I suspect, however, that there are many other owners of small family businesses who have not yet caught up with this news and who do not yet know that the ‘son of IR35 out of Section 660A’ may well be aimed at a much broader target than was IR35 and may affect many more companies than have so far been affected by Section 660A.

Background

In the Pre-Budget Report last week we saw a Treasury release on 'Delivering a modern and fair tax system'. Lets look first at what that said. In paragraph 5.88 it outlines the issue that the Government wishes to address as being:

”5.88 A central requirement of a modern and fair tax system is that everyone pays the proper amount of tax and receives the benefits they are entitled to. Tax avoidance and evasion
distort the incentives that the tax system aims to deliver and unfairly shift a greater tax burden onto honest and compliant taxpayers. …... The Government is therefore determined to take the necessary steps to protect tax revenues for the benefit of all taxpayers, by tackling evasion and fraud, and by addressing areas where tax avoidance risks compromising the integrity of the tax system.”

Once again we see the use of phrases like “the proper amount of tax” that suggests, as with IR35, there will be issues about what is a fair reward to receive from a business?

Will this allow owners to make a ‘profit’ from their actions and their time investment in the business or, like IR35, will the Government’s view be that the target taxpayers can only earn a salary?

In paragraph 5.91 the release goes on to say:

“5.91 The Government has introduced a range of measures and targeted tax reductions to support small businesses; including through reform of capital gains tax, reducing the rate of corporation tax for smaller companies and the introduction of a zero rate, Stakeholder Pensions, and the abolition of advance corporation tax. These measures are encouraging the creation of more small companies, including through self-employed people incorporating their businesses. The Government is keen to ensure the measures it has introduced provide support for these firms taking on the opportunities and responsibilities involved in that transition, and to encourage them to reinvest their profits and grow their businesses. “

It then gets to the nub of the matter by adding:

“At the same time, the Government is concerned that the longstanding differences in tax treatment between earned income and dividend income should not distort business strategies, or enable reductions by tax planning of individuals’ tax liability, and that support should continue to be focused on growth. The Government will therefore bring forward specific proposals for action in Budget 2004, to ensure that the right amount of tax is paid by owner managers of small incorporated businesses on the profits extracted from their company, and so protect the benefits of low tax rates for the majority of small businesses.”

It seems ironic that the many of the longstanding differences that are referred to above are the result of earlier policies of this Government – such as raising the rate of employer’s NIC to 12.8% and adding an NIC ‘surcharge’ of 1% on all salaries above the top NIC threshold.

It seems as if ‘cause’ and ‘effect’ are not concepts that the Government is fully conversant with!

The apparent thrust of the expected proposals seems likely to be to make unearned income, extracted by owner/managers in small businesses, liable to additional tax and/or National Insurance charges.

However, an immediate problem will be how these aims can be achieved in a way that does not adversely affect the stated aim of protecting “the benefits of low tax rates for the majority of small businesses” ?

It seems simplistic to think that there will never be tax planning incentives to explore differences in tax treatment of earned and unearned income, unless that distinction itself is removed – in which case new issues arise, such as how to encourage savings and personal provisions for retirement?

Already accountants’ forums are buzzing with debates about what steps might be planned or taken to achieve these aims. We can only speculate at this stage but if we make some assumptions as to what the government is and is not prepared to consider then we might be able to identify at least some possible avenues.

The targets?

Clearly not all small businesses are being targeted. This suggests that the Government might still be preoccupied with businesses that provide personal services, the target of IR35.

The Government appears to still have problems accepting that the sale of skill and knowledge, through a business that has relatively low capital needs, is just as valid a small business as one that makes widgets or uses a piece of capital equipment such as a van.

But there seems to be little valid logic in differentiating between, say, the directors of a small company that carries out small scale building works or hires out one or two pieces of earthmoving equipment, and who take their rewards in the form of a low salary and reasonable dividends; and the knowledge based freelancer who sells his/her skills to a series of clients and uses exactly the same strategy to reduce the tax and NIC costs of their reward package.

So, logically, any measures should target any company where the directors are also shareholders and have the power to determine the split of their overall rewards package between elements that attract PAYE and NIC and those do not. There is already a classification of company that more or less covers this requirement – closely held companies.

A close company is one that is

· under the control of five or fewer participators, or of participators (however many) who are also directors (ICTA 1988, s. 414(1)/ICTA 1988, s. 414/) or

· where more than half of the assets which could be distributed in a winding-up, would be distributed to five or fewer participators, or to director participators (however many).

Obviously there are subsidiary issues as to what is control and who are participators? However, broadly, the definition of control is not in fact one definition but a number of overlapping ones any of which can be applied on deciding whether an individual, or group of individuals, can control a company.

A participator, in general terms, is either a shareholder or person with some other interest in the income or assets of the company. Also included are associates of participators, (which include close relatives amongst others) and the rights and interests of a participator are usually taken to include those of his associates.

It is also possible that the Government might use two interlocking criteria. Hence, if their concern is about companies that are exploiting the lower rates of tax for small companies – or, more accurately, companies with small profits – then they could restrict measures to those close companies that qualify for the small company rate of taxation.

The mechanisms?

It seems logical that the Government would try to avoid introducing totally new measures if there are existing measures that can be tailored to meet their needs.

The first that springs to mind is the provision that says that close investment companies cannot take advantage of the small companies tax rates.

If this were applied to all qualifying companies, however defined, it would mean that any profits not paid out as salaries would be taxed at the normal corporation tax rate of 30% instead of the small profits rate of 19%.

There is also a precedent for restricting the application of the tax credit on dividends in certain circumstances. So it could be possible to construct a regime where dividends are paid out of corporate profits that have been taxed at 30% and where the controlling participators cannot reclaim any tax credit on dividends received.

However, the problem for arrangements such as these would be setting parameters to distinguish between those businesses that pay very low salaries and those who pay ‘market rate’ salaries (however defined) – if it were the Government’s intention to allow the latter to be able to pay dividends that did not attract any penal tax treatment out of any ‘super’ profits available after market rate salaries had been paid.

It is possible that the Government could opt for a simpler approach of applying NIC to all dividend payments from close companies to directors and their associates – either at the normal rates or by establishing a new rate that ensured that the total tax take on the dividends was equal to the tax paid on an equal amount of salary.

However, this approach could result in all close companies being subject to the new provisions without any attempt to distinguish between those that have paid market rate salaries and those that have not.

Another issue that might arise is whether any attempt will be made, as is currently the case under IR35, to apply the new rules to income received by the company, regardless of whether it is paid out or retained in reserves. We have to hope not.

The Treasury document talks about profits “extracted” from the business, which implies only attacking dividends and other distributions. But there may be measures to prevent profits being accumulated with a view to extracting income at a later date when the circumstances of the directors might result in a lower tax rate.

Again, however, any such measures will raise issues about retaining income for re-investment and growth – one of the Government’s stated aims.

Conclusions

It seems inevitable that there will be considerable speculation amongst advisers and businesses about what might be the Government’s intentions at the next budget. There will also be renewed debate about the wider issues of ‘fairness’ in taxation. Past experience suggests that the final product will be neither ‘fair’ nor well targeted!

Past experience also suggests that the only bodies who might be able to influence the intended course of these measures will be the main accounting and taxation professional bodies and, possibly, the CBI. We will have to hope that these bodies can exert a moderating influence to ensure that any resulting legislation leaves knowledge based businesses no worse off than any other small, closely held company. We also have to hope that these bodies ensure that all companies, whether large or small retain the ability to invest for the future and to distribute reasonable levels of profits to shareholders without attracting penal taxation that prejudices their ability to compete against larger businesses.

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Kevin Miller, MA FCA
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