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The Government’s admirable Office of Tax Simplification (OTS) recently published a number of reports that have a specific focus on micro-businesses. One was their “Small company taxation review”, the other a review into “closer alignment of Income Tax and National Insurance”.
Both are excellent contributions to the debate. Indeed, in the 2016 Budget the Chancellor welcomed them and commissioned further work by the OTS. But what the detailed, painstaking work behind both reports also shows is that while tax simplification is great in theory, getting there is not so simple.
The small company taxation review shows a very good understanding of the range of businesses with a clear focus on micro-businesses. Immediate recommendations include bringing filing dates for HMRC and Companies House in line to make keeping track of deadlines easier, with the ultimate goal of combining filings into a single online process.
The report also recommends removing many of the current deductions and adjustments that can be made to year-end accounts. Most freelancers, contractors and micro-businesses don’t even use them, but the possibility of applying them adds complexity to the Year End process.
Complexity was a concern when the OTS examined the proposals submitted for a ‘third way’ option to allow a new form of incorporation. The proposals, revelling in names like ‘SEPA – Sole Enterprise Personal Assets’ or ‘Freelancer Limited Company’, aim to offer a simpler form of limited liability for what the report terms ‘nano businesses’.
However, it also notes that adding another option to choose from when starting out – one which may be tricky to change from should a firm want to grow – is shifting complexity rather than eliminating it. The report suggests these ideas are worthy of further study, but not immediate consideration.
Simplifying company accounting and taxation is given extensive study in the report. Two ideas are of particular note. The first is exploring whether the smallest companies could use cash accounting as sole traders do. The main advantage of this is that tax would be due on income once received in hand, rather than payable the moment an invoice is issued. So you’d only owe tax on the cash you have.
For many micro-businesses, cash accounting is how their owners actually understand and run their businesses, so the accruals-based accounts they have to file with Companies House are of no practical value, just a regulatory requirement being met. The challenge will be deciding which companies can use cash accounting and what happens if a firm transitions from one system to another.
The other proposal, which the OTS has committed to study further, is the idea of ‘look-through’ taxation. This would mean the profits of a company are taxed as if they were the direct income of the owners.
Such an approach would eliminate the need for calculating and filing returns in relation to Corporation Tax and Dividend Tax, vastly simplifying the processes for all involved. However, it would be a disincentive for retaining profit in a company to re-invest in future growth – the profits would be taxed as owner income, regardless of whether they were withdrawn or kept in the company. Hence such a proposal would need to be opt-in, so that firms with growth ambitions could retain profits for reinvestment without attracting Income Tax.
Once again the simplicity of taxing profits after costs, like a sole trader does, would be at the cost of complexity in choosing whether you need to opt in or out of such a system.
The short term recommendations in the review are all worthwhile: aligning filing dates, combining forms, reducing special allowances and deductions. But the longer term ideas raise as many questions as they do answers.
The other major OTS report examines the tricky landscape of how Income Tax and National Insurance interact. It’s a fascinating, well produced study that cogently explores the difficulties businesses and staff face in navigating the differences between the two systems. The report’s headline findings are worth quoting in full, as they are spot on:
Wise to political realities, the OTS doesn’t suggest merging Income Tax and National Insurance, but does propose a range of very sensible medium term changes to remove the anomalies between the two systems – such as the different ways they both handle expenses and benefits in kind.
Immediate suggestions in the report include working to combine definitions so that both Income Tax and National Insurance use common understandings for concepts like ’benefit in kind’ (which covers perks like company cars and private health insurance) and converge from their currently entirely separate legal systems. As a result, the OTS suggests HMRC too should combine its advice and guidance on the two.
There are two other longer term recommendations of interest to the micro-business community. The first is to bring self-employed NICs in line with what employees pay, in return for improving the benefits they can receive. This simplification would not only reduce the disparities in who pays which level of National Insurance, but could also see better unemployment, maternity and illness benefit to the self-employed.
The other major proposal is to shift NICs to being annually assessed. In the same way that Income Tax is charged across all your combined income, so too would National Insurance be assessed.
As the report shows in detail, at present two people earning the same amount annually can pay vastly different amounts of NICs because they are assessed per employment and per ‘earnings period’, which can be weekly or monthly (except for directors, for which it is annual). So earning £15,000 in one job over 12 months would result in £832 NICs, but if all paid in one month would cost £572 in NICs. If paid as £5,000 each from three different jobs, it would result in no NICs being due. Clearly a perverse outcome.
Changing to annual NICs assessment to match the Income Tax assessment process would result in winners and losers. The OTS calculates that 7.1 million workers would pay an average of £175 per annum less NICs (£1.2 billion in total), and 6.3 million workers would pay on average £275 per annum more NICs (£1.7 billion in total). It is estimated that lower earning workers are more likely to be better off.
Not only would such a system be simpler to understand and administer, it would also work much better in the flexible new economy, in which many are combining regular jobs with ‘5 to 9’ gigs.
As our economy continues to evolve, there’s no doubt that the tax and benefits system also needs to keep pace. These two OTS reports explore huge changes that would affect millions of businesses and workers. While we wouldn’t expect such major changes overnight, our hope is that by welcoming these reports, the Chancellor will take another step forward towards a brave new world of simpler tax.
You might avoid a fine if a close relative died shortly before the self assessment deadline, you've been seriously ill, or if you had major IT problems.