The Changing Face of UK Taxation
01 January 2008
A Labour government has now been in power in the UK for 10 years. How have things changed in a fast moving international environment and against the background that a previous Labour chancellor pursuing socialist policies in the 1960s had promised “to squeeze the rich until the pips squeak”? What has New Labour delivered on the tax front?
During the 1960s and early 1970s, income tax rates were breathtakingly high, capital gains and corporation tax were introduced, and the dividend regime was changed from a withholding tax system to an imputation system with ACT being paid to frank the shareholders’ tax credit.
The late 1970s and 1980s saw a switch to a lower tax economy, enormous growth in London as a financial centre and the increasing importance of the multinational. The UK was completing its switch of emphasis from an industrial economy (evidenced by the 1970s focus on capital allowances to encourage investment in modern machinery) to a service economy.
In the early 1990s came some new legislation to deal with financial instruments and corporate debt, as well as a series of anti-avoidance rules to deal with international and domestic tax avoidance. Whereas previously avoidance might be said to have been driven by unreasonably high tax rates, new tax planning ideas tended to come from the City’s ability to innovate in seeking the cheapest possible source of finance as well as from the cross fertilisation of ideas and tax mismatches between jurisdictions.
The four decades had thus seen frantic activity – with much tax reaction and counteraction.
TIME TO DRAW BREATH
Probably the most important feature of taxation under “New” Labour has been an acknowledgment of the importance of business and the clear desire to create an environment in which domestic and multinational business would flourish. Many of the changes made have been pragmatic in recognising that the UK has to exist in an internationally competitive environment.
CHANGES ON THE DOMESTIC FRONT
Domestically the effect of the move to a more accounts-based regime has been to reduce the number of book/tax differences and make the tax payable more transparent (even as accounts themselves have become more impenetrable).
The limits of broadening the domestic tax base in legislative terms have now, however, probably been reached.
ATTRACTING AVOIDANCE
To raise more tax to find increased public spending or, in the phrase of the time, “make sure everyone paid their fair share” – the modern wave of corporate avoidance also had to be tackled.
Avoidance can be motivated by different things – but, in the corporate sector, peer group pressure counts for a lot. If a domestic competitor’s effective tax rate is lower than yours, the assumption would be that they were proactive and had got things right whereas you were sluggish and not doing the best for your shareholders. If an international competitor’s rate is lower, questions would be raised as to whether you were in the right place.
The growth of domestic tax avoidance in the corporate sector meant that the government was perpetually playing catch-up and each budget was tinged with sadness (a scheme that you were not aware of killed before you could use it) and joy (no challenge to something that had been implemented).
At some point, this merry-go-round had to come to an end and the disclosure regime, brought in after full consultation and with great care, has been a success. Most of its success has arisen from its moderation and the sense that professionals and bankers need to operate the regime in a way that preserves a balanced relationship with HMRC or much worse will follow.
THE NEW DEAL
At the same time, HMRC realised that it had to change the corporate culture and again, there has been some success. Attempting to assert that there was a moral aspect to paying tax is all well and good in the sphere of personal taxation, but it cuts little ice in the commercial sector where companies are custodians of their shareholders’ funds and subject to many other pressures that make “voluntary giving” a less easy decision. The relationship with HMRC needed to be looked at like any other business relationship – pay what you had to, consistent with gaining the best out of the system and avoiding continual fights if you could.
So, at the operational level, HMRC are trying to understand business better and taxpayers are benefiting from the more open approach. There is a new realism which means that, in many cases, small things get cleared up more quickly. But that is not where the big bucks are. Big things can still get referred and blocked centrally (transfer pricing and CFC disputes being good examples of that) and there are still no significant tangible prizes for good behaviour. There are no tax discounts on offer and HMRC have a statutory obligation to treat all taxpayers equally – even the ones who are not perceived to have toed the line – so the jury is still out on how much business is really benefiting from the new approach to tax collection.
HMRC’s attempts to establish a more direct relationship with business (its customers) all inevitably lead to a focus on the activities of intermediaries. The fact that “intermediaries” may now be less well regarded reflects some of the changes that have taken place in the professions over the years. The marketing of tax schemes and payment by results does tend to reinforce any prejudice. That is a pity because the vast majority of professional advice is directed at wanting to make sure that business is able to function properly while paying the right amount of tax.
UNWELCOME INTERFERENCE FROM EU FREEDOMS
One of the most difficult things for HMRC to grapple with during this period has been the inroads that the ECJ has made into UK taxation. As the government has tried to get more out of the UK system without changing the rates (the current focus being very much in the international area), HMRC must have felt that someone with an ECJ application in the other hand was drilling a hole through the bottom of their bucket.
The ambulance-chasing mentality of EU litigation has certainly caused problems – but so has HMRC’s apparent unwillingness to seek immediate solutions, fighting every battle to the last, almost as if it were in denial that the EU treaties should have any impact on taxation at all.
In some respects, one has sympathy for HMRC. It is clear that the EU treaties were drafted without any great thought being given to the impact on taxation. Had the tax issue been addressed, there is no doubt that specific tax provisions would have been put it in.
So, we have seen our domestic rules having to become more complicated simply to make sure that we could defend them internationally (domestic transfer pricing and thin capitalisation) – with some sense now coming back into the system as the ECJ has accepted not only that there must be freedom of movement in the relevant areas but also that jurisdictions have the right to protect themselves against tax avoidance.
TAX LITIGATION
The natural response to artificial tax avoidance schemes during the 1970s and 80s had been more tax litigation and an attempt through the courts to find a magic bullet that would strike down all tax-motivated transactions.
Eventually, however, the courts have come round to the view that tax needs to be clear and certain. So the plain words of the statute must be applied to the facts – and opportunities to recharacterise transaction or interpret legislation liberally are limited. It is not the place of the courts to rewrite tax law to cover situations that, had they been known about, would “certainly” have been caught. Where the statute is unclear or ambiguous, however, resort can be had to purpose to aid interpretation.
Litigation remains nevertheless a time-consuming and uncertain process for resolving complex problems.
MORE UNCERTAINTY IN LEGISLATION – MOTIVE TESTS AND TARGETED ANTI-AVOIDANCE
The attempt in the early 80s to introduce a general anti-avoidance rule (which failed largely because HMRC realised that they could not offer it, as initially promised, with a clearance system) has now been replaced by targeted anti-abuse rules in most new legislation that comes through. Targeted rules are better than a general rule because they tend to be more focused but, to the extent that they concentrate on motive, they create great uncertainty and give HMRC too much discretion. The major problem here is in finding a sensible comparator on which to base the answer to the question whether or not less tax is being paid than “ought to be”.
ARE CLEARANCES THE ANSWER?
A review is under way currently to see whether or not we can have a more general clearance system. There are profound
difficulties in that. HMRC are very good in dealing with major transactions at present and giving business the certainty that it can – recognising, of course, that there are limits both under the law and in terms of being obliged to give the same treatment to all. Whether it will be possible to introduce a clearance regime covering all areas of taxation and without professional negligence costs being reduced to virtually zero because advisers stop giving advice and simply compose safety net clearance applications to HMRC remains to be seen. HMRC may be expecting needles but it is likely to receive haystacks.
THE EFFECTS OF INTERNATIONAL CHALLENGES
History and the position of the City as one of the world’s major financial centres has given the UK more than its fair share of multinationals.
Multinational taxation has, however, been something of a rollercoaster ride in recent years. In some respects (no interest allocation rules requiring debt to be pushed offshore, a manageable CFC regime, flexibility on mixing foreign tax credits and a good treaty network coupled with no withholding tax on outbound dividends), the UK had an attractive tale to tell. There are other areas (ACT until abolished and the lack of a full
participation exemption on capital gains) where the story was less happy, but fighting head to head with other jurisdictions, the UK often won out on international mergers.
There are signs, however, that this may be about to change and this is a very dangerous development for the UK multinational community – especially when continental European regimes are often more generous or more benevolent in relation to the taxation of non-domestic earnings and passive income.
As regards inward investments, the UK has had a good track record despite the geographical disadvantage of not being part of mainland Europe. Tax is only one of a number of factors that comes into making investment decisions but it is an important one. A 28 per cent domestic tax rate and linking tax more to accounting profits will do no harm – but rules that seek to restrict interest deductions below levels which, on a fair and objective basis, seem proportionate and reasonable to the business carried on here will do no good if they are pursued aggressively. One of the great selling points of the UK in recent years has been the ability to get sensible certainty in reasonably short order on how a UK operation should be funded.
On outward investments, HMRC’s focus for increasing tax yield is in the cross-border area (including transfer pricing and a less relaxed attitude in relation to CFCs). A particularly harsh line is being taken following the ECJ decisions in the Cadbury and FII GLO cases. The proposal is that CFC rules should be broadened to pick up not only all true passive income but also phantom income attributable to brand or IP value. The extent to which a company can be said to have a “good” business establishment in another EU jurisdiction is far more limited than Cadbury would suggest it ought to be. UK based multinationals are talking about effective tax rates going up by 5 to 10 per cent if these proposals are not sensibly revised.
There is a feeling at present that HMRC and the Treasury may be playing poker with the multinational community and that cannot be a good thing. If the impression develops that the UK is not sympathetic either to inward investments or to multinational companies based here, then it will be quite difficult to reverse that impression as business reacts to the sentiment. It would be surprising if business is not listened to on these points.
Companies – like individuals – can leave, a fact that has just been recognised by the government resisting appeals to tax non-domiciled people living in the UK in full and deciding to impose instead an annual fee for the privilege of retaining the benefits of the current remittance regime. No signs of squeezing the lemon too much there!