No surprise contractor limited companies contributing to a greater small business tax gap -- advisers

The first large set of tax figures in front of the new Labour government don’t bode well for contractor limited companies.

In fact, official figures show that “small businesses,” which includes PSCs, are now culpable for the vast majority of the tax gap.

In HMRC terms, small businesses have increased their share of the £39.8billion tax gap, from 44% (in 2018-19) to 60% in 2022-23.

That means small businesses, officially defined as sole traders and incorporated limited companies, contribute £24.1bn to the tax gap.

While actually published before Labour took office on July 5th, the HMRC figures relate to a pledge made by Sir Kier Starmer.

‘Close the tax gap’

On June 13th 2024, Starmer vowed to “close the tax gap” by tackling avoidance and increasing “registration and reporting requirements”.

The Labour manifesto which he was elected on says it will invest an additional £855m a year in HMRC, whose powers it will “strengthen.”

Ominous, then, for official stats to now show that the Revenue has “lost control of small business tax,” warns Tax Policy Associates.

If the small business tax gap had been closed as effectively as its other gaps, HMRC would net £15bn more each year, TPA tots up.

‘HMRC random enquiry program in 2020-21’

Other tax wonks (the CIOT) say that despite the wealthy and big biz often causing populist uproar, their tax gap is only a quarter of the small biz gap.

“The small business figures reflect big upward revisions from HMRC as a result of a random enquiry programme carried out in 2020-21.

“[The HMRC programme] identified greater inaccuracy and non-compliance than previously forecast,” says the CIOT’s John Barnett.

‘Failure to take reasonable care’

Chair of the CIOT’s technical oversight committee, Barnett continued: “HMRC have not broken down these figures by different types of behaviour within the small business population.

“[But] given that failure to take ‘reasonable care’ and ‘error’ make up nearly half of the overall tax gap, it is reasonable to surmise that a lot of this is due to small business-owners making mistakes.”

Unsurprised, Meredith McCammond, technical tax officer for LITRG, says it’s more than reasonable -- it’s actually very likely.

‘People form a limited company without thinking’

“We’re not massively surprised [at this increase in the small biz tax gap] based on what we see with limited companies and unrepresented taxpayers,” McCammond told ContractorUK.

Referring to the corporation tax chunk of the small biz tax gap being £10.9bn (a hefty 32.2% of total theoretical liabilities), McCammond said too many contractors don’t factor in CT.

“We see individuals form a limited company without thinking.  

“Often they are under the illusion that this is how you must trade if you want to be in business.

“Perhaps sometimes though they set up their limited company on the advice of a friend. Or someone in the pub.  

“With these cases, usually the individuals have very little understanding of how such legal entities must operate.

“And they often cannot separate out their own affairs from those of the company -- and may mistakenly consider or call themselves ‘self-employed.’”

‘Messy limited company filing’

Such individuals “stand very little chance of successfully dealing with HMRC,” the Low Incomes Tax Reform Group’s technical tax officer warned.

“That’s quite apart from Companies House requirements,” McCammond added.

“The upshot for individuals is messy limited company filing and corporation tax compliance issues that they cannot deal with. Both of these can go on to follow the individuals around for years and years.” 

‘Uncertainties in the contractor market may have fuelled the tax small business tax gap’

Taking a forensic approach to assessing the small biz corporation tax gap, with a nod to the IR35 off-payroll rules, is Chart Accountancy boss Teodora Dimitrova.

Dimitrova is equally unsurprised that the gap between what HMRC assesses as being owed by small businesses and what it actually collects is growing, to the extent of now being unparalleled.

“The uncertainties in the contractor market over the last two years, plus the ongoing cost-of-living crisis, might have contributed to delays in corporation tax payments by small businesses,” Dimitrova told ContractorUK, referring to the OPW rules of April 6th 2021.

“It should be noted that small businesses include freelancers and contractors [and their] corporation tax payment deadline is, a little awkwardly, nine months and one day after a company’s year-end.

“If, during this period, small businesses lost their major fee-earning contracts, cash flow issues would have arisen.”

‘Strange anomaly’

Also Chart’s practice manager, Dimitrova says HMRC not charging penalties for paying corporation tax late is a “strange anomaly.”

“As such, small businesses struggling to survive the crisis might have had to default on their corporation tax payments to maintain payments for other liabilities,” she says.

“The increase in corporation tax rates [effective since April 6th 2023] also could have contributed to the financial issues.”

‘Disconnect’

Formerly of HMRC, ex-tax inspector Tom Wallace told ContractorUK that unfortunately, there isn’t just one switch, in one part of the tax system which HMRC can simply flick to fix things.

“Those [of us] at the coalface will know that there is a disconnect between HMRC and the [small business] taxpayer at this moment,” said Wallace, now WTT Group’s tax investigations director.

“While this disconnect continues, HMRC can expect this number [£24.1bn] to increase -- year-on-year. 

“Additional resources, sufficient training, and upskilling of the [tax department’s] current workforce are the only things that will bring this [small biz tax gap] figure down.

“Not behavioural science and not nudge techniques -- which are mostly what HMRC is currently relying on.”

‘Labour to raise £5.2bn by investment in reducing tax avoidance’

In their general election 2024 manifesto, Labour promises to raise £5.2billion (by 2028-29) from closing further non-dom tax loopholes and “investment in reducing tax avoidance.”

Richard Murphy of Tax Research think it’s all pie in the sky -- both Labour’s figures and HMRC’s figures.

“Apparently [according to the HMRC data], at the same time as business is not paying its corporation tax liabilities, it is paying a great deal more of the VAT that it owes.

“That makes no sense at all. Behavioural changes of the sort implied by this data do not happen. 

 “[And really] have a look too at the data on that unpaid corporation tax. It's all down to small businesses, but apparently, they only do not pay their corporation tax.

“That cannot be true. If profits are not taxed so are turnover and payroll untaxed, but the tax gap data does not reflect that fact.”

‘Labour’s existing policies won’t close the tax gap’

As for Labour, Murphy says the party won’t succeed at closing the tax gap – at least “not with its existing policies.”

In a post, the tax researcher continued “And not without spending £1bn to reopen HM Revenue & Customs offices in the community, to get closer to the source of the problem.”

To help ensure “everyone pays their fair share” of tax, Labour last month said it would invest in “new technology” and “build capacity within HMRC.”

‘Business taxation roadmap’

The party has also committed to publishing a “roadmap” of business taxation, so traders can have “confidence” in investment plans.

Further to capping corporation tax at 25 per cent, Labour vowed in June to “give firms greater clarity on what  qualifies for allowances”.

The party adds that due to “disincentives” and “undue [financial] burden,” it will replace the current business rates system, to help “support entrepreneurship.”

‘Not a huge amount of money’

Sounding more akin to a complaint which a high street shop-owner might make in the current climate, chancellor Rachel Reeves reportedly said on election night, “There’s not a huge amount of money [out] there.”

But Reeves does sound interested in hypotheticals in research which, relating to the small business tax gap, has been totted up to net the Treasury’s coffers that extra £15bn more a year in revenue.

In her first speech as chancellor of the exchequer, Reeves, a former BoE economist said last week:

“New Treasury analysis that I requested over the weekend shows that, had the UK economy grown at just the average rate of other OECD economies this last 13 years, our economy today would have been over £140bn larger.

“This could have brought in an additional £58bn in tax revenues in the last year alone. That’s money that could have helped revitalise our schools, our hospitals, and other public services.

“Growth requires hard choices – choices that previous governments have shied away from. And it now falls to [the new Labour government] to fix the foundations. There is no time to waste.”