small business taxation: policy issues and the uk

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SMALL BUSINESS TAXATION: POLICY ISSUES AND THE UK

Judith Freedman*

Introduction‘Small business’ is a buzz phrase to governments. Small businesses are associatedwith entrepreneurship, economic growth and job creation. There is a largeliterature on the validity of these associations and it is quite clear that not allsmall businesses are entrepreneurial.1 On average, small firms tend to providelower productivity, lower wages and less secure jobs than large companies.2

Nevertheless, among major industrialized economies, there is a positivecorrelation between entrepreneurship and the level of per capita GDP as well aswith GDP growth.3 Most new jobs in Europe are being created by microenterprises.4

This has led governments to search for methods of boosting entrepreneurshipand small business tax reliefs are a feature of most tax systems as a result. Thesereliefs raise many questions about equity and efficiency. They also increase thecomplexity of the tax system. This can itself be a disadvantage for small businesses,given the regressivity of compliance costs. On the other hand, special reliefs havecome to be expected by small businesses and, having been introduced, are hard toremove. The best reliefs level up an uneven playing field, giving small businesses

1. Storey, Understanding the Small Business Sector (London and New York: Routledge, 1994)2. Cosh and Hughes (eds), Enterprise Britain ESRC Centre for Business Research, University of Cambridge

1998 cited in Institute for Fiscal Studies, The Green Budget: January 2000 (London: IFS Commentary 80, 2000).

3. Bridging the finance gap (Consultation document) (London: HM Treasury 2003). 4. European Commission SMEs in focus: Main results from the 2002 Observatory of European SMEs

(http://europa.eu.int/comm/enterprise/enterprise_policy/analysis/doc/execsum_2002_en.pdf ). For statistics on US small businesses see the paper by Professor Karlinsky in this volume. In Australia small businesses generate 30% of economic activity and the number of small businesses has grown by 3.5 per cent per annum since 1983 compared with growth of 2.5 per cent for large businesses employing 200 or more (Commonwealth of Australia: Annual Review of Small Business 2002).

* KPMG Professor of Taxation Law, University of Oxford and 2003 ATAX Visiting Fellow. This paper draws upon a paper written in 2002 with Malcolm Gammie (both authors acting as Senior Fellows of the Taxation Law and Policy Research Institute, Deakin University, Melbourne). The author acknowledges the input of Malcolm Gammie and is grateful for his comments and those of Maurice Parry-Wingfield on this latest version but she alone is responsible for its current contents. She is also grateful to Atax and to those attending the Atax Small Business Symposium in 2003 for their support and comments on the first draft of the paper.

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14 TAXING SMALL BUSINESS

an opportunity to get established, but the worst actually create distortions. Evenderegulatory measures can give rise to complexity if poorly designed – thephenomenon of complex deregulation.5 A major question is whether particularreliefs actually achieve the aim of boosting entrepreneurship or in fact largelyresult in a deadweight cost. Targeting reliefs is a major problem.

This paper starts by examining the arguments for and against specialtreatment of small and medium sized enterprises (SMEs) and outlines the type ofpolicy initiatives that these arguments would seem to favour (Part I). The paperwill then discuss, briefly, some definitional problems, which are a key issue andcan themselves cause complexity with proliferating thresholds for differentpurposes (Part II). In Part III, the paper will examine the UK tax treatment ofsmall businesses in outline, measuring this up against the benchmarks suggestedin Part I, and Part IV concludes.

Part I: Should tax systems favour SMEs?6

There are several arguments for tax measures favourable to SMEs.First, there may be market failures that affect small firms, such as asymmetric

information, for example on markets or products, monopoly power of large firmsmaking entry into the market difficult, or difficulties for small firms in raisingfinance. These may be used as a justification for general tax reliefs or for specificschemes to promote investment in small firms.

Second, it may be important to counter the disadvantages of being small byspecial measures, as in the case of the regressive nature of burdens on business.Compliance cost work in various countries7 has established the regressive natureof tax and other burdens on small businesses and this is widely accepted as beinga problem that may legitimately be addressed by reliefs and exemptions and byremoving certain reporting and disclosure requirements from small firms.

Third, losses bear more heavily on SMEs than on other businesses. Tax is paidimmediately on taxable profits, but relief for tax losses may have to wait until thebusiness generates sufficient taxable profits to absorb past accumulated losses.

5. A term coined and explained in Freedman, ‘“One Size Fits All”– Small Business and Competitive Legal Forms’ (2003) 3 JCLS 123.

6. This section draws on OECD, Taxation and Small Businesses (Paris: OECD, 1994) and Institute for Fiscal Studies, Green Budgets 1999 and 2000 (London: IFS).

7. For example Sandford, Godwin and Hardwick, Administrative and Compliance Costs of Taxation (Bath: Fiscal Publications, 1990); Evans, Ritchie, Tran-Nam and Walpole, Taxpayer Costs of Compliance (Canberra: Australian Taxation Office, 1997). For reviews of the compliance cost literature see Pope and Sandford in Lamb and Lymer (eds.), Interdisciplinary Research in Taxation: Research Approaches and Bibliographic Survey (London: ICAEW, 1999) and Chittenden, Kauser and Poutziouris, ‘Tax Regulation and Small Business in the USA, UK, Australia and New Zealand’ in (2003) 21 International Small Business Journal 93.

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SMALL BUSINESS TAXATION: POLICY ISSUES AND THE UK 15

This is less of a problem for mature firms, which are likely to be generating profitsfrom existing business and can claim immediate relief for any loss on the newinvestment. This option is not open to new firms without existing taxable profits,so that there is discrimination against investment spending by new firms, or bysmall firms during a high-growth phase in which investment spending is highrelative to current profits. The same is true for high-risk investments, where thedifferent availability of loss reliefs and the risk of catastrophic failure are likely tofavour investment by mature firms as compared with start-up firms.8

Fourth, and underlying also all the other reasons, it might be argued that smallcompanies generate such benefits for the rest of the economy that they should bepromoted by government policies.

There are, however, many problems with ensuring that the objectives outlinedabove are satisfied through special small business tax reliefs.

First, there is the issue of targeting. When politicians talk about smallbusinesses, they generally give the figures for all small businesses in existence, yetthose of importance to the economy in terms of likely growth and job creationmake up a much smaller number.9 It is notoriously difficult to distinguish growthand non-growth businesses ex ante.10 Reliefs aimed at all small businesses areavailable, inevitably, to non-growth firms, so called life style businesses and evenbusiness operations which governments aiming at growth and job creation wouldnot consider to be ‘genuine businesses’ but rather ‘disguised employees’. Indeed,the creation of reliefs and exemptions may result in the reorganisation of businessactivity in order to create ‘small businesses’ at least partly in order to obtain thetax advantages: an activity sometimes characterised by government as taxavoidance.

Second, the provision of tax reliefs and exemptions for small businesses runscounter to the key principle of neutrality. It may distort the choice of businessorganisation, commercial decisions about forms of expenditure, timing andmethod of change and transfer into other hands. Reliefs might even result inbarriers to growth at the margins if restricted to businesses below certainthresholds. It is arguable that a simple and neutral system of business taxationcould be more important to small businesses than many special provisions, whichcreate a complexity of their own.

8. IFS Green Budget 2000 ch. 8, supra fn 6.9. As discussed in Part II below.10. Attempts have been made to predict which firms will grow based on such factors as the characteristics of

the owners. Even these have limited predictive value ex ante and they could certainly not provide the basis for differential tax regimes: See Storey, supra fn 1 at p 158.



Third, tax incentives and reliefs to small business may result in economicinefficiency if they interfere with the market and result in the allocation ofresources to small, less efficient, firms rather than to larger, more efficient, ones.Alternatively, they may not be effective at all.

In a report on this topic the OECD comments that, from a strict economicefficiency viewpoint, all special provisions for small businesses need to bejustifiable in terms of market failure or malfunction.11 It recognizes, however, thatthere may be objectives beyond pure economic efficiency, such as encouragementof economic growth or income distribution, which might justify special tax andother provisions for small firms.

The OECD also recognises that it is possible to argue that certain obstaclesthat appear to hinder small businesses, such as lack of finance in somecircumstances, are manifestations of market imperfections. These argumentsdepend upon the belief that the market economy allocates resources inefficientlybetween small and large firms and that the government can intervene effectivelyusing tax policy to bring about a better allocation of resources. Market failures ofone form or another may be pervasive, and government intervention may producebetter outcomes in many contexts. But government intervention can also produceunintended results, and this is particularly true when governments try to use thetax system to bring about some change in behaviour. The market could be gettingit right and there might be good efficiency reasons why there is a lack of financefor some activities or types of firm.

Tax measures are most likely to improve on the free market outcome insituations where the nature of the market failure is clear (such as inability of firmsto raise funds for worthwhile projects with a good chance of success). In additionthere needs to be evidence that the failure is significant, and a tax measure mustbe available that tackles the source of the inefficiency, has a significant effect onthe behaviour in question and does not produce major distortions elsewhere. Thiswill be quite a rare combination of circumstances. Where market failures aresuspected but their effects are unclear, or where the effects of a particular tax policyare highly uncertain, there is a strong case for introducing measures on a pilot basisand evaluating their effects, before proceeding to nation-wide implementation.12

The OECD recommends that countries must first decide what problems arefaced by small businesses and then, if they consider the problems are sufficient towarrant government action, the relative merits of preserving a neutral tax system(in so far as one exists) and using direct expenditures to pursue small business

11. Supra fn 6.12. IFS (2000), supra fn 6.



policy objectives should be considered, since non-tax measures will often be bettertargeted than tax measures.

This analysis of the arguments for and against special tax measures for SMEssuggests benchmarks against which to test small business tax provisions. Inpractice, measures introduced to assist SMEs often do not accurately address theproblems identified here. For example, given that SMEs often make losses in theirinitial years, it can be questioned whether higher depreciation or other taxallowances and reductions in tax rates are as valuable as they may initially seem.They provide larger initial tax losses at start up (which cannot be sold in mostsystems due to anti-avoidance provisions) without the benefit of immediate relief.At the same time they may incur cost to the exchequer by benefiting alreadyprofitable firms through a reduction in their tax bills. This points to a need to paycredits in some circumstances, as recognised in the R&D tax relief now availableto SMEs in the UK. The finance leasing industry absorbs some of these taxallowances and passes some benefit on to small businesses in the form of lowerfinancing costs, but part of the relief intended for the small firms is then pocketedby the lessors.

Reductions in formalities for small firms which address the very realcompliance cost issues seem more likely to be helpful, although not if deregulationresults in the creation of thresholds which create barriers to growth, or encouragesmall firms to engage in poor practice (for example regarding account keeping)which inhibit development.

Reliefs designed to meet lack of finance for small firms are commonly foundin tax systems. To some extent it is arguable that the higher risk of lending to smallfirms should be reflected in the cost of borrowing in order to allocate resourcesefficiently and prevent the creation of moral hazard through uncompensated riskshifting, but there may be market imperfections such as lack of information aboutsmall firms and excessive caution by conservative lenders, as well as hightransaction costs for smaller loans. Here some tax relief might be acceptable,although some deadweight cost is to be expected and some inefficient fundingmay be supported.

In designing measures to assist small businesses it is vital to look at the needsof different parts of the sector separately. The evidence may be that overall thereis not a great funding gap, for example,13 or that only a small percentage of SMEsperceive employee share schemes as a potentially useful instrument,14 but it could

13. Bridging the finance gap, supra fn 3.14. 10%, according to the 2002 Observatory of European SMEs (European Commission: Highlights from the

2001 Survey 2002/ No 1) (http://europa.eu.int/comm/enterprise/enterprise_policy/analysis/doc/smes_observatory_2002_report1_en.pdf ).



be that assisting the small minority which do require such help would amount toa well targeted relief, if the firms which are seeking such assistance are firms whichare likely to grow and create jobs. Such demand led reliefs maybe the mostvaluable even if they are not widely needed.

In order to understand this need to look at different parts of the SMEgrouping differently, it is important to have some background information aboutthe small business sector.

Part II: What is a small business?The heterogeneity of the small business sector is well known15 and one of themajor difficulties of designing policy for this area is that many different groupsare lobbying for preferences under one description but in fact covering a widerange of diverse interests. Reliefs introduced for very small firms are oftenextended to larger firms under such pressure and the threshold is always very hardto draw. Often it is reasonable to ask why a relief made available to one groupshould not be extended to larger firms and the answer may be a purely pragmaticone based on cost. If that is so then the rationality of the relief may need to bequestioned. On the other hand the value of reliefs may be reduced if they areextended too far up the scale so that there is a consequent need for anti-avoidanceprovisions, for example.

There are strong arguments for a uniform definition for all purposes for thesake of clarity and simplicity. In practice, however, it is clear that differentfunctions require different definitions. Attempts are often made to formulatequalitative definitions based on concepts such as ownership and control, but theseare unlikely to operate adequately within a tax environment, where objective,quantitative measures are needed.

It is clear from the statistics that the vast majority of businesses in the UK andEurope are small under any definition. In the UK there are around 3.7 millionbusinesses (incorporated and unincorporated).16 Of these, nearly 2.6 million haveno employees and 99% have fewer than 50 employees. There are fewer than 7,000businesses with over 250 employees (large businesses), but it is to be noted thatthese large businesses account for 45% of non-government employment and 49%of turnover. Thus, defining small businesses as those with fewer than 50

15. Hertz, In Search of a Small Business Definition (Washington D.C.: University Press of America, 1982); Freedman, ‘The Quest for an Ideal Form for Small Businesses – A Misconceived Enterprise?’ in Rider and Andenas (eds.) Developments in European Company Law Volume 2 (London: Kluwer Law International, 1999).

16. Statistics are from the start of 2001 and taken from the UK government Small Business Service website (www.sbs.gov.uk/content/statistics/stats2001.pdf ).



employees, 99% of all UK businesses are small and they account for 43% of non-government employment and 36% of turnover.

A similar picture can be seen in Europe more generally. There are 20.5 millionenterprises in the European Economic Area and Switzerland. The generallyadopted European definitions of size are on the basis of employee numbers, andthe breakdown across Europe is as follows:

Table 1

Figures from Observatory of European SMEs 200217

In some European countries a relatively high number of SMEs want to grow (34-41% in the UK, Italy, Greece and Ireland) but in other countries as few as 15%of SMEs want to grow (Austria, Finland and Germany). SMEs account for a highpercentage of employment in Europe overall – 66% as compared with 33% inJapan and 46% in the USA.18

84% of European SMEs that needed a loan in the last three years obtained theloan, but almost 40% of the SMEs in the survey did not need a loan, reflectingthe fact that many have no desire to grow. 12% reported that they did not get theloans they needed and 23% of these gave the reason for this as being that theycould not provide enough collateral.19 This is consistent with information onborrowing from the UK that overall SMEs in the UK do not have financingproblems, with many SMEs without sufficient collateral being able to use theSmall Firms Loan Guarantee scheme. A gap was identified, however, in the caseof young or potentially risky SMEs with high growth aspirations. As can be seenfrom the figures, these are a minority but they may be an important minority interms of growth. They require equity rather than debt finance and this suggests anemphasis on equity capital provision in the provision of tax incentives.20

A complicating factor in considering tax provisions for small businesses is thatin most countries small businesses operate in a variety of legal forms and that theseforms are treated differently for tax purposes, sometimes out of necessity becausethe different legal forms dictate some differences. It is important to examine

Micro enterprise 0-9 employees 93%

Small enterprise 10-49 employees 6%

Medium sized enterprise 50-249 employees 1%

Large enterprises 250+ employees 0.2%

17. Supra, fn 4.18. Ibid.19. Ibid.20. Bridging the finance gap – supra fn 3.



whether all the differences present are essential, however, since they are complexand potentially create distortions.21

In the UK, the three most widely used legal forms for small businesses arecurrently sole proprietorship, partnership and the limited liability company (thatis the ordinary corporate form, not to be confused with the US LLC). Limitedpartnerships are not used extensively in the UK, although when they are utilisedit is frequently at least partly for tax reasons and usually for raising venture capitalfor property investment rather than for straightforward trading. A new legal formwas introduced in 2000 in the UK, which is called the Limited LiabilityPartnership (LLP) although it is in fact corporate in legal form. Nevertheless it istreated as a partnership for many tax purposes.22 This curious hybrid was notoriginally designed for use by small businesses but rather by professionalpartnerships. Nevertheless LLPs are now being put forward in some quarters assuitable for use by small businesses. It remains to be seen whether they will bedeveloped for their use: they certainly add another choice and anothercomplication from a tax point of view but very few have been created to date.23

There is no standard form constitution for LLPs and there has been someuncertainty about their tax treatment and their accounting position, which hasnot encouraged their use, although the accounting position has now been resolvedto some extent.24

Of the 3.7 million businesses in the UK currently, around 62% are soleproprietors, 15% are partnerships and 23% are companies.25 The focus ofgovernment policy is usually on the corporate sector, which is seen as more likelyto include growth businesses, but the significance of the unincorporated sectorshould not be forgotten. Many small businesses start out as unincorporated andthen become incorporated, so omitting unincorporated firms from targeted reliefscould be a mistake. Politicians and economists too often equate entrepreneurshipwith incorporation without any clear foundation for the omission ofunincorporated firms. It is easier to incorporate in the UK than in other Europeancountries, most of which still have a minimum capital requirement, and so the

21. OECD paper, supra fn 6.22. This gives professional partnerships a measure of limited liability without loss of the advantages they gain

in terms of tax and National Insurance Contributions through transparency. For a detailed analysis of the Limited Liability Partnership Act 2000 and the events leading up to it see Freedman, ‘Limited Liability Partnerships in the United Kingdom – Do they have a role for small firms?’ (2001) 26 The Journal of Corporation Law 897 and Finch and Freedman, ‘The Limited Liability Partnership: Pick and Mix or Mix-Up?’ [2002] JBL 475.

23. There were 4,442 LLPS on the register at the end of March 2003 (DTI: Companies in 2003-4, July 2003, http://wsl.companieshouse.gov.uk/frame.cgi?OPT=about).

24. SORP for Accounting for LLPs 2002. (London: The Consultative Committee of Accountancy Bodies 2002) (http://www.icaew.co.uk/ccab/documents/SORP.pdf ).

25. Small Business Service SME Statistics for the UK 2001, supra fn 16.



percentage of unincorporated firms in those countries is often even higher than inthe UK.

In the UK, as in most other tax systems, each legal form is taxed under adifferent regime, but in the UK the differences have been increased by recentreforms. This is encouraging incorporation for tax purposes, which is leading inturn to anti-avoidance legislation.

Small businesses are defined differently for different purposes under UKcompany law and tax law, but the most common definition is enshrined in theCompanies Act and is derived from EU law.26 Under this definition a company issmall (or medium) if it satisfies at least two of the following conditions• its turnover is not more than £2.8 million (medium £11.2 million).• its balance sheet total is not more that £1.4 million (medium £5.6 million).• it has not more than 50 employees (medium 250 employees).

In May 2003 the EU Council of Ministers increased the EU thresholds by 16.8%and the Chancellor announced in the 2003 Budget that he intends to increasethe UK limits to the maximum permitted under EU law.27 The small businessthresholds would then be: turnover £5.6 million; balance sheet total £2.8 millionand medium sized businesses could have a turnover of up to £22.8 million. Theseare thresholds that would extend far beyond what many would think of as smallbusinesses and the increases raise questions about the suitability of thesethresholds for tax and other purposes. There is currently a consultation underway, for example, about the extent to which the audit exemption thresholdshould be increased and whether this should be linked to the small companiesdefinition.28

The government seems to intend to use the increased threshold for some taxpurposes,29 but in practice this quantitative form of definition is not alwayssuitable for tax purposes, though it is used in some contexts. What is often neededfor tax legislation is a definition of an owner/managed company. The taxlegislation uses a complex concept of close companies to approximate to this insome circumstances.30

26. Section 247 of the 1985 Companies Act implementing EU Directive 78/660/EEC.27. Inland Revenue PN06, Budget 2003.28. DTI, Raising the Thresholds Consultation Document (London: July 2003).29. Inland Revenue PN06, Budget 2003.30. A close company is ‘one which is under the control of five or fewer participators, or of participators who

are directors’. In defining control, regard has to be paid to associates: section 414 Income and Corporation Taxes Act 1988.



Part III: UK Tax Treatment of Small Businesses31

BackgroundThe Labour Government has focused strongly on small business taxation in theUK since it was elected in 1997. This is in tandem with concerns in other areas ofregulation about reducing the burdens on small businesses, encouraginginvestment and enterprise and promoting entrepreneurship. In doing so, they arecontinuing a pattern established by previous Conservative Governments. Smallbusinesses are seen as being ‘an engine of economic growth and job creation’, andtherefore worthy subjects of government assistance. More specifically, it seemsthat often incorporation with limited liability is associated with entrepreneurshipand essential risk taking and therefore seen as something to be encouraged.

Recent UK Budgets have focused on ‘a new enterprise economy’, aiming anumber of reliefs at SMEs on the grounds that this will encourageentrepreneurship and remove tax barriers to small business growth. The aim is totarget growing businesses although it may be questioned whether this targeting isalways achieved. Similar attitudes are widespread throughout Europe and are alsoreflected in European Union policy pronouncements, directives andrecommendations. The Commission’s pronouncements about small firms alsousually focus on entrepreneurship and fast growing small firms, for which theremoval of regional and national barriers is important. This is now dealt with bythe Enterprise Commission. This focus has been criticised by the Economic andSocial Committee. It has stated that32

“…we must avoid unrealistic expectations at this stage which are likelyonly to result in disappointment. There are of course many fast growingfirms, which contribute to the growth of employment. But at the sametime there are also many microenterprises that offer people working forthem a decent standard of living. These firms are not growing howeverand do not want to grow. And yet these often locally operating firms makeup the bulk of the small business sector and play an irreplaceable role inEuropean economies.”

In the UK, sole traders and partnerships are taxed similarly, in the sense that theyare both unincorporated business forms subject to income tax, NationalInsurance contributions and capital gains tax. They can be described togetherunder the heading ‘self-employed’. The essential feature of unincorporated

31. A more detailed but now dated account can be found in Freedman and Ward, “Taxation of Small and Medium-Sized Enterprises.” European Tax 40: 158 (2000).

32. Opinion of ECOSOC on the Communication from the Commission to the Council, Fostering entrepreneurship in Europe: Priorities for the Future (27 May 1998) (IND/668).



business taxation is that business and personal taxation are fully integrated. Bycomparison corporate profits are potentially subject to several layers of taxation.The company will pay corporation tax on its profits, which include capital gainsbut net of salary. Directors and employees pay income tax on their salary. Boththe employing company and the director or employee pay National InsuranceContributions (“NICs”) on salary so that the total payable is considerably higherthan for the self-employed taxpayer or partner. To the extent that the companydistributes its post-tax profits, shareholders will receive a credit, but higher rateincome tax payers will pay additional tax on the dividends. Capital gains tax willbe paid on disposal of the company’s shares.

One way to look at the tax treatment of small businesses is to compare thedifferent ways they may be taxed depending on their legal form and this section isdivided as follows.

A Comparison of how small companies and their owner/managers are taxedrelative to large companies (usually publicly listed), their managers andshareholders.

B Comparison of how corporate SMEs are taxed relative to unincorporatedSMEs.

C Comparison of the relative personal tax positions of the self-employed andemployees.

D A fourth section will review deregulatory measures that apply to all typesof firm.

A. Comparison of the taxation of corporate SMEs and larger companies

Computation of profitsThe aggregate of the company’s income and chargeable gains for the accountingperiod forms its profits for corporation tax purposes. Profits for tax purposesbroadly follow accounting profits although there are case law and statutorydifferences. The starting point is generally accepted accounting practice.33 Theaccounting standards applying to SMEs and larger companies vary as there is aspecial financial reporting standard for small entities (FRSSE) which offersopportunities for some simplification and reduced reporting, but the basicmeasurement requirements are the same.34 In 2001 the Inland Revenue put

33. Section 42 Finance Act 1998 as amended. 34. See the outline on the website of the Accounting Standards Board at www.asb.org.uk/technical/frsse.html.



forward the idea of moving small companies further towards aligning taxable andaccounting profits but seems to have been persuaded that its proposals could notbe confined to small companies as this would have created definitional difficultiesand disparities.35

From 2005, the EU will require all listed companies in Member States to useInternational Accounting Standards (IAS). In the UK, as in most of the otherMember States, unlisted companies will have a choice of whether to use IAS orUK accounting standards.36 It is not clear yet how far the UK standards will followIASs and so it is not possible to say for certain whether this will result in profitmeasurement differences of any significance for tax purposes. A major concernexpressed by consultees about the move to IASs was the impact on taxation,however. Particular mention was made of IAS40, which requires propertyinvestment companies to credit any revaluation of properties to the profit and lossaccount instead of the revaluation reserve, which seems to lead to potentialtaxation of unrealised profits, which is not the case under UK accountingstandards.37 Thus the different accounting requirements could lead to differenttreatment of unlisted firms for tax purposes. The government is now addressingconcerns about the move to IAS combined with moves towards greater alignmentof taxable and accounting profits and has indicated that it understands thepractical difficulties this would create.38

The close relationship between the company and its owner/managers mayraise issues that do not normally have to be addressed by larger companies. Forexample, there are special rules dealing with loans to shareholders by closecompanies.39 There were anti-avoidance rules that attributed profits of suchcompanies to shareholders, but these were complex and unworkable and wererepealed. There have been suggestions that they might be re-introduced due to theincrease in use of companies as a tax shelter as described below.

Capital allowances (investment allowances)In recent years, both Conservative and Labour Governments have enactedmeasures allowing small and medium sized businesses (as defined under the

35. Inland Revenue, A Review of Small Business Taxation Technical Note (London: Inland Revenue, March 2001). Since then, consultation papers on corporation tax reform generally have suggested moves towards greater alignment with accounting profits for all companies but this is not unproblematic and continues to be discussed: Inland Revenue: Reform of Corporation Tax (London: Inland Revenue, August 2002) (hereafter CT 2002); Inland Revenue Corporation Tax Reform (London: Inland Revenue, August 2003). (hereafter CT 2003).

36. DTI News Release P/2003/406 (17 July 2003).37. http//www.dti.gov.uk/cld/iassummary.pdf. 38. CT 2003 and Background Notes, part C. 39. Supra fn 30.



Companies Act but extended to unincorporated SMEs fulfilling the samecriteria) to receive a higher rate of initial allowance on investment in machineryand plant than the 25% allowed for other firms. The Labour Government firstenacted such a measure in 1997 as a temporary measure for a year (at 50%). Itthen extended the measure for a further two years (at 40%), and in 2000extended the relief at 40% indefinitely. The 2000 Finance Act also provided100% write off for expenditure by small companies on information andcommunications technology incurred between 1st April 2000 and 31st March2003 and this has been extended to March 2004 in the 2003 Finance Act. Thismay affect the timing of expenditure rather than overall volume.40 Also, asmentioned above, capital allowances will only assist companies once in profit andthen will be of value only to the level of the corporation tax payable, which in thecase of small companies in the UK is a reduced rate. Thus the enhanced capitalallowances offered are not as valuable to business as might at first seem and thiscan be seen by the low level of government expenditure they produce. Theimpact on levels of investment is therefore unlikely to be significant.

The 2002 consultation document on Corporation Tax suggested a move awayfrom the current capital allowances regime towards a system of following accountsdepreciation. The 2003 document reported that concerns were expressed byrespondents that such a regime would be less generous than the present regime insome sectors and that introducing tax considerations into the judgement aboutcommercial depreciation might result in biases in the commercial accountingtreatment of capital assets. The 2003 Budget press release announcing extensionof the special relief for IT expenditure does not suggest that capital allowanceshave been abandoned as a method of attempting to stimulate investment and the2003 consultation document states that ‘the Government is not committed tochange in this area’, but throws open the consultation to a wider debate on therole of capital allowances and the extent to which they influence the level andtiming if investment.41 Hopefully this will result in some serious research baseddata but the fear is that the consultation process will merely throw up anecdotalevidence, which, if it comes from lobby groups, could simply be self-serving.

Research and development expenditure42

The 2000 Finance Act introduced an enhanced relief for SMEs for R&Dexpenditure. This was extended to all companies in the Finance Act 2002 and the

40. Even the timing effect is not without doubt – see Dilnot and Giles (eds), The IFS Green Budget: Summer 1997, Commentary no 61 (IFS: London 1997).

41. CT 2003 paras 2.49-2.50 supra fn 35.42. Finance Act 2000, Schedule 20.



2003 Budget announced further extensions and consultations on broadening therelief. A report is expected in autumn 2003 from the DTI Innovation Reviewand it is intended that this will, inter alia, review the impact of fiscal policy.

Under general tax principles all companies can claim a 100% deduction forR&D expenditure against current income. The special R&D credits give SMEs afurther deduction of 50% (150% total) and large companies are entitled to afurther 25% (125%) of their qualifying revenue expenditure on R&D. For thesepurposes an SME is one falling within the definition of the EC Recommendationsfor State Aid purposes (reflecting that the relief falls within the State aid rules ofthe EC Treaty). Thus a company is an SME if, together with any company inwhich it holds more than 25% of the capital or voting rights, it has—• fewer than 250 employees, and either or both of• an annual turnover of not more than Euro 40 million (about £25 million)• an annual balance sheet total of not more than Euro 27 million (about £17

million).

A company does not qualify as an SME if 25% or more of its capital or votingrights are owned by enterprises that are not themselves SMEs unless—• those enterprises are public investment corporations, venture capital

companies or institutional investors that do not exercise control either individually or jointly over the company, or

• the capital is spread in such a way that it is not possible to determine by whom it is held, and the SME declares that it can legitimately presume that it is not owned as to 25% or more by one enterprise or jointly by several enterprises falling outside the definition of an SME.

It used to be the case that the SME’s annual R&D expenditure had to be not lessthan £25,000 but the Finance Act 2003 reduces this to £10,000, as the thresholdwas found to be too high for SMEs. The definition of qualifying R&D43 is nowconsidered too narrow and the government is consulting about its extension.44

Currently innovative work in science and technology are included but notcommercial developments without a clear link to such activities.45

An interesting feature of this relief is that if the company has no taxable profitsor has not started trading, it may claim a refundable credit. This is equal to thelower of 16% of the loss46 and the total amount of the company’s PAYE and NICs

43. Income and Corporation Taxes Act section 837A.44. HM Treasury, DTI and Inland Revenue, Defining Innovation (2003)(http://www.hm-treasury.gov.uk/

media/1B65C/Defining%20Innovation_360.pdf ).45. Laing, Defining Innovation. CCH Weekly Tax News issue 272, 1 August 2003.46. 24% of the expenditure incurred – 16% of 150 expenditure being 24%.



liabilities for the period. This recognises the limitations of ordinary reliefs forsmall and start up businesses discussed above and so is a valuable development. Anumber of OECD countries now have R&D credits of this nature, marking atrend away from direct grants and towards indirect assistance on the basis thatbusinesses have better information than governments as regards whichprogrammes of research are likely to be successful. Tax credits keep control overthe nature and direction of research in the hands of the business.47

This measure does not extend to unincorporated SMEs. They and otherentities outside this definition continue to be entitled to the 100% scientificresearch allowance for spending on R&D as defined.

Corporation tax rates and payments on accountThe ordinary rate of corporation tax is 30%. Reduced rates apply, however,where the company’s total profits plus any dividends from other UK companies(other than intra-group dividends) fall below specified limits. These are shown inthe table in the appendix below. Taper provisions at the margins result in thehigher marginal rates shown in the table because the lower rates are phased out asprofits rise. To avoid profit splitting, the limits are divided between associatedcompanies. Nevertheless, some 85% of companies paying corporation tax stillfall within these small profit limits and a further 5% are within the taperinglimits. The lower rates are strictly a “small profits” relief rather than a specificSME relief.

Companies that are liable to pay corporation tax at the 30% rate must makequarterly payments on account of their liability. The instalment payment systemreplaced the liability to account for Advance Corporation Tax (ACT) ondividends, which was abolished from 6th April 1999. Companies must base theirquarterly instalment payments on their estimate of the current period’s profits.Instalments are not based on the preceding period’s results. Companies liable topay corporation tax at the reduced or tapering rates only pay their corporation taxnine months after the end of the accounting period.

The taxation of company owner/managersIn the case of a larger company, there is usually little reason for the InlandRevenue to deny a deduction for the cost of salary and benefits paid to directorsand senior employees. They represent the results of an arm’s length negotiation.In theory, there may be more scope for the Revenue to seek to disallow salary andbenefits paid to an owner/manager that seem excessive. This may be more in

47. Institute for Fiscal Studies, The Green Budget 2003 (London:IFS, 2003).



point where family members are paid for little work to make use of their incometax allowances and reliefs. The settlement anti-avoidance provisions discussedbelow in relation to distributions could also be used here.48

In the normal case, however, SMEs can usually deduct employment costs infull, including the salary and cost of benefits to owner/managers. In fact SMEowners will often prefer to pay themselves dividends as explained below, so thatthe anti-avoidance measure that is really required is to tax excessive dividends asemployment income.49 Employments costs will be subject to income tax(normally collected by deduction at source from the company under the Pay-As-You-Earn [PAYE] scheme) and to NICs (also collected at source). The employingcompany and the individual employee each pay NICs in respect of all salary andbenefits. The rates of NIC for 2003/2004 are shown in the appendix. These rulesare the same for SMEs and larger companies.

DistributionsNeither SMEs nor larger companies can deduct dividends in computing profits.Companies no longer have to account for ACT on paying a dividend. Thedividend forms part of the shareholders’ income. Dividends continue to carry atax credit, and for basic rate and starting rate taxpayers the tax on the dividends isentirely discharged by this credit. This is so even where the nil rate of corporationtax has been applied since, with the abolition of ACT, the credit need no longerbe related to any tax paid by the company. The tax credit is one-ninth, i.e. 10%of the aggregate of the dividend and the tax credit. The dividend and tax creditare treated as the highest part of an individual’s income and further tax must bepaid if the individual’s aggregate income takes him into the higher rate bracket.Tax at the higher rate is normally 40% but dividend income that falls within thatbracket is taxed at 32.5% with a 10% tax credit. This corresponds to the 40%rate on the dividend with the 20% tax credit that existed prior to the abolition ofACT.50

Dividend income is not subject to NICs, so there may be a strong incentivein the case of small companies to pay out profits by way of dividend. This may becounteracted by the Personal Service Companies legislation discussed below. Inaddition, the Inland Revenue have recently confirmed that they might usesettlements anti-avoidance legislation, for example in cases where dividends arepaid to family members and friends and a low salary to the owner/manager or

48. See infra, fn 51.49. See infra, p.37. 50. This complied with the Labour Government’s pre-election pledge not to increase the top rates of income

tax.



where dividends are waived by one shareholder so that higher dividends can bepaid to shareholders paying lower rates of tax.51

Share investment incentives– general provisionsAn individual who borrows to acquire shares in a close trading company, or tolend money to the company, is entitled to relief from tax against his generalincome for the interest he pays on the borrowing. The company must becontrolled by five or fewer shareholders (including their associates) or by itsdirectors, and the individual must own more than 5% of the issued ordinaryshare capital of the company or work for the greater part of his time in themanagement of the company or its associated companies.52

When a shareholder sells shares in the SME, he may have to pay capital gainstax on any gain. Correspondingly, he will be entitled to set any loss against othercapital gains, unless the loss qualifies as a venture capital loss in unquoted tradingcompany for which he can claim relief against his general income. In 1998, theGovernment reformed the taxation of capital gains for individuals and trusts. Itfroze the indexation of base costs at April 1998 and introduced a tapering relief.The first slice of aggregate capital gains for a year (£7,900 in 2003/2004) isexempt from tax. The balance is taxed as if it formed the top tranche of theindividual’s income (so at 10%, 20% or 40%).

Gains are reduced by a specified percentage, tapering according to thenumber of complete years that the asset has been held. The percentage variesaccording to whether the asset is a business or a non-business asset. The maximumreduction after 10 years for a non-business asset is 40%, leaving 60% in charge totax and an effective tax rate of 24% for higher rate taxpayers. For business assets,the maximum reduction after 2 years is 75%, leaving 25% subject to tax (aneffective tax rate of 10% for higher rate taxpayers).

In relation to shareholdings, the following qualify as business assets53 —• any shareholding in an unlisted company• any shares held by directors or employees in a listed trading company

51. Inland Revenue Tax Bulletin, Businesses, Individuals and the Settlements Legislation, Issue 64, April 2003. This statement by the Inland Revenue has been met by an angry response from an almost unprecedented combination of tax representative bodies (including the major accounting bodies) who have issued a paper taking issue with the Inland Revenue’s interpretation and application of the legislation and stating that ‘small family businesses have for decades been organized in a way that now seems to have caused offence to the Inland Revenue’; CIOT, ICAEW, ICAS, ACCA, ATT, AAT, FSB and Working Together, Section 660A: Commentary on Tax Bulletin Article, September 2003 (http://www.tax.org.uk/attach.pl/1932/753/s660A%20paper%20final100903.doc).

52. Income and Corporation Taxes Act, sections 360-363.53. Taxation of Chargeable Gains Act, Schedule A1.



• any shareholdings that command 5% or more of the voting rights in a listed trading company

• shares held by directors or employees of non-trading companies where the shareholder does not have a material interest in the company (broadly a 10% interest, direct or indirect)

Taper relief does not apply to the capital gains of corporations although anindexation allowance is available. Capital gains on disposals of substantialshareholdings by trading companies or members of a trading group have beenexempt from tax, however, since 2002.54 A substantial shareholding is, broadly,10% or more of the ordinary share capital and must have been held for acontinuous period of 12 months during the two years before the disposal. Thisrelief does not of course target SMEs but may encourage investment inshareholdings generally.

Share investment incentives – special provisionsThere is a long history in the UK of offering special incentives for shareinvestment in SMEs. These seem to be under regular review and there is frequentchange. In April 2003 the Treasury published a consultation paper, Bridging thefinance gap, that reviews existing arrangements and considers introducing a UKvariant of the Small Business Investment Company programme (SBIC), whichhas been successful in the United States, according to the paper.55 TheAssociation of Certified Accountants commented that there is already a plethoraof financing programmes in operation in the UK and that the Governmentshould examine carefully the need for a SBIC, and the economic and culturaldifferences in modes of venture capital investment in the US and the UK, beforeintroducing yet another scheme.56 Similarly the Birmingham Chamber ofCommerce noted that ‘If funding gaps are to be filled, [businesses] would find iteasier if existing schemes were extended rather than new ones being created’.57

The Confederation of British Industry is more positive towards the SBIC butalso notes the different cultures in the two countries.58

The Business Start-Up scheme set up in the 1980s and the BusinessExpansion Scheme that followed it were not well targeted and, as a result, were

54. Finance Act 2002, section 44 and Schedule 8.55. Bridging the finance gap, supra. fn. 3. Professor Karlinsky describes the US version in more detail in his

paper in this volume.56. Bridging the finance gap. Comments from ACCA July 2003.57. ‘Funding gap still hampering new businesses’ (http://www.birmingham.businesslink.co.uk)58. CBI Response to HM Treasury Consultation (July 2003) (http://www.cbi.org.uk/ndbs/press.nsf/

33a87f2eee41b54e80256803004f04e4/51a3f6d08874d7e280256d6d003f3825/$FILE/Bridging+the+Finance+Gap+Consultation+-+CBI+Submission.pdf ).



used by tax planners for low risk activities, which needed no subsidy. They werereplaced by the more narrowly drawn Enterprise Investment Scheme (EIS) andthe Venture Capital Trust (VCT) scheme introduced in 1994 and 1995respectively.59 There is also a Small Firms Loan Guarantee scheme, which is not atax relief. A report on the EIS and VCTs was published in April 2003 as part ofthe Bridging the finance gap review of small business finance.60 The reportconcludes that more than half the money invested in the EIS and most of themoney invested in VCTs would not have been invested by those investors in theabsence of the schemes. The schemes also had a positive effect on companyperformance. Post-tax rates of return on EIS investments have comparedunfavourably with rates of return on comparable investments (although this is notthe case for all sub-groups of investors). On balance post-tax rates of return onVCT investments have been about the same as those on comparableinvestments.61 This appears to be a failure of the immediate objective of theschemes as set out in the report itself, which is to improve post-tax return. Evenso the report concludes that the schemes were achieving their ultimate objectivesto some extent. The cost effectiveness of the schemes was less clear and difficult tomeasure without external benchmarks, although it appeared that the EIS wasmore cost effective than the VCT. The report found that the schemes do not paya major role in the overall supply of funds to SMEs but they play a ‘significant andgrowing role in the supply of private equity funds in the UK’.

The Government is now consulting on enhancing the focus of the VCTscheme to make it more clearly focused on smaller, early stage investments andsimplifying and enhancing the flexibility of both schemes. EIS investee companiesare typically younger, smaller businesses seeking start-up or early stage financewith half of all EIS companies raising less than £100,000 through the scheme.VCT investee companies are typically larger and more mature raising an averageof over £1.5 million. Commercial venture capitalists tend to want to invest over£1 million due to high fixed transaction costs, shortage of available exit optionsand a perceived greater risk in investing in early stage companies. While the overallnumber of private equity investments has increased by 17% since 1997, thenumber in the £500,000 – £1 million range has declined by 10%. Government isnow trying to focus on this apparent gap in financing.

59. Finance Act1994 s137 and Sch 15 as amended by Finance Act 1995. 60. Public and Corporate Economic Consultants, Research into the Enterprise Investment Scheme and Venture

Capital Trusts (April 2003) (www.inland-revenue.gov.uk/research/report-pdf ).61. This is contradicted by Cumming, who argues that almost all VCTs have under-performed relative to

comparable stock exchange indices, as well as private venture capital funds: ‘The Structure, Governance and Performance of UK Venture Capital Trusts’, (forthcoming) Journal of Corporate Law Studies (2003). Even if the report for the Inland Revenue is correct, the scheme is falling short of a major objective.



The EIS allows an individual to claim front-end income tax relief at the rateof 20% on subscriptions of up to £150,000 per annum in a qualifying SME. Theshares must normally be held for at least three years and are then exempt fromcapital gains tax on disposal. Where the investor incurs a loss on the shares, he mayclaim the benefit of a separate relief (for the cost of subscription, net of income taxrelief) that is given against other income for investment losses in unquoted tradingcompanies. Investors may roll over gains on other assets into the subscription ofEIS shares.

The EIS relief is denied to individuals who (alone or with their family andother associates) own more than 30% of the company, and generally also to paiddirectors. New investors who receive directorships as a result of their investmentmay still qualify for relief. An SME for these purposes is an unquoted companywith assets not exceeding £15 million immediately before the share issue and nomore than £16 million immediately thereafter.

The three-year qualifying period is seen as restrictive by some investors andthe 2003 consultation document considers whether relief could be tapered torelate to how long the investment was held whilst not losing all of it on an earlysale.

VCTs are collective investment schemes for investing in companies thatsatisfy the EIS tests. Investors in VCTs receive 20% up-front tax relief on theirinvestment of up to £100,000 per year in all VCTs and relief on dividends andfrom capital gains tax. There is CGT deferral where chargeable gains on otherassets are invested in new VCT shares. A VCT may invest no more than a£1million per year in any company and may not hold more than 15% of itsinvestments in any single company.

In addition to these schemes, the Corporate Venturing Scheme wasintroduced in 2000. Its objective is to encourage larger companies to invest insmall high-risk trading companies, so fostering wider relationships betweeninvesting companies and those in which an investment is made. In this case,companies rather than individuals receive 20% up-front corporation tax relief onsubscriptions for shares in trading companies that they hold for at least three years.The trading company must meet similar tests to those for EIS companies,including the requirement for gross assets of less than £15 million. Individualsmust also hold at least 20% of the company’s ordinary share capital. The investingcompany must be part of a trading group and must not carry on a financial tradeor investment business, or hold more than 30% of the company’s total ordinaryshare capital and convertible loan capital. Investing companies may deferchargeable gains on qualifying investments if they reinvest the proceeds in further



qualifying shareholdings. They may also claim relief for losses (net of tax reliefalready claimed) incurred on investments under the scheme. This scheme is notdiscussed in the government’s consultation document, Bridging the finance gap,and is probably too small in scope and too new to be very significant.

The Small Business Investment Company (SBIC) mooted in the consultationdocument would combine privately raised capital with government guaranteedfunds. Where an SBIC loses money it is the private capital that is at risk of firstloss. The consultation paper gives evidence of success in the US for this kind ofarrangement, which ensures that investment decisions are made on a commercialbasis and that any government support is the least necessary to encourage privatecapital into the area affected by market failure. In the US in 2002, 58% of venturecapital investments to SMEs were by SBICs, although this was only 11% of thedollar amount of the financing. This was because the amounts provided wererelatively small, thus filling the equity gap for small loans. SBICs in the UK wouldtherefore be targeted at the perceived equity gap between EIS and VCTs. Whetherthe introduction of yet another form of incentive is necessary to target this gap orwhether modifications to the VCT would not be preferable is a matter fordiscussion and some of the comments of consultees have been noted above.62 TheCBI’s response supports the introduction of SBICs but calls for the targeting tobe less limited with a threshold of £3 million rather than £1 million and alsorecommends the enhancements of VCTs and EISs through more generous taxbreaks and the removal of many restrictions on their use.

Employee share schemesThere are a number of employee share schemes which give tax and nationalinsurance incentives for share ownership: Company Share Option Plans, Shareincentive Plans and Save as You Earn schemes. These are not confined to smallcompanies and so will not be discussed further here.

The Enterprise Management Incentive scheme was introduced in the FinanceAct 2000, specifically to encourage high quality managers to share in the risks andrewards of running SMEs. This scheme is justified on the basis that a keyconstraint for a small ambitious company is the quality of its management andthat it is difficult to get high calibre managers to move from mature companiesinto growing businesses. The scheme provides a targeted tax advantaged shareincentive scheme for options over shares worth up to £100,000 granted to eligibleemployees (they must work 25 hours per week in the company or 75% of their

62. Cumming, ibid, argues that VCTs are inherently inefficient and that expansion of the tax reliefs is not warranted.



working time if less). There is no income tax on the grant or exercise of theoptions. When the shares are sold capital gains tax is payable, but with the benefitof taper relief from the date of grant of the option.

To qualify a company’s gross assets must not exceed £30m, it must beindependent, its trading activities must be conducted wholly or mainly in the UKand it cannot undertake certain activities, such as dealing in land.

A proliferation of schemes and thresholdsThe large number of different thresholds makes it difficult to describe clearly thedifferences in treatment between small companies and others. It can be seen thatthe wide range of reliefs for small firms results in significant complexity. Eachrelief is defined and targeted differently. The attempts at targeting and preventinguse of the reliefs by those for whom they were not intended can be understood inpolicy terms but the resulting complications could deter people fromunderstanding and therefore utilizing the schemes. Many of the schemes aim tolift SMEs from debt funding to equity funding, which is an important stage oftheir development, but it is clear from the small business literature that manyentrepreneurs fear loss of control. The 2003 report on EISs and VCTs states thatnearly half the EIS companies and four in ten of the VCT companies found thatusing the tax schemes also introduced them to investors or fund managers whogave helpful business advice and contributed expertise. Mentoring and support isalso seen as an important potential advantage of SBICs. This seems to be the besttype of tax intervention, since it also deals with structural barriers to growth. Theempirical evidence on the efficiency of these schemes is, however, less thanconclusive.

B. Comparison of the taxation of corporate SMEs and unincorporated SMEs

There is a tendency amongst economists and politicians to equateentrepreneurship with incorporation and to ignore unincorporated firms despitethe fact that they are in the majority, as described above. Recent changes to taxrates in the UK in particular have encouraged incorporation even where this maynot be desirable or necessary for commercial reasons. It is already very cheap andstraightforward to incorporate in the UK63 and government plans to make it even

63. Unlike the position in most other European countries where there is a minimum capital requirement for all companies and where the formalities for set-up can be quite demanding. Since the decision by the ECJ in Centros ([1999] ECR 1-1459) however, making it clear that companies can use the UK as a place of incorporation – i.e. jurisdiction shopping – there has been pressure in other European countries for relaxation of these requirements.



simpler. The Company Law Review Steering Group took a ‘think small first’approach to company law, which the government has adopted in its White Paperon Company Law reform so that further simplification of company law andprocedures for small companies can be expected.64

Tax neutrality between legal forms is clearly not high on the government’sagenda. There are tax reliefs for unincorporated businesses which incorporate butthere are no disincorporation reliefs. A number of incentives, in addition tofavourable tax rates, are confined to incorporated firms. Recent proposals forreform of business taxation have concentrated on corporation taxation, whichmight lead to divergence between incorporated and unincorporated firms onfundamental issues such as the extent to which accounting practice is followed incalculating taxable profits.65

The LLP has been introduced and his has been deliberately given taxtransparency for trading purposes as urged by the large professional firms, sincefor them the NICs position and capital tax issues make transparency desirable.Although well hidden in the debates, this was a major reason for the largeprofessional firms’ demands for the LLP – they are already permitted toincorporate but had chosen not to, in part due to disclosure requirement but alsofor tax reasons. In most cases small trading firms will be better off for tax purposesif they incorporate, given the flexibility this gives to organise earnings anddividends in a tax advantageous way, and the favourable tax rates, although theability to set losses of a partnership off against general income may favour the useof LLPs in the early years of a new business. Once again government has been keento make incorporation from LLP status a tax neutral event but has not providedreliefs for a move in the opposite direction.

Despite this apparent government encouragement to incorporate, firmswhich do incorporate to take advantage of the tax benefits of incorporation mayfind themselves subject to anti-avoidance legislation, as we shall see below.

Computation of profitsThe computation of trading income for incorporated and unincorporated SMEsare in theory the same, based on the business accounts, prepared in accordancewith generally accepted accounting practice and showing a true and fair view ofthe trading profits but, in practice, the accounting of unincorporated SMEs islikely to be less sophisticated than it is for corporate SMEs. If their accounts useaccounting standards at all they will use the FRSSE described above. One reason

64. Modernising Company Law Cm 5553-I and II (London: TSO, 2002).65. See Corporation Tax Reform documents cited in fn 35 supra.



why the small business taxation review in 200166 foundered was that it proposeda move to an accounting basis for taxation for small companies but was unclearabout the position of unincorporated firms, which might not have accounts inthe same sense. (This point seems to have been lost in the current debate onalignment of taxable profits with accounting profits which is focused on largercompanies). The favourable rate of allowances for capital equipment and ITexpenditure by SMEs (see above) applies for both corporate and unincorporatedSMEs. The enhanced relief for R&D expenditure by SMEs, however, onlyapplies to corporate SMEs.

Financial income that companies (both SMEs and larger companies) derivefrom loan relationships and from securities is dealt with under a new regimeintroduced in 1996. This ensures that such income is taxed on a recognizedaccruals accounting basis. An accounts basis also applies for income derived fromforeign currency transactions and interest rate and currency derivatives and tointellectual property and goodwill.67 These regimes also apply to give relief forfinancial costs (including foreign currency and derivative losses). None of theserules apply to unincorporated SMEs. Like a close company shareholder, however,a partner in a partnership who borrows to fund his partnership capital is able todeduct the interest on those borrowings against his general income.

Corporate gains are still calculated on the basis of indexed base costs. Thetapering system introduced in 1998 for the gains of individuals does not extendto corporate gains. Thus gains on disposal of business assets are differentlycomputed for corporate and unincorporated SMEs. Both however, benefit fromrollover relief for gains on certain major business assets (goodwill, land andbuildings, fixed machinery and plant). Companies, unlike individuals, do notreceive any annual exemption for gains but they do have the exemption fordisposals of substantial shareholdings, which is not available to unincorporatedfirms.

Rates and payment of taxThe corporation tax rates applicable to corporate SMEs have been discussedabove (and see Appendix). Unincorporated SMEs pay income tax and NICs inrespect of their entire earnings at the rates set out in the appendix. CorporateSMEs must account for tax on owner/managers earnings immediately throughthe PAYE system and pay tax nine months after the end of the accounting period.

66. Technical Note March 2001 fn 35 supra.67. These are legislative accounts bases –- accounting practice is used but also modified and usage is controlled

by the statute so that the legislation is far from simple.



Basically, unincorporated businesses pay tax by two instalments, on 31st Januaryin the current year of assessment and on 31st July following the end of thecurrent year. The tax paid is calculated by reference to the profits of theaccounting period ending in the current year, with special rules for years ofcommencement and cessation.

The most notable feature of unincorporated SME rates of tax is the lowerNICs burden, as compared with the aggregate NICs burden on companies andemployees. Sole traders and partners do receive lesser entitlements as a result,although this does not fully account for the difference in tax burdens. Howeverincorporated firm owners can also obtain the advantage of the lower rate of NICsto a considerable extent. Business owners may reduce their NICs burden byincorporating companies and retaining earnings within the company taxed at thenil or lower rate or they may distribute the earnings as dividends, which avoidsNICs. This has led to anti-avoidance measures described elsewhere in this paper.68

There are many other detailed differences in the taxation of unincorporatedSMEs and incorporated SMEs. For example, the proprietor of an unincorporatedSME is able to carry losses in the first four years of operation back to set againstgeneral income in the three preceding years. A company must rely on generatingprofits before it can secure relief for start-up losses. The various incentives forinvestment in SMEs, outlined earlier in this paper, are restricted to shareinvestment in companies and do not extend to investment funds provided tounincorporated businesses (including LLPs).

A European Commission Recommendation emphasises the importance ofworking towards greater tax neutrality between enterprises with different legalforms so as to avoid distortion of competition.69 It particularly notes that soleproprietors and partnerships are generally subject to progressive taxation, whichhampers the development of the self-financing capacity of such enterprises bycomparison with enterprises subject to corporation taxes. Member states areinvited to consider giving unincorporated firms the right to opt to pay corporationtax. Alternatively they are asked to consider restricting the tax charge on reinvestedprofits to a rate comparable with that of corporation tax. Member states are alsoinvited to take measures to eliminate tax obstacles to changes in the legal form ofenterprises, particularly the incorporation of sole proprietorships andpartnerships. As noted above, the UK tax system has not resolved the problem ofdistortions between different legal forms and some new reliefs and reforms

68. I.e. the settlements provisions (see fn 51 supra and text thereto) and the Personal Service Company provisions described in the next section, below.

69. European Commission Recommendation of 25 May 1994 concerning the taxation of small and medium-sized enterprises (94/390/EC).



actually exacerbate that distortion, but there are provisions to preventincorporation of a business incurring a tax penalty.

C. Comparison of the relative personal tax positions of the self-employed and employees

It will be apparent from earlier sections of this paper, that the tax burdens ofindividuals may differ significantly, depending upon whether they are employees,whether they qualify as self-employed or whether they are owner/managers ofincorporated SMEs withdrawing earnings as a combination of salary, dividendsand capital gains. Further differences may arise between these three categories asa result of the different forms of pension provision that each can make.

A consequence of these differences has been the use of personal servicecompanies (PSCs) by many individuals attempting to avoid employment taxes.Tax has not been the only motivation for these companies. Large client companiesoften seek to avoid employing staff for employment law and health and safetyreasons or simply because they do not wish to have to integrate casual workers intotheir work force and the workers may be left with no choice but to incorporateunder pressure from the clients. This partly just reflects changing work patterns.Some of these personal service company owners may also be buddingentrepreneurs, given the chance, but others will only ever work for one client. TheGovernment has seen this development as a form of tax avoidance and hasimposed, from April 2000, special rules for taxing PSCs. These rules have beenmet with much discontent and litigation. There was a real abuse to be counteredbut the wide way in which this has been done and the disregard for employmentlaw issues has led to resentment and may mean that workers pay tax as employeesbut without any of the non-tax benefits. In addition some genuine entrepreneurialactivity may be deterred.70

The legislation71 subjects the earnings of personal service companies and otherentities (such as partnerships) to income tax and NICs, as if the individual hadearned them. The rules apply where –• a worker provides his services to a client (originally this was only a client which

was a business but this provision was include all workers in the 2003 Finance Act, apparently to prevent avoidance by domestic workers)

• the arrangements are made through an intermediary (company, partnership, etc.)

70. For a fuller discussion of these issues see Freedman, Employed or Self-employed? Tax Classification of Workers and the Changing Labour Market ((London: IFS, 2001).

71. Finance Act 2000.



• the worker would have been treated as an employee of the client for tax and NICs purposes, had the arrangement been made between the worker and the client.

Where these rules apply, the client continues to pay the intermediary gross andsalary paid by the intermediary to the worker is subject to PAYE and NICs rulesin the normal way. But to the extent that the intermediary does not pay out itsentire earnings as salary, the intermediary is treated as paying a salary to theworker on the last day of the tax year (or earlier, if the relationship with theintermediary ceases before then). In addition, benefits in kind paid to theintermediary are taxed in the same way as employee benefits. Dividend tax reliefis given to prevent double taxation, and a deduction is allowed for expenses ofrunning the intermediary equal to 5% of the receipts from the engagementscaught by the legislation. Any amounts spent by the intermediary, which couldhave been claimed as expenses against income tax had the worker been employedby the client and had paid them himself, can be deducted but only under themore restrictive employee deduction rules.

In determining whether the worker would have been an employee of the clienthad there been a direct relationship between them, the existing case law that seeks todistinguish the employed from the self-employed is used. This case law is fact-basedand lacking in clarity, leaving workers and intermediaries in a state of uncertainty.

The legislation against personal service companies illustrates that despiteGovernment enthusiasm for small firms, when individuals are perceived to beexploiting the different tax treatment of different forms of SME, anti-avoidancelegislation is introduced. This stems from a desire by the Government to distinguishindividuals who they regard as “ordinary workers” from those whom they regard as“entrepreneurs”. But the attempt to distinguish “genuine” small businesses, whichshould attract reliefs and exemptions and a relaxed regime because they are the“engine of the economy”, from “non-genuine” businesses, which are to be deniedreliefs, has no basis in logic and seems doomed to failure. It is impossible to knowex ante which firms will grow and which will not, and there is no reason why a serviceprovider should be any less “entrepreneurial” in terms of growth than a provider ofgoods, especially within the new “knowledge based” economy.72

D. Deregulatory measures which apply to all types of firmReduction of compliance costs is a strong factor behind many of the tax and non-tax special measures for small firms in the UK, especially in the area of VAT, but

72. Freedman 2001, IFS, supra fn 70.



does not seem to be uniformly considered when new tax proposals are made,despite the requirement for new legislative proposals to be accompanied byregulatory impact assessments. While the Government has indicated its strongdesire to reduce the compliance burdens of small firms, many of its other changesto the tax system have imposed significant burdens. Thus the expansion of taxcredits, delivering social security benefits via the tax system, and the introductionof student loans have added considerably to the burdens on employers, and theseburdens fall hardest on SME employers.

VAT compliance reliefs for small firms are a strong feature of the UK system,however, as a result of work showing the highly regressive nature of these burdensand of strong lobbying from the small business organisations to this effect.73 TheUK has the highest registration threshold in the EU and the highest permitted byEU law – £56,000 annual turnover from April 2003. Below this, registration isvoluntary for firms of all types. A flat rate scheme was introduced in 2002 forbusinesses with a turnover of £150,000 or less. Under this scheme, VAT is paidon a percentage of turnover, which is intended to reducing accounting work forindividual transactions, although proper business records are still needed for thepurposes of taxation on income so it is questionable how much time is saved. Thescheme is meant to be revenue neutral and could apply to around 700,000 firmsbut an estimate given in May 2003 by Customs and Excise suggested that take uphad been at around the 10,000 user mark.74 Firms with a turnover of under£150,000 also benefit from a relaxation of automatic late penalty payments. The2003 Finance Act introduced a new incentive scheme to encourage smallbusinesses into the VAT system, including reduced penalties for late notification.Businesses with a turnover of up to £600,000 may also opt for cash accounting(avoiding bad debt problems) and annual accounting (available immediately forfirms with turnover of up to £150,000 but only after a year for those with a higherturnover). These schemes are subject to strict anti-avoidance provisions and arenot taken up by all eligible for them.75

Although these schemes attempt to meet real needs and so are examples ofgood small business reliefs in the sense of targeting, they are also good examples

73. Sandford, Godwin, et al., fn 7 supra.74. Customs and Excise advise that there has been increased take-up since this date and a report on the figures

is expected at the end of 2003(correspondence between the author and Customs and Excise Policy division, 17th September 2003). Although the scheme is intended to be revenue neutral, small business owners may be reluctant to use it, as they cannot check whether this is actually the case without keeping the very records they are dispensing with under the scheme.

75. There are no published up to date figures available on take-up of these schemes (correspondence referred to in fn 71 ibid). In the case of cash accounting this is understandable, since businesses do not have to notify the authorities when they leave or join the scheme, but it is not clear why figures have not been published on annual accounting. They may be forthcoming when the report referred to in fn 74 is published.



of complex deregulation with a variety of thresholds, some of which are not easilyascertainable in advance for firms, and with detailed anti-avoidance provisions. Atthe same time there is some concern that the high registration threshold results inunfairness for those just above the threshold, especially those supplying tohouseholders and other exempt customers. There may be considerable evasion orsuppression of activity in order to keep below this threshold.76

In the past the European Commission has made various recommendationsconcerning taxation of SMEs. Many of these are concerned with the problems oftaxation on transfer, particularly from one generation to another, which mightresult in closure of the business with consequent loss of employment and wealthgeneration.77 These issues are not the focus of this paper but it is worthmentioning in passing that the UK has a number of tax reliefs aimed at easing thetransfer of businesses, particularly inheritance tax business relief, and so conformsto the recommendations in a number of respects. The basis for theserecommendations and the reliefs on transfer is not entirely clear, however. Forexample, why is it assumed that the transfer of a business to the second generationis necessarily better than, say, the purchase of a business by a third party? Theevidence from the small business literature suggests this is not necessarily the case.A better guiding principle would seem to be neutrality as between these differentoutcomes to allow the commercial considerations to govern, although tax reliefsmay be necessary to prevent transfer in general from being a barrier tocontinuation.

Part IV: Conclusion and questionsThis paper suggests three main issues that require further tax policyconsideration—

1 First, there are significant tax differences between the main forms in whichSMEs may conduct their activities. This begs two questions: whether suchdifferences are at all desirable and, if not, whether they are necessary?

2 Second, as a matter of personal taxation, we would normally prefer thatthe tax system achieved a degree of equity between taxpayers: horizontalequity so that those with like means bear similar tax burdens; and verticalequity so that those with greater means bear greater tax burdens than thosewith lesser means. To what extent do the differences in tax outcomes

76. Evidence of this kind of activity is extremely difficult to collect cf. The Informal Economy, Lord Grabiner QC (London: HM Treasury, 2000).

77. European Commission Recommendation of 7 December 1994 on the transfer of small and medium-sized enterprises (94/1069/EC); European Commission Communication on Recommendation of 7 December 1994 on the transfer of small and medium sized enterprises (94/C 400/01).



according to whether a person is classified as employed, self-employed,employed with a PSC or an entrepreneur, compromise those aims?

3 Finally, there is a prevailing belief in the need for special measures tobenefit SMEs but, as discussed above, these measures need to be measuredin terms of cost effectiveness, targeting and the distortions they create.How do the UK SME reliefs look, measured against these benchmarks?

The material discussed here shows the difficulties of targeting small businessreliefs and assessing their cost effectiveness and the trade-off that is necessarybetween complexity, proliferation of thresholds and distortions on the one handand the provision of incentives on the other. Governments should not besurprised if attempts to introduce reliefs through the tax system result in effortsby taxpayers to take advantage of those reliefs in the least risky way possible.Reliefs given for one group of tax payers and not others will inevitably provideincentives to move into the group so privileged. To castigate those who makethese attempts as aggressive tax planners may be unfair in view of the incentivestructure being set up. Failure to take note of the desirability of neutralitybetween different legal forms will result in attempts at arbitrage which are costlyfor the revenue authorities and business alike, especially as businesses may end upusing legal forms not suitable for their commercial needs.

Proliferation of thresholds may cause confusion and even barriers to growthand attempts at deregulation which have to be hedged about by anti-avoidancelegislation can create, instead of reducing, complexity. New investment may beencouraged at a cost – it is necessary to ask whether the activity invested in isworthwhile in itself.

UK SME reliefs do not always stand up well to these tests and it is to be hopedthat the latest review of finance investment incentives in the UK will consider awide range of empirical studies, as well as non-tax issues and cultural differencesbetween the UK and the USA, before introducing yet another tax scheme. Theissue of neutrality between different legal forms urgently needs addressing in acomprehensive way, rather than dealing with it by piecemeal provisions such asthe PSC legislation. On the other hand, the R&D incentives do seem to have beenthought through carefully and are proving a success, and some compliance costmeasures, such as those found in VAT, may be helpful for small firms, althoughmore research is needed on take-up rates and the reasons for popularity orotherwise of schemes intended to give relief from burdens.

In all considerations of small business taxation it needs to be rememberedabove all that change is costly in itself. Whilst professional groups may lobby fornew reliefs, many small business owners might prefer a simpler system with lower



levels of tax overall. This is something that our political processes in the UK, aselsewhere, seem ill designed to deliver, since politicians love to provide‘incentives’!

Appendix: Rates of Tax in the UK – 2003-4

INCOME TAX RATES

Starting Up to £1,960 (taxable income) 10%

Basic £1961-£30,500 22%

Higher Above £30,500 40%

CORPORATION TAX RATES

Profits Tax rate

£1 to £10,000 0%

£10,001 to £50,000 23.75%

£50,001 to £300,000 19%

£300,001 to £1,500,000 32.75%

£1,500,001 + 30%

NATIONAL INSURANCE CONTRIBUTIONS(rates for employees not contracted out of state

pension scheme)

Employees: Rate

First £89 p.w. 0%

Next £506 p.w. 11%

Excess 1%

Employers

First £89 p.w. 0%

Excess 12.8%

Self-employed

Class 2 £2 per week (on profits over £4,095pa)

Class 4

£4,615- £30,940 (profit) 8%

Above £30,940 1%


TAXING SMALL BUSINESSDeveloping Good Tax Policies

Neil WarrenEditor

Australian Tax Research Foundationin association with

Australian Taxation Studies Program, University of NSW, Sydney

and

AUSTRALIAN TAX RESEARCH FOUNDATIONConference Series 23


The views expressed in this and other publications of the Foundation are not necessarily those ofthe Foundation or those who sponsor its publications. They are published on the basis that theyrepresent a significant contribution to public understanding of aspects of taxation policy.

Taxing Small Business: Developing Good Tax Policies

ISBN 0 949482 79 XISSN 0 818 1616

© The Australian Tax Research Foundation and the authors, 2003

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, ortransmitted in any form or by any means, without the prior permission of the Foundation.

Other ATRF publications can be viewed at www.atrf.com.au


small business taxation: policy issues and the uk

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