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Is it one step back, two steps forward for corporation tax?

Author: ICAEW Insights

Published: 26 Apr 2021

Newcastle University’s Tracey Wilson, who specialises in tax and financial reporting, reflects on the reintroduction of a tiered system of corporation tax, its complexities and effectiveness and alternative models of taxing business.

Announced at the Budget, from April 2023 the corporation tax rate for the most profitable companies - those earning £250,000 or more - will rise from 19% to 25%. Small companies with profits of up to £50,000 will continue to be taxed at 19%, and there will be tapered rates between 19% to 25% for the businesses that fall between the thresholds.

The government describes the change as a “fair way to deliver more sustainable public finances” while protecting the UK’s competitive position.

In his Budget speech, the Chancellor confirmed only 10% of companies would pay the higher rate and that approximately 70% (1.4m businesses) would remain unaffected. He added that the 25% corporation tax would still be lower than fellow G7 members the US, Canada, Japan, France, Germany and Italy.

With a huge budget deficit amid the coronavirus pandemic, the government is having to perform a balancing act, providing support and incentives to encourage economic recovery and growth while seeking to bolster public finances.

Still, the planned change to the corporation tax rate is significant and has the potential to adversely impact UK economic growth, investment levels and entrepreneurship, according to Tracey Wilson, a senior lecturer at Newcastle University’s Business School who is researching the effectiveness of corporate tax incentives on growth for her doctorate.

Tax complexities

In 2015, the small companies’ rate of tax was abolished and replaced by a unified rate that applied to all companies. Previously, the small companies’ rate applied to profits under £300,000, the main rate to profits over £1,500,000 and marginal relief was available to companies whose profits fell between the upper and lower profit limits. Critics argued that this three-tiered approach created additional complexity to the system and disincentivised small company growth, says Wilson.

“The new proposals will inevitably see the re-emergence of the previous problems associated with the three-tiered system. Furthermore, given that the new upper and lower profits limits of £50,000 and £250,000 respectively are considerably lower than previously, more companies will end up paying tax at the main rate”, explains Wilson. She adds: “The rationale for re-introducing a tiered rate system remains questionable.”

She suggests that there is an assumption in the creation of the tiered approach that only small companies have small profits. “This might not be the case,” she says. “You might have bigger companies with large expenditure having profits of less than £50,000. By adding this layering effect for the rate of corporation tax under the new proposals, you’re adding additional complexity to the system.”

The 25% corporation tax rate might also be a disincentive for some companies to invest, Wilson says, pointing out that empirical evidence suggests that corporation tax is the most economically distortive tax.

“It might lead to profit shifting or organisations leaving the UK because the rate is deemed to be too high,” she adds.

There is also a potential interaction with the super-deduction announced alongside the changes to corporation tax. Created to incentivise investment, the two-year measure introduced on 1 April 2021 will enable companies to claim 130% of the cost of qualifying plant and machinery in tax deductions.

Wilson says the extent to which the super deduction will provide a much-needed boost to UK investment depends on whether the benefits of the enhanced tax relief outweigh the risks of investing in times of uncertainly. Furthermore, the complexities linked to the operation of the super-deduction, particularly in relation to the asset’s subsequent disposal, require careful consideration.

She points out: “Disposal proceeds will be treated as balancing charges on the subsequent disposal of assets rather than the normal deduction from the plant and machinery pool. The rules relating to disposal proceeds differ depending on whether the disposal takes place pre or post 1 April 2023. These additional considerations will need to be factored into the decision-making process.”

Alternative options

During her research on corporate tax incentives and growth, Wilson has also looked at various potential alternatives or reforms to the corporate tax system.

She says the current corporate tax system is biased towards debt financing, with interest being tax-deductible, and no equivalent deduction for the cost of equity. One alternative, a cashflow-based model, aims to overcome this bias as “companies would be taxed on their net cash inflows from operating activities, plus the proceeds from the sale of any capital assets with allowable deductions for capital expenditure,” explains Wilson.

She adds: “Essentially, companies would claim 100% deduction for capital expenditure as incurred. The debt bias would be eliminated from investment decisions as interest would not be tax-deductible under the cashflow model”.

A second proposal relates to a dividends-based tax system, similar to the current Estonian tax system. Here, corporation tax is charged at the point when profits are paid out to the shareholders in the form of dividends. Profits retained within the business remain tax-free, increasing the amount available for additional business growth, she says.   

A third option that has previously been suggested is a sales tax aimed at preventing multinational tax avoidance. Wilson says: “A sales tax works on the basis that whilst profits can be shifted, sales can’t, which could offer an alternative way to try to get multinational companies to pay tax in the countries that they actually operate in.”

However, she also points to potential challenges with this approach. “It assumes that a company with high turnover has high profits. For companies with very low margins, potentially the additional tax may turn that company from a profitable to a loss-making one,” she explains.

“This issue could be resolved by introducing different rates for different types of industries to try to overcome the problem that some industries are more profitable than others. However, that would mean introducing an extra layer of complexity into something that was designed to be simpler to operate.”

In April 2020, the UK implemented a digital services tax (DST) and other countries have been introducing their own equivalents, while the Organisation for Economic Cooperation and Development (OECD) is working towards a global framework for taxing digital services. Wilson says: “A key issue surrounding the implementation of a DST is that countries have been quick to adopt unilateral measures to tackle a multinational problem.”

She also highlights that as the tax is currently predominantly on US-based multinationals, there could be a risk of retaliation from the US, such as through trade tariffs.

She adds: “Is the DST an effective way of getting the multinational companies to pay their fair share of tax? Government estimates suggest that the UK DST will raise over £400 million a year from 2021/22 onwards, a much-needed boost to the public purse. However, early indications suggest that some multinationals will pass the cost of the tax on to the consumer. Ultimately then it’s the individual consumer that suffers rather than the multinationals for whom the tax is intended.”

Reflecting on the options and the UK’s strategy to encourage growth and competitiveness, Wilson concludes: “It will be interesting to see how the corporation tax rate change pans out in the next couple of years. It does feel like a U-turn in tax policy given the previous commitment to lower taxes to boost economic growth.

“If the increase in the rate of corporation tax can raise more revenue for the Treasury without adversely harming economic growth, then these measures have got to be a good thing. However, it remains to be seen whether the previous problems associated with high tax rates come back into play.”

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