I have recently been considering the alternatives to IR35, having concluded that the present rules are long overdue an overhaul as they are essentially impossible to apply fairly across the targeted businesses. But doing away with IR35 means that solutions are needed, and here I consider in some depth one alternative suggested by members

The IR35 rules as written require complex decisions to be made about the business which parallel the employment status considerations used outside IR35. However, as I have discussed in the article IR35 – time to go? [1] This presents difficult practical issues for all concerned. A number of members proposed alternatives in response to my article, the most common suggestion being some sort of surcharge on dividend income.

The tax savings available presently are largely generated by the extraction of profits by way of dividends. Although the taxation of dividends spreads far wider than the small business sector, any knock on effect to the wider business / investor community could be limited by making any additional tax charged apply only to dividends in close companies. The proposal would, however affect businesses not currently caught by IR35, which would see their tax burden rise as a result.

Although adding this term into the income tax computation would add to complexity somewhat, it is already in common use in this sector, and advisers need to consider close company status when there are loans to participators from the company. The degree of additional complexity is slight.

Possible Benefits

The additional tax charge on the dividend income could easily be collected through the Self Assessment system. Shareholders and directors of affected companies are likely to be within SA.

Use of the close company definition, although new in this area (SA) would not present additional complexity in reality for affected taxpayers.

Set at the right level, the change may lead to some directors extracting more realistic salaries, and the tax being collected through the PAYE system which would be both simpler and quicker.

Possible disadvantages

New legislation would be required to implement the measure. This could be problematical if not adequately thought through and tested.

If the measure leads to profits being artificially retained within the company, this could result in a reduction in tax revenues. However, the impact of this outcome is likely to be slight, as in reality owners would need a minimum level of income to subsist.

The measure could stimulate businesses disincorporating to save tax if the surcharge was set too high. For those in the contracting sector it is unlikely that this is a viable option as they would struggle to find work as self employed consultants.

The measure could be avoided by taking loans from the company and bearing the tax due under Section 419 ICTA. This has the added advantage of being tax due by the company and not the individual, saving tax on the funds which would otherwise have to be extracted to meet the tax liability. This could require some careful consideration and may lead to the necessity of an increase in the rate of Section 419 tax to prevent this route being an option. This would add further complexity.

Computations

The surcharge is added by calculating 5% of the gross dividend income – that is the dividend plus tax credit. This would be the simplest way to execute such a change through the self assessment system. The figures below assume that 100% of the company profits are extracted by way of salary equal to the NI threshold and the remainder by way of dividend

• Profits of £15,000. Self employed tax and NIC £2,573. Corporation tax (no surcharge) £1,949; Dividends surcharge at 5% tax burden £2,356; dividend surcharge 10% tax burden £2,763




• Profits of £25,000. Self employed tax and NIC £5,373. Corporation tax (no surcharge) £4,049; Dividends surcharge at 5% tax burden £4,895; dividend surcharge 10% tax burden £5,741




• Profits of £50,000. Self employed tax and NIC £13,169. Corporation tax (no surcharge) £9,459; Dividends surcharge at 5% tax burden £11,403; dividend surcharge 10% tax burden £13,346




• Profits of £100,000 Self employed tax and NIC £33,669, Corporation tax (no surcharge) £29,834; Dividends surcharge at 5% tax burden £33,972; dividend surcharge 10% tax burden £38,110

The model produces a disincentive to incorporate at £100,000 profit at both rates of tax. However, it is highly likely at this size that some of the profits would be retained to invest in growth, so the tax burden would be lower in any event.

Using the surcharge to “replace” NIC
A much higher level of surcharge would be needed to mimic the National Insurance charges when profits extracted by way of salary.

Profits of £40,000

• Tax burden – self employed £9,573




• Tax burden – incorporated no surcharge £7,199




• Extract salary of £25,000 plus dividends £10,925




• Rate of surcharge needed to match tax burden 12.4%

Profits of £75,000

• Tax burden – self employed £23,419




• Tax burden – incorporated no surcharge £19,647




• Extract salary of £25,000 plus dividends £26,466




• Rate of surcharge needed to match tax burden 11.2%

I have probably addressed a wider issue in this article than merely replacing IR35, as the suggestion imposes additional tax on all businesses operating through limited companies. However, this might be an acceptable solution in return for abolishing IR35, and might also address in part concerns about income shifting, by imposing an additional tax burden on all limited companies distributing their profits by way of dividend.

What is still in doubt is whether some members can carry the argument that contractors should be “compensated” through the tax system for their loss of employment rights. Is this a price that the general public should pay for a mobile and flexible workforce, or should large companies – those who engage these workers now face a surcharge themselves to replace employer’s NIC lost to the Exchequer?