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Pre-Budget Report – what’s driving policy?

Category Technical Articles
AuthorTechnical Department
Article by Christopher Sanger, a senior manager at Andersen and a former adviser to the Treasury. Published in the January 2002 issue of Tax Adviser. The 2001 Pre-Budget Report (PBR) saw a return to the old days – no, not the old days of ‘Tax and Spend’ as picked up by many of the newspapers, but the ‘old days’ of pre-Budget reports. Those were the days back at the end of the last century when the Pre-Budget Report was exactly what it said it was, rather than being, as we’ve seen more recently, a ‘mini-Budget’. This is a welcome rest and a chance to work on the details of the forthcoming reforms.

This happy state of affairs was not unexpected, given that the year contained a pre-election Budget, an election manifesto, an ‘Enterprise Statement’ and a consultation on the government’s strategy towards the taxation of large business. Some elements of the PBR have been included in all four of these and, in the case of the long-running reform of taxation of intellectual property, in many of the preceding Budgets and PBRs.

Large business taxation – building on principles?

The PBR was the first policy document to follow the July 2001 consultation document, ‘Large business taxation: The government’s strategy and corporate tax reforms’. This document built from the statement of ‘tax principles’ in the government’s first Budget in July 1997 and applied these principles to business taxation. It identified two aims of the business tax system, business competitiveness and fairness, and four key objectives:

  1. maintaining a low rate/broad base system;
  2. reducing tax distortions;
  3. removing outdated and ineffective restrictions; and
  4. countering tax avoidance.
In addition, it acknowledged that long-term investment requires stability, which it interprets as stability of direction, or transparency. Given this aim, it is unsurprising that there was nothing totally ‘new’.

These objectives have clearly influenced the policies that were announced at the PBR and are indeed repeated in the latest consultations on substantial shareholdings and intellectual property, as well as other Treasury and Inland Revenue documents. They should provide the direction for change over this Parliament and a useful guide to the future.

Substantial shareholdings

Changes in the capital gains area were first floated by the government upon coming to power in 1997 and since then we’ve had large amounts of consultation. The proposed regime for substantial shareholdings has moved from a deferral (or rollover) regime to a limited exemption regime. The PBR brought with it a welcome ‘target date’ of 1 April 2002 by which time the legislation will be in operation (although still passing through the House of Commons).

The aim of this policy is to improve business competitiveness by removing the tax charge on reorganisations, which restricts the ability of companies to structure efficiently. While any tax is by its nature restrictive, this charge can be deferred, sometimes indefinitely, through the use of offshore structures and was a prime example of decision-making being driven by tax considerations rather than commercial factors. This is clearly against the government’s objectives.

With the removal of this tax charge, and the recent changes to the taxation of foreign dividends, the government hopes to remove the incentive to hold subsidiaries away from the United Kingdom (UK).

But will it work? The PBR confirmed the basic system – relief for trading companies (and groups) disposing of substantial shareholdings in trading companies (and groups). This restriction, which originated through the development of the exemption regime via a deferral regime, is aimed at ‘bringing about a use of the proceeds which will contribute to productivity gains’.

Whilst one can understand the desire of government to ensure that this relief is not used by individuals to avoid their (now much reduced) capital gains tax on disposals, this restriction does seem to be ‘outdated and ineffective’. With large groups typically using offshore holding companies, the restriction will purely extend the lifetime of these companies and reduce the effectiveness of the reform. It would be better to target anti-avoidance specifically on individuals rather that to restrict the relief for everyone.

One point still outstanding is the possibility of introducing a ‘soft test’ to qualify for the regime. The government is justifiably nervous that a strict 20 per cent ownership test would leave the structural holdings of some companies out of the regime. This is particularly true for those in regulated industries that have artificial restrictions on the levels of share ownership. However, the government has not managed to find a soft test that would reliably and objectively distinguish and which did not bring with it a large amount of complexity and uncertainty. It remains to be seen whether the equity accounting test will be attractive.

Intellectual property and royalty withholding tax

The PBR also brought a target date for the IPR reforms (transactions occurring on or after 1 April 2001) as well as a technical note including 60 pages of draft clauses written in the new ‘Tax Law Rewrite’ format. The legislation, while long in page length, makes easy reading and the introduction of legislation in this format is a welcome outcome.

This reform is focused on removing tax distortions and provides for tax relief broadly in line with the accounts. The inclusion of re-investment relief and the availability of a four per cent per annum alternative relief are aimed at maintaining the business competitiveness of the UK.

The government also announced a proposal to introduce an optional scheme reducing the compliance on making royalty payments overseas. Under the scheme, companies will be able to decide not to withhold tax, but with the proviso that the Inland Revenue may return to them if the liability is ultimately payable.

Foreign Exchange, Financial Instruments, Corporate Debt

One of the most welcome announcements was the deferral of the introduction of the new foreign exchange, financial instruments and loan relationship rules to accounting periods beginning on or after 1 October 2002. Without this delay (a full 12 months for calendar-year-end companies), the new legislation would have applied before it had received any scrutiny and would have given tax advisers only the last few weeks of December in which to prepare. That would not have been a very nice Christmas present!

Instead, by the time you read this, draft clauses should be available and companies can take the appropriate time to review the effect of the new legislation. Any changes to the clauses in this complex area can be made prior to them coming into effect, avoiding the calls for retrospection.

Again the changes are aimed at reducing tax distortions. They will integrate the separate foreign exchange legislation with the financial instruments and loan relationship legislation; extend the scope of the financial instruments legislation to cover the majority of derivatives contracts; and address the issue of connected party bad debt. One downside of the delay is the deferral of this last element. The connected party bad debt provisions have long been seen as acting unfairly in some circumstances and will change under the new regime. It would have been good to see these uncontroversial changes brought into effect at the original date of 1 January 2002 or the earlier date of 26 July 2001, from when the anti-avoidance provisions apply.

Research and development

The PBR heralded the arrival of a further consultation note on the large business Research and Development (R&D) tax credit, which was published a week later. It was good to see that the government has revised its proposals and is now focussing on a ‘volume-based’ credit rather than the previously proposed complex incremental credit. The work is not yet complete however, as the document offers either a simple volume credit or two complicated ‘variants’.

Given that the R&D credit is designed to reward the amount of R&D undertaken (on the basis that there are benefits for society as a whole), it seems odd that the Government should believe that companies undertaking the most R&D should not be correspondingly rewarded. The two variants are driven by the desire of the government to stimulate the highest increase in R&D. These bring with them the complexities of the incremental approach and should be avoided.

Small- and medium-sized businesses and the entrepreneur

On the small business side, the government takes a much more interventionist approach. It sees taxation as a tool of economic and social policy and will use tax to help drive decisions. We have therefore seen in the past parliament many different initiatives including first year capital allowances, corporate venturing, enterprise management incentives, capital gains business asset taper and R&D tax credits.

The PBR continued this theme although we were still left guessing as to how generous the Chancellor will be in extending the ten pence rate, which is currently costing £160m per annum. The early adoption of the increase in gross asset limit to £30m for the Enterprise Management Incentives is welcome, but other than this the cupboard was pretty bare of new items.

The PBR confirmed again the cut in capital gains for business assets to ten per cent after two years, but said little on a number of the other elements of the Enterprise Statement, such as the consultation on simplifying capital gains tax and dealing with the large differential between the business and the non-business asset taper.

The government did publish a summary of the responses to the Budget 2001 paper on Small Business Taxation, but without providing commentary as to whether the government agrees with the views set out. It seems we will have to wait for the Budget before seeing any 'bold steps' toward the ‘radical simplification’ that was offered through aligning tax and accounts.

Other small business measures included the continuing development of the value added tax (VAT) small business package (the optional flat-rate scheme, the changes in the annual accounting scheme, and a new ‘helpful’ approach by Customs and Excise to the VAT penalty system) and changes to the Construction Industry Scheme.

Other business elements

No Budget or PBR would be complete without at least some mention of the environment and this PBR was no exception with, among others, extensions of enhanced capital allowance benefits to more ‘green technology’, consultation on the company car fuel scale charges and a review of the effectiveness of the voluntary pesticides package.

It also included reviews on the administration of payroll and the Revenue’s links with business. Whilst neither of these reviews deal with changes in policy, these have provided a useful base from which to develop the ideas further.


The policies of the PBR followed the government’s key objectives for the business tax system – which is not surprising given that the strategy document was only published four months before. The test for the government will be to see if it can stick to these principles for the future and offer business a sense of ‘stability of direction’. We have to wait and see.

Technical Department
020 7235 9381

January 2002 by Christopher Sanger


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