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OUR SURVEY SAID … that you were more or less equally split between the three different options we gave you for allowing businesses to use cash accounting. According to the poll on our website, at the time of writing about a third of you thought all small businesses should be able to cash account, a third that only unincorporated businesses should be able to cash account, and a third that none of them should. The poll stays open until 30 November, so please do continue voting.
We put the poll up in response to a debate on AccountingWEB advocating that small businesses should be able to simply report their cash surplus of income over allowable expenses and be charged income (or corporation) tax on that, rather than on profit calculated under strict financial reporting standards. The idea seems to generate strong feelings both for and against, some of which have been aired on AccountingWEB and also this week in our Feedback pages. Richard Murphy has also put a cogent summary of the argument against cash accounting on his blog at http://snipurl.com/murphyblog. Most of this is addressed at issues around what is expected from a set of financial statements.Judith Freedman also argued against it in this year's Hardman lecture, suggesting that it was an example of 'attractive complexity' and should be resisted. I am beginning to wonder whether part of the problem might be the terminology: perhaps we should not be talking so much about cash accounting but rather a simplified tax regime for smaller businesses, which incorporates cash reporting, but which does not pretend to be creating a set of financial statements at all.
True and fair
The problem is that as soon as we talk about 'accounting' we bring so many other expectations into play. If we are using accounting principles to produce a statement of the profit of a business, then quite rightly the assumption is that the statements produced stand on their own, and can be used by a range of stakeholders — by management, by government, by creditors, by investors. A statement of receipts and expenses does not meet that expectation.
But, in the real world, the vast majority of businesses which this system would be aimed at are actually one person making a living from his or her own skills and time. Depending on the business, they may have stock and employees, but most of them will not. They will be service-based, one-person, micro-businesses. Their records will be an analysed cash book, or the electronic equivalent on a spreadsheet or personal finance package which they will eventually (after several reminders) bring in to you together with a couple of lever-arch files containing bank statements, invoices paid and copies of invoices issued. You will produce the accounts several months after the year end, showing a profit figure which is meaningless to the client and is of little use at this stage in running his business. The figure that he is interested in is the bank balance, which he is generally aware of and monitor on a weekly, if not daily, basis. Unless he is looking to take out a mortgage, and needs the accounts to show the lender, the only question he is likely to ask about the profit is 'how much tax will I have to pay on that?'
Why profit?
By statute, and previously by case law, tax on businesses in the UK is charged on their profit as determined by accountancy principles, modified by any specific Taxes Acts provisions. But it doesn't have to be that way, particularly not for small businesses.
In France, small businesses have the option of being taxed on a basis similar to that for flat rate VAT. They submit a calculation of their turnover but do not have to report expenses at all — they simply deduct a set percentage dependent on whether they are a trading or professional business. That seems a peculiar basis on which to assess businesses, but it has the merit of being much more straightforward, and it is a good contrast to the 'one size fits all' basis of the UK system.
Australia never seems to have developed a full-blown view that unincorporated businesses should be assessable on their profits based on accounting standards; a ruling from the Australian Tax Office sets out two possible ways of accounting: accruals or cash. The decision between the two is not a choice; it depends on the type of business. Broadly speaking, trading businesses are expected to use accruals, services and professions to use cash. However, Australia also has a simplified tax system for smaller businesses which has allowed a modified version of cash reporting for all small businesses which opted into it. It appears that this has recently changed, and we will try to get some details about the Australian experience in the near future, to inform the debate here in the UK. Finally, the USA, I understand, also allows cash reporting for tax in some circumstances.
So there are examples of other ways of assessing small businesses to direct taxes, albeit that there are also some lessons to be learned. Following the Australian model, if we looked at a simplified tax regime for smaller businesses, which they could opt into if they wanted, and which was based on cash reporting, what would it look like?
Turnover limits
The first question to answer is how the businesses which are to be allowed to use the simplified system should be selected. The obvious criterion to use is turnover, but at what level should businesses be required to use full accrual accounting?
One approach would be to align it with the cash accounting threshold for VAT purposes, which is now £660,000. That seems to be logical: cash accounting for VAT, cash accounting for direct tax. But this is a fallacious comparison; the point about cash accounting for VAT is that it solves the problem of bad debt relief. The issue for direct tax is one of records and sophistication of financial systems. What we are looking for is a level at which a business typically has records based on the cash book rather than on a purchase and sales ledger.
There are two other existing thresholds which might make sense. One is the threshold for the VAT flat-rate scheme, on the basis that this is a scheme which approximates the 'true' liability to VAT, so it would be appropriate to do the same for direct tax. The other would be to say that the scheme can only be used by businesses which are not VAT registered, and would not have to be VAT registered if all their supplies were taxable, on the grounds that they are the ones which have the least need for a sophisticated accounting system. This would put a maximum threshold of £60,000 in place, but also exclude businesses which choose to register voluntarily.
Of the two, initially at least, I would favour the latter. I see this as a scheme that is really designed for those 'businesses' which are not really businesses at all, in the sense that they are not run by entrepreneurs who want to grow and expand, and who therefore do not need the accounting information that tells them what their true profit is so that they don't overstretch themselves.
What should happen when turnover goes above the limit, and businesses have to move over to full accrual accounting? Various contributors to the debate have suggested that there should be transitional reliefs, but my preference would be for a simple catch-up in the year of transition. The point is that the simplified system is not intended for businesses which are growing fast, it is intended for those that are highly unlikely ever to exceed the limit. We are used, for VAT purposes, to businesses having to register when they exceed the threshold and staying registered thereafter even if they fall back just below it; there is no reason why the same rule should not apply to the simplified tax system.
Companies too?
Should companies be allowed to report for corporation tax on a simplified basis too? It can be argued that the Holy Grail which is currently being sought is a system whereby the form in which a small business is carried on should not affect the way that it is taxed, but that project does not at present seem to be progressing very quickly.
In any case, companies are a different legal vehicle, with different legal consequences. One of the prices that you pay for limited liability is public scrutiny; the financial position of the company is (at least to some extent) on public record at Companies House. By definition, therefore, the financial statements have to be prepared on a basis which all stakeholders and likely users of the accounts can understand on a consistent basis.
The result is that the financial statements themselves will have to be prepared on an accruals basis. It would be very peculiar, and defeat the object of simplification, if the financial statements were 'readjusted' to a cash basis. The point is to relieve businesses from having to adjust records that will initially be on a cash basis so that they reflect accruals; if that has to be done anyway, then that is what should be reported.
More simplification
One of the issues in the debate is whether cash reporting for tax implies 100% capital allowances. I don't see any necessary correlation between the two, but if the intention is to produce a simpler system for smaller businesses, it would obviously help if it did. The Australian system has a limit of £400 per asset in order to get 100% relief in the year of acquisition. That seems to be the right idea but too low a figure — what about £5,000? That should cover most items that businesses of this size would use, and mean that there is no need to understand capital allowance pooling: you deduct what you pay out and bring in as a receipt any proceeds of sale of assets.
The exception would have to be cars — how do you account for the inevitable private use, etc? Again, though, there is a straightforward answer which links in to the threshold being that for VAT registration, which is to provide that all businesses using the simplified taxation scheme must also use the mileage allowance basis for motor expenses, rather than actual costs and capital allowances.
Anti-avoidance
This is intended as a simplified regime, not a way of avoiding tax. Obviously it is likely to result in some delay in tax liabilities, particularly in the first year, but it is unlikely to trigger wholesale avoidance, if only because the main effect is a timing difference. Yes, you can significantly reduce the tax liability in the first year by delaying invoices, or even (depending on how the system is designed) by delaying banking cash or cheques, but you then have to continue doing so in future years simply in order to prevent the first year advantage from reversing. It is the equivalent of the old 'teeming and lading' accounting fraud, and any tax adviser who understands the new system should be advising clients that it is not worthwhile.
Significant purchases of stock shortly before the year end is another way of misusing the system. The Australian simplified tax system includes a rule that stocktakes have to be carried out if the estimated increase in stock over the year exceeds a certain threshold. This seems a complicated and piecemeal way of approaching the issue, however, and it would make more sense to include a general anti avoidance rule for the simplified system.
A general rule would negate the tax benefit from any transaction undertaken where the main purpose, or one of the main purposes, was to take advantage of the special provisions in the simplified tax system. One would expect HMRC to operate it with a light touch, because most of the advantages are timing differences, but it would be there to provide a backstop against aggressive avoidance. If it was combined with a minimum period of, say, three years during which businesses had to remain within the scheme (unless they exceeded the registration threshold), and a similar period before they could re-enter it after voluntarily coming out of it, that should be enough to stop most of the more obvious problems.
Will it happen?
Will the Government want to consider such a system? I don't see why they shouldn't. It certainly needs more work and consultation, and it would have to be an optional system. The need to prevent major tax avoidance has to be considered, but at the same time there is no point in having a supposedly simplified system which actually has a raft of complex anti-avoidance rules within it. It does, however, seem to me to offer a significant reduction in complexity for that very large number of smaller businesses on whom the current system imposes an unnecessary burden.
