An article (by Adrian Rudd, PricewaterhouseCoopers, Tax Adviser's representative on the Technical Committee) summarising a report prepared by Colin Davis, one of the Institute’s technical officers, which was submitted to the Inland Revenue and the Treasury. In it the Institute urges that consideration be given to abolishing the remains of the schedular system as it applies to companies, which would simplify the computation of profits and losses and would reduce compliance costs for companies and the Inland Revenue.
In March 2001 the Revenue published a Technical Note: A review if small company taxation. This makes many of the same points as the Institute, in the context of small companies only. The Institute believes that these principles can, and should, be applied to all companies.
Published in the October 2001 issue of Tax Adviser.
Introduction The schedular system applies to companies in a substantially modified form. It is sufficient in this connection to point to the special tax treatment of loan relationships, foreign exchange and other financial transactions.
Abolishing the remains of the schedular system for corporation tax purposes would mean that it would no longer be necessary to identify sources of income, and compute the income or loss from each source according to its own rules. Instead, a company’s commercial activities and investments would be regarded as a single aggregate business, whose operating profits or losses would be calculated in one computation. This would eliminate questions relating to whether an item of income or expense falls within Schedule D or some other schedule, or whether it falls within Case I or some other Case of Schedule D. It would also eliminate the distinction between trading losses and other losses.
The purpose of the proposed change is to simplify corporation tax computations and to facilitate the closer alignment of accounting and taxable profits at some future time. This would not constitute a basic change, but rather recognition of the new era into which company taxation has already moved. This is without prejudice to the question whether capital allowances should be replaced by a deduction for accounts depreciation and other questions relating to the computation of profits under Schedule D Case I.
The Institute sees this as a logical step following the reform of the tax law relating to exchange gains and losses, financial instruments, loan relationships, Schedule A and intellectual property.
Colin’s report was concerned with removing the requirement that income be taxed on a source-by-source basis, which is a legacy of the origin of corporation tax as an offshoot of income taxation of individuals. Two related issues are the closer alignment of tax with accounting rules, and the traditional capital-revenue distinction. The Institute believes that these issues should be addressed, but as a separate exercise on a slower timetable.
Aligning tax and accounting profits
Abolishing the schedular system would facilitate closer alignment of the computation of tax with accounting profit – but it is logically distinguishable from it. Although the Institute supports closer alignment, developments in accounting standards over the next few years are likely to pose significant issues for how this should be implemented. It is likely that there will be a move away from historic cost accounting to regular revaluation of a wide range of assets and liabilities on a mark-to-market basis. It is also likely that the gains and losses on such revaluations will be taken to reserves other than the profit and loss account. This reflects the fact that while these revaluation gains and losses affect the value of the underlying business (which is clearly of interest to creditors and shareholders) they do not reflect how well it is doing in terms of the results of its business operations. The key questions which will have to be resolved are whether, when, and to what extent, these reserve movements should be taxable/relievable.
If reserve movements are all taxable/relievable immediately and in full, then companies will face the risk of major tax liabilities – without realised profits or corresponding cashflows – arising from revaluation surpluses. The Revenue would face the opposite risk of severe losses, or at least volatility, to the Exchequer – arising from fluctuating rates in the capital markets which do not directly impact the corporate sector’s ability to pay tax. For example, the market value of a corporate’s fixed-interest debt liability could fluctuate very significantly inversely to market interest rates, and quite independently of the real performance of the business, but if the debt is intended to and does remain unpaid to maturity, then all these fluctuations will cancel out over its life.
If however, such reserve movements are not to be immediately taxable/relievable, then rules will be needed to determine which of those items taken to reserves are taxable/relievable, and which are not. It will also be necessary to ensure that cumulatively all gains and losses are brought into account at some stage and do not ‘drop out’ of tax altogether. The Institute believes that these issues – which can only sensibly be tackled as the expected accounting changes become clearer – do not preclude abolishing the schedular system in the shorter term.
Income v capital
There is a case for saying that capital as well as income profits and losses should be treated as part of the results of the overall business and not separately computed and taxed. The implications of this are that capital losses could be set against relieve income profits, that indexation relief would be withdrawn, and capital gains would potentially be taxed before they are realised.
The Institute feels that there would be difficulties and unpredictable consequences for both corporates and the Revenue. Therefore the scope of the current proposal is the taxation of income, leaving the capital-revenue distinction intact, although it will continue to be impacted by other reforms such as the current review of the taxation of intellectual property and purchased goodwill.
Simplification of tax computations
At present, different rules apply to the computation of income from different sources. Where losses arise, different rules apply for granting relief for the losses.
The abolition of the schedular system would involve the treatment of all commercial activities and investments as one source of income. There would be one set of rules for computing income and losses, based on Schedule D Case I principles, and one set of rules for loss relief, based on the rules for trading losses.
The harmonisation of the loss relief rules would result in more flexible treatment for non-trade losses than is given under existing law. In addition utilisation of losses may be accelerated in the short term, although the Institute does not believe that such a change would have long-term revenue implications.
Non-commercial activities, etc
It would be necessary to draw a boundary line between commercial activities and other items included in the accounts. This would be of particular relevance to owner-managed companies. For example, the provisions of ICTA 1988, s. 74 would have to be extended to cover the computation of commercial profits under the proposed one source rule. It is for consideration whether the “non-arm’s length” provisions of FA 1993, s. 136 and FA 1994, s. 167 should be extended by way of codification of the law established in Sharkey v Wernher ((1955)36 TC 275) and Petrotim Securities Ltd v Ayres ((1963)41 TC 389).
Debt and equity
The existing rules would need to be retained, or a revised set of rules introduced, to distinguish between debt and equity.
UK company dividends
UK company dividends should remain outside the scope of corporation tax.
Summary
The Institute calls for all income items to be put into one computation, rather than seeking to maintain outmoded distinctions between different categories of income, which are increasingly irrelevant in a service-based economy with novel financial dynamics. This proposal would bring together the computation of profits and losses on a consolidated basis within a single company. It is likely that this would result in a saving of compliance costs for companies and the Inland Revenue.
The Institute does not envisage doing away with the revenue/capital distinction in relation to companies at this stage.
In the case of owner-managed businesses it might well be necessary to introduce measures to ensure that the boundary between commercial activities and private enjoyment was observed.
Technical Department
020 7235 9381
October 2001 by Adrian Rudd
