Policing the tax frontier - family businesses in the firing line?

15 December 2015

George Bull

HMRC has got a predicament on its hands when it comes to policing the boundary between low corporation tax rates, capital gains tax for individuals, and income tax. This continuing trend away from taxing companies and instead taxing individuals means change is on the horizon, and could family businesses be next in the firing line?

No, this isn’t another article about the OECD tax initiative. Nor do I mean the border between England and Scotland. What I am thinking about here is HMRC’s predicament in policing the boundary between low corporation tax rates (20 per cent: set to reduce to 18 per cent by 2020) in England and Wales, capital gains tax for individuals (with rates varying from 10 per cent to 28 per cent) and income tax. The top ‘headline’ rate of income tax is 45 per cent but (even ignoring the ‘boundary effects’ which produce astonishing marginal tax rates when various tax reliefs or allowances are withdrawn) when added to employee’s and employer’s national insurance contributions, the tax/NICs liability can easily exceed 60 per cent.

In other words, income paid out of companies is taxed heavily; profits retained within companies are taxed much less severely.

It will come as no surprise, then, that this changes the way business owners behave.

For those tempted to accumulate profits at a relatively low rate of tax within their companies, then liquidate the company and pay only capital gains tax on the proceeds, disappointment may be just around the corner. In such circumstances, next year’s Finance Bill will impose an income tax charge on owners of close companies: should they become involved in a similar business within the next two years they are at risk of having their entrepreneurs’ relief withdrawn and the proceeds taxed as dividends.

But what about close companies – those controlled by five or fewer shareholders – who are continuing to trade profitably? Where profits exceed the immediate needs of shareholders/directors, excess profits can be left in the company and taxed at 20 per cent. That too may be about to change. With the future of corporation tax under the spotlight, HMRC is known to be looking at ‘solutions’ to what it regards as a ‘problem’ in ways as diverse as: 

  • making small companies tax-transparent so that all their profits are taxed on their owners at income tax rates;
  • taxing as dividends paid to shareholders those company profits which haven’t been distributed and which the company directors can’t prove are needed for future business purposes. Perhaps there really is nothing new under the sun: years ago the UK had just such a system. In those far-off days, it was called ‘close company apportionment’ and – in summary - was a complete nightmare for both the taxman and the company. If we are to return to anything like that, let’s hope the 21st century version doesn’t rely on tax inspectors second-guessing the business decisions of company directors who are trying to do their best in difficult situations. However, the taxman may be rubbing his/her hands with glee at the prospect of collecting 45% income tax instead of 20% corporation tax.

While it’s too early to say what will happen, the continuing trend away from the taxation of companies and towards the taxation of individuals makes change inevitable.

Unless of course the Treasury decides to raise UK corporation tax rates and so surrender its crown of offering the lowest business tax rate in the G20. Unless that happens, government-led international business tax competition seems set to increase tax bills for family companies in England and Wales.