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TaxationWeb by Roger Jones

Roger Jones, Author of ‘Incorporating a Business’, considers how possible changes in tax law may affect the decision whether small business should incorporate in the future.Is incorporation the future of all small businesses? If the commentary in many professional journals over the last few years is anything to go by, the answer must be an unequivocal yes. It is not just the immediate tax savings which have a major influence. Every time the Chancellor of the Exchequer gets to his feet in a Budget and announces more help targeted at small businesses, he always seems to mean companies. There appears to be a mind set in Westminster that small business directly equates with company.

The decision to incorporate a business is a complex one with many factors to consider. However, there is no doubt that at the present time many business proprietors and professional advisers are letting one matter alone override all the others. This is especially true at the bottom end of the market – that is to say businesses showing profits of less than, say, £40,000 for a sole trader (or a multiple thereof for a partnership).

The potential for tax saving is so attractive under the present regime that there almost has to be an argument that every business should be incorporated. The common thread is the ability of the corporate business proprietor to take remuneration by way of dividends. This suffers lower effective rates of tax and no NIC, as compared to either the trading profit of an unincorporated business or drawing by way of salary. The corporate profits themselves attract lower rates of tax than personal profits – in some cases, down to zero. The application of the non-corporate distribution rate where dividends are taken from very small companies does little to disturb this.

It all sounds too easy. The pessimist has to offer some caution and say what could go wrong. Consider:

 is it possible to swap salary for dividends at will?

 is it excessively naive to think that there is no NIC on dividends?

 will the Government realise the tax leakage that is going on and do something about it?

Ignoring for the moment the first two, might the Government come to its senses? If so what could it do? There might seem to be three possibilities:

 Extension of National insurance contributions.

 Return of close company apportionment.

 Return of investment income surcharge.

Extension of National Insurance Contributions

If existing case law is not enough to justify the levying of NIC on dividends, what are the odds on specific legislation. In the period of uncertainty between the 2003 pre-Budget Report and the 2004 Budget this was certainly the favourite of many commentators.

The vast majority of the mischief in tax saving through dividends will come from close companies. If an attack comes, then they have to be the prime target.

There seem to be two choices. The first would be to redefine earnings in SSCBA 1992, s 3, to include dividends from close companies. They would then fall within the scope of Class 1 NIC.

Alternatively, a new class of NIC could be created (might this be 1C or 5?) specifically charging contributions in respect of dividends from close companies. In this case, one would expect the amount to be comparable with Class 1.

The author continues to doubt it will happen for two real reasons:

 First, it would be the ultimate admission that NIC is really a tax (something which governments have wanted to steer clear of).

 Second, how would it be levied on non-director shareholders, particularly trustees?

Return of close company apportionment

In its former existence, close company apportionment was there to prevent private companies being used as moneyboxes in times of very high personal tax rates. The effect was to treat certain amounts of profit as being distributed from the close company whether they were or not. Such amounts were apportioned to the participators pro rata to their shareholdings and the individuals were taxed as if they had received dividends of that amount.

Some commentators suggest the return of some form of close company apportionment as a means of combating the use of dividends to gain a tax advantage. Clearly close company apportionment in its former guise would not help. That treated the amounts apportioned as if they were dividends; now it is the use of dividends that causes the problem (if problem it be).

‘New close company apportionment’ would have to create a minimum standard of distribution by way of salary, so that the amounts in question would be charged to income tax at effective rates of 10%/22%/40% rather than Nil/25%. Both employers’ and employees’ NIC would also be due.

Have we not heard this before? In reality, is this not what ITEPA 2003, Part 2, Chapter 8; FA 2000, Sch 12, (the IR35 rules) do? In effect, that says that the company earnings are the directors’ earnings and the latter should be taxed on them. One hopes that, should such an approach be considered for all close companies, it would not be so simplistic. There is no mischief in the trade of most close companies; it is the manner of distribution of the profit which could trouble the authorities.

Could we therefore see an IR35 type calculation applied to an acceptable standard of profit distribution by way of salary (50%, 75%, 90% – who knows, name your own figure). Unless and until this happens, the present advantages can continue undisturbed.

Return of investment income surcharge

Until 1984/85, differential rates of income tax applied to earned and investment income. This was effected by levying a surcharge on investment income above a certain threshold. The rationale for its abolition was that, whilst income from large fortunes might reasonably be exploited, it was a disincentive to more modest savings.

At present, one could almost regard the present system as applying an earned income surcharge. This is because investment income suffers only income tax but earnings suffer both income tax and NIC. Logically, this does show, at least, a degree of inequity.

It might be fairly neat, simple and effective to reintroduce an investment income surcharge. If this were applied across the board to all forms of investment income then it might provoke some howls of anguish. However, if dividends taken from close companies are perceived to be an abuse of the system, maybe such an impost could be limited to them.

The charge should be such as to ensure that the overall effective rate is 41% (the same as an unincorporated business proprietor would pay on the top slice of his profits). Could there also be an interim rate for a nominally basic rate taxpayer?

Roger Jones
September 2005

Roger Jones is Senior Tax Manager at Larking Gowen in Norwich. The above is extracted from ‘Incorporating a Business’ (2nd Edition), published by Tottel Publishing (price £59.95). To order a copy of this book, click here