Corporation tax is tax paid by incorporated entities, such as companies, and unincorporated associations, such as sports clubs, etc.
The UK did not originally differentiate between incorporated and unincorporated businesses: both paid income tax Opens in new window on their income.
A separate tax on companies was first introduced in 1965. The introduction of a separate tax on company profits some years after the introduction of income tax occurred in many countries.
Systems for Taxing Company Profits
There are three main systems for taxing company profits as follows.
1. Classical System
This does not differentiate between a company’s distributed and retained earnings, and the shareholders are treated as being completely independent of the company.
The taxation consequences of this are that:
- the company is liable to corporation tax on all its taxable income and gains whether distributed or not;
- the shareholder is liable to income tax on dividends received from the company; and
- the shareholder is liable to capital gains tax on taxable gains realized on the disposal of shares in the company.
A classical system is easy to understand and administer, but is often felt to have distorting effects on the economy, as follows.
- As shareholders and company are independent for tax purposes, dividends are taxed doubly, which may distort the company’s dividend policy.
- The system is not neutral between debt and equity capital because of the double taxation of dividends.
Interest on debt finance is more attractive because it is deductible from pre-tax earnings, so there is an incentive towards high gearing.
- The classical system encourages companies to retain earnings, which could lead to potential double taxation when shareholders dispose of their shares.
- The system encourages companies to fund investment from retained earnings, which could distort invest decisions and lead to the inefficient use of resources.
2. Imputation System
Under the imputation system, all or part of the underlying corporation tax on distributions is imputed to the shareholder as a tax credit, thereby avoiding the problem of the double taxation of dividends.
There are two types of imputation system:
- Full imputation, where all the underlying corporation tax is imputed to the shareholder. The economic significance of full imputation is that the system is neutral between debt and equity finance (ignoring retentions).
- Partial imputation, where part of the underlying corporation tax on the distribution is imputed to the shareholder.
Under partial imputation, the system will become more neutral between debt and equity the nearer the corporation rate is to the rate of imputation.
On the whole, imputation systems of CT alleviate many of the problems of a classical system, but in doing so ignore the possible double taxation with regard to retained earnings and capital gains tax.
The UK introduced corporation tax originally in 1965 under a classical system, though this was changed in 1973 to a partial imputation system. Later reforms attempted to remove the still remaining bias in favor of debt finance, and make the system more neutral.
3. Split Rate Systems
These make the distinction between distributed and retained profits by charging a lower rate of tax on distributed profits in order to avoid the double taxation of dividends. Using a lower rate for distributed profits can operate under either a classical or an imputation system of corporation tax.
How Corporation Tax Works
The starting point for corporation tax is the amount of profit a company makes in an annual accounting period, which will most usually be found in a set of the company’s annual accounts and reports.
Most countries that operate a corporation tax have a similar set of adjustment rules. Corporation tax is applied at the appropriate rate to the taxable profit.
In the UK, a company’s corporation tax is due by means of a single payment nine months and one day after the end of its accounting period unless the profits are deemed ‘large’ by reference to specific criteria, in which case payment by installment is required.