Many local authorities set up LATCOs with the intention of generating financial returns. Over the last 12 months Council funding has faced unprecedented pressure, and so the question of how best to extract profits from the LATCO has never been more pressing.
Paying dividends up to the parent body is the default mechanism for profit extraction. However, dividends can only be paid out of retained profits, so if the LATCO has made losses at any stage there could be a restriction on the amount of dividend that can be paid. It is important not to pay more than the available reserves as that would result in the dividend being unlawful.
In addition, dividends are paid out of taxed profits, so do not reduce tax leakage. However, there are other methods of profit extraction to consider before dividends.
In many cases, the LATCO will receive support from the Council, particularly with management, finance and administration services. The Council should charge the LATCO for these services and, provided the charges are not excessive, they will be deductible in calculating the LATCO’s tax position.
When LATCOs charge for services provided, Councils need to be alert to the transfer pricing rules. These mean that the LATCO’s tax calculation has to apply arm’s length pricing for its transactions with the Council; if the Council charges more than a commercial rate for the services, the tax deduction is restricted to the lower, arm’s length amount. Generally, for support services, an arm’s length charge could be calculated by reference to a mark up on the Council’s costs or to a commercial hourly rate.
Many Councils provide initial funding to their LATCos in the form of a loan. Interest paid on the loan is tax deductible, subject to the application of the Corporate Interest Restriction cap (currently £2 million spread across all related companies).
Transfer pricing principles also apply to funding arrangements, so the tax deduction for interest payable is restricted to an arm’s length amount. This means it is important to consider would an unconnected lender have loaned that amount, at that interest rate and with that security? To answer that question, a thin capitalisation review looks at commercial rates of interest, loan to asset value and interest to profit ratios.
An important point to remember is that the LATCO must be left with sufficient reserves to fund its activities, whatever method is used to return profits to the Council.
If you want to explore profit extraction methods in more detail for your LATCO, please contact one of Ensors’ LATCO team.