A new corporate tax agenda?

On 12 August, the Inland Revenue took aim and fired at two grouse.

Not the feathered kind, being shot at on the moors of northern England and Scotland that day, but two of the key grumbles which had been moving into their sights for some time: the European Court of Justice and the issue of finance leasing.

The new paper on corporation tax reform was published with comments invited by 3 November 2003. There are the two new items just referred to, plus the three main areas of focus from the paper of 12 months earlier: reform of the schedular system; reducing the tax differences between trading and investment companies; and the tax treatment of capital assets.

The August 2002 proposals on the schedular system and the trading/investment divide had generally been well received; the third attracted mixed responses.

However, reform will be taken forward in all three, at least to some extent.

The paper states that the intention is to replace the current corporate capital gains regime with rules that align more closely with the accounting treatment and to stop regarding it as separate from income based taxes.

Capital losses brought forward seem more likely to disappear than be available as income losses in future. Indexation would be abolished beyond that already accrued.

The Revenue suggests that there is a good economic case for taxing unrealised gains on an accounts basis, but that real property is a special case where gains should be taxed only on disposal.

Despite respondents to the August 2002 consultation broadly supporting the continuation of the existing system of capital allowances, reform is still very much on the cards. One approach would be to follow the accounts’ depreciation. Another would be to continue with capital allowances but using a much wider range of rates. It is clear that this area remains open to consultation.

An important change is suggested for leased plant, namely that lessees rather than lessors should obtain capital allowance where the lease is effectively a financing transaction. In general, lessees would obtain the same allowances as if they had borrowed money and bought the assets.

This will cover not just finance leases, but also operating leases that the Revenue regards essentially as financing transactions.

The Revenue is already focusing on transactions which, although they are accounted for as operating leases, set a residual value at a level such that there is only a remote risk of the value not being realised.

This argument could apply to any operating lessor that is running a profitable business and is indicative of the Revenue’s generally hostile approach to the tax-based leasing industry.

Any such change to the tax basis of leasing would remove the ability of businesses to obtain a value for tax depreciation in a year when they were not paying tax.

This particularly applies to inward investment and start ups generally and is likely to remove an important factor in decisions to make new investment, particularly in areas such as manufacturing, in the UK.

Such a move might conceivably be balanced by a tax credit system similar to that available for research and development expenditure.

The new proposal on leasing and capital allowances is a direct reversal of the implicit position set out in the August 2002 paper.

This could be interpreted as a general hardening of approach to the leasing industry by the Revenue in the intervening 12 months.

The first of the absolutely new proposals concerns the extension of the scope of the transfer pricing legislation to transactions between all related enterprises, even where both are in the UK. This is intended to avoid a possible challenge following recent European Court of Justice cases on the UK’s tax rules.

Using the ECJ has become the weapon of choice for UK corporate taxpayers hoping to overturn Revenue decisions. Next year Marks & Spencer is expected to use the court to win back £30m it says was overpaid in corporation tax.

The need to meet the full documentation and evidence requirements of the existing transfer pricing rules for all intra-group transactions will be substantial although it appears likely to be mitigated by some exemptions.

The second major new area is the extension of thin capitalisation rules so they apply to intra-UK as well, by bringing them into the existing transfer pricing regime, which will itself be extended to deal with purely UK-only transactions.

Overall, the paper aims to simplify the system. This will not only reduce the administrative burden on taxpayers (although increasing it again by imposing cross-border rules within the UK) but, it is anticipated, reduce the scope for tax avoidance and make the UK’s corporation tax system robust against legal challenges, in particular from the ECJ.

Major changes of this type are fraught with difficulty, both in predicting the impact on taxpayers and the effect on government revenues with any degree of certainty.

Hopefully, further consultation will include draft legislation being published far enough in advance of its enactment so that proper consideration may be given to the practical workings of any new system.

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