Luiza, the finance director of Damiana plc, requires advice on the corporation tax treatment of the company’s expenditure on research and development (R&D) and the consequences of the late filing of its recent corporation tax returns. Luiza also wishes to know the tax implications for her of two alternative ways of acquiring shares in Damiana plc.
Damiana plc:
– Is a UK resident quoted trading company.
Damiana plc – R&D expenditure:
– Damiana plc is a large company for the purpose of tax relief for R&D expenditure.
– During the year ending 31 March 2018, Damiana plc will incur expenditure on qualifying R&D of £169,000.
– Damiana plc will have taxable total profits, before any deduction in respect of R&D expenditure, of £1,675,000 in the year ending 31 March 2018.
Damiana plc – late filing of corporation tax returns:
– Damiana plc prepared accounts for the 18-month period ended 31 March 2016.
– The corporation tax returns for this period were filed on 15 July 2017.
– All previous corporation tax returns have been filed on time.
Luiza:
– Is employed as the finance director of Damiana plc, earning a gross annual salary of £165,000.
– Has no other source of taxable income.
– Has been offered two alternative ways to acquire ordinary shares in Damiana plc.
– In either case she will sell these shares on 10 November 2020 when their market value is expected to be £32·70 per share.
– Uses her annual exempt amount for capital gains tax purposes each year.
Acquisition of Damiana plc shares – alternative 1:
– Damiana plc will transfer 5,000 ordinary shares (a 1% holding) to Luiza on 1 November 2017 for which Luiza will pay £1 per share.
– The market value of these shares on 1 November 2017 is expected to be £24·50 per share.
– Damiana plc does not expect to pay a dividend in the foreseeable future.
Acquisition of Damiana plc shares – alternative 2:
– Damiana plc will grant options over 5,000 ordinary shares to Luiza on 1 November 2017 under its newly established enterprise management incentive (EMI) scheme.
– The exercise price of these options will be £23·00 per share.
– Luiza will exercise the options on 2 November 2020.
Required:
Explain, with supporting calculations, the tax relief available for the research and development (R&D) expenditure incurred by Damiana plc in the year ending 31 March 2018, and the amount of corporation tax which will be saved as a result of claiming this relief.
Damiana plc
Relief for research and development (R&D) expenditure
As Damiana plc is a large company for R&D purposes, it can claim an ‘above the line’ (ATL) tax credit for its qualifying R&D expenditure of £169,000. The amount of the credit is calculated as 11% of the qualifying R&D expenditure in the accounting period. This is treated as a taxable receipt of £18,590 (11% x £169,000), and a tax credit to be offset against its corporation tax liability equal to the same amount.
Accordingly, the total corporation tax saving attributable to the R&D expenditure is:
Identify the accounting periods for which corporation tax returns were required from Damiana plc in respect of the 18-month period ended 31 March 2016. State the due date(s) for filing the returns in each case, and the implications for Damiana plc in respect of their late filing.
Late filing of corporation tax returns
There are two accounting periods within the 18-month period ended 31 March 2016 for which corporation tax returns should have been filed. The first is the 12 months ended 30 September 2015 and the second is the six months ended 31 March 2016.
Both returns should have been filed by 31 March 2017 (12 months after the end of the 18-month period of account).
As the returns have been filed more than three months late, each return will attract a fixed late filing penalty of £200, as previous returns have been filed on time.
Tutorial note: It has been assumed that HM Revenue and Customs issued notices requiring the returns to be made before 1 January 2017, so that the later three-month filing rule does not apply.
Explain the tax implications for Luiza if she acquires 5,000 ordinary shares in Damiana plc alternatively, (1) by means of a transfer on 1 November 2017, or (2) as a result of exercising the share options on 2 November 2020. On the assumption that she sells the shares as planned on 10 November 2020, calculate Luiza’s net increase in wealth under each alternative.
Alternative 1 – transfer of shares to Luiza on 1 November 2017
As Luiza is an employee of Damiana plc, she will be treated as receiving a taxable benefit equal to the amount underpaid in respect of her shares. She is an additional rate taxpayer, so she will incur an income tax liability of £52,875 ((£24·50 – £1) x 5,000 = £117,500 x 45%) in the tax year 2017/18. The shares are in a quoted company, so fall within the definition of ‘readily convertible assets’, therefore Luiza will also have a liability to Class 1 national insurance contributions (NICs) of £2,350 (£117,500 x 2%).
On the sale of the shares on 10 November 2020, there will be a chargeable gain of £41,000 ((£32·70 – £24·50) x 5,000) arising in the 2020/21 tax year. As Luiza will have already used her annual exempt amount, capital gains tax will be payable on £41,000 at the rate of 20%. Entrepreneurs’ relief will not be available as Luiza will not hold 5% of the shares in Damiana plc. The capital gains tax payable will therefore be £8,200 (£41,000 x 20%).
Luiza’s net increase in wealth will be £95,075 ((£32·70 x 5,000) – (£1 x 5,000) – £52,875 – £2,350 – £8,200)
Alternative 2 – Enterprise management incentive (EMI) scheme
The value of shares in the scheme on 1 November 2017 will be £122,500 (£24·50 x 5,000), which is within the £250,000 limit.
No income tax or NICs will be payable by Luiza on the granting of the options in 2017/18.
On exercise of the options on 2 November 2020, income tax and NICs will be payable on the difference between the market value at the date of grant and the exercise price of the options, i.e. £7,500 ((£24·50 – £23) x 5,000). This is the amount chargeable as it is less than the difference between the market value at the date of exercise and the exercise price. The income tax and NICs payable are therefore £3,525 (£7,500 x 47%).
As before, a chargeable gain will arise on disposal of £41,000. The gain will be charged at 10% as entrepreneurs’ relief will be available. This is because for an EMI scheme there is no requirement for the shareholder to have a minimum 5% shareholding in the company, as long as the option was granted at least one year before the date of disposal, and the individual has worked for the company for at least one year prior to the date of disposal. The capital gains tax payable will therefore be £4,100 (£41,000 x 10%).
Luiza’s net increase in wealth will be £40,875 ((£32·70 x 5,000) – (£23·00 x 5,000) – £3,525 – £4,100).