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Reform of corporation tax

Category Technical Articles
AuthorTechnical Department
TC Newsdesk article by Adrian Rudd of PricewaterhouseCoopers, Tax Adviser’s representative on the Technical Committee. The article was published in the November 2002 issue of Tax Adviser.
This month’s article outlines the Institute’s response to the consultation document issued by HM Treasury in August 2002. The consultative document proposed some major changes to the corporation tax regime, principally:

  • the tax treatment of capital assets not covered by earlier reforms;
  • rationalisation of the way in which the schedular system taxes various types of income; and
  • the differences in the tax treatment of trading and investment companies.

Overview

The Institute pointed out that this review of corporation tax follows many recent changes in the corporation tax legislation, whose effect has been to move the computation of taxable profits closer to accounting profits. Notwithstanding those changes, the consultation document raises some fundamental issues regarding the computation of the profits on which companies should pay tax.

The Institute believes that views of tax practitioners on such a wide-ranging document differ, and put forward some general propositions which, it believes, most practitioners would support.

(1) The government should be prepared to take time over this consultation. The Institute believes that recent reforms in the areas of intellectual property, substantial shareholdings, and derivative contracts, foreign exchange and corporate debt, all benefited from extensive consultation undertaken.

(2) The Institute called for some effort to be spent reviewing the place of corporation tax within the tax system as a whole. In particular, the relationship between companies and their shareholders should be considered. Why in principle should corporate profits be taxed, and is it right that there should be an element of double taxation when profits are distributed to shareholders? Of course in practice over the last 10-20 years such profits have become a major contributor to government revenues, but at the very least the answers to such questions will inform the debate on the desirable shape of corporation tax.

(3) It is important that each element of the proposed reform is not simply adopted as a matter of theoretical elegance, but is subjected to a practical cost/benefit assessment. The upheaval of change, and the existence of an additional regime throughout the transitional period are factors on the cost side of this assessment. One possible outcome is that no fundamental change is desirable.

The Institute believes that the elements of the package which are likely to bring the greatest benefits in terms of reducing compliance burdens and economic anomalies are:
(i) the abolition of ‘tax nothings’ particularly in the area of capital expenditure, and
(ii) the abolition of the schedular system.

(4) These proposals would be the latest in a series of reforms, which have brought about a significant divergence between the taxation of companies on the one hand, and of individuals and partnerships on the other. The agenda for these reforms has principally been driven by larger corporate groups with significant international operations. Smaller companies have been swept along. The Institute questioned whether this divergence between smaller companies and individuals and partnerships is sensible or justified. Should shareholders in smaller companies be able to elect to have the company taxed as a partnership, as can be done in the United States (US)?

(5) It is not sensible to tax companies systematically on a revaluation basis. It is also important that such a move does not come about inadvertently, e.g. as a consequence of the adoption of International Accounting Standards (IAS) in the United Kingdom (UK). The impact of cash tax liabilities under such a regime is likely to be severely damaging for the corporate sector, as well as creating significant volatility and unpredictability over tax receipts for the government. The result would also be asymmetric, in that a steady stream of profits would be cumulatively taxed, whereas major losses reversing previous revaluation gains might not be relieved for many years given limited loss carryback periods. The Institute supports simplicity, but the damage that would be done by taxing revaluations without any rollover provisions is out of proportion to the supposed simplicity of this approach.

(6) In principle the abolition of the distinction between trading and investment companies will be a worthwhile simplification. The trading/investment distinction is however used throughout the tax system, and careful consideration must be given to the implications, especially outside the corporate tax area, such as in the case of capital gains taper relief.

(7) Reform along the lines proposed would appear to mean that controlled foreign companies (CFCs) would be taxable in respect of their capital gains. The Institute suggested that any moves in this direction should be the subject of conscious debate and decision rather than happen by default, not least because the further the regime moves along this spectrum, the more open to challenge it is likely to be by reference to European Union (EU) or other international obligations.

(8) Subject to these points, there is support for the abolition of what is left of the capital/revenue distinction. Although the result may be to replace one borderline by another (or others), and although the impact of doing so needs to be practically assessed, the historical capital/revenue distinction is often unclear and arbitrary in practice, and a poor proxy for the policy objectives behind the borderlines required.

(9) Costing changes of this nature is not easy. The Inland Revenue are, however, in possession of more comprehensive information than anyone else and the Institute suggested that if they asked large companies for some further information on a voluntary basis to assist with these decisions there would be a favourable response. The Institute feels that the document overstates the risk to the Exchequer from the abolition of the schedular system and capital allowances/depreciation reform, which funds may need to be recouped by taxing capital gains and CFC profits more fully. The Institute would prefer to approach the issue of schedular system effects through transitional or maybe targeted anti-avoidance rules. As to capital allowances/depreciation, prima facie evidence (such as the prevalence of deferred tax liabilities in corporate accounts) suggests that change in this area is likely to be a net revenue raiser

(10) The abolition of old borderlines may create a need for new anti-avoidance rules. It is essential that these are targeted to any perceived abuse, and that the corrective effect is commensurate and appropriate to it. If wide-ranging and vague provisions are introduced, little will be gained from the abolition of existing anomalies.

On what ‘profits’ should a company pay tax?
The Institute has previously proposed that taxable profits should be brought more closely into line with accounting profits, and that any divergence (e.g. the disallowance of entertaining expenditure) should only be made as a result of a policy decision.

It appears that accounting standards are now moving away from the old objective of computing the historical profit of the accounting period on the ‘historical cost’ convention, and towards the valuation of a company’s assets and liabilities as at the balance sheet date, so that the profit or loss figure may become simply a comparison of the net value with the corresponding figures at the preceding balance sheet date. This change is no doubt driven by the needs of investors, investment analysts and fund managers in relation to listed companies. However, they are concerned with decisions about buying or selling the company’s shares or securities, whereas the Revenue are concerned with determining how much tax the company should pay. The Revenue’s needs are different from those of investors. Therefore, some adjustments will continue to be required to get from accounting profits to taxable profits, albeit it is desirable that these adjustments are clear and transparent, and both profit figures are based on the same transparent information.

Corporation tax liabilities must be discharged in cash. However, the revaluation of an asset does not generate cash. There should, therefore, be a presumption against taxing unrealised profits.

It would be necessary to introduce a special category of assets that are taxed on a realisations basis. This will become even more important if revaluation adjustments are to be credited to profit and loss account in due course, as the UK adopts IAS. The Institute proposed that this category of asset should be the same as the category of assets qualifying for rollover relief on replacement of business assets.

Rollover relief
The Institute believes that rollover relief on the replacement of specified business assets should continue. Similarly, there will be a need to retain the existing relief for intra-group transfers of assets in order to facilitate the reorganisation of businesses within a group.

The Institute does not see the ‘capital into income’ switch as bringing about fewer borderlines in the system. However, it may be justified if it results in one composite scheme for replacement of business assets, whose borderline is clearer and better supported than the current distinction.

Capital allowances v depreciation
The Institute believes simply exchanging capital allowances rates for depreciation rates for existing categories of qualifying expenditure is not worthwhile. Reform is worthwhile only if ‘nothings’ can be dealt with. This would remove the bias in the present system towards manufacturing and heavy industry and against the (increasingly important) service sector.

There will be some losers in a change from capital allowances to allowing depreciation, as some assets that are not depreciated qualify for capital allowances under the present system.

The schedular system
The Institute has previously advocated the abolition of the schedular system, as a simplification measure. Special rules may be required to deal with unrelieved losses brought forward, in view of the amount involved. Existing rules may need to continue to apply to such losses, which will mean that the companies concerned will be required to continue to compute trading profits, loan relationship surpluses, etc. until the losses are fully relieved, but the majority of taxpayers will be free of the complexities of the schedular system.

Groups
The Institute believes that corporation tax should continue to be levied separately on each company, subject to group relief, etc. The difficulties of moving to the taxation of a group as a single entity are too great. Other countries that have adopted a group taxation basis require a compilation of individual company results, rather than a true consolidation. However, it is likely that the group relief legislation will need amendment in the light of any changes that are introduced.

International and EU aspects
Businesses operate increasingly internationally. It will be desirable to ensure, as far as possible, that changes in the UK legislation do not have the effect of causing it to diverge from corporate tax systems in our major trading partners, especially other EU member states.

Transitional rules
The Institute is concerned to avoid complex transitional rules. The Finance Act 2002 (FA 2002) rules relating to intangible fixed assets have resulted in two parallel systems in operation, one relating to ‘existing’ assets and the other to ‘new’ assets. This type of situation should be avoided if any reform of corporation tax is to lead to simplification, and to a reduction in compliance burdens. The Institute called for some time limit (e.g. six years) on any transitional provisions.

Technical Department
020 7235 9381

November 2002 by Adrian Rudd

 

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