Clause 68 - Qualifying contracts for unallowable purposes

Part of Finance Bill – in a Public Bill Committee at 6:15 pm on 11th June 2002.

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Photo of Ruth Kelly Ruth Kelly Financial Secretary, HM Treasury 6:15 pm, 11th June 2002

Clause 68 is the first of 18 clauses and six schedules that form a package to modernise the structure of the taxation of corporate debt and derivative contracts, and to protect the Exchequer against avoidance schemes in the period before the structural reforms take effect.

It might help hon. Members if I put the reforms in an overall context before dealing specifically with the clause and the amendment. I gave prior notice to the hon. Member for Arundel and South Downs of my intention to do that. I shall start with a brief account of the background to the reforms as a whole, an outline of what we seek to achieve and an indication of how the clauses fit together.

The existing legislation is as follows: first, the foreign exchange gains and losses—or forex—legislation enacted in the Finance Act 1993, which introduced a statutory regime for taxing companies' foreign exchange gains and losses. Secondly, there is the financial instruments legislation enacted in the Finance Act 1994, which introduced another statutory regime for taxing companies' profits and losses from interest rate and foreign currency swaps, options and futures. Thirdly, the corporate and Government debt—or loan relationships—legislation enacted in the Finance Act 1996, which brought in a new statutory regime for taxing gilts and corporate debt instruments, including ordinary borrowing and lending.

Although all three regimes were thought radical in their time, they have suffered from two main problems: complexity and lack of fairness. The 1993 forex legislation was particularly complex. Companies and tax professionals have long complained about the incomprehensibility of some of its drafting. Few will mourn its passing. The 1994 financial instruments rules were prescriptive, and do not cover all the derivative instruments now available in the markets.

The 1996 loan relationships legislation was drafted in a more user-friendly way, in most cases following companies' accounts. However, it was criticised even before the Act had passed its parliamentary stages

because its detailed rules for determining when bad debt relief is available were unduly harsh. With the passage of time, it has become apparent that those rules can act as a disincentive to lend, especially to smaller companies, or to participate in corporate rescues. All three regimes have proved to be highly susceptible to artificial avoidance arrangements. The Government are determined to remove avoidance opportunities as far as possible, so that all companies pay their fair share of tax and compete on a level playing field.

The Government's objectives in formulating these reforms are those that underlie our strategy for corporate tax reform generally. We aim to create a coherent regime governing the taxation of debt and derivative contracts that is generally as applicable as possible, minimises departures from the profit or loss shown in the accounts, is comprehensive—retaining exclusions only where they can be fully justified—and is based on principles that will provide stability for business in the longer term.

The clauses introduce three structural reforms, all taking place concurrently. First, we are repealing the existing financial instruments regime and replacing it with a new regime that covers a far wider range of derivative contracts, is aligned more closely with accounting practice, and is more user-friendly. Secondly, we are repealing the current regime for foreign exchange gains and losses, and merging the necessary rules into the legislation for loan relationships and derivative contracts. Thirdly, we are changing the loan relationships rules, mainly to make them fairer by allowing bad debt relief in a range of circumstances where relief is not available at present.

Those structural reforms will take effect from a company's first accounting period to start on or after 1 October 2002, giving companies the time they need to plan properly for their implementation. The design of the structural reforms is intended to minimise avoidance opportunities, but in advance of their implementation the Government are not prepared to allow tax avoidance to undermine the corporate tax system. We are, therefore, bolstering the existing regimes with a series of measures intended to stop particular avoidance arrangements. To be effective, those need to operate from the dates they were announced.

The hon. Member for Arundel and South Downs queried why we could not delay their implementation, but if we did that, significant sums would leak from the Exchequer during the interim period. We have published draft clauses to allow companies to implement and take on board the changes from the date on which they were published. The reforms have been the subject of extensive consultation since November 2000. Three consultation documents have been issued--the latest, which contained the draft clauses, in December 2001.

In addition, there have been substantial informal discussions, which have been very constructive and helpful in developing the legislation, among the

Revenue, representative bodies and tax practitioners. Many companies have participated in the consultation process both individually and through the CBI and other representative bodies. I should like to take this opportunity to thank all those who took part in the consultations, which resulted in widespread agreement that the reforms should be implemented.

Before I deal with the amendments tabled by the hon. Member for Arundel and South Downs, I shall turn to the clause itself, which will insert a new anti-avoidance rule into the 1994 financial instruments legislation. It is closely modelled on the unallowable purposes rules that the loan relationships legislation has contained since its enactment in 1996. The clause will allow tax deductions where the main purpose, or one of the main purposes, of a company being party to a financial instrument is not commercial. A purpose related to activities outside the corporation tax net will not be considered as a commercial purpose. The clause is aimed at stopping certain types of artificial tax avoidance. To the extent that tax avoidance is a main motive behind a company becoming party to a financial instrument, it will be denied tax deductions, thereby defeating the avoidance.

As was noted in 1996 when the original loan relationships and allowable purposes rules were introduced, companies that enter into schemes with the primary aim of avoiding tax will inevitably be aware of that fact. The transactions at which the rule is aimed are not those into which companies stumble inadvertently. As a top tax adviser said at the time, ''Companies will know when they are entering serious tax avoidance. Apart from anything else, they are likely to be paying fat fees for clever tax advice and there will commonly be wads of documentation.'' Consequently, provided that companies enter into financial instruments with genuine commercial activities or investments, they should have nothing at all to fear from the unallowable purposes rules, but if they go in for artificial tax-driven arrangements, they may find themselves caught.

Amendments Nos. 114 to 116 seek to introduce clearance procedures for the unallowable purposes rules. There are three amendments because the Bill introduces unallowable purposes rules in three places. Clause 68 will add an unallowable purposes rule to the existing financial instruments rules, which will be replaced by the new derivative contracts rules in clause 82 that include their own unallowable purposes rule.

The abolition of the separate forex rules means that foreign exchange gains and losses will become subject to the existing unallowable purposes rule in the loan relationships rules. As the hon. Member for Arundel and South Downs has explained, the amendments would each provide a clearance procedure so that a company could apply to the Inland Revenue for confirmation, or otherwise, that the relevant unallowable purposes rule would not apply to any transaction for which the company obtained clearance. For reasons that I shall explain--they bear some similarity to the debates that the Committee has already had on other aspects of the Finance Bill--such clearance procedures would be both unnecessary and

undesirable. I therefore have to tell the hon. Gentleman that I shall not recommend that the Committee accept the amendment.

First, the clearance procedure is unnecessary. It is modelled on existing clearance mechanisms, but such statutory clearances are relatively rare in tax law. Where they do exist, it is normally for historical reasons. Tax law contains a large number of anti-avoidance provisions, most of which do not have a statutory clearance procedure because they do not need one. The main exceptions to the rule that anti-avoidance provisions do not contain clearance procedures are the anti-avoidance provisions on transactions in securities contained in section 703 and those on mergers and reconstructions in section 138.

The amendments are based on provisions introduced in 1960 and 1977 respectively, when the idea of anti-avoidance provisions was novel. Section 703 is often said to be the first anti-avoidance provision, and it is understandable that a statutory clearance procedure was thought necessary to allay fears. We have come on a long way since then. Anti-avoidance provisions are now commonplace and well understood, so that more modern provisions do not have clearance procedures. That is true of the unallowable purposes rule for loan relationships, which is commonly known as paragraph 13 and was enacted in 1996. It has existed for six years without a clearance procedure.

Although this provision is said to give rise to some uncertainty, we are not aware of its having constituted a significant barrier to legitimate commercial activity. However, it has been a significant and effective inhibition on tax avoidance. We see no reason why the new provisions should cause the damaging level of uncertainty that the hon. Gentleman foresees.

The second reason for rejecting the amendment is that a statutory clearance procedure would be undesirable in practice, partly because of the resource implications. The number of qualifying contracts and loan relationships for which clearance might be sought is huge. Today's sophisticated financial markets trade many thousands of derivative contracts every day and many thousands of loans are taken out and debt instruments issued every day. That may be contrasted with the situation in which there is already, in practice, a statutory clearance procedure. The Inland Revenue receives a substantial number of applications--around 4,000 a year for company reconstructions--but the number of reconstructions is far fewer than the number of derivatives or loan relationships.

It may be argued that a statutory clearance procedure would not be needed for every derivative transaction or loan relationship. That is so, but nevertheless, clearance procedures add unnecessary administrative and compliance costs. If there is a statutory procedure, applications must be made, if only as an insurance, even when there is no realistic likelihood that the provision could apply. The resources that would be devoted to clearance

applications by companies and their advisers and within the Inland Revenue make that an impractical proposition.

A statutory clearance procedure would also be undesirable if it was abused, as I fear it could be, by the minority of companies that seek to avoid paying a fair share of tax. Artificial, marketed avoidance schemes have been a feature of the financial instruments regime. That is one reason for replacing the existing financial instruments regime with a new derivative contracts regime. The ability to test the limits of acceptability, perhaps by using a series of clearance applications, could facilitate yet more avoidance.

Having said all that, I fully accept that companies and their advisers need to have some idea of what transactions are likely to come within the unallowable purposes rule. Most companies that enter into avoidance schemes will inevitably be aware of that fact. Companies do not stumble inadvertently into the sort of transactions at which the rule is aimed. If they enter into transactions for genuine commercial activities or investments, they should have nothing to fear.

To assist them even further, the Inland Revenue has already published guidance based on its experience of operating paragraph 13, to which the hon. Member for Arundel and South Downs referred, and the existing loan relationships unallowable purposes rule. Companies should be able to take comfort from the fact that, if they stay within that guidance, they will not fall foul of the anti-avoidance test. If they are in any doubt, they can of course approach their tax inspector informally. The hon. Gentleman said that companies may be reluctant to ask their tax inspector whether what they are doing is legitimate, but perhaps he agrees that if there is real tax avoidance, companies will have sought professional advice on how to avoid tax in a particular circumstance. If their activities are genuinely commercial, they have nothing to fear from the provisions and should have no hesitation in discussing what they are doing with their local tax inspector.

For all those reasons, it is both cheaper and more effective to have no formal statutory clearance mechanism. I therefore urge the Committee to reject the amendment.