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Taxing losses Back  
Corporation tax should be paid only on profits. That seems a reasonable proposition. Yet our tax system is designed so that a company with net losses may still pay taxes. This needs to be reviewed.
Corporation tax is charged on the profits of a company in an accounting period. Profits are defined as being the income of the company, and its capital gains in the period. That seems eminently reasonable.

So how does a company which makes losses come to pay tax? The answer lies in the way in which income is computed, and in the way in which losses are treated in determining profits.

A company may carry on several activities. It may make losses on some of these activities, and it may make profits on others. Every businessman and accountant knows that the bottom line will reflect the offsetting of these various profits and losses. That is true of economics and accountancy, but not of taxation.

Corporation tax rules do not permit the simple offset of losses against profits in the same period, in order to determine net profit. Whereas income is taken into the taxation ‚€ėbottom line‚€ô in a straightforward way, losses are subject to complex restrictions that can often result in their being disregarded at the bottom line.

The Finance Act 2001 introduced new restrictions on the offset of trading losses against other income and against capital gains in the same period. This has made a bad situation worse. The time has come to review this unhappy decision and also to review fundamentally the taxation treatment of losses.

Problem with two parents
The restriction of relief for losses, and the consequent overstatement of taxable income arises from two broad sets of circumstances:
‚€Ę Ring fencing of losses due to legislative provisions over the last few decades and
‚€Ę The design of the income tax system in 1803 (book your seat now for the 2003 fireworks display at the Customs House?).

Since 1980 a 10 per cent rate of corporation tax has been available for manufacturing and a variety of other activities. In 1988, at a time when the standard rate of corporation tax was 47 per cent, a restriction was introduced to ring fence manufacturing losses (ie losses from activities whose profits would be taxed at the 10 per cent rate of corporation tax) to prevent offset against income taxable at the standard rate of corporation tax.

The huge disparity between the manufacturing rate of tax and the standard rate of tax made some restrictions inevitable.

In subsequent years restrictions were introduced on the offset of losses from leasing activities against other income. These restrictions seem to have been driven by a belief that the capital allowance rates available on the leasing of plant made it too easy to generate tax losses on leasing. Of course the same capital allowance rates were available to other trades so the logic did not hold up very well.

A variety of other ring fences were introduced at one time or another - losses from shipping trades, farming losses, certain partnership losses. None of these have had the clear justification which the contrast between a 10 per cent rate of corporation tax and a 47 per cent standard rate of corporation tax appeared to have. Mostly the thinking was little better than that the restriction would yield more tax. That it did so by charging tax on what were not true profits did not seem to be viewed as an objection.

FA 2001 crude
The Finance Act 2001 introduced further restrictions on the offset of trading losses against other income. It did so against a background where the standard rate of corporation tax on trading income will be 12.5 per cent by 1 January 2003 (currently 20 per cent). The rate of corporation tax on unearned income is 25 per cent, and the effective rate of corporation tax on capital gains is 20 per cent. As can be seen, the contrast between the rate of tax on trading income and the rate of tax on other income and gains is by no means as stark as it was back in 1988 when the restrictions were introduced on manufacturing losses. Indeed, in 2001 when the restrictions take effect, the contrast is hardly worth mentioning. The restrictions introduced eliminate the ability to offset losses of trades taxed at the standard corporation tax rate against investment income, or against capital gains.

The effect can be that a company which has a net loss from its trading activities may nonetheless have to pay tax on investment income generated from placing surplus cash flows on deposit, or subletting part of its premises.

For example, if a company loses £1 million on trading, but earns £500,000 on subletting part of its factory and from deposit interest on seasonal cash flows, overall it has made a loss of £0.5 million for the year. But it will be faced with a tax bill of £125,000. In economic terms, and in justice, that is nonsense.

The solutions
The Government had available to them two alternate solutions neither of which would have produced such a nonsensical result.

Firstly, it could have reduced the amount of relief being given for trading losses, rather than entirely eliminating it. For example, once the rate of corporation tax on trading income is 12.5 per cent, it will be exactly half the rate of tax on investment income. So why not give an offset of £2 of trading losses against every £1 of investment income? Such a solution, given the figures in the example above, would ensure that the company which had made a loss would not actually pay tax. Justice and economic common sense would be satisfied.

Alternatively the Government could have adopted a continental approach by permitting £1 for £1 offset of trading losses against investment income in the year in which the losses arise. However when trading profits arise in subsequent years (should they do so) the relief granted for the trading losses would be clawed back. The investment income which had been earlier relieved by trading losses would now be fully charged to tax, but the trading losses would be instead relieved against the trading income. The result would be that ultimately, if a trade returned to profits, its losses will have been relieved only at a tax rate of 12.5 per cent. But in the short term, this approach ensures that a company does not pay tax on more than its true profits.

The reality is that our scope for making our headline tax rates more attractive to international investment is all but gone. 12.5 per cent is as good as it is going to get. Against that background it makes little sense to handicap ourselves by introducing computational rules that increase the effective rate of tax on inward investment. Our continental fellow members of the EU have shown great skill at using the computational rules in the opposite direction - to produce effective rates of corporation tax that are but a fraction of their headline rates. Time to wake up! Time to read the small print.

Back to 1803‚€¶
The focus of my comments have been on the Finance Act 2001 restrictions. In fact fundamental problems in the area of the treatment of losses go back to 1803, when income tax was the tax paid both by companies and individuals.

‚€ėGentlemen‚€ô objected to bureaucrats being made aware of the extent of their income. The solution adopted was to permit them to separately report the various components of their income to different inspectors of taxes.

A by-product of this peculiar form of Georgian snobbery was that generally speaking losses from the various sources of income could not be offset against income from other sources, since the various sources were separately reported. That rule was relaxed for trading losses (gentlemen didn‚€ôt trade!). However it has remained in place for other forms of losses.

For example, interest charges or heavy repair bills may lead to a loss on the renting of property. Even though that loss has to be financed in cash flow terms out of other income, the loss cannot be relieved for tax purposes against other income. This is fundamentally unjust.

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