NI/income tax: Difficult to mix

by Chris Jones, LexisNexis

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15 Jul 2011

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Merging income tax and National Insurance

THE CHANCELLOR announced in his last Budget that the operation of national insurance (NI) and income tax would be merged. This proposal was born from the work of John Whiting at the newly-established Office of Tax Simplification (OTS).

This much discussed merger is an aspiration that will be consulted on over time and is not likely to be introduced for many years to come. This is made more obvious by the continuation of the contributory nature of pensions. If pension entitlement is still to be based on earnings, NI will still exist in some form. This will add a further level of complexity.

However, in addition to simplifying the system, such a merger could address one of the most problematic areas of tax: IR35.

To understand this, we must look at how the system presently works.
Currently, the employed pay higher NI than the self-employed who pay at a rate 3% lower for incomes up to about £42,000.In addition, employers pay secondary NI at 13.8% on their employees'earnings above £7,000 or so.

A limited company can avoid NI altogether by taking a low salary and the balance received by way of dividends without losing any entitlement to the state pension.

Where an individual is running a micro business through a limited company it is in HMRC's interest to look for evidence that there is an employer/employee relationship between the worker and his client(s) under IR35.

IR35 treats the company owner as an employee of the company, thus creating a NI liability on both the individual and the company.

There have been many proposals to deal with this issue. Below is a summary of a possible new tax code that could solve the IR35 conundrum.

This new regime would:

o Establish a ‘look through' principle(as in Spain & other countries) where the company is not part of the tax regime and instead tax the individual on the company's profit;
o Aligns NI - employed and self-employed pay the same amount;
o Abolishes the "Small Profit" corporation tax rate putting all companies on an equal footing and thus creating less of an incentive to set up as a company for tax/NI reasons;
o Broadens the special R&D tax regime to include unincorporated businesses in order that this regime becomes "entity neutral" and open to all businesses, however structured;
o Incorporates Secondary NI into the overall tax burden placed on business;
o Introduces "entrepreneurial incentives" to encourage micro businesses to start up and to provide compensation for higher NI - high initial incentives to reward risk-taking which taper off as the business grows and less "state support" is needed;
o Brings certainty and fairness to all taxpayers;
o Removes the artificial categorisation of employed and self employed.
A ‘look through' regime can resolve many challenges that self-employed and employed status brings about especially when a self-employed person has established a micro business.

To make this happen, it will require cross party support and political will. However, the prize is a genuinely simplified and fairer system that should allow micro businesses to flourish and wealth to be created.

Chris Jones is director of tax & accountancy at LexisNexis

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