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Tolley's Practical Tax by Andrew Hubbard

Andrew Hubbard, Director of Tax, Tenon Group, ponders over the demise of the non-corporate distribution rate and the future of small business taxation.When I am commissioned to write a tax article my immediate reaction is usually: “how on earth can I deal with such a complex topic in so few words?”

But for once I have the opposite problem. When your editor asked me for an article on the abolition of the non- corporate distribution rate my initial draft read, in its entirety:

The non-corporate distribution rate has been abolished

Now, at the generous rate that TPT pays for an article this would have put me up in the J K Rowling category if we work out the fee per word ratio. But it would also have left your editor with a lot of space to fill. So I suspect that what is really required are some thoughts about what the abolition of the NCD rate has done to the taxation of smaller businesses, and – more pertinently – what may come in its place, particularly with the Arctic Systems case still unresolved.

I doubt that anybody will mourn the passing of the NCD regime. The draftsman of the 2006 Finance Act has done his best to put it out of its misery as quickly as possible. There are no transitional rules. Any amount of excess NCD carried forward at 31 March 2006 simply disappears forever into the ether. There are, as would be expected, rules to deal with accounting periods straddling 31 March 2006, but other than that the legislation is as simple as it could be.

Everybody accepts, privately or publicly, that the NCD regime was a mistake – a classic example of a quick fix to plaster over cracks in the system rather than something designed to deal properly with the underlying problem. HMRC always thought that the profession overplayed its view of the complexity of the system, but in truth there were many problems with it.

Once people started to understand the quirks in the carry forward system and the ways in which the timing of dividend payments could have a major significant impact on the total tax liability of a company, it was inevitable that the days of the NCD regime were numbered.

So what is the problem, and why has it proved so difficult to solve? The essence of the difficulty is, I believe, that there is a huge gap between theory and practice when it comes to small companies. We were all brought up to know that a company is a different legal person to its shareholders and that there is a strict difference in rights and responsibilities between shareholders and directors. We also know that in economic theory there is a fundamental distinction between return on capital invested and return on labour.

But none of this actually has the remotest relevance to the owner manager of a small company. A person who sets up in business as a company to provide, say, plumbing services, is interested in how much cash he has left after deducting costs from income. Whether this is his money or the company’s, or whether the money represents a return on investment or labour is a matter of absolutely no consequence. He is earning a living from carrying on his trade and wants to enjoy the profits. Of course when a business becomes more substantial and starts to employ people and use retained profits for business development some of these distinctions do become significant. In my view, however, that is to look through the wrong end of the telescope. The overwhelming majority of businesses in this country are very small, and don’t employ permanent staff. But the tax system is designed for the comparatively small number of bigger businesses, and the interests of the very small business tend not to be uppermost in the mind of the policy maker.
If you want a real example of the problems that this causes you only have to speak to Mr and Mrs Jones. I am sure that when they started their business their objective was not to win the Tax Personality of the Year award, but the fact that they did speaks volumes about just how much of a mess small business taxation has become. Mr and Mrs Jones’ business affairs, and that of their company, are very straightforward and there is no dispute about what was earned and where the money ended up.

Yet here we are in mid 2006 still unable to say how the Joneses should be taxed on monies received by them as long ago as 1999. Two Commissioners and four Judges have so far failed to agree about how the dividends should be taxed, and even where they have agreed they have used different reasons to come to their conclusions.

When you add to that the different views of the lawyers and tax advisors who have been directly involved in the case and the very different analyses produced by the many other commentators who have spilled ink on the subject you have to say that something here is fundamentally wrong.

Where does the blame lie?

I don’t think that it lies at the feet of taxpayers and their advisors, who have tried to make the best of the opportunities which a complex tax system has offered them. Neither do I really think that it can all be blamed on HRMC.

I share the frustrations of most people over how HMRC has gone about handling the whole S660A issue, but it is hard to criticise them too much for trying to test what the law actually means. No, the real problem is the failure over a long period to create a tax system which is actually designed with small business in mind. Over the years we have seen times when it is more tax efficient to incorporate and times when it is more efficient to operate as a sole trader. We have also seen times when companies face a higher rate of tax if they don’t distribute profits and times when they face a higher rate of tax if they do distribute. We have seen a 0% rate come and go, and now the abolition of a regime introduced only two years ago specially to solve the problems caused by the 0% rate.

Small businesses must be in utter confusion. All they want is to earn the profits and pay the tax (OK they don’t actually want to pay the tax, but if they are going to have to pay tax then they do at least want to be able to have some idea of how much tax they are going to have to pay). Instead we have a wholly unstable system and a complete lack of certainty: that cannot be right.

The future

Until we have a final judgement in the Arctic Systems case (which will probably be later in the year) I suspect that nothing much will happen. My advice to business at the moment is to stay as they are and continue their existing remuneration and profit extraction practices until and unless the House of Lords tells them otherwise. But the final decision in Arctic will not be the end of the matter. Once that is out of the way we must hope that HMRC and the Treasury sit down with the professional bodies to hammer out a system of small business taxation which is fair, stable, transparent and above all certain.

The distortions in the system at the moment sometimes work in favour of the taxpayer and sometime in favour of HMRC. Everybody will probably have to accept some degree of compromise, but if that does leave us with a tax system for small business which is actually designed with those businesses in mind it will be surely be worth it.

Andrew Hubbard
July 2006

This article was originally published in Tolley’s Practical Tax, LexisNexis Butterworths leading information service for small to medium sized tax and accountancy practices. It provides the day-to-day information needed to deal with all tax compliance issues and general client problems. For more information or to order this title please visit www.taxationweb.co.uk/lexisnexis