REV/ C&E 1

27 November 2002

A MODERN AND COMPETITIVE BUSINESS TAX SYSTEM

Further steps to remove distortions in the tax system and tackle market failures, to ensure that business decisions are made for commercial reasons, were announced in today's Pre-Budget Report. The steps will also reduce the tax and compliance burden on business and maintain an efficient tax system that reflects the realities of today's business environment.

Steps announced today include:

introduction of a statutory corporation tax deduction for the cost of providing shares for employee share schemes, for accounting periods starting on or after 1 January 2003, to further encourage employee share ownership;
abolition of North Sea Royalty with effect from 1 January 2003, delivering a significant boost to companies and creating a stable long-term framework for investing in the North Sea; and
a consultation on reform of the Construction Industry Scheme, to reduce the regulatory burden on construction businesses.

In addition to these steps, the Government is also:

consulting on options for reform of corporation tax. Over 150 responses to the consultation document published in August 2002 have been received. The Government intends to consult further when the responses have been analysed;
publishing draft legislation and guidance in respect of the measure, announced in Budget 2002, to modernise the taxation of foreign companies operating in the UK through branches, for accounting periods starting on or after 1 January 2003;
taking forward work to replace the offshore funds tax regime with new rules in Finance Bill 2004. The Government is committed to continuing constructive dialogue with fund managers and other stakeholders on the implementation of a new regime;
making further changes to the rules on deduction of tax at source on interest payments;
making changes to the approach followed when recognising overseas stock exchanges for tax law purposes; and
retrospective legislation to ensure that subsidiaries of UK companies in the Hong Kong and Macao Special Administrative Regions of China continue to be able to benefit from the Exempt Activities Test in the controlled foreign companies rules in cases where it was always intended that they should.

In addition to the announcement in September to stop unfair tax avoidance through the exploitation of the financial instrument rules, the Government is also setting out a number of other steps being taken to protect UK revenue and tackle abusive tax avoidance schemes, including:

immediate legislation to stop companies abusing the rules governing commercial property development to avoid paying VAT on the sale of new freehold buildings;
immediate legislation to counter the avoidance of tax and national insurance contributions through the abuse of Employee Benefit Trusts;
legislation to close, for accounting periods beginning on or after today, a loophole in the rules for controlled foreign companies, which allows some companies selling extended warranties, credit protection and similar products to escape UK tax on the profits; and
immediate legislation to stop businesses from exploiting the rules on capital allowances by entering into artificial transactions which accelerate capital allowances on their qualifying expenditure.

Further information on other business tax reforms is provided in the separate press notices REV/ HMT/ C&E 1 and C&E 1.

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DETAILS

Corporation tax (CT) and employee share schemes

Currently employers are not guaranteed a CT deduction for their employee share schemes. Instead there is a mixture of statutory and ?case-law? routes by which a deduction might be obtained. Following widespread support during informal consultation in summer 2002, the Government is introducing a statutory CT deduction for the cost of providing shares for employee share schemes. This will provide companies with the certainty of getting a CT deduction, and encourage more companies to set up employee share schemes.

The statutory CT deduction will be available for employee share schemes where the employees are subject to UK tax on award of shares, or would be but for the fact that the shares are obtained under an Inland Revenue approved scheme or Enterprise Management Incentives. This makes the UK regime more generous than the US, where the CT deduction is limited to the amount taxable on the employee. Smaller companies in particular will benefit from the certainty of the CT deduction when offering share participation to their employees. They will not need to set up complex and expensive trust structures in order to generate a CT deduction for the cost of shares.

The rules relating to Qualifying Employee Share Ownership Trusts (QUESTs) are being changed at the same time to remove duplication and simplify the statutory rules for the CT treatment of share schemes. Companies using QUESTs for Save-As-You-Earn schemes will continue to receive a similar deduction under the new rules. In addition, CT benefits currently enjoyed by small family-owned companies using QUESTs will be preserved by the provisions of the Employee Share Schemes Act 2002 that made some changes to the CT provisions in the Share Incentive Plan legislation.

North Sea Royalty

The decision to abolish North Sea royalty payments forms part of an overall package to create a stable long-term fiscal framework for the next stage of development of the North Sea.

Budget 2002 introduced important measures to modernise the taxation of the North Sea, so that from Budget day:

companies pay a 10 per cent supplementary charge on North Sea profits; and
companies will receive a 100 per cent first year allowance for capital expenditure in the North Sea to promote investment.

Reform of the Construction Industry Scheme (CIS)

The Government is seeking views on a series of new proposals to reform the CIS. The proposals respond directly to concerns from the industry about the current CIS, and fulfil three key objectives:

to reduce the regulatory burden of the scheme on construction businesses;
to improve the level of compliance by construction businesses with their tax obligations; and
to help construction businesses to get the employment status of their workers right.

The main proposals are:

to replace Registration Cards and Gross Payment Certificates with a verification service;
to introduce an employment status declaration;
to replace vouchers with periodic returns; and
to replace the Inland Revenue computer system with a new system capable of supporting the use of e-services and helping to trace non-compliant businesses.

A partial Regulatory Impact Assessment published today shows that proposals are set to cut industry costs by between 50 and 70 per cent compared to the current scheme.

Reform of Corporation Tax

The Reform of Corporation Tax, published in August 2002, sought views on three potential additional reforms. These were:

the tax treatment of capital assets not covered by earlier reforms;
rationalisation of the UK's schedular system of taxation; and
the differences in the tax treatment of trading and investment companies.

The consultation process included a series of meetings with groups from business and representative bodies. Over 150 formal written responses to the document have been received and the Inland Revenue and the Treasury are now in the process of reviewing those responses.

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Modernising the taxation of foreign company branches

Budget 2002 announced the introduction, from 1 January 2003, of a measure to modernise the taxation of foreign companies operating in the UK through branches. Under this measure an amount of capital will be attributed to a UK branch for tax purposes, based on the capital that would be needed if the branch were an independent, free-standing company trading in the UK in the same or similar conditions and circumstances.

The Inland Revenue published draft legislation on 25 July 2002 and has since consulted interested parties on the practical details of this legislation and its implementation. Building on these constructive discussions, the Government is now publishing updated draft legislation and draft guidance. The Government will shortly publish a partial Regulatory Impact Assessment. This will help ensure a smooth and timely implementation, delivering certainty and consistency going forward.

The draft legislation, guidance and partial Regulatory Impact assessment have been published today, and are available on the Inland Revenue website.

Offshore funds consultation

Respondents to the recent consultation on the offshore funds regime were unanimous in wanting change. The majority ruled out abolition, favouring reform or replacement of the current scheme.

The introduction of a replacement regime, rather than adapting the existing rules, received clearest support. Respondents suggested a number of ways such a regime could be designed.

The Government remains committed to a tax system that does not create obstacles for providers or impede fair competition. In particular, the tax rules should be simple for providers and consumers. Work is therefore being taken forward to replace the offshore funds tax regime with new rules to ensure that investors in offshore funds and equivalent UK products are subject to similar tax treatment.

Deduction of tax at source on interest payments

The Government will introduce legislation, to come into force on 1 April 2003, to ensure annual interest payments made by recognised clearing houses and recognised investment exchanges while providing central counter-party clearing services can be paid without deduction of tax at source.

The Treasury has today made an Order to allow annual interest and other payments to UK tax-exempt bodies via nominees to be paid without deduction of tax at source in circumstances where direct payments could be made gross. This will take effect from 1 December 2002.

Recognised stock exchanges

The Inland Revenue is today publishing a policy statement setting out the approach it will follow when recognising stock exchanges outside the UK for tax law purposes. The statement is available on the Inland Revenue website.

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Tackling tax avoidance

Measures announced today to protect the revenue and prevent tax avoidance include:

closing the loophole on VAT and freehold buildings. The sale of the freehold of a newly constructed commercial building is liable for VAT during the first three years of the building's life (when it is still considered ?new?). However, companies are exploiting a loophole which allows them to pay VAT at the point of payment rather than at the point of sale. These companies then arrange freehold sales with an associated company which delays the bulk of the payment until after the three year period, and effectively purchase the property VAT-free. New legislation will block this loophole;
new legislation on Employee Benefit Trusts (EBTs). EBTs are vehicles through which remuneration and other benefits are indirectly provided by employers to employees. There is evidence that some are being used to avoid paying income tax and national insurance. The new legislation will defer the contributor's corporation tax deduction until a payment is made out of the EBT in a form that gives rise to a liability to income tax and national insurance, and will apply for contributions made on or after today. Changes to the national insurance regulations, which come into force tomorrow, will make clear who has ultimate responsibility for paying national insurance. This legislation will not adversely affect companies contributing to trusts that qualify for relief under the proposed statutory corporation tax deduction for employee share schemes. Draft EBT legislation is today published on the Inland Revenue website;
new legislation on capital allowances. Some businesses have attempted to exploit the capital allowances rules by entering into artificial transactions which depress the market value of their qualifying assets on a sale. The effect of this device is to accelerate the remaining capital allowances relating to those assets, so that the business may obtain a tax advantage. New legislation, effective from 27 November 2002, will block this device by giving no further allowances to the vendor on any shortfall between the written down value and the sale proceeds of the assets, where the purpose of the transactions includes tax avoidance. Draft legislation is today published on the Inland Revenue website; and
new rules on extended warranties and similar products. Extended warranties or service agreements on domestic goods and services, and credit protection insurance on loans are often sold as part of a package. As a matter of law such products are governed by separate contracts from those for the goods or services themselves. Those contracts are sometimes negotiated by a retailer acting on behalf of an associated company located offshore, and in some cases this means that payment of tax that would normally arise under the UK rules for Controlled Foreign Companies (CFCs) can be avoided - see Notes for Editors. The CFC rules will therefore be revised to ensure that profits from these packaged products are taxable for accounting periods of CFCs beginning on or after 27 November 2002. Draft legislation is today published on the Inland Revenue website.

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NOTES FOR EDITORS

North Sea Royalty payments

Royalty is the payment that a company makes in exchange for the right, granted under the licence, to extract oil and gas belonging to the Crown. It is charged at 12½ per cent of the gross value of oil and gas won in a particular licence area, less an allowance for the costs associated with the conveying, treating and initial storage of the oil and gas between the well head and the point of valuation- usually the terminal onshore. Royalty is payable on a licence, not a field, basis. Royalty was abolished in the 1980s for all fields given development consent on or after 1 April 1982. It is administered by the Department of Trade and Industry.

Construction Industry Scheme (CIS)

Special taxation arrangements have been in place for construction businesses since 1972. These arrangements were revised in 1999 but the CIS retains the basic structure of its predecessor, relying on paper vouchers to evidence payments between contractors and sub-contractors.

Following the introduction of the current Scheme concerns have continued about the processes and costs to businesses of complying with it. The Paymaster General therefore announced a fundamental review of the Scheme during the passage of this year’s Finance Bill.

The consultation document and accompanying Regulatory Impact Assessment are available on the Inland Revenue website. In addition the Inland Revenue will be arranging a series of focus groups to talk to construction businesses about the proposals.

Reform of Corporation Tax

The Reform of Corporation Tax consultation document was published jointly by the Inland Revenue and HM Treasury on 5 August 2002. The deadline for responses was 29 October 2002. This consultation follows on from the Large Business Taxation: the Government’s strategy and corporate tax reforms consultation document published in July 2001.

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Offshore funds consultation

The offshore funds regime was introduced in 1984. It governs the taxation of all UK resident investors in overseas collective investment schemes or ‘offshore funds’. Its purpose is to counter the use of particular types of fund to convert income flows into capital gains. Prior to its introduction, a UK resident investor could accumulate income in a particular type of offshore fund and, when the investment was realised, be subject only to capital gains tax rather than having to pay income tax on the accumulating income.

The operation of the scheme has attracted increasing criticism in recent years, not least because of the nature of the compliance obligations a fund has to meet annually if its investors are to preserve capital gains tax treatment on the disposal of their interests. One of the main aims of the consultation exercise has been to identify ways to make the scheme, or any successor to it, more user-friendly while preserving the competitiveness of similar UK investment products.

Both the consultation document and a summary of responses are available on the Inland Revenue website.

Capital Allowances

Capital expenditure (and depreciation) is disallowed in computing taxable profits from a trade, property letting or other taxable source. Capital allowances are given instead for various types of capital expenditure. The rules about capital allowances are contained in the Capital Allowances Act 2001, as amended.

Controlled Foreign Companies (CFCs)

A CFC is a company which is not resident in the UK (but which is controlled to a significant extent by individuals or companies who are) and which is subject to a level of taxation less than 75 per cent of the level that it would have paid had it been resident in the UK. The CFC rules are designed to stop UK companies reducing their tax liabilities by diverting profits to CFCs located in low tax regimes. The rules work by charging UK parent companies of CFCs on an amount equal to the profits that would otherwise avoid tax. There are a number of exemptions from the CFC rules which exclude the vast majority of overseas subsidiaries from the effects of the rules, but these exemptions should not be available where business which really arises in the UK is artificially diverted abroad.

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Pre Budget 2002: Press Notices index