Pre-Budget Report 2009 commentaries - Business

"The commentaries below are written in general terms. Details can also be found in our downloadable Pre-Budget Report brochure. You are strongly recommended to seek specific advice before taking any action based on the information given, both in the commentaries and in the publication."

Corporation Tax Rates

The main rate of corporation tax applicable to taxable profits above £1.5m for the financial year commencing 1 April 2010 is to be kept at 28%.

The PBR also announced that the small companies rate of corporation tax would remain at 21% for the financial year commencing on 1 April 2010, and that the proposed rate increase to 22% has been deferred for one year. The lower and upper limits for marginal relief calculations remain unchanged at £300,000 and £1.5m respectively, which means that the fraction used for calculating marginal relief will remain at 7/400.

Comment

The deferral of the increase in small companies’ corporation tax rate to 21% looks sensible, although plans to increase to 22% as from April 2011 still remain.

Intellectual Property Reform

There is planned legislation in time for the Finance Bill 2011 to be operational from April 2013 for a 10% rate of corporation tax for income from patents. There is no actual detail so far, however, the Chancellor’s speech suggested that it is targeted at the pharmaceutical and biotech industries so that the UK remains an attractive location for innovation given reduced corporation tax rates for IP income in Netherlands, Belgium and Luxembourg.

Comment

The so called ‘patent box’ approach certainly looks attractive on paper but there remain a number of questions, not least whether related R&D spend is somehow how ring-fenced and in so doing the present enhanced and generous, R&D reliefs are restricted. It is not difficult to envisage the position where as is often the case, in the pharmaceutical and biotech sectors investment is front loaded, with the result that what is initially presented as a ‘tax break’ turns out to be a revenue raising measure.

It should be noted that the Netherlands ‘Patent box’ rate reduces from 10% to 5% from 1 January 2010 and tax relief on research expenditure is not restricted to the patent tax rate. It remains to be seen whether the UK draft rules are couched such that they genuinely compete with the IP regimes in other European countries.

Tax and Accountancy: Changes to accounting standards on Financial instruments

Financial Reporting Standard (FRS26), and its International Accounting Standard equivalent (IAS39) deals with the recognition and measurement of financial instruments. The International Accounting Standards boards are proposing changes to IAS39 which are expected to flow through into FRS26. The plan is to introduce enabling legislation in the Finance Bill 2010 to allow any associated tax changes thought appropriate to be enacted through secondary legislation. This would be by way of statutory instrument which allows such changes to be made outside of a Finance Bill timetable. There are planned changes on the accounting side under four main areas. They are:

the way the financial instruments are classified and measured for accounting purposes;
timing of balance sheet recognition;
how impairment losses are quantified; and
how hedging arrangements should be accounted for.

The Government is consulting informally with businesses and their advisers about the implications of these changes for tax law.

Comment

The tax treatment, subject to exceptions of course, is based on the accounting. It is good that the Government is consulting but whilst its pre-occupation with secondary legislation in favour of primary legislation may be expedient, and not withstanding the consultation process, the lack of parliamentary scrutiny can be of concern particularly in highly technical areas such as this.

Capital Allowances Anti-avoidance

When a company is sold, its inherent tax attributes, tax written down values and tax losses normally transfer with the company for the benefit of the purchaser and its group. There are existing anti-avoidance rules in relation to tax losses where a company changes ownership but these do not specifically cover unclaimed capital allowances. New anti-avoidance legislation is to be introduced in the Finance Bill 2010 arrived at restricting the purchaser’s ability to use those allowances. The law is to be targeted at tax motivated transactions where parties have entered into arrangements where the main purpose or one of the main purposes is to acquire an interest in those allowances.

By way of background, anti-avoidance rules in relation to tax losses either disqualify tax losses entirely as at the date of change of ownership, but if not disqualified are allowed to be offset against profits arising from the same trade.

The new rules in relation to capital allowances, however are as follows:

they only apply to a tax motivated transaction where one of the main purposes was to acquire ‘latent capital allowances’;
where the anti-avoidance rules apply, the allowances are restricted in the way they can be used so that they can only be set against the profits that would have arisen had the company sale not taken place – in other words, continuing profits, arising from the same trade; and
this means any excess allowances will not be available by way of group relief or offset against other profits within any new group and these new rules effectively mirror the general principal that tax losses can only be used against profits of the same trade, by ring-fencing and denying the ability to pass the relief on to other companies within the purchaser group.

Comment

This brings broadly the anti-avoidance rules for capital allowances into line with those for the trading losses. The fertile ground for disagreement is as usual, around determining whether the anti-avoidance rules apply in the first place, namely the purpose of any particular transaction.

Electric vans: 100 per cent first-year allowances

It has been announced that, subject to confirming the state aid position, businesses purchasing new (unused) electric vans will be able to take advantage of 100% first year allowances (electric cars already qualify for first year allowances). The new rules are proposed to come into effect for expenditure incurred on or after 1 April 2010.

By way of background, capital allowances are generally available for businesses to obtain tax deductions for the cost of acquiring capital assets (as opposed to the accounting depreciation charge). Capital assets qualifying for the main pool should qualify for capital allowances at the current rate of 20%. First year allowances are available for certain assets which provide accelerated tax deductions.

Comment

The new rules to allow 100% first year allowances will be welcomed by business intending to purchase new electric vans after the effective date on the basis that a full tax deduction is accelerated and obtained in the year of acquisition. However, it is not clear how many businesses this measure will assist and therefore may only be of limited benefit in the near future, but as technology and the whole infrastructure improves this may prove much more popular.

Worldwide Debt cap

Finance Act 2009 introduced debt cap legislation as part of the measures to reform the taxation of foreign profits, although it can affect large groups which only have UK operations. Refinements to the way the debt cap rules operate in practice were announced on 9 November and draft legislation for these amendments was published with the PBR.

The debt cap acts as a potential restriction on the net finance costs of certain UK members of a large group if those costs exceed the group worldwide gross accounting finance cost. The rules are effective for accounting periods commencing on or after 1 January 2010, and apply after all other tax adjustments such as transfer pricing, thin capitalisation, tax arbitrage, loans for unallowable purposes.

Certain entities are excluded from the application of the debt cap rules. The excluded groups are (i) qualifying financial service groups and (ii) groups which meet a ‘gateway test’. The gateway test excludes large groups from the debt cap where the net debt of all ‘relevant group companies’ (those UK resident entities that are group members to the extent of at least 75%) is 75% or less of gross group worldwide debt.

Group definition points:

the draft legislation excludes securitisation companies from the definition of relevant group companies, but they are still included for the purpose of assessing the gateway test;
international entities (for example non-UK LLPs) that would otherwise meet the requirements for definition of a collective investment scheme are excluded from being ultimate parent companies for determining what is a group and a relevant group company for the purpose of the debt cap; and
the definition of financial instrument is clarified for the purposes of assessing whether a group meets the qualifying financial service exclusion.

Gateway test points:

for the purpose of the gateway test where liabilities of relevant group companies would be different in amount to the same liability of the worldwide group, the amount will be determined for both using the accounting standard applicable to the worldwide group; and
liabilities for the purpose of the gateway test do not include liabilities representing preference shares.

Calculation and allocation points:

for the purpose of calculating interests costs where the loan is from a partnership, the interests costs for the purpose of the available amount of the worldwide group will be assessed on a similar basis to the costs for the tested amount of relevant group companies;
there is a relaxation for the election to exclude group treasury companies from the calculation of the tested amount and the requirement to have 90% income from group treasury activities will be assessed on a company by company basis, rather than for all companies undertaking group treasury activities;
guarantee fees will be included in the assessment of finance income; and
where a disallowance has to be allocated it will be possible to elect to exclude specific companies from that allocation. This exclusion will apply whether the allocation is performed by taxpayer return, or by statutory allocation. To protect existing anti-avoidance dual resident investment companies will automatically be excluded companies for this purpose.

Comment

These amendments help the practical application of the debt cap rules. These rules are nevertheless complex, and there may well be further refinements as practical problems emerge. All large groups should be reviewing their financing arrangements to see if the debt cap rules apply. Finance Act 2009 included anti-avoidance to exclude certain arrangements undertaken specifically to avoid the debt cap rules, but indicated certain arrangements specified in regulations would not be treated as ‘excluded’. While these regulations had not been issued by 9 December, HMRCs website doses now have draft guidance indicating those arrangements that would be regarded as acceptable.

BUSINESS PAYMENT SUPPORT SERVICE

The 2008 Pre-Budget report announced the launch of the Business Payment Support Service (BPSS). This was introduced in response to the worsening economic position and recognised the impact of the recession on business profitability and, more seriously, the problems faced by many businesses regarding cash flow.

This service was designed to assist all businesses that were unable to pay their tax by providing a fast track response for time to pay applications. Time to pay arrangements have been available for years, but their availability was not previously well known. The BPSS brought the existing facility into the open and made it more accessible.

Statistics indicate that over 160,000 businesses have been helped in the period to date involving tax liabilities of over £4bn. The Chancellor confirmed that the service is to continue for as long as necessary.

From a date to be announced HMRC will require businesses seeking time to pay arrangements worth £1m or more to provide an Independent Business Review (IBR) in support of their request.

Comment

The BPSS has been very successful in providing a sympathetic hearing for businesses whose cash flow suffered as a result of the recession.

However there have been difficulties over time to pay arrangements for partnerships because of the way in which they are structured. Taxable profits from a partnership are allocated to individual partners and the resulting tax liabilities are charged to the individual and the way that the BPSS operated meant that HMRC expected each of the partners to make individual time to pay applications, notwithstanding that none of them may have had a detailed knowledge of the firm’s financial position. We understand that new guidance will be issued shortly making it clear that partnerships are covered by the BPSS.

The forthcoming requirement for an independent business review indicates that the bar is being raised for larger applications.

Research & development tax relief

Prior to the Pre-Budget report, small or medium sized enterprise companies (SMEs) could only claim enhanced tax reliefs for expenditure on research and development (R&D) or, if expenditure was subsidised, large company relief (no cash credit but enhanced losses at a lower rate than for SME relief) if it owned any intellectual property (IP) attributable to the R&D expenditure.

Legislation will be introduced in Finance Bill 2010 to abolish the IP ownership condition which means an SME company will not need to own the IP in respect of R&D expenditure incurred in an accounting period ending on or after 9 December 2009.

It should be noted that for the purposes of R&D relief, the SME thresholds are higher than those set out by the European Commission and the SME must have less than 500 employees and satisfy one out of the following two tests:

Turnover ≤ €100m or;

Balance sheet total ≤ €86m

Comment

This is a welcome simplification that removes one of the most problematic bars to claiming relief. Accordingly, more SME companies should be able to benefit from R&D reliefs. It is notable that the time period from which relief can be claimed using the new rules extends to expenditure incurred before the PBR announcement.

Sale of Lessor Companies

A permanent tax deduction from leasing could be achieved prior to Finance Act 2006 by group relieving the tax losses normally achieved in the start up phase of a leasing business, and then selling that business as it become profitable, but prior to the generation of taxable profits. Finance Act 2006 reduced this possibility by requiring a tax charge on the vendor based on the tax timing difference at the point of sale. Tax relief for the value of this charge could then be obtained by the purchaser in its own group. The tax charge was triggered when there was a change in economic ownership.

However the Finance Act 2006 changes made certain commercial non-tax motivated transactions difficult to complete, particularly where the buyer was loss making or not part of a group (and so unable to use group relief). They also provided a situation where a leasing business owned by a consortium could avoid the charge imposed by Finance Act 2006.

Changes made in Finance Act 2009 partially relieved the adverse impact of the 2006 anti-avoidance by permitting a longer period over which the relief could be surrendered, but did not resolve the position for a buyer that was not part of a group, or was unable to use the relief over the permitted extended period.

To reduce impediments to commercial transactions, the Pre-Budget Report introduces an election to compute the tax charges on a sale of a lessor business on a different basis to that in Finance Act 2006. The alternative basis treats the leasing business as ring fenced and collects tax on the deferred profits of the business as they arise. It includes provisions to prevent manipulation of the results of the ring fenced business. The draft legislation has effect for transactions made on or after 9 December 2009.

New draft legislation also tightens up the application of the tax charge imposed by Finance Act 2006 legislation in the case of consortia. This is achieved by broadening the definition of a company owned by a consortia for group relief for the purpose of assessing whether the Finance Act 2006 charge applies, from one which is a 90% subsidiary of a company owned by the consortium to one which is a 75% subsidiary.

Comment

The design of anti-avoidance legislation for one set of circumstances does not always make sense in different economic circumstances. The Government has responded after consultation with the leasing industry by introducing new provisions to facilitate commercial transactions subject to its desired policy aims of not using losses generated from leasing capital allowances to offset profits from unrelated businesses to an excessive extent. It has also acted to close down a weakness in the original anti-avoidance legislation with respect to leasing companies owned by consortia.

Use of Partnership Structures for EIS fund-raisings

HMRC has announced a change in its interpretation of the Enterprise Investment Scheme (‘EIS’) legislation in relation to the use of partnership structures for EIS fund-raisings. A typical structure involved companies becoming corporate members of a Limited Liability Partnership (‘LLP’), where the qualifying trade was carried on by one entity, the LLP, with EIS funds of £2m raised in each company (the annual limit per company) and contributed as capital to the LLP. HMRC viewed this as a way of getting round the funding limits and other restrictions (eg, the gross assets test) using one entity to carry on the trade, and has published a technical explanation of why the legislation does not allow such partnership structures.

Comment

This is a blow to encouraging private investment in unquoted trading companies, at a time when many individuals are keen to reduce their income tax liabilities with the 50% top rate of tax applying for high earners from 6 April 2010.

There is likely to be some resentment to this change of HMRC interpretation in the venture capital and private equity industries. There is likely to be some consternation that partnership structures will not be allowed for EIS fund-raisings even though such structures are allowed for Venture Capital Trusts (VCTs) investing in qualifying companies. A call may come from these industries for the EIS legislation to be brought into line with the VCT legislation in relation to qualifying companies, to enable partnership structures to be used once again for EIS fund-raisings.

HMRC has decided that it will not apply its new interpretation retrospectively. If the relevant shares have been issued on or before 9 December 2009, investors' EIS relief will not be withdrawn where partnership structures have been used as long as either HMRC has issued compliance certificates or HMRC granted provisional approval for that share issue.

Draft Legislation on Specific Changes to the Venture Capital Schemes

HMRC has published draft legislation to implement changes to the EIS and VCT rules, and has asked for comment by 1 February 2010.

There are four specific changes which are required to maintain state aid approval from the European Commission for the schemes :

a new requirement that to qualify under either scheme, a company must not be in difficulty;
the current requirement that to qualify under either scheme a company must carry on its qualifying trade wholly or mainly in the UK, to be replaced with a requirement that the company must have a permanent establishment in the UK;
the current requirement for a VCTs shares to be included in the Official UK list, to be replaced with one that their shares must be traded on an EU regulated market; and
the current requirement that a VCT must hold at least 30% of its qualifying holdings by value in qualifying ordinary shares to be increased to 70%.

HMRC has also proposed a new definition of the size of a company that can benefit under the schemes, to be aligned more closely with the European Commission definition.

Comment

Apart from the proposed new definition of size for qualifying companies, all of these proposed changes were expected, having been first announced when the schemes obtained formal state aid approval from the European Commission in April this year.

The most significant proposal is for companies to be able to raise funds under the EIS and from VCTs where the majority of their trading activities are not carried on in the UK, which is not the case at present. The only requirement in this respect will be that the company has a permanent establishment in the UK, based on the OECD Model Tax Convention. A permanent establishment is essentially a fixed place of business and could include a branch, office or factory for example. This change should lead to a far greater number of companies qualifying for investment under the venture capital schemes.

The proposal to disallow investment in companies in difficulty (defined by reference to the EC Guidelines on ‘State Aid for Restructuring Firms in Difficulty’) is a response to individuals investing in companies in order to generate a capital loss that can be set off against income.

Risk-Transfer Schemes

New legislation is to be introduced in Finance Bill 2010 to restrict the utilisation of losses arising from certain hedging transactions.

Under normal tax rules a deduction is available for accounting losses arising under generally accepted accounting principles, and is available to offset against all taxable profits earned by the group. New legislation will be introduced whereby, in certain circumstances, losses arising from the hedging of loan relationships and derivative contracts will only be available to offset against future profits arising from the same transaction. Broadly the new legislation aims to target those instances where the accounting loss recognised for tax in each individual group entity exceeds the economic loss suffered by the worldwide group in respect of these transactions.

This new legislation will be effective for all accounting periods beginning on or after 1 April 2010. Where the accounting period straddles this date, the accounting period will be treated as consisting of two accounting periods with the first period ending on the day before the commencement date, and the second period beginning on the commencement date. The new rules will apply to the deemed accounting period beginning on the commencement date.

Comment

The application of these anti avoidance provisions should only apply to large multinational groups of companies who have entered into hedging transactions that meet the specific criteria as set out in the draft legislation. Therefore we would not expect these provisions to have a wide application outside this group.

Plant and machinery leasing: anti-avoidance

The 2009 Pre Budget announced additional anti-avoidance rules introduced in relation to two relatively specific areas of abuse concerned with the leasing of plant and machinery.

The first scheme at which the new rules are targeted are those where lessor companies are potentially able to sell the right to lease rental income without being subject to tax on the full amount of income, whilst retaining the right to claim capital allowances on the full cost of the asset being leased, thus generating UK tax losses without a corresponding economic loss. A variation of the scheme purports to achieve a similar result but with losses being generated from rental rebates. The new rules apply to broadly restrict the amount on which capital allowances may be claimed to the present value of income in connection with the lease brought into account for tax. In addition, the amount of tax deduction allowed for rental rebates will be restricted to the taxable income received in connection with these leases.

The second type of scheme targeted by the anti-avoidance is one broadly intended to turn an initial tax free sum received from the sale of lease rental income (which should be taxed at a later date) into permanent tax free amount by ceasing to be within the charge to tax before the income has been taxed. The new rules will ensure that where a leasing business ceases to be within the charge to tax using scheme arrangements, a capital allowance disposal amount is brought within the charge to tax as if the scheme arrangements had not been entered into.

These measures will have effect for expenditure incurred on plant and machinery on or after 9 December 2009, or for businesses ceasing to be within the charge to tax on or after this date.

Comment

The tightening up of the UK tax regime by introducing this anti-avoidance is understandable, though it does again demonstrate the Government’s lack of success in introducing fair and effective legislation from the outset.

Index Linked Gilt Edged Securities

The government has acted with immediate effect to restrict those companies or groups entering into transactions involving Index Linked Gilt Edged Securities (IGLs) from benefitting from the tax exemption where the inflationary increase in the IGL value is not taxed where the group benefits economically

This is a specific measure aimed to counter situations where companies undertake artificial structured finance transactions that take advantage of legislative provisions enabling a tax free valuation uplift in IGLs which are hedged to reduce the inflationary exposure.

Comment

The government has acted quickly to target specific transactions that seek to abuse legislative provisions in this area by implementing measures that seek to tax the economic gain.