Tax - Pre-Budget special report - The pre-Budget report

A round-up of the key direct tax issues by Francesca Lagerberg, national tax director at Smith & Williamson.

On 10 December 2003 the chancellor of the exchequer gave his precursor speech to next spring's Budget. However, this was far more than a warm-up act as the pre-Budget report contained a number of major initiatives, proposals and decisions that will affect the UK tax system.

Small owner-managed companies under attack

The Budget next year will include measures to restrict the ability of such companies to exploit differences in the tax treatment between earned income and dividend income. There was little concrete detail as to exactly what the government has in mind but following hot on the heels of the IR35 debacle and the raised profile of the settlements legislation, small businesses must be wondering what they have done to deserve this close attention. If any change is limited to incorporated businesses only, it will catch those many thousands who have recently incorporated to take advantage of the improved corporation tax rates. Hopefully the Revenue will be undertaking thorough consultation before taking any action.

Tax rates affecting trustees to rise

With effect from 6 April 2004 tax rates for certain trusts will increase.

The income tax changes only affect trusts where the trustees can exercise their discretion over the income, ie, accumulation and maintenance and discretionary trusts. However, the capital gains tax (CGT) changes not only affect all types of trusts (excluding charities), but also estates of deceased persons.

The rate of income tax payable by trustees of accumulation and maintenance and discretionary trusts for most types of income is currently 34% and is set to increase to 40%. Following the change to the taxation of dividends from 6 April 1999, the tax rate on dividend income was 25% but this will now increase to 32.5%. The CGT rate is to increase from 34% to 40%. The changes will not affect a beneficiary's ability to reclaim income tax on distributions made where they are not higher rate taxpayers.

Also in relation to trusts, with effect from 10 December 2003, CGT holdover relief will no longer be available for gifts to settlor-interested trusts.

This applies both where the trust is settlor-interested at the date of the gift, and where it becomes settlor-interested before the sixth anniversary of the start of the tax year next following the one in which the disposal was made. In the latter case any holdover relief already given will be recovered. The changes will not apply to trusts for the disabled and trusts linked to maintenance funds for historic buildings. The same legislation will also restore the ban on holdover relief on gifts of shares to companies, which was introduced in 2000 and mistakenly repealed from 6 April 2003; this takes effect from 21 October 2003.

Related to the previous announcement is a raft of measures aimed at what the Revenue sees as exploitation of the CGT private residence relief.

These also take effect from 10 December 2003. These will remove the tax advantages of a range of existing planning using trusts.

No changes yet on the residence and domicile rules

Despite plenty of speculation, the government has held off from announcing changes at this stage. However, a formal consultation paper is expected and this is still an area likely to be subject to reform.

New tax breaks for property

The government looks set to introduce a tax transparent vehicle to encourage investment in residential property. This may be based on the US model of Real Estate Investment Trusts (REITs). The expected structure, which has been successful in other countries, will involve a corporate entity that is not taxed on its own profits as long as most of those profits are distributed. The shareholders would be taxed on their receipts as dividends.

In addition, but subject to state aid approval, it is proposed that 100% capital allowances be made available for the capital costs of renovating business property in a Disadvantaged Area that has been vacant for more than 12 months. The UK has 2000 Disadvantaged Areas, mostly inner city areas and often surprisingly undisadvantaged, like Islington and Canary Wharf. A full list of these areas can be found at

Transfer pricing

Reacting to recent European Court of Justice decisions, the government has moved to protect the UK tax base and will introduce transfer pricing within the UK from 1 April 2004 with exemptions for small and medium-sized businesses.

From 1 April 2004 (subject to transitional rules which will apply for a two-year period), UK companies will have to carry out transactions with connected companies also in the UK on an arm's length basis (ie, using the price which would apply between unconnected parties in the same transaction).

They will also need to prepare and retain documentation in support of the adopted pricing.

Since this could place a disproportionately large administrative burden on smaller entities, there is an exemption for small or medium-sized companies.

These are defined in the European Commission recommendation published on 6 May 2003 - broadly, a company which employs fewer than 250 people, and has either an annual turnover of no more than EUR50m or a balance sheet total not exceeding EUR43m. Such companies will not have to apply the arm's length policy to transactions with related parties either in the UK or in countries with which the UK has a double taxation treaty containing an appropriate non-discrimination article.

Note that the UK is extending the small and medium-sized company thresholds, set out in company law but also used for tax purposes, to the maximum permitted under EU law. This will have a particularly favourable effect on capital allowances, potentially doubling the amount of investment qualifying for the 40% first year allowances.

The other principal development in this area has been to bring the 'thin capitalisation' rules within the ambit of transfer pricing. These rules apply where a UK company has an excessive level of debt in terms of what its balance sheet or earnings would typically support, and where this debt is provided by, or with the support of, a connected party.

Inheritance tax planning

Targeted measures are to be introduced to further restrict the use of the gifts with reservation rules to avoid tax. This involves gifts where the former owner continues to enjoy the benefits of ownership of an asset.

There will be legislation to impose a charge on the benefit gained from using the asset.

Research and development (R&D)

More enhancements were announced to the existing credits in this area.

These include new guidelines defining R&D which removes references to 'innovation and novelty' and focuses on the requirement that the overall project should seek to achieve an advance in technology or science. There is also to be the introduction of a new category of expenditure to replace 'consumable stores' and expenditure on software licences is also intended to be a specific qualifying cost.

Pensions reform

The current intention is to introduce a simplified pension regime from April 2005. The expected lifetime limit cap remains at 1.4m but with a reduced recovery charge on the excess (25% rather than 33%). However, the whole reform programme is still subject to review and possible delays in implementation.

Income tax and NIC rates

After two years of static personal allowances for those under 65, there will be an inflation increase from April 2004. This will take the personal allowance up to 4,745 from 4,615. The personal allowances for those over 65 will rise in line with earnings.

The National Insurance Contributions (NICs) threshold and limits will increase in line with inflation. There will be no change in NIC rates for employers and employees, or the profit-related NICs paid by the self-employed, in 2004-2005.

Taxation of offshore funds

The government intends to introduce changes in the 2004 Finance Bill to the taxation rules for offshore funds. These will amend the rules which determine whether investments in offshore funds can be treated as investments in 'distributing' funds, so that UK resident investors in offshore funds will, in a wider range of circumstances, be charged to tax in the same way as an investor in an equivalent UK fund.

Employer-supported childcare

New measures are to be introduced with effect from April 2005 to amend the existing tax and NIC exemptions for employer-contracted childcare and childcare vouchers. These will broaden the attractiveness of the relief with the removal of the need for the employer to have management responsibility for the childcare provision and extending the tax exemption to cover any formal registered childcare or approved home childcare contracted by the employer. This would include a parent's local nursery, out-of-school club or childminder.

Management expenses

A new regime is to be introduced with effect from 1 April 2004. Relief for expenses of managing investments will no longer be restricted to investment companies; trading companies which also hold investments will from that point be able to claim the relief for their investment-related costs.

There is no requirement that the company has to be UK resident to benefit and the rules will be applicable to companies carrying on investment activity through a permanent establishment in the UK.

However, expenses of a capital nature will, for the first time, be expressly excluded from the relief, subject to express provisions to the contrary.

The definition of what equates to capital is not expanded on, and the significant body of case law on the point will therefore continue to be relevant.

EU interest and royalties directive

The Inland Revenue is introducing measures to adopt the recent EU directive on interest and royalties. As a result, tax will not have to be withheld on interest and royalty payments from a UK company to a company (or permanent establishment) in another EU member state. At present not all double tax treaties between EU countries will reduce the withholding tax to nil.

EIS and VCT changes

The Treasury has issued a paper outlining methods for improving growth capital for small businesses. The proposed methods are to enhance the existing Venture Capital Trust (VCT) and Enterprise Investment Scheme (EIS) rules.

The government is considering withdrawing the existing CGT deferral relief for investments in VCTs, which in turn invest in (typically) small entrepreneurial companies. In place of the CGT deferral, there will be a corresponding increase in the income tax relief. Meanwhile it proposes to increase the upper investment limit for the 20% income tax relief for the EIS.

Construction industry scheme

Significant consultation has taken place on changes to the Construction Industry Scheme (CIS). These changes will be included in the Finance Act 2004 but the implementation date will be delayed from April 2005 to April 2006 to allow industry to prepare for the changes.

Tax and accounting

The Inland Revenue is working with consultative groups to consider the impact of International Accounting Standards (IASs) on the calculation of taxable profits. The IASs are expected to be introduced in 2005, and will affect certain current reliefs if the accounting profit computed under their principles forms, as it will, the starting point for the calculation of taxable profits.

Legislation will accordingly be introduced to counter any negative effects, and will relate, for example, to R&D tax credits and to the tax treatment of hedging arrangements using derivative contracts, as well as foreign currency liabilities.

Amateur sports clubs

In the 2002 Budget the government announced various tax breaks for amateur sports clubs which became qualifying community amateur sports clubs (CASCs).

The Local Government Act 2003 has already introduced a mandatory rates relief of 80% for CASCs in England and Wales which will take effect from April 2004.

The pre-Budget report has announced further enhancements to the existing reliefs. CASCs will be exempt from corporation tax on profits derived from trading, if their trading income is under 30,000, and on profits derived from property, if their property income is under 20,000. This doubles existing thresholds. CASCs that do not exceed these thresholds will not have to complete a corporate tax return on an annual basis.

•   Francesca Lagerberg is national tax director at Smith & Williamson, the accounting and financial advisory group.

Income tax personal and age-related allowances 2004/05 ( per year) 2003/04 Change 2004/05 Personal allowance (age under 65) 4,615 (+130) 4,745 Personal allowance (age 65-74) 6,610 (+220) 6,830 Personal allowance (age 75 and over) 6,720 (+230) 6,950 Blind person's allowance 1,510 (+50) 1,560 Married couple's allowance* (aged less than 75 & born before 6 April 1935) 5,565 (+160) 5,725 Married couple's allowance* (aged 75 and over) 5,635 (+160) 5,795 Married couple's allowance* - minimum amount 2,150 (+60) 2,210 Income limit for age-related allowances 18,300 (+600) 18,900 *Married couple's allowance given at the rate of 10%. Working and child tax credits 2004/05 per year (unless stated) 2003/04 Change 2004/05 Working tax credit Basic element 1,525 (+45) 1,570 Couple and lone parent element 1,500 (+45) 1,545 30 hour element 620 (+20) 640 Disabled worker element 2,040 (+60) 2,100 Severe disability element 865 (+25) 890 Childcare element of the working tax credit Maximum eligible cost for one child (per week) 135 (+0) 135 Maximum eligible cost for two or more children (per week) 200 (+0) 200 Per cent of eligible costs covered 70 (+0) 70 50+ return to work payment (16-29 hours) 1,045 (+30) 1,075 50+ return to work payment (30+ hours) 1,565 (+45) 1,610 Child tax credit Family element 545 (+0) 545 Family element, baby addition 545 (+0) 545 Child element 1,445 (+180) 1,625 Disabled child element 2,155 (+60) 2,215 Severely disabled child element 865 (+25) 890 Income thresholds and withdrawal rates First income threshold 5,060 (+0) 5,060 First withdrawal rate (%) 37 (+0) 37 Second income threshold 50,000 (+0) 50,000 Second withdrawal rate (%) 6.67 (+0) 6.67 First threshold for those entitled to child tax credit only 13,230 (+250) 13,480 Income disregard 2,500 (+0) 2,500 Child benefit/guardian allowance rates 2004/05 per week 2003/04 Change 2004/05 Eldest/Only child 16.05 (+0.45) 16.50 Other children 10.75 (+0.30) 11.05 Eldest/Only child (lone parent rate) 17.55 (+0.00) 17.55 Guardian's allowance 11.55 (+0.30) 11.85 National insurance contributions 2004/05 Item 2004/05 Lower earnings limit, primary Class 1 79 per week Upper earnings limit, primary Class 1 610 per week Primary threshold 91 per week Secondary threshold 91 per week Employees' primary Class 1 rate 11% of 91.01 to 610 per week 1% above 610 per week Employees' contracted-out rebate 1.6% Married women's reduced rate 4.85% of 91.01 to 610 per week 1% above 610 per week Employers' secondary Class 1 rate 12.8% above 91 per week Employers' contracted-out rebate, salary-related schemes 3.5% Employers' contracted-out rebate, money-purchase schemes 1.0% Class 2 rate 2.05 per week Class 2 small earnings exception 4,215 per year Item 2004/05 Special Class 2 rate for share fishermen 2.70 per week Special Class 2 rate for volunteer development workers 3.95 per week Class 3 rate 7.15 per week Class 4 lower profits limit 4,745 per year Class 4 upper profits limit 31,720 per year Class 4 rate 8% of 4,745 to 31,720 per year 1% above 31,720 per year
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