Small business » Tax Research UK

How to tackle the crisis in small business taxation

Corporation Tax, HMRC, Small business Comments Off

Feb 042012

This weeks ‘scandal’ at the Student Loan Company, where a director who appears to be an employee has been paid through a personal service company has excited lots of attention. I know there will be more similar stories: I have been called about them.

But I’m not interested in the stories of the people involved; I am more interested in the systemic issues. There are two of these. The first is the problem that small business tax is too complicated and fails to reflect the economic reality of the way in which many small businesses work. The second is that the government through H M Revenue & Customs and Companies House is simply failing to collect the tax due from small companies.

I deal with the first here. I wrote the following in 2007 when H M Revenue & Customs had lost its last major anti-avoidance case against the use of a small limited company to both receive the income of what was claimed to be a disguised employment and which then split that benefit between a husband and wife. I wrote then:

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.

That invitation still stands: the problem remains. I remain sure I have offered a viable alternative. I know it was well read and discussed in the Treasury at the time. Is this the time for change?

Yesterday the economics of the playground, today the verges of madness

Auditing, ConDems, Small business 7 Responses »

Mar 172011

I missed this letter in the Guardian on Tuesday from Philip King, CEO of the Institute of Credit Management, but it’s well worth noting:

The business secretary announced on 4 March that small firms will no longer have to produce independently audited accounts in a measure he believes will save 42,000 businesses £40m per year. I’ve always respected Vince Cable and have no doubt of his commitment to helping small business, but such a move demonstrates a naivety that verges on madness. I agree with him when he says that “one of the barriers to growth is the burden of regulation ‚Ä¶ it takes up time and stops business growing, and that means our economy does not grow”. That is why the ICM supports the reduction of red tape. But please can we understand that producing accounts is not “administration” and neither is it unnecessary red tape.

Far from helping small businesses, the move is more likely to damage a company’s access to credit, therefore restricting growth and in fact adding to their costs. The government needs to get away from this idea that reducing red tape will always mean reducing costs to small businesses. Businesses extend credit to one another based on the trust that comes from knowing that the company is financially viable, and one of the essential proof points is a set of audited accounts.

Banks too look to lend on the basis of sound financial data, so limiting the amount of financial information available will do more harm than good. The government must stop sending mixed messages. If it wants small businesses to drive the economy, this is not the way to do it.

Precisely.

But the neoliberals who think all government is bad and all regulation a burden continue their march towards……..well, the verges of madness.

And yet more evidence is provided of the economics of the playground dominating thinking in the Treasury, BIS and elsewhere.

Office for Tax Simplification adopts Tax Research UK idea

Small business 4 Responses »

Mar 102011

The Office for Tax Simplification has published its first report on simplifying small business tax.

I submitted evidence to this review and met the OTS.

And they seem to have listened. One recommendation is for a reform I first suggested in 2006 – and which was (I know) reviewed extensively by HMRC at the time (I know because I met them to discuss it). This is for a flat rate deduction for expenses for small business. In other words, all a small business would have to record would be its income and a standard offset percentage would be allowed, if they wished, for expenses.

Tax fraud at this level is on income – so the whole focus should be on that. And of course this would not stop a business preparing accounts if it wanted.

This is a move in the right direction.

Merging NIC and income tax is another issue.

CIOT supports small business tax reform

Small business, Tax management 2 Responses »

Mar 262008

The Chartered Institute of Tax issued the following press release today:

The Chartered Institute of Taxation (CIOT) welcomes the second Early Day Motion (EDM) on income shifting that has been tabled in the House of Commons. When the first EDM was tabled the CIOT said that it had long been of the view that fundamental reform to the structure of small business taxation was necessary if small businesses were to be able to plan their tax affairs with any degree of certainty.

The second EDM says: “That this House‚Ä¶ calls on HM Treasury and other affected departments to use the additional year that they have allowed themselves for consultation on this issue to undertake a thorough review of more appropriate means of providing smaller enterprises with a suitable legal entity designed for use in the 21st century, and not the 19th century as the limited company was, that will simultaneously reduce the taxation, accounting and regulatory burdens on smaller enterprises, so freeing them to generate wealth and employment in the UK economy, whilst ensuring that they can with minimum effort comply with the taxation and other requirements imposed upon them by law in a way that minimises risk of tax avoidance, creates a level playing field in which all in the sector can compete fairly and ensures that the right person is taxed on the reward they have earned at the right time and in ways which do not create artificial and inappropriate incentives to recategorise employment as self-employment, and the reward for labour effort expended as investment income.”

Rob Ellerby, CIOT President, says: “The MPs who tabled this motion are right to say that by extending the process for another year, the Government has given itself a great opportunity to think through the issue more fundamentally with a view to coming to a better answer.”

The EDM, tabled by David Drew MP, is based upon Tax Research’s submission on this issue to HM Revenue & Customs. I welcome CIOT’s endorsement of this approach.

SME tax reform

Accounting, Small business 2 Responses »

Mar 202008

I have triggered a lot of debate it seems on SME tax reform.

I just posted the follwoing comment on AccountingWEB and thought I would repeat it here. It does in part answer questions posed here:

Can I summarise what I have actually recommended since I think this might help?:

a) That Limited companies have a minimum capital requirement – at least £10,000, maybe more. This means they will not appeal to many of the small enterprises where income shifting is a problem. They will still be available to those who need to commit capital to their enterprise and they will keep the tax rates that are designed with that intention in mind – which I hope deals with Mark’s point on this issue. This limit may need to increase over time. This is EU consistent as far as I can see.

b) Those who do not meet this requirement, or do not want to should be re-registered as LLPs. This does not remove their liability risk. I am well aware that CGT transitional relief will be needed. This will be a cost to HMRC. Can we complain at that?

c) An LLP will not be compulsory. An unlimited partnership could still be used (although why people do that when an LLP is available beats me). The income shifting rules would apply to partnerships though. After all, their tax rules are the same.

d) An LLP could pay a reward for capital contributed to whoever provides it, including a risk premium. That would be fair. I have suggested a simple method of calculation.

e) If it is apparent (and it always is when this is true) that one party is the main income earner in the LLP then their spouse / civil partner / cohabitee could earn a de minimis profit share for the sort of support Emily has referred to – even though this puts them in a wholly unfair situation when compared with employees, where the same practice is, I am sure, commonplace.

f) Reward should then be calculated by default on contribution – and I have given indicators as to how this might be assessed. Not all need be used, other may be much more appropriate (I’m not being prescriptive here – I am just showing these things are possible).

g) If this gives rise to a result the partners don’t like it’s up to them to establish the rationale for a different reward ratio – and to evidence it. For example, if a great idea is being paid for, it would have to be shown that the idea resulted in an increased profit with no greater effort expended. Then it could be justified. This is not hard to do if it is accepted that precision is not possible (and I have always found an understanding of that in my career in tax investigations).

h) The result is a big saving in admin time and effort. No PAYE, no benefit in kind hassle, take money when you want, no CT returns, easier accounting for expenses, and on and on and on. A massive cut in accountancy fees. Is that why the profession does not like this, I wonder?

i) Yes, all profit will be taxed at marginal rates of income tax. Most will be at 20% then, lower than the planned small company CT rate, because that’s what most self employed people pay. And as is obvious, most limited companies also distribute all their profit, so this is the case now as well. And it’s true NIC will be paid at self employed rates. But these are lower than for an employee, so there is still an advantage to being self employed, but the massive distortion that exists now will be removed, which will be a benefit to good market based (rather than tax driven) decision making.

So, tax is paid more fairly, business can be managed much more flexibly with easily changed reward ratios and vastly reduced admin, and even a guarantee that some income shifting is acceptable.

I know accountants hate tax. But isn’t this fairer than now? Easier than now? Less admin for most businesses than now? Much less hassle than what HMRC proposed?

Seriously, it may be flawed, but where are the flaws for the vast majority of small businesses who could win from this bar some additional NIC payment (which the government is clearly intent on getting somehow or other)?. Isn’t this a viable working compromise? And if not, why not? I’m still struggling to see why it isn’t for most clients of most accountants, bar the fact that the accountant will, I know, make less from this arrangement.

I do have a terrible feeling that the last point may be the most important. That worries me.

Are accountants really so incapable?

Accounting, Small business 13 Responses »

Mar 192008

AccountingWEB’s Business Zone has covered David Drew’s EDM on income shifting. What’s really interesting though is the reaction of Grant Thornton’s George Bull, who has said:

At the heart of this EDM are the same problems for HMRC, [which is] how do you value the contribution of different people in a small business? You end up with the same problem of having to find a statutory method of measuring an individual contribution to a business.

Amazing isn’t it? Accountants are meant to be able to measure value, but profess they can’t when it suiots them. Accountants are meant to believe in the market, but suggest that there is no market indicator in this case. Do they really believe that, because if they do I have a simple answer. Statute should provide the basis of apportionment if the market does not work.

Perhaps they’d like to reassess their capabilities in that case and work just how the market should indicate value arises. Let’s start with these key performance indicators, some or all of which could be used to indicate a basis for apportionment, and none of which need take long to assemble on an annual basis:

1) What does the business do. Who of those sharing its rewards has the training or qualifications to provide that service?

2) How many hours does each participant in reward work for the enterprise each year, approximately?

3) Of the hours worked, what proportion were spent in dealing with customers?

4) Who runs the administration of the business? Administration includes (but not exclusively) billing, accounting, managing correspondence, liaising with suppliers, dealing with accountants, taxation and business regulatory issues. Separate estimates for each category of administration can be given if appropriate.

5) Does each participant in the rewards of the business have their own computer? If not, why not?

6) How many business emails were sent by each participant in the reward of the business each year? Can this be proven by the use of different email addresses?

7) Does each participant in reward have their own business mobile phone? From billing records can it be shown what proportion of business calls were made by each?

If the company has a vehicle who usually drives it?

9) Do any of the participants have other employment? If so, how many hours a week do they, on average, spend on that employment?

10) If neither has other employment do either have child care or other care obligations? Do these limit their capacity to work?

Answer these (and in the case of Tax Research LLP my guess is my wife and I could answer these questions, accurately, in less time than it took me to type them) and you’ll have a very good overview of who is generating the profits in an enterprise.

That will be true for 97% of all businesses affected by income shifting, in my experience (and I’ve seen hundreds of this sort of entity in my time). The rest will have to create their own evidence. That’s always true of all systems, so the exceptions are not a problem.

Having determined who is generating the profit it’s then a matter of assessing the value of the supporting partner’s services. I’ve suggested a de minimis be allowed, which I think is fair. Try to increase that and evidence must be given (and reasonable and supported answers to the above would be a good starting point in supplying relevant evidence). And if the rate to be attributed to support time is to be beyond market rates then again reason must be given for use of a non-standard, out of line with market figure.

Is this fair? Yes.

Is this what accountants do all the time? Yes.

Is it a burden? No.

Are those accountant who say it is not possible to do this simply hiding tax avoidance? You know the answer to that.

Small business taxation Early Day Motion

Small business 2 Responses »

Mar 192008

The following Early Day Motion was tabled in the House of Commons yesterday:

EDM 1195

INCOME SHIFTING AND THE FUTURE OF SMALL BUSINESS TAXATION

17.03.2008

Drew, David

That this House welcomes the decision announced in the Budget to defer legislation on what has been described as income shifting within small limited companies and partnerships; and calls on HM Treasury and other affected departments to use the additional year that they have allowed themselves for consultation on this issue to undertake a thorough review of more appropriate means of providing smaller enterprises with a suitable legal entity designed for use in the 21st century, and not the 19th century as the limited company was, that will simultaneously reduce the taxation, accounting and regulatory burdens on smaller enterprises, so freeing them to generate wealth and employment in the UK economy, whilst ensuring that they can with minimum effort comply with the taxation and other requirements imposed upon them by law in a way that minimises risk of tax avoidance, creates a level playing field in which all in the sector can compete fairly and ensures that the right person is taxed on the reward they have earned at the right time and in ways which do not create artificial and inappropriate incentives to recategorise employment as self-employment, and the reward for labour effort expended as investment income.

I warmly welcome this EDM. David takes forward the ideas I discussed in my papers on this issue, parts at least of which I know have been placed in the House of Commons library.

It would be very good if this EDM now got wide support, and it already has signatories from all the main parties. Small business does not now need a ‘lash up’ solution on income shifting. Real change is needed to provide it with an appropriate structure and accounting and tax environment for the 21st century.

Income shifting

Small business, Tax management Comments Off

Mar 122008

The Chancellor has listened to me: the rules on income shifting will be postponed for a year.

Let’s hope he really consults.

Income shifting: why accountants are protesting too much

Accounting, Ethics, Small business, Tax management 9 Responses »

Dec 142007

I have been reading the reaction on AccountingWEB to the HM Revenue & Customs’ paper on income shifting.

As far as I can tell I am the only accountant who thinks income shifting is a problem. That of course probably means I have the support of the vast majority of the population, since accountants are usually out of step with public opinion on most issues so this does not unduly concern me.

Let me also be clear: I do not think this document has got the arrangements for income shifting right. My own paper on this shows that HM Revenue & Customs should be much more comprehensive in its approach and it is the application of this approach to self employed income alone that is in this case the mistake HM Revenue & Customs have made.

But let me come to my main point, which is that the Revenue should dismiss much of the comment that has been written on AccountingWEB.

First of all, it is easy to do so. I’m sure the Revenue must wonder, as I do , what advice accountants who only seem capable of moaning actually offer their clients.

Second, even from some more able commentators much of what has been said is wholly unrealistic. A husband who comes to rescue a self employed wife whose car has broken down is not offering a business service. I did the same for my wife when she was in employment – and never expected reward from her employer. You do this because you are married. It is quite absurd to suggest that this is a business supply.

Third, it is also absurd to suggest that in this day and age people need a wife (and it seems almost exclusively to be wives who do this) sitting at home by the phone to get business. You don’t, and anyway, I’ll guarantee they don’t stay there all day. This is an excuse, not a justification. Mobile communications have completely destroyed this argument and those who will not use them need to get a life, not a servile wife.

But worse, and fourthly, there seems implicit in the comments a level of surrealness that is hard to credit. An attack by HM Revenue & Customs on income shifting is not an attack on marriage, it is an attack on tax abuse. A requirement to prove that an expense is properly incurred by a business is no more than suggesting that proper books and records be kept. Can anyone, let alone an accountant, object to that? And the same is true of the allocation of reward to capital if the dividend route is adopted and the payment is out of proportion to the risk that the capital bears – and this will not be an issue if it is not. Again, what is unreasonable about that? We have always known that records need be kept for business purposes.

Which makes the suggestion from the accountancy profession that it will not be possible to prove the proper allocation of reward a simple cry of incompetence. I wonder, are those who claim this really accountants at all? Is it beyond their wit to come up with some key performance indicators that might suggest degrees of involvement in a business? Some such indicators might be:

1) Time spent business planning, which is an hours measurement;
2) Dealing with correspondence (count the emails – it’s an easy test);
3) Time on the accounts – not hard to prove – sign the vouchers as they’re processed and keep copies of signed cheques as evidence of involvement and the case is proven, I suggest;
4) Log the business phone calls received – doesn’t that make sense anyway, and won’t a simple book by the phone do for the job?
5) Estimate the work contribution to productive output if there is one – but be realistic as to what it is and what it’s worth. My wife, for example, reads some of my stuff before it is published to offer a second opinion, style comment and so on even though she has no tax knowledge. That has a value. Is it beyond anyone’s wit to attribute reasonable value to that, and to keep a record? No one will be seeking precision to the last 10p, after all.

My answer is that this is entirely feasible, perfectly possible to do, and necessary if you want the tax advantage. I just don’t see the issue.

Or rather, I think I do. You see over very many years during which I have been responsible for thousands of sets of accounts I can’t recall more than a handful where a salary was paid to a spouse. But once I worked for a firm where it was routine to income split – indeed the client was never asked for their consent. It was routine.

My approach required me to justify why I income split, although it was never a problem – the most basic questions could establish if there was a real partnership or not. And if it existed then a note was made as to the reasoning, because I believed that the settlement legislation applied in the 1980s, not just now. And the reasoning would not have been extensive but would have covered key issues on which evidence could be secured of the type noted above so that if enquiry arose the matter could be dealt with. I just thought that common sense.

But the reality is, I suspect that this was an unusual approach to accountancy and that the routine claiming of deductions for which there is no support and the reallocation of income without economic justification has been the norm and that as a result many accountants have been assisting an unjustifiable exploitation of the tax system which they know has now been rumbled.

That’s what the protests are about. And that’s why they should be ignored.