A UK resident company is taxed on its worldwide total profits.
Total profits are the aggregate of (i) the company's net income from each source and (ii) the company's net chargeable gains arising from the sale of capital assets.
The main sources of income are (i) profits of a trade, (ii) profits of a property business, (iii) non-trading profits (or losses) from loan relationships, mainly interest receivable or payable, (iv) non-trading gains (or losses) on most intangible fixed assets, and (v) non-exempt dividends or other company distributions. The amount of income for sources (i) to (iv) is measured based on the company’s accounts, with specific adjustments. Taxable income from non-exempt dividends and calculating chargeable gains or income from other sources is based on actual amounts.
The rules for measuring the gross income are different for each category, and there are subtle differences in the rules about tax deductions and how gains are calculated. Because of this continuing reliance on taxing companies on a 'source-by-source' basis, it is difficult to explain the rules about income determination and deductions as two wholly separate topics.
Basic rules for accounts-based sources
The main source of profits is often from trading. A company's trading profits are based on its worldwide profit before tax in its accounts. Adjustments are made for non-trading receipts (such as dividends from other companies and income from property) and non-deductible expenditure (such as capital expenditure). Depreciation for tax purposes (known as capital allowances) is calculated and substituted for the depreciation charged in the accounts. A number of other statutory adjustments are made; three important ones are that pension contributions, deferred pay, and benefits in kind are broadly deductible only when paid, that a deduction is available for the notional cost of certain share awards to employees, and that, where certain acquired intangibles (but, in particular, not goodwill and customer-related intangible assets acquired on or after 8 July 2015) are not depreciated in the accounts, a 4% flat-rate deduction can usually be claimed. There are many other adjustments.
Similar principles apply in relation to the calculation of profits of a property business.
Financial profits from a company's trading and non-trading loan relationships and related matters are usually based on the accounts, and the distinction between 'capital' and 'revenue' receipts and deductions is not relevant. Instead, all credits and debits in the accounts are aggregated in order to find the net profit or deficit. Certain statutory adjustments have to be made, which include an interest capping limitation ('debt cap').
For traders, any profit or loss on loan relationships, and/or on intangibles, is generally included within the trading profits. If the company doesn’t have a trade, then loan relationships and intangibles are treated as a separate source of income or loss.
Where a loss arises in respect of a particular source of income, there are detailed rules regarding the possible offset of the loss. Carryback and sideways reliefs are often allowed within limits; carryforward is generally allowed and carried forward losses do not time expire. Losses can also be utilised by other group companies (see the Group taxation section).
More specifically, dealing with the main sorts of income losses,
- trading losses may be set off against any other source of profit or gains in the same year, may be carried back one year (three years on the cessation of the trade) against any other source of profit or gain, or may be carried forward without time limit against profits of the same trade only
- property losses may also be set off against any other source of profit or gains in the same year, or may be carried forward without time limit against profits of any sort; they cannot, however, be carried back, and
- non-trading deficits (i.e. interest and financing losses) can again be set off against any other source of profit or gains in the same year, may be carried back one year against non-trading credits (i.e. interest and financing profits), or may be carried forward without time limit against non-trading profits.
Non-trading companies may deduct non-capital management expenses incurred in managing their investments from their total profits. Any excess management expenses can be carried forward without limit to set against profits in future years.
While income losses can generally be offset against capital gains of the same accounting period, capital losses are never available for offset against any type of income.
There are complex anti-avoidance rules that restrict the utilisation of all types of losses where there is a change in ownership of the company. Specific rules can also deny or limit loss relief or deductions arising from brought forward losses or potential losses where certain conditions are met.
Proposals were made in March 2016 for significant reform to the treatment of losses from April 2017. Whilst these proposals are not yet law (because of delays in the legislative process), it is anticipated that these reforms are likely to be implemented, and that the effective date will be 1 April 2017. However, further changes to the provisions may be made before implementation. The reforms include:
- allowing losses to be more flexibly set off against other income, including setting carried forward loss against taxable income of other UK group companies, and
- for companies with profits over GBP 5 million, restricting the utilisation of losses brought forward to GBP 5 million plus 50% of the current year profits in excess of that amount.
In general, the book and tax methods of inventory valuation will conform. In practice, inventories are normally valued for tax purposes at the lower of cost or net realisable value. A first in first out (FIFO) basis of determining cost where items cannot be identified is acceptable, but not the base-stock or the last in first out (LIFO) method.
Gains on capital assets are taxed at the normal corporation tax rates. The chargeable gain (or allowable loss) arising on the disposal of a capital asset is calculated by deducting from gross proceeds the costs of acquisition and subsequent improvements, plus the incidental costs of sale and indexation allowance. Indexation allowance compensates for the increase in costs based on the percentage rise (if any) in the UK retail prices index to the date of disposal. Indexation allowance is, however, limited; it cannot create or increase a capital loss, it can only reduce or eliminate a chargeable gain. Generally, these calculations must be done in sterling, so any foreign exchange gains and losses will be taxed (or relieved) on disposal.
Special rules apply to assets held at 31 March 1982.
Most acquisitions and disposals between UK group companies are treated as made on a no gain no loss basis (i.e. at base cost plus indexation). Otherwise, acquisitions from, or disposals to, affiliates are treated as made at fair market value, as are other acquisitions or disposals not at arm's length.
Capital losses are allowed only as an offset to capital gains. An excess of capital losses over capital gains in a company's accounting period may be carried forward without limitation but may not be carried back. There is no ability to surrender capital losses to fellow group members, but gains or losses arising on a particular asset can be allocated to another group member. So, the capital losses of one company can sometimes be set against the gains of a fellow group member in the same or subsequent period.
There is a good deal of anti-avoidance legislation concerning the computation of chargeable gains, notably to stop losses being created or gains avoided where assets are depreciated by intra-group transactions, or where losses are 'bought in' from third parties.
Gains realised on certain types of assets can be deferred where all or most of the proceeds are reinvested in other assets of those types within a specified period (generally three years). The 'rolled-over' gain then crystallises as and when the latter assets are sold. At present, the main asset categories qualifying for roll-over are land and buildings used for a trade.
Most disposals by trading groups of shareholdings of 10% or more are exempt from tax. The main exceptions will be those of non-trading subsidiaries or subgroups, or of companies acquired within the previous year. Note that gains on goodwill and other intangibles acquired after March 2002 are taxed as income, not as capital gains.
Most foreign and UK dividends received by UK companies are exempt from corporation tax; however, one of several criteria has to be met, but these are widely drawn (one test, for example, is that the recipient controls the payer). For non-exempt, foreign-source dividends, double tax relief (DTR) will be available on a dividend-by-dividend basis. It is unusual for companies to be taxed on UK dividends because of the breadth of the exemption; however, where they are taxed, there is no concept of DTR for UK dividends.
Royalty income received by corporates will normally be taxed in the same way as other forms of income. To the extent it arises from a trade, it is taxed as trading profits. Royalties from intellectual property (IP) not comprising a trade will be taxed as income from intangible fixed assets.
Realised and unrealised exchange gains/losses
Unrealised exchange gains and losses tend to arise on debts and derivatives; they are then taxed or allowed, together with realised amounts, on an accounts basis in the same way as other debits and credits arising out of loan relationships. Where gains or losses arise on other payables or receivables, to a trader or property investor, they will again generally be taxed or allowed on an accounts basis. For a trader, the taxable or allowable amount will become simply part of the trading profit or loss; for other companies, it will become a separate source of taxable profit (a 'non-trading credit') or loss (a 'non-trading deficit').
Where unrealised differences arise on other capital assets, they will not generally be taxable or allowable at that stage; instead, the exchange difference becomes part of the computation and is effectively taxed or allowed when the asset is disposed of and any difference is realised.
In broad terms, if companies participate in UK partnerships (whether general partnerships, limited partnerships, or limited liability partnerships [LLPs]), they will be taxed on a flow through basis. This will, in very broad terms, mean that UK corporate partners will be taxed on trading, property, or financing income as it arises in the partnership accounts, and on non-exempt dividends on a receipts basis. There are specific anti-avoidance provisions in respect of LLPs with both corporate and individual partners.
When considering overseas entities, the UK authorities will not be bound by how the entity is classified in its country of origin. Case law has determined a number of matters that should be considered when establishing whether a non-UK entity should be taxed in the United Kingdom as if it were a company or a partnership. HMRC also maintains a public list of non-UK entities and the decisions it has previously made regarding their classification. However, if the parties have flexibility regarding the constitution of such entities, then their classification may be viewed differently, either by HMRC or the courts. This area is complex; consequently, specialist advice should be sought.
In principle, the United Kingdom taxes on a worldwide basis, although non-UK PE profits can be exempted from UK taxation by election. The election applies to all accounting periods starting after the election is made and to all the PEs of the company (so it cannot be made on a PE-by-PE basis). The election is irrevocable and has the effect of exempting all profits of the PE, including gains, subject to certain adjustments. Equally, relief for PE losses will be denied. Profits will be measured by reference to DTTs, or, in absence, OECD principles. The adjustments include:
- Gains attributable to a foreign branch of a close company are not exempt.
- Profits attributable to a foreign branch of a small company are not exempt if the PE is in a territory other than a 'full treaty territory' (broadly, a territory that has a DTT with the United Kingdom that has an exchange of information article).
- If the branch concerned has previously been in a loss making position, loss transitional rules may prevent the exemption being available immediately.
- To the extent the branch profits are considered to have been artificially diverted from the United Kingdom, the anti-diversion rule will stop them qualifying for the exemption (akin to the CFC rules that apply to profits of subsidiaries).
Where no election is made, profits from non-UK PEs are computed and taxed in the normal way for UK tax resident companies. However, UK tax will generally be reduced by credit for local direct taxes paid, either under a treaty or via the UK's unilateral relief rules (see Foreign tax credit in the Tax credits and incentives section for more information).