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KEY POINTS
- Certain 'fault lines' in the tax system generate far more legislation than they should.
- Schedule 7, on remittances, is almost as long as Finance Act 1965.
- Distinction between employment and self-employment does not reflect economic reality.
- Need for the underlying causes to be dealt with, but how will this happen?
So here we are, in that brief period of calm between the passing of one Finance Act and the Pre-Budget Report, which starts the process for the next.
In fact, even that is untrue, as the time between then and now will be filled with consultations and representations on some of the issues that are likely to feature in the Pre-Budget Report. It is an unending production line, designed to pump out more and more legislation. What is far from clear is whether the legislation is actually creating a worthwhile tax system.
It is generally reckoned that the UK now has the longest tax code in the world, having recently overtaken India. The only way that the Yellow Book has stayed within its four volume limit in the past two years is because each page is now slightly larger than it was, and the amount of white space without print on it is smaller. If this goes on much longer we will have to issue a magnifying glass with each set.
We cannot, surely, go on like this for much longer. Instead of churning out more and more tax legislation, we have to find a way of creating a better tax system. It is surprising, when you look at it, how much of the tax system which we actually use on a regular basis is contained in just a few sections of the Taxes Acts.
The main sections defining and taxing business profits of the self-employed, for example, do not take up a great deal of space in the Yellow Book, while the rules for IR35 and Managed Service Companies do. It seems that there are certain fault lines in the tax system, generating a volume of legislation that is far beyond their real importance.
Perhaps if we could stop trying to fill in the cracks each time they appear, and deal with the underlying stresses that are causing them, we might get a better result.
Remittance basis
This issue of Taxation, which concentrates on the Finance Act, is going to the wider CIOT membership as well as to our subscribers. The annotated Finance Act, which LexisNexis produces for the CIOT members, has a foreword this year from Sir Andrew Park in which he points out that Schedule 7, dealing with the remittance basis, is almost as long as the whole of Finance Act 1965, which introduced two new taxes — corporation tax and capital gains tax.
Yet it deals with an area that until now has been virtually ignored by legislation, and was governed instead by practice derived from a few cases.
The derivations were not always as soundly based as they might be, but it was generally accepted that if you remitted money from a mixed fund of income and capital then you were to be treated as having remitted income first until the total income in the fund had been exhausted.
Apart from a few cases on issues such as whether giving money to someone else who brought it into the UK constituted a remittance, that seemed to be enough; certainly there were no new leading cases on whether a remittance was one of capital or income.
So why do we suddenly need so much legislation on the subject now? It might be argued that the issue was rarely relevant before, since it was so easy to avoid making a remittance at all.
But does anyone seriously believe that, once advisers have had time to study them, similar loopholes will not be found in the new legislation? In any case, it is still possible to maintain a pure capital account offshore untainted by income or gains from which remittances can be made safely.
The Treasury will no doubt say that much of the complexity has arisen from the consultations with the profession, and the queries they raised. But that was an inevitable result of legislation which charged a flat fee for maintaining the remittance basis; it focused attention on exactly what was being bought for the price.
Instead of trying to precisely define what was being remitted and when, would it not have been better to ask whether the remittance basis was a sensible approach for taxation in the first place?
I was against the idea of allowing taxpayers to keep the remittance basis by paying a fee at all, but if such a scheme was to be introduced, the Conservative approach of making a flat charge and then not taxing subsequent remittances had a lot to recommend it. Instead we end up with the excessively complex system, which Tim Keeley tries to explain for us in this issue.
Simplification failure
Just under a year ago, before the loss of the data discs but after the pre-budget report, Alistair Darling was looking like a genuinely simplifying Chancellor.
The proposal to allow IHT nil rate bands to be transferred between spouses was a case where adding to the legislative burden at least made will writing simpler, removing the need for nil rate band trusts in the wills of the average married couple. Chris Whitehouse analyses some of the implications of the new rules in his article.
But it was in CGT that the greatest simplification was to be achieved. Sweeping away taper relief and indexation would take us back to the simplicity of that original 1965 system, but at a lower rate of 18%.
Unfortunately, the weak position the Chancellor found himself in subsequently has meant that his simple system has been complicated by the addition of entrepreneur relief, recreating from taper relief the (as yet untested) division between companies which qualify and those which do not.
Again the legislation creates a fault line, and no-one seems to stop and ask whether it is necessary. When people make capital gains, they should be taxed on them. In some situations it may be appropriate to provide for the gain to be rolled over into the purchase of a new asset, but there is no obvious economic reason why it should ultimately be either untaxed or taxed at a lower rate simply because it has come from a business investment.
It is true that investments in small businesses will normally have to give a greater reward to attract capital, but that is the function of the market, not the tax system.
The only real argument for entrepreneur relief was that people who had a legitimate expectation of selling their business at a profit in the near future and paying only 10% would now find they were paying 18%.
If that was the perceived injustice then at least entrepreneur relief could have been given a limited lifespan of five years or so. Alternatively, taxpayers could have been given the right to deem their chargeable assets to have been sold and reacquired as at 5 April 2008, perhaps with payment of the tax deferred for a few years or until a real disposal, whichever came sooner.
Instead we have the worst of both worlds, with a fault line caused by entrepreneur relief that has no end date in sight, and a much-used planning technique of transferring assets between spouses in order to try and 'bank' the indexation prior to 5 April.
The problem is that the legislation is so opaque that it is not clear whether this has been achieved in some cases. Mike Thexton's article analyses this, but as he says it is extremely difficult to be sure what the law is saying, because it has been so patched together over the years.
Income shifting
Quite apart from the fault lines made visible by the latest Finance Act, there are the ones which have not been dealt with in previous years. Top of the list, and likely to feature prominently in the next Finance Act, is the issue of what the Treasury now call 'income shifting' and the rest of us refer to as 'husband and wife companies'.
So much effort has gone into this dispute, on both sides, since the days before any of us had ever heard of Arctic Systems. The likelihood appears to be that we will get a more targeted rule attacking income shifting in the next Finance Act; we can only wait and see if it is both workable and effective. However, would it not make more sense to ask whether trying to prevent income shifting makes sense?
In the vast majority of cases, income shifting such as this occurs because a couple who are living together try to rectify the injustice caused by our inflexible system of independent taxation.
What is the logic for saying that spouses can transfer IHT nil rate bands on death, and that tax credit claims have to be based on joint income, but insisting on seeing a couple as two unconnected taxpayers when calculating their income tax liability?
The ability to file a joint return with combined allowances and rates is common in many other countries, and means that the fault line of income shifting simply does not arise. So why do we insist on attacking the symptom rather than dealing with the root cause?
Personal service
And finally, the biggest fault line of them all, of which income shifting is a subsidiary part. In economic terms, there is a spectrum of activity between full employment and the running of an entrepreneurial business. It passes through temporary contract work, a portfolio of part-time appointments, and freelancing.
From the point of view of the person doing the work and the person hiring them to do it, there is often very little difference between some of them, but in tax terms a great deal of effort is put into maintaining the dividing line between employment and self-employment.
So the fault line acts like the border between the USA and Mexico — everyone is trying to get onto the 'better' side. As a result we have the tax equivalent of border patrols and wire fences, the IR35 and managed service company legislation, which have so far proved just as inefficient at keeping the problem under control.
Again, is it not time to look at the bigger picture? The solution is by no means clear, but it is easy to see the sort of issues to be considered. Do we need such a big difference between the allowable expense regimes for short term contract and freelance workers?
Should the tax treatment of a personal service business operated through a company differ so much from that of one operated as a sole trader? Is National Insurance an idea that has had its day?
Conclusion
I am not suggesting that any of these questions have easy answers, but I am pessimistic about the will to genuinely engage with them at present. HMRC no longer seems to have the power to get them on the agenda, the Treasury does not seem to understand them, and the politicians are scared of anything which produces winners and losers.
But until we can have a grown-up conversation about a tax system that fits the needs of a modern country, we will continue to, literally, paper over the cracks with longer and longer Finance Acts.
