OXFORD LAW UK Corporation Tax and Small Businesses Judith Freedman Pinsent Masons Professor of Tax Law, Oxford Law Faculty, Director of Legal Research, Oxford University Centre for Business Taxation Oxford Centre for Business Tax Summer Conference 2015
Outline What is a small business? Small businesses at the heart of the corporate tax problem. Corporation tax as a backstop to income tax. UK corporation tax and the small business experience Rethinking small business taxation in the 21 st century.
Focus: defining the indefinable Owner managed Closely controlled/ not publicly owned Size (various turnover/profits/balance sheet/employees Definition depends on purpose
Ways of doing business (UK terminology) Employee Unincorporated sole trader Unincorporated partnership with full liability Pass through with limited liability LLP Owner managed/closely controlled limited liability company (not pass through) through spectrum via private equity to publicly owned company
Impossibility of equal treatment Completely equal treatment through this spectrum is impossible: different legal rights and duties, practical differences. Align as far as possible to prevent distortion and lack of equity? Or accept differences? Is there any reason why IT and CT should be aligned/integrated? If accept differences where to draw lines?
Small businesses the heart of the matter Focus on large firms in economic literature, tax, corporate finance and corporate law. Small business/ owner managed businesses do not fit well into nexus of contracts and principal/agent theory of the firm The one person company and the large public company seem obviously different creatures but spectrum so not so simple. Key difference is mixing of labour income and income on capital thus focus here on owner /managed firms not size Cannot design corporation tax with small businesses as an afterthought.
Reducing/removing corporation tax David Gauke 1 st June 2015 ETPF and IFS (on continuing existence of corporation tax).. there are a number of domestic and international arguments for its continued existence. It remains a key part of the international tax system and our domestic system, not least because of the interaction with income tax. The experience of the nil rate and 10 per cent rates of corporation tax was that this led to a great deal of tax motivated incorporation for little economic benefit. Indeed, to go below a 20 per cent rate of corporation tax may require us to address some of the structural issues in our system. And, of course, corporation tax continues to bring in around 40bn per annum.
UK corporation tax and small business Closely controlled companies used to shelter before introduction of CT (Stopforth and Goodacre BTR 2015) Anti avoidance provisions where income not distributed within reasonable time since 1922 Close company provisions tightened in 1965 and apportionment introduced ie company deemed to have distributed up to 60% net trading profits except to extent could show retained profits needed for business. Apportionment abolished 1989 when IT and CGT harmonised (but now detached again). Apportionment did not work well but suggestions it could return especially if government wants to reduce CT further.
One person companies 1965 Inland Revenue wanted special provision for public entertainers operating through one man companies but draftsman in hurry so left it out! (Stopforth) Now personal service companies legislation so called IR 35 treats corporate income as equivalent to employment income in some circumstances but uncertain application and limited success for HMRC, criticised in HL report (2014) Government estimates cost of abolition would be cost 550m (response to HL June 2014) Integration of tax and national insurance (social security) would not solve but would help greatly
CORPORATION TAX RATES COMPARED WITH INCOME TAX RATES 1982 2015 Financial year Basic rate of income tax Rate of Corporation Tax Small profits* rate Starting rate up to 10,000 (CT) 1982 30% 52% 38% 1985 30% 40% 30% 1986 29% 35% 29% 1987 27% 35% 27% 1988 89 25% 35% 25% 1996 24% 33% 24% 1997 98 23% 31% 21% 1999 23% 30% 20% 2000 01 22% 30% 20% 10% 2002 05 22% 30% 19% 0%# 2006 22% 30% 19% Abolished 2007 22% 30% 20% 2008 2010 20% 28% 21% 2011 20% 26% 20% 2012 2013 2014 20% 24% 23% 21% 20% 2015 20% 20% Abolishednot nec. Companies with profit between 0 and 300,000 paid tax at the small profits rate, with tapering marginal relief for profits between 300,000 and 1,500,000. At 1,500,000 the full corporation tax rate applied to all profits of the company.
Employee Income tax on wages (return on labour) 20%, 40%, 45% Social security contributions (NICs) on wages (employee and employer) Self-employed (sole proprietorship or partnership) Income tax on profits (mixed return on labour, capital and economic rents) Lower NICs than employees Capital gains tax on sale of business assets Owner-manager of company Company pays corporation tax on income profits and capital gains (mixed return on labour, capital and economic rents) Tax on dividends (credit for ct (even if none paid) plus additional payment by higher rate taxpayer at personal level) Income tax and NICs on wages as employees (but flexible level) Capital gains tax paid by shareholders on sale of shares
Cumulative change of number of businesses: 1996 2009 Cumulative percentage change (1996=base) -30-20-10 0 10 20 30 40 50 60 70 80 90 100 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Year Sole Proprietorships Partnerships Companies Source: BIS SME statistics 1996 2009, accessed via: <http://stats.bis.gov.uk/ed/sme>. (with thanks to Li Liu)
Pass through entities LLPs introduced 2000 (in effect 2001) Not designed for small firms but give limited liability and pass through treatment No tax incentive to use pass through vehicle and untried from business form point of view so low take up In 2014 there were 1.5 million actively trading limited companies and 3.3 million sole proprietorships (small business statistics) but only 56,000 LLPs in total (Companies House).
Rethinking corporation tax for small businesses:i Corporation as tax shelter from income tax Solutions o higher rate of CT than IT (non competitive, discourages investment, contrary to current trends, tps will seek pass through solution as in USA so resulting in planning activity) OR o align all rates of tax CT, IT flat rate and credit for CT (unlikely to be acceptable, no progressivity, social security payments?)
OR o OR o Rethinking corporation tax for small businesses:ii mandatory pass through for small companies o no incentive for voluntary if lower rate of CT than IT (and volunatery leads to tax planning opportunities) o Therefore definitional problem along the spectrum: size? Qualitative definition? o If no choice, no lower rate for genuine companies building capital as in eg previous apportionment system. o Not a level playing field vis a vis large companies o deals with shelter and disguised labour issues to an extent though labour income can still be converted to income on capital (as in USA escaping social security payments etc) Apportionment provisions complex and pressure for some relief for retentions to encourage investment, but could achieve similar result to mandatory pass through.
Mirrlees proposal (Crawford and Freedman (2010)) Exempt normal rate of return on capital at corporate level through ACE At shareholder level through Rate of Return Allowance (RRA) Tax above normal returns to capital, and labour income at the same rate (including NICs facilitates integration) progressivity can be added if desired for domestic shareholders. Capital thus taxed at a lower effective rate so CT rate can be higher without being uncompetitive or discouraging real investment One person companies with no investment (for example) would be taxed at same rate as employees with no need for arbitrary definitions self regulating
Problems with Mirrlees proposal Based on Nordic dual income tax system (though adapted) Difficulty of scope and definition of capital base, especially goodwill. Does not solve income splitting Only works in a Mirrlees world where other normal returns being exempted. At corporate and personal levels. But useful thought experiment in terms of finding a method that requires no externally imposed thresholds.
Conclusion Ultimately need to make decisions about where to break continuum along spectrum Large/small distinction more difficult to draw than at first appears not easy to strip out the owner/managed small business Mirrlees approach of self regulating splitting out of labour income and income on capital solves some, but not all problems Pass through should be approached with caution.