Understanding the 26.5% Marginal Corporation Tax Rate for SMEs
As a small or medium-sized enterprise (SME) owner, navigating the complexities of taxation is crucial to managing the financial health of your business. Recent changes in the UK tax regime, particularly in corporation tax rates, can have significant implications for your business if your profits fall within certain thresholds.
In this blog, we’ll break down what this means for you and how employer pension contributions for directors can be an effective way to manage your tax liabilities.
Corporation Tax Explained
In April 2023, the UK government implemented a tiered structure for corporation tax. Under this system, businesses with profits up to £50,000 pay a rate of 19%, while businesses with profits above £250,000 are taxed at 25%. The tapered corporation tax rate between these points mean that, for businesses with profits between £50,000 and £250,000, a marginal tax rate of 26.5% applies.
This may seem counterintuitive at first, but the reasoning behind this higher marginal rate is to ensure a smooth transition between the lower and higher tax bands. Essentially, the 26.5% rate is designed to phase out the benefit of the lower 19% rate as profits rise toward the £250,000 mark.
For SME directors, this can have a substantial impact on cash flow and overall financial strategy, especially if your profits regularly fall into this range. In this context, it’s important to understand that effective tax planning can help you minimize the impact of this marginal rate on your bottom line.
The Role of Employer Pension Contributions
One of the most effective tax planning strategies for SMEs in this situation is making employer pension contributions on behalf of directors. Employer contributions to a director’s pension scheme are typically treated as an allowable business expense. This means they can be deducted from your taxable profits, reducing the amount of corporation tax you pay.
Example: The Impact of Pension Contributions
Let’s say your business has profits of £200,000 before making any pension contributions. Under the current tax regime, you would pay:
19% tax on the first £50,000 of profits (£9,500)
26.5% tax on the remaining £150,000 (£39,750)
Your total corporation tax liability would be £49,250.
Now, imagine that instead of leaving your profit at £200,000, you make an employer pension contribution of £60,000 to the director’s pension scheme. This reduces your taxable profit to £140,000. The corporation tax calculation would then look like this:
19% tax on the first £50,000 of profits (£9,500)
26.5% tax on the remaining £90,000 (£23,850)
Your total corporation tax liability would now be £33,350, a significant reduction from the original £49,250. In this example, the pension contribution has not only saved £15,900 in corporation tax, but has also added to the director’s pension pot for future retirement.
Further Tax Savings
Employer pension contributions offer several advantages beyond immediate tax relief. Contributions made by the business are free from National Insurance contributions, adding another layer of savings for the company. Additionally, pension funds grow in a tax-advantaged environment, meaning that investments within the pension scheme can grow free of income tax, capital gains tax, or dividend tax.
For directors, pension contributions provide an efficient way to extract profits from the business without incurring personal income tax until retirement, when withdrawals are typically subject to lower tax rates. Furthermore, up to 25% of the pension fund can usually be taken as a tax-free lump sum upon retirement.
Key Considerations for SME Owners
Before making large pension contributions, it’s important to consider a few key factors:
Annual Allowance: The total amount you can contribute to a pension each year while still benefiting from tax relief is subject to an annual allowance, currently £60,000 (or Net Relevant Earnings, whichever is lower) for most people. If contributions exceed this limit, there may be tax charges to consider.
Typically SME owners can make employer pension contributions of up to £60,000 subject to the wholly and exclusivity test. The wholly and exclusively test requires that employer pension contributions must be made wholly and exclusively for the purposes of the business to qualify as a deductible expense for corporation tax. This means contributions should be made solely for genuine business purposes, such as attracting or retaining employees, and should not include personal benefits unrelated to business needs or intentions. Your accountant should be able to provide confirmation/further information, if required.
Lifetime Allowance: While the lifetime allowance has been abolished as of April 2023, it’s important to stay informed about potential future changes that could impact large pension pots.
Cash Flow: Pension contributions are a long-term commitment. While they provide immediate tax relief, you won’t be able to access the funds until you reach retirement age (currently 55, rising to 57 from 2028). Ensure that your business has enough liquidity to meet ongoing obligations after making a pension contribution.
Conclusion
For SME owners, the 26.5% marginal corporation tax rate brings an added financial strain. However, with strategic planning, you can reduce your tax liability while simultaneously building up a retirement fund through employer pension contributions. By taking proactive steps, you can optimize both your tax position and long-term financial security. Always consult with a professional financial adviser to ensure that your strategy aligns with both your business goals and personal financial planning.
If you’re based near Bath or the West Wiltshire area and are interested in exploring how employer pension contributions can benefit your business, feel free to contact us. We’re here to help you make the most of the tax landscape and safeguard your financial future.
Please note: The content of this blog is for your general information purposes only and does not constitute investment advice. It is based upon our understanding current HMRC legislation and guidance. While we believe this interpretation to be correct, it cannot be guaranteed that such information is accurate as of the date it is received or that it will continue to be accurate in the future. We cannot accept any responsibility for any action taken or refrained from being taken as a result of the information contained. Thresholds, percentage rates and tax legislation may change in Finance Acts. Reliefs from taxation are subject to change and their value depends on an individual’s personal circumstances.
The Financial Conduct Authority does not regulate tax advice. Your capital is at risk. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available.