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7. Small Business Taxation And Tax Reliefs Notes

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Corporate & Business Taxation (BCL)/Magister Juris (MJur)

Bachelor of Civil Law

7. SMALL BUSINESS TAXATION AND TAX RELIEFS

1. Theoretical Background to Small Business Taxation A. The Problems (Mirrlees Review Chapter 19) B. The UK Situation C. Possible Reform Ideas

2. Special Rules Applying to Small and "Close" Companies A. Reliefs including the Small Profits Rate Relief B. Small Profits and Associated Companies

3. Incentives to Incorporate and Anti-Avoidance Provisions A. Distributions and the Non-Corporate Distribution Rate B. Income-Splitting Avoidance Methods

4. Personal and Managed Service Companies Anti-Avoidance (IR 35); Employed v. Self-Employed A. "IR 35" Anti-Avoidance Measure (Personal Service Companies) B. Managed Service Companies Legislation C. The Employee v. Self-Employed Distinction

5. The Treatment of "Close" Companies A. The Meaning of "Control" B. Who has Control?
C. Consequence 1: A Wider Definition of "Distribution" - Benefits in Kind to Participators D. Consequence 2: Quasi-Distributions - Loan to Participators E. Consequence 3: No Small Profits Rate for "Close-Investment Holding Companies"

6. Incorporation and Disincorporation A. Incorporation B. Disincorporation

7. (Capital Gains) Tax Reliefs Available to Small Businesses A. Incorporation (Roll-Over) Relief B. Disincorporation Relief C. Gift of Business Assets (Roll-Over) Relief D. Replacement of Business Assets (Roll-Over) Relief E. Entrepreneurs' Relief F. Summary - Most Effective Use of the Reliefs on Incorporation

8. BCL Past Exam Questions & Essay Plans _______________________________________________________________________________

1. Theoretical Background to Small Business Taxation

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Corporate & Business Taxation (BCL)/Magister Juris (MJur)

Bachelor of Civil Law

A common BCL exam question on small businesses will ask about the UK tax advantages and disadvantages of incorporating a small business, as well as the availability of tax reliefs. Many of the practical problems with the UK tax system, which will be identified in due course, stem from unsound government policy, unexplored theories or poor definitions.

A. The Problems (Mirrless Review Chapter 19)

1. DISTORTIONS: If the tax treatment of companies differs depending on the legal form of the company then the tax system will likely have a significant impact on the ways in which small businesses are structured and distortions should ideally be avoided. An owner-manager has considerable discretion over the way in which he derives his taxable income from the firm - he can choose to pay himself a lower salary and thereby increase the profits of the firm, then distribute these profits by dividend to himself and pay a lower rate of income tax. This is even though he is performing the same tasks as a self-employed or employed individual; so tax offers a distorting incentive to incorporate.

2. HORIZONTAL EQUITY: Should the tax system deliberately seek to increase the share of small businesses in the economy? There is an enormous heterogeneity in the small business sector and many small businesses may not be innovative at all. Blanket support for small businesses is not likely to be an efficient policy response. If, for example, we thought there is too little investment by small businesses as a result of financing difficulties perhaps we should support them through targeted investment allowances rather than preferential tax rates for all small businesses. This may be a problem of defining "small business."

3. COMPLIANCE COSTS: Compliance with the tax system puts disproportionately higher costs on small businesses than it does compared with larger firms. It is not clear that such differences in compliance costs rationalise a lower rate of tax on profits below some set threshold (as UK law dictates, see below). Indeed, among the firms under that threshold, this approach provides the least advantage to those with the lower profits. Further, compliance costs may be off-set by greater opportunities for tax avoidance or non-compliance by small businesses (regardless of the rate of tax) e.g. by converting labour income into more lightly taxed forms of capital income (as described above and below).

4. LOSS ASYMMETRY: When taxable profits are positive, they are taxed. Losses may be "carried back" to offset against positive profits made in a limited number of previous years (producing an immediate tax repayment) 2

Corporate & Business Taxation (BCL)/Magister Juris (MJur)

Bachelor of Civil Law

but when the provision is exhausted the losses can only be carried forward (X-Reference Notes on Loss Relief). There is no compensation for the time delay before they can be used to reduce future taxable profits, and there is also a significant risk of the firm ceasing to trade in the interim period before losses can be used. This can discourage risk-taking by firms and is more heavily suffered by smaller firms than by larger firms, because smaller (younger) firms are less likely to have a history of taxable profits. The appropriate response in this case would be to achieve symmetrical treatment of allowable losses for all firms e.g. allowing losses to be carried forward but with an interest mark-up to compensate for the delay. B. The UK Situation

1. EMPLOYED v SELF-EMPLOYED: The self-employed pay significantly lower rates of National Insurance Contributions (NICs) than the employed, and there is no employer NIC. Although this is offset by lower entitlements to some state benefits for self-employed individuals, and the absence of employer NIC raises the level of taxable income, this still represents a large inducement to be self-employed in situations where the individual is otherwise indifferent.

2. OWNER-MANAGERS: Owner-managers can reduce their tax bill relative to the employed and self-employed by: (1) paying themselves a wage below the personal allowance for income tax and the NIC earnings threshold, (2) then taking the rest of their remuneration as distributed profits (paying corporation tax on these profits at a lower rate); and (3) although the dividend income is taxed at the low rate of 10% this is offset by the tax credit, leaving no personal income tax to be paid (where the taxpayer is "basic-rate" because of step (1)). On the other hand, this is somewhat oversimplified; dividends will generally be paid out less frequently than wages, joint ownership of firms may restrict the ability of individuals to arrange the company in a taxefficient way, and some companies may choose to pay minimum levels of NICs so as to take advantage of the state social security benefits.

3. RATIONALES: There is a tension between the desire of governments to stimulate certain activities associated with particular kinds of small businesses, and to protect the personal tax base from advantages taken by small businesses of poorly-targeted tax breaks. This tension has led to complex anti-avoidance legislation, such as IR 35 and the "associated companies" legislation described below, to deal with individuals (who might otherwise be employed) from setting up a small company providing the same service to the client, thereby permitting substantial tax savings in the manner described above. 3

Corporate & Business Taxation (BCL)/Magister Juris (MJur)

Bachelor of Civil Law

Whatever one thinks about the economic case for subsidising particular kinds of small businesses, it is difficult to rationalise tax advantages on this scale for all small businesses. By tackling the symptoms rather than the root (that is, the difference in rates at which labour income and capital income are taxed), the result has been increasing complexity in the legislation covering these aspects, rather than a coherent solution. C. Possible Reform Ideas (Mirrlees Chapter 19)

1. TARGETED TAX ADVANTAGES: Instead of preferential tax rates for all small businesses, it is suggested that fiscal support is better done by targeted tax allowances for e.g. R&D firms, more generous corporation tax treatment of investment expenditures undertaken by smaller businesses, or more generous personal tax treatment of those investments. This would mean that innovative small businesses continue to benefit while the incentives to incorporate small businesses which have no desire or capacity to innovate would be greatly reduced. In turn, the need for complex anti-avoidance legislation will be reduced.

2. ALIGINING CAPITAL AND LABOUR INCOME TAX: A piecemeal approach of aligning the tax treatment of distributed profits with that of employment income would be to introduce a tax on dividends paid by firms broadly equivalent to NICs paid by employers/employees Further, currently basic-rate taxpayers are not liable for additional personal tax on dividend income, because of the 10% tax credit, so most basic-rate taxpayers who receive dividends do not file annual tax returns. Although taxing dividend income received by basic-rate taxpayers would require more of them to file tax returns, there could be a de minimis exemption for annual dividend income under a small amount, below which the tax revenue at stake would not justify the additional compliance costs. And although aligning the tax rates applying to labour income and distributed profits would increase the cost of capital for small companies who are reliant on issuing new equity (i.e. issuing new shares) as a source of investment finance, may be an unattractive side effect, a RATE OF RETURN ALLOWANCE (RRA) would exempt the normal return on capital invested in company shares from personal taxation and an ALLOWANCE FOR CORPORATE EQUITY (ACE) would exempt the normal return on equity-financed investments from corporation tax.

2. Special Rules Applying to Small and "Close" Companies A. Reliefs including Small Profits Rate Relief

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Corporate & Business Taxation (BCL)/Magister Juris (MJur)

Bachelor of Civil Law

Some reliefs depend on the size of the business or the amount of its profits e.g. Research and Development Expenditure enhanced relief under the Finance Act 2000 applies only to small and medium-sized businesses as defined therein, and only to incorporated firms. Some reliefs are available only to certain types of business e.g. Inheritance Tax Business Asset Relief is available at a higher rate for unquoted than for quoted businesses (Section 110 IHTA 1984); and the nature of the company in which the shares are held may also make a difference for the purpose of capital gains tax taper relief. The most important reliefs however - relating to capital gains - are discussed below. The main rate of corporation tax for the financial year 2013 is 23% and for 2014 is 21%, but a lower rate of corporation tax - the "small profits rate" - applies where profits do not exceed £300,000, and it is currently set at 20% (Section 24 Corporation Tax Act 2010) There is also a marginal relief where profits do not exceed £1.5m, resulting in a 27.5% marginal rate on profits between these thresholds (viz. £300,000 and £1.5m) but the small profits rate reliefs have to be divided between "associated companies", if any.

B. Small Profits and "Associated Companies"


The "associated companies" legislation can best be described as "antiavoidance" legislation Unfortunately it is some of the most ill-defined and poorly-drafted legislation in the UK's corporate and business taxation system. Not only is it heavily reliant on non-statutory material of dubious constitutional status, but is also widely drafted and uses vague terms such as "substantial commercial interdependence" with which English judges may be poorly-equipped to tackle.

This creates considerable uncertainty for taxpayers, many of whom will be caught by the legislation without having done anything "wrong" from a policy perspective.

Cross-Reference with the Notes on Tax Avoidance/GAAR (and particularly the essay plans contained therein) for a detailed critique of various UK anti-avoidance legislation, including the associated companies legislation found in Section 25 ff. Corporation Tax Act 2010.

Section 25 Corporation Tax Act 2010 - Attribution of rights and powers of partners (1) For the purposes of section 24, a company is another company's associated company in an accounting period if it is an associated company (see subsection (4)) for any part of the accounting period.

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Corporate & Business Taxation (BCL)/Magister Juris (MJur)

Bachelor of Civil Law

(2) The rule in subsection (1) applies to each of two or more associated companies even if they are associated companies for different parts of the accounting period. (3) But an associated company is ignored for the purposes of section 24 if—
(a) it has not carried on a trade or business at any time in the accounting period, or (b) it was an associated company for part only of the accounting period and has not carried on a trade or business at any time in that part of the accounting period. (4) For the purposes of this Part, a company is an associated company of another at any time when—
(a) one of the two has control of the other, or (b) both are under the control of the same person or persons.

"Control" is defined in Section 450 CTA 2010, detailed below.

Finance Act 2011 amended Section 27 CTA 2010 to include that the small profits relief must be divided between associated companies; Section 27 CTA 2010 sets the requirements:

Section 27 CTA 2010 - Attribution to persons of rights and powers of their associates (1) This section applies if—
(a) it is necessary to determine in accordance with section 25(4) and (5) whether a company is an associated company of another company, and (b) the relationship between the two companies is not one of substantial commercial interdependence. (2) In the application of section 451 (meaning of "control…") for the purposes of the determination, any person to whom rights and duties fall to be attributed under subsections (4) and (5) of that section is to be treated, for the purposes of those subsections, as having no associates. (3) The Treasury may by order prescribe factors that are to be taken into account in determining whether a relationship between two companies amounts to substantial commercial interdependence for the purposes of this section." Jowett (Inspector of Taxes) v O'Neill and Brennan Construction Ltd

The taxpayer company carried on the trade of supplying labour and equipment to building contractors in the UK; an associated company 6

Corporate & Business Taxation (BCL)/Magister Juris (MJur)

Bachelor of Civil Law

(WCL) commenced the same trade in respect of the construction sector in Germany and made profits. It placed £100,000 in a bank account in 1994, ceased trade in October 1994, and by January 1995 the account had roughly £80,000 in it; WCL resumed a new trade in 1997 The tax inspector refused the taxpayer company's claim to small companies' relief during the accounting period for 1 January - 31 December 1995 on the ground that it had an associated company and therefore the maximum amount for the relief fell to be divided The Special Commissioner allowed the taxpayer's appeal because WCL had not carried on any trade or business at any time during the relevant accounting period (the year 1995) Park J upheld that finding, since the Special Commissioner did not err in law, even though the normal conclusion when a company earned an income return was that it was carrying on a business, but that was not inevitable as a matter of law and this was an exceptional case

Park J

Nothing much turns on the small print of the statutory words, but it is worth commenting that they assume that a company can exist without carrying on a trade or business By choosing the criterion of whether or not the company had a trade or business, the legislature implicitly recognised that a company could have income and could exist without necessarily carrying on a trade or business The inspector relied on Lord Diplock in American Leaf Blending when he said "in the case of a company… any gainful use to which it puts any of its assets prima facie amounts to carrying on a business"; since WCL put money on deposit for gainful use, it carried on trade The Special Commissioner did not agree; he found that on the facts of American Leaf the company let out its premises for rent but had originally acquired them to occupy itself in the course of its trade; that was he said a far cry from a company putting money on deposit He then found that WCL putting its money on deposit was not a business investment but that during 1995 and 1996, WCL was "in a state of suspended animation" and did not trade I see no misstatement of law in his decision: the inspector accepts that WCL was not carrying on an investment business merely by having money on deposit, but when I asked him what business it carried on he said it was "in the business of gainfully employing its assets while keeping itself in existence pending any trading opportunity" To my mind that is not a kind of business but merely a description of the company's profile in the relevant period - the Special Commissioner

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