Professional bodies call for reform of IR35

The professional tax bodies have called on the Government to replace IR35 with a radical overhaul of employment status issues relating to small businesses.

The Tax Faculty and the Chartered Institute of Taxation (CIOT) have produced a discussion paper in response to the Government's review of small business taxation. It argues the case for clarification and reform of a number of issues affecting small businesses, including a complaint that the IR35 rules are 'fundamentally flawed'.

In the Budget 2004, paragraph 5.95 of the 'Red Book' said that:

‘To ensure that targeted tax incentives support the Government’s objectives for growth, enterprise and productivity, the Government proposes to consider the issues raised by the interaction with the tax system of definitions of income of self-employment, and the remuneration paid to owner-managers, in a discussion paper which will be issued at the time of the 2004 Pre-Budget Report.’

The Government has come in for criticism that its review has been inward looking and it has failed to consult with professional bodies and other interested parties.

Taxrep 36/04

Now, the Tax Faculty and the CIOT have produced Taxrep 36/04, which sets out areas of concern in relation to the current tax system and the way that it often hinders rather than supports growth, enterprise and productivity.

The Tax Faculty said: "We think that the issues that we have set out need to be considered further and that they should inform a meeting between tax representative bodies, business organisations and the Inland Revenue and other Government officials to discuss issues arising from paragraph 5.95."

The paper concentrates on what the professional bodies believe are the main tax issues causing difficulties for owner managed businesses, namely:

• IR35;
  
• the settlements legislation in Section 660A, ICTA 1988;
  
• construction industry issues; and
  
• the new 19 per cent rate on non-corporate distributions.

It also draws attention to the considerable differences between the tax rules and rates for incorporated and unincorporated businesses.

No information on IR35

Taxrep 36/04 is critical of the lack of information to show that the objectives of IR35, one of which was to raise £900 million, were being achieved.

It said: "The lack of available data to support the Government's estimate of £900 million at risk in the absence of the measures, and a similar lack of data on the administrative and employment costs arising from IR35 investigations, begged the question "whether the tax raised by IR35 has fallen far short of its intended target".

Paymaster General, Dawn Primarolo, was asked for this information in a Parliamentary Question from her opposite number, Mark Prisk, in January 2004. But she was unable to give figures for the additional revenue raised by IR35 or the costs of pursuing claims or how many investigations had been made.

The Taxrep paper said that this was not a satisfactory position, and that it led to two possible conclusions:

• the data is unavailable, which is surprising given the expectation that the Revenue would be able to substantiate its IR35 Regulatory Impact Assessment in this area; or
  
• the necessary processes to collate data have not been put in place sufficient to capture the data with confidence.

It also begged the question as to whether the tax raised by IR35 has fallen far short of its intended target.

The paper concluded: "We think that the IR35 rules are fundamentally flawed. If they are intended to raise revenue it appears that this objective is not being achieved in practice and certainly there are no statistics to show that this has been the case.

"We understand the Government's policy purpose for wishing to tackle the issue of 'disguised employment'. However, if this policy purpose is to be achieved, we believe that the solution is a radical overhaul of the issue of who is employed and who is self employed. We believe that the IR35 rules should be replaced with a much clearer system for determining employment status.

"We believe that if IR35 is to continue in its current form, then at the very least the practical problems [as set out in the paper] should be properly considered and addressed.

Section 660

The paper also called on the Government to take a pragmatic view in applying the settlements legislation (Section 660) to smaller tax enterprises such as husband and wife companies.

The Revenue's interpretation of Section 660, the so-called married couple's business tax, has been widely criticised by the professional bodies, as the Revenue attempts to tax dividend payments to a spouse as income earned by the main fee-earner in the business.

The results of the Arctic case which was recently heard by the Special Commissioner and is seen as the first real test of the Revenue's approach, are eagerly awaited by small businesses and their advisors.

The paper concludes: "We believe that for smaller tax enterprises, such as husband and wife companies, the Government should take a pragmatic view in applying the settlements legislation.

"Clearly it needs to weigh up the revenue risk involved but we must question whether it is worth pursuing such enterprises for small sums of money and seek to impose a complex tax regime based on the uncertainties which surround the settlements legislation?

"Given the push to encourage entrepreneurs and growth, we believe that the Revenue should not get too entrenched in operating Section 660A and take a light touch in applying the settlements legislation. We would welcome further discussion and debate on this issue."

Dividend tax

Other suggestions in the paper included the abolition of both the nil rate of corporation tax and the repeal of the new 19 per cent rate on distributed profits.

This arose after the Government introduced an incentive of zero corporation tax for small business, only to redefine it as a loophole 18 months later and introduce a 19 per cent rate on dividends in this year's Budget, the so-called IR591 issue.

The paper said: "In his 2004 Budget speech the Chancellor referred to the fact that he had considered removing the nil rate band, but decided on the new legislation we now have because he wished to promote investment. That is a laudable policy aim but in this instance we believe that it is misplaced. We would argue that, in the majority of cases, where a company makes small profits, it requires these funds to be paid out to support the shareholder/directors of those businesses and that in many cases they simply cannot afford to re-invest profits at these low levels. We would argue that the cost of abolition of the nil rate band to small companies outweighs the added compliance burden of the new legislation."

Construction Industry Scheme (CIS)

The professional bodies are participating in the discussions on the reform of the CIS and claimed that they appreciate the need for a review of the existing system and recognise the compliance issues at stake.

However, they felt that there is little doubt that the smaller, owner-managed businesses have had the most difficulty understanding and administering the new rules.

Confusion

The paper also repeated a common complaint that the present "major structural differences" between the tax treatment of incorporated and unincorporated businesses caused confusion for owner managers.