Tax relief caps could catch out the unwary

Take action now to avoid hidden tax rises…

Many aggressive tax schemes seek to offset certain income tax reliefs against taxable income. It has been deemed appropriate to use a ‘belt and braces’ approach to counteract unacceptable planning but it will have the effect of increasing tax payments for the innocent and/or unrepresented taxpayers. The capping provisions are set to be introduced for 2013/2014 at the higher of £50,000 or 25% of taxable income (Finance Bill (no 2) issued 28th March – pdf).

Which losses will be capped?

Reliefs not previously subject to any statutory caps are caught, including trade loss relief against general income and qualifying loan interest. These and others are very common reliefs and will catch out those legitimately claiming them, not simply those manipulating losses for tax avoidance purposes.

Which losses are unaffected?

Reliefs which are subject to existing limits include EIS relief, and other reliefs have been excluded for policy reasons, notably Gift Aid.

This is new ground for many taxpayers who have not had to consider these matters previously.
Unincorporated traders with several businesses (not an unusual circumstance) could face tax payment shocks if they do not plan now. If the businesses are not sufficiently linked according to tax definitions losses which would previously have been relieved could become stranded.

If you are worried about being affected you are urged to seek advice early in the 2013/14 tax year.

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Abolishing the UK’s complicated tax system?

Credit: moonfire8 @sxc.hu

A ‘Big Bang’ – the removal of allowances combined with a low tax rate or ‘Flat Tax’ system – is a theoretical possibility, but it is far more likely that the current system will continue with every opportunity taken to make it simpler. It is often quoted that the UK has one of the longest and most complex tax codes in the world. 50 years ago there were about 600 pages of tax legislation, but the last Finance Act (2012) alone contained over 700 pages.

Between 1997 and 2010, the Tax Law rewrite project made the tax code easier to understand but did not change its technical content. The world has become more complex in the last 50 years and new industries have sprung up requiring their own special code, e.g. North Sea oil. And, arguably, the moral mood of our society has changed leading to more and more anti-avoidance legislation – for example the recent ‘Disguised Remuneration’ legislation, which was introduced to block schemes like K2 of Jimmy Carr fame.

Simplification vs politics

‘Flat taxes’ sound attractive but there will be many losers and unintended consequences. Another problem is that they do not allow policy objectives to be pursued, such as attracting inward investment to the UK through CFC reform, R&D relief, SEIS, EIS and so on. Their regressive nature could make flat taxes unpopular with voters, so political expediency dictates mere simplification of the current system. This should not necessarily rule out wholesale changes in some areas with the protection of legacy positions, though this may lead to more legislation in the short term. Significant IHT reforms have been mooted for a while, as has the merger of national insurance with income tax.

Baby steps

The Office of Tax Simplification (OTS) led by John Whiting, an ex-PWC tax partner, has been doing a sterling job pushing the technical and administrative simplification agenda. Recent examples are proposals to simplify both tax-advantaged and unapproved share schemes, disincorporation relief and cash flow accounting for micro businesses.

Procedural efficiency is part of the battle too, and HMRC have responded to growing criticism by introducing Collaborative Dispute Resolution and providing more staff to man phone lines to at least ease some of the administration of dealing with the system.

Ride the winds of change

Political reality may ultimately spoil the dream of simplification, but there is still room for bold ideas and innovative thinking. This will inevitably create risks and opportunities, but with the right knowledge and planning the former can be minimised and the latter exploited.

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A development of interest in the financial world

On 27th March HMRC released a consultation document entitled ‘Possible changes to Income Tax rules on interest’. This drearily-named paper proposes a series of anti-avoidance measures aimed at removing exemptions for withholding tax at source on interest payments. Whilst this may all seem rather insignificant, together they amount to a minor assault on common methods of company financing.

The three main proposals are:

  1. Quoted Eurobond exemption
  2. Funding bonds
  3. Yearly interest

Quoted Eurobond exemption

Eurobonds, not to be confused with the proposed Euro-area government bonds of the same name, are international bonds denominated in currencies other than that of their country of issue. In 1984 an exemption was introduced in the UK for quoted Eurobonds, allowing their interest to be paid gross. This was in response to similar exemptions in tax havens, and discouraged offshore tax avoidance whilst promoting the growth of the UK Eurobond market. However, in recent years groups have issued Eurobonds in territories such as the Channel Islands and Cayman Islands for intra-group financing to take advantage of this exemption. Despite being quoted these bonds are not actually traded, and “enable companies to make gross payments of interest out of the UK to fellow group companies, where otherwise deduction of tax would be required.”

HMRC wish to halt this avoidance of tax on the interest on inter-company debt, and therefore propose to remove the exemption “where the Eurobond is issued to a fellow group company, and listed on a stock exchange on which there is no substantial or regular trading in the Eurobond.” This shouldn’t affect third party financing arrangements, but groups using Eurobonds as part of their intra-group financing may find their existing arrangements will be hit as no mention is made of grandfathering.

Funding bonds

Funding bonds are those where interest payments are made in kind, rather than cash. These payments may take the form of shares or loan notes, and are often used when a company has insufficient liquidity to pay in cash. Currently HMRC is obliged to accept such payments in kind when they collect 20% withholding tax on interest payments. The consultation document proposes that companies will have to pay the withholding tax to HMRC in cash. Whilst this will make HMRC’s job easier it could put undue strain on struggling companies, and may have knock-on effects in private equity where such bonds are sometimes used to take advantage of late interest rules.

Yearly interest

Loans which pay ‘short’ rather than ‘yearly’ interest do not suffer withholding tax on interest; these are typically loans which are under one year in duration. HMRC considers this “somewhat archaic” and wishes to strike the term ‘yearly interest’ from the statutes, thereby disregarding loan duration. Whilst this may seem to them to be a reasonable simplification of the tax code, as Allen & Overy point out HMRC appear to have failed to consider the effect this would have on the colossal commercial paper market. It could also have a significant impact on private equity where short term bridging loans are common.

Other proposals

  • For tax on interest to be withheld, the debt must have “arisen in the UK”. Some have argued that if the physical evidence for the debt resides offshore, then it cannot be said to have arisen in the UK. HMRC dispute this, and wish to have their interpretation written into law.
  • HMRC are proposing that the interest element of compensation payments be subject to withholding tax in cases where this is currently disputed.
  • The extending of ‘disguised interest’ anti-avoidance measures to cover individuals in addition to companies.

Conclusion

These proposals will likely have an adverse impact on corporate financing, especially private equity. However, the consultation is open until 22nd June so if you feel your company would be affected by the changes there is still time to make your voice heard.

Striking off companies

The death of a company

When a solvent company comes to the end of its life, it can either be wound up or struck off. Winding up is the formal process, involving the appointment of a liquidator to sell assets and pay off debts, and distribute the remainder to shareholders. This surplus is then subject to capital gains tax. The disadvantage of liquidation is cost. According to HMRC, winding up “a small business with straightforward affairs” typically costs around £7,500.

The alternative is striking off. This is a simpler process, but has less attractive legal consequences. Distributions to shareholders are treated as dividends, with potentially disadvantageous tax implications. Historically, however, extra-statutory concession C16 has allowed distributions to be treated as capital in the hands of shareholders in the same way as a formal liquidation.

The death of a concession

Extra-statutory concessions (ESCs) are just what they sound like – concessions to the law made by HMRC. However, in 2005 the House of Lords ruled that HMRC should not be making new laws, but administering existing ones. Since then there has been a programme to abolish ESCs and where appropriate codify them in law.

On the 1st March 2012, ESC C16 succumbed to this fate. The old extra-statutory concession was enacted in law under The Enactment of Extra Statutory Concessions Order 2012, but not in its original form. Concerned with tax avoidance, the Government has put a £25,000 cap on distributions that are subject to capital gains tax. If distributions exceed this amount, all payments will be treated as dividends, not just the excess over £25,000.

Capital gains vs income tax

This creates a powerful incentive to conduct a formal winding up of a company if distributions will exceed £25,000. The tax treatment of capital gains is typically more favourable than dividends, with a maximum rate of 28% instead of 42.5% for dividends (dropping to 37.5% next year) and an annual tax-free allowance of £10,600 (2011/12). Distributions may even be subject to Entrepreneurs’ Relief, meaning a 10% rate of tax. However, for those with very little income the tax liability on dividends may be more favourable, so each case must be judged on its own merits.

Winding up vs striking off

If distributions are under £25,000 then striking off should be the cheaper option. For amounts over this, winding up is increasingly likely to be more favourable depending on commercial considerations, the tax position of the shareholders and the costs of liquidation.

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Simplifying income tax for small businesses

Credit to Ayla87 @ sxc.hu

This was trailed in the 2012 Budget and proposed details were issued last week in a consultation document. The simplified tax system for businesses with a turnover of up to £77,000 p.a. could find its way into next years’ Finance Act.

Qualifying businesses

The proposal only applies to unincorporated ‘nano’ businesses of which there are currently some 3.5m in the UK. Some will be excluded from participating such as authors, financial traders, property businesses and limited liability partnerships.

Cash is king

The system will work on a simple ‘cash in cash out’ basis with some actual expenses being replaced by a flat rate allowance (e.g. use of home/car for business). Once an election has been made to use the system it will not be necessary to exit it until turnover exceeds a surprisingly high £150,000.

The choice is yours

The new system is voluntary so it will be possible to calculate whether the simplified cash basis will be advantageous. Once a business has opted in it is not yet clear how opting out will work. The year in which a business switches regimes may be challenging as new transitional rules will need to be respected.

Simplicity itself?

The cash basis will still involve some calculations. Non business use of assets will need to be adjusted for as will disallowed or ‘excessive’ expenditures and the costs of ‘more durable’ assets. Perhaps confusingly those registered for VAT are to have receipts and expenditures included in the ‘cash in cash out’ tax calculation. It will only be possible to carry forward losses under the cash basis which may not suit many, for example those who are starting self-employment for the first time or others wishing to use sideways loss relief.

Existing businesses opting into the cash basis will need to examine the difference between accrual and cash accounting for at least the first year of cash operation and make the correct adjustments.

What are the ‘fixed allowances’ to be?

The proposal includes fixed mileage for cars (45p per mile etc.) to replace the costs of vehicle ownership, a flat rate of between £8 and £24 per month for use of home rather than actual costs and flat rate disallowances (e.g. £500 per month for two persons) for personal use of business premises.

Simplified systems in other countries

Many other countries, such as Germany and Austria, have simplified systems for smaller businesses, which allow cash accounting for tax purposes at far higher levels of turnover. South Africa introduced a new system in 2009 but it has only had a take up of 10% indicating that design is crucial.

Will it be worth it?

Whether a business will benefit from the system is down to its individual circumstances. It will be necessary to determine which system will be cheaper, taking into account administration savings. The irony, of course, is that this process itself will add to the administration burden of nano businesses.

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Budget 2012 – Special Report

“Britain is open for business” may just be a catchy political slogan, but it appears the Government is taking it seriously nonetheless.

Away from the headlines on the cut of the top rate of tax to 45p and the clampdown on stamp duty land tax, this was an unashamedly pro-business Budget.

We take a quick look at the biggest changes for large companies and small businesses alike.

Boost for big business

The Corporate Tax Road Map is aimed squarely at multinationals and footloose capital. In addition to the eye-catching extra percentage point off the main rate of corporation tax, a range of measures aimed at keeping large and innovative companies in the UK will be introduced in the Finance Bill 2012:

  • Controlled Foreign Companies reform – a relaxation of the rules that aim to prevent UK resident companies diverting profits to low tax jurisdictions.
  • The Patent Box – a 10% reduction in corporation tax for profits attributable to “qualifying IP”.
  • “Above the line” R&D Tax Credit – a payable credit, aimed at improving the uptake of R&D relief by moving the calculation “above the line” in company accounts.

These, combined with the recent full exemption on dividends, add up to a very competitive tax environment, albeit through a somewhat bloated and opaque set of rules.

Something for the little guy

Small, unincorporated businesses with turnovers below the VAT registration threshold (which will be climbing to £77,000) will be able to choose a cash basis for calculating tax. This measure, due to be introduced from April 2013, should help to ease the administrative burden for micro businesses. Other simplifying measures (pdf) have been trailed, such as standardised expenses for unincorporated businesses and disincorporation relief.

Continuing the avoidance clampdown

Finally, it simply wouldn't be a Budget without talk of “morally repugnant” tax avoidance. In addition to stamp duty land tax avoidance (politically important but fiscally trivial), two major measures were confirmed:

  • A General Anti-Abuse Rule (GAAR) – a consultation based on Graham Aaronson's proposals, with an aim to introduce legislation in 2013. The GAAR will also be extended in scope to cover stamp duty land tax.
  • Extension of Disclosure of Tax Avoidance Schemes (DOTAS) – another consultation, this time aimed at extending the definition of “hallmarks” to require more tax avoidance schemes to be reported.

Personal service companies have also come under the spotlight, and will be the target of anti-avoidance measures to be introduced alongside simplified IR35 legislation in Finance Bill 2013. This will likely include “requiring of?ce holders/controlling persons who are integral to the running of an organisation to have PAYE and NICs deducted at source by the organisation by which they are engaged.”

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Construction Industry Scheme

What it is and how it might apply to your company, even if it isn't in the construction industry

What is it?

CIS

The Construction Industry Scheme (CIS) has been around for over 30 years, and governs the payment of tax by contractors and subcontractors in the construction industry. However, it can also apply to businesses that regularly spend large amounts on construction even if that is not their main business. Those who didn't even realise they should be operating the scheme may nonetheless face penalties for not doing so.

To whom does it apply?

The CIS applies to ‘contractors’ and ‘subcontractors’ who are involved in a wide range of construction work, including construction, alteration, repair, extension, demolition and dismantling.

A subcontractor is “any business which has agreed to carry out construction operations for another business or body which is a contractor or deemed contractor”.

A contractor is “any person carrying on a business which includes construction operations”. However, ‘deemed’ contractors are those whose spending on construction averages over £1 million annually over a three years period. This means that many companies that carry out significant construction work, such as retail businesses and property management companies, should be operating CIS.

What does it entail?

New rules introduced from April 2007 did away with the paper-based system of gross payment certificates, registration cards, vouchers and end-of-year returns. In their place came a system of subcontractors registering with HMRC, verification by contractors with HMRC of whether registered subcontractors should be paid net or gross, and monthly returns.

This administration can be complex, but HMRC have a comprehensive guide and a helpline.

And what about the penalties?

A new penalty regime came into force in October 2011, with a concession to those who have never filed returns before. Fines for late returns are as follows:

DelayPenalty for Late CIS Return
1 day lateFixed penalty of £100
2 months lateFixed penalty of £200
6 months late£300 or 5% of the CIS deductions shown on the return, whichever is the higher. This is as well as the penalties above.
12 months late£300 or 5% of the CIS deductions shown on the return, whichever is the higher.
In serious cases you may be asked to pay up to £3,000 or 100% of the CIS deductions shown on the return, whichever is the higher.
These are as well as the penalties above.

However, unlike the old system there is a cap for the fixed fines, which will accumulate monthly for each missed return. The cap is £3,000, but it should be noted that this doesn't apply to tax-geared penalties. As a result, being unaware of your CIS obligations could be a costly business.

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Patent Box – an important new incentive for innovation

After two consultations, the Patent Box has reached a near-final form in the draft 2012 Finance Bill. The Patent Box seeks to identify profits made as a result of ‘qualifying IP’ developed and owned by a company within the charge to UK corporation tax, and then to tax these profits at a reduced rate.

During the consultations, the Government has listened to companies and expanded the regime. The Patent Box has the potential to save innovative companies significant amounts of tax and should be closely examined by all those potentially affected as the scope for the reduced tax rate is greater than may be appreciated at first sight. Although the regime does not apply until 2013 you are urged to think about its application now as it may affect decisions that you are making today.

What is qualifying IP?

Intellectual property obviously incorporates much more than just patents, for example copyright and trademarks. However, the Patent Box is limited to patents issued by the UK IP Office and the European Patent Office, with a few patent-like additions aimed largely at the pharmaceutical sector.

The IP must have been created or developed by the company to qualify for the Patent Box. In order to claim relief for qualifying IP the company must hold the IP or an ‘exclusive licence’ for it in one or more territories. Relief may still be available if the company no longer holds the IP, allowing for deductions from income received from infringements of a patent after it has expired. However, patents must be held for trading purposes, so deductions are not available for passive IP holding companies that sue trading companies for infringements, colloquially known as ‘patent trolls’.

How is the relief calculated?

Effectively a reduced corporation tax rate is applied to the worldwide ‘relevant profits’ attributable to a particular patent or patents. This is done by allowing a deduction from the trading profits for corporation tax purposes:

RP x (MR – IPR)/MR

This means the effective rate of tax is 10 percentage points lower than the normal CT rate.

How are the relevant profits calculated?

This is where things start to get complicated. The full rules as laid out in the draft legislation (pdf) are beyond the scope of this article, but essentially it is a 3 stage process:

  1. Identify the profit arising from the patent by looking at the ratio of patent expenditure to overall expenditure;
  2. A ‘routine return’ percentage of 10% of certain costs is deducted to give ‘residual profits’;
  3. Deduct a notional brand royalty to take into account branding value to give ‘relevant profits’.

What about smaller companies?

Smaller companies can elect for simpler administration, for example by ignoring step 3 above and calculating their relevant profits as the lesser of 75% of residual profits or £1m. For smaller companies patents can be expensive, so they may wish to create joint ventures to spread the cost. In this case, they must be careful to maintain ‘active ownership’ for their IP by remaining involved in its development and/or management.

Given the significant benefits offered by the Patent Box, it may be worth companies patenting things they would not previously have patented to allow more of their profits to fall within the regime. Taken together with the improved R&D relief regime, the Patent Box has a real chance of ensuring innovative companies remain and thrive in the UK.

Update

As announced in the 2012 Budget, the Patent Box will be introduced in the 2012 Finance Bill.

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