Zero corporate rate goes in clampdown on loopholes

The chancellor executed a U-turn yesterday by scrapping the zero rate of corporation tax he introduced just three years ago in a bid to prevent self-employed people becoming incorporated merely to avoid tax. The move was part of plans to clamp down on tax avoidance measures revealed in the pre-budget report which are expected to save well over £1bn in tax revenues over the next four years.

Having demanded last year that tax experts disclose their tax avoidance ruses, the Treasury moved to close some of the more glaring loopholes. But one of the largest holes was created by the chancellor himself in 2002, when he created a zero rated corporate tax band in order to encourage small companies to retain and re-invest their profits for growth.

The Treasury admitted yesterday that many self-employed and employed people were being advised - quite legally - to incorporate simply to reduce their tax and national insurance contributions. A flood of sole traders became companies, taking advantage of the zero rate and paying themselves a dividend rather than a salary to reduce their NI contributions. Experts reckon that by 2008 the move will have cost the Treasury £530m.

Tax experts pointed out that they had warned the Treasury this would happen. "All the changes [in the pre-budget report] are doing is going back to how the situation was before he started tampering," said Frank Haskew, head of the tax faculty at the Institute of Chartered Accountants.

Last year the Treasury tried to clamp down on the more outrageous abuses of the system but yesterday it announced plans to replace the so-called non-corporate distribution and zero rates with a new single banding set at the current small companies rate of 19%.

Mr Haskew warned that some sole traders who incorporated to take advantage of the favourable rate may now find themselves penalised. The pre-budget report also included measures to protect tax revenues which the Treasury estimates will save £755m annually by 2008. The Treasury is changing the rules so capital losses can only be created and used as a result of genuine commercial transactions. An estimated £300m extra a year is expected in the government's coffers by 2008/9.

The report also extended the current disclosure regime so that businesses must provide information on direct tax schemes and arrangements devised "in-house" within 30 days of implementation, bringing them in-line with accounting firms. Steps were also included to prevent UK residents avoiding tax by exploiting offshore companies and trusts. The Treasury also announced a clampdown on schemes to avoid inheritance tax and reiterated plans to tackle missing trader fraud and tobacco smuggling.