Introduction
NCL Investments
Complicated tax base
Comment
The recent political discourse in the United Kingdom is shining a spotlight on the key distinction between tax rates and the tax base. The candidates to replace the incumbent prime minister are jostling for position and the issue of tax rates has been, perhaps surprisingly, at the top of the agenda. A particular issue is the rate of UK corporation tax, due to rise from 19% to 25% in April 2023, and whether this should be reviewed. However, in among the discussion of rates, there is little discussion of the underlying tax base, which can have as much, or greater, impact on the overall tax take. This could be because the computation of the corporate tax base in the United Kingdom is complicated and requires a nuanced understanding of different factors – a point highlighted by the recent Supreme Court decision in NCL Investments.(1)
This article uses NCL Investments as a reminder of some of the issues that need to be considered when computing taxable profits for corporation tax purposes. The discussion in that case arose in respect of accounting debits recognized within a UK resident company (the taxpayer) in respect of share options provided to employees of that company by its parent. The business of the relevant company was to provide employees to other members of its group. This article does not go into detail on the facts of the case or the detailed accounting standards but it is relevant to note that the standards in this case (International Financial Reporting Standard 2 (IRFS 2)) required the taxpayer to recognize the debit separately to the actual recharge payments made to its parent company (ie, the debit did not relate to the actual payment of any expenses) and that the opposite entry to the debit was a credit to equity to reflect a notional capital contribution by the taxpayer's parent in granting the option.
The key issue arising from the above was whether the IRFS 2 debit should be included within the tax base calculation and therefore, ultimately, reducing the tax payable by the taxpayer.
Her Majesty's Revenue and Customs (HMRC) attempted to challenge the inclusion of the debits within the computation of taxable profits by reference to a number of the key principles involved in calculating such profits.
The starting point is that the relevant profit is calculated in accordance with generally accepted accounting profits, subject to any adjustment required or authorised by law. It was not argued that the debit should not have been included based on IRFS 2. However, HMRC did argue that the debit should be disallowed as an adjustment required by law. Typically such disallowances would be mandated by statute and legislation has subsequently been passed clearly denying a corporation tax deduction in these circumstances. With no such statute in force at the time, HMRC relied on what is referred to as judge-made law (ie, common law) to find an adjustment. In this case, the common law was not sufficiently clear to result in such an adjustment to the accounting profit but that the question was asked shows the uncertainty that can arise in this area and that taxpayers generally need to have regard to more than just the tax legislation.
HMRC's next contention was that the debit was not incurred wholly and exclusively for the purposes of the taxpayer's trade. An accounting debit would not be allowed for the purposes of the tax base calculation unless it was so incurred wholly and exclusively for the purpose of its trade. The taxpayer's trade was the provision of employees to group companies, and the debit was found to be incurred for that purpose, but HMRC considered that "incurred" required the taxpayer to actually have suffered an expense. For support in this respect, HMRC referred to how the relevant legislation had been drafted in a prior iteration which referred to items "laid out or expended" rather than "incurred". The previous iteration had existed until the Corporation Tax Act 2009, which was intended as a tax consolidation and re-write exercise rather than to change tax law. The decision was broadly that reference should be made to the words in the existing statute and HMRC did not succeed on this point but a note of caution was sounded by the Supreme Court that this point was likely to be discussed in the future. Going forward, some uncertainty can be expected on this issue of interpretation and, again, taxpayers may have to have regard to more than just the tax legislation currently in force.
The debate moved on to whether the debit should be disallowed as a capital item. There has long been a distinction between revenue items and capital items with only the former being deductible in determining profits subject to corporation tax. In this case, despite the equivalent credit to equity representing a capital contribution, the Supreme Court found "compelling" reasons for the debit being revenue in nature given the taxpayer's trade. There is a long history of case law in relation to whether expenses are capital or revenue in nature and the distinction is often not clear cut, causing uncertainty in particular where the amounts expended might be significant and the difference in tax treatment stark.
Finally, HMRC went on to consider further statutory provisions that they considered could have disallowed the deduction. These were specific to the case in hand and none were found to apply but all required careful consideration.
This case can be considered from a number of different angles. Many practitioners are particularly interested in the treatment of the tax-rewrite legislation and how that would apply in other contexts. There is the substantive outcome in respect of the tax deduction available on the grant of the options (denied from March 2013 by statute with deductions typically available only on the exercise of options under specific statutory regimes). However, this article focuses on the fact that this case made it to the Supreme Court at all and how difficult it is to calculate the tax base including in respect of something so commonplace as the grant of share options. Truly, the UK tax system is complex and simply changing rates does nothing to improve this compliance burden on business. Here is hoping that one of these leadership contenders starts tacking such complexity in the tax base as well as the headline rates. They just might get better headlines for it.
For further information on this topic please contact Jamie Robson at Pinsent Masons by telephone (+44 20 7418 8250) or email ([email protected]). The Pinsent Masons website can be accessed at www.pinsentmasons.com.
Endnotes
(1) Commissioners for Her Majesty's Revenue and Customs v NCL Investments Ltd and another [2022] UKSC 9.