Andrew Morrison is a member of the Scottish Conservative & Unionist Party's Policy Forum.
> Policy summary
To close the tax-loophole whereby directors pay themselves dividends out of their own companies in place of a salary which often results in a nil tax liability whereas the typical employee of the same earnings would be paying 22% income tax and 11% national insurance.
> Policy explanation
Although technical in nature, it is important that the ordinary taxpayer comprehends this one issue because at its heart is a fundamental unfairness between ordinary employees, and self-employed people who are able to establish their own small private company, and become directors of that company. Whereas the employed person receives a salary and must pay tax and national insurance on those earnings, often at very high marginal rates, the person who becomes director of his own company can declare dividends payable to himself amounting to approximately £32,000 per annum and have a nil tax liability.
The Inland Revenue recently entrenched this inherently unfair practice through their Inland Revenue Ruling 35 ('IR35' for short) which provoked an uproar among the accounting profession. This ruling has served as a 'green light' to directors of smaller and medium sized entities (known as SMEs) to continue this totally legal tax efficiency practice.
The Inland Revenue has a definition in tax law of these smaller companies, which are referred to as 'close companies'. A company is defined as being 'close' if it is under the control of the directors. This in practice means the directors have a majority shareholding.
To redress this imbalance in the tax system which deprives the treasury of tax receipts each year, all we would need to do is change tax law so that any dividends made from a company defined as being a 'close company', to a director of that company, so that the sums are treated as being a wage instead.
> Political risks and opportunities
While the Conservative Party, and any other centre-right party for that matter, has typically been affiliated with at least the agreement that a low tax economy is a healthy economy, and at least harbour the desire for a tax cut even if its actual policies are contrary to that, it is important that by actioning this policy we spell out to the public that this is not a tax rise; instead, we are making the system fairer by closing down an easily exploited loophole.
The primary opportunity of this policy is if the treasury is collecting the proper amount of taxes that the spirit of the law intends, then the government will have sufficient funds to offer strategic tax cuts, such as for low earners and abolishing inheritance tax, without being accused of cutting back funds allocated to public services. This reconciles with the party's pledge to maintain investment in the NHS, and improving the armed forces, schools, infrastructure and so on.
There may be some protests from groups championing the causes of the smaller entity however. What is needed to counter these is a clear demonstration in layman's terms that we are restriking the balance to employees and directors of owner-managed small companies so both are taxed at the same rates appropriate to their earnings. Support by the wider public would drown out criticisms from those benefiting from the existing unfair scheme, so long as the issue is put forward in a clear manner that the wider public can comprehend.
> Questions for ConservativeHome readers
- Does this tax reform seem fair, or do directors deserve to earn ~ £32000 per annum tax free?
- Can you think of a manner to sell this policy to the public, so we can gain more political capital from its enactment?
- Are there any other tax-loopholes which could be closed that come to mind?
> Costs
There are no costs envisaged in implementing this policy, other than resources spent in Parliament enacting the necessary legislation. What would occur as a result of this however, is a boost to the amount of tax receipts receivable at the treasury. Increasing tax receipts by collecting the proper amount of tax that the spirit of the law intends would in fact permit the government to cut taxes elsewhere.
The author is incorrect that Company Directors can pay themselves dividends and thus avoid any tax. Dividends are taxed at up to 32.5%.
The reason why Company Directors choose to pay themselves a basic salary and pay the rest in dividends is to avoid National Insurance, which is an entirely different matter. N.I. is supposed to pay for unemployment, sickness and pension benefits. Unemployment and sickness benefits are not available to company directors as, if their company is in receipt of no income, they are not deemed unemployed, if they fall sick the company is responsible for sickness payment, and if they wound up their companies then they would be deemed to have volountarily ceased employment.
The author mentions IR35 as an attempt by the Treasury to get Company Directors, who have only 1 end-client, to pay their fair contribution. IR35 does not do this. If a company director were truly a 'disguised employee' then he should be taxed as an employee would be and pay N.I. as an employee would be. That could be considered moral. IR35, on the other hand demands that the 'disguised employee' also pay the employer N.I. of his 'disguised employer'.
Posted by: John Lilburne | May 31, 2007 at 12:10 PM