UKTECH's 2004 Budget tax proposals to CBI

The CBI is conducting its annual exercise of seeking comments on technical tax issues they consider should be addressed at the next Budget.

UKTECH has consulted with its Accountants Special Interest Group which has more than 100 members, and has made the following submission to the CBI.

The submission began by explaining the background to UKTECH, which provides information and services to knowledge based freelancers, who mainly work via their own limited companies, and to their advisors. We have around 35000 members of our on-line community and an accountants’ special interest group with around 100 accountants who serve the freelancer market.

UKTECH made the following suggestions for technical tax matters that should be addressed in the 2004 Budget.

Re: TECHNICAL TAX PROPOSALS FOR 2004 BUDGET

TAX LEGISLATION FOR THE PROVISION OF SERVICES VIA AN INTERMEDIARY (‘IR35’)

The tax and NIC legislation, generally known as IR35, has had a significant and adverse impact upon the knowledge based freelancer community. While we have concerns about the whole premise that underlies this legislation there are two technical aspects we believe need to be addressed.

5% expense allowance

Where freelancers have engagements that are considered under the legislation to be ‘disguised employment’ – known as relevant engagements – the worker is permitted to claim a general expense allowance of 5% of the fees from those relevant engagements. This allowance was intended to cover the essential running costs of their company.

This allowance tends to disadvantage freelancers whose fees are low. In particular, at a time when many freelancers are without client contracts for long periods, they find themselves quite unable to meet the fixed operating costs of running their company. For most companies these costs will include:

· Employing an accountant to maintain the accounting records and company payroll

· Employer’s liability (compulsory even for a ‘one man’ company) and public liability insurance

· Professional indemnity insurance to cover the professional costs of dealing with a tax or VAT investigation – increasingly important in view of the inherent uncertainties of current tax legislation

· General administration costs

· Marketing costs – especially important as these businesses need to maintain their profile in the market place at a time of falling levels of demand and in the face of Revenue assertions that they are not ‘real’ businesses but disguised employees.

· Training costs – but see our separate point below.

There appear to be several ways of addressing this issue.

The most logical would be to change the allowance from a turnover linked value to being an allowance for an agreed set of expenses that all businesses can reasonably expect to incur. This approach would follow the logic that freelancers operating via a service company will incur various costs in running the company. For example:

· Accountancy, taxation and legal services and advice

· Insurances – employers and public liability insurance and professional indemnity insurance

· Training costs (again see below)

· The costs of maintaining an office

· Marketing costs such as the costs of advertising and the costs of running a web site.

· The costs of appropriate computer hardware and software.

Instead of the 5% allowance being a standard deduction that can be claimed with no supporting evidence it would be necessary for the company to have evidence of the actual costs incurred providing these necessary expenses. This appears to be a more logical approach and is one that better reflects the way all businesses claim deductible expenses.

However if this approach is considered to involve too much additional administration for the Inland Revenue then we suggest that the expense allowance be restructured with a basic flat rate element and an additional variable element linked, as at present to turnover. In this way companies with low turnovers will not find themselves in a downward spiral of falling income and insufficient expense allowances to help them arrest the fall in income.

If this route were to be adopted we suggest that the allowance be set at a basic level of £5000 plus 5% of turnover in excess of £100,000. This would mean no change in the allowance for a business with turnover in excess of £100,000 but would provide those with lower turnover with the ability to offset essential expenses against their income from relevant engagements. However using ‘fixed’ allowances has the problem of needing to keep the fixed allowance adjusted to reflect inflation.

Training

Associated with the previous point is the issue of training costs. Again freelancers who only have income from relevant engagements must fund their training out of their 5% expense allowance. Hence, when work is scarce they are caught in a downward spiral of having to fund essential training costs out of much reduced income and having very little leeway in terms of expense under the 5% allowance. In the world of knowledge based freelancing being out of contract for several months can leave you out of date technically, making new training essential.

If the previous proposal regarding the expense allowance were to be accepted then this would provide adequate allowance for business running costs and training. However, if no change were to be made to the current treatment of expenses then we believe, most strongly, that training costs up to a level of say £2500 pa should be deductible from relevant income in addition to the 5% expense allowance.

Freelancers consider that the current treatment of training costs places them at a great disadvantage compared to workers from larger consultancies whose training is paid for by their employer who has no restrictions on their ability to claim training costs from taxable income.

SECTION 660A

The recent issue of tax bulletin 64 by the Revenue has highlighted the fact that the Revenue will seek to exclude from the Section 660A (6) exemption for gifts between spouses where the gift is ordinary shares in a family company if, as is the case for many knowledge based companies, the company has low capitalisation. This approach appears to be biased against companies that have little need for higher levels of investment in fixed assets or stocks. It calls into question whether ordinary shares with normal shareholder rights can ever be regarded as being wholly or substantially a right to income?

This issue may not be resolved until a suitable test case has examined the issue. In the meantime there are many family companies who were advised to adopt as a normal tax planning approach a share structure in which ordinary shares were split between spouses on the understanding, common amongst advisers for many years, that ordinary shares (unlike preference shares) could not be regarded as wholly or substantially a right to income.

One family company now finds itself with a demand for over £40,000 in back taxes on the basis that dividends paid to one spouse were a settlement under Section 660A and should be the income of the other spouse. This claim goes back six years notwithstanding the fact that the Revenue has been aware of the share structure throughout that period.

We strongly recommend that whilst this issue is clarified the Revenue should agree that claims under Section 660A against family companies where only ordinary shares are involved will not be made in respect of any period prior to April 2003 when they issued their clarification in tax bulletin 64.

FLAT RATE VAT

Many of our community work in the area of computer and IT consultancy or data processing. Under the flat rate VAT scheme, which is supposed to reduce burdens on small businesses the rate to be used is 14.5%.

In practice this has meant that few if any of the businesses in this sector have taken advantage of this scheme because the rate effectively penalises them. The rate is applied to their VAT inclusive turnover. Hence for example an IT consultant with fees of £100K a year will have VAT inclusive turnover of £117,500 on which they pay VAT of 14.5% i.e. £17037.50.

This implies that their input VAT, which they can reclaim against output VAT, is no more than £17,500 less £17037.50, that is £462.50. This equates to costs of £2643.

This appears to be totally inconsistent with other Government assumptions in this area. For example under the IR35 legislation, referred to above, the Government accepts that basic business running costs are 5%, which implies input VAT of around £875.

We recommend therefore that the rate be revised to 14%. This would require a flat rate payment of £16450 which, on £5000 of VATable expenses, gives the business an incentive of £1050 less £875, i.e. £175 to businesses in this category to use the flat rate scheme.