Smallest company tax rate - Dead or only sleeping? Christopher Sanger & Charles Havisham
Those following policy on small business could be forgiven for a distinct sense of déjà-vu. Eight years ago we had a single system of taxation for profits of up to £300,000 per annum, something that we'll again be seeing from April 2006. More recently, a year ago, we were all coming to terms with a tax regime designed to tackle the perceived 'evil' of tax-motivated incorporation and looking forward to see what a court made of the Arctic Systems case. One year on, we have had another go at tackling tax-motivated incorporation and we're awaiting another court hearing.
Given this, it is tempting to think that we are back where we started. However, despite the similarities, we are in a different position and there is a good chance that the next move could prove more sustainable. This article looks at the background behind the recent turns on 'the policy roundabout' and where we could expect the next turn to take us.
What's it all about?
The Treasury has made much of its desire to support growing businesses. Budget 1999 introduced the starting rate of corporation tax at 10 per cent, the most generous (to those that qualified) that the UK had ever seen. In the speech announcing it, the Chancellor said that this should:
... give new incentives for men and women to start their own business and work their way up, [benefiting] those who [genuinely] take risks. And 85 per cent of the firms gaining from the new 10p tax rate have fewer than 10 employees - the very firms we most want to see grow, the very firms whose growth will create the greatest number of new jobs.
Three years later, this was again confirmed when the Government cut the '10p rate' to zero and the general rate to 19 per cent:
The small firms of today are the big firms of the future.
We want to see a more enterprising Britain where, in every region, more small businesses are starting up and where you can work your way up - a ladder of opportunity from employment to self-employment, from micro business to growing business - with government on businesses' side as firms hire for the first time, as they invest, as they seek equity, as they export and grow ... This Budget seeks to build from this a culture of entrepreneurship in every community.
These measures were hailed as creating 'the most favourable corporation tax regime for small companies in any of the advanced industrial countries'. However, only two years later we saw the effective withdrawal of the zero rate, with the introduction of the non-corporate distribution rate, denying the zero rate where profits were distributed to individuals, followed by the completion of the policy reversal in PBR 2005.
So where did it all go wrong?
So with the Chancellor praising the tax cuts as 'the strongest signal about the importance we attach to small businesses and the creation of wealth', how is it that we are seeing a £530 million increase in tax on small business this year, following a £490 million rise in 2004? Why is tax-motivated incorporation such an issue?
The answer to this relates to the desire of Government to focus on 'the big firms of the future' - ie, those businesses with the appetite and drive for growth. The accepted wisdom is that, when introduced in 1999, there were relatively few non-growth or 'life-style' companies, for which growth was not a key business driver, or which were based around the direct personal labour of the owner-manager. However, the increasing disparity between the taxation of self employed taxpayers and owner-managed companies led to the self employed incorporating their businesses and hence increasing the deadweight (ie, tax relief being given to those not within the aim of the policy) to breaking point.
Incidentally, although this 'wisdom' is understandable and supported by many anecdotes, the latest Government figures do not seem to support it. If there was a torrent of incorporations from individuals earning (say) double the average national wage, we would expect to see the number of companies showing profits of up to £50,000 per annum to increase accordingly. In fact, we saw a reduction of 2.6 per cent, from 467,169 in 2000/01 to 455,022 in 2003/04. Of course, the yet to be released figures for 2004/05 may hold a significant increase.
The end of the road?
At the moment, having tackled tax-motivated incorporation, the Government is leaving this issue to rest, noting in PBR 2005 that the preferred option from many small businesses was 'simplification over ... complexity'. However, there is a risk that in focusing on tax-motivated incorporation, it has missed out on an opportunity to further growth as it originally intended.
Going back to the principles in Budgets 1999 and 2002, it is clear that the Government's objective was to encourage entrepreneurial risk-taking occurring within the discipline and safeguards of a limited liability company. The resulting rise in the number of taxpayers affected, and hence deadweight, does not undermine the drivers behind this policy or mean that the original objective cannot be achieved in another way - one in which the incentives are better targeted. It is also somewhat ironic that, in seeking simplicity over complexity, the Government has abolished the simplest way of enhancing returns for entrepreneurs. Unlike complex incentives for research and development, or the more esoteric incentives (such as for water-efficient urinals), this was simple to understand and claim and hence was factored into the plans of entrepreneurs.
However, the design of any broad and simple measure needs to consider the constraints under which policy must operate. The business and labour market can be categorised into 'employment' type activity, small and medium enterprises, and large businesses on one hand, and legal form (companies, individuals and legal partnerships) on the other. This gives rise to the matrix below.
Legal form
Company A
IT and NICs
(through IR35)
Personal Service Co B
CT on profits
IT on dividends
Company C
CT on profits
IT on dividends
Company Individual IT and NICs
Employment
D IT and NICs
Partnerships or LLPs
E IT and NICs
Partnerships or LLPs
F Single employment SME Large business
Size
Simply targeting reliefs and incentives at companies means that the boundaries between the boxes in the diagram are put under significant pressure and behavioural change is likely to mean that benefits 'leak' to unintended recipients. This tends to drive anti-avoidance measures to reinforce the boundaries or lead to changes in the contents of the boxes. For instance, the zero per cent rate was available to personal service companies until IR35 introduced the boundary between Box A and Box B. The changes to the zero per cent rate reflect the pressure between Box B and Box E.
If the Government wishes to focus tax relief of growth, then perhaps a better option might be to target the benefit of lower taxes to those businesses genuinely taking entrepreneurial risk, and to do so explicitly. The challenge of such a policy is how to distinguish these companies.
One option would be to follow a tried and tested route: qualifying trades under the Enterprise Investment Scheme (EIS) and relief for investments in Venture Capital Trusts (VCTs). EIS or VCT relief is not available for investments into certain industries - including those backed by land or by assets for leasing, or financial or agricultural activities. These restrictions serve to ensure that the reliefs are targeted to those businesses taking genuine entrepreneurial risk in trading activities. Using this model, only those companies engaged in qualifying trades would qualify for a zero per cent or other very low rate, with other small companies paying the normal 19 per cent rate. This would have the benefit that companies would know whether they were within the rules (or not) and the tax position of those outside this would be unaffected.
Alternatively, if the Government was concerned about the relief being diverted to businesses that sold only the proprietor's labour, restrictions might be imposed on the number of staff employed by the business. Employing staff imposes risks on the business that do not apply to those dependent on the proprietor's labour alone, while providing scope for business growth and benefiting the wider economy.
Conclusion
The Government's original impulse was to help the small firms of today become the big firms of the future. The need to help small businesses grow exists as much today as it did back in 1999, at the start of this cycle of tax rates. The fact that the tax system has returned to broadly the same position as seven years ago should not be read as a reversal of policy but more as a realisation of the power (and danger - of a too-widespread response) of tax as a tool of social engineering.
A low rate remains the simplest method for encouraging behaviour and the challenge is to ensure that the relief is appropriately targeted without introducing complexity. A tax benefit that is more carefully targeted, by supporting entrepreneurial risk explicitly, should allow the Government to realise its objectives in this area without giving too much away to the deadweight. Revisiting this once more might pay dividends to us all.
Christopher Sanger leads Ernst & Young's Policy Development practice and is the Vice Chairman of the Tax Faculty and a former adviser to HM Treasury. Charles Havisham is a manager in Ernst & Young's Policy Development practice.