Thinking Small - FRANCESCA LAGERBERG ACA, Barrister considers the possible future for the taxation of small business.

In America, there is a saying that a business is like a car: it will not run by itself except downhill. Nurturing a fledging enterprise is a delicate balance and tax advisers tend to see first hand from their clients and their own practices how complicated it can be to get everything right. In addition to the actual business, there is a raft of other challenges to consider, such as the perils and pitfalls of VAT registration and administration and the apparent inexorable rise of regulation and red tape. As a business takes off, there are employment issues to consider, such as payroll compliance and the new world of tax credits.

It is therefore not surprising that any government should take an interest in the fate of small business and ways of letting it get on with what it should do best, i.e. doing business. With this high-minded intention presumably in mind, the Government issued a Technical Note in March 2001 entitled 'A Review of Small Business Taxation'. This is an important document that raises some fundamental issues about the way tax is determined in the United Kingdom.

Off-target

Those of us who live and breathe by looking at the pronouncements of the revenue authorities raced to the Technical Note expecting to see some of the big issues outlined above being tackled. However, the note opted for a different target and was described instead as a 'radical simplification of the way small businesses are required to calculate the tax due on their profits by aligning their profits for tax purposes much more closely with those reported in their accounts'. Therefore, it is aiming at changing the tax computation.

It would be wrong to protest at anything that might help tax simplification and gives a helping hand to business, but the tax computation itself is probably not high up in the list of priorities of a small business looking for ways to ease administrative burdens. Therefore, it can only be hoped that the Technical Note is just the start of a much broader review into issues that do need addressing even more urgently to help small businesses.

Getting technical

So what does the Technical Note suggest? It is a broad ranging paper that covers a number of ideas but seems almost deliberately short on detail. It gives the impression of being the type of paper one might use to stimulate a brainstorming session on a 'how to improve the tax system' awayday. Harsh critics have suggested it must have been knocked up on the back of an envelope on a Friday afternoon in the local pub, but that misses its point. This is a document that is looking for a reaction and is seeking to see which issues generate positive and negative noises.

It is just a first step in a consultation process that will be going on all year. A much more formal and detailed consultation document is expected in the autumn once the initial reactions to this Technical Note have been obtained and assimilated. Depending on the results of the election there is supposed to be a slot timetabled into the Finance Bill 2002 to take forward some of the issues covered by the note.

The note contains a series of very general proposals about how radical simplification might be achieved. These include replacing capital allowances with commercial depreciation, taxing capital profits on the basis shown in the accounts and removing the special tax rules for rental income and other investment income and using instead the commercial accounts basis.

Is small beautiful?

The fact that 'small businesses' are being touted for different tax treatment immediately raises an important issue. Should not all businesses operate from a level playing field? Why should one entity be treated differently from another? Will not such a process in itself lead to further complexity, as one will need to know different tax régimes? And what about the business which teeters on the knife-edge of what ever dividing line one chooses for determining 'small' – will not that business have to cope with potentially moving in and out of different tax régimes with alarming regularity?

The Tax Faculty of the Institute of Chartered Accountants in England and Wales in its formal response to the Technical Note (which is published as TAXREP 9/01 and can be viewed in full on the Faculty's website at www.taxfac.co.uk) has noted that:

A burden is a burden, be it on big or small businesses. It would, therefore, be far better to remove the burdens generally than to simply seek to relieve some businesses from them.

The definition of 'small' being suggested is the Companies Act definition based on at least two of the following three features:

As definitions go, this is probably as good as anything and it has the attraction of being a well-known and much-used marker. However, like any threshold, there needs to be plenty of scope for manoeuvre around the edges to assist those businesses that may fall in and out of the definition during good and bad years.

Accounts-based taxation

The main thrust of the Technical Note is about moving towards using accounts profits for tax. As we know, the business accounts are the starting point for the tax computation, so what the paper is considering is somehow finding a better alignment between the tax computation and the accounts – which points to fewer adjustments being necessary. Could this mean allowing, say, a tax deduction for business entertaining for small businesses or a full deduction for legal expenses? The Technical Note leaves the reader to guess exactly what a new system could involve.

It does not stipulate whether it means that businesses should be taxed purely on the profits in the accounts or whether there should remain some or a variety of adjustments. The trade-off in any move will be simplification for small business against fairness for all and the need to consider any compliance costs that might be incurred. There is little point in moving to a new régime if the end result is more costs for small business or more uncertainty or, even worse, a higher tax liability.

Any move to a new system will lead to winners and losers. For example, the Tax Faculty has noted that taxing capital gains on an accounts basis would be particularly unwelcome, but this review might be a very good opportunity to consider the current system where the tax on gains by the entrepreneur are alleviated by a generous taper relief, whereas those realised by the company itself are still heavily taxed.

Rental income

The Technical Note questions whether it is desirable to remove the special tax rules for rental income and other investment income and instead use a commercial accounts basis. This appears to relate mainly to losses, as rental income is of course calculated on the same basis as trading profits.

There is some merit in this idea, particularly for investment companies. Currently they have to draw up their computations on a source-by-source basis rather than starting from the profits per accounts, so any move would have clear time and cost savings. However, if such a move is made, there will need to be some adjustments such as that required to preserve the exemption for United Kingdom dividends.

Commercial depreciation

The other major part of the Technical Note is the issue of whether commercial depreciation should be used instead of tax capital allowances for the majority of business assets. At present, of course, one has to add back depreciation and use capital allowances instead. The capital allowances rules themselves take up a sizeable chunk of legislation, as seen in the recent rewritten version of the Capital Allowances Act. There are also some areas clearly in need of improvement, such as the need to treat so-called 'expensive cars' separately.

The depreciation/capital allowances debate has arguments on both sides. For example, on the one hand, the capital allowances rules are extremely complex. On the other there is an element of uncertainty with using commercial depreciation, as the appropriate rate to be used comes down to a matter of judgment. The worry is that any move to commercial depreciation will lead to protracted arguments with the Revenue about rates of depreciation. There are also inevitable complications with any transitions from one form of taxation to another. There is no doubt that any change will benefit some and penalise others and this needs to be weighed against the regulatory savings.

The Technical Note rather muddies the waters on this issue by stating that if there was a move to commercial depreciation it should be only for 'the majority of business assets'. The intention appears to be the welcome one of ensuring that there is maintenance of all the various incentives surrounding capital allowances, such as 100 per cent first year allowances. However, by watering down the proposal at the outset, there is a potential for even further complication than we already have, as once again there is a prospect of several systems being in operation at any one time.

A part-way measure would be to look long and hard at the current régime of capital allowances and seek to make some of the improvements so clearly highlighted in the work surrounding the rewrite of the capital allowances legislation.

Standards of company accounts

There are some worrying comments in the Technical Note on the issue of company accounts. The inference is that these need to become more 'standardised' and the quality of the accounts are clearly an issue interesting the Government. In the Labour Party Manifesto for Business it mentions the need for greater 'accountability and transparency' in relation to company law issues such as 'audit and accountancy'.

Accounts are formed on a 'true and fair' basis which allows for materiality to play a vital part in arriving at a sensible result. The Revenue has accepted for a long time that accounts are prepared using the concept of materiality and it is obliged to accept them as the starting point for the tax computation. However, the Revenue is less accepting of the materiality concept in relation to the adjustments in the tax computation and to non-accounts based calculations such as chargeable gains. Could this become even more of a battleground in the future with a different approach being adopted for small businesses? Could this lead to higher costs of compliance, more enquiries and more need to justify accounting policies?

The Revenue, like anyone else, can comment on the outputs of the Accounting Standards Board which releases exposure drafts on new proposals for accounts, but it is only one of a range of users of accounts. However, a move to take a more active approach would move away from the long-held principle that accounts are prepared on a commercial basis for commercial reasons and are not prepared solely with tax compliance in mind.

The Technical Note then really goes off the rails by suggesting that everyone should be encouraged to use software 'kite marked' by the Revenue which would ensure that all accounts were prepared 'in accordance with accepted accountancy standards'. Such behaviour would lead to companies reducing the 'risk of being selected for technical enquiries'.

Firstly, this would make the kite marking akin to 'recommendation' –something the Revenue has always been very loath to do as it aggravates the commercial software suppliers and raises all sorts of questions - such as on what basis was the software tested, to exactly what standards, and agreed by whom?

The Technical Note also supposes that the preparation of accounts is some kind of box-filling exercise with little judgment or subjectivity. To produce accounts on a true and fair basis requires more skill and experience than any software is currently capable of. Also, the results from any software will only be as good as the data input by the user – poor input will give rise to poor output, however great the package.

Unincorporated businesses

Although there is a lot of talk about companies in the Technical Note, unincorporated businesses do get a special mention, which is welcomed, as of course these do account for a substantial number of 'small businesses' and they do have some different issues from companies. The difficulty is that the note suggests they may require differing tax treatment, which could lead to yet another dividing line between the tax treatment of businesses of different legal construction, which could lead to yet more complications.

What now?

The next step is for the Revenue to assimilate and feed back on the responses to the Technical Note – the consultation on which closed at the end of May. Hopefully, this will then be followed by a round of in-depth discussions with the representative bodies and affected parties. Therefore, if you have any comments on any aspect of the Technical Note, it is not too late to make your point heard. The more people who comment on these important issues, the better the chance of achieving a worthwhile conclusion. The full Technical Note can be downloaded from the Revenue's website (www.inlandrevenue.gov.uk) and it includes an address for comments.

There is a lot of sense in seeking to address the issues of small businesses, but this Technical Note should be only a start. There are many factors to consider (many more than the note itself touched upon) and much to talk through. It is vital that the arising issues are discussed in detail and the practical problems debated so that a sensible outcome can be obtained. It would be a tragedy if a consultation in this area was rushed through and we were left with a situation that was no better, or even worse, than the present state of affairs.

Francesca Lagerberg is a Senior Technical Consultant to the Tax Faculty of the ICAEW although the views expressed in this article are her own and do not necessarily reflect those of the Tax Faculty and its membership. To find out more about the work of the Tax Faculty call 020 7920 8646 or visit www.taxfac.co.uk or email tdtf@icaew.co.uk.

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