Corporation tax: Time for change?
In this conceptual article, Northumbria University’s Tracey Wilson explores whether the current corporate tax system is in need of reform for the benefit of the region’s high-growth firms.
Corporation Tax reform is not a topic that you would normally associate with a Scaleup feature. Paying corporation tax is part and parcel of running a successful limited company; yet, most business owners would not cite tax as being one of the main drivers of business growth. However, tax incentives such as the Enterprise Investment Scheme (EIS) and enhanced tax relief and credits for research and development (R&D) play a key role in supporting growth ambitions.
In a recent survey of 1,000 SME and mid-market firms, KPMG (2019) found that firms with higher growth expectations are more likely to engage with the corporate tax system. From a regional perspective, respondents based in the North East/Yorkshire were less confident in the role tax played in supporting business growth compared to other regions, whilst still acknowledging the value of R&D and EIS reliefs and the need for tax simplification.
To what extent are these findings representative for high growth firms in the North East? Well, that is exactly what Tracey is keen to find out – but she needs your help!
Corporation tax and the Scaleup firm
During a period of rapid growth a company may pay little, if any, corporation tax due to the benefit of offsetting tax losses incurred in earlier periods, R&D tax relief or through buying plant and machinery.
However, despite having no corporation tax to pay, scaleup activity is far from tax-free. As the business grows and employee numbers rise, so does the burden of employers’ national insurance, business rates, and the apprenticeship levy. Consequently, the total tax contribution from a Scaleup can be a sizeable cost irrespective of whether a penny of corporation tax is due. By creating jobs and increasing its economic value added, the Scaleup clearly still pays its ‘fair share’ of tax by other means.
As the growing business turns a profit and the business starts to pay corporation tax, the complexity of the corporate tax system starts to kick in. With less after tax cash available to reinvest in the business, further growth is stifled by having to pay corporation tax.
When the firm reports a taxable profit of £1.5 million it may well find itself in the quarterly instalment payment (QIPs) regime. Under the QIPs system, the firm needs magic powers to predict its year-end profit & its subsequent tax bill at months 7 and 10 in the year to ensure it pays the correct tax instalments, and wait for it, is penalised by HMRC if it gets its calculations wrong.
Should the company then evolve into a group, extend its range of business activities or expand abroad, further complications arise in terms of its corporation tax footprint. Without going into the technical detail, as the business grows and becomes more complex, you can pretty much guarantee that the corporate tax system will also do the same. So why is corporation tax so problematic?
The problem with corporation tax
Companies pay corporation tax but the tax is ultimately borne by individuals, which means that whilst the company may write the cheque, individuals end up bearing the cost of it. Extensive research into the ‘incidence’ of corporation tax has found that corporation tax is borne by shareholders in the form of lower distributable profits; employees, through lower wages and consumers through higher prices. The extent to which each stakeholder group is affected depends on a range of variables, and differs from business to business.
For the owners of the business, corporation tax creates a double tax charge on the profits of the business. Initially when the company’s profits are subject to tax under the corporate tax regime and then subsequently when those after-tax profits are paid back to the owners in the form of dividends and appear in their income tax computations.
So why bother having it then? The most obvious answer is that corporation tax generates a sizeable chunk of revenue for HM Treasury. Over the last five years, corporation tax receipts have risen each year despite a cut in the rate of corporation tax, due to improvements in economic conditions and new restrictions on the deductibility of loan interest and tax losses, which have hit large companies hardest. In 2018-19, corporation tax receipts generated a total of £55.1 billion of tax revenue, with the Financial & Insurance sector being the highest net contributor with liabilities of £14.1 billion. According to recently published HMRC statistics, the distribution of tax liabilities is highly skewed and it would appear that the largest companies pay the greatest amount of corporation tax. For example, in 2017-18, £31 billion of corporate tax liabilities came from approximately 4,400 firms (less than 0.3% of UK companies), and represented more than 50% of the total UK corporation tax collected in the year. In contrast, 67% of UK firms reported tax liabilities of less than £10,000, and accounted for 6% of total tax liabilities.
Over the years, additional arguments have been presented in order to justify the existence of corporation tax. The two most important being to prevent individuals abusing the corporate form to avoid income tax and secondly, to keep the voting public happy.
Corporation tax is essentially a ‘backstop’ for personal income tax. Without it, there would be nothing to prevent wealthy individuals from setting up a company purely to hold their personal wealth and income generating assets tax-free. Theoretically, individuals could then defer the payment of income tax indefinitely until either a dividend was paid or the shares sold, leading to mass tax avoidance. One of the simplest ways to prevent individuals doing this is to tax corporate profits as and when they are earned in the company. Corporation tax therefore represents a proxy for the personal income tax not yet due.
Secondly, corporation tax is a convenient political tool. Voters don’t like paying taxes and the opportunity to pass on the tax burden on to a faceless company which, theoretically, can afford to pay their ‘fair share’ is politically appealing. The apparent reluctance by previous governments of any colour to abolish corporation tax suggests that it is likely to stay for the foreseeable future. Indeed, the recent election promise by Prime Minister, Boris Johnson, to delay anticipated reductions in the headline corporation tax rate from 19% to 17% in 2020 bears this out.
Given that evidence from HMRC suggests that a relatively small number of firms pay corporation tax, would it not be better to give unquoted growing firms the opportunity to opt in to a simpler less convoluted mechanism that would encourage growth rather than stifling it?
An alternative: Cash flow taxes?
Anyone involved with a growing business will know only too well that “growth sucks cash” (Harnish, 2014). With less access to finance compared to their quoted counterparts, Scaleup firms need to keep their eye on the ball when it comes to cash flow management. Would it not make sense therefore, to rebase the current corporate tax system to reflect the cash needs of the business?
The concept of a cash flow tax alternative is nothing new, with its origins dating back to the 1970s. Various connotations of a cash flow tax have been proposed. However, cash flow taxes tend to fall into one of two categories: at one end of the spectrum there is the taxation of the company’s real cash flows (the ‘R’ base) and at the other the stock (dividend) cash flow (the ‘S’ base).
Real cash flows (R base)
Under the R base, companies are taxed on their net cash inflows from operating activities and proceeds from the sale of capital assets with allowable deductions for capital expenditure. No distinction exists between revenue and capital expenditure and the tax base represents the difference between the net cash inflows less net cash outflows. In periods of scale when a business is a net cash spender, there will be no corporation tax to pay. Corporation tax would be payable only when the business reports a net cash inflow. For a small, high-growth firm, with activities based solely in the UK, the move to a less complex cash flow system could well be beneficial, reducing the time and cost associated with complying with the current system.
Unlike the current capital allowances regime there would be no cap on the deductibility of capital expenditure for tax purposes. All good, but how many growing firms spend more than £1 million per annum on plant and equipment? If you do, you’re a winner, but if not, you might not find much difference between this and the current system. Businesses with high levels of borrowing may also lose out under this proposal, as interest would not be tax deductible. The R-base was originally designed to address a perceived inequality between debt and equity finance which economists believed distorted the tax system and encouraged firms to take on higher levels debt finance. In the post-recession era, it is likely that small high growth firms with a turnover of less than say £20 million have less access to debt finance compared to pre-2008, and the need to operate a tax system that penalises borrowings might not be as relevant as it once was.
Dividends (Stock – S base)
With the S base, profits grow within the business tax free, with corporation tax only being due when the profits are paid out by the company in the form of dividends. During a period of growth when cash flows are tight, the firm need not worry about having to fund a corporation tax bill. It is only when the retained profits are no longer required and distributed back to shareholders that the tax charge occurs.
The dividend system currently operates in Estonia, whose tax system is recognised as the most tax competitive system in the OECD by the Tax Foundation. Not only could this alternative approach benefit scaling firms but could also encourage more foreign investment as the UK becomes more tax competitive.
The extent HM Treasury could lose out on tax revenue depends upon whether business owners stop taking dividends from the company. If however, those retained profits were put to work funding growth and creating new jobs, that tax revenue gap would be filled by additional employment tax and national insurance contributions. Critics of a dividend tax argue that a dividend-mechanism removes the ‘backstop’ from personal income tax and could encourage firms to disguise dividend payments to avoid paying tax. However, anti-avoidance provisions could easily address any unintended tax consequences.
& the winner is ……
Which of the two alternative models detailed above would be of most benefit to growing firms is debatable. If the prospect of linking tax payments to the firm’s cash flows would facilitate further growth, then these options need exploring further and the findings presented to HM Treasury for consideration.
HM Treasury regularly consults with stakeholders on a number of tax policy issues. Typically, the same usual suspects respond each time including the ‘Big 4’ and mid-tier accounting firms, professional bodies and trade organisations. Often smaller firms are unaware of the issues under consideration or feel they have little to contribute.
This is your chance to have your say on how corporate tax affects your firm, and express your views on tax reform for growth.
Calling all Scaleup firms
Do you think that the current corporate tax system needs reforming in order to support your growth ambitions?
If so, Tracey would love to hear from you.
Please contact her at email@example.com to share your views on the current corporate tax system and your thoughts on the two alternative cash flow proposals detailed above.
Tracey Wilson BA (Hons), FCA, CTA, FHEA Tracey Wilson is Associate Head of Department – Accounting and Financial Management, Newcastle Business School, Northumbria University. She is a Chartered Accountant and a Chartered Tax Adviser and is currently working towards a professional doctorate in corporate tax reform for high growth firms.