The reform agenda

In response to Gordon Brown's Pre-Budget Report (PBR), Kevin Nicholson, UK head of enterprise and private client at PriceWaterhouseCoopers, argues that small businesses need more consistency in the government's reforms.

In Gordon Brown's 2002 Budget statement he said, "to send out the strongest signal about the importance we attach to small businesses and the creation of wealth I propose to reduce the starting rate of corporation tax from 10 pence to zero percent". The 10% rate had been introduced in 1999 to encourage enterprise. In this week’s Pre-Budget Report (PBR), the Chancellor scrapped the lower rates of tax for small companies and introduced a flat rate of 19%.

The Chancellor said he was making this change "to close a relief under which for tax reasons only, people are being persuaded without changing what they do to set up a company". So why has this happened? The problem is that the reduction in the rates increased the number of small businesses who incorporated - an inevitable result of the reforms which many commentators predicted at the time.

The government appears to have a genuine interest in encouraging enterprise. The Chancellor highlighted the success of the government’s reforms in creating 3,500 new companies per week and it is proud of its record in cutting headline tax rates and has also hit the headlines for introducing many new incentives and reliefs to assist small businesses.

Businesses, however, need to see more consistency in the reforms. They want to be able to plan their affairs with some certainty and to continue creating wealth for the economy.

As is well known, the zero percent corporation tax rate meant that if an incorporated business made profits of £10,000 the owner could dividend those profits to themselves and suffer no tax either in the company or personally. This is because there was 0% tax charge on the profits and no additional tax to pay on a dividend assuming the owner was a basic rate tax payer. There was also no National Insurance (NI) due on the dividends which would have been payable if the profits had been charged as income. If a self employed person had made £10,000 of profits, tax and NI of approximately £1,300 would have been due, which could be seen as a clear incentive to incorporate even if the individual’s business had not changed.

As a result, in 2004 a new 19% tax charge was introduced on profits paid out as dividends to individuals, which would otherwise have benefited from the zero percent corporate tax rate. This reduced the benefit of incorporation.

There was still, however, a benefit for those who were reinvesting their profits. The company would still not pay corporation tax and no additional tax would be due as the profit was not being dividended to the owner. The change announced in this week's PBR removes this benefit.

In an effort to soften the blow, the Chancellor did announce an increase in the capital allowances due to small business. Tax relief of 50% will be available on qualifying expenditure in the year of purchase. This is an increase from 40% and accelerates the tax relief on expenditure on assets such as plant and machinery and fixtures and fittings. The increased relief isn't however, an overall reduction in the tax bill, just a timing difference, and not all expenditure will qualify. For example, a small business which uses the profits to acquire a freehold property would not get any additional relief and so would pay more tax than under the current regime.

All small companies which previously reinvested some of their profits will pay more tax and as a consequence will have less profit to reinvest in the business. It is telling that PBR figures show that ‘tackling’ tax motivated incorporation ‘is expected to raise almost £1 billion over the next three years, whereas the costs of capital allowances gives some £50 million back over the same period.

So was there any good news for small business? In a document released on 2 December 2005 called "Supporting Growth in Innovation" the government announced some assistance for small businesses in claiming relief for research and development (R&D) costs. This is a generous relief to reward and encourage R&D but many small businesses have found it difficult to understand what can be claimed. The new document announced the creation of specialist R&D units of HM Revenue & Customs to assist small and medium sized businesses with their claims. They will also consider widening the relief for small businesses to allow some capital expenditure to qualify. This is a very welcome initiative.