Pre-budget tension affected the corporate sector in a quite unusual way this year. For the first time in memory the issue was not whether there would be a rate reduction - this had been well flagged in advance - but rather its size.
Given that in accordance with previously announced plans the mainstream corporate rate has to fall to 12.5 per cent by January 2003, just over four years away, the Minister has started the reduction process with the most obvious cut of 4 per cent, and has removed uncertainty by specifying the reductions in succeeding years.
The rate of tax on passive income will not, however, fall below 25 per cent. Guidelines have been provided to assist in determining how passive income is to be recognised. By and large, these follow existing law and practice except that profits from dealing in and developing land will always be regarded as passive.
The lower rate of 25 per cent which applied to small companies has not been reduced this year, but there is significant compensation in the form of an increase in the profit threshold below which the rate applies - to £100,000. This will obviously have an important and welcome consequence of increasing the amount of retained earnings for companies in this sector, where cash flow is normally tight and borrowing capacity may be stretched.
The significant widening in the gap between the top personal tax rate, which is unchanged at 46 per cent, and the lower corporate tax rate will provide an incentive for sole traders and partnerships to incorporate. Be warned - it is already very difficult to extract money from a privately-owned company in any form without attracting an income tax liability, and the Minister has hinted at measures to make it even more difficult.
The proposals which the Minister announced for a transition to a 12.5 per cent rate by 2003 will have far-reaching consequences for corporate tax policy. Some immediate implications which come to mind are that falling tax rates may make Ireland an attractive location for service-type or medium to long-term financial-type enterprises, even where these are established outside the IFSC or Shannon. Furthermore, with effect from 1999 the mainstream corporate tax rate in Ireland will be lower than that applying in countries from which the bulk of our inward investment is sourced. This will have implications in deciding the most effective location for the booking of any related borrowings. Finally, an Irish-headquartered group is likely to find it possible in future to repatriate profits from overseas subsidiaries without incurring any additional Irish tax liability.
The Minister has heralded a series of revenue-raising measures to offset in part the corporate tax rate reductions. The withholding tax on dividends is one that has been specified.
It will apply to resident individuals and certain non-residents only. Presumably he is hoping that this will repeat the unquestionable success of DIRT as a money-spinner for the Exchequer, despite the fact that the extent of individual ownership of shares in Irish companies is likely to be much lower than that of deposit accounts.
The proposal has several other potential consequences. In quoted Irish companies, the administration of the new withholding tax, particularly coping with decisions on exemption for a constantly churning shareholder base, is likely to prove a nightmare for registrars.
The proposal may breathe new life into scrip dividend offers. While there are suggestions in the Budget material that these will be the subject of special arrangements, it is difficult to envisage how a withholding tax could reasonably be applied in such circumstances.
A dividend withholding tax together with the advent of EMU may cause investors to think of switching out of Irish and into European equities. However, it should be noted that dividends from non-resident companies are already subject to a withholding tax on encashment, although it may be observed that under longstanding practice the withholding tax has not been applied to dividends from UK companies. Another consequence of corporate tax rate reductions will be a further squeeze on the viability of tax-based lending products aimed at the manufacturing sector. The tax arbitrage between a falling mainstream rate and the existing manufacturing rate of 10 per cent is becoming narrow and opportunities to generate significant savings are disappearing.
Enda Faughnan is head of tax at PricewaterhouseCoopers in Ireland