Simpler income tax for the smallest businesses

Comments from ACCA to the Office of Tax Simplification, June 2012.

Executive summary

ACCA believes in the simplification of tax for all businesses, and indeed all taxpayers. Small businesses are an excellent place to start on tax simplification; they are by definition engaged in the pursuit of profit, but it is now well established that the burden of tax administration and compliance costs bears down disproportionately upon them. Those businesses for whom financial profit is the primary motivation will welcome any reduction in their administrative costs and burdens. In cases where the primary motivation is for example life style benefits of self-employment, freeing up the owners’ time from non-productive work to spend on other activities will be a genuine benefit, albeit not directly financial.

There are over 1.2m of low income micro-businesses, around 20% of all businesses, and 14% of all self-assessment return compilers. Too often, tax policy for SME’s is predicated on the myth that all SMEs want to grow, and that tax is a suitable policy weapon to address the causes of their failure to grow. The current proposals reverse this trend, and are aimed squarely at small businesses which do not grow beyond a certain level.

The majority of incorporated SMEs in the UK are in the financial sector, and can so be expected to have a greater level of financial awareness than those in say the agriculture and fishing sector (which is dominated by unincorporated businesses). Equally, it is more likely that businesses in the financial sector are likely to grow beyond the point where simplified accounts would remain appropriate, whereas the scope for growth is typically smaller in other sectors. The introduction of simplified accounting for just the smallest businesses will aid those most in need of it, but should be targeted specifically at them.

Response to consultation questions

Question 3: If you don’t think the proposed entry and exit limits above are appropriate, what figures would you suggest instead?
In our response to earlier consultations by the Office of Tax Simplification, ACCA recommended the introduction of a simplified tax regime, but at a lower level of income than is currently proposed. ACCA is concerned that the upper limit of £150,000 goes beyond the policy objectives of simplifying taxation for the smallest businesses.

ACCA recognise that there is considerable variation between different sectors, and the turnover levels needed to conduct a viable business in some lower margin sectors are far higher than in higher margin activities.

Nevertheless, extending the regime to cover businesses beyond the ‘hobby’ or ‘subsistence’ type of activities runs the risk that larger commercial undertakings will use a system which is inappropriate for effective long term financial management. This carries a corresponding risk to both the owner of the business and other affected stakeholders.

We would observe that linking domestic direct tax thresholds to current VAT measures will not necessarily represent a useful simplification in the long run. The UK tax registration limit is the highest in the EU by some margin, and it is not inconceivable that the VAT regime may be subject to considerable revision as pan-European simplification and modernisation is pursued. It is also not clear whether the intention is to revise the thresholds for simplified direct taxes in line with the annual revisions of VAT thresholds. To do so would again run counter to the simplification agenda.

Question 4: Should new small businesses be required to make an active choice between the cash basis and the normal rules? Alternatively should the cash basis apply to a new small business by default, unless they indicate otherwise?
Businesses should be clearly informed in the supporting material when registering for tax of the implications of their choice, and then be free to choose the appropriate accounting method. Imposing a default option runs the risk that serial entrepreneurs or others with some accounting knowledge might opt to maintain accrual accounts only to discover at year end (or even after submission) that these are not suitable for the tax regime which is being applied to them.

For those for whom the cash basis is appropriate, they will have some guidance from the very beginning of their business on what records they need to keep. . Those businesses which are likely to grow to a point where the cash basis will no longer apply will in general be operated by individuals with sufficient financial knowledge to appreciate the burdens and benefits of full accrual accounting.

In those few cases where an individual might generate significant income, but not have financial acumen (eg artists, entertainers or sportsmen) it is to be expected that they would engage advisers to assist in the operation of their business. Whether such advisers are engaged before the first decision to trade independently is made, or at a later date when the business is already established, the adviser should as a matter of course be able to deal with any complexity arising. Complexity at this level is not going to be such as to cause problems for professional advisers, although it must be recognised that it will introduce an extra element of administrative time for which they would need to be reimbursed.

Question 5: Are there any issues or transactions relevant to small businesses eligible to use the cash basis that have not been considered or addressed adequately?
The issue of foreign residents eligible to use the cash basis merits further consideration. The consultation paper does not address the issue of how profits would be apportioned to the UK activities of say a small market trader who operates across borders. If applied solely to cash receipts received in the UK and expenses paid in the UK there is a clear risk of double taxation to the extent that the associated stock costs of the UK income are not relieved. Forcing such businesses to enter the world of double tax relief calculations predicated on different calculations of income does not constitute a simplification.

In many cases at the moment, and overseas based business coming into the UK to do business has probably already had to overcome significant logistical hurdles, and may be able to cope with such a burden. However this is not the case for businesses crossing land borders, such as from the Ireland to Northern Ireland, or potentially in the future from Scotland to England, depending upon the future shape of any devolved tax administration.

Question 6: Are there any significant tax avoidance risks, which would not be adequately controlled by the proposed design?
While it is impossible to predict the shape of the commercial and legislative landscape in the future, the major risks do appear to have been identified and dealt with at this stage.

Question 7: Do you agree that the same rules should apply to barristers or advocates, and the current special rules for barristers or advocates should be withdrawn?
While there are arguments in favour of aligning the treatment for all small businesses, barristers as a clearly defined group suffer in particular from cashflow restrictions in their early years, making cash accounting particularly suitable for them, regardless of actual income levels. As the existing scheme is well known and operates effectively for those to whom it is relevant, the requirement for transitional rules 

Question 8: Is a statutory restriction on switching between the ordinary and cash basis needed? If so, how should the restriction operate?
Yes. The potential for abuse of the parallel regimes justifies a restriction. In the absence of any such restriction, compliant business will be forced to consider on an annual basis which regime may best suit them for the coming period simply in order to remain competitive with those businesses who are prepared to ‘fine tune’ their operations to such an extent. It is to be expected that in almost every case the burden of calculating and comparing results under the two different regimes would exceed the difference between them, changing what is supposed to be a simplification into an extra burden.

Restricting changes to once every three years would strike a suitable balance between flexibility and simplicity.

Question 10: What are the pros and cons, as well as any other implications, of the cash basis? Please list these.
One aspect of the proposals which is not explored in the consultation document is the impact on small businesses who may currently use their business accounts for purposes other than preparing their tax return.

Such uses would typically be related to the raising in one way or another of finance, whether for personal or business related purposes. The existence of ‘a set of books’ will be of more or less comfort to any proposed lender. The lender will be able to make a decision, based on their own knowledge of the applicant and of similar applicants, as to the level of reliance they should place on those books as being an accurate representation of the individual’s credit-worthiness.

It remains to be seen what level of comfort, if any, a lender could draw from a properly prepared current cashflow statement. In particular, the lack of any kind of balance sheet, or list of assets and liabilities, would leave a lender totally in the dark as to the future solvency of the aspiring borrower.

The arguments would be similar whether the borrowing was to take the form of a capital injection into the business, a specific loan to purchase plant or equipment, or simply a mortgage application.

Individuals who have perfectly properly prepared their cashflow statement would be at a disadvantage compared to those who have gone to the trouble and expense of drawing up traditional accounts which give some indication of potential future cashflows as well as past flows.

It is of course not a tax consideration that the figures prepared for tax purposes might be of no use to other users. Indeed, one of the arguments regularly put forward for small businesses not to have to prepare formal accounts is that the tax authority is the only significant user of them. In all but the tiniest of businesses this is not an argument that ACCA has ever agreed with, and we would in any event maintain that for any activity which seeks to turn a profit, the ability to recognise which efforts are generating a return and which not is essential. Profits being a function of numbers, getting a handle on the numbers is therefore vital.

Question 11: Do you have any comments on the tax impact assessment for the cash basis in Chapter 5?
The impact assessment refers in passing to the interaction between the calculation of income for individuals and the benefits system. Though not specifically mentioned in the consultation, it is assumed that the calculations of income used for tax purposes under this method would also apply for calculating liabilities to National Insurance Contributions.

Care must also be taken to ensure that the change of basis does not cause difficulties with income based benefits calculations.

Question 12: Would a 3-tier banded rate or single fixed rate for business use of home strike the most appropriate balance between simplification and fairness?
Given the policy aim of simplification, a single fixed rate for use of home would be appropriate. However, it is not clear from the consultation which activities would qualify for a deduction and which not. In particular, the exclusion for “preparation of…cash income calculations” may be problematic. For many small businesses it may be hard to distinguish between the inherently trade related activity of writing up sales and purchases, and preparing the cash income calculations. Stock control is an integral part of running a successful business for a small retailer, and is core to remaining profitable. Placing orders for new stock is part and parcel of ‘providing goods to customers’ and would need to be included in the list of activities which contribute towards the use of home allowance.

However, distinguishing this from the preparation of figures for tax purposes would be unduly complicated for a small business, involving a degree of fine judgement which runs counter to the proposed simplification aims.

Under the three tier system, businesses would be required to retain a rolling record of work undertaken for each month in order to support the deduction claimed for that month. Given that the majority of businesses in the scheme will be paying tax a t a marginal rate of around 20%, the value of the distinction will be up to £10 per month, or £120 over the year under the three tier proposal.

Question 13: Are there any issues or transactions relevant to businesses eligible to use simplified expenses that have not been considered or addressed adequately?
In the context of micro businesses eligible for the cash basis, ACCA would welcome an exploration of whether business entertaining expenses should qualify for a deduction. The treatment of such expenditure is problematic even for large businesses, Removing that burden from micro business would further the simplification agenda. Business entertaining is typically associated with growth in sales, which is typically less relevant to a lifestyle or ‘subsistence’ micro business than it would be to a high growth start-up of the type which is less likely to use the simplified accounting and expenses methods.

The rationale for denying any deduction for interest also remains unclear. The timing of the deduction for business costs is, over the life of a business, less important than its overall deductibility. Two otherwise comparable businesses will pay the same tax on differing levels of real net income over their lifetime if one borrows and the other does not under the cash basis, whereas under the ‘full’ accounts rules, the two companies’ calculations would be the same.

Question 14: Do you have any other comments on the details of the proposals for simplified expenses?
The commitment to reform of the guidance on subsistence expenses, while not a change to the system itself, is welcome. Equally, the proposal to simplify treatment of phone and internet costs is welcome. In practice, given the relatively low cost of handsets and contracts, many small traders will already have a dedicated phone for business use, personal use of which is minimal. For broadband an internet connections, calculating the marginal cost of either personal or business use is virtually impossible, so the simplification is the only sensible course.

The proposals for stationery and the like however, do not immediately seem so useful. Attempting to calculate costs based on a unit price for business transactions is unlikely to represent a reduction in administrative burden, and may even increase it. Rather than simply assessing use broadly at the end of a period, businesses would need to maintain accurate contemporaneous records of correspondence. Moreover, there is a risk of distortionary behaviours if businesses decide the can ‘make a profit’ on short letters; they will be tempted to generate otherwise unnecessary paperwork. While the monetary sums involved for each individual business may be small, the cumulative impact on the Exchequer could be significant. However, in the absence of detailed figures and research to support any proposed revision to the current treatment, it is not possible to conclude which is the better option; apportionment or flat rate deduction. Simply allowing a deduction for all stationery, as with telephone and broadband costs, would represent a genuine simplification.

Question 16: Do you have any comments on the tax impact assessment for simplified expenses in Chapter 5?
The net fiscal impact of the simplified regime is to increase the financial burden of taxation on small business. For many, this would be offset by the financial saving associated with implementing the cash basis for calculation of profits. However it is not clear whether any detailed work has been undertaken into whether the simplified basis would be more or less attractive to those businesses for whom it would be voluntary, and accordingly whether there is any likelihood that they would be inclined to take it up.

If the impact of the simplified basis on businesses which are not using the cash basis is to increase their tax bill by more than the associated administrative reductions (bearing in mind that these businesses will be preparing full accruals based accounts) then its value to the economy as a whole will be called into question. Assuming the aim of the package to be promotion of economic growth rather than protection of Exchequer revenues, this might call into doubt the overall utility of the optional expenses elements of the package. The existence of not two but three different regimes for small businesses (cash/simplified, accruals/simplified, accruals/actual) would inevitably increase complexity. With this in mind we would suggest further detailed analysis of the expected costs and benefits of the optional simplified expenses regime for all parties.