CentreForum: Three tax changes to help rebalance the economy

Tax ConsiderationsVince Cable this month launched our new publication on helping small and medium sized businesses access stock market finance. Here, I’d like to concentrate on three tax changes that could address the broader challenge of ‘rebalancing the economy’ away from an over-reliance on debt and unproductive investment.

I’m all for a highly progressive tax system that doesn’t privilege ‘capital income’, but that doesn’t mean the current system works in a fair or sensible way, as these three bizarre distortions show.

Corporation tax

As George Osborne said in opposition:

Our corporate sector’s excessive dependence on debt is deep rooted in the structure of our economy. In particular, economists have long pointed out that our corporate tax system favours debt financing over equity. Interest costs are fully deductible with very limited restrictions, while the returns on equity receive little or no tax relief.

We should indeed “look again at the generosity of [this] interest deductibility” and the party’s tax policy working group is doing so. But this is not ideal and would kill off many investments that would otherwise go ahead, debt finance being indispensable for many firms. An economically ideal alternative would be to add an equivalent for the cost of equity finance, as is done in Belgium and elsewhere. A revenue-neutral approach, however, may be to partially reduce the debt relief generosity while introducing an equivalent for equity at the same level. We should also look at measures to tackle particular abuses of interest deductibility.

Stamp duty on shares

The UK already has a financial transaction tax in the form of stamp duty on shares. This is a tax with no economic rationale; only that – along with the ‘hat tax’ – it was once the best the taxman could manage.

What’s worse, this transaction tax applies only to certain assets – shares in UK (or UK-listed) companies. This “has helped fuel the market for derivatives contracts, which don’t attract the same tax. [...] By promoting trade in share-substitutes, the tax increases “financial leverage and risk””. Whether the aim is higher taxes on UK companies, pensions, ISAs, or ‘bankers’, this is an absurd way to do it.

The reasons why this hasn’t yet been abolished or reduced are simply public perception and possible cost (though Osborne has found money for the poorer choice of corporation tax cuts). In our report, we suggested a cheap, next-best option would be abolition of stamp duty only for smaller, high-growth companies.

Capital Gains Tax (CGT) on shares

I support taxing capital gains at the same rates as labour, provided that we don’t tax the ‘normal’ rate of return. But there’s a strong case that shares should get a preferential rate to take account of corporation tax – just as is done for dividend income.

To illustrate this, imagine someone invests £100 in gold: it gains in value by £50 and they pay, say, 28% CGT on that gain, getting back £136. If they invest in a company and it makes £50 profit, the profit is taxed under corporation tax at 24%, and then the remaining capital gain taxed again at 28%: they get back £127. So – even ignoring stamp duty – an expanding company making exactly the same return as some unproductive asset speculation is made unattractive to investors.

Depending on what broader CGT reforms we opt for, fixing this bias could mean lowering rates for shares (and again we could do this just for small and medium enterprises (SMEs)), or increasing them for second homes and other non-share assets.

It’s not easy to ‘rebalance the economy’ or improve the tax system at a time of budget-tightening and poor growth, but we must rise to the challenge. On this same theme, in another post I’ll look at ending the taxation of regular bank account interest, and later at the favoured investment treatment of real estate. In the meantime, our report looking especially at SME finance is available at centreforum.org.

* Adam Corlett is an economics researcher at CentreForum, the liberal think tank, and vice-chair of the Liberal Democrats for Drug Policy Reform.

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36 Comments

  • Paul in Twickenham 25th Feb '13 - 11:46am

    A technical point but (I think!) an important one: if a private UK resident wishes to buy £100 of gold then they would do so by buying UK gold coins (e.g. sovereigns or Britannias) that attract no CGT (or VAT) whatever. Note that this CGT exclusion doesn’t apply to non-UK coins such as Kruggerands but it is a very attractive feature of UK gold coins.

    Given the nature of our current economic malaise it might be a risky but firmly directional strategy for government to impose an extra tax on (as you choose to describe them) “unproductive assets”. There is certainly precedent such as EO 6102- the Roosevelt administration’s prohibition on the private ownership of gold. Personally I’d be aghast at such at such a law – in fact I’d flatly disobey it – but I can easily imagine it happening.

  • Liberal Eye 25th Feb '13 - 5:00pm

    How does it help SME’s if there is no stamp duty on shares? Surely there is a key difference between new issues (that raise money for the company) and trading – that merely creates ‘churn’ in the shares and makes money for brokers but not the issuing company.

    As for capital gains the risk is that policies aimed at promoting ‘good’ capital gains (arising from providing patient and supportive capital to growing firms) will quickly be converted to tax avoidance schemes where taxable profits are somehow made to mutate into non-taxable ‘capital gains’.

  • Alex Sabine 25th Feb '13 - 5:31pm

    By and large I agree with Adam’s proposals, especially on the nonsense of stamp duty on share deals, which has all the downsides of other transaction taxes like its equivalent on property transactions.

    As the IFS have argued and both the theoretical and empirical evidence suggests, stamp duty depresses share prices (particularly for firms whose shares are frequently traded), increasing the cost of capital faced by firms and thus deterring investment and retarding economic growth. It also distorts the signals that share prices send about the profitability of firms, since share prices are also affected by expectations of future turnover volumes and stamp duty rates? Therefore scrapping stamp duty would unambiguously improve economic welfare and a rational tax policy would do away with it.

    Adam, you say ‘I support taxing capital gains at the same rates as labour, providing we don’t tax the ‘normal’ rate of return’. But does the existing Lib Dem policy contain this important proviso?

    As it stands, The coalition’s CGT system (inherited from Alastair Darling but with the rate increased) still taxes purely paper gains, thus ultimately working as a back door capital levy rather than a tax on gains. It would certainly be in advisable to raise CGT further without restoring an indexation allowance (to exclude inflation) or, as you suggest, introducing a rate-of-return allowance.

  • jenny barnes 25th Feb '13 - 6:11pm

    I’m puzzled about why corporation tax is fetishized. It’s all very well to imagine that it’s paid out of “profit” and therefore doesn’t affect anybody else, but in fact it’s paid by the corporation’s customers. Like employers national insurance contribution, it doesn’t really matter whose pocket it comes out of, what’s important is the size of the tax wedge between buyer and seller. Maybe we would be better off with a zero rate of corporation tax, and taxes instead on, say, internet searches, internet purchases, and coffee? Just thinking of things at random

  • The difficulty with all tax reforms is that the losers shout much louder than the winners, even if the changes are entirely logical. Moreover, unless governments are willing to increase short-term borrowing, any sensible reductions in taxes in one area of economic activity have to be balanced by increases in other areas. However, if we are talking about medium to long term changes I think there is a strong argument for reintroducing indexation. One of the traditional reasons British people invested in owner occupation was as a hedge against inflation – any increase above the inflation level was merely a bonus. Similarly, the argument in favour of equity investment has always been that over the medium to long term a broad portfolio of shares will outpace inflation and can be expected to grow in real terms at least broadly in line with the rest of the economy. However governments have been unwilling to extend inflation proofing to traditional savings accounts – RPI linked government bonds are too much of a risky investment for the average saver because their capital value can fall as well as rise over a short or medium term. I would therefore argue that tax should only be levied on the excess return over RPI, irrespective whether the return is interest or capital appreciation. This might encourage governments to control inflation better, and also ensure that public expenditure only grows in line with the economy, or at least force governments to justify increasing taxes to pay for increased public expenditure, rather than relying on fiscal drag and a tax system which no one really understands.

  • Eddie Sammon 25th Feb '13 - 9:01pm

    Interest on debt is a legitimate business expense so should remain fully tax deductible. In my opinion It is not for the government to say which form of financing is better for the business owner.

    Regarding a tax deductible equivalent for equity investment: the only way you can encourage a business owner to sell shares rather than take out a loan is by offering even lower rates of capital gains tax or more Enterpreneur’s Relief. Overall I am not a fan of Entrepreneur’s Relief because it favours wealthy business owners and discriminates against people who have smaller share-holdings. It would be fairer to simply scrap Entrepreneur’s Relief and lower capital gains tax for everyone. The tax system should treat all share holders equally.

    Stamp duty on shares: I would be in favour of removing or reducing this however I do not believe this is affecting investor behaviour to any material extent because the rate is so low at 0.5% per purchase.

    Capital gains should be taxed at the same rate as dividends. Gains are accrued post corporation tax exactly the same as dividends therefore they should be taxed exactly the same. A business should not be penalised for deciding to retain profits for reinvestment rather than distribute to shareholders in the form of dividends. The dividend tax credit also complicates the system greatly and could do with being abolished in return for lower rates.

    I plan to respond to the party’s latest tax consultation but in the meantime please be careful because the consultation sounded very anti business to me and it also sounded like it included ignorance because there was no mention of capital gains being taxed at lower rates to reflect the fact they have already been subject to corporation tax.

    A VAT reduction would help businesses as well as consumers…

  • Eddie Sammon 25th Feb '13 - 9:08pm

    PS, the net rates for dividend tax once the tax credit has been taken into account are: 0% for basic rate tax payers, 25% for higher rate tax payers and 36.1% for additional rate tax payers. It would make sense to harmonise capital gains tax rates with these. If you did this you could also scrap the CGT annual allowance.

  • Eddie Sammon 25th Feb '13 - 9:28pm

    Alex, what do you mean the capital gains tax system taxes purely paper gains? It only taxes crystallised gains and is simply the sale price minus the acquisition price. “Paper gains” are certainly NOT taxed.

  • Eddie Sammon 25th Feb '13 - 9:55pm

    PS again, sorry about my tone, I must learn to count to 10! :)

  • Eddie Sammon 25th Feb '13 - 10:22pm

    For your information, once the additional rate is reduced to 45% the corresponding dividend net tax rate will be 30.56%, rather than the current 36.1%.

  • Adam Corlett 25th Feb '13 - 11:07pm

    Thanks for the constructive comments, all!

    @ Paul – That’s very interesting, thanks. Is there a good reason why these coins are minted, classed as legal tender, and therefore exempt from CGT?

    @ Liberal Eye – Aside from abusive churning, I don’t think that key difference between new issues and secondary trading is there. No-one is going to buy shares at a low price if they’re worried they won’t be able to sell them on to others (and this is self-reinforcing). So poor market liquidity is bad for the issuing companies too.

    @ Simon and Jenny – I don’t think you can imply that a tax can be both tiny (it’s only 0.1%!) and yet raise half a trillion pounds or so (and without lowering the volume of trade). One of the good things about income tax is that at least we know who’s hit by it. As with corporation tax – quite right, Jenny – do we know who’d ultimately pay this FTT? Would it be passed on in smaller pensions, lower pay or higher prices, or would the hundreds of billions come only from bankers?

    @ Alex and Graham – I’ll write more about this soon. I’m led to prefer the ‘rate of return allowance’ over inflation indexing, Graham, and will (try to!) explain that in a post. As far as I can see, existing party CGT policy is basically the status quo so I hope the upcoming paper can improve on that.

    @ Eddie – Funnily enough, in our paper we recommended removing the 5% ownership threshold for entrepreneurs’ relief. But that’s not the tax deductibility equivalent I was referring to. I’m talking about an explicit Allowance for Corporate Equity, which could be offset against corporation tax, thus providing a level playing field between debt and equity. I guess Alex meant to refer to below-inflation gains. I’ll look at that issue and the interaction between dividends and capital gains in my next post, but we shouldn’t have a lower CGT rate for everything – just for shares.

  • Eddie Sammon 26th Feb '13 - 12:17am

    Thanks for the reply. I don’t believe there needs to be a level playing field between debt and equity because interest costs the shareholders money whilst paying a dividend benefits the shareholders.

    I also don’t believe that “shares” should be treated differently to other assets because then I would be better off buying shares from an overseas property company than I would making a direct property investment in the UK. You could just make an allowance for UK companies but what actually is a UK company? It is this sort of thinking that allows the likes of Google and Amazon to avoid taxes.

    I’m not trying to disagree for the sake of it, I’m just trying to help the party and our tax system.

  • Alex Sabine 26th Feb '13 - 1:46am

    Eddie: As you say, CGT ‘only taxes crystallised gains and is simply the sale price minus the acquisition price’. When there is no allowance for general economy-wide price inflation (ie the decline in the purchasing power of money), tax is being levied on purely nominal, inflationary gains (hence my reference to ‘paper gains’) as well as any ‘real’ gains over and above that.

    If the sale happens within a couple of years of the acquisition, and inflation is low, then this effect might be dismissed as negligible. However, in times of higher inflation or simply if an asset is held for a long period of time, the cumulative effect can be very significant. This has the perverse result that the longer you hold an asset, and the less successful the Bank of England is in controlling inflation, the higher the effective tax rate will be.

    So to take the UK example, from its introduction in 1965 until Nigel Lawson aligned it with marginal income tax rates in his radical 1988 budget, CGT was charged at a flat rate of 30pc. Until Geoffrey Howe introduced an indexation allowance in 1982, no allowance was made for inflation.

    In the rampant inflation of the period, this led to confiscatory taxation in which CGT fell mainly on purely paper profits and bit deeply, and capriciously, into the original capital itself. This was widely recognised as manifestly unjust, not least because of its arbitrariness. The introduction of indexation benefited the economy by unlocking assets that had been virtually sterilised because of the penal tax that would have arisen on any sale.

    While it’s true that many parts of the tax system aren’t indexed to inflation, it’s particularly important with CGT because the gains can accrue over many years and the cumulative impact of even modest inflation rates can therefore be quite significant.

    For example, let’s assume CGT rates are aligned with income tax rates and you are a 40p rate taxpayer. You buy an asset for £1000, own it for 10 years and sell it for £1500. Inflation averages 3% per year. If you sell it for £1500, your ‘paper’ profit is £500, and your tax bill would be 40% of £500 = £200. But your real profit, adjusted for inflation, is more like £160. So your tax bill actually exceeds the real profit you’ve made and your effective tax rate is more than 100%.

    This is plainly unfair and would also be economically damaging because it would mean that, although the headline rates of income tax and CGT were the same, in practice the CGT regime was much more punitive, indeed confiscatory. Without indexation, and with rates aligned with income tax, we would be seriously over-shooting the taxation of capital gains compared to income in a distortionary way, and causing arbitrary redistribution based on how long an asset is held (the longer it’s held, the more punitive the tax) and how successful the MPC are in controlling inflation.

  • Alex Sabine 26th Feb '13 - 2:06am

    Adam – I agree there is a strong case for taxing shares more lightly so as to avoid double taxation, since company profits that give rise to capital gains have already been subject to corporation tax.

    In principle, I also agree with Eddie that Entrepreneurs Relief should go (though only as part of a wider reform). CGT should not discriminate between ‘business’ and ‘non-business’ assets. People should be left to decide unbribed whether to put their money in a bank account, housing, shares, or into their own business based on their judgement of the risks and returns involved.

    As Robert Chote has argued, we should be wary of the argument that investing in one’s own business is a virtuous act deserving of subsidy in a way that investing in somebody else’s business is not. People should decide whether and how to build an enterprise on the basis of its commercial fundamentals, not its tax treatment.’

    Likewise, we should not try to bribe people into holding assets for longer than they would otherwise wish to do so – economic welfare is best served by having assets owned by the people who value them most.

    The previous government justified taper relief as a way to discourage short-termism, but encouraging people to hold assets for longer than they want is not the same as encouraging companies to undertake productive investments that may take a long time to pay off.’

    (Chote points out that capital allowances are a more effective way of doing this because they specifically reduce the tax on capital investment rather than on the other factors that generate capital gains.)

  • Alex Sabine 26th Feb '13 - 2:44am

    So reforming and fully aligning CGT with income tax, as the Lib Dems claim to want, would not simply involve hiking the rate in a crude bash-the-rich gesture. It should involve
    - reintroducing an indexation allowance (although a rate of return allowance might be better still)
    - aligning the rates with those on earned and dividend income, ideally with a single tax-free allowance
    - giving relief on shares to reflect corporation tax already paid, mirroring the dividend tax credit in income tax

    The latter point is especially important if the CGT headline rates are raised. As the IFS explained when analysing Lib Dem policy at the time of the last general election: ‘The fact that the Lib Dems do not propose this means that the reform would actually over-shoot equal treatment: in some cases, capital gains would be taxed more heavily than income, instead of less heavily as at present. In respect of higher-rate taxpayers in particular, it would replace the current artificial incentive for companies to retain profits to increase the value of the company (rather than paying them out in dividends) with an artificial incentive not to retain profits in the company – except where gains would qualify for Entrepreneurs Relief.’

    The difficulty in devising a rational CGT system is the balance that needs to be struck between on the one hand minimising the scope for tax avoidance that exists when gains are taxed more lightly than income, and on the other trying to keep capital taxes as low as possible to avoid discouraging saving and investment.

    Indeed there is a serious theoretical case put forward by many orthodox economists for abolishing taxes on savings and investments altogether and moving to a pure ‘expenditure tax’ system, but that would be a much more radical reform than anything that’s on the table at the moment. Exempting the ‘normal’ rate of return from CGT would be a step in this direction though. Within the parameters of our current mixed tax system the reforms outlined above would at least be a coherent package.

  • Eddie Sammon 26th Feb '13 - 8:31am

    I agree with pretty much everything in those 3 posts Alex.

    The more I think about limiting tax relief on debt-interest the more I disagree with it. It would reduce risk in the economy but it would also reduce economic growth. It is not a zero sum game either: greater risk leads to greater expected growth. It would also increase taxes for businesses struggling to pay debts.

    I’m not a complete economic liberal, I actually think the net wealth tax is a good idea and goes one better than the mansion tax because it is non-discriminatory.

  • Can we not look at this a different way? If we taxed corporate income based on the UK EBITDA cash flow we wouldn’t need to tax dividends and as interest would come out of after tax net income this would level the playing field between equity and debt finance. Capturing all the UK corporate wealth creation in the tax net would permit a much lower rate of tax to be set and be a significant step towards clamping down on corporate tax avoidance. If we also made intellectual property costs only payable out of the taxed income we would simultaneously remove another major loophole in corporate tax avoidance.

    Stamp duty on both shares and property needs to go. It is an arcane historical tax with no useful role in a modern economy. A Tobin or financial transaction tax is definitely the way forward.

    These two new forms of taxation would allow us a complete rethin k and overhaul of the current tax regime.

  • Adam Corlett 26th Feb '13 - 3:05pm

    @ Eddie – Yes, that’s a fair point about the problem of their different corporation tax rates around the world. In many cases we have a lower corporation tax rate, but there may be a case for only allowing this lower CGT rate to be used for shares listed in countries with high enough rates – or just blacklist tax havens.

    The point about the level playing field is clearer, I think, if you imagine a company that can choose to raise £10m through debt (in return for near-certain interest) or by issuing new equity (in return for expected dividends later). The two aren’t that different from the company’s point of view, and there’s no reason for the tax system to favour debt finance in that situation.

    @ Alex – I agree with pretty much all of that. Do respond to the LD tax group’s new consultation if you can. My only other point is that a rate of return allowance would also solve the issue of dividend alignment and is theoretically equal to an expenditure tax. It’d be great if you could email me at my.name[at]centreforum*org ahead of the rate of return allowance post I’m doing. Thanks!

    @ Mike – Some sort of cash flow corporation tax basis may also do the trick, but I think that would be an even more radical shake-up than introducing an Allowance for Corporate Equity. Totally agree on current stamp duties, but not sure an FTT is any better.

  • Eddie Sammon 26th Feb '13 - 5:08pm

    So you are saying if I raise £10 million through debt then I pay the financier through interest charges which are tax deductible, but if I raise the £10 million through equity financing then the dividend payments are not tax deductible.

    I now see where you are coming from but it is still the incorrect way of looking at it because interest payments cost shareholders money whereas dividend payments don’t cost the shareholders a thing. This is why one is tax deductible and the other is not.

    If you still disagree then we’ll have to agree to disagree but please take these considerations on board.

  • Liberal Eye 26th Feb '13 - 6:42pm

    @ Adam,

    I take your point about investors wanting an exit and that this is most easily achieved by having a liquid market in the shares. But what of possible side effects of this arrangement? In particular, it means that investors may have (and AFAIK usually DO have) a shallow relationship with the company; they can easily come to regard the company as a mere gaming chip, cashing out at the first uptick. This is the exact opposite of the patient and supportive capital that is the gold standard here.

    There are many investors who want long term growth (eg pension funds) so could there not be a way of deploying their capital into small but growing firms? Individually, such firms would probably be too high a risk but bundled together into a portfolio and well managed (‘well managed’ is the key) they could offer a high return with reasonable risk.

    In proposing this I have in mind the example of a company I once worked for that had a (relatively) small R&D programme that, as it happened, was exceptionally well managed. The MD wanted to cut it because it was “obviously high risk” but on investigation it turned out to produce exceptionally high and reliable returns.

  • >In our report, we suggested a cheap, next-best option would be abolition of stamp duty only for smaller, high-growth companies.

    Please provide the objective measures by which “smaller, high-growth companies” can be identified BEFORE they achieve high-growth and so can take advantage of favourable tax treatment, or is this just another tax-rebate that will only be claimable after the event on shares that HMRC deem to be high-growth?

  • Paul In Twickenham 27th Feb '13 - 12:12am

    @Adam – re. CGT on UK gold coins. I assume that you are asking a rhetorical question, effectively “isn’t it time that this loophole allowing unlimited, tax-free capital gains on UK gold coins was closed?”. But I could be wrong.

    The point I was making is that given the unprecedented, secular depression in which the UK (and much of the western world) finds itself, it seems to me entirely plausible that the government will take measures – previously regarded as unthinkable – to make it unattractive or illegal to hold cash or cash-equivalent assets.

    You have no doubt seen The Times headline tonight reporting that Paul Tucker at the BoE is proposing a negative interest rate on savings – in effect, taxing savers for engaging in the anti-social practice of hoarding money – a classic example of an “unproductive asset”, and a perfect exemplar of the sort of policy direction that is now emerging.

    Of course it’s cargo-cult economics .

  • Jon Hunstman, one of the Republican candidates for the US presidential nomination, was interviewed on BBC’s Hardtalk programme on Monday night. He made the point that the current circumstances in the states provide an ideal opportunity for a wide-ranging reform of the US tax code – in particular the elimination of a broad swathe of tax deductions and reliefs in both corporate and personal taxation as part of a medium-term package aimed at bringing the US deficit under control.

    It would appear to me that we are at or approaching a similar juncture here in the UK. The main problem with the UK tax system (as in the USA) is its use to incentivise specific behaviours thought desirable at different times by varying shades of government. Tax raising should focus exclusively on a simple and easily understandable means of taxing national income in an equitable and fair manner across industrial/commercial sectors and personal income bands. Economic incentives should be dealt with directly by grants/matched funding, low interest loans, R&D tax credits or other such direct methods. The economic costs of externalties should be recouped by levies and direct charges appropriate to costs such as fuel duty, carbon emission charges etc.

    On the issue of debt v equity, I would advocate a full tax deduction for dividend payments (as is the case for interest) and elimination of the dividend tax credit entirely.

    Stamp duty on share transactions is a minor tax that is effectively only paid by retail customers. A more important and effective reform is the abolition of stamp duty land tax and its replacement with a series of new council tax bands at the upper limits.

    Capital gains should be taxed at the same rate as other sources of income (subject to the important proviso noted by Alex Sabine) that full indexation should be allowed in computing gains. I believe this is more acceptable method of ensuring equity with other savings income than a rate of return allowance. If dividends are allowed as a tax deduction, there is no need for preferential treatment of gains arising on shares.

    These reforms would provide the backdrop for more radical tax reform in the form of a flat rate of tax across all income sources with higher rate income taxes replaced with Land Value Taxes.

  • @ Joe Bourke

    I agree – many good points.

    Further to the stamp duty land tax, one ‘innovation’ that seems to have attracted remarkably little attention is the Community Interest Levy (CIL) which is a tax on new developments – houses, commercial property or whatever. AFAIK it is determined at the planning stage but actually payable when construction starts. It’s down to councils to set the exact rates and basis but in some cases the rates are high – e.g £80/m2 for private houses/extensions – and I have seen £250/m2 for some commercial developments..

    For a 3-bed house of, say, 140m2 that is £11,200, high in relation to stamp duty. I’m not sure how this is supposed to help as it seems directionally quite wrong.

  • Eddie Sammon 27th Feb '13 - 12:43pm

    Joe, can you not see that a dividend payment is a return of equity and not a cost on equity? We are not comparing apples and apples, Microsoft and Apple never paid any dividends for years – they aren’t a cost of equity investment. If we want to encourage people to raise equity instead of debt then the only way we can do this is by reducing the capital gains tax they pay when they sell their shares to raise money.

    Also, where is the billions of pounds going to come from to implement this bizarre tax break? Do we actually have any tax experts in the tax working group?

  • Eddie Sammon 27th Feb '13 - 1:01pm

    Ignore my point on CGT, i’m getting mixed up between directors cashing out and raising new money for investment. My point on dividends not being a business expense remains the same.

  • Eddie Sammon 27th Feb '13 - 1:45pm

    All profit should be chargeable to corporation tax and dividends are a form of profit. It is this kind of backwards logic that created capital allowances. All expenses should be deductible against taxable profits, including interest.

  • @Paul In Twickenham re: The Times headline tonight reporting that Paul Tucker at the BoE is proposing a negative interest rate on savings.

    The only thing new about this is the name. As any investor will know investment companies already levy charges on the total value of a fund, typically to cover their “administration costs”. If this ever gets implemented we’ll probably see that a 0.5% deduction by the BoE will result in a significantly higher (eg. 1.5.%) deduction from financial services customers to cover the “administration costs” etc. of having to deal with such matters.

    I didn’t really get where Paul Tucker was coming from other than he was suggesting that perhaps we need to think outside of the box a little more.

  • Richard Dean 27th Feb '13 - 4:44pm

    Tax is charged on profits before dividends are taken. So in effect dividends are profits that have already been taxed.

    I think (perhaps someone can confirm?) that. unless the recipient earns very little, dividends are then taxed again, as part of the recipient’s income.

  • Eddie Sammon 27th Feb '13 - 5:44pm

    Yes Richard, you are very broadly correct but it’s too complicated to go into detail.

  • Eddie Sammon/Richard,

    See this link for s dscussion of the concepts behind cost of capital Cost of capital.

    In many cases large firms have found debt financing to be a lower cost method of financing expansion than raising equity, in large part because of the tax advantages of debt financing over equity financing. The private equity industry is wholly dependent on leveraging businesses that have financed themselves with lower risk equity capital with high levels of debt, which has the effect of eliminating corporation tax bills for the new investors.

    Almost all developed economies have a witholding tax on dividends. The UK is an exception and this is one of the reasons that the UK sees billions of pounds of dividend payments remitted to off-shore residents of tax havens without any income tax being collected by the exchequer in the process.

    A witholding tax on dividends will more than compensate for any reduction in corporation tax receipts arising as a consequence of allowing companies a tax deduction for dividend payments

  • Alex Sabine 28th Feb '13 - 2:55am

    Richard Dean, yes you are right: Companies pay dividends to shareholders from profits on which they have already paid (or are due to pay) corporation tax.

    The dividend tax credit takes account of this and is available to shareholders to offset against any income tax that may be due on their dividend income.

    The way this works in practice is pretty damn confusing. Basically, all UK dividends carry a ‘notional’ tax credit which is 10% of the dividend paid. The dividend issuing company is deemed to have deducted the basic rate of tax on dividend income (10%) at source on your gross dividend income – although it doesn’t actually send any money to HMRC – before sending you your post-tax dividend cheque. Once this rigmarole is complete, the dividend you actually receive is the actual dividend advertised by the company…

    The statutory rates on dividend income are 10%, 32.5% and 42.5% and the tax credit reduces the marginal effective rates to 0%, 25% and 36.1%. The route is rather convoluted but the result is to reduce the distortion that arises from the double taxation of dividend income (once at the corporate level and again at the personal level). In effect it means that basic rate taxpayers have no liability on their dividend income, while higher rate taxpayers have a reduced liability.

    However there is no corresponding provision in capital gains tax to reduce the liability on shares, even though the company profits that give rise to any gains have already been subject to corporation tax. This is both iniquitous and an undesirable departure from neutrality in the way the CGT system treats different kinds of gains (penalising those who invest in companies rather than, say, physical property).

    Of course CGT is horrendously complex and full of anomalies anyway, and arguably a more radical overhaul is required as part of the wider reform package that Joe rightly advocates. But ending the taxation of illusory nominal gains and the double-taxation of shares (preferably in a simpler way thn the dividend tax credit) would be two important blows for tax fairness.

  • Eddie Sammon 28th Feb '13 - 7:14am

    Joe, If you look at the fundamental principle behind corporation tax: it is a tax on profit and not a tax on the cost of capital. If you also look at international accounting reporting standards: profit calculations should explicitly exclude “distributions from and distributions to owners”. Adding interest to this exclusion would create a further disparity between taxable profit and reported profit. They designed it like this for good reason.

    What the government are genuinely considering is limiting deductions for interest and I believe this would be bad for economic growth. Yes it could create a more stable economy, but a less productive one. You only have to look at the long-term growth of equities compared with bonds or cash to see the long term benefits of accepting volatility. In two words: risk premium.

    The problem with the leveraged private equity sector, I expect, is caused by capital allowances. Capital allowances allow someone to invest £100,000 and then write £100,000 from taxable profits, when they have only really lost the depreciation because the asset is sitting on the balance sheet and can be sold at any time. However I am not an expert on this sector’s problems.

    I strongly disagree with a UK withholding tax on dividends because one of the foundations of our tax system is that we only tax UK residents. If we are not happy with that then we should change the fundamental principle, not dividend taxation alone.

    The solution to multinational corporations using tax havens is to implement a new sales tax that applies on everything (including books so Amazon can’t avoid it). You should also make it so company’s can’t claim any back. The concept of company’s having a residency is out of date because of the internet and in all honesty corporation tax is now fundamentally flawed. This would be a huge winner politically.

    Alex, I agree on removing inflation from CGT calculations: the global “currency war” is creating a lot of artificial gains so it is more important than ever. I misread your statement when you first mentioned it. I agree dividend rates should be equalised with capital gains (if that is what you are saying).

    Best wishes all and let’s hope and try for a good result in Eastleigh today!

  • Eddie,

    as perhaps ypu will know, corporation tax is levied on adjusted taxable profits not accounting profits. As you note, accounting profits are adjusted to add back depreciation and deduct capital allowances. Certain other business expenses are added back e.g. entertaining, fines or certain legal fees and interest in some cases. In groups of companies losses of one company can be offset against the profits arising in another. There are a myriad of adjustments that may be required by tax law to be made to accounting profits as defined by Financial reporting standards.

    I would agree with your contention that the deductibility of interest should not be restricted. I would however advocate the allowance of dividends as an adjustment to the computation of taxable profits for corporation tax. The corollary to this would be a witholding tax on dividends at a flat rate of tax (I would suggest 32% as the current combined level of income tax and NI).

    Companies that typically distributed 50% of their profits would pay corporation tax only on retained profits. Shareholders (resident and non-resident) would pay income tax by way of a witholding tax. Shareholders in developed countries would continue to benefit from tax credits available in their home countries unde double taxation agreements. Shareholders resident in tax havens would pay UK tax on UK dividends. The pot of distributable profits is increased as the company is not paying corporation tax on profits paid out as dividends and all shareholders, where ever resident, suffer the same rate of UK tax on UK dividends.

    Eastleigh Libdems sounding very positive as we await the count.

  • Eddie Sammon 1st Mar '13 - 10:33am

    Hi Joe,

    You make some good points, I’m glad you agree interest should remain fully deductible. I still don’t think it’s fair to tax dividends differently to capital gains but I am not vehemently against this idea, as I am on limiting interest deductibility.

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