TAXATION - Solving those age-old questions

Some of the hot air being blown over the abolition of the tax credit for pension funds has been misdirected.

Ignoring the formalities of corporate structure, a company’s profits and the dividends it pays are not distinct sources of taxable income. A dividend is simply an allocation of profit. That is recognised in the imputation system under which corporation tax paid by the company on its profit is credited against a shareholder’s tax liability on the dividend.

Admittedly, the imputation is only partial because the credit is given at the rate of advance corporation tax which, in any case, has recently fallen. Although the tax credit is set to fall further in April 1999, from 20% to 10%, basic and lower rate taxpayers will not have to make up the shortfall between the 10% credit and their marginal tax rate, nor will higher rate taxpayers pay any more than at present. In essence, therefore, partial imputation is being retained and dividends are not being taxed more heavily.

The major change is that from 2 July pension funds can no longer take back the tax credit on their UK dividend income. This will lessen their ability to generate pensions.

Someone will have to bear this cost. Companies will have to increase their funding of final salary schemes and individuals will pay higher personal pension contributions for the same pension. Prudent self-employed individuals will have contributed the maximum they are allowed to under the tax rules, in the expectation of having a pension that doesn’t fall too far behind the final salary pension of luckier colleagues.

Hopefully, in its promised review of pensions the government can be persuaded, as a quid pro quo, to increase the maximum that individuals can put in.

Tax-credit fairness

The seriousness of this for pension funding depends on a large number of factors, such as the extent to which pension funds switch their investments away from UK equities or indeed persuade companies to increase their dividends.

But is it unfair that pension funds should no longer get the tax credit back?

To a large extent, the imputation system prevents dividends from being considered an additional taxable source, separate from the profits out of which they have been paid. But to pay the tax credit to pension funds involves the transformation of taxable profits at company level into tax-free profits at shareholder level. This goes beyond imputation – and this is why it has been described as an anomaly.

One can complain about the abruptness of such a radical change and bemoan the fact that it was made without widespread consultation. One can worry about the effect it may have on different parts of the economy once its broader consequences have been fully understood, such as to favour debt funding at the expense of equity. These concerns undermine any semblance of logic which the removal of the tax credit might have.

Profits overseas

In any case, our imputation system contains a related anomaly for UK groups that earn a lot of their profits overseas. When they pay dividends out of their foreign income they cannot recover the ACT they have to pay.

In their case, ACT is tax on dividends, not a prepayment of corporation tax. In these circumstances, the payment of the tax credit is not an anomaly as the underlying profits of the company remain fully taxable, even though the UK tax is offset by relief for the foreign tax. At present, a company can get round this by paying foreign income dividends (FIDs). The trouble with FIDs, though, is that they are due to be abolished in 1999. The government has said that it is looking sympathetically at the position of UK groups with substantial foreign income. Let’s hope they manage to do something to get rid of this second anomaly in the imputation system; it reduces the yield to all shareholders, not just pension funds.

A simple solution may commend itself: abolish ACT and make companies pay their corporation tax in instalments, as individuals do. This will not be welcome to private companies that don’t pay dividends – they will just pay their tax more quickly.

Maurice Parry-Wingfield is a tax consultant with Deloitte & Touche.