With this it will be convenient to discuss the following amendments: No. 109, in schedule 15, page 196, line 11, leave out subsection (5).
No. 110, in schedule 15, page 196, line 27, leave out from ‘subsection (4)’ to end of line 33 and insert
“genuine business activities” means business activities which—
(a) are actually carried on in any EEA territory in which the controlled foreign company has a business establishment in any part of the relevant accounting period, and
(b) are actually carried on in that territory through that establishment, having regard to premises, staff, equipment and assets.’.
No. 111, in schedule 15, page 196, line 39, leave out subsection (9).
Thank you, Mr. Illsley, for that rapid canter through the provisions on insurance. Now I shall slow down the Bill’s progress—[Interruption.] Well, I shall slow it just a little, to ensure proper scrutiny of this important schedule about how the Government have chosen to effect their response to the Cadbury Schweppes judgment on controlled foreign companies.
It is worth starting with a general point about the whole interaction between our taxes and EU law; my hon. Friends will be keen for me to make it. We had a lengthy debate on the issue in last year’s Finance Bill Committee, although we do not intend to reprise that at any great length this year.
As the European Court of Justice judgment recognises, it is the sovereign right of member states to determine their policies on direct taxes. However, there are conflicts between that principle and other areas of EU policy; later, when we consider some of the changes to the rules on venture capital trusts, we shall come to another issue in which that conflict exists.
If I might summarise the European Court of Justice judgment on Cadbury Schweppes, it is that where a company was incorporated to undertake a genuine economic activity in another member state, the fact that the motivation to do so—or to use a more familiar term, one of the main purposes of so doing—is to enjoy the lower rates of tax in that territory does not mean that the company’s profits should be taxed at the higher rate applying in the UK. In particular, that issue emerges when the mainstream rate of corporation tax in the UK diverges from rates elsewhere in the EU.
The Court ruled that the profits of a business established in another European economic area state can be taxed at the UK rate only if the arrangements were wholly artificial. Let me quote from the Court judgment:
“If checking those factors leads to the finding that the CFC is a fictitious establishment not carrying out any genuine economic activity in the territory of the host Member State, the creation of that CFC must be regarded as having the characteristics of a wholly artificial arrangement. That could be so in particular in the case of a ‘letterbox’ or ‘front’ subsidiary.”
The Government have taken the Court judgment and sought to apply it to UK law; that is what schedule 15 seeks to achieve.
Indeed, when one examines the schedule and particularly the guidance that was published at the time of the pre-Budget report, one sees that the Government’s view is that the only form of legitimate economic activity in the context of CFC legislation is one that is based on labour, as it profits only from labour that can fall outside UK taxation. If the profits are generated by capital, then broadly they must be included within UK taxable profits. So a company that decides to manage its intellectual property in one member state rather than in the UK would find that its profits from that intellectual property were taxable at the UK rate.
Even the definition of what the Government consider to be labour for the purposes of the rules is tightly defined. If a UK company sets up a subsidiary in another EU state and that company outsources some of its functions, the value created by the outsourcing does not count towards genuine economic activities. It is to broaden that definition that we have tabled amendment No. 111. Furthermore, the schedule also assumes that seeking a lower tax charge is not a valid creator of economic value, which I suppose is rather odd to all those companies that have sought to leave the UK for lower tax rate jurisdictions elsewhere in the EU. Amendment No. 109 would remove the relevant subsection from the Bill.
In a way, it is odd that we have this quite narrow definition of what constitutes genuine economic activity, since it is predicated on the basis of labour. As the hon. Member for Wirral, West perceptively pointed out, the economy has changed somewhat since the second world war and we are now a more knowledge-based economy. There is much more intensive use of intellectual property and different types of assets to generate revenue, so it seems rather strange to create the distinction between profits from labour that is not outsourced, which is a good thing, and profits from outsourced labour and from the utilisation of capital and other assets, which are a bad thing.
What I have sought to do in tabling amendments Nos. 110 and 111 is broaden in two ways the range of activities that can be deemed to be genuine business activities. Amendment No. 110 would define general business activities by reference to the wording used in the Court judgment and amendment No. 111 would eliminate a rather artificial and old-fashioned distinction between staff employed by the company and other labour, in order to recognise that a large number of companies seek to outsource part of their activities as a way of maximising value.
Amendment No. 110 would also change the period from
“throughout the relevant accounting period” to during the accounting period, to ensure that where, say, something has been set up or closed during the accounting period, its profits can be excluded from UK taxation for the purposes of this legislation.
The wording that I have chosen in amendment No. 110 comes from the ECJ judgment: it deals with an establishment having regard to premises staff, equipment and assets and also reflects the Government’s representations during the hearing. Let me quote from paragraph 66 of that judgment:
“That incorporation must correspond with an actual establishment intended to carry on genuine economic activities in the host Member State”.
It is also worth listening to the opening of the judgment. Paragraph 67 states:
“As suggested by the United Kingdom Government and the Commission at the hearing, that finding must be based on objective factors which are ascertainable by third parties with regard, in particular, to the extent to which the CFC physically exists in terms of premises, staff and equipment.”
My amendment No. 100 reflects Government representations made at the time. It is odd that they have not sought to reflect those representations in their definition of economic activities under schedule 15.
With your permission, Mr. Illsley, I should like to make two further comments to preclude the need for a stand part debate on schedule 15. The schedule changes procedure so that a UK company has to make an application for the profits of a EEA entity to be excluded from UK tax computation. Seeking that approval increases uncertainty and could be an impediment to reasonable tax planning. Could there not be a pre-transaction clearance procedure? In the previous debate we discussed one in respect of the insurance clause. The Government are not dogmatic in their opposition to pre-clearance procedures, so perhaps they could again demonstrate their flexibility by introducing one.
The schedule contains no deadlines setting out a time by which HMRC has to grant or refuse approval. The Chartered Institute of Taxation suggested in its submission that the onus should be on the tax authorities to show that the arrangements are artificial, rather than on the company to persuade the tax authorities that they are genuine. The CIOT also thinks that the list in the appendix to the explanatory notes of the 20 items that a business must provide to HMRC to get clearance is deliberately long and unduly onerous and almost suggests that it is a disincentive for people to apply for such clearance.
I shall conclude with an extract from the CIOT’s representations, which captures part of the problem with the measure. Last year, we discussed a similar problem when considering the treatment of group relief on the Marks and Spencer case, where the Government took a fairly narrow interpretation of the ECJ judgment which I think is now subject to challenge. The CIOT is probably right in saying:
“We think the whole approach is fundamentally defective and unacceptable, even as an interim measure pending conclusion of the discussions on the reform of...taxation”.
Even given the further reforms that my hon. Friend the Member for Chipping Barnet mentioned this morning, the schedule is defective and unacceptable in the eyes of industry experts.
Again, echoing the comments of the hon. Member for Fareham, I shall make observations relating to the stand part debate so that we do not need to have the same debate again.
First, in addition to the representations made by the Chartered Institute of Taxation, the Institute of Chartered Accountants in England and Wales has some serious concerns and has noted that the provisions in schedule 15 are identical to the draft schedule published at the time of the 2006 pre-Budget report in December last year. I should like the Minister to confirm whether the schedule is identical to the draft schedule, and if that is so, whether the Government took into account the serious concerns of various professional organisations.
Secondly, I am trying to understand the basis on which the decision was made to introduce the schedule as a stop-gap before more detailed, permanent formulations are introduced. I understand that a consultation is due to start in the next few weeks. However, the Institute of Chartered Accountants has stated that
“we do not believe it is appropriate to attempt to introduce UK domestic legislation, even for a short period, which is contrary to the EC Treaty as determined by the Judgment in the Cadbury Schweppes case. Aside from the uncertainty and litigation that will inevitably follow, the approach brings UK tax policy formulation into disrespect internationally, undermining efforts to ensure that the UK remains an internationally competitive location to do business.”
I should appreciate a more detailed explanation from the Minister about why it was necessary to introduce the stop-gap legislation now, rather than engage in proper consultation that would have resulted in legislation that did not provoke the number of concerns that organisations such as the Chartered Institute of Taxation and the Institute of Chartered Accountants have raised.
As my hon. Friend the Member for Fareham mentioned, we discussed at some length last year the consequences of ECJ judgments on corporation tax. He will be pleased to know that I do not intend to revisit that debate at any great length, other than to say that the judgments collectively have cost the Exchequer billions of pounds; they have on occasions caused complications for British business; and Parliament has not at any point consented to direct taxation being under the jurisdiction of the ECJ.
In holding that belief, as I do, I can have some sympathy with a Government who wish only grudgingly to implement ECJ judgments. However, the difficulty is that that leads to uncertainty, and the remarks that my hon. Friend the Member for Fareham and the hon. Member for Falmouth and Camborne made highlight that point. The hon. Lady referred to a consultation document on the taxation of foreign profits, which we discussed this morning. The word from the Chief Secretary was that the document would be published shortly; I do not know whether the Financial Secretary can be any more precise about that point. The document was due to be published in the spring, but we still do not have it. I do not know whether “published shortly” means later this month or next month. I understand that the Treasury is somewhat distracted by other matters, but it would be useful to know whether there has been any progress.
As the hon. Lady mentioned, and as I believe is the case, the contents of the schedule are the same as were published at the time of the pre-Budget report in 2006. Several bodies have made representations highlighting the difficulties with that situation. Since then, the ECJ has also made its judgment on the thin capitalisation legislation, in respect of which measures introduced by the House were again reviewed to check whether they were appropriate and allowable. It covers similar ground to that which we are discussing, particularly with regard to whether a national measure restricting freedom of establishment may be justified in particular circumstances. The ECJ’s judgment on 13 March was that it may be so where it specifically targets wholly artificial arrangements.
In light of that judgment, I should be grateful to know whether the Financial Secretary still considers the schedule consistent with the attitude of the ECJ to the extent that we can anticipate a future case on the matter, whether he thinks that the thin capitalisation case can give us clues about whether the schedule’s wording is appropriate and whether he has considered revising that wording as a consequence of the judgment.
May I welcome you, Mr. Illsley, back to the Chair this afternoon, and Committee members back to the proceedings? If the amendment is pressed, I shall ask them to reject it, and I shall explain why in a moment.
I shall first deal with a couple of the points raised by the hon. Members for Falmouth and Camborne and for South-West Hertfordshire, after which I shall cover the purpose of the controlled foreign companies rules, because that will put the matter into context and help explain why the amendments tabled by the hon. Member for Fareham would not help, and in some ways, would hinder the proper operation of the rules.
The hon. Lady and the hon. Member for South-West Hertfordshire were both concerned about consultation and the timing of the proposals. We published the draft for the measure alongside the pre-Budget report for the purpose of consultation and, since then, we have been in detailed discussions with those with a direct and representative interest in the matter. Most of the comments then were about the guidance that accompanies the operation of the rules. We will be issuing revised guidance shortly to reflect those comments. We have carefully considered the points that were made and how they applied to the Bill, and it remains essentially as it was set out in the pre-Budget report. That is not because we have taken no notice of the responses that we received. We considered them carefully, and we believe that we are taking the correct approach as I shall explain.
In response to the hon. Member for Falmouth and Camborne, I want to explain that we are taking such an approach now rather than waiting for the UK court judgment for two reasons. It is important that we act as soon as possible after the judgment to be able to deal with any potential uncertainty that can remain in light of the judgment if we do not amend the rules. Moreover, it is a fact that the UK court may take some time before it reaches it own judgment, and it does not seem sensible to wait for that.
I say to the hon. Member for South-West Hertfordshire that we do not implement such rules on the CFCs grudgingly. We implement them accurately and in a way that we judge to be fully and rightly in accordance with the European Court of Justice’s judgment.
A similar comment could be made about the real estate investment trust relief provisions last year in the Marks and Spencer case. Since then, a court judgment held that what the Government did last year was inadequate to meet the ECJ’s judgment on Marks and Spencer. I am merely pointing out that the same thing might be about to happen.
If a court such as the European Court of Justice makes a judgment that has ramifications for, or is relevant to, our legislation, we have to take it into account as we are doing under schedule 15. We doing so in a way that we believe is entirely in accordance with the judgment and as accurately as is necessary. We are taking such action in that spirit, not grudgingly.
I shall now deal with the rules themselves after which I shall come to the points made by the hon. Member for Fareham. They are designed to prevent groups of companies from avoiding UK tax by diverting profits artificially to low-taxed foreign subsidiaries and therefore play an important role in protecting the UK tax base. Similar rules are in place and are in common with those in many other major economies. Their use is endorsed internationally by the Organisation for Economic Co-operation and Development, which also helpfully provides established principles for international taxation.
Our rules were subject to the challenge in the Cadbury Schweppes case at the European Court of Justice. The judgment in 2006 confirmed that the CFC rules are in principle compatible with European law providing that they are not applied to profits from genuine activities undertaken in an actual business establishment located in another member state. I may keep coming back to that because it is at the heart of the principles that the European Court of Justice affirmed in its judgment.
Let me quote from the judgment. The hon. Member for Fareham did, and I do not want to miss out. It states:
“By providing for the inclusion of the profits of a CFC subject to very favourable tax regime in the tax base of the resident company, the legislation on CFCs makes it possible to thwart practices which have no purpose other than to escape the tax normally due on the profits generated by activities carried on in national territory...such legislation is therefore suitable to achieve the objective for which it was it adopted.”
The court said that the parent company must be given an opportunity to produce evidence that a controlled foreign company is established in another member state and that its activities are genuine, which, incidentally, is what our clearance process is designed to do. If that is the case, the CFC rules must not be applied to the profits of those genuine activities.
UK rules already provide a number of generous exemptions to cover genuine activity undertaken by controlled foreign companies. However, we believe that there may be circumstances at the margins where the application of the rules is not entirely clear in light of the court judgment. For that reason, we announced our intention to amend the rules in the pre-Budget report.
It is important to be clear about what the European Court of Justice did and did not do; what it did and did not define. The ECJ did not define in any detail what might constitute profits arising from genuine economic activities undertaken in a business establishment in another member state. To provide the clarification that is needed, schedule 15 first establishes a clear and more certain application procedure through which a UK company should produce the evidence to prove the extent of a CFC’s genuine economic activities in a business established in another member state. Secondly, the schedule provides clear statutory tests on what constitutes such activities and, thirdly, it states how to calculate the profits arising from them. The schedule provides that profits are those created for the group as a whole by staff working for the controlled foreign company in a business establishment that has genuine substance in another member state.
The clause and the schedule have a particularly focused role: to provide clarity about how the CFC rules will operate following the judgment. The legislation achieves that without undermining the effectiveness of the existing CFC rules in preventing as far as possible the artificial diversion of profits from the UK. If I understood the remarks of the hon. Member for Fareham correctly, he did not dispute the importance or the principle behind having the CFC rules, but he was concerned about the practice of their implementation. His amendments would increase the uncertainty of the situation and the scope for the artificial diversion of profits. I will say why in a moment.
On the particular points that the hon. Gentleman raised, when he quoted the court, he talked about wholly artificial arrangements, which was a term used in the judgment. At that level, it is not a term that can be taken literally or can be considered outside the context of the rest of the judgment, which focuses on the purpose of the freedom of the establishment and the importance of ensuring that CFC rules do not tax profits from genuine business activity. It is clear that when the judgment was read in the round, the ECJ intended a meaningful distinction between profits from genuine activities and artificial transfers of profit within the same economic group. The legislation is designed to achieve that clarification.
The hon. Gentleman also suggested that the definitions and the workings of schedule 6 somehow entirely exclude the profits from capital. That is not the case as long as they arise from genuine business activities that are carried out in another member state and not from the artificial diversion of profit to that member state. The ECJ has spoken clearly about the purpose of the freedom of establishment and about the objective factors that indicate that a business is genuinely established and undertaking a genuine activity. The draft guidance makes it clear that that implies a distinction between profits created in another member state and profits diverted within the same economic group so that they can be located artificially in a member state with a lower tax rate.
The hon. Gentleman posed two questions, one of which was: why not have pre-clearance arrangements? Such arrangements are not normally established in this sort of procedure, and I do not see any good reasons to establish them here. There are established clearance arrangements, which after all underpin the operation and the application of the CFC rules.
The hon. Gentleman also asked about the idea of a timetable, set out perhaps in statute, for HMRC to respond. HMRC operates very tightly according to performance expectations. To a large extent, particularly in cases such as this, its ability to come to judgments and assessments, which is what we are discussing, depends on the quality and the comprehensiveness of the information that it receives from taxpayers.
The amendments, as I think the hon. Member for Fareham said, attempt to broaden the scope of the exemptions and application of the CFC rules. He said that particularly in relation to amendment No. 110, but more generally as well. He seems to have attempted to frame the amendments using the type of general language used in the ECJ judgment but when the ECJ hands down a judgment, it is not writing legislation. It is our job to write legislation in a way that captures the principles that underpin the Court’s judgment and puts them in our own tax code. The reason why we are introducing clause 47 and schedule 15 is to make explicit how the rules will apply in accordance with those EU principles, so that we have a firm basis for both HMRC and taxpayers to operate and apply the rules in practice.
If the clause and schedule were amended as the hon. Gentleman proposes, they would have the opposite effect. They would leave the legislation in a state that neither dealt with the uncertainty arising from the judgment nor protected the UK tax base against the artificial diversion of profits.
Amendment No. 109 appears to be explicitly aimed at facilitating the sort of tax avoidance that we are concerned about, because it would delete the provision in the schedule that excludes a reduction or elimination of a tax liability from the scope of the new legislation. If we accepted that, we would in effect be allowing some big businesses to avoid tax by unfairly exploiting the ECJ’s decision, leaving the general taxpayer to pick up the bill. It is not in the interests of business or the Government to make the effect of the new legislation unclear and to make it potentially open to abuse. I therefore hope that the hon. Member for Fareham will not press his amendments to a vote. I ask my hon. Friends to reject them if he does.
Finally, I want to emphasise the point with which I started. The Government are not acting grudgingly to ensure that the ECJ’s judgments are given proper effect in our rules. The potential revenues are very significant. In the pre-Budget report, we identified the revenue impact of the changes that we propose in this legislation. The forecast of our tax revenues will be adjusted as a result of the changes that we are making—from this year by £100 million and next year £175 million, and by 2009-10 we are talking about a reduction in the forecast tax revenues through the changes that we propose of £0.25 billion. The sums potentially at stake are very significant. Therefore, the onus on us is great to get the legislation right in a way that gives effect to the principles of the ECJ judgment but protects properly the UK tax base by preventing the artificial location of profits.
The amendments do not focus on genuine business activities. If they were made, groups would be able to set up tax avoidance schemes within the new rules. They would undermine our controlled foreign companies rules and would put the public purse at substantial risk. They would also put the measures at odds with aspects of the ECJ judgment. The proposed changes would increase, not decrease, uncertainty for business and HMRC in operating the rules.
I thank the Minister for his thorough and well-reasoned response to the amendments and for his justification of the Government’s activities. My hon. Friend the Member for South-West Hertfordshire hit the nail on the head when he went back to last year’s debate on the Marks and Spencer case. The way in which the Government have sought to interpret and implement that judgment through schedule 15 leaves them open to challenge. People out there will push back and challenge the rules, and they may well prove to be right, in which case the Government will have to reconsider the matter.
It is difficult to strike a balance between what is a genuine business activity and what is wholly fictitious, to use the language in the judgment. In considering that point, I looked at the draft guidance that was published at the time of the pre-Budget report. Diverting profits to a controlled foreign company using intra-group loans is given as an example that would involve some deliberate tax avoidance through the structuring of the transaction. I found the next example, about relocating intellectual property in another European economic area member state, less clear. It could be managed there, rights could be sold and value could be generated, and the guidance says that there could be some profit related to the administration of those activities. That example illustrates the difficulty of putting the judgment into practice, because I should have thought, from my reading of the judgment, that a business could reposition a property in an EEA state and have all those profits chargeable at the lower rate, rather than simply the return on the administration costs.
Part of the problem with future interpretations will lie with whether the Government have complied with the ECJ judgment. This afternoon’s debate is partly intended to probe the Government’s thinking; I suspect that the place where the measures will really be scrutinised and tested is not here, in this Committee Room, but in court. We might well come back to this topic next year, just as we have been referred back, this year, to what happened in the Marks and Spencer case. I beg to ask leave to withdraw the amendment.