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If an individual engages in a business (as a sole trader) and makes a profit, that is taxed. If two or more individuals engage in business (as a partnership or limited liability partnership) and make a profit the partnership does not pay tax but the profits flow through to the individuals who pay tax on their share of that profit.

If an individual or a number of individuals engage in a business as a Corporation (e.g. a limited company) and make a profit, that profit is subjected to tax. In the UK that tax is called Corporation Tax. In other countries it may be called company or corporate income tax”.

In law companies are have a legal personality separate from that of their owners. That’s one of the reasons why the owners are not responsible for the debts of the company (though if they manage it badly directors can be held liable). So it seems logical to treat a company in the same way as an individual and tax the profits it makes.

That is what corporation tax does and I have written elsewhere explaining how corporation tax works. However the case for taxing companies is based on a serious misunderstanding and is in fact complicated and difficult to manage – not only by the company and its accountants but by HM Revenue & Customs (“HMRC”) itself.

This probably isn’t the place to supply an explanation of how it is that the profits shown in a company’s annual accounts can differ substantially from the taxable profit it pays corporation tax on. Just accept that this is normal and far more often than not is caused by governments deliberately providing allowances designed to stimulate a particular sector of the economy, area of the country, or some similar legitimate purpose (for example the costs of remediation of contaminated land has a 150% tax allowance).

It is the fact of this complexity, not to mention opacity, which leads politicians and media commentators to accuse large businesses of tax avoidance. Very often the seemingly low tax paid is simply caused by a company investing some of its profits in new plant or machinery, new buildings and so on. If the company had to purchase these out of taxed income they wouldn’t spend so much. Which means the businesses they buy from would sell less, make less profit, and pay less tax.

The fact is that whilst companies are conduits for economic activity. They are not individuals profiting from the use of their own capital. At the end of the day it is the shareholders and employees who pay the tax. If the objective is to tax returns to capital, it makes sense to cut out the middleman, and tax the suppliers of capital, the shareholders directly on their returns.

Shareholders are rewarded for the use of their capital by receiving dividends on their shares but as dividends can only be paid out of profits (which have already been subject to corporation tax) when they receive their dividend they are given tax credits so if they are basic rate taxpayers the dividend is tax free and if they are higher rate taxpayers they pay some tax but at a lower rate than for other types of income.

This over complicated system has been criticised for many years but few accountants and tax advisors are motivated to call for simplification. However, the Institute of Directors (IoD) and the Taxpayers Alliance have done just that.

Earlier this year they published their 2020 Tax Commission Report. This is a 420 page comprehensive plan for growth drawn from of 18 months’ evidence gathering by the 2020 Tax Commission which:

  • Presents a comprehensive plan for growth, vital to address problems within the current tax system and the double dip recession;
  • Calls for taxes to be simplified and eight taxes (including corporation tax) to be scrapped entirely;
  • Calls for a single proportionate income tax at 30 per cent; and
  • Sets out a detailed plan for radical but realistic reforms that could be implemented by 2020

Now the IoD have published How to Get Rid of Corporation Tax. This 10 page guide comprehensively explains how a system of taxing corporate profits in the hands of shareholders can provide both simplicity and transparency.

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Category: Taxation

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