Long standing issues in small business taxation have so far proven to be intractable, the Office of Tax Simplification said in its interim report, ‘Small business tax review’, presented to the Chancellor last week. The ‘overwhelming’ conclusion was that genuine and long lasting simplification can only be brought about through major structural changes to the UK’s tax system.
Real simplification, the OTS suggested, will follow only if major issues such as the integration of the tax and national insurance systems are addressed. The rationale for a separate system of NICs has reduced, and maintaining both systems leads to anomalies that distort behaviour, it argued.
The anomalies lead to decisions being taken that are ‘wholly tax driven’, the OTS said. Self-employment status creates a significant NIC saving, and a ‘considerable incentive’ to operate through a limited company and receive dividends still exists. The fact that capital gains do not attract NICs provides an incentive for remuneration to be provided in the form of capital, it added.
The Mirrlees Review, released by the Institute for Fiscal Studies last year, also recommended the merger of income tax and NICs and called for the tax treatment of employment, self-employment and corporate source income to be ‘aligned’. It observed that corporation tax is 'not properly integrated' with personal taxes.
IR35 ‘encapsulates tension’
The ‘IR35’ intermediaries legislation proved to be the ‘thorniest’ topic encountered by the OTS. ‘It encapsulates the tension between HMRC, who are tasked with applying the tax code in order to protect and gather revenues, and individual businesses who see IR35 as a barrier to them running profitable small enterprises with all the risks that this involves,’ the OTS said.
IR35 should become obsolete if the integration of income tax and NICs reduced the differential between rates applicable to different incomes and reduced pressure on the boundary between employment and self-employment, it suggested. But reducing that differential would not be easy, and would need to be considered in relation to the corporation tax small profits rate.
In the meantime, the government should consider either suspending IR35 ‘with the intention of permanent abolition’, or improve its administration.
Abolition would be ‘very welcome amongst the contractor community’, the OTS said, but would carry a clear risk of increasing the use of intermediaries to reduce tax on employment income.
A third alternative would be to consider reducing the size of the IR35 population by providing a ‘safe haven’ to people who passed a range of simple business tests.
Quick wins
The OTS suggested other changes that could be introduced in the shorter term to ease some of the burdens faced by small businesses, including:
‘Fear of investigation’
For very small unincorporated businesses, the OTS suggested that options including a tax based on turnover rather than profit, and fixed or flat rate expense deductions, were ‘worth considering’.
The task of preparing accounts and calculating tax liabilities can be disproportionately burdensome for very small businesses, it said. ‘In addition to the fees charged by advisers, it is important to factor in the opportunity cost of tax compliance and the fear of investigation, which were reported to the OTS as being disproportionately high for very small businesses.’
HMRC ‘needs overhaul’
Phil McCabe, senior policy adviser at the Forum of Private Business, said reform must come hand in hand with a ‘light touch’ approach from HMRC, ‘a body that is itself in need a root-and-branch overhaul’.
‘Taxation has a disproportionate impact on the UK’s smaller firms and, combined with the daily administrative struggle with our highly complex tax system, is one of the most significant barriers to business growth and job creation,’ he said. The review should be seen as ‘the first step in a complete simplification’ of the way business taxes are levied.
‘A great opportunity’
The OTS’s conclusions may not all be the right ones, the Institute of Directors said, but ‘this is a great opportunity to set off a debate that could make a real difference to our tax system’.
Richard Baron, the IoD’s Head of Taxation, said ‘We can, and should, implement some quick wins. But to do more than that, we must look again at some fundamental features of our tax system.’
The IoD said there will be a lot of debate about merging income tax and NICs. ‘Until we have that debate, we cannot be sure what the best way forward will be.’ It expressed disappointment that a new business test was only the third option suggested for short-term change to IR35, rather than being the ‘lead option’.
The IoD added: ‘In the longer term, there is one big question to answer. Should different ways of working be taxed differently because of factors such as the risk of fluctuating earnings and the investment of capital, or should the tax system treat income from all ways of working the same? We must not duck that question.
‘Some of the quick wins – administrative improvements and de minimis limits for employee expenses – are worthwhile ideas that the government should take forward. We have more doubts about the proposal for flat rate business expenses that might bear little relationship to the correct figures.’
‘A fair and balanced view’
Anthony Thomas, Deputy President of the CIOT, said: ‘There is a real need to simplify the way small businesses are taxed. Too often sticking plasters have been applied to problems when what was needed was a thorough review. Small firms should be able to make commercial decisions that are not distorted by hasty and ephemeral changes in tax policy,’ he said.
Full integration of income tax and NICs raised ‘major problems’, he added, ‘but that must not stop serious investigation of partial moves.’
Thomas said the OTS had presented ‘a fair and balanced view’ of IR35, which he described as ‘an almost intractable problem’. The report, he said, recognises that ‘taxation is not the only (or even the main) driver towards individuals operating through a personal service company and therefore a tax-only solution cannot be the right answer’.
A business test could act as a very effective filter relieving ‘a whole swathe of people’ of the worry of whether IR35 would apply to them, he suggested. ‘In a modern, flexible labour market, workers and engagers should be free to form the contractual relationships they choose, without having their arrangements second-guessed because the tax consequences of their choice differ from those of another possible arrangement.’
Frank Haskew, head of the ICAEW Tax Faculty, said: ‘As might have been expected in this complicated area, [the OTS report] is strong on highlighting the issues without being able to provide all the solutions.
‘It is important that as we search for simplification we do not settle for quick wins while leaving the harder areas unresolved.’
‘Brave recommendations’
David Bywater, middle market tax partner at KPMG, said: ‘The report attempts to tackle some areas that have previously been put into the “too difficult” pile and makes one or two brave recommendations, but much of the review will take a long time to come through, assuming that changes are unlikely to be rushed through without proper consultation.
‘Therefore, whilst some very positive measures have been suggested, the wider proposed strategic changes to the tax system will not in the short term help small businesses currently struggling with their growth agendas.’
Integration of income tax and NIC would have an impact on every taxpayer in the UK, he said. ‘The review will cover rates of income tax on savings income, will impact pensions and is potentially a political hot potato, with some very careful consideration required to manage the impact on the inevitable winners and losers from this change.’
If pursued with proper considered consultation, the change is ‘unlikely to be implemented in this parliament’, he added. The idea of an alternative approach to the taxation of small unincorporated businesses suggested a ‘turnover tax’ rather than a tax on profits.
‘Some of the OTS's proposals are truly radical,’ said Alex Henderson, a partner at PwC. Reforms such as the integration of the tax and NIC systems would allow large amounts of legislation to be removed or simplified but ‘would inevitably cause disruption with winners and losers’. Careful consultation would be needed, he warned.
Ten tenets
The OTS said it had focused on micro businesses, those with fewer than 10 employees and either turnover or total assets below €2 million per annum, which represented 95% of UK businesses.
It took account of the ICAEW Tax Faculty’s ‘ten tenets for a better tax system’, published in October 1999. The Faculty said the tax system should be statutory, certain, simple, easy to collect and to calculate, properly targeted, constant, subject to proper consultation, regularly reviewed, fair and reasonable, and competitive.
The OTS will now await the Chancellor’s response, expected at or shortly after this month’s Budget, and further instructions with a view to preparing a final report and specific recommendations later this year.
Long standing issues in small business taxation have so far proven to be intractable, the Office of Tax Simplification said in its interim report, ‘Small business tax review’, presented to the Chancellor last week. The ‘overwhelming’ conclusion was that genuine and long lasting simplification can only be brought about through major structural changes to the UK’s tax system.
Real simplification, the OTS suggested, will follow only if major issues such as the integration of the tax and national insurance systems are addressed. The rationale for a separate system of NICs has reduced, and maintaining both systems leads to anomalies that distort behaviour, it argued.
The anomalies lead to decisions being taken that are ‘wholly tax driven’, the OTS said. Self-employment status creates a significant NIC saving, and a ‘considerable incentive’ to operate through a limited company and receive dividends still exists. The fact that capital gains do not attract NICs provides an incentive for remuneration to be provided in the form of capital, it added.
The Mirrlees Review, released by the Institute for Fiscal Studies last year, also recommended the merger of income tax and NICs and called for the tax treatment of employment, self-employment and corporate source income to be ‘aligned’. It observed that corporation tax is 'not properly integrated' with personal taxes.
IR35 ‘encapsulates tension’
The ‘IR35’ intermediaries legislation proved to be the ‘thorniest’ topic encountered by the OTS. ‘It encapsulates the tension between HMRC, who are tasked with applying the tax code in order to protect and gather revenues, and individual businesses who see IR35 as a barrier to them running profitable small enterprises with all the risks that this involves,’ the OTS said.
IR35 should become obsolete if the integration of income tax and NICs reduced the differential between rates applicable to different incomes and reduced pressure on the boundary between employment and self-employment, it suggested. But reducing that differential would not be easy, and would need to be considered in relation to the corporation tax small profits rate.
In the meantime, the government should consider either suspending IR35 ‘with the intention of permanent abolition’, or improve its administration.
Abolition would be ‘very welcome amongst the contractor community’, the OTS said, but would carry a clear risk of increasing the use of intermediaries to reduce tax on employment income.
A third alternative would be to consider reducing the size of the IR35 population by providing a ‘safe haven’ to people who passed a range of simple business tests.
Quick wins
The OTS suggested other changes that could be introduced in the shorter term to ease some of the burdens faced by small businesses, including:
‘Fear of investigation’
For very small unincorporated businesses, the OTS suggested that options including a tax based on turnover rather than profit, and fixed or flat rate expense deductions, were ‘worth considering’.
The task of preparing accounts and calculating tax liabilities can be disproportionately burdensome for very small businesses, it said. ‘In addition to the fees charged by advisers, it is important to factor in the opportunity cost of tax compliance and the fear of investigation, which were reported to the OTS as being disproportionately high for very small businesses.’
HMRC ‘needs overhaul’
Phil McCabe, senior policy adviser at the Forum of Private Business, said reform must come hand in hand with a ‘light touch’ approach from HMRC, ‘a body that is itself in need a root-and-branch overhaul’.
‘Taxation has a disproportionate impact on the UK’s smaller firms and, combined with the daily administrative struggle with our highly complex tax system, is one of the most significant barriers to business growth and job creation,’ he said. The review should be seen as ‘the first step in a complete simplification’ of the way business taxes are levied.
‘A great opportunity’
The OTS’s conclusions may not all be the right ones, the Institute of Directors said, but ‘this is a great opportunity to set off a debate that could make a real difference to our tax system’.
Richard Baron, the IoD’s Head of Taxation, said ‘We can, and should, implement some quick wins. But to do more than that, we must look again at some fundamental features of our tax system.’
The IoD said there will be a lot of debate about merging income tax and NICs. ‘Until we have that debate, we cannot be sure what the best way forward will be.’ It expressed disappointment that a new business test was only the third option suggested for short-term change to IR35, rather than being the ‘lead option’.
The IoD added: ‘In the longer term, there is one big question to answer. Should different ways of working be taxed differently because of factors such as the risk of fluctuating earnings and the investment of capital, or should the tax system treat income from all ways of working the same? We must not duck that question.
‘Some of the quick wins – administrative improvements and de minimis limits for employee expenses – are worthwhile ideas that the government should take forward. We have more doubts about the proposal for flat rate business expenses that might bear little relationship to the correct figures.’
‘A fair and balanced view’
Anthony Thomas, Deputy President of the CIOT, said: ‘There is a real need to simplify the way small businesses are taxed. Too often sticking plasters have been applied to problems when what was needed was a thorough review. Small firms should be able to make commercial decisions that are not distorted by hasty and ephemeral changes in tax policy,’ he said.
Full integration of income tax and NICs raised ‘major problems’, he added, ‘but that must not stop serious investigation of partial moves.’
Thomas said the OTS had presented ‘a fair and balanced view’ of IR35, which he described as ‘an almost intractable problem’. The report, he said, recognises that ‘taxation is not the only (or even the main) driver towards individuals operating through a personal service company and therefore a tax-only solution cannot be the right answer’.
A business test could act as a very effective filter relieving ‘a whole swathe of people’ of the worry of whether IR35 would apply to them, he suggested. ‘In a modern, flexible labour market, workers and engagers should be free to form the contractual relationships they choose, without having their arrangements second-guessed because the tax consequences of their choice differ from those of another possible arrangement.’
Frank Haskew, head of the ICAEW Tax Faculty, said: ‘As might have been expected in this complicated area, [the OTS report] is strong on highlighting the issues without being able to provide all the solutions.
‘It is important that as we search for simplification we do not settle for quick wins while leaving the harder areas unresolved.’
‘Brave recommendations’
David Bywater, middle market tax partner at KPMG, said: ‘The report attempts to tackle some areas that have previously been put into the “too difficult” pile and makes one or two brave recommendations, but much of the review will take a long time to come through, assuming that changes are unlikely to be rushed through without proper consultation.
‘Therefore, whilst some very positive measures have been suggested, the wider proposed strategic changes to the tax system will not in the short term help small businesses currently struggling with their growth agendas.’
Integration of income tax and NIC would have an impact on every taxpayer in the UK, he said. ‘The review will cover rates of income tax on savings income, will impact pensions and is potentially a political hot potato, with some very careful consideration required to manage the impact on the inevitable winners and losers from this change.’
If pursued with proper considered consultation, the change is ‘unlikely to be implemented in this parliament’, he added. The idea of an alternative approach to the taxation of small unincorporated businesses suggested a ‘turnover tax’ rather than a tax on profits.
‘Some of the OTS's proposals are truly radical,’ said Alex Henderson, a partner at PwC. Reforms such as the integration of the tax and NIC systems would allow large amounts of legislation to be removed or simplified but ‘would inevitably cause disruption with winners and losers’. Careful consultation would be needed, he warned.
Ten tenets
The OTS said it had focused on micro businesses, those with fewer than 10 employees and either turnover or total assets below €2 million per annum, which represented 95% of UK businesses.
It took account of the ICAEW Tax Faculty’s ‘ten tenets for a better tax system’, published in October 1999. The Faculty said the tax system should be statutory, certain, simple, easy to collect and to calculate, properly targeted, constant, subject to proper consultation, regularly reviewed, fair and reasonable, and competitive.
The OTS will now await the Chancellor’s response, expected at or shortly after this month’s Budget, and further instructions with a view to preparing a final report and specific recommendations later this year.
