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Clause 148

Volume 405: debated on Wednesday 14 May 2003

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Non-Resident Companies: Basis Of Charge To Corporation Tax

With this it will be convenient to discuss amendment No. 67.

The two amendments to which I am about to speak should be viewed in the context of some of the wider issues associated with clause 148, and I hope that the House will grant me indulgence if, rather than making certain points twice, I speak more widely around the amendments at this stage of our discussions.

Clause 148 was foreshadowed in last year's Budget and the Government's proposals were summarised in a subsequent press release that stated that the new proposals were
"aimed at modernising the UK tax regime by eliminating a weakness in the existing rules, and so bringing the UK more into line with other major industrialised countries, such as France, Germany and the USA".
That was essentially because

"recent work by the OECD … highlighted the fact that the UK was out of step with other major countries, and the changes here … make the UK approach similar to that seen elsewhere".
The press release stated that the changes would apply to accounting periods commencing on or after 1 January this year. Clause 148 gives effect to those proposals, although, curiously, clause 147, which defines the term "permanent establishment", contains no commencement provision and so will take effect from Royal Assent. I am not clear whether clause 148 can take effect from 1 January as the crucial definition will not have been enacted at that point.

Amendment No. 66 deals with the issue of the permanent establishment having the same credit rating as a non-resident company. Ratings are given to companies, to corporate debt and sometimes to specific transactions, and it is not clear what is being referred to here. Only a few companies that carry on business in the UK through a permanent establishment will have a credit rating. It is surely not appropriate to treat a UK permanent establishment, which might carry on only one or a limited range of the activities carried on by the company itself, as having the same credit rating as the company as a whole.

Both the OECD model and the draft legislation attribute to the permanent establishment the profits that would have been realised by a separate enterprise carrying on the same or similar activities. If any rating were to be assumed, it should be that which the assumed separate enterprise would have to have had, having regard to the activities that it carries on. It is illogical to assume a credit rating equivalent to that of the company itself.

The term "shareholders' loan" is also an issue. Given that "loan" has a meaning that does not include unpaid purchase money, a definition would be required if, contrary to what we feel is appropriate, the provision is to be retained. Failing that, debt securities issued as a consideration for an acquisition would not be included.

The explanatory notes to the Bill refer to equity capital and loan capital. That would probably be acceptable for financial institutions where there is a substantial amount of guidance, but for other companies it would be difficult to work out what is meant by the term.

Subsection (5) also permits the Revenue to make regulations for the application of subsection (2) to insurance companies, including the attribution of capital to a UK permanent establishment. That confers an unacceptable degree of power on the Revenue.

We are also concerned that the terms of the accompanying schedule 25 are discriminatory. The effect of paragraph 5 is that a permanent establishment would be in a worse position than a subsidiary that borrowed from its parent company. That could make organisations think more carefully about whether to set up in the UK as a branch or subsidiary. To be able to deduct interest would require the permanent establishment to have its own credit rating and deal at arm's length with other parts of the organisation. It could be discriminatory if the branch were not treated in the same way as a subsidiary.

The commentary in the OECD model is a flexible document and there is an ongoing debate about whether a branch should be treated as independent. There is a risk that, if the commentary is changed, the UK provision will then be out of line. If provisions are included in the Bill based on the current version of the commentary, there is a risk that that will restrict the Revenue's flexibility.

The clause is not specifically about European issues, but it is based on the long-standing principle of the UK's "territorial" basis of taxation for overseas companies, so it indirectly allows European issues to be raised; it focuses on European issues. Indeed, some of the commentary on the proposals from professionals has suggested that it contravenes EC treaties.

The premise from which the clause proceeds is that British companies should be taxed on all their profits, wherever they arise, and that non-UK companies should be taxed on their UK profits. In both cases, the tax yield is protected by a number of rules that prevent assets or profits from being siphoned out of the UK through transfer pricing, tax-free transfers of assets or excessive interest payment. The UK tax base is also protected by allowing offset of losses only where those have arisen in the UK.

The Paymaster General will be aware that a number of recent decisions have challenged some fundamental aspects of the corporate tax system of EU countries and our own corporate tax system. Indeed, they could challenge clause 148 and its accompanying schedule. The challenges seek to argue that the application of different tax rules to transactions with foreign companies from the rules that apply domestically is unlawful discrimination, but from a domestic perspective such discrimination is necessary and has been practised to ensure that companies do not simply siphon off profits to low-tax countries.

Those challenges are a significant threat to the UK's ability both to control its tax borders and to exercise its own corporate tax policies. For example, it may be unlawful to restrict interest deductions to EU companies where those payments represent excessive deductions designed to shift profits overseas. That is raised in the German Lankhorst case and the awaited Dutch Bosal case. It may be illegal to apply transfer pricing rules to transactions within EU companies, an issue that has not yet been litigated but which follows in principle from other European Court of Justice decisions. The UK may need to allow tax-free transfers of assets to EU companies because they are permitted between UK companies. The controlled foreign companies rules that prevent British companies from accumulating tax-free cash outside the UK may be unlawful. Again, that issue has not yet been litigated but there are relevant French cases. The well known Marks and Spencer case currently being litigated would require Britain to allow losses of foreign subsidiaries against UK profits. The recent decision in the Lankhorst case may well undermine the usefulness and effectiveness of the clause as interest payments to other EU members of a group would still be deductible.

The Government have to date refused to discuss—indeed, the Revenue appears to have buried its head in the sand—the impact of European Court of Justice decisions on the UK tax system. We welcome the announcement in the Red Book that that issue will be looked into, but it is the first acknowledgment that a major problem exists.

I would like in that context to make the following key points to the Paymaster General. The first is about whether the Government are confident of the forecast yield from clause 148, particularly in light of the slowdown in the financial services industry in the City as well as the EU issues. Secondly, the European Court's decisions have made provisions that are designed to prevent abuse of domestic tax rules unlawful. That challenges the UK's ability to protect its corporate revenues. What are the Government doing to defend the UK's tax rights over UK and non-UK companies operating in the UK?

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The Government's failure to face up to the problem so far leaves them with only two—potentially unattractive—options. They can extend the rules that are designed to apply only to international transactions to cover all domestic businesses, which would be highly regulatory and would impose unnecessary compliance costs on UK businesses. Alternatively, they can abandon the rules that prevent international tax avoidance, which would mean the loss of significant tax revenues.

How do the Government propose to balance the need to raise revenue with the competitiveness of our tax system? The Red Book suggests that they are more concerned with protecting the tax yield than with the all-important issue of competitiveness. They have, at least overtly, ignored all the warning signs that sovereignty is being undermined in this crucial tax area, and are now acting in a way that will have an adverse effect on British business interests and the vital attractiveness of Britain as an international business location.

Will the Government consider tabling an amendment to the European treaty as part of the 2004 intergovernmental conference, to ensure that specified tax rules designed to prevent international tax avoidance are agreed not to be unlawful, so that we can retain national sovereignty in these areas and, indeed, ensure that what is proposed in clause 148 is effective?

Clause 148 could, I think, cause serious problems for the City of London and therefore for the country as a whole, as the City is a major contributor to our economic well-being. The clause alters the tax treatment of UK branches of non-UK companies, which will have a particularly adverse effect on overseas banks operating in the City. It could seriously jeopardise the City's position as the world's leading international financial and business centre, as foreign banks downsize their operations in London.

Let me say a little about the importance of the City to the kingdom as a whole. It is no exaggeration to say that it is a global powerhouse at the heart of the UK's financial services, a sector whose net contribution to the UK's current account has been over £13 billion, a significant amount of which has been generated within the square mile. There is a daily foreign exchange turnover of over $500 billion in London, and 56 per cent. of the global foreign equity market and 70 per cent. of eurobonds are traded there. London is the world's leading market for international insurers: the worldwide premium income reached £157 billion in 2001 alone.

I must declare an interest. I was a fund manager before entering the House, which enables me to testify to the importance of foreign banks to the City's prosperity and wealth generation. About 500 foreign banks currently operate in London, employing some 60,000 people. They contribute enormously to the City's pre-eminent financial position. I believe that this tax change will threaten that position, because it has been built on a false premise by a Government who misunderstand the way in which the City works—and, I suggest, misunderstand the economic facts of life. The Chancellor tries to justify this move by claiming that such changes in the tax treatment of foreign companies simply bring us into line with the US and with other European countries. However, he misses the point that this country's existing favourable tax treatment helps to compensate foreign companies for other factors that make doing business in London, in particular, less attractive when compared with other cities.

One example is the capital's transport infrastructure, which is a mess. Average journey times have increased by about 16 per cent. since 1998, and motorway congestion is up by 250 per cent. since 1997. Meanwhile, congestion charging has added a further marginal cost to businesses operating in London. At the same time, train punctuality has worsened each year under this Government. By withdrawing the advantage of a low-tax regime, they have made the decision whether to locate to London or elsewhere a more finely balanced one for foreign companies. This Government fail to understand that when it comes to the City, increasing mobility of labour and modern technology mean that business undertaken in the London branches of foreign banks can easily be done elsewhere.

Ian Mullen, chief executive of the British Bankers Association, said of the tax change last year, when it was first mooted:
"This will massively increase the costs of foreign banks operating in the UK and have an adverse impact on jobs and the competitiveness of the City".
In a letter to the Financial Times last year, Angus MacLennan, chairman of the Foreign Banks and Securities Houses Association, said that he guarantees that this tax change will result in business going abroad—in the first instance, by way of assets being moved to reduce additional tax, and afterwards as income follows the assets. He said:
"the reduced revenue base and increasing costs of being in London (compare these with the US, France or Germany…) will lead many to conclude that, economically, they should not be here at all".
He concluded his letter by saying:
"This is the reality. Short-term gain and long-term destruction of the best industry in the UK. Our competitor countries must be laughing with anticipation".

Does my hon. Friend agree that Ministers are especially short-sighted in this matter, given that they know, as we do, that this country has already sacrificed two thirds of its competitive tax advantage since 1997, relative to other members of the European Union?

I readily agree with those figures and that sentiment. What worries Conservative Members is that this country's competitiveness appears to be being continually eroded by these tax increases and regulations. Independent statistics suggest that we are slipping down the competitiveness league tables, which is causing a loss in productivity that will eventually result in the loss of our pre-eminent economic place.

It is true that these measures will generate income for the Treasury over the short term. Estimates vary, but it is suggested that some £350 million will be generated in the first year, with perhaps another £650 million being generated in 2004–05. However, as my hon. Friend the Member for Buckingham (Mr. Bercow) has just suggested, they will prove to be among the many tax measures that raise money in the short term but lead to a loss of revenue to the Treasury in the longer term—a loss that will far exceed any short-term gain, as foreign banks and employees quietly move out of London.

This issue is important to the country as a whole. By attacking the jewel in the UK industry's crown, the Chancellor is eating away at our competitiveness and longer-term prosperity. I urge the Government to reconsider their position, because, as sure as night follows day, the tax increase will result in a loss of prosperity and revenue in the longer term to the detriment of us all.

The central issue at stake in clause 148 and its supporting schedule—the amendments are designed to attack and eradicate it—is whether it is fair that foreign banks operating in the City of London, which are competing with UK banks, should, on account of their structure, pay little or no corporation tax. Is it fair for UK banks to compete for business against foreign branches that pay no tax? That is the central issue.

I am not posing a question for the hon. Gentleman to answer, but opening my case on the clause and the amendments. I shall urge the Committee to reject the amendments, comment on the key aspects of the clause and respond briefly to the hon. Member for Arundel and South Downs (Mr. Flight), who posed wider issues about the European Court of Justice, though I realise that that is strictly outside the remit of the amendments and I shall try to remain in order.

The amendments would remove the main charge introduced by clauses 147 to 155 and by schedules 25 to 27. The charge remedies what I would politely call a weakness in UK domestic law and ensures that UK branches of foreign companies will pay a fair share of UK corporation tax, reflecting the profits that they make from their UK activities. The bulk of clause 148 and schedule 25 set out in UK law the rules that the UK applies in taxing foreign companies. They also modernise the terminology used in UK law.

The one truly new element of clause 148 is set out in new section 11AA(3), which changes the way in which the taxable profits of branches are measured. For the first time, consideration will have to be given, for tax purposes, to the amount of equity and loan capital that a branch would have at arm's length. That is, consideration will need to be given to the capital that the branch would have if it were a separate entity carrying on the same or similar activities under the same or similar conditions.

Amendment No. 66 would remove that change. If it were accepted, the winners would be UK branches of foreign banks—it is primarily banks that operate through branches—which would continue to pay little or no corporation tax in the UK. The losers would be the UK Exchequer and UK incorporated banks that compete with foreign banks for their business.

It might be helpful briefly to explain the deficiency in the old legislation. Previously, there was no requirement for a UK branch to have regard to the amount of capital that it would require commercially in order to support its business. That meant that a UK branch of an overseas bank could, for tax purposes, borrow every pound that it lent to customers, and the interest cost of that borrowing would significantly reduce the UK profit. In contrast, a UK bank would need to have equity capital and would not borrow every pound that it lent, so it would have a smaller deduction for interest expense. The result was that nine out of 10 of the top foreign bank branches in the UK were paying no corporation tax on their UK profits, despite their large and long-standing UK operations.

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Amendment No. 67 would remove the new provision in new section 11AA(5). That provision would give the Board of Inland Revenue the power to make regulations specifying how the new capital requirements are to apply to insurance companies. That will enable the new rules to be adapted for insurance companies, because their capital requirements are organised differently from those of banks and other companies.

The hon. Member for Arundel and South Downs raised several issues, the first of which was the question of guarantee fees paid to head offices. The new legislation specifies that when computing the profits of a permanent establishment, it should be treated for tax purposes both as if it were a distinct and separate enterprise and as if it were trading in the same or similar activities under the same or similar conditions. That is based on the wording used in article 7 of the OECD model tax convention. There is an inevitable tension here, which arises from the fact that a branch is clearly not the same as a subsidiary, and different economic and legal consequences arise from adopting one structure over another. If the permanent establishment is assumed to be acting under the same or similar conditions, that must logically apply to the actual cost at which it can raise funds. The cost at which it can raise funds will be dependent on the company's credit rating. While it is our view that the assumption of the same or similar conditions means that the permanent establishment must have the same credit rating as the rest of the company, that matter was specified in the legislation to provide clarity and put the matter beyond doubt.

Is the Paymaster General talking about the profits of the branch operating in the UK?

I am talking now about the ability of the branch in the UK to raise loan moneys at cheaper cost, because it has the credit rating of its parent company. The whole clause refers to the profits of branches raised specifically from their UK operation.

Yes. We are seeking to ensure that the profits accumulated in the UK are correctly taxed within the UK net.

The question of guarantee fees is complex and it should be noted that the assumption of the same credit rating is also in line with the current OECD view. If the UK were to take a different view on credit rating, it would be out of line with international consensus, which could lead to double taxation for the foreign branches of UK banks.

Various representations have suggested that a permanent establishment should not be regarded as having the same credit rating as the company of which it is part and that guarantee fees should be allowed, but it is difficult to justify that both logically and legally. All parts of the same company will have the same credit rating. The permanent establishment will therefore have a certain actual cost of funding. It would be inconsistent with the arm's-length principle to treat the permanent establishment as funded at anything other than the actual rate at which it could borrow funds from third parties. Guarantee fees paid by one part of the same company to another will have no legal effect, and as the permanent establishment can access funds at a certain cost, it is difficult to see why it would pay such a fee.

The hon. Member for Arundel and South Downs also raised the question of whether the proposals are incompatible with European law.


The aim of the legislation is not to treat branches and subsidiaries as though they were exactly the same. There are clear economic and legal consequences to adopting one or the other structure. Branches and subsidiaries are not the same, and we cannot pretend that they are. For instance, a branch is able to access the capital of the company as a whole to support its business, and that is why banks often choose to trade through branches. If a bank chose instead to trade as a bank in another country through a separate company, it would need to raise further capital to support the activities of that subsidiary, rather than being able to benefit from the capital and credit rating that it already held. The Bill will create a more level playing field between branches and subsidiaries, so that the way in which the profits of branches are computed reflects the commercial reality: that they have access to company capital to support their business. The Bill will mean that UK branches of foreign banks will now pay a fairer share of corporation tax. That does not mean that branches are being treated more harshly than subsidiaries.

The new provisions require consideration of the amount of equity and loan capital that the branch would have at arm's length. The Bill adopts a capitalisation approach, which produces a more level playing field between the branches and subsidiaries of foreign banks, and so removes discrimination. That is entirely in line with current practice.

No, I will not.

The hon. Member for Arundel and South Downs asked why the terms "equity capital" and "loan capital" were not defined. The Inland Revenue saw no need for those terms to be defined in the Bill. Although some have commented that the terms should have been defined, other respondents have agreed that there was no need. The hon. Gentleman recognised that the terms are well established among the banks that form the main group of foreign companies affected by the changes made by the clause.

I turn now to the issue of decisions with regard to European law, and to the points raised on that matter by the hon. Member for Arundel and South Downs.

No. I want to continue to make my points.

The Committee will no doubt be aware that there have been recent judgments in the European Court of Justice, and there are ongoing challenges under European law. The particular case to which the hon. Member for Arundel and South Downs referred was in fact a ruling against the German tax system, not the UK's. As a result, the Government are of course aware that some uncertainty may have developed.

We accept that there is a need to restore certainty as quickly as possible. That point is reflected in the Red Book, in the proposals on corporation tax reforms and the next stage of consultation. The hon. Member for Arundel and South Downs will be well aware of the excellent relationships that have existed between this Government and interests in the City of London, especially in connection, for example, with matters arising from discussion of the draft directive on the taxation of savings. At every point, the Government have discussed—with business in general and with those sectors that have a specific interest in the matter—the developments that we want to secure. We want to ensure that we continue to have a corporation tax system and a general tax system that enhance the Government's objectives of establishing fair tax competition, increasing productivity and ensuring that the UK is the most competitive place to do business.

No, I will not give way. The hon. Gentleman has stood up repeatedly, but I will not be giving way to him.

This summer's forthcoming consultation on corporation tax reform will provide an opportunity for the Government to consult business on the legislative options to achieve our objectives of continuing to modernise and develop our tax system with regard to the objectives that I set out. We look forward to receiving input from the companies involved. It would be foolish in the extreme to speculate on what might be in the consultation document, and I am sure that the hon. Member for Arundel and South Downs does not seriously expect me to address those points, or to prejudge consultations with the very businesses with which we have worked so closely and in such detailed partnership.

The final points related to whether the measure would damage the City of London. The Government's credentials for acting in the best interests of the City and for defending its competitive advantage cannot be challenged either in Parliament or in the City itself. Indeed, our credentials are not challenged: we continue to receive accolades from all concerned on our exemplary conduct of the debates.

No, I will not give way.

It is clearly not the case that the measure will drive foreign banks from the City of London. Those banks are there for good business reasons. The City is one of the world's premier locations for conducting business of that type. The banks are there because of the crucial networks and support systems. There is nothing to rival the City in the rest of the European Union, and foreign banks will continue to do business there, but they will do so on the same competitive basis as UK banks, which is entirely fair and correct.

I ask the Committee to reject the amendments, and urge hon. Members to support the clause when we reach that point in today's business.

There are two key points on which I want to put further questions to the Paymaster General. I also want to respond to her comments about the ingredients for the continuing prosperity of the City of London.

I went into the first point at some length when I asked the Paymaster General whether the judgments of the European Court of Justice to date, and the principles on which they were based, pose an inherent threat to what clause 148 and schedule 25 seek to achieve. As I pointed out, the recent Lankhorst decision could undermine the clause, as interest payments to other EU members of a group would still be deemed to be deductible. If any EU banks or a significant number of foreign banks in the City of London are based in other EU countries, the whole issue of not allowing the charging of wider interest, which the clause is substantially about, could be undermined by the ECJ's principles and rulings.

Secondly, although I acknowledge the fact that the Government have consulted widely, and in the main effectively, with the City on a number of issues and that, in fighting our patch with the EU, there has by and large been effective collaboration between the Government and enterprise, I passionately believe that it is a mistake to think that the continuing prosperity of the City relies purely on geography, networks and established talent. Having lived through 30 years of history, I have to point out to the Paymaster General that that prosperity always related fundamentally to tax.

In 1970, the City of London was a dead duck. It was too large for the UK economy, and it came to life only when the then Labour Government agreed with the Governor of the Bank of England on what amounted to tax-free Euro-banking, which thus took off in London rather than in Zurich or any other location. There is a mixture: the City has to be competitive tax-wise and regulatory-wise, and it has to be attractive tax-wise and regulatory-wise, as well as using its inherent advantage of a pool of talented people. If the City becomes uncompetitive regulatory-wise or tax-wise, business will go to New York, Zurich and other places, as sure as eggs are eggs. We must thus consider how we tax overseas businesses in London in comparison with how they are taxed in New York, Zurich and so forth. As I said earlier, I am well aware that the provisions have been consulted on and that they appear broadly comparable to the arrangements in New York and other locations and therefore are not immediately a threat.

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Amendments Nos. 66 and 67 would not undermine those provisions; they would address the two little, specific issues to which I referred. We will not want to press the amendments to a vote, because they are not of fundamental importance, but I wish to tell the Paymaster General that, although the provision itself was done and dusted last year, certain things have changed, and in particular the way in which the ECJ has responded, which may render it inoperative. However, I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Clause 148 ordered to stand part of the Bill.

Schedule 5 agreed to.