Contracting experts have given mixed reviews of the Office of Tax Simplification’s (OTS) recommendations on simplifying the tax regime for limited company contractors and other small companies.
The OTS recently released its ‘Small company taxation review’, containing a raft of new proposals. These include ideas for various new business models, as well as a proposed restructuring of the taxation of limited companies.
“The report highlights a number of areas where we could simplify the tax system,” acknowledges Duncan Strike, director of contractor accountants Intouch. “But I would have grave concerns if any new structure was put in place that was mandatory rather than optional.”
“You can never guarantee the government will take up a particular recommendation, but the OTS has been put onto a statutory footing, and so I believe its recommendations will be given full consideration,” adds Andy Chamberlain, deputy director of policy at the Association of Independent Professionals and the Self Employed (IPSE).
‘Look-through’ deemed inappropriate by experts
One idea that the OTS intends to develop further is the concept of a ‘look-through’ system of taxation. This would mean taxing a limited company contractor’s profits through the shareholders rather than through the company itself.
A particularly divisive concept, this would mean the shareholders being assessed for Income Tax and National Insurance Contributions (NICs) on their share of the company profits. Dividend distributions would not be taxed as the profit share would have already been charged.
The OTS claims a look-through system would provide simplification whilst addressing distortions in the tax system. However, as Strike highlights, profits retained within the company would be subject to full Income Tax and NICs, reducing the funds available for investment:
“I disagree with this idea that you should pay tax on money that is not available for your use, which is exactly what this look-through policy would invite, unless appropriate changes were reflected in the Companies Acts. Other than in circumstances where a contractor takes out all of their profits, it’s inappropriate to tax income as personal.”
‘Look-through would remove key flexibility’
A further concern is that a look-through system would encourage contractors to distribute profits more frequently. For Chamberlain, this defeats one of the key benefits of trading via a limited company:
“With look-through, it would appear that contractors may be restricted in terms of how much money they can retain in their company, meaning they may be forced to distribute their profits. So for the majority of contractors, look-through would remove a key flexibility that the current limited company arrangement offers.”
The OTS is yet to determine whether or not the look-through system would be compulsory. Whilst respondents were heavily in favour of making adoption of the system optional, OTS argues that this may generate complexity in itself.
Tax not a main motive for incorporation
When asked about their reasons for incorporating, limited company contractors reported that tax and NICs savings held the least influence over their decision, with more emphasis placed on enhanced credibility and the necessary part incorporation plays in engaging clients.
For Strike, this serves to highlight HMRC’s longstanding problematic approach to contractor tax affairs: “The Revenue’s attitude is that limited company contractors are automatically tax avoiders, and this is a huge barrier to collaboration, openness and transparency.
“HMRC does not encourage openness. You cannot seek guidance from HMRC without potential consequences. Therefore contractors are left to interpret legislation, and if they get it wrong, they receive penalties and interest.
“A large proportion of contractors do want to pay the correct amount of tax but they find it difficult to do so because they don’t understand the rules.”
‘Sole Enterprise Personal Assets’ model poses questions
On the other hand, limited liability was deemed the second most popular reason for incorporation amongst respondents. Identifying the need to extend this protection beyond limited company contractors, the OTS has proposed the ‘Sole Enterprise Personal Assets’ (SEPA) model.
Whilst contractors trading under this vehicle would not have a separate legal identity, there would be provision for protecting their assets, including their home and non-business vehicles.
“We can certainly see merit in developing this idea further,” notes Chamberlain. “However, one question I would raise is whether or not clients and agencies would feel comfortable with it.
“Many clients and agencies insist on the limited liability structure being in place, and there’s no way of knowing whether they would feel equally comfortable with this new structure. Guarantees need to be put in place to make the clients and agencies feel comfortable. Otherwise it won’t work and people won’t take it up.”
‘SEPA not a necessary structure’
Despite highlighting potential problems that SEPA could cause with agency legislation and IR35, Strike acknowledges that there is an argument for sole traders to receive some personal asset protection without having to incorporate. However, he notes an alternative solution is already readily available:
“There is quite clearly a good opportunity here for the self-employed freelancer. But we already have the infrastructure for that. We have the limited liability partnership (LLP), and a single-person LLP would be a simpler way of addressing that. A new structure would just require further choices to be made and would hence complicate matters further.
“However, as we know, the agency legislation acts as a barrier to engaging clients and agencies working with individuals, whether as a sole trader or LLP. The OTS recognises this and a fully-rounded solution would be needed.”
Administrative burdens deemed excessive
Approximately two-thirds of survey respondents claim tax administration burdens have been greater than they expected prior to setting up their company. Meanwhile, little fewer than half of respondents wouldn’t approach HMRC for assistance with tax uncertainties. For Chamberlain and Strike, these findings come as no surprise.
“We’ve seen an unprecedented amount of recent legislation and the sector has really had to struggle to stay on top of it all,” highlights Chamberlain, who identifies dividend taxation changes and the digital tax regime as two recent examples set to place further strain on contractors.
“What businesses need is predictability,” explains Strike. “Every year, something changes. Inevitably, that creates a burden for contractors. This constant tweaking around the edges is what creates difficulty for small businesses.”
Ambiguity places further strain on contractors
In addition to the sheer amount of changes, Strike adds that the ambiguity over relevant legislation is also a significant drain on contractors as they attempt to remain compliant:
“As accountants, we spend a lot of time studying legislation, trying to understand what the Revenue is trying to say. If we have to undertake that burden, businesses must too - but we’re trained in the area and they’re not.
“So the approach of allowing the courts to interpret new laws that are written in a broad context is wrong. That has been HMRC’s approach for the past ten years. Laws have been written in such broad terms that you never get clarity early enough to make a decision that stands the test of time.”
Corporation Tax poses most problems for contractors
“If you look at the tax picture as a whole, contractors now have to account for Income Tax, Corporation Tax, NICs, dividend tax and possibly VAT,” explains Chamberlain. “Even in a very small company, contractors have a lot to deal with.”
OTS survey findings suggest that Corporation Tax causes the most uncertainty amongst contractors. In an effort to tackle this, it proposes calculating Corporation Tax on a cash basis. It also puts forward ideas for a single tax rate that covers various types of taxes.
Both Chamberlain and Strike see merit in simplifying and harmonising taxes, but insist that Corporation Tax should be the least of contractor’s concerns.
“The situation with Income Tax and NICs is far more complicated,” explains Strike. “Corporation Tax is, in essence, already based on accounting profits, with similar adjustments whether you consider Income Tax or Corporation Tax. It’s not difficult to calculate and the Corporation Tax return is no more complicated than the self-assessment tax return.
“However, the idea of a single tax rate would be an interesting approach, and basing that on turnover level in the same way that flat rate does for VAT could be a very simplified way of dealing with a non-complex situation.”
‘Freelancer limited company’ aims to end IR35 concerns
The report also promotes the concept of a freelancer limited company (FLC) - a business structure initially proposed to the OTS by IPSE, aimed at guaranteeing clarity over employment status.
“We were really pleased that the FLC was given a positive write-up,” notes Chamberlain. “We’re looking forward to progressing this idea along further.”
Chamberlain explains that the FLC would be an optional structure, and a normal company in law, but there would be certain eligibility and operating criteria to be met for a business to qualify. For example, the company would have to be trading and must have a single shareholder.
He explains: “The idea is that once you satisfy these criteria, you are satisfying the powers that be that you are not in ‘disguised employment’, and that you are in fact a proper business. Therefore, IR35 would not apply to the FLC.”
However, Strike is concerned that HMRC may consider and focus negatively on contractors that decide the FLC is not appropriate, even for the right reasons.
“This could result in unintended consequences, and I am not convinced that adding to the range of business structures is helpful in either simplifying tax or easing the burden on business,” he concludes. “A contractor could be faced with the prospect of running two businesses, each one selected for specific circumstances.”