Corporation tax – why all the fuss?

Up until recently the words “corporation tax” belonged firmly in the business world and even then were only used by businesses lucky enough to make profits and thus be subject to taxation.

However, with the announcement in last week’s budget of a three-month consultation on the issue, corporation tax is now entering the everyday lexicon of Northern Ireland’s politicians, journalists and even the general public. So what’s all the fuss?

In simple terms, companies which make profits will pay corporation tax. Those companies that make a small amount of profit pay tax at 20% and those making larger profits or are part of a larger group of companies pay tax at 28%. However, most companies, be they large or small, see corporation tax as a cost to their business and not as a contribution to society. Therefore, where there is an opportunity to reduce costs, businesses will look carefully at how they can achieve this.

Our neighbours South of the border recognised this issue many years ago and as far back as the 1950s introduced a corporation tax rate of 10% for companies involved in manufacturing. Eventually during the 1990s the EU cried foul and told the Republic of Ireland that they could no longer provide a tax relief solely to manufacturing companies.

To side step the problem, the Republic of Ireland deftly introduced a corporation tax rate of 12.5% for all trading companies. The fact that this rate of corporation tax coincided with the start of the Celtic Tiger is more than mere coincidence and the enormous impact that this policy had on attracting foreign direct investment – FDI – is well documented. Indeed, despite the financial turmoil of 2010, the Irish Government fought tooth and nail to retain the 12.5% corporation tax rate despite fierce opposition from France and Germany.

The rewards obtained from low corporation tax have since continued via the ongoing steady flow of foreign direct investment into Ireland. The obvious cost of increasing this rate would be a significant exodus of such FDI companies which would “up sticks” and seek to locate in another jurisdiction providing low corporation tax.

For some time, there has been a significant campaign by those who have identified a reduction in corporation tax for Northern Ireland as a means of kick starting the Northern Ireland economy, where the private sector is pitifully small in comparison to other parts of both the United Kingdom and the Republic of Ireland.

One of the main obstacles to this proposal was always felt to be the European Union. However over the last decade, the EU has indicated that small autonomous regions can indeed operate their own low corporation tax regime as long as three key principles are adhered to. These are:

1. The region has to have its own independent legislative authority – which in Northern Ireland would be the Northern Ireland Assembly.

2. The region must have the ability to make its own decisions with respect to reducing the rate of corporation rate. At present, the Northern Ireland Assembly does not have this power but if the power was devolved from Westminster, then the Northern Ireland Assembly could make the decision to reduce the rate of corporation tax.

3. The region would have to bear the cost of reducing the corporation tax without assistance from central Government.

As noted, the Northern Ireland Assembly would need to have devolution of tax varying powers from Westminster before a reduction in corporation tax in Northern Ireland could be introduced. This would require the consent of the Government at Westminster. The current Secretary of State, Owen Paterson, has embraced this idea and is a very keen advocate of granting the necessary powers to the Northern Ireland Assembly as a means of rebalancing the economy.

However, even if the decision to devolve corporation tax to Northern Ireland was taken, it is the cost to the block grant, being the third requirement of the EU principles of tax devolution, that would require careful consideration by the Assembly.

A reduction in the corporation tax rate could result in a reduction in the overall corporation tax yield from Northern Ireland companies. This reduced tax take would have to be compensated for by a reduction in the Northern Ireland block grant from the Treasury. However, whilst this many seem painful, there are several key points which must be considered carefully before the inevitable claim from local politicians that such a cost could not be afforded.

Firstly, the upfront cost could be significantly reduced if the reduction in corporation tax from 28% to 12.5% was phased in over a period of five or six years. This would reduce the initial dead weight cost of reducing the tax rate whilst enabling both local businesses and foreign direct investment to gear up and grow so as to generate additional profits. This would be a much cheaper option than making a one-off reduction in the corporation tax rate in year one.

Secondly, when considering the reduction in corporation tax yields one must also consider that there will be additional jobs created and additional supplies made within Northern Ireland. The increased payroll taxes and VAT can and should be used to defray the corporation tax cost. Once again, this should have a significant impact in reducing the costs to the Northern Ireland block grant.

Thirdly, the reduced rate of tax need only apply to trading profits and not to investment income or capital gains. This is what happens in the Republic of Ireland. Not only would this target the relief at trading activities, which is where job creation comes from, but it would significantly reduce the cost of reducing the corporation tax rate

Fourthly, the Northern Ireland Economic Reform Group estimated that over 90,000 new jobs could be created over 20 years by reducing the rate of corporation tax to 12.5%. No other economic policy would appear to come close to achieving this type of job creation. Indeed, with Northern Ireland being unable to offer grants to new businesses with effect from 2013, it is hard to see how else many new jobs will be created in the Province via foreign direct investment in the short to medium term.

Finally, people should not only consider the cost of implementing a reduction in the rate of corporation tax, they should also consider the cost of not implementing a reduction in the rate of corporation tax. At present, the economic outlook for Northern Ireland is gloomy. Many of the recent inward investment successes have been partly or wholly dependent on the awarding of grants. As such grant assistance will soon disappear, future inward investment is likely to become worryingly thin. Businesses are unlikely to come to Northern Ireland solely because of our good weather!

So what’s all the fuss? A reduced rate of corporation tax in Northern Ireland will act as a beacon to foreign direct investment, an incentive to local companies to reinvest and generate profits and a key plank in the growth of our private sector, and it will help provide long term sustainable and well paid jobs. That’s worth making a fuss about!

Eamonn Donaghy is Head of Tax at KPMG