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Surcharge proposal Back  
There is a risk that the next budget will introduce a surcharge on undistributed trading income of close companies.This would transform the 12.5 per cent rate of tax, due in 2003, into a 19 per cent tax for Irish indigenous business. The arguments in favour of this surcharge are not convincing.

The proposal
Civil Service planning documents released under the Freedom of Information Act revealed proposals to introduce a surcharge on undistributed trading income of closely held companies. The surcharge would be calculated so as to yield an effective tax rate of 19 per cent on trading income, and 30 per cent on other income. Prior to the publication of this document, it had been generally understood that the planned tax rates for Irish companies were 12.5 per cent on trading income and 25 per cent on other income. Indeed those are the rates that have been legislated for.
The surcharge proposal appears to be driven by a fear that trading companies might not distribute to their shareholders such of their profits as are surplus to their investment needs. Since the shareholders would typically be paying income tax on such distributions at a rate close to 46 per cent, the Department of Finance appear to fear that they would suffer a loss of tax receipts as a result. When the consequence of taking a dividend from a company you control is that you must hand 46 per cent of it to the State, then indeed any sensible shareholder would take no more dividends than the circumstances demand. On the face of it therefore, the Department of Finance fears might seem reasonable.

Why it may be wrong
What this argument overlooks is the fact that the cost of taking dividends from an Irish company has always been expensive. Ever since the tax exemption in relation to dividends out of export sales relieved profits was abolished, shareholders have been careful about the level of dividends they take from companies. A large part of the Irish business base is already on a 10 per cent corporation tax rate without there being any apparent need to introduce a surcharge on trading income. It is not therefore clear that the introduction of a universal 12.5 per cent corporation tax rate changes anything much in that regard.

Furthermore, shareholders must live. Either in the form of salary or dividends, they need to take from the company sufficient to maintain their style of living. Unless they adopt Spartan habits of living, there is little they can do to avoid recognising at least that level of income needed to maintain their lifestyle. This would suggest that the Department’s fears are not well founded.
It is difficult for a shareholder to take money out of a company in any form which is not actually taxable income. There are complex rules to ensure that they cannot borrow money from the company without tax consequences. There are benefit in kind rules that ensure that the company does not fund their lifestyle directly. These rules have all proved effective in the era when many companies paid tax at the rate of 10 per cent and when personal tax rates were above 50 per cent. Why now can these rules not be relied on with a corporation tax rate of 12.5 per cent and
a personal tax rate dropping towards 40 per cent?

It has been suggested that shareholders might avoid recognising income by crystallising a capital gain on their company shares instead. However existing tax rules, and in particular s817 of the Taxes Consolidation Act, make it difficult for a shareholder to realise shares in his family company on a piecemeal basis, without attracting an income tax charge rather than a capital gains tax charge. For that reason, the capital gains route is usually available to a shareholder in a family company only once in his lifetime.

Equity red herring
There also appears to be a fear that there would be a ‘lack of equity’. An unincorporated butcher might pay tax at 46 per cent, while his incorporated neighbouring butcher might be paying tax at 12.5 per cent. Certainly that contrast might at first sight seem strange. But it must be borne in mind that the corporate butcher has to take a salary or dividends if he does not want to starve and be homeless. He will pay tax potentially at 46 per cent on that salary or dividend. How many small businesses actually make surplus profits over and above the necessary remuneration to their owners, and their investment needs? If there are in fact large numbers of such businesses,
it is strange that there are any unincorporated businesses left as corporate tax rates have long been lower than personal income tax rates!

Of course there may be some situations where the contrast illustrated above will exist, but it would not seem sensible to fundamentally reshape our tax system, and seriously damage our low tax strategy for economic development, to cater for a handful of situations. That would not be so much a case of the tail wagging the dog, as the flea on the tail doing so.

What’s wrong with savings?
The surcharge proposal would run contrary to the recommendations that the Commission on Taxation, which reported back in 1985. It envisaged a universal tax system that taxed not income, but only that part of income which was spent. It recommended that savings should not be taxed. The tax system contains a plethora of tax reliefs all designed to encourage savings in one form or another. Why therefore should the Department be so concerned if savings were built up inside a company? The shareholder cannot spend them unless he pays full income tax.

If cash did build up inside a trading company, the Department’s assumption appears to be that it would lead to passive investments, possibly bank deposits. Given the low rate of return on most passive investments these days, it is far more likely that the entrepreneurs running the company would be encouraged by the presence of the cash surplus to think of new trading ventures in which they could employ it, or new ventures in which they could take a stake.

Money which is distributed out of a company by way of dividend is far more likely to end up in large houses and Mercedes than in a new business. Money which is retained inside a company on the other hand has a reasonably good chance of ending up in new productive investment sooner or later. For that reason it seems to be a strategic error to discourage the retention of cash inside a company.

The practical workings of a surcharge present difficulties. If the surcharge were applied by examining each company separately, to determine how much cash it needs for trade expansion, the Revenue would require an army of economists to second guess entrepreneurs. If the favoured method, an arbitrary rule of applying the surcharge where one half of the profits were not distributed were applied, you would get a rule which in economic terms is meaningless. Companies with growth potential would be penalised, and stagnant companies rewarded. Such an approach simply rejects any attempt to be economically sensible. It is the equivalent of the
tax-man putting on a blindfold and striking out wildly around him.

It can only lead to haphazard economic damage.

The Department of Finance and the Revenue have played a critical role in Ireland’s economic development since the mid-1950s. Their pursuit of a focused business friendly direct tax system
helped to create the Celtic Tiger. It is to be hoped that the they will retain the faith they have shown in the power of low tax rates to stimulate economic growth and high tax revenues.

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