Chancellor prepares to give ACT the chop

As Gordon Brown ponders the arithmetic for his Budget, Tom Stevenson looks at the case for reducing or abolishing Advance Corporation Ta

Gordon Brown has tackled some thorny problems in his first month in office, giving the Bank of England a measure of independence and setting in train a radical overhaul of City regulation. His biggest challenge lies ahead, however - can he get his head around ACT, the tax many have heard of but few would claim to understand?

This matters because the Government's need to raise extra tax revenue means the Chancellor is widely tipped to tamper with the current system, announce a review or abolish it altogether in his first budget. The implications of messing around with ACT are far-reaching for companies, pension funds, charities and the stock market as a whole.

Introduced in 1972, Advance Corporation Tax was an attempt to save shareholders from paying tax twice on their dividend income. Before ACT, companies paid dividends out of taxed income and shareholders paid a further levy on the payout.

ACT, and the so-called imputation system on which it hinges, attempted to put that right. Now, when a company pays a dividend it simultaneously pays tax to the Exchequer at a rate of 20 per cent of the gross payout. So an 8p net dividend to a shareholder incurs a 2p tax payment.

This makes no difference to most companies, because they can set off the tax payment against their subsequent corporation tax bills. For shareholders, however, it means they are only taxed once and, importantly, at their own marginal tax rate.

Basic-rate taxpayers are deemed to have settled their tax bill. Higher- rate taxpayers have to stump up an extra 20 per cent slice of tax to bring their total payment up to 40 per cent. Non-taxpayers, including pension funds and charities, are able to claim back the 20 per cent tax bill already paid on their behalf by the company.

The estimated cost to the Government of this credit to the gross funds is estimated at around pounds 5bn a year. Because its main beneficiaries are faceless institutions, it is not hard to see why it is likely to be targeted by a revenue-hungry Chancellor.

There are some strong intellectual arguments for getting rid of ACT. It is arguable that the existence of a tax credit on dividends encourages the City's short termism at the expense of the longer-term investment that characterises countries such as Germany and Japan. Pension funds are largely concerned with the cashflow from their investments and the current tax system gives them a strong incentive to put pressure on companies to pay high dividends. Labour has a stated desire to shift the playing field back towards long-term investment.

It is also arguable that even if the Chancellor were not instinctively inclined to tamper with ACT, events in the rest of Europe might force his hand. The Irish have recently moved away from the imputation system and in Germany moves are afoot to abandon a similar regime. Some continental companies such as Hoechst are challenging the Inland Revenue, claiming their UK subsidiaries are being made to pay a tax that their own shareholders are unable to claim back.

Yet as individuals are increasingly called upon to provide for their own retirement welfare, it could be unfair to reduce the tax advantages of saving for old age. It can also be claimed that some of the most vulnerable in society would pay for a cut in ACT because charities, whose funding depends to a large extent on dividend income from shares, would be badly hit by a change. The Wellcome Trust, which funds medical research, has estimated it could be pounds 1m a week worse off.

Finally, it is possible that reducing the tax credit could be self-defeating. If companies are forced to pay more into their own pension schemes to make good a shortfall in the value of their funds they will report less taxable profit, cutting the Government's corporation tax take.

Assuming the Chancellor does take an axe to the gross funds' tax credit, one of the most noticeable effects could be a fall in the level of stock market. In theory a 20 per cent reduction in the value of pension funds' income could mean they were only prepared to pay 20 per cent less for that cashflow and the market could fall commensurately.

In practice the outcome is likely to be less clear cut. Although pension funds are the biggest single class of investor in the stock market, they still only control perhaps 40 per cent of shares. Other investors will not suffer in the same way and shares will retain their value to them.

Also, when the last government reduced the ACT tax credit four years ago from 25 per cent to 20 per cent, raising pounds 1bn, the market shrugged off a 6 per cent reduction in its gross dividend income.

Companies would be affected in different ways. For those UK-based companies which simply pay their ACT and set it off against later Corporation Tax, a reduction or abolition would make no difference except they would have a slight cash flow gain - they would not have to pay their tax in advance.

Businesses with a high proportion of overseas earnings might welcome a change. For some companies the amount of ACT they pay on their dividends exceeds the Corporation Tax they pay on the small proportion of earnings they generate in the UK. Ruses such as Foreign Income Dividends (FIDs) have been concocted to get around the problem, but for many companies surplus ACT has to be written off as an expense.

The major implication for companies, however, is the possibility that their final salary pension schemes might be rendered underfunded by a reduction in their income. Tax experts believe a significant proportion of company schemes would be trapped in this way and would have to pay substantial amounts to make good the shortfall.

Charities have estimated the cost of an abolition of the tax credit to them might be pounds 250m a year, equal to the amount distributed by the National Lottery Charities Board. Dividend income is one of the few areas in which charities' revenues have grown recently. Other losers include the 2 million holders of Personal Equity Plans (PEPs) for whom the abolition of the tax credit would mean the only advantage of holding shares in a tax-free package would be relief from capital gains tax.