The government is being urged to review the taxation of small businesses to eliminate the tax benefits of employees working through service companies.

The recommendation is from the Lords Economic Affairs Committee after reviewing the crackdown on Managed Services Companies in the Finance bill and the previous IR35 initiative.

Peers were told by witnesses - including ICAEW - that what Treasury ministers were doing amounted to 'sticking plaster' legislation papering over obvious cracks , but that their approach 'does little to address the underlying structural difficulties in the UK tax system that give rise to the problem'.

The report said the Treasury's approach was to try to unmask the real employment relationship underlying many service companies and deal with the issue as a compliance problem.

But the committee warned: 'There can be no satisfactory resolution of the issues raised by personal and managed service companies without tackling the underlying structural issues, however difficult they may be to resolve'.

It called for 'structural changes to reduce the differences in outcome in terms of tax and NICs payable whether an individual is employed, self-employed or operating though a company'.

Tory chairman Lord Wakeham said: 'More action is needed to level out tax rates for employees and the self-employed to discourage people misrepresenting their true employment status to achieve tax benefits.'

The wide ranging report on the bill avoided the rates of tax - the Lords has no power over taxation - but it also urged new criminal investigatory powers proposed for Revenue and Customs should be subject to 'stringent monitoring' on how they are used.

Peers demanded annual reports to parliament and called for the early introduction of safeguards, with consideration of a taxpayers' charter. The committee also called for rights of appeal against imposed penalties and an informal dispute resolution process.