Revenue Tax Briefing
■ Tax Briefing 48: Professional Service Company Surcharge
RELEVANT PAST EXAM QUESTIONS
■ 2015, Summer, Question 3
■ 2015, Autumn, Question 1 (ii)
■ 2015, Autumn, Question 3(a)
■ 2016, Summer, Question 3(a)(b)
■ 2016, Summer, Question 5(b)
■ 2016, Autumn, Question 4(a)
■ 2017, Summer, Question 3(a – c)
■ 2017, Autumn, Question 4(a)
■ 2017, Autumn, Question 5
■ 2018, Summer, Question 1(ii)
■ 2018, Summer, Question 4(a)
10.1.Explain the reason behind close company rules
The close company provisions are comprehensive anti-avoidance provisions with the aim of preventing participators (as defined) from extracting funds from a close company (as defined) in a way that avoids or reduces potential tax liabilities.
Without close company legislation, the following could happen:
Mr. A earned €100,000 income in 2018 – he paid tax on this of €40,000 (ignoring the USC and PRSI) and received cash of €60,000.
If Mr A had
1. Set up A Ltd in 2018
2. A Ltd earned the income and paid €12,500 in tax
3. Mr. A took an interest free loan from A Ltd out of the after-tax trade income and received €87,500 (€100,000 less tax at 12.5%).
4. Mr A would have received €27,500 more in cash through A Ltd than as a sole-trader.
This example ignores the potential company law implications of loans to directors (see below) and also the BIK implications of an interest free loan.
It was the above type of scenario that the close company legislation sought to prevent.
Now that the gap between income tax (40% income tax, plus PRSI, and the USC) and corporation tax (12.5% or 25%) is wider than it ever has been, a greater focus can be expected on the anti-avoidance aspects of the legislation.
10.1.1.Company law restrictions on transactions between a company and its directors
Before we explore the tax implications of close company status in more detail, throughout the remaining sections of this chapter, it is important that you remind yourself of the company law restrictions on transactions between a company and its directors which are dealt with in detail in the Law manual.
These company law restrictions apply regardless of the provisions outlined in this chapter and any breach of the company law restrictions is of course illegal and may carry criminal and/or civil penalties for the company directors involved.
The company law restrictions should always be in the back of your mind when considering the relationship between a company and its directors.
10.2.Outline the meaning of terms specifically related to the close company rules
10.2.1.Close company (Section 430(1) TCA 1997)
A close company (subject to certain exceptions outlined below) is an Irish resident company, which is controlled by:
a) five or fewer participators or
b) participators who are directors, without any limitation on the number.
The legislation provides that the rights of associates of participators be added to the participators’ own rights when determining whether ‘control’ exists i.e. a participator and his associate are treated as one (see the below section on “control”).
Before dealing with the exceptions, we will analyse some of the new terms included in the above definition of a close company.
10.2.2.Participator (Section 433(1) TCA 1997)
A participator is any person having an interest in the capital or income of a company. The term includes (i.e. not exhaustive):
a) a shareholder (the most common example you will come across)
b) any person who possesses or is entitled to acquire share capital or voting rights in the company i.e. an option holder
c) any loan creditor of a company (defined below)
d) any person entitled to receive or participate in distributions from the company or any amounts payable by the company to loan creditors by way of premium on redemption
e) any person who can secure income or assets (whether present or future) of the company which will be applied either directly or indirectly for his benefit i.e. position of power.
10.2.3.Associate of participator (Section 433(3) TCA 1997)
An associate means, in relation to a participator:
a) any relative or business partner of the participator.
b) the trustees of any settlement of which a participator or any relative of his (living or dead) is the settlor
c) where the participator is interested in shares of the company which are subject to any trust or are part of the estate of a deceased person, an associate would be any other person interested therein e.g. trustees, executors and beneficiaries. In this definition trusts for employees, directors and their dependants and approved pension funds are specifically excluded.
For the purposes of the definition of associate, relative means husband, wife, civil partner, ancestor, lineal descendent, brother or sister (Section 433(3)(a) TCA 1997). Therefore all ‘in laws’ are excluded, as are nieces and nephews. Note – this definition of relative is different to that used to determine “connected persons” in Section 10 TCA 1997 and has a very narrow application.
Compare and contrast the meaning of “relative” in Section 433(3)(a) and Section 10 TCA 1997.
As noted above, the interests of a participator and their associates are aggregated and treated as one participator in determining whether the company is under the control of five or fewer participators. For the purposes of determining the aggregate, an associate of an associate cannot be linked to a participator e.g. a man’s wife’s sister’s shareholding cannot be added to his shareholding if he is taken as the participator. However, if the wife is treated as the participator then the shareholdings of her husband and her sister would be added to her shareholding as her husband and her sister are each associates of the wife in their own right.
10.2.4.Director (Section 433(4) TCA 1997)
This term includes:
a) any person occupying the position of directors by whatever name called
b) any person in accordance with whose directions or instructions the directors are accustomed to act (e.g. shadow directors)
c) any person who is a manager of the company and is either on his own or with one or more associates the beneficial owner of or able to control (directly or indirectly) 20% or more of the ordinary share capital of the company.
Remember that the definition of a close company specifically refers to directors, in that once a company is controlled by directors (regardless of number) it is a close company.
10.2.5.Loan creditor (Section 433(6) TCA 1997)
The term means a creditor in respect of any debt incurred by the company:
a) for any money borrowed or capital assets acquired by the company or
b) for any right to receive income created in favour of the company
c) for consideration the value of which to the company (at the time the debt was incurred) was substantially less than the debt.
The term also includes any redeemable loan capital issued by the company.
Ordinary trade creditors are not considered to be loan creditors. Also, a bank will not be regarded as a loan creditor in respect of any money lent by it to the company in the ordinary course of its (i.e. the bank’s) business.
10.2.6.Associated company (Section 432(1)> TCA 1997)
A company is to be treated as another’s associated company at any given time if, at that time or any time within the previous year, one of the two has control of the other or both are under the control of the same person or persons. Remember – “person” includes companies and individuals.
10.2.7.Control (Section 432(2) TCA 1997)
Hopefully you have noticed an important recurring term in most of the above definitions – control.
The term “control” in Section 432(2) is very broadly defined – it can be direct or indirect, actual or contingent. While this section relates primarily to the interpretation of the close company rules, other provisions within the Taxes Act import this definition of control. For example, you will recall from Chapter 2 that Section 247 TCA 1997 uses the meaning of control within this section to determine whether an investing company has a material interest in an investee company. Section 10 TCA 1997 also uses the definition of control in Section 432 TCA 1997. Other provisions may include their own definitions of control or use the general meaning of control set out in Section 11 TCA 1997 (e.g. Section 130(5)(b) TCA 1997 uses the definition of control in Section 11 TCA 1997).
Under Section 432(2) TCA 1997, a person (individual or company) is regarded as having control of a company if that person exercises, is able to exercise or is entitled to acquire control, whether direct or indirect, over the company’s affairs and in particular if that person possesses or is entitled to acquire the greater part of:
(a) the share capital; or
(b) voting power of the company; or
(c) the income of the company on a full distribution among participators (ignoring the rights of loan creditors); or
(d) the assets of the company on a full distribution to shareholders in the event of a winding up.
The following additional points should be noted in assessing control:
(i) Where two or more persons together satisfy any of the above conditions they will be regarded as having control of the company.
(ii) The rights and powers of nominees of a person are to be taken into account in determining whether a person has control of a company
(iii) There will be attributed to any person the rights and powers of any company or companies which he/she alone or with his/her associates controls and also the rights and powers of his/her associates. Note that it is not necessary to attribute the rights and powers of an associate to that person
(iv) Rights which a person is entitled to acquire at a future date or will at a future date be entitled to acquire must be included.
10.3.Outline which companies are specifically excluded from being close companies
Certain companies are specifically excluded from close company status:
1) Companies not resident in Ireland (Section 430(1)(a) TCA 1997).
3) Building societies and life assurance companies (Section 430(1)(c) TCA 1997).
4) Companies controlled by or on behalf of the State which would not be close if the State’s interest were ignored i.e. must include interest of State in ‘control’ assessment. This also includes companies controlled by EU Member States or states with which Ireland has a double tax agreement (Section 430(1)(d) and (da) TCA 1997).
5) Any public/quoted companies which satisfy certain conditions outlined in next section (Section 430(1)(e) TCA 1997).
6) Companies controlled by one or more other companies which are ‘open companies’ (not close companies) provided they cannot be treated as ‘close’ except by including as one of the ‘five’ or fewer participators’ a company which is not close (Section 430(4) TCA 1997). In determining whether a company is controlled by companies which are not close companies, a non-resident company which holds shares in the company in question is deemed to be a close company for the purpose of this analysis if it would be a close company if it were Irish resident (Section 430(5) TCA 1997).
7) Companies which would not be regarded as close except by including non close loan creditors as one of the ‘five or fewer participators’ entitled to the greater part of the assets for distribution on a notional winding up and accordingly are regarded as controlling the company (Section 430(4)(b) TCA 1997).
10.3.1.Public companies (Section 431 TCA 1997)
Quoted companies which satisfy a number of conditions are not to be regarded as close even if they are under the control of five or fewer participators or of participators who are directors regardless of the number.
To qualify for this exception the following three conditions must be satisfied:
a) at least 35% of the voting power in the company is owned unconditionally by the “public” (Section 431(3) TCA 1997) and
b) these shares giving the voting power are listed on a recognised stock exchange and there have been dealings in these shares within the preceding twelve months (Section 431(3) TCA 1997) and
c) the “principal members” of the company do not possess over 85% of the total voting power (Section 431(4) TCA 1997).
10.3.2.Public (Section 431(6) and 431(7) TCA 1997)
Under Section 431(7), the shares will not be treated as beneficially held by the “public” if they are held by:
a) any director of the company or his/her associates
b) any company which is controlled by such a director(s) and their associates
c) any associated company
d) principal members (with the exception of open companies and approved pension or superannuation funds which are not for the benefit of past or present employees or directors).
Shares held by nominees for a person will be treated as held by that person in determining whether they fall into any of the above exclusions (Section 431(7)(b) TCA 1997 which applies Section 432(5) TCA 1997 – note the limited application of Section 431(7)(b) TCA 1997).
Under Section 431(6) TCA 1997, shares are deemed to be beneficially held by the public if:
a) they are held by a resident company which is an open company
b) they are held by a non-resident company which if resident would be an open company
c) they are held by an approved superannuation fund which is not for the benefit of past or present employees or directors of the company
d) they are not part of a principal member’s holding (except those noted in the d exceptions above)
10.3.3.Principal member (Section 431(2) TCA 1997)
If the principal members of a company hold greater than 85% of the total voting power then the quoted company is not exempt from close company status.
A person is a principal member of a company if he possesses more than 5% of the voting power and is one of the top five such persons (with associates and nominees rights included) who hold the greatest percentage of the voting power.
If two or more persons tie for fifth place, they all qualify as principal members. If less than five participators each hold more than 5% of the votes then there are less than 5 principal members.
Figure 10.1. Determine whether close company qualifies for public company exemption
10.4.Judge whether a company is a close company or not
Figure 10.2. Determine whether a company is a close company
The following chart is useful in determining whether or not a company is a close company.
A Ltd has an issued share capital of €100,000 held as follows:
Mrs. Apple and the trustees of the settlement made by Mr. Apple are associates (as a relative of Mrs Apple was the settlor of the trust). Therefore, the rights and powers of the trustees are attributed to Mrs. Apple. The company is regarded as close as Mrs. Apple controls 51% of issued share capital.
B. Ltd is an unquoted company and has an issued share capital of 50,000 €1 ordinary shares and 100,000 in €1 preference shares. The preference shares are non-participating and non-voting. None of the directors are participators in the company.
The capital is held as follows:
1. Only 34% of the voting power is controlled by five or fewer participators, therefore not close company using this test.
2. However, more than half of the total issued share capital (ordinary and preference) is held by five or fewer participators, i.e. 75,800 out of 150,000, therefore the company is close.
C Ltd. has an issued share capital of 100,000 held by the following Directors:
Is C Ltd a close company? Would your answer be different if F is a manager of the company, not a director?
(i) The company is not under the control of five or fewer participators. However, it is under the control of its directors and is therefore a close company irrespective of the number of directors.
(ii) The company is not under the control of five or fewer participators (because F does not hold 20% or more of the ordinary share capital he does not rank as a director). The company’s directors then hold 48% of the issued share capital which means that it is not director controlled and is therefore an “open” company.
D Ltd. has an issued share capital held as follows:
D Ltd is a close company as A is deemed to control 51% of the company.
A’s own interests are aggregated with those of his associates i.e.
A, B, C, D, E, G, Fab Ltd and H
Note that F who is A’s niece is not an associate as she is not within the scope of the definition of relative.
E Plc, a quoted company trading on the ISEQ has the following issued share capital held:
To determine whether E plc is a close company the approach below is adopted:
1. Is E plc under the control of five or fewer participators or any number of participators who are directors? C is deemed to be a director as he is a manager holding in excess of 20% of issued share capital. Therefore, as the directors B, C & D hold 60% of the share capital the answer is Yes.
2. Do the principal members hold more than 85% of voting power? Only 4 ‘persons’ hold over 5% of voting power each. Together these four principal members hold exactly 85% so the answer to this question is (Note that when considering the ‘85% test’ all principal members are included i.e. there is no exception for open companies or approved pension funds.) No.
3. Does the public hold at least 35% of the voting power? The public comprises A Ltd and the unconnected shareholders who together hold 36% of the voting capital so the answer to this question is Yes.
4. Does E plc trade on a recognised Stock Exchange? Yes – ISEQ
5. Have there been share transactions in the last 12 months? We need to find out to determine whether E Plc satisfies the conditions necessary for exemption from close company status.
It should be clear to you by now that almost all domestic Irish companies are close companies for tax purposes.
The purpose of all the anti-avoidance rules you will study in this chapter is to make it difficult if not impossible for family held companies to enter into artificial arrangements designed to achieve “non-close” status.
Alpha Ltd has an issued share capital of €150,000 made up as follows:
Is this company within the definition of a close company?
Companies Delta and Gamma are quoted on the Irish Stock Exchange and their shares have been dealt with in the preceding twelve months. The shares are held as follows:
Are these quoted companies close companies?
Summary of the disadvantages of close company status
There are a number of disadvantages, for both the company and its shareholders, which arise from a company being regarded as a close company.
The ‘Close Company’ legislation is found in Part 13 of the Taxes Consolidated Act 1997. It consists of a number of penal anti-avoidance measures that have the potential to impact on almost all Irish companies. It is essential that you become intimately familiar with these provisions.
The main disadvantages are considered in detail in the following parts of this section and can be summarised as follows:
1. Certain benefits in kind and expense payments to participators and their associates are treated as distributions (Section 436 TCA 1997);
2. Interest paid to certain directors or their associates in excess of a prescribed limit is treated as a distribution (Section 437 TCA 1997);
3. Loans to participators or their associates must be “grossed up” and income tax paid (Section 438 TCA 1997);
4. Loans to participators or their associates which are subsequently written off or forgiven will be treated as income in the recipient’s hands i.e. assessable to income tax (Section 439 TCA 1997);
5. A surcharge of 20% is levied on the undistributed after tax investment and rental income of trade companies and an additional surcharge of 15% is levied on 50% of the after tax professional income of a ‘service company’ (Section 440 and Section 441 TCA 1997 respectively).
Students should remember that these are in addition to the normal rules which apply to items to be treated as distributions as discussed in Chapter 8, such as transfers of assets or liabilities at undervalue are treated as a distribution (Section 130(3)(a) TCA 1997) as well as resulting in negative capital gains implications (Section 547 & Section 589 TCA 1997);
10.5.Detail the issues surrounding the provision of benefits to participators and associates
Any expenses incurred by a close company in providing benefits or facilities for such things as living accommodation, entertainment, domestic and other services of any kind for a participator or an associate of a participator will be treated as a distribution made by the company (Section 436(3) TCA 1997).
Specific provisions counter two or more close companies from arranging to make payments to one another’s participators. The expense payments are deemed to be made by the respective close companies to their own participators (Section 436(7) TCA 1997).
The following expense payments are not treated as distributions:
1. Any expense made good i.e. reimbursed to the company by the participator (Section 436(3)(a) TCA 1997)
2. Any expense incurred in providing benefits or facilities to directors or employees which are already assessable as benefits in kind under Schedule E (Section 118 and Section 436(3)(b) TCA 1997)
3. Any expense incurred in connection with the provision for the spouse, children or dependent of any director or employee of any pension, annuity, lump sum or gratuity to be given on his death or retirement (Section 436(3)(b) TCA 1997).
Amount of the distribution
The amount of the distribution is determined in accordance with Section 436(3) TCA 1997 as an amount equal to so much of the expense as is not made good to the company.
Dividend withholding tax on the amount of the distribution will be determined in accordance with Section 172B(3) TCA 1997 on the basis that the distribution would be regarded as a non-cash distribution. Please refer to Chapter 6 for details on how non-cash distributions are treated.
Effect on taxable income of company and recipient
The amount of the distribution determined in accordance with Section 436(3) TCA 1997 (i.e. the expense not reimbursed by the participator to the company) is a distribution and therefore not an allowable deduction in the computation of the Case I tax adjusted profits of the company.
Where the recipient is an Irish resident individual, the distribution is treated as income received under Schedule F. The individual is liable to income tax on the total distribution (i.e. the expense amount not reimbursed and the DWT on the grossed up amount if DWT on the net amount is not paid over to the company) at his/her marginal rate of income tax (plus PRSI and USC). He/she may claim a credit for the DWT incurred against his/her own income tax liability.
Where the recipient is an Irish resident company, the distribution is treated as Franked Investment Income and is exempt from corporation tax but may be subject to the Close Company Surcharge (see section 10.10 below).
For foreign resident companies and individuals receiving the dividend certain exemptions from dividend withholding tax may apply as outlined in Chapter 8.
Generous Ltd incurred an expense of €1,500 in providing a luxurious Caribbean cruise for an Irish resident individual shareholder who is neither an employee nor a director in March 2018. The shareholder is a participator in Generous Ltd. which is a close company.
Accounts are prepared to 31.12.18.
A) Corporation Tax
1. The expense of €1,500 is disallowed and is added back in the adjusted Case I profit computation as it is treated as a distribution.
2. The company is deemed to have made a distribution and must account for dividend withholding tax. Assuming that the shareholder will not reimburse the company for the DWT liability, the expense must be grossed up to €1,875 (€1,500/80) to calculate the amount of the relevant distribution for DWT purposes.
DWT of €1,875 × 20% = €375 is payable. If the company records the DWT expense “above the line” in operating profit in its financial statements, the DWT amount must also be added back in calculating the Case I tax adjusted profits of the company.
3. The net effect of 1. & 2. above is that the company has paid €1,500 for the holiday and also €375 withholding tax. The grossing-up effectively assumes that the recipient will not pay over the DWT to the company, and has effectively treated that unrecovered DWT as part of the distribution; that is:
The original DWT in respect of the distribution would have been €300 (i.e. €1,500 × 20%). Assuming this DWT was not repaid, it would be regarded as an additional distribution giving rise to additional DWT of €60 (€300 × 20%). This unpaid additional DWT would be regarded as an additional distribution resulting in additional DWT of €12 (i.e. €60 × 20%). Reiterating this gives rise to further additional DWT of €2.40 (i.e. €12 × 20%), €0.48 (i.e. €2.40 × 20%), etc. The total of all these DWT liabilities (including the additional DWT liabilities arising on the unpaid DWT liabilities being treated as distributions) is €374.88 which is approximately equal to the €375 DWT liability determined by grossing-up.
If the participator/recipient had repaid the initial DWT in respect of the benefit, it would not be necessary to gross-up as the total benefit that would have been received would be the value of the benefit less the DWT repaid (i.e. in the example above, if the shareholder repaid the initial DWT of €300 (i.e. €1,500 × 20%) the net benefit received would have been €1,200 and the individual would not have received the benefit of the unrecovered DWT).
In effect, it would leave the individual in the exact same position as if the company had simply made a cash distribution of €1,200 after applying DWT of €300.
For the purposes of your exam, unless stated otherwise, where a non-cash distribution is made (including distributions in specie) you should assume that the initial DWT liability is not repaid such that gross-up provisions apply.
B) Income Tax
The shareholder is not assessed under Schedule E as he is not an employee or director but is treated as having received a distribution liable under Schedule F. The assessable amount is €1,875 with a credit for the related DWT of €375.
If the shareholder pays income tax at the marginal rate, then the income tax computation would be (ignoring the impact of PRSI and the USC):
The company is entitled to demand repayment from the shareholder of the tax credit but will rarely do so in practice.
If the shareholder repaid the initial DWT to the company, assuming the shareholder pays income tax at the marginal rate, the income tax computation would be (ignoring the impact of PRSI and the USC):
i.e. by repaying the initial DWT, the shareholder would reduce his income tax liability by €75 (i.e. €375 – €300) but increase the overall cost of the dividend (i.e. total cost of €600 (DWT of €300 and income tax of €300) compared with a total cost of €375 (i.e. the income tax) where the DWT is not repaid). Therefore, the shareholder is better off not repaying the DWT.
Mr. A holds 2% of the ordinary share capital of X Ltd which is a close company. Mr A is not an employee or director of X Ltd.
X Ltd. pays the rent on Mr. A’s house of €9,000 per annum, this amount is charged each year in X Ltd’s accounts under rental expenses.
What are the tax implications of the above transaction for X Ltd and Mr. A in the year ended 31st December 2018 assuming Mr. A does not repay the DWT to X Ltd.
10.6.Detail the issues surrounding assets held on trust for participators and associates
Section 436A TCA97 treats the transfer of any asset on or after 21 January 2011 to a trust held for the benefit of a participator (excluding a loan creditor) or a relative of a participator as a distribution by the company to the trustees of the settlement.
When a participator or relative of a participator receives a benefit from the settlement, either directly or indirectly they will be subject to a charge to tax under Schedule D Case IV if the benefit is not already subject to income tax. Consideration should also be given to whether any CAT Issues arise (although this is outside the scope of this module).
This applies to benefits received from a relevant settlement on or after 21 January 2011 regardless of when the settlement was originally made.
This section does not apply where it is shown that the settlement was not made as part of a scheme or arrangement the purpose or one of the purposes of which was the avoidance of tax.
10.7.Detail the issues surrounding interest paid to directors and directors’ associates and detail the transactions that affect the Director’s current and loan accounts
The anti-avoidance provisions that apply to any interest on loans paid by a close company to a director (as defined in Section 433 TCA 1997) or his associate are outlined below.
Interest paid to directors and their associates (Section 437 TCA 1997)
This piece of legislation is concerned with any interest on loans paid by a close company to, or to an associate of, a person:
a) who is a director of the close company or of any company which controls or is controlled by the close company (Section 437(3)(a) TCA 1997) and
b) who has a material interest in the company or a company which controls the close company (Section 437(3)(b) TCA 1997). Section 437(2) TCA 1997 provides that a person has a material interest if he, either on his own or with any one or more of his associates is the beneficial owner of, or is able to control, directly or indirectly more than 5% of the ordinary share capital. The director is also caught if any associate of his controls more than 5% of the ordinary share capital.
Such interest payments in excess of a prescribed limit will be treated as distributions (Section 437(4) TCA 1997). The practical effect of this treatment is:
i) For the company – excess interest is added back in the tax adjusted Case I profit computation. The company must account for dividend withholding tax at the standard rate of income tax (currently 20%) when paying the excess interest to the director (Section 172B TCA 1997) and must account for withholding tax at the standard rate under Section 246 TCA 1997 when paying the amount below the prescribed limit to the director.
ii) For the recipient – excess interest is treated as a distribution received, taxable under Schedule F (as opposed to interest income taxable under Schedule D, Case IV). The amount below the prescribed limit continues to be treated as interest income and is taxed accordingly. The recipient will obtain a tax credit for any DWT or interest withholding operated by the company in making the payment.
The prescribed limit is calculated firstly as an “overall” limit. The overall limit is then apportioned between the various directors affected (those with a material interest) on the basis of the amounts of interest paid to each of them (Section 437(5) TCA 1997).
The overall limit is 13% per annum on the smaller of:
a) The total of all loans on which interest to directors (or their associates) with a ‘material interest’ was paid by the company in the accounting period. Where the total of all loans varied during the accounting period, the average total over the period is to be taken (Section 437(6)(a) TCA 1997), or
b) The nominal amount of the issued share capital of the close company plus the amount of any share premium account, taken at the beginning of the accounting period (Section 437(6)(b) TCA 1997).
Basically, if the total amount of interest paid to the directors with a material interest in the accounting period exceeds the overall limit, the excess is treated as a distribution.
Apple Ltd is a close company whose issued share capital is €10,000 of €1 ordinary shares. In the accounting period ended 31.3.18 it received the following loans:
What are the corporation tax and income tax consequences for Apple Ltd, a close company?
The following directors are affected by the provisions of Section 437 TCA 1997
1. Mr. A is a director and holds 33% of ordinary share capital
2. Mr. B is a director and together with his associates i.e. his wife he holds over 5% of the ordinary share capital.
3. Mr. C does not come within this provision as he holds exactly 5% of the ordinary share capital and does not therefore have the necessary ‘material interest’.
Interest paid to directors with a material interest is:
This excess of €6,200 is added back in Apple Ltd’s tax adjusted Case I profit computation.
The overall limit is apportioned among the relevant directors according to the interest paid to each:
Assuming Mr A and Mr B are both Irish resident individuals, per Section 172B(1) TCA 1997, the DWT liability of Apple Ltd in AP ended 31.3.16 is:
€6,200 × 20% = €1,240
As the distribution is in the form of cash Section 172B(1) TCA 1997 applies. The DWT should be retained from the interest payments to be made. If the company pays over the total interest amounts without deducting the DWT, Revenue could technically seek to treat the interest payments as “net” and require the company to pay over additional DWT. This would also impact on the amount of income assessable in the hands of the recipient of the interest in that they would be liable to income tax on the “grossed-up” amount.
The income tax implications for the directors on receiving the distributions are as follows (assuming taxed @ 40%):
Apple Ltd is obliged to deduct DWT at the standard rate of income tax (currently 20%) from the element of interest that B treated as a distribution and pay this over to the Collector General within 14 days of the end of the month in which the distribution was made.
In relation to the interest allowable as a deduction against Apple Ltd’s income, the company must withhold income tax at the standard rate (currently 20%) from these payments and pay the tax withheld to the Collector General with its corporation tax liability under Section 239 TCA 1997.
This allowable amount of €1,300 and Mr C’s interest of €1,500 = €2,800. The interest withholding tax amount is €560. Mr A, Mr B and Mr C will be liable to income tax on the amount of interest actually received plus the tax withheld by Apple Ltd, in addition to the schedule F distribution noted above. They may then claim a credit for the €560 tax withheld against their own income tax liability, in proportion to the interest they received.
Discuss the tax consequences of Example 10.8 above if Apple Ltd was not a close company.
Y Ltd. had the following Statement of Financial Position at 31.12.18:
The rate of interest payable on loans from the director is 10% per annum. Calculate the amount of interest to be treated as a distribution, assuming that Y Ltd. is a close company.
The share capital has not changed during the accounting period.
The loan is from one director (who owns 51% of the ordinary share capital) and has been outstanding throughout the year.
How to prepare a Directors Current Account
Step 1: Identify any opening balance on the director’s current account.
Step 2: Identify what transactions the directors have had with the company in the period.
■ What is their agreed annual remuneration?
■ Are there any benefits agreed as part of this?
■ Are there any expense claims for the period?
■ Have the directors taken any goods/services from the company for their own personal use?
■ What payments in respect of these have been made to the director?
■ Have the directors borrowed any funds from the company in the period?
■ Have the directors lent any funds to the company in the period?
■ Is there any interest due on any loans outstanding?
Step 3: Identify any payments made to the director, either in respect of the opening balance or in respect of transactions during this period.
Editors Ltd is a music publishing company.
■ It has four directors, Paul, Aidan, Frank and Dermot.
■ Paul and Aidan each own 35% of the shares in Editors Ltd, while Frank and Dermot own 15% each.
■ Paul and Aidan each receive remuneration of €10,000 per annum while Frank and Dermot receive €25,000 each.
■ During 2018 Paul gave his car to Editors Ltd for use as a company car. The car was valued at €15,000 at the time.
■ Aidan has a side project, a band he’s provisionally calling Prometheus, and Editors Ltd has provided Prometheus with €5,500 worth of services during the year.
■ To finance Prometheus, Aidan has borrowed €5,000 from Editors Ltd. This was originally meant to be a short-term loan but is still outstanding at year end. The other directors think that Aidan will be able to pay it back in the near future.
■ During the year Dermot borrowed €10,000 from Editors Ltd to buy a car. He repayed the €10,000 to Editors Ltd before the year end.
■ Editors Ltd made a dividend payment of €2,000 during 2018.
Payments made to directors during the year amounted to:
The opening balance on the current accounts were as follows:
Paul’s director Account
You will notice that the dividend does not go into these accounts. The dividend is paid to Paul in his capacity as shareholder and not in his capacity as director. The shareholder and the director have different legal personalities and this legal separation is reflected in the accounts. You should now complete the director accounts for Aidan, Frank and Dermot (Answer at end of chapter).
10.8.Detail the issues surrounding the transfer of assets at an undervalue
The anti-avoidance provisions which apply to the transfer of assets at undervalue are outlined below.
Company law considerations
In addition to the tax issues on transfers at under value, there are a number of company law implications. A transfer of this nature must be authorised by the company’s Constitution. The directors should also ensure that they have the full support of the shareholders and that no other stakeholders could be affected, for example creditors or employees. If the shareholder is also a director there is additional legislation governing transactions between directors and the company to comply with such as those covering restrictions on ‘substantial property transactions’ between directors and a company.
A substantial property transaction is one that involves assets with a value greater than the lower of:
■ 10% of the company’s net assets, or
Such transactions must be approved in advance by the majority of the shareholders at a general meeting.
Close company issues
When an asset is transferred to a participator at undervalue there are four main tax implications:
1. The company is treated as disposing of the asset at full market value under Section 547 TCA 1997. Therefore the company will be taxed on proceeds in excess of what it actually received.
2. The difference between the asset transfer price and market value is treated as a distribution. The company must operate dividend withholding tax (see Chapter 8) and the individual is taxed under Schedule F on the undervalue (Section 130(3)(a) TCA 1997). As the distribution is a non-cash distribution Section 172B(3) TCA 1997 would apply to the distribution as outlined in Chapter 8.
3. Section 589 TCA 1997 reduces the shareholders base cost in the shares of the close company when calculating any gain or loss on disposal in the future.
4. The participator may be subject to CAT on the gift element included in the transfer at undervalue. You will see in your studies of CAT in Capital Taxes: Application and Interaction that CAT provides for a credit for CGT arising on the same event. Note that this credit does not apply to a company suffering CT on chargeable gains on the same event.
It should be noted that 1, 2 and 4 above apply equally to open companies.
Mr. A purchased shares in A Ltd in April 2004 for €125,000. Mr. A is the only shareholder. In July 2018 the company transferred a property it had purchased in June 2005 for €75,000 to Mr. A for €100,000. The market value and the current use value of the property was €150,000 in July 2018.
Mr. A sold his shares in A Ltd for €175,000 in November 2018. Assume Mr. A repaid the initial DWT on the deemed distribution arising on the transfer of the asset at undervalue.
Compute the taxation implications of the above transactions.
1. A Ltd is treated as disposing of the property to Mr. A at market value
Regross: €75,000 × 33%/12.50% = €198,000 × 12.50% = €24,750
2. Mr. A is treated as receiving a distribution of €50,000 (€150,000 – €100,000) as he repaid the initial DWT. A Ltd must pay over Dividend Withholding Tax to the Collector General as follows:
€50,000 × 20% = €10,000.
Mr. A is taxed under Schedule F as follows:
3. Mr. A’s base cost in the shares of A Ltd is reduced by the undervalue when disposing of the shares:
The transfer at undervalue effectively cost Mr. A an additional €20,000 in income tax (ignoring PRSI and the USC) and €16,500 in CGT (i.e. the reduction in base cost of €50,000 × 33%) – a total of €36,500 in taxes. It also resulted in a corporation tax liability for the company of €24,750 as a result of the chargeable gain arising on the transfer of the property to Mr. A.
Outline the tax consequences if Mr. A paid full market value for the property.
Take the same facts as the Example 10.9 above, except that A Ltd. has three shareholders; Mr. A, Mr. B and Mr. C, who own 25%, 35% and 40% of the share capital respectively.
The transfer of the property to Mr. A for €100,000 will have the same income tax implications for Mr. A and give rise to the same deemed chargeable gains for A Ltd. However, in the event of the subsequent disposal of the shares in A Ltd. by Mr. A, Mr. B and Mr. C., in accordance with Section 589 TCA 1997, each of the shareholders will have their respective base costs (before indexation) reduced by a proportion of the undervalue of the transfer to Mr. A apportioned according to their shareholding at the time of the transfer i.e. their base costs would be reduced by €12,500, €17,500 and €20,000 respectively.
In addition, Section 589(3) TCA 1997 provides that where one of the shareholders is itself a close company, the amount of the undervalue apportioned to the shares held by that close company are further apportioned to the holders of the shares in that close company.
10.9.Detail the issues surrounding loans to participators
Company law considerations
A company can only make loans to its directors (or persons connected with the directors) up to a maximum of 10% of the net assets from its last audited set of financial statements (refer to your Tax Accounting manual for the definition of net assets). If no financial statements were made up, then this 10% limit applies to the called up share capital of the company. Directors should be aware that if the net assets of the company fall then the amount that may be lent under this 10% limit will fall and outstanding loans may need to be repaid. Company law provides that this repayment must be made within 2 months.
Where this 10% limit is breached, there are civil and criminal penalties on the directors of the company who granted the loan. There are more severe penalties where the company is insolvent.
Payments on behalf of directors (such as bills etc.) are also caught under this 10% restriction as ‘quasi-loans’. Where, for example, directors use a company credit card to pay for personal expenses, with the intention of repaying the company at a later date, those payments would constitute a quasi-loan.
The purpose of this restriction is very similar to the reason for the restrictive rules around a company’s distributable reserves – to stop the capital reserves of a company being depleted.
The anti-avoidance measures which apply where a close company makes a loan to a participator or his associate are outlined below.
Loans to participators (Section 438 TCA 1997)
Where a close company makes a loan to an individual who is a participator or an associate of a participator, the company will be required to pay income tax in respect of the amount of the loan grossed up at the standard rate (currently 20%) as if this grossed up amount were an annual payment (not schedule F) (Section 438(1) TCA 1997).
The income tax due cannot be reduced by any loss claims such as Section 396B TCA 1997. When the loan, or part of the loan is repaid by the participator (or associate), the tax paid or a proportionate part of it will be refunded to the company (without interest) provided a claim is made within 4 years of the year of assessment in which the loan is repaid (Section 438(4)(b) TCA 1997).
There are three exceptions to the above treatment of loans to participators:
1. Where the business of the company is or includes the lending of money and the loan is made in the ordinary course of that business (Section 438(1)(a) TCA 1997)
2. Loans made to directors or employees of the company (or an associated company) if:
(a) the amount of the loan together with all other loans outstanding made by the company (or an associated company) to the borrower (or his spouse) does not exceed €19,050 (Section 438(3)(a) TCA 1997) and
(b) the borrower works full time for the company (Section 438(3)(b) TCA 1997) and
(c) the borrower does not have a material interest (as defined previously – more than 5% of ordinary share capital) in the company or an associated company. If the borrower subsequently acquires a material interest, the company will be requested to pay income tax in respect of all loans outstanding to the borrower at that time (Section 438(3)(c) TCA 1997).
3. The debt is incurred for the supply of goods or services in the ordinary course of business unless the period of credit given exceeds six months or is longer than credit terms normally given to customers (Section 438(2) TCA 1997).
Note that the loan is not regarded as income in the individual’s hand unless and until the loan is forgiven by the company (Section 439(1) TCA 1997). However, where the loan is made to an employee or director of the company and the interest rate on the loan is less than the “preferential loan” rates in Section 122 TCA 1997 a benefit-in-kind under Schedule E arises during the period that the loan is outstanding.
Where the loan is forgiven, the income tax is not recoverable by the company and the ‘grossed up’ loan is assessed on the participator for income tax purposes. In determining the amount of the loan assessed on the participator, the loan is “grossed-up” at the standard income tax rate applicable in the year of forgiveness and not the rate for the year it was advanced (Section 439(1)(a) and (b) TCA 1997). Also, the write off is not deductible against the company’s Case I profits.
This piece of legislation is primarily concerned with loans to individuals, however a special provision, Section 438(6) TCA 1997, penalises close companies making loans to a company who is acting in a fiduciary or representative capacity or to a company which is not resident in an EU Member State and which is a participator or an associate of a participator.
Also, you will remember that the definition of a close company specifically excludes industrial and provident societies, however for the purpose of applying the provisions for loans to participators, industrial and provident societies are not excluded (Section 438(8) TCA 1997).
Section 438A TCA 1997 extends the application of Section 438 TCA 1997 to loans by companies controlled by close companies. Where a company controlled by a close company makes a loan which otherwise would not give rise to a charge under Section 438 TCA 1997, that section applies as if the loan had been made by the close company (Section 438A(2) TCA 1997). It also applies where a company, which is not controlled by a close company, makes a loan, and subsequently becomes controlled by a close company; Section 438 TCA 1997 applies as if the loan had been made by the close company immediately after the time it acquired control (Section 438A(3) TCA 1997). Where two or more close companies control a company that makes or has made the loan, each of the close companies are treated as controlling the company, and as if the loan had been made by each of the close companies, with the loan apportioned between those close companies in proportion to their interests in the company that makes/made the loan (Section 438A(4) TCA 1997). However, the provisions of Section 438A(2) and (3) TCA 1997 will not apply where it can be shown that no arrangements have been made (otherwise than in the ordinary course of a business carried on by that person) resulting in a connection between the making of the loan and the acquisition of control, or between the making of the loan and the provision by the close company of funds for the company making the loan. The close company will be regarded as providing funds for the company making the loan if it directly or indirectly makes any payment or transfers any property to, or releases or satisfies (in whole or in part) a liability of the company making the loan.
Wealthy Ltd makes a loan of €40,000 to a full time working director, Mr. A, in the accounting period ended 31.12.16. Mr. A holds 10% of the close company’s ordinary share capital. The loan is subsequently forgiven in AP ended 31.12.18.
What are the corporation tax and income tax consequences?
Note: This loan to a participator does not qualify for the exception at 2) earlier in this section because Mr. A has a material interest in the company and the amount of the loan exceeds €19,050.
1. Corporation Tax for Wealthy Ltd
a) AP ended 31.12.16: Income tax of €40,000 × 20/80 = €10,000 is payable by the company.
b) AP ended 31.12.18: The income tax paid is now irrecoverable and the write off is not a tax deductible expense in the adjusted Case I profit computation.
2. Income Tax for Mr. A
a) Year of assessment 2016: No implications for Mr. A unless the interest rate on the loan is below the prescribed preferential loan rates in which case a benefit in kind under Schedule E arises.
b) Year of assessment 2018: The loan write off is treated as Schedule D Case IV income of €40,000 × 100/80 = €50,000. Credit is given for the €10,000 suffered by the company so that only a higher rate liability arises (i.e. 40%). Note that if Mr. A has insufficient income tax payable to fully utilise this credit, the balance is not repayable (Section 439(1)(d) TCA 1997).
Mr. A owns 100% of A Ltd, which has surplus funds of €1,000,000 on deposit. In order to facilitate Mr A borrowing this money from his company and to avoid a Section 438 TCA 1997 charge the following schemes had arisen:
1. B Ltd (an open 100% subsidiary of an EU bank) grants a loan to Mr. A of €1,000,000. This is B Ltd’s only asset.
2. A Ltd pays €1,000,000 for the shares of B Ltd (effectively paying the EU bank for the loan to Mr. A).
3. B Ltd only has one asset, a loan to Mr A for €1,000,000 granted when B Ltd and Mr. A were not connected with one another, therefore a charge under Section 438 TCA 1997 would not arise.
Section 438A TCA 1997 counters this scheme by deeming the loan to have been made immediately after A Ltd took control of B Ltd, Section 438A(3) TCA 1997.
R. Ltd, a close company, made interest free loans to the following shareholders in the accounting period to 31st December 2018:
What are the tax consequences for R Ltd assuming that no other loans had been made to the three individuals in the past. Also assume that both Mr. Ben and Mr. Carl work full time for the company.
10.10.Calculate the surcharge on undistributed investment and estate income
Close company surcharge on undistributed income (Section 440 TCA 1997)
The marginal corporation tax rates suffered by a company are likely to be lower than those experienced by top income tax payers: thus owners of a close company may prefer to leave profits within the company rather than suffer high personal tax rates i.e. 40% (together with PRSI and the USC) on dividends distributed to them.
The surcharge exists to prevent advantage being taken of this situation.
An additional surcharge of corporation tax is levied on a close company that does not distribute income derived from:
A) investments (including franked investment income) or rental property (termed ‘investment’ and ‘estate’ income respectively) (Section 434(1) TCA 1997). A surcharge of 20% after tax applies (Section 440 TCA 1997).
B) the provision of professional services, or of facilities and services to a connected person(s) carrying on a profession (unless income forms the smaller part of total trading income) (Section 441(1) TCA 1997). A surcharge of 15% after tax applies in this case to the undistributed income.
Calculating the close company surcharge involves the application of a number of steps the purpose of which is to identify the undistributed passive income of the close company.
This passive income is typically made up of rental income and investment income.
Because you are trying to get undistributed income you are automatically looking at the after-tax income of the company. In calculating the surcharge you will be required to carry out a ‘notional’ corporation tax computation which excludes relief for any losses carried forward or set back from a subsequent period. You are allowed, however, to claim a small trading deduction to reflect costs of administration (see below).
The most common mistakes made in computing the surcharge are:
■ Not including Franked Investment Income (“FII”)
■ Not including the 7.5% trading discount
■ Giving relief for losses forward/set back
■ Not giving relief for the tax arising on the income.
Franked investment income, broadly speaking being dividends paid by one Irish company to another Irish company, for the purposes of the calculation of the close company surcharge is defined in Section 434(1) TCA 1997 as excluding:
(a) a distribution made out of exempt profits within the meaning of Section 140 TCA 1997 (e.g. distributions out of profits or gains from the occupation of certain woodlands),
(b) a distribution made out of disregarded income within the meaning of Section 141 TCA 1997 (distributions out of income from exempt patent royalties),
(c) a distribution made out of exempted income within the meaning of Section 142 TCA 1997 (distributions out of profits of certain mines),
Section 434(3A) TCA 1997 provides that if one close company makes a distribution to another close company, they can jointly elect that the recipient is not surcharged on the dividend received and the payee does not receive a deduction against its own surcharge for the dividend paid.
The election operates most efficiently when a trading company, which would not generally suffer a surcharge on its income, pays a dividend to its parent, which would normally incur a surcharge liability on such a receipt. The joint election would therefore have no adverse consequences on the paying company and would remove the surcharge on the dividend income of the recipient company.
Section 434(1) defines estate income as Case III, IV and V income, other than interest, arising from the ownership of land.
Section 434(1) defines investment income as income other than earned income (as defined in Section 3 TCA 1997) which essentially is all income other than income from a trade or profession. This includes franked investment income which is income other than earned income.
Investment income would therefore include dividends received from both Irish and foreign companies. Specifically excluded from this definition is a distribution received from a company which would qualify for relief under s. 626B TCA 1997. This section contains Ireland’s participation exemption legislation which was introduced in order to strengthen Ireland’s position as a headquarters location for multinational companies and to keep the country in line with other European legislation. You will learn more about s. 626B TCA 1997 in Part 3 of your course.
In order to ensure that the close company surcharge would not negate the benefits of introducing the participation exemption, the definition of “investment income” in Section 434(1) TCA 1997 for the purposes of the close company surcharge was amended. Consequently, where an Irish close company receives a dividend from a foreign subsidiary, on which it would be able to claim the participation exemption if the foreign subsidiary were being disposed of, the dividend is excluded from its investment income.
Relevant charges are defined as charges on income paid in the accounting period by the company and which are allowed as deductions under Section 243 TCA 1997 (relief against total profits for charges) other than so much of those charges as are paid for the purposes of an excepted trade within the meaning of Section 21A TCA 1997.
Estate and investment income
Section 434(5) TCA 1997 sets out how the estate and investment income of a company is calculated for the purposes of the surcharge formula.
The estate and investment income of a company is calculated as the sum of:
(i) the amount of franked investment income for the accounting period, and
(i) the amount of relevant charges, and
(ii) the amount which is an allowable deduction in computing the total profits for the accounting period in respect of expenses of management by virtue of Section 83(2) TCA 1997.
Distributable estate and investment income
Section 434(5A)(a) TCA 1997 states that the definition of “distributable estate and investment income” of a company means the estate and investment income of the company for the accounting period after deducting the amount of corporation tax which would be payable by the company for the accounting period if the tax were computed on the basis of that income.
Distributable trading income
“Distributable trading income” is defined in Section 434(5A)(a) as the trading income of the company for the accounting period after deducting the amount of corporation tax which would be payable by the company for the accounting period if the tax were computed on the basis of that income.
Trading discount for estate and investment income
Section 434(5A)(b) provides for a 7.5% reduction in the distributable estate and investment income of a trading company.
10.10.2.Calculation of surcharge
Section 440 TCA 1997 investment and estate income surcharge
The 20% after tax surcharge set out in Section 440(1) TCA 1997 is imposed on the excess of the distributable estate and investment income (as reduced by 7.5% if appropriate) of the accounting period over the distributions made for that accounting period (including dividends declared for the period and paid within 18 months after the end of the period).
If the accumulated undistributed income (all types of income) at the end of the accounting period is lower than said excess, the 20% after tax surcharge of Section 440 TCA 1997 is imposed on that lower figure.
Effective rate of tax on income charged to Section 440 TCA 1997 surcharge
Tax on Case III/IV/V – 25%
Effective Surcharge – 15% (100% income less 25% tax × 20% surcharge)
Total Tax on III/IV/V – 40%
10.10.3.Step-by-step surcharge calculation for trading company
Step 1: Calculate Income – Income from Case I, III, IV and V
Deduct current losses (but not group relief)
Deduct relevant trade charges (i.e. non excepted trade)
Step 2: Calculate Estate and Investment Income (using the formula set out above from s.434(5)
Plus Franked Investment Income
Less relevant charges (charges against all profits) (excluding excepted trade charges) and expenses of management.
Step 3: Calculate Distributable Estate and Investment Income
Answer from (step 2)
Less Corporation Tax on passive income as reduced by relevant charges and expenses of management
Less 7.5% trading deduction on above sum (if relevant)
Step 4: Calculate surcharges – deduct distributions from (step 3) and multiply by 20%.
A Ltd, a close company, has the following income, chargeable gains and charges on income for its 12 month accounting period ended 31 December 2018.
Assume that A Ltd makes the following distributions for its 12 months accounting period ending 31 December 2018:
Dividends declared for the AP to 31 December 2018:
Other distributions paid in AP to 31 December 2018:
Note that, for the purposes of the surcharge of Section 440 TCA 1997, only dividends declared for an accounting period which are paid within 18 months after the end of the accounting period count as distributions for that accounting period.
In addition to ordinary dividends declared and paid, deemed distributions such as participators’ expenses (s436 TCA 97), settlements (s436A TCA 97), excess interest to directors (s437 TCA 97) and distributions under s130 TCA 97 are also included in reducing a company’s undistributed earnings for surcharge purposes.
In order to determine whether there is a corporation tax surcharge under Section 440 TCA 1997 for the accounting period ending 31 December 2018, it is necessary to determine the distributable estate and investment income for that accounting period.
The steps are as follows:
Note that the estate income for the accounting period is the rental income (State and non-State) totalling €31,700 and that the investment income totals €46,300 so that the “aggregate of the estate income and the investment income” totals €78,000.
Ascertain “the income for the accounting period” – the amount of income as computed in accordance with Section 434(4) TCA 1997.
Note that only trading losses or losses under Cases III, IV and V of Schedule D incurred in the same accounting period are to be deducted in computing the income for the accounting period (but no losses carried forward or back from an earlier or later accounting period are deducted). In this example, there are no losses to consider.
Note also that the only charges on income which Section 434(4) TCA 1997 requires to be deducted in arriving at the income for the accounting period in this step are any charges on income wholly attributable to a trade chargeable at the standard rate which are only allowable against that income under Section 243A TCA 1997.
Applying Section 434(4) TCA 1997, the income for the accounting period to 31 December 2018 (for the purpose of Section 434 TCA 1997) is determined as follows:
For step 2, note that the total amount of income included in the “income for the accounting period” is €223,000 – the figure before deducting the relevant trading charges and, if there were any, losses for the accounting period (excluding any losses carried forward or carried back). Note also that the aggregate of the estate income and investment income included above is €78,000.
The “estate and investment income” for the accounting period (as defined in Section 434(5) TCA 1997) is now calculated, applying the definition of the term. The calculation is:
Income for AP (as above): €220,000
A = aggregate of estate income and investment income included in calculation of “income for AP”: €78,000
B = total amount of income included in same calculation: €223,000
Fraction of income for AP (per Section 434(5)(a)(ii) TCA 1997):
Section 434(5A)(a) TCA 1997 provides that the “distributable estate and investment income” is calculated by deducting from the estate and investment income an amount equal to the corporation tax which would be payable for the accounting period if the tax were computed on the basis of that estate and investment income.
Since this concerns “passive income”, the 25% rate of corporation tax is used in arriving at the tax deduction, but no tax applies in respect of the franked investment income element of the estate and investment income (as these amounts are exempt from corporation tax). Also, the charges on income allowed under Section 243 TCA 1997 are deducted from the estate and investment income (excluding the franked investment income).
If the company is a trading company (as in this case), the “distributable estate and investment income” as first calculated is reduced by 7.5% i.e. so that only 92.5% of it comes into the surcharge calculation (Section 434(5A)(b) TCA 1997).
On this basis, A Ltd’s distributable estate and investment income for the accounting period ending 31 December 2018 is calculated as follows:
The surcharge under Section 440 TCA 1997 is now calculated for A Ltd’s accounting period ending 31 December 2018 by reference to the excess of the final distributable estate and investment income figure over the distributions made for that accounting period as set out at the start of this example.
The calculation is as follows:
The surcharge for 2018 of €1,653 is paid with the corporation tax of the following accounting period, as the company has 18 months to declare and pay distributions.
1. The “relevant charges” deductible in the calculation of the estate and investment income are restricted to those charges on income which remain deductible from total profits under Section 243 TCA 1997. Due to Section 243A TCA 1997, the charges on income attributable respectively to trading income chargeable at the standard rate are not deductible under Section 243 TCA 1997.
2. The amount liable to the 20% surcharge may be reduced under Section 440(2) TCA 1997 to the “accumulated undistributed income” at the end of the accounting period (31 December 2018) should that figure be lower than the €8,266 “excess” calculated above. See examples further on.
10.10.4.Restrictions to surcharge under Section 440 TCA 1997
The example above has shown the calculation of the excess of the distributable estate and investment income over the distributions made for the accounting period on which the 20% after tax surcharge is applied by Section 440(1)(a) TCA 1997. This normal calculation always has to be made first. Then the possibility of a cancellation or a reduction in the surcharge under either Section 440(1)(b) or (2) TCA 1997 may have to be considered, by either of the following two restrictions:
(1) De minimis relief
Section 440(1)(b) TCA 1997 provides that no surcharge is imposed in any case where the excess of the distributable estate and investment income for an accounting period over the distributions made for that accounting period is €2,000 or less.
There is also an element of marginal relief where the “excess” to which the 20% surcharge is applied exceeds €2,000 by a small amount. This limits the amount of the surcharge so as not to be higher than 80% of the amount by which the “excess” is greater than €2,000. In fact this works out that the marginal relief applies if the “excess” is between €2,000 and €2,668.
Surchargeable amount €2,500 × 20% = €500.
Can limit to - €2,500 – €2,000 = €500 × 80% = €400.
The €2,000 figure assumes that the close company concerned has no associate companies and that the accounting period is of 12 months in length. For shorter accounting periods or where there are associated companies, the €2,000 de minimis figure is proportionately reduced.
(2) Reduction if accumulated undistributed income less than excess
Section 440(2) TCA 1997 provides for a reduction in the amount (the “excess”) on which the surcharge is levied for an accounting period if the “excess” is higher than the “accumulated undistributed income” of the company at the end of that accounting period. If this occurs, the 20% after tax surcharge is calculated on the amount of that accumulated undistributed income (subject to the same €2,000 de minimis exclusion mentioned above).
The accumulated undistributed income at the end of the accounting period is taken as the retained earnings as per the accounts of the company plus any transfer to capital reserves, bonus issues or other transactions which would reduce the accumulated income available for distribution.
Section 434(7) TCA 1997 provides that where a company is subject to any legal restriction as regards making a distribution this should be taken into account in determining the amount of income on which a surcharge would be imposed. For example, if the distributable reserves in 2018 and/or 2019 are less than the surchargeable amount for 2018 then the surcharge will only be levied on the amount that could be distributed legally.
Take the case of A Ltd, the close company dealt with in Example 10.13. If the financial accounts at period end December 2018 show reserves available for distribution of €7,000 this figure would be surchargeable instead of the €8,266 as previously calculated.
Surcharge: €7,000 × 20% = €1,400.
B Ltd has the following results for the accounting period ended 31 December 2018:
B Ltd paid charges of €3,000 in respect of its trading activities and claimed €4,000 of loss relief under Section 396(1) TCA 1997 for a loss which arose in AP ended 31.12.17. The company made distributions of €2,000 in the year ended 31 December 2018 and paid expenses of €400 for a participator, who repaid the DWT credit.
AP ended 31.12.18.
Step 1: Calculate the ‘income’ of the company
(Ignore the loss carried forward – not deductible in arriving at the “income” for the period).
Step 2: Calculate the Estate and Investment Income
Step 3: Distributable Estate and Investment Income
Step 4: Surchargeable amount
As noted in AP ended 31.12.18 B Ltd incurred expenses on behalf of a participator of €400.
In addition, the final dividend for year-end 31.12.18 was declared and paid on
1 February 2018 at €2,000.
This surcharge is treated as part of the corporation tax liability for the accounts year-ended 31.12.19 (as the company has 18 months to declare and pay dividends, it has until the following year to actually pay the surcharge) and is payable if no further distributions are made by the company before 30.06.20.
The payment of certain expenses of a participator are treated as a distribution in accordance with Section 436 TCA 1997. Assuming the expenses were paid on behalf of the participator, the benefit the participator received was a non-cash distribution subject to the provisions of Section 172B(3) TCA 1997. As noted the participator repaid the initial DWT in respect of the expenses to the company, and therefore the €400 is not regrossed.
10.11.Calculate the surcharge on service companies
10.11.1.Meaning of service company
Up to now, we have looked at a surcharge which applies to the passive income of a closely held company.
You will remember why the surcharge was introduced i.e. to prevent the use of corporates as a planning measure in an era where the personal tax rates are far higher than the corporate rates.
It was felt that the surcharge should also be applied to “active” income where professional persons tried to avoid paying the top rate of personal tax on their fee income. This surcharge is known as the professional services surcharge and is levied on professional income at 15% after tax. Passive income is still levied at 20% after tax.
A service company is defined in Section 441(1) TCA 1997 as a close company:
a) whose business consists of or includes the carrying on of a profession or the provision of professional services;
b) having or exercising an office or employment; or
c) whose business consists of or includes the provision of services or facilities of whatever nature to or for:
(i) a company within the categories (a) and (b) described above
(ii) an individual or partnership which carries on a profession
(iii) a person who holds or exercises an employment
(iv) a person or partnership connected with any of the above.
Services provided to an unconnected person or an unconnected partnership are ignored. The term ‘service company’ applies only where the principal part of the company’s income which is chargeable under Case I and II is derived from the profession, the provision of professional services, the provision of certain services or facilities or a combination of these activities, e.g. auctioneers, journalists, opticians.
‘Professionals’ include architects, auctioneers, surveyors.
See the Revenue Precedents listed after Section 441 TCA 1997 and Tax Briefing 48, Page 19.
Section 441 TCA 1997 service company surcharge
The 15% after tax surcharge set out in Section 441(1) TCA 1997 is imposed on the amount by which
(a) the aggregate of 50% of the company’s “distributable trading income” (as defined in Section 434(5A) TCA 1997) and 100% of its distributable estate and investment income (because this portion has already been subject to the 20% surcharge) exceeds
(b) the distributions made by the company for the accounting period.
In effect, the distributions are first deemed to be made out of the distributable estate and investment income (reducing the 20% surcharge) and then out the distributable trading income (reducing the 15% surcharge).
Effective rate of tax on Case II income charged to Section 441 TCA 1997 surcharge
Tax on Case II – 12.50%
Effective Surcharge – 6.56% (100% income less 12.50% tax × 50% × 15% surcharge)
Total Tax on Case II – 19.06%
10.11.2.Close service company surcharge
Section 441 TCA 1997 provides for the formula used when calculating the surchargeable amount in respect of close service companies.
The amount on which the surcharge of a service company is levied on is arrived at as follows:
1. Calculate the distributable trading income. (Trade income less relevant trade charges and after standard rate corporation tax).
2. Calculate half of distributable trading income.
3. Add the distributable estate and investment income (net of the 7.5% trading discount). This is the same calculation as used for the Section 440 TCA 1997 surcharge, steps (i) to (iii).
4. From the figure at 3 above, deduct all distributions for the accounting period and paid during or within 18 months of the end of the accounting period to give the total surchargeable amount.
5. From the distributable estate and investment income (as calculated at 3 above) deduct all distributions for the accounting period and paid during or within 18 months of the end of the accounting period
6. Apply 20% surcharge to the total surchargeable amount at 5
7. Deduct the amount surcharged at 5 above from the total at 4 above and apply a surcharge of 15%. Add this amount to the surcharge at 6 above to arrive at the total surcharge.
B Ltd (a service company) has the following results for the accounting period ended 31 December 2018:
B Ltd paid charges of €3,000 in respect of its trading activities and claimed €4,000 of loss relief under Section 396(1) TCA 1997 for a loss which arose in AP ended 31.12.17. The company made distributions of €2,000 in the year ended 31 December 2018 and paid expenses of €400 for a participator (for the purposes of the example, assume the participator did not repay the initial DWT arising in respect of the expenses to the company).
1. The distributable trading income of the company is calculated as follows:
2. To calculate half of the distributable trading income, i.e. €25,375 divided by 2 = €12,687.
3. Add to amount at Step 2 the distributable investment and estate income (net of trading discount) of €10,929 (as calculated in Example 10.15).
5. Excess of distributable estate and investment income over distributions made
6. Surcharge at 20% on €8,429 = €1,686
7. Surcharge at 15% €
Surcharge at 15% = €1,903
Therefore, total surcharge assessed on company; €1,686 + €1,903 = €3,589.
This surcharge is payable with the corporation tax liability for the year ended 31 December 2019.
For the purposes of the exam, unless otherwise stated, assume the participator did not repay the initial DWT arising in respect of the expenses incurred by the company on behalf of the participator such that the gross-up provisions apply.
10.12.Recommend how a company can still meet its commercial objectives while reducing the surcharge payable
This example takes the same facts as Example 10.16 (B Ltd).
The company wishes to avoid the surcharge entirely and request details of the minimum dividend they can declare and pay and by the latest date possible.
B Ltd (a service company) has the following results for the accounting period ended 31 December 2018:
B Ltd paid charges of €3,000 in respect of its trading activities and claimed €4,000 of loss relief under Section 396(1) TCA 1997 for a loss which arose in AP ended 31.12.17. The company made distributions of €2,000 in the year ended 31 December 2018 and paid expenses of €400 for a participator (for the purposes of this example, assume the participator did not repay the initial DWT such that gross-up applies).
1. The distributable trading income of the company is calculated as follows:
2. To calculate half of the distributable trading income, i.e. €25,375 divided by 2 = €12,687.
3. Add to amount at point 2 the distributable investment and estate income (net of trading discounts.
Distributable Estate and Investment Income:
Surcharge at 15% = €0
As the surchargeable amount is €2,000 there is no liability (Section 441(4)(b) TCA 1997)
The distribution must be paid on or before 30 June 2020, 18 months after the period end.
For the purposes of the exam unless otherwise stated, assume the participator did not repay the initial DWT arising in respect of the expenses incurred by the company on behalf of the participator such that the gross-up provisions apply.
One other option would be declare directors’ fees to reduce both the taxable trade income and therefore the income surchargeable. However, as only 50% of the service income is surcharged the fees would need to be much higher than the dividend.
There is also the possibility that the fees might not be allowable against corporation tax if it were felt that they were not wholly and exclusively incurred in running the business.
Close company rules are designed to prevent shareholders in family companies from extracting funds from their companies without paying income tax at the marginal rate.
The 20% and 15% surcharges are imposed to narrow the gap between the tax the company pays on its profits (12.5% or 25%) to what the shareholder would pay if he or she earned the profits personally (c. 25% – 55%).
Mr. J Jones associates are as follows:
As Mr. J Jones possesses 56% of the voting power, the company is close.
The rights of an associate of an associate of Mr. J. Jones cannot be attributed to him i.e. Beta Ltd.
The rights of ‘in laws’ cannot be attributed to Mr. J Jones as an ‘in law’ is not a relative.
For a quoted company not to be treated as close, it must satisfy all of the above conditions.
(A) Corporation Tax
1. The rental expense of €9,000 is disallowed to X Ltd in arriving at its profits assessable to corporation tax as it is treated as a distribution of €11,250 (€9,000/80%) (X Ltd is a close company and Mr A is a participator)
2. X Ltd. has a dividend withholding tax liability of €11,250 × 20% = €2,250.
(B) Income Tax
Mr. A will be assessed under Schedule F on the distribution. If Mr A pays income tax at the marginal rate, then the income tax computation would be:
If Mr. A repaid the initial DWT liability the value of the distribution would be €9,000. This amount would be disallowed by X Ltd. in determining its tax adjusted Case I profits and would be taken into account for the purposes of determining the company’s close company surcharge for the period (if any).
Mr. A would be assessed under Schedule F on the distribution. If Mr A pays income tax at the marginal rate, then the income tax computation would be:
i.e. by repaying the initial DWT, Mr. A would reduce his income tax liability by €450 (i.e. €2,250 – €1,800) but increase the overall cost of the dividend (i.e. total cost of €3,600 (DWT of €1,800 and income tax of €1,800) compared with a total cost of €2,250 (i.e. the income tax) where the DWT is not repaid). Therefore, the shareholder is better off not repaying the DWT.
If Apple Ltd was not close the entire interest charge of €9,000 would be allowable against the company’s income.
The company would deduct tax of €1,800 from the gross interest prior to paying the relevant amounts to Mr A, Mr B and Mr C. Each director would suffer tax under Schedule D Case IV with a tax credit for the tax withheld.
Under Section 239 TCA 1997 the company would include the €1,800 as a liability in its corporation tax return.
The limit of interest which is allowed is the lower of:
∴ the limit of interest allowed is €1,300
Interest paid to the director in 2018 = €4,000
∴ excess treated as a distribution = €2,700
1. A Ltd disposes of the property to Mr. A at market value
Regross: €75,000 × 33%/12.50% = €198,000 × 12.50% = €24,750
2. Mr. A has paid full market value and therefore there is no distribution.
3. Sale of Mr. A’s shares:
By paying the full market value Mr A avoided income tax on the distribution of €20,000 (ignoring PRSI and the USC) and saved €16,500 in CGT (i.e. by avoiding the reduction in base cost of €50,000 × 33%) – a total of €36,500 in taxes. It also resulted in the company paying corporation tax on the chargeable gain based on income it actually received, rather than notional income.
R Ltd will be required to pay income tax in respect of the loans to Mr. Ben and Mr. Alan grossed up at the standard rate of 20% as if the grossed up amount were an annual payment. The tax penalty for the company is calculated as follows:
The loan to Mr. Carl is not caught because Mr. Carl:
Is a director
Does not have a ‘material interest’ in the company
The loan is less than €19,050
R. Ltd must pay the income tax of €5,550 to the Collector General.
Answer to question in Example 10.9
Aidan Director Account
Frank Director Account
Dermot Director Account