Article by Christopher Sanger in the April 2002 edition of Tax Adviser. Christopher Sanger is a senior manager at Andersen and a former adviser to the Treasury.
Even in the new days of ‘openness’ and ‘consultation’, it is rare for the government to expose its thinking sufficiently in advance for others to participate in policy formation. Cynics believe that consultation is only undertaken once the government is certain of the approach it wants to take and needs to get the proposals ‘rubber stamped’.
It was a pleasant surprise therefore when in February Chris Wales, a member of the Treasury’s Council of Economic Advisers, spoke to the British Branch of the International Fiscal Association. In his address, he set out a possible future for the corporate tax system, tackling many of the ‘bugbears’ that have become ingrained and now form the fundamental axioms that ATT and ATII students take for granted.
Stability … of direction
The first point to note is that, whilst the Government is considering change, it is maintaining ‘stability of direction’ – i.e. the changes can be seen as a direct continuation of the approach set out in the July 2001 consultation document, Large business taxation: The government’s strategy and corporate tax reforms. That document focused on the twin aims of business competitiveness and fairness, and identified the four key objectives of: maintaining a low rate and broad base system, reducing tax distortions, removing outdated and ineffective restrictions and countering tax avoidance.
Considering the business tax system with these aims and objectives in mind, there are a number of anomalies which we now seem to take for granted. Questioning the rationale behind these, particularly in the rapidly changing environment of the 21st century, is essential if the United Kingdom (UK) tax system is to remain competitive and not a burden. Staying with an outdated system purely to avoid change is short-sighted and the principled approach to reform is welcome.
So what are the areas under consideration?
(1) Capital vs Revenue
Over the last century, one of the fundamental principles of UK taxation has been the distinction between capital and revenue. This has become increasingly challenged, with the loan relationship rules and the new intellectual property rules bringing previous “capital” items within an income regime – providing relief on an ongoing basis and taxing disposals to income rather than capital. This raises the question of whether the distinction remains sensible or whether an income regime should be adopted throughout.
Within the business taxation system, there remain three main areas where capital taxation still applies: real estate, tangible movable property and shares (and investments).
Tangible property - real estate
The ongoing costs of owning real estate are given very little relief under the formal tax system. Depreciation on real estate is an expense of the business and yet the scope for capital allowances is severely restricted. Given the government’s desire to remove tax distortions, this is clearly an area for reform. The intellectual property reform brings intangible assets within an income regime and this approach could be extended to cover tangible assets.
Tangible movable property
Most tangible movable property already features within the income regime through capital allowances. The key issue is whether relief should be based on the depreciation in the accounts rather than rates set out in statute. Again the intellectual property regime provides a glimpse of how this could be achieved.
A note of caution is needed here – the government has made extensive use of capital allowances as a method of incentivising small business and it seems unlikely that it would be prepared to give this up (or indeed should do so). We could therefore be looking at a basic regime that follows the accounts and an ‘override’ to provide special reliefs, such as first year and enhanced capital allowances.
The exemption for gains on structural shareholdings has changed the landscape of taxation for shares. In theory, the remaining shares could be regarded as trading investments in nature and, arguably, taxed as such within an income regime. Again current reform shows how this could be achieved, this time in the shape of the financial instrument (now called ‘derivative contracts’) legislation.
However, life is not that simple. The exemption is restricted to ‘substantial’ rather than ‘structural’ shareholdings, which means that companies with smaller structural shareholdings would lose out. The consultation on this reform raised options for tackling this – the development of a so-called ‘soft test’ that looks at the reasons for holding the investment rather than absolute percentage holding. We wait with hope to see what will be included in the Budget.
The other major concern here is the restriction to trading companies and groups. This would leave some groups exposed to income taxation on structural holdings that do not qualify as ‘trading’. Fear of tax avoidance may be driving this restriction, but in that case closer targeted anti-avoidance would be a better option than a blanket exclusion.
(2) Trading and investment companies
Concerns over the restriction to trading companies may become academic since another proposed area for reform is the abolition of the trading and investment company distinction. Whilst there are clear differences between a quoted multinational and a small closely owned company that holds a single investment, the case for distinguishing in general between trading and investment companies is unclear. Is there really such a fundamental difference between a property trading company and a property investment company? How does this fit with the government’s focus on improving UK productivity? Isn’t this yet another outdated tax distortion?
Drawing a distinction between the two types of companies introduces complexity into the system and a closer examination of the policy behind this is welcome.
(3) The schedular system
The business tax system inherited the schedular basis of taxation – which was originally designed to ensure that no one Inspector could see the whole of a gentleman’s wealth. In the 21st century, the world of computers and ‘cross-working’, the schedular system seems archaic. It brings with it much complexity and many traps for the unwary. The low rate and broad base approach would suggest that a single calculation of business profits would be appropriate – after all, businesses don’t aim to produce ‘Schedule D Case I’ profits.
Some restrictions to this approach could be necessary – such as distinguishing between UK profits and dividends (both UK and overseas). However, the scope for simplification is large and will help avoid losses being stranded and unusable purely because of the vagaries of the present system.
The cost to the exchequer of these changes will be hard to predict and will depend on how efficiently companies are currently utilising their losses. On a macro level, with rumours of large losses being carried forward unused, this change will require much examination.
(4) Group taxation
Further down the policy line is a look at the aggregation of companies. In a similar fashion to the schedular system, operating a ‘company-only’ system of taxation brings with it the possibility of stranding losses in particular companies.
With this system, companies are encouraged to structure their activities in particular companies purely for tax reasons – another tax distortion. The government has started to tackle this with the new ‘notional transfer’ for capital gains purposes. It also looks to group accounts in structuring many of its anti-avoidance rules.
This approach would also be consistent with the direction of the European Union (EU) which has been discussing the benefit of sharing tax revenues between member states based on the consolidated group accounts (which will have to be produced under International Accounting Standards (IAS) for quoted companies from 2005).
Reliance on the accounts
The proposals above will lead to the profits figure used for tax purposes shifting closer to that shown in the profit and loss account (P&L) of the published accounts. However, UK generally accepted accounting principles (GAAP) and IAS are increasingly focusing on the balance sheet position, leaving the P&L account as the balancing movement between the two years. This shift in focus has meant the that P&L is more volatile – as highlighted in the current debate about Financial reporting Standard 17 (FRS 17) (Retirement Benefits).
Is such a volatile P&L suitable for tax purposes – or should the government be looking elsewhere? The answer to this will depend on how GAAP develops over the next few years. The government’s focus is on ‘commercial profit’ for which the accounts are the best proxy at the moment. Increased volatility may prompt the government to re-evaluate whether this remains the case.
The final(?) result
So after all this change, what would the tax system look like? In summary, the profits chargeable to taxation would be the commercial profits of the group, be they revenue related or capital, investment or trading, property or otherwise. Expenses would be available to offset income, even where the two elements were in different companies.
The changes can be seen to ‘level the playing field’ and would bring the corporate tax system closer to that envisaged by the July 2001 consultation document.
So is this achievable? The answer is ‘yes, but …’. Change of this nature is achievable – indeed the government’s first term saw some similarly large changes. However, this is a long programme of reform and there are many challenges to be met along the way. In a time when there are few government funds available and little scope for achieving ‘revenue-neutrality’, this may be difficult to implement and take a long time.
The success of the ultimate programme will depend on tackling these issues and the Treasury’s ability to keep close to the core principles without adding those extra ‘frills’ that can be so tempting.
In any event, the clear sense of direction is welcome.
The views expressed in this article are the author’s own and do not necessarily reflect the views of the firm.
020 7235 9381