OTS report: what does it mean for small business?

Is the UK’s tax system too complicated?

Many small business owners would say a resounding “yes” as they struggle with the demands of income tax, national insurance, VAT, payroll…

Could this be made easier?

That’s what the Office of Tax Simplification is there to find out – and it’s now published its report into small business tax in the UK and how it could be simplified.

I was very impressed with the report. Despite its length, it’s written in plain simple English and contains some very practical ideas.

Here’s a brief summary of its findings, and some thoughts from an accountant…

Key areas for attention

The report’s main focus is, from its executive summary:

• The integration of income tax and national insurance contributions (“NICs”); and
• Introducing a radical new approach to taxation for the very smallest unincorporated businesses.

It also looks at:

• Improving elements of HMRC administration (and thereby its relationship with taxpayers);
• Choice of legal form;
• Simplifying reporting requirements on reimbursed expenses and benefits for employees;
• Improvements to the capital allowances regime; and
• Considering a simpler VAT system for small businesses that undertake international activities.

As far as IR35 goes, removing the distinction between income tax and NICs would also take away the need for IR35. But unless and until that’s implemented, the report suggests the government could:

• Suspend IR35 with the intention of permanent abolition, using the period of suspension to investigate behaviours and costs; or
• Keep IR35 legislation unchanged, but improve the way it is administered by HMRC; or
• Introduce a new “business test” to see if an individual is actually employed or self-employed.

What implications might these have?

I’m going to look at the potential implications of two of these suggestions, both in the context of what the report contains and also my own thoughts.

Integration of income tax and NICs

The report points out that the current system creates a lot of anomalies.

IR35 and the “low salary, high dividend” remuneration route for limited companies is one example. Because there are no NICs due on dividend income, one individual trading through a limited company could potentially pay a lot less to Mr Osborne than he/she would as a sole trader.

Because employers, as well as employees, have to pay NICs, there is an incentive for employers to take on workers who are self-employed. This also means that employers don’t have to provide, for example, paid annual leave, or sick leave. Removing the distinction between income tax and NICs would also remove this issue, which at the moment is a large grey area.

Another example is benefits in kind legislation. Some benefits are exempt from both income tax and NICs, some from one or the other, and some from neither… confusing!

Would this be a good idea?

In my opinion it would certainly lead to simplification but it could also be an unpopular move for the government.

NICs are a tax by any other name, true enough – but remove them and charge only income tax, and the headline rate of income tax would have to go up, as the report says.

The report also points out that there are some groups who could potentially pay more to Mr Osborne, such as pensioners, and individuals whose income comes from savings and investments, because pension income, savings income and dividend income are not subject to NICs, only to income tax. So in order not to penalise these individuals, the change to income tax rates would need to be judged very carefully.

I’m also not convinced that it’s entirely fair to give no tax savings to the self-employed. Despite the opinion of various high-profile sceptics, self-employment is definitely not a job, it is a business! There are additional stresses involved with being self-employed – for example, no right to paid time off when you’re ill – and I think that should be rewarded with tax advantages. Otherwise why would anyone ever want to set up their own business?

An alternative approach to the taxation of the smallest unincorporated businesses

From the report:

OTS analysis of HMRC administrative data indicates that in 2007/08 there were over 3.6million unincorporated businesses (sole traders and partnerships) of which over 2million (56%) had turnover of under £20,000. Over 40% of these were not represented by a tax agent, compared with just 15% unrepresented larger businesses. This presents greater scope for errors in the record keeping and returns of the smallest businesses. 

Filing a short tax return can make life easier for these very small businesses, since that removes the need to divide up all their expenses.

However, the report suggests two further possible simplifications which are used in some overseas countries:

• A tax based on turnover, rather than profit; and
• Fixed, or flat rate, expense deductions.

The first of these would work something like the VAT flat rate scheme, but the report does not mention different rates for different trades, and admits that this could be problematic because, “the turnover-based tax inevitably ignores profitability and potentially taxes the trader with a modest profit harder than the service business”, as under the current system, income tax is paid on profits.

The OTS envisages that these suggestions would be optional rather than enforced. But does having different options not create increased confusion?

There would also be the temptation to avoid keeping proper records. The OTS has suggested that VAT-registered businesses would not be eligible for these schemes – and of course neither would limited companies.

My own opinion is that this is a good idea in theory but I’m not convinced it would work in practice.

I’ll be watching with interest to see which – if any – of these suggestions are put into practice in tomorrow’s Budget.