Welfare Reform Bill

Memorandum submitted by the Low Incomes Tax Reform Group (WR 20)

Self-employment and the universal credit

This paper is prepared by the Low Incomes Tax Reform Group, an initiative of the Chartered Institute of Taxation to give a voice to the unrepresented. Its purpose is to explore, in the light of proposals in the DWP White Paper Universal Credit: Welfare that Works (‘the White Paper’), the nature of self-employment, the importance of encouraging self-employment in a system that promotes work incentives, and how people who choose to be self-employed can best be supported through the welfare system.

At present, working tax credit can be claimed by both employed and self-employed people who fulfil certain requirements about age and working hours. The entitlement of self-employed people is based on the ‘trading income’ of the tax year: the trading income is the amount of taxable profits of the trade, profession or vocation (or share thereof if in partnership) [1] . If there is a trading loss, it is set off against current year income of the claimant or claimants, then any surplus is carried forward against future profits of the trade [2] .

Under universal credit, the White Paper suggests that once a business has become ‘established’, a floor of assumed income equal to the national minimum wage for the reported hours will be introduced. We would be very concerned for the continuation of the present work incentives for the self-employed in the welfare system if their treatment under universal credit were to diverge from tax credits and the tax system to that extent, and in our view the DWP should seek to retain the tax definitions and measurements of income in universal credit, not force the two systems apart.

Who are the self-employed?

There are some 4 million self-employed people in the UK. The self-employed are a diverse body of people, ranging from budding entrepreneurs to those with little or no business acumen, and all sorts in between. Self-employment can also be an important option for people for whom traditional employment may not be suitable (eg for health reasons), or where employment is scarce. Self-employment can be a long term career choice or it can be a short-term option to tide someone over until the next employment comes along. It can be full-time or part-time, or any variable – some will invest virtually all their time in their business, while others may work only a few hours here and there.

At one end of the spectrum, there are the entrepreneurs with an idea which they wish to pursue, or a skill they wish to exploit, for their own benefit rather than that of an employer. They may have capital with which to start their business, and even means on which to live while developing it. Alternatively they may be working on a private business activity, perhaps at evenings and weekends, while working for an employer as a ‘day job’.

At the other end of the spectrum, there might be people with few means but who wish to exploit a work opportunity, or a literary or artistic vocation with an irregular or uncertain income. They can include the ‘accidental’ self-employed who drift into self-employment to generate some income or extra income; people with disabilities for whom self-employment is a convenient avenue back into work; people (often older people) who have been made redundant and whose redundancy pay can wholly or partly fund a business start-up.

In addition there are some who are essentially self-employed, but because they choose (or are told) to work through a company they no longer strictly rank as self-employed.

Self-employment can be precarious, or it can be a long time before it begins to generate profit. Take, for example, the self-employed person who buys a field with his redundancy money, fills it with Christmas trees and tends them over their life cycle. Or the example of someone who spends the first five years of his self-employment in an uncertain occupation borrowing from friends or family to live and who even once the business becomes ‘established’, so to speak, does not know from one year to the next whether it will flourish or struggle.

How self-employment should be recognised in the welfare system

Work incentives in the tax and benefits systems should encourage those in self-employment at least as much as the employed worker. There is an argument that support from the State should be more generous for the self-employed, given the advantages enjoyed by the employed in return for their NI contributions – reduced rates where an employer contributes to their pension, holiday pay, protection during illness, paid leave for maternity paternity and adoption – none of which are available to the self-employed.

Self-employed people on low incomes, without family or friends to support them, may rely very heavily on the state to help them through the difficult times, and it is to the advantage of the state to provide that support in order to foster and encourage this kind of work. The benefits system recognises this and specifically targets the self-employed through the self-employed credit designed to encourage them off benefits and into working for themselves.

To do this effectively, it is imperative that welfare systems, like tax, should aim to reflect the economic reality of a business. It is right that as a business becomes more profitable, welfare support for the entrepreneur should diminish; equally, declining profits, trading losses and substantial investment in or expenditure on essential equipment can be a drag on the performance of a business and welfare provision for the entrepreneur should reflect that.

At present this is broadly achieved through the structure of working tax credit (WTC). As the basis of assessment of WTC is the tax year, and the measure of income is broadly the profit or loss for income tax self-assessment purposes, the tax credits award simulates how the business is doing financially. Relief for losses through tax credits operates in much the same way as for income tax, with adjustments to reflect the fact that tax credits are awarded jointly to couples, and to remove the facility for carrying losses back to earlier assessment periods that are closed for tax credits purposes. Crucially, as for income tax, loss relief is only granted where a business is ‘carried on upon a commercial basis with a view to the realisation of profit’ [3] – thus manipulation and avoidance can be countered, and support directed towards those whose business activity is genuine and not simply a (possibly extended) hobby.

As the tax system recognises, and as is currently reflected in the WTC, periods of little or no profit, or of substantial investment in the wherewithal to carry on a business, are not confined to the early years. It is important to note that a business can experience difficulties at any time, not just when it is starting out. For example, a one-person business can easily dip into loss when the proprietor decides to take on a new employee, perhaps for the first time. A state that helps and encourages people into work should equally support new employers to provide that work.

In a recession, credit is hard to come by, customers may find it more difficult to afford the goods or services they relied on previously, and the effects are felt right through the small business economy. The bankruptcy of an important customer can have devastating repercussions on a supplier. Even slow payers can cause real problems. A bad debt may spoil what might otherwise have turned out to be a good year. Clearly the intention expressed in the White Paper, to base welfare support on an ‘income floor’ equal to the national minimum wage once a business is established, will run counter to the economic reality of a business that is experiencing difficulties mid-term and will damage the incentives provided by the working tax credit to enter self-employment and to persevere through difficult times.

Moreover, a business in trouble could be incentivised to under-declare the number of hours spent in the business if every hour produced a ‘deemed income’. Such a system might also encourage ‘avoidance’ behaviour and reap unintended consequences.

What do the self-employed live on if their business is not generating any profit?

The answer to this question varies. Some self-employed people may also have a traditional employed job, at least while they are getting their business off the ground. For example, someone with ambitions to be a writer might work, for example as a journalist or teacher, while putting together a body of work for publication – it might be some years before they see any return from their endeavours.

Alternatively, people might subsist on loans in the early stages of a new business. The source of the loan finance may range from a bank to a relative or friend, or a business ‘angel’. Or there may be some equity capital in the form of, for example, redundancy pay or an inheritance. Many self-employed people rely on a spouse or partner to support them, particularly in the early stages before the business becomes profitable, and in lean times.

Or they might draw on whatever money comes in to the business for their living expenses. They will not necessarily know until their accounts are drawn up whether their business income exceeds their outgoings, including investment in equipment and premises. Few people are able to say, at any point during a period of assessment, what their results are likely to be for that period. Even if it looks like they are doing well at the start of a period, an unexpected event (such as is discussed above) or an unexpected outlay (for example a vital piece of equipment breaking down and having to be repaired or replaced) could change all that in a moment.

The self-employed often have expenses which need to be apportioned between business and personal use and only obtain the evidence for that analysis at a later point in time.

At present, the tax system and the WTC both recognise those economic realities, and reflect the peaks and troughs during the life cycle of a business.

How Universal Credit should support self-employment

Calculation of income

Like WTC, universal credit should follow the tax system by basing the business results, on which welfare support is calculated, on the tax year/accounting period. It is absolutely crucial that the same measurement of income and profit should be used as for income tax self-assessment.

But it needs to be recognised that for the self-employed income or profits however measured do not always occur regularly or uniformly in the way they do for employees or pensioners and the concept of a weekly or monthly income can be difficult to replicate in real time. In a universal credit system that is intended to operate more in real time this presents a real difficulty.

There is a further difficulty in that WTC uses a tax-based measure of income whereas housing benefit and council tax benefit, both applicable to low-income self-employed, currently use an adjusted accounts basis which may or may not be the same as the tax basis as the measure of income. A third basis for irregular royalty time income is also used. For universal credit there needs to be some harmonisation especially if a real time basis is intended to be a realistic option.

Recognition of losses and business expenditure

Tax (and consequently WTC) gives relief for (a) capital investment (in premises, equipment etc), (b) revenue expenditure (day-to-day costs incurred in generating profit) and (c) trading losses.

In principle universal credit should, like WTC, follow the tax treatment, which in turn reflects the economic reality. There might arguably be exceptions. For example where the tax treatment differs from standard accounting practice (such as in the annual investment allowance) there might need to be some adjustment. But the fundamental principle remains that there should be one basic measurement of income throughout the tax and benefits system, one that recognises and caters for the reality of business expenditure and losses.

Determining working hours

Availability of WTC is restricted to those who work defined hours – thus people who work less than 30 hours a week are entitled to less WTC than are those who work 30 hours or more, while those who work less than 16 hours a week are entitled to none. Universal credit will abolish the working hours rule which is a welcome step forward. That said, working hours will be relevant for purposes of conditionality. Universal credit should – like WTC – recognise that not only hours spent in actually doing the job, but also work preparatory to carrying out the tasks of the business (eg cleaning vehicles, advertising and looking for customers, etc), should be taken into account as hours during which a person is engaged in self-employment [4] .

Whether work or hobby

Again, for purposes of conditionality, it will be necessary to decide whether a person is engaged in a self-employed enterprise, or merely pursuing a hobby. The main test there will be whether or not the work is done for payment or in expectation of payment [5] , whether in cash or kind and with a view to making a profit.

HMRC’s compliance function regularly challenges the existence and validity of trades and their experience should be sought.

Basis of support

As many self-employed workers often have no idea how their business is doing until the accounts are prepared several months after the end of the accounting period/tax year, it will equally be difficult to determine how much welfare support to give them during that period. It may be necessary to base support initially on the results of the previous year, or indeed the previous year’s income if this is the first year of a new business. If universal credit is to be paid monthly, it could perhaps be based on the results of an earlier period with later adjustments to take account of current year results when known.

This does mean that it might sometimes be necessary to claw back payments from a self-employed person whose results turn out to be better than expected. There will also need to be some safeguards for the authorities against inflated claims.

For tax purposes, payment on account of current year’s liability is made after six months, based on the previous year’s results; and the trader may adjust the payment on account to reflect what he expects his results to be (eg if he expects them to be less than the previous year, he can apply to pay less on account of the current year’s liability). There may be some way in which payments of universal credit could be similarly adjusted to reflect the tax payment on account. A half-yearly review such as this might help the seasonal worker who makes all his money in the first half of the year but needs support for the second half; in the converse situation, support might be adjusted downwards at the half-year point.

If self-employed awards are based initially upon the income from a previous year, it might be possible to institute a generalised reporting system, for example on a quarterly basis, which might give reassurance to both the self-employed and the DWP that no significant under or over payments were accruing. But no reporting system will cope with the unexpected events that quite frequently affect the self-employed.

Manipulation of income to secure higher benefit

We are conscious of the problem in the benefits system that claimants may manipulate their income between periods and/or exaggerate disregards in an attempt to secure or increase an entitlement to benefit. The notional income rules, which are also in working tax credit, should provide a reasonable level of protection against that, and we assume they will be re-enacted in universal credit.

The notional income rules basically allow the DWP (or HMRC in the case of tax credits) to treat a claimant as having income which he does not strictly have. For example a claimant can be treated as still having income of which he has deprived himself in order to maximise entitlement, or he can be treated as paid at the going rate for the job he is doing when in fact he is paid less [6] .

Here again we would emphasise that if tax-based figures are used, then these have the merit of scrutiny by HMRC under their normal compliance operations.

Conclusion

While universal credit has many advantages, we would urge Government not to abandon the features of working tax credit which have made it a particularly suitable method of supporting the self-employed.

March 2011