Tax on profit –
how much does
a business pay?
You may recall that earlier in the year, The Café had an article on the rise in the standard
rate of VAT from 17.5% to 20% which occurred on 4th of January. VAT is an indirect tax
i.e. it is not a direct deduction from profits and is only paid when an item is bought.
Basically, any business with a turnover of £68,000 or more a year has to register with
Her Majesty’s Revenue and Customs (HMRC - “the taxman”). All VAT registered
businesses must pass on the VAT they charge their customers to HMRC. They can
also claim VAT back from certain goods and services that they have used (e.g. fuel
expenses for transporting goods around) and set that against what they owe to HRMC
themselves.
Of course, all businesses have to pay taxes on
profits as well as VAT, and this article is about
direct taxation; the corporation tax or income tax,
which is taken directly from a business’ profits.
Let us take an obvious but sometimes
overlooked fact first; corporation tax is levied
(charged) on profit not revenue. A business
might sell £100m worth of goods but it would
hardly be fair to tax it on that amount if it had
costs of £99.9m! Corporation tax is therefore
levied on profit and HRMC has rules as to what
can be claimed as a cost. Wages, raw materials,
and interest payments might seem obvious
enough but what about the purchase of new
machinery? Or claiming an amount to replace
machinery that has worn out or become obsolete?
This is not so straightforward and that is why
companies normally hire accountants to determine
what can and cannot be allowed as an expense.
It is, however, not correct to say that “businesses
pay corporation tax”. A company does because it
is a corporation , i.e. it is a totally separate entity
from its owners - the shareholders. (Note that
its shareholders on receiving their dividend will
probably be liable for income tax on that payment
since it counts as income). However, as you
know, not all businesses are companies. If the
business is a sole trader or a partnership, then in
the eyes of the law the business is inseparable
from its owners; they are one and the same. The
owners of these types of business therefore pay
income tax not corporation tax. Just as is the
situation with a company, there are allowances
granted by HRMC as to what can legitimately
be claimed as a cost in order to reduce the sole
trader or partner’s liability for tax.
So, what are the current rates of tax in the UK
and what is the significance of them? Taking
income tax first, an entrepreneur who is a sole
trader or partner has a liability for income tax
depending on how much profit they make (in
exactly the same way as ‘an ordinary employee’
is liable depending on how much s/he earns).
For the 2011-12 tax year there is a personal
allowance of £7,475; this is the amount of
income a person can earn before paying any
income tax. (In practice this is usually divided by
12 and given as 12 monthly allowances against
© Copyright 2009 Tutor2u Limited
tutor2u
Tax on profit –
how much does
a business pay?
continued
earnings rather than someone suddenly starting
to pay tax as soon as they earn £7,476). Income
tax comes in several bands – also known as
thresholds.
The basic tax rate is payable at 20% on
profit/income of up to £35,000
The higher tax rate is payable at 40% on
profit/income between £35,001 and
£150,000
The additional rate is payable at 50% on
profit/income over £150,000
(There is also a 10% tax rate for those on low
incomes but the operation of it is quite
complicated and it does not affect our analysis).
Another very important point when considering
tax paid by entrepreneurs (and employees) is
that the payment of tax at the higher rates only
applies to amounts in excess of the band.
Consider this example. The UK tax year always
ends on the 5th April. For simplicity let us ignore
the tax free allowance. If you were a sole trader
who had made £34,950 profit by April 3rd you
are £50 below the threshold for 40% tax and
would be facing a tax bill of £6990 (20% x
£34,950). You would NOT be considering
closing the business for two days on the grounds
that if you earned another £51 profit you would
now be making over £35,000, be into the higher
© Copyright 2009 Tutor2u Limited
band and would then have to pay £14,000.40
(40% x £35,001). That is not the case; you only
pay the higher rate of tax on the amount of profit
above the threshold – in this case an extra 40p!
(Once again, this is the same for ‘ordinary
employees’ as well).
Corporation tax in the UK can be complicated,
but it is also banded; essentially it is currently
20% on profits of up £1.5m and 26% on
amounts exceeding that amount. It is often
claimed that the government should cut
corporation (and income tax) to make the country
more attractive to entrepreneurs. This would
create more wealth and jobs. The logic seems
simple enough; for example if there is a company
selling mainly to the EU, why operate from the
UK and pay a higher rate of tax when it could
operate where corporation tax is lower and keep
more profit for dividends or expansion?
This is fair enough but the government faces the
problem that if rates are cut it may well experience
a fall in tax revenue in the short term - hardly
what is needed at a time of a huge budget
deficit. (Although in fact George Osborne did
just that in the last budget, cutting the higher
rate from 28%.) It may be several years before
companies abroad make the decision to relocate
to the UK; it will not be a case of “Oh the rate
tutor2u
Tax on profit –
how much does
a business pay?
continued
of corporation tax has fallen in the UK, lets move
the entire company there at once”. Why? To
answer this, let us turn the argument around. If
corporation taxes are lower elsewhere why don’t
UK companies all immediately go abroad? The
answer is that corporation tax is only one of
several factors when making a location decision.
Some countries have undemocratic governments,
liable to confiscate factories and buildings; if this
is the case, then no matter what the rate of
corporation tax, that country is hardly a desirable
destination. That problem is unlikely to occur in
the EU but nevertheless, there are still issues;
the rate of corporation tax in Macedonia (one of
the newer EU members) is 10% - a very tempting
rate. However will it stay at 10%? If not, how
much might it rise by? This needs careful
thought. In addition, perhaps the country’s
infrastructure and suppliers are not to the same
standard as the UK’s, perhaps it workforce does
not have the skills needed. If this were the case
then there would be increased transport and
training costs to consider. In addition, corporation
tax is not the only tax a business must pay, what
is the rate of VAT? What other taxes at national
and local level have to be paid?
Finally, the board of directors of a company
might reason that its senior executives and key
employees may not want to relocate elsewhere
(even if well compensated to do so); they have
family ties and cultural loyalties just like anyone
else.
So in summary:
• The government needs to levy direct taxes on
profit (and income) to help fund its spending
program.
• Direct taxation creates issues with
entrepreneurship. Whilst entrepreneurs ‘love
a challenge’, this challenge combined with a
high rate of tax may deter them from setting
up, ‘having another go’ if they fail, or in the
case of a larger company, cause it to move
abroad. A recent example of this was that in
July it was announced that a key part of
Richard Branson’s Virgin empire is to move
abroad to Geneva.
• Nevertheless, the rates of tax that have a
deterrent effect on entrepreneurs are not clear
cut and the rate of tax is only one factor (albeit
a very important one) when making a location
decision.
© Copyright 2009 Tutor2u Limited
tutor2u