Companies through the looking glass

Is lookthrough taxation viable?

Earlier this year, the Office of Tax Simplification (OTS) made a number of suggestions on how to simplify tax for micro businesses, in their ‘Small Company Taxation review.’ The report contained the idea of a lookthrough taxation model which the OTS want to develop further and, with this in mind, have recently published a discussion paper inviting comments by 12th September or 30th September by the very latest.

What is lookthrough?

Lookthrough taxation is a way of taxing small companies and their owners by allocating the profits of the company to the proprietors. For tax purposes, the company is ignored and instead the owners are taxed directly on the company’s income under tax and capital gains tax (CGT) rules. This would mean that shareholders would have to pay income tax and Class 4 NIC on their share of the profits and corporation tax would become redundant. No further tax would be due on dividends, as the profit share would have already been taxed.

Lookthrough is only concerned with the taxation of the company’s results, so all other company implications and matters remain unchanged.

Five key issues are considered in the discussion paper:

• Who would lookthrough apply to?
• How would it apply?
• What tax consequences would ensue?
• Would this be an optional, default or compulsory system?
• Would lookthrough deliver simplification?

Who would lookthrough apply to?

The ‘Small Company Taxation review’ suggested that there was a common group of companies that could materially benefit from lookthrough, namely:

• Those that do not intend to increase in size;
• Those that are effectively one-person businesses;
• Companies that distribute all or almost all of their profits; and
• Those that have few assets or need for investment funds.

As lookthrough is targeted at micro companies, the OTS believe it necessary to define and limit its application to protect against abuse. This could be achieved by imposing a monetary limit, e.g the VAT registration limit, currently £83,000, or if a larger figure is required, the VAT cash accounting threshold –  taxable turnover of £1.35 million.

To prevent businesses deliberately reducing trade to remain within the qualifying limits, a multi-year rule could be implemented, e.g companies must leave lookthrough only if they have two or more years outside of the qualifying criteria.

How would it apply?

All the company’s profits, investment income and capital gains would be taxable in the same way as for unincorporated businesses. This would mean allocating such income in proportion with shareholdings. Dividends would be ignored.

As individual shareholders would have to report their share of company income on their Self-Assessment tax returns, then the corporation tax return would become extinct.

Many companies pay salaries to the proprietors so it would be necessary to properly account for this in the tax computation to avoid double taxation, e.g allocating profits after salaries.

A number of other issues would also have to be considered such as interest on directors’ loans and benefits-in-kind; would the latter effectively be ignored and so regarded as taxed under the sole trader rules?

What tax consequences would ensue?

Trading profits

Would have to be adjusted for tax purposes in the same manner as for sole traders to account for disallowable items and include capital allowances. The bottom line would then be subject to income tax and Class 4 NIC.

Other income

Such as rents, interest, etc. would only be liable to income tax and not NIC.

Capital gains

Made by the company would be treated as belonging to the individual, who would then pay CGT if their total gains in a tax year exceed the annual exemption, currently £11,100.

Losses

Would be relieved in the same way as for self-employment, e.g a trading loss would be allocated to a shareholder in the same way as a profit and be available for offset against the shareholders’ income from other sources thereby reducing their tax bill.

Benefits-in-kind (BIK)

The BIK rules would be ignored and so, for example, a company car would be treated as the proprietor’s under the self-employed rules.

PAYE & NIC paid on salaries

Would have to be refunded or credited against the individual’s tax/NIC bill.

Paying the tax

As the shareholders would have to meet the tax liability, then this would be payable under Self Assessment, with payments arising bi-annually on 31st January and 31st July.

One of the arguments against lookthrough is that shareholders would be subject to higher rates of tax than the company but the OTS have batted this off by arguing that the introduction of the new dividend tax has eliminated some of the differential.

Optional or compulsory?

There are two broad approaches for implementing lookthrough taxation. Firstly, an optional (or default) model would give companies a direct choice as to whether they wish to be a lookthrough company. Only those therefore that are likely to benefit will choose to do so but this is likely to involve some tax planning.

The alternative approach is to make it compulsory for companies that are within the scope. This however could capture some businesses that would be adversely affected by lookthrough, e.g if they wish to retain funds for investment. It would therefore be necessary to have some form of escape clause if investment can be demonstrated.

Does lookthrough mean simplification?

The OTS believe that greater simplification could be achieved if lookthrough were combined with cash accounting. Cash accounts are significantly simpler than the way company accounts have to be prepared and have proven sufficient for 1.1 million small unincorporated businesses that have opted to use cash accounting.

Pros	Cons
No corporation tax calculations or compliance to worry about	Same adjustment of profits exercise as corporation tax
No unexpected consequences of drawings/directors’ loans	Need to adjust aspects of salaries
No dividend taxation	Possibility of need for an ‘allocation’ return
Simpler calculation of tax against benefits such as company cars	Optional basis means more complexity and advice required
A compulsory system would be simpler	Optional basis risks exchequer costs and may mean minimal take up
	Undoubted complexity and confusion following the introduction of a new set of rules
	Paying the tax may be cumbersome
	Careful rules would be needed to cover all types of income, losses and expenses etc
	Companies looking to retain profits for future investment could be adversely affected if a simple investment relief system is not devised

Once they have received all responses to this latest discussion paper, the OTS plan to publish their final report in October.

The discussion paper can be download below.

Lookthrough Discussion Paper.pdf