UK: UK Corporation Tax - Further Reforms

Last Updated: 12 August 2002
Article by Naomi Belcher
The Government published on 5 August a consultation document heralding further, potentially far-reaching, reform of the UK corporation tax regime.

Specifically, the consultation document considers the following three (inter-related) proposals for change:

  • the taxation of certain capital assets not already addressed by earlier reforms;
  • the rationalisation of the schedular system; and
  • the distinctions in tax treatment between trading and investment companies.
The report does not come out of the blue. The Government has been discussing and consulting on major reform of UK corporation tax for some time. There have been a number of earlier consultation documents, in particular Large Business Taxation: the Government’s strategy and corporate tax reforms (July 2001), A Review of Small Business Taxation (March 2001) and Review of Links with Business (November 2001). Press releases issued as part of Budget 2002 also suggested the Government’s intention to consult on further aspects of corporation tax reform in due course.

A general concern of the Government has been to align taxable profits more closely with accounting profits (subject to specific disallowances, for example for corrupt payments and business entertaining expenditure). To a large extent, this already happens with trading profits, though depreciation is not an allowable expense and it is still not uncommon to find that a payment will be classified as made for the acquisition or improvement of a “capital asset” (within the very flexible approach which has been adopted by the courts) and is therefore not allowable for tax purposes even though deducted, in accordance with applicable accounting rules, in the profit and loss account. The consultation document does not go into great detail about how such general closer alignment might be achieved, but focuses more on the three specific areas above. There is a passing reference to the taxation of groups on a consolidated basis but this is seen as a step subsequent to that now in contemplation.

In keeping with its earlier statements, the Government has reiterated its intention “to produce a regime that is modern and competitive and reflects the realities of the business environment”. Its stated aims are simplification, clarity, transparency and certainty.

Considering, then, the proposals in some more detail:

Taxation of capital assets not already addressed by earlier reforms
For the purposes of corporation tax, many capital assets owned by companies have either been removed to an accounts driven income tax charge (loan relationships, financial instruments and intangibles, for example) or excluded from the charge altogether (shareholdings falling within the substantial shareholdings relief introduced by the Finance Act 2002, for example). What remains is land and buildings, plant and machinery and financial assets not falling within another regime (such as the substantial shareholdings, loan relationships and derivatives regimes). In relation to these capital assets therefore, the suggestion is that gains and losses should be treated in the same way as income profits or losses.

Perhaps unsurprisingly, the consultation document specifically mentions the possibility that any draft legislation will be similar in structure to that introduced by the Finance Act 2002 for the taxation of intangible assets and financial instruments. Very broadly, this would mean:

  • profits and losses to be taxed on the basis of the amounts recognised in the company’s accounts;
  • companies to obtain relief for commercial depreciation on assets according to the amounts recognised in the company’s accounts (see panel below) as to potential interaction with capital allowances regime);
  • where accounting standards do not require gains on revaluations of assets to be taken to the profit and loss account, tax to be deferred until disposal (but, otherwise, tax to be charged on a mark to market basis);
  • indexation relief not available;
  • rollover relief a possibility (except for income profits realised on the sale of shares).

The position of capital allowances
If a basis similar to that adopted by the Finance Act 2002 for intellectual property is pursued, then it would follow that a company would obtain relief for commercial depreciation on assets in accordance with the company’s accounts. However, some assets may already have qualified for capital allowances. This is an additional layer of complexity which will need to be addressed.

One possibility would be to run the two regimes in parallel, so that only those assets outside the capital allowances code would be brought within a system of commercial deprecation. Assets currently qualifying for capital allowances would continue to enjoy that relief.

The document appears to favour a wholesale move towards an accounts-based depreciation regime, subject to special rules for allowances specifically intended to give a tax benefit above commercial depreciation, for example 100% reliefs for energy-saving technologies.

Clearly this summary is something of an over-simplification, and there will be a great many complexities to address. In particular, provisions governing the transitional period are likely to be very intricate.

It is recognised that certain special types of companies (for example, life assurance companies and unit trusts) and certain types of asset (for example, leased assets, often viewed for accounting purposes as having been acquired by the lessee) will need special treatment.

Who is likely to be affected by the changes?
Certain groups of taxpayers are more likely to be dismayed by the proposals than others. For example:

Multinationals and insurers with offshore captives
Capital gains are currently excluded from the UK’s controlled foreign company regime but (for groups whose parent is a close company) may be within Section 13 of the Taxation of Chargeable Gains Act 1992. However, if gains were to be taxed as income then such profits would surely fall to be taxed under the CFC rules? Such a reform could have very significant adverse consequences for UK companies with interests in companies located in low tax jurisdictions (including UK insurers with offshore captives), at least until the CFC regime is abandoned, or its scope curtailed (to comply with EU law).

Property companies
Changes which will result from the introduction of international accounting standards (in 2005) may from that date adversely affect property investment companies which are currently not required by UK accounting standards to reflect gains on the revaluation of assets through their accounts. Such revaluations may be taxable under a new tax regime.

The loss of indexation allowance on the move to an accounts based charge will also be significant to property companies (and indeed any other companies) which have held land and buildings for a significant period.

Long life equipment
Companies owning assets with a long useful economic life (e.g. ships, aircraft, oil and gas installations) may be worse off on a switch away from capital allowances (see further earlier panel), which in some cases front-load tax relief for expenditure on such assets by comparison with the rate at which the asset is depreciated in the accounts.

Rationalisation of the schedular system
The existing schedular system of taxation of income, which segregates particular streams of income, was introduced over 200 years ago. Its chief effect for companies today is to restrict the availability of losses, and to complicate compliance. There is no corresponding generally accepted segregation of profits and losses for accounting purposes. The consultation document therefore considers rationalising the existing system. (Note however, that the Government specifically states that it does not intend to relax the rules currently applicable to “bought in” tax losses.)

In terms of approach, one possibility would be to abandon the schedular system entirely in favour of a system in which all types of profits are aggregated into a single pool of business profits and taxed under a single head of charge. An alternative would be to rationalise the rules for computing profits and losses under each of the Schedules. Any number of intermediate positions may also be available.

Clearly it is important that a rationalisation of the schedular system dovetail with any reform of the taxation of capital assets. If profit hitherto taxed as capital gain is in future to be taxed as income, the rules governing the computation and treatment of such income profit must be clear.

The treatment of trading and investment companies
UK tax law currently differentiates in a variety of ways between trading and investment business. For example, the deductions of trading companies are based on the expenses shown in the accounts (subject to certain prohibitions) whilst deductions for investment companies are statutorily prescribed. In addition, a number of reliefs are available to trading companies but not to investment companies (these include demergers and the new exemption for disposals of substantial shareholdings).

However, this current method of distinguishing between companies is no longer always appropriate, even if it once was. The business carried on by many companies cannot simply be classified as “trading” or “investment”. Many businesses include an element of both, and classifying a company as one or another may cause significant economic distortion. Other companies qualify as neither, which can also be very disadvantageous and cause economic distortion. The Government therefore suggests a move towards the similar treatment of all classes of taxable income. But how, exactly, should the boundaries be moved or altered? The Government seems reluctant simply to abolish the distinction between trading and investment companies entirely, yet it agrees that it must be revised.

Again, the issue is related to the reform of the taxation of capital assets and of the schedular system discussed above. In particular, a move towards aligning tax profits to accounting rules should ease the distortion. Modifications to the schedular system will also help. The consultation document also suggests the following specific reforms:

  • distinguish the treatment of “active” investment companies from “passive” investment companies and treat the former in the same way as trading companies, subject to protection against exploitation;
  • extend some of the reliefs currently available only to trading companies to investment companies;
  • treat an investment company which is in substance an adjunct to, or an integral part of, a group’s trading activities, as though it were itself carrying on a trade.
What now?
The document does not indicate when or in which order the changes may be introduced. Clearly, the introduction of any of the three proposals would represent a very significant departure from the existing corporation tax regime.

Herbert Smith will continue to consider the impact of the consultation document in specific industry sectors. Where appropriate, we will make representations to the Government on the proposals. If you would like to be involved in this process or if you have any representations which you would like us to consider, please contact any of our tax partners, Heather Gething, Ross Fraser, Neil Warriner, Bradley Phillips or Howard Murray.

© Herbert Smith 2002

The content of this article does not constitute legal advice and should not be relied on as such. Specific advice should be sought about your specific circumstances.

For more information on this or other Herbert Smith publications, please email us.

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