Corporation tax explained

There are two tax schemes that provide a subsidy to R&D activities: the small and medium-sized enterprises (SME) R&D relief scheme and the R&D expenditure credit (RDEC) for larger companies. In both cases, qualifying expenses are those that relate to employing people or buying raw materials or software (but not capital costs or the cost of premises) and that can be shown to contribute to achieving a significant advance in applied science or technology (projects related to social sciences or theoretical fields such as pure mathematics do not qualify).

SME R&D relief allows companies to deduct an additional 130% of qualifying expenditure from taxable profits (on top of the standard 100% deduction of current expenses, making 230% in total). It is available to companies with fewer than 500 employees and either an annual turnover under €100 million or a balance sheet total under €86 million. Total SME R&D relief available on a particular R&D project is capped at €7.5 million.

If a company claiming SME R&D relief makes a loss (after the relief is taken into account), it can choose to give up the right to offset losses equivalent to 230% of its R&D expenditure (or its total losses, if these are smaller) against future profits in return for a cash payment from the government of 14.5% of the losses given up. 

For companies that cannot claim SME R&D tax relief, the RDEC provides a tax credit of 13% of qualifying R&D expenditure which can be deducted from the company’s tax liability (unlike the SME relief, which is a deduction from taxable profits). This credit is itself taxable, meaning that it is first added to the company’s taxable profits as taxable income and then subtracted from its corporation tax bill. For example, imagine a firm that has £200 of revenue and £100 of qualifying R&D expenditure. The credit will increase taxable profit to £113 (i.e. £200 – £100 + £13). When the corporation tax rate is 19%, the tax bill is £8.47, calculated as the tax rate multiplied by taxable profit (19% × £113 = £21.47) minus the credit of £13. With a 19% corporation tax rate, the value of the 13% taxable credit is approximately 10.5% of R&D expenditure. If the company makes a loss (after the RDEC is taken into account), the value of the RDEC can be paid out to the company, up to a limit (equal to the income tax and National Insurance contributions on the R&D workers’ salaries); anything in excess of that limit is carried forward to the following year.

Comparing the RDEC with the SME scheme: with a 19% tax rate, the 13% tax credit is equivalent to a deduction of 55% from taxable profits. Conversely, the 130% deduction from taxable profits available under the SME scheme is equivalent to a 30% (taxable) credit against corporation tax liability. The SME scheme is therefore much more generous than that available to larger companies.

In the March 2021 Budget, the government launched a wide-ranging review of the design of the R&D tax reliefs.

The capital allowances available for investment depend on the type of asset bought. Some capital allowances can be thought of as crudely allowing for depreciation, the decline in an asset’s value over time (e.g. as a result of wear and tear). Others are clearly more generous than that and can better be thought of as treating the asset purchase itself as a business expense, or as encouraging certain kinds of investment over others. 

The detailed rules are complicated, but as a broad summary:

• The annual investment allowance (AIA) allows businesses to immediately deduct the first £1,000,000 of plant and machinery investment – the biggest category of investment, covering everything from computers and desks to lorries, industrial equipment and other tools of the trade – each year. The exact amount that can be deducted under the AIA has varied a lot over time and is due to fall to £200,000 in January 2022, as shown in the chart below. Plant and machinery investment in excess of the AIA is deducted on an 18% ‘declining-balance’ basis, meaning that for each £100 of investment, taxable profits are reduced by £18 in the first year (18% of £100), £14.76 in the second year (18% of the remaining balance of £82) and so on. For a two-year period – 1 April 2021 to 31 March 2023 – a temporary ‘super-deduction’ is in place which allows companies to deduct 130% of the cost of their total (uncapped) plant and machinery investment.
• Plant and machinery that lasts at least 25 years or is integral to a building (such as lifts, air conditioning or lighting systems) is deducted more slowly, on a 6% declining-balance basis (if it falls outside the AIA). This has been temporarily increased to 50% from 1 April 2021 to 31 March 2023.
• Cars are treated differently from other plant and machinery: they do not qualify for the AIA, and are deducted at 100%, 18% or 6% depending on the car’s CO2 emissions rating, when it was bought and whether it was new or second-hand. Certain other environmentally friendly investments can also be deducted immediately. 
• The cost of buying, building or renovating a commercial building can be deducted on a 3% ‘straight-line’ basis, meaning that for each £100 of investment, profits are reduced by £3 per year for 33⅓ years. This allowance is only available if contracts for the construction work on the building were signed on or after 29 October 2018; there is no allowance for the purchase of older buildings or of land.
• The treatment of intangible assets (such as intellectual property, software licences, brand assets, customer lists and goodwill) is complicated. Depending on the details, such expenditure is sometimes treated as plant and machinery (and subject to the allowances described above), sometimes deducted at the rate used in the company’s accounts (with an option of using a 4% straight-line deduction instead), sometimes deducted on a 6.5% straight-line basis, and sometimes cannot be deducted at all. There are no capital allowances for financial assets (such as shares in other companies) or other ‘non-depreciable’ assets.
• Capital expenditure on any assets used for qualifying R&D except land and intellectual property (but including plant, machinery and buildings) can all be deducted immediately. 

The March 2021 Budget announced the creation of a ‘super-deduction’ to be in place from 1 April 2021 until 31 March 2023. 

Under the super-deduction, companies can deduct 130% of investment in most forms of plant and machinery. In other words, for each £1 a company spends on an eligible investment, its taxable profits reduce by £1.30. There is no limit on the amount of investment that is eligible for the super-deduction.

The super-deduction was introduced at the same time as it was announced that the main rate of corporation tax would rise from 19% to 25% in 2023. This matters for the effects of the policy. Preannouncing an increase in the tax rate would tend to discourage investment. This is because, for investments undertaken before the rate rise but generating revenue after the rate rise, the costs would be deducted at a lower rate (19%) than the subsequent revenue was taxed (25%). This would create an incentive not to invest until the rate increased and the cost could be deducted against the 25% tax rate. For investments that would normally qualify for a 100% deduction under the AIA, the super-deduction simply removes this disincentive effect, because deducting 130% of costs at a 19% tax rate is almost equivalent to deducting 100% of costs at a 25% tax rate (i.e. 130 × 0.19 ≈ 100 × 0.25). In effect, the super-deduction can be thought of as allowing companies to deduct their investment against the new, higher tax rate, before the higher rate is in place. 

This can be seen in a simple example. Imagine a company is looking to buy £100 of equipment this year that will generate £105 of income in 2024 – i.e. a 5% pre-tax return. The effect of tax depends on the treatment of costs and profits: 

• If the tax rate is a constant 19%, a company can deduct (using the AIA) the investment cost, saving £19 in tax. £19.95 in tax would be paid on the income (i.e. 19% tax on the £105 income). So, after tax, the investment would cost £81 and yield £85.05: still a 5% return.
• If costs are deducted at 19% this year, but income taxed at 25% in 2024, £26.25 in tax would be paid on the income (i.e. 25% tax on £105). Now, after tax, the investment would cost £81 and yield £78.75: the project would be loss-making and thus discouraged by the tax system. 
• But using the super-deduction, a company can deduct 130% of the investment cost this year at a 19% tax rate, giving a tax reduction of £24.70 (almost exactly the same as the £25 that would be available from deducting £100 at 25%). In this case, the investment costs £75.30 and yields £78.75 (after income is taxed at 25%): the project has a return of 4.6%, almost the same as if costs and income were both subject to a tax rate of 25%. The super-deduction roughly neutralises the disincentive effect of the rate rise.

For many investments, the super-deduction is simply a rebasing of the AIA that prevents the preannounced rate rise from discouraging investments. In other cases – including for investments above the AIA – the super-deduction is an incentive to increase or bring forward investment. And for investments that do not qualify for the super-deduction – such as investments in buildings, cars and most intangible assets – the disincentive effect of the forthcoming rate increase has not been neutralised, so that doing such investments before 2023 looks particularly unattractive (including relative to investing in plant and machinery).

The super-deduction does not apply to investment in long-life plant and machinery – but for the same two-year period, the reduced 6% rate of capital allowances that normally applies to such investment (above the AIA) has been increased to 50% in the year of purchase.

Losses made by companies can be used to offset taxable profits made in other years. 

A loss from trading can be set against profits made in the previous year (but generally not earlier). For instance, if a company made a £100,000 profit last year and a £100,000 loss this year, it could choose to pay tax as if it had made zero profits in both years. In this example, that will mean the company receiving a refund from the government for the corporation tax paid last year. In most circumstances, trading losses can only be carried back one year, except that losses made in the first four years of trading or in the final year of trading can be carried back for up to three years. But in the March 2021 Budget, the Chancellor announced that between 1 April 2020 and 31 March 2022, all companies would be permitted to carry back up to £2 million of trading losses for up to three years instead of the usual one. 

Alternatively, losses can be carried forwards. If a company makes a loss this year, it can offset that loss against profits in future years. For instance, if a company makes a £50,000 loss this year and a £200,000 profit next year, it can carry forward its loss so that corporation tax is paid next year on profits of only £150,000. Losses can be carried forward indefinitely as long as the company carries on the same trade.

Companies are limited in the amount of profits they can offset against carried-forward losses. In each year, companies are permitted to offset £5 million of taxable profits against past losses, plus a maximum of 50% (or 25% in the case of banks) of the profits remaining after the £5 million has been deducted. Any unused losses can be carried forward to subsequent years. An example of how these restrictions work is given in the chart below.

More restrictive rules apply if a company makes a capital loss on the sale of an asset. Capital losses can only be offset against capital gains, even in the same year (though the converse is not true: trading losses can be offset against capital gains as well as against trading income). Capital losses can be carried forward indefinitely but cannot generally be carried back to past years. 

Where companies form part of a group – meaning, broadly speaking, that they have a common owner – loss-making members of the group are able (subject to certain constraints) to offset their losses against the profits of other group members. This practice is known as ‘group relief’. 

A reduced 10% rate of corporation tax applies to profits made from exploiting patents that fall within the UK’s patent box regime. This includes income from selling goods or services that make use of a qualifying patent and, in some cases, income from licensing and royalties. The relief was introduced in phases between 2013 and 2017. The patent box rules are complex and were revised substantially in 2016. Broadly, in order to qualify for the patent box, a company must own (or exclusively license) a UK- or EU-registered patent relating to an invention that it played a significant part in developing or incorporating into a final product (in other words, the patent cannot simply be purchased from another company). While only UK-resident companies can qualify for the patent box, there is no requirement for the research that led to the patent to have been carried out in the UK.  

The bank levy is charged on certain UK liabilities and equity, as recorded on banks’ balance sheets. Liabilities are what a bank owes to others, including all of the deposits at the bank (which are owed to the customers who made the deposits). Equity measures a bank’s net worth – i.e. total assets minus total liabilities. The exact definition of which liabilities and equity are taxable is complex. Deposits that are insured through the government’s depositor protection schemes are exempt, for example. The first £20 billion of each institution’s taxable liabilities are also exempt from the levy, meaning that in practice only the largest financial institutions are subject to the levy. There have been a number of changes to the levy over time. Most recently, from 2021, overseas activities of UK-headquartered banking groups are no longer subject to the bank levy.

There are two main rates – one for short-term liabilities with maturities of a year or less and one for long-term liabilities and equity. The bank levy rate was cut each year between 2015 and 2021 (see chart below). 

Corporation tax on North Sea production is ring-fenced, so that losses on the mainland cannot be offset against offshore profits. The main rate of ring-fence corporation tax is 30%, higher than the main corporation tax rate. Prior to April 2007, corporation tax was charged at the same rate within the ring-fence as on the mainland. Since then, changes to onshore corporation tax rates have not applied to ring-fenced profits – including the 2016 abolition of the small profits rate, which still exists for ring-fence corporation tax (see table below). 

Since 2002, profits earned within the North Sea ring-fence have also been subject to a supplementary charge. Strictly speaking, this is separate from corporation tax, but in practice it is almost identical (and is always included within offshore corporation tax revenue). The supplementary charge is levied at a flat rate on the same base of taxable profits to which corporation tax applies, except that costs associated with debt finance cannot be deducted. The 10% supplementary charge can therefore be broadly seen as a ‘top-up’ to the ring-fence corporation tax rate.

North Sea oil and gas producers formerly faced a further tax, petroleum revenue tax (PRT), on profits from fields approved before March 1993. Since January 2016, the rate of PRT has been set at 0%. The reason for setting a zero rate rather than abolishing the tax entirely is to continue to allow oil and gas producers to offset current losses against profits made in past years (triggering a refund of PRT paid in previous years). This is important as companies can face substantial costs of decommissioning oil and gas installations after production has finished. 

While higher rates of corporation tax are charged on offshore profits, the capital allowances available to the North Sea oil and gas sector are significantly more generous: virtually all capital expenditure can be deducted immediately (as well as current expenditure, as usual) – and some investment receives additional allowances on top of that, creating a net subsidy. Ring-fenced activities are not eligible for the temporary super-deduction announced in the March 2021 Budget, however.

There are complex rules and tax treaties that dictate when a company is taxable in a specific country. What follows is a high-level, simplified summary. 

Companies that are either incorporated in the UK or have their central management based in the UK are usually considered resident in the UK for the purposes of corporation tax. 

Where a company has some activities in the UK but is not tax-resident in the UK, it may still be liable to pay corporation tax if it is considered to have a ‘permanent establishment’ in the UK. The legal definition of a permanent establishment is complex and has been subject to change in recent years, but broadly refers to a place of business (such as a factory or an office) or representatives that are empowered to conclude contracts on behalf of a non-UK company. Companies whose operations in the UK are deemed only to be ‘preparatory or auxiliary’ (e.g. if a company’s only activity in the UK is storage and delivery) are generally not deemed to have a permanent establishment in the UK.

Companies that are subject to UK corporation tax are usually taxed on the profits that are deemed to arise from UK-based assets and production activities. There will usually be a credit given for any foreign tax paid on income that has arisen abroad (e.g. from sales via a foreign permanent establishment). Companies can, however, irrevocably elect to exempt income from foreign permanent establishments from UK corporation tax. Dividends received from an overseas subsidiary (i.e. an overseas company that is owned by a UK ‘parent’ company) have been exempt from UK corporation tax since 2009.

To understand how the system of transfer pricing works, consider how it would apply in the car production example above if all of the activities in different countries were done by the same multinational company. The part of the multinational company that sells cars in the UK would make a transfer payment to the French manufacturer to reflect the value of the cars imported into the UK. This payment is a tax-deductible cost for the UK company and taxable revenue for the French company, ensuring that the value associated with manufacturing the cars is taxed as part of the French company’s profits. The French manufacturer would similarly make transfer payments to other parts of the multinational company to reflect the value of any car parts imported into France. This broad approach applies not just to physical goods (such as cars) but also to services, including financial services (such as loans) and the use of intellectual property. In our example, the French company would also make a payment to the Swiss company to account for the value of the designs created there. 

The arm’s length principle is an attempt to ensure that transactions within multinationals are priced as if they were taking place between unrelated parties. If that were the case, there would be a market price for the transactions that would, in effect, determine how profit was allocated to (and therefore taxed in) different countries. In reality, there is no market price for transactions between related companies – and indeed one reason multinational companies exist is that they enjoy some advantage that cannot easily be replicated by arm’s-length transactions between unrelated firms. 

With something like cars or car parts, determining the transfer price may be relatively straightforward because there will often be a market price (for other similar cars or parts that are traded on the open market) to compare to and use as a benchmark. But for many activities that happen within a multinational, there will be no comparable market price. This will often be true of intangible assets – such as designs or brands – that are unique. Moreover, multinationals are often much more complex than our simple example. Imagine our example multinational has headquarters in Italy, an R&D team that is split across the UK and Germany, patents that are managed from the Netherlands, and subsidiaries selling cars in every European country. How much of the company’s total profits are attributable to each of the countries? How can we say what proportion of the value relates to German innovation or Italian management, for example? In such cases, even with perfect information about all of a company’s activities, there is no conceptually right answer to the question of how much profit is attributable to the activities in one specific country. Ambiguities of this kind create the scope for multinationals to use transfer prices to shift their profits to lower-tax countries, and can make it difficult for tax authorities to challenge the transfer prices companies choose. 

The diverted profits tax was introduced in 2015. It can be charged on both UK-resident companies and non-UK-tax-resident companies (including those with no permanent establishment in the UK). It applies at a rate of 25%, higher than the current main rate of corporation tax. The rules determining which profits have been ‘diverted’ (and therefore not otherwise subject to UK corporation tax) are complex. Broadly, the tax targets cases where a company has artificially avoided setting up a UK permanent establishment or where transfer prices have been artificially manipulated to reduce tax payments. Companies with revenue of £10 million or less from UK sales are exempt from the tax.

The diverted profits tax has raised negligible amounts of revenue. This does not necessarily indicate that the tax has been a failure, however, as its main objective is to act as a deterrent to aggressive corporation tax avoidanceThe use of lawful means to pay less tax, particularly where contrary to the clear intention of parliament.Read more rather than to raise revenue directly. 

The digital services tax was introduced in 2020. It is a tax on revenue: unlike a tax on profits, there is no deduction of costs. Companies that provide search engines, social media services or online marketplaces and that have worldwide revenue of more than £500 million are taxed at a flat rate of 2% on any revenue in excess of £25 million that is deemed to be attributable to UK users. The digital services tax applies even if the company is not tax-resident in the UK and has no permanent establishment here. This approach is markedly different from corporation tax, which does not seek to allocate taxing rights based on the location of users. 

The government has said that it sees the digital services tax as an interim measure and will remove it if an international agreement on an alternative approach to taxing profits related to digital activities is implemented.