Schedule 8 — Financing of companies etc: transfer pricing and loan relationships

Orders of the Day — Finance Bill – in the House of Commons at 6:45 pm on 13th June 2005.

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Photo of Philip Hammond Philip Hammond Shadow Chief Secretary to the Treasury 6:45 pm, 13th June 2005

I beg to move amendment No. 10, in page 124, line 23, leave out

'in relation to the financing arrangements'.

The First Deputy Chairman:

With this it will be convenient to discuss the following amendments:

No. 8, in page 124, leave out lines 29 and 30.

No. 38, in page 124, line 32, leave out 'the'.

No. 9, in page 124, line 33, after 'arrangements', insert 'for A'.

No. 7, in page 125, leave out lines 3 and 4.

No. 12, in page 125, line 5, leave out 'B' and insert

'One of the affected persons (B)'.

No. 13, in page 125, line 6, leave out 'the'.

No. 14, in page 125, line 7, after 'arrangements', insert 'for B'.

No. 17, in page 125, line 9, leave out 'person' and insert 'persons'.

No. 15, in page 125, line 34, after 'provision', leave out 'relates to' and insert

'has been made or imposed in connection with'.

No. 39, in page 125, line 35, at end insert

'and would not have been made or imposed in the absence of those financing arrangements'.

No. 19, in page 126, line 23, at end insert—

'(6) after paragraph 13 insert—

"Transfer pricing guidelines

Schedule 28AA ICTA 1988 is amended as follows.

13A The Treasury may for the purposes of paragraph 4A Schedule 28AA ICTA 1988, by regulations—

(1) make provisions determining what may constitute arm's length provision for any financing arrangement, by making reference to—

(a) income cover; and

(b) debt: equity ratios in respect of a company's financing arrangements as defined in paragraph 4A.

(2) Under subparagraph (1) different provisions may be made for different categories of business.

13B (1) Where, for an accounting period, the financing arrangements of a company or group of companies come within the parameters set in the regulations made in accordance with paragraph 13A then paragraph 5(1) of this Schedule shall not apply to such financing arrangements unless they differ from the financing arrangements that would have been made as between independent enterprises.

(2) For the purposes of this paragraph and paragraph 13A of this Schedule, "financing arrangements" means arrangements made for providing or guaranteeing, or otherwise in connection with, any debt, capital or other form of finance.".'.

Photo of Philip Hammond Philip Hammond Shadow Chief Secretary to the Treasury

Schedule 8 is complicated—it deals with the financing of private equity finance companies and the loan relationships that typically underpin them—and we want to explore a number of issues with the Government over the next couple of hours.

Schedule 8 amends the scope and the effect of application of the transfer pricing rules, which are well-established in our tax law to deal with situations in which parties who are not at arm's length might manipulate pricing arrangements. That might involve the pricing of interest rates in relation to loans, the terms of such loans or, at an altogether different level, the price at which goods are transferred between a parent company and a subsidiary or a subsidiary and a parent company, which could, if left unchecked, give rise to considerable distortions in tax charges. Tax experts have told me that transfer pricing is, perhaps unsurprisingly, the most common area of dispute between taxpayers and the Revenue.

Schedule 8 attempts to address an area of transfer pricing that has not hitherto been caught by the snappily titled schedule 28AA to the Income and Corporation Taxes Act 1988. As I said on Second Reading—I am sure that the Financial Secretary knows this—there is a considerable degree of resentment in the private equity venture capital industry at how a change to the arrangements affecting that industry is being badged as anti-avoidance legislation, when the industry has clearly asserted that its practices have hitherto been in pursuance of a model well known to and agreed with the Revenue and the Treasury.

The industry accepts that the Government and the Treasury can determine that it must change its arrangements, which were acceptable in the past, but it would send a positive signal to the industry if the Minister were to acknowledge that schedule 8 is about changing the rules rather than addressing an avoidance mechanism that has been used in the past, which is part of the industry's problem with how those issues are being presented. The Minister should acknowledge that the model used by most of the private equity industry is long-established and has been subject to regular discussions between the industry, the Treasury and the Revenue and that the legislation relating to schedule 8 was amended at the request of the industry, and with the agreement of the Revenue, as recently as the Finance Act 2004.

The Government say that they want to address narrow concerns. The industry's fear is that the Bill is potentially wide-ranging and that it could have significant negative impacts on both the UK private equity and venture capital industry and UK businesses that are financed by private equity or venture capital.

Paragraph 1 of schedule 8 amends the definition in paragraph 4 of schedule 28AA, which defines persons who are deemed to be participating in the management, capital or control of a company. Paragraphs 1(2) and 1(3) of schedule 8 deal with a situation which is not covered by schedule 28AA and which the Government clearly feel needs to be addressed. Schedule 28AA deals with transactions between a parent and a subsidiary and with the situation in which a transaction is between two parties and a third party controls both those two parties, but it does not deal with transactions that fall within what might be deemed the normal private equity financing model, whereby a number of unconnected parties act through a common investment vehicle, none of whom individually has control, as defined in tax legislation, but all of whom have an aligned interest in their relationship with the operating company, and all of whom collectively, were they to act collectively, have control.

Typically, such a structure will involve a limited partnership that is probably not in the United Kingdom. There will be several private equity investors who are partners in that limited partnership, and the partnership will invest in an acquisition vehicle, typically a company, which will then acquire the business ultimately to be financed. That might be a young, dynamic, growing business that seeks an injection of private equity, perhaps to get it to the next stage through a rapid phase of growth to the point where it can go to the public markets. It might be a larger business that has hit troubled times and is crying out for an injection of private capital to allow it to be restructured and its management to be refocused—that needs, as it were, to go into the intensive care ward that private equity funds can often provide. Or it might be a non-core business of a large conglomerate that has been ignored or on to which the focus of its parent has not been properly directed, and where the management are willing and able to take the business forward to ensure that it grows and venture capitalists or private equity investors can see the opportunity to come in behind the management team and allow the business to grow. It is very important, from the point of view of UK plc, to help the most dynamic businesses in our economy to grow and to help established businesses that may not be performing as they should to get themselves turned around. It would be a great shame were the Government inadvertently to introduce legislation that damaged the way in which the private equity venture capital model operates.

Paragraph 1(3) introduces new paragraph 4A into schedule 28AA to try to deal with the problem identified by the Government by creating a wider definition of control. This is fairly complex and tortuous stuff, but I shall try to get it right. A person, P, will be deemed to have control of a company, A, where P and others have "acted together" in relation to financing arrangements for A. That is very legalistic, but I take it to mean that where P has been involved in setting up the private equity funding deal that backs company A, P will be taken to have control of A if it is not a requirement that P has control over A, but if P and the other parties with whom he acted together in setting up the financing arrangements for A, taken together, have control of A—in other words, the rights and powers of each of those investors, when pooled, amount to control—then P will be taken to have control of A, and that will be sufficient to bring the private equity limited partnership transactions within the scope of the existing transfer pricing rules in schedule 28AA. That gives rise to several issues that we will explore later.

We recognise the problem that the Government have identified. Clearly, arms-length pricing of transactions is the proper way to proceed and the proper basis on which to levy tax, and if there is evidence of a serious abuse of arms-length pricing, it is right that anyone continuing such abuse should be brought within the scope of the transfer pricing regime. As I said earlier, where there is a group of parties who are technically unconnected in terms of the existing legislation but who have an absolute identity of interest because they all own the target company, A, it is equally likely that they will have the ability to manipulate the pricing arrangements in their transactions with A, as would be the case were it a single controlling entity.

We entirely accept that, but I must reiterate the point that I made on Second Reading about babies and bathwater. Of course we understand the Government's motivation, but the numbers that they have put forward suggest that relatively modest amounts of tax are at stake. The concern in the industry and more widely is that this measure is very widely targeted and could, if we are not careful, have a very detrimental effect on the industry as a whole, perhaps, ironically, even reducing the overall tax take over a period of time. For us, the point is to try to narrow the focus of any change in the rules to address the mischief that has been correctly identified while ensuring that it does not spill over to have unintended consequences elsewhere.

This group of amendments is intended to avoid a situation whereby the Government, in dealing with what they see as an abuse, inadvertently open up another loophole. Given that a group of investors has been identified as being outside the existing transfer pricing rules, and given that the Government want to bring those investors inside the existing transfer pricing rules, it might be thought that the simple way would be to define them and to say that they too are persons subject to those rules. However, that is not what the paragraph does. It limits the extent to which those parties are brought within the transfer pricing rules to "provision"—that is, something that is done—in relation, to any extent, to financing arrangements for A, which is the company that the investors, one of whom is P, collectively own. It is unusual for me to stand here saying that a provision might be too narrowly drafted, but in this case we are worried that the Bill, by narrowly drafting the extension of the transfer pricing rules to apply only to those matters that relate to any extent to financing arrangements, may not catch everything that it needs to catch. If it identifies people—in this case, an investor group—who should be subject to the transfer pricing rules through having acted together to arrange finance for the company, which is typically the company that does the borrowing, surely all transactions between those persons and the person of whom they are each deemed to have control, not only those that relate to the financing arrangements, should be subject to the transfer pricing rules.

For example, what about management fees that are charged between the parties to such an arrangement? What about consultancy fees or intellectual property licensing fees? All those matters should be of concern if the Government's fundamental anxiety is justified and there is evidence of non-arm's-length pricing between groups of parallel investors who invest in a target company and that company. An obvious avoidance route is open to those parties if the arrangements that the Government are extending are limited to matters that relate only to the financing arrangements.

The identity of interest between the parties creates the motive but, as drafted, the transfer pricing rules cannot be applied to transactions other than those that relate to the financing arrangements because schedule 28AA is amended to include people who have such indirect control only in respect of financing arrangements.

Let me briefly go through the amendments. Amendment No. 10 would simply change the heading in line 23, replacing

"Persons acting together in relation to financing arrangements" with "Persons acting together".

Amendment No. 8 would delete proposed new paragraph 4A(1)(a), which requires the provision to relate to financing arrangements for A.

Amendments Nos. 38 and 9 would reword proposed new paragraph 4A(1)(c) so that it read: "P and other persons acted together in relation to financing arrangements for A".

Sub-paragraph (2) deals with a position whereby a party has control of both parties to the transaction. Amendment No. 7 would delete (a). Amendment No. 12 would reword (b) and amendments Nos. 13 and 14 would reword (c).

The amendments seek the overall effect of ensuring that all transactions between parties deemed to have control under proposed new paragraph 4A of schedule 28AA would be subject to the transfer pricing rules. Presumably that is the Government's desired outcome. We see no reason for including the potential controlling party in respect of only one sort of transaction. I hope that the Financial Secretary understands what we are trying to achieve. Perhaps one of the weaknesses of the system is that we have to table amendments, to which a Minister has to prepare responses, guessing the arguments behind the amendments.

If the Financial Secretary will not accept the amendments or at least their thrust, he needs to explain how he can prevent the tax planners in the big accountancy and law firms from simply moving to exploit other transactions between the same parties that are now defined as being subject to the transfer pricing rules, thus perpetuating what he clearly perceives to be an abuse.

Amendment No. 17 deals with a small and technical point in proposed new paragraph 4A. Perhaps the Financial Secretary can throw some light on it. Sub-paragraph (2) deals with a party who, with the rest of the investor group, controls a borrower and a lender—in other words, a single party that is deemed to have control of both the borrower and the lender in a loan relationship. The amendment simply questions whether the word "person", which appears in line 9 on page 125, should be changed to "persons". Sub-paragraph (2)(d) reads:

"Q would be taken to have control of both B and the other affected person"— in the singular—

"if, at any relevant time, there were attributed to Q the rights and powers of each of the other persons mentioned in paragraph (c) above."

That should be straightforward: B is the borrower and the other affected person—in the singular—is clearly the lender. They are the two parties to the transaction as paragraph 1(1)(a) of schedule 28AA defines them. It refers to a provision

"made or imposed between any two persons" and defines them as the "affected persons".

However, now that we are introducing the concept of limited partnerships as one of the "affected persons" who can be subject to the transfer pricing rules, we are therefore including in those rules an entity that is tax transparent. Including the tax-transparent entity—the private equity funding partnership—in the rules is the purpose of the schedule. I understand that, when a tax-transparent partnership is introduced as the lender, tax law will look through that partnership and consider a loan relationship to be in place between each partner and the borrower. In those circumstances, the language of proposed new paragraph 4A(2)(d) and, indeed, of paragraph 1(1)(a) of schedule 28AA does not quite do the business any more.

The possibility of more than two affected persons—more than one lender for the one borrower who is caught by the transaction—must now be contemplated. If I am wrong, I am sure that the Financial Secretary will explain the reason. We are simply asking whether there could now be "B and other affected persons" in the plural. I am sure that, if that is the case, the Financial Secretary will consider whether some redrafting should take place of proposed new paragraph 4A(2)(d) and paragraph 1(1)(a) of schedule 28AA, where it specifically refers to affected persons being "any two persons" between whom provision is "made or imposed".

Amendment No. 19 again simply probes the Government on their willingness to lay down some rules about what constitutes arm's-length provision in different circumstances. If the Government accepted the amendment or something like it—I say that in all humility because amendment No. 19 is not perfectly drafted and does not do what we want it to do but we hope that it is clear enough for the Government to take its point—it would create a safe harbour for investors who complied with the criteria or parameters that the Treasury set down. That would be helpful and I understand that it is common practice in other jurisdictions.

In amendment No. 19, we propose to introduce new wording at the end of section 28AA—that is the end of the effective provision in the section—to provide that the Treasury may make regulations about, specifically, the minimum income cover in a financing arrangement and the maximum debt equity ratio in respect of a financing arrangement that would be acceptable to the Treasury so that an investor might know that, provided there was compliance with those ratios or criteria, as set down by the Treasury, it would not be deemed to be within the scope of paragraph 4A and thus subject to the transfer pricing rules. The idea is simply that provided that arrangements fall within defined parameters they will not be caught by the provision.

I hope that the Financial Secretary will concede that there is some merit in providing certainty by having these defined safe-harbour provisions. We accept that they would have to be defined to allow for different ratios in different circumstances and in different types of sector. For example, a service industry would clearly need to have different ratios and parameters laid down when compared with a capital-intensive business such as oil and gas production.

In the absence of safe-harbour type provisions, the danger is that nearly all private equity deals will face an additional and unwarranted degree of uncertainty, as it is necessary to consider for the given arrangements in any deal whether the Treasury or the Revenue commissioners are likely to treat them as being at arm's length or not. Who knows? I think that the Government are trying to send soothing signals to the industry that only the most blatant abuses will be targeted, using these provisions. However, I think that the Minister would acknowledge that the Treasury's scope, or that of the Revenue, for focusing its view and challenging arrangements at the margin is considerable within the schedule as drafted. That will inevitably introduce uncertainty.

The Chancellor is fond of reminding us how important stability is to the development and growth of the economy. Anything that tends to undermine certainty and predictability—anything that looks like creating uncertainty, and certainly anything that looks like arbitrary or capricious unravelling of arrangements that have been put in place and agreed to over a long time—is likely, or even certain, to make the UK a less attractive climate for overseas private equity or venture capital investors, and is likely to make it thus commensurately more difficult for UK-based businesses seeking private equity or venture capital funding to obtain that funding.

We are talking about a very competitive area. It is a field in which, currently, the United Kingdom is a very major player. We are second only to the United States in the volume of private equity funded business. The British Venture Capital Association estimates that £127 billion worth of sales generated by businesses in the UK economy are backed by venture capital private equity and that some £23 billion worth of taxes that are payable to the Exchequer flow from these private equity and venture capital backed sectors of our economy.

I am sure that the Financial Secretary would be the first to confirm that the Government do not want to do anything that would destabilise what has proved to be an extremely successful model that has been financing businesses that on average grow faster than the economy as a whole. On average it has created jobs more quickly than the economy as a whole. I hope that the Financial Secretary will be able to respond to the intention behind amendment No. 19, even though I have acknowledged that, as drafted, it does not quite do what we would like it to do.

Amendments Nos. 15 and 39 were attempts to tighten the language of sub-paragraph (7). I do not think that they add a great deal of substance and I do not propose to detain the Committee by speaking to those amendments.

Photo of John Healey John Healey The Financial Secretary to the Treasury 7:15 pm, 13th June 2005

I pay tribute to the reflective and serious way in which Mr. Hammond moved the amendments and introduced a fairly wide range of general remarks on the nature and principle of the provisions. The clause gives effect to schedule 8.

The purpose of the legislation is to make the tax treatment of company finances fair between all companies regardless of their ownership and of their financing structures. The clause gives effect to changes in transfer pricing and loan relationship rules that will provide a more even playing field for business. The legislation should help to ensure that changes in companies' ownership and financing happen for the right reasons—in other words, to deliver real economic benefits rather than just to chase tax advantage. I think that the hon. Gentleman was clear about that.

When applied to a company's financing arrangements, transfer pricing rules limit deductions for interest payments to the amount that the company would be entitled to had it borrowed at arm's length to an independent vendor. The hon. Gentleman said that these transfer pricing rules are well established and, as he said, properly so. However, existing transfer pricing rules apply only if one of the parties to the arrangement has control of the other or if both are under common control.

We became aware that companies and their investors were being advised by some professional advisers to put in place financing and ownership structures specifically designed to get around the rules so as to achieve an unfair tax advantage. The schedule anticipates such problems on a wider scale and seeks to close the loophole. It will ensure that the transfer pricing rules also apply if two or more parties who together control a business act together in relation to its financing arrangements.

In addition, transfer pricing rules are extended to cover financing arrangements put in place after six months before a control relationship between the parties involved. The schedule also tightens loan relationships that regulate deductions for late-paid interest and discounts owed to connected parties.

I was interested that what seemed to drive the amendments was not entirely what was obvious from reading them. What seemed to drive them was the hon. Gentleman's concern that the Bill and the schedule might be too narrowly drawn, or too narrowly focused. The group of amendments generally appear to seek to change the scope of the transactions that are affected by the rules as they apply where persons act together in relation to the financing arrangements of a business.

The hon. Gentleman said that the rules seemed tightly to relate to financial arrangements. The measures relate to transactions related to financing and not only to the financing itself. Where there is abuse—for instance, with related activity perhaps such as consultancy or management fees—HMRC will act to challenge that as well.

Photo of Philip Hammond Philip Hammond Shadow Chief Secretary to the Treasury

Is the Financial Secretary saying that, where parties act together in the financing arrangements for a company, any transaction that those parties enter into with that company will be a transaction relating to the financing arrangement? Is that his position?

Photo of John Healey John Healey The Financial Secretary to the Treasury

The hon. Gentleman is drawing too wide a definition. The provisions of the schedule are for transactions related to the finance arrangements. Rather than the wider span that transfer pricing rules can bite on, this is a narrower focus relating to financial arrangements. The rules will have no tax consequences for transactions made on an arm's length basis, so there is no reason why the scope of the rules should cause any real problems for ordinary commercial transactions.

Photo of Philip Hammond Philip Hammond Shadow Chief Secretary to the Treasury

A specific example came to me as the Financial Secretary was answering my intervention. Were the investing group to purchase real estate that was then rented to the target company as its premises, would he regard that transaction as related to the financing arrangements, or would it be too remote, so that a non-arm's length rental would not be caught by the inclusion of such people within the transfer pricing rules?

Photo of John Healey John Healey The Financial Secretary to the Treasury

No, such a transaction would, in my judgment, be well beyond those related to the financing of the company, and would not therefore fall under this clause and schedule.

Generally, we have tried to limit the scope of the rules to transactions that relate to financing arrangements and to target changes for particular avoidance risks that we have identified, which is the route of the provisions in the schedule. We know that some professional advisers are beginning to advise some clients to structure their affairs in that way. The reason that we are extending the rules is that some of those advisers are promoting ways for companies to get around the existing rules and we want to ensure that that cannot happen in the future.

The other substantive amendment that the hon. Gentleman tabled was what he described as a probing amendment, amendment No. 19. It would create the power to make regulations specifying the criteria that determine whether or not financing arrangements are on an arm's length basis. What constitutes an arm's length financing arrangement depends, as he will appreciate, on all the facts and circumstances relating to the particular provision of finance. He is creating a problem if he believes that that can somehow be determined by a formula set out in regulations. The problem with looking for a formula, particularly one codified in regulations, is that it simply could not take into account the facts and circumstances that are likely to exist in a range of situations. To that extent, the danger is that it would become inflexible.

If we had a standard formula, which I understand to be envisaged under regulations that could be laid under amendment No. 19, it would inevitably be too generous to some and too tight and mean to others. Those who were treated generously would make use of that to avoid the impact of the new rules. The practical effect for some companies of having such a set of rules would be that financing could still be set up on a non-arm's length basis and still stay outside the scope of the transfer pricing rules, which is the purpose of schedule 8 brought in by clause 40. Such companies could therefore continue to obtain tax deductions for excessive interest with impunity, which is precisely what we wish to stop.

Photo of Philip Hammond Philip Hammond Shadow Chief Secretary to the Treasury

Is not the other practical effect that, without clear guidelines, people entering into such relationships or transactions will simply not know whether they are deemed arm's length transactions until later, so they will have to price in an additional measure of risk and uncertainty?

Photo of John Healey John Healey The Financial Secretary to the Treasury

I appreciate the general argument that business prefers certainty and that businesses are looking for guidance. I will come to that in a moment. What I am saying, in direct response to the hon. Gentleman's probing amendment, is that to try to codify that in regulations is likely to introduce, first, an inflexibility into arrangements, and secondly, a formula that will inevitably be too generous and allow the sort of avoidance and arrangements that we are keen to close down under this schedule.

Let me give the hon. Gentleman more reassurance on certainty and guidance. Many existing companies, such as members of groups of companies, must already apply transfer pricing rules to their financing arrangements as a matter of routine, so there is considerable existing guidance on the application of such rules to loans, which is equally relevant to the application of the new rules. That guidance, which is available on Her Majesty's Revenue and Customs website, was comprehensively updated and expanded in 2004. In addition, since the announcement of the new rules on 4 March this year, we have set up and been operating a central hotline, which investors or companies can contact to discuss the implications of the new rules for particular investment deals. As the hon. Gentleman might be aware, details of that hotline are also on the website.

Photo of Philip Hammond Philip Hammond Shadow Chief Secretary to the Treasury

The Financial Secretary referred to the existing rules and guidance and said that they will apply equally. Is not he making any concession to the private equity financing model? Is he saying that the same criteria will apply to a private equity finance deal through the traditional private equity finance route as would apply to any other corporate financing?

Photo of John Healey John Healey The Financial Secretary to the Treasury

No, I am making a more general point that there is plenty of guidance and experience on the operation of such rules and, to that extent, amendment No. 19 is misconceived. I therefore ask the hon. Gentleman to withdraw his amendments.

Photo of Theresa Villiers Theresa Villiers Shadow Chief Secretary to the Treasury

Transfer pricing is horrendously complex and we have heard that it is one of the most common areas of dispute between companies and the Revenue. Given its complexity, it comes as no surprise that it boasts such an unfortunate statistic.

We must not lose sight of the vital importance of the venture capital industry. We must bear in mind its enormous importance in economic efficiency, not only as an incubator for encouraging small businesses, but in taking over ailing businesses and turning them into profit-making enterprises. We are extremely lucky to have a flourishing and healthy private equity sector in this country—many western nations would give their eye teeth for such a successful sector. It is worth reminding the Committee that it was one of the Chancellor's favourite areas a few years ago. He has stopped talking about it, but he used to like to cite the private equity and venture capital industry as a model to be encouraged. He sought to introduce that model in a range of different areas and I recall him lecturing some of our European partners on the importance of the private equity sector. That makes it doubly important for us to examine these provisions with great care. In this part of the debate, I am reminded very much of some of the issues that we discussed in relation to real estate investment trusts: the Government talk about the importance of enterprise and of creating the right climate to encourage enterprises, yet fail to deliver on the detail.

Of course, like everyone else in the Committee, I agree completely with the overall aim of closing down tax loopholes that enable companies to avoid an excessive amount of tax. I can agree with the spirit of what the Government are trying to do, but as other Conservative Members said, these anti-avoidance provisions are drawn too widely. I therefore appeal to the Government to consider with great care the clarifications and limits proposed in the amendments. I would not say exactly that the Treasury is taking a sledgehammer to the private equity industry, but the proposals as drafted in the Bill are too wide-ranging and would impact negatively on the venture capital industry without commensurate benefit to the Treasury and taxpayer.

Photo of Philip Hammond Philip Hammond Shadow Chief Secretary to the Treasury 7:30 pm, 13th June 2005

My hon. Friend talks of people avoiding an excessive amount of tax. Whatever language we may use, does she agree that essentially we are in a competitive position? What matters, surely, is how this jurisdiction stacks up against other jurisdictions, either as a home for private equity and venture capital funds or as a destination for their investments.

Photo of Theresa Villiers Theresa Villiers Shadow Chief Secretary to the Treasury

Absolutely. One crucial aspect is the role played by the private sector in bringing investment into this country. Accepting a new framework that deterred that could significantly damage our competitiveness and the foreign direct investment of which the Government are so proud.

There is a slight undertone in the Bill suggesting that some of the structures commonly used in the venture capital industry are somehow dodgy because they have a foreign or offshore component. That is a misconception. Not only have those structures been in long-established use with the knowledge of the Revenue—after negotiations with the Revenue—but they are not, in the main, designed to avoid or reduce tax liability. They are simply convenient legal structures to facilitate foreign investment. On that ground alone, the Government are wrong to stigmatise such arrangements. Although it is not stated explicitly, there is an implicit suggestion that the use of special purpose vehicles or offshore holding companies is in some way nefarious. In fact, it has proved to be an efficient way of attracting the foreign direct investment that is so vital to the effective functioning of our economy.

Amendment No. 19, which the Minister discussed at some length, is one of the most important illustrations of a broader point that I have tried to make: that the provisions, while making a degree of sense in some ways, are too widely drawn. The Minister did not accept the need for further clarity and a more precise formula, which is the aim of the amendment. He said that he thought that there would be too much inflexibility, that some circumstances would not be covered properly by a black letter-type formula and that there should be a less prescriptive approach.

We need more certainty and clarity in tax legislation than in other legislation. It is a basic tenet of not just tax law but our constitutional settlement that, if the Government are to deprive citizens of their money, they must ensure that their legislation is very clear indeed. They are under more of a burden to provide clarity and certainty in that area than in any other area of our legal system. The background to that is Parliament's constitutional struggle with the Executive to ensure that citizens were not taxed without due constitutional process and the acceptance of Parliament.

On that ground alone, clarification of this fundamental part of the Bill is vital. How is it to be decided whether a transaction is on an arm's-length basis? I urge the Committee to look carefully at amendment No. 19. I hope that the Minister and the Government will deem it a constructive contribution to ensuring that venture capital funds have a better idea of what the Bill is designed to do and that the Bill does nothing to damage a vital sector: the flourishing investment sector that is so important to the health of our economy, the health of enterprise and the health of business start-ups.

Photo of Philip Hammond Philip Hammond Shadow Chief Secretary to the Treasury

I apologise for my hesitation in rising. I had understood through the usual channels that more inspiration had come to the Minister in the last few moments, and that he wanted to share it with the Committee. Apparently, that is not the case. I listened carefully to my hon. Friend Mrs. Villiers. She made some important points, which reinforced Conservative Members' concerns. I want, however, to concentrate on the Minister's remarks.

The Minister began by saying that the motive for schedule 8 was to create equality between different ownership structures. I take that to mean that the Government wanted to ensure that corporate bidders would not be routinely outbid by private equity bidders because of a structural advantage. I do not think that the Minister was suggesting that the structure had been adopted, or was being abused, specifically to gain a tax advantage. He was, I think, observing that it none the less delivers an advantage to private equity partnerships bidding for a UK company financing opportunity.

My problem with what the Minister said is that he has addressed his perception of inequality between corporate bidders and private equity partnership bidders by levelling down—by burdening private equity partnership bidders with some of the disadvantages that he says corporate bidders currently suffer. Like my hon. Friend the Member for Chipping Barnet, I fear that corporates cannot and will not do all the things that private equity funds and venture capitalists are very good at doing. It would be a terrible shame if, in levelling down to try and create a level playing field, we created a playing field that was level but, for the purposes of some transactions, was under water, and if those transactions were not completed, to the detriment of the economy as a whole.

The Minister said that some transactions had been set up with the use of limited partnerships to exploit the ability to charge or recover higher levels of interest and offset those charges against UK corporation tax liability in the acquiring vehicle. I agree with him that on some occasions transactions have been structured in that way for that purpose, but the point about mainstream private equity funds is that by and large, over the past 12 to 18 months, they have not been set up as a result of some dodgy scheme marketed by a tax planner to avoid taxation or to gain some taxation benefit.

I am no expert, but I understand that the model used by most private equity houses has been established and used for many years. Many private equity investments are made with underlying funds originating in the United States. It is natural and unexceptional for an offshore limited partnership vehicle to be used to channel those funds. I hope that the Minister will acknowledge what I think he came close to acknowledging—that the private equity industry as a whole structured itself in this way not to gain a tax advantage, but because it was the sensible structure for it to have as it grew up, financed primarily—at least initially—with funds from the United States.

On the amendments that seek to include arrangements between the parties other than those relating to the financing arrangements, the Minister did not deal effectively with the question of what would happen in the example that I gave of a property investment made by private equity finance partners. If they are engaged in the abuse that the Minister is talking about, and if their previous scam would have been to lend more money than is reasonable in order to have a larger interest deductible in the UK, it would be perfectly sensible, if proposed new paragraph 4A were then to slap them down, for them to consider as an alternative purchasing the real estate assets that the UK business needs to operate—the factories, offices and warehouses—and renting them to that business at exorbitant rates. Those rents would be deductible and would not be subject to the transfer pricing rules because one of the parties to the transaction would be a limited partnership that is not caught by schedule 28AA, except in so far as proposed new paragraph 4A brings them within the scope of the provision. Indeed, it does so only in relation to transactions connected to the financing arrangements.

I ask the Minister to think about that point. I have to say to him in all modesty that I have not laid awake at night dreaming up new ways of avoiding tax once proposed new paragraph 4A comes into force, but I have talked to people who are involved daily in these matters for a living. The fact that they see scope for avoiding the intended impact of that provision suggests that the Treasury should look at this issue.

I noticed that the Minister did not address what I confess was a fairly long and tortuous argument about whether "person" should be "persons" and about the effect of bringing tax-transparent limited partnerships into the scope of the transfer pricing rules. I do not know why he did not address it—I would expect inspiration to reach him—and if my argument was wrong, I would expect him to enjoy explaining why. We raised the issue not in an aggressive way, but simply in a spirit of inquiring whether the provision's drafting needs to be addressed. I am happy to let the matter pass for now if the Minister has no further comment to make, but perhaps he would be kind enough to write to me explaining why my point is wholly misconceived or, if it is not, what he intends to do about it.

On amendment No. 19, the Minister said that a formula would be too inflexible, but later on he gave the game away rather by saying that a formula would be too generous. What he really means is that a formula would be too generous because, if it is not going to be unreasonably constraining on the taxpayer, it would have to be set in such a way as to give the taxpayer the benefit of the doubt. I understand that point, but my understanding of the Treasury's explanation of the discrepancy between the Government's assessment and the industry's assessment of the revenue raised by these measures—I think that the Minister has already made this point—is that the Government intend that the measures be used in a limited and sensible way to target flagrant abuses, and not to nitpick the fine detail of every arrangement in order to see whether it complies at the margin with the most rigorous test of arm's-length pricing.

If my understanding of the Treasury's explanation is correct, the concern that a formula would be too inflexible is not well founded, because one would expect it to be set a little on the generous side so that arrangements that approximately constitute an objectively assessed arm's-length pricing arrangement could be deemed okay. Only when participants had moved beyond what could be reasonably argued as that position would the formula kick in and cut them off. That seems a fairly sensible way to proceed.

It cannot be in the interest of the taxpayer that every single arrangement be scrutinised in detail to see whether it is entirely compliant. It certainly cannot be in the Revenue's interest to have to examine thousands of transactions in detail to see whether they are entirely compliant with what might be deemed an arm's-length arrangement. Nor can it be in the interest of the economy as a whole to have such uncertainty and the introduction of such a compliance burden. I am little surprised that the Minister is not more favourably inclined toward some form of fixed parameters, particularly given that they exist, operate quite successfully, and are appreciated by taxpayers in other jurisdictions. In fact, they operate elsewhere in the Revenue's guidance, as the Minister has already mentioned.

However, the intention was simply to raise these issues and I am grateful to the Minister for the way in which he has responded to them, although I would be even more grateful if he could respond more fully in due course, perhaps in writing. I do not intend to detain the Committee by pressing the amendment to a vote. I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Photo of Philip Hammond Philip Hammond Shadow Chief Secretary to the Treasury 7:45 pm, 13th June 2005

I beg to move amendment No. 16, in page 125, line 35, at end insert—

'(8) This paragraph shall apply only to a person where that person, or a connected party to that person, owns shares or an interest in shares, in either A or B.'.

Those members of the Committee who have been paying attention will remember that A, in proposed new paragraph 4A(1), and B, in proposed new paragraph 4A(2), are the subject company—the acquired UK company. The amendment's purpose is to limit the class of person who can be deemed, by virtue of that paragraph, to have control—and who can thus be subject to the transfer pricing rules—to those who have a shareholding relationship or an interest in the borrower's shares. I say "the borrower" because we are talking about loan relationships, so A or B will be the borrower in the circumstances envisaged in the schedule.

Even if the Government were to accept the amendment, there would still be serious concerns about banks with private equity investments. Many banks these days either have an interest in a private equity house or have one of their own. Although they operate at arm's length from each other, the private equity division of a bank may find that its corporate debt financing division is lending money to an entity in which it is itself an investor, thus creating a relationship.

We are also concerned about banks that advance mezzanine debt—ironically, a form of debt that is designed to reduce the coupon payable and thus the interest that would be deductible in calculating the borrower's corporation tax charge, but that typically comes with an equity warrant attached for the benefit of the lender, so that the lender forgoes some of the coupon that he would normally have demanded for that class of lending in exchange for an equity kicker if the borrower performs and the equity price rises.

If the amendment were accepted, however, it would at least make it clear that third-party banks in a simple lending relationship could not be caught by the provisions. The Minister is well aware of the considerable concern among the financial community that, as it stands, the provision is not clear cut or plain for all to see. The Treasury says that banks in arm's-length third-party relationships will be caught by the schedule, but that it will be simple to demonstrate the arm's-length pricing. The Treasury's approach is to say that everyone is caught by this pretty much all-embracing provision, but that most of those embraced will be able to wriggle out of the clutches of the Revenue pretty easily. That, we would suggest, is going about it the wrong way and creating an additional compliance burden on businesses and on lenders, while introducing an element of further uncertainty.

It would be perfectly possible to exclude the third-party lenders who are lending at arm's length by writing in the words that are proposed in amendment No. 16, so that a person is made subject to the transfer pricing rules by virtue of new paragraph 4A only if he has an equity interest of some sort in the borrower. The problem is that sub-paragraphs 1(c)and 2(c) define P or Q respectively as a person who "acted together" with others in relation to the "financing arrangements" for the borrower, who is A or B respectively. That definition is bound to catch banks, even where they are involved only in arm's-length third-party lending.

Typically, in putting together a private equity deal the lending bank will have been involved with private equity investors and another department of that bank may or may not have been involved in another capacity, but all that is required for the bank to be caught within the scope of paragraph 4A is that it, together with other persons, acted in relation to the financing arrangements. That, I suggest to the Minister, will embrace all the banks that were involved in putting the finance package together.

The subsequent paragraphs go on to define P or Q as having effective control if his rights and powers over A or B, the target companies, together with the rights and powers of the other persons with whom he has acted, amount to control when they are taken together in aggregate. The problem with that is that P, the bank, may actually have no rights or powers. If control is defined in relation to a person P by the aggregate of the rights and powers that he and all the other persons involved have, and if all the other persons involved have rights and powers but P has no rights and powers at all, P would, bizarrely, under the paragraph 4A still be taken to have all the rights and powers that the other persons have and thus to have control.

If P is a bank and it acts together with private equity investors in arranging finance for a company, it will mean, at its simplest, that equity is coming from the private equity fund and debt from the bank P. In those circumstances, P, the bank, will be deemed to have control by virtue of the private equity investors' rights and powers as shareholders, even though P has none himself. Aggregating means ignoring entirely the stand alone rights and powers of each of the parties.

Banks, we suspect, will recoil at being deemed

"indirectly participating in the management, control or capital" of the companies to which they are lending on account of the relationship that they had with the private equity house in arranging finance for that company. There will be an increase in compliance burdens because all bank debt will now be theoretically subject to the transfer pricing rules and the company must satisfy itself as to the eligibility of the payments that it is making to the bank for deduction against its corporation tax liabilities. I put it to the Financial Secretary that when this provision was first thought up, it cannot possibly have been the intention to bring into the scope of the transfer pricing provisions arm's-length lending by established third-party banks.

Amendment No. 16 would require a further qualifying characteristic before P or Q could be brought into the transfer pricing net—that there is a shareholding relationship or "an interest in shares". It would exclude all categorically arm's-length straightforward bank lending, except—there is still a flaw in the arrangements—where the bank in question is also involved through another part of its parent company's operations in private equity financing. The Government have said that they do not intend to catch third-party bank debt and their expectations of revenue from these measures underpin the position that is set out, but the industry's concern is that the scope could be much wider.

Will the Financial Secretary address the need to exclude third-party bank debt in line with the amendment? In responding to the amendment, will he go further and deal with the practical problems that arise from the complexity of modern banks' business? They are often in many different businesses, including equity investment, senior debt lending, mezzanine financing and so forth. Will he also address concerns that go, frankly, beyond the scope of the amendment—about the position of banks that are involved in mezzanine funding where equity warrants are attached to the debt instruments, and about banks involved in equity funding where they are providing a complex package of funding for a company, almost as an alternative to private equity funding?

I would be most grateful if the Minister could address those concerns. Will he confirm first, that he recognises the problem, and secondly, that he has some means of dealing with it?

Photo of Stephen Hammond Stephen Hammond Conservative, Wimbledon

As a mere equity investor and equity analyst, I have followed the discussion with some difficulty, but it seems to me that private equity funds and venture capital funds are always typically structured by way of limited partnerships. The partners are effectively unrelated and the lending arrangements are traditionally third party.

If I understand my hon. Friend Mr. Hammond correctly, amendment No. 16 is designed to deal with some particular concerns. The first is that there are a number of changes in the legislation being badged as anti-avoidance measures, although they seem to be based on a model that the private equity industry has traditionally agreed with the Revenue. Secondly, unless the amendment is accepted, it seems that there will be additional uncertainty for the industry, and the current wording will catch a wider range of transactions than initially envisaged.

As has been said by others, the venture capital and private equity industry has been hugely beneficial, and if the tax framework is altered in the way suggested, it could become less attractive for inward investors.

The Revenue's concerns seem to be that in some cases borrowing and interest charged have been excessive, and could accrue relief beyond a reasonable commercial return. The new rules seem designed to catch a wider range of transactions than initially envisaged by the phrase "acting together". The rules seem to place a higher compliance burden on banking and finance operations. There are many relationships in which a private equity division of a bank has an arm's-length relationship with its corporate lending side, and there are many cases illustrating the fact that a lending bank can be involved with private equity investors, and another arm of the bank could also be involved.

If all bank debt is to be subject to transfer pricing rules, there will be an even greater growth of the compliance industry. As I understand it, the amendment is intended to limit the provision to situations in which the lender has an equity interest in the underlying business, so we should seek to address only a limited number of arrangements—those in which the borrowing company obtains a benefit from the investor in paying a higher borrowing charge, by reducing the borrowing company's tax bill.

That practice does not happen widely, so it is important that we should not change or damage the tax treatment specifically created to assist the private equity and venture capital industry. The previous regime was created so that that industry would know what its limitations and rules were, and the change to the rules in the Bill would have an impact on that. The Government's aim seems to be to stop interest accruing on shareholder funds to owner-managed companies where interest is not paid—meaning that there would be an excessive benefit.

The amendment is designed to regularise and clarify the rules to ensure that properly structured private equity and venture capital arrangements long agreed with the Treasury would not be caught by measures branded as anti-avoidance. By tightening the legislation as my hon. Friend suggests, greater certainty would be granted to the industry. My hon. Friend Mrs. Villiers was concerned about the competitive threat to the industry and to Britain as an attractive location for inward investment, and as a basis for private equity and venture capital houses. I hope that the Government will accept the amendment.

Photo of Philip Dunne Philip Dunne Conservative, Ludlow 8:00 pm, 13th June 2005

I support the amendment moved by my hon. Friend Mr. Hammond, and echo some of the comments that have already been made by my hon. Friends about the importance of the private equity industry to the economy. I should—probably to the amusement of the Minister—declare another interest, in that I am the director of a venture capital trust that is quoted on the stock exchange. It is a very domestic business—in contrast to the issues that the Bill is trying to reach, which involve primarily offshore relationships.

In this country we have the most effective and substantial private equity industry outside the United States, and each of the funds that raise capital in this country does so on a global basis, with which I am familiar, ranging from the United States to Japan, and including Canada and most of continental Europe. Most of those investments are structured through vehicles not designed primarily to evade tax at the underlying corporate investment level. They are efficient structures, designed to allow funds from around the world to come together and support investments made by the fund managers. We should not therefore try to introduce a level of complexity that would drive such transactions into more tortuous structures.

Secondly, increasingly sophisticated measures are being introduced to support companies that have been taken private. I refer not only to mezzanine finance, as referred to by my hon. Friend the Member for Runnymede and Weybridge, but to high-technology companies, some of which are offered distribution agreements by other companies. Some of the insurance companies are involved in providing insurance products, so other financial arrangements may become involved within the transactions, and they might inadvertently get caught by the legislation.

Many of the lenders may not necessarily be banks. In the case of mezzanine finance, for example, they are often banks provided with an equity kicker, which would be caught by the suggested arrangements, but some mezzanine finance is now provided by insurance companies without an equity kicker, through a loan-note structure with a high interest rate, which would not be caught by our amendment because there is not an equity relationship.

The whole picture of private equity in this country is increasingly sophisticated, and by drawing the provisions as the Government have, I fear that they may impose unnecessary and undue burdens on our very successful investment management industry. For that reason, I support the amendment.

Photo of John Healey John Healey The Financial Secretary to the Treasury

I hesitated a little before speaking, because I noticed the activity of the Opposition Whip among the Back Benchers earlier, so I wondered whether there were any more Back Benchers with a sudden interest in the particularly narrow provision that we are considering under the schedule. Stephen Hammond and Mr. Dunne made a series of points wider than the narrow provisions covered by Amendment No. 16, which might have been more suited to a stand part debate. They paid tribute to the successful venture capital industry in this country, so no doubt they will welcome many of the policies that we have put in place since 1997 to help that—regional venture capital funds, booster venture capital trusts, the enterprise investment scheme, and the 10 per cent. cut in capital gains tax on business assets held for more than two years.

As I have said, amendment No. 16 is narrowly drawn, to narrow the scope of the parties affected by the new transfer pricing rules. As the hon. Member for Runnymede and Weybridge said, to limit the class of persons within the scope of the new rules, the amendment would restrict the extension of the new rules to parties with an interest in the shares of the company involved. However, the chance for interests to act together to set up abusive financing transactions is not limited to such parties, so narrowing the scope of the new rules in that way would risk opening new loopholes. The new rules have no tax consequences for transactions made on an arm's length basis, so there is no reason why their scope should cause any real problems for ordinary commercial transactions.

The hon. Gentleman was particularly concerned about banks and third-party bank lending. Let me confirm clearly for him that where banks act together in relation to the financing of a business with other persons who control a company, the new rules apply. However, if the bank lends on an arm's-length basis, the tax position will not change. Indeed, businesses should not expect to obtain deductions for costs of debt finance over and above the arm's length amount.

The position with regard to the hon. Gentleman's concern about mezzanine finance with equity warrants is similar. That can be provided, and often is, on an arm's-length basis. There is no reason, as far as I can see, why that should give rise to particular difficulties in applying the new rules, so long as it is provided on an arm's-length basis. A couple of hon. Gentlemen, including the hon. Member for Runnymede and Weybridge, talked about the complex nature of banks' activity and the imposition of these rules. Where banks are just providing an ordinary loan on an arm's-length basis, the work undertaken in the normal course of that lending should be sufficient to demonstrate that. Therefore, the provisions of the schedule are not an additional compliance burden with significant costs for banks, about which the hon. Member for Wimbledon was concerned.

The reason why we are extending these rules—

Photo of Philip Hammond Philip Hammond Shadow Chief Secretary to the Treasury

Will the Financial Secretary talk about the situation in which a bank's corporate lending department is lending and its private equity division is investing? As my hon. Friend Stephen Hammond pointed out, that is not uncommon these days. As the Financial Secretary will know, such matters are dealt with at arm's length in the large banks. What would be the position then?

Photo of John Healey John Healey The Financial Secretary to the Treasury

The principle is clear and well established. When lending is done on an at arm's-length basis, the rules do not apply. We are extending the rules in the schedule because some professional advisers are now promoting ways for companies to work around the existing rules and we need to ensure that that will not happen again. I hope that the hon. Gentleman will withdraw the amendments.

Photo of Philip Hammond Philip Hammond Shadow Chief Secretary to the Treasury

The Financial Secretary just said that when lending was on an at arm's-length basis, the rules will not apply, but I think that he meant to say that they would apply but would not have any tax effect, which has been the thrust of his argument. I have listened with interest to my hon. Friends the Members for Wimbledon and for Ludlow (Mr. Dunne) and I am sorry that the Financial Secretary found it necessary to make a churlish remark about the interventions from Opposition Back Benchers. I note for the record that we have not been entertained by any such interventions from Labour Members or, indeed, from the Liberal Democrats who some weeks ago were asking incredulous electors to consider them a potential real opposition. They have not managed to muster their forces to demonstrate that tonight.

The Financial Secretary understands our concerns. We all accept that no tax consequences will arise for arm's-length transactions that are caught within the scope of the rules, but we find it bizarre to introduce a new regime that will catch hundreds, perhaps thousands, of innocent transactions, placing the burden on the taxpayer to demonstrate that he should not suffer a tax disadvantage. A compliance burden will be placed on business. Why do we find that extraordinary? Because it would be very simple to exclude that group of arm's-length corporate bank lenders from the scope of the rules. The amendment that we have tabled may not be perfect, but I have not heard the Financial Secretary criticise it from a technical point of view. It would remove a significant compliance burden from a large number of transactions and businesses, and he has not demonstrated, to my satisfaction, why it would not be a good idea to introduce such a provision. Therefore, I ask my hon. Friends to support the amendment in the Lobby.

Question put, That the amendment be made:—

The Committee divided: Ayes 177, Noes 289.

Division number 10

See full list of votes (From The Public Whip)

Question accordingly negatived.

Photo of Philip Hammond Philip Hammond Shadow Chief Secretary to the Treasury

I beg to move amendment No. 18, in page 125, line 45, leave out from beginning to end of line 23 on page 126.

Schedule 28 AA of the Income and Corporation Taxes Act 1988 provides that where an interest payment is disallowed or reduced under the transfer pricing rules, thus increasing the tax payable by one party to the transaction, a corresponding adjustment is available to the other party. That is a sensible measure, which avoids double taxation occurring where part of a transaction has been disallowed under the transfer pricing rules.

Sub-paragraph (5) of paragraph 1 inserts a new sub-paragraph (4A) in paragraph 6—not to be confused with the paragraph 4A that we were debating earlier; for some reason everything in schedule 8 relates to a paragraph 4A. The new sub-paragraph (4A) excludes the entitlement to a corresponding adjustment where two conditions are met: first, that the provision subject to the transfer pricing rules is subject to them only as a result of the paragraph 4A introduced by sub-paragraph (3) in paragraph 1; and, secondly, that a guarantee is provided in relation to the security issued by the debtor by a person who has a participatory relationship with the debtor. That participatory relationship is defined so as to include the subsidiaries of the debtor.

If A is one of the private equity investor group defined by sub-paragraph (4A) of schedule 28AA as participating in the management, control or capital of B—the acquisition vehicle—and B is both the acquisition vehicle and the debt issuer, it would be perfectly normal in those circumstances for B's obligations as a debt issuer to be guaranteed by its operating subsidiary. To put that in practical terms, the companies generating the cash flow will, typically, guarantee the debt obligations being taken on by the holding company in the form of a raft of cross-guarantees between companies in the group.

The transaction is subject to transfer pricing rules because of the sub-paragraph (4A) to be inserted in schedule 28AA. So, B's interest charge may be reduced or disallowed for corporation tax purposes but, because of sub-paragraph (5), the lender is not entitled to reciprocal treatment, thus reducing its interest receivable for corporation tax purposes.

Why is that? The question does not arise because we are being a little slow on the uptake. No one, including the body of expert opinion in the City, which considers these matters very closely, is sure of the answer. What is the relevance of the guarantee? Why does the existence of the guarantee relationship between a subsidiary and its holding company invalidate the right to claim a corresponding adjustment in the corporation tax return of the lender where a corporation tax deduction has been disallowed or reduced in the hands of the borrower? What is the abuse that the Government imagine they are addressing by the inclusion of sub-paragraph (5)?

In many cases in which straightforward bank debt is involved, there will be no disallowable interest because the transaction will clearly be at arm's length. However, to rehearse the argument that we had on the last group of amendments, what about banks with an equity participation in the target company? What about banks that have a private equity division or those that have provided an integrated financing package for the company, including equity and debt as an alternative to a conventional private equity investment? On the face of it, those banks will not be able to secure a corresponding adjustment.

For example, when the lending that takes place is not senior debt lending but mezzanine lending—high coupon lending that takes a subordinate security to the senior debt—the correct pricing of that arrangement may not be so clear-cut for it to qualify as an arm's length transaction. I am not talking about a situation in which an equity kicker is attached to the mezzanine funding, but about one in which there is relatively high coupon debt with a subordinate security interest.

It is not clear to us what the mischief is and what the relevance of the guarantee is, but it is clear that the provision must be wrong in principle. The existing provision that allows for an offsetting adjustment on the other side of the transaction when any adjustment is made is a neat and simple double-entry type solution to what could otherwise be a serious injustice. It is clear that, in the absence of an entitlement to an offsetting adjustment, these arrangements could give rise to a double tax charge where a partial or total disallowance of interest is made and both parties are within the charge to UK corporation tax.The provision potentially puts UK taxpayers at a disadvantage compared with non-UK taxpayers who will often be able to achieve a corresponding adjustment through a double tax treaty adjustment.

The amendment probes the Government on their attitude to the problem by seeking to delete sub-paragraph (5) in its entirety. I have to say to the Financial Secretary that I have seldom been in receipt of such unanimously perplexed sets of briefing notes from different qualified external advisers. I am sure that he will have seen some of the briefings and noted the genuine perplexity of specialist practitioners in this sector about what the Government are seeking to address, the perceived mischief and the relevance of granting an intra-group cross-guarantee.

I hope that the Financial Secretary will be able to explain all these things, and we will listen carefully to what he says. I assure him that the expert bodies that have expressed mystification will also look closely at what he says to see just how the provisions are intended to work. Are they really intended to apply to group cross-guarantees? Why are they intended to apply to them; what do they seek to address; and how will they work in practice? We will listen carefully to his reply before deciding how we should proceed.

Photo of John Healey John Healey The Financial Secretary to the Treasury 8:30 pm, 13th June 2005

Mr. Hammond is right that amendment No. 18 would remove the restriction preventing compensating adjustments from being claimed in relation to guaranteed loans. It is our view that that would open up the scope for the compensating adjustment mechanism to be abused.

When compensating adjustments were introduced in the Finance Act 2004, their purpose was to ensure that if transactions between members of a group of companies were affected by transfer pricing rules, the position in the group could be balanced out. The compensating adjustments are intended for enterprises such as groups that must apply transfer pricing to different parts of the enterprise. We deliberately limited the scope of the adjustments in 2004 so that they could not be used by third-party lenders. If a company is denied a tax deduction for interest on a guaranteed third-party loan under existing transfer pricing rules, the third party is thus not allowed to claim a compensating adjustment.

The restriction on compensating adjustments in the schedule ensures that that policy is maintained under the new rules. If, for example, an independent lender was able to claim a compensating adjustment, the effect would be to enable the lender to receive interest tax free. A lender should expect to pay tax on the interest received on a loan, whatever the tax treatment of the borrower, so it would be wrong for a lender to receive such a tax benefit.

The hon. Gentleman asked about a loan guarantor's ineligibility to claim the compensating adjustment under the new rules. Our worry is that the adjustments could be abused if they were made available to loan guarantors under the new rules. In many cases, the loan guarantor will have a control relationship with the borrower and will thus be able to claim a compensating adjustment under existing rules.

The hon. Gentleman was also concerned that without compensating adjustments, there could be the risk of a double tax charge. Guarantees enable a third party, which is often, although not exclusively, a bank, to lend more than a borrower can borrow on an arm's-length basis. The tax treatment of the lender's income should not be affected by the tax treatment of the borrower in such circumstances. The purpose of compensating adjustments was to ensure that an enterprise did not suffer double taxation because it was structured as several entities, such as a group of companies. The rules of the compensating adjustments for which the Finance Act 2004 provided continue to achieve that.

The approach to compensating adjustments under the new rules is consistent with the policy that underlies the rules under the Finance Act 2004. Those rules did not extend compensating adjustments to a third-party lender, even if the borrower had to make a transfer pricing adjustment in respect of interest on the loan. The schedule is consistent with the 2004 rules, and we are in discussion with the British Bankers Association and others. We are worried that the amendment would narrow the scope of the provision and create the opportunity for precisely the abuse that we are trying to avoid, so, on that basis, I hope that the hon. Gentleman will withdraw it.

Photo of Philip Hammond Philip Hammond Shadow Chief Secretary to the Treasury

The key point in the Minister's response was his last—namely, that discussions are ongoing. Until then, he had closed his mind to the problem as I presented it and had attempted to convince us that there was nothing to address other than that the entire financial world had suffered a bout of collective incapacity in being able to understand what the Government are about. The fact that he is in discussions gives us some cause to hope that the problem will be resolved to the satisfaction of all parties concerned.

We are not here to champion the cause of tax avoiders—that does no one any good—and we recognise that every Government have a duty and necessity to try to close down tax avoidance routes as they open up, as they surely always will. It is a constant battle—a bit like painting the Forth bridge. However, we are concerned that they should get the balance right between protecting revenue on the one hand and using heavy-handed legislation and regulation that will have a negative impact on business on the other. The Minister will agree that no one among the body of official representatives of the financial sector or any other sector would defend tax avoidance. All such bodies agree with the principle of needing to close tax avoidance loopholes, but they want to ensure that it is done in a way that does not inflict collateral damage on other parts of the economy, industry or business.

Ideally, such measures should involve proper consultation with the affected parties and their official trade bodies to find a way forward that not only works—the Government clearly think they have something that works—but is well understood by business so that there is clarity and certainty. I understand that in relation to tax avoidance there is often a temptation to legislate first and consult afterwards. Perhaps discussions are ongoing as a result of the delay that has occurred this year in implementing those parts of the original Finance Bill that are now in this Bill.

I hope that the Minister is committed to finding an agreed solution to the perceived problem in the financial community so that his undoubtedly correct objective is achieved without creating negative fallout or, if he can resolve that problem, without creating the perception of the possibility of negative fallout, which would be equally damaging to business.

I hope that by the time we discuss the Bill on Report, the Minister will be able to tell us that his discussions have come to a fruitful conclusion. In view of what he said, I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Photo of Mark Field Mark Field Shadow Financial Secretary

I beg to move amendment No. 26, in page 126, line 23, at end insert—

'( ) Paragraph 5D shall be amended as follows—Leave out subparagraphs (1) to (6) and replace with—

"(1) Small enterprise means an enterprise that has no more than 50 staff, and either an annual turnover in the preceding accounting period or a net asset value at the end of the preceding accounting period of less than £7 million.

(2) Medium enterprise means an enterprise that has no more than 250 staff, and either an annual turnover in the preceding accounting period of less than £35 million or a net asset value at the end of the preceding accounting period of less than £30 million.

(3) "Annual turnover" and "net asset value" shall be defined in accordance with generally accepted accounting practice.

(4) The number of staff shall be determined on the basis that staff that are not full time should be counted at the appropriate fraction.".'.

Photo of Michael Lord Michael Lord Deputy Speaker (Second Deputy Chairman of Ways and Means)

With this it will be convenient to discuss the following amendments: No. 21, in page 127, line 5, leave out from 'time' to end of line 7.

No. 24, in page 127, line 7, after 'the', insert

'accounting period immediately preceding the'.

No. 22, in page 127, line 16, leave out from 'satisfied' to end of line 18.

No. 25, in page 127, line 18, after 'the', insert

'accounting period immediately preceding the'.

No. 23, in page 127, line 23, leave out from '1988' to end of line 25.

No. 28, in page 128, line 5, after 'the', insert 'immediately preceding accounting'.

No. 29, in page 128, line 17, after 'the', insert 'immediately preceding accounting'.

Photo of Mark Field Mark Field Shadow Financial Secretary

The amendments relate to definitional elements of small and medium-sized businesses. They deal with the proposed Government change to schedule 9 of the Finance Act 1996 which makes an exception if the debtor company is a small or medium-sized enterprise.

It is sensible to break up the amendments into three separate groups, starting with amendments Nos. 21, 22 and 23, which would disapply the exception. In schedule 8, the exclusion in paragraphs 2(3) and 3(6) of small and medium-sized enterprises from the latest interest rules in paragraph 2 of schedule 9 of the 1996 Act presumably acknowledges the fact that the private equity market provides valid support to start-up businesses as well as ailing companies that might otherwise fail. If that is the correct rationale—I am sure that the Minister will confirm that it is—do those rules produce satisfactory results? In our opinion, the definition of small and medium-sized enterprises derives from the annexe to the European Commission's recommendation in May 2003. The application of that definition to private equities is complex, but in determining which enterprises are being measured we must consider private equity funds and all the investee groups that they control or over which they have significant influence.

Those issues of control and significant influence are at the heart of our concern. The practical implication is that many private equity-backed groups are unlikely to fall within the definition of an SME, regardless of the size of the individual investment. We understand that that is not the Treasury's intention, but I should be grateful for the Minister's guidance. In addition, as the definition of a medium-sized company is relatively low, it will not assist the majority of ailing companies, which will be considered large for these purposes. Any unfavourable treatment of such companies would have a significant impact on the available funding and hence the prospects of those companies. I hope that the Minister can explain in detail why the Government have sought that criterion and whether, on balance, they accept that the size of the debtor company should not be a factor in their anti-avoidance proposals.

Amendment No. 26 seeks to allow businesses, whether SMEs or otherwise, to plan carefully. It would prevent their qualification under the provisions from hinging on the vagaries of the currency markets. As the Minister is aware, the definitional thresholds for small and medium sized enterprises are based on euros in the Finance Act 1996, as amended.

Photo of Adam Afriyie Adam Afriyie Conservative, Windsor 8:45 pm, 13th June 2005

My background is in business. There are many small and medium-sized businesses in the UK, including investment banking companies, private equity firms and so on. In business, one wants certainty. Throughout the ups and downs of the business cycle and currency fluctuations one needs certainty about the nature of one's business and the nature of the legislation and the way in which it affects one's company. I am glad that the Opposition have raised the issue of definition, because if the size of a business is based on euros, rather than sterling, that is a profoundly unstable way for businesses to try—

The Second Deputy Chairman:

Order. The hon. Gentleman must take his seat when the Chair rises to speak. May I just tell him gently that it sounds as if he is going to make rather more than an intervention? It may be a good idea to keep his powder dry and make a proper speech in due course.

Photo of Mark Field Mark Field Shadow Financial Secretary

Thank you for your indulgence, Sir Michael. I thank my hon. Friend Adam Afriyie, who took the words out of my mouth. I shall, however, come on to the point that he was making in a moment.

As I was pointing out, our proposal would calculate the threshold with reference to sterling. I noted the amusement on the face of the Economic Secretary when mention of the word "euros" brought one of my colleagues to his feet. Many more would have done so, had they been here to play a part in our debate. [Interruption.] That is right—where are they all when one needs them? Doubtless, the proposal would appeal as a matter of principle to some of my hon. Friends who are not here today. I stress, however, that there is no Eurosceptic agenda, although the events of the past week may mean that we are all Eurosceptics now. We all recognise that in the relatively calm currency waters of the past three or four years there have been periods of turbulence that would create unacceptable uncertainty for the most susceptible businesses. That is very much the point that my hon. Friend was making.

I accept that all thresholds are to some extent arbitrary, but at least if currency risk is eliminated from the equation, a company can expand at a controlled rate from year to year and thereby qualify or stand outside the provisions. It is important to remember that small and medium-sized enterprises are often the very businesses that have least exposure to the foreign currency market, so they might find the idea of couching their definition in euros least relevant. Furthermore, such companies are least able to afford uncertainty and are without the internal back-up that would be needed to monitor the currency markets and act accordingly if they were getting near the thresholds. I hope that the Financial Secretary will be able to give us some guidance about why euros are being used, especially at a time when this country has little prospect of joining the single European currency, which may not have been the case when the initial definition was put in place.

Amendments Nos. 24, 25, 28 and 29 seek simply to promote commercial certainty. The Government's current rules for the relevant accounting period mean that a business may discover that it is not an SME after the relevant period has come to an end. Surely, that cannot be a sensible way to proceed. I accept that we are talking not about an enormous mass of businesses, but about a small number of companies that are getting near the threshold. Inevitably, there are always concerns about thresholds. In relation to certainty, surely it is better to adopt our proposal to refer to the previous accounting period rather than the current one. Let me give as an example a company that is not only worried about the vagaries of the currency market, but potentially reluctant to acquire new business that might take it above the threshold unknowingly in the last few months of its financial year. We always have to keep an eye on the collateral impact of any such proposals.

In conclusion, three factors are at stake. First, there is the question whether the base is in euros or sterling. Secondly, on the notion of a current year valuation, we propose returning to levels in the near past, for certainty's sake. Finally, we query whether an SME is an appropriate part of the entire criterion. I hope that we can have a sensible discussion on these matters. I know that we will discuss another set of amendments that propose to do something slightly different at a later stage, but I hope that the Financial Secretary will give us at least some guidance about re-adopting a provision in the Finance Act 1996, which is now nine years old.

Photo of Adam Afriyie Adam Afriyie Conservative, Windsor

My apologies, Sir Michael, for making an incorrect intervention earlier. I am beginning to find my feet, and when I hear the words "currency" and "euros", my blood boils and off I go.

I speak as a former business man. There are many businesses of all different sizes throughout the country, and a significant minority will be affected. What one craves in business is a sense of certainty. There are enough uncertainties in day-to-day trading and business decisions to keep one occupied and cause concern for the future, without the added uncertainty of currency fluctuations, which will also be used in a retrospective fashion in defining a company's size. I ask the Financial Secretary to take a look at the definitions and to anchor the definition of a company's size in sterling, which British companies can be certain of month to month and quarter to quarter, rather than make it subject to financial fluctuations. Indeed, given the current uncertainty surrounding the euro, I wonder whether such uncertainties and fluctuations will grow in months and years to come.

If one's company's size is defined by the current accounting period, one is left in uncertainty, because one never knows how the current trading period will be considered in the future. We are against retrospective legislation, which creates stress and uncertainties in the business environment and for individuals. If the Financial Secretary were to examine historical accounting periods, I am sure that the business community, and especially those involved in the relevant section of the industry, would be pleased.

Photo of John Healey John Healey The Financial Secretary to the Treasury

I shall try to explain why we have drafted schedule 8 in this way and, by extension, why the Opposition amendments are unacceptable.

Amendment No. 26 is the key amendment. It changes the definition of an SME for the purposes of the exemption from the transfer-pricing rules in the Finance Act 2004. The same definition is also used in the new loan relationship party rules introduced by schedule 8. The exemption removes most SMEs from the requirement to apply transfer-pricing rules, including the relevant documentation requirements.

The definition is used in existing legislation, and it is a standard European Commission definition that is used for many purposes, including for tax purposes. One of its features is that it groups an enterprise with other enterprises with which it is linked. That means that a company with a small turnover or a small number of employees that is a member of a group of companies with a large turnover or a large work force is not treated as a small enterprise and does not qualify for the exemption, which is the result that we want to achieve. Amendment No. 26 does not include any such grouping rule, which is a serious flaw that would allow a small UK subsidiary company within a giant multinational group to benefit from the exemption from transfer pricing rules, which would not be appropriate.

Mr. Field asked whether small companies controlled by private equity limited partnerships are eligible for the SME exemption. The principle is consistent, and I hope that it is clear: a business controlled by a private equity limited partnership will be treated in the same way as a business controlled by a company or by an individual, and the SME exemption will operate in exactly the same way as it does under existing transfer pricing rules, using a standard European definition to determine whether a company qualifies as a small enterprise or as a medium-sized enterprise. I must tell the hon. Members for Cities of London and Westminster and for Windsor (Adam Afriyie) that that definition is calibrated in euros and that it will continue to be calibrated in euros, although it makes the blood of the hon. Member for Windsor boil.

The hon. Member for Cities of London and Westminster also asked what happens when debtors are no longer small or medium-sized enterprises. In that case, such enterprises lose their exemption from late-paid interest or discount rules. The exemption exists to encourage funding in SMEs, which are the businesses that are most likely to grow and to create jobs. The Government put a great deal of policy attention and support behind those businesses, often with the support of the Opposition. When such businesses are no longer SMEs, however, it is difficult to justify the continuation of that protection at the taxpayer's expense. Those are the key reasons why I ask the hon. Member for Cities of London and Westminster to withdraw the amendment.

Photo of Mark Field Mark Field Shadow Financial Secretary

Again, I thank my hon. Friend Adam Afriyie for his brief contribution. He added some interesting observations about likely fluctuations in the currency market that applied to part of the amendment.

The Minister rightly notes that amendment No. 26 is at the crux of the concerns that we have tried to address. As he says, the exemption of SMEs from a requirement to apply transfer pricing should not be applied across the board where there is an issue of international control. Equally, it is fair to say that in some small subsidiaries of large international groups the issue of control may not be entirely straightforward. We could not necessarily deal with that in an amendment, but it will perhaps be explored in future years, as clearly much of the work that relates to the venture capital industry in various Finance Acts will be subject to continual change as that market matures.

We are concerned, for the reasons that we have set out, about the notion of the standard definition as produced by the European Commission. I accept, from the Minister's perspective, that there has to be some sort of threshold and that there are rightly tax treatments that make life easier for SMEs but perhaps not for all companies. None the less, it is a somewhat stark distinction, and the uncertainty that we have identified will need to be examined in future years.

There has been significant lobbying by the venture capital industry, which has expressed certain concerns, but we have had a chance to articulate them during the debate. On the basis of the replies that we have had, I hope that we will be able to return to this in due course, particularly if it is found that there are ongoing problems in the venture capital and private equity industries, which are so important to this country, and that the Minister will be open-minded about that. With that in mind, I am happy at this juncture to beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Photo of Mark Field Mark Field Shadow Financial Secretary 9:00 pm, 13th June 2005

I beg to move amendment No. 20, in page 126, line 25, leave out paragraph 2.

The Second Deputy Chairman:

With this it will be convenient to discuss the following amendments: No. 27, in page 127, line 26, leave out paragraph 3.

No. 30, in page 128, line 39, leave out sub-paragraph (3).

No. 34, in page 129, line 3, leave out 'or (3)'.

No. 33, in page 129, line 11, leave out 'or (3)'.

No. 31, in page 129, line 14, leave out sub-paragraph (6).

No. 32, in page 129, line 36, leave out 'or (3)'.

Photo of Mark Field Mark Field Shadow Financial Secretary

Amendment No. 20 would render the entire previous debate redundant, as it seeks not to make any amendments at all to schedule 9 of the Finance Act 1996. It might have been easier had we had that debate initially.

Sufficient complications still surround collective investment schemes and plague the venture capital industry. We accept that changes to their tax treatment have largely come about as a result of fierce lobbying by those involved in the industry and many of those are to be welcomed. However, there is a strong view in the marketplace that some of the proposals concerning transfer pricing and loan relationships may reduce the number of private equity deals being done in the UK. As my hon. Friends the Members for Runnymede and Weybridge (Mr. Hammond) and for Chipping Barnet (Mrs. Villiers) said during the debate on the whole issue of transfer pricing, innovation, flexibility and commercial certainty must be the imperatives, and we fear that the Treasury's real motivation is to increase tax take to overcome an increasingly unmanageable black hole in finances.

As ever, it is the unintended consequences that we must ward against. In particular, the proposal to collect an increased share of tax, sooner rather than later, on a crude interest may reduce the volume of private equity deals in the UK. Ultimately, as is the difficulty with all such matters, we will not know the truth until it is too late. However, we are also convinced that there is a fear that the proposal will reduce the UK tax take and we need to remember that the venture capital industry does not invest only in tremendously successful industries and that its returns are by no means always the sure thing of tabloid legend. Indeed, private equity plays an important and full part in resuscitating—or at least attempting to resuscitate—ailing businesses. There is a genuine sense of foreboding that the plans might inadvertently boost the rate of business failures in the UK.

We support the current arrangement whereby tax is deductible from interest payments that are payable when the private equity investor sells the investment on. Such schemes will typically last four or five years. Some last for a shorter time but, as a rule of thumb, four or five years is a useful benchmark. The tax deductions for the interest charge arise when it accrues in the accounts, not when such interest is paid. It is clear from the Government's proposals that they regard that as something of a loophole, notwithstanding the established agreement between the venture capital industry and the Inland Revenue, which was brokered as recently as the Finance Act 2004. It covers a wider range of investment vehicles, which could lend to borrowers, and the borrower could still obtain a tax deduction for late paid interest.

Our concern is that the risk will have an adverse impact on the pricing of many private equity transactions, to the potential detriment of UK business. As the Financial Secretary understands, the private equity business is still, even by British standards, a fledgling business, but is emerging strongly in many other parts of the world. Ten years ago, Australia had no private equity business to speak of but is now a significant competitor.

It is very much a global market and we fear that the Government's proposal would restrict the borrowing company to claiming group relief against the profits of only a single year—the final year of the scheme. That may cause difficulties. If the interest deductions are all delayed until the interest is paid rather than eked out over the period of a scheme, there will be only one substantial tax deduction. Clearly, there is then a risk that the aggregate interest would be more than the overall profit in that final year.

We must always remember that the profitability of any company may be cyclical for a host of reasons for the duration of the scheme. Those reasons may go to the heart of the nature of the business. Perhaps the business is growing and looking to grow more, thus having less of a profit in the final year under venture capitalists. Profitability may also be cyclical simply for general economic reasons. If total interest exceeds profits in the final year, the borrowing company runs the risk of some its accrued interest payments having zero economic value, even when there can be no reasonable suggestion of the scheme having been created deliberately or artificially to avoid tax.

In practice, the excess interest deduction may prove hard to use and undermine the profitability of the proposed scheme. Our difficulty is that, if the profitability of a proposed scheme is undermined, in a global market for private equity, more deals will leave these shores. The probable result of that is a lower tax take. Nothing would be worse than trying to ensure a bigger slice of a much smaller cake. I appreciate that that is the perennial problem of Treasuries through the years.

The other amendments in the group are all consequential. I hope that the Financial Secretary will provide at least some guidance about our proposals and whether there is any way in which we can try to ensure that some of the more negative consequences to which I referred are put to bed.

Photo of John Healey John Healey The Financial Secretary to the Treasury

The hon. Gentleman is right to say that the private equity business is strong in the UK. Indeed, it is second only to that of the United States, but it is competing increasingly in a global market. We are clearly concerned about its health in the UK because it is an important part of funding, especially for many of our small and rapidly growing companies. However, I believe that some of the wider and dramatic impacts that some hon. Members claim that the schedule will have are hugely overstated.

To set the scene for discussion of the amendments, it is important that the Committee remember that the loan relationship rules, which are the corporation tax rules that tax interest paid and received by companies, operate by reference not to the interest paid or received in cash but to the amounts of interest shown as accrued in the company accounts. It has always been necessary, as I think the hon. Gentleman will well know, to have special rules to deal with cases where a company is deducting interest in its accounts in respect of loans from connected parties where there is a potential for the manipulation of lending and borrowing to shelter company profits from UK tax.

At the same time, it has always been recognised that such rules could bite harshly on smaller companies and on start-ups, particularly where there are close relationships with a relatively few venture capital providers. It is common for a lender in those circumstances also to take a small equity stake.

Photo of Adam Afriyie Adam Afriyie Conservative, Windsor

Earlier today, I asked for quantitative evidence of some of the items that are being discussed. I ask for a rough idea of how many businesses will be affected by the measures contained in the provisions that we are discussing.

Photo of John Healey John Healey The Financial Secretary to the Treasury

I do not want to return to clause 11, which was being discussed when the hon. Gentleman asked his question. I do not know whether he will find my answer satisfactory. The principal purpose of clause 14 and schedule 8 is to anticipate the development of new avoidance arrangements. This is the answer to Mr. Field. By the scored amount in the current year for the revenue gain of the whole schedule, we are talking of only £5 million. Knowing what professional advisers are beginning to advise their clients, the point is to anticipate potential avoidance arrangements. Therefore, it is impossible to give the precise answer that hon. Members might wish for.

The loan relationship connected party rules have included exemptions to protect venture capital investment in company start-ups and in early stage expansion. The changes made in the Finance Act 2004 clarified how the exemption applied in the case of certain sorts of foreign venture capital providers but did not otherwise affect the scope of the exemption. However, it has become clear that the exemption can be used not only for venture capital investments in start-ups and in growth companies but also to facilitate private equity investment in management buy-outs of large, long-established and profitable companies, and not only the ailing companies that the hon. Member for Cities of London and Westminster was concerned about.

Amendments Nos. 20 and 27 would therefore undo the very purpose of the changes that we are introducing. They would mean that the exemption was not targeted on the growth companies and the start-ups for which it is intended. The benefits of the venture capital exemption would continue to be available for all private equity deals, management buy-outs and mature low-risk businesses with a steady and well-established cash flow, and would certainly be less risky than the growth businesses that we want to encourage.

The amendments would also allow the other avoidance opportunities that are closed down by paragraphs (2) and (3). I hope that on that basis the hon. Gentleman will consider withdrawing his amendments.

Photo of Mark Field Mark Field Shadow Financial Secretary

The Minister will be glad to know that the Opposition will withdraw the amendments. In part, they were probing amendments. It was important to have some discussion about whether small and medium-sized enterprise distinctions should be made at all within the context of the Minister's proposals.

We are rightly proud of the strength that the UK has in our private equity business. It is particularly important that that is maintained, not least given the strength of the two great economic superpowers of the future—China and India—and our links with those countries. Inevitably, there will be a significant role for a number of joint ventures. Much venture capital will find its way in various different guises either in the UK or beyond that. It is therefore important that the pre-eminence of our private equity business is seen to be maintained.

Clearly, the Opposition are being lobbied, just as the Government are lobbied, and, inevitably, the Armageddon and appalling outcomes that are sometimes presented can be exaggerated. Equally, my hon. Friend Mrs. Villiers rightly articulated one of the Opposition's concerns when she referred to the notion of such overseas arrangements being somehow nefarious and having complicated structures, which is an inevitable part of that sort of transaction.

I have some understanding that the Treasury wishes, as the Minister rightly puts it, to anticipate new avoidance arrangements. Inevitably, the best tax lawyers and tax structurers are likely to be one or two steps ahead of the game, so it is legitimate for the Revenue and the Treasury to try to have such an understanding. Certainly, it surprised me when the Minister said that the proposed revenue gain was as little as £5 million, which is very much small fry. None the less, one hopes that, if there is to be a genuine move towards anticipation of new avoidance arrangements, there will also be a recognition that it is wrong—we will no doubt discuss this in greater detail in Committee in the next two weeks—for any of this legislation to be retrospective or retroactive. If there is to be a policy from the Treasury to anticipate avoidance arrangements, surely it is part and parcel of that, and fair game, to ensure that retroactivity and retrospection is kept to an absolute minimum—nil from the Opposition's perspective.

We have had a reasonably amicable, albeit shortish debate on this matter. Again, the Liberal Democrats—the real opposition—have not sought to make any contribution, which is a matter of some surprise. Silence is golden—or perhaps orange.

We shall not press the matter to a vote. I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Question proposed, That the schedule be the Eighth schedule to the Bill.

Photo of Philip Hammond Philip Hammond Shadow Chief Secretary to the Treasury 9:15 pm, 13th June 2005

This has been an interesting debate, if a little lopsided in its geometry around the schedule. I suppose that we can forgive Liberal Democrat Members—no doubt, over the next year or so, they will get their act—

The Second Deputy Chairman:

Order. I am happy to allow a debate on this schedule being the eighth schedule to the Bill, but I hope that we will not cover any of the ground that we have already covered, as we have had an extensive debate.

Photo of Philip Hammond Philip Hammond Shadow Chief Secretary to the Treasury

I am certain that you will guide me, Sir Michael, if I seem to be falling into that trap.

We are discussing an extension of the transfer pricing rules to cover loan relationships and the capture of a group of people who were not hitherto caught by schedule 28AA, which the Government clearly feel is a necessary measure, and which, in its current drafting, the venture capital and private equity industry sees as an attack on an established model that has operated within parameters agreed with the Inland Revenue over a not inconsiderable period. As I said earlier, a degree of concern exists about the way in which some of these measures have been badged as anti-avoidance.

When a change is announced by the Government to a treatment that was agreed in 1998, and which has been constantly reviewed by the industry and the Treasury since then, it is bound to lead to some concerns. I want to quote from a letter that the British Venture Capital Association sent to the Chancellor on 23 May. It wrote:

"The apparent change in policy by the Inland Revenue over the agreement we reached in 1998 about the application of transfer pricing to private equity limited partnerships is particularly unfortunate, not least because of the level of distrust this move has now introduced to the relationship between the industry and the Inland Revenue."

This is a widely drafted provision, extending existing transfer pricing rules and restricting a deduction that has been available for accrued interest and discount. It will affect the pricing of transactions.

A subject of concern that covers the whole schedule, including parts that have not been addressed in detail today, is the way in which it catches banks. We have certainly had that discussion, but I suggest to the Financial Secretary that in some circumstances the schedule could also catch corporate joint ventures, through what is effectively the disapplication of the 40:40 rules in paragraph 4 of schedule 28AA to the Income and Corporation Taxes Act 1988. The Minister spoke of seeking to level the playing field between partnerships and corporations. That measure will disadvantage corporate JVs and bring them—perhaps unintentionally—within the scope of the schedule.

Many private equity funds have for many years been structured as multiple parallel partnerships, for very good commercial reasons. Private equity houses will typically seek to ensure that in any fund that is investing, they have an appropriate identity of interest between investors in that fund. It might be done on a geographical basis: German investors might be collated in a fund that might then have a bias towards investing in German concerns. Ethical investment funds in the United States particularly, but increasingly in this country, have restrictions—for obvious reasons—on the types of investment that they are willing to make. Indeed, Sharia investment funds have such restrictions. It makes perfect sense for a fund to be structured as multiple parallel partnerships to try to ensure that investors can be grouped in an appropriate way—and, overarchingly, in a way that matches different classes of investors' appetite for risk with the opportunities that are available. Many of the investors in private equity concerns are quite risk-averse organisations, pension funds being the obvious example. As I hope we have established this evening, it is not the case that multiple partnership structures are all or mostly tax-driven. That is not to deny that some funds are using those structures to generate tax saving, as Conservative Members have clearly recognised.

This is a important industry for the United Kingdom. Private equity-backed companies generate £187 billion worth of sales and £23 billion of taxes every year. The industry in Britain is second only to that in the United States. It brings a huge dynamism to the economy, whether it backs growing businesses—the kind we all want to expand so that they can become larger, eventually perhaps going to the public markets for capital—or whether mature, sometimes ailing, businesses need the support of new capital funds and the close attention that private equity houses can often provide.

The breaking of that 1998 consensus between the Revenue and the industry without prior consultation and with retrospective effect—I shall have something to say about the retrospective effect and the timing of implementation provisions in proposed new sub-paragraph (4) in a moment—has in itself seriously damaged the UK's attractiveness as a location for private equity and venture capital houses, and, indeed, its attractiveness as a destination for investments by those funds, wherever they are based.

Of course, although the Government have approached this as a tax-avoidance loophole-closing measure, some of the loopholes are rather small—more like the eyes of needles, to judge by what the Minister was saying earlier. The real danger is that the end result could be less tax, through less private equity investment and less business generated in this country, and more business failures and job losses as companies that might have been rescued and turned around by private equity funds are left to their fate. There is no doubt that uncertainty will be created in straightforward and established transactions. Mezzanine debt, with or without equity warrants attached—which, ironically, is intended to reduce the tax-reducing interest chargeable—could now become a less attractive instrument because of the doubt surrounding its treatment.

One issue that has not been touched on so far this evening is the relative attractiveness and complexity of shareholder debt financing, which is an important part of the private equity deal. Typically, private equity houses are burdened with large funds—if one can imagine such a thing—that they need to invest. Such funds often exceed their capacity to make equity investments, and a standard technique that they employ is to provide part of the debt financing required in the package as shareholder debt financing.

Until now, most people felt it reasonably easy to price shareholder debt financing. However, such financing will now be brought within the transfer pricing rules through the application of proposed new paragraph 4A, and such people will be required to show that the debt has been priced at arm's length. That will be much more difficult than might be thought, because most comparable transactions that would form the basis for demonstrating to the Revenue that the pricing of an arrangement is arm's length will be caught within the new rules. Therefore, no clear and substantial body of shareholder debt financing will exist that falls outside proposed new paragraph 4A. That in itself will create uncertainty and it will undoubtedly make shareholder debt financing a less attractive instrument.

As we have already heard this evening, there is doubt surrounding the status of leading banks where another division of the same bank might be involved as an equity investor in the private equity house. There are also concerns about the workability of the small and medium-sized enterprise exception at paragraphs 2(3) and 3(6). As my hon. Friend Mr. Field set out clearly, there is a real fear that, despite the best intentions of Her Majesty's Revenue and Customs, very few private equity groups will in fact qualify as SMEs and thus gain exemption from the schedule's timing of interest provisions. We still do not understand the need to eliminate double counting provisions, as provided for in sub-paragraph (5), but we accept that the Minister is engaged in an ongoing voyage of discovery in this regard. We hope to hear from him in due course.

The changes to the rules on the timing of interest payments where there is a loan relationship is a specific problem for the private equity model. It presents the very real possibility of deductions becoming available only at the exit point, typically after four or five years when the private equity investor exits. There is a real danger that the accrued interest deductions will, by that stage, be so large as to be incapable of being used up in year, and thus are likely to become unrelievable because there will not be sufficient non-trading income in the vehicle to offset the loss during the year. Trapped losses will be delivered, which is bound to have an effect on the pricing of a private equity deal, and they will not have been priced into the deals that have already been done.

The Revenue says that about £20 million is at stake in respect of changes to the rules on the timing of interest deductions. The industry, as the Financial Secretary knows, believes that as much as £1 billion of loss deduction is at stake, so there is a huge gap between what the industry perceives and what the Government perceive. It is a shame that there appears to have been no opportunity for the two sides to get together in order to understand each other's point of view or for the Government to create some reassurance. There is a very uncertain position and genuine concern within the industry that the deductions will be disallowed on a much greater scale than envisaged by the Government.

I hope that the Financial Secretary will respond to this short debate, as I would like to put this question to him. Given that the interest deduction is allowed only when arm's-length terms are in place, is there any need for special treatment of shareholder debt? I see no such need, and we have already asserted that paragraphs (2) and (3) have no necessary place in the armoury that the Government are seeking to create. They already have the weapons to deal with shareholder debt that is not priced at arm's length. The other point that arises from the changes made in those paragraphs, I am told by the experts, is that we are likely to see zero coupon notes disappearing as a financing mechanism as a result of the difficulty of showing that they have been priced at arm's length.

All that is interfering with a private equity funding model that works; that has been shown to work over a number of years; that has delivered for the UK economy by financing hundreds, perhaps thousands, of businesses throughout the country, as well as fuelling a vibrant sector of the financial economy itself; and that has been agreed on and run for many years with the full understanding and acquiescence of the Inland Revenue. The Government are taking an extremely dangerous step in unravelling that long-agreed model.

It is not clear why persons caught by the extension of the rules in paragraph 2(2)(b), (c) and (d) are not subjected to the benefit of the grandfathering provisions in paragraph 4(3). That sub-paragraph provides a grandfathering provision for many of the caught transactions, but it excludes those falling within the scope of schedule 28AA under those sub-paragraphs of paragraph 2. Interest on loans made by such persons—those who are not entitled to the benefit of the grandfathering provisions—will be subject to the late interest rules from 4 March 2005, not 1 April 2007. It is not clear to us why that sub-class of investor should be disadvantaged in that way.

There is also confusion about the wording of paragraph 4(3)(b). The debtor relationships to which transitional provisions apply are those entered into before 4 March 2005 and

"not varied after that date".

That seems fairly straightforward—but the line goes on to say:

"or not varied until after that date".

I do not pretend to the Committee for a moment that we have dreamed up this query ourselves, but I can tell the Financial Secretary that some of the sharpest minds in the specialist tax advisory sector do not know whether the two phrases in the line

"not varied after that date, or not varied until after that date" together effectively embrace everything, as would appear on a plain English reading of the text, or whether they are intended to mean something else. Can he tell us whether those two phrases together cover all existing loan relationships? Is that the intention, and if so, could it be stated a little more clearly? I am sure that the industry would be pleased if it could.

There is an issue of retrospection with all the provisions in the schedule. Deals in the sector are typically done on the basis of cash-flow projections, which will have been built by factoring in an interest deduction, and assuming that a lower rate of corporation tax would be payable in the early years. As the Minister will know, when we consider the discounted cash flow of a business forward, the exact time when the deduction comes and the cash hit is taken is very significant. Moving it forward from the fourth or fifth year to the current year, by not allowing the deduction to be taken until exit, is potentially very significant—and that has been done without warning or consultation. The impact will fall on private equity businesses. Their liability to pay the interest will not change, but they will not get the corporation tax deduction that they have factored into their cash-flow projections. They will have to make the interest payment provided for by contract, and also make a corporation tax cash payment that in their business model and their cash flow forward they will have assumed would not have to be made at that time.

Has the Treasury really looked at the case for a permanent exclusion of all pre-March 2005 debt, so that there will not be that element of retrospection and transactions that have already been priced and contracted for, where a loan relationship already exists, will be allowed to run their natural course? In the case of a private equity financing, that would typically be only four or five years; most private equity financiers would be unhappy if they were not out by the end of five years.

That brings me to another important point—a very different point, but germane to the Government's assessment of the overall impact of the schedule. I am thinking about the joined-up government approach, and about considering not just what the measure will do for the Treasury's revenues and what it will do to the industry, but its relationship with other Government policies and initiatives.

Schedule 8 will have an impact on the private finance initiative. The financing of PFI deals tends to be structured in a similar way to private equity deals. There are good commercial reasons why PFI deals are structured in that way, and they are known by, and have been structured to benefit, the public sector. The PFI industry is aware that clause 40 and schedule 8 are intended for the private equity industry, but there is a concern—I am sure that the Treasury is aware of it—that a blanket application of the new rules would prejudice providers of PFI and push up the cost to the public sector. I know that Labour Back Benchers are deeply concerned about that possibility.

A particular concern is that it is rare that profits are extracted from PFI contracts by investors without being subject to UK tax in their hands. The removal of a corresponding adjustment in the proposed legislation at paragraph (1)(5) will affect investors in PFI contracts that are caught by the new legislation, given that the investors in PFI contracts are nearly always subject to UK corporation tax. That will make PFI deals less attractive as an investment and will potentially make existing PFI contracts loss-making, which would hardly send the message that the Government would want to the industry as a whole, given the central role that PFI plays in their financing strategy and in enabling them to maintain their desired levels of public investment without breaching the Chancellor's sustainable investment rules.

As all members of the Committee will be aware, PFI contracts tend to run for much longer terms than private equity deals, so any change of the rules in respect of existing deals—unwelcome as it will be to private equity financiers—will wash out within four or five years maximum, because that is the maximum length of time that private equity investors expect to be in an investment. However, any application of the new rules to PFI would affect those contracts disproportionately, as the impact would be felt for a much longer period—10, 20 and 25 years are not atypical—and the net present value effect of rule changes that impact on the cash return over 20 years would be significant, as the Financial Secretary will be the first to grasp.

In addition to the impact on existing contracts and in the absence of certainty about how PFI contracts will be caught in a net that was, admittedly, cast for a different purpose—to deal with private equity financing—new PFI contracts will surely be priced by providers on the assumption that these rules will apply. Such a move could make PFI more expensive for the public sector at a time when the pressure is on to try to make PFI deals less expensive. Indeed, given the general interest rate climate, one could probably expect that PFI deals would become generally less expensive, if not for these changes, which I might characterise as a potential own goal.

It is imperative that the Government—perhaps the Financial Secretary will do so in his response—confirm that the new rules are not intended to affect PFI contracts. Existing rules can be used to deal with perceived abuses—for example, the Revenue's response already delivered to the proposed refinancing of older PFI contracts, which would be perfectly sensible commercial transactions. Applying the new rules would have an adverse impact on the public sector via higher costs and by making PFI less attractive as an investment, hence reducing competition for PFI projects and increasing the cost to the public sector.

Throughout our consideration of the schedule and our amendments, we have tried to narrow the Government's focus and to get back to the intended core purpose. Indeed, we should like to get the Government to state exactly what target they are trying to hit, so that people fretting needlessly that they will be inadvertently caught hear a clear message from a qualified Government spokesman that it is not the Government's intention to allow them inadvertently to be damaged by measures proposed for a quite different purpose. For example, banks lending mezzanine finance need reassurance that they, or the companies to which they have lent, will not be involved in complex discussions with the Revenue that might lead to a loss of deductibility of interest, which in turn could lead to a reduction in the viability of the business in which the bank has invested and thus a reduction in the security against which the bank thought it was investing.

Widespread concern has been expressed in the industry about the lack of consultation. There is widespread concern, too, about the way that the measures were badged as anti-avoidance provisions, implying that people in the industry who pride themselves on having stuck to a model agreed with the Revenue have in fact been doing something untoward.

I shall quote again from the letter to the Chancellor from the chief executive of the British Venture Capital Association of 23 May, two days before the Bill was published. He says:

"These proposals, if given effect, would seriously damage this industry and in our judgement could well be a deterrent to private equity to continue to increase its investment in the UK. This cannot be an outcome you either intended or would welcome."

I certainly hope that it is not the outcome the Government intended, but with all that well-informed warning floating around, of which the Treasury is well aware, the Opposition must insist that the Government reconsider the matter and address the concerns that are being expressed.

There will be deferment until 2007 in several areas as a result of paragraph 4, so the need may not be as pressing as the Government have suggested—the abuse at which the rule changes is aimed is not as widespread as the Treasury may fear. The real impact of the sudden introduction of that new regime will be on deals in progress, under discussion or being negotiated when it is announced. Uncertainty as to the need for review of those arrangements and uncertainty as to what will be deemed to constitute an arm's-length consideration in proposals currently being negotiated will inevitably lead to private equity deals currently under negotiation being priced up to reflect that uncertainty. That is bound to be bad for business.

I suggest to the Financial Secretary that the sensible thing would be to leave the schedule out of the Bill—not to abandon it nor to give up on the intention behind it. In his press release, he has already signalled that 2 March will be his start date so that is clearly on the record for everybody to see. By pulling the schedule from the Bill, the Financial Secretary would have an opportunity to reconsider both the principle behind the measures being introduced and the detailed drafting. He would have an opportunity properly to consult the industry and users of private equity finance. He would have an opportunity to undertake a proper study of the likely impact of these measures and he could come back in next year's Finance Bill and present us with a much more tightly drafted proposal to tighten up schedule 28AA to the Income and Corporation Taxes Act 1988 and schedule 9 to the Finance Act 1996. I am sure that the Committee would be delighted to give a fair wind to that.

Many concerns from many responsible and reputable sources have been voiced through us tonight. If the Financial Secretary does not want to listen to our concerns, he must at least be cognisant of the need to listen to the concerns of those responsible and reputable observers in the business world, the City and elsewhere. I know that they have been briefing him as they have been briefing us.

Little will be lost by leaving the schedule out for another year. Even at this late stage, I urge the Financial Secretary to take that opportunity.

Photo of John Healey John Healey The Financial Secretary to the Treasury 9:45 pm, 13th June 2005

We have had an extensive debate on the schedule, and the hon. Gentleman has made an extensive speech. I shall try not to retread old ground.

Either deliberately or unwittingly, the hon. Gentleman has conflated the application of existing transfer pricing rules with the extension of those rules to specific areas in the clause. The transfer pricing rules are established; they are essential; they are accepted; and they protect huge amounts of revenue to the public purse. They have been in existence for more than 50 years, and they have applied to partnerships for years. The Bill extends the rules to specified areas to which they do not currently apply. The changes apply only from 4 March 2005, which is when the changes were announced. The clause and the schedule do not apply retrospectively.

The hon. Gentleman talks about the venture capital industry being badged as an avoidance industry. Let me make it clear again that the Bill and the schedule are about the extension of transfer pricing rules. In fact, the letter that he quoted from the British Venture Capital Association makes it clear that its argument is about the application of existing transfer pricing rules.

There is a process for settling all disputes about the application or operation of tax rules. Her Majesty's Revenue and Customs applies and manages the operation of the tax system, and taxpayers have a right to contest the way that it does that. The legal system will settle matters of fact. There is a dispute about the enforcement of the existing rules, but it is not relevant to the Bill, which is about the extension, not the application, of transfer pricing rules. It is about their extension to syndicates in which companies are owned by more than one equity partnership, which means that they are, at the moment, able to get tax deductions beyond the rules. It is about heading off the fragmentation of ownership to get around those rules and dealing with what we now see as advice from professional advisers about how to do just that.

We are not in any way suggesting in the Bill that all private equity finance is somehow based on tax avoidance, but we are aware of professional advisers promoting opportunities for structuring ownership and financing of companies to get around existing rules. The purpose of the schedule and the clause that enables it is to protect likely future revenue loss. The hon. Gentleman therefore needs to understand that any suggestion that the cost to the private equity industry will be £1 billion or more is hugely wide of the mark. That could be the case only if the rules disallowed all the interest costs arising from private equity deals, and the rules will not do that. Companies will still be able to obtain tax deductions for interest on debt finance up to the arm's-length amount, and we have had a detailed discussion about that.

The hon. Gentleman mentioned the private finance initiative for the first time today. Let me make it clear that no changes are being made to the existing transfer pricing rules that apply to many PFI deals. We do not expect the changes to have any effect on PFI funding and there is no evidence of any impact on PFI deals since the changes were announced in March. The changes close loopholes to prevent companies from restructuring to get around the existing rules. They do not alter the way in which the existing rules apply to companies involved in PFI deals or other companies. The hon. Gentleman might like to know that HMRC has had discussions with PFI representatives, who I understand have been reassured. However, I am happy to hear of any further concerns that they may have.

In summary, the purpose of the changes is to make the tax treatment of company finances fair for all companies, regardless of their ownership or financing structures. The changes introduced by the schedule will ensure that there is a coherent and consistent set of tax rules for companies with different ownership structures, including, albeit not exclusively, companies controlled by private equity investors. The new rules are in line with those of our major competitors, such as Germany and the USA. They will sustain the UK's position as an attractive location for international investment, and I commend the schedule to the Committee.

Question put, That the schedule be the Eighth schedule to the Bill:—

The Committee proceeded to a Division.

The Second Deputy Chairman:

I ask the Serjeant at Arms to investigate the delay in the No Lobby.

The Committee having divided: Ayes 333, Noes 157.

Division number 11

See full list of votes (From The Public Whip)

Question accordingly agreed to.

Schedule 8 agreed to.