Background

The reaction to Gordon Brown’s latest budget from the small business community has been predictable. They don’t like it. Take this from David Frost, director-general of the British Chambers of Commerce:

"The results of our survey make worrying reading for Gordon Brown. 71% of UK businesses think that the rise in the Small Companies’ Rate from 19 to 22 per cent will harm their business”

"As a Chancellor who champions enterprise and acknowledges the importance of small business to the UK economy, many of our members feel let down and are dismayed by the measures taken which will hit their competitiveness and increase their tax burden”.

What might have been added, but wasn’t, is that this change of tack in increasing tax rates on one part of the small business community is just the latest of many apparent changes of direction in strategy for this sector. Indeed, so many are the changes that its possible to suggest that there is no apparent strategy in use.

History supports this view. Since taking office, when Labour cut the corporation tax rates for small business, there has been a general trend downward in corporation tax rates for small business that the latest announcement is the first to reverse. In addition, Labour introduced both 10% and even 0% tax rates on part of small corporate income, and then seemed amazed at the response when people incorporated to take advantage of these incentives. The backlash has been harsh and includes

• IR35; 
  
• The use of settlement legislation with resulting uncertainty as to how the income of many small incomes is to be both determined or taxed which is ongoing at the time of writing;
  
• Increases in national insurance all round which only emphasised the problem of dealing with incorporated businesses;
  
• Recent attacks on composite companies and some specific sectors where self employment is prevalent, such as the construction industry.
  

There’s no doubt the Chancellor would like to accept the suggestion that he’s a champion of enterprise and small business, but is he, and if he is, how should he proceed now? These are big questions his successor and he will need to address.

Some facts

It’s important that the terms of any such debate be clear. They frequently are not. David Frost is one of many to completely miss the most obvious point about small business tax in the UK because he, like most commentators, assumes that small companies (as defined for corporation tax) are synonymous with small business in general. They are not. According to statistics on the HMRC web site in 2004-05 (the last year for which data is available) there were some 4.64 million self employed people in the UK. Admittedly, 875,000 of these had income of under £1,000 but that still leaves almost 3.8 million who probably undertake some serious self-employed activity. 879,000 self employed people made more than £20,000 a year. As such it is clearly quite wrong to think that small business and those running small companies are one interest group.

That said, there are over 2.3 million active companies in the UK in April 2007 (http://www.companieshouse.gov.uk/about/busRegArchive/statsMarch07.pdf). Of these only 10,877 are PLCs. It is not known how many companies are small, but it is thought to be over 90%. Of these a fair proportion will be dormant i.e. they do not trade. In addition, it should be noted that there are just 23,000 active Limited Liability Partnerships in the UK.

What this does makes clear is that despite all the claimed benefits of running a small business through a limited company, a significant majority of people who engage in entrepreneurial activity do not do so. Anecdotally, it is also apparent that by no means all those who use limited companies do so ‘tax efficiently’ by paying themselves minimum salaries and maximum dividends. Many would say that in this case they voluntarily pay more tax than is necessary. Why LLPs, which are the obvious compromise between the two states, appear so little used is another question any policy consideration needs to address. 

The apparent tax issue

First though, let’s get the tax issues straight. I recently did some calculations based on the tax year 2007/08 as to the relative tax payments that would be due if £50,000 was available to a small enterprise for distribution payment to a proprietor for services supplied. I allowed for admin costs of a little over £1,000 a year for both an LLP and a company. I assumed a company would pay a salary of £6,000 per annum to its director to ensure NIC was paid and would thereafter pay dividends (subject to all the uncertainties we know inherent in this strategy at present). The resulting figures for net benefit arising out of the £50,000 available were:

                                                                 Tax due                     Net benefit received

Salaried employee                                    £17,827                               £32,173

LLP / self employed                                  £13,558                               £35,242

Limited company                                      £10,356                                £38,243

I stress, these should be considered indicative, but that said the indication is clear. It appears to make little tax sense to run a limited company and pay rewards to the owner / directors as salary whilst limited companies paying low salaries and high dividends are apparently more ‘tax efficient’ than those using LLPs or having self employed status. This contrast is almost entirely due to the lower rate of tax on dividends and the savings in Class 4 NIC.

Confusing the tax issue

It has also to be noted that the clarity of the conclusion is actually nothing like as obvious as it seems at first instance. There are good reasons for saying this:

1. Those who opt for the PAYE option for extracting rewards from a company do so for one simple reason in most cases. This option means that they do ‘pay as they earn’ and that is exactly what they want to do. As a seasoned tax practitioner I have seen the financial affairs of many people over many years. In my experience 85% of people cannot save, and just 15% live within their means. For the first group even saving for tax bills is hard. PAYE prevents the need to do this, although the fact is ignored in most discussion of this issue.

2. Limited companies impose a massive admin burden on small business if they are to be run ‘tax efficiently’. Management accounts must be prepared before dividends are paid. Board minutes and dividend documentation must accompany every payment. Director’s loan accounts need careful monitoring. PAYE is still operated. Year end tax returns multiply in number and complexity. Benefits in kind have to be accounted for. If self employment allows a 5% increase in productivity because none of these issues have to be worried about then it’s easy to overturn the apparent tax advantage of the limited company.

3. Many people do not need limited liability, hate administration and want to be able to raid their business bank account as if they were their own property whenever they like. Self employment offers all these advantages. So however do LLPs offer many of the limited liability and contractual advantages of companies for the entrepreneur with much of the admin ease of self employment and yet very few tax advisers seem aware of this. Why is that?

Whichever of these, or other factors is given weight, what is clear is that many of those who are ‘self employed’ and earning significant sums apparently make the wholly economically irrational choice to pay more tax than they theoretically might. The message from this should be obvious. People are either not the rational economic beings many accountants (and economists in the Treasury) assume them to be or other issues are more important to them. This has major implications for policy.

Likely trends

What should tax policy for small business be in the light of this? I suggest that the following trends are likely:

1. The ‘tax advantage’ of incorporating remains large. Since a majority of small businesses do, despite this, not take advantage of this option it is apparent that it is not needed to encourage entrepreneurial activity. I am sure the Treasury know this. Continued attacks on ‘tax efficient’ use of limited companies are likely as a result, whatever the Lords decide in the Arctic Systems case;
 
2. It should be assumed that ‘disguised employment’ will continue to take place through limited companies. Anyone choosing such a structure should assume a higher probability of tax challenge than a self employed person or LLP might suffer;

3. Having given small business a substantial tax cash flow advantage by granting 100% first year allowances on much of their capital spend it should be assumed that a precedent has been set. I think it likely that a convergence of tax rates between the small and mainstream tax rates is likely over the next decade, but with small business getting increasing tax incentives putting them on a basis closer to ‘flat taxes’ as a way of easing admin, tax and cash flow consequences;

Policy requirements

Against this background there does, however, remain a clear need for s strategy for this sector encompassing tax, and more besides to ensure small business gets what it really wants. I suggest these wants are:

1. The opportunity to agree tax status in advance and the supply of documentary evidence from tax authorities that this has been secured, with a fee being due for provision of the service, subject always to the trader doing what they claimed they would;

2. Easily available limited liability unless the trader abuses it;

3. Low admin, even when limited liability is available;

4. Sensible accounting rules (which do not exist at present);

5. Transparency in exchange for limited liability;

6. The opportunity to pay tax on account regularly, and to earn interest on it if paid earlier than now;

7. Flexibility in the case that the business needs to restructure or simply be laid aside as personal circumstances require without significant tax cost arising (so that, for example, goodwill is usually ignored or rolled over in these cases);

8. Clear guidance on acceptable parameters for what can, and cannot, be claimed for tax purposes by the self employed and their businesses;

9. A continuing lower tax rate overall (including NIC) than is suffered by the employed to reflect the additional risk shouldered by the self employed, but with a level playing field between self employed people whatever trading medium is chosen, and without denial of benefits in the event that the self employed person cannot work for reason beyond their control.

This list requires significant policy changes from the Treasury, HMRC, the DTI and the professions, for example with regard to accounting. The comprehensiveness of that list does however reflect the need for real debate on this issue and the need for change if a strategy that fosters real enterprise is to be created. Tax is only part of that, albeit an important part, and tax rates should not be the focus.

What the practitioner can do now

So, finally, what can a tax adviser do now? I suggest the following:

1. Look at LLPs. They provide a structure that can meet the needs of many more people than are using them at present;

2. Think beyond tax because it’s clear that small business is doing so;

3. Assume that there must be a limited life to the ‘tax efficient’ use of small limited companies, and warn clients that this is the case;

4. Broaden the basis of their advice to cover the issues of concern that seem to most pre-occupy small business;

5. Lobby for change, but in positive fashion and without a focus on tax rates.

There is much to do if the UK is to have a coherent policy that encourages small business.

Article Added Thursday, 03 May 2007 | 2679 Hits

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