The UK corporation tax system
12 misunderstood concepts
Contents
Foreword3
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
The UK corporation tax system: 12 misunderstood concepts
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
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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.
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
Within that tax portion the government needs to
all of those taxes. However, much public focus falls
decide how much to raise from certain sectors of the on the corporation tax paid by companies on their
economy – individuals and businesses, for example profits, and this paper will reflect that public focus.
– and within those groups from what types of
activity. Further decisions need to be made as to the Corporation tax is one of the ways in which British
businesses are taxed. It is calculated based on the
type of tax to be used to raise money from certain
profits they earn – not on the income they receive.
activities or sectors – income, property,
That broadly means they are taxed on their income
consumption, etc – and the government must also
after deducting the costs (eg manufacture, labour,
decide whether certain activities within certain
transport, premises, finance) of earning that
sectors should be treated differently.
income. These costs could include the costs of raw
Recently, governments have begun to use the tax
materials and services received from others such as
system to deliver other governmental goals. This
advertising and marketing. The costs may also
might be something in the individual sector like the include funding costs such as interest paid on
child credit, in the corporate sector it may be the
money borrowed for use in the business. The costs
desire to encourage research and development
may be payable to a supplier based either in the UK
through use of a tax credit, or the wish to discourage or abroad. This is how most countries across the
certain types of environmental activity by use of
developed world typically tax businesses on their
‘green’ taxes. This has resulted in a daunting
profits.
amount of legislation built up over many years.
In relation to business, in all developed economies
It is important to note that while some tax legislation there will be a system of accounting rules which
reflects a coherent policy rationale, much reflects ad help to give investors, regulators and the company
hoc responses to historical problems that have long itself an accurate picture of the economic state of a
since passed away. Tax law will always be playing
company at a single point in time (the ‘year end’).
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
The UK corporation tax system: 12 misunderstood concepts
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.
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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 2011. 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.
The UK corporation tax system: 12 misunderstood concepts
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.
• C
ake sales make a profit of £300
• Biscuit sales make a loss of £100
•O
verall 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:
• C
ompany X makes a profit of £300 on cake sales – and pays tax
on all £300 of this profit
•C
ompany 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
•G
roup 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.
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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:
• T he location where value adding functions – eg sales and
marketing are performed
• T he location where risks that determine the level of value
generation are assumed
• T he location of key value adding risk management and function
leadership (substance required to manage value adding
functions and risks)
• T he 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).
The UK corporation tax system: 12 misunderstood concepts
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.
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.
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.
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.
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.
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.
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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.
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.
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.
The UK corporation tax system: 12 misunderstood concepts
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.
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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.
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:
• T ake 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
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.
• 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.
The UK corporation tax system: 12 misunderstood concepts
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 email 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.
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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 A
dd 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 R
educe 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.
The UK corporation tax system: 12 misunderstood concepts
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.
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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.
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.
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).
The UK corporation tax system: 12 misunderstood concepts
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:
•W
hether a payment to terminate an onerous contract is a trading
payment (allowable for tax) or a capital payment (not allowable)
•W
hether the prices used to buy or sell goods from related parties
are reasonable ‘arm’s length’ prices under international transfer
pricing principles
•W
hether 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.
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.
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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
•W
hether an amount is an ‘arm’s length price’ for goods or
services received or supplied
•W
hether the accounting treatment of a financial instrument
‘fairly represents’ the taxable profit or loss
•W
hether 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).
The UK corporation tax system: 12 misunderstood concepts
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)20 7395 8098
E: richard.woolhouse@cbi.org.uk
CBI
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or dealt with in whole or in part
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