Contractors aren't tax-led to PSCs, finds HMRC
The "blanket assumption" of tax avoidance that HM Revenue & Customs makes when it approaches Personal Service Companies has been left in tatters by its own research.
Stephen Herring, head of tax at the Institute of Directors, revealed this tendency of HMRC to regard PSCs as “automatic evidence of some form of tax avoidance” to the Lords in January.
Sitting face-to-face with the peers, Mr Herring bravely took on the Revenue by arguing that, contrary to what its officials usually believe, tax is not the ‘raison’ d être’ of PSCs.
Now, he has been vindicated - by no less than the tax authority itself. In fact, a study run for HMRC shows that limited liability status, not tax saving, is the top reason to incorporate.
Put another way, being able to minimise their tax bills is less of driver to registering a business as a company to individuals than its legally protected status is.
Even when prompted by Ipsos MORI, which ran the study, tax and national insurance savings were only the fourth most widely cited reason that people said they decided to become ‘Ltd.’
When they weren’t prompted, 19% spoke of the potential tax benefits to explain why they incorporated, compared to 24% who said it was down to the safeguard of limited liability.
Indeed, despite HMRC’s age-old stance on PSCs that tax is their determining factor, some of those polled said NI and tax savings had “no bearing” on their decision to incorporate.
“The report at [Section 1.4] is consistent with my evidence,” said Mr Herring, pointing yesterday to both the report, Reasons behind incorporation, and his testimony in January.
He maintained: “There is a world of difference between a decision being made on the tax treatment only and tax being taken into account before a decision is made, or afterwards”.
Mr Herring was not the only Lords’ expert witness to say that tax was not driving incorporations, which the HMRC study also attributes to contract criteria and credibility.
Jason Piper of the Association of Chartered Certified Accountants (ACCA) and Martin Hesketh of Brookson were also expert witnesses. They too spoke to ContractorUK yesterday.
Mr Piper, in a joint-statement with ACCA’s small business expert Manos Schizas said: “The most common reason for incorporation is still a business reason - the protection provided by limited liability.
“We don’t believe tax should be the number one reason - incorporation should be driven by the business’ needs. However, tax is very clearly an influence on incorporation as a choice.”
Mr Hesketh, a contractor accountant, reflected on the 117-page report: “It’s helpful in that it informs HMRC that there are many drivers for businesses to incorporate.
“[These drivers] include limited liability protection and contractual requirements, and [so] incorporation is not purely driven by tax and NI savings.”
Yet actually, it is the driver for a small minority who HMRC is keen to talk up in the report, which says that for some respondents the tax and NI deductions were a “prime motivation.”
This assertion in the report seems to stem from the finding that out of those PSCs who said tax was an ‘important consideration,’ about 30% of such answerers “strongly agreed” it was.
An even more disapproving tone appears when, talking of respondents who incorporated for non-tax reasons, the report says “particular strategies” to reduce tax were subsequently used.
It states: “Once the business was incorporated and became profitable, they recognised the financial benefits of incorporation and used particular strategies to reduce their tax liability.”
Mr Hesketh reflected: “The apparent disapproval by HMRC of taxpayers using ‘financial strategies’ to reduce their tax liabilities is concerning.
“The vast majority of limited company contractors operate within the law and should not be discouraged from taking advantage of the tax benefits available.
“These advantages have been put in place to encourage people to take on the risks associated with running their own business, such as uncertainty and the lack of employment rights.”
Writing exclusively for CUK today, The Low Tax Group agrees: “Whilst HMRC are disapproving of financial ‘strategies’, it is unreasonable to claim that the legitimate management of a limited company is a financial strategy.”
According to the HMRC study, a combination of salary and dividends is the most common remuneration “strategy,” followed by dividends only (used by 20%), then salary only (used by 18%).
And when they did incorporate with some awareness of the potential tax and NI savings, such respondents emerged as the most likely of those PSCs polled to make a profit.
“The correlation between successful businesses and those which actively planned for and around taxes is no great surprise,” said Mr Piper, ACCA’s technical and business manager.
“Owners who are aware enough to make and run a successful business and make stronger profits can be expected to have considered all the relevant factors around their operations.
“If a legal tax advantage is available they are more likely perhaps to be aware, and take advantage, of it than those less financially-aware individuals who struggled to make a profit.”
However it is only a potential advantage, as Mr Herring, a former accountant, outlines: “From the service provider’s standpoint, payment through their own company might save national insurance but there are costs (time and money) of maintaining the company’s records and procures.”
He added: “If the service provider does not need to draw the fees paid to her/his company there is, of course, a saving between income tax at 40%, or even 45%, and corporation tax at 20% but, at some point, a dividend or bonus will be paid or a capital gain will be realised, thereby losing a good proportion of the saving.”
But low awareness of the possible tax saving by incorporating was not the biggest indicator of making a loss, which tends to be the hallmark of PSC owners who had a PSC before.
“We are very interested in the 29% who are clearly repeat incorporators,” said the ACCA. “They are the core constituency of the incorporation regime, and HMRC would benefit from understanding them as a client base.”
According to the association, such repeat entrepreneurs make a disproportionately high contribution to economic growth, so encouraging them would help the economy as a whole.
HMRC is likely to take notice, as the whole point of the study was to help it target policies to “aid company growth” which, alongside reducing costs for firms, is “an HMRC priority.”
So the department might focus any action it takes in response to the study on the finding that the administrative burden of incorporation emerged as the only drawback of incorporation.
The picture at the other end of the process – disincorporation – is bleaker and may be acted on too, as the qualitative and quantitative research in the study each found confusion. Disincorporation tax relief, for example, was only familiar to one in eight respondents.
But if encouraging growth is the goal (as HMRC says it is), and if tax is being seen as an incentive to incorporate (as the study found), then Mr Piper says a “reduced financial burden” on PSCs is the only real answer.
Yet he cautioned: “A policy of actively promoting incorporation through the tax system would need to be carefully managed against the background of IR35, and the perception that some parts of HMRC view all small companies as little more than tax avoidance vehicles.”
Editor’s Note: About 1,000 mostly one-person firms took part in the HMRC study which was run by Ipsos MORI over the phone between Nov 2013 and Jan 2014. Further detail on the research methodology, including the fact that the qualitative research only involved firms whose incorporation was tax-influenced, is explored on CUK today by The Low Tax Group.