PBR (6): SMEs and 'tax motivated incorporation'

As regular Budget and Pre-Budget Report watchers are aware, the 'interesting' parts of the Chancellor's announcements are frequently revealed in the detailed papers which are released after he has sat down.

Experts and advisers will be scrutinising the details which will emerge in the next few days and determining whether there is any devil in the detail. One area which could be of interest is what the Chancellor describes as 'tax motivated incorporation'.

During his speech, the Chancellor said that he is 'closing a relief under which, for tax reasons only, people are being persuaded without changing what they do to set up a company, replacing the £10,000 starting allowance with a rise in the investment allowances for smaller businesses to 50 per cent.'

Early reviews of the Post-Pre-Budget-Report publications (found on the Treasury's website) indicate some of his intentions for small businesses.

Essential enterprise

The full documentation, particularly Chapter Three on Enterprise, reinforces the Government's commitment to enterprise. It says: "Enterprise is essential to a dynamic, modern and growing economy, helping to boost productivity, create employment and prosperity, and revitalise communities......Going forward, the Government will focus on further improving the UK business environment and tackling barriers to business growth to allow the UK to fulfil its potential as an entrepreneurial economy."

Much of the 'Enterprise Chapter' has a section devoted to 'Supporting Small Businesses', outlining some of the initiatives proposed by the Government including:

• Flexible payment option - To help small businesses with cashflow difficulties and reduce administrative burdens, the turnover threshold up to which businesses will be able to take advantage of the Annual Accounting Scheme will be increased from the current level of £660,000 to £1,350,000 from April 2006.
  
• VAT bad debt relief - to look at providing more help through the VAT bad debt relief scheme to those businesses
  affected by customer insolvencies.
  
• Access to finance - the Government will announce the future level of Venture Capital Trust reliefs at Budget 2006. It also reinforced recent measures taken with the Small Firms Loan Guarantee Scheme.
  
• Enterprise culture - measures to help young people develop entrepreneurial skills and aspirations.
  
• Women - initiatives to increase entrepreneurial involvement in under-represented groups, including women and people living in disadvantaged areas.

Tax motivated incorporation

The Government has previously signalled its concern about what it saw as tax-motivated incorporation. It closed what it thought was a loop-hole with IR591 - the so-called dividend tax which reversed a previous decision to have a zero corporation tax incentive for small firms after it felt small firms were taking advantage of the tax break - and it indicated that future action was likely.

Its discussion paper in 2004 said that the Government believed that the choice of legal form that a small business takes should reflect commercial rather than tax considerations.

The 2004 report continued: In Budget 2004, the Government expressed its concerns about the increasing numbers of self-employed individuals adopting the corporate legal form for tax reasons rather than as a step to growth, often as a result of marketed tax-avoidance schemes. The Chancellor therefore introduced a 19 per cent minimum rate of corporation tax where profits are distributed to individuals by way of dividends, in order to target low tax rates more accurately towards those small businesses that reinvest their profits for growth. The Government will continue to monitor this area to ensure that its objectives for the tax system continue to be met."

In this PBR, the Government also addressed the need to take 'further action' on what it believes to be 'tax motivated incorporation', whilst still encouraging small firms - whatever their legal status - to invest in their businesses.

The PBR explains:

• Tax motivated incorporation - Para 3.58 says: Chapter 5 sets out the further action the Government is taking in response to continuing tax-motivated incorporation. The Government will replace the non-corporate distribution and zero per cent rates with a single banding set at the current small companies' rate of 19 per cent. This will simplify the corporation tax calculations for most small companies, refocus incentives, and leave the small companies' rate at its lowest since its introduction in 1973.
  
• First year capital allowance - Para 3.59 says: To support this, and in the light of representations received from a number of small businesses and their representatives, first-year capital allowances will, in the year from April 2006, be increased to 50 per cent for small businesses investing in plant and machinery. This will reward up to 4.2 million small businesses, irrespective of their legal form, who choose to invest their profits for growth.

In Chapter Five 'Building a Fairer Society', the Report includes a short section on the taxation of small businesses. It says:

• 5.92 The zero per cent and minimum rates of corporation tax were introduced to encourage small companies to retain and reinvest their profits for growth. However, many self-employed and employed people are being advised to incorporate simply to reduce their tax and NICs liability. The Government has considered the issue of continuing tax-motivated incorporation in the light of responses to its 2004 discussion paper where most respondents favoured simplification over options which risked introducing additional complexity. The Government has therefore decided to replace the non-corporate distribution and zero per cent rates with a new single banding set at the current small companies' rate of 19 per cent. This will simplify the corporation tax calculations for most small businesses, refocus incentives, and leave the small companies' rate at its lowest since its introduction in 1973.
  
• 5.93 To ensure that small businesses are provided with incentives to invest for growth, the Government will extend their first-year capital allowances to 50 per cent in the year from April 2006, benefiting 4.2 million small businesses. As outlined in Chapter 3, to assist more small traders with their cashflow, the Government will double the VAT Annual Accounting Scheme turnover threshold to £1,350,000 from April 2006, and has written to the European Commission for derogation to increase the Cash Accounting Scheme turnover threshold to the same level. These measures will benefit both small companies and sole traders, with up to 1 million small businesses able to benefit from a range of more flexible payment options to suit their business needs.
  
• 5.94 The Government will continue to keep the structure of tax and NICs under review to ensure an appropriate balance between fairness for individuals and employers, incentives to work, save and invest, and reducing administrative burdens.

U-turns and lack of clarity

PKF accountants and business advisers predicted that thousands of small companies face an extra tax bill of up to £1,900 a year because of the removal of the nil starting band of corporation tax.

Peter Penneycard, national director of tax at PKF, said: "This is a direct reversal of Gordon Brown's own policy, first introduced in April 2000. It seems that too many entrepreneurs took up this incentive and even the introduction of the horribly complex Non-Corporate Distribution Rate of Corporation tax in 2002 did not control the cost to the Treasury. At least by taking away this incentive the chancellor has allowed the tax rules to return to the straightforward situation that applied before he interfered."

In a parallel announcement, the Chancellor reintroduced the enhanced 50 per cent first year allowance for small business investment in plant and machinery made in the period 1 April 2006 to 31 March 2007.

Peter Penneycard added: "This is another about turn from the Chancellor – the 50 per cent first year allowances only ceased on 1 April 2005. Such back and forth changes with the tax system hardly live up to the Chancellor's claim of providing stability for business."