Read And Respond

RICHARD CURTIS summarises the main points for discussion in the new corporation tax consultation document.

'I WOULD URGE businesses and all those with an interest in corporate tax to read and respond to the consultation'. These were the words of Dawn Primarolo as she introduced the Government's consultation document, Reform of Corporation Tax, on 5 August. The document maintains the Government's momentum for reform in this area and follows recent measures (substantial shareholdings, intellectual property, etc.) with the hint of more fundamental reforms, encompassing three areas:

• the treatment of capital assets not covered by earlier reforms;
• the rationalisation of the schedular system; and
• the differences in the treatment of trading and investment companies.

The consultation document is 'one of a series' and should be read in the light of the earlier A Review of Small Business Taxation (the March 2001 technical note), Large Business Taxation: the Government's strategy and corporate tax reforms (the July 2001 consultation document) and the measures included in Finance Act 2002.

The Government acknowledges that the basic framework of the reforms is 'revenue raising', but the 'key criteria' for reform are:

• 'business competitiveness' (removing tax distortions so that business decisions are driven by commercial, rather than tax, considerations); and
• 'fairness' (ensuring that businesses 'pay their fair share', using the tax system as a 'policy instrument to correct market failures that impose wider costs on society').

The Government has as its objectives in these reforms:

• maintaining a low rate, broad based system;
• reducing tax distortions and market failures;
• removing outdated and ineffective restrictions; and
• countering tax avoidance.

Representations on the modernisation of the corporation tax system have requested simplification, clarity and certainty for the taxation of particular transactions. To achieve these aims, the following measures have been suggested as worthy of debate.

• Elimination of 'tax nothings'.
• Abolition of the capital/revenue divide.
• Abolition or rationalisation of the schedular system.
• Relief for depreciation of assets that are not eligible for capital allowances.

The corporation tax régime can affect the growth of the economy, employment, investment, innovation, etc. To avoid rocking the boat, the Government suggests that a neutral régime should not distort investment patterns, etc. and this could be brought about by aligning taxable profits as closely as possible with those used for business or economic purposes and taxing capital gains in a similar manner to income. The document then looks in more detail at the following three areas.

Taxation of capital assets

The review of this subject starts from the basis that recent reforms (intangible assets, corporate debt, derivatives, loan relationships, foreign exchange gains and losses and substantial shareholdings) have effectively already removed some assets from the capital gains tax régime, which now largely applies to:

• land and buildings;
• financial assets not within the above categories; and
• tangible movable property when sold at a profit.

These categories are referred to as 'capital gains assets' in the document and one suggestion is that the approach taken in Finance Act 2002 for intangible assets could be extended. This would mean profits and losses being recognised in the annual accounts and relief being given for depreciation as shown in the accounts. If accounting standards do not require annual valuations, any profit or loss would be taxed on realisation (which would avoid unnecessary annual valuations). Indexation relief would be abolished and rollover relief might follow the rules for intangible assets.

The Government sees advantages in such an approach as follows.

• Coherence with existing rules for intangible assets, etc. (which were arrived at after consultation).
• Companies would receive relief by reference to depreciation.
• Taxable profits would be closer to commercial profits.
• Record keeping would be reduced.
• Annual tax computations would be made easier.

A period of transition would, of course, be needed to move from the old to the new system and again this might follow the new rules for intangibles. The length of this period is an issue that the report would particularly like to be addressed by respondents, as is rollover relief. The Government sees no case for this relief to apply to disposals of shares, but acknowledges an argument when related to land, buildings, plant and machinery, etc. A balance between restricting a company's cash flow and 'Exchequer yields' is required.

Depreciation

The convenience of tax relief for depreciation, rather than write-backs and a separate capital allowances system, seems beneficial and the Government would like input as to how such a move should be balanced with the current capital allowances régime, especially where one or the other could result in substantial tax gains or losses. A hybrid régime is seen as increasing complexity and the document seems inclined towards a depreciation based scheme, with (subject to provisos) the Government wishing 'to examine and discuss with business the case for moving wholly to a régime based on accounts depreciation'.

Other issues

The proposals would have implications with regard to, for example, leased assets, life insurance companies, collective investment schemes and controlled foreign companies and the Government would like input on these and the other issues raised.

The schedular system

The world has moved on somewhat since the schedular system of identifying taxable income was introduced 200 years ago; the sub-divisions are now seen as artificial and 'convergence is a desirable object'. The Government sees potential for simplification and cost saving, but warns that 'there is, however, no general intention to relax the present rules where companies with losses are bought and sold'. It suggests that reforms might address:

• the different rules for computing Schedule D, Case I, Schedule A and investment income of trading and investment companies; and
• streamlining the carry forward of losses.

It is suggested that the United Kingdom's schedular system of recognising income 'is out of step internationally' and Annex A to the document summarises the main features of the treatment of business profits and losses of our main trading partners.

The 'Exchequer effect' features earlier in this section of the document and the Government would like to gain a deeper understanding of the likely effects of any changes. It notes that provisional data for the financial year ended 31 March 2001 indicates that there were total losses of around £80 billion (£65 billion for the year 2000) of which £15 to £17 billion (£15 billion for 2000) are likely to be unutilised and available to carry forward. These losses mainly relate to Schedule D, Cases I and III and the fear must be that any simplification leading to the earlier use of losses will result in a substantial reduction in tax yield.

Approaches to rationalisation

Possible suggestions for reform range from a 'minimalist approach' of rationalising the computation rules, but retaining the loss relief rules, to abandoning the schedular system in favour of 'business profits' (encompassing Schedule D, Cases I, III, V and VI and Schedule A) with losses immediately available for set-off, carry forward or carry back. Various other intermediate approaches are suggested, including the adoption of a system that recognises profits from either an 'active' or 'passive' source, with losses being retained in each stream. The Government rules out a complete abolition of the distinctions on the grounds of cost.

Respondents are asked for views as to how different approaches might affect both their own businesses and in the broader context. In this way, the Government hopes to be able to prioritise in the event that reforms are made in stages.

Other issues

How the move from capital gains to income will fit into the rationalisation of the schedular system is a main area of concern, especially with regard to the utilisation of losses. Transition is also important, with measures being required to deal with pre-existing losses, anti-avoidance legislation and whether any changes would introduce 'distortions' into the system. Although seen as a step following the main issues raised in the consultation document, views regarding the effect of rationalisation on group taxation are also welcomed; should this lead to the taxing of groups on a consolidated basis or should the group relief rules themselves be rationalised?

Finally, it is noted that there is no intention to dismantle the 'ring fence' around the North Sea oil régime as part of these changes.

Trading and investment companies

Somewhat similar to the schedular system being eroded by changing income sources over the years, it is acknowledged that the distinction between trading and investment companies has also become blurred, especially 'for companies which change character and shift from one category to the other'. Historically there might have been some justification for these distinctions when trading activities were seen as more likely to create employment and demand, but the structure of the economy and the businesses within it have changed.

Current issues noted in the document are that:

• the differences between the rules regarding deductions for trading and investment companies can result in timing differences as to when expenses are recognised for tax purposes;
• capital gains rollover relief relates to trading assets and therefore favours trading companies;
• the rules regarding, for example, surplus management expenses and Schedule A losses are more generous than for trading losses;
• the substantial shareholdings relief is only available for trading companies or groups; and
• capital gains tax taper relief is dependent upon the shares being held in a trading company.

It is also noted that there are 'hybrid' companies that might not fall under either a 'trading' or 'investment' heading. Having said that the historical reasons for the distinction are no longer applicable, the document states that simply removing the distinction may not be fair or effective. As an example it suggests that it might then be possible for individuals to obtain favourable tax treatment for personal investments. It concludes by suggesting that, while 'some distinctions may remain justified', consideration should be given as to whether this was necessary at both corporate and shareholder level.

The options for change

Suggestions for change in this field range from a minimum of more closely aligning the rules for computing profits with accounting rules to changes in the boundaries between the different types of company.

A more central approach might be to:

• distinguish 'active' from 'passive' investment companies and align the former with trading companies, subject to anti-avoidance measures;
• extend some of the present tax reliefs for trading companies to investment companies; or
• treat some investment companies, where they are an adjunct to or an integral part of a group's activities, as being trading companies themselves.

The term 'Exchequer protection' appears again in this section. The Government does not want to see abuse of the system by, for example, 'corporate wrappers' for personal assets. Annex B of the document comprises a useful summary of the differences between trading and investment companies.

Conclusion

In 'keeping up to speed' with its corporate tax reform programme and by publishing the consultation document, the Government is actively welcoming input both at a detailed level (Annex C summarises the consultation points), but backed with views regarding the relative importance of the proposals and possible order of introduction. The fundamental reforms posited in the consultation document have the potential to affect every corporate entity in the country (and therefore their accountants and tax advisers) as the proposals dig further into the underlying strata of the tax than did the other recent reforms. The report should certainly be read by those practitioners with particular interest and experience in corporation tax. The document helpfully includes a 'wish list' at the end of the main chapters covering the topics on which comments are particularly welcome. The outcome will depend on how the Government balances the interests of the corporate players with the perceived Exchequer constraints and costs.

The consultation document, Reform of Corporation Tax, is on the Revenue website (at www.inlandrevenue.gov.uk/consult_new/corporation_tax.htm) or is available from

Inland Revenue Visitors Information Centre
Ground Floor
South West Wing
Bush House
Strand
London WC2B 4RD.

Comments (to reach him by 29 October 2002) should be sent to

Peter Marriott
Inland Revenue
Business Tax
Room 5E1, 5th Floor
22 Kingsway
London WC2B 6NR
tel: 020 7438 6442
fax: 020 7438 6815
e-mail peter.marriott@ir.gsi.gov.uk).

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