The Arctic Systems case has been widely reported, but much of the comment made upon it has been high on emotion, but low on analytical content.
I wrote on this case, and as a result was challenged to produce a suitable response. That I have now done. The full paper is available here. The summary says:
This paper analyses the way in which the owners of many small limited companies reward themselves and members of their families out of the income that their labour generates for those companies. This is particularly relevant in the light of the recent House of Lords ruling in what is known as the 'Arctic Systems' case. The paper shows that many of these arrangements do constitute tax avoidance because the rewards paid do not much the underlying economic substance of the transactions that are taking place.
In the interests of promoting tax justice for all taxpayers HM Revenue & Customs have a consequent duty to promote new arrangements that will encourage tax compliant behaviour in this sector. Tax compliance is defined as paying the right amount of tax (but no more) in the right place at the right time where 'right' means that the economic substance of the transaction accords with the declaration made for taxation purposes.
The paper does then show that this problem is almost insoluble whilst these businesses are operated through the medium of small limited companies which were not designed for and are unsuitable for the type of activity they undertake.
As a result this paper proposes that:
1. A change in company law to allow the re-registration of small limited companies as LLPs. An LLP is tax transparent: its income is taxed as if it belongs to its members even though it is a legal entity that is separate from them for contractual purposes;
2. The introduction of new capital requirements for the incorporation of limited companies undertaking trades, and over time forced re-registration of those that do not meet that standard as LLPs;
3. The introduction of a new investment income surcharge at rates broadly equivalent to national insurance charges that would have the benefit of reducing the incentive to split income, restore the taxation balance between income earned from all sources and allow a reduction in the base rate of income tax without adding substantially to the burden of administration for taxpayers since those liable will, in the vast majority of cases, already be submitting tax returns;
4. Create new, economically justifiable and verifiable standards for splitting income in LLPs so that the risk of legal challenge to such arrangements will be substantially reduced whilst recognising the significant role that the partners of those who supply their services through owner managed corporate entities play in the undertaking of that activity.
If this were done then:
a. The administrative burdens for many small businesses would be reduced;
b. The certainty of the arrangements under which they can operate would be increased;
c. The rewards that they rightly seek to pay to those who contribute to the management of these companies from within domestic relationships will be rewarded, but within appropriate constraints;
d. The attraction of freelance status in tax terms would be retained;
e. The current injustice that sees income from labour more heavily taxed in the UK than income from capital would be eliminated in large part without prejudicing the required favoured status of pensioners;
f. The incentives for tax planning would be reduced, so simplifying tax administration;
g. The tax yield might either rise, or a reduction in the tax rate might result.
The challenge in creating such a system is significant because it requires cooperation across government departments, but far from insurmountable. It is part of the challenge of creating an enterprise culture that meets the needs of the UK in the 21st century, and that is a challenge that any government needs to meet.
As I note at the end of the paper, suggestions and comments are welcome. But please do read the paper first and not just the summary.
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Richard – I like this bit:
“particularly relevant in the light of the recent House of Lards ruling”
You’re not suggesting that our peers are Fat B*****ds are you?
Proof reading never was my strongest attrribute
Now amended. Thanks!
[…] Arctic Systems: Moving small business taxation on in the UK […]
😕 It didn’t help when the government introduced a zero rate bands for CT that almost anyone would have read as an invitation to incorporate and save, not avoid, avoid tax. There seemed to be no other reasonable interpretation at the time.
But is not the heart of this problem the separate NIC regime, in that it’s the discrepancies between employed and self-employed contributions that make up the lion’s share of the overall taxation differential?
Until something is done to make NICs fairer, the self-employed will have an advantage in this area. Until something is done to ease the tax burden on retained profits for the self-employed, companies will have an advantage.
If you want income via a company to reflect the substance of the transaction, might not a quick fix pending an overall review be to stipulate that whatever total rewards are drawn from companies with pre-directors’ remuneration profit of say £100k at least 75% of those rewards must be taxed as earnings. This would surely be much simpler to implement than forcing small companies into LLPs and fairer than making no allowance for undrawn/retained profits that have been reinvested in the business.
The trouble with NIC is that pensions do depend on it. I can’t see it going.
And candidly I don’t mind if the self employed get a small advantage: optimality is not possible
Retaimed profits are irrenleavnt though: 99% of small businesses don’t need them or have them. If they do, then they need capital and I have allowed for those to stay in the limited company system.
Which is better than forcing dividends to be earnings as they might not be in the case of an investment company, for example, and which would also be inappropriate if paid to a non-UK investor.
Richard
Richard and Nick,
Labour (laughingly) purports to encourage entrepreneurship/the smaller business, this was signaled (a false signal it would now appear) by the 0% Corporation Tax band that was introduced just long enough to trap more small businesses into the corporate structure.
What I am constantly seeing on this blog, and more so in Nick’s suggestion of directors being forced to take 75% of profits as remuneration is more ‘theoretical’ ranting that do nothing at all to help encourage small business in the UK.
Richard you mention the ‘right amount of tax’ so often, yet when as in the Artic Systems case the highest court in the land supports the claim they have paid the right amount of tax you seem at ease with ignoring it and going on about changing the rules (goal posts), why? Are you running for a government position we all should be made aware of?
What about risk and reward, those who run their own small businesses take the risk of having no income if they can’t find any work, so why shouldn’t they have the reward, and if through this they take their income in such a manner as Artic Systems then why not, after all they ‘have paid the right amount of tax’!
Your views are so out of step with the modern age, even the divorce courts recognize the role the spouse has to play in any business and rewards them accordingly, come on, be more imaginative and stop towing the HMRC line.
Jason
You seem to forget that the ‘right amount of tax’ is defined by law, but that law may result in the wrong answer, economically. Then we have injustice (and we have here).
So the law must be changed. What is wrong with that? And since I propose guaranteed income splitting, lower admin and lower tax rates than on employment for the self employed can you please tell me just what is wrong with what I propose?
Ranting really does not help. That’s why I’ve produced a reasoned paper.
Richard
The law may result in the wrong answer? Richard, what I think you mean is if you don’t get the anwer you want it is wrong.
That is not reasoned, far from it, you talk about injustice, yet the law of the land has stated it is just, are you now putting yourself above the ‘law of the land’, sounds like a ‘Murphy dictatorship’ to me 🙂
SMEs are responsible for the majority of employment, and they have the highest mortality rates – especially the smallest firms. The evidence shows that what kills them is not the cost of finance (although it’s a common complaint), nor yet the complexity of taxation (ditto), but rather it is uncertainty. Three particular kinds of uncertainty – that related to the performance of the particular industry sector or of the macroeconomy as a whole, that related to the (current and future) availability of finance and that related to the legislative and regulatory environment.
The first type of uncertainty is simply a part of running a business, albeit that government can improve the macro-environment – e.g. by giving independence to the central bank is a valuable stabilising policy, perhaps the best Brown policy move to date.
The possibility of a credit crunch due to under-regulation of lending in the States is clearly a worry in terms of the second type of uncertainty, but the UK appears likely to be somewhat insulated at least.
The third type of uncertainty is directly in government control though. The danger of the political process, as has been amply demonstrated in the NHS over the last twenty years, is that politicians have incentives to be seen to act – leading to a series of frequently reversed policy changes. This has been rubbish for the NHS, as Richard’s wife can no doubt testify, and with Darling and Redwood/Osborne apparently bent on battle over regulation, we can expect much more of this for small business to deal with. Redwood’s proposals to bin regulation are largely regressive, anti-consumer and foolishly myopic (with built-in likelihood of reversal). But the noises from the government have not been great either.
What is really needed by small business is a stable regulatory-cum-legislative environment. Richard’s proposal might ultimately provide this; in any case, it highlights the need for a full discussion of possibilities, with _broad agreement_ on the final form so that small businesses can plan with certainty and see their volatility and mortality correspondingly fall.
I would not normally have allowed a comment such as that Jason posted above at 12.15pm on this site.
I have done so for one reason only: to show how difficult it is to hold rational debate with many in the small business lobby. This sort of comment does, for example, abound at AccountingWEB and makes many serious commentators want to curl up with embarrassment.
I will not be allowing similar comments on this subject hereafter.
Richard
Alex
Thanks. I agree with what you have written.
Richard
‘Serious commentators’, personally I see myself as a serious commentator, but I am not a professional one (more an amateur who is learning as he goes), just frustrated Richard that you would always appear dismiss those whose opinion conflicts with yours.
But rather than denigrate this posting and its comments, I will refer to your posting, I have to firstly admit I have not had time to read the full paper (yet, sorry), however, why would a Limited Co want to re-register, as an LLP carries the same ‘red tape’ issues of a Limited Co without the obvious tax advantage given by tax legislation. Granted the taxation of an LLP is transparent, you are taxed as an individual end of story.
I agree with a minimum capital requirement, I have always thought this should be set at £1,000 at least this would make my job easier and only those serious about their venture and operating as a Limited Co with all its obligations would choose this route. Any higher an amount I feel would disadvantage to less fortunate who have a good business/idea but it maybe anything more than £1,000 would prove difficult to fund.
I have to ultimately state that changing the law to rectify what HMRC considers a ‘loop hole’ is ultimately not the answer in my view, but the little man is a soft target, I would personally like to see government waste dealt with, I know this is the wrong blog for this Richard but it directly effects how much taxation has to be collected which has the knock on effect on tax rates.
Control government tax waste, deal with those who are not declaring income (including the black market), deal with clear and overtly designed schemes to avoid tax for the wealthy, deal with benefit cheats etc then maybe, just maybe Richard, our debate would be totally different, with lower rates of tax and maybe even a better social system to boot.
But hey, utopia, guess it will never happen.
Jason
I think I am entitled to differ with those who have not read what I have said
And I do not by any means denigrate all who differ with me – frequently I engage with them. But only when a credible argument has been offered.
As for government waste – where do you think it goes? Straight into the private sector in almost all cases – who are the people who persuaded the government to buy products that don’t work.
Richard
Richard,
I read your paper with interest, as I have some of your previous writing on this subject.
But I happen to disagree with the central premise that the economic rewards of each participant do not reflect the value of the inputs made by them in such a case.
If we assume that we all have the right to a family life unimpeded by the State, then each family must make economic decisions based on this situation.
In many of these cases the results are as you describe, since the difficulties of split working arrangements are many, added to which the possibility of two lots of convenient part-time working being economically sufficient are remote.
In reality then, one partner opts to ‘stay at home’ while the other ‘goes to work’. In a very real sense, the ‘stay-at-home’ partner has provided a key enabler for the other partner to generate income, and without this enabler that partner would simply not be able to do that even in these days of ‘flexible working arrangements’. It is simply disproportionately more effective for one partner to be able to devote their full energies in pursuit of family income.
If I were to purchase software which enables me to generate significant economic value via an intellectual or creative process, I would be very happy to pay some proportion of the additional value for that software. We see this pricing model hard at work in many parts of the software industry.
If I were to purchase domestic assistance services, or perhaps a domestic robot (don’t tell my wife!) which enabled me to free up time to generate economic value, again the equation makes sense even if the market dictated it that such a service was priced far in excess of its apparent cost.
I conclude therefore that the economic value added by the stay-at-home partner in these cases is in fact significant even if they were to fail to lift a finger to do any of the required ‘management activity’. Without their support, the entire enterprise would simply be untenable.
This might be the conclusion reached in the hearts of many in this situation – ‘tax justice’ to them is actually being well-served by income splitting – hence the lack of compunction with which these arrangements seem to be created.
The question should be how can the system be changed to permit such arrangements made available to those in employment, not how such arrangements should be squashed in the one place where they can flower!
Ed, I think there’s something in this; but you’re talking about the problem of valuing the economic contribution of a primary carer or a “home-maker”, to use that unfortunate Americanism. The relevance of this problem is far from limited to this case, and it’s not clear to me that you’d be able to make a case for valuing it here more highly than elsewhere – but any sensible general approach would be valued, I imagine. It doesn’t seem a great criticism of Richard’s approach, if we take him to be addressing the existing system though.
Ed
BUT the same privelige is not afforded to those in employment – who are the majority and who also add considerable value to the economy.
If we allowed income sharing in the family unit for all there would be tax justice in what you say (so long as the people not in such relationships got tax releif on all their domestic maintenance costs – a proposition which shows how unlikely income sharing is). But we don’t, and I’m sure we won’t allow income sharing. In which case there is no tax justice in what you suggest, at all.
Richard
It’s probably not worth labouring the point, since I’m sure that income sharing will not come to pass.
I think I was thinking layman’s terms of Justice vs Fairness.
It is perfectly Fair for that privilege to be removed from the latter if it is not available to the former.
But it would be Just for both those in employment and those self-employed to be able to income share.
I think Justice is preferable to Fairness, but perhaps less likely ;->
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