The Inward Investment and International Taxation Review: United Kingdom
Over a number of years, the UK developed a very competitive tax system for business with low tax rates and wide-ranging reliefs and exemptions. However, reductions in tax rates and the introduction of a more permissive tax regime has been accompanied by an increasingly onerous compliance burden, particularly on large business, and this burden risks undermining the UK's competitiveness. Despite the burden of compliance, the UK's tax regime and corporate tax rate remain attractive, but the future of the UK as an attractive business location remains uncertain until the impact of Brexit and the covid-19 pandemic become clearer and can be evaluated.
Common forms of business organisation and their tax treatment
There are many different entities and business organisations through which business can be conducted in the United Kingdom. Numerous factors influence the final choice; notably, market practice in the business sector, regulatory requirements and tax treatment. The most common types are described below.
The most commonly adopted vehicle for doing business in the United Kingdom is a limited liability company. Such companies can be incorporated quickly and cheaply, subject to agreeing the preliminary details such as the names of its officers, its registered address and its name; it is common to buy pre-formed or 'off-the-shelf' companies.
Although such companies can be limited by guarantee or unlimited, businesses generally use a 'limited liability' company, which is liable for all its debts and obligations without limit but where the investing shareholders' liability is limited to the share capital they invest. This reflects the fact that generally, under UK law, a company and its shareholders are separate legal persons. In very limited circumstances, notably where a person seeks to deliberately avoid an existing liability or restriction by interposing a company they control, a court may look through the corporate veil to the controlling person.
There are two forms of limited company: the private limited company (designated with the suffix 'Limited' or 'Ltd') and the public limited company (designated with the suffix 'plc').
Limited companies can issue share capital of different classes, if required, with each share class conferring different rights (to dividends, on voting, etc.). Share capital in a UK company can be denominated in a currency other than sterling. There are no minimum capital requirements for private companies, but a public limited company must have a minimum share capital to comply with UK company law, which is derived from the Second Company Law Directive (77/91/EEC). A UK public company has a minimum capital requirement of either £50,000, and this must initially be satisfied entirely in either sterling or euros (although only one-quarter, or £12,500, of this needs to be paid up, and the company may have shares denominated in currencies other than sterling).
Only public companies can offer shares to the public, so it follows that all listed companies will be plc's. Not all plc's, however, are listed on recognised investment exchanges, or for that matter offer their shares to the public.
In return for providing the shareholders with limited liability, the law requires a degree of disclosure, and limited companies must file annual information that is kept on a public register, notably annual audited accounts (with some exceptions for small companies), details of its directors and shareholders, and details of share transfers.
Unless prohibited by the company's constitution, the directors and the company secretary can conduct the company's affairs and bind it. The directors are subject to statutory obligations that ensure that when they act, they pay proper regard to the interests of shareholders, creditors and employees; thus, for example, if a director allows a company to continue to trade while insolvent, that director may be held personally liable for the company's debts.
Directors of UK limited companies do not have to hold shares in the companies or reside in the United Kingdom, and no professional qualifications are required.
A detailed description of how companies are taxed is set out below. Broadly, however, a UK-resident company is taxed on its worldwide profits calculated on the basis of the profits shown in its audited accounts as adjusted in accordance with tax principles.
Partnerships are used by many businesses in the United Kingdom, notably by professions such as accountants, lawyers and doctors, and as investment vehicles for private equity. They can take several forms: contractual or general partnerships, limited partnerships and limited liability partnerships (LLPs).
A straightforward contractual partnership has no separate legal personality (although a Scottish partnership is an exception), and the partners are liable for the acts of the partnership. For tax purposes, a contractual partnership is transparent.
A limited partnership must have a 'general' partner, which has unlimited liability for the partnership, and which generally manages the partnership's business affairs. The limited partners' liabilities are limited to their capital contributions, rather like a shareholder in a limited company, and they are not permitted to participate in the general management of the partnership.
The Limited Liability Partnerships Act 2000 introduced LLPs. An LLP has similar disclosure and filing requirements to UK limited companies, including the filing of an annual return and accounts. An LLP has separate legal personality from its members, but for tax purposes is transparent provided it carries on a trade (profession) or a business for the purpose of making a profit. Her Majesty's Revenue & Customs (HMRC) has confirmed that the word 'business' may be widely interpreted, so, for example, it would only be in exceptional circumstances that holding and managing a portfolio of investments, or letting a building on a commercial basis, would not be considered a business.
Despite the general rule that a partner in an LLP's exposure is limited to capital invested, under the Finance Act 2020, members and shadow members of an LLP involved in tax avoidance, evasion or phoenixsm (the practice of carrying on the same business or trade successively through a series of companies where each becomes insolvent) may become jointly and severally liable for tax due to HMRC. This may happen if the LLP becomes subject to an insolvency procedure or such involvement is likely. A shadow member of an LLP is a person in accordance with whose directions or instructions the members of the LLP are accustomed to act, other than those providing advice in a professional capacity. If a partner is a trustee for a person who is absolutely entitled to that partner's share of profits (a 'beneficiary'), it is the beneficiary that is treated as the partner for tax purposes.
UK general partnerships, limited partnerships and limited liability partnerships are all generally transparent for UK tax purposes. The activities of the partnership are treated as being carried on by the individual partners and not by the partnership as a body. Partners are individually responsible for reporting and paying the tax due on their share of the partnership's profit and gain.
Although generally one partner is nominated to complete and file a tax return for the partnership showing the aggregate taxable profits and the partners' allocated shares, the only purpose of such return is to enable the partners to extract their share of the profit from it to include in their tax returns. The partnership tax return is not used to pay tax for the partnership, as happens when a corporate entity submits its tax return. In 2019, a first-tier tribunal case (Inverclyde Property Renovation LLP and another v. HMRC  UK FTT 408(TC)) held that an LLP should not be treated as a corporate so not transparent for tax administrative purposes. However, this judgment was subsequently overturned and provisions were introduced in the Finance Act 2020 to make it clear that an LLP is treated as a partnership for administrative purposes, and its activities treated as carried on by its members, even if the LLP does not carry on a business with a view to a profit.
One complication of this system is that the partnership must calculate its profits and losses on the same technical basis as applies to its partners. Thus, a partnership comprising UK resident companies and individuals and non-UK-resident companies and individuals would have to prepare a tax computation under the rules applicable to each type of partner, so four different tax computations. To simplify the system, provisions were introduced in the Finance (No. 2) Act 2017 that broadly calculate the partnership profits as if each partner is the same then allocates profits to each partner based on their profit share.
An individual partner is normally self-employed for tax purposes, so there are more liberal rules about offsetting expenses, and because partners are not employees (although salaried partners may be), no employers' national insurance contributions (NIC) will be payable and partners will be subject to a different rate of NIC.
There are rules that counter some perceived abuse in the use of partnerships in certain areas that cause loss of tax to the UK Treasury. In particular, these rules apply where firms disguise what in reality are employment relationships as self-employed arrangements by making employees partners in limited liability partnerships (to benefit from the above NIC advantages). Also, where there are partnerships with non-individual members, in certain circumstances profits allocated to such non-individual members may be reallocated to an individual member; for example, if an individual member forms a company, makes it a partner in the LLP and then artificially diverts his or her profit share to that company.
As regards disguised employments: in broad terms, if three conditions are met by a member of an LLP incorporated under the Limited Liability Partnerships Act 2000, that person will be treated as an employee, but if any of the conditions are not met, then the member can be treated as a self-employed partner.
Broadly, the three conditions are:
- it is reasonable to expect that at least 80 per cent of the total remuneration received by the member during the relevant period is disguised salary (i.e., not linked to the LLP's profits);
- the member does not have significant influence over how the affairs of the LLP are run. The logic is that one would expect the owner of a business to have such influence whereas an employee would not; and
- the member's capital contribution to the LLP is less than 25 per cent of the total amount of the disguised salary.
Although, for tax purposes, the activities of a general partnership are treated as carried out by the individual partners, registration for value added tax (VAT) purposes can be made in the name of the partnership. HMRC treat an LLP as a body corporate for VAT purposes, making the partnership rather than the members liable to register for VAT.
iii UK permanent establishment (place of business or branch)
An overseas company can set up a UK permanent establishment (PE). For example, a French company could rent an office and employ staff and start to trade in the UK through that office. Such a UK PE is the same legal entity as its non-UK parent, which is therefore liable for the obligations incurred by its UK business.
UK law (the Overseas Companies Regulations 2009) governs foreign companies operating in the UK. It provides that foreign companies (but not partnerships or unincorporated bodies) must, within one month of opening a UK establishment, register prescribed particulars of the foreign company and the UK establishment with the Registrar of Companies (the authority charged with the administration of English companies), including:
- the non-UK company's corporate name, legal form, register in which it is registered and its registration number;
- a certified copy of the foreign company's constitutional documents, together with a certified translation if they are not in English;
- details of the directors and secretary of the foreign company; and
- particulars of the UK establishment including its name (if different from the name of the overseas company), address, the date it was opened, the business carried on by it and the name and address of every person resident in the UK who is authorised to accept service of documents on behalf of the foreign company with respect to the establishment.
From 1 October 2011, overseas companies no longer need to register charges they create over their UK assets with Companies House. In general, foreign companies must file with the Registrar of Companies any accounting documents that they are required to prepare and disclose under the law of the country in which they are incorporated. The specific filing requirements vary depending on whether a foreign company is incorporated within or outside the European Economic Area (EEA), it is a credit or financial institution, or it is a company whose constitution does not limit the liability of its members.
Every foreign company that has registered a UK establishment must, with some exceptions, display at its places of business its name and the country in which it is incorporated. Its name and other prescribed information must also appear on all business letters, websites and other specified correspondence used in its UK activities. There are also restrictions on the name the overseas company can register in the United Kingdom.
A non-UK-resident company that carries on a trade in the United Kingdom through a UK PE is subject to UK corporation tax on its UK derived profits, broadly calculated and charged as if the PE were a UK company. Income realised outside the UK but derived from property or rights held by the UK PE will be attributed to, and taxed in, the UK PE. Like a UK incorporated company, a UK PE is taxed on profits, but only to the extent that they are properly attributable to such PE as if such PE is a stand-alone entity dealing on an arm's-length basis with the non-resident company. HMRC broadly follows Organisation for Economic Co-operation and Development (OECD) guidelines on profit attribution. Agreeing how profits should be allocated can sometimes be an area of dispute. Unlike a UK company, which needs to pay a dividend to extract profits, the net profit of a UK permanent establishment can simply be paid to the non-UK owner.
A PE is sometimes used where the non-UK company anticipates that in the early period of UK trading, losses will be made that can be used to offset profits of the non-UK owner if the business is run through a PE.
If a non-UK resident company has a trade of dealing in UK real estate or developing land with a view to disposing of it, such company can be taxed irrespective of whether it is carried on through a UK PE.
Direct taxation of businesses
i Corporation tax
UK companies are subject to corporation tax on all worldwide profits, whether such profits are income or capital in nature. Profits for corporation tax purposes must be calculated in accordance with generally accepted accounting principles (GAAP), subject only to any adjustments required or authorised by law. The key adjustments are for losses, allowances and expenditure that, while reflected in the accounting profits, are not allowed for tax purposes so are added back when calculating profits for tax purposes.
Calculation of taxable profits
UK resident companies (see Section IV) are subject to UK corporation tax on their profits, wherever they arise. A non-UK company that trades in the United Kingdom through a PE (branch or agency) is subject to corporation tax on the profits of the branch or agency, which are broadly calculated as if the PE were a stand-alone company in its own right.
Corporation tax is charged on the profits of each financial year, which runs from 1 April (so, for example, the 2018 financial year is the year from 1 April 2018 to 31 March 2019). The tax charged for that financial year is based on the accounts of the company prepared for the accounting period that falls in that financial year (an accounting period is generally 12 months, but while it cannot exceed 12 months, it can be less). Where the company's accounting period and accounts for that period do not coincide with the financial year, the profit shown in the relevant set of accounts is, when required, apportioned, on a time basis, between the financial years that overlap the accounting period.
Calculation of income profit
The most common adjustments to accounting (income) profits before they are taxed are as follows.
Although all expenses incurred by the company will depress accounting profit, not all such expenses will be allowed for tax purposes. To be deductible, an expense must be 'wholly and exclusively' incurred for the purposes of the company's trade. Whether an expense is so incurred is a question of the company's intent in incurring a cost and is thus a question of fact. It is often clear and obvious that an item of expenditure was incurred to promote the interests of the trade, such as paying staff salaries or suppliers of raw material used to make products produced by the trade. The position is not always clear, however, and there is a great deal of case law that considers when an item of expenditure, deducted in the accounts, is also deductible for tax purposes; for example, expenditure may be incurred on fees connected with changes to share capital, which would generally be regarded as non-deductible, as such an expense is incurred in connection with the company's capital structure, not its trading activity. In addition, expenditure incurred with a dual purpose, such as the cost of an airfare of an employee who goes on holiday but visits a customer while on the holiday, would generally be disallowed.
In addition to the general rule that expenditure must be wholly and exclusively incurred for the purpose of a trade to be deductible, there are a few important cases provided for in legislation that make specific items of expenditure deductible or non-deductible for corporation tax purposes, irrespective of whether such cost was incurred in the course of trade. The most important example of this is probably expenditure on client business entertainment. Irrespective of the purpose of incurring expenditure on business entertainment or gifts, the general rule is that it is not deductible. Conversely, incidental costs of obtaining loan finance, such as bank fees and commissions, which under the general rule may be regarded as linked to capital rather than trading, are specifically allowed as a deduction.
Depreciation (capital allowances)
Accounting depreciation is generally not the basis upon which tax depreciation is based, and tax depreciation is based on a system of capital allowances. There are a number of exceptions, where tax broadly follows accounting amortisation, most notably in the case of intangible fixed assets and loan relationships.
'Intangible fixed assets' defined by GAAP include patents, trademark and copyright. Such assets, provided acquired or created after 1 April 2002 (internally created goodwill for accounting periods starting after 22 April 2009), will be amortised in accordance with the amortisation in the accounts prepared in accordance with GAAP. As a result of changes made in the Finance Act 2020, all intangible assets acquired after 1 July 2020, including those acquired from related parties, can fall within the intangible assets regime. However, the Finance Act 2015 introduced measures that denied relief for 'relevant assets', notably goodwill, customer information and unregistered trademarks. This made the UK less generous than many other countries, as well as creating tax differences in the treatment of intangibles that was not consistent with their accounting treatment. In response to these concerns, the Finance Act 2019 introduced relief for the cost of goodwill, customer information and unregistered trademarks from 1 April 2019, with exceptions for those assets acquired as part of the acquisition of a business.
Although not all capital expenditure qualifies for capital allowances, allowances are normally given for expenditure on things such as plant and machinery, and R&D.
Expenditure on plant and machinery is pooled for capital allowance purposes and generally depreciated for tax purposes at 18 per cent per annum on a reducing balance basis. In the case of long-life assets (assets with an anticipated working life of 25 years or more) and parts of a building regarded as integral such as heating and air-conditioning systems, the rate is 6 per cent per annum from 6 April 2019.
If assets are sold at a price above their tax-depreciated value, there may be a clawback of allowances, or if assets have been under-depreciated there may be a balancing allowance.
Many companies claim an annual investment allowance (AIA) that is designed to encourage businesses to invest in equipment by giving tax relief (broadly a 100 per cent offset for cost in the year in which it is incurred) for qualifying business capital expenditure up to a maximum annual sum of £1 million per annum for expenditure incurred between 1 January 2019 and 31 December 2020, then of £200,000 per annum for expenditure incurred on or after 1 January 2021.
Trading and income losses
If there is a trading loss in any year, the loss can be offset against total profits (income or capital) for the current accounting period of the company. The trading loss can be set against all profits (including chargeable gains) and not just the profits arising from the same trade as that in which the loss was incurred.
Excess trading losses can also be surrendered to another UK company in the same group or consortium (see below for a description of the taxation of groups) or carried back to set off against the company's total profits (income or capital) of the preceding year.
Income and trading losses realised prior to April 2017 can also be carried forward indefinitely and offset but only against income profits arising from the same trade. However, the Finance (No. 2) Act 2017 allows companies to set certain carried-forward losses (notably trading losses) made after April 2017 against total profits, rather than be restricted to set off against profits of the same trade. However, the Finance (No. 2) Act 2017 imposes a new restriction on the amount of trading profits that can be reduced by carried-forward trading losses. Losses made prior to April 2017, can be carried forward and fully offset against a future accounting period's profits, but under the new regime only 50 per cent of profits can be reduced by post-April 2017 losses. Companies are entitled to a £5 million allowance against which carried forward losses can be fully offset before the restriction applies. The Finance Act 2020 extended these restrictions to capital losses for periods starting on or after 1 April 2020.
R&D tax credit
Relief is available for expenditure on revenue on R&D. The nature and rate of relief depends on whether the company is a large company or a small or medium-sized enterprise (SME).
The relief for SMEs provides a greater than 100 per cent deduction for all qualifying R&D expenditure in computing profits for corporation tax purposes. Relief is given at 230 per cent for SMEs in relation to expenditure incurred on or after 1 April 2015. The enhanced tax benefits used to apply only to small companies but now extend to medium-sized companies (companies with fewer than 500 employees, with an annual turnover not exceeding €100 million or a balance sheet not exceeding €86 million and meets certain independence and going-concern tests). If an SME is loss-making after deducting the R&D relief, it can elect to surrender the loss relating to the R&D expenditure and SME R&D relief and take credit in cash from the HMRC, worth up to 14.5 per cent of the surrendered loss. Draft legislation was published following a consultation process, the outcome of which was published on 12 November 2020 and that will apply for accounting periods beginning on or after 1 April 2021.The new legislation is aimed at preventing abusive behaviour and involves capping the repayment at an amount arrived at by adding together a minimum amount of £20,000, 300 per cent of the company's own pay-as-you-earn (PAYE) and NIC bill and, potentially, 300 per cent of some PAYE and NIC of connected companies.
A separate relief, similar to that available to an SME with some modification, existed for large companies but was phased out and replaced by an R&D expenditure credit (RDEC, also known as the 'above the line' tax credit) for R&D expenditure incurred on or after 1 April 2016. Large companies may make an irrevocable election to use the R&D expenditure credit for expenditure incurred on or after 1 April 2013.
Under the RDEC regime, large companies work out the eligible costs directly attributable to R&D, reduce relevant subcontractor or external staff payments to 65 per cent of the original costs, and then multiply the figure, currently by 13 per cent, to obtain the expenditure credit. This credit can then be used to settle the company's corporation tax liability for the accounting period with any excess being reduced by applying a notional tax charge to it based on the main rate of corporation tax for the accounting period. The remaining amount can be used for various purposes including paying outstanding corporation tax for other accounting periods or surrendered to any group member.
An added attraction of this new regime is the way in which it appears in the company's accounts. The credit is recognised as part of the company's profit before tax (hence the reason it is called an 'above the line credit') and so will have a favourable impact on a company's accounting profits.
Expenditure that qualifies for R&D credit is defined by reference to expenditure that qualifies under GAAP, subject to certain exclusions. Most notably, in order to qualify, the R&D must seek to achieve a general advance in knowledge or capability in a field of science or technology, not just a company's own knowledge or capability; furthermore, the research does not have to be successful for the revenue expenditure to qualify for R&D credit.
Calculation of capital (chargeable gains)
A company is potentially liable for corporation tax on any chargeable gains arising from the disposal of a capital asset. The gain is taxed at the same rate as an income trading profit and is the difference between the original acquisition cost and the disposal value minus designated allowable expenses (e.g., the costs of improvements).
If a capital asset qualifies for capital allowances, these are deducted from the acquisition cost, but only to eliminate or reduce a loss so that if, for example, the asset is sold at a gain, capital allowances are ignored.
Unlike trading losses, capital losses can only be set off against chargeable gains in the same or future accounting periods. Capital losses can be carried forward, but from 1 April 2020, the proportion of annual capital gains over a £5 million allowance that can be relieved by brought-forward capital losses will be limited to 50 per cent.
Anti-avoidance rules exist that restrict the ability to buy loss-making companies in order to use their capital losses, and the use of capital losses made on transactions with related parties.
Rollover relief is available to companies that reinvest the proceeds from disposals of certain types of capital assets into new capital assets. This allows any gains on such assets to be deferred until the new asset is sold, unless the proceeds of that sale are also reinvested.
Subject to the selling company and the company being sold meeting certain trading company criteria, broadly a company that holds at least 10 per cent of the share capital of another and has held such interest for 12 months at any time within a six-year period prior to disposal, may qualify for substantial shareholder exemption (SSE) on a disposal of those shares so that any gain arising on disposal is completely exempt from tax on the capital gain. The Finance (No. 2) Act 2017 introduced certain changes that relax the trading requirements, notably for institutional investors.
Rates of corporation tax
The rates of corporation tax are set for each financial year, and if the rate changes during a company's accounting period, the profits are generally split between the two financial years on a time-apportioned basis and the different rates applied to the relevant part. The corporation tax rate for the financial year commencing on 1 April 2020 and confirmed for 2021 is 19 per cent. Plans to reduce the rate have been shelved and any reduction seems highly unlikely in the light of the covid-19 crisis. There is a great deal of speculation that the rate will have to be increased at some stage to pay for the large deficit accumulating as a result of the pandemic.
Unlike the position in some other jurisdictions, a group is not taxed as a single entity in the United Kingdom, and members of a group are taxed on an entity-by-entity basis but with rules to allow sharing of tax reliefs and movements of assets between group members on a tax-neutral basis. The definition of a group for UK tax purposes differs according to the context, but as a broad rule a company will be grouped with another if 75 per cent of a company's ordinary share capital (which gives proportionate economic rights, broadly 75 per cent of the right to any dividend paid and assets distributed on a winding-up) is owned by that other company.
Subject to certain exclusions, UK companies within a capital gains tax group may transfer assets between the UK members without triggering a capital gain or UK stamp duty. Strictly capital losses in one company cannot be offset against chargeable gains made by another group member but broadly the same outcome can be achieved by group companies jointly electing for a capital loss that arises in one company to be deemed to have been realised by another group company.
Current year trading losses including carried-forward losses (subject to a cap) and certain other deductions such as debits on loans can be surrendered between group members and within a consortium (a consortium company being a one 75 per cent owned by consortium members that each hold at least 5 per cent of the shares of the consortium company).
Administration and payment
UK companies self-assess by submitting a tax return generally within 12 months of the end of their accounting period. Returns must be filed with HMRC online in a specified format and the accompanying accounts must also be in a specified format.
If the return is filed late there is a small fixed penalty, which increases to 10 per cent of the unpaid tax if the return is submitted more than 18 months after the end of the accounting period, and then to 20 per cent if the return is more than two years late. Small companies must pay their tax 9 months after the end of the relevant accounting period. Companies (other than small companies) pay their corporation tax by quarterly instalments, the timing of which depends on whether the company is categorised as a large company (one with profits including non-group dividend income exceeding £1.5 million in an accounting period, a figure that is reduced proportionately to reflect profits of associated companies) or a very large company (one with profits including non-group dividend income exceeding £20 million in an accounting period, a figure that is reduced proportionately to reflect profits of associated companies). In the case of a large company, the first payment is due six months and 13 days after the start of the accounting period; the second three months after the first payment; the third three months after the second payment; and the final payment three months after the third payment. However, for very large companies, the first quarterly payment is due two months and 13 days after the commencement of the accounting period, then the second three months later and so on, so all tax is effectively paid within the accounting period.
Compliance and reporting
As part of increased compliance and reporting requirements, companies are required to take action outside of the normal requirements to submit accurate tax returns on a timely basis. Large companies (those with turnover greater than £200 million or balance sheet assets over £2 billion) must supply HMRC with the name of their senior accounting officer, who must certify annually that the accounting systems are adequate for the purposes of accurate tax reporting. Penalties are chargeable for careless or deliberate failure to meet these obligations.
Certain tax planning and structuring transactions and arrangements must be disclosed to HMRC before or on implementation of the transaction under the Disclosure of Tax Avoidance Schemes (DOTAS) regime or the Disclosure of Avoidance Schemes for VAT and Other Indirect Taxes (DASVOIT) regime.
Other noteworthy reporting requirements include the obligation to publish tax strategy and country-by-country reporting, discussed in more detail below.
Under the UK Finance Act 2016, all large businesses operating in the UK are required (in respect of all financial years commencing on or after 15 September 2016) to publish, before the end of the first relevant accounting period, their UK tax strategy online. This applies not only to UK companies, UK permanent establishments and UK partnerships with turnover exceeding £200 million and having a balance sheet total of over £2 billion, but also to multinational groups with a global turnover exceeding €750 million that have any UK presence no matter how small.
The strategy is restricted to UK strategy and need not divulge how much UK tax is paid or commercially sensitive information but must set out the following relation to UK tax:
- the company's approach to risk management and governance arrangements;
- the company's attitude to tax planning;
- the level of risk the company is willing to accept;
- the company's approach towards dealings with HMRC; and
- a statement that the company regards the publication as complying with its duty under the Finance Act 2016.
The strategy must be accessible free of charge on the internet and be republished every subsequent year.
The Criminal Finances Act 2017 introduces new strict liability offences with potentially hefty fines for failing to prevent facilitation of UK and non-UK tax evasion. Businesses in the financial services, legal and accounting sectors are likely to be most affected, but it applies to all companies and partnerships. There is a statutory defence where there are reasonable preventative procedures in place to prevent its associated persons from committing tax evasion facilitation offences. In practice, this will mean that businesses will probably start to introduce policing procedures and start including provisions in commercial contracts, employment contracts, etc., to protect against financial and reputational risk.
The UK country-by-country reporting obligations apply to accounting periods beginning on or after 1 January 2016. UK-parented multinationals with revenues above €750 million or entities with a non-UK parent in a country that has no country-by-country reporting or effective exchange of information mechanism with the UK will need to submit a report (following the OECD template) in respect of the global group or UK subgroup, as appropriate, to HMRC within 12 months of the year end. Following OECD recommendations, a multinational group can file in the UK on a group-wide 'surrogate' basis.
ii Other relevant taxes
The United Kingdom has no capital duties but does levy stamp duties. Stamp duty land tax (SDLT) is charged on the execution of some documents that transfer land in England and Northern Ireland generally at rates of up to 5 per cent on commercial property and 12 per cent on residential property, unless the purchaser is a non-natural person (see below). Temporary special reliefs and exemptions are in force that last until 31 March 2021 that were introduced in response to the covid-19 pandemic, notably an exemption from stamp duty for first time buyers of properties worth less than £500,000. If the residential property is leasehold and the total rent over the life of the lease is more than £250,000 the buyer also pays 1 per cent on the portion over 1 per cent. SDLT does not apply in Scotland, where Land and Buildings Transaction Tax applies or in Wales when from April 2018 a Land Transaction Tax will apply. Stamp duty is charged on instruments that transfer UK company shares or securities (usually at 0.5 per cent). Securities generally exclude ordinary commercial loan capital, provided such loan capital has no equity-type characteristics, such as a yield linked to profit. Higher rates of SDLT apply to the purchase of additional residential properties (such as second homes and buy-to-let properties) for chargeable consideration exceeding £40,000, subject to certain covid-19 relief that lasts until 31 March 2021. The higher rates are 3 per cent above the current SDLT rates for residential property. There will be a further 2 per cent SDLT surcharge on non-UK residents purchasing UK residential property after 1 April 2021.
To discourage the practice of buying residential property in an offshore company then transferring shares in such company without paying SDLT, SDLT is charged at 15 per cent on interests in residential dwellings costing more than £500,000 purchased by certain non-natural persons such as companies, collective investment schemes, and partnerships with one or more members who are either a body corporate or a collective investment scheme. In addition, any such non-natural person that owns a residential dwelling will be subject to an annual tax on enveloped dwellings (ATED). The amount of ATED is worked out using a banding system based on the value of the residential property. Properties on which ATED is paid and which were owned on 1 April 2017 need to be revalued to that date for the purposes of the ATED charge. Currently, there are six valuation bands and six corresponding levels of charge from £3,700 per annum for properties worth between £500,000 and £1 million up to an annual charge of £226,950 (proposed to be increased to £236,250) for a residential property worth more than £20 million. Capital gains tax applies on a sale of properties in this regime, even for non-UK resident entities. In respect of both the SDLT charge and ATED, there are exclusions notably for companies acting in their capacity as trustees for a settlement and property developers or property rental businesses that meet certain conditions.
Agreements to transfer UK company shares or securities, or shares of a non-UK company that maintains a UK register of such shares or securities, may attract stamp duty reserve tax (SDRT) (usually at 0.5 per cent). If stamp duty is paid on the instrument of transfer within prescribed time limits, the SDRT charge on the contract predating the formal transfer document need not be paid. Generally, there is an exemption for transfers within a (75 per cent) group. In the past, duty was charged on what was paid irrespective of market value but the Finance Act 2019 imposed a market value rule if listed shares or securities are transferred to a connected company in cases where group relief does not apply. The Finance Act 2020 introduced similar provisions for unlisted shares and securities where part of the consideration involves the issue of shares.
Value added tax
VAT is a tax on non-business consumers, and for most business is an administrative burden rather than a tax cost. VAT is charged on goods and services supplied in the course of business. If the customer is itself a business, is registered for VAT and uses the supplies it receives for business purposes, the business will receive credit for the VAT it pays (input tax), which it can offset against the VAT it charges (output tax). If a business is charged more VAT than it charges its own customers, it can reclaim the difference, but if it charges more than it is charged, it pays the difference to HMRC. Thus, generally the burden is passed down the supply chain until it reaches the ultimate non-business consumer who bears the cost.
Certain supplies are exempt from VAT, notably supplies of shares and securities (including loans) and certain supplies of land and buildings. Other supplies are zero-rated, such as books, food, transport, children's clothing and supplies of goods and services outside the United Kingdom. In cash terms, a zero-rated supply (where VAT is charged at zero per cent) is the same as an exempt supply (where no VAT is chargeable), but the difference is that a business can generally recover VAT incurred on costs incurred in connection with a zero-rated supply but may not recover VAT on costs incurred in respect of exempt supplies.
Currently, UK businesses with a taxable turnover greater than £85,000 in the preceding 12 months (it is proposed that this £85,000 limit will apply to April 2021), or where there are reasonable grounds for expecting that turnover in the next 30 days will exceed this limit, must register for VAT. Businesses may also choose to register if they anticipate being able to reclaim material amounts on VAT charged by their suppliers.
VAT has been generally charged at 20 per cent, with some exceptions such as a rate of 5 per cent on home energy. Taxpayers are required to maintain detailed records of output and input tax. Large taxpayers pay tax monthly, as do those who regularly reclaim; others may pay quarterly.
From 1 April 2019, businesses registered for VAT (other than certain exempt and complex businesses) must keep their VAT records in digital format and must use software to submit their VAT returns electronically.
Income tax and social security contributions
Unlike corporate tax rates, the United Kingdom's income tax rates are relatively high and higher still in Scotland; this is a factor that a business thinking of moving into the United Kingdom and relocating staff will need to take into account. In the current tax year (to 6 April 2021), individuals in England, Northern Ireland and Wales pay no tax on the first £12,500 of their total chargeable income then at 20 per cent (the basic rate) on the next £37,500 of their income, then at 40 per cent (the higher rate) on income above £50,000 up to £150,000, then at 45 per cent (the additional rate) on income above £150,000. In Scotland, there is a five-band structure with the top two bands charging tax at 41 per cent above £43,431 and 46 per cent above £150,000.
There are personal (tax-free) allowances on the first slice of income (generally £12,500 in the current tax year with different allowances in Scotland). Dividend income above £2,000 is taxed at slightly lower rates and interest is tax free up to £1,000 then taxed above this, although those with higher incomes have less relief and those with income in excess of £150,000 pay tax on all of their savings income.
Employers are required to deduct income tax from their employees at source and account to HMRC under a system known as pay-as-you-earn (PAYE).
In addition to income taxes, UK employees (other than the very low paid) and their UK employer are subject to NIC. In the current tax year (to 5 April 2021), a UK employer must pay NIC at 13.8 per cent of their employees' gross earnings. The self-employed also pay NIC, but at lower rates.
Employees must also pay NIC on their earnings and the employer is responsible for collecting it from their earnings. It is charged at a fixed rate (currently 12 per cent) between a threshold and an upper earnings limit (currently £962 per week), and thereafter at 2 per cent.
Digital services tax
The UK Finance Act 2020 introduced a digital services tax (DST) that takes effect from 1 April 2020 and applies a 2 per cent tax on the revenues of search engines, social media platforms and online marketplaces, which derive value from UK users when the taxpayer group's worldwide revenues from these activities exceed £500 million with more than £25 million of such revenue derived from UK users. Revenue is this context is determined by looking at the activities of the whole of a taxpayers group. For example, if group member A derives revenue that is attributable to the digital services activities of group member B, group member A's revenue is included.
The legislation details five cases describing what is meant by UK DST revenue, the first three of which describe revenues from an online marketplace transaction either: where a UK user is a party to the transaction; or where the revenues are in connection with accommodation or land in the UK; or related to advertising, and such advertising is paid for by a UK user. The other cases describe revenues from other online advertising revenues where advertising is viewed or consumed by a UK user or any other revenues arising in connection with UK users.
The UK government, frustrated by the slow progress of the OECD, introduced this unilateral tax pending arriving at a consensus at OECD level. The decision to restrict DST to search engines, social media platforms and online marketplaces was deliberate and intended to restrict the application of the tax to the areas where the UK government saw the most need for change; where the contribution of a UK user base is a key value driver that is not caught by traditional transfer pricing legislation.
Tax residence and fiscal domicile
UK residence is central to the taxation of businesses. A UK-resident company is subject to UK corporation tax on all its worldwide profits, wherever they arise. A non-UK resident company that carries on a trade in the United Kingdom through a UK PE is also subject to UK corporation tax on its profits, wherever they arise, but only to the extent that such profits are properly attributable to that PE.
Chapter 3A in Part 2 of the Corporation Tax Act 2009 exempts all profits (including chargeable gains) attributable to non-UK PEs of UK-resident companies from UK corporation tax. To apply, the UK company must make an irrevocable election. Elections are made on an individual company basis, covering all PEs of the electing company. The relevant profits of the non-UK PEs are determined in accordance with the relevant double taxation treaty (DTT) with the jurisdiction where the PE is based. The regime contains anti-avoidance rules to prevent the artificial diversion of profit from the UK to an exempt PE.
If a company is not UK-resident, nor has a UK trade carried on through a UK PE, its exposure to UK tax is limited, primarily to taxes on UK-sourced income and gains realised on the sale of UK real property.
i Corporate residence
A company can be UK-resident either by being incorporated in the United Kingdom under the UK Companies Acts or, if incorporated outside the UK, by virtue of having its central 'management and control' exercised in the United Kingdom.
This test derives from case law, notably the leading case of De Beers Consolidated Mines v. Howe,2 in which the House of Lords adopted a fact-based test of UK residence, which became known as the central management and control test.
The De Beers case laid down two important principles: that a company is UK-resident if managed and controlled in the United Kingdom, and that where such management and control is exercised is a question of fact. These principles were expanded and clarified in later cases.
In the case of American Thread Co v. Joyce,3 the House of Lords made it clear that management and control is not day-to-day management but strategic and policy decisions, and that such decisions are generally as a matter of fact taken by directors. HMRC is threatening to change this test so it is more akin to the OECD test for a 'place of effective management', which takes into account wider management functions.
However, while the presumption is that management and control are exercised by a company's board, the facts are still paramount, so if, factually, control is exercised outside the board, one looks to where that control is actually exercised. When considering where the 'central management and control' exists, it is essential to distinguish cases where management and control are exercised through a company's constitutional organs from cases where the decisions of those constitutional organs are usurped, and to further distinguish between cases where an 'outsider' proposed, advised and influenced decisions taken by the constitutional organs, and cases where such an outsider dictated the decisions and 'usurped' such constitutional organs.
The cases illustrate the importance of ensuring that the board exercises real discretion and does not merely rubber-stamp decisions taken elsewhere and that contemporaneous records supporting this are kept.
Residence questions are rarely clear-cut, and the determination will be dependent on what occurs in practice and on the supporting evidence.
Sometimes different tests of residence are applied in different jurisdictions, with the result that a company may be regarded as resident in more than one jurisdiction. In such cases, the company is dual-resident, and one has to look to DTTs to avoid exposure to double taxation and specifically to provisions often referred to as tie-breaker provisions. Treaties that follow the OECD model usually contain a clause that refers to a company being resident in the jurisdiction where it has its 'place of effective management'. The OECD commentary states that the place of effective management is the place where key management and commercial decisions necessary for the conduct of the company's business are made, which is normally where the board of directors makes its decisions, but stresses that one must consider all facts and circumstances. HMRC takes the view that this means that, when looking at the 'place of effective management', one has to have regard for the day-to-day management of the company, and not just the highest level of decision-making required by the UK management and control test.
ii Residence through a UK branch or PE
As stated above, a non-resident company is only subject to UK corporation tax if it carries on a trade in the United Kingdom and such trade is conducted through a UK PE. There are two notable exceptions to this rule: (1) diverted profits tax (broadly, where there is manipulation to avoid a UK PE); and (2) where a non-UK resident company has UK real property income. From 6 April 2020, non-UK companies that carry on a UK real property business or trade of dealing or developing UK land or have other UK property income will be charged to UK corporation tax on such profit (also certain capital gains derived from UK real property will also be taxed).
What constitutes a trade is a question of fact determined by looking at certain criteria known as 'the badges of trade' laid down by UK case law, as there is no satisfactory statutory definition of what constitutes trading.
The UK definition of a PE is based on the OECD Model Treaty definition and means a fixed place of business through which its business is wholly or partly carried on. A fixed place of business includes:
- a place of management;
- a branch;
- an office;
- a factory;
- a workshop;
- an installation or structure for the exploration of natural resources;
- a mine, an oil or gas well, a quarry or any other place of extraction of natural resources; or
- a building site or construction or installation project.
UK law also follows the OECD model in excluding from the definition of what constitutes a UK PE, activities carried on at a place of business that are preparatory or auxiliary in character. For activities to be regarded as preparatory or auxiliary in character, they must be sufficiently remote from the actual realisation of profits by the enterprise that it would be difficult to allocate part of that profit to the potential UK PE. Such activities include:
- storing, displaying or delivering the company's goods or merchandise;
- maintaining the company's goods or merchandise for the purpose of storage, display or delivery, or processing by another person;
- purchasing goods or merchandise for the company; and
- collecting information for the company.
In addition, if a non-UK company has a UK agent that habitually exercises authority to conduct the company's business in the United Kingdom, such agent will also be a PE of the company unless such agent has independent status and acts for the non-UK company in the ordinary course of its (the agent's) business.
It is not enough for a company to have a PE in the United Kingdom: it must also be trading in the United Kingdom, not just with it. To determine this, one must look at where the operations take place and where the profits arise, and a key factor is where the contracts are entered into (see Firestone v. Llewellin).4
Tax incentives, special regimes and relief that may encourage inward investment
As stated elsewhere in this chapter, the United Kingdom can be attractive as it has:
- low corporate tax rates;
- no withholding from dividend payments and a wide exemption from tax on receipt of dividends;
- a wide treaty network that offers treaty relief from withholding from interest and royalties;
- generous rules for allowing deductions for borrowing costs even if such borrowing was for a capital purpose such as acquiring a subsidiary; and
- substantial shareholder exemption that can exempt gains on the sale of 10 per cent (or more) shareholdings in trading companies.
The United Kingdom introduced a patent box regime from 1 April 2013 that applies to all patents (but not copyright, know-how, etc.) first commercialised after 29 November 2010.
The regime applies an effective 10 per cent tax rate to all relevant profits (royalties, fees, sale proceeds, sales of products with embedded patent rights and compensation) derived from the active exploitation of qualifying patent rights.
A qualifying patent is restricted to those registered with the European Patent Office or United Kingdom Intellectual Property Office. The party claiming relief need only to have a beneficial interest.
The regime was modified by the Finance Act 2016 to bring it in line with recommendations from the OECD Forum on Harmful Tax Practices. The key change was the introduction of a 'nexus' (or R&D) fraction, which takes into account the location, and nature of a company's underlying R&D activity, in determining the available patent box benefit. This restricts the relief where R&D is subcontracted out even within the UK group.
To date and despite a UK government desire to encourage innovation, the regime has not proved terribly successful. Many reasons have been advanced for its relatively low take-up, most plausible of which is the regime's sheer complexity, leading to compliance expense that discourages all but the largest companies. Also, much modern innovation falls outside the patent regime.
Withholding and taxation of non-local source income streams
There is no UK withholding tax from dividends paid by a UK company irrespective of the status or location of the holder. Since 1 July 2009, the United Kingdom has operated an exemption regime (prior to 2009 it operated a credit scheme) for dividends received by a UK company, the effect of which is broadly that, provided the company is not involved in a tax-avoidance scheme of which the dividend forms part, dividends are exempt upon receipt. To be exempt, a dividend must meet a number of conditions apart from the tax-avoidance condition. The exemption will not prevent dividends received by share traders and others receiving dividends on trading account being taxed in the normal way.
A small company (one that has fewer than 50 employees, and whose annual turnover or annual balance sheet total (or both) does not exceed €10 million) can receive all dividends free of tax provided the dividend is not capital in nature, is not deductible for the payer and the payer is not based outside the United Kingdom in a non-qualifying territory. A qualifying territory is one with which the United Kingdom has a DTT containing a non-discrimination provision.
All other companies can receive dividends on an exempt basis if, as well as meeting the anti-avoidance test and the dividend being non-deductible for the payer, the dividend falls into an exempt class.
The main exempt classes of dividend are:
- the 'control exemption': dividends paid by a company to a company that controls it;
- the 'ordinary shares exemption': dividends paid in respect of (non-redeemable) ordinary shares;
- the 'portfolio exemption': dividends paid on portfolio shareholdings where the shareholder holds less than 10 per cent of the issued share capital of the paying company; and
- the 'relevant profits exemption': dividends paid out of 'relevant profits' being effectively ordinary profits derived from transactions that do not have the effect and main purpose of having a more than negligible reduction in UK tax.
Non-exempt dividends are taxed at the normal rates of corporation tax subject to potential credits for withholding and underlying taxes. UK individuals are taxed on dividends received, and the corporate exemption has no equivalent.
As UK domestic law only imposes withholding tax on dividends paid by UK companies in limited circumstances Brexit is unlikely to have much impact. However, a UK parent receiving dividends from a subsidiary based in the UK after Brexit if it happens may, depending on the terms upon which the UK leaves the EU, have to rely on its tax treaties to mitigate EU state (non-UK withholding) from dividends paid to the UK.
The United Kingdom imposes withholding tax (currently at 20 per cent) on payments of annual interest by a UK resident (interest on loans with a term of less than a year can be paid gross). There are a number of important exceptions to the obligation on the payer to withhold and account for tax, notably on:
- interest paid on bonds listed on a recognised stock exchange;
- interest paid to UK corporates;
- interest paid to a UK PE of a non-UK corporate where the UK PE brings such interest into the charge to UK tax; and
- interest paid to a UK 'bank' and interest where it is paid without withholding because of the application of a relevant DTT.
Many (but not all) UK treaties eliminate UK withholding tax from interest; however, in order for the relief under a DTT to be applied, the UK payer and non-UK payee must submit an application that can take a number of months to process, and that often causes problems with the first interest payment when interest is payable quarterly or more frequently.
As a member of the EU, the UK was party to both the EU Council Directive 2011/96/EU (Parent-Subsidiary Directive) and Council Directive 2003/49/EC (Interest and Royalties Directive). If Brexit happens and the UK leaves the EU from 1 January 2021 (that is still unknown at the time of writing but should be clear at the time of publication), the Parent-Subsidiary Directive and Interest and Royalties Directive will no longer apply. This should have relatively little impact on withholding from UK source interest and royalties as the UK's tax treaties generally exempt such payments from withholding but the relevant treaty would need to be checked.
Interest is generally deductible for a UK business payer, subject to thin capitalisation and corporate interest restriction rules (described below), provided that the loan does not have equity characteristics that result in the interest being recharacterised as a distribution (e.g., interest that varies in line with the payer's profits).
Payments of copyright royalties to non-UK residents and payments of patent royalties are subject to withholding tax (currently at 20 per cent), but many UK DTTs eliminate such withholding. As stated above, certain payments between 25 per cent-associated companies within the EU can be made free of withholding from royalties (and interest).
The Finance Act 2016 made some significant changes to withholding from royalties paid to non-UK residents, notably where:
- the payment is part of arrangements that exploit the UK's double tax treaties to ensure that little, or no, tax is paid on such royalties in the UK or elsewhere, in which case a withholding may have to be made even if this would normally be reduced or eliminated by a double tax treaty. There is an exception where the royalty is covered by the EU Royalties Directive (unless broadly the arrangements are designed to avoid tax and have been made to fall within the Directive); and
- a UK permanent establishment obtains intellectual property rights as a result of its non-UK parent paying a royalty to another non-UK entity. In such a case, the UK permanent establishment is potentially required to withhold from that non-UK royalty payment (previously such a royalty would not be treated as having a UK source so would not be subject to UK withholding).
iv Tax treaties
The United Kingdom has an extensive network of treaties with all developed non-tax-haven countries and the majority of countries in the developing world. Most treaties are based on the OECD model, and some have provisions against treaty shopping.
Taxation of funding structures
i Thin capitalisation
The UK no longer has a specific thin capitalisation rule, although, de facto, there is such a regime included within the transfer pricing regime. Where there are financing transactions between connected parties, transfer pricing rules require tax to be calculated on the basis of what the arm's-length financing provision would have been should the actual financing confer a tax advantage in comparison with an arm's-length result. These rules apply to transactions between UK taxpayers, as well as cross-border transactions.
For the transfer pricing rules to apply, there has to be a 'special relationship' between the companies concerned. A special relationship is defined as a relationship where one company controls the other, or both are controlled by the same person or persons. This is a narrower definition of special relationship than one typically finds in the United Kingdom's DTTs. If there is a special relationship, one has to consider if the financing is at arm's length. One is required to ask a number of questions, most notably:
- whether the loan would have been made at all in the absence of the special relationship;
- the amount of the loan that would have been made in the absence of the special relationship; and
- the rate of interest and other terms that would have been agreed in the absence of that relationship.
Thus, if, for example, X lends its subsidiary Y £300 million at an arm's-length interest rate on normal commercial terms, but the loan would not have exceeded £200 million had there been no special relationship between X and Y, then the interest paid on the £100 million of debt that exceeds the arm's-length facility may be disallowed. If the principal was at an arm's-length amount but the interest rate is, say, 5 per cent, whereas the arm's-length rate would be 4.75 per cent, then the 0.25 per cent excess rate paid by virtue of the special relationship is likely to be disallowed.
In addition to the thin capitalisation rules in the transfer pricing regime described above, interest costs may be disallowed as a tax deduction under specific rules: under the debt cap prior to 31 March 2017 and post 1 April 2017 under rules introduced by the Finance (No. 2) Act 2017 (the corporate interest restriction regime) in response to the OECD Base Erosion and Profit Shifting (BEPS) that replace the debt cap.
The corporate interest restriction (CIR) regime applies to companies and their subsidiaries with net tax-interest expense amounts of £2 million or more. The rules are intended to stop groups placing disproportionately high levels of debt in high-tax countries or using intragroup loans to generate interest deductions that exceed third-party borrowing costs or debt to generate tax-exempt income. The default position is that a UK group's deductible net tax-interest expense for a period is limited to broadly 30 per cent of its taxable EBITDA that cannot exceed the group's net finance-related expense plus certain carry-forward amounts from previous periods. A company may elect that, instead of the 30 per cent limit, a percentage is used based, broadly, on the ratio of the group's net interest expense to its accounting EBITDA (ignoring amounts payable to shareholders and on equity-like instruments); again, that cannot exceed the group's net finance-related expense plus certain carry forwards.
Interest and loan expenses in excess of the limited amounts are not lost but can be carried forward. Where a deduction is denied, the allocation of allowed and denied interest costs can be allocated as the group choses.
ii Deduction of finance costs
Subject to thin capitalisation and interest limitation rules, the costs of acquisition finance are generally deductible (this includes not only interest but ancillary costs such as arrangement fees). The United Kingdom does not disallow funding costs because they are incurred for a capital purpose rather than for the trade itself.
An exception to the rule that interest costs are deductible is where the debt has equity characteristics that render the interest liable to being recharacterised as a (non-deductible) distribution, such as a coupon that is to any extent linked to the results of the issuer's business or interest on convertible securities. Apart from the notable exception of interest at an excessive rate, if an interest coupon is liable to be treated as a distribution, it generally will not be where the recipient is a UK corporate or a UK PE that brings the coupon received into the charge to UK corporation tax.
Increasingly, HMRC are seeking to deny a deduction for acquisition finance costs where the finance is structured to obtain tax efficiencies; see, for example, Blackrock Holdco No 5 LLC v. The Commissioners of Her Majesty's Revenue and Customs  UK FTT 443 (TC).
iii Restrictions on payments
Apart from potential restrictions on paying dividends in a company's constitution, its directors are under a duty to safeguard a company's assets and settle debts as they fall due, so must consider how paying a dividend may affect these areas. Those factors apart, and subject to additional considerations for public companies, the general rule is that a UK company can only pay a dividend to the extent it has 'distributable reserves', which are that company's accumulated, realised profits (as far as not previously used by distribution or capitalisation) less its accumulated, realised losses (as far as not previously written off in a reduction or reorganisation of capital). Whether a profit is a 'realised profit' is determined in accordance with GAAP. Thus, unlike many jurisdictions, even if a UK company has material current-year profits, it cannot pay a dividend if it has accumulated deficits that exceed the profit. If the accumulated deficit is, say, £100, and the current year profit is, say, £150, only the excess £50 is distributable, leaving cash of £100 in the company – a situation often referred to as a dividend trap. There are a number of possible solutions, one of which is described below.
Public companies must also beware of an issue called financial assistance, which is designed to stop a target assisting in its own sale (e.g., by waiving debt it is owed by its selling parent). Financial assistance no longer applies to private companies.
iv Return of capital
UK companies can return cash to shareholders by reducing their equity capital. This may be done for a variety of reasons, such as where there are a large number of UK-resident individual shareholders for whom a return of capital is more tax-efficient, but it is often used by companies who have insufficient distributable reserves to return the cash they want to return to their shareholders by way of dividend.
The reserve created by reducing capital is generally treated as a realised profit that can thus be offset against accumulated realised losses, or can increase distributable reserves, or both. Some UK-listed companies have reduced capital to counter the deficits created by their pension funds following changes to the rules on how such funds should be accounted for.
Public companies have to reduce capital through a court scheme, but since 2008, private companies can also use a non-court scheme, provided the directors are satisfied that returning capital will not affect the company's solvency over the next 12 months. This latter route is known as the solvency statement route.
Acquisition structures, restructuring and exit charges
Often, a UK holding company is used to acquire a UK target. This enables the acquirer to push acquisition debt into the holding company (but see comments made above and below about HMRC attacks on the basis that such debt has an unallowable purpose), the ongoing cost of which can be surrendered into the target group and offset against future trading profit. In cases where a deduction is also potentially available elsewhere in the acquirer's group, the taxpayer also needs to consider UK anti-avoidance rules that can prevent a double deduction of interest costs.
The amount of debt that can be successfully injected needs careful thought in the light of thin capitalisation and debt cap considerations and, from 2017, the new debt ratio rules. Furthermore, HMRC is aggressively denying deductions for the cost of acquisition debt in situations where it regards debt as pushed into a UK entity without adequate commercial rationale, citing the Corporation Taxes Act 2009, Sections 441–442 that attack debt that has an unallowable purpose.
Subject to certain conditions, UK selling shareholders can roll over gains on the sale of shares to the extent they receive shares in the acquirer or the acquirer's loan notes. Even if there is a large cash element, a proportionate part of the gain can still be rolled over. The shares or loan notes must be issued by the acquirer (i.e., if X Inc acquires the target but X Inc's parent Y issues the consideration shares, roll over will not be available; there may be an exception to this rule if the acquisition is structured through a cancellation scheme through the court rather than the more usual tender or exchange offer).
As previously stated, the United Kingdom allows UK companies under a common parent to be grouped even if such common parent is not a UK company. This means that it is generally possible to consolidate any newly acquired UK group into the purchaser's existing UK group on a tax-free basis. There are also rules that now facilitate merging or consolidation across borders within the EU. It is unclear at the time of writing what impact Brexit will have on such rules.
If the purchaser wants to move parts of a newly acquired group out of the United Kingdom into another part of the group in a non-UK jurisdiction, then the general rule and starting point is that any such transfer will be treated as taking place at market value, and the difference in value between the historical tax basis and current market value will be recognised as a taxable gain. The United Kingdom's SSE relief may assist, as may the rules facilitating mergers and transfers within the EU.
A point to note in this context is that under UK tax law, if a target company is acquired at market value, the tax basis that the target company has in underlying subsidiaries' shares and assets remains at the historical tax basis, and assets cannot be rebased to reflect the open market price paid for the shares in the target. The United Kingdom has no equivalent to the US Section 338 election.
Anti-avoidance and other relevant legislation
i General anti-avoidance
On 17 July 2013, the United Kingdom introduced its first general anti-avoidance rules (GAAR) to ensure that there was a comprehensive rule for combating abusive tax avoidance encompassing present and future tax provisions. A study group commissioned in 2010 to study the benefits of such a regime did not recommend a 'broad spectrum' GAAR, which it was felt would undermine sensible and responsible tax planning, and would require an onerous, comprehensive clearance system that would give an excess of power to HMRC. The report recommended a more measured, targeted approach aimed at highly abusive, contrived and artificial schemes that are widely regarded as intolerable, but that would not affect responsible tax planning. This was generally accepted in the Finance Act 2013 and has been confirmed by guidance provided by HMRC, which accepts that there may be tax avoidance arrangements that are not within the scope of GAAR because they are not abusive.5 Under the United Kingdom's Tax Code, in many circumstances, there are different courses of action from which a taxpayer may choose; HMRC has emphasised that any reasonable choice of a course of action is outside the scope of GAAR.6 In contrast, arrangements will fall within its scope if they are demonstrably contrary to the spirit or policy of the law, seek to exploit shortcomings in legislation or are contrived or abnormal arrangements that produce tax results inconsistent with the economic effect of the underlying transactions.7
The Scottish government has its own GAAR for taxes devolved to Scotland.
The United Kingdom currently has a wide range of specific anti-avoidance rules contained in both statute and common law that are detailed and complex and beyond the scope of this chapter. Particular points to note are that there is a regime effective from 1 January 2017 introduced in response to Action 2 of BEPS that widens previous tax arbitrage rules and targets 'hybrid mismatches'. The UK also has disclosure of tax avoidance schemes (DOTAS regime) requiring disclosure where certain classic hallmarks of avoidance are present, such as premium fee arrangements and confidentiality agreements surrounding the arrangements and similar provisions aimed at the promotors of such schemes (POTAS). In July 2020, HMRC initiated a consultation process aimed at strengthening the DOTAS, POTAS and GAAR regimes.
HMRC are pressing for a law change that will require large businesses to notify them when taking action based on an interpretation of law that HMRC may not agree with. Professional bodies are lobbying hard against this as such a law would be inherently unclear and would lead to unfairness. The UK imposes material compliance burdens on business and measures such as the one proposed that are making it increasingly onerous.
The UK introduced a diverted profit tax (DPT) from 1 April 2015. The tax (generally at the rate of 25 per cent, so 6 per cent higher than the normal corporate tax rate, with higher rates for the oil and banking industries), applies in two cases:
- where a UK company (or permanent establishment) enters into arrangements with a related person where that person or the transaction lack economic substance resulting in a reduction of the UK taxable profits, significantly greater than the increase for the other person; and
- a person carries on an activity in a manner that avoids creating a UK permanent establishment.
DPT does not apply to small- or medium-sized enterprises or to a PE with annual sales of less than £10 million or where profit is diverted to a jurisdiction whose tax rate is 80 per cent or more of the UK corporation tax rate.
ii Controlled foreign corporations (CFCs)
The UK CFC regime has been considerably revised and made more taxpayer-friendly (by providing a number of gateways and exemptions) and came into force for accounting periods starting after 1 January 2013. Although quite complicated, the basis of the regime is that most bona fide non-UK companies not being used to artificially divert profit from the UK should fall outside the regime. In response to the final OECD Report on strengthening transfer pricing rules, published in October 2015, the UK government has stated that it is not proposing any change to the UK regime that it regards as already covering the points made by the OECD.
Subject to exceptions, a non-UK company with a UK parent (or one that is controlled by UK persons) is potentially subject to the UK CFC regime. If not excluded by one of the gateways that has to be passed through to be potentially caught by the regime, or if not excluded by one of the many exemptions, a CFC's profits are deemed apportioned to the UK parent and taxed in the United Kingdom, subject to credit for non-UK tax paid.
There are a series of exemptions, notably:
- the low tax exemption: a company is only subject to CFC treatment if it is subject to a headline tax rate of less than 75 per cent of the equivalent UK tax rate;
- the low profits exemption: a CFC is ignored if it has accounting profits of less than £500,000 and non-trading profits of less than £50,000;
- the exempt activities test: there is a safe harbour if the CFC conducts certain types of business and has business premises and its effective management in a low-tax jurisdiction; and
- the excluded territories exemption: the CFC is based in a jurisdiction on a published list provided its total income within certain categories (generally income that is exempt or subject to a reduced rate of tax) does not exceed 10 per cent of the company's pre-tax profits for the accounting period (or £50,000 if greater).
There is also a high-level gateway and a number of specific gateways that can exclude the application of the regime, but as these are more subjective, an adviser generally prefers to see if one of the exemptions applies in the first instance.
The general gateway is subject to a number of safe harbours that if all the conditions are met mean the gateway is not passed through and the CFC regime does not apply, making it unnecessary to consider other gateways and exemptions. The safe harbour conditions include:
- the main purposes safe harbour: broadly, a series of questions aimed at establishing whether arrangements exist that are intended to reduce or eliminate United Kingdom taxation;
- the UK-managed assets or risks safe harbour: broadly, aimed at establishing whether the CFC's assets and risks are independently managed. The test is failed if assets or risks are significantly managed in the United Kingdom by connected parties unless they could be replaced by non-connected companies; and
- the commercially effective safe harbour: even if assets and risks are UK-managed, the test may still be satisfied if the CFC could effectively commercially manage the assets or risks were the UK-connected company to cease such management.
There are a series of specific gateways that can apply based on specific activities the CFC carries out.
iii Transfer pricing
Since 2004, to comply with EU laws on discrimination, the UK transfer pricing rules have applied to all transactions even if all the parties are subject to UK tax. The UK transfer pricing rules are expressly based on OECD guidelines and provide that the UK law in this area must be construed in the light of such OECD guidelines. Thus, as one would expect, the UK legislation requires that transactions between related parties be undertaken in accordance with the arm's-length principle in Article 9 of the OECD Model Law.
Basic UK law
The UK transfer pricing regime applies to 'provisions' (broadly equivalent to OECD conditions) of transactions (transactions being defined widely to include arrangements, understandings and mutual practices as well as matters such as contracts), or series of transactions, between certain specified parties. In common with many transfer pricing regimes, the UK regime requires comparison of the actual provision (price, terms and conditions of supply, etc.) with the arm's-length provision that would have applied in the same transaction between independent parties. The basic rule will apply where the actual provision has created a potential UK advantage because income or profits are less or losses greater than they would have been had the transaction been at arm's length.
The rules apply where one of the parties to a transaction directly or indirectly participates in the management, control or capital of the other, or where the same person (or persons) directly or indirectly participates in the management, control or capital of the parties. A person is treated as directly participating if that person is a corporate or a partnership and 'controls' the other person. In evaluating whether a person (e.g., X Ltd) has control, one takes into account not just current voting power exercisable by X Ltd, but also factors including rights and power that X Ltd is entitled to acquire, or will become entitled to acquire, at a future date, and rights and powers held by a person connected with X Ltd.
The transfer pricing rules also apply if X Ltd exercises indirect control over another person through rights held by connected persons, rights exercised on X Ltd's behalf or through deeming entitlements to future rights to have been exercised, or because X Ltd is a 'major participant'.
X Ltd is a major participant if it and another person (taken together) have control and each has at least 40 per cent control of the relevant entity – this is particularly relevant to joint ventures.
Where there are two UK companies, it is likely that in many cases there will be no loss to the UK Treasury, as a deduction in one company will be matched by a corresponding receipt in another. In recognition of this, the regime allows the company that is disadvantaged by the pricing adjustment to make a claim to have its tax calculated on the same deemed arm's-length terms as the company that obtained an advantage as a result of the adjustment, and tax-free compensatory payments to be made.
The United Kingdom adopts OECD methodology to determine an arm's-length price, notably the transactional methods (the comparable uncontrolled price method, resale price method and cost plus method) and the profit-based methods (the profit split method and transactional net margin method). In the 2016 Finance Act, the UK government adopted the OECD guidelines on transfer pricing currently in force or as updated. In addition, the UK introduced legislation (Taxes (Base Erosion and Profit Shifting) (Country-by-Country) Reporting Regulations 2016), which requires a UK-resident parent company to report prescribed information, so implementing another OECD BEPS recommendation.
The UK does permit advance pricing agreements (APAs) under which the taxpayer agrees with HMRC an acceptable pricing method in advance of the relevant transactions taking place. These are typically used in more complex transactions, and HMRC has detailed guidelines on the mechanics of negotiating and agreeing an APA.
Over recent years, the European Commission has attacked tax rulings given to taxpayers by tax authorities in Member States on the basis that such rulings amount to an illegal tax benefit and so are contrary to EU State Aid rules. There have been a number of well-publicised examples, notably the August 2016 European Commission decision that tax rulings grated to Apple by Ireland amounted to state aid and the decision published on 4 October 2017 that rulings given by Luxembourg to Amazon in 2003 and 2011 amounted to selective tax treatment and state aid. In the light of these attacks, the position of UK APAs, notably those given to large multinational enterprises, needs to be monitored.
iv Tax clearances and rulings
Of particular relevance in the context of this book is that HMRC will provide advance rulings where there is significant inward investment into the United Kingdom amounting to more than £30 million or that, while less than that figure, may be regarded as significant to a particular region or in the wider public interest (SP2/2012). Under such rulings, HMRC will provide written confirmation of how HMRC will apply UK tax law to specific transactions or events.
Statutory clearances can be sought under a number of statutory provisions, notably on share exchanges and certain types of restructuring and merger. Typically, these clearances do not confirm to the taxpayer that the conditions for relief are met, but simply that the relief's availability will not be challenged on the basis that it is for tax-avoidance rather than for bona fide commercial purposes. Clearances are only effective if the taxpayer makes a full and frank disclosure. There is generally a clear timetable that requires HMRC to respond within 30 days, although if HMRC feels that more information is needed, it can ask for such information, and when the taxpayer responds, the 30-day clock starts again from zero.
As well as formal statutory clearance, there is a procedure known as a Code of Practice 10 Ruling, which allows a taxpayer to seek clarification on how recent legislation (that being legislation introduced in the past four years) applies to it where there is material uncertainty. It is possible to request such a ruling going back beyond four years, but in such cases the taxpayer must show that the uncertainty is commercially significant to its business. HMRC will not give a ruling where it believes that the transaction that creates uncertainty is not a primarily commercial one but is rather a tax-driven transaction or a tax-planning exercise.
A taxpayer may also approach HMRC informally but is only likely to receive a satisfactory response if the informal ruling is a question in respect of a transaction that has already happened, and the taxpayer is looking for guidance on how it should deal with an aspect of such transaction in its tax returns.
Year in review
2020 following on from 2019 has been characterised by uncertainty. Uncertainty over what type of Brexit will be delivered and its impact on UK trade and taxation and uncertainty caused by the covid-19 pandemic. The UK traditionally delivers an annual budget setting out spending plans and tax measures in the autumn that eventually becomes a Finance Act in the summer of the following year. The Budget scheduled for November 2019 was cancelled because of an impasse in Parliament that led to a snap election and the budget was rescheduled and was eventually delivered on 11 March 2020. The budget due to be delivered in October or November 2020 has been deferred because of the covid-19 pandemic. The Autumn 2020 budget was intended to set out medium term plans for spending and taxation to rebuild the UK economy after six months of shrinking consumer spending and job losses, but it is felt that this would be undesirable at a time when the economic outlook is impossible to predict with any certainty.
What is clear is that initiatives to prop up the UK's ailing economy, notably the Coronavirus Job Retention Scheme and August 2020's 'Eat Out to Help Out' subsidy for people eating out, introduced to assist the hospitality industry, has led to a seismic shift in the UK economy. The Office for Budget Responsibility published figures for the year ending 31 March 2020 (i.e., effectively showing the state of the UK economy before the effects of the pandemic started to manifest to any degree) that showed UK net borrowing for the year of £56 million or 2.5 per cent of GDP. The Institute of Fiscal Studies published a forecast in late October 2020 for the year to 31 March 2021 predicting figures between £345 billion and £376 billion or 16.7 per cent to 18.9 per cent of GDP.
Outlook and conclusions
Until the outcome of Brexit and the pandemic become clearer, it is hard to predict what lies ahead for the UK. However, given the budget deficit, it is reasonable to speculate that increased taxation will be required to reduce this and to produce income needed to spend on measures to stimulate the UK economy. Restricting tax law change to technical change is unlikely to generate the sums required, so it is likely that there will be increases in the rates of the main taxes. What changes will be made is speculative but if, for example, the basic rate of income tax is increased from 20 per cent to 21 per cent, it is predicted to raise circa £4.7 billion per annum. Increases to higher rates are likely for political as much as practical reasons (these raise considerably less tax revenue than changes to the basic rate), so, for example, if the 40 per cent rate increases to 41 per cent, it is estimated this will raise circa £1 billion per annum. The rate of corporation tax at 19 per cent is well below the OECD average of circa 24 per cent and some increase seems possible. There has been a lot of speculation that personal capital gains tax will increase to fall into line with income tax rates paid by the person realising the gain.
As well as changes to the rates and manner of applying taxation, it is reasonable to assume that HMRC will be increasingly aggressive in enforcement and levying fines and penalties. HMRC's November 2020 grant funding document seeks additional funds and states that one of its key objectives is to 'maximise revenues due and bear down on avoidance and evasion'. In the abstract this seems unobjectionable but over recent years the compliance burden on UK companies has increased dramatically as has HMRC's willingness to impose material penalties for minor technical infringements.