Think big!

KEY POINTS

• Disproportionate administrative burdens placed on small businesses.
• The big idea – a composite flat tax rate.
• Accept the notion of rough justice.
• The French flat rate applies to proprietors.

As a banking specialist, I don't know a lot about small businesses.

But contrary to Alexander Pope, who thought ‘a little learning is a dang’rous thing', I feel that an outsider's view sometimes prompts basic questions, and that radicalism based on a big picture more often has value than our somewhat over-complex modern world allows.

Let’s consider the following fact patterns about very small businesses.

PAYE

The biggest burden of tax administration that small businesses face is PAYE. Estimates of such burdens prepared for the UK Government suggest that over 10% of all the administrative burdens on business across the whole tax system were (only) those of the payroll-related burdens borne (only) by businesses with one to ten employees.

By contrast, businesses with no employees – despite their small size – suffered proportionately fewer burdens than the average business.

This confirms the anecdotal evidence that, when you take on your first employee, all bureaucratic hell breaks loose. It is one thing where this reflects some kind of employee protection, quite another when it just makes tax compliance more difficult and costly.

After all, the burdens imposed on business are often matched by administrative costs for HMRC in running the system. Of course the main determinant of employment levels is the level of demand in the economy.

But past recessions show that recovery takes a long time to filter through to reductions in unemployment. Making recruitment and business expansion easier could help change that pattern next time around.

Accounting rules

Even the smallest business, incorporated or unincorporated, is required to calculate its tax liability by reference to profits computed under generally accepted accounting principles (GAAP). For public companies, this rule is beneficial – or would be if it was followed consistently.

It is, generally speaking, both deregulatory (meaning companies do not have to maintain, in effect, two sets of accounting records) and useful to the authorities in curtailing avoidance, because there is a limit to which companies can maintain two sets of numbers and exploit that fact.

However, microbusinesses have no reason to produce GAAP accounts, other than for tax purposes (leaving aside Companies Act requirements for incorporated microbusinesses which are frankly perfunctory in such circumstances).

Bank managers, creditors and counterparties are more concerned with cash than GAAP, as are the owner managers struggling to run the business.

The burden of producing GAAP accounts is becoming ever more complicated, as it is harmonised internationally, driven by the need to impose standard reporting requirements on public companies to enable the capital markets to make better informed decisions in a globalised world.

Well, that's the justification given. At this rate, the UK's tax system will end up imposing international financial reporting standards on corner shops.

This is not just a theoretical nightmare. It is a recipe for breeding more and more issues such as the brouhaha that blew up on the valuation of year end work in progress a few years ago; this is just the first foretaste of the shape of things to come, if nothing is done.

VAT

One of the concessions made by the VAT system for small businesses is the ability to elect to be taxed at a flat rate on outputs, rather than on outputs minus inputs as the logic of the VAT system requires.

To try to approximate the results to what would be payable if the full complexity of VAT accounting was applied, the flat rate depends on industry sector.

For example, if an industry sector is believed to have a ratio of inputs to outputs (typically) of one third, then a 10% tax rate on outputs equals a 15% rate on outputs net of inputs.

The general perception is that this scheme is of limited value, as people work out quite carefully whether it will cost them more or less VAT before committing to join, a process that reduces any benefit from compliance cost savings.

Administrative burdens are made up of a complex of interacting requirements: to make a real difference you have to attack them over a wide enough canvas. If the VAT flat-rate scheme is not a big enough saver to motivate take-up, it must be transformed into something bigger and more attractive.

Too tentative

For some years the Government has seemed to want to find things it can do, including through the tax system, to 'help' small business, and has come up with a number of initiatives. It has, however, never been able or willing to come up with something perceived of as big enough to make a real difference.

All the while, broader trends to more employment and consumer protection and regulation – much of it no doubt for good reason – has made the environment in which small businesses have to operate more bureaucratically burdensome.

In the tax area, the 0% starting rate for corporation tax had to be abandoned after, predictably, stimulating incorporation as a form of tax planning. Furthermore, even had it been successful, it would not have tackled the biggest burden of PAYE.

Now for some more conceptual stuff. Let's keep it simple and assume revenue equals VATable outputs and non-labour costs equals VATable inputs.

In that case, the formula would be:

Revenue/outputs – costs/inputs – labour costs – finance costs = profit.

It follows mathematically that:

Revenue/outputs – costs/inputs = labour costs + finance costs + profit.

Now the first side of this equation (revenue/outputs – costs/inputs) is the 'normal' VAT base.

The second side of the equation (labour costs + finance costs + profit) is the combined income tax, corporation tax and National Insurance base in respect of the individual or corporate proprietor of the business, and the dividend, finance or employment income of the shareholders, finance creditors and employees.

The big idea

So if the industry-specific flat rate of tax on revenue can approximate to the properly calculated VAT rate on a business in that industry, why can the same approach not be used to approximate to the properly calculated income, corporation tax and NIC rates applying to all income which proprietors, shareholders, finance creditors and employees take from the business?

That, in short, is the Big Idea. For each industry for which a flat VAT rate has been established, calculate a composite direct tax rate to approximate to the 'take' from income/corporation tax and NICs. Payment of the total 'flat' rate would totally frank any income which the stakeholders derive from the business.

The direct tax element only of the composite rate would apply for businesses in scope but below the VAT threshold.

The result would be one simple computation of liability based on revenue, and no income or corporation tax computations. More importantly, there would be no National Insurance or PAYE liability.

By way of example, the rate of tax on turnover applying to a microbusiness with turnover above the UK threshold in a sector where inputs were estimated at one-third of outputs, might be calculated as follows:

Research would be needed to establish the composite rate to derive approximately the same revenue at a national micro level and to review it periodically. But the same rate would apply regardless of whether each individual business had employees, or if so how many it had.

There are inevitably all sorts of problems or issues that may arise from this approach.

 How does one define the industries or guesstimate the appropriate composite rates to apply within each? What about employment contracts, and protection rights related to gross salary (e.g. minimum wage)? And so on.

The key to addressing these issues is rough justice. The philosophy is that the administrative savings will compensate for a certain amount of loss on the swings and roundabouts.

Few businesses probably get all the detailed calculations that they supposedly should perform right in any event.

Do microbusinesses comply with the detailed benefit in kind rules or the latest Accounting Standards Board pronouncements on revenue recognition or provisioning? Of course not.

Do HMRC provide such successful guidance or such well-judged intervention that they are all guided unfailingly to the straight and narrow (or one should rather say, the convoluted and narrow) way of the law?

No, and nor could they, however good they were. It is just too complicated a task.

Likely target areas

There could be net pay levels of minimum wage set for employees of such businesses and employment contracts could be translated to net pay amounts.

Rulings could be obtained for a few years at a time as to what sector a business was in and what reduction for inputs applied. In such negotiations the rates applying to competitors could be persuasive evidence as to what the right industry sector was.

Remember that as an economic fact, who really bears the burden of a tax is not the same thing as who is legally liable for it – as anyone who has ever been offered a discount for paying in cash will have cause to reflect on.

If that example is too suggestive of outright evasion, an example from the safe harbour of state-sponsored avoidance would be the signs in bank or building society windows advertising ‘tax free returns’, but the returns leave much of the benefit to the banks.

If the burden of the simplified system imposed on a given business is not exactly right, but competition between businesses whose products or services are truly substitutes for each other are not materially distorted, then the benefit or burden will get widely diffused across the economy.

Given we are talking about micro-businesses in a competitive market, the same reasoning justifies averaging out some personal allowances, basic rate, and higher-rate tax with similar corporation tax and National Insurance complexities into a single composite rate. True justice does not require exact parity of theoretical legal liabilities.

One difficulty always arises for any scheme targeted at business below a certain size: the threshold problem of what happens when businesses grow above it. There is no perfect answer.

But whatever the drawbacks, they will not be as great as the current threshold problem, i.e. the spike in tax administration caused by a would‑be compliant business taking on its first employee.

The key is to be looking at the wood, not the trees. This would bring other benefits. Enforcement action would focus, not on the minutiae of PAYE compliance, but on the question of whether revenue is fully recorded.

Failure of some businesses to report revenue, while others not only pay tax, but face PAYE audits, is surely the greatest injustice in this area at the moment and the greatest cause of any tax gap.

Certainly it is easier for HMRC to check up on the detailed compliance of the registered rather than go after those outside the formal system – but we cannot always be guided by the Homer Simpson principle that ‘if a thing’s hard, that means it’s not worth doing’.

À la Française

We often like to compare the flexibility and deregulation of our economy with the supposedly more bureaucratic French. But how do the French tax small business?

They impose a flat rate of tax on revenue, computed by a deemed ratio of expenses to revenues. How many different rates do they have? Two, compared with umpteen industry rates in the UK flat VAT scheme.

The home of égalité is content with very rough justice indeed. The answer to concerns about getting it precisely right is a Gallic shrug.

But all is not lost. ‘Courage, mon brave!’ The French scheme applies only to the taxation of proprietors.

We have the opportunity to leapfrog our neighbours and restore our reputation for pragmatism, by creating an option for a single, comprehensive, flat tax for microbusinesses.

Pope was indeed wrong – at least when it comes to tax policy. It is not learning, but simplification, of which ‘shallow draughts intoxicate the brain’, and which must be drunk deep to achieve real results.

John Cullinane is a tax partner with Deloitte

Issue: 4195 / Categories: Comment & Analysis , Business , Companies , Income Tax , VAT