Andrew Morrison: Close directors' dividends loophole

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.

 

Comments

[John Coles]

This is unbelievable. A real adolescent whine from someone who doesn't understand the tax system.
You may have misled the Editor, Mr Morrison, with your claim to knowledge of taxation, but you don't fool many on this board. I suggest you read what follows, learn and issue an apology for "passing off" as an expert.
Firstly, no dividend is "tax-free": it is taxable in the hands of the recipient. See Les at 1209 for a very accurate summary of the position.
Now see Mark McArthur-Christie at 1251. As he says, have you, Mr Morrison, considered the impact on the wealth-generator - the small businessman? As Mark M-C says, are you in the right party?

I just cannot believe, Mr Editor, that you have allowed this utterly ill-informed whinger to initiate a discussion, borne of ignorance and envy, on ConservativeHome.
Thank God that my business career is over and that I thrived in the heady years of Thatcherism: I employed hundreds over time and, whenever appropriate to my circumstances, payed myself Dividends. Which, pace any Scottish Socialists, were taxed.

[Og]

This idea comes straight from Gordon Brown Central Casting. And it smacks of the sort of thinking that one gets from politicians who have never taken risks with their own money. In fact, if the cyclopean gloomster gets to hear of this idea, I dare say he will rush it through in time for next month's budget.

[Deputy Editor]

We largely leave it up to "the wisdom of the crowds" to pick apart policy ideas, John.

[Austen]

Oh dear what a lack of taxation and commercial knowledge is displayed in this post. Its straight from new labour and I suggest that the writer applies to cross the floor of the house immediately. If this is the best conservative available in Scotland I do not hold out much hope of a conservative revival in Scotland.

Very sad to see this, and what was the editor doing.

If you want to find out about taxation for one man businesses join the Professional Contractors Group at www.pcg.org.uk.

[TomTom]

You have to distinguish between:
A) REINVESTED profits, that are largely untaxed (e.g. staff training, research and development, marketing, plant and machinery) and when I say "untaxed" I mean full tax relief is given (albeit over a number of years for capital allowances).
AND
B) RETAINED profits, that just means profits not paid out as dividends. I see no reason why companies should be given tax breaks to hoard cash in the bank. This inevitably leads to companies getting too rich for their own good, underpaying dividends and ending up like GEC/Marconi.

Posted by: Mark Wadsworth | February 08, 2007 at 03:27 PM

The concept of "Reinvested Profits" is novel since Mark Wadsworth mixes P&L items with Balance Sheet items. Training, Marketing etc are SG&A items which go in the Costs as line items

PP&E is capital budgeting which is a Balance Sheet item and the Depreciation hiots the P&L but the Amortisation comes from those post-tax funds which have to go to Retained Earnings.

Since the Corporation Tax is c. 28% that means 72% interest expense is borne by the Company. The Amortisation of LOans is not usually covered bu Depreciation which is why companies Lease to finance the operating leases through the SG&A.

One consequence is that if the company suffers a drop in sales it can end up making a post-tax loss which reduces Equity. If there are insufficient Retained Earnings the business is a candidate for a CVA.

Mark wadsworth would do well to review the chapters on Profit & Loss and on Balance Sheet before mixing Costs and Capital Budgeting

[TomTom]

RETAINED profits, that just means profits not paid out as dividends.

The technical term for this is bullshit.

Dividends are the yield on invested capital to the Equity-holder.

Retained Earnings are the surplus reinvested in the Equity Base of the Company which allow the business to gear up using Leverage and give Banks the comfort blanket that the Debt/Equity ratio will not be excessive.

The main failure of Private Equity buyouts is the excessive Debt/Equity ratio which is why firms like Benjys can go bust twice since July 2006 when Sales downturn pushes the business into losses and there is no Equity cushion this gives the Lenders a breach of Covenants and a trip to the Administrators.

There is no merit in weakening the capital base of SMEs unless one is a Communist determined that companies should not have the ability to expand or to cushion themselves against economic volatility.

I see no reason why companies should be given tax breaks to hoard cash in the bank.

This is the language of the Communist. As for Weinstock's GEC - at least it was a FTSE 20 company and a blue-chip paragon - where exactly is it now that Simpson and Mayo followed Mark Wadsworth's advice ?

[A Dilbert]

How any conservative could propose such an idea without any apparent grasp of tax system astounds me.
No! 32K taken as dividends would NOT attract nil tax. It is subject to Corporation tax and income tax. What wouldn't be paid is employers NI & employees NI (about 24& combined).
So bearing in mind that unlike an employee a self employed director will not get holiday (or bank holiday) pay , sick pay, maternity/paternity leave, pensions or training. It would appear that they are at a substantial disadvantage to an employee.
Let's not even mention the tsunami of red tape they have to deal with.
How does subjecting them to a marginal rate of tax approaching 60% make things 'fair'.

In order to keep my business going through thin times and keep a dozen people employed I had to sell my car and my house.
Now what would be my motivation under these proposals?
We don't all want to live off the nipple of the state but this idea would totally destroy any independant endeavour.

[Matt]

Andrew Morrison is clearly Dawn Primarolo in drag, and I claim my £5.

[Sasquatch]

Oh, I get it! New Labour have stolen all the Tory ideas, so New Tories are going to steal all Old Labour's ideas. Good Idea. That should get you back into power.

Andrew, get your facts straight.

1. Dividends are NOT tax-free. They are paid after Corporation Tax, which is roughly equivalent to basic rate tax. If the dividend takes the recipient into 40% band the extra is taxed at the difference rate.

2. Payment of profits as salary merely reduces a company's profits, so less CT is paid; net income to the Government - no change.

3. NI is not a tax, is it? Or are you admitting that it IS a tax? So how come saving NI is tax avoidance? [NI is of course in effect a punitive tax on employers and employees and should be reduced anyway.] Now, a Director of his own company receives NO employment benefits like an employee does, so it is only fair that he does not pay excessive NI. Neither does a truly Self-Employed person (sole trader) pay higher rates of NI or receive employment benefits, so avoiding NI is entirely in keeping with the status of the Director. The Director can't go on the dole if the company has no work, so it is only fair that he preserves the company's income to tide him over the bad times, and can pay out justified dividends when times are good.

The solution is to have a flat tax whereby it doesn't matter how you earn money it is taxed the same.

Andrew, you should be ashamed of yourself.

[Mark Wadsworth]

TomTom, as somebody who has worked in tax and accounts for the best part of two decades, I find it difficult explaining this all in the space of a few lines to people who would rather bandy round terms that they scarcely understand.

I am perfectly well aware that tax relief for capital investment (PP&E) is not given immediately in the year the money is spent.

But, are you prepared to accept that "investment" means when a business takes its profits and uses them to expand the business, whether by spending money on market research, product development, staff training, plant and machinery, advertising?

In the grander scheme of things there is no fundamental difference between "cost" and "capital" budgeting (to use your rather archaic terms), one is more short term and the other is more long term, that is all, as long as tax relief is given, then this will all even out.

To refer back to your original example of tobacco companies with gold fittings in the bathrooms, that is exactly where GEC ended up. Would it not have been better to keep tax-neutrality between paying out or not paying out dividends (already taxed at company level, so no further tax at shareholder level)?

If profits are taxed once and once only (in the company's hands) then what happens next should depend purely on whether the company can use those profits to expand its business, and if not, it should pay out those profits as tax-free dividends.

Plus where will you draw the line between a company that pays no tax on "retained profits" and a sole trader or partnership, that pays tax on all profits, whether "retained" or not?

Let's meet up for a proper economics lecture, I am obviously wasting my time here, this is tantamount to me telling you how to run an NHS Trust, a topic in which I have no experience and on which I would not seek to lecture you.

[Automated Robot]

Andrew Morrison is a member of the Scottish Conservative & Unionist Party's Policy Forum.

And, one suspects, not an entrepreneur, businessman or wealth creator. A bright future in policy beckons, sir!

[Paul]

One thing that has not been pointed out is that taking one's entire renumeration as Shares is not the most tax efficient way.

An employee will be able to get approx £5K tax free. As has already been pointed out. The money paid out in Shares has already been taxed. Further should the income of the person getting the divident enter the higher rate band then any stocks will also attract further tax.

Such a suggestion acts as a positive disincentive for anyone to invest in a company since the dividend is a return on their investment.

It's also worth noting that a number of very large companies are entirely owned by a handful of investors who may indeed be directors. Is the author seriously suggesting that these companies, which employ a large number of people, should equally have their stock taxed in this way.

[Andrew Morrison]

I did say this policy was technical in nature. The misunderstandings above are testament to this.

For a start, only shareholdings from ‘close’ companies to directors (i.e. using the tax law definition of a typically small company where the directors are also the majority shareholders) would apply under this policy. Any dividends received by a mere shareholder would still be treated as a normal distribution, and have the corresponding 10% tax credit, meaning for those not yet higher rate taxpayers, for whom the dividend tax rate is 10%, will have nothing to pay. For higher rate taxpayers, where the rate is 32.5%, the liability would not increase. As such, investment would not be damaged. The ordinary employee, or unincorporated self-employed person, would not be at a disadvantage. Nor would the major directors of companies that are not defined as being ‘close’, such as all publicly listed companies.

If the directors of these SMEs electing to pay themselves via dividends rather than fully salary, then they would be on an equal playing field with people earning the same amount such as accountants, lawyers (remember there are some professions where I believe you cannot operate out of an incorporated company for legal reasons) and others whom the bulk of the Conservative vote depends, such as doctors, teachers, nurses, servicemen in the armed forces, and so on. Standing up for those people is hardly being a ‘Red’, a ‘Communist’, or a ‘Slothful Scot’ as some have implied. Especially after I clearly stated the additional amount of money raised (i.e. the amount the spirit of the law intended), these additional resources could be spent on strategic tax cuts, such as abolishing inheritance tax.

No jealous person envious of other’s wealth would ever, ever offer such a proposal. A few hot-headed individuals need to offer me an apology.

Any mainstream party does not support loopholes. Why would a responsible government dream of deliberately creating a loophole in it’s own legislation? Perhaps that’s why the sensible element of the Party has today, according to the BBC, has warned the Government of loopholes surrounding the new gambling legislation. Would we REALLY want to pass law ourselves riddled with intentional loopholes?

I recognise the fact those hard-working people who start up their own companies are not only necessary to have a thriving economy, but I also recognise that they take on a risk. As do nurses and teachers these days, having to work with the public – they suffer a threat to personal safety. Do we purposefully offer up loopholes to these people too? Of course not…

If the people we need to win over to win power were to read these comments, I tell you what, there would be a few expulsions being issued by the party (assuming you are all even party members!) and Labour would be in power for another few terms. Good work chaps(!)

To the man who thinks a cap on the amount of tax paid is a good idea: if it’s that great, go write up a quick email to the editors here (rather than joining your cohorts in slandering their noble attempts at bringing free speech to ConservativeHome) and let’s see how it gets on.

Yes, companies pay Corporation Tax… but they would pay that regardless of whether a dividend is paid or not. The proposed policy has no effect at the margin on this particular tax, so it’s irrelevant. The whole focus is on what the individual recipient of the dividend paid from his/her ‘close’ company pays in tax (that definition is important – it doesn’t apply to all shareholders, all directors, nor all companies limited by share capital).

Dividends are taxed at present. If you are not a 40% taxpayer, then you only pay 10% on investment income. The 10% tax credit attaching to UK-sourced dividends thus equate to a nil tax liability.

Furthermore, I believe that NI is also a tax. I have never ever disputed this, and only a Labourite would tell you different. That is NOT me, contrary to what some say. I may be the only One Nation Conservative around these parts – so it seems – but that does not make me a communist, that does not make me jealous of the rich (why would I join this party in the first place?).

[A Dilbert]

You are in the wrong party.

Let me spell out your position.

Mrs Mop works for mega cleaning corporation. The directors charge her out at 15 per hour and pay her the minimum wage. On the dividends they collect from her work they play golf all day. Mrs Mop decides to set up her own company and provide cleaning services. Why in Gods name are you going to tax her company at a higher rate?

It isn't a loophole. Any citizen of this country is entitled to set up a valid corporate structure and offer services under that structure. Or are you like NL who believe you have to work for the State or Big Business?

I am frankly appalled. I voted these clowns in in 97 (sorry) and was think of returning to the Tory fold but there is no way I'd have any truck with a party that proposed such an inequity.

[Tapestry]

OK I admit it. I am an alcoholic. No that's not true, but I do admit to being a successful entrepreneur and a high net worth individual, which in social pariah terms is actually worse than being an alcoholic.

In taxation terms I am also an idiot. I put all my money into a trading and manufacturing business in which the survival rate of companies is about 10%. Had I put it into a large house instead, I would be able to sell it and walk away tax free. If I sell my business, the CGT would be low at around 10%.

But I am a total idiot. I actually want to keep my compnay and run it as I enjoy doing that. If I were stupid enugh to actually pay myself a bonus it would be taxed at around 65% (Income tax plus the employer/employee NHIns). With dividends, the total tax including Corporation tax and income tax is not far different. If NHIns wers charged in addition, I would actually get 0%.

Thanks for nothing.

[James Hellyer]

Dividends are paid out of a company's retained income after tax. Salaries are paid before tax, and are an allowable expense. Sole traders or partnerships have their profits taxed and keep the residue. So one can see that of these income types, dividends are the only one paid out from taxed income. Andrew Morrison's proposal would therefore ensure that every dividend, rather than just those of higher rate tax payers, was income that was in effect taxed twice. That's hardly equitable.

[John Coles]

You still don't get it, Mr Morrison. You simply do not understand the structure of the private limited company nor the unique position of the Director-Shareholder. Try to ask yourself this question: what entity benefits from the present regime? Cui bono, Mr Morrison, cui bono?
It's not an easy answer, but once you've thought your way around it, resolve not to dabble about in the field of taxation again and then drop the Scottish Labour party a line to see if they would welcome you on board. Ye'll be gae happier there, mon.

[Liam]

I am astonished that Andrew Morrison has come back to try and defend his ludicrous policy proposal. As far as I can see there are no "misunderstandings" in the posts above. This is a typical politicians repsonse from someone who clearly doesn't understand the implications of what they are suggesting.

The "risk" comparison to nurses & teachers is also a joke. Health & Safety law means that all employees should be protected from un-necessary risk. If they were injured in the course of the job then they could sue their employer (for potentially millions - now that is what I call a risk). That is the risk company directors take.

Small businesses account for over 99% of the total number of UK firms are nearly 70% of these have no employees. The taxing of close company dividends is basically a Labour Policy and was suggested in Browns PBR fo 2003. Labour have quietly dropped the idea for very obvious reasons.

[Neil Reddin (FCCA)]

This proposal has been well commented on and taken apart, but what the hell ...

I would reiterate the fact that companies do pay corporation tax at 19% (minimum). Also, that those who set up such ventures are usually taking more risk (one of the key indicators that would otherwise bring them within the IR35 rules).

If Mr Morrison is looking to equalise the tax treatment between "ordinary" employees and everyone else then what will he do about the self-employed ("Schedule D" as was) - who "enjoy" more liberal rules on deductability of expenses and lower NIC rates? Will they be next in the firing line?

This is the sort of under-the-radar tinkering that Gordon Brown has turned into an art form. Such attacks on "unfair" tax avoidance distracts from a key fact - that the level of tax avoidance (and even evasion) should be viewed in the first instance as an indicator of the real burden that taxation is imposing on the population.

Reduced tax = reduced avoidance.

Lastly, to quote Lord Tomlin:

“Every man is entitled, if he can, to order his affairs so as that the tax ... is less than it otherwise would be.

“If he succeeds ..., then, however unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax.”

(IR Commissioners v. Duke of Westminster 1936)

[Chappers]

Mr Morrison's position is wholly untenable when we remember that the tax burden is already high enough and business regulation is ever-increasing. As many people have said here, starting a small business is hard enough without proposals such as this withering the reward available to those who manage to make a profit. Dividends are a reward for success - they are only payable out of profits, as has been said, after HMRC has had its slice of corporation tax.

If you don't like the pay disparities between health staff and directors, surely the best way forward is to find ways of reforming the health service and cutting waste, and then to pay the health staff more. That is the proper course of Conservative policy.

Mr Morrison tries to pretend that his closing of the loophole wouldn't be that serious because he would "only" be closing it for close companies. These companies are the epitome of the enterprise we should be incentivising. There are a great many companies of this kind. Directors often see such companies fight for survival, putting their personal assets on the line in the first few years of existence.

I agree with Mr Morrison that loopholes are undesirable but simply say this in response: proposing to close the loophole is fine if the tax rate is then brought down so that the tax burden on dividends stays the same, and the change is revenue-neutral. Any Conservative member is correct to be infuriated by the suggestion of tax increases, especially in the current climate.

Perhaps the worst thing about Mr Morrison's suggestion is that it would be another piecemeal interference with the tax system. Gordon Brown has doubled the size of the tax handbook. What the Conservatives must suggest is a complete overhaul of the tax system. It should be transparent, and if we incentivise correctly there is no need for loopholes. Simplifying the tax system would make life easier for everyone, strengthen the economy and save a lot of time. This is Brown's enormous failure. Solving this is the way for the Conservatives to win back trust on the economy. The Conservatives are the only party we can look to for reforms of this kind.

[Csodalatos]

Never mind once the Tory heirarchy see his ramblings perhaps Mr Morrison will join Mr. Sheridan's party. His views would not be out of place there.

[Londoner]

The response from Mr Morrison has not convinced!! (I am a master of understatement.)

Would it not be better for those involved in the Scottish Party's policy-making processes to concentrate on how the Scottish economy might become more successful, so it needs less subsidy from England, instead of proposing more tax on a crucial wealth-creating sector in England, i.e. the proprietor-owned business? I think actually he is as likely to be serving the interests of the Scot Nats as Old Labour with this policy, as if this were thought to be representative of Scottish thought, it would only boost the case for English (i.e. Scottish) independence.

However, let's not be alarmist. This "policy" has no status with anyone and is not likely to get it. Time for the Editor to announce its rejection, if only to calm matters?

[Angelo Basu]

It is a shame that it has been decided not to publish voting levels on the 100 policies proposed as I suspect this one would have a record NO vote.

I'm still scratching my head over how Mr Morisson came up with the idea that it is a loophole he is closing rather than an intentional policy which provides some small degree of favour to small businesses.

[Andrew Morrisson]

Ok guys, I have reassed this and I now feel that I am wrong. I often wonder why my Conservative membership is not revoked.

[Andrew Morrisson]

Oops my spelling is poor today! I mean reassessed of course.