Corporation tax

From open-encyclopedia.com - the free encyclopedia.

Jim Callaghan, the Chancellor of the Exchequer who introduced corporation tax in 1965.

Corporation tax is a direct tax levied in the United Kingdom on the profits made by companies or associations that are either tax resident in the UK, or which are trading in the UK through a permanent establishment. Profits are only chargeable to corporation tax if there is a specific provision that brings them within the charge to tax. This is known as the source rule. Corporation tax was introduced from 1 April 1965 by the Finance Act 1965, which simultaneously removed companies and associations that became liable to corporation tax from the income tax charge.

Schedular system

Profits are taxed if they fall within one of the following, and are not otherwise exempted by an explicit provision of the Taxes Acts:

Notes:

1. The heads of charge listed above are mutually exclusive. No income or gain can fall within more than one head of charge.
2. In practice companies do not get taxed under Schedule F. Most companies are exempted from Schedule F and there is a provision for those companies which are taxed on UK dividends (ie dealers in shares) that removes the charge from Schedule F to Schedule D.
3. A controlled foreign company ("CFC") is a company controlled by a UK resident that is not itself UK resident and is subject to a lower rate of tax in the territory in which it is resident. Under certain circumstances, UK resident companies that control a CFC pay corporation tax on what the UK tax profits of that CFC would have been. However, because of a wide range of exemptions, very few companies suffer a CFC charge.
4. There used to be a Schedule B and a Schedule C that applied to companies, but these have now been merged with Schedule D. Schedule E, which was repealed in 2003, only applied to individuals.
5. Authorised unit trusts are not liable to tax on their chargeable gains.

Cases of Schedule D

Schedule D is itself divided into a number of cases:

Notes:

1. Income can fall within more than one of Case I, III and V. Where this happens, the income is only taxed under one of the Cases. The Inland Revenue (the UK taxing authority) decides which Case will be applied.
2. Where interest-type income and gains.losses on loans, derivatives, financial instruments and intangibles relate to a trade, they fall within Case I not Case III. The one exception to this is life assurance companies taxed on the I minus E basis, where they always fall within Case III. Overseas interest-type income, etc. falls within Case I or III, as appropriate, and never under Case V.
3. There is a Case II, which applies to income from professions and vocations. It is not believed that a company within the charge to corporation tax can have such income.
4. There used to be Cases IV, VII and VIII, but these have all been abolished.

Relief for expenses

The computations of income and taxable chargeable gains include deductions for direct expenses. However, not all sources of income have direct expenses (particularly those falling within Cases III and VI of Schedule D, foreign dividend income falling within Case V and income falling within Schedule F). Also a company may incur expenses managing a subsidiary which does not tend to pay dividend income to it.

Relief is therefore given for management expenses incurred by a company with investment business (before 1 April 2003 investment companies), and for certain management expenses of a life assurance company taxed on the I minus E basis. Relief is also given as a deduction from profits chargeable to corporation tax to certain payments to charities, certain royalty payments made by non-traders and some manufactured overseas dividends.

Future of the Schedular system

Since 2002 the British government has been publishing consultation documents and proposals for the abolition of the Schedular system. These changes are imminent, but have not yet been legislated.

Rates

The following applies as from 1 April 2003. The main rate of corporation tax is 30%. However, lower rates are sometimes applicable.

Notes:

1. The bands shown on the right hand side are divided by one plus the number of associates (usually the only associates a company has are fellow group companies, but the term is more widely defined)
2. The reduced rates do not apply to close investment holding companies (companies controlled by fewer than 5 people (plus associates) or by their directors/managers, whose main activity is the holding of investments)
3. Authorised unit trusts are taxed at 22%
4. Life assurance companies are taxed at 30% on shareholder profits and 20% on policyholder profits (See also: I minus E basis)
5. Companies active in the oil and gas extraction industry in the UK or on the UK continental shelf are subject to an additional 10% charge on their profits from those activities

Calculation of profits

Case I of Schedule D and Schedule A

Subject to specific statute or case law to the contrary, Case I of Schedule D and Schedule A profits are calculated based on profits as calculated using UK Generally Accepted Accounting Practice. The same is true for the deduction for management expenses that is available to companies with investment business. Where a company prepares its accounts under International Financial Reporting Standards, it will use profits computed on that basis instead from 2005 onwards, subject to specific statute or case law to the contrary.

The main exceptions to this rule are that no deductions are allowed under Case I of Schedule D (or Schedule A) for expenses not incurred wholly and exclusively for the trade (or rental business) and that no deductions are available for capital (ie deductions are only available for revenue items).

In recent publications the Inland Revenue has split the various exceptions to the "follow the accounts" rule up into 11 somewhat arbitrary categories, of which 1 is the miscellaneous residual category. The other ten are

• Public policy
• Transfer pricing
• Structural
• Avoidance
• Tax neutrality
• Capital items
• Fiscal incentives
• Symmetry
• Realisability and Tax capacity
• "True reflection"

Tax depreciation

Since no capital deductions are allowed, depreciation on capital assets is not deductible, although tax depreciation, known as "capital allowances" is available for expenditure on some capital assets. Note that expenditure on finance leases (as opposed to, say, lease or hire purchase agreements) is considered to be revenue. Therefore interest payments and depreciation on finance leases is deductible. If the finance lessor owns the asset, however, it may be able to make a claim for capital allowances.

The main allowances are a 25% reducing balance basis allowance for plant, machinery, fixtures and fittings. This would mean that if a piece of plant, say, was bought for £400 in year 1, 25% of £400 (ie £100) would be deductible from taxable profits as tax depreciation in year 1. Then 25 % of £(400-100) (ie £75) would be so deductible in year 2, and so on. The 25% figure is reduced to 10% for certain assets leased overseas and 6% for most assets with an expected life of 25 years or more. There are also 100% capital allowances for expenditure on energy-saving plant and machinery, and 40% first year allowances for small and medium-sized companies and companies in Northern Ireland

Capital allowances on a 4% straight line basis allowance are given for industrial and agricultural buildings. Tax depreciation is also potentially available for expenditure on: mineral extraction, flat conversion, research and development, know-how, patents, dredging and assured tenancy. In particular, no allowances are available for non-industrial or agricultural buildings, land and abortive expenditure or capital expenditure which does not give rise to a capital asset.

Tonnage tax

Shipping companies may elect to compute their Case I profits using a formula based on tonnage rather than fiscally adjusted accounting profit.

Case III of Schedule D

Gains and losses on loans, derivatives, financial instruments and intangibles are taxed as well as income. The basic rule for calculating Case III profits is to follow the accounts, although there are detailed anti-avoidance rules to stop the most obvious abuses. Only direct expenses, such as costs incurred in obtaining a loan, are deductible in the Case III computation. If the result is negative, Case III profits are taken as nil, with the negative result being treated as non-trading debits. Similar calculation rules apply to loans, derivatives, financial instruments and intangibles that are taxed under Case I (although losses are treated as a Case I expense rather than non-trading debits).

Case V of Schedule D

Overseas property income and income of a wholly overseas trade are calculated in the same way as Schedule A and Case I of Schedule D income respectively. Overseas dividend income is usually accounted for and taxed on a receipts basis. Double tax relief (see below) may be available where the overseas income has suffered foreign tax.

Case VI of Schedule D

Where the Case VI charge relates to casual annual income, it is usually taxed on a cash basis, though usually the Inland Revenue will accept an accruals basis. Relief is usually available for direct expenses if they would have been allowable in a Case I computation.

Chargeable gains

Chargeable gains (or allowable losses) are calculated as gross proceeds less direct selling costs less base cost less indexation allowance. Indexation allowance is base cost multiplied by the change in the retail price index movement between the month of purchase and month of sale. Indexation allowance cannot create or increase a loss. Losses may only be set off against chargeable gains of the same or a future accounting period (except certain allowable losses of life assurance companies (see: I minus E basis).

The UK operates a participation exemption called the "substantial shareholding exemption". Assuming all the relevant entities or groups are trading companies and groups, if a company together with its fellow group companies has a shareholding of over 10% in another company, and has held those shares for more than 12 months, disposals of those shares are exempt from chargeable gains. The figure of 10% is increased to 30% for shares held by the long-term insurance fund of a life assurance company. The detailed rules, however, are complex, and companies need to study them closely to see whether the substantial shareholding exemption applies.

There are also other exemptions and holdover and rollover reliefs that apply: for example, where a business property is sold and a new business property is acquired with the proceeds, no chargeable gain will immediately arise. These are such that most companies will only rarely have a chargeable gain. The main exception being life assurance companies taxed on the I minus E basis: these companies pay the bulk of the tax paid on chargeable gains.

CFC charge

In addition to being taxed on its own profits, a UK company may be taxed on the profits from a controlled foreign company in which it has an interest. This is an anti-avoidance provision. There is a wide range of exemptions, and usually groups arrange their affairs so a CFC charge does not arise. When it does arise it is equal to what the overseas company's UK taxable profits would have been on the assumption that the overseas company is UK resident, and ignoring chargeable gains. Relief is available for UK tax paid on dividends received from a CFC where a CFC charge is or was payable and for overseas tax suffered.

Relief from double taxation

There is a risk of double taxation whenever a company receives income that has already been taxed. This could be dividend income, which will have been paid out of the post-tax profits of another comapny and which may have suffered withholding tax. Or it could be because the company itself has suffered foreign tax, perhaps because it conducts part of its trade through an overseas permanent establishment.

Double taxation is avoided for UK dividends by exempting them from tax for most companies: only dealers in shares suffer tax on them. Where double taxation arises because of overseas tax suffered, relief is available either in the form of expense or credit relief. Expense relief is straightforward: the overseas tax is treated as a deductible expense in the tax computation.

History

A feature of a classical tax system which includes corporate taxation is double taxation, in that profits made by a company are subject to corporation tax, but further tax (usually income tax) is payable by the company's shareholders when the same profits are distributed by way of a dividend.

However, under an imputation tax system, some or all of the tax paid by the company may be attributed pro rata to the shareholders by way of a tax credit to reduce the income tax payable on a distribution. For many years, from 1973 to 1999, the UK operated a partial imputation system, with shareholders being able to claim a tax credit reflecting advance corporation tax (ACT) paid by a company when a distribution was made. A company could set ACT off against the annual corporation tax liability of the company.