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Radical reforms proposed for small business taxation

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The Office of Tax Simplification, set up by the Government to review the operation of the tax system, has recommended a radical overhaul of small business taxation in its interim report.

Foremost amongst the recommended changes is a merger of income tax and national insurance contributions.

This, the OTS argued, would put pay to the anomalies that currently affect the regime, in particular the vexed issue of the divide between employment and self-employment which gave rise to the IR35 regime.

By merging or aligning the two taxes, the OTS maintained that the move would involve a one-off cost of £200 million but would save employers £759 million a year and HM Revenue and Customs (HMRC) £300 million annually.

The report cited the example of raising the 2011/12 primary threshold for employee NICs so that it matches the income tax personal allowance. This would reduce tax receipts by over £1 billion a year, but, to make good the deficit from the loss of employer NICs, the Treasury could raise tax rates on savings and dividends.

The OTS report also recommended that the Treasury take a look at the way in which NICs are collected. Specifically, the report highlighted the fact that self-employed Class 2 NICs are recouped outside the self assessment system and suggested that people with multiple sources of income may be overpaying their national insurance contributions.

To reduce the cost of complying with the tax laws, the OTS suggested two new policies for firms with sales below £20,000. One would be to base taxation on turnover rather than profit; another would be to base it on fixed or flat rate expense deductions. This would duplicate the scheme that currently exists for VAT payments.

On the IR35 regime, the OTS noted that, in 2009, fewer than 10,000 taxpayers operated within the rules.

The IR35 regime was set up to prevent contractors operating as employees and so curtailing their tax liabilities. But, the OTS said, the “current lack of clarity” over the employment status of individuals poses barriers to self-employment and is inhibiting one-person firms from hiring staff.

Integrating income tax and NICs would make the need for the IR35 rules obsolete, the OTS claimed.

However, the OTS said that abolishing IR35 could be seen as unfair by actual employees, given the present economic climate, and that scrapping the rules could condone “the significant underpayment of NICs by some individuals”.

Nevertheless, the report concluded that the issue of IR35 will need to be addressed, and that the underlying problems associated with it would continue unless structural reforms are made to the income tax and NIC systems.

The OTS recommended that, until a final decision is made on reforms to the small business tax regime, the Treasury should either suspend IR35 in preparation for abolition or should change the way it is enforced. But any move needs to be linked to a timetable for judging whether the income tax and NIC systems should be merged.

A third option offered by the OTS on IR35 would be to introduce a business test along the lines of assessing salary level as a proportion of turnover in order to distinguish employees from contractors.

John Whiting, tax director at the OTS, said: “Our aim is develop practical ideas that will make things easier for small businesses when it comes to their tax responsibilities.

“Having listened to the concerns raised through our roadshow events and many representations, we hope we’ve identified the main problem areas and that people will agree these initial recommendations will improve matters. We’ve suggested ways forward on the thorny issue of IR35, though it’s clear there is no easy solution there.

“We want to stimulate more debate on our findings, so whether you agree with us or not, we are keen to hear your views to help us develop our final report to the Chancellor later in the year.”

The Institute of Directors (IoD) expressed disappointment that a business test for IR35 was only made as a third choice.

The IoD argued: “We can all support clarity: it should be easy for each person to work out his or her tax status. We are therefore disappointed that a new business test is only a third option for short-term change to IR35, rather than being the lead option.

“In the longer term, there is one big question to answer. Should different ways of working be taxed differently because of factors such as the risk of fluctuating earnings and the investment of capital, or should the tax system treat income from all ways of working the same? We must not duck that question.”