Could action on tax avoidance trouble small businesses?

21st June 2012

Many celebrities are taking advantage of the more generous tax treatment for companies over individuals, but in reining in abuses, does the government risk accidentally disincentivising those small businesses who are deemed to be the engine of future economic growth? Is it possible to halt avoidance schemes while still allowing generous reliefs to small businesses?

For those with flexible earnings patterns, one of the main ways to reduce a tax liability is to incorporate as a company. The tax treatment of companies is far more generous than those for individuals as the following ‘This is Money' article points out: 

"By channelling their earnings through a private limited company, high earners can pay themselves a small, sometimes tax-free, wage. They then supplement this with regular dividends paid to themselves as shareholders. The results of incorporating as a company can be dramatic. Instead of paying income tax at 20 per cent 40 per cent and 50 per cent and NICs at 12 per cent and 2 per cent, company directors take the lion's share of their earnings as dividends. These are taxed at 10 per cent , 32.5 per cent and 42.5 per cent and attract no NICs, but carry a 10 per cent notional tax credit to offset part of the tax due."

Ken Livingstone was one of the first to feel the heat over this type of scheme: "Mr Livingstone has been accused of using a loophole allowing him to avoid his full liabilities by being paid for media appearances and other work through a private firm. This means he is able to pay corporation tax at lower rates of 20 per cent or 21 per cent rather than income tax at up to 40 per cent."

This would seem to present a dilemma. The Government deliberately incentivises small businesses with lower tax rates. In tackling abuses, does it risk creating more problems for the already beleaguered small business sector?

There are two things that suggest this does not have to be the case. The first is that the recent scandal involves a far more complex scheme than simply incorporating as a company: The ‘This is Money' article reveals the nature of the scheme allegedly used by Barlow and, among others, comedian Jimmy Carr: "Its members redirect their earnings into a Jersey-based trust. The trust then grants interest-free or low-interest loans to members, on which little or no tax is payable. The borrowers then quietly 'forget' to repay these loans, which the trust later writes off against the earnings it holds."

The Government should not have to change any of the rules governing smaller companies to stop this sort of scheme. In fact, the powers to stop it may already be in the making. In March of this year, George Osborne announced plans to introduce a generalised anti-avoidance rule: "(At the moment) HMRC needs to legislate against each and every individual tax avoidance scheme deemed to be aggressive. A GAAR would act like a blanket legislation to differentiate between what counts as responsible tax planning and what is abusive tax avoidance."

But the Ken Livingstone-style company scheme is more difficult to tackle without disturbing the tax incentives for small businesses. HMRC could take action against one person limited companies, but as this piece on the – admittedly self-interested – Contractor UK site points out, rules already exist to stop abuses under IR35. Any increase in corporation tax rates to narrow the gap with income tax rates would create an uproar among business leaders in the current environment.

There remains a significant question over whether this needs tackling at all. The tax savings from this type of scheme are not nearly as great as the Carr/Barlow scheme. Corporations may only pay tax at between 20% and 24%, but every time an individual takes money from the company, he will pay an additional slug of tax on that income. Therefore, the ultimate tax bill for individuals using this scheme is often only marginally smaller than those that pay directly by PAYE. Plus, there is a cost to administer the schemes. The real advantage is that it allows people to time when they pay their tax bill – they can roll up money within the company and pay the lower rate of tax, until they need to draw the money out, when they will pay the rest.

Incorporating as a company is not the path to riches and tinkering with the rules risks using a sledgehammer to crack a nut and potentially stifling small business creation. The recent exposure of the tax dodges of celebrities may prove advantageous in focusing attention on the real abuses of the tax system.


More on Mindful Money:

Is Finance immoral? – Mindful Money’s response to The Guardian

Whose fault is today's bad economy?

The Consequence of Tax on Foreign Investment

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