The U.K. government’s Finance Bill 2021 raised the corporate income tax rate from 19% to 25%, effective April 2023.
The prospective tax rate increase is to offset tax revenue shortfall from the Covid-19 downturns. However, the tax rate increase is softened with a radically new corporate tax law, called the “Super” deduction.
Corporations can write-off 130% of the cost of new capital assets purchased and placed into service during a two-year period beginning in April 2021 and ending in March 2023, which is when the higher tax rate kicks in. Contracts for the purchase of capital assets entered into after March 3, 2021, also qualify.
The British government believes this generous capital allowance law will incentivize new capital investments in equipment and machinery. The U.K.’s finance minister, Rishi Sunak, called it “the biggest tax cut in modern history.” The estimated tax cost reduction from the “Super” deduction is 25 billion British pounds ($34 billion).
There is no limit on costs that qualify for the 130% write-off. However, assets purchased for leasing do not qualify and the government can claw back the “Super” tax benefit of assets sold during a tax period in which the corporate tax rate is 19% by treating the disposal value as being equivalent to 1.3 times the actual proceeds. There are more “bells and whistles” to this “Super” tax deduction law that are beyond the scope of this article.
So why is the U.K. ‘Super’ deduction a big deal?
This novel corporate tax law is metaphorically a “carrot and stick” designed to induce corporate investment and tax savings currently in anticipation of a future tax rate increase. It also presents a unique financial reporting complexity discussed in Part II.
The U.K., like its former colony the U.S., is not a stranger to complex tax laws. For example, in 2015 the U.K. government enacted the diverted profit tax (DPT) law to claim taxation rights on business profits attributable to certain corporate structures the U.K. deemed to be abusive. This time, the U.K. government wants to promote capital investment, while also raising the corporate tax rate from 19% to 25% effective from April 2023.
Now the Brits tried to “neutralize” the tax rate increase by setting the “Super” deduction tax rate with a multiplier of 1.3 to get as close as possible to the 25% tax rate increase due April 2023. Hence, the “Super” deduction effective tax rate is about 25% (130% x 19% or 24.7% to be exact).
But is it really tax neutral?
U.K. tax depreciation rules are unique, as is the “Super” deduction. Depreciable assets go into two “deprecation pools” or classes. The “main” pool, for plant and machinery assets, is depreciable at 18% annually (equivalent to a five to six-year recovery period). The “special” pool, for most long-lived assets and fixtures, is depreciable at 6% annually (equivalent to a 16- to 17-year recovery period). The main pool’s effective rate is 3.42% (18% times 19%), and the special pool’s is 1.14% (6% times 19%).
There is also an annual investment allowance (AIA) of full write-off in the first year worth 19% and capped at £1 million ($1.36 million) (a “100%-bonus” depreciation rule permitted for all assets). The Finance Bill 2021 extended this AIA through the end of 2021.
With the “Super” deduction, the first-year tax benefit is worth 24.7% of the cost (130% times 19%), which is better than 19% (100%-bonus depreciation) and far better than 3.42% (main pool) or the 1.14% (special pool).
For example, new machinery purchased on July 1, 2021, for £1 million can yield a current income tax benefit of £247,000 (£100 x 19% x 130%). Under the AIA provision, the tax benefit would be £190,000.
But there are more variables
Consider a company with current and expected near-term losses with no need for additional tax savings. If the company expects profits beyond 2023, it might choose to forgo the “Super” deduction in lieu of slower cost recovery or to defer capital investments. However, U.K. tax law allows the carrying of losses into future tax years indefinitely (no expiration) until fully utilized. Therefore, a large current deduction that increases a current year trading loss can, in theory, reduce profits of future years.
What about carrying back losses to claim a refund of taxes paid? The Finance Bill 2021 made an important change to the carryback rule. Trading losses incurred in accounting periods ending between April 2020 and March 2021 can reduce taxable income in the prior three years (instead of one) for a refund of tax paid in back years, starting with the earliest year. This expanded carryback rule could be beneficial for companies that were profitable and paid tax in 2017, 2018, and 2019 before the Covid-19 outbreak.
Let us consider the following example to illustrate the cash flow impact:
An asset costing £1 million is purchased and placed in service on July 1, 2021. The asset has a six-year recovery period (“main” pool), and the corporation is profitable in all years and files financial statements on a calendar year basis, but its U.K. tax year ends in March/beginning of April. Cash flows in the initial two years (2021-2023) would have a tax cost of 19%, thereafter increasing to 23.5% and 25%. Under a “base case” scenario the total expected cash tax saving from the asset’s recovery is £225,700 if deducted within six years. The table below summarizes the “base case” scenario cash tax effects.
If AIA is elected, the first-year tax benefit is £190,000 (19% x £1,000,000), and not enough to cover the tax rate increase (time-value of money and cost of capital would need to be large enough to offset this deficit).
However, the “Super” deduction yields a tax saving of £247,000 (£1,000,000 cost times 19% times 130%) entirely in the first year. The “Super” deduction is more beneficial than regular and AIA, nearly neutralizing the higher tax amortization benefit if capital investment were deferred to 2024 and beyond when the tax rate is 25%.
Now, the decision analysis is not always going to be clear if losses are anticipated in 2021 and 2022. The “time value” of money, inflation, and a firm’s cost of capital are additional considerations.
In full disclosure, the British government’s belief that businesses react favorably to partial or full write-off of capital assets acquisitions is not new. Academic research is more favoring than against it. For what it is worth, the Americans have two main provisions in U.S. law (tax code Sections 179 and 168 (k) (bonus depreciation) allowing write-off of the entire acquisition cost.
To prepare for Part II (financial reporting of the “Super” deduction), we need to determine whether the “Super” deduction is a “special tax rate,” or a tax basis increase.
You might think this is a distinction without meaning, because the economics is the same: The U.K. government wants to stimulate capital investments, through corporate income tax, by funding 25% of brand-new capital assets. How? By setting up a “special” corporate tax rate for first-year capital allowance akin to a “bonus” depreciation on “steroids” (130% instead of 100% write off).
The accounting profession’s thought leadership “gatekeepers,” however, argue the law “increases” the tax basis of acquired assets over the cash cost.
While this is a distinction without meaning (the “Super” deduction is a corporate income tax benefit), it leads to a different accounting outcome discussed in Part II, the Financial Reporting Accounting of the U.K. Super Deduction.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Author Information
Yosef Barbut is a tax accounting consultant who previously was a partner in BDO USA’s National Office, and prior to that, an income tax accounting consultant in the PwC National Accounting office.
Special acknowledgment of Ingo Harre, a German-based certified public accountant and income tax accounting specialist and former senion tax manager with BDO Germany, for his review and contribution.
Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at [email protected].