Weekly Tax Brief - 9 February 2012

George Bull
Senior Tax Partner

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In this edition of Baker Tilly’s weekly round-up of the most important tax news, we cover the latest developments.

1. Don’t shoot the goose
Colbert, who recently made an appearance in the first instalment of the BBC2 series on Versailles, famously advised Emperor Louis XIV, the Sun King,that the art of taxation was like plucking a goose: best if done with the minimum of hissing.

So why have UK politicians of all political persuasions recently been taking pot-shots at the tax-paying goose, apparently not caring whether it lives or dies?

The answer is not difficult to find.

In the early years of this extended financial crisis, 2007-2010, the political emphasis was on rebuilding the economy, supporting enterprise and creating jobs.

By contrast, since 2011 the thrust has shifted dramatically, to shoring up the government’s finances by cutting expenditure and maximising tax revenues.

In maximising tax revenues, targets are as diverse as:
- high income groups (but as we saw in last week’s Weekly Tax Brief, the top 10% of earners already pay more than half of all UK income tax),
- recipients of large bonuses (although, as we have already pointed out, waiving bonuses in cash or shares to which there is already an entitlement can cause horrendous tax problems), and
- businesses generally and large corporations in particular.
On the expenditure side, moves to encourage the transfer of government functions to employee-owned companies are raising tax issues of their own, compounded by recent concerns over NIC avoidance by government departments contracting with service companies rather than employing individuals direct. We take a look at this below.

No reasonable person contests the idea that we should all pay our proper dues. Nevertheless, in a week when it has emerged that HMRC wrote off £10.9 billion last year (with the Treasury expressing ‘some surprise’ according to the Public Accounts Committee) and with a high-profile criminal trial producing a ‘not guilty’ verdict, the government would do well to remember its own responsibility to behave appropriately.

In recent months an approach calculated – quite reasonably - to raise the profile of tax issues in public debate has morphed into labelling many businesses and groups of individuals as fair game for the tax man. This damages the credibility of job creators and individuals alike, with potential long-term adverse consequences for the UK.

Those who wish to be heard and respected should pick their words carefully, before attacking the next tax target, which seems to be higher rate tax relief on pension contributions. Among other things, continuous rhetoric aimed at targets which change every couple of weeks undermines stability and social order. All the geese in the flock start hissing alarm calls.

Back to Colbert, what happened next? In a nutshell, Louis XV became emperor and spent much of his adult life doing what some commentators describe as ‘going to war for fun’. As a result, Louis XVI inherited a bankrupt country and we all know what happened next. Revolution.
2. HMRC freezes Business Records Checks

Among the many sporting postponements last weekend due to the snow, HMRC announced a postponement of its own - the temporary freezing of the much criticised Business Records Checks (BRC) programme. Under this, HMRC has been carrying out real-time checks of the records of small businesses.

Introduced in a rush last April with little consideration of a consultation exercise, BRCs have now been subject to an in-house review by HMRC. This sets out the department’s thoughts on how BRC should develop and acknowledges the potential damage that its insistence on pressing on with the programme has done to its relationship with the professional tax advisors acting for small businesses.

We now have a ‘hiatus’ under which HMRC will refrain from commencing fresh BRCs while a further, more constructive, consultation with all parties takes place.

HMRC’s review reveals some interesting statistics. Almost 2,500 BRCs have been carried out with about 40% showing inadequacies in small business record-keeping. Overall, 11% have seriously sub-standard records and because of this HMRC intends to improve, rather than scrap, the BRC project. When BRCs re-commence, possibly in April or May, HMRC envisages an approach which both (a) educates and supports traders who want to get things right and (b) identifies and follows up by checking the records of those who have poor records and are thus more likely to fail to comply with their tax obligations. The latter are likely targets for the maximum £3,000 penalty which underpins the BRC programme.

Since the concept was announced in late 2010 we have called on HMRC to justify its claim that BRC would raise an additional £600m over 4 years. That target has now been scaled back to less than one quarter of the original sum sought, yet is still in our view a stretching figure, particularly if HMRC is unable to secure funds to properly advertise the BRC programme. Given resources sufficient to carry out only 12,000 checks per year, focusing exclusively on small businesses, and mainly on those in risky sectors such as cash traders, HMRC seems unlikely to raise anything near the anticipated figure of £124m from the 1,320 or so (11%) checks that appear to show serious problems. It will be interesting to see in due course how much this project has cost and how much it has raised. The information should become available under the Freedom of Information Act in a few years’ time.
3. Ed Lester may not be avoiding as much tax as estimated
Sometimes, people can’t see a conclusion without jumping to it.

Estimates of how much tax is saved by civil servants operating through companies have outraged the public, but everyone outside the particular taxpayer’s own circle is guessing: and nobody can even begin to guess without the full facts. There may have been no tax savings whatsoever for all we, as outsiders, know. It is nowhere near as simple as saying 'He's only paid 20% corporation tax, instead of full income tax' – he will be taxed a second time when he takes the money out of the company.

Paying a consultant via a limited company has advantages for organisations, as it transfers all sorts of liabilities away from the organisation. For that very reason, many big businesses will only take on specialists as contractors working through their own companies. If it makes sense in the private sector, dedicated as it is to efficiency and no waste, why shouldn’t the public sector get involved?

HMRC will no doubt take a keen interest in ensuring that, if appropriate, the IR35 rules are applied to extract the maximum tax and NIC from the arrangement.

There are three main reasons why service workers use single person companies:
1. Limitation of liability for damage caused by errors - just like any other company.
2. Transfer of some income to a spouse (by way of a gift of shares, or an investment by the spouse) who may have personal allowances and basic rate band to spare, so whatever is transferred is not taxed at 40% or 50% in the hands of the skilled worker. The Arctic Systems case (Jones v Garnett) was a typical example of a computer specialist selling his services through a limited company owned by himself and his wife, and it was held by the highest courts to be legitimate.
3. It is also possible that they want to defer some income from a good year to cover lean years in future, when the tax rate might be lower. If your income was £182,000, you could keep your personal earnings subject to income tax below the 50% tax band this by retaining some profit in the company, paying only 40% on drawings, but you'd pay more 20% corporation tax instead. In a later year where you earned below £150,000, you'd draw a bit more from the company's reserves and pay tax at 40% or 20%.
If Ed Lester's service company is within IR35, it is unlikely to have saved him anywhere near as much tax as has been suggested, although it may have transferred the employer NIC liability from the SLC to him. It will also have saved the SLC some administrative and pension costs, as they will probably have paid twelve invoices a year with no employee-related administration or accrued employment rights (eg, it might be cheaper if they come to sack him, because he's not an employee with rights).

If it is not an IR35 company (and we'll only know from HMRC records, which are not public), he may have been able to transfer some income to his wife to have it taxed at a lower rate, or left it in the company, having paid corporation tax on it first, but they'll pay income tax on it when they withdraw the money in due course.

The conclusion is probably far from some of the wilder ideas that have been floated.
4. Furnished Holiday Lettings...some good news for a change

At last there is a glimmer of good news for anyone running a furnished holiday lettings business. There have been a number of recent changes which have watered down the tax reliefs available for income and capital gains tax purposes. However, one area which has always been arguable has been whether these lettings qualify for the very valuable 100% business property relief for inheritance tax purposes.

HMRC have always taken the view that to qualify as a business for these purposes, significant services should be provided either by the owner or agent, almost to the extent that the letting is akin to providing a hotel room. For most holiday lettings, services have included cleaning the room pre and post the letting period, perhaps the provision of bedding and towels and general upkeep of the property. That has generally not been considered enough to be regarded as a business.

However, HMRC’s view was successfully challenged at the first tier tribunal, the first stage in any tax case. Mrs Pawson died having owned 25% share in a holiday letting business. The Suffolk letting was owned by the Pawson family for some years and the services provided extended to a caretaker to look after the property, a laundry service and preparation of the property prior to letting (eg, heating turned on). Additionally, the property was well advertised and was correctly insured for commercial letting.
Even though there was some personal use by the family, all of the factors built a picture of the property being exploited for business purposes, rather than, as in some cases, a second home which is available for holiday letting and is on occasion actually let.

This provides the opportunity for those who have a holiday letting, operated with the mind-set of a business, to claim the 100% business property relief, where there is an inheritance tax charge. Previously, the advice may have been that it would have been open to immediate challenge from HMRC.Whether HMRC appeals against the decision remains to be seen.
5. Taxman’s newfound flexibility

The announcement by HMRC that it is to keep the P45 rather than scrapping it as a deregulation measure as part of the Real Time Information (RTI) project adds to the feeling that HMRC is really beginning to listen. It is genuinely welcome.

RTI is intended to modernise the PAYE system by moving virtually all reporting online, with savings in paperwork for all concerned. For a modern, digital economy, this has got to make sense. However, while the details of leavers are to be e-filed with HMRC (which is already the rule, pre-RTI), the plan was to allow employers to design their own ‘leaver’s statement’ for the employee’s use, as every employee needs a record of pay and tax when leaving a job. The problem that the professional bodies and employers put to HMRC was that creating a free-for-all would increase the paper burden, as most employees hand over the paper P45 to a new employer who uses it to set up the employee’s payroll record using well-established processes. Scrap the form and you scrap the process, leaving employers to deal with a multiplicity of different leavers’ statements and a heavier administrative burden than before – not exactly what was intended. One large employer pointed out to HMRC that it processes over 3,000 P45s every month, and that it could potentially have to deal with 3,000 different forms as a result of the proposed change. HMRC is to be congratulated on seeing sense and reversing the decision to drop the P45.

This willingness to listen and change follows on closely from the decision to change the Business Record Checks programme in response to loud protests from the tax profession, which objected to the misconceived, intrusive and largely pointless exercise that was developing. HMRC has recognised that its original target of raising £600m of extra tax from the SME sector was a touch optimistic so has agreed to scale back its activity and focus on the riskier sectors, which is where the best return on investment was always going to be found.

We welcome HMRC’s willingness to listen and change. Let us hope it is matched in the Treasury: in particular, the project to merge PAYE and NIC operation by employers runs the risk of substituting one complex system for another, with a transition cost and without achieving any real simplification. Making changes to make it seem like something is being done should not be an option. There are easy changes that could make employer life less burdensome, quickly and without massive upheaval in regulations, guidance, staff training and IT systems. Here’s hoping ….
6. Tax allowance policy hits NIC collection – ‘reverse fiscal drag’

When the Chancellor decides to increase personal allowances by more than inflation, he ‘pays’ for it by lowering the starting point for 40% tax.

Mr Darling started the trend with his panic reaction to the 10p tax mistake, and Mr Osborne is sticking to the policy. The single tax allowance rose by £1,000 last April and is set to rise by £630 or 8.4% this April, and we hear promises of a £10,000 personal allowance by 2015. To prevent those in the 40% band from benefiting from the extra tax-free pay, their 40% threshold is reduced by the same value: they save on £630 at 20% but pay on £630 at 40%, so they continue to pay the same total tax. Oddly, while the number of 40% taxpayers rises, their total income liability does not, all other things being equal. This policy is aimed at helping the lower paid, but hundreds of thousands more people each year become higher rate taxpayers, so they lose child benefit. They are also paying ever more tax because of fiscal drag: the personal allowance goes up by more than inflation, but they see no benefit, and pay more tax at 40% as their earnings rise.

Perversely, this approach to raising the personal allowance and funding it by lowering the 40% threshold has the opposite effect on National Insurance, because the 40% threshold and the NIC upper earnings limit are now always set at the same amount, which is fixed, its value eroded each year by inflation. With the NIC starting point rising with RPI each year, the amount of NIC at 12% payable by workers shrinks, to be replaced by the charge at the lower 2% rate.

If we ever reach a £10,000 personal allowance, with the NIC threshold matching it, the 12% NIC band could be worth only £32,475, compared with £38,150 at the start of this Parliament. This reduces employee NICs for higher earners by up to £567 a year. Since there are already 4 million people in the 40%-plus bracket, the cost to the NI Fund from this one policy could be around £2.3bn a year, rising as more people are dragged into the 40% net. And there will be no offset for savings in state second pension (S2P) payments, as the last government froze the upper limit for S2P base earnings at £40,040 – below the now-frozen upper limit for 12% contributions.

Every time the Chancellor repeats the allowance trick, his NIC take falls. Few people ever expect reverse fiscal drag, but that’s exactly what we have in NIC terms. It would seem the only way to keep the NI Fund in balance is to up the NIC rate – watch this space…
7. Dissolving your company? Should you take action before the end of February?

New legislation is due to come into effect from 1 March 2012, which will affect companies being wound up. The proposed new legislation introduces a £25,000 cap to the total distributions which qualify for capital treatment, and there are some hidden complexities, so companies who have started this process should aim to complete before the end of February.

The current legislation, Extra statutory Concession C16 (ESC C16), has historically provided many companies with a cheaper, and more tax effective, way of closing down their company. Where ESC C16 applies, distributions under dissolution may be treated as a capital payment rather than subject to income tax, thus avoiding the expense of a formal winding-up process.

The stated intention of the new legislation was to formalise the extra-statutory concession, however the proposed £25,000 cap on the total distributions that qualify for capital treatment at has led to on-going discussions with HMRC and the Government over whether this limit is appropriate, with many feeling it should be higher.

Some companies may have rushed to obtain HMRC approval that ESC C16 applies to them, in the hope that they can then dissolve their company under the ‘old rules’. However, HMRC have indicated that, even where such approval has been granted, there could be issues if distributions from the company straddle 1 March. Their interpretation of the rules is that any pre-March distributions are taken into account when looking at whether the £25k limit is breached for post-1 March distributions. If the total comes to more than £25k, then all of the distributions made after 1 March could be liable to income tax.

Several of the professional bodies are in on-going discussions with HMRC and the Government on this point. However, until clarity is obtained, companies who are already going through this process should note that the timing of the distribution payments may be key in determining the tax treatment. They may therefore wish to ensure that, where commercially practical, they make any necessary distributions prior to the 1 March to get clarity on their tax position.
8. UK CFC reform – latest developments

After nearly five years, the end is finally in sight for the UK’s long-awaited reform of its controlled foreign companies (CFC) rules.

The rules were first introduced in 1984, to prevent UK group’s avoiding tax by accumulating profits offshore in low-tax territories or tax havens, unless there were overwhelming commercial reasons for the arrangement. Despite modifications over the intervening period of nearly thirty years, the current rules are fundamentally the same, despite business practice and the tax rules of the UK’s competitors having changed greatly over that period.

The government launched a consultation exercise on reforming the rules back in 2007. After numerous twists, turns and redrafts, it introduced ‘interim improvements’ in 2011, which were intended to be a temporary easing of the existing measures, ahead of full reform. Draft legislation reflecting the intended permanent new rules was finally issued just before Christmas and this was supplemented by the issue of a final tranche of draft legislation on 31 January. The consultation period on this legislation ends on 10 February and the new rules will be implemented in this year’s Finance Act, to take effect from 1 January 2013.

The positive news is that, despite the long, and at times tortuous, path that has been taken to reach this point, the proposed new rules contain numerous new exemptions and partial exemptions that were not present in the old legislation. As a result, they are much more accommodating of modern business practice. They also help to address the UK’s tax competitiveness gap compared with many other of our European neighbours who do not have CFC rules, whilst still trying to protect the UK tax base from the artificial diversion of profits to low-tax offshore jurisdictions.

The cost of this is a huge increase in complexity. This is not helped by the far from helpful structure of the new legislation, which no doubt reflects the inelegant process by which the current proposals have been arrived at, and also the rapidly dwindling time remaining to HMRC and the parliamentary draughtsmen before the March Budget. Baker Tilly has responded to the consultation with constructive suggestions to help address these shortcomings, though it remains to be seen to what extent these are reflected in the draft Finance Bill 2012 when it is published on 29 March.

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