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.