Jolyon’s approach to what the profession would regard as aggressive tax avoidance has, I believe, moved the debate on quite significantly. There is still a considerable way to go, but the discussions on his blog on badging tax risk show that a consensus looks viable.
However, while there is considerable agreement on some of the aggressive schemes we might encounter, I am also concerned about the much greyer areas of tax advice that we, the tax profession, might find that the wider public take a very different view of.
In considering reliefs, Jolyon has written several times about pro-purposive use and anti-purposive use. One being an appropriate use of a relief, which Government intended, the opposite being tax avoidance as a minimum. However, there are other situations where a very attractive tax result might be achieved for a client in much simpler circumstances; situations which are not susceptible to the same analysis, and about which the public might take a different view.
Let’s think about a sole trader with total profits for tax purposes of £40,000 and no other income. His total tax and national insurance contributions on that income this year will be £9,743, leaving him with net pay of £30,257. If we were to advise him to form a limited company, and from the same profits draw a salary of £7,956 (equal to the NIC entry point) and the balance of profits after corporation tax as a dividend, his tax bill (there is no NIC payable) will reduce to £6,409, and net pay increases by 11% to £33,591. I am not comparing these two situations with those of the “man on the Clapham Omnibus” who is salaried at £40,000 a year with a much lower take home pay, as our business man has uncertainty about his income, and other factors to take into account. However, whether he trades as a sole trader or a limited company, the profit outcome is likely to be broadly similar (subject to some administrative costs). Not only that, but our company director is in a far superior position regarding state pension, as he is credited with an earnings related element in addition to the basic state pension entitlement, despite having paid no NIC at all.
Bigger numbers – bigger difference
Why not scale this up? Another sole trader has profits of £100,000 a year. As a sole trader his current year tax and NIC liability would be £34,701, leaving net pay of £65,299. If he decides to trade through a limited company (which he might do for entirely non-tax reasons) and takes the same profit extraction route as described above, his overall tax liability falls to £29,177, a saving of £5,512. This overall saving at 8% is smaller in percentage terms than the example above. However, having taken advice he has given 50% of the shares to his wife, protected by the outcome in Jones v Garnett. The overall tax bill now falls further, to only £19,984, a total saving against a self employed position of £14,717, and an increase in overall net return of 22%.
I am not for one minute arguing that I believe that this is unacceptable behaviour – indeed I would probably be negligent for not suggesting it – but maybe some people think that it is. Is the mischief limited company status? I don’t think so, because if the director chose to take all of the profits by way of salary his tax bills would be significantly larger – indeed they would be higher by reason of employer’s NIC in addition to employee contributions.
So is the problem the method selected for extraction of profits? What if his needs are modest and the profits are almost all retained in the company, bearing tax of only 20%? If he retains, say £25,000 of profit in the company, his tax bill falls to £23,563 as a sole shareholder – a saving of £11,317 against his position as a sole trader, and to £18,409 as a joint shareholder, saving £16,292. Some will still argue that this is unacceptable, but the fact is that the valid choices made about how to structure a business and how the profits are extracted has a major impact on the tax charge.
Bad or not?
What does HMRC or Government think about these situations? They have been well known about since Jones v Garnett but after some initial suggestions to address that case we have heard nothing further. We now have the GAAR but given this sort of planning is well known about it looks like the GAAR is not in point. So it is all right then?
I do think this is an important area for this debate to consider. It would disturb the lay reader who might consider that professional tax advisers are at fault for suggesting it. And yet we are only doing what every other tax adviser would do – and should do if they are not to be held negligent. However at present HMRC has shown little or no to appetite to tackle this type of bread and butter planning.
What could or might be done? I promised Jolyon a blog about “how we got here” – meaning the way that we arrived at the current tax rules, but it proved difficult to establish an overall theme. What I did observe was that Governments of the last 50 years have had very differing agendas and the constantly moving tax rules to reflect those views. Taxing unearned income at a premium of 15% for some considerable time, as “bad” income. Taxing companies which distributed most of their profits at a greater rate for some time, and then in a complete volte face, imposing additional tax on company profits which were not distributed (many will remember close company apportionment calculations).
The first step would be to reach an agreement about whether we regard these wide variations in tax burden on essentially the same income as an acceptable outcome of choice, or an unfair advantage. Then we might think about what comes next.
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I suspect a lot of it will depend on whether you believe that returns on capital should get the same treatment as returns on labour, as well as the employed/self-employed divide within returns on labour.
It’s not necessarily something that there’s an easy answer to, and it may not just be a tax thing – after all, the DTi, or whatever BiS was called in 2004, was still busy promoting the 2 shareholder structure, with dividend payments to spouse, at the very time that the IR was litigating Jones v Garnett. (If I get the chance I shall go and find it on the Wayback engine; IIRC they did take that advice down some time around the Court of Appeal or House of Lords hearing)
Is it really up to tax professionals to ‘draw the line’? I thought that was the role of the government.
Perhaps HMRC have not shown an appetite to tackle bread and butter planning because (i) it’s not thought to be unacceptable and (ii) how exactly would they tackle it without a change in the law which, again, is the job of the government?
Maybe, in the example above of the businessman retaining profits in his company and so paying less tax, we should be less worried about whether we should be changing the whole taxation system so this sort of unacceptable (in some people’s eyes) thing can’t happen and more concerned with educating people that the £25k will be subject to corporation tax and the balance retained might be invested in growing the business or held until such time as it IS paid out at which point it will be taxed then.
We (the tax profession) seem to have allowed the debate to be reduced to “what’s the most amount of tax that can be squeezed out of a particular level of income and how on earth can you justify organising your tax affairs such that you pay a single penny less than that amount?”
Andrew, I was not seeking to draw the line myself, but in fact to prompt the profession to think about these issues and the fact that we think very differently from the wider public.
The profession has come under heavy fire from the press, public and indeed the PAC for facilitating and promoting what is regarded by them as inappropriate tax avoidance (which is, of course, perfectly legal). What I wanted to do here is illustrate that it is almost impossible to define tax avoidance in a way that would be generally agreed upon. I doubt whether any practitioner advising smaller businesses would regard the position I have described as avoidance or even questionable. In fact as I have pointed out not at least considering it would be far more questionable.
But there is no doubt that the view taken by “the other side” (and I don’t at the moment mean HMRC) is of concern to many in the profession, as nobody wants their professional reputation tarnished. The wider view of those who criticise tax avoidance is potentially “someone who pays less than I do”, and I think the issue I have highlighted serves to show that this is an issue tax professionals should face. In this, I agree with your final statement – it sums up the wider public perception very well.
For our profession to simply say “they are wrong, they don’t understand” does not address the issue – and maybe we’ll decide that the issue cannot be appropriately addressed but it is worth examining. What is tax avoidance?
One final comment, if you forgive me, to address a comment I have seen elsewhere. Incorporation is a big decision, and for many businesses it is not done purely (or even mainly) for tax reasons. The big tax differential is down to profit extraction decisions. Can the public swallow that?
Is the contention that all small businesses should face the same burden of taxation, however they are structured?
It seems to me that the sole trader and the director of a small company are in objectively different positions, and can legitimately rely on the different tax treatments that currently apply.
If the public wants a different result, they need to vote for politicians who will legislate for that different result.
First of all Rebecca is to be congratulated on discussing the subject. I would not agree with any commentator who might now expect her to experience criticism from her profession for doing so; those ideas are best left for conspiracy theorists to explore. She has, however, addressed received wisdom head on; always to be commended.
I would also thank her for making it clear early on that the comparison is strictly with self-employment; not employment. Disguised employment income DOES conflict with the inferred intention of Parliament, which has set out clearly how it wishes income from employment to be taxed.
That said, I do wonder how this tax planning could ever be “bad”, or even if the question could be legitimte here. Taxes derive from the decisions of Parliament. One cannot avoid what Parliament does not intend to be taxed. Avoidance can only occur if Parliament’s express or inferred intention to tax something is being subverted. Let’s be clear, Parliament has never indicated that incorporation as opposed to self employment could be considered avoidance. So “we all do it” do we? That would be because it’s fine!
I would also throw an idea into the mix (for what it’s worth): we concentrate on the advantages, sometimes the disadvantages, of incorporation over self-employment. We also talk frequently of the advantages the self-employed enjoy over the employed. Do we though ever consider a singular disadvantage the self-employed suffer relative to the employed? The employed are charged on a receipts basis. Delay your receipt; delay your charge. This is the underlying principle of pension contributions, regardless of any emotive and frankly silly claims that they enjoy a “subsidy”. The self-employed by contrast are charged as the profit is made. If they do not draw the money, choosing perhps to reinvest in and grow the business, they are still charged. Could incorporation be viewed legitimtely in part as removing this disadvantage?
A final though: Jason P’s excellent comment did contain a reference to returns on capital. We are not talking here of ‘investors’ in the standard sense but rather proprietorial businesses often, using only one or two people to carry out the enterprise. As the choice here is between having your labours received personally or channelled through a company, are we right to regard this as a return on capital at all?
I feel a touch ungracious taking the point with Ironman after his very generous description of my comment – but are we necessarily talking about ‘proprietors’ as opposed to ‘investors’ here? I don’t think Rebecca (deliberately or otherwise) has specified how the sole trader is making their profits – whether a highly active window cleaner, a skilled qualified professional, or the proprietor of a small machine shop housing £250k of (owned) tooling.
Of course in most cases a small sole trader will be relying on returns on labour – but some have capital intensive businesses, maybe set up with redundancy money or savings; where would we draw the line? A long distance lorry driver who is the owner/operator of a their own tractor unit undoubtedly has capital at risk – but then of course as Ironman has pointed out, building that capital up is far easier with a company than as a sole trader.
Or, perhaps more controversially, what of the IT consultant who can command a 4 figure daily rate because they have invested many years of their life in training, qualifications and experience. Should we recognise that through the tax system by allowing them to use the profit extraction route which treats their return as being on capital? And if not, why not?
This excellent discussion reminds me of a debate many years ago when I worked for a development NGO. There was much academic debate on the meaning of terms like ‘developed’, ‘developing, or ‘under-developed’. Matters came to a head in a series of increasingly tetchy letters to The Times. One eminent economist ruled there were no clear differences in the numbers, so the terms were meaningless. To me the matter was settled by the reply (the next day) which said on that basis there was no distinction between day and night since that too had no clear boundary.
When non tax professionals respond to “structures” or “arrangements” they may imagine a clear, bright line, boundary between acceptable tax planning and unacceptable tax avoidance. Is this the profession standing in one place and the non-professionals standing, as it were, in the dark? Maybe the view we take depends on where we are standing?
Rebecca – sensibly – did not invoke any references to ‘morality’ or even ‘fairness’ but I suspect it will be concepts like these that influence the judgements of non-professionals. A person deciding to save money by switching from working as an employee at £40K to a sole trader at £40K is probably regarded as getting a ‘fair’ return for the risks taken to earn that £40K. Nothing in the shadows about that.
Arrangements such as the ones LITRG have recently commented on for umbrella arrangements (‘Pay Day by Pay Day’), and the disguised employment Ironman mentions, may not be seen in the same way. Why? Perhaps it is because there is a sense that the likely complexity of such ‘schemes’ betrays something odd. A belief that it is goes against their own experiences, usually as employees, so that others in apparently the same position are gaining what they should not gain. In other words, it goes against horizontal equity, i.e. giving the same treatment to people in an identical situation.
So, returning to Rebecca’s incorporation, I think most non tax professionals do not see that as something of the night. They would not normally compare companies with individuals, although there may be some objections to the rules that apply to companies, maybe additional deductions, or possible pension advantages.
I believe the real focus of the public discontent is more the behaviour of the (larger) businesses themselves. For example, being incorporated does not require you to set up structures that maximise the UK rules on interest deductibility and move profits offshore and back again. But the professional advisers involved in all this activity clearly believe they are still in the light.
In my view that mixture of professional advice and taxpayer behaviour lies behind any public belief “We (the tax profession) seem to have allowed the debate to be reduced to “what’s the most amount of tax that can be squeezed out of a particular level of income and how on earth can you justify organising your tax affairs such that you pay a single penny less than that amount?”
We also have to look at the other option of profit extraction from a small owner managed company. Rebecca mentioned it briefly. How absurd is it that if the director decides to take salary and not dividends then he will have a much higher overall NI burden with E’ees and E’ers contributions compared to the self-employed version.
So what should he choose to do? Should he “be immoral” (as some would suggest) and take dividends to his tax/NI benefit or should he “do the right thing” and pay more tax and NI than a self-employed businessman? Or should he work out what is the exact balance of dividends and salary that means that his overall tax/NI bill is the same as the self-employed version?
How often do we get to choose how much tax we pay? What would the general public do if given that choice? I hazard a guess that 99% would pay the lowest amount offered….
So the problem is NOT that we have a morally corrupt businessman the problem is that we have an absurd and over complicated tax and NI system, which no politician has the guts to deal with.
Or just maybe it is the government’s intention that all but the very smallest self-employed traders should incorporate their businesses and save that NI because small businesses are the life blood of our economy, small business owners take enormous financial risk and it’s ruddy hard work and stressful running your own business so maybe, really they deserve a tax break…?
I have another question – which maybe is because I am relatively young and don’t have decades of historical tax and political policy to enlighten me – but why is “earned income” taxed more heavily (by including NI) than “unearned income”? It seems a bit tough on the working man and woman..?
I would echo Iain’s observation that the tax profession has not stood it’s ground enough and made the case that arranging one’s affairs to pay a lower amount when Parliament has provided you with legitimate opportunity simply is not ‘immoral’. We do not need to tie ourselves in not with what is moral behaviour; it is enough to know that ‘legal and intended’ means not immoral.