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Details required on small business tax plans

    It was announced in the Budget that the Government will consult on the details of a new scheme to allow small unincorporated businesses to calculate their tax on a cash basis.

    Up to 3 million businesses would be given the chance, if they wished, to pay tax on this basis rather than on the usual earnings basis. Someone paying tax on the earnings basis is, for example, liable to tax on an amount as soon as it is invoiced to the customer, and needs to work out differences in opening stock and closing stock to calculate his profit. These matters are not directly relevant to someone paying tax on a cash basis.

    But the details of the scheme will indeed be important to see how much simpler the new scheme will be.  As recently as November 2008 there was a consultation document on whether small companies should be able to calculate tax on the basis of their cash flow. The summary of the responses to that consultation was “The cash flow option did not have convincing overall support. There was some limited support for exploring the cash flow option, but this was not widespread and even this support tended to lessen when the detail was considered. Therefore this idea will not be pursued further.”

    While the latest proposal is for unincorporated businesses, most of the same points apply as for companies.  It does seem surprising that the Budget proposal was made without addressing the reactions encountered in the earlier consultation. The risk is that many of the 3 million taxpayers faced with the choice will be reaching for the paracetamol, instead of enjoying much simpler tax compliance.

    So, what sort of details will need to be considered with the new proposal? Unfortunately it can only really be seen why these matter by setting out many of the issues, so that one can begin to assess their total impact.

    For example:-

    A. Transitional arrangements:-

    1.    Rules would apparently be needed to give relief for the cost of trading stock held when the new regime begins to apply to a taxpayer, so that tax would be due only on the profit on a subsequent sale of this stock. Similar considerations apply to other assets held upon a change to the cash basis for which no prior relief for the cost was obtained, (e.g. where a businessman sells his lease, or even where a gardener who has not bothered claiming capital allowances on a lawn mower moves to the cash basis and then sells lawn mower).

    2.    Debts due to and from the business would apparently need to be identified, so that if their tax consequences had been taken into account on an earnings basis before the transition, they would not be taken into account again afterwards on a cash basis when the debts were paid.

    B. How the rules would work after the transition

    1.  Rules would still apparently be needed for expenses not wholly and exclusively incurred – for example, business entertaining, payment of tax penalties, expensive car hire etc. What others might need to apply?

    2.  Rules would also apparently be needed to catch appropriations from trading stock (e.g. fruit seller deducts the cost of buying fruit, but then sells two-thirds of his stock while his family eats a third of the stock,). Similar rules would be needed where other items are appropriated out of business use (e.g. a trader claims relief for the cash cost of a business computer which he then gives to his son, and then buys a new computer, deducting the cost).

    3.  It would be necessary to address barter transactions (e.g. a trader cleans a windows for someone who gives them in return vegetables from their garden). The Office for Tax Simplification have recognized this point, and say that the new regime might more accurately be described as a “payments and receipts basis”, rather than a cash basis.

    4.  Would a cash basis encourage more evasion - especially if a trader no longer needs to keep a record of work done?

    5.  Would one need avoidance rules for dealing with related parties, if one is on a cash basis and the other is on an accounts basis? Would you need avoidance rules where a business is artificially split into two, to stay below the limits to retain the cash flow basis for each?

    6.  Rules may also be needed for identifying the interest element of loans made and received - assuming the cash basis of tax would not apply to the loan principal.

    7.  What about, for example, pre-trading expenses, or the averaging basis for farmers and artists?

    8.  Will losses still be available for carry-back, carry-forward, or sideways against other income? Would, for example, sideways loss relief be restricted where losses are generated by asset purchases?

    9.  Would the cash basis be available for small property businesses as well as trades? If so, would any special rules be needed for a sales and reconveyance, which has the same commercial effect as a lease, but very different tax consequences on the cash basis? This could be especially relevant if one party is on a cash basis, generating a cash loss on a purchase, whereas the other party is on an accounts basis.

    10. Will rules be needed to prevent artificial acceleration of payments (e.g. a trader pays two years rent in advance), or the deferral of receipts (e.g. into next tax period)?

    11. Would the same rules for basis periods apply as at present, for e.g. the commencement of trade in a given tax year?

    C. Moving out of the new regime as turnover increases

    1. Once the business gets too big to use the cash flow basis, what further rules will be needed, (apart from the inverse of those issues mentioned in A above)?

    2. Will the business be expected to see the problem coming (and adjust its records accordingly) or will it be able to defer for a year or so afterwards the use of the usual earnings basis.

    D. Other issues arising

    1. Will the Government Consultation address the basic issue of whether the cash basis is a good basis for charging tax? Cash flows are not of course a measure of profit, and in some situations may not be even be an approximate measure of profit. For example, a loss making trader may want to sell a capital asset to raise cash for the business, and as a result still find he has a tax liability through using the cash basis (even though the asset may not have been sold for a profit).  The cash basis will inevitably mean therefore that some people may make a substantial profit and pay no tax (e.g. those who continually purchase capital equipment) whereas other people making a loss will pay tax. The latter problem could apply where a loss making trader receives a substantial prepayment at the end of a tax year. Could this factor distort the decision about whether to ask for a prepayment? Could the cash basis distort business decisions as to whether to buy or sell assets?

    2. Will traders prepare tax calculations on the usual earnings basis and also the cash basis to see which saves tax – i.e. could the proposal actually cause more work and not less? Will the trader be missing useful information as to how his business is doing if he does not calculate his profit on the usual earnings basis?

    3. Finally, what about returns of business profits for other purposes? If, for example, a farmer makes a profit of £50,000 on a conventional basis but buys a tractor for £40,000, so that he only makes a profit of £10,000 on a cash basis, will the £10,000 figure be acceptable if he applies for state benefits, or if he applies for financial help from an independent school for his child? If not, he would apparently still need to prepare ordinary accounts in addition to his cash flow accounts, and would end up doing more work than before, not less.

    Conclusion

    Although the above issues need to be addressed they are not necessarily insuperable. Other countries have adopted a cash flow basis for small business. But (a) we need to recognise that other countries are different and have different tax cultures concerning the extent of avoidance as well as the extent of evasion, (b) when taxpayers consider the detail the option may prove less attractive to them (as happened in 2008), and, importantly, (c) we have not yet made a real effort to simplify our tax system. If this were done small businesses might have much less cause to opt for a very different basis of taxation.

    David Martin enjoyed a career spanning 23 years as a tax lawyer within a large City Law Firm, latterly as Head of the Tax Department, before taking early retirement in 2002. During that time he advised both company and individual clients. He now lives a less pressurised life in Devon with his wife and two daughters and maintains an active interest in tax law.

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