FINANCE BILL OF SPRING 2004 TAX FACULTY REPRESENTATIONS AND INLAND REVENUE RESPONSES. (Amended version)

Transcription

1 FINANCE BILL OF SPRING 2004 TAX FACULTY REPRESENTATIONS AND INLAND REVENUE RESPONSES Text of replies from the Inland Revenue issued in September 2004 to representations issued as TAXREP 19/04 submitted in April 2004 and TAXREP 23/04 submitted in June 2004 by the Tax Faculty of the Institute of Chartered Accountants in England and Wales to the Chancellor of the Exchequer (Amended version)

2 FINANCE BILL OF SPRING 2004 TAX FACULTY REPRESENTATIONS AND INLAND REVENUE RESPONSES CONTENTS Paragraph FOREWORD (i)-(vi) WHO WE ARE 1-3 KEY POINT SUMMARY 4-32 TOWARDS A BETTER TAX SYSTEM

3 PART 3: INCOME TAX, CORPORATION TAX AND CAPITAL GAINS TAX Key point summary The non-corporate distribution (NCD) rate Trusts Transfer pricing and thin capitalisation Expenses of companies with investment business Loan relationships and derivative contracts Accounting practice Duty of a company to give notice of coming within charge to corporation tax Construction Industry Scheme Childcare and childcare vouchers Vans Gift aid Gifts with a reservation Minor amendments to ITEPA 2003 Enterprise incentives Exemption from income tax for certain interest and royalty payments Chargeable gains Avoidance involving loss relief or partnership Avoidance finance leasebacks Reliefs for business PART 4: PENSION SCHEMES PART 6: OTHER TAXES Stamp Duty Land Tax and Stamp Duty PART 7: DISCLOSURE OF TAX AVOIDANCE SCHEMES PART 8: MISCELLANEOUS MATTERS

4 Abbreviations The following abbreviations apply in this memorandum: ADP Acceptable Distribution Policy (for CFCs) C&E HM Customs & Excise CFC Controlled Foreign Corporation EC European Community ECJ European Court of Justice EU European Union FA Finance Act FB Finance Bill FII Franked Investment Income HRA Human Rights Act 1998 IR Inland Revenue ICTA 1988 Income and Corporation Taxes Act 1988 ITEPA 2003 Income Tax (Earnings and Pensions) Act 2003 NAO National Audit Office NCD Non-Corporate Distribution RIA Regulatory Impact Assessment SWA Scotch Whisky Association TCGA 1992 Taxation of Chargeable Gains Act 1992 VATA 1994 Value Added Tax Act

5 FINANCE BILL OF SPRING 2004 TAX FACULTY REPRESENTATIONS AND INLAND REVENUE RESPONSES FOREWORD (i) (ii) (iii) (v) In April 2004 the Faculty of Taxation of the Institute of Chartered Accountants in England and Wales submitted a memorandum (issued as TAXREP 19/04: see to the Chancellor of the Exchequer commenting on the Finance Bill issued in April A supplementary letter was sent in June 2004 (TAXREP 23/04: see Copies were sent to, inter alia, Treasury Ministers, members of the relevant House of Commons Standing Committee, the Inland Revenue and HM Customs and Excise. Evidence was also provided in March, April and May 2003 to the House of Lords Economic Affairs Committee Finance Bill Subcommittee (report and evidence published in June: see Meetings were held between representatives of the Tax Faculty and the Revenue and Customs. In addition to responding to a number of matters at the meetings, the Revenue and other Government departments have subsequently provided written comments on the points in TAXREPs 19/04 and 23/04. This memorandum reproduces the text of TAXREP 19/04 so far as concerns the taxes under the control and management of the Revenue and TAXREP 23/04 and in italics the text of the written responses made by the Revenue. The original paragraph numbers in TAXREPs 19/04 and 23/04 have been retained. The paragraphs in TAXREP 23/04 have been inserted after paragraph 345. A separate representations and responses memorandum will be published covering taxes under the care and management of other Government departments. The reader should bear in mind that the Clauses referred to in this memorandum are as published in the first Finance Bill issued in April 2004, without taking account of amendments made at the Standing Committee or Report stages of the Bill, except to the extent that subsequent amendments are referred to in the responses. (vi) In order to assist reference to the legislation as finally enacted, the Finance Act 2004 section or Schedule number has been added in each main paragraph heading. 5

6 FINANCE BILL OF SPRING 2004 WHO WE ARE 1. The Institute of Chartered Accountants in England and Wales is the largest accountancy body in Europe, with more than 128,000 members. Three thousand new members qualify each year. The prestigious qualifications offered by the Institute are recognised around the world and allow members to call themselves Chartered Accountants and to use the designatory letters ACA or FCA. 2. The Institute operates under a Royal Charter, working in the public interest. It is regulated by the Department of Trade and Industry (DTI) through the Accountancy Foundation. Its primary objectives are to educate and train Chartered Accountants, to maintain high standards for professional conduct among members, to provide services to its members and students, and to advance the theory and practice of accountancy (which includes taxation). 3. The Tax Faculty is the focus for tax within the Institute. It is responsible for technical tax submissions on behalf of the Institute as a whole and it also provides various tax services including the monthly newsletter TAXline to more than 11,000 members who pay an additional subscription. KEY POINT SUMMARY 4. This memorandum contains points of general relevance to the 2004 Finance Bill together with specific comments on individual clauses. 5. This first section summarises the main points covered in the detailed commentary sections. It is followed by a section Towards a Better Tax System which highlights the extent to which this year s Finance Bill fails to meet the ten principles that we believe should underpin all tax legislation. 6. Whilst all the points we have made need to be addressed, this initial summary highlights our key points. In each case we have included a cross reference to our more detailed comments later in this memorandum. Excise duties Duty stamps 7. There is considerable disagreement at the present time as to the cost to the Exchequer of spirits fraud and the Office of National Statistics is currently carrying out work on this in conjunction with Customs and the Scotch Whisky Association. There is also considerable disagreement as to the compliance costs of these measures: 13 p per bottle according to the Government compared to 50p per bottle according to the industry. In the light of this uncertainty we recommend that this provision should either be withdrawn or not brought into effect. [see paragraphs 47 to 60 for detailed comments] (Secretarial note: reproduced in representations and responses guidance note covering Customs taxes.) 6

7 Value Added Tax Disclosure of VAT avoidance schemes 8. We are concerned that the current proposals are so widely drawn that anything that does not maximise the VAT cost to business can be classed as a tax avoidance scheme. We have illustrated in the main VAT section a number of entirely innocuous and every day transactions that would be caught by the current proposals. 9. Our main concerns are as follows: Customs have not produced any definition of what constitutes unacceptable tax avoidance. The definition in Sch 11A is so widely drawn that it means that anything which does not maximise the VAT cost to business is a tax avoidance scheme. Assuming that businesses will not be required to maximise their VAT costs, there is no clear definition of what tax planning is acceptable to Government, and what is not. there has been no credible estimate of the extent of tax avoidance, and thus the financial justification for these measures is unclear the notification requirements for VAT go considerably further than those from the Inland Revenue both business and Customs will incur significant compliance and administration costs, but no estimate of these has been given Parliamentary scrutiny and supervision of these provisions is reduced by the use of secondary legislation (yet to appear) to define major concepts there is considerable doubt whether the provisions comply with Human Rights law and European Law more generally, and therefore whether they are lawful. the notification provisions are only the first stage of a developing regime. It is therefore even more important that the law is clear and properly focussed from the outset. [see paragraphs 61 to 120 for detailed comments] (Secretarial note: reproduced in representations and responses guidance note covering Customs taxes.) Income tax, corporation tax and capital gains tax The non-corporate distribution (NCD) rate 10. The Government has introduced this measure to combat what it considers to be exploitation of the corporate legal form by small businesses simply to reduce the amount of tax they would otherwise have to pay. This followed the decision two years ago to introduce a 0% rate of corporation tax for the first 10,000 of business profits. The simplest solution would have been to abolish the 0% corporation tax rate instead of introducing nine pages of extremely complex legislation, particularly in relation to groups of companies. 11. The proposals have the potential effect of taxing at a 19% rate distributions of reserves brought forward from previous years when the distributing company has low profits in the year of distribution. [see paragraphs 133 to 158 for detailed comments] 7

8 Special rates of tax attributable to trusts 12. The decision to increase the rate of tax trusts pay to 40% has been coupled with some extremely complex rules introducing a FIFO matching rule for section 677 ICTA Section 677 will raise less and less money in the years following the introduction of the new 40% trust tax regime, on 6 April 2004, so we recommend that a Regulatory Impact Assessment should be undertaken to ascertain how much tax revenue would be at risk if sections 677 and 678 were simply to be repealed. 14. This is the first Finance Bill which has been drafted in accordance with the Tax Law Rewrite principles, so it is particularly disappointing that these particular proposals are so poorly drafted. [see paragraphs 159 to 164 for detailed comments] Transfer pricing and thin capitalisation 15. We recommend that the UK Government should rethink its approach to EU harmonisation issues and rather than increasing business burdens by downward harmonisation it should consider the approach of other EU member states, such as Spain, which have disapplied thin capitalisation and CFC provisions for intra EU transactions. [see paragraphs 165 to 178 for detailed comments] Expenses of companies with investment business 16. We are disappointed that after two major consultations on Corporation Tax Reform the only change in this area is to change a long standing relief and introduce a new tax nothing : a legitimate business expense for which the tax system provides no relief. [see paragraphs 179 to 188 for detailed comments] Construction industry scheme 17. We are concerned that the proposals will impose an unreasonable burden on business because it is so reliant on the correct identification of the employment status of an individual which is often difficult to ascertain, particularly for a non tax specialist. 18. We believe the penalties are overly harsh. If the status of the engagement is misunderstood, there is a penalty of up to 3,000 per month. The correct determination of status in the early years is vital. Honest mistakes could be too harshly penalised and there could be a disincentive to put right earlier errors after several years of misunderstanding. 19. We are also concerned that the online employment status tool should be accurate and correctly implemented. [see paragraphs 204 to 213 for detailed comments] Childcare and childcare vouchers 20. We are concerned that the proposals represent a piecemeal approach to this whole area of ensuring that there is better provision of childcare in the UK. In particular we are concerned that the existing workplace nursery scheme is going to carry on in parallel with 8

9 the new scheme but it will be more limited than at present. We also believe that the current proposals favour employees as opposed to the self-employed. If this encourages the self-employed to incorporate in order to benefit from the new regime are we going to be facing a change of policy in a couple of years time when the relief is by then considered to be unfairly exploited? [see paragraphs 214 to 227 for detailed comments] Gift aid giving through the self assessment return 21. Whilst we support any initiatives which encourage charitable giving, we have some reservations about how this scheme will work in practice. Our first concern is what will happen if the amount passed to the charity is incorrect which might happen in a number of circumstances which are outlined in the detailed comments paragraphs. We are also concerned about the position of unrepresented taxpayers, who may find themselves giving more to charity than they had planned or having to account for excess repayments or shortfalls of Gift Aid tax. [see paragraphs 231 to 240 for detailed comments] Gifts with reservation 22. We believe this charge is wrong in principle. In our view the proper approach to problems in this area is to strengthen the gifts with reservation rules. 23. If the new provisions are introduced we recommend that the rules should only consider ownership in the previous seven years and not go back, as proposed, to March Taxpayers are only required by law to retain records for six years so it is unrealistic to base a tax charge on knowledge going back nearly 20 years. We also believe that the tracing rules will be almost impossible to comply with. 24. Finally, we are also concerned that so much of the detailed legislation is to be introduced in secondary legislation where it is unlikely to receive adequate scrutiny. [see paragraphs 241 to 302 for detailed comments] Other taxes Stamp duty land tax 25. We remain concerned that this new tax has been introduced on a piecemeal basis which has led to mistakes and omissions necessitating rewritten and secondary legislation. 26. This is a highly technical area which will take time to fully implement and we are already hearing that our members have found it difficult to obtain answers from the SDLT Helpline. 27. We understand that the SDLT policy team is to be disbanded shortly and we are concerned that this will further place in jeopardy the continuity of technical expertise. SDLT is a self assessed tax and we see this lack of resource within the Revenue as an indication that there is an unwelcome shift of cost and risk from the Revenue to the taxpayer. [see paragraphs 346 to 380 for detailed comments] 9

10 Disclosure of tax avoidance schemes 28. We are concerned to ensure that the proposals do target those areas where there is a genuine risk of loss of tax revenue and that the new rules do not cause further unnecessary regulatory burdens for UK business and UK taxpayers. 29. The policy purpose behind the proposal is, we understand, to receive advance notice of tax avoidance schemes which are actively promoted and marketed. 30. The problem with these proposals is that they are so widely drafted that they encompass not just marketed tax avoidance schemes but also include all kinds of other tax advice that should not be included. 31. The overall result is that the provisions are uncertain in scope and are not likely to achieve their policy purpose of enabling the Revenue to receive an early warning of marketed schemes. 32. We are also concerned that these provisions may be in breach of the Human Rights Act 1998 despite a specific statement to the contrary in the Regulatory Impact Assessment. [see paragraphs 381 to 441 for detailed comments] 10

11 TOWARDS A BETTER TAX SYSTEM Ten Tenets Towards a Better Tax System 33. In October 1999 the Tax Faculty published a position paper Towards a Better Tax System in which it formulated ten principles that should underpin all tax legislation (TAXGUIDE 4/99, see The ten principles were that a Better Tax System should be: 1. Statutory: tax legislation should be enacted by statute and subject to proper democratic scrutiny by Parliament. 2. Certain: in virtually all circumstances the application of the tax rules should be certain. It should not normally be necessary for anyone to resort to the courts in order to resolve how the rules operate in relation to his or her tax affairs. 3. Simple: the tax rules should aim to be simple, understandable and clear in their objectives. 4. Easy to collect and to calculate: a person s tax liability should be easy to calculate and straightforward and cheap to collect. 5. Properly targeted: when anti-avoidance legislation is passed, due regard should be had to maintaining the simplicity and certainty of the tax system by targeting it to close specific loopholes. 6. Constant: Changes to the underlying rules should be kept to a minimum. There should be a justifiable economic and/or social basis for any change to the tax rules and this justification should be made public and the underlying policy made clear. 7. Subject to proper consultation: other than in exceptional circumstances, the Government should allow adequate time for both the drafting of tax legislation and full consultation on it. 8. Regularly reviewed: the tax rules should be subject to a regular public review to determine their continuing relevance and whether their original justification has been realised. If a tax rule is no longer relevant, then it should be repealed. 9. Fair and reasonable: the revenue authorities have a duty to exercise their powers reasonably. There should be a right of appeal to an independent tribunal against all their decisions. 10. Competitive: tax rules and rates should be framed so as to encourage investment, capital and trade in and with the UK. 35. It is now nearly five years since that position paper was issued and we are concerned that in many respects the tax system is in worse shape than it was then. The current Finance 11

12 Bill will do nothing to redress the balance. 36. We have set out below some of the major problems we see with the 2004 Finance Bill evaluated by reference to the Ten Tenets set out above. Length, complexity and drafting 37. At 574 pages this year s Finance Bill is more than 25% longer than the 2003 Finance Bill which was the fourth longest Finance Bill on record. 38. Some of the provisions make already complex legislation even more complicated with little indication that any significant amounts of tax are at stake. See the provisions amending section 677 ICTA 1988 contained in clause 29 and Schedule 4. Breach of Ten Tenets: Simple, Easy to collect and calculate and Constant Conflict with EC law 39. There are several provisions which appear to us to be contrary to EC law. These include clauses 48 and 49 as well as clause It is clear from the EU treaty and a long history of judgements of the European Court of Justice that UK domestic legislation must be compliant with the European law and we do not believe this is the case. Breach of Ten Tenets: Statutory and Competitive Conflict with Human Rights Act We are particularly concerned that the provisions on Disclosure of tax avoidance schemes breach the Human Rights Act and in our detailed representations below we have urged the Government to publish the advice that it has received that this is not the case. Breach of Ten Tenets: Statutory Use of regulations 42. It has proved almost impossible to comment on some parts of this Finance Bill as so many of the provisions are to be relegated to Statutory Instrument. This is particularly true of the provisions on Disclosure of tax avoidance schemes. 43. Statutory Instruments are subject to even less scrutiny than the Finance Bill itself and once enacted they are more difficult to access, particularly for the ordinary taxpayer who is not represented by a qualified advisor. Breach of Ten Tenets: Statutory and Subject to proper consultation 12

13 Provisions which are retroactive 44. There are provisions which will affect transactions which taxpayers entered into many years ago with no understanding that these actions would have consequences in the future which could not have been anticipated. This is particularly true of the proposals on Gifts with reservation contained in clause 84 and Schedule These would appear to breach the doctrine of reasonable expectations and legal certainty which have been supported very recently by the ECJ in two joined decisions (Case C-487/01 Gemeente Leusden and (Case C-7/02) Holin Groep BV v Staatssecretaris van Financien. Breach of Ten Tenets: Constant, Properly Targeted and Fair and reasonable Regulatory impact assessments 46. We support the publication of RIAs but are concerned that many of them do not make a sufficient case to justify the proposals set out in the Bill. We believed that RIAs are an essential tool and that they should include a detailed assessment of how the provisions reviewed comply with the ten tenets set out above. 13

14 PART 3 INCOME TAX, CORPORATION TAX AND CAPITAL GAINS TAX KEY POINT SUMMARY The non-corporate distribution (NCD) rate 121. The Government has introduced this measure to combat what it considers to be exploitation of the corporate legal form by small businesses simply to reduce the amount of tax they would otherwise have to pay. This followed the decision two years ago to introduce a 0% rate of corporation tax for the first 10,000 of business profits. The simplest solution would have been to abolish the 0% corporation tax rate instead of introducing nine pages of extremely complex legislation, particularly in relation to groups of companies The proposals have the effect of potentially taxing at a 19% rate distributions of reserves when the distributing company has low profits in the year of distribution. Special rates of tax attributable to trusts 123. The decision to increase the rate of tax trusts pay to 40% has been coupled with some extremely complex rules introducing a FIFO matching rule for section 677 ICTA Section 677 will raise less and less money in the years following the introduction of the new 40% trust tax regime, on 6 April 2004, so we recommend that a Regulatory Impact Assessment should be undertaken to ascertain how much tax revenue would be at risk if sections 677 and 678 were simply to be repealed This is the first Finance Bill which has been drafted in accordance with the Tax Law Rewrite principles, so it is particularly disappointing that these particular proposals are so poorly drafted. Transfer pricing and thin capitalisation 126. We recommend that the UK Government should rethink its approach to EU harmonisation issues and rather than increasing business burdens by downward harmonisation it should consider the approach of other EU member states, such as Spain, which have disapplied thin capitalisation and CFC provisions for intra EU transactions. Expenses of companies with investment business 127. We are disappointed that after two major consultations on Corporation Tax Reform the only change in this area is to change a long standing relief and introduce a new tax nothing : a legitimate business expense for which the tax system provides no relief. Construction industry scheme 128. We are concerned that the proposals will impose an unreasonable burden on business because it is so reliant on the correct identification of the employment status of an individual which is often uncertain We are also concerned that the online employment status tool should be accurate and correctly implemented. 14

15 Childcare and childcare vouchers 129. We are concerned that the proposals represent a piecemeal approach to this whole area of ensuring that there is better provision of childcare in the UK. In particular we are concerned that the existing workplace nursery scheme is going to carry on in parallel with the new scheme but it will be more limited than at present. We also believe that the current proposals favour employees as opposed to the self-employed. If this encourages the self-employed to incorporate to benefit from the new regime are we going to be facing a change of policy in a couple of year s time when the relief is by then considered to be unfairly exploited. Gift aid giving through the self assessment return 130. Whilst we support any initiatives which encourage charitable giving, we have some reservations about how this scheme will work in practice. Our first concern is what will happen if the amount passed to the charity is incorrect which might happen in a number of circumstances which are outlined in the detailed comments paragraphs. We are also concerned about the position of unrepresented taxpayers, who may find themselves giving more to charity than they had planned or having to account for excess repayments or shortfalls of Gift Aid tax. Gifts with reservation 131. We believe this charge is wrong in principle. In our view the proper approach to problems in this area is to strengthen the gift with reservation rules. We recommend that the rules should only consider ownership in the previous seven years and not go back, as proposed, to March Taxpayers are only required by law to retain records for six years so it is unrealistic to base a tax charge on knowledge going back nearly 20 years. We also believe that the tracing rules will be almost impossible to comply with Finally, we are also concerned that so much of the detailed legislation is to be introduced in secondary legislation where it is unlikely to receive adequate scrutiny. DETAILED COMMENTS CHAPTER 1 CORPORATION TAX Clause 28 and Schedule 3 (section 28 and Schedule 3) The non-corporate distribution (NCD) rate 133. It is rather unfortunate that having introduced the 0% band two years ago, the Government has now had to produce nine pages of legislation to correct the perceived mischief caused by it, rather than to simply abolish the 0% band which caused the problem We understand the Government s policy purpose behind these proposals, namely to encourage companies to retain earnings. However, we think that the resulting complexity from this new measure will defeat the policy purpose behind this proposal These new rules will mean that many shareholders of owner managed companies will need to perform simultaneous equations in order to arrive at the amount they will need to distribute. The result is a considerable increase in complexity for very small incorporated businesses. 15

16 136. In the interests of simplicity and certainty we believe that the 0% corporation tax rate should be abolished and these provisions withdrawn. I am sorry that you consider the new measures to be complex because others have found that they strike a sensible balance between technical detail and avoidance of complexity. The legislation occupies less than 8 full pages and is considerably simpler than, for example, the ACT regime. There is very little extra that most companies affected by the new provisions have to do compared with what was previously required and there is no need for complex mathematical computations. The process of the basic scheme is extremely simple and has no more additional complexity than working out a percentage and being able to subtract. The process is as follows: work out the company s tax liability including marginal relief in the normal way, as before, and if the percentage tax due is less than 19%, then: check whether there has been a distribution to a person who is not a company, and if so: charge the amount of profit that matches the amount of the non-corporate distribution at 19% and the remainder at the rate that applies in the normal way under the first bullet above. It is important to recognise that well over 90% of those companies affected by the noncorporate distribution rate need do no more than the above simple calculation. The remaining measures relate to situations where distributions exceed profits, especially where there are groups of companies. They provide the minimum level of safeguards necessary to prevent tax avoidance. The Government does not wish to abolish the starting rate of tax because it wishes to encourage small business to retain profits for investment and growth. The non-corporate distribution rate, coupled with low other rates of corporation tax, achieve this aim We note that the NCD rate is to be such rate as Parliament may from time to time determine (clause 28(1) introducing new section 13AB(3)). The rate is not specifically linked to the small companies rate of corporation tax which we would have expected Please clarify: whether this is deliberate; whether there is an intention that the NCD rate may in future deviate from the small companies rate of corporation tax We would also welcome an assurance that if the 0% rate band is withdrawn in the future these provisions will be withdrawn. During the debate in the Committee of the Whole House on 27 April 2004 the Paymaster General said that the measure does not represent a strategic change in direction. She went on to say the Government s deliberate and cumulative aim is to underpin all the measures that the Government have taken to encourage businesses to grow and to be 16

17 more enterprising and productive in the medium and long term and not to operate year by year by playing around with the tax system. She also commented that it is not possible for any Minister to say that there will never be a change in the business tax regime for small businesses and referred to the discussion document announced in the Budget As currently drafted the NCD rate applies to a distribution to a recipient who is not a company (paragraph 2(1) Schedule 3). It would therefore apply, for example, to recipients which are pension funds, charities, unincorporated associations and authorised unit trusts. We do not believe that this is the intention and that it should apply only to individuals and trusts We think that the clause should be amended to make it clear that it does not apply to the above recipients. The intention and effect of the clause is that the non-corporate distribution rate should potentially apply where distributions are made to non-companies, the definition of company being the existing definition contained within section 832(1) Income and Corporation Taxes Act We would welcome clarification as to why the provisions require distributions to be matched against basic profits for the period, up to the full amount of the basic profits, when that amount could not actually have been distributed out of the current year profits, assuming no FII or other non-taxable income. In our view the clause should be amended so that the matching is limited to basic profits less the 19% tax charge In strictness, the matching should be limited to basic profits less tax at the true rate, to include the charge under section 13AB itself, but we imagine that would be considered to be too complex a formula We would welcome clarification as to why excess NCDs have always to be carried forward. In reality they must actually represent distributions of retained earnings (again assuming no FII), which originated before section 13AB came into force and quite possibly before the introduction of the starting rate so to that extent should have already borne tax at the small companies rate The clause should be amended so that distributions which cannot be matched against the current year s basic profits, in the company or its subsidiaries, should next be set against distributable reserves existing at 1 April 2004, and only then should any excess be carried forward. The points made in your representations do not recognise the nature of the non-corporate distribution rate. It is not a tax on distributions made out of taxed reserves, but a rate of tax applied to current profits. If there are no profits, there is no tax to pay. If, for example, the Government had abolished the starting rate of corporation tax, as 17

18 some commentators have proposed, the minimum rate of corporation tax on all profits would be 19%. No one would have suggested that this should be calculated net of tax, or that it should take into account distributable reserves including FII. The non-corporate distribution rate is simply a method of establishing the appropriate tax rate for current profits. Just as an increase in profits may trigger higher corporation tax liability, under the new provisions the presence or absence of a distribution may also impact on the corporation tax rate. It is therefore irrelevant from which profits the amounts distributed arose and there is no justification for matching profits with an amount net of tax. You ask why excess NCDs are carried forward, not backwards. As I have explained, the period during which distributed profits are earned is not relevant, and to carry any excess back would cause the reopening of earlier years with attendant complexities. You will appreciate that there is a need to carry the excess forward to prevent tax avoidance. Your representations have mentioned the need to avoid complexity. I hope that you can accept that the design of the measure avoids the added complexity that would follow were the Government to follow the route of introducing a separate distributions tax and to adopt your suggestions for matching of net profits and carry back of excess NCDs It is also not clear why, in paragraph 7(3) Schedule 3, the parent s excess NCDs have to be matched against the subsidiary s basic profits reduced only by its own NCDs. The subsidiary s basic profits should be reduced by the full amount of any dividends which it has paid outside the group, whether corporate or non-corporate. Otherwise one ends up levying the additional tax charge on profits which have been distributed by the subsidiary to corporate shareholders through the paragraph 7 mechanism, even though such profits are of course excluded from the section 13AB charge computed directly on the subsidiary s own NCDs We believe that the clause should be amended to reflect the above comments. However, we believe that it is appropriate to allocate excess NCDs to be matched against profits of the subsidiary which have been distributed to the parent itself in order to make the system work. The provisions are designed to focus on non-corporate distributions when determining the rate of corporation tax. You have rightly acknowledged that the allocation of excess NCDs to other group companies that match distributions paid up is necessary. It follows that any provisions that require separation of this element and further identification of payees would inevitably be highly complex, particularly bearing in mind anti-avoidance provisions that would be necessary. An important objective in designing the legislation was to keep the complexity proportionate to the risks and population of companies affected. The number of groups to which the non-corporate distribution rate applies is relatively small, and there are far fewer still with subsidiaries having both non-company and non-group company shareholders which is the situation relevant to your representation. The justified principle of focusing on non-corporate distributions when computing 18

19 corporation tax rates is followed in paragraph 7 as drafted. In our view, there is no significant principled, proportionate or practical benefit to be derived from introducing the additional complexities and consequential measures that would be necessary if your suggestion were to be adopted We question whether the draft provisions deal fairly with a company which is in receipt of franked investment income, when, in reality, it may well be the franked investment income that is being distributed and when there are profits elsewhere in the group which have paid tax at 19% or more. The following examples illustrates the problem. Example 149. Holdco has no income other than 5,000 from one investment. It also has two subsidiaries, A Ltd and B Ltd, which make profits which they need to retain to develop their business. Holdco distributes its 5,000 investment income to its shareholders all of whom are individuals. It appears that all of Holdco's distribution is Excess Non Corporate Distributions (NCD) which must be allocated to A Ltd and B Ltd. The measure operates by taking account of distributions to non-company shareholders only. If franked investment income were to be taken into account, the measures would have to identify and separate group and non-group FII including tracking non-group FII received by subsidiaries and passed up through the group. They would also have to provide a matching mechanism for FII and distributions made, including rules for which type of FII were being matched. This would introduce considerable complexity, would require anti-avoidance provisions and would not encourage overall retention of group profits for growth and investment. The measure as drafted in the clause has the benefit of being simple, proportionate and principled We question whether the existing provisions are reasonable in that a group can decide how to allocate an excess of NCDs whereas the parent must itself utilise as much of the NCD as it is able to. Example 151. Parent has 2,000 of bank interest but no other income. It has two subsidiaries, C Ltd which has profits of 20,000 and D Ltd which has profits of 50,000. Parent pays a dividend of 10,000. Each company pays the starting rate on 3,333 and the full small companies rate on profits of over 16,667. Accordingly C Ltd and D Ltd are both paying corporation tax at 19% on combined profits of 70,000 which is ample to frank the 10,000 dividend, yet the rules require an additional 19 per cent tax to be paid on 2,000 of the dividend. This is because the legislation requires Parent to be allocated a third of the starting rate and for 2,000 of the dividend to be allocated to it. If the bank interest had been received by one or other of the subsidiary companies there would have been no extra tax to pay by Parent. We question whether the provisions are fair. 19

20 The principle adopted for groups follows that for singleton companies. It is logical for the provisions to consider the company making the distribution in the first instance before considering where any excess should be allocated. In many cases involving groups, it avoid consideration of other group members at all, making the system simpler to operate. The associated company rules and their impact on rates of corporation tax are well understood and there is no need to make special provision when the non-corporate distribution rate is being applied We also believe the provisions could work unfairly where there are outside shareholders in a subsidiary. Example 153. Holdco owns 100 per cent of E Ltd and 50.1 per cent of F Ltd. It receives a distribution (as group income) from E Ltd of 50,000 which it distributes to its own shareholders. The companies can decide between them how the 50,000 is allocated. If they do not do so the Revenue will decide. In fairness the Revenue should decide to allocate it wholly to E Ltd but the Revenue could allocate it in some other way. The provision should be amended so that the Revenue s power must be exercised to achieve a just and reasonable result and this should be capable of appeal. You state that the Revenue s power to allocate excess NCDs should be exercised to achieve a just and reasonable result and this should be capable of appeal. The power for an officer of the Board to make an allocation is within paragraph 10(2) and is relevant only where a necessary allocation has not been made by the relevant companies. But even if a Revenue allocation is necessary, that allocation can be varied by agreement between the relevant companies. The provisions are therefore explicit in giving the companies the power to amend an officer of the Board s allocation and there is therefore no need for the allocation to be capable of appeal. In the debate during Committee of the Whole House on 27 April 2004 the Paymaster General said: The measure also provides for companies to amend those allocations, so no further safeguards are necessary. It is not a one way street in which the Government simply impose conditions We would welcome clarification as to how paragraphs 14(3) and (4) of Schedule 3 work together. Example 155. Holdco owns 100 per cent of G Ltd and 40 per cent of H Ltd. G Ltd is a share dealing company and owns a further 15 per cent of H Ltd as dealing stock. H Ltd pays a dividend of 10,000 of which 4,000 is received by Holdco and 1,500 by G Ltd. Under paragraph 14(3) H Ltd seems to be treated as a 51 per cent subsidiary of Holdco. However, 20

21 paragraph 14(4) excludes the shares held by G Ltd from being taken into account and therefore we assume that H Ltd is not a 51% subsidiary of Holdco We would be grateful for confirmation that our understanding is correct. Paragraph 14(4) operates for the purpose of the paragraph and therefore overrides paragraph 14(3). This is because income from shares held by share dealing companies is taken into account in computing trading profits and is therefore treated in a different way to dividend receipts of other companies. It follows that, as in other similar situations, those shares are disregarded. In practice, we do not expect many share dealers to be affected by these measures but their situation was dealt with to provide consistency We would also welcome clarification as to how paragraphs 14(3) and 15 work together? Example 158. Holdco owns 100% of J Ltd and 40% of K Ltd. The companies all prepare accounts to 30 June. On 1 August 2005 K Ltd pays a dividend to its shareholders of 10,000 of which Holdco receives 4,000. On 31 December 2005 Holdco sells a property to K Ltd for 200,000. The accounts of Holdco for the year to 30 June 2006 are selected for enquiry and in the enquiry it is agreed that the property was only worth 197,000 on 31 December. As a result K Ltd has made total distributions of 13,000 in the year to 30 June 2006 of which 7,000 ( 4,000 dividend plus 3,000 distribution under section 209(4), ICTA 1988) was paid to Holdco, so K Ltd is deemed by paragraph 14(3) to be a 51% subsidiary of Holdco. It is not clear if it is deemed to be such a subsidiary for the year to 30 June 2006, the period 1 August 2005 to 30 June 2006 during which distributions were made, or only on 31 December 2005 when it received the offending distribution. The Paymaster General said during the Committee of Whole House debate on 27 April: Finally, the hon. Gentleman asked me about the deeming provisions in paragraph 14 and 15 of schedule 3. Of course, the Revenue will be issuing guidance explaining exactly how those measures work. That guidance will cover the kinds of situations to which you refer. Trusts Clause 29 and Schedule 4 (section 29 and Schedule 4) Special rates of tax applicable to trusts 159. We would welcome clarification as to what paragraph 1 of Schedule 4 is trying to do. The explanatory notes issued by HM Treasury on 8 April do not cover Schedule 4 but we understand that this was an oversight and that notes will be published shortly. Please 21

22 confirm that this is the intention Given that these provisions are meant to be drafted in Tax Law Rewrite style, the result is not satisfactory. As drafted the purpose and effect of the provisions are far from clear. We request that the provisions are reviewed and redrafted to improve clarity Sections 677 and 678 ICTA 1988 are already highly complex provisions and we question why it is considered necessary to make section 677 even more complex by introducing a FIFO matching rule (paragraph 1(4) of Schedule 4 inserting new section 677 (7A) ICTA 1988) Indeed we question whether sections 677 and 678 are necessary now that the trust rate of tax is 40 per cent for UK resident trusts? We recommend that a Regulatory Impact Assessment is undertaken to ascertain how much tax revenue would be at risk if sections 677 and 678 were to be repealed with effect from 6 April In other words adding to the inherent complexities of the existing provisions with the introduction of FIFO matching rules from 6 April 2004 seems unlikely to be justified by the tax revenues at stake which are likely to be small in the first year and will inevitably become less and less as each year passes The increase in the rate applicable to trusts to 40 per cent is particularly unfair where a discretionary trust received dividend income prior to 6 April 2004 which it distributes to beneficiaries after that date. The deemed tax rate under section 687(3)(a1) seems to be the rate at the time the dividend was received, i.e. 25% per cent (Schedule F trust rate) less 10% (Schedule F ordinary rate) = 15%, so the trust will have to pay an extra 25% if the dividend was its only income. However, if it had received the dividend after 5 April 2004, the section 687(3)(a1) adjustment would be 32.5% less 10% = 22.5% leaving only an additional 17.5% payable by the trustees We request that Schedule 4 is amended to include a transitional relief in respect of payments out of the trust which are subject to section 687. The Explanatory note for Schedule 4 was omitted from the published set of Explanatory Notes due to a printing error. We apologise for this error: the note was quickly added to the HM Treasury web-site. Schedule 4 stops a settlor from receiving credit for tax that the trustees have not paid. The amendment is a necessary consequence of the increase in the rate applicable to trusts. Schedule 4 aims to ensure the tax credit given to the settlor of a trust in calculating his income tax liability on the capital payment from the trust more closely matches the tax paid by the trustees. The complexity of anti-avoidance legislation is driven by the ingenuity of the tax avoidance industry. As these anti-avoidance provisions are still needed to ensure that wealthy settlors pay the right amount of tax their repeal has not been costed. Income received by trustees loses its character when it is paid out: beneficiaries do not receive dividends from trustees but annual payments. The section 687 increase follows the increase in the Rate Applicable to Trusts. Beneficiaries get an increased tax credit, and transitional relief is not considered to be necessary. 22

23 CHAPTER 2 CORPORATION TAX: GENERAL General comments on clauses 30 to 36 (sections 30 to 36) - (transfer pricing and thin capitalisation) 165. We understand the Government s concern to ensure that the UK tax laws are robust and not subject to challenge in the European Court of Justice. However, we are concerned that the UK s approach to EU issues appears to be downward harmonisation. Our concern is that this will reduce the competitiveness of the UK and is not consistent with the stated EU Lisbon Agenda which is to create in Europe the most dynamic knowledge based economy in the world by It appears that other EU countries are tackling this issue the other way around and adopting upward harmonisation. For example, Spain has disapplied its thin capitalisation and CFC provisions for intra-eu transactions We believe that the transfer pricing and thin capitalisation rules should be disapplied for intra-eu transactions In relation to EU harmonisation issues generally, we believe that the UK Government should seek to approach them from a position which will enhance rather than reduce the UK s competitive position, i.e. to embark upon upward harmonisation wherever possible. We would be very happy to meet and explore the issues further. The transfer pricing and thin capitalisation provisions in the Finance Bill address the issue of competitiveness by introducing a new exemption for small and medium sized enterprises, which disapplies transfer pricing and thin capitalisation rules from these enterprises in most circumstances. Transfer pricing Clause 30 and Schedule 5 (section 30 and Schedule 5) Provisions not at arm s length: transactions between UK taxpayers 168. Paragraph 4 of Schedule 5 repeals in its entirety paragraph 20 Schedule 24 ICTA Paragraph 20(2) provides that there is no requirement to make a transfer pricing adjustment between two CFCs facing apportionment or pursuing an acceptable distribution policy (ADP) but the new paragraph 6B of Schedule 28AA ICTA 1988 introduced by clause 32(3) seems to apply only to apportionment situations and not ADPs New paragraph 6B should be amended so that it applies to the situation where two CFCs are pursuing an acceptable distribution policy. The purpose of the enhanced rules for compensating adjustments is to address double UK taxation where a transfer pricing adjustment is fully tax effective in the computation of profits and losses. Dividend income returned to the UK only needs to cover 90% of the CFC profits and can be deferred by 18 months or more. It is inappropriate to extend the 23

24 availability of a compensating adjustment if the transfer pricing adjustment itself is not subject to full taxation. Clause 31 (section 31) Exemptions for dormant companies and small and mediumsized enterprises 170. We request confirmation that in relation to clause 31(4) any such election is irrevocable in new paragraph 5B(3) relates only to the chargeable period concerned and does not prevent paragraph 5B from applying in a later accounting period We question the potential retrospective nature of the ability of the Board to give a notice under new paragraph 5C(1)(b). It is not until a notice is given, which can be up to three years after the transaction takes place, that a company will be told that the tax bill in respect of a particular transaction is greater than the company believed was going to be the case at the time it entered into the transaction We question why in clause 31(4) new paragraph 5C is far more widely drawn than was indicated in BN17. That stated that the change would enable the Revenue in exceptional circumstances to require a medium-sized enterprise to apply transfer pricing rules. New paragraph 5C contains no limitation to exceptional circumstances. It gives the Revenue a blanket power to apply the rules for any reason whatsoever. There is no requirement to even tell the company why it is being required to do so and the only right of appeal in the section is in relation to whether the company was a medium-sized enterprise. This seems to be taxation by administrative edict and lacks the necessary certainty We request that new paragraph 5C(1)(b) be amended so that the Board can only issue a notice in exceptional circumstances, and that there should be a requirement to give the reason for issuing the Notice We believe there will still be problems for companies that become dormant after the introduction of the new legislation and request that the exemption be extended and not restricted to companies that are dormant in the pre-qualifying period but become dormant at a later date. We confirm that an election by an exempt small or medium sized enterprise applies for the accounting period only. The notice provisions do not have effect before 1st April The issue of a transfer pricing notice is restricted to medium sized enterprises and will only be made in exceptional circumstances where there is a significant tax risk. It should therefore come as no surprise to the few companies affected, if they are required to make a return on an arm s length basis. The exemption for Dormant Companies ensures that there is no need for Groups to disrupt existing structures, and no need to reorganise or activate companies dormant for a period before 1 April 2004 as a result of the changes. The exemption has not been extended to companies that become dormant later because we need to avoid creating loopholes that could be exploited by businesses to avoid taxation in the future. Looking forward, businesses can plan their corporate structures in the light of the new legislation. 24