Tax treatment of financing costs and income

Question proposed, That the clause stand part of the Bill.

This is an important clause. A number of issues have emerged since it was tabled, including the number of Government amendments to it. The extensive nature of the new rules on anti-avoidance and financial services groups is also important and needs to be addressed.  However, I want to say something more broadly about the debt cap, because it is has given rise to some concern about what sort of behaviour it will incentivise. Is it the best way to tackle the issue that concerns the Government? Are we at risk of introducing a cumbersome process that will add to the compliance cost of business? Let me talk through some of those issues.

As the Minister indicated in the debate on clause 34 stand part, some of the cost of the dividend exemption has been offset by the introduction of the debt cap. That leads to interesting issues as to whether those reforms are linked, in the sense that if clause 34 is introduced, does clause 35 have to be introduced, or are the reforms taking place in parallel, with one raising revenue and one leading to a loss of revenue just a matter of convenience rather than a matter of planning how the tax structure will work? Clearly, when the debate about the taxation of foreign profits started in 2007, the Government had other ideas about how to tackle some of the behavioural challenges that arose from it. It was only when the original ideas on the control of companies ran into a degree of flak that they then moved on to the debt cap.

The aim of the worldwide debt cap is to target situations in which a UK group bears more debt than is required to finance the worldwide group. In addition, the measure could provide an effective means of targeting many upstream loans to the UK that are used to repatriate overseas cash. However, in order to protect those groups that are temporarily cash rich, the Government intend to allow the worldwide debt cap measure to be set aside where the group is in a short-term cash-rich position. Of course, that stems from the point that has been quite widely debated over several years that the UK has a very generous regime for interest expense—it is fully deductible. It is one of the issues that has perhaps led to an increase in leverage among a number of companies over the course of recent years and has certainly led to concern about whether it has incentivised a particular type of behaviour.

Although the Government flagged up last year that that is what they wanted to do, there is still concern about the workability of the proposals. Deloitte said:

“Unfortunately the provisions remain very complex and represent a major compliance burden for groups even if they will have no ultimate disallowance of interest.”

Adding 32 pages of tax codes could make the risk overly burdensome. The Institute of Chartered Accountants believes this matter could have been addressed in other ways:

“We believe that the same policy objectives, which are to prevent the ‘dumping’ of debt into the UK part of worldwide operations and the penalisation of upstream loans to the UK, could equally well be achieved by tightening up the existing thin capitalisation regime and introducing targeted rules against upstream loans.”

Could other policy routes have been used to tackle unnecessary upstreaming that would not have added to the compliance burden on businesses? In the brief stand part debate, the Minister referred to the different commencement date for the debt cap arrangements. Will the gap between commencement dates be used for further consultation and to explore the alternative solutions, or are the Government determined to take this route?

Since the original proposals were published in draft last year, there has been movement by the Government and some of the complexity has been ironed out. However, UK-only groups will still be caught by the measure and will have to go through some compliance steps, which is regrettable. The proposals are meant to deal with debt that is incurred outside the UK by international groups, yet it appears from the drafting that UK companies will have to pay unnecessary additional taxes.

The debt cap places restrictions on the relief given to UK companies that form part of a worldwide group relating to the interest and finance expenses on transactions with related companies. The extent of that restriction on the intra-group interest and finance costs will depend on the external financing costs of the worldwide group. The Chartered Institute of Taxation questions why those restrictions are required, saying that

“It is not clear to us why these provisions are required at all in addition to the many existing rules which are intended to restrict interest relief in certain situations, including transfer pricing, arbitrage provisions and” provisions of the Finance Act 1996. Both CIOT and ICAEW have concerns about the Government’s approach.

The Minister suggested that the proposal was a move towards a more territorial system of taxation, and he is right: it is only a move towards that. It has not been fully articulated as the end point. Will he clarify whether we should move to a territorial system of taxation and whether the proposal is a staging post along that route or the end of such movement? If it is a staging post, what does he think the next moves should be?

There is a more fundamental concern about the impact of the measures on businesses. I have talked about compliance costs and about whether there are other ways to tackle the concern about loading UK-based companies with high levels of debt. There have been a number of comments from business and outside advisers about how the proposal will affect the way in which companies are structured and financed.

The Law Society has suggested that the proposals might encourage UK groups to incur more debt; encourage multinationals to transfer assets out of the UK; discourage inward investment into the UK; put over-leveraged companies at an advantage over cash-rich companies in making acquisitions in the UK; and discourage outward investment. I shall illustrate just one of those points, as it is quite important to reflect on the potential outcome. We could have a situation in which a UK-based company is being targeted by two potential acquirers. One could be an overseas company that is cash rich, but it would seek to finance its acquisition of the company through intra-group loans. Alternatively, there could be a highly-leveraged private equity situation, where there is quite a high level of external debt. Again, the company in that situation would use debt to finance the acquisition of the original UK-based company.

The concern that has been expressed to me is that, because the overseas parent company is cash rich, it has low levels of external debt or, as in this case, no external debt. The restriction on debt interest—the worldwide debt cap—would kick in on that company. By contrast, if the UK company was acquired by a highly-leveraged private equity fund that had external debt, the fund would be able to use debt; it would not face the restriction on the deductibility of interest that the cash-rich non-UK  company would face. As a consequence, it could borrow more to fund that acquisition; it could pay a higher price to acquire that other company.

Given that one of the concerns expressed recently has been about over-leverage in the markets, we seem to have a situation here whereby the proposed measures could encourage more leverage, rather than encourage companies to have significant cash resources, whether those resources are acquired through the retention of profits or through arranging money via share issues. The behavioural issues are causing some concern to outside bodies, and this could be an opportunity for the Minister to explain the Treasury’s view.

As I understand it—I am sure the Minister will correct me if I am wrong—we are the only country that has introduced a worldwide debt cap. Other jurisdictions have considered introducing some cap on tax deductibility debt within their own jurisdiction, but not outside it. Deloitte suggests:

“The introduction of the debt cap cannot be regarded as a move which will enhance and support UK competitiveness and this aspect of the policy design of the debt cap seems more likely to damage the UK’s competitive position than to enhance it.”

Is the Minister prepared to comment on that assessment?

The second issue that I want to touch on relates to the compliance cost. I alluded to the fact that purely UK groups would also have to go through the process of calculating what their external financing is, even though they do not have any non-UK business. As I understand it, the problem is the gateway test that has been used. When the measures were originally consulted on, it was suggested that there would be a number of gateway tests, one of which would enable a purely UK group to avoid going through that process of calculating external finance. Will the Minister explain why there is to be only one gateway test?

The Chartered Institute of Taxation suggests that the reason why there is only one gateway test is our old friend, EU law, which we discussed in relation to the last schedule. It was said that EU law aims to ensure that the arrangements are waterproof and free of the possibility of legal challenge, which would mean that we will end up putting an additional burden on UK-only groups that should not really apply, given the nature of the debt cap rules. I should be grateful if the Minister explained why we have only one gateway test.

Three themes run through the general commentary on the measure. First, is it the best way to tackle the issue of the upstreaming of loans into the UK? Secondly, is the compliance cost too great? That partly links back to the fact that there is only one gateway test, which means that UK-only groups are caught by the measure. Thirdly—the problem that exercises a number of people—the measure could perversely lead to companies taking on more external debt, but would be to the detriment of inbound investment into the UK and perhaps outbound investment, too.

I echo the words of my hon. Friend in introducing the subject. I ask the Minister for an indication of the Treasury’s broader thinking. No one can dispute that it is quite acceptable at times to utilise the tax system to incentivise or disincentivise certain behaviours. However, my concern is that the worldwide debt cap that has been  put in place in the whole regime, rather short-sightedly, simply reacts to the specific economic problems of today, instead of looking at the long-term future.

We have a Finance Bill every year and I suppose that it is quite legitimate for any Government on a short-term basis to put such a regime in place to deal with the problems of the day, which can then be done away with in a year or two’s time, but the proposed regime obviously adds an extra layer of complexity, not least because the worldwide debt cap applies to global companies—companies with significant interests here in the UK, but which also have operations overseas. Given that it is a worldwide debt cap, I would be interested to have some indication from the Treasury as to precisely what negotiations have taken place with other countries and whether the measure is part and parcel of a concerted international process.

I worry that the measure may have been put in place because of the present problems. I accept that the genesis may not lie in September 2008, but may be found a little bit before that. That raises the obvious question that my hon. Friend mentioned in relation to the private equity industry. In many ways, we have seen a skewing of the tax system over the past decade or so: extremely low tax rates have made the putting of debt on to the balance sheet a much more attractive proposition. We are moving away from that now, and the Minister will rightly point out that, in the present climate, he wants to disincentivise having a hell of a lot of debt on the balance sheet. That may be an academic point, because I suspect that many private equity providers will not be able to get that much debt on their balance sheet, even if they want to. Many private equity players have problems, but because of the lack of liquidity they are trying to raise relatively small sums of money for debt-for-equity swaps. That is probably a more desirable way to run those businesses in the longer term.

Above all, I am keen to know what the Treasury’s broad thinking is. Is this a short-term measure given our specific problems at the moment, or is it part of a longer-term regime to incentivise longer-term behaviours in relation to debt?

I rise to be constructive about clause 35 and the schedule that follows. It seems to be about the understanding of complex companies and their financial footprint. That is highly desirable. It ensures that profits are appropriately taxed and placed. It ensures that parent companies are identified. It is not always easy to find the parent company of a subsidiary. It is also mindful of the need to avoid double taxation. It is an exceptionally difficult area. The difficulty is well illustrated by the number of Treasury amendments that have appeared since the legislation was put before us. It also seems to me to be about an area on which most of us cannot directly comment. It is highly technical. Schedule 15 refers to things such as staple companies and stranded deficits. It also incorporates a fair amount of algebra, which other Members may be able to explain, but I certainly cannot.

It is also fundamentally about imposing international accountancy standards fairly rigorously, which I welcome. That is a recipe for business efficiency. People talk about  tax efficiency as though it is the same as business efficiency, but when companies such as Amazon export things to Jersey in order to import them back into the country, one realises that the pursuit of tax efficiency can be quite different from efficient business practice.

The arguments and concerns with clause 35 are ones that we will hear in connection with any clause of this nature. People always talk about compliance benefits and capital flow. Those arguments are used so often that it is almost like crying wolf. One wants to know whether there is any credibility attached to the complaints here. It seems that some of the more vocal people voicing these concerns are those who are prepared to pay huge sums of money on tax advisers. Surely that could go some way towards meeting the client’s costs.

In the previous clause we discussed the dividend exemption—the cornerstone of this package—and the benefits to business of its introduction. The dividend exemption will come at a cost of tax forgone and could also lead to multinational groups taking undue advantage of those generous UK interest relief rules referred to by the hon. Member for Fareham. Clause 35 in schedule 15 introduces a limited restriction on the deductibility of interest in computing taxable profits.

Will the Minister explain a little further the link that he perceives between the dividend exemption rules and this particular clause? If this is about a group trying to transfer money into the UK, it could now make a distribution or pay a dividend that was tax free. How does he think that that is going to lead to greater use of upstreaming of loans into the UK?

I will respond directly to the point and argue that these two measures do indeed belong together. I will explain why in a moment and will also answer the hon. Member for Cities of London and Westminster. We are introducing a clear and fair principle to be applied to the treatment of interest for UK tax purposes. The UK is prepared to allow finance expense in calculating the UK profits of a group up to the amount of the group’s entire worldwide external finance cost. That is a very generous rule by international standards, but it does prevent groups putting more debt into the UK than they have borrowed externally for their worldwide business. I want to be sure that the Committee has grasped that fundamental point. We are saying that companies will not be permitted under this arrangement to put more debt into the UK than they have actually borrowed across the whole world in gross terms. It is clear that that is a pretty generous constraint compared to others that we might have applied.

How and why does that measure belong with the dividend exemption? There are a couple of points on that. First, as we discussed earlier, there is a revenue gain from the debt cap to offset from the revenue loss resulting from dividend exemption; but dividend exemption would also open up potentially large avoidance opportunities, and the debt cap provides the limitation in a principled and relatively straightforward way to address that. It is certainly a simple idea in principle: a company should not charge in the UK more debt than it has across the whole world. The conclusion that we drew from the consultation over the past couple of years is that it is the most straightforward in practice as  well as in principle. I do not claim that the measure has no complexity or that it is absolutely obvious how it applies in every case, but it is more straightforward than the alternatives.

The hon. Member for Cities of London and Westminster raised an interesting point. I do not see this as a short-term measure. It is certainly not part of our fiscal consolidation, for example, if that is what he was suggesting. It addresses a general problem of companies putting too much debt into the UK, which could become more prevalent once dividend exemption applies. So, the two measures belong logically together, and not just from the point of view of the measure providing some additional revenue that will be forgone as a result of dividend exemption.

I am still at a loss as to exactly where the link is between the two. I understand completely why the increased revenue that will come from the worldwide debt cap is there, and why it could be used to offset the losses that arise from the dividend exemption. However, the Minister is yet to demonstrate the linkage. What mischief will be created by introducing a dividend exemption policy that could be made worse by the tax deductibility of interest in the UK? The Minister has asserted strongly that there is a link, but has not given an example of a transaction that could suffer—he might have one in his hands as we speak. It would help to know exactly how he sees the two things linked, other than simply through offsetting losses and gains of tax.

What we have generally seen in the current regime is that companies use upstream loans to offset their tax liability on foreign dividends. With dividends to the UK exempt from UK tax, there is no case for allowing interest relief for loans to the UK because dividends can be paid instead. The two things belong together: dividend exemption could lead to business reorganisations that take advantage of both dividend exemption and the generous UK interest relief rules. We need to have measures in place to prevent that.

Will the Minister tell the Committee what proportion of intra-group loans upstream of the UK is there to tackle the issue of the tax payable on dividends in the existing regime, and what proportion is there for normal financing arrangements, for when an acquisition has been funded for example? A more factual basis for the Minister’s argument would help if we are to be convinced that there is a real reason why the two measures are linked, other than simply to offset revenue.

I do not have those figures. From the point of view of HMRC, it is not always clear—there is no particular reason why it should be—why a company is doing a particular thing. What is certainly true is that a large amount of tax that would otherwise, under the current regime, be payable on foreign dividends is offset by the effect of upstream loans. I perfectly accept the point that there are other reasons for having those loans, but it is a substantial feature of multinational taxation currently that upstream loans offset what would otherwise be tax paid on dividends.

Will the Minister give way?

Let me just respond to some of the other questions that the hon. Member for Fareham raised, and then I shall gladly give way to his hon. Friend.

The hon. Member for Fareham and a number of other people have made the point that perhaps we could have achieved the constraint that we need in other ways. It is true that there are alternative approaches that can be adopted to address what you might call “debt dumping”, but each would imply compliance burdens on business. Before deciding that the debt cap was the right answer, we looked at other possible approaches and found that each of them presented its own challenges, and we concluded that the debt cap was the best way to proceed. Other countries adopt other approaches, and the hon. Member for Fareham has made the point that the UK is the first country to adopt an arrangement of this kind, which is probably true. However, if we look at the way such matters are handled in the US, our arrangement is much more straightforward and its attractiveness may well become apparent to other jurisdictions.

The hon. Gentleman asked whether the gap in the commencement date between 1 July and 1 January would be used for further consultation. After much consultation, we believe that the rules being introduced are appropriate. It is, of course, true that we can use the period between now and 1 January to listen to any remaining concerns, although I think that all the material issues have been addressed. If there are any other issues, people have the opportunity to raise them.

Will the Minister give way?

Let me pause in answering the questions asked by the hon. Member for Fareham. I will first give way to the hon. Member for Henley before giving way to the hon. Member for Wellingborough.

I thank the Minister for his generosity in giving way. He has said that it is not always possible to ascertain why companies do something, yet there is a test in the provisions to decide whether a loan has been taken out for a genuine commercial purpose. What are the parameters of the test? The complexity of the issue has also been raised. We have seen it go through a number of iterations in draft legislation, and it is quite clear that we are still on a journey. Will he tell us more about how that journey will be concluded? Clearly, a lot of things in the provisions are still inadequate.

I do not agree with the hon. Gentleman at all. There certainly was concern at one stage with our proposals. We discussed those concerns extensively and, in the discussions in which I have been involved, there has been a general welcome for the progress that has been made, and an acceptance that we now have a solution. Indeed, on Second Reading, the shadow Chief Secretary generously paid tribute to the consultation that had taken place and the conclusions that we reached as a result of it.

So I certainly do not agree with the hon. Member for Henley that the relevant clauses, together with our amendments today, leave us with legislation that is not ready—it most certainly is ready. My only point is that there will be a pause between Royal Assent for the legislation and the debt cap taking effect. It is open to  people to raise concerns if they have any, but I underline very strongly that I think that we now have the answer that we need.

Will the Minister give way?

Will the Minister give way?

I will give way to the hon. Member for Henley again before giving way to the hon. Member for Wellingborough, just so we do not lose our train of thought.

My point picked up on the comment made by the Chartered Institution of Taxation that, without the full picture, it is difficult to comment on  whether we think that the whole package will work. CIOT clearly does not think that it has the full picture.

Well, in terms of dividend exemption and the debt cap, it does. As I have repeatedly made clear, we want to complete the review of the CFC rules, which is an important next step. In response to the hon. Gentleman’s question about our journey towards a territorial system of taxation, that review will be the next step in that direction. On the narrow topics with which the four clauses under discussion deal, the full picture is complete and in good shape.

I am very grateful—

The Chairman adjourned the Committee without Question put (Standing Order No. 88).

Adjourned till this day at half-past Four o’clock.