FSB options: A new approach to simplifying taxation for smaller businesses December 2015 A paper informed with substantive input from EY and FSB members
Contents Executive summary... 1 1. Introduction... 2 1.1 The impact of a complex tax system on small business... 2 1.2 Aim of simplification... 3 2. A new approach to simplification... 4 2.1 A taxpayer centred approach to simplification... 4 2.2 Segmentation of taxpayers... 4 2.3 The benefit of bespoke regimes... 4 2.4 The need for optionality... 5 2.5 Interaction with Making Tax Digital... 5 3. Potential options for reform... 6 3.1 Option 1: A simplified small business regime... 6 3.2 Option 2: A tax transparent corporation... 10 3.3 Option 3: A distributed profit tax... 11 Conclusion... 13
Executive summary Simplification of the tax system has been, and continues to be, an ongoing challenge for the government. The Office for Tax Simplification (OTS) was set up in 2010 with the express aim of addressing this issue for both businesses and individual tax payers. For small businesses, the burdens associated with meeting tax obligations are particularly high, often incurring unnecessary costs. This is a significant challenge, where simplification through incremental change is unlikely to produce the level of improvements required. The review of small company taxation provides the ideal opportunity to consider new ways to address this increasing tax burden on small businesses. This paper recommends that the Government takes a bolder approach to tax simplification through a taxpayer-centred approach. Crucially, this calls on the OTS to look beyond simplifying elements of existing taxes within the current architecture of the UK tax system. Instead, the OTS would examine the broader approach required to reduce the overall burden on the tax payer; designing a tax system around the taxpayer as opposed to merely simplifying the taxes themselves. This paper sets out several options for small business taxation reform. These would be regimes into which the taxpayer could elect, and that would: Reduce complexity for small businesses by providing an alternative to the full tax system through abolishing existing taxes, or replacing elements of the current tax system. Reform the tax system to make it less complicated and burdensome which would reduce error and mean businesses can spend more time running their business. This will have benefits not only for businesses and the economy but also for Government through minimising loss of revenue and compliance. Help small businesses to understand their tax position, have greater certainty and reduce the cost and time involved in complying. Complement HMRC s other policy priorities such as the introduction of a digital tax account through the Making Tax Digital and tackling avoidance and evasion. Provide a simplified option for the majority of small business which would maximise the benefits of simplification for both business and Government. Options for reform include: Option 1: Providing a simplified small business regime, which could replace many taxes with one, based on sector analysis already developed by HMRC. Option 2: Introducing a tax transparent corporation, mimicking the benefits of the Limited Liability Partnership, but without the requirement of a second person. Option 3: Replacing corporation tax with a distribution tax that applies only when distributions are made out from the company. The FSB would welcome the opportunity to discuss these options further. 1
1. Introduction The Summer Budget 2015 announced the Office for Tax Simplification (OTS) review of small company taxation. The aim of the review is to develop recommendations for the Chancellor and Financial Secretary to the Treasury on how to simplify the system, increase certainty and reduce administrative burdens caused by the tax system. The project will report to the Chancellor ahead of the 2016 Budget. Alongside the OTS small company taxation review, the Government has announced plans to Make Tax Digital. This programme aims to transform tax administration so it is more effective, efficient and easier for taxpayers, providing access to a personalised digital tax account for five million businesses and ten million individuals by early 2016, increasing to more than 50 million individuals and businesses by 2020. Introducing reforms now to simplify the tax regime will complement the digitisation of tax administration by improving the accuracy of the data reported and reducing the number of enquiries that HMRC will receive as a result of the change to digital reporting. The purpose of this paper is to set out a number of initial proposals for how simplification might be achieved and articulate the benefits it could bring. This paper will form the basis of a discussion between the Federation of Small Business (FSB) and the OTS. This should support further detailed analysis and discussion of how any solution would operate and which solutions warrant further work. As such these options should not be viewed as definitive proposals. 1.1 The impact of a complex tax system on small business Simplification of the tax system is an issue that has been considered over many years and in numerous reviews. The OTS was created in 2010 with the express aim of identifying areas where complexities in the tax system for both businesses and individual taxpayers can be reduced. The benefits of tax simplification are broad ranging from cost savings for small businesses at the micro level to the stimulation of growth in the economy at a more macro level. Streamlining current processes for meeting tax obligations benefits both business and government: it reduces time and resources spent by HMRC on policing tax affairs; and in turn stimulates small business growth and competitiveness by enabling businesses to spend less time fulfilling tax obligations instead of running their business. A tax system that is simple to understand is also likely to result in greater accuracy and compliance by taxpayers, reduce the need for tax agent advice, and enable businesses to use simpler and less expensive business software. The benefits of reduced error and greater accuracy will flow through to HMRC revenue. According to the Brookings Institution 1 the positive impacts of a simplified system of taxation are numerous and include: Reduced taxpayers overall burden of complying with the system in terms of time, money, and mental anguish. Greater effectiveness of incentives since tax provisions that are more simplistic are more likely to be used (e.g. provisions aimed at encouraging certain activities are more likely to be utilised if they are easy for the taxpayer to understand and apply). 1 Tax Simplification: Issues and Options, based on testimony submitted to Congress of the United States and House of Representatives, (17 July 2011) 2
Increased compliance, since clarifying and simplifying tax laws can only work to enhance taxpayers understanding of the purpose and application of the law, and will likely make it easier to enforce as well. Greater public support, which should be an essential part of any effort to improve the delivery of government services. 1.2 Aim of simplification When looking at a preferred solution and combination of options for reform, FSB identified the following benefits that they wanted simplification to bring: Cheaper/easier compliance: Make it cheaper and easier for small business to comply with the tax system. Certainty of tax liability: Create an environment where there is greater certainty for small business and they know what will be their tax liability enabling businesses in their planning, for example, of growth or retirement. More effective tax incentives: Improve information and simplify processes to make it easier to claim tax reliefs and deliver the economic benefits the Government intended. Easy to predict tax payments: Allow small business greater flexibility in the tax system to enable small businesses to better manage cash flow challenges. Simpler relationship with HMRC: Create more effective working relationships with HMRC. Alignment with other policy changes: Be compatible with wider HMRC reforms such as the Making Tax Easier reforms. In addition the tax system should be stable over time to avoid businesses having to regularly learn new rules, incurring costs and increasing business uncertainty. The initial proposals contained in this report are based on the above approach of considering the system as a whole, focusing on the experience of the taxpayer rather than its component parts. This paper uses the benefits listed above as the basis for evaluating a number of initial proposals. 3
2. A new approach to simplification 2.1 A taxpayer centred approach to simplification The current scope of the OTS review looks at simplifying the administration and differing requirements imposed by the tax system on small businesses. The OTS review affords the opportunity take a much broader approach to the issues and pave the way for radical change to the system. Taking a taxpayer-centred approach would focus on the day to day complexity and experiences that confront taxpayers in their dealings with the system rather than seeking to reduce complexity by changing each of the many sections of the tax system with which businesses must interact. Incremental simplification of each of the separate existing taxes will not result in truly significant simplification to the system. The OTS should be concerned with how the design of the tax system impacts business, HMRC operational practice as well as tax legislation. 2.2 Segmentation of taxpayers A taxpayer-centric approach would involve a radical change of the focus of the tax system. It should be cost effective and clearly identify the different types of taxpayer (i.e. employees, businesses etc.). Ultimately, the compliant taxpayer wants certainty that he/she is paying the right amount of tax, with the least amount of effort and hence in theory is relatively indifferent about the form that that tax payment takes. Taxpayers are not a uniform group and therefore any tax system that seeks to treat all taxpayers alike will necessarily result in complicated rules that only apply to a subset of the taxpayers. In contrast simplification based on the taxpayer can be suitably tailored. Concerns are different for businesses with different models and at different stages - some example categories are shown below: Each of these taxpayer groups above have different characteristics and concerns that need to be considered when designing a simplified regime. FSB s perception is that compliance costs faced by companies differ at different stages of their life cycle. Contractors and startups are often hit with a high compliance costs in the first few years of operation as they set up their reporting and compliance processes. Once these processes are in place, established firms tend to face continued costs over time, with new investments and economic conditions changing year on year. Other problems faced by businesses include cash flow when investing in the growth of the company. This paper sets out options for a simplified tax system that would particularly apply to businesses in a constant state such as the steady growers/lifestyle/ and family businesses. Importantly, this would cover the majority of smaller businesses. 2.3 The benefit of bespoke regimes The development of a bespoke regime for particular taxpayers should provide a simplified regime for that particular taxpayer at that particular time. It has been argued however that 4
this provides a choice to the taxpayer that will inherently increase the complexity of the tax system, as the taxpayer needs to understand both systems at the time the choice is made. To date, this has deterred the government from pursuing this option. However, where the choice of an alternative regime is simple, transparent and will last for the foreseeable future, the investment made by the taxpayer in understanding the alternative is both small and long-lasting. Hence the small additional complexity of considering and opting into an alternative tax system is outweighed by the considerable simplification offered, the savings in time and cost to be made in the future, and the peace of mind of being tax compliant. Furthermore, a generic single tax regime will have inherent difficulties in trying to cover all tax payers, compared to one based on the particular characteristics of the taxpayer population. 2.4 The need for optionality Given the different characteristics of different types of business model, small businesses should be able to choose whether to enter a simplified tax system. In designing any tax simplification solution, mechanisms can be used to tailor/constrain a new system to accommodate the varying concerns and characteristics of different business models and to ensure the system meets the requirements of the Government. Providing a simplified tax system as an option empowers businesses to choose a system that works for them and will provide the optimal solution to suit their business needs, without imposing compliance requirements that are less relevant or complex on others. For instance it would be inappropriate to force a high growth start up into a simplified tax system only for it to go through additional burden of then transitioning to the normal regime shortly thereafter as it exceeds any threshold rules. HMRC will be able to safeguard revenues by setting appropriate rates and thresholds designed to prevent opportunistic and short term use of a simplified system. The design of the entry, transition and exit mechanisms will be important in ensuring that the new regime does not cause unintended consequences either for businesses or in terms of HMRC revenues. 2.5 Interaction with Making Tax Digital The review of small company taxation comes at a critical time in the journey of the UK tax system to a digital environment. The proposals in Making Tax Digital point to the abolition of the annual tax return and a more regular engagement between the taxpayer and the tax authority. The digital tax account can be expected to make the process of submitting a tax return easier. However, the digital tax account can only be as good as the data used to populate it. In such an environment, it is important that the tax system is simple enough for businesses to readily understand the tax implications of the activities that they undertake. Today, for many, tax remains too difficult to understand and a burden that is completed with the associated cost of a tax agent. Simplification is necessary for the digitisation of tax to be effective for HMRC and meaningful for smaller businesses. 5
3. Potential options for reform This section will set out some specific options for change and assess the different potential options against the framework above. These options are aimed at the majority of smaller businesses, i.e. those that have steady growth, such as life-style or family businesses. 3.1 Option 1: A simplified small business regime This provides a proxy of a business s tax liability, replacing the complexity of applying a number of different taxes. The business would calculate its overall tax liability by applying a flat tax rate (provided by HMRC, determined for each sector) to numbers drawn from the businesses accounts. This builds on the existing Flat Rate Scheme (FRS) that is applied for Value Added Tax (VAT) which is well established, having been in use for over a decade. To simplify the tax regime and increase the accuracy of tax returns, only limited, easily verifiable and obtainable information would be required to calculate the tax liability and the tax payment would cover many tax obligations of the business. The aim of a new Small Business Simplified Regime would be to provide the basis for a business to calculate its overall tax liability using only: Sales it makes to its customers. Payroll total. Interest payments made. With just these three pieces of information, and the correct categorisation of business, industry or sector, tax could be calculated. The following taxes seem appropriate for inclusion within the single payment (that is, settled by the new simplified payment): Corporation tax of the business. Employers National Insurance Contributions. Value Added Tax (based on the flat rate scheme already in existence). This option could be further extended. Work undertaken by the FSB 2 has shown that Non- Domestic Rates (Business Rates) could be replaced by a 1% tax on the turnover of a small business. Based on this analysis, Business Rates could be included in the amount applied to the turnover of the business, thereby removing yet another burden on the small business. Even if only applied to corporation tax and VAT, this would avoid significant complexity. How would the model work? The first stage would be to categorise the business. This is critical because the categorisation aims to ensure that all those businesses in that category are very similar, allowing the use of simplifying assumptions about costs as a percentage of turnover. This approach is already adopted in the VAT (FRS) which, by assuming the ratio of VATable expenses to VAT-inclusive sales, provides a single flat rate that can be applied to the gross turnover to generate broadly the same amount of net VAT that the business would suffer if it operated the full system. The premise for this new Small Business Simplified Regime (SBSR) is that the flat rate scheme operates effectively and that the groups are categorised appropriately. To ensure that the FRS reflects the actual VAT that the business would pay, the rates applied to different sectors vary, reflecting the differences in margin between the different types of 2 Based on a study Proposals for reform of the non-domestic rating system conducted by the Centre for Economics and Business Research, commissioned by FSB. 6
businesses. These run from 4% for food retailing and newspapers (where expenses are a large proportion of sales) to 14.5% for legal services (where there are low costs excluding salaries and funding costs). In determining the FRS rate, the tax system assumes a level of expenses, as is shown in the examples below. This means that for these types of business, HMRC has an estimate of the profits after VATable expenses. All that is needed to estimate the profits for corporation tax is therefore an estimate of the other expenses. Step 1 The examples below show profit and loss accounts for businesses in a 10% FRS band and a 6.7% band. The existence of a Flat Rate for VAT means that there is an estimate of income less VATable expenses (shown below as profit before employment costs). All that is necessary after that is to estimate the non-vatable expenses to identify the taxable profits. Case A - A buisness has turnover 100,000, employment costs of 20,000 and other costs of 40,000 Sales ex VAT 100,000 Costs (40,000) Profit before emp. costs 60,000 Employment costs (20,000) Taxable profits 40,000 Under the normal VAT rules, VAT of 12,000 would be due (VAT at 20% on turn over, less input VAT on costs). To achieve a fiscally neutral outcome under the flat rate VAT scheme the flat rate would need to be 10% to collect VAT of 12,000. VAT Flat rate % Imputed Profits Rate Sales inc VAT 120,000 20,000 Cost inc VAT (48,000) (8,000) 12,000 10 50 % Case B - For a business with higher VATable costs Under the normal VAT rules, VAT of 8,000 would be due (VAT at 20% on turn over, less input VAT on costs). To achieve a fiscally neutral outcome under the flat rate VAT scheme the flat rate would need to be 6.7 to collect VAT of 8,000. Sales ex VAT 100,000 Costs (60,000) Profit before emp. costs 40,000 Employment costs (20,000) Taxable profits 20,000 VAT Flat rate % Imputed Profits Rate Sales inc VAT 120,000 20,000 Costs inc VAT (72,000) (12,000) 120,000 8,000 6.7 33 % Whilst the profit before employment costs can be calculated from the single flat rate number, in practice it is expected that HMRC would publish both a Flat Rate for VAT and the percentage of the sales that represent the profits before employment costs (called the Imputed Profits Rate or IPR). Step 2 The next step is to take from the imputed profits any non-vatable expenses. The biggest of these will be employee costs. Since it is assumed that the obligation to run a payroll is 7
retained due to real time information requirements, this will be known to the business. The formula would be: Simplified Taxable Profit = (IPR x Turnover) employment costs Step 3 It would be possible to develop variants of this model to take account of other non-vatable costs faced by business. Another key cost could be interest paid to banks. In this case the formula becomes: Simplified Taxable Profit = (IPR x Turnover) employment costs interest Comparing the outcome under the simplified system with those delivered by the current regime it can be seen that the simplified system need not reduce the overall tax take. Current regime Case A Sales ex VAT 100,000 Tax Costs (40,000) Profit before emp. costs 60,000 Employment costs (20,000) Taxable profit 40,000 8,000 Case B Sales ex VAT 100,000 Costs (60,000) Profit before emp. costs 40,000 Employment costs (20,000) Taxable profit 20,000 4,000 The same results are delivered by the simplified system, but without the burdens and cost imposed on the small business by the current regime. Simplified system IRP Turnover Emp Costs Simplified profit Tax Case A 50 120,000 20,000 40,000 8,000 Case B 33 120,000 20,000 20,000 4,000 Extending the regime to Employers NIC A further simplification could be achieved in the calculation of Employers NICs. Given that most, if not all, of the employees in these businesses are earning below the upper NICs threshold, it would be possible to estimate the level of employer NICs by reference to the level of employee NIC without the need for detailed employer NICs calculations. 8
Rather than calculating the actual Employers NIC, the tax could be calculated as: Estimated Employer NIC = Employee NIC paid x (Employer NIC rate/employee NIC rate) = Employee NIC paid x 1.15 Combining this all together It would be possible to pay an estimate of corporation tax, VAT, and Employer NIC using only the categorisation of the business (which provides the relevant rate) and the following information from the business: Sales to customers. Employment costs (and interest paid). Employee NICs paid. Thresholds and entry/exit The expansion of the Flat Rate Scheme to encompass more taxes would necessitate a review of the qualifying criteria for entry. This would include consideration of the turnover threshold and the time within which a company must remain in the system. The intention is to provide a simple system that the company chooses to adopt rather than an opportunity for a company to flip between different options depending on which results in less tax in a particular year. Who would the scheme be suitable for? In essence, the system is designed for businesses with a relatively constant net margin before employment costs over time (so may vary within a year but relatively constant over the longer term) and that the margin of the business is close to that which is estimated by HMRC. Hence this scheme would be suitable for the majority of smaller businesses which are steadygrowth businesses, for which the sales margin could be expected to be relatively constant over a year. The simplified small business regime is not a pure turnover tax as employee costs are deducted from the imputed profits before the tax rate is applied. Consequently, the regime does not suffer the criticism applied to turnover taxes that a shortfall of sales, resulting in a loss, would nevertheless give rise to a tax liability. Under this regime, such a shortfall would give rise to a loss that could be carried forward or backward as usual. Assessment against framework The scheme has the potential to deliver the following benefits: Cheaper/easier compliance: The scheme means that businesses need only a few pieces of information to work out their tax liability. It removes the need for them to spend time and money on tax agents and expensive software. Instead they could invest in the growth of their businesses, providing longer term economic benefits. 9
Certainty of tax liability: The scheme eliminates the need for a detailed profit and loss account by allowing firms to calculate their tax liability using a limited amount of information. This provides reassurance to firms they are paying the right tax at the right time. Easy to predict tax payments/simpler relationship with HMRC/aligned with other policy changes: In making the tax burden far more predictable, the scheme would enable smaller businesses to be better informed for their business planning. The use of available and understandable information would make it easier for smaller businesses to maintain accurate tax information. The accuracy of tax information would complement the easier reporting processes proposed through the Government s Making Tax Digital reform agenda. 3.2 Option 2: A tax transparent corporation This option would allow a company to elect to be treated as a tax transparent vehicle. Similar to a partnership, this would mean that a business could elect into the system and its income/expenses would then be considered to be earned directly by shareholders who would report it on their individual Income Tax returns. For example, if you hold 60 percent of the stock in a corporation and the company has a taxable profit (computed under income tax rules) of 50,000, you are responsible for reporting 30,000 of that as income and would pay tax on it, based on the owner s marginal tax rate. The entity would submit a yearly tax return. The entity would, however, still retain corporate characteristics for all purposes other than tax, such as limited liability and the ability to contract. The company would have a rigid profit and loss allocation; profits and losses would automatically flow to the owners based strictly on the percentage of ownership. How would the model work? Although this would be a corporate body, for tax purposes the vehicle would operate in a similar manner to an LLP for tax purposes. The shareholders would be deemed to have undertaken a proportion of the activities of the company. Profits distributed to shareholders would not be taxable income since they would already have been taxed due to the tax transparency. This system could be designed as an addition to the current system, creating a new solution to tax-motivated incorporation. Addressing Governments concerns around compliance Again, this option would be designed to be a long-term option rather than one that allows companies to choose annually. The transition from tax opaque to tax transparent could be covered by the existing disincorporation rules and the opposite by the incorporation rules. The protections applying to the misuse of LLPs should equally protect the Exchequer from abuse in this situation. 10
International comparisons Companies in the US are currently able to submit a tax return as an S-corp. They are then treated as a tax transparent vehicle in US with the following restrictions: A limit of 100 shareholders. Only one class of stock, although it can have both voting and non-voting shares. Foreign ownership is prohibited, as is ownership by certain types of trusts and other entities. Benefits reported by companies in the US include, flow through of loss, taxation at the individual level and avoidance of double taxation. Assessment against the framework The scheme has the potential to deliver the following benefits set out as priorities in the evaluative framework: Cheaper and easier to comply/easy to predict tax payments: Pass-through taxation means that owners report their share of profit and loss on their individual tax returns. Double taxation elimination: Income is not taxed twice (as corporate income and again as dividend income). Simpler relationship with HMRC/aligned with other policy changes: Shareholders would provide their IT returns via on online account as per the MTE reforms. HMRC has the ability to audit returns on a quarterly basis. Who is this option suitable for? This option would suit all types of small business, in particular sole traders and contractors who have as yet been deterred from moving to corporate form due to the tax complexities. It would also benefit those who are currently incorporated who would choose disincorporation but for the loss of limited liability. 3.3 Option 3: A distributed profit tax This option removes the need for a company to pay corporation tax and instead taxes distributions out from the company. A company would operate its accounts in the normal manner; however tax would only apply to distributions. The distribution tax would be set at a higher rate to substitute for corporation tax. How would the tax work? A standard (say, 25%) distribution tax rate would be set payable by shareholders based on the profits distributed by the company to them. This tax would replace corporation tax. 11
To prevent untaxed income being indefinitely deferred and held by the entity, a distribution threshold would apply (for example the company must distribute at least, say, 50% of profits to shareholders annually). The threshold for eligibility could be based on turnover (for example companies with an annual turnover of 3m or less), beyond which companies would revert to being subject to the existing tax system. However any threshold would need to be carefully set to avoid adverse behaviour at the margin. Addressing Government s compliance concerns Requirements could be imposed in terms of minimum distributions or maximum cash/investment holdings. International comparisons The cost-based Estonian tax system with a flat rate of 21% corporate income tax is considered to be one of the most competitive and simple tax regimes in the world. Deferral of taxation shifts the time of taxation from the moment of earning the profits to that of their distribution. Therefore, undistributed profits are not subject to income tax. Instead taxation on the profit earned by resident companies, actual and deemed profit distributions (usually in the form of dividends) are taxed at the rate of 21% on the gross amount of the distribution. Assessment against the framework The scheme has the potential to deliver the following benefits set out as priorities in the evaluative framework: Cheaper/easier to comply: The system introduces a simple flat rate distribution on profits, therefore removing the need to apply tax at the company and shareholder level (double taxation). The system removes significant compliance costs of working out employer liability for corporation tax and NICs. Certainty of tax liability/easy to predict tax payments: the tax is set at a standard 25% on distributions, no other taxes on the company are due. Aligned with other policy changes: would replace the dividend tax and corporation tax for a company. Could be administered online, in line with the Making Tax Easier reforms. Who is this option suitable for? This option would be suitable for all small business, particularly those that are growing and reinvesting profits into the business. 12
Conclusion Further work will be needed to develop the detailed design of any solution. This stage will need to further consider the risks and benefits of each option, for industry as well as Government (for example administrative costs, increase or loss of tax revenue through greater compliance or avoidance, and political risks of the policy). An evaluation of the options, as discussed in this paper, is shown in Diagram 1 below: Diagram 1: Evaluative Framework Industry/Government aims Cheaper/ easier to comply Certainty of tax liability Easier to claim reliefs Easy to predict tax payments Simpler or the same level of relationship with HMRC Directly aligned with other current policy changes Areas of change Simplified small business regime Tax transparent vehicle Distribution tax n/a x? x? A combination of the above options could be used to address the concerns of different business models across their life cycle. 13