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Post-Covid recovery: where to employ tax increases

As the UK economy intends to reduce the budget deficit, its focus is firmly placed on taxation. Yet with conflicts to ‘all’ tax policies, the challenge for the government now will be how to reform its tax systems.

With the pandemic becoming more steadily controlled, the spotlight has shifted onto how the UK economy now plans to recover. Yet according to PwC, “even before the Covid-19 crisis, many economies were in a difficult situation,” suggesting it will be far from plain sailing. The firm disclosed many labour markets had not “fully” regained strength from the financial crisis of 2008, with “reduced levels of business activity” and “low wages” dubbed to have significantly worn-down the UK’s tax base – now factor in the addition of Covid-19 – it has only “worsened” the economies financial position.

Although GDP has risen since the “steepest” drop ever recorded, the House of Commons Library underlines it is still sitting well below pre-pandemic levels. It suggests the guidelines designed to mitigate some of the negative repercussions, subsequently bled the UK’s finances – since the few firms being able to trade led to a sharp fall in taxable revenue – it may come as no surprise then that we see the Government instil more stringent policies due to the “magnitude” of the recession being “unprecedented” in modern times.

“Productivity fell, therefore it affected the tax take; if you’re not doing things, you’re not making profits, and if you’re not making profits there is nothing to actually tax,” says Eloise Walker, global head of corporate tax at Pinsent Masons. Now tallying her 14 year at the firm, Walker has long been considered a specialist in the profession. Her position notably involves overseeing lawyers in businesses who are involved in corporate tax advisory work and transactional matters. She alludes to the fact that nearly all tax mechanisms provisioned by the Government were mostly temporary measures, proposing the economy should expect to see a sharp increase in tax revenues.

“If you were deferring your VAT, you’ve not been let off the hook from paying it, it’s merely been deferred.” Surely that is a positive step on the road to recovery? It is not that simple, however. Walker displays it is in fact quite contentious – suggesting the effect is “two-fold.” “In the perspective of the treasury, it means they get their money, yet it’s going to be difficult for a lot of businesses because now they’re trying to recover, and at that very moment they’ve suddenly got to find extra cash to pay tax bills that have come due.”

On the one hand the economy will see its tax returns rise, yet subsequently it is hindering business productivity which may see a reduction in firms’ taxable profits in the near-future.

To make matters more problematic, a latest assessment from Pinsent Masons draws upon HMRC’s recent analysis of underpaid tax. The institute names foreign firms responsible for a third of the total, accounting for approximately £11.5bn of £35.8bn unpaid. HMRC also holds US-owned businesses answerable for the highest percentage (47%), with the revenue missing out on £5.4bn as a result. US-owned firms are now a “key target” for investigation by the institute, assigning particular focus onto the use of ‘transfer pricing’ and ‘base erosion’.

“Transfer pricing is contentious because you’re arguing about, as a factual matter, ‘what is the correct price?’” Walker contends. “That in itself, is not objective.” In the opinion of the country that the overseas firm is operating in, its “correct price” will differ to that of the country the firm is owned by. “There’s not necessarily such a thing as the ‘correct price’. There could be a whole range of correct prices,” states Walker. She proposes this is why it is such a disputed area, as both parties will argue as to ‘who’ is correct. Yet there is increasing concern over the extent to which this tax underpayment rings true. Walker contends there are a lot of international entities who would say they are pricing appropriately. “It’s not that firms are escaping tax, it’s just that they’re not paying it in the UK.”

According to PwC, advanced legislation such as OECD refinements, additional documentation and, namely, hardened tax authority around transfer pricing have been provisioned by Governments to restore lost tax revenues. Some may question that with such an ‘array’ of “weapons in HMRC’s arsenal,” how is it that foregin firms are still underpaying tax? Walker describes the use of transfer pricing to a ‘sledgehammer’, underlining it is frequently employed to obtain extra revenue: “Transfer pricing is often used by HMRC as it is a sledgehammer to try and get a little bit of extra money.” She proposes that firms may not be underpaying tax, yet it is a convenient way to exploit foreign-owned businesses since it is at the Government’s discretion.

The accessibility of transfer pricing is queried however, as it yields “two difficulties.” Firstly, she says HMRC lack the “bodies” to undertake all the necessary investigations, and secondly, the UK courts “couldn’t take it,” suggesting that regardless of whether a firm is thought to be underpaying tax or not, it may be too complex to govern. Walker correspondingly indicates the use of ‘base erosion’ is just as contentious: “When you look at a foreign firm’s taxable base, they may have a huge turnover, but very low profitability because they are paying big franchise payments in another country. However, the country that the firm is operating in may dispute that the foreign company is not paying enough tax in comparison to the large revenues it is generating.”

Yet PwC underlines that there are conflicts to all tax policies. It warns the “challenge” for governments now will be how to reform their tax systems. Walker alludes to the recent increase in corporation tax from 19% to 25% proposing the incentive behind this measure is to “limit” the ability of people to use their losses. Concurrently, PwC suggests this could be more damaging as it acts as a “disincentive to investment”. A recent study by KPMG, cited by World Economic Forum, strengthens PwC’s proposal, displaying 41% of UK SMEs deem ‘reliefs aimed at investors’ the most important due to their need to raise funding.

According to PwC, cuts to public spending was the principle way the economy recovered from the financial crash of 2008, yet the firm underlines the scope for cuts post-pandemic is “more limited.” The current Conservative Government “will not want to increase income tax,” contends Walker, however the OECD tax policy analysis, cited by PwC propose if the UK economy is to recover, they will need to.

The UK Government has a great task at present. Whilst contending with a “peacetime” recorded budget deficit (2020/21) according to the UK parliament, it must now choose carefully how the economy is to recover – which breeds a seperate list of difficulties: not only is it disputing queries over firms, chiefly foreign-owned businesses, falling short on tax payments, the options available to amend its deficit becoming less simple to deploy. Walker compares this contention to “bargaining at a Turkish bazaar,” suggesting both businesses and the Government are stubborn to change. The UK also has the sensitive task of deciding where to impose future tax increases, which can be said will be far from easy. It may prefer to keep a close eye on the business landscape amid the corporation tax increase before employing further tax policies. With regards to increasing income tax as a way to recover the economy, Walker notes the Government will need to decide “when they are going to do it” and in the current political environment, “do they think they can get away with it?” In actuality, it may be more likely that we see the Government “leverage” off the back of rumours surrounding multinational companies not paying enough tax. “that might be a more preferable way for the UK to get more money back,” she concludes.

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