OTS rejects lookthrough taxation system for small business

The Office of Tax Simplification (OTS) has rejected the viability of introducing lookthrough taxation for small companies as it would not simplify the current tax system for small business and would deter entrepreneurs

The government briefed the OTS to consider the pros and cons of introducing a lookthrough system, following publication of the organisation’s own Small company taxation report in March, which raised the initial idea.

The over-riding conclusion of the review was that a lookthrough system would create more complexity than currently exists and would require intense rewriting of current tax law to balance out new anomalies over reporting capital allowances, benefits and expenses, and losses. It could also deter entrepreneurship and investment in startups.

The basic premise of lookthrough taxation for a small company is that direct profits taxes are not levied on the company; rather one looks through the company and levies taxes directly on the shareholders on their allocated share of the profits.  

This obviates the need for company taxation; potentially lookthrough puts small companies and sole traders on the same footing with similar tax on similar profits. In practice, once the accounts (which would still be required for lookthrough companies) have been developed, the corporation tax compliance burden is modest and tends to be dealt with in parallel.

While the OTS rejected the introduction of lookthrough taxation, it did concede that as part of a wider radical overhaul of company taxation, lookthrough could play a part.

‘We can see considerable merit in a long range, strategic review of taxation in this area, to look at the whole question of how labour income should be taxed and whether capital returns should be taxed differently,’ the OTS stated.

‘This could result in a framework for small business taxation, bringing greater certainty to the direction of tax policy – a constant call from business, as the OTS has often recorded.  The changing nature of the economy, with the growth of the gig/sharing, makes this increasingly in point.’

The simplification gained by eliminating the need for corporate tax compliance is outweighed by the  technical issues that such a process raises, especially as there would still be a need for an ‘adjustment of profits’ exercise, the OTS said.

‘Lookthrough potentially damages the funds retained for investment by taxing retained profits at full income tax and national insurance contribution (NIC) rates’.

The introduction of this taxation method could also discourage entrepreneurs. 

In the response to the OTS consultation, there was support for allowing the smallest companies to use cash accounting (though with the obvious caveats about most companies needing full accounts), something that is not possible under current rules.

Some suggested that if lookthrough were to apply, cash accounting should be available to impacted companies.

There were also concerns about the extent of the impact of any reporting change as it would have a knock-on effect on the way companies offset losses, pension contributions and even treatment of student loan payments.At the same time, it is likely that the current expenses and benefits rules would have to be changed to take into account the new taxation method, particularly if benefits were payrolled under the new rules.

Potentially recent changes to the dividend rules with the introduction of the £5,000 allowance in April 2016 would create additional complexity, as income reporting would become more convoluted.

Directors loans

Lookthrough does offer some simplification on directors loans. Many company directors struggle with separating company and personal income, and with keeping appropriate records, especially when they are the sole shareholder and are operating as a personal service company.

Any overhaul of the tax framework ‘potentially eliminates the tax issues that arise with overdrawn directors’ loan accounts. However, company law issues around such accounts would remain’, the OTS said.

‘Our conclusion is that lookthrough does not offer sufficient simplification to justify its introduction. On balance we feel that it would actually be more complicated than the current corporation tax system, given the additional rules that would be needed.’

Over 40 organisations, professional institutes and individual tax advisers contributed to the review, through written submissions and attendance of workshops and meetings.

The 26-page OTS Lookthrough taxation final report was published on 3 November 2016.

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