What is corporation tax in the UK?
Corporation tax is a tax levied on the profits of limited companies (both private and public). Unlike income tax, however, corporation tax is currently levied at a single rate for all companies. At present, the corporation tax rate is 19%. Income tax, by contrast, increases in bands.
Corporation tax is not paid by sole traders as they and the business are considered to be the same legal entity.
Example of corporation tax
John and Jane Smith decide to form a limited company together. They call it J & J Smith. In its first year, J & J Smith Ltd makes a pre-tax profit of £150K. The company pays £28.5K corporation tax on this, leaving it with a net profit of £121.5K. This profit belongs to the company J & J Smith, not John and Jane directly.
John and Jane are, however, J & J Smith’s sole directors and owners. What happens with this profit is, therefore, entirely up to them to decide.
They can choose to leave it in the company (perhaps to finance investment for future growth). Alternatively, they can withdraw some or all of it to increase their private income. If they withdraw it, they will be taxed on the income as private individuals.
For example, if they pay themselves a salary and/or award themselves bonuses, they will pay income tax and national insurance on this income. If they pay themselves dividends, these will be subject to dividend tax.
Minimising corporation tax
At a basic level, corporation tax is paid on a company’s profits. That means everything that is left over after all allowable expenses. It is, therefore, important to ensure that businesses claim all allowable expenses.
Expenses that can be deducted before corporation tax is calculated are generally known as tax-deductible expenses (or just tax-deductibles). As a rule of thumb, any expenses that relate to essential purchases are likely to be tax-deductible.
Understanding what is and isn’t legally considered an essential purchase can, however, be complicated. For this reason, it’s generally best to have company accounts prepared by a qualified accountant. This ensures that you pay your tax liability in full but do not overpay.
Corporation tax and other taxes
Corporation tax is separate from other taxes but it can influence them. Here is a quick guide to what this can mean in practice.
Corporation tax and income tax
Corporation tax is paid by the company itself. If company funds are used to pay employees/workers and/or service providers (e.g. freelancers), it will lower the company’s pre-tax profits. This will mean that the company pays less corporation tax. The people paid by the company, however, will need to pay income tax and national insurance on the money they receive.
Regular employees (and service providers) will typically need to be paid the going market rate for their services. Directors who are also employees are mandated to pay themselves at least the minimum wage. They can choose to pay themselves more but not less.
Directors who are employees also have the option to divert regular income into pension contributions. These are counted as part of their pay but are not liable for income tax or national insurance (subject to certain limits).
Corporation tax and dividend tax
Dividends are paid out of a company’s post-tax profits. This means that, in itself, paying dividends will not reduce the amount of corporation tax a company pays. If, however, directors who are employees take payment in dividends rather than a salary, it will reduce the company’s liability for employers’ national insurance. This may increase the company’s profits and hence its liability for corporation tax.
The shareholders who receive the dividends will be liable for dividend tax. This may, however, be more economical for them than paying income tax and national insurance on a salary and/or a bonus.