The Mechanics of Uncertainty
As a brief recap, “small” companies for preliminary tax purposes enjoy a safe harbour whereby they are permitted to pay 100% of their prior-year liability in month 11 of their financial year or 90% of the actual liability for that year. This approach offers companies certainty and the simplicity of a single payment based on 100% of the prior year liability. However, “large” companies are forced into a complex instalment schedule where the minimum payment must satisfy the following:
- Instalment 1 (month 6): 50% of the prior year’s liability or 45% of the liability for the current year.
- Instalment 2 (month 11): A “top-up” to bring the total to 90% of the current-year liability (i.e. there is no facility to pay 100% of the prior-year liability).
- Final instalment: The remaining 10% is settled on the filing of the company’s tax return, typically nine months after the year-end.
Although mathematically this all sounds straightforward, the practical reality is very different!
The option for large companies to pay instalment 1 based on 50% of the prior-year liability is largely uncontroversial. However, here is no such equivalent with respect to instalment 2, and instead a forecasting exercise is necessary. The absence of a safe harbour for Instalment 2 appears to be on the assumption that larger companies have more sophisticated accounting processes and thus are in a better position to project the final outcome for the year. However, no amount of sophistication provides a company’s tax or accounting function with the ability to foresee the future.
Indeed, the complexity of a large company makes it harder, not easier, to finalise its tax position. The final month of a company’s financial year is often the most volatile, where a currency fluctuation, business shift or regulatory change can all fundamentally alter a company’s tax profile. Yet by 23 November, companies must commit to a 100% accuracy rate on a 90% estimated outcome when potentially only 75% of the financial data is available. The rules might work for those companies that generate profits evenly across the year and have foresight of any material adjustments, however, we know of no such business!
The Hidden Burden
Whatever about companies’ being required to predict the unpredictable, the most egregious element of the rule is not so much the rule itself but the consequences where a company fails to meet its preliminary tax obligations. Crucially, if a company fails to meet the minimum 90% threshold for instalment 2, its ability to rely on the 50% prior-year rule for instalment 1 is revoked and the legislation applies a retrospective “legal fiction” whereby:
- 45% of the actual final liability is deemed to have been due in month 6 and
- 100% of the actual final liability is deemed to have been due in month 11.
Thus, if a company underestimates its success in the final quarter, it is penalised such that there is an acceleration of the entirety of its corporation tax to month 11, with 45% of that liability’s deemed to have arisen in month 6. It is irrelevant that the profits may not have actually been earned or anticipated by the instalment date, yet interest (at a rate of 0.0219% per day) is charged as if those profits had existed.
The following examples illustrate some of the challenges with the current rules.
Example 1: The “success penalty”
Consider a multinational that estimates a €10m tax liability in November and pays €9m (90%). On 1 December it signs a landmark contract that had not been expected to complete until the following January, which pushes its final liability to €12m. The 90% test has been failed, and Revenue will now charge interest on the “underpayment” as if 45% of the tax was due back in June and 100% of the tax was due November.
Example 2: The “remitter”
A company pays a royalty on a new patent on 31 December, triggering a withholding tax (WHT) obligation. As WHT is remitted as part of the company’s corporation tax liability, this late-year transaction causes the company to fail the 90% test. The company faces interest backdated to June and an immediate top-up payment to stop interest arising by virtue of 100% of the tax liability treated as being due in November. This is despite the fact that the obligation to remit the WHT did not exist when the November estimate was paid.
Example 3: The “timing trap”
An Irish SME experiencing strong growth discovers that its tax liability is €201,000 for the prior year when finalising its accounts and tax return in September, making the company “large” (albeit marginally so) for the first time. By this point the company has already missed instalment 1 for the current year, as it was not anticipating being “large”. The company has involuntarily defaulted on its obligations and faces backdated interest and an accelerated payment schedule.
Defensive overpayment
Once the instalment 2 deadline passes, there is no meaningful mechanism for companies to make a top-up payment after year-end and once actual figures are known. To the extent that you fail the 90% threshold (even if it is by €1), you are in default of your obligations, and penalties apply!
Whilst, the legislation does cater for certain limited exceptions (where a top-up payment may be facilitated after year-end without penalty), this is largely confined to chargeable gains arising on disposals made after the instalment date and gains arising on financial derivatives. Ironically, these exceptions highlight the fact that the legislators acknowledged that forecasting is impossible for certain items yet arbitrarily did not extend that same logic to normal trading activity or genuine market volatility.
Consequently, companies are increasingly forced to make a “defensive overpayment” to avoid these penalties. This results in companies tying up vital working capital while the Exchequer benefits from an “interest-free loan” and ultimately gives rise to the scenario where the taxpayer bears all of the risk.
The Case for Reform: Aligning Compliance with Reality
A fair tax system should be based on predictability, proportionality and transparency and should not require the use of a crystal ball. Ireland has consistently reiterated its commitment to simplifying our corporation tax regime, and reform of our preliminary tax rules may well be a good place to start.
Fortunately, unlike the rules themselves, the necessary reform does not necessarily have to be complex. Most of the frustrations could be addressed by way of relatively minor amendments while preserving the integrity and timing of Exchequer receipts. For example, the following pragmatic updates could bring the rules into the modern era:
- Safe harbour/top-up window: The ideal outcome is that large companies be offered some form of safe harbour (e.g. basing instalment 2 on 100% of their prior-year liability). Absent that, companies should at a minimum be permitted to make a top-up payment without penalty after year-end to align instalment 2 with actual year-end results.
- Abolition of the look-back applying to instalment 1: Where a company fails to meet the 90% threshold, interest should apply only to the shortfall on instalment 2, and the look-back penalty should not be invoked. Instalment 1, if paid correctly based on 50% of the prior-year liability, should remain protected. Indeed, it is difficult to understand the policy rationale of the current rule.
- Modernising the thresholds: The €200,000 threshold for “large” company classification has remained unindexed for 18 years. This bracket creep has inadvertently pushed hundreds of Irish SMEs into a “large company” regime that is predominantly designed for multinationals. Increasing this threshold to, say, €1m would significantly reduce the compliance and cash-flow burden for the sector.
Retiring the Crystal Ball
Today, Ireland’s preliminary corporation tax rules are somewhat bizarre – a rule that is effectively based on the use of estimates and that then imposes onerous penalties where a company operating in good faith gets those estimates wrong. Pragmatic reform of the rules would allow businesses to focus on driving strategy rather than estimating defensive overpayments, ensuring that tax compliance is based on the reality of the ledger rather than the fog of a crystal ball. In a modern and increasingly volatile global economy, certainty is surely the ultimate competitive advantage.
