Welcome to the May 2005 edition of the PMMC Freelance eNewsletter.

The demand for freelance and contract resource continues to grow unabated, especially in the Public Sector. While this is good news for contractors, recent developments in the application of anti-avoidance legislation make it clear that the UK may no longer be as (small) enterprise-friendly as it once was.

In this edition we look at the implications of the failed appeal by Arctic Systems in the High Court against a Special Commissioners ruling on so-called Section 660 regulations and we put S660 in context, six years after its distant cousin, IR35, changed contracting in the UK forever.

We conclude with an essay in which James Bartholomew explores what could have been if only Britain managed to steer clear of the 'tax and spend' trap.

If you find the newsletter informative and useful, please feel free to forward it to friends or colleagues by using the link at the bottom of this message. You are also invited to contribute to future editions: if you would like to air your opinion, pass on pertinent information for freelancers or contractors, place an 'advertorial' or simply comment on the newsletter in general, please contact us.

In what has been described as a huge blow for small business, Arctic Systems, an IT company owned and operated by a husband and wife team, lost their appeal in the High Court in April 2005. In a landmark case funded by the Professional Contractor Group (PCG), the Court upheld the controversial September 2004 ruling of the Special Commissioners in which Arctic Systems was hit with a hefty additional tax liability based on regulations known as Section 660. This ruling could now pave the way for increased challenges from the Inland Revenue which, if successful, could generate substantially higher tax bills (related to the last six years) for up to 200,000 husband and wife businesses in the UK.

The Court's decision to ratify an apparent Government clampdown on previously accepted tax planning cast a dark shadow over many small businesses already struggling to keep up with a deluge of anti-avoidance regulations and bureaucracy. Six years after the hotly contested introduction of the somewhat aggressive anti-avoidance measures known as IR35, S660 is set to become the new thorn in the side of small business.

Section 660 is not new. The rules regarding so-called settlement (i.e. where income or assets are being passed to someone else, e.g. a family member, in order to reduce tax liability, with the intention to reclaim those assets or benefit from the proceeds of the income later) date back to the 1920's. While these regulations have been on the statute books in their current form since 1988, it is only recently that the Inland Revenue has begun to claim that the S660 rules can be applied to dividend income received from a limited company.

For decades businesses have reduced their tax bills (on the advice of accountants and even the Inland Revenue itself!) by transferring profits, normally in the form of dividends, from a company director to his/her non-fee earning spouse as a joint-shareholder in the company, benefiting from reduced tax liabilities based on the lower tax band and additional personal allowances of the spouse. Under the new interpretation of S660, known by many as the 'married couples business tax', the Inland Revenue now seek to attribute for tax assessment most if not all of the income to the fee earning spouse in cases where the non-fee earning spouse's contribution to the business is not in proportion to the income they receive. Many people have now received letters from the Inland Revenue, demanding payment of additional tax for up to six years.

In a nutshell, the Inland Revenue lists as an example the case of a business owned by a husband and wife where the shares are divided between them. One of the parties is the major fee earner who receives a salary from the business. The profits are then paid out as dividends between the shareholders. The Inland Revenue claims this is a transfer (or settlement) of earnings from the higher tax payer to the lower tax payer in order to avoid tax. They seem to suggest that, although both the husband and wife draw salaries from the business and contribute to it in different ways, the husband is the business's fee-earner and therefore the business's profits should be his and that he is using the dividend route to give his wife income, which would otherwise be his. From that the Revenue concludes that he is avoiding tax because the income from the dividends has been taxed at his wife's basic rate of income tax rather than his higher rate.

As a general guide, you and your business could fall prey to Section 660 if:

• Your spouse owns shares in your company and the amounts of money you and your spouse bring into the company are not in proportion to the number of shares you each own
• You share profits with / pay dividends to any relatives, spouse or close partners who do not play an active part in the business.

Tax planners, accountants and small business owners are struggling to come to terms with the implications of S660. For many, the risk and uncertainty of Section 660, coming on top of IR35 and other regulatory issues, is the final straw, with many people choosing to close down businesses or seek alternative means of arranging their affairs.

A properly structured umbrella and/or composite services company that operate within Inland Revenue guidelines can go a long way towards alleviating some of the concerns around compliance with IR35, S660 and a whole raft of other regulations, compliance issues and fiduciary duties.

Johan Steyn

Editor's Note: Johan Steyn has been working as a freelance Enterprise Resource Planning (ERP) & Management Consultant for 10 years and he is the Managing Director of PMMC (UK) Limited.

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It is 1961 in Hong Kong. A balding, bespectacled civil servant has just been promoted. John Cowperthwaite, 46, has been made Financial Secretary, the number three in the official hierarchy.

He goes to live in the Government home provided, which is grand by Hong Kong standards. But he lives modestly. Cowperthwaite is Scottish through and through - not Scottish like Rob Roy or Billy Connolly. A flinty kind of Scottish. The Hong Kong press soon finds he's not media-friendly.

He doesn't willingly give interviews or show off his family. His manner is dry almost to the point of rudeness. His only concern is to get on with his job. The Hong Kong whose finances he now manages is an oddity of history - a little bit of the Empire that has not yet been handed over to someone else. It has been flooded with refugees, coming with no more than they can carry. The population has soared, from 600,000 or less in 1945 to 3,200,000. The refugees have built shanty towns or live in boats or cramped Government-provided units.

Cowperthwaite is constantly urged to increase taxes and spend money on supposedly worthy causes. Back in Britain, that is precisely what his boss, the British government, is doing under the premierships of Harold Macmillan and Harold Wilson. But Cowperthwaite is the financial secretary who likes to say "no".

He is urged to extend Government housing to the middle class. He refuses. He says that all public housing involves subsidy. It would be wrong to subsidise the middle-classes, who should pay for their own housing. Some businessmen want the Government to build a tunnel across Hong Kong harbour. He declines again. He says that if they think the project would be so beneficial, they should build it themselves. (In due course, they do.) He is urged to allow mortgage interest to be charged against salaries tax, as in Britain. He says "no". It would only benefit those with substantial incomes.

He is urged to tax people on all their incomes, as in Britain, instead of only on their salaries. Yet again, he says "no". Tax on all income is inevitably "inquisitorial", he says, and would discourage investment and enterprise. Although never himself in the top job, John Cowperthwaite dominates policy in Hong Kong.

Cowperthwaite's most important reason for playing Scrooge through the 1960s was to keep down taxes. He thought high taxes slowed economic growth. Low taxes would eventually produce more revenue than higher ones, he argued, because of the growth they would encourage. Fast growth would also benefit the poor by boosting demand for labour and pushing up wages. Fast growth produced "a rapid and substantial redistribution of income". Successful capitalism benefited the poor.

Because he kept to his creed, at the end of his time in Hong Kong, the standard rate of tax was 15%. Even the richest were not asked for more than 15% of their gross income. Profits tax was similarly low. There was no tax at all on dividends or foreign income.

Back in Britain, however, a succession of politicians was building a more all-embracing welfare state. It was, of course, well-intentioned. The early provisions were made by the Liberal government in 1911. The Labour government of 1945-50 took the idea further and so did most of the following administrations of both major parties. By 1971, Government spending had reached 40% of economic activity, a similar level to today. That compares with a mere 10% of economic activity at the start of the 20th century.

So there was a big contrast in the policies followed by Britain and Hong Kong. How did the two places do economically?

Britain, in 1945, was one of the most advanced countries in the world. It had hospitals and doctors admired around the globe, some of the finest engineers and scientists, who only recently had developed the Spitfire fighter and penicillin, among other achievements. It was far richer than the vast majority of countries.

Conversely, Hong Kong was a Third World country, like Kenya or India, only probably even poorer than either of those. In 1945 it was described as "a barren rock". Immediately after the war, average incomes actually fell because of the influx of penniless people. In 1960, the per capita output of Hong Kong was a mere 21.5% of what advanced Britons produced. Britain was nearly five times more productive per capita and, broadly speaking, correspondingly vastly wealthier.

Then, from 1961 - the year John Cowperthwaite became Financial Secretary in Hong Kong, as it happens - output per person began to grow very fast. The rate in the 1960s was 6.0%, while Britain was growing at a snail's pace in comparison - only 2.3% a year.

In the 1970s, Hong Kong's output per person grew even faster - at 6.5% a year. Meanwhile, Britain had to go, cap in hand to the International Monetary Fund, because its credit had run out. Our per capita growth slumped to a mere 1.5% a year.

By 1992, Hong Kong's growth had been so outstanding - and so vastly better than Britain's - that its output per head overtook that of the "mother country". Hong Kong, under the influence of Cowperthwaite, had transformed itself from being a poor relation - a poverty-stricken colony making cheap plastic toys - to Britain's equal. Hong Kong caught up with Britain in a mere three decades.

The contrasting stories of Hong Kong and Britain are powerful evidence that 'tax matters' - but one comparison, of course, does not make for proof. What other countries might provide evidence?

Japan, in 1960, had markedly lower government expenditure than elsewhere. In most advanced countries, spending was around 30% of GDP. But in Japan, government expenditure was not much more than half that - only 17.5%. How did its growth compare? Other countries managed an average growth rate of 4.25% between 1950 and 1973, but Japan did nearly twice as well with an average annual growth rate of 8.0%.

At the other end of the spectrum, the Swedish government, in 1980, accounted for 60% of all that country's expenditure. Over the period that most probably reflects such spending (and the correspondingly high taxes), between 1973 and 1999, what was the Swedish growth rate? A mere 1.4%. When Swedish spending and taxing was at its peak, its growth was lower than that of any other leading country in the world.

The OECD has looked at many countries to establish the relationship between tax and growth. It has come to the conclusion that for every one per cent of a country's economic output that is taken by tax, the output per person falls by 0.6% to 0.7%. So, if a country has, like Britain, taxation of approaching 40% of GDP (compared to well under 10% in the late 19th century), it has reduced its GDP by about 20%. To put it another way, if we had not increased taxation, our output - and income - per capita would be a quarter higher.

So let us imagine, for a moment, that Britain had not massively developed its welfare state (which accounts for well over 60% of all British Government spending). Using the OECD estimate, how wealthy might Britain be now? Instead of having output per capita of US$27,650 in 2003, as we did, it would have been US$34,562. We would have ranked as the third-richest country in the world, instead of the 15th. We would have had higher average incomes than the Swiss or the Japanese. The only countries with higher output per person than ourselves would have been America and Norway. And since we would not have been as heavily taxed as these countries, our take-home pay would have been a little higher even than theirs - the highest in the world.

It seems reasonable to suppose that there are also cumulative effects to being a low-tax country that are not captured by the OECD analysis. Without the welfare state, and the tax it has made necessary, Britain would now have high rates of saving, investment and research (based on retaining virtually all profits made); it would consequently be a leader in technology and medicine. Instead of the top innovative companies in the world being overwhelmingly American, they would include a large number of British names, as used to be the case.

Britain's welfare state did not achieve what it was set up to achieve. It led to lower standards than would otherwise have been realised in healthcare and education. And in addition to these effects, the tax that the welfare state made necessary stopped Britain from reaching its economic potential.

Britain could have been the wealthiest country in the world. But we lost the chance because we created the welfare state.

James Bartholomew

Editor's Note: This essay, published in The Daily Reckoning, has been adapted from James Bartholomew's book, 'The Welfare State We're In' (Politico, 2004).

To find out more, visit Mr Bartholomew's site or The Daily Reckoning.