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Corporation Tax reform: the next stage

Category Technical Articles
AuthorTechnical Department
Article by Christopher Sanger, a member of the CIOT Tax Policy Committee, a director of Deloitte & Touche and a former adviser to the Treasury. He reviews the government's latest proposals for reforming the UK's Corporate Tax system. This article appeared in the September 2002 issue of Tax Adviser. The British summer has many traditions and it seems that the government has decided to add another one just for us – the corporate tax policy consultation document, a lively addition to your holiday reading! Outlined in the Budget and building on informal discussions with businesses since then, the scope of the paper was clearly known and is not surprising. Nonetheless, the changes if implemented will be important to all businesses, representing a significant step change in the taxation of companies.

Focus of the consultation

In the time since the Budget, the government has concluded that business would like:

  • a sense of stability of direction for the tax system;
  • a simpler system of corporation tax, and; and
  • certainty of treatment for individual transactions.

In addressing the first of these concerns, the government has made it clear that this consultation builds on the principles set out in last summer’s publication: 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identified four key objectives of: maintaining a low rate and broad-based system, reducing tax distortions, removing outdated and ineffective restrictions and countering tax avoidance.

The government is seeking to address the other two concerns of business through its middle two objectives (reducing tax distortions and removing outdated restrictions) thus producing a more neutral tax system. While this focus on neutrality is nothing new, the difference here is the acceptance that a neutral tax system is not an aim in itself, but one of a number of objectives, to be considered in context.

Three reforms under the spotlight

The consultation focuses on three main reforms:

  • moving corporate assets still within the capital gains regime into an income regime;
  • rationalising the schedular system, replacing it with a single source (or reduced number of sources) of profits; and
  • aligning the treatment of trading and investment companies.

While all three of these changes were covered in my article: Business Tax Policy: a vision for the future? (Tax Adviser, April 2002, and under discussion since the Budget, the consultation document provides an update on the government's thinking as to how far it is comfortable proceeding with these changes.

Commercial accounts

Before considering the changes, it is important to acknowledge one of the axioms behind the proposals – that taxable profits should be aligned with commercial profits, i.e. 'those used for business and economic purposes'. While sensible, this pre-supposes that an appropriate measure of 'commercial profits'; exists.

The obvious contender is the profits per the company's audited accounts as prepared under United Kingdom (UK) generally accepted accounting principles (GAAP). However, the UK is due to adopt International Accounting Standards (IAS) in 2005 for consolidated accounts of quoted companies and, while the corporation tax system is based on single company accounts rather than consolidated accounts, the Department of Trade and Industry (DTI) is considering whether IAS should be applied to more categories of companies and accounts.

Given these uncertainties, the government has confirmed that it is prepared to temper the impact of particular accounting rules. We therefore face the risk of proceeding with reform, only to once again face divergence from accounts.

Proposal 1: Capital Gains

The first proposal is the replacement of the capital gains system for companies with a new regime based on the intangible asset and the derivative contract rules legislated in Budget 2002. This would apply to the limited range of assets that remain within the capital gains regime following the introduction of the substantial shareholding regime, namely: land and buildings; those financial assets excluded from the derivative contract and substantial shareholdings regimes; and tangible moveable property.

The new regime would tax profits and relieve losses on the basis of the amounts that pass through the accounts and would:

  • tax all items to income rather than capital; and
  • provide relief for the depreciation of assets at rates used in the accounts.

The effect on the tax liability of a particular business will depend critically on its circumstances, as the consequences of this change include:

  • abolishing indexation allowances;
  • taxing any uplift in value of the asset on the basis that it is recognised in the profit; and loss account, rather than, as currently, on realisation;
  • bringing current capital gains into the scope of the controlled foreign companies legislation as income;
  • replacing capital allowances, possibly resulting in the removal of investment incentives and the tax benefit achievable by finance lessors; and
  • introducing a new form of rollover relief, based on the format used for intellectual property.

The government sees this as a package of measures, with the introduction of relief for depreciation on assets not currently qualifying for capital allowances as being partially offset by the loss of indexation – although it argues that indexation is itself a distortion and unnecessary in a macroeconomic environment which delivers low and stable inflation.

A number of these elements are controversial, particularly the taxation of accrued capital gains before the company receives any proceeds. The consultation stops short of proposing annual revaluations (‘mark to market’) for all assets and instead looks to tax gains only where they are recognised in the accounts. As, under UK GAAP, most assets are held at lower of cost and market value, these instances will currently be rare.

Capital allowances have proven to be one of the Chancellor’s favourite tools for seeking to influence taxpayer behaviour, having been used to promote both enterprise and energy-saving technologies. Their consequential abolition as part of this reform would leave the government looking for another route to promote investment. Without such a route, there will be a large temptation to introduce a complex shadow regime.

Proposal 2: Schedular system

The CIOT has called for the abolition of the schedular system for many years, as it is clearly outdated and brings complications to the tax system without any benefit. The danger of the current system is that, because it arbitrarily separates some sources of profits and losses from others, companies risk having losses segregated from profits arising in the future.

The consultation identifies economic arguments that point towards replacing the system with a single pool of business profits. However, it falls short of whole-heartedly endorsing such a significant reform and instead considers partial abolition, focused at aligning the definition of profits under the schedules or combining some of the schedules but leaving distinct categories.

Such reticence is perhaps understandable given the uncertainty over the quantum of losses stored in the current system. Apparently £15 billion of losses were carried forward from the year ended 31 March 2000 alone, although it is unclear how much is due to the losses being trapped or just insufficient profits in the period. If it is primarily the latter, then the reform is unlikely to be particularly costly in relation to newly generated losses.

While the UK system of schedules is unique, many countries operate a separate system for income and capital losses and the government is leaving this option open, despite consulting on the abolition of capital gains. Again, this offers to complicate the reform and frustrate the promised simplification.

Proposal 3: Investment vs Trading

The last proposal is the abolition of the investment and trading company distinctions. While it is easy to distinguish between a personal investment company and a multinational, the borderline between investment and trading has become extremely difficult to discern commercially, particularly with property companies. Given this difficulty, the case for change is clear.

The consultation document considers expansion of the scope of trading reliefs to cover investment companies as well as other possible changes, such as distinguishing between active and passive investment companies.


The proposals would produce a simpler and more coherent regime for new companies. However, for existing companies there could be significant winners and losers. The challenge will be to introduce the changes in such a way as to avoid creating complex transitional rules that undermine all the good intentions and yet prevent windfalls to taxpayers or the Exchequer. One only has to look to recent history and the tax planning undertaken around the introduction of the 1993 foreign exchange legislation to see how transitional rules can distort business decisions.

One key area of concern will be the treatment of existing capital assets and losses. The government has proposed following the Intellectual Property reform route, i.e. maintaining the current rules for existing assets and only operating the new rules for assets purchased after commencement day. While this may have a greater degree of fairness, it maintains a complex two-tier system until the final asset is sold. Given the number of companies that still hold properties with March 1982 values, we could expect a long transition. Another option would be to shorten the transition, for example allowing the two systems to run side-by-side for (say) six years before moving all the assets into the new regime.

The transition for losses trapped in the schedular system is also complex. Those operating under the current regime have a legitimate expectation that they will be able to use their losses against future profits. Consequently, abolishing the losses is unacceptable while the complete transfer into a single pool could prove too costly for the Exchequer. One answer here could be allowing companies to opt into a shadow regime that follows the old system.

Commentary and conclusions

All in all, the consultation document delivers what was promised at the Budget – a review of some proposed reforms to the corporation tax system that have developed from the policy direction set out last year. While the lack of surprises is welcome, it is disappointing to see the government already laying the groundwork for exceptions that provide the scope for frustrating the clarity and simplicity that the reforms are designed to achieve.

These exceptions are born from concerns over the cost of the reforms and consultation may help to allay any doubts within government. Any ongoing costs relate to the inefficiencies inherent in the tax system and should point towards reform rather than against. Any compromises that are ultimately made should be in moving from the current regime to the new one rather than corrupting the new regime.

As with all changes, the devil is in the detail. These proposals offer a chance to simplify the system for the majority of companies, but will need active input from business to ensure that the transition isn’t too painful. Although this consultation closes on 29 October 2002, there will be many more iterations before we get to a workable solution.

Technical Department
020 7235 9381

September 2002 by Christopher Sanger


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