Jim Callaghan, the Chancellor of the Exchequer who introduced corporation tax in 1965.

Corporation tax is a direct tax levied in the United Kingdom on the profits made by companies or associations that are either tax resident in the UK, or which are trading in the UK through a permanent establishment. The tax raised over £28bn for the UK Exchequer for the year to 31 March 2003.

Corporation tax was introduced from 1 April 1965 by the Finance Act 1965, which simultaneously removed companies and associations that became liable to corporation tax from the income tax charge. Profits are only chargeable to corporation tax if there is a specific provision that brings them within the charge to tax. This is known as the source rule, and there are very detailed rules about which profits fall within the charge.

History

Introduction of the tax

Before 1965 companies were liable to income tax and profits tax. They were not taxed on capital gains. The then Chancellor of the Exchequer James Callaghan changed this in the Finance Act 1965. From 1 April 1965, UK resident companies and overseas companies trading through a UK branch were removed from the income tax charge, and instead made liable to corporation tax. Corporation tax was then charged a uniform rate on all profits, but with an additional charge to income tax when profits were distributed.

In the same Finance Act, capital gains tax was introduced for individuals. Companies were exempted from capital gains tax, but became liable to corporation tax on their chargeable gains, which were calculated in the same way as individuals' capital gains were taxed. Although some short-term capital profits had been taxed under the income tax rules in the past, this was the first time most capital receipts became taxable.

Introduction of a partial imputation system

In 1973, a partial imputation system was introduced. When companies paid dividends, they also paid advance corporation tax, which could be set off against the mainstream corporation tax charge, subject to certain limits (which meant that the full amount of ACT paid would not be recovered where significantly large amount of profits were distributed). Individuals and companies who received a dividend from a UK company received a tax credit representing the UK tax suffered by that company. Individuals could set off the tax credit against their income tax liability. Companies could set off the tax credit against ACT they had to pay. Certain other reliefs were available to companies in respect of the tax credit.

Gordon Brown, the Chancellor of the Exchequer who abolished ACT and introduced the quarterly instalment régime in 1999.

The imputation system of advance corporation tax (ACT) and associated tax credits was abolished in April 1999. Technically, dividends from UK companies are still accompanied by a tax credit, but that tax credit is not recoverable, and individuals are effectively taxed as though it did not exist.

Abolition of the imputation system

In the 1980s there was briefly a higher rate of tax imposed for capital profits, and the details of how the mechanics of how the Inland Revenue assessed the tax changed, but the structure and format of corporation tax then largely remained the same until 1999.

From 6 April 1999 the imputation system was replaced. ACT no longer became payable. The tax credit on dividends was reduced to 10%, but the tax credit no longer had any value for companies. However, those subject to income tax can set off the tax credit against their income tax liabilities. ACT that had already been suffered could still be set off against a company's tax liability, provided it would have been able to set it off under the old imputation system.

To avoid undue Exchequer cost, for accounting periods beginning on or after 1 July 1999, large companies had to pay tax in quarterly instalments, starting (for 12 month accounting periods) on the 14th day of the 7th month of the accounting period. Companies that are not large have to pay their corporation tax liability within nine months and one day of the end of an accounting period.

Rates

Initially corporation tax was charged at 40%, a figure that rose to 45% in the 1969 Budget. The rate then fell to 42.5% in the second Budget of 1970 and 40% in 1971, which is where it stayed till 1973, when a full rate of 52% was introduced, together with a smaller companies' rate of 42%. Rates remained high until the early 1980s, when they progressively fell reaching 35% and 25% by 1988. Since then there have been a series of steady falls to the current rates of 30% and 19%. Also, although the full rate of corporation tax has always been set independently from the income tax rates applicable to individuals, from April 1983 to March 1997 the small companies' rate was pegged to the basic rate of income tax. Since then, there has been no correlation between corporation and income tax rates for most companies.

Method of charge

Corporation tax is an annual tax, which means it must be passed annually by parliament, otherwise there is no authority to collect it. Up until the Finance Act 1997, the charge was passed in that year's Finance Act: so the charge for the financial year beginning 1 April 1997 was imposed by the Finance Act 1997. In 1998 this changed - so the Finance Act 1998 imposed the charge for the 1998 and 1999 financial years, and the Finance Act 1999 imposed the charge for the 2000 financial year, and so on.

Accounting periods

Corporation tax is charged in respect of accounting periods. An accounting period begins whenever a company comes within the corporation tax charge, and whenever an accounting period ends without the company ceasing to be within the charge.

An accounting period ends with the earlier of:

• 12 months passing from the beginning of the accounting period;
• an accounting date of the company or, if there is a period for which the company does not make up accounts, the end of that period;
• the company beginning or ceasing to trade or to be, in respect of the trade or (if more than one) of all the trades carried on by it, within the charge to corporation tax;
• the company beginning or ceasing to be resident in the United Kingdom;
• the company ceasing to be within the charge to corporation tax;
• the commencement of a winding up (in which case, thereafter an accounting period can only end on the expiration on 12 months or by the conclusion of the winding up;
• when a life assurance company transfers some of its long-term business to another company.

Every UK company, and most overseas companies, prepare accounts known as financial statements for 12 month periods. Therefore, for most active companies, accounting periods coincide with the period for which they draw up accounts.

Assessment

Up until 1999 no corporation tax was due by a company unless the Inland Revenue raised an assessment to corporation tax on that company. A company was, however, under an obligation to report certain details to the Inland Revenue so that the right amount could be assessed. This changed for accounting periods ending on or after 1 July 1999, when self-assessment was introduced. Self-assessment means that companies are required to assess themselves to corporation tax and take full responsibility for that assessment. If the self-assessment is wrong through negligence or recklessness, the company can be liable to tax-geared penalties. From 2004 there has been a requirement for new companies to notify the Inland Revenue of their existence.

Schedular system

In the United Kingdom the source rule applies. This means that something is taxed only if there is a specific provision bringing it within the charge to tax. Accordingly, profits are only charged to corporation tax if they fall within one of the following, and are not otherwise exempted by an explicit provision of the Taxes Acts:

Notes:

1. The heads of charge listed above are mutually exclusive. No income or gain can fall within more than one head of charge.
2. In practice companies do not get taxed under Schedule F. Most companies are exempted from Schedule F and there is a provision for those companies which are taxed on UK dividends (ie dealers in shares (stock)) that removes the charge from Schedule F to Schedule D.
3. A controlled foreign company ("CFC") is a company controlled by a UK resident that is not itself UK resident and is subject to a lower rate of tax in the territory in which it is resident. Under certain circumstances, UK resident companies that control a CFC pay corporation tax on what the UK tax profits of that CFC would have been. However, because of a wide range of exemptions, very few companies suffer a CFC charge.
4. There used to be a Schedule B and a Schedule C that applied to companies, but these have now been merged with Schedule D. Schedule E, which was repealed in 2003, only applied to individuals.
5. Authorised unit trusts are not liable to tax on their chargeable gains.

Cases of Schedule D

Schedule D is itself divided into a number of cases:

Notes:

1. Income can fall within more than one of Case I, III and V. Where this happens, the income is only taxed under one of the Cases. The Inland Revenue (the UK taxing authority) decides which Case will be applied.
2. Where interest-type income and gains.losses on loans, derivatives, financial instruments and intangibles relate to a trade, they fall within Case I not Case III. The one exception to this is life assurance companies taxed on the I minus E basis, where they always fall within Case III. Overseas interest-type income, etc. falls within Case I or III, as appropriate, and never under Case V.
3. There is a Case II, which applies to income from professions and vocations. It is not believed that a company within the charge to corporation tax can have such income.
4. There used to be Cases IV, VII and VIII, but these have all been abolished.

Relief for expenses

The computations of income and taxable chargeable gains include deductions for direct expenses. However, not all sources of income have direct expenses (particularly those falling within Cases III and VI of Schedule D, foreign dividend income falling within Case V and income falling within Schedule F). Also a company may incur expenses managing a subsidiary which does not tend to pay dividend income to it.

Relief is therefore given for management expenses incurred by a company with investment business (before 1 April 2003 investment companies), and for certain management expenses of a life assurance company taxed on the I minus E basis. Relief is also given as a deduction from profits chargeable to corporation tax to certain payments to charities, certain royalty payments made by non-traders and some manufactured overseas dividends.

Rates

The following applies as from 1 April 2003. The main rate of corporation tax is 30%. However, lower rates are sometimes applicable.

Notes:

1. The bands shown on the right hand side are divided by one plus the number of associates (usually the only associates a company has are fellow group companies, but the term is more widely defined)
2. The reduced rates do not apply to close investment holding companies (companies controlled by fewer than 5 people (plus associates) or by their directors/managers, whose main activity is the holding of investments). Nor do they apply to companies in liquidation after the first 12 months
3. Since 1 April 2004, if profits distributed have not suffered tax at a rate of at least 19%, the tax charge for the period is increased so that tax at 19% does get charged on them. However, this does not apply to profits distributed to companies
4. Authorised unit trusts and open-ended investment companies are taxed at 22%
5. Life assurance companies are taxed at 30% on shareholder profits and 20% on policyholder profits (See also: I minus E basis)
6. Companies active in the oil and gas extraction industry in the UK or on the UK continental shelf are subject to an additional 10% charge on their profits from those activities

Revenues

For the financial year ended 31 March 2003 the tax raised revenues of £28.2bn from 512,269 companies. Only 18,802 companies had a liability in excess of £100,000.

Calculation of profits

Case I of Schedule D and Schedule A

Subject to specific statute or case law to the contrary, Case I of Schedule D and Schedule A profits are based on profits as calculated using UK Generally Accepted Accounting Practice. The same is true for the deduction for management expenses that are available to companies with investment business. Where a company prepares its accounts under International Financial Reporting Standards, it will use profits computed on that basis instead from 2005 onwards, subject to specific statute or case law to the contrary.

The main exceptions to this rule are that no deductions are allowed under Case I of Schedule D (or Schedule A) for expenses not incurred wholly and exclusively for the trade (or rental business) and that no deductions are available for capital (ie deductions are only available for revenue items).

In recent publications the Inland Revenue has split the various exceptions to the "follow the accounts" rule up into 11 somewhat arbitrary categories, of which 1 is the miscellaneous residual category. The other ten are

• Public policy
• Transfer pricing
• Structural
• Avoidance
• Tax neutrality
• Capital items
• Fiscal incentives
• Symmetry
• Realisability and Tax capacity
• "True reflection"

Tax depreciation

Since no capital deductions are allowed, depreciation on capital assets is not deductible, although tax depreciation, known as "capital allowances" is available for expenditure on some capital assets. Note that expenditure on finance leases (as opposed to, say, lease or hire purchase agreements) is considered to be revenue. Therefore interest payments and depreciation on finance leases is deductible. If the finance lessor owns the asset, however, it may be able to make a claim for capital allowances.

The main allowances are a 25% reducing balance basis allowance for plant, machinery, fixtures and fittings. This would mean that if a piece of plant, say, was bought for £400 in year 1, 25% of £400 (ie £100) would be deductible from taxable profits as tax depreciation in year 1. Then 25 % of £(400-100) (ie £75) would be so deductible in year 2, and so on. The 25% figure is reduced to 10% for certain assets leased overseas and 6% for most assets with an expected life of 25 years or more. There are also 100% capital allowances for expenditure on energy-saving plant and machinery, and 40% first year allowances for small and medium-sized companies and companies in Northern Ireland

Capital allowances on a 4% straight line basis allowance are given for industrial and agricultural buildings. Tax depreciation is also potentially available for expenditure on: mineral extraction, flat conversion, research and development, know-how, patents, dredging and assured tenancy. In particular, no allowances are available for non-industrial or agricultural buildings, land and abortive expenditure or capital expenditure which does not give rise to a capital asset.

Tonnage tax

Shipping companies may elect to compute their Case I profits using a formula based on tonnage rather than fiscally adjusted accounting profit.

Case III of Schedule D

Gains and losses on loans, derivatives, financial instruments and intangibles are taxed as well as income. The basic rule for calculating Case III profits is to follow the accounts, although there are detailed anti-avoidance rules to stop the most obvious abuses. Only direct expenses, such as costs incurred in obtaining a loan, are deductible in the Case III computation. If the result is negative, Case III profits are taken as nil, with the negative result being treated as non-trading debits. Similar calculation rules apply to loans, derivatives, financial instruments and intangibles that are taxed under Case I (although losses are treated as a Case I expense rather than non-trading debits).

Case V of Schedule D

Overseas property income and income of a wholly overseas trade are calculated in the same way as Schedule A and Case I of Schedule D income respectively. Overseas dividend income is usually accounted for and taxed on a receipts basis. Double tax relief (see below) may be available where the overseas income has suffered foreign tax.

Case VI of Schedule D

Where the Case VI charge relates to casual annual income, it is usually taxed on a cash basis, though usually the Inland Revenue will accept an accruals basis. Relief is usually available for direct expenses if they would have been allowable in a Case I computation.

Chargeable gains

Chargeable gains (or allowable losses) are calculated as gross proceeds less direct selling costs less base cost less indexation allowance. Indexation allowance is base cost multiplied by the change in the retail price index movement between the month of purchase and month of sale. Indexation allowance cannot create or increase a loss. Losses may only be set off against chargeable gains of the same or a future accounting period (except certain allowable losses of life assurance companies (see: I minus E basis).

The UK operates a participation exemption called the "substantial shareholding exemption". Assuming all the relevant entities or groups are trading companies and groups, if a company together with its fellow group companies has a shareholding of over 10% in another company, and has held those shares for more than 12 months, disposals of those shares are exempt from chargeable gains. The figure of 10% is increased to 30% for shares held by the long-term insurance fund of a life assurance company. The detailed rules, however, are complex, and companies need to study them closely to see whether the substantial shareholding exemption applies.

There are also other exemptions and holdover and rollover reliefs that apply: for example, where a business property is sold and a new business property is acquired with the proceeds, no chargeable gain will immediately arise. These are such that most companies will only rarely have a chargeable gain. The main exception being life assurance companies taxed on the I minus E basis: these companies pay the bulk of the tax paid on chargeable gains.

CFC charge

In addition to being taxed on its own profits, a UK company may be taxed on the profits from a controlled foreign company in which it has an interest. This is an anti-avoidance provision. There is a wide range of exemptions, and usually groups arrange their affairs so a CFC charge does not arise. When it does arise it is equal to what the overseas company's UK taxable profits would have been on the assumption that the overseas company is UK resident, and ignoring chargeable gains. Relief is available for UK tax paid on dividends received from a CFC where a CFC charge is or was payable and for overseas tax suffered.

Relief from double taxation

There is a risk of double taxation whenever a company receives income that has already been taxed. This could be dividend income, which will have been paid out of the post-tax profits of another company and which may have suffered withholding tax. Or it could be because the company itself has suffered foreign tax, perhaps because it conducts part of its trade through an overseas permanent establishment, or because it receives other types of foreign income.

Double taxation is avoided for UK dividends by exempting them from tax for most companies: only dealers in shares suffer tax on them. Where double taxation arises because of overseas tax suffered, relief is available either in the form of expense or credit relief. Expense relief is straightforward: the overseas tax is treated as a deductible expense in the tax computation. Credit relief is given as a deduction from the UK tax liability, but is restricted to the amount of UK tax suffered on the foreign income. There is a system of onshore pooling, so that overseas tax suffered in high tax territories may be set off against taxable income arising from low tax territories.

Loss relief

Detailed and separate rules apply to how all the different types of losses may be set off within a company. A detailed explanation of these can be found in: United Kingdom corporation tax loss relief.

Group relief

The UK does not permit tax consolidation. Tax consolidation is where companies in a group are treated as though they are a single entity for tax purposes. One of the main benefits of tax consolidation is that tax losses in one entity in a group are automatically relievable against the tax profits of another. Instead, the UK permits a form of loss relief called "group relief".

Where a company has losses arising in an accounting period (other than capital losses, or losses arising under Case V or VI of Schedule D) in excess of its other taxable profits for the period, it may surrender these losses as group relief, provided there is a suitable group member with sufficient taxable profits in the same accounting period. (There are separate rules for life assurance companies and dual resident companies not covered here.)

A company may accept group relief against its own profits chargeable to corporation tax. However, a company in the oil and gas extraction industry may not accept group relief against the profits arising on its oil and gas extraction business, and a life assurance company may only accept group relief against its profits chargeable to tax at the standard shareholder rate applicable to that company.

Full group relief is permitted between companies subject to UK corporation tax that are in the same 75% group. Broadly speaking a 75% group is one where companies have a common ultimate parent, and at least 75% of the shares in each company (other than the ultimate parent) are owned by other companies in the 75% group. The companies making up a 75% group do not all need to be UK resident or subject to UK corporation tax relief. An open-ended investment company cannot form part of a group.

Consortium relief is permitted where a company subject to UK corporation tax is owned by a consortium of companies that each own at least 5% of the shares and together own at least 75% of the shares. A consortium company can only surrender or accept losses in proportion to how much of that company is owned by each consortium group.

Interaction with European law

Although there are no European Union directives (laws) dealing with direct taxes, tax laws need to comply with more general European legislation. In particular legislation should not be discriminatory, and must be consistent with EU directives on freedom of establishment and freedom of movement.

Key cases decided by the European Court of Justice that have had a direct impact on UK tax law include:

• Hoescht - where the Court found that the way the partial imputation system operated prior to its abolition in 1999 was discriminatory;
• Lankhorst-Hohorst, which was a German case, that implied that the UK's transfer pricing and thin capitalisation legislation may have been contrary to EU legislation (the 2004 Finance Act made changes to counter this threat);

Also, the case of ICI v Colmer led to the UK amending its definition of a group for group relief purposes to that outlined above. Previously the definition required that all companies and intermediate parent companies in a group to be UK resident.

There are also a number of other cases making their way, slowly, up to the European Court. Most of these are expected to be found in favour of the taxpayer. In particular:

• Marks and Spencer - where it is claimed that UK parents should be able to relieve the losses of overseas subsidiaries against the tax profits of their UK subgroup;
• A group litigation order arguing that dividends received from overseas companies should be exempt from tax in the same way as dividends received from UK companies are exempted from tax;
• Claims that the UK CFC legislation is contrary to EU law.

Recent developments

Corporation tax reform

There have recently been a number of proposals for corporation tax reform. So far only a few have been enacted:

• In March 2001 the Government published a technical note A Review of Small Business Taxation. The note considered simplification of corporation tax for small companies through the closer alignment of their profits for tax purposes with those reported in their accounts.

• In July 2001 the Government published a consultation document Large Business Taxation: the Government's strategy and corporate tax reforms. It set out the Government's strategy for modernising corporate taxes and proposals for relief for capital gains on substantial shareholdings held by companies.

• In August 2002 Reform of corporation tax - A consultation document was published, outlining initial proposals for the abolition of the Schedular system. This was followed up in August 2003 by Corporation tax reform - A consultation document, which further discussed the possible abolition of the Schedular system, and also whether the capital allowances (tax depreciation) system should be abolished. It also made proposals that were ultimately enacted in the Finance Act 2004. The first two of these listed below were in response to threats to the UK tax base arising from recent ECJ judgments. The changes were to:
  • introduce transfer pricing rules for UK to UK transactions (transfer pricing rules require certain transactions to be deemed to have taken place at arm's length prices for tax purposes when they did not in fact take place at arm's length prices)
  • merge thin capitalisation rules with the transfer pricing rules. Thin capitalisation rules limit the amount a company can claim as a tax deduction on interest when it receives loans at non-commercial rates (eg from connected parties),
  • extend the deduction for management expenses to all companies with an investment business (previously a company had to be wholly or mainly engaged in an investment business to qualify)

• In December 2004 Corporation tax reform - a technical note was published. It outlined that the Government had decided to abolish the Schedular system, replacing the numerous schedules and cases with two pools: a trading and letting pool; and an everything else pool. The Government had decided that capital allowances would remain, though there would be some reforms, mostly affecting the leasing industry.

Recent enactments

So far, the following main reforms have been enacted:

• Relief from tax on chargeable gains on disposals of substantial shareholdings in trading companies and groups (enacted by the Finance Act 2002)
• Introduction of UK to UK transfer pricing rules, coupled with the merging of the thin capitalisation rules with the transfer pricing rules (enacted by the Finance Act 2004)
• Extension of management expenses rules so that companies do not need to be investment companies to receive them, coupled with a specific rule preventing capital items being deductible as management expenses (enacted by the Finance Act 2004)

Additionally, in the Finance Act 2004 tax avoidance disclosure rules were introduced. These make promoters of certain tax avoidance schemes that are financing or employment related have to disclose the tax avoidance scheme to the Inland Revenue. Taxpayers who use those tax avoidance schemes must also disclose which schemes they have used to the Inland Revenue when they submit their tax returns. This is the first time anyone has been obliged to alert the Inland Revenue to tax planning techniques they are using.

See also

• Corporate tax
• Taxation

References

• Inland Revenue Company Taxation Manual (http://www.inlandrevenue.gov.uk/manuals/ct123manual/index.htm)
• Income and Corporation Taxes Act 1988 (link is to the Act as originally enacted) (http://www.legislation.hmso.gov.uk/acts/acts1988/Ukpga_19880001_en_1.htm)
• Taxation of Chargeable Gains Act 1992 (link is to the Act as originally enacted) (http://www.legislation.hmso.gov.uk/acts/acts1992/Ukpga_19920012_en_1.htm)
• Capital Allowances Act 2001 (link is to the Act as originalled enacted) (http://www.legislation.hmso.gov.uk/acts/acts2001/20010002.htm)
• Finance Acts 1965-2004 (the Finance Acts from 1988 onwards, as originally enacted, are available under "Public Acts" on this link (http://www.legislation.hmso.gov.uk/acts.htm). Note: earlier Finance Acts were consolidated into the Income and Corporation Taxes Act 1988, the Taxation of Chargeable Gains Act and the Capital Allowances Act 2001
• The Taxes Acts 2002 (ie all legislation extant in 2002) are available here (http://www.inlandrevenue.gov.uk/taxes_act_2002/index.htm)
• The Inland Revenue website section on Corporation Tax (http://www.inlandrevenue.gov.uk/businesses/tmacorporate-tax.shtml)
• Reform of corporation tax - A consultation document (August 2002) published by HM Treasury and the Inland Revenue (pdf) (http://www.inlandrevenue.gov.uk/consult_new/taxreform_final.pdf)
• Corporation tax reform - A consultation document (August 2003) published by HM Treasury and the Inland Revenue (pdf) (http://www.inlandrevenue.gov.uk/consult_new/corp-tax-reform.pdf)
• Corporation tax reform - A technical note (December 2004) published by HM Treasury and the Inland Revenue (pdf) (http://www.inlandrevenue.gov.uk/pbr2004/sup_ct-reform-tech-note.pdf)
• Key economic events 1955-1979 by Biz/ed (http://www.bized.ac.uk/dataserv/chron/kf5579.htm#1972)
• Rate of Corporation tax by the Inland Revenue (pdf) (http://www.inlandrevenue.gov.uk/stats/corporate_tax/table_a6_december04.pdf)
• Summary of Hoescht by lawreports.co.uk (http://www.lawreports.co.uk/ecjmar0.4.htm)
• Summary of Lankhorst-Hohorst by lawreports.co.uk (http://www.lawreports.co.uk/ecjdecc0.1.htm)
• The Lankhorst-Hohorst judgment (http://curia.eu.int/jurisp/cgi-bin/gettext.pl?lang=en&num=79978787C19000324&doc=T&ouvert=T&seance=ARRET&where=())