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Budget 2008 - Key Tax issues facing the Chancellor

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With the Budget just days away, BDO Stoy Hayward has taken an in-depth look at some of the key issues facing Alistair Darling, and possible solutions, ahead of his first full Budget. Don't forget - check out the latest rates, allowances and reports on Budget Day, here at Bytestart.

The Chancellor will be keen to ensure that there are no repeats in taxation policy of the calamitous reforms of Capital Gains Tax (his first strike) and Non-Domiciles Taxation (his second strike) announced in last October’s Pre-Budget Report (PBR) which have required extensive, unanticipated climb-downs. Nevertheless, we hope that the Chancellor will not treat this as a reason to avoid the long overdue imperative to reform and simplify the UK taxation system.

Due to an uncertain economic climate and the size of the Budget deficit, the Chancellor clearly has less room for manoeuvre than he did in the PBR, and although it is likely that some incentives will be given to benefit business, these are likely to be offset by increases elsewhere. What we are likely to see in this Budget is a raft of measures intended to cut the administrative burden on business but which do not reduce the Treasury’s overall tax take.

BDO Stoy Hayward Senior Tax Partner, Stephen Herring, looks at the issues:

Tax simplification: over complicated taxation a burden on the taxpayer

Problem: Under Gordon Brown’s Chancellorship it would be fair to say that UK taxation legislation became more complicated for both businesses and many individual taxpayers. However, Darling demonstrated at last year’s PBR that he is more inclined towards tax simplification by the changes he made to Capital Gains Tax (CGT) confirming his credentials as a potentially tax simplifying Chancellor.

What Darling should do: Continue to demonstrate to UK businesses and taxpayers his commitment to the cause of tax simplification by the introduction of further tax simplifying measures. For example, self-assessment has become increasingly complicated over recent years, making it harder for taxpayers to file their tax returns. Introducing a clear cut commitment to simplifying the self-assessment system and only introduce tax reforms where they are simple to operate would be hugely popular and would not, in principle, reduce his total tax take.

Corporation Tax: is the UK rate still competitive?

Problem: With many of the UK’s international competitors continuing to reduce their headline corporation tax rates, the UK is in real danger of losing its international tax competitiveness. Ireland’s corporation tax of 12.5 per cent (introduced in 2003) has proved highly successful, attracting a stream of cross border business investment. As more and more businesses are actively considering locating business activities to lower tax jurisdictions, many other countries are now following Ireland’s lead with sizable corporation tax cuts. UK corporation tax is set to drop from 30 to 28 per cent on 1 April 2008, but this is still too high a rate to compete internationally. The figures below highlight some of the corporation tax rates across Europe:

• Austria 25 per cent
• Greece 25 per cent
• Germany c.26.3 per cent
• Netherlands 25.5 per cent
• Finland 26 per cent.

Many corporation tax rates in Central/Eastern Europe are below 20 per cent and these countries actively compete with the UK for many support functions which generate employment opportunities.

What Darling should do: Show his willingness to restore the UK’s competitive edge by announcing a plan to reduce our corporate tax rate further. This could be done by reducing the headline corporation tax to no more than 25 per cent over a three year period. Doing this would protect and enhance the UK as a location of choice for overseas investors and give a positive signal to UK business.

Corporation Tax – Providing tax incentives for innovation

Problem: A number of other European countries have also introduced reductions in corporation tax on patent royalties. This step was aimed at fostering and encouraging entrepreneurship and innovation by providing creative business people with worthwhile tax incentives. The UK currently provides no reduction in corporation tax on royalty income while in contrast Ireland taxes defined patent royalties at 0 per cent. Other European jurisdictions have introduced, or will shortly be introducing reduced tax rates on specified royalty income, namely France, Luxembourg, Netherlands and Spain.

What Darling should do: The Chancellor would be wise to introduce additional reliefs in this area to ensure the next generation of international entrepreneurs is not discouraged from investing in the UK.

UK-REITs

Problem: There is widespread belief that the introduction of UK-REITs, which saw most of the leading listed property investment companies convert to UK-REIT status on 1 January 2007 is inflexible. Other leading REIT regimes such as Australia and USA permit privately owned REITs and these have flourished. The Treasury and HM Revenue & Customs (HMRC) have already indicated they would not rule out such a move in the future. Indeed, the difficulties faced by many open ended real estate funds which have been forced to suspend unit redemptions by investors because of the downturn in the UK commercial real estate market demonstrates the advantages of the closed ended UK-REIT model.

What Darling should do: Introduce legislation to allow private unlisted UK-REITs, with a minimum number of unconnected shareholders of around 50.

Private Equity

Problem: Under present UK tax law, certain private equity backed companies have to pay a higher level of taxation than comparable independent companies. This is particularly true for smaller private equity backed companies which carry out research and development, typically some of the most dynamic and innovative companies in UK plc. This uneven playing field in taxation treatment is due to the way that tax legislation amalgamates the business interests of private equity backed companies compared to other companies. Therefore, although companies owned and backed by private equity funds are run completely separately and independently from each other, they may suffer from the business amalgamation rules in the tax law.

Among other points this means:

• Private equity backed companies are paying corporation tax at 30 per cent, compared to a corporation tax rate of as little as 19 per cent paid by similar size companies.

• Private equity backed companies do not benefit from the enhanced (150 per cent) tax deduction (or tax recovery from the Treasury) for expenditure they incur on research and development. Instead they only currently benefit from a 125 per cent tax deduction.

Clearly this means less free cash is available for such companies to invest back into growing the business.

What Darling Should do: Level the playing field for private equity backed companies so they can benefit from the same tax incentives as other similar size companies which are not backed by funds from private equity.

Income shifting – Will the Chancellor seek to resolve the fall-out from the recent House of Lords’ decision in favour of Arctic Systems?

The Problem: The House of Lords’ decision last summer in favour of the Jones family was regarded as a victory for certain small businesses such as Arctic Systems. However, as BDO Stoy Hayward predicted, the hostile reaction by business groups to the subsequent HMRC consultative document proposals to limit the effect of the decision demonstrates that the outcome of the case and HMRC’s response to it both cascades confusion and creates uncertainty. We consider that businesses will never be comfortable with anti-avoidance such as this (and, indeed, some of the draft legislation seems fairly petty) but HMRC is unlikely to accept that appropriate controls are required to provide a fair taxation system for the great majority of married taxpayers unable to benefit from the House of Lords decision. HMRC perhaps understandably, considers that the Arctic Systems verdict means that married couples who do not run such businesses will pay more tax on the same combined earnings than those who do.

What Darling should do: He should allow all married taxpayers to elect, but only if they so choose, to aggregate their personal allowances and lower tax bands for the purposes of calculating their total tax liability. This has the advantage that it would be simple to apply and, indeed, is already available to married couples in, for example, both Ireland and the USA. If this is not done, there will be ongoing dissatisfaction as business groups seek to prevent the HMRC proposals biting and HMRC attempt to introduce legislation to prevent what they consider to be tax avoidance. No amount of consultation, compromise or fine-tuning of the tax legislation will ever resolve these opposing views.

Employment tax – Clarification needed from the Treasury on legitimacy of company salary sacrifice schemes

Problem: It is common practice for employers to include benefit schemes as part of their employees remuneration, some of which (eg childcare vouchers) offer National Insurance savings for both the employer and the employee; and often tax savings for the latter. There are a wide range of schemes now available, however HMRC does not consider it is appropriate to comment on the schemes themselves but will comment specifically on the salary sacrifice and benefit in kind aspects. Following the withdrawal of the ‘Home Computer Scheme’, and more recently the amendment to the Holiday Pay Scheme, employers have been left in doubt as to the whether such schemes are compliant.

What Darling should do: The Chancellor needs to instruct HMRC either to formally acknowledge the legitimacy of these schemes (where correctly structured) or issue guidance to employers clarifying the policy HMRC takes in relation to such matters. This will help employers who wish to utilise such schemes remain compliant and enable them to offer appropriate benefit schemes to reward and incentivise their staff.

Non-domiciles – will the Chancellor’s measures to collect more taxation from this group of individuals damage the British economy?

Problem: The Chancellor would no doubt have hoped before the PBR that this decisive - but high risk - action to tackle the perceived issue of foreign billionaires based in the UK paying little or no tax on their income would end the media spotlight surrounding this practice. However, unfortunately for Darling, the issue has not gone away and the introduction of legislation in October’s PBR to charge non-domiciles working in the UK a £30,000 fixed tariff once they had been resident in the UK for seven years has been the subject of further controversy. An increasingly vocal UK plc has voiced concerns on the effect this charge will have on the prosperous, but not extremely wealthy, non-domiciled middle-ranking executives who might, for example, be working in financial or professional services. For this section of society, £30,000 a year would be a significant cost to bear and may encourage some to look to relocate to other financial centres in Europe.

What Darling should do: Although Darling has recently sought to calm fears of a mass exodus of wealthy foreigners living in the UK by diluting plans for the proposed clampdown on non-domiciles, he still has a very long way to attempt to regain the confidence of UK business, if this is still possible. He must assure UK plc of his commitment to maintaining the UK as the financial centre of choice for these high net worth entrepreneurs, business men and women.

National Insurance

Although it is unlikely that the Chancellor will make any substantive changes to National Insurance in this year’s Budget there is growing feeling that greater transparency is needed around what we are actually contributing towards when we pay it.

The current rate of national insurance is 12.8 per cent for employers (it is 11 per cent for the majority of employees). National insurance raises in total over £90 billion for the Chancellor (second only to income tax which raises over £160 billion) but this would not be a good year to increase what is a tax on employment costs. It should be noted that although the 11 per cent employees rate is not changing, fiscal drag will pull more employees into paying national insurance at the full rate.

It should be noted that the Government Actuary acknowledges that the National Insurance Fund now generates increasing annual surpluses over the amounts required to fund the prescribed contributory benefits (mainly retirement pensions, incapacity benefit, statutory sick pay and maternity benefits etc). Accordingly, this already represents (even without the increases from 6 April 2008) little more than an increasing ‘stealth’ tax.

Inheritance Tax (IHT) – is the current exemption threshold too low?

Problem: Although there has been marked slowdown in house price inflation in the last six months, the spectacular year-on-year increase in house prices in recent years coupled with a threshold that has only tracked retail inflation, means that, although IHT raises around one per cent of total tax revenues, it is a deeply unpopular tax. In last October’s PBR the Chancellor did attempt to draw a line under the political and media scrutiny aimed at IHT by introducing legislation that will allow married couples to transfer the nil rate band between them. Under the new legislation, if this nil rate band is not used by a taxpayer at their time of his/her death, their spouse’s executors may claim an additional nil rate band to reduce the inheritance tax on their own death. However, this change has not gone far enough as it has not addressed the issue that the threshold for exemption is still too low relative to the increased value of residential property in the UK.

What Darling should do: Increase the exemption threshold to at least £500,000 (note that the Conservatives proposed last year to increase this to £1 million), making sure that the tax hits those it was meant to, and not moderately affluent house owners. Darling could even scrap IHT entirely without reducing Treasury receipts, by treating death as a disposal for capital gains tax purposes. It would however be necessary to provide a sensible and generous threshold to, say, the first £125,000 of gains.

What Darling should not do: Merely exempt principal private residences from IHT, which would create economic distortions and stoke house price inflation at the expense of first time buyers.

VAT – Simplification measures to reduce the administrative burden on business

Problem: It is sometimes forgotten that VAT collects over £80 billion for the Chancellor each year (the third largest tax collection after income tax and national insurance). A certain number of the UK’s principle competitors now have higher VAT rates (eg France 19.6 per cent, Sweden 25 per cent, Ireland 21 per cent and Germany 19 per cent). We fear that the Chancellor may look to this to fund his public spending commitments in the future by increasing the UK’s (now) relatively low VAT rate. This would not be a good year to do so, however, because of the anaemic increases in consumer spending affecting many high street retailers.

What Darling is likely to do: In last year’s PBR the Chancellor announced measures to reduce the red tape businesses have to go through if they wish to opt to tax property transactions, enabling them to get VAT recovery on their associated costs. This business friendly initiative comes into force later this year. Although it will be welcomed by business as it will reduce the complexities and the time taken to make an option to tax, it will not cost the Treasury any money as it will have no effect on the national tax take. Most land and real estate transactions are exempt from VAT, but a taxpayer can normally opt to tax such transactions, although where he/she has already received VAT exempt income from it the rules for doing so can be complex. It is these rules which we expect may be simplified.

Stamp Duty Land Tax – Clarification needed following introduction of anti-avoidance legislation

Problem: In the 2006 PBR the then Chancellor, Gordon Brown, introduced anti-avoidance legislation on Stamp Duty Land Tax (SDLT) to plug perceived loop holes which were allowing certain commercial purchases of businesses to proceed without paying the full SDLT liability. However, the new provisions have been the subject of much criticism as their wording is vague and it does not include a purpose/motive test. Companies undertaking legitimate commercial land transactions can currently be subjected to HMRC’s challenge.

What Darling should do: Bring clarity to this legislation and introduce a purpose/motive test.

Stamp Duty - Partnerships

Problem: The existing partnership legislation is extremely complex, particularly as a result of a number of changes and amendments as an attempt to block perceived loopholes in the original provisions.

What Darling Should do: Simplify the rules for determining the SDLT charges on property contributed to and withdrawn from partnerships.

Stamp Duty - Lease Rules

Problem: The existing lease rules mean that SDLT on the grant of new leases can prove prohibitively expensive for certain occupiers such as hoteliers and can sometimes even jeopardise a deal.

What Darling should do: Help occupiers of commercial property (for example, hoteliers and nursing home operators) currently suffering a high initial SDLT charge the ability to spread the payment of SDLT on leases of over, say five years.

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Posted March 7, 2008