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Post-Budget review: UK tax competitiveness

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Have the Chancellor’s Budget proposals done enough to retain and attract business to the UK? The three key changes concern reductions in the CT rate; changes concerning CFCs including the introduction of an exemption from the CFC rules for financing foreign investment; and the introduction of a patent box regime, whereby income from patent rights is taxed at 10%. The Chancellor’s goal to make the UK’s tax system the most competitive in the G20 is still a little way off but we are now moving in the right direction.

Over 200 years have passed since Adam Smith observed: ‘There is no art which one government sooner learns from another than that of draining money from the pockets of the people.’

While the statement is still true today, what has changed over the past 200 years is that companies are now much more mobile. If they really do not like the tax system, they can leave and a good number have left the UK.

Conversely, companies are also free to return to the UK and may do so if the tax regime becomes more attractive. This is exactly what Chancellor George Osborne hopes will happen following his Budget on 23 March.

But will it work and will the government succeed in attracting businesses back to the UK and dissuade others from leaving?

Sir Martin Sorrell, Chief Executive of advertising group WPP has told the BBC that ‘it looks as though we will make the recommendation’ to return to the UK from Ireland.

UBM and Shire, two other groups that also moved their holding companies to Ireland have also been reported as being interested in the UK tax proposals and will, no doubt, consider their position.

So are the government’s proposals enough?

The key changes

The government is making three important changes:

  • it is reducing the rate of UK corporation tax to 26% from April 2011 and by 1% in following years until it reaches 23% by April 2014;
  • it has listened to representations on the controlled foreign company (CFC) reforms and is now proposing an effective tax rate for financing foreign companies of one quarter of the UK rate (ie, 5.75% by April 2014); and
  • it is still committed to introducing a patent box regime, whereby income from patent rights is taxed at 10%, although there is still no indication they will extend the regime to other intangible property, such as brands or trademarks.

The main rate of corporation tax

It was 1937/38 when the tax rate for companies was last as low as 26%. It was 5s. 0d. in the pound in that year (25% in new money) but increased to 5s. 6d. (27.5%) the following year. During the Second World War the rate rose to 50%. It fell to 40% by the early 1970s, rose to 52% between 1975 and 1983 and has since fallen, reducing to 28% in 2008.

So the rate of tax itself is not the reason for leaving the UK because it is the lowest it has been for 70 years.

Therefore, reducing the rate of tax will certainly make the UK more attractive to new businesses from higher taxed countries and there will be more higher taxed countries to move from now that our rate is falling.

The CFC rules

However, the CFC rules and their impact on the way in which UK groups can finance their overseas operations has been a bugbear of the UK system for many years. Non-UK groups have been able to circulate capital around their foreign subsidiaries using overseas financing companies without creating tax under CFC provisions.

The UK CFC rules have prevented UK groups from being able to do the same until now and this has put the UK at a disadvantage when compared not only to countries with no comprehensive CFC regimes, such as Switzerland, Ireland and the Benelux countries, but also at a disadvantage in relation to countries such as the US that do have extensive CFC provisions but also exemptions for intra-group financing income.

The US only ‘invented’ income tax in 1916 (just 117 years after William Pitt the Younger had introduced income tax in the UK to fund a disagreement with France). Nevertheless, it soon caught on and the US introduced CFC rules in 1962 under ‘Subpart F’ of the Tax Code.

The UK followed the US lead on CFC provisions with its own version coming into effect on 6 April 1984.

Initially the UK rules were only aimed at the most egregious cases, with a generous list of excluded countries (reduced by 16 countries by the second version of the list), a lower level of tax of 50% of the corresponding UK tax rate (subsequently increased to 75%) and an acceptable distribution policy test of a 50% distribution for trading companies (increased to 90% for all companies and then abolished).

So as time passed the UK CFC rules changed from lamb to lion, dissuading all but the most intrepid overseas groups from using the UK as a location from which to invest abroad.

But there is now light at the end of the tunnel. The UK is to introduce an exemption from the CFC rules for financing foreign investment. Provisions with similar effect have been included in US tax legislation for many years in the ‘same country’ exemption and in more recent years in the so-called CFC related payment look-through rules.

So the UK announced changes to financing foreign group companies, with an effective rate of tax of one-quarter of the UK tax rate, is very welcome and now makes the UK almost as competitive as the US in this respect.

The patent box regime

Intangible assets are a big part of British businesses as the power of the brand is visible in every household in the land. Intangible assets are also easily relocated or located into lower taxed jurisdictions.

The patent box regime, announced by the previous government, but still being supported by the present coalition, is welcomed but it is too narrowly focused.

To be truly competitive the UK still needs to include brands and trademarks within the scope of these provisions and encourage rather than discourage major brands groups to establish themselves in the UK.

A further consultation paper is to be published in May 2011 setting out the detail of how the new regime will operate and draft legislation is promised for autumn 2011.

The new regime will start from 1 April 2013. To date the government has indicated that a 10% corporation tax rate will apply to profits from patents first commercialised after 29 November 2010. But the patent box will apply just to patent rights.

The proposed 10% rate of tax for income from patents is certainly a lower level of tax, but it will not make the UK as attractive as, for example, the Benelux countries, although it will significantly reduce the tax savings of moving there from the UK.

Still a little way off...

In conclusion, the Chancellor’s goal to make the UK’s tax system the most competitive in the G20 is still a little way off but we are now moving in that direction.

Paul Smith, Head of International Tax, Grant Thornton