The UK Government’s 2006 Budget was unveiled by the Chancellor of the Exchequer, Gordon Brown, on 22 March.
Although the accompanying documentation was as voluminous as ever (the Finance Bill, published on 7 April 2006 which will enact the proposals, runs to nearly 500 pages), this in truth was an unremarkable budget for international taxpayers. Many of the principal announcements had been previously trailed, and the Chancellor largely failed to respond to calls to cut and simplify the corporate tax regime. Once again, anti-avoidance measures feature prominently, many resulting directly from disclosures made under the avoidance disclosure regime introduced in 2004 (which itself will be extended).
EU Issues—Cross-border Extension to Group Relief
The most eye-catching change for multinationals was a proposal to extend the availability of group relief, which is the mechanism whereby a group company can surrender its current-year losses and set them against the profits of another group company.
The changes represent the UK Government’s response to the recent decision of the European Court of Justice in the Marks and Spencer case. This found that the current rules, which restrict the availability of group relief to situations where both companies are taxable in the UK, contravened the rights to freedom of establishment under the EU treaty.
The changes will allow a subsidiary of a UK parent resident elsewhere in the European Economic Area (EEA) to surrender its losses to the UK parent, provided such losses are incapable of relief in the subsidiary’s place of residence and provided that no intervening countries in the chain of ownership can use the losses in their country of residence. Anti-avoidance measures will accompany the new legislation to prevent groups from entering into arrangements which result in unrelievable losses outside the UK, where the main purpose or one of the main purposes is to obtain relief in the UK.
The changes proposed take an extremely narrow interpretation of the Marks and Spencer judgment. They do not permit EEA companies to surrender to UK subsidiaries in non-UK parented groups, and companies resident outside the EEA can only surrender losses arising in respect of their EEA permanent establishments. Further, cross-border relief is not extended to consortium relief claims. Qualifying losses can only be group relieved if they cannot be used in the country in which they arose, whether in the current, prior or future periods, by the surrendering company or another non-UK person.
The UK courts are currently further considering the Marks and Spencer case, and a number of other claims are awaiting hearing in the European Court. These decisions will determine whether the amendments bring the UK fully into compliance with EU law or whether further extensions of group relief are needed.
UK corporation tax regime compliance with EU law is likely to remain a live issue with a number of additional cases awaiting hearing or judgment at the European Court. These consider, amongst other issues, the UK system’s compatibility with EU law for the taxation of foreign dividends and controlled foreign company rules.
Multinationals with subsidiaries or branches in the UK should:
- If they have not done so already, consider seeking advice on whether to pursue claims for group relief in the UK for losses of foreign group companies.
- Bear in mind the extension of the group relief rules, and the potential new relief it offers to UK companies, in the context of their European group structuring.
Real Estate Investment Trusts (REITs)
Following extensive consultation, the Government published legislation to introduce real estate investment trusts to the UK with effect from 1 January 2007. The move is intended to encourage greater investment in the UK property market and follows similar legislation in other European countries, as well as the long-established regime in the United States.
REITs (which, despite their name, will in fact be limited companies) will be exempt from tax on their income and capital gains deriving from real property located in the UK and elsewhere. They will be subject to corporation tax in the normal way upon all other income and gains.
REITs will be required to distribute 90 per cent of their tax-exempt profits every year, which will be paid out to investors under deduction of the basic rate income tax of 22 per cent. Such income will be taxable as property income in the hands of each shareholder.
Various additional requirements will apply to REITs, notably they must be UK resident and listed on a recognised stock exchange. Also the benefits of the REIT regime will be denied to the extent that any single investor is beneficially entitled to 10 per cent or more of distributions. The reason for this last condition is seemingly that investors holding more than 10 per cent would be entitled to treaty relief from withholding tax on distributions and, in the absence of such provisions, would receive dividends wholly or substantially free from UK tax depending on the terms of the relevant treaty.
Additionally, REITs must maintain a ratio of interest expense on loans to rental income of less than 1.25:1 and must pay a conversion charge of 2 per cent of the market value of their investment properties at the date they entered the regime.
The property market has generally reacted positively to the introduction of REITs, but it remains to be seen how extensively the new structure will be adopted. The numerous restrictions, which reflect the Treasury’s insistence that the introduction of REITs is revenue neutral, may limit take up. In particular the 10 per cent cap on holdings will likely discourage many investors.
Disclosure of Tax Avoidance Schemes
The rules requiring disclosure of certain tax avoidance schemes, originally introduced in 2004, will be substantially remodelled and extended in scope. Previously limited to relatively specific arrangements involving financial and employment-related products, they will now cover the whole of income tax, corporation tax and capital gains tax from 1 July 2006. Whether a scheme is disclosable will be determined by reference to various hallmarks, which will target new and innovative schemes, mass-marketed tax products and areas of particular risk (with these including tax loss schemes and certain leasing arrangements).
The disclosure obligation normally falls upon the promoter of the particular scheme, but where a scheme is devised in-house or where the adviser is legally unable to disclose, the obligation falls upon the taxpayer.
Considerable uncertainty remains as to the scope of the existing regulations (in particular, as to when privilege subsists to prevent disclosure), and this extension of the rules will likely add to the uncertainty. Further the information will be available later in April when the draft revised regulations will be published.
Alternative Finance Arrangements
The new legislation amends the taxation of alternative finance arrangements structured to ensure that there is no receipt or payment of interest (to comply with Islamic law, for example). Changes will apply to arrangements entered into on or after 6 April 2006 for corporation tax purposes, 1 April 2006 for income tax purposes and 22 March 2006 for specified arrangements made available to employees.
The new provisions extend existing legislation to three additional alternative finance arrangements: agency-style contracts equivalent to a saving account, partnership-style arrangements used to finance the purchase of property or other assets, and arrangements equivalent to low-interest loans from employers to employees. The provisions charge to tax amounts paid under these arrangements equating economically to interest on the same basis as interest.
Corporate Capital Losses
Three targeted anti-avoidance rules will be introduced to ensure that the creation and use of capital losses is restricted to genuine commercial transactions. The legislation will be introduced in the Finance Act 2006 when it receives Royal Assent but will retrospectively apply to transactions entered into on or before 5 December 2005.
The legislation is aimed at deterring transactions which involve the creation of corporate capital losses, the purchase of capital gains and losses, the conversion of income streams into capital gains, and the creation of a capital gain matched by an income deduction (where the gains are then wholly or partly franked by capital losses). When the provisions apply, tax relief is denied for relevant capital losses relating to transactions where the main or one of the main purposes of the transaction is to secure a tax advantage.
Value Added Tax—Measures Targeting “Carousel” Fraud
The UK tax authorities seek to change existing VAT legislation in order to target “carousel” VAT fraud. The proposed legislation would only apply to certain specified goods such as mobile phones, computer chips and some other similar electronic items which are susceptible to this type of fraud.
Currently, the seller of taxable goods is liable to account to the tax authorities for VAT paid by the purchaser. In a carousel fraud a fraudulent business seller, having acquired goods VAT-free from another European Community (EC) trader, will not then account to the tax authorities for VAT paid to it by the purchaser on the onward taxable sale of the same goods. The proposed legislation would impose the liability to account for VAT on the purchaser (via the reverse charge mechanism) instead of the seller thereby removing the opportunity for fraud.