INSIGHT: U.K. Autumn Budget 2018—Everything in the Balance

Delivered, as it was, in the shadow of Brexit, Budget 2018 was inevitably more about the short-term shoring up of the current Conservative government than setting out a long-term vision of a new post-Brexit economic model for the U.K.

However, while the precise shape of Brexit (let alone its economic consequences) remains unclear, the factional divisions within the Conservative party anything but. Add to that the extreme fragility of the government’s working majority, Hammond (a naturally prudent Chancellor) had to navigate a treacherously fine path.

Even after eight years of austerity, and boosted by higher than expected tax revenue, U.K. growth remains relatively weak and government debt remains stubbornly high (at around 85 percent of GDP). Yet the political pressure to confirm, “austerity is coming to an end”—effectively already promised by the Prime Minister just last month—on the proviso, the U.K. gets a “good Brexit deal” with the EU, to loosen the public purse strings, seemed irresistible.

Small, British, retail, businesses, struggling to adapt to the changing shopping habits of their customers and the huge disruption caused by online marketplaces, were the primary focus of the Chancellor’s help. Changes in the corporate and international space were generally less welcome.

Digital Services Tax (“DST”)

The main announcement potentially affecting international business is that the U.K. government will act unilaterally to introduce a new DST. No longer willing to wait for international consensus, the U.K. will charge the revenues of certain digital businesses to the DST, at a rate of 2 percent. After a period of consultation, the U.K. DST will take effect from April 2020.

The scope of the U.K. DST, however, will be relatively narrow. It will only apply to the revenues specific digital businesses where such revenues arise from “user participation.” The affected businesses are:

Search engines—generating revenue from advertising relating to the result of search terms inputted by U.K. users;
Social media platforms—generating revenue from adverts targeted at U.K. users; and
Online marketplaces—generating revenue from commission by facilitating transactions between U.K. users of that marketplace.

The U.K. DST will be deductible as an allowable expense for U.K. the purposes of U.K. corporation tax but, crucially, because it is not a tax on profits, it will not be within the scope of the U.K.’s double tax treaties and so treaty relief will not be available.

A number of exceptions and exemptions will also apply. These include:

A double threshold—only businesses generating relevant revenues of at least 500 million pounds sterling ($571 million) globally will be liable. In addition, the first 25 million pounds of relevant U.K. revenues will be exempt.
A safe harbor—businesses may be able to elect to calculate their DST liability under an (as yet unspecified) “alternative basis.” This should ensure that only profitable businesses would be liable to DST, while those with very low profit margins will be liable at a reduced rate.
A five-year review clause—the U.K. DST will be formally reviewed in 2025.

The U.K. government has recommitted itself to the OECD’s efforts to facilitate a global solution, and confirmed that (assuming any such solution is, in its view, “appropriate”) it will abolish the DST once (if) that solution is agreed.

Diverted Profits Tax (“DPT”)

The government has announced its intention to amend the U.K. DPT rules.

DPT is an anti-avoidance regime that counters contrived avoidance arrangements designed to erode the U.K. tax base. The DPT attacks two main avoidance techniques, namely:

Avoiding creating a U.K. permanent establishment (“PE”); and
Using arrangements or entities that lack economic substance.

Budget 2018 introduces new measures to:

Address planning designed to circumvent the regime;
Clarify that diverted profits caught by DPT are not also subject to U.K. corporation tax; and
Several technical modifications to the mechanics of the regime.

Anti-fragmentation Rule

In another measure tackling measures designed to artificially avoidance creating a U.K. PE, the U.K. government has announced that it will introduce new, domestic, anti-avoidance, rules designed to prevent U.K. businesses attempting to ensure U.K.-taxable business profits accrue to entities resident in offshore tax havens.

The new rules will complement identical changes made to the U.K.’s portfolio of double tax treaties following its adoption (and implementation), of the Organization for Economic Co-operation and Development’s Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS.

The rules will change the definition of “permanent establishment” in U.K. law to prevent non-U.K. resident companies benefiting from the activities “of a preparatory or auxiliary character” exemption (from creating a U.K. PE) through the artificial fragmentation of their business operations.

Offshore Receipts in Respect of Intangible Property (previously the Royalties Withholding Tax)

Previously known as the Royalties Withholding Tax, income arising from intangible property held in low-tax jurisdictions will be subjected to U.K. tax, with effect from April 6, 2019, to the extent the relevant income is “referable” to U.K. sales.

The government has announced some technical changes to ensure the new regime will apply as intended and is not open to abuse. The changes include:

Collecting the tax directly, by taxing offshore entities that realize intangible property income in low-tax jurisdictions; the original plan to apply a withholding tax has been dropped;
Broadening the scope of the tax to include royalties and income received from the indirect exploitation of intangible property; and
Introducing a de minimis (of U.K. sales of 10 million pounds sterling) and two exemptions (for income that is taxed at appropriate levels and for income relating to intangible property that is supported by sufficient local substance).

Corporate Capital Loss Restriction

The government intends to bring the tax treatment of corporate capital losses into line with the treatment of income losses.

Although subject to further consultation, with effect from April 1, 2020, the proportion of annual capital gains that a company can relieve with carried-forward capital losses will be restricted to 50 percent. The new aligned regimes will allow companies to use of up to 5 million pounds sterling of capital or income losses each year, unrestricted. The aim is to ensure 99 percent of companies are unaffected by the restrictions but that large companies pay tax when they make significant capital gains.

Other Previously Announced Measures

Confirmations of a couple of previously announced measures are also worthy of note, namely:

U.K. property income of non-U.K. residents—with effect from April 6, 2020, non-U.K. resident companies carrying on a U.K. property business, or having other U.K. property income, will be charged to U.K. corporation tax (instead of income tax). This change ensures U.K. and non-U.K. resident companies will be taxed in the same way, preventing offshore property ownership structures being used to exploit any difference.
EU Anti-Tax Avoidance Directive (“ATAD”)—despite Brexit, the U.K. remains committed to full implementation of the EU ATAD. The government has announced minor changes to both its Controlled Foreign Company (“CFC”) rules and its hybrid mismatch regime to ensure they comply with ATAD. The CFC changes (relating to the definition of control and the treatment of certain profits generated by U.K. activity) will take effect from January 1, 2019. The hybrid mismatch changes (relating to the treatment of certain permanent establishments and the treatment of regulatory capital) will take effect from January 1, 2020.

Despite all the new commitments and spending (e.g. for the NHS), the Chancellor had suggested the extra spending might be at risk if Parliament rejected any Brexit deal brought back from Brussels by the Prime Minister. Number 10 helpfully clarified that what the Chancellor had actually meant was not new promises might not be met, but merely that the U.K. would need a different, no doubt starker, Budget in the event of a potentially catastrophic, disorderly, “no-deal” to pay for them.

Ominously, the Chancellor has already earmarked the Spring Statement 2019 for an upgrade to a full fiscal event, should it be proven necessary. One senses, a bit like Brexit, some of the Budget might just have been kicked down the road.