Maud Clear considers how the surcharge on undistributed income of service companies is preventing this cohort of taxpayer from investing in their own future.

The history of the close company provisions contained in Irish tax legislation today stem from the introduction of a ‘super-tax’ on the income of high earners in 1909. Taxpayers liable to this super-tax were incentivised to defer their liability by sheltering income within a company. Thirteen years later, anti-avoidance provisions within Finance Act 1922 allowed Revenue to collect the super-tax from the undistributed profits of companies with a small number of shareholders, to which the super-tax would have applied if the profits had been distributed.

These anti-avoidance provisions were maintained and expanded in the Corporation Tax Act 1976, preventing the deferral of personal tax through a corporate vehicle by introducing a surcharge on the undistributed earnings of companies under the control of five or fewer natural persons. The provisions applicable today, contained in Part 13 TCA 1997, continue to prevent avoidance or postponement of personal income tax through companies held by five or fewer participators with the application of a 20 percent surcharge on undistributed investment and estate income, and a 15 percent charge on certain undistributed income of service companies.

The differentials in corporation tax and income tax rates continue to present challenges. However, it was a recommendation of the Commission on Taxation, established in early 1980, that close company surcharges should be abolished and for close companies to be charged as partnerships. Further recommendations contained in the Commission on Taxation Report in 2009 noted that the rate differential did not justify a complete abolishment of close company rules but highlighted strong grounds for the abolishment of the service company surcharge for companies supplying professional services. Given the uncertainties within the multinational driven corporation tax base the case for the abolition of these rules should be reconsidered in the context of wider policy support of SMEs.

Service companies

Section 441 TCA 1997 imposes a service company surcharge of 15 percent on half of the company’s distributable professional and service income, and 20 percent on the company’s distributable investment and estate income on aggregate in an accounting period. The amount of distributable investment and estate income is reduced by 7.5 percent in the case of a trading company. No surcharge applies where the distributable income amounts to €2,000 or less in an accounting period, and marginal relief applies to amounts slightly above €2,000.

Under section 441(2) TCA 1997 a close company is considered a service company where the principal part of its income, which is chargeable to tax under Case I and Case II of Scheduled D and Schedule E, is derived from carrying on a profession, providing professional services, having or exercising an office or employment, as well as companies providing services or facilities to such persons carrying on a profession, other than genuine cases where the services or facilities are provided to persons not connected with the company.

What’s considered a profession?

Neither the terms “carrying on a profession” or “professional services” are defined in legislation. Factors indicative of a profession, adopted in the decision in CIR v Maxse [12 TC 41], include a requirement for intellectual skill or a skill controlled by the intellectual ability of the operator.

Guidance1 calls for each case to be examined on its own merits, but lists particular professions as falling within section 441 TCA 1997; accountants, actors2, archaeologists, architects3, auctioneers/estate agents, barristers4, computer programmers, dentists, doctors, engineers, journalist5, opticians6, private schools, quantity surveyors, solicitors and veterinary surgeons.

Until recently, guidance had included management consultants in the list of professions falling within section 441 TCA 1997.7 This followed consideration of the issue by the Tax Appeals Commission8, which placed significant weight on the decision in Mac Giolla Mhaith (Inspector of Taxes) v Cronin & Associates Ltd9 that highlighted the following factors as important in the identification of a “profession”:

1. A requirement for an educational qualification;
2. A code of practice governing members of the profession; and
3. A disciplinary function imposed by a governing body.

The Appeal Commissioner also referred to other sections within the legislation which provide a definition of professional services, for their own purpose. Having considered the academic commentary and jurisprudence on the difficulties in establishing the meaning of the word “profession”, the Commissioner placed their understanding of the word as to involve “not only a certain educational requirement, relevant experience, a public interest dimension but also some form of regulatory control over persons engaged in the profession.” In the absence of a formal education structure to qualify the Appellant’s staff and external experts in performing their work, and the lack of accountability and regulation by a supervising regulator the Commissioner concluded that the Appellant, a company engaged in the provision of management consultancy services, was not engaged in a “profession” or in the “provision of professional services”, as envisaged by section 441 TCA 1997.

The Commissioner’s determination emphasised the absence of clear and precise wording within section 441 TCA 1997 and sought to avoid an “unfair imposition of liability by use of oblique or slack language”.

Principal part of income

Where a company providing professional services generates the principal part of its income from work that is “non-professional” in nature, it may not be subject to the service company surcharge. Revenue guidance notes that while accountants are listed as a profession to which the surcharge applies, bookkeeping, payroll and VAT compliance are considered not to constitute a professional activity in themselves. Revenue guidance also details that the income of a professional service company should be considered on a client-by-client basis relative to the services provided.

The issue of whether the principal part of a company’s income is derived from a profession was considered in another Tax Appeals Commission determination10. Here the Appellant, a company operating an accountancy practice, argued the income of the company could be broken down into constituent parts relative to the professional and non-professional activities carried on, in establishing whether the principal part of its income related to providing professional services.

The Commissioner agreed to an extent noting the matter of whether income was derived from professional, or non-professional activities was dependant on “the nature of those activities and their composition within the whole”. It was determined that the chargeable hours of junior trainee accountants undertaking the preliminary and intermediate steps associated with the preparation and audit of financial accounts, and in support of the client audit process, were associated with the professional service activities of the company. The inclusion of the fee income related to these chargeable hours served to substantiate Revenue’s assertions that the principal part of the company’s income was derived from providing professionals services.

Covid and cash flow

A surcharge will not apply where the income concerned is distributed within 18 months of the end of the accounting period in which it arose. This encourages the company to pay dividends and pushes a tax charge onto the shareholders.

In recognition of the need for companies to retain cash during the difficult circumstances arising from the pandemic, Revenue, on application, extended the 18-month period for distributions by a further nine months. This applied to accounting periods ending from 30 September 2018 onwards for which distributions to avoid surcharge would be due by 31 March 2020 onwards. This concession is said to “enable companies to be better-informed, in relation to the impact of the current circumstances”11.

The impact of the pandemic highlights the inequity the provisions imposing the service company surcharge were said to create in the 2009 Commission on Taxation Report.

Inequity

In that report, the arguments made against the surcharge for service companies included the fact that the decision to incorporate was driven by commercial reasons, such as limited liability reasons or insurance/professional indemnity reasons, not the avoidance of tax. It was further argued that the tax regime is very different to the one under which companies operated when the provisions were introduced. The report set out the inequities caused by the provisions as including a limitation on the ability of companies to reinvest their trade, an impediment on survival during economic downturn and the impact on a company’s ability to obtain credit.

It is widely recognised that retained earnings are an important source of financing for growth and investment for SMEs, so why is it that tax policy continues to treat service companies in this way. Is it the view that the tax avoidance risk still exists, despite the recognition of the inequities caused by the provisions during Covid?

The amount of service company surcharge returned since 2014 has doubled from €9 million to €18 million. While this is a relatively small amount in Exchequer terms, it represents lost opportunities for the companies concerned, along with the amounts distributed to avoid the imposition of the surcharge.

Is the suspicion of tax avoidance still relevant when the history of these provisions is considered? It would be worthwhile to conduct a full cost-benefit analysis on these provisions – is the tax collected greater than the impact of the growth opportunity forgone by service companies? Maybe this is something for the 2021 Commission on Taxation and Welfare to consider. Where companies are given the opportunity to invest in their own future, increased profits are likely to lead to increased corporate tax payments, job creation and potentially increased taxes at the point of shareholder exit.