UK: Pre-Budget Report

Last Updated: 28 November 2002

The Chancellor delivered his Pre-Budget Report on 27 November 2002. The Report contains very little in the way of new and radical reform. Rather, and not unexpectedly, there is more in the way of a tightening up of existing rules, together with the introduction of a number of anti-avoidance provisions. There are also a number of provisions in relation to environmental matters, with the promise of more to come in the future.

Simplification of corporation tax rules for employee share schemes

The Government has announced that it intends to introduce a statutory corporation tax deduction for the cost of providing shares for employee share schemes for accounting periods

beginning on or after 1 January 2003. Such a deduction is not always available under current law. The deduction will be available where:

  • the employee is subject to UK tax on an award of shares; or
  • the employee would be subject to UK tax but for the fact that the shares are obtained under an Inland Revenue approved scheme or Enterprise Management Incentive scheme.

The Government will also take this opportunity to reform the rules relating to Qualifying Employee Share Ownership Trusts (QUESTs) to simplify the scheme and avoid any element of duplication.

Taxation of UK Branches

As part of Budget 2002 the Government proposed a significant reform of the taxation of UK branches of overseas companies. Under the proposal an amount of capital is to be attributed to the UK branch of a foreign company for tax purposes, based on the capital that would be needed if the branch were an independent free-standing company trading in the UK in the same or similar conditions and circumstances. This has the effect of limiting the amount of interest that can be deducted in computing taxable profits. It is intended that the change will

take effect for accounting periods beginning on or after 1 January 2003.

At the same time, the terminology will be updated, so that "branch or agency" will be replaced by the internationally used concept of "permanent establishment".

Draft legislation was initially published in July 2002, but was sketchy. A vigorous consultation period ensued, and the Government has now published more detailed legislation including specific provisions relating to non-resident insurance companies. Guidance on the attribution of capital to UK branches of overseas banks has also been published.

Withholding on interest payments

The Government is to introduce the following two changes to the rules on deduction of tax at source:

  • From 1 April 2003 annual interest payments made by recognised clearing houses and recognised investment exchanges while providing central counter-party clearing services may be paid without deduction of tax at source;
  • From 1 December 2002 annual interest and other payments made to tax-exempt bodies via nominees may be paid without deduction of tax at source in circumstances in which direct payments could be paid gross.

Controlled Foreign Companies

A number of changes have been announced in relation to the Controlled Foreign Companies (CFC) rules. Draft legislation has been published in relation to each.

The first change ensures that subsidiaries of UK companies in the Hong Kong and Macao Special Administrative Regions of China are entitled to benefit from the exempt activities exemption to the CFC rules. This was always intended to be the case, and the draft legislation makes this clear.

Secondly, the Government has published draft legislation, effective immediately, to ensure that profits from the sale of extended warranties, credit protection and similar products fall within the CFC charge. (There is otherwise a potential loophole where warranties or service agreements are governed by separate contracts from those for the goods or services themselves, and those contracts are entered into by offshore companies.)

Recognised Stock Exchanges: Policy Statement

The Government has published a policy statement setting out the revised approach it will follow when recognising stock exchanges outside the UK for tax law purposes.

In future the Inland Revenue will follow a more broadly based approach which is likely to result in the recognition of a larger number of stock exchanges outside the UK. The concept of "recognised stock exchange" is significant for a number of purposes in tax law, for example the quoted eurobond exemption.

Offshore Funds

The Government is continuing its work on the reform of the offshore funds tax regime. It intends to replace the regime with rules ensuring that investors in offshore funds and equivalent UK products are subject to similar tax treatment. It is anticipated that legislation

will be contained in the Finance Bill 2004.

General reform of corporation tax

The Government is still considering responses to its August 2002 consultation paper on the reform of corporation tax, which included proposals for the reform of taxation of capital assets, reform of the system of classifying income and losses for tax purposes, and the treatment of trading and investment companies. A further consultation paper is expected in

due course.

Environment

  • Landfill Tax – a package of measures will be introduced, to be tax-neutral overall but to include raising the annual landfill tax escalator to £3 per tonne from 2005/2006. Landfill tax is currently set at £13 per tonne with an annual escalator of £1 per tonne. In the medium-to-long term a rate of £35 per tonne is envisaged;
  • Landfill Tax – reform of the landfill tax credit scheme from 1 April 2003 (detailed provisions not yet available);
  • Bioethanol – introduction of new duty rate for bioethanol, to be set at 20p per litre below the prevailing rate for ULSP;
  • Lorry Road-User Charge – the Government is to carry out further work on the introduction of a lorry road-user charge;
  • the Government is to consider the possibility of using economic incentives to ensure the aviation industry reduces its contribution to global warming and environmental pollution;
  • a consultation paper will be issued shortly on possible extension of aggregates levy to encourage positive use of aggregates waste;
  • the Government is to consider new tax incentives to encourage donations towards the running costs of Urban Regeneration Companies.

Construction Industry Scheme

A consultation document considering possible reform of the construction industry scheme has been published. It is hoped that the proposals will cut industry costs by 50 – 70%. The main

proposals for reform are:

  • replacement of registration cards and gross payment certificates with a verification service;
  • introduction of an employment status declaration;
  • replacement of vouchers with periodic returns; and
  • replacement of the current Inland Revenue computer system with a new system capable of providing the support required.

Pensions

The Pre-Budget Report does not include any proposals for changes to tax reliefs for pension contributions or to the tax-free lump sum which can be drawn down from a pension on retirement. Both of these items were mooted as potential candidates for change in the run up to the Pre-Budget Report. However, reform may be likely in the future, since the Government is to publish a green paper on pensions in December 2002, and has also indicated that it will consult on wide-ranging proposals to simplify the taxation of pensions. A consultation paper on the VAT treatment of pension fund management has also been published.

Employment and Incentives

The Pre-Budget Report included a number of measures relating to employment and incentives. In particular:

  • simplification of corporation tax rules for contributions to employee share schemes (see further above);
  • introduction of anti-avoidance measures, effective immediately, in relation to employer deductions for contributions to employee benefit trusts. The rules will defer a contributor’s corporation tax deduction until a payment is made out of the employee benefit trust in a form that gives rise to a liability to income tax and national insurance;
  • the Government is to consult on tax and national insurance contributions incentives for employer provided or funded childcare.

Personal Taxation

In relation to tax allowances:

  • basic personal allowance to be frozen at £4615 for 2003/2004;
  • personal allowances for people aged 65 and over to be increased above rate of inflation;
  • all other personal allowances to increase in line with inflation

In relation to National Insurance Contributions:

Employers and Employees

  • primary (employee) and secondary (employer) thresholds for Class 1 contributions to be frozen at £89 a week for 2003/2004;
  • upper earnings limit for primary Class 1 contributions to be raised in April 2003 in line with inflation from £585 to £595 per week (£30,940 pa);
  • all employees to pay an additional 1% on all earnings above primary threshold from April 2003. This means that the standard rate of primary Class 1 contributions below the upper earnings limit will be 11%, and above the limit will be 1%;
  • from April 2003 employers pay 1% more on earnings above secondary threshold. Hence the standard rate of secondary Class 1 contributions will be 12.8%.

Self-Employed

  • rate of Class 2 contributions to be frozen at £2 a week;
  • annual lower profits limit to be frozen at £4,615;
  • upper profits limit for liability to Class 4 contributions to be raised to £30,940 in line with inflation;
  • self employed to pay 1% more Class 4 contributions on all their profits above the lower profits limit. As a result, the rate of Class 4 contributions will be 8% on profits below the upper profits limit, and 1% on profits above that limit.

Gifts to charity

The Government has agreed to extend the existing 10% Government supplement on donations to charity through the payroll for one further year until 2004.

Residence and domicile

A review of the rules on residence and domicile was announced in Budget 2002. It has now been announced that a background paper will be published (no date specified) which will assess how the current rules work in practice and how this compares with the Government’s

objectives of fairness, clarity, competitiveness and ease of operation.

VAT

Anti-avoidance and "new" freehold buildings

The Government has announced the introduction of anti-avoidance rules, effective immediately, preventing companies avoiding VAT by exploiting the VAT rules applicable to the sale of a "new" freehold building. The scheme targeted involves the artificial delay of

payment until after the expiry of the compulsorily VAT standard-rated three-year

period.

"Protecting Indirect Tax Revenues"

The Government has published a paper – "Protecting Indirect Tax Revenues" – setting out its strategy for tackling VAT revenue losses caused by fraud, avoidance and non-compliance. This will include increasing the number of challenges against "abusive" VAT avoidance schemes and identifying and challenging new schemes before they can be widely marketed. It is hoped that this initiative will deliver more than £2 billion per year in additional VAT

revenues by 2005-2006.

Extension of VAT flat rate scheme

The VAT voluntary flat rate scheme for small businesses will be extended from April 2003 to businesses with an annual turnover of up to £150,000.

Extension of reformed VAT penalty scheme

Extension of the reformed VAT penalty system for small businesses from April 2003 to businesses with an annual turnover of up to £150,000. The reformed VAT penalty system allows business support and advice before penalties are incurred.

In addition, the Government is to continue its consultation exercise on the simplification of VAT rules for imports, and to consult on a further increase in the statutory audit threshold for small companies.

Capital Allowances

The Government has published draft legislation, effective immediately, to prevent businesses from exploiting rules on certain capital allowances by entering into artificial transactions which accelerate allowances on the qualifying expenditure on a sale. The transactions concerned seek to depress the market value of qualifying assets on a sale, thereby accelerating any remaining capital allowances relating to those assets. The new rules apply to industrial buildings allowances,flat conversion allowances, agricultural buildings allowances, mineral extraction allowances and assured tenancy allowances. Plant and machinery allowances are unaffected. The legislation therefore prevents the obtaining of further allowances by a vendor on any shortfall that exists between the written down value and the sale proceeds of assets on which allowances have been claimed, where one of the main purposes of the transaction is tax avoidance.

Stamp Duty

No new announcements were made in connection with stamp duty other than a reiteration of the Government’s intention to abolish stamp duty on transactions in commercial property in disadvantaged areas (Enterprise Areas), subject to EU state aid approval. The Government continues to consult on details of a new regime for stamp duty on land and buildings to be introduced late next year, and reports that draft clauses covering the main charge will be

published shortly. [Draft legislation was published on 29 November 2002.]

Other

Other changes include:

  • North Sea royalty to be abolished from 1 January 2003;
  • a working tax credit and child tax credit to be introduced from April 2003;
  • the Government proposes an innovation and business-university collaboration review, as part of which consideration will be given to extending tax credits for research and development expenditure.
  • Following successful consultation earlier this year, the Government is now considering how to replace bingo duty with a tax on gross profits.

© 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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