Health and Social Care tax changes – impact on SME deals

Last Tuesday’s announcement of tax rises to fund social care and the NHS represented one of the biggest increases in taxation in recent decades. But what could the changes mean in practice for deals in the SME sector and for investment structuring?

What changes were announced?

The headline measure was presented as a 1.25% levy on earnings, covering those in employment, the self-employed, and business owners paid through dividends. The detail is slightly more complicated. Both employer and employee will pay an additional 1.25% on employment income, meaning the extra tax cost is 2.5% of earnings. Self-employed workers will pay 1.25%. And the income tax rates for dividends at all income levels will be increased by 1.25%, regardless of the source of the dividend income. This means that investments producing dividend income will see an increase in the applicable tax rate while interest-bearing or property investments see no changes.

From April 2022 the tax on earnings will be collected through a temporary increase to national insurance rates, before being replaced by a separate “Health & Social Care Levy” from April 2023.

Which sectors will see the biggest impact?

The changes effectively tax employment, regardless of the profitability of the business. This means that the impact will be felt most by people-intensive businesses. In the context of a tight labour market already experiencing upward wage pressures, these businesses could see a hit to projected profits and valuations.

Does this affect deal and investment structures?

The increase in dividend tax rates with no corresponding change to non-savings income rates means that earning returns as interest rather than dividends is increasingly attractive. Although headline income tax rates for interest are still higher than they are for dividends, where interest is deductible against the paying company’s corporation tax bill, the overall tax cost of paying out profits as interest is likely to be lower.

The gap between capital gains tax, with rates as low as 10%, and dividend income tax has also widened so that the tax on dividends can be almost 4 times that on capital gains, which will increase the incentive to structure transactions for capital return wherever possible.

Should we expect more tax increases?

Tuesday’s changes were tightly targeted at NHS funding with some contribution to social care in future years. They do not raise any money to deal with other demands on the Exchequer. There are good arguments to delay tax increases while the economy recovers from the Covid effect, but as the Government has decided to begin tax rises from April 2022 it would not be a surprise to see further increases as part of the 27 October Budget that was also announced yesterday. Boris Johnson’s refusal to rule out further tax increases at Tuesday’s press conference suggests that there may be more to come.

What tax changes might we see?

We have already had increases to corporation tax, to income tax (by freezing thresholds) and now to national insurance. If further increases are spread more widely then capital gains tax is an obvious target, due to the widening gap between CGT and income tax rates. Early polling from Opinium Research following Tuesday’s announcements also suggests increases to CGT are more popular with voters than other options.

A wealth tax or increases in inheritance tax are other possibilities, though the complexity of raising significant amounts through these taxes makes them less likely.

CGT rises have been discussed repeatedly in recent years, and the October Budget is just the latest in a long line of possible tax-raising dates. Nevertheless, investors and business owners looking to exit businesses by sale or liquidation may want to complete transactions by 27 October to reduce the risk of an unwelcome increase in tax on their proceeds.