Expect forward-looking UK corporate tax reform in coming months

For almost two years, Sunak's primary focus has been introducing reactionary tax measures aimed at safeguarding the UK economy as it battled simultaneously with the Covid-19 pandemic and the immediate repercussions of Brexit. Focus is now expected to shift to developing the UK’s corporate tax system to respond to an increasingly globalised digital world, whilst evaluating how UK tax policy needs to change to support the country's transition to net zero carbon emissions by 2050.

Implementation of OECD's two-pillar framework

Pillar 2 and the global minimum tax rate

In January, HM Treasury published a consultation that sought views on how a global 15% minimum corporate tax rate should be introduced domestically. The new tax rate was proposed by the Organisation for Economic Cooperation and Development (OECD) and forms the second ‘pillar’ of its proposed two-pillar international solution to address the tax challenges of the digitalisation of the global economy. The proposals were agreed by 136 countries in October 2021, with model rules published in December 2021. The pillar 2 framework is designed to ensure large multinational enterprises pay a minimum 15% tax on profits in each country where they operate – creating a more standardised international regulatory environment and minimising tax avoidance opportunities, particularly attempts to artificially shift profits from high to low tax jurisdictions.

The OECD's framework will operate on a country-by-country basis. The UK’s consultation considers the general application of the proposed minimum tax, including:

• to whom the rules should apply;
• transitional rules; and
• how businesses within scope should report and pay the tax.

The UK consultation has proposed that a business will only fall within scope of the new minimum tax framework when its revenue in consolidated financial statements is greater than €750 million in at least two of the previous four fiscal years. The consolidated revenue threshold is only expected to apply to businesses that operate in more than one jurisdiction. In contrast, the OECD's proposals allow countries to apply the new framework to groups with consolidated group revenue of less than €750m. Given the potential complexity of the new regime, the UK's departure from the OECD's framework is likely to be welcomed by smaller UK-headquartered groups.

However, HM Treasury is also exploring the idea of introducing a domestic minimum top-up tax for UK-headquartered businesses with over €750m of group revenue. This measure is intended to boost domestic tax receipts and prevent foreign jurisdictions from taxing the revenue instead.

The consultation closes in April 2022. Draft legislation is expected to be published this summer, in preparation for the new rules taking effect from April 2023.

Progress on pillar 1 taxing rights

Whilst the path to progress on pillar 2 has been clearly delineated, it is also hoped that 2022 will herald developments on pillar 1 of the OECD's framework. Pillar 1 focusses on where large global businesses are required to pay corporate taxes. Although it was included as part of the October 2021 political agreement, the details have not been finalised. It is hoped that pillar 1 will be introduced through a multilateral convention that will be available for signature in 2022, with the rules becoming effective in 2023.

Pillar 1 involves a partial reallocation of taxing rights over the profits of the largest and most profitable multinational businesses to the jurisdictions where consumers, rather than the businesses, are located. It is currently envisaged that multinational businesses with global turnover above €20 billion will be subject to tax on a proportion of their profits in the countries where they operate. Extractive industries and regulated financial services will be excluded. Countries in which the multinational business derives at least €1m revenue will benefit from the new taxing right. For smaller jurisdictions with gross domestic product (GDP) that is lower than €40bn, the threshold will be set at €250,000. The UK government is keen to see pillar 1 implemented, considering that it will resolve "longstanding concerns that the international corporate tax framework has not kept pace with the digital economy and how highly digitalised businesses generate value from the active interaction with their users". However, the timetable for implementation is extremely ambitious, particularly given the political challenges of securing agreement to pillar 1 in the US Senate.

Review of R&D tax reliefs

Draft legislation that will amend aspects of the UK's research and development (R&D) tax relief system is expected in Summer 2022 and will be ready for implementation in April 2023. The new provisions were outlined in a report published by HM Treasury in December 2021, as part of its ongoing review into the R&D tax relief system.

The report confirmed that territoriality restrictions will be introduced to re-focus tax relief towards R&D investment and innovation undertaken in the UK. However, the new rules will include certain limited exclusions, such as allowing UK companies to continue to claim tax relief on the costs of software, data and cloud computing sourced overseas as well as payments for clinical trial volunteers overseas.

There has been widespread concern across R&D intensive sectors following the chancellor's surprise announcement about territoriality restrictions in last autumn’s Budget. Currently, there is no requirement that the R&D activity must be undertaken in the UK for companies to be eligible for R&D tax reliefs. UK companies that incur R&D expenses overseas may still be eligible for full tax relief. The government has said that it is introducing restrictions to ensure that the reliefs incentivise UK innovation and are appropriately targeted in a way that best benefits UK industry.

UK businesses subcontract R&D activity overseas for a variety of reasons including regulatory requirements, involvement of non-UK based scientists and other experts, scarcity of skilled UK labour, and geographical or environmental factors necessitating activity overseas.

The availability of tax relief for overseas R&D is often essential to businesses in the UK's life sciences sector, where vital elements of the development of a new technology or drug often need to be undertaken outside the UK. For example, to gain licensing approvals for new drugs or vaccines, to conduct clinical trials, or to involve medical experts.

Having recently attended a roundtable discussion with HM Treasury, it is evident that they are constructively engaging with stakeholders to understand the situations where R&D is undertaken overseas for necessity, rather than to reduce costs. It is possible that businesses will continue to be able to claim tax relief for some forms of R&D that cannot be undertaken in the UK, where that R&D activity is essential to UK-based innovation. However, as is often the case with tax changes, no clarity as to the extent of any exceptions is expected until draft legislation is published.

Draft legislation is also expected detailing an extension to the definition of R&D to include cloud computing and data costs. Two new categories of R&D expenditure will become eligible for relief: licence payments for data sets and cloud computing costs that can be attributed to computation, data processing and software. The government hopes the changes will "ensure the reliefs better incentivise cutting edge R&D methods which rely on vast quantities of data that are analysed and processed via the use of the cloud”.

Further detail on new measures to combat abuse of R&D tax reliefs is also expected. Changes announced in the December 2021 report include requiring all claims to be made digitally with endorsement by a named senior officer of the company; requiring advance notice to HMRC before making a claim; and a requirement for greater detail about the claim, with details of any agents who advised the company on making the claim.

While the objectives behind these measures are appreciated, it will be a careful balancing act to ensure that the claims process does not become overly complicated and inaccessible to small businesses and start-ups that may be reliant on R&D tax reliefs as a source of financing for the innovation.

Announcements about further reforms to R&D tax reliefs are also anticipated this year. The December 2021 report confirmed that the government's review into the tax relief system remains ongoing. Details of the wide-ranging review were first published in March 2021.

Climate change tax policy

This year will hopefully finally bring some clarity regarding the government's vision for a sustainable tax policy able to respond and support the UK's net zero strategy. The government's commitment to transition to net zero carbon emissions by 2050 has been widely publicised. However, its October 2021 strategy report was surprisingly light on the role of tax policy. Beyond highlighting the expected positive impacts of the plastic packaging tax, coming into force from April 2022, and the previously announced review into landfill tax, the report provided few clues regarding new tax measures that may be on the horizon.

The government may not consider tax a primary driver in influencing carbon reducing behaviours. However, HM Treasury has acknowledged that decarbonisation is likely to have a significant adverse impact on the UK's public finances, owing to the "erosion of tax revenues from fossil fuel related activity". For example, fuel duty and vehicle excise duty receipts, which totalled £37bn in fiscal year 2019-2020 (equivalent to 1.7% of UK GDP), are expected to reduce towards zero as the UK transitions away from petrol and diesel cars. In the October 2021 report, HM Treasury indicated that it does not support funding the transition to net zero through increased borrowing; therefore, the government may need to consider introducing tax changes and new sources of public revenue for the UK to deliver a sustainable net zero economy.

HM Treasury acknowledges that carbon taxes or similar levies associated with fossil fuel usage may support the UK's transition to net zero. However, given that receipts will decline as decarbonisation progresses, they are unsustainable and, therefore, a complete overhaul of UK tax policy may be required. In the short term, tax reliefs may be introduced to support innovation in green technology, but new forms of taxation will be inevitable in the long term.

New UK asset holding company regime

An elective tax regime for companies that hold investment assets as part of fund structures is being introduced from 1 April 2022. The new regime will allow funds to use UK structures to hold their assets in a tax-efficient way rather than having to use Luxembourg or Irish structures. This should reduce costs and simplify compliance. The government also hopes that the new regime will generate jobs across the UK asset management sector.

Broadly, the new regime aims to ensure that where funds hold assets through UK tax resident companies, UK investors are taxed on returns as if they invested in the underlying assets directly. It will be interesting to see whether there will be a slew of elections once the regime is launched. Publication of user statistics or HMRC's response to the inevitable freedom of information request by the end of the year is expected.

A version of this article was first published in the International Law Office (ILO) corporate tax newsletter.