The UK corporation tax system 12 misunderstood concepts

Transcription

1 The UK corporation tax system 12 misunderstood concepts

2 Contents Foreword 3 An introduction to a complex system 4 Building blocks of the tax base 6 Concept 1 Losses 6 Concept 2 Groups 7 Concept 3 Where income is earned 8 International cross-border concepts 9 Concept 4 Transfer pricing 9 Concept 5 Tax residence 10 Concept 6 Worldwide and territorial taxation 11 Concept 7 Tax havens 12 Concept 8 Controlled foreign companies (CFC) rules 13 Accounting and administration 14 Concept 9 Cash tax and book tax 15 Concept 10 Deferred tax accounting 16 Concept 11 Provision for nncertain transactions 17 Concept 12 Agreement and settlement 18

3 The UK corporation tax system: 12 misunderstood concepts 3 Foreword A year ago we launched a report Tax and British business: Making the case. This aimed to bring a more informed voice to the UK debate over business tax and to help support pro-growth tax policies. It highlighted the significant contribution that business does make across all taxes. It discussed the way in which the corporate tax system works. It also attempted to explain how the landscape of corporate tax management had changed significantly over the past decade. In particular it made a clear statement that the CBI does not support abusive tax arrangements which serve no commercial purpose and that the majority of businesses manage their taxes with complete integrity and fully engage with HMRC. Since the launch of that report the debate has clearly moved forward. The Public Accounts Committee hearing last December brought tax issues onto the front pages of the newspapers. The government has made great progress towards making the UK corporate tax system more competitive in recent years. So, it is important that this good work is not undermined by a misinformed debate about business and taxation. Part of our report last year was a chapter titled Nine tax rules which can lead to confusion. This was well received and we have had a number of requests to expand this work. In this document, therefore, we now cover twelve tax concepts in more depth, ranging from issues around the definition of the corporation tax base to international issues such as transfer pricing and tax havens to complex accounting issues and conventions. We hope this document will support and inform the public debate on the corporate tax system and the importance of maintaining a competitive tax regime which promotes growth. John Cridland CBI director-general

4 4 The UK corporation tax system: 12 misunderstood concepts Introduction Why is tax so complicated? The collection of tax revenue is fundamental to the sound functioning of a stable and prosperous society, and is one of a government s oldest and most well-established roles. That is as true for the UK as any other government. So, once the UK government has decided which services to provide it then seeks to raise the money to pay for those services by a number of means, one of which is through the collection of tax. Within that tax portion the government needs to decide how much to raise from certain sectors of the economy individuals and businesses, for example and within those groups from what types of activity. Further decisions need to be made as to the type of tax to be used to raise money from certain activities or sectors income, property, consumption, etc and the government must also decide whether certain activities within certain sectors should be treated differently. Recently, governments have begun to use the tax system to deliver other governmental goals. This might be something in the individual sector like the child credit, in the corporate sector it may be the desire to encourage research and development through use of a tax credit, or the wish to discourage certain types of environmental activity by use of green taxes. This has resulted in a daunting amount of legislation built up over many years. It is important to note that while some tax legislation reflects a coherent policy rationale, much reflects ad hoc responses to historical problems that have long since passed away. Tax law will always be playing catch-up with business practice, simply because business is constantly evolving in response to changing market conditions, consumer preferences etc, while making and changing law is a lengthy process. This process of falling behind and catching up makes the law sometimes appear ineffective, and responses make it still more complex and more easily misunderstood. So the UK tax system is very complicated. There are currently more than 20 major taxes in the UK and a number of them are borne wholly or partly by business. In determining the effect of tax on business we need to look at the collective burden of all of those taxes. However, much public focus falls on the corporation tax paid by companies on their profits, and this paper will reflect that public focus. Corporation tax is one of the ways in which British businesses are taxed. It is calculated based on the profits they earn not on the income they receive. That broadly means they are taxed on their income after deducting the costs (eg manufacture, labour, transport, premises, finance) of earning that income. These costs could include the costs of raw materials and services received from others such as advertising and marketing. The costs may also include funding costs such as interest paid on money borrowed for use in the business. The costs may be payable to a supplier based either in the UK or abroad. This is how most countries across the developed world typically tax businesses on their profits. In relation to business, in all developed economies there will be a system of accounting rules which help to give investors, regulators and the company itself an accurate picture of the economic state of a company at a single point in time (the year end ).

5 The UK corporation tax system: 12 misunderstood concepts 5 While this accounting picture may be important for tax, tax rules are trying to do something different raise tax, but without endangering the viability of the company by challenging cashflow, in particular, or the company s ability to grow, more generally, by requiring tax revenue before a profit has actually been realised. Therefore, there are always going to be significant differences between the economic snapshot of the accounting rules and the more pragmatic approach of the tax rules. This paper also has a particular focus on international tax issues where interaction with foreign laws can add another level of complexity. This is true for UK headquartered companies expanding overseas, and is equally true for overseas based companies looking to do business in the UK. For UK-based businesses going overseas, it is crucial that they can compete with companies from other countries, and the UK government explicitly recognises that in certain areas, and makes provision for it. Equally, the UK tax system is one of the factors that an overseas business looking to set up operations in the UK will take into account. Some businesses may be able to establish their operations in another EU member state or elsewhere in the world, and the government offers certain incentives to encourage them to invest in the UK. The result of all of these interactions between conscious policy decisions, ad hoc responses, use of the tax system for non-tax purposes, calculation of profit (as opposed to income), accounting rules that differ from tax rules, and the international overlay, makes for an incredibly complex tax system. We should clearly aim for greater simplicity, but we need also to acknowledge that a complex world is probably going to result in a complex tax system.

6 6 The UK corporation tax system: 12 misunderstood concepts BUILDING BLOCKS OF THE TAX BASE Concept 1 Losses Particularly during the financial crisis, the losses companies have incurred and can carry forward have attracted significant attention. Where a company makes a loss for corporation tax purposes, calculated according to the statutory rules, there is no immediate negative payment or refund from HM Revenue & Customs (HMRC). There are rules which allow a company to obtain some relief for the loss by way of set-off. If a company makes a loss in a particular trade or business, it can offset that loss against total profits from all trades and businesses it carried on in that period. If you have only one trade or business or insufficient total profits, you may be able to choose to offset the loss or remaining loss against total profits in a specified period or periods during a given length of time ( carry it back ). Otherwise it will be carried forward to be set off against the profit from that trade or business for future periods. If you are a member of a group of related companies, you may also be able to surrender that loss to another of those group companies so that it can offset the loss against its current year profits, enabling the group as a whole to benefit more immediately (see Concept 2). The rules for carrying back losses may require some detailed calculations. If you ve previously paid corporation tax, you can claim for the loss to be offset against profits for the12-month period before the accounting period in which the loss arose. But you can only do this if your company was carrying on the same trade at some point in the accounting period or periods that fall in the preceding 12-month period. For example, if your company has a trading loss of 100,000 in the 2012 calendar year accounting period and profits of 220,000 in the preceding 2011 calendar year, you can carry back the 100,000 loss to be offset against the profits for the previous accounting year, reducing them from 220,000 to 120,000. If an accounting period doesn t match that 12-month period exactly, the profit for that period is time apportioned and the loss can only be offset against that portion of the profit falling within the 12-month period. In the same example above, assume that the company changed its accounting date, so that it had taxable profits of 25,000 for the accounting period 1 July 2011 to 31 December 2011 and 110,000 in the accounting period 1 July 2010 to 31 July You can claim to offset both 25,000 of the loss against the profit of the later period and 55,000 (6/12 x 110,000) against the profits of the earlier period. Apart from the potential for surrendering the loss to another group company by way of group relief, any amount not set off against current or prior year profits can be carried forward indefinitely for offset against profits from the same trade. In the example above, 20,000 ( 100,000 25,000 55,000) can be carried forward in this way. There are also complex rules that can apply where a trade or business changes significantly in nature to restrict or eliminate relief in future periods.

7 The UK corporation tax system: 12 misunderstood concepts 7 Concept 2 Groups The taxation of groups, particularly multinational groups, is often misunderstood. Large or complex businesses often involve one parent company owning shares in a number of other companies which it controls as part of a wider group. There are UK rules which apply to companies in such group relationships. Some of these rules provide relief where the group is disadvantaged by being set up as a group of separate companies, rather than as divisions of one company. In the UK, businesses can organise themselves in different ways as individuals running a small business alone, as partnerships (operated by a number of people) or as companies. For large or complex businesses typically one parent company will own shares in a number of other companies which it controls as part of a wider group. Together, these companies operate the overall business or businesses of the group. It would not be unusual for a very large business to have hundreds of these subsidiary companies in its group structure. There are many non-tax reasons why groups contain multiple companies rather than just one single company as part of their structure these include: operational or management organisation, legal/regulatory requirements or simply historical reasons (eg groups formed through mergers or acquisitions). Companies are generally taxed on the profits which they make as a whole, aggregating the taxable profits of however many trades or businesses they carry on (see Concept 1). This means that if one business division makes a profit, but another makes a loss, the company only pays tax on the net result of both businesses taken together ie on its overall profit as a single company. To ensure that the same overall corporation tax is paid regardless of whether a business chooses to operate through a single or multiple companies formed into a group, tax rules allow one company in a group to surrender its loss to be set against the profit of one or more other members of the same group. The loss can be shared among more than one company in a ratio which the group decides. Effectively this group relief puts the group in the same tax position as if it had chosen to put all of the business divisions into one single company ie tax is paid only on the overall profit made by the group. Group relief enables the current year sharing of tax profits and losses within different companies in a group to give a fair overall taxable result, for example: Company X operates two business divisions cake sales and biscuit sales. Cake sales make a profit of 300 Biscuit sales make a loss of 100 Overall profit of Company X is 200, and tax is paid on this overall profit amount. However, if instead Company X needed, for non-tax reasons, to operate cake sales itself, but to set up Company Y (a separate company owned by Company X) to operate biscuit sales, the results could look different: Company X makes a profit of 300 on cake sales and pays tax on all 300 of this profit Company Y makes a loss of 100 on biscuit sales and pays no tax If group relief did not exist, overall as a group, tax would be paid on profits of 300 even though the net overall profit was only 200 Group relief enables Company Y to surrender its 100 loss to Company X to reduce its taxable profit to 200, so that the group suffers tax on the same amount of profit as if it had operated its business in divisions rather than separate companies. The group tax rules mean that looking in isolation at the statutory accounts of just one company which is part of a larger group will not give an accurate indication of the tax that should be paid by the group as a whole the profits of the individual companies need to be consolidated in order to appreciate the overall profit made by the group, and the level of tax that the group might be expected to pay. Transfers of capital assets between companies in the same group are generally deemed to take place so that no loss or gain is recognised for corporation tax purposes. The principle behind this is similar in nature to that for group relief: economic gains or losses that arise during the ownership of an asset by a group should only be taxed or relieved when the asset leaves the group.

8 8 The UK corporation tax system: 12 misunderstood concepts Concept 3 Where income is earned The question of where income is earned is critical for the application of the UK tax rules. Under the UK tax system each corporate legal entity that is tax resident in the UK is required to pay UK corporation tax on the taxable profits it makes from doing business in the UK. Legal entities which are not tax resident in the UK pay corporation tax on the taxable profits they make from doing business in the UK provided they have a sufficient branch or other presence in the UK which constitutes a permanent establishment earning income in the UK. The UK is home to a larger number of multinationals than might otherwise be expected based on the size of the UK economy alone. This is through a fortuitous mix of history, the pre-eminence of the London financial markets, investments in infrastructure and a stable regulatory environment. These UK headquartered multinationals may generate huge revenues from their worldwide operations but have only small or sometimes no UK based operating activities. It is important to understand that the headline sales number (sometimes also referred to as turnover or gross revenues) is not equivalent to net profits or net income, as this figure does not take into account all the business expenses incurred to generate those sales revenues. Taxable profits are gross sales or revenues, less business expenses, plus or minus any adjustments required or permitted by the tax law (see Concept 9). In the case of a UK permanent establishment of an overseas company, the profits are based on amounts attributable to that business activity in the UK. Where a UK company has established a business presence in another country (either as a subsidiary or as a branch/permanent establishment) then, subject to certain exceptions, the taxable profits of those companies earned in other countries will not generally be subject to UK taxation (see Concept 6). Businesses may differ significantly from each other as to which part of their business activity generates the most value. For example, a business participant in a market that has few barriers to entry and is highly competitive is likely to succeed due to excellence in operational delivery and the management of the supply chain and cost base. On the other hand, success in the luxury goods market requires excellence in maintaining and protecting the brand, supported by strong marketing, design and high quality standards. In the case of a multinational company with a UK business, understanding the value chain of the business and where that value is generated or owned is fundamental to properly allocating income to the value that is generated from the business activity undertaken in the UK. Factors to be considered include: The location where value adding functions eg sales and marketing are performed The location where risks that determine the level of value generation are assumed The location of key value adding risk management and function leadership (substance required to manage value adding functions and risks) The location of value generating assets, both intangible and tangible. In the case of a multinational group, the transfer pricing rules in particular will help to ensure that taxable income is recognised in the country in which it is earned (see Concept 4 for more detail on transfer pricing). If a key value driver of the business is moved from the UK to another part of the multinational group outside of the UK, the transferring UK business will be taxed on a fair market price for what has been moved. After a UK company has paid its taxes, paid interest on or repaid its debts and paid dividends to its shareholders, any earned taxed income left over is available for reinvestment in the UK business or elsewhere, or returned to shareholders where the reinvestment opportunities are insufficiently attractive. Interest income and royalties received by UK companies are subject to corporation tax while, with some exceptions, returns from investments in the form of dividends and capital returns are generally not taxed in the hands of UK companies (see Concept 9).

9 The UK corporation tax system: 12 misunderstood concepts 9 INTERNATIONAL CROSS-BORDER CONCEPTS Concept 4 Transfer pricing Transfer pricing prices charged between related companies has been much in the news owing to concerns over erosion of the tax base. Long-standing OECD rules require where sales take place between connected businesses that sale must take place at the same price that unconnected parties would arrive at (the arm s length price ). The transfer pricing rules apply to transactions between UK parties as well as transactions between UK and overseas parties. Transfer pricing adjustments must be made in the self-assessment tax returns. While a company s taxable profits for UK corporation tax purposes are based on accounting profits with detailed tax adjustments that are required or permitted by law (see Concept 1), there is an overriding requirement that for transactions between connected persons, the UK tax liability will be calculated by reference to the arm s length price for the goods or services. Where a UK company is part of an international group of companies, and there are transactions that take place between the UK and the international member companies of that group, it can be more difficult to determine the arm s length price for the transactions to ascertain what profits relate to the business activity in the UK. Take the example of a UK company that is not part of an international group, and which buys clothes for retail sale from a company based in Portugal. Let s assume that the commercial deal the UK company has agreed with its Portuguese supplier means that it is not able to return any unsold clothes and therefore ordering the right amount of stock and the right clothing lines will have a large effect on the amount of profits it makes. Also, because no returns of unsold stock are permitted, the UK company may have been able to buy large volumes of clothes at a discount. The business profits that the UK company makes will be a direct reflection of how successful the UK company is at operating its business, including managing business risks such as stocking the right amount and type of clothes. Now consider a situation that is identical in all respects, except that the Portuguese supplier is now a member of the same international group as the UK company. You would expect in both cases that the UK company would make the same amount of business profits, that the price paid by the UK company for the clothes supplied by the Portuguese company the transfer price should be the same in both cases, and that s exactly what the transfer pricing rules are designed to do. The UK tax authorities have an interest in ensuring that the price paid by the UK company to the Portuguese supplier is not too high, and the Portuguese tax authorities have an interest in ensuring that the price received by the Portuguese supplier from the UK company is not too low. In each case the tax authority interest is backed up by legal and audit rights. This seems fairly straightforward, so why can getting the transfer price right become difficult in practice? Using our earlier example, what if the international group decided it made economic sense to have all the clothes designed by a group company in Spain, the clothes manufactured by a group company in Portugal, and all the manufactured clothing stock purchased by another group company in Switzerland that is responsible for the marketing strategy across Europe and that sells the clothes to a group company in the UK on the basis that any unsold stock is bought back on request. The UK company is now protected from making any business losses from not managing the business risks that relate to the amount and type of clothes to stock. The UK company also benefits from the marketing campaigns run by the Swiss company. The UK company is still responsible for operating its business well and should expect to earn the level of profits that is commensurate with this UK located business activity and risks. However, this will be only a share of the total business profits created from the entire group s operations, as clearly Spain will want to tax the business profits from the clothes design, Portugal will want to tax the business profits from the clothes manufacture, and Switzerland will want to tax the business profits from the marketing and distribution activities, including a reward for taking the stocking risks and owning marketing intangibles. The transfer price or arm s length price will need to be established for each of these intercompany transactions, so that the profits are fairly allocated between all the countries where business activity takes place. This will also ensure that the UK company s income is not taxed more than once, as this would put the UK company that is part of an international group at a competitive disadvantage to a UK company that is not part of an international group.

10 10 The UK corporation tax system: 12 misunderstood concepts Concept 5 Tax residence As noted earlier in relation to where income is earned, where a company is resident is crucial for determining its tax liability. However, not all the rules on residence are immediately understood. The tax residence of a company is established by applying relevant tax rules to certain facts about the company, such as where the company is established and where certain key activities are carried out. Whether a company is tax resident in the UK or not will determine how much UK tax it has to pay on its profits, especially where the profits are earned outside the UK (see also Concept 4 and Concept 6). A company is tax resident in the UK if it is incorporated in the UK or its central management and control is in the UK. What constitutes central management and control has been the subject of numerous cases determined in the courts over a lengthy period. Whether a company is tax resident in another country depends on the domestic tax legislation in that country, although not all countries scope their taxes based on residence. There are a number of tax consequences to changing the tax residence of a company: these can be positive or negative, or a combination of both positive and negative impacts, depending on the company and the countries involved. A change of tax residence is not something a company undertakes lightly since it means the company has to change the way it operates, and this involves tax effects. That said, several years ago, some companies who were unhappy about the way the UK tax rules applied to their profits, chose to move their tax residence to a country that they felt had a better tax regime. In many cases, this was because the old UK tax rules used to tax profits that were earned outside of the UK, even if those profits were already taxed in the country where they were earned. We see this less now and, in fact, many companies that previously moved away from the UK have now chosen to return because of recent improvements to the way the UK taxes profits from overseas. It is important to remember that a company s profits earned in the UK are generally subject to tax in the UK, no matter where the company itself is tax resident. Tax residence is usually quite easy to determine, but where the answer is not clear or obvious countries will often agree between themselves some specific tie-breaker tests which they will apply. These are set out in agreements between the countries called double tax treaties. Even if a territory does not charge tax according to residence, that concept will be important in relation to double tax treaties, which aim to prevent double taxation of the same income, usually by reference to the residence territory having primary taxing rights. It stands to reason that if some key facts about a company change, the tax residence can change as a result. Likewise, if a company wants to be subject to tax in the UK or in another country, it needs to change the way it operates in order to meet the requirements of the tax rules to be UK or overseas resident.

11 The UK corporation tax system: 12 misunderstood concepts 11 Concept 6 Worldwide and territorial taxation Recently the UK has changed its rules to move from a worldwide system to a more territorial system. Territorial taxation is based on the principle that a country taxes profits made in that country and leaves other countries to tax profits earned in their country. Worldwide taxation (which is now quite unusual in developed countries) is a method whereby a country taxes profits of its residents wherever they are earned in the world. UK companies conduct business overseas either through foreign branches of their UK companies or through foreign subsidiaries of those UK companies. Foreign governments will impose their own taxes on the profits earned in their countries. The UK tax system has rules which govern how profits earned outside the UK by UK companies, or by UK parented multinationals, should be dealt with for UK tax purposes. These rules are carefully designed so that they do not put UK companies at a disadvantage when competing for business overseas, and do not create a tax incentive for foreign takeovers of UK parented multinationals. This situation can arise when the UK tax system imposes incremental UK taxes on profits earned overseas in circumstances where a comparable foreign parent company would not suffer such an incremental layer of tax. International tax systems generally have laws which follow either territorial taxation principles or worldwide taxation principles when dealing with foreign profits. The distinctions between these two approaches are explained below. Territorial taxation broadly imposes tax on profits earned within the territory in question. If a UK company has established companies in other countries then, subject to certain exceptions, the taxable profits of those companies earned in other countries will not generally be subject to UK taxation. One exception to this is in relation to controlled foreign companies (CFCs see Concept 8), although an updated regime which comes into effect in 2013 makes this more territorial. Another exception is when those profits are remitted to the UK as interest or royalties. In that case, because these payments are generally deductible in the country of payment they will be subject to tax when received in the UK. Similarly, the profits or losses attributable to a permanent establishment of the UK company in another country will usually be taxed or relieved in that other country without also being part of the company s taxable UK profits, either under the terms of a double tax treaty (see Concept 5) or by virtue of an election for profits and losses to be disregarded. In a worldwide taxation system relief is normally given for taxes already paid overseas but the system is generally very complex and burdensome to apply because the parent has, in some fashion, to analyse and re-compute everything, wherever done, on a basis which is consistent with the parent company s tax law. A worldwide taxation basis is expected to have the effect that the total tax suffered on profits earned in a given jurisdiction is at the higher of the tax rate in the local jurisdiction and the rate in the home jurisdiction (ie the UK). On an international basis tax regimes have increasingly moved towards a territorial basis of taxation as being a simpler and more appropriate basis of taxation. The UK tax system was originally founded on a basis which followed worldwide taxation principles but has been changed over recent years so that territorial principles now predominate. This change followed a non-partisan review initiated under the prior government, has continued and been completed under the current government. This responded to significant concerns that the existing worldwide taxation basis was putting UK companies at a competitive disadvantage and providing a tax incentive for foreign, rather than UK, ownership of multinational groups. The review lead to legislative update which, among other changes, included an updated approach to the taxation of foreign dividends and foreign branches together with an updated controlled foreign companies (CFCs) regime.

12 12 The UK corporation tax system: 12 misunderstood concepts Concept 7 Tax havens Tax havens have been at the centre of public scrutiny over the past months. In fact there is an important distinction to be drawn between low tax jurisdictions and secrecy jurisdictions. Tax havens have traditionally been considered to be low or no tax countries which attracted corporations and wealthy individuals to deposit large quantities of money offshore in order to avoid paying significant amounts of tax on the interest. However, those same countries do provide other non-tax benefits for companies which are often forgotten or ignored. There has been increased public and press interest in the use of tax havens by multinationals in recent years. Although there is no common international definition of the term tax haven the US government Accountability Office describes the features of a tax haven as: A country with nil or nominal taxes; a lack of effective exchange of tax information with foreign tax authorities; a lack of transparency in the operation of legislative, legal or administrative provisions; no requirement for a substantive local presence; and self-promotion as an offshore financial center. The use of the term tax haven has sometimes been stretched beyond this concept in recent years by tax activist organisations, to include jurisdictions such as The Netherlands and the US state of Delaware. Many groups have companies registered in The Netherlands, traditionally as holding companies of overseas subsidiaries due to the extensive tax treaty network, or in Delaware to take advantage of the favourable corporate law regime, but not to avoid tax. Nor could it be said that countries such as The Netherlands or the state of Delaware fit the usual concept of a tax haven. With the UK significantly reducing its main corporation tax rate and offering special rates for exploiting patents (the patent box), it has even been described by some as a tax haven. The traditional benefit of investing cash though a tax haven has largely been negated as high tax countries have evolved rules to tax interest arising in a tax haven. Therefore, the tax benefit of holding cash offshore no longer exists for most companies when undertaking legitimate tax planning. In addition, punitive withholding tax rates on interest paid to a company located in a tax haven have negated much of the benefit of routing intra group funding through a tax haven entity. So why do corporates still use tax havens to locate group companies, particularly given the increased focus by non-governmental organisations and the associated negative press which assumes that the primary use of subsidiaries in tax haven jurisdictions is to avoid tax? In fact there are a number of non-tax reasons to use companies located in tax haven territories, such as the stability of the government and a clear legal framework (circumstances often overlooked). Many of the reasons that corporate groups use tax havens are predicated on the ability to: Take advantage of the clear legal framework and to protect from unpredictable local laws where the activity is carried out Take advantage of beneficial regulatory requirements Provide a neutral tax territory for joint ventures Sell or provide services within the tax haven country itself. Increasingly the focus of the OECD and other international bodies is on tax secrecy jurisdictions, where it is possible for wealthy individuals and corporations to hide away income and therefore evade tax in the country in which they reside. The tax secrecy jurisdiction will not exchange information with other countries and so it is not possible for another country to enforce their local tax laws which seek to tax the overseas income of their residents. Additionally, there is often no requirement to disclose beneficial ownership of shares and the use of nominee shareholders and directors is common in order to avoid transparency. Tax evasion has no place in society and the vast majority of multinationals do not engage in such activity. Furthermore there is significant pressure on tax secrecy jurisdictions to open up to other nations and exchange information about the funds that flow through their country in order to ensure that these amounts are fully taxed where necessary. Legislation has been introduced by the US ( FATCA ) to ensure that foreign banks provide data to the US revenue authorities or alternatively suffer a 30% withholding tax on their US source income. HMRC has recently announced that agreements have been reached for the automatic exchange of information about accounts held by UK residents in the Crown dependencies of Jersey, Guernsey and the Isle of Man and overseas territories such as the Cayman Islands and the British Virgin Islands (BVI). Therefore assets hidden away in tax secrecy jurisdictions have become increasingly vulnerable to detection by, and therefore taxation by the UK and others tax authorities.

13 The UK corporation tax system: 12 misunderstood concepts 13 Concept 8 Controlled foreign companies (CFC) rules Controlled foreign company (CFC) rules, which deal with the taxation of income arising in overseas subsidiaries of UK groups, are a necessary part of protecting the UK tax system. CFC rules are designed to prevent profits which should properly be taxed in the parent jurisdiction from being inappropriately re-characterised or relocated and dealt with as foreign profits, and thereby suffering tax only in a no tax or lower tax jurisdiction. Whether the UK has a worldwide basis of taxation or a territorial basis (see Concept 9) some protective CFC anti-avoidance rules are required first to prevent groups from locating profits in low tax jurisdictions and therefore avoiding UK tax and second to prevent stripping of the UK tax base into foreign subsidiaries. For example, for a UK parented group, inappropriate treatment as foreign profits would achieve deferral of UK tax (perhaps indefinite deferral) under a worldwide taxation regime, or exclusion from UK tax under a territorial taxation regime. Thus both the UK s old worldwide taxation based system for taxing foreign profits, and its modernised territorial-based system, have CFC rules in place which protect the UK s right to charge tax in respect of profits which should be allocated and treated as UK profits. Well-designed CFC rules need to draw a fine (and very difficult to achieve) balance which gives appropriate rights to the UK to tax what reasonably belongs to it but doesn t claim the right to tax more than that. If additional UK tax is charged on profits which are really foreign profits rather than UK ones, solely because there is a UK parent company, this provides an advantage for foreign owned multinational groups and increases the likelihood of UK parented groups being taken over by foreign parented groups (because the UK is essentially providing a tax incentive for such acquisitions). The rules also need to be as easy as possible to apply and able to accommodate technological or other changes in background which can fundamentally change the way normal commercial business is carried on. If they are not, then the rules will become obsolete and difficult to apply, and will be unlikely to achieve their intended balance of taxing what belongs to the UK but no more. This will have the same effect of providing an incentive for foreign ownership because it will not be possible for business to predict with any confidence what UK tax will be due on foreign profits if they are held under UK ownership. It has been suggested that the changes made to the UK CFC rules were a simple weakening of the UK s defences against UK tax avoidance made so as a favour to business. This is not true. The changes made to the UK s CFC rules were made to modernise them so that they could cope with the way in which normal modern business is conducted and were well targeted so that they protected UK rights to tax UK profits (without going further than necessary to achieve this). In 1984, when the prior CFC rules were introduced, there was no general access to or internet. This meant, for example, that all supporting functions for individual businesses had to be located with those businesses rather than, as will now often be the case, there being specialist centres supporting particular functions of multiple businesses within and across different countries. The world has changed and the tax rules needed to change to reflect that. The principles which underlie the modernised UK CFC rules are international principles for the allocation of profits which were developed by the OECD. The CFC rules apply these principles in a way which asks simply whether the profits should be attributed to the UK or whether the profits should be attributed as foreign profits. They do not attempt to test whether the allocation of those foreign profits between different foreign jurisdictions gives a fair balance of taxing rights between each of those jurisdictions. They thus do not seek to counter foreign tax avoidance a matter for foreign jurisdictions to address for themselves by developing their own tax laws which adequately protect their rights to tax profits which belong to them. There are international agreements in place to help reach common principles or counter unacceptable regimes and practices.

14 14 The UK corporation tax system: 12 misunderstood concepts ACCOUNTING AND ADMINISTRATION Concept 9 Cash tax and book tax Differences between cash and book taxes lead to great misunderstandings but can be attributed to tax and accounting rules. Cash tax is what companies ultimately have to pay in relation to their corporation tax liabilities. Book tax is the amount of corporation tax charged against profit as shown in the company s financial statements. Figures in the accounts referring to tax are determined by accounts rules rather than tax rules. The amount of tax paid by a company for any period ( cash tax ) is almost invariably different to the tax charge for that period shown in the company s accounts ( book tax ). While the starting point for working out the profit on which UK corporation tax is charged is one of generally accepted accounting procedures, a company s taxable profit in its tax return is hardly ever the same as its accounting profit on which the book tax charge is based. There are many adjustments which tax law requires to be made to the accounts profit in order to arrive at the taxable profit. The UK s corporation tax rules essentially result conceptually in four types of adjustment to accounts profits to arrive at a taxable profit: 1 Add back to accounts profit those items of expenditure that are not tax deductible - such as most penalties, entertaining expenses, dividends and provisions for future liabilities. The write-down in the value of assets by way of accounts depreciation is also not deductible for tax, although the impact is reduced in some cases by specific allowances capital allowances that are deductible as set out below. 2 Deduct from accounts profit allowances and reliefs which are provided for in the tax rules. Capital allowances are available at different rates and over different periods for some specific types of capital expenditure. Occasionally, a tax deduction can be claimed in respect of expenditure over and above the amount actually spent a super-deduction as with the current research and development (R&D) regime. 3 Reduce accounts profit by amounts which are not taxable for that period. An example of this results from fair value accounting, particularly in relation to assets/liabilities other than debt, where the accounts reflect unrealised profits but the tax return does not include them (this stems from the corresponding rule that does not allow unrealised falls in value for tax purposes on the basis of an accepted accounting procedure). Most dividends are not subject to corporation tax in the recipient company. 4 Increase accounts profit to include amounts which are taxable for that period but not shown as such in the financial statements. For instance, related to the provision of capital allowances in relation to certain expenditure on an asset, if you sell the asset for more than the amount still to be claimed in future periods its tax written down value, the tax rules can sometimes clawback some of the allowance given by imposing a balancing charge which needs to be added in to taxable profits. One of the largest causes of difference between cash and book over the last recent years has been pension contributions because of the ever increasing deficits in the pension funds. These contributions are generally eligible for tax relief on a paid (not accounts) basis. While there is no limit on the amount of contribution which an employer can make in each period, when a contribution is paid in an accounting period which is large compared with the prior year contribution, the company may not receive tax relief for the entire payment in that period. Instead, part of the tax relief is spread forwards into future periods according to a formula. Group and multi-employer pension schemes require additional complex rules to determine any tax relief. Companies are also increasingly seeking alternative ways to fund their pension schemes which do not solely rely on cash contributions but utilise other assets owned by the company or group: tax reliefs are often available for these kinds of contributions provided certain rules are followed. Losses may also give rise to a difference between cash and book tax. Tax losses do not normally result in current period cash tax relief but can only be set against taxable profits in other ways. Because of the necessary adjustments it is even possible to have on the one hand an accounts profit and a tax loss or on the other hand an accounts loss and a tax profit for a particular period. We looked further at losses in Concept 1.

15 The UK corporation tax system: 12 misunderstood concepts 15 A company might carry on more than one trade or business, in which case the tax rules also need to be applied to each separately. This can complicate things further. In a cross-border scenario these issues are even bigger and could lead to more divergence between the two concepts. Cash tax and book tax are even more unlikely to be the same in the overall consolidated accounts of an international group operating in several different countries, as both amounts will be the result of adding together figures from the various countries. We consider groups in Concept 2. In addition, unrealised intercompany profits/losses in individual company accounts are adjusted out for consolidated accounts purposes, whereas they are likely to remain taxable particularly if they relate to cross-border transactions. International issues are considered in Concepts 4 to 8. There are some accounting concepts which also impact the differences between cash tax and book tax. Concept 10 looks at how accounts seek to smooth out some of the difference via deferred tax accounting and Concept 11 covers the need to reflect liabilities conservatively by way of provisions for uncertain transactions.

16 16 The UK corporation tax system: 12 misunderstood concepts Concept 10 Deferred tax accounting The difference between current and deferred tax accounting is complex and causes endless confusion. Deferred tax accounting is a set of rules that impact the amounts of corporation tax shown in the accounts of a business in addition to the current tax charge. It deals primarily with the timing differences that can occur when items of income or expense are included in the financial accounts in different periods to those in which they are included in a tax return. The UK tax rules specify the amounts of income and expenses that are tax deductible. For example, the way capital allowances work may mean that only part of the money that a business spends on equipment in any one year is allowed as a deduction against the tax due on profits made in that first year. Similarly, there are accounting rules that determine when items of income and expense must be included in the accounts of a business. For example, an item of new equipment depreciates in value over its useful life. In the same way that only part of the cost is allowed for tax when it is spent, only part of the accounting depreciation is charged as an accounting expense in the year that the cash is spent. Deferred tax assets and liabilities in the balance sheet represent the tax effects of timing differences between accounting and tax rules that will reverse in future periods. For example some expenditure qualifies for a 100% capital allowance in year one, in this case a deferred tax liability can be booked because the amount of the tax allowance exceeds the amount of depreciation. This liability will gradually decrease over a numbers of years as the cumulative accounting depreciation starts to catch up with the amount of the tax allowances (which are generally more generous or less conservative). The liability will be extinguished when there is no longer a timing difference, because the cost of the asset may have been fully depreciated and all available tax allowances used. Deferred tax assets can arise in the alternative situation where tax relief is given in future periods for an amount of expenditure that has already been charged in the accounts. This can occur, for example, where a business makes an accounting provision for future expenditure that is not immediately deductible for tax. Tax losses may also give rise to a deferred tax asset to the extent that it is probable that the asset will be realised: this is usually determined by reference to future profit forecasts because future tax deductions will only be of future benefit if there are likely to be future taxable profits to offset them (see Concept 1 for more on losses). There are many differences between the accounting rules and the tax rules, as explained in Concept 9. This creates a mismatch between the amounts that have been included in the tax return and those included in the accounts for a period. Deferred tax accounting seeks to address this mismatch so that the tax in the accounts relates more closely to the profit in the accounts on a like-for-like basis, and reflects all of the tax that will ultimately be due on that profit. It affects the book tax for a particular year insofar as it reflects adjustments in the amounts which are allowed by accounting rules to be held as deferred tax assets or deferred tax liabilities in the balance sheet.

17 The UK corporation tax system: 12 misunderstood concepts 17 Concept 11 Provision for uncertain transactions In some of the commentary on HMRC settlements there has been clear misunderstanding on the requirements for companies to provide for certain tax liabilities in their accounts. Companies may need to make a provision in the accounts for the uncertainty surrounding certain transactions when they expect to discuss the interpretation of difficult tax rules with HMRC. In the UK, a company must file its tax return within 12 months of its year end, so will prepare detailed computations of the tax due at that point. This is part of the self-assessment process ie the company s view of the correct tax treatment of all the transactions which have taken place in the year. At this stage, even though HMRC may not have reviewed the computation, the company will be aware of a number of items where it is likely that there will need to be a discussion with HMRC before the tax treatment can be finalised. For example, there may be questions such as: For example, a company may believe that a particular payment should qualify as an allowable trading payment, but may also be aware that HMRC have won a tax case on a similar payment, but with some factual differences, so the outcome for the company is uncertain. It may take several years before complex transactions are agreed with HMRC. At each year end, the company will review its provisions, and either increase them (if it thinks HMRC s case is stronger than previously) or reduce them (if it is more confident of there being a lower final amount of tax payable). An increase in a provision results in an additional tax charge in the profit and loss account; a reduction results in a credit (lower tax cost). When an issue is finally settled (see Concept 12), the remaining provision will be released to the profit and loss account. The final amount of tax due will be compared to payments already made, and any over or underpayment will result in a further release or charge to profit. Whether a payment to terminate an onerous contract is a trading payment (allowable for tax) or a capital payment (not allowable) Whether the prices used to buy or sell goods from related parties are reasonable arm s length prices under international transfer pricing principles Whether a particular piece of equipment qualifies for capital allowances. The accounting rules apply to tax provisions in the same way as they apply to any other uncertain liability. There must have been a transaction which has given rise to a potential obligation to make a payment, and it is more likely than not that a payment will have to be made. The company must also be able to estimate the amount of the payment with reasonable accuracy, and the amount of the provision will have to be approved by the company s auditors.

18 18 The UK corporation tax system: 12 misunderstood concepts Concept 12 Agreement and settlement There has been much talk of sweet-heart deals between HMRC and taxpayers. There is however a very robust and recently strengthened set of settlement rules in place by HMRC. If HMRC and the taxpayer cannot agree on a particular tax issue, then ultimately it will proceed to litigation and the Tax Tribunal or higher courts will reach a final decision. But litigation is expensive and uncertain, so it is often in the best interests of both sides to reach a settlement. HMRC will only settle an issue on a basis which is a feasible outcome of litigation, so if there is an all or nothing issue, HMRC cannot simply agree to split the difference. However, if there is a range of possible outcomes, HMRC can settle for any reasonable figure within that range (but could not settle for a figure outside the range). There can be a genuine difference of view between HMRC and a company on how tax law applies to a particular transaction. This does not necessarily mean that the company has used a scheme. Questions such as Whether expenditure is capital or revenue in nature Whether an amount is an arm s length price for goods or services received or supplied Whether the accounting treatment of a financial instrument fairly represents the taxable profit or loss Whether all the conditions for a particular relief have been satisfied. need to be taken into consideration. Some issues will be all or nothing (or binary ) issues: for example, either a relief can be claimed or it cannot. Other issues can have a range of outcomes for example, an arm s length royalty is not a precise figure, but an acceptable range such as (say) between 3% and 5% of sales income. HMRC s Litigation and Settlement Strategy (LSS) sets out the key principles on which it will resolve disputes. This provides that in strong cases it will settle for the full amount HMRC believes the tribunal or courts would determine, or otherwise litigate. In all or nothing cases it will not split the difference; and in weak or non-worthwhile cases it will concede rather than pursue. HMRC will not do package deals if there are several issues to be agreed, each one must be considered on its own merits. If agreement cannot be reached, then an issue will proceed to litigation. It is usually binary issues which are resolved in this way. The case will initially be decided at the tax tribunal but either side may be able to appeal to a higher UK court and, in some instances involving EU law, to the Court of Justice of the European Union (although higher UK courts may also refer issues directly to the CJEU for pronouncements on the interpretation of EU law). After a finding in any court about the interpretation of legislation, the matter may revert to the court system or for settlement to be reached between the taxpayer and HMRC on the interpretation of that finding to the facts. When HMRC settles for a figure the LSS means it should be one which could have been reached in litigation, and there is no question of any tax being waived. The total settlement may be less than HMRC originally hoped, but in any dispute (whether in tax or the commercial world) the final figure is rarely all that either party had hoped to achieve (see Concept 11 for an explanation of how companies need to make provision for uncertain transactions).

19 The UK corporation tax system: 12 misunderstood concepts 19 For enquiries about this report or a copy in large text format, please contact: Richard Woolhouse CBI head of tax and fiscal policy T: +44 (0) E: richard.woolhouse@cbi.org.uk Copyright CBI 2013 The content may not be copied, distributed, reported or dealt with in whole or in part without prior consent of the CBI. CBI Our mission is to promote the conditions in which businesses of all sizes and sectors in the UK can compete and prosper for the benefit of all. To achieve this, we campaign in the UK, the EU and internationally for a competitive business landscape. Product code: