‘Myriad knock-on consequences from increase in the UK’s corporation tax rate’

Introduction

The CIOT is hosting the 14^th Young International Corporate Taxation conference (https://www.tax.org.uk/14thyoung) on Thursday 23 September and Friday 24 September, virtually by Zoom. I first presented at this event over a decade ago (even then my colleagues queried the 'young' description…) and it is my pleasure to be moderating sessions at this year’s event as well as presenting on the practical implications of the increase in the UK’s corporation tax rate.

This blog sets out two key issues that arose from my preparation for the conference in terms of the broader consequential impacts of a material rise in the CT rate:

1. Will the change raise more money for the Exchequer?
2. What are the likely knock-on impacts for the UK’s tax regime (and, crucially, do they apply evenly as between different types of taxpayer)?

I should stipulate two caveats up front: first, this blog assumes that the corporation tax rise in April 2023 comes into effect as legislated for in the Finance Act 2021; and, secondly, this blog is not in any way intended as a political commentary on whether increasing corporate taxation is the right thing for the Government to do to balance the books. I do, however, support evidence-based policy making which is clear for taxpayers to understand and simple to apply.

Is there evidence that an increase in tax rate increases tax proceeds?

On 3 March 2021, Rishi Sunak, the Chancellor of the Exchequer, announced that from 1^st April 2023 the corporation tax rate will increase from 19 per cent to 25 per cent. This is an increase of more than 30 per cent in terms of the headline tax rate itself and is also the first increase of the corporation tax rate in my lifetime (even though I am no longer quite as young as I once was). It is therefore untested in the modern UK corporate tax environment, if not exactly unique in a global or historical context.

According to Budget red book, the corporation tax rate increase is forecast to raise an additional £11 billion – £17 billion per year from 2023 onwards, which is roughly a 30 per cent increase in corporation tax so assumes the same profits will be subject to tax just at a higher rate. The Government is correct to point out that the 25 per cent rate remains competitive when compared to other G20 economies’ headline corporate tax rates. But will it in fact raise any more money for the Government?

If I had been writing this back in the 1980s (when I really was young), I might have pointed to the Laffer Curve and argued that to maximise tax receipts the UK ought instead to be considering rate cuts. Arthur Laffer formalised the theory that the relationship between tax rates and tax collected follows an inverted U-shape. Or to put it another way, that putting the tax rate up beyond a certain point can actually reduce the amount of tax collected overall.¹ This blog considers whether the UK may be approaching this tipping point.

There have been numerous critiques of this view of tax rates and behaviours, not least that the curve does not specify any actual rates. However, as it happens, corporation tax receipts have materially increased since the rate has been reduced to 19 per cent, at least until the pandemic lockdown in 2020. Partly this is due to increased economic activity. It is also a consequence of the effective tax rate (ETR) not decreasing to the same extent as the headline tax rate.

The tax base has expanded in many ways, from disallowances of expenses and timing differences. The corporate interest deduction is one example of a change to UK corporate taxation which, by reducing the extent to which financing costs are deductible, increases the ETR of UK companies. If the combined impact of these changes to the UK’s tax code over the past few years stands at, say, a five per cent ETR increase (which seems to be borne out by the corporation tax receipts over this period) then the actual ETR once the rate rise comes into force could be more like 30 per cent. Banks are subject to subject to an eight per cent surcharge (although this seems likely to be reduced prior to the rate rise coming into effect), so as it currently stands subject to a headline rate of 33 per cent on banking profits and an ETR which could be materially higher. The ETR sits less easily with the Budget description of ‘the UK’s strongly competitive position as the nation with the lowest corporation tax rate in the G7’.

In an international context, many countries impose a higher headline rate of corporation tax and still collect plenty of tax revenues. However, (often smaller) countries which impose a lower corporate tax rate to attract mobile inbound investment, such as Ireland, are fully aware that increasing the rate of tax does not necessarily increase the amount of tax collected. A rise in rates could in fact lead to lower tax proceeds if business that could be based or carry on business in the UK move elsewhere (especially coming hot on the heels of the UK’s departure from the EU).

Consequently, it is not a given that increasing the rate of corporation tax will increase receipts in the same 30 per cent proportion as the rate rise; receipts may increase by a much smaller amount or, in an extreme scenario, potentially even decrease. The knock-on consequences to the UK’s tax code of the rate rise should be considered in this context.

Domestic tax impacts

Reliefs

The 130 per cent ‘super-deduction’ for research and development (R&D) expenditure attracted many headlines. What was under-reported is that this was necessitated by pre-announcing the future rate rise. R&D investment in the UK may otherwise have been delayed until the introduction of the higher rate in order to offset those costs against more highly-taxed profits. The super-deduction increases the value of the deduction such that, if taxpayers can leap the anti-avoidance hurdles, 130 per cent x 19 per cent = 24.7 per cent, nearly equivalent to the value of deductible expenditure once the rate rise has been implemented in 2023. This neatly illustrates the taxation gymnastics required to neutralise the impact of the rate change (which has not even been implemented yet) on the R&D regime, one discrete area of UK tax law.

The diverted profits tax rate will increase to 31 per cent in line with the corporation tax increase. But what of special regimes which entail a lower rate of corporation tax? The patent box regime involves, very broadly, a 10 per cent corporation tax rate being applied to profits made from exploiting patented inventions in the UK. Assuming this rate remains the same, the differential between the taxation of patented invention profits and other profits will increase, thereby increasing the demand to fall within the patent box regime wherever available.

Exemptions

Exemptions from corporation tax, such as the substantial shareholding exemption or chargeable gains rollover or reorganisation relief, become more important in an environment where the amount of tax saved is higher. The same is true for intra-group reorganisations which are eligible for tax neutral treatment. But will the desire of taxpayers to benefit from these exemptions be met with sterner scrutiny by HMRC?

Increase in challenge and litigation

Put simply, when there is more tax at stake, the additional cost to taxpayers warrants further focus by C-suite executives. HMRC may also be motivated to raise enquiries if more tax is at stake, such as on a transfer pricing matter where the ‘right’ price might validly fall within a range and the taxpayer has specified a price that is not at the same end of that range that HMRC might prefer to see. What if the expected additional corporation tax receipts in fact do not arise as forecast, as discussed above? Will there be further pressure on HMRC to challenge taxpayers to balance the books? The relationship which taxpayers have built up with HMRC may come under strain as a result. All of this seems to make disputes and, potentially, litigation more likely. The higher rate could also have an impact on the interpretation of the law by the courts – as a huge generalisation, some key decisions in favour of taxpayers have been handed down at a time when much higher tax rates applied.

Simplicity and fairness

A key question is whether the knock-on effects of the rate rise affect businesses equally and, if not, whether this is the policy intention.

SMEs

Small businesses with profits below £50,000 will continue to be taxed at 19 per cent. A sliding scale of taxation applies to profits up to £250,000, above which the new 25 per cent rate will apply. As well as adding to the complexity of calculating tax liabilities by applying multiple rates of corporation tax, could the higher rate have an unintentional impact of disincentivising smaller businesses from expanding?

Incorporating business

Incorporated businesses with individual owners, a structure common among tradespeople for example, seem to bear a disproportionate burden of the rate rise in the event that their taxable profits exceed the £250k threshold. The rate rise leads to higher tax on companies, that much is clear. The rate of income tax which applies to dividends is lower than the rate applied to earned income to reflect the fact that the income has already been taxed once in the hands of the company. One might expect the rate of income tax applicable to dividends would be reduced to compensate. Not so, if the recently announced 1.25 per cent rise in income tax on dividends (alongside the national insurance contributions rise) is an indication of government thinking in this area. The combined rate rises result in an effective marginal tax rate of approximately 55 per cent for additional rate taxpayers receiving dividends from their (corporate) businesses. This looks to be an example where impact of the rate rise could be borne unevenly between different types of legal structure carrying on the same business, and disincentivise incorporating business.

International impact

The international impacts are many, including in relation to controlled foreign companies and overall tax planning. Notably, however, the increase in UK taxation may be less important for multinational corporations headquartered outside the UK which can credit UK tax against tax in their home country. That could potentially disadvantage UK headed groups vis-à-vis non-UK headed groups, although it could potentially also have the effect of collecting UK tax at the expense of other tax authorities.

On the other hand, the UK’s corporation tax rate increase sets a higher ceiling for the creditability of non-UK tax on profits derived abroad but paid to the UK (such as withholding tax on interest or royalties), which could have the converse effect of enabling other countries to raise taxes at no net expense to UK-headed groups. A side effect may be to make the dividend exemption and branch profits exemption less valuable if subjecting those profits to corporation tax permits more foreign tax to be utilised.

Conclusions

The increase in corporation tax rate is more than merely a mathematical adjustment. Rather, myriad knock-on consequences arise. Some of those consequences have the potential to make the UK’s tax system more complicated at the expense of certainty and fairness of taxation between different taxpayers. The nature of taxpayers’ relationship with HMRC and judicial attitudes to the interpretation of tax legislation may change over the coming years due to the change. The practical implications of the corporation tax rise are therefore more varied and complex than might first meet the eye.

Guest blog by Martin Walker, Principal at ADE Tax ([email protected])

Notes for editors

1. See Laffer Curve Definition (investopedia.com)