Entrepreneurs

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Capital versus revenue
Entrepreneurs’ relief
Incorporate or not incorporate?
Office of Tax Simplification – small business review
Office of Tax Simplification - review of IR35

Capital versus revenue

Since 6 April 2010, individuals with income over £150,000 have been subject to income tax at the additional rate of 50%. However, the capital gains tax (CGT) rate for an additional rate taxpayer is relatively low at 28%, for gains accruing on or after 23 June 2010. This rate differential means that taxpayers are considering possible ways to plan their tax affairs to benefit from the lower CGT rates. Where Entrepreneurs’ Relief is available, the CGT rate drops even further to just 10%.

Taxpayers should consider whether their economic activities can be organised so receipts can benefit from the 28% or even 10% rates. Specialist advice needs to be sought as to whether a receipt is income or capital in nature, as this is covered both by tax legislation and case law.

Entrepreneurs’ relief

(Updated 3.28pm 23 March)

The Chancellor announced that the lifetime limit on capital gains qualifying for entrepreneurs’ relief (ER) will be doubled to £10 million from 6 April 2011.

As a result, an individual who qualifies for the relief should only pay CGT at a rate of 10% on the first £10 million of qualifying gains. Taking into account the increase in the highest rate of CGT to 28%, the relief which started in April 2008 as a modest £80,000 tax saving is now potentially worth £1,800,000. The Emergency Budget 2010 previously increased the lifetime limit for ER from £2 million to £5 million from midnight 22 June 2010.

In order to qualify for ER, the assets being sold must have been held for at least 12 months. The relief is then available broadly where there is a disposal of a business, or shares in a company. If it is shares that are being sold, the individual must have been an officer or employee of the company and must have held 5% of the shares, throughout the year before the sale.

There are many pitfalls which may prevent the relief from being available.

In its review of tax reliefs published on 3 March 2011, the Office of Tax Simplification recommended that ER could be simplified by:

• Introducing a simple checklist or flowchart approach to lead a taxpayer through the conditions required to qualify for the relief
• Aligning the conditions regarding the sale of shares and assets The Office of Tax Simplification also received representations that:
• The 5% rule should be abolished as it can lead to administrative burdens and unfairness
• Consideration should be given to further increasing or removing the lifetime limit to encourage serial entrepreneurs

In this budget the Chancellor did not implement the OTS’ recommendations.

Incorporate or not incorporate?

(Updated 9pm 23 March)

With the reduction in corporation tax rates, particularly the small companies rate from 21% to 20%, and the main rate from 28% to 26% with effect from 1 April 2011, together with the current 50% rate of income tax for those with income over £150,000, is there yet another incentive for businesses to incorporate?

In the not so distant past, the nil tax rate for companies meant that a number of business sought to incorporate to take advantage of the beneficial nil tax rate but this was subsequently changed by the previous Government to avoid such tax planning. Is incorporation beneficial? When considering this option, it should be noted that there is still the issue of the second layer of taxation when it comes to extracting profits from a company by an individual. If profits are extracted via dividends, the effective tax rate is 25% for higher rate taxpayers, or for those whose income exceeds the £150,000 threshold, the rate is around 36%.

Facts in each case would need to be considered to obtain an accurate assessment of whether incorporation would be beneficial from a tax perspective. As a rule of thumb, the larger the business, the more incorporation makes sense as profits are more likely to be retained within the company. Some simple 'what if?' planning can certainly help the decision making process.

Office of Tax Simplification – small business review

(Updated 9pm 23 March)

On 20 July 2010, the Chancellor and Exchequer Secretary launched the Office of Tax Simplification (OTS), to provide the Government with independent advice on how the UK tax system could be improved and simplified.

The second of the reviews to be carried out by the OTS was on areas of complexity and uncertainty for small businesses and the interim report was published on 10 March 2011, setting out its recommendations to the Chancellor, who made a formal response on 23 March 2011 as part of his Budget statement.

The overwhelming conclusion to the report is that major structural changes need to be made to the UK tax system to ensure a genuine and long lasting simplification. The two key areas recommended for reform are:

• The integration of income tax and national insurance contributions (NIC) – the two separate systems lead to many anomalies and this in turn can distort behaviour. The integration of income tax and NIC would reduce the differential and result in reduced and simpler administration. In his Budget Statement, the Chancellor announced the launch of a consultation in this area
• Introducing a new approach to the taxation of very small unincorporated businesses – a tax based on turnover (rather than profit) or a fixed or flat rate expense deduction could reduce compliance costs and costs of administration

As the above recommendations can only be implemented over the longer term, the report also recommended the following short term priorities:

• Improving elements of HM Revenue and Customs administration (and thereby its relationship with taxpayers)
• Choice of legal form
• Simplifying reporting requirements on reimbursed expenses and benefits for employees
• Improvements to the capital allowances regime
• Considering a simpler VAT system for small businesses that undertake international activities
• The report also recommended several amendments and alternatives to IR35 (see below) 

Office of Tax Simplification - review of IR35

(Updated 9p,m 23 March)

In its ‘small business review’ the Office of Tax Simplification (OTS) made several recommendations for amendments and alternative approaches with respect to the anti-avoidance ‘intermediaries legislation’ which is more commonly known by its original guidance name of IR35. The review concluded that there are three options available :

• Suspend the operation of IR35 with the intention to abolish.
• Keep IR35 unchanged but improve the way it is administered.
• Introduce a new business test to exclude a large proportion of those currently affected by IR35

Subsequently, in the documents released as part of Budget 2011, it has been confirmed IR35 will be retained with the intention of simplifying the regulations. This would be achieved by improving the way in which it is administered.

It is intended that these improvements will:

• see the introduction of a dedicated Helpline staffed by specialists in order to provide greater pre-transaction certainty;
• introduce better guidance on those types of cases HM Revenue & Customs (HMRC) view as outside the scope of IR35;
• restrict reviews to high risk cases that will be carried out only by specialists teams; and
• introduce a dedicated IR35 forum with a view to promoting more effective engagement between HMRC and other interested parties.

The choice of a less controversial way forward is unlikely to appease the contractor groups who have been keen to see IR35 abolished. Equally the suggested reforms do not seem sufficiently deep enough to tackle an area of law that has been in existence for a decade and spawned literally hundreds of tax cases as taxpayers and HMRC have done battle over the meaning of the rules.

It would appear the option of a new replacement business test was not the most attractive option perhaps because it could see the replacement of one controversial set of rules with another set of potentially controversial rules.

The challenge for HMRC is to show that it can provide an administrative framework for improvement in an area. If this is not achieved, IR35 may be back on the reform agenda in a short period of time.