Clause 58

Finance Bill – in a Public Bill Committee at 12:00 pm on 16th June 2009.

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Manufactured overseas dividends

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

Photo of Greg Hands Greg Hands Shadow Minister (Treasury)

Clauses 58 to 64 relate to anti-avoidance and we broadly support them. Since the Finance Act 2008, various attempts have been made to eliminate so-called MODs, which are manufactured overseas dividends, not the 1960s bikers seen in films such as “Quadrophenia”. Clause 58 and schedule 29 refer to repurchase agreements, or repos. The essence of the clause is that tax credit is being given for deemed payments on repos, rather than for actual payments, and the clause seeks to ensure that tax credit is only given for actual payments.

I might be the only member of the Committee who has ever carried out a repo, or repurchase transaction, so, seeing as that is the subject of schedule 29, it may be helpful if I explain what it is. An explanation will not necessarily help, however, because even though I might have an advantage in understanding the sorts of financial instrument behind clause 58 and schedule 29, that knowledge does not give much assistance in understanding the technical nature of the clause and schedule.

A repo allows a borrower to use a financial security—an equity, a bond or pretty much any financial instrument—as collateral for a cash loan at a fixed rate of interest. In a repo, the borrower agrees to sell immediately a security to a lender and also agrees to buy back the same security from the lender at a fixed rate at some later date. A repo is therefore equivalent to a cash transaction combined with a forward contract; it is a little bit like a foreign exchange, or forex, swap, where the price of the trade-back is a function of the relevant interest rate for that period. The cash transaction results in a transfer of money to the borrower in exchange for legal transfer of the security to the lender, while the forward contract ensures repayment of the loan to the lender and return of the collateral of the borrower. The difference between  the forward price and the spot price is the interest on the loan, while the settlement date of the forward contract is the maturity date of the loan.

A repo is therefore economically similar to a secured loan, with the buyer receiving securities, or a security, as collateral to protect against default. There is little that prevents any security from being employed in a repo: for example, probably one of the most frequently repo’d instruments would be a gilt, or a US treasury bond. Corporate bonds can be repo’d, as well as stocks and shares. The relevance to clause 58 is this: coupons or dividends, which are paid while the repo buyer owns the securities, are, in fact, usually passed directly onto the repo seller. It might seem counter-intuitive that the ownership of the collateral technically rests with the buyer during the repo agreement; however, that is where—I am guessing from the clause—that the problems arise in relation to the avoidance of tax, or more specifically, the creation of a manufactured overseas dividend.

As I understand it, HMRC has become aware of complicated schemes involving intra-group sale and repurchase agreements undertaken by bank groups—that is, within two parts of the same banking family—which are intended to produce a perceived tax advantage. As a result of the structure of the transaction and the prescriptive nature of the UK rules relating to manufactured overseas dividends, one party to the transaction is deemed for UK tax purposes to receive a MOD. In addition, that deemed MOD is treated as having been subject to deduction of foreign withholding tax and the recipient of the MOD is entitled to relief for that foreign tax. However, since the receipt is deemed an MOD rather than an actual payment, there is no actual deduction of foreign tax from any amount actually received by the recipient. Therefore, as I understand it, HMRC’s view—I would be grateful if the Minister confirmed this explanation—is that the recipient does not actually bear the economic cost of the foreign tax, despite the fact that it is entitled to relief for that tax.

That is the technical explanation I have been given, but it seems to me that certain foreign securities have been repo’d solely or mainly for the purpose of creating a credit or a debit against foreign tax paid or received, typically within the same banking group. The purpose of the clause, as I understand it, is to prevent that practice.

I am also puzzled by the fact that the clause, according to the explanatory notes, relates to repos that would normally relate in terms to fixed income instruments, or bonds. My understanding is that most of the MODs are actually created from equities, so I would be grateful for more explanation of what sort of underlying repo transaction we are considering that has been used in the pursuit of avoiding UK tax.

It would also seem sensible, if we are looking at repo agreements, to examine their stablemate, the buy-sell agreement, or the buy-sellback agreement. Those differ slightly from repos in that, with the sell-buyback agreement, any coupon payment on the underlying security during the life of the sell-buyback agreement will generally be passed back to the seller of the security by adjusting the cash paid at the termination of the sell-buyback agreement. In a repo, the coupon will be passed on immediately to the seller of the security. My guess, therefore—and I would be grateful in the Minister could confirm it—is  that it is not possible to manufacture an overseas dividend, or an MOD, using a sell-buyback transaction. It would be important to have that confirmed by the Minister; otherwise we might have to reconsider all of this again if people stop using repos and start to use sell-buyback agreements instead.

The Bill counters that type of transaction by preventing relief for foreign tax, either by credit or deduction, when the recipient of a manufactured overseas dividend does not bear the economic cost of the foreign tax. In other words, relief for overseas tax in excess of the amount borne cannot be claimed. The legislation, as I read it, takes effect for dividends paid on or after 22 April 2009. We will have no problem supporting the clause if the Minister is able to confirm that my understanding of the situation is correct, that the clause covers equities as well as fixed income, and that sell-buybacks and buy-sellbacks are accounted for on the same basis and we do not need to be troubled by whether they might be used for the manufacture of overseas dividends in the future.

Photo of John Pugh John Pugh Shadow Minister (Health), Shadow Minister (Treasury)

I thank the hon. Gentleman for that useful lesson. I shall now test my understanding of this fairly complex schedule and clause.

As I understand it, it is intended that manufactured overseas dividends will qualify for exemptions from double taxation, as real dividends do. Manufactured overseas dividends are characteristics, as the hon. Gentleman has said, of repo deals. I believe that the scam to be targeted involves one might call an illusory repo deal between two companies in the same group—phantom dividends, an allowance for foreign tax liability but no actual foreign tax liability. If I am correct that that is what the Minister wishes to target, my only question is: how prevalent is the scam and what are the savings to the Exchequer in closing that loophole?

Photo of Stephen Timms Stephen Timms Financial Secretary (HM Treasury) (also in the Department for Business, Innovation and Skills)

I am grateful to both the Opposition spokesmen for their support.

The clause and schedule 29 counter a complex tax avoidance scheme whereby the recipient of a manufactured overseas dividend claims relief for overseas tax that he has not paid, as the hon. Member for Southport described. The description of what is going on given by the hon. Member for Hammersmith and Fulham is broadly correct. The manufactured payments arise under repo or stock-lending transactions. They are payments that are representative of interest or dividends paid on securities such as gilts or shares, and are intended to compensate the transferor of the securities for not receiving the real interest or dividends.

Nearly all manufactured payments are made by companies under routine transactions involving banks, securities houses and insurance companies. Earlier this year, we became aware of a complex tax-driven scheme involving the sale and repurchase of a foreign shareholding between two group companies. Part of the repo agreement involves what is, in substance, an obligation to pay a manufactured overseas dividend, which does not bear any overseas tax and is equal in amount to the gross overseas dividend. Despite that, the recipient claims relief as if overseas tax had been deducted. That is the heart of the scam.

The hon. Member for Southport asked about the potential losses from the scheme. Our assessment is that more than £150 million per year would be at risk if the measure was not put in place. Tax avoidance is unfair to the majority of taxpayers. It can undermine the funding of public services, and we are determined to take appropriate and prompt action to counter it. The set of clauses before us contain a number of instances of such action being taken.

The hon. Member for Hammersmith and Fulham asked about the extent to which the measure is applicable in slightly wider circumstances. Other non-avoidance legislation deals with transactions other than repos, but repos cover sale and buyback transactions, and the legislation will apply to those. Only dividend repo transactions are affected by the avoidance legislation in the clause and schedule, because only dividends can give rise to double taxation relief. I therefore commend the clause and the schedule to the Committee.

Question put and agreed to.

Clause 58 accordingly ordered to stand part of the Bill.

Schedule 29 agreed to.