An Improper Debate

ANDREW GOODALL argues that there has been insufficient thought given to the effect of the new nil rate band for corporation tax.

THE RECENT PARLIAMENTARY debate on the new nil rate band for corporation tax deserves some scrutiny, given the controversy surrounding the Budget proposal. Having read the transcript, I doubt whether the new tax régime will last very long. Tax advisers may welcome the extra work, but they need to tread carefully.

The Government failed to justify a régime that may well be seen as grossly unfair by many self-employed taxpayers and employees, who face increases in their National Insurance contributions. It may be able to shoulder the growing criticism. But the signs are that the rules will be changed once again, should the loss of tax revenue significantly exceed Government estimates, which many consider inadequate.

The Finance Bill Standing Committee discussed the new corporation tax rates on 16 May. The fire alarm sounded during clause 30, just as Paymaster General Dawn Primarolo announced that some 150,000 companies, those with profits of up to £10,000, would have a corporation tax starting rate of zero per cent, once the Bill had been agreed. She did not know whether to carry on speaking, or run for the door.

The Institute of Fiscal Studies had already demonstrated how the new system can put the self employed running unincorporated businesses at a clear disadvantage compared with, say, a one-person company. Howard Flight moved an amendment designed to produce fairness, which would allow unincorporated businesses to 'retain' profits and take advantage of the lower rates of corporation tax without going through the 'hassle' of incorporation. Ms Primarolo rejected this, saying it would be indulging in fantasy and would be difficult to write into the legislation.

Imperfect balance

Mr Flight had not been the first to ask whether the Government was trying to drive businesses to incorporation through the tax system. Mr Mark Hoban asked:

'Is the Paymaster General aware of the depth of feeling among sole traders and unincorporated businesses about the growing fiscal advantages that there appear to be to incorporation? It would appear that for a sole trader with profits of £42,000 in 1996-97, the fiscal advantage of incorporation was about £1,400. In the 2003-04 tax year, it will be about £4,000. Many unincorporated businesses feel that the Government is trying to drive them towards incorporation. They do not wish to incur the additional costs of incorporation, but the tax régime is such that they feel almost obliged to do so because if they did not, they would be significantly worse off.'

Ms Primarolo claimed that the Government sought to strike a balance 'as best we can' in not driving businesses to a particular structure. 'The balance is not perfect' she said, and continued:

'The decisions that businesses take, the access they have to different relief and their structure are very much choices for them. We are not deliberately driving people into incorporation: we recognise the differences. I understand and recognise the strong feelings that are held by some in the unincorporated sector. As the Minister concerned, I continue to look carefully at that, and at how the tax system works for the different company (sic
) structures.'

The Paymaster General talked of the need for a balance 'between certainty and fairness for the taxpayer and for all other taxpayers, because we take collectively as a society the decision all to pay our fair amount in the collection of the revenue that pays for our public services … If the hon gentleman looks at the tax reforms that the Government has undertaken since 1997, he will see that we have been trying at all points to take out of the system distortions that drive companies to take decisions based on tax rather than the decisions that they would otherwise take'.

It is difficult to square this claim with a Budget measure that introduces a major, and probably unprecedented, distortion for taxpayers on modest incomes.

Rush to incorporate

Mr Flight's understanding was that the self employed were 'virtually lining up on the streets' to become incorporated. He warned of a massive and undesirable rush to incorporation of businesses that would (otherwise) be better off as sole traders, saying:

'The situation is not sustainable. We do not want three million sole traders becoming incorporated and clogging up the system.'

Edward Davey quoted the Institute of Fiscal Studies as follows, '… by setting up a company a person would be able to pay himself a personal allowance of £4,615 against income tax, and on top of that make profits of up to £10,000, which would be paid out in dividends, while facing no tax liability'. He added that, 'as a result of the clause, a person who incorporates could earn £15,000 and pay no tax. Labour members may want to reflect on the distributional issues raised by the measure'. He pointed out that there would be no extra economic activity as a result of sole traders deciding to incorporate.

The Institute of Fiscal Studies had estimated the net loss of revenue at between £1.2 billion and £2.5 billion, and said it was 'difficult to see how providing a large tax incentive to people to change the form in which they do business will be beneficial'.

Distributional issues

Mr Davey suggested that if the Institute was right, the measure would amount to questionable use of taxpayers' money, and he had a word for employees too:

'Labour members should be aware that it could mean a huge tax cut for a particular group at a cost to the wider community, and that that could cause distributional issues. I shall remind them of the figures that compare a self-employed person with an employed person, each earning just under £15,000 under the régime. The self-employed person pays no tax, and the employed person pays, I am told by the Institute for Fiscal Studies, £3,827. That is a huge difference, which I am not convinced that Labour members want.'

Having illustrated the disparity between incorporated and unincorporated businesses and employees, the committee then began to analyse the Institute of Fiscal Studies scenario. It raised some serious questions. Some members had not seen the Institute paper, although it was on the Internet. Rob Marris, who used to be a solicitor, was confused. Using the example of a newly-incorporated Ted's Window Cleaning Ltd, he asked 'would the £10,000 dividend not be subject to 22 per cent income tax?'. Mr Flight was helpful:

'My understanding is, no doubt the Paymaster General can correct me, that because the company has paid whatever its corporation tax due is, the money paid out by way of dividend will qualify as a dividend that has suffered corporation tax. The recipient would pay further tax on such a dividend only if he were paying higher tax rates. This recipient would, therefore, not pay any further tax on that dividend.'

Mr Marris, it seems, could hardly believe it, asking '... is the hon gentleman saying that I then do not pay income tax at all on that dividend, or that I only pay it if I am a higher rate taxpayer?'.

Tax advice in committee

Mr Flight rose again, but the Paymaster General was not happy. She hoped that the advice Mr Flight was giving was free. Mr Marris was still not clear. He confirmed that the shareholder director in his example would not be paying higher rate tax. 'I shall leave it for the Paymaster General to explain further', he said.

The chairman was not having it. 'Order. I am conscious that some extremely expensive advice is being offered free to hon members this afternoon, but I think that we had better come back to the matter in hand', he said. What, I ask, was
the matter in hand? The committee was discussing an unfair anomaly, and exploring how it arose.

The Paymaster General was grateful. 'Thank you so much, Mr Gale. I do not want to go down Ted's route at all, thank you'. Perhaps she did not want the committee to be offering tax planning advice to the outside world. Well, this time we only have to read the papers!

Ms Primarolo preferred to remind the committee of the Chancellor's commitment to small businesses and the creation of wealth. She reasoned:

'The measure recognises that businesses growing beyond a certain size will often be companies. We believe that cutting corporation tax is an effective way of targeting support at small and growing businesses. It also encourages would-be entrepreneurs to set up new companies … The estimated impact also takes into account likely significant or quantifiable effects on behaviour. The estimates have been made on the basis of the likely shift, but the economic rationale is clear. The measure is a targeted reduction in tax to help small and new companies thrive and grow.'

The nearest Ms Primarolo came to justifying this anomaly was to point out that the self employed already receive 'appropriate incentives' such as the carry-back of losses sustained in the early years. This relief, however, is of no help to the self employed making profits.

She suggested that we should not expect a mad rush to incorporate now, apparently because it has not already happened under the existing rules:

'Some 78 per cent of businesses, nearly three million of them, are unincorporated, despite the fact that there are already theoretical tax benefits for incorporating that would demonstrate to those companies (sic
) that they could be better off. There is no shortage of tax advisers seeking to earn a fee from advising companies (sic
) that that is the best way forward, but we have still not seen that change.'

Incorporate with care

The Government stood by its estimate of costs rising to £450 million. Mr Davey asked for an assurance that, if the measure is exploited as anticipated by the Institute of Fiscal Studies, the Government would take action to stem the loss of revenue. Ms Primarolo assured him that 'the Government continues to cast an eagle eye on the way in which the tax system is used'. Mr Davey's response carries a note of caution for professional advisers:

'I am glad that the Paymaster General is so keen to ensure that the measure is not exploited. She should understand the effect that it would have if, in a year's time, the Institute of Fiscal Studies turns out to be even half-right and the Government decided to take action, because accountants would have spent a great deal of valuable time persuading companies (sic
) to incorporate. If the Government then changes, those companies would be free to try to unincorporate, but that would be an extra deadweight cost.'

The quality of this debate does nothing to instil confidence in the new régime. The Government failed to advance any sound economic argument for favouring small companies, to this extent, over unincorporated businesses.

Julian McCrae, co-author of the recent Institute of Fiscal Studies briefing note, told me:

'There is a history of tax measures which have resulted in a large loss of revenue due to people taking advantage of them, and later changes to claw back such losses have been deeply unpopular. One of the most surprising aspects of this proposal is that the Government appears to be saying that it is not trying to provide incentives to incorporate, whereas it is clear that this measure will provide such an incentive.'

The next few months will be interesting. First, the introduction of the zero rate may become deeply unpopular among those who cannot, or will not, form a company just to save tax. The Government might just shrug that off, and carry on regardless. Secondly a dash for incorporation, the like of which has never been seen before, may well prompt a re-think. The options will include levying National Insurance contributions on dividends paid to shareholders holding substantial voting rights. The usual caveats surrounding tax planning advice must never be overlooked.

Andrew Goodall, ATII
is a freelance writer: www.andrewgoodall.co.uk.

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