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UNITED KINGDOM
LINKS IN THIS SECTION
INTRODUCTION
INTERNATIONAL TAX ISSUES
THE EU DIMENSION
ADDITIONAL RESOURCES
REV BN 24: DOUBLE TAXATION RELIEF
REV 2: A MODERN TAX SYSTEM
RELATED INFORMATION

The UK's International Competitiveness


Introduction

Although the UK has not historically set out to compete with countries such as Holland and Denmark, which set their cap at international businesses with extremely permissive taxation structures, reckoning that the gain from extra employment and trade would outweigh the loss of tax, the UK has nonetheless been an acceptable place in which to have your headquarters, if that was where it needed to be.

Thus, large international companies with listings on the London Stock Market, or which had British origins, could put up with being based in the UK even if it wasn't ideal from a tax point of view, because the rules for the treatment of overseas profits were reasonably flexible. In particular, it was possible to 'mix' highly-taxed profits from some overseas markets with lowly-taxed profits from other markets, generating a blended rate which would offset the maximum amount of mainstream UK corporation tax and reduce double taxation. It was also possible to retain profits in overseas companies in many circumstances without incurring UK taxation.

Over recent years this convenient equation has been thrown into doubt, with the Finance Act 2000 in particular worsening the UK's tax regime for international companies to such an extent that some large ones, such as Vodaphone and BAT threatened to move their base of operations out of the UK altogether.

The 2001 budget contained some detailed measures to improve the ill-thought-out onshore mixing rules contained in the Finance Act 2000, the promise of further consultation on the bigger issue of a possible participation exemption for income and capital gains, and the threat of a further tightening of the CFC (Controlled Foreign Corporation) rules. Indeed, enabling legislation in the 2002 Finance Act allowed the British government to alter the tax treatment of controlled foreign companies in jurisdictions which are considered to allow 'harmful tax practices'.

Further changes to the taxation of CFCs were brought forward in the 2005 budget. The 2005 Controlled Foreign Companies (Excluded Countries) (Amendment) Regulations aimed to prevent CFCs from manipulating their profit location in order to evade taxes, to stop them from secreting income in non-corporate entities, and to exclude them from receiving the benefits of the CFC regime if they are not liable for tax in another country. The measures came into full force on March 31st.

A spokesman for the Inland Revenue (as HM Revenue & Customs was known at the time) explained that: "All of the changes made are a reaction to schemes including some that were identified via the disclosure rules. The government could not have allowed significant amounts of tax to remain at risk."

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International Tax Issues

There are three main issues which have traditionally dominated the international tax competitiveness argument in recent years:

1. Double Tax Avoidance

This is mostly the 'mixing' question. The Finance Act 2000, after changes made in response to pressure from business, allowed some types of 'onshore mixing', that is, companies could mix highly-taxed and low-taxed income streams in the UK, but there are so many limitations ('anti-avoidance' provisions) that what started as a good idea, to allow companies to do at home what they had previously had to do in offshore or tax-privileged overseas countries such as the Netherlands, became an expensive straight-jacket. For example, the mixing privilege only extended to the first layer of subsidiaries, unless the intermediate company was in the UK, which would have forced on many groups a complete global restructuring, with other uncalculable tax consequences.

Onshore mixing (called 'pooling' by the Treasury) was also limited to 30% for many foreign income streams, with some allowance for tax paid up to a maximum of 45% in some special circumstances. The 2001 Budget however went a long way towards allowing flexible mixing of income streams, mostly removing problems caused by the 'first layer only' problem.

See Inland Revenue (now HMRC) notes below which explain the detail of the amended system included in the Finance Act 2001.

In February 2005, in advance of the budget, UK Paymaster General at the time, Dawn Primarolo, announced a package of new measures to 'prevent tax avoidance by companies', including a rule that relief for foreign tax on income received as part of a company's trade would be restricted to the UK tax on the net profit derived from that income. The change was initially due to enter into force on Budget day. However, the Treasury saw fit to bring the rule forward so that it would apply to income received from February 10.

The budget itself in March 2005 contained threatening wording: "The disclosure rules have revealed a number of areas of the tax system at risk from high levels of tax avoidance. International transactions have emerged as a particular concern, with increasing globalisation presenting new opportunities for those attempting to avoid their obligations."

"Building on the action taken in the 2004 Pre-Budget Report, the Government is introducing two new anti-avoidance rules which will allow the Inland Revenue to issue a notice to counter a tax advantage in specific circumstances where a UK tax avoidance motive is present. These new measures will tackle arbitrage, where companies seek to gain a tax advantage by exploiting differences within and between tax codes and excessive claims for double taxation relief."

See Inland Revenue (now HMRC) notes on the future of UK corporate taxation as envisaged by the tax authority at that time.


2. Controlled Foreign Companies

The Finance Act 2000 tightened up on the definition of control, and changed the detail of the various tests concerned with the character of income, ie whether it should be permitted to remain in the foreign jurisdiction or not. Business protested (it was this that caused Vodaphone to make its threat rather than loss of offshore mixing), but the Treasury has not backed down on the CFC regime.

Predictably, the 2001 Budget did not contain any loosening of the CFC rules. Indeed, buried in a footnote of one of the Inland Revenue's budget documents was a threat to tighten the rules still further: the Finance Act 2001 contained new rules against 'artificial avoidance schemes, which exploit a loophole in one of the exemptions from the UK's Controlled Foreign Company regime'.

The UK Finance Bill, 2007, implemented changes to the Controlled Foreign Company regime made in response to the previous year's high-profile Cadbury-Schweppes decision by the European Court of Justice.

Although CFCs were not mentioned in the Chancellor's March Budget speech that year, the Treasury released a detailed response to the ECJ's decision, which commentators said represented the minimum that the Government could have done to comply with Cadbury.

The new provisions restricted the application of CFC rules to profits arising from the activities of employees but not of capital, meaning that they will only become significant in respect of trading operations in a 'low-tax' EU or EEA territory. The ECJ did not make such a distinction. To the disappointment of many tax advisers, the Treasury had not provided for an advance clearance mechanism for the CFC regime. In addition, the Treasury stiffened the effective management test, making it more difficult for EEA-based companies to satisfy the Exempt Activities exemption.

Under United Kingdom tax legislation, the profits of a foreign company in which a UK resident company owns a holding of more than 50% (known as a controlled foreign company, or CFC) are attributed to the resident company and subjected to tax in the UK, where the corporation tax in the foreign country is less than three quarters of the rate applicable in the United Kingdom. The resident company receives a tax credit for the tax paid by the CFC. That system is designed to make the resident company pay the difference between the tax paid in the foreign country and the tax which would have been paid if the company had been resident in the United Kingdom.

There have traditionally been a number of exceptions to the application of the legislation, inter alia where the CFC distributes 90% of its profits to the resident company or where the ‘motive test’ is satisfied. In order to obtain the latter exception, a company must show that neither the main purpose of the transactions which gave rise to the profits of the CFC nor the main reason for the CFC’s existence was to achieve a reduction in UK tax by means of the diversion of profits.

Cadbury Schweppes plc is the parent company of the Cadbury Schweppes group which operates in the drinks and confectionery sector. The group includes, inter alia, two subsidiaries in Ireland, Cadbury Schweppes Treasury Services (CSTS) and Cadbury Schweppes Treasury International (CSTI), which are established in the International Financial Services Centre (IFSC) in Dublin, Ireland, where in 1996 the tax rate was 10%. Those two companies are responsible for raising finance and providing that finance to the group. In the view of the UK courts, CSTS and CSTI were established in Dublin solely to take advantage of the favourable tax regime of the ISFC and in order not to fall within the UK tax regime.

In 2000 the Commissioners of Inland Revenue, taking the view that the CFC legislation applied to the two Irish companies, claimed corporation tax from Cadbury Schweppes of GBP8.6m on the profits made by CSTI in 1996. Cadbury Schweppes appealed before the Special Commissioners of Income Tax, maintaining that the CFC legislation was contrary to Community law, in particular in the light of freedom of establishment. The Special Commissioners asked the Court of Justice whether Community law precluded rules such as the CFC legislation.

Said the ECJ: 'The Court recalls that companies or persons cannot improperly or fraudulently take advantage of provisions of Community law. However, the fact that a company was established in a Member State for the purpose of benefiting from more favourable legislation does not in itself suffice to constitute an abuse of the freedom of establishment. Therefore the fact that Cadbury Schweppes decided to establish CSTS and CSTI in Dublin for the avowed purpose of benefiting from a favourable tax regime does not in itself constitute abuse and does not prevent Cadbury Schweppes from relying on Community law.

'The Court notes that the CFC legislation involves a difference in the treatment of resident companies on the basis of the level of taxation imposed on the company in which they have a controlling holding. That difference in treatment creates a tax disadvantage for the resident company to which the CFC legislation is applicable. The CFC legislation therefore constitutes a restriction on freedom of establishment within the meaning of Community law.

'As regards the possible justifications for such legislation, the Court points out that a national measure restricting freedom of establishment may be justified where it specifically relates to wholly artificial arrangements aimed solely at escaping national tax normally due and where it does not go beyond what is necessary to achieve that purpose. Certain exceptions in the UK legislation exempt a company in situations in which the existence of a wholly artificial arrangement solely for tax purposes appears to be excluded (for example distribution of 90% of a subsidiary’s profits to its parent company or performance by the SEC of trading activities).

'As regards the application of the ‘motive test’, the Court notes that the fact that the intention to obtain tax relief prompted the incorporation of the CFC and the conclusion of transactions between the CFC and the resident company does not suffice to conclude that there is a wholly artificial arrangement. In order to find that there is such an arrangement there must be, in addition to a subjective element, objective and ascertainable circumstances produced by the resident company with regard, in particular, to the extent to which the CFC physically exists in terms of premises, staff and equipment, showing that the incorporation of a CFC does not reflect economic reality, that is to say it is not an actual establishment intended to carry on genuine economic activities in the host Member State.

'It is for the Special Commissioners to determine whether the motive test lends itself to an interpretation which takes account of such objective criteria. In that case, the legislation on CFCs should be regarded as being compatible with Community law. On the other hand, if the criteria on which that test is based mean that a resident company comes within the scope of application of that legislation, despite the absence of objective evidence such as to indicate the existence of a wholly artificial arrangement, the legislation would be contrary to Community law.'

Then in July 2008, it emerged that Vodafone had won a key legal battle against the UK tax authority in a judgment that cast major doubt on the compatibility of the UK's controlled foreign companies (CFC) regime with European Union law.

Mr Justice Edward Evans-Lombe ruled in the High Court on 4th July that Vodafone does not have to pay UK corporation tax on income attributed to its Luxembourg holding company Vodafone Investments Luxembourg Sarl (VIL). Consequently, he ordered HMRC to shut an ongoing tax inquiry into Vodafone's tax for the year to March 2001.

Vodafone estimated that the court victory has saved it more than GBP2bn (USD4bn) in tax and interest that it might have been ordered to pay had the judgment gone against the company.

However, the ruling also had ramifications that go much wider than Vodafone's corporate arrangements, and several UK-based multinationals with subsidiaries in favourable EU tax jurisdictions such as Ireland, Luxembourg and the Netherlands, who are said to be under a similar type of scrutiny from HMRC, are likely to be breathing a sigh of relief as a result.

The case dates back to 2002 after Vodafone set up VIL to dispose of its shares in the German telecommunications group Mannesman, which it acquired in 2000. VIL is also used to circulate cash and profits around the group and as a vehicle to fund other acquisitions.

HMRC argued that under the UK CFC rules, it had the right to tax the difference between rate a subsidiary pays in a low tax jurisdiction overseas and the rate it would have paid on that income in the UK - a principle that it attempted to apply in the Vodafone case.

However, Justice Evans-Lombe referred back to a precedent set in 2006 by the European Court of Justice (ECJ) in the case involving Cadbury-Scweppes, which said that the UK CFC rules were incompatible with EU law because they were too restrictive and should only be applied in cases where companies set up artificial arrangements aimed solely at avoiding tax.

While the UK Treasury moved to amend CFC regulations in the wake of the Cadbury-Schweppes ruling, Justice Evans-Lombe argued that these amendments had not gone far enough to address their incompatibility with EU law, and he urged the government to revisit the legislation.

"In my judgement, the CFC legislation must be disapplied so that, pending amending legislation or executive action, no charge can be imposed on a company such as Vodafone under the CFC legislation," he said, going on to add that:

"It seems to me that all UK taxpayers, including Vodafone, were and are entitled to be told by legislation, of which the meaning is plain, what the tax consequences for them will be if they decide to incorporate a controlled foreign company in a (EU) member state."

The UK government was in the process of reviewing its stance on the taxation of multinationals' international income at the time of the July ruling, but tax experts said that the latest judgment had thrown the situation into chaos, and may have left the UK with a completely unenforceable set of CFC legislation.

“The High Court has expressed ‘some doubt’ as to the efficacy of sticking plaster amendments introduced in 2006,” Mark Persoff of Clifford Chance, the legal firm was quoted as saying by the Financial Times. “This means, as matters now stand, the UK probably has no enforceable CFC legislation so far as EU/EEA subsidiaries are concerned.”

Peter Cussons, a tax partner at PriceWaterhouseCoopers, described the ruling as a "blockbuster judgement."

"This is big news because there are thousands of UK companies with foreign subsidiaries in the European Union," he told the Telegraph. "There will have been CFC tax paid over the years, hundreds of millions of pounds per annum, and potentially, upon claims being made, all that tax is up for grabs," he added.

The Finance Act 2009 foreign profits package was expected to be implemented during 2009 and included:

  • A dividend exemption for most foreign dividends irrespective of the level of shareholding
  • Interest cap, a comparison of a UK tax group’s gross intra-group finance expense with the global group’s net finance expense after excluding gross external finance expense of the UK tax group, with some corresponding UK taxable income exclusions.
  • Super para 13 looks to whether any group company, and not just the borrower, is part of arrangements whereby there are increased debits or reduced credits, and is currently very wide reaching.
  • Controlled company regime to be modified to remove the ADP exemption and holding company tests, with a further review after Budget 2009.
  • Treasury consent to be repealed and replaced by a retrospective quarterly reporting requirement.

In May 2009, Stephen Timms, Financial Secretary to the Treasury, announced that the government had amended its proposed changes to the taxation of foreign profits in an effort to simplify the legislation.

A letter circulated by Timms on April 30 explained that changes to the debt cap element of the reforms would be inserted into the 2009 Finance Bill, which was published on the same day, following discussions with business.

“The legislation in the bill has been subject to extensive consultation over the past year, and we have worked to ensure the responses are accommodated, where possible, and the bill is as complete as it can be,” Timms wrote.

In its original form, Clause 34 and Schedule 14 of the 2009 Finance Bill determine the scope of the corporation tax charge on both UK and foreign company distributions. According to the relevant Budget Note, the result of the reforms, due for introduction on July 1, 2009, will be that the great majority of distributions will be exempt from corporation tax. The Schedule also contains anti-avoidance rules to prevent abuse of distribution exemption.

Clause 35 and Schedule 15 of the Finance Bill make provision for the restriction of the tax deduction available for finance expenses of groups of companies (the 'debt cap'). The effect of the new measure is to limit the aggregate UK tax deduction for the UK members of a group of companies that have net finance expenses to the consolidated gross finance expense of that group.

Timms stated, however, that “a couple of areas” of the proposed reforms “have given rise to significant comment.” These include the exclusion for financial services and the targeted anti-avoidance rule. “We plan further discussions (on these two aspects of the reforms) before the final legislation is published,” Timms explained.

“There are also points of detail relating mainly to further exclusions and interaction with other parts of the tax code that have not yet been reflected in the Bill because of time constraints,” Timms continued. “Proposed amendments to be made during the passage of the bill for these straightforward areas will also be published on HMRC’s website.”

The areas concerned include:

  • Rules allowing groups to state they are satisfied that their tested expense amount, if calculated, would be less than their available amount for any particular period of account of the worldwide group.
  • The definition of the available amount will be amended to include capitalized interest.
  • The calculation of the UK measure and worldwide measure – providing a method whereby the comparison is made using the functional currency rather than sterling.
  • Provision will be made to cater for exempt financing income received by charities, non-departmental public bodies, educational establishments, local authorities and health service bodies.
  • Where a company brings into account a loan relationship debit on a paid basis, rules to disregard any amounts accrued but unpaid for periods of accounts of the worldwide group before the debt cap applies.
  • A consequential amendment to Schedule 28AA to make clear that this Schedule applies before the debt cap to any amount of financing expense of financing income.
  • A consequential amendment to ensure that profits of a controlled foreign corporation apportioned to a UK group company are not doubly taxed in respect of any finance expense amount payable to that CFC.

In Janaury 2010, The UK government published a discussion document on proposals for reforming the UK tax treatment of CFCs.

The proposals set out in the discussion document are intended to enhance the competitiveness of the UK, while providing adequate protection of the UK tax base. The discussion document sets out the overarching framework of the new rules and proposals for how monetary assets and intellectual property could be treated.

The reforms aim to address growing concern from business that the UK's CFC rules are too complex and reverse a steady flow of companies shifting their tax bases to jurisdictions considered to have more business-friendly tax regimes such as Ireland, Luxembourg and Switzerland.

In an attempt to achieve this, the discussion document sets out proposals for a more targeted CFC regime to catch profits being artificially diverted to low-tax jurisdictions, rather than a "one size fits all" approach.

The discussion document also outlines possible approaches to reform the treatment of intellectual property with the aim of more effectively targeting situations "where there is a risk of erosion of the UK tax base."

The current CFC rules generally target income from IP on the grounds that it is passive income from a mobile asset. The government is therefore concerned that there is a risk that UK tax can be avoided through the artificial movement of intellectual property (IP) into a low tax jurisdiction. Business, however, has emphasized that many offshore IP companies undertake genuine and effective management activity with the aim of maintaining or increasing the value of their IP, and that a new CFC regime should reflect the extent to which active management of IP takes place offshore.

One proposal for a new regime would be to identify companies that carry on sufficient IP management activity offshore and to exempt these companies from the CFC rules. However, the paper also suggests that an additional tax charge be applied in certain circumstances, for example where IP is transferred out of the UK before its value can be accurately determined.

The discussion document also highlights the need for the new CFC rules to interact efficiently with current UK transfer pricing rules, and points out that the proposed "patent box" regime announced in last month's pre-budget report, which will offer a reduced rate of corporate tax on patent income, will have a bearing on the reforms.

Financial Secretary to the Treasury Stephen Timms said: “Modernizing these rules is crucially important to maintaining and enhancing the UK’s attractiveness as a base for global business. This report, drawing on our discussions with businesses, is a key step in designing a system that better recognizes the way multinationals operate today, while protecting our tax base.”

This reform is the second part of the foreign profits package. The first part was introduced in Finance Act 2009 and included an exemption for foreign dividends and an interest restriction measure.

The consultation period for this discussion document began on January 26 and ran to April 20, 2010. The government released a further document on the proposals along with draft legislation later in 2010.

The Finance Bill 2011 included interim improvements to the CFC rules, including:

  • an exemption for certain intra group trading transactions;
  • an exemption for CFCs with a main business of intellectual property (IP) exploitation under certain conditions;
  • low profits exemption of GBP200,000 as long as non-trading income does not exceed GBP50,000;
  • a statutory three-year exemption for certain foreign subsidiaries.

Following further consultation, major changes to the CFC rules are expected to be announced in the Finance Bill 2012 and to apply from later in the year. The major points of the changes are:

  • tax exemption of overseas activities as long as the activities are not designed to artificially reduce the UK tax base;
  • partial exemption for finance companies - up to three quarters of finance profits to be exempt;
  • the regime is to apply to foreign branches of UK companies and foreign subsidiaries;
  • capital gains, including property income, will be excluded;
  • low profits exemption of GBP500,000 as long as non-trading income does not exceed GBP50,000;
  • low profit margin exemption if the adjusted accounting profits are below 10%;
  • exemption if the profits are derived in a territory where they will be subject to at least 75% of UK tax.

The government has designed a 'gateway' to assist companies in establishing if the profits from the foreign subsidiary fall outside the scope of the CFC rules. The latest version of the gateway was published on February 29, 2012, and can be found at: http://www.hm-treasury.gov.uk/controlled_foreign_companies.htm.


3. Capital Gains Tax On Disposals Of Substantial Shareholdings

In the UK, capital gains tax for corporates has been to a great extent a voluntary tax, in the sense that there was usually some kind of structure for a deal which would avoid it - but the consequences in terms of loss of economic efficiency were often severe, and it takes teams of expensive professionals to optimise on each occasion, making a participation exemption more attractive. A number of foreign countries have this, including several EU member states.

The Treasury has traditionally come at this from the opposite direction, of course, in order to preserve the existing tax base, although there were glimmerings of light in the Government's consultation document, reflecting a Blairite take on UK plc:

'Developments in technology are fast opening up new markets and increasing international competition. The Government's aims are to ensure that in the new global economy the UK is seen as an attractive place in which to do business, and UK businesses can compete successfully.'

'To achieve these aims, the Government is promoting innovation and modernisation in UK business, as well as working to make the UK a more competitive environment for businesses generally.'

' Certain aspects of the current tax code for capital gains can hinder businesses' international competitive position and distort their commercial decisions, forcing them to adopt structures that they would not have needed otherwise. It may also act as a disincentive to companies that are investing to innovate and modernise. In particular, it can result in a charge to tax where a company sells a shareholding in a successful business that it has developed in order to invest in further developing the business or in developing another business.'

' To address these problems, the Government is considering introducing a substantial relaxation in the taxation of corporate capital gains by introducing a new tax relief for companies alongside the existing rollover relief so that the charge to tax is deferred where a company realises a gain on the sale of a shareholding in a business or assets of that business; and invests the proceeds in developing that business or another business or acquires shares in another business.'

But then the Treasury took over, and started talking about trading companies v non-trading companies, taper relief, etc etc. The whole emphasis was on a carefully limited loosening of the current rules; although to be fair the Government did propose to reduce the definition of 'substantial' from 30% to 20%.

In April 2002, the UK government announced plans to put in place (with effect from April 1) a participation exemption meaning that, in certain circumstances, a UK company would not be subject to UK tax on gain from the sale of shares in a subsidiary in which the UK company holds a 'substantial' (10% or larger) share.

The participation exemption also aims to prevent UK companies from recognizing taxable losses on the disposal of shares in circumstances where the exemption applies.

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The EU Dimension

One of the reasons for the relative lack of action on international company taxation in the UK has been the series of European Court of Justice rulings in defence of 'freedom of establishment' which threatened to drive an express train through the ability of EU Member State governments to apply national tax regimes to their resident companies.

In September 2004, for instance, the ECJ ruled to allow a Finnish investor to collect a tax credit in his home country for a dividend received from an overseas firm. Under Finnish tax law, foreign dividends do not carry a tax credit, whilst domestic dividend payouts do. However, the ECJ announced that this was in contravention of European laws on the free movement of capital, and ruled to allow the taxpayer in question, Petri Manninen, to claim a 10% tax credit for the dividend paid out by a Swedish company.

Head of KPMG's EU tax group in London, Chris Morgan, suggested that although the case related to an individual, there were likely to be ramifications for corporate taxpayers as well. "The implications of the case are pretty huge - confirming the ECJ's position on the tax treatment of domestic and foreign dividends - which will be of financial benefit for both individuals and corporates throughout the EU, including the UK," he explained.

Then in March, 2005, came the initial result of the much-followed Marks and Spencer case. Marks & Spencer had argued that UK provisions on group tax relief were in breach of European law, as they prevent an EU-based parent company from offsetting losses incurred by subsidiary companies in other member states, thus violating the principle of freedom of establishment, a reading of the situation with which Advocate General Mr Poiares Maduro agreed.

European Union finance ministers however vowed to find a "defence mechanism" to counter the likelihood of tax revenue shortfalls should the British retailer ultimately be successful in its legal bid to offset losses made by foreign subsidiaries against tax. The issue formed one of the main talking points during an Ecofin meeting of EU finance ministers. "There is great concern about this," remarked Jeannot Krecke, Economy Minister of Luxembourg, which was the then holder of the rotating EU presidency. He went on to add that EU ministers "will try to find a defence mechanism" against such claims.

The AG stated that the risk of significant falls in tax revenues, as Germany had been arguing, was not a justifiable defence of the current system. But he also argued that firms should not be able to offset tax loses against profits in the country where the parent company is based if they can also offset losses in the country where their subsidiary is based - which may offer an escape route to governments.

The Advocate General's opinion was supported later that year by the full ECJ.

The UK Treasury's relative powerlessness in terms of corporate tax legislation was rammed home forcibly in April 2006 when European Court of Justice Advocate General, Leendert Adrie Geelhoed, gave an opinion in favour of four UK companies who had claimed that corporation tax charged on dividends received from EU subsidiaries was illegal under EU free movement of capital rules.

Between 1973 and 1999, when the UK scrapped its Advanced Corporation Tax system, which allowed UK companies to pay up dividends domestically at a favourable rate, dividends from non-UK EU subsidiaries of UK companies were charged at higher rates.

Although the four companies in the present case, British American Tobacco, British Petroleum, Aegis Group and Imperial Chemical Industries, were claiming refunds of 'only' some hundreds of millions of pounds, the UK government warned during court proceedings that the total cost of an adverse ruling might be as high GBP7 billion if many companies applied for refunds, and - following Germany's example - that the ECJ should therefore reject the companies' case on the grounds that the UK's financial stability could be affected. Mr. Geelhoed denied this reasoning.

At first sight, UK plc should have been having a party based on the Advocate-General's ruling, but companies worry that the Government might react in ways which could cost them more than they will save through the ruling.

At issue was the highly complex system of 'onshore pooling' in which foreign dividends are mixed with domestic ones according to an intricate set of rules before final taxation rates are determined.

In December 2006, the European Court of Justice followed the earlier Advocate General opinion, and ruled that ACT operated illegally between 1973, when the UK acceded to the EU, and 1999, giving rise to the prospect of substantial rebates to companies which had paid this tax in the past.

The Treasury warned that such a ruling could leave it open to repay claims totalling GBP9 billion, although draft blocking legislation which would limit a company's claims to six years would reduce this to about GBP2 billion, the government estimated.

The Court referred the matter back to the UK courts to determine whether the UK rules operate to achieve this parity.

In March 2007, Gordon Brown surprised many by announcing a 2% reduction in the rate of corporation tax (to 28%) and a 2% cut in the basic rate of income tax, representing the first major cut in these taxes in many years.

According to the then Chancellor, this would bring the UK's corporate tax rate below both the OECD and EU15 average. However, tax experts suggested that while Brown had given with one hand, he would claw back much of this lost revenue with the other through changes in capital allowances.

According to the Treasury, the reform of the capital allowance regime would "better reflect true economic depreciation," by ensuring that business investment decisions reflect commercial rather than tax considerations. But for manufacturers and companies with large property portfolios, the changes could well cancel out any benefit brought by the cut in corporate tax.

From 2008, capital allowances for plant and machinery were reduced from 25% to 20%, allowances for cars, electrical and cold water systems and other items was reduced to 10%. At the same time, an annual investment allowance (AIA) of GBP50,000 was introduced. The AIA allows investments of any type up to GBP50,000 to be fully deductible for tax purposes. Furthermore, a business is free to chose the type of investment against which the AIA is to be used.

The AIA was increased to GBP100,000 from April 6, 2010. However, this increase will be reversed and reduced to GBP25,000 from the 2012 tax year. At the same time the rates for capital allowances will be reduced from 20% to 18% and 10% to 8% for main rates and special rate expenditure respectively.

Corporation tax, meanwhile, was reduced to 26% in 2011. The Chancellor, George Osborne, said the budget was designed to set the UK on the route "from rescue to reform, and reform to recovery". Mr Osborne went on to say that: "By 2014, corporation tax will be reduced to 23%."

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Additional Resources:

Below is the text of the two Inland Revenue Budget 2001 documents describing changes to the corporation tax regime in the UK:

REV BN 24: Double Taxation Relief

Summary of measures

Two changes to double taxation relief were announced in the Pre-Budget Report:

extension of on-shore pooling rules for DTR to allow relief for rates of foreign tax paid up to 45% even if this was at more than one level in a chain of companies; and changes to the way in which the mixer cap is calculated. These will be supplemented by:

  • allowing companies to claim relief for less than the full amount of foreign tax if they so wish. This will mean that the mixer cap is not triggered in relation to a particular dividend, so that eligible unrelieved foreign tax (EUFT) arising on other dividends may be credited against the UK tax payable on it. This will also help companies which try to keep the rate of tax at or below 30% but which subsequently find that the actual rate is above that figure;
  • deeming the rate of underlying tax attributable to dividends from UK subsidiaries held by an overseas holding company to be equivalent to the UK corporation tax rate at the date that the dividend was paid; and
  • amending Finance Act 2000 where it refers to "accounting periods" ending on or after 21 March 2000 in the provision that extends double taxation relief to non-residents trading here. This will be changed to "chargeable periods" to ensure that the provision works properly for non-residents other than companies.

Apart from the last bullet point, these changes apply for dividends paid to the United Kingdom on or after 31 March 2001.

The Inland Revenue has had very useful discussions with business about the DTR regime. The Government intends that this dialogue will continue both on specific issues and to ensure that the DTR regime fits with other elements of the system for taxing companies.

Two matters in FA2000 were left to be dealt with by regulations. These were detailed provisions on the mixing of dividends within a country and for surrendering eligible unrelieved foreign tax around a group.

Following further discussions with business, it will now also be possible to claim relief for part only of the foreign tax. In addition the rate of underlying tax on dividends paid from UK subsidiaries via an overseas holding company will be deemed to equate to the main rate of corporation tax.

These additional changes mean that:

it will be possible to pay a dividend from a high-taxed company through a chain of companies without worrying whether the rate of underlying tax will exceed 30% and produce an amount of EUFT which would taint other, lower taxed, dividends within the chain. This will mean that it will now be possible for the mixed dividend to be pooled with others onshore so that EUFT arising elsewhere can be used against it, as provided in Finance Act 2000;

Many groups hold one or more UK subsidiaries below an overseas holding company. UK tax paid by UK sub-subsidiaries held in this way has always been treated in the same way as foreign tax for the purposes of double taxation relief. A dividend from the overseas holding company will be taxed in the hands of its UK parent, and if it includes an element of already-taxed UK profits then UK tax already paid on them will be available for relief;

However the rate of underlying tax is based on a different calculation from that of taxable profits. If the rate of underlying tax is less than the rate of corporation tax additional UK tax would be payable on the portion of the foreign dividend which represented profits already subjected to UK tax, and if more, then EUFT might arise. To prevent such anomalies the rate of underlying tax paid on a dividend from a UK subsidiary paid to an overseas holding company will be deemed equal to the rate of corporation tax in force when the dividend was paid.

FA 2000 introduced a general rule allowing any non-resident with a branch in the UK to claim credit relief for foreign tax paid on the profits of the branch, and this applies in relation to "accounting periods" ending on or after 21 March 2000. However only companies have "accounting periods". To ensure that the change works for persons other than companies, the start date will be amended to refer to "chargeable periods".

Background notes

A company which receives a dividend from an overseas company may claim a credit against the UK tax payable on the dividend for tax paid on the profits of overseas company and its subsidiaries. Pre FA 2000, if the tax exceeded the UK tax payable on the dividend, the UK recipient could not get relief for all the foreign tax. Offshore intermediate companies were therefore set up to mix high-and low-taxed dividends so that they came into the UK at an averaged rate. FA 2000 introduced provisions to prevent this. Since then the Revenue has been consulting with business and studying the effects of the new provisions in detail.

The proposals announced today and on 8 November will mean that the FA2000 provisions operate in the way in which they were intended to work. They will significantly benefit UK groups who acquire or already have existing business structures where tax in excess of 30% is paid at several levels in that structure, or tax at rates both below and above 30% are paid at different levels.

REV 2: A Competitive and Modern Tax System for Multi-Nationals and Large Business

The Government is committed to further reform of the company tax system to ensure long-term stability and strengthen the competitiveness of business, the Chancellor confirmed today.

Three strands will be taken forward to secure a competitive environment for business that, with globalisation, can change very quickly:

A consultation paper will be published in June that will set in a broader context the current proposals for a relief on gains arising on the disposal of substantial shareholdings. Considerable progress has been made on developing this relief. The further consultation will allow consideration of detailed proposals. It will also provide the opportunity to consult business on possible associated reforms aimed at producing a flexible and competitive tax system for parent companies based in the UK;

A new technical note published today by the Inland Revenue gives details of a proposed new regime for providing relief to companies for the costs of intellectual property, goodwill and other intangible assets. The technical note builds on earlier detailed discussion with business on the design of a more up-to-date regime, and includes draft legislation.

The changes to the regime for double taxation relief (DTR) announced in the Pre-Budget Report will be supplemented by further measures to make the system more flexible for UK-based parent companies. The Government has consulted further with business about the DTR regime over the last year and intends that this dialogue will continue, both on specific aspects and to ensure that the DTR regime fits with other elements of the system for taxing companies.

Commenting on these announcements, the Paymaster General, Dawn Primarolo, said: "These take forward the Government's reforms of the company tax system, and the consultation we now propose offers business an excellent opportunity to shape the outcome."

The Chancellor also announced a range of measures aimed at providing a more modern environment in which businesses can thrive:

  • A consultation document 'Increasing Innovation' examines the case for further measures to boost UK innovation and to seek views from businesses and others on the design of a new tax R&D tax credit aimed at encouraging innovation by larger companies.
  • Consultation on the design of a new, targeted tax credit and related measures to encourage development and distribution of vaccines and drugs and to tackle the major killer diseases of the developing world;
  • Abolition of out-dated requirements for the deduction of tax on most intra-UK payments between companies of interest, royalties, annuities and annual payments;
  • Measures to protect the tax base while facilitating business efficiency and promoting competitiveness.

Details

Substantial shareholdings

The Inland Revenue's Technical Notes of June and November 2000 consulted on a deferral relief for gains realised by companies on substantial shareholdings in trading companies. A large number of helpful responses were received. In addition there have been many meetings between representatives of the business community and Inland Revenue and Treasury officials.

The deferral relief that has emerged would be much more flexible than that originally envisaged. The present form of the relief is outlined in the Budget Note (REV BN 23) which sets out the significant changes that have been adopted as a result of consultation.

The Government considers that the introduction of such a deferral relief would provide a significant advantage to UK companies. Multinationals with UK bases would then benefit from a parent company tax regime that provided: one of the lowest rates of corporation tax among major industrialised countries; generally, relief for interest expense on loans funding investment in the UK or overseas; a system for crediting overseas tax that can substantially relieve tax on foreign dividends; and the opportunity to defer the charge to tax on the disposal of a substantial shareholding in a trading company or group.

The consultation now announced will give a further period to assess the detailed deferral proposals and allow them to be considered in a broader context.

The UK today is a very attractive location for multinational business for tax and non-tax reasons. The Government is committed to ensuring that this remains the case and recognises that, with globalisation, the competitive environment can change very quickly. A reform package should therefore look beyond the immediate future and reflect the need for flexibility. In this context the Technical Note that was published in November floated the alternative of an exemption, rather than a deferral, for most company gains on substantial shareholdings in trading companies.

Many of those who responded to the Technical Note felt that an exemption for gains would be preferable, but recognised that this could have far-reaching implications. One of the main questions that arose was whether an exemption for gains on substantial shareholdings could be introduced without changes elsewhere in the system and this will be important in the further consultation.

For example, some felt that an exemption for gains might point to an exemption for foreign income as well. And some were concerned that, in evaluating the options, it should be clear whether the Government's view was that any wider changes might involve some restriction of interest relief where loans were funding investment overseas.

The introduction of an exemption for gains and foreign source dividends, together with some form of interest restriction, would bring the UK system closer to that of many other European countries and a reform of that sort could enhance the competitive position of UK companies. But while some UK based multinationals would welcome such changes, others more affected by an interest restriction would probably not. And for Government, the possibility of a new restriction on interest deductibility raises important practical issues.

These are important issues for the future direction of company taxation. Business has expressed considerable interest in a broader discussion of this nature and the Government considers that it is right that there should be a full and open discussion of the issues. The Chancellor therefore proposes to publish a further consultation paper in June, which will launch a period of open discussion on the changes that should be introduced and the wider implications for the competitiveness of businesses based in the UK. Underpinning that consultation is a strong presumption in favour of introducing a major new relief for capital gains on the sale of substantial shareholdings in Finance Bill 2002.

Double Taxation Relief

Two changes to double taxation relief were announced in the Pre-Budget Report (details in Inland Revenue Press Release REV5/2000).

In response to further consultations, further changes are to be made to the provisions in Finance Act 2000. Full details are in the Budget Note (REV BN 24).

Two matters in Finance Act 2000 were left to be dealt with by regulations. These were the detailed provisions for the mixing of dividends within a country and for surrendering eligible unrelieved foreign tax around a group. The regulations are now on the Inland revenue website, and business will have a brief opportunity to comment at them (until 19 March) shortly after which they will be made and laid before Parliament.

Increasing Innovation

In the Pre-Budget Report, the Chancellor said that the Government would be looking at measures aimed at boosting investment in R&D across business. Last year, the Government introduced new R&D tax credits to encourage research and development by small and medium sized enterprises (SMEs). This provided SMEs with an additional deduction for qualifying current R&D spending over and above the amount deducted in the accounts by raising the effective rate of relief from 100 per cent to 150 per cent.

With the publication of "Increasing Innovation", the Government is seeking views on the design of a new tax incentive aimed at encouraging innovation by larger companies.

The consultation paper describes what would be involved in the design of an incremental R&D tax credit incentive. An incremental R&D tax incentive would reward businesses in proportion to their additional R&D expenditure above current levels.

The paper outlines the issues that would need to be considered, including eligibility criteria, base periods and amounts, how groups might be dealt with, the treatment of sub-contracted expenditure, and the interaction with the existing SME reliefs. Two main options are described, a CT incremental credit and a wages-based incremental scheme.

The Government invites views from businesses and other interested parties on the full range of issues that need to be resolved for such a tax incentive to be successfully introduced. The consultation paper can be found on the Internet at: www.inlandrevenue.gov.uk/budget2001

Simplifying and Protecting the Tax Base

The Government is aware that the requirements of the tax system can lower profitability and reduce competitiveness. Unnecessary and outdated tax rules that detract from business efficiency are to be cut. These include abolishing outdated requirements for the deduction of tax on intra-UK payments between companies of interest, royalties, annuities and annual payments. This will increase competitiveness and reduce administrative burdens for businesses.

The Government is grateful for the responses to the Technical Note issued at PBR about corporate debt, financial instruments and foreign exchange gains and losses. The reform and simplification proposals were broadly welcomed. Most respondents felt careful consideration of the details over a reasonable time scale was needed. The Government will therefore publish a consultation document in the summer that further develops the ideas raised in the Technical Note in light of the representations.

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LINKS IN THIS SECTION
INTRODUCTION
INTERNATIONAL TAX ISSUES
THE EU DIMENSION
ADDITIONAL RESOURCES
REV BN 24: DOUBLE TAXATION RELIEF
REV 2: A MODERN TAX SYSTEM
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