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BRIEFING PAPER

Number 05945, 25 July 2016

Corporate tax reform (2010-16)

By Antony Seely

Inside: 1. Corporation tax: introduction 2. Budget 2010: the Corporate

Tax Road Map 3. Budget 2011: cutting the

main rate, reducing capital allowances

4. Budgets 2012-2015: further cuts in the main rate

5. Corporate tax avoidance 6. The Conservative

Government’s approach

Number 05945, 25 July 2016 2

Contents Summary 3

1. Corporation tax: introduction 5

2. Budget 2010: the Corporate Tax Road Map 11

3. Budget 2011: cutting the main rate, reducing capital allowances 16

4. Budgets 2012-2015: further cuts in the main rate 23

5. Corporate tax avoidance 37 5.1 Taxing multinational companies 37 5.2 Avoidance & the Corporate Road Map 42

The Controlled Foreign Companies (CFC) rules 42 Vodafone’s legal challenge to the CFC rules 47 Reforms to the CFC rules in 2012 55 Starbucks, Amazon, Google & using a ‘GAAR’ 63 The new Diverted Profits Tax 70

5.3 International efforts to tackle evasion & avoidance 77

6. The Conservative Government’s approach 82 6.1 Budgets 2015-2016: further rate reductions 82 6.2 Tax avoidance and evasion 93

The OECD’s Base Erosion & Profit Shifting initiative 93 Restricting interest relief 102 The Google tax settlement 108 Country-by-country reporting 115 A corporate offence of failing to prevent evasion 120

Cover page image copyright: Gladstone’s red box by The National Archives UK. Image cropped. No

known copyright restrictions.

3 Corporate tax reform (2010-16)

Summary Corporation tax is charged on the profits made by companies, public corporations and unincorporated associations such as industrial and provident societies, clubs and trade associations.1

Corporation tax is estimated to raise £44.1 billion in 2015/16. It is the fourth largest contributor to the Exchequer after income tax, National Insurance contributions and VAT.2

The Coalition Government set out its priorities for taxation in its agreement, published in May 2010; in this, it stated that it would “reform the corporate tax system by simplifying reliefs and allowances, and tackling avoidance, in order to reduce headline rates. Our aim is to create the most competitive corporate tax regime in the G20, while protecting manufacturing industries.”3

In his first Budget on 22 June 2010 the Chancellor, George Osborne, announced that the main rate of corporation tax would be cut by 1% each year over the period 2011 to 2014, from 28% to 24%. In addition the small profits rate would be cut by 1% to 20% from April 2011. These rate reductions would be funded partly by cuts in the rates of capital allowances and the annual investment allowance from April 2012.4 In November 2010 the Government set out its wider programme for reform in its ‘corporate tax road map’: specifically, changes to the ‘controlled foreign company’ (CFC) rules, the tax treatment of innovation and intellectual property, and the taxation of foreign branches.5

Over the next three years the Chancellor announced four further reductions in the main rate of tax, so that it fell from 26% in 2011/12 to 20% in 2015/16.6 From April 2015 the main rate is aligned with the small profits rate, setting a single rate of corporation tax. In its last Budget in March 2015 the Government noted that the UK was expected to have the joint lowest rate of corporation tax across the countries composing the G20, and a rate significantly lower than the US, Japan, France and Germany.7 At the time the Institute for Fiscal Studies estimated that the net annual cost of the Coalition Government’s reforms to corporation tax reached about £7.9 billion by 2015/16.8

One of the changes made in the Coalition Government’s first Budget in June 2010 was a cut in the value of capital allowances – the reliefs given to business to offset their capital investment against their taxable profits. Subsequently in December 2012 Mr Osborne announced that the value of the Annual Investment Allowance (AIA), which had been cut from £100,000 to £25,000, would be increased to £250,000 from 1 January 2013, for two years. In his 2014 Budget Mr Osborne announced that from April 2014 the allowance would be doubled, to £500,000, until December 2015.9

1 A basic description of the tax is given with statistics on its yield, the cost of allowances, and liabilities by

sector, in HM Revenue & Customs, Corporation tax statistics, August 2015. 2 Office for Budget Responsibility, Economic and fiscal outlook, Cm 9212, March 2016 p111 (Table 4.6).

Receipts from these taxes are estimated to be: income tax: £169.9bn; NICs: £114.9bn; VAT: £115.8bn. 3 HM Government, The Coalition: our programme for government, May 2010 p10 4 HC Deb 22 June 2010 cc174-5 5 HM Treasury, Corporate tax reform: delivering a more competitive system, November 2010 6 Budget 2011 HC 836, March 2011 para 1.74; Budget 2012 HC 1853, March 2012 para 1.186; Autumn

Statement Cm 8480, December 2012 para 1.130; Budget 2013 HC 1033 March 2013 para 1.121 7 Budget 2015, HC 1093, March 2015 p36 (Chart 1.10) 8 Helen Miller & Thomas Pope, Corporation tax changes and challenges, IFS Briefing Note BN163, February

2015 p9. This is based on official policy costings. The reductions in the main rate alone were estimated to cost about £7.6bn by 2015/16.

9 Autumn Statement, Cm 8480, December 2012 para 2.74; Budget 2014 HC 1104, March 2014 para 2.107

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In his first Budget after the 2015 General Election, the Chancellor, Mr Osborne, announced two further reductions in the rate of corporation tax over the next Parliament: a cut to 19% in 2017, and to 18% in 2020. In addition the Annual Investment Allowance would be set permanently at £200,000 from 1 January 2016. 10 Subsequently in his Budget on 16 March 2016 Mr Osborne confirmed that the rate would be cut to 17% in 2020, to ensure that the UK would have the lowest tax rate across the G20.11 The Chancellor also announced a series of measures for the next four years to reduce tax avoidance and to simplify and modernise the tax regime, set out in a ‘business tax road map’ published alongside the Budget.12 Taken together these further reductions in the rate of corporate tax are forecast to cost just over £3.8 billion in 2020/21.13

The Government estimates that the cuts in corporation tax since 2010 “will be worth almost £15 billion a year to business by 2021.”14 In a recent report on the changes to the composition of tax revenues, the Institute for Fiscal Studies has commented that, on current forecasts, the Government’s policy choices will lead to a decline in corporation tax receipts: “this marks a break with a long-run trend that shows volatility with the economic cycle but no persistent decline in receipts.”15

Following the EU referendum vote on 23 June, Mr Osborne suggested that there was likely to be a Budget statement this autumn.16 Subsequently Mr Osborne argued that as part of its ongoing strategy to attract business investment the Government should aim to cut the rate of corporation tax further to its existing plans for a 17% rate.17 However, on 13 July Theresa May succeeded David Cameron as Prime Minister, and appointed Philip Hammond to be Chancellor. In his first interview Mr Hammond ruled out an emergency Budget, while confirming that he would set out the Government’s revised economic strategy in the Autumn Statement.18

This note discusses the Coalition Government’s approach to corporate tax reform since 2010, focusing on the reductions made to the main rate, the decision to set a single rate of tax, and the reforms made to tax reliefs for capital investment. It goes on to examine the debate over corporate tax avoidance and the international efforts, led by the OECD, to tackle avoidance by multinationals through ‘Base Erosion and Profit Shifting’ (BEPS). It concludes by looking at developments in both these areas following the establishment of the new Conservative Government after the 2015 General Election.

10 HC Deb 8 July 2015 c332; Summer Budget 2015, HC264, July 2015 para 1.239-42 11 HC Deb 16 March 2016 cc957-8; Budget 2016, HC901, March 2016 para 1.54-9 12 HM Treasury, Business tax road map, March 2016 13 Budget 2016, HC901, March 2016 p85, p87 (Table 2.1 – item 18; Table 2.2 – item ac) 14 op.cit. para 1.159 15 Helen Miller & Thomas Pope, The changing composition of UK tax revenues, IFS Briefing Note BN182, April

2016 p2 16 HM Treasury press notice, Statement by the Chancellor following the EU referendum, 27 June 2016 17 In answer to an urgent question on his plans, Mr Osborne said, “we should aim for a rate of 15% and

preferably lower, because if we are pro-business, we are pro-jobs, pro-living standards and pro-working people” (HC Deb 4 July 2016 c622).

18 “Philip Hammond: Financial markets 'rattled' by Out vote”, BBC news online, 14 July 2016; “New chancellor Philip Hammond to scale back austerity”, Financial Times, 14 July 2016

5 Corporate tax reform (2010-16)

1. Corporation tax: introduction Corporation tax is charged on the global profits of UK-resident companies, public corporations and unincorporated associations. Firms not resident in the UK pay corporation tax only on their UK profits. The profit on which corporation tax is charged comprises income from trading, investment and capital gains, less various deductions.

In 2015/16 corporation tax is charged at a main rate of 20%. In previous years a reduced ‘small companies’ rate of tax was charged on profits below a set level, with the rate gradually rising to the main rate for profits above this threshold. Tax on North Sea production is ‘ring-fenced’, so that losses on the mainland cannot be offset against profits from continental-shelf fields. The rate of tax on these activities is 30%.

In broad terms, current expenditure (such as wages, raw materials and interest payments) is deductible from taxable profits, while capital expenditure (such as buildings and machinery) is not. To allow for the depreciation of capital assets, however, firms can claim capital allowances, which reduce taxable profits over several years by a proportion of capital expenditure. Capital allowances may be claimed in the year that they accrue, carried forward to set against future profits or carried back for up to three years.

Different classes of capital expenditure attract different capital allowances:

• The annual investment allowance allows a set amount of investment in plant and machinery investment to be written off against taxable profits immediately. This is set at £200,000 from January 2016. Remaining expenditure on plant and machinery is ‘written down’ on an 18% declining-balance basis.19

• Expenditure on commercial buildings, industrial buildings and hotels may not be written down at all. However, fixtures that are integral to a building can be written down on an 8% straight-line basis.

• Intangible assets expenditure incurred before 8 July 2015 is written down on a straight-line basis at either the accounting depreciation rate or a rate of 4%, whichever the company prefers. Expenditure incurred after this date is not eligible for a deduction.

• Capital expenditure on plant, machinery and buildings for research and development (R&D) is treated more generously: under the R&D allowance, it can all be written off against taxable profits immediately.20

Large companies are required to pay corporation tax in four equal instalments on the basis of their anticipated liabilities for the accounting

19 The declining-balance method means that for each £100 of investment, taxable profits

are reduced by £18 in the first year (18% of £100), £14.76 in the second year (18% of the remaining balance of £82) and so on. The straight-line method with an 8% rate simply reduces profits by £8 per year for 12½ years for each £100 of investment.

20 Additional tax relief for current R&D expenditure is also provided, both for SMEs and for large companies. Guidance is collated on Gov.uk on these schemes.

Number 05945, 25 July 2016 6

year. Small and medium-sized companies pay their total tax bill nine months after the end of the accounting year.21

In a report on corporate tax avoidance published in July 2013, the Lords Economic Affairs Select Committee noted that debates over companies paying their ‘fair share’ of tax tended to ignore the fact that individuals – not companies – bore the tax:

Indignation over corporate tax avoidance reflects the view that corporations should pay their "fair share" of tax, and that full compliance by corporate taxpayers lightens the tax burden on individuals. Moore Stephens LLP expressed the contrasting, more usual, view that companies cannot actually bear tax burdens, but must pass them on to individuals: "Companies are artificial constructs, with no existence apart from the individuals who make up their shareholders, directors and workforce. They cannot ultimately bear the burden of taxation (or any other burden). The burden of the tax paid by the company is borne by shareholders in the form of reduced dividends, by employees in the form of reduced remuneration, by customers in the form of increased prices, or (if the company has enough leverage in the market) by suppliers in the form of reduced prices." Malcolm Gammie QC agreed: "There is no such thing as a "fair share" for corporate tax, because companies do not bear the tax anyway."22

The Institute for Fiscal Studies has suggested it is reasonable to assume that a significant share of the burden of the tax is shifted to employees:

The ultimate incidence of corporate tax always lies with households and is borne either by the owners of capital (in the form of lower dividends), by workers (in the form of lower wages) or by consumers (in the form of higher prices). We do not know with any precision who is made worse off as the result of the corporation tax.

However, estimates suggest that, because capital tends to be much more mobile than workers or consumers, a significant share of the burden of corporate tax tends to be shifted to domestic factors – and specifically labour.23 In other words, there is reason to believe that at least a part, and in some cases a large part, of the corporation tax that companies are subject to is ultimately passed on to workers in the form of lower wages.24

In its report, the Lords Economic Affairs Committee went on to observe that, despite this aspect of the tax, there were “good reasons to tax corporations”:

21 Institute for Fiscal Studies, A survey of the UK tax system: Briefing Note BN09,

November 2015 pp29-32. Historical tax rates are in HMRC, Rates of corporation tax since 1971 (Table TA6) & Corporate tax rates of capital allowance (Table TA5), August 2015.

22 Tackling corporate tax avoidance in a global economy, 31 July 2013, HL Paper 48 of 2013-14 para 12

23 Workers may receive lower wages as a result of the corporation tax because (i) a lower level of capital investment results and this reduces labour productivity and therefore wages and/or (ii) the effect of lower after-tax profits feeds directly into lower wages. See, for example, W.Arulampalam, M.Devereux and G.Maffini, The direct incidence of corporate income tax on wages, Oxford University Centre for Business Taxation, Working Paper 07/07, 2007, and references therein.

24 “Chapter 10: Corporate tax, revenues and avoidance”, IFS Green Budget, February 2013 p290

7 Corporate tax reform (2010-16)

One is to limit the scope for tax avoidance by individuals who might otherwise have a strong incentive to incorporate so as to escape personal income tax. Another is to draw revenue from non-resident shareholders in British companies. As Professor Kay and Mr Mervyn King (now Lord King of Lothbury) pointed out: "The easiest way of extracting tax revenue from British subsidiaries of foreign-owned companies and from shareholders of British companies who reside overseas is to have an independent corporate tax."25

Corporate tax receipts are one of the most volatile forms of government revenues; over time, they vary substantially more than total receipts or national income. In their 2013 Green Budget the Institute for Fiscal Studies illustrated the pattern of receipts over the last 30 years:

Figure 10.1 shows real corporate tax receipts (in 2011–12 prices) as well as the share of corporate tax receipts in total receipts and in national income over the past three decades. Real corporate tax receipts were higher in 2011–12 than in all years before 1999.26 Over the past three decades, corporate tax revenues have represented between 2% and 4% of national income and between 4% and 10% of total tax receipts.

Sources: IFS Fiscal Facts data. Figures for 2012–13 onwards from table 4.6 of Office for Budget Responsibility, Economic and Fiscal Outlook, December 2012. Real corporate tax receipts deflated using 2011–12 GDP deflator. National income (GDP) and GDP deflator from HM Treasury.27

25 HL Paper 48 of 2013-14 para 13 26 Note that onshore corporate tax revenues were particularly low in the early 1980s. In

1981–82 corporate tax receipts (in 2011–12 prices) were £13.2 billion but excluding North Sea revenues were just £2.2 billion. Note that trends shown in Figure 10.1 look comparable if North Sea revenues are excluded.

27 IFS Green Budget, February 2013 p283

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The authors went on to note that despite substantial reductions in the rates of corporation tax, revenues had remained relatively high:

It has long been predicted that corporate tax receipts will fall as firms exploit opportunities to shift taxable profit offshore (which may be increasing if income is becoming more mobile) and as governments take policy measures to reduce the corporate tax burden with a view to maintaining tax competitiveness vis-à-vis other countries. The main rate of corporate tax in the UK has more than halved from over 50% at the start of the 1980s to 24% in 2012–13. Similarly, the small companies’ rate … has fallen from 40% in 1980 to 20% today.28

Despite this, corporate tax revenues have remained relatively high. As shown [above], notwithstanding the volatility, real corporate tax receipts increased over the period from the 1980s until the start of the crisis. The share of those revenues in either national income or total tax revenues showed no obvious downward trend before the crisis.

Indeed this is a pattern seen across many other countries:

Figure 10.4 shows that OECD countries have also seen volatile corporate tax receipts, but no downward trends in the share of those receipts in national income. In fact, corporate tax revenues have tended to be higher as a share of national income in the UK than in France, Germany and the US, which have higher headline corporate tax rates. For example, over the five years up to 2010, the UK raised an average of 3.3% of national income in corporation tax. In contrast, France and the US raised around 2.5% of national income and Germany 1.8%.

Note: The OECD series is an unweighted average of OECD countries. Source: OECD revenue statistics (measure ‘Tax revenue as percentage of GDP’ for ‘1200 Corporate’, available at http://stats.oecd.org).29

28 The main corporate tax rate was 52% in 1980. The main reductions were to 45% in

1984, 40% in 1985, 35% in 1986 and 30% in 1999. There have been gradual reductions to 24% in 2012. See HMRC, table A.6

29 IFS Green Budget, February 2013 pp287-8

9 Corporate tax reform (2010-16)

In February 2011 the Centre for Business Taxation at Oxford University published a report on corporation tax drawing on tax data provided by HM Revenue & Customs (HMRC). One of its most striking findings was that although the UK had had a relatively low rate of tax for many years, tax receipts were generally above the average across the G7 nations. The authors also found that by far the greatest share of tax was paid by the very largest companies, even though they paid at lower rates than small businesses.30 A short extract is reproduced below:

• In 2010 the UK had the 7th lowest corporation tax rate in the G20, and the lowest in the G7.

• For over 25 years the UK’s corporation tax rate has been well below the G7 average.

• Despite this, as a proportion of GDP, UK corporation tax revenue has generally been above the G7 average. Revenue peaked in 2007/08 at around £46 billion, before falling back to less than £36 billion in 2009/10.

• UK corporation tax revenues have been volatile: more volatile than both GDP and personal income tax revenues. Revenues from the financial sector have been particularly volatile.

Aggregate revenue figures mask significant differences between companies. [In our report] we investigate the distribution of corporation tax liabilities and payments … Note that all distributional results relate to individual companies, rather than consolidated groups.

• One reason for the growth in corporation tax revenue up to 2007/08 was a substantial increase in the number of companies with positive taxable income. This more than doubled from 450,000 in 1998/99 to over 920,000 in 2007/08 before falling back slightly.

• The growth in the number of companies was associated particularly with the reduction to zero of the starting rate of corporation tax between 2002/03 and 2005/06.

• Despite the growth in the number of companies, corporation tax payments are highly concentrated. The top 1 percent of all companies pays 81 percent of UK corporation tax.31

HMRC do not publish detailed statistics on the amounts of tax paid by size of company.32

Writing in May 2013, amid controversy over the amounts of tax paid by Apple, Google and other multinationals, the then BBC economics editor, Stephanie Flanders, discussed the fact that, contrary to many 30 “Large companies pay lower rate of corporation tax”, Financial Times, 2 March 2011 31 Michael P Devereux & Simon Loretz, Corporation tax in the United Kingdom, Oxford

University Centre for Business Taxation, February 2011 p6. See also, IFS Green Budget, February 2013 pp288-9 & National Audit Office, Tax Reliefs, HC 1256, 7 April 2014 para 1.21

32 In March 2014 the Government published figures breaking down receipts by the rate at which the tax was paid (HC Deb 12 March 2014 cc221-2W).

Number 05945, 25 July 2016 10

expectations, corporate tax receipts across many countries had remained so strong:

When I was first studying economics 25 years ago, my teachers were all expecting corporate taxes to disappear. In a global economy in which capital and companies could go wherever they wanted, the assumption was that there would be an international "race to the bottom" when it came to corporate tax rates. Governments would either have to spend less or jack up personal income or consumption taxes instead ... [However] corporate tax revenues overall have not fallen sharply as the world has become more globally integrated, or more digitally connected; rather the opposite.

IMF economists looked at this recently.33 They found that globalisation had pushed down corporate tax rates quite dramatically in the UK and around the developed world. (Especially in the 1980s - think of the successive corporate tax cuts under Nigel Lawson). The median corporate tax rate in the largest 19 OECD countries fell from 50% in 1982 to 34% by 2003. But the researchers do not find this translating into lower corporate revenues: "...in fact, for the US and all regions save for Sub-Saharan Africa, revenues have risen over time."

Economists might not be surprised by that in itself. If corporate tax rates start out high, tax experts would say that cutting the marginal rate doesn't need to cost the government revenue, if the government broadens the tax base at the same time by cutting loopholes and deductions. In large parts of the world, a lower rate might also encourage more black market companies to join the legitimate economy and pay tax for the first time. All of those things would tend to push up revenues, even if rates are going down. But you can't usually raise revenues by cutting the tax on corporate profits to zero.

With all the competition out there, economists might still wonder why corporate profit taxes are still with us at all, let alone be raising roughly the same amount as they were in the 1960s …And governments, for their part, might be somewhat relieved that all the talk of scams and mounting avoidance has yet to seriously damage their capacity to tax companies overall. But companies that choose not to send their profits into the outer atmosphere - or any other offshore location - will not find that reassuring at all.34

33 Kumar & Quinn, Globalization and Corporate Taxation, IMF, 22 October 2012 34 “The real corporate tax puzzle”, BBC News online, 21 May 2013

11 Corporate tax reform (2010-16)

2. Budget 2010: the Corporate Tax Road Map

In his first speech as Chancellor, a few days after the establishment of the Coalition, George Osborne explained that corporate tax reform would be a priority for the new Government, and that the forthcoming Budget would “set out a 5 year road map” for this reform.35 In his Budget speech the next month Mr Osborne set out a series of corporate tax measures to foster a “sustained, job-creating recovery”, the centrepiece to which was a four-year cut in the main rate of corporation tax from 28% to 24%, funded, in part, by a reduction in the tax allowances given for corporate investment:

Corporation tax rates are compared around the world, and low rates act as adverts for the countries that introduce them. Our current rate of 28p is looking less and less competitive, so we will do something about it. Next year we will cut corporation tax by 1%, to 27p in the pound, the year after we will cut it again by 1%, and again the year after, and again the year after that-four annual reductions in the rate of corporation tax that will take it down to just 24%. That will give us the lowest rate of any major Western economy, one of the lowest rates in the G20 and the lowest rate that this country has ever known.

At the same time, we will agree with businesses a long-term approach to the taxation of foreign profits, the treatment of intellectual property and the proposals from James Dyson on research and development. We will also reduce the small companies’ tax rate … we will cut the rate to 20%, which will benefit some 850,000 companies…

In the current climate, with the deficit the size that it is, all those reductions in tax must be more than paid for by other changes to business taxation ... There will be a small reduction in the rates for capital allowances, which will remain broadly in line with economic depreciation. For the majority of plant and machinery assets, the rate of the allowance will fall from 20% to 18%, while the allowance for longer-lived assets will fall from 10% to 8%. In other words, businesses will still receive full tax relief on their qualifying expenditure, but over a longer time frame.

I have also decided to reduce the annual investment allowance to £25,000 a year, to ensure that support is focused on investment by smaller firms. Over 95% of businesses will continue to have all their qualifying plant and machinery expenditure fully covered by this relief … Ihave listened to the argument that changing those crucial allowances during the early stages of the economic recovery could be disruptive, so I will delay the reductions in capital and investment allowances to April 2012. That will give businesses the extra early advantage of the tax cuts, which will start to come in from next year.36

Initial responses from the business community were very positive – both for the proposed cut in the tax rate and for the Government’s ambition

35 HM Treasury press notice, Speech by the Chancellor of the Exchequer … at the CBI

Annual Dinner, 19 May 2010; “Osborne promises to protect industry”, Financial Times, 20 May 2010

36 HC Deb 22 June 2010 cc174-5. See, Budget 2010, HC 61 June 20101 para 1.61-2

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to give businesses certainty about future changes.37 The Times quoted the CBI’s director-general, Richard Lambert, saying, “business strongly commends the new and refreshing approach to tax policy-making which should help to ensure that the UK tax regime returns to the forefront of international competitiveness.”38

At a post-Budget presentation by the Institute for Fiscal Studies, Stuart Adam argued that taken together, these measures were not a simplification: although the cut in the main rate was welcome, the cut in the small profits rate was less so as there was “no clear reason to favour companies with low profits” and it would worsen the avoidance problem as individuals incorporated their businesses rather than pay tax at income tax rates on their profits. He was also critical of the decision to raise money by cutting capital allowances as “capital allowances are an efficient way to promote investment.”39

Provision to set the rate of corporation tax at 27% for 2011 was included in the short Finance Bill published just after the Budget, limited to the Government’s ‘key priorities’: the rise in the standard rate of VAT to 20%, and the introduction of a new higher rate of capital gains tax.40

While debate on the Bill focused on the rise in VAT, mirroring the general public debate on the Budget, the Opposition raised some concerns when the House considered the 1% cut in the main rate.41 Speaking for the Labour Party Stephen Timms was critical that the Bill only provided for the first of the four annual rate reductions: “if certainty for business is the aim, it surely must be done this year at least.” In response the then Exchequer Secretary David Gauke replied “this is the usual convention as the corporation tax main rate is usually set a year at a time.” The Minister went on to explain why the Government regarded cuts in the rate of corporation tax as a priority:

I make four arguments for prioritising this move to reduce corporation tax. First, corporation tax rates are important in themselves in selling the UK. They are an advert for the economy and for the UK as a good place to do business. By reducing our rate we are sending the strongest possible message that Britain is open for business. Secondly, this cut is a necessary step to help to rebalance the economy. As we take tough measures to scale back the public sector, we must provide the necessary boost to the private sector. Thirdly, the OECD's estimates suggest that corporation tax is an inefficient and growth-damaging tax. Lower corporation tax rates encourage investment, which this country needs to support the recovery. Finally, far from merely being a tax cut for profitable companies, they will provide the boost to investment that is vital for Britain, and they will support jobs in the private sector.42

37 For example, “Industry welcomes 24% target rate”, Financial Times, 23 June 2010 38 “Corporation tax cuts make us global players, say business leaders”, Times, 23 June

2010 39 Stuart Adam, “Business & capital taxes”, IFS Post-Budget presentations, 23 June

2010 40 Budget 2010 HC 61 June 2010 para 2.118 41 HC Deb 12 July 2010 cc 683-751 42 HC Deb 12 July 2010 c745, c750

13 Corporate tax reform (2010-16)

At an earlier stage of the debate Mr Timms argued that there should be a lower rate of corporation tax “for companies that lose out from the reduction of [capital] allowances above a certain threshold.” The Minister opposed such a move on the grounds that, “by not implementing the changes to allowances for two years, but reducing corporation tax rates next year, we are giving companies a full year to benefit from the reductions in rates, alongside current levels of allowances. Further reductions in the main rate of corporation tax follow in later years and capital allowances remain broadly in line with average rates of economic depreciation.”43

In November 2010 the Government published its ‘corporate tax road map’, setting out the principles that would underpin reforms to other aspects of the tax system:

Principles for corporate tax reform

Lowering rates while maintaining the tax base – It is the Government’s view that in general a low corporate tax rate with fewer reliefs and allowances will provide the best incentive for business investment with the fewest distortions.

Maintaining stability – A stable tax system is vital to business. The Government will avoid unnecessary changes to tax legislation. In bringing forward reform, the Government will work with business to ensure that any changes improve the sustainability and long-term stability of the corporate tax system.

Being aligned with modern business practice – The way businesses operate changes over time, and with globalisation and technological development the pace of change over the last 20 years has accelerated. The tax system needs to keep pace with these developments and not stifle adaptation or create perverse incentives for business.

Avoiding complexity – The Government considers simplicity to be a feature of good tax policy. However, complexity in how businesses operate and the diversity of the business population will mean some complexity in the corporate tax system is unavoidable. In bringing forward reforms, the Government will seek to avoid complexity where it can.

Maintaining a level playing field for taxpayers – The tax system should be fair across corporate tax payers without distorting commercial decisions. This can support a limited number of special allowances and reliefs, for example where there are market failures.

The paper went on to acknowledge that “in practice, there will be a degree of tension between these principles”:

For example, the pace of change in business practices can mean that there is pressure to make quick changes to the tax system, which can affect its stability. Similarly, widespread grandfathering of existing arrangements, while improving stability, may create excessive complexity. Government and business need to debate these trade-offs openly in order to get the balance right.44

43 HC Deb 12 July 2010 c740, cc 740-1 44 HM Treasury, Corporate tax reform: delivering a more competitive system,

November 2010 p11. See also, “Tax policy: the corporate tax roadmap”, Tax Journal, 6 December 2010

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The paper set out changes to three aspects of corporate taxation: the ‘controlled foreign company’ (CFC) rules, the tax treatment of innovation and intellectual property, and the taxation of foreign branches. On the rate of tax, it noted “the reductions in the main rate continue to lower effective tax rates for business even after the reductions in capital allowances take effect in April 2012. Based on announced plans in other jurisdictions, these reforms will give the UK the lowest main rate in the G7 and the fifth lowest in the G20.”45

In their Green Budget published in January 2011, the Institute for Fiscal Studies looked briefly at this issue, noting that the costs of cutting rates might be less than anticipated, though in the longer term, all governments, the UK included, would probably have to accustom themselves to getting less from corporate taxation:

The official estimate of the cost of the lower tax rate does not include any impact on tax revenues of firms carrying out more investment as a result of the tax cuts.46 However, the behavioural effects, state that business investment will be ‘around 1 per cent higher in 2014 than in the pre-Budget forecast’ as a result of ‘measures to reform corporation tax, which are estimated to reduce the cost of capital faced by firms by about 3 per cent’.47 Accounting for this would further reduce the estimated cost of the policy.

The reductions in the statutory corporate tax rate are in line with the trend of falling rates across Europe in recent years.48 Research suggests that part of this fall in rates can be attributed to governments lowering tax rates in response to lower rates elsewhere, in an attempt to attract and retain increasingly mobile capital.49 The government currently raises a non-trivial amount of revenue from corporate tax – around £43 billion, or 8% of total revenue.50 Over time, in the face of even more mobile capital and potentially greater tax competition, governments should expect to raise less revenue from corporate tax.51

The authors went on to discuss the likely impact from the changes to be made to capital allowances from April 2012:

The cuts in both the statutory and small profits rates will reduce the tax burden faced by firms. However, this is partly offset by

45 Corporate tax reform …, November 2010 p13. Subsequent reforms to the CFC rules

– which aim to prevent firms artificially shifting income to lower-taxed jurisdictions – are discussed in the last section of this note.

46 This does not mean that the Treasury made a mistake with their costing. Their method for producing these costings intentionally excludes any change in revenue arising from ‘indirect behaviour changes’ by holding constant the post-reform state of the economy. But these indirect effects are then included in the overall fiscal forecast (previously by the Treasury and, under the new arrangements, by the Office for Budget Responsibility) by adjusting the macroeconomic forecast.

47 For OBR quotes, see paragraphs C.25 and C.26 of the June 2010 Budget. 48 See section 9.3 of A. Auerbach, M. Devereux and H. Simpson, ‘Taxing corporate

income’, in Mirrlees et al. (eds), Dimensions of Tax Design 49 See M. Devereux, B. Lockwood and M. Redoano, ‘Do countries compete over

corporate tax rates?’, Journal of Public Economics, 2008, 92, 1210–35 50 In 2010/11, total government receipts are due to be £548 billion, of which £43 billion

(8%) is attributable to corporation tax. See chart 2 of the June 2010 Budget. The trend in corporate tax revenue is shown in figure 9.3 of Auerbach et al., ‘Taxing corporate income’, in Mirrlees et al. (eds), Dimensions of Tax Design.

51 “Chapter 10. Corporate taxes and intellectual property”, IFS Green Budget 2011, January 2011 p226-8

15 Corporate tax reform (2010-16)

restrictions in some allowances, which effectively broaden the tax base. From April 2012, the main rate of capital allowances will fall from 20% to 18%, the special rate from 10% to 8% and the Annual Investment Allowance from £100,000 to £25,000. These changes operate to reduce the proportion of the previous year’s capital expenditure that can be deducted from revenue to calculate taxable profits.

Broadening the tax base alongside cuts to the rate is a trend we have seen across developed countries for the last 30 years. The Treasury estimates that the 2014–15 revenue gain from reducing allowances, allowing for some changes in behaviour but not accounting for any change in the level of investment, will be £2.8 billion, almost exactly offsetting the estimated cost of reducing the main rate.52 The OBR forecast included in the June 2010 Budget sets out its judgement that the cuts in the corporation tax rate will more than offset the reduction in investment allowances such that the ‘cost of capital for new investment is lower for all non-financial companies, and the rate of return from the existing capital stock is higher’.53

The largest beneficiaries from the package of measures will be high-profit, low-investment firms (excluding those subject to the Bank Levy also announced in the June 2010 Budget), which gain more from the rate cuts than they lose from the base broadening. Similarly, the base broadening will have the largest impact on those firms with capital-intensive operations – with long-lasting equipment and machinery – that currently benefit most from the capital allowances. This is likely to apply more to firms in the manufacturing sector, but it may also be true for some capital-intensive service sectors such as transport.54

52 This figure is composed of £1.8 billion from reducing capital allowances and £1.0

billion from reducing the Annual Investment Allowance. See page 15 of HM Treasury, Budget 2010 Policy Costings, June 2010.

53 See paragraph C.57 of the June 2010 Budget. Financial companies are an exception due to the introduction on 1 January 2011 of the bank levy.

54 IFS Green Budget 2011, January 2011 p229

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3. Budget 2011: cutting the main rate, reducing capital allowances

The Chancellor presented his 2011 Budget on 23 March, and in his speech announced an additional cut in the main rate of corporation tax for the coming tax year:

Making our tax system more competitive is another challenge for the times we live in. Again, let us face facts. Other countries are quite deliberately making their tax systems more competitive and attracting multinational companies away from the United Kingdom. We could stand there and do nothing, but increasing the living standards of every hard-pressed family in the country depends on keeping companies, and the jobs, the investment and the tax revenues that come with them, here in the United Kingdom.

So we will go ahead with the highly competitive tax rate on profits derived from patents in industries like pharmaceuticals; we will fundamentally reform the complex rules for controlled foreign companies and make them more territorial; and we will introduce new rules that effectively apply an ultra-competitive 5.75% rate on overseas financing income … But today I want to do even more, so I can announce that from April this year, corporation tax will be reduced not just by the 1% I previously announced, but by 2%, and it will continue to fall by 1% in each of the following three years, taking our corporate tax rate right down to 23%-16 % lower than America, 11% lower than France and 7% lower than Germany-the lowest corporation tax in the G7.55

The Budget report estimated that the cost of the extra 1% cut would be £425 million in 2011/12, rising to just over £1 billion by 2015/16. The report gave updated estimates of the cost of the cuts in corporate tax rates and the yield from lower capital allowances which had been announced the year before:56

55 HC Deb 23 March 2011 c955 56 Budget 2011 HC 836 March 2011 p42, 44 (Table 2.1 – items 1, x, y, z, aa)

£ million 2011/12 2012/13 2013/14 2014/15 2015/16Corporation tax: decrease main rate to 26% in 2011/12,25% in 2012/13, 24% in 2013/14, and 23% from 2014-15 -425 -810 -910 -1,000 -1,075

Corporation tax: decrease to 27% in 2011/12, 26% in 2012/13,25% in 2013/14, and 24% from 2014-15 -430 -1,200 -2,150 -3,300 -4,100

Small Profits Rate: decrease to 20% from 2011/12 -50 -800 -1,200 -1,300 -1,400

Capital allowances: decrease main rate to 18% andspecial rate to 8% from 2012/13 0 600 1,600 1,700 1,700

Annual Investment Allowance: decrease to £25,000from 2012/13 0 200 1,200 1,000 1,000

17 Corporate tax reform (2010-16)

Businesses generally welcomed the announcement of the extra 1% cut.57 At a post-Budget briefing, IFS director Paul Johnson noted “by 2014/15 the main rate will have fallen from 28% to 23%. This is a substantial cut which should have some impact on corporate activity in the UK.”58

Robert Peston, then the BBC’s business editor, noted that the changes were not uncontroversial – even taken on its own the extra 1% cut in the main rate “will cost £900m next year and thereafter. Which is a lot of money at a time when the Government doesn’t have a lot of money.” Mr Peston observed that multinationals would stand to gain from the other changes announced by the Chancellor – the reforms to the Controlled Foreign Company rules – but that, for the Chancellor, “the reality of globalisation … means that the burden of taxation has to increasingly switch to income taxes on individuals and to indirect taxes like VAT”:

After a lengthy review of the so-called Controlled Foreign Company rules, which are hated by most multinationals, the Treasury has opted to apply a very low rate of just 5.75% on cash held by multinationals in non-trading entities overseas. By 2015/16, the low rate of tax on this cash … will cost the exchequer £840m per annum compared with the current tax system … A further £80m a year of revenue will be lost by a decision not to levy tax on dividends brought into the UK from branches of multinationals - which the government would see as the logical extension of a decision by the previous chancellor, Alistair Darling, not to levy tax on dividends repatriated from overseas subsidiaries. So in toto, big companies have arguably secured tax breaks which will eventually save them around £2bn a year … Critics of these changes to the global taxation of British multinationals believe the ultimate loss of revenue for the exchequer will be much greater than the Treasury's estimates.

Mr Osborne however would see the corporation tax cuts as a sprat - albeit a plump juicy sprat - to catch a lovely silver mackerel. He would argue that the UK's long term growth and prosperity - on which the UK's ability to finance public spending depends - requires big companies to invest as much as possible in the UK. And he fears that if the tax regime for big companies isn't as competitive as anything on offer from other rich developed economies, those big companies will take their head offices and their investment to other parts of the world. For Osborne, the reality of globalisation - where businesses can locate more-or-less wherever they like - means that the burden of taxation has to increasingly switch to income taxes on individuals and to indirect taxes like VAT.

So in that context it is significant that Mr Osborne is raising around £1bn from cracking down on what he calls disguised income, or tax loopholes exploited by the super-wealthy and those who run multinationals. The tax free status of offshore employee benefit trusts, for example, is being abolished, which will be a blow to the directors of big companies who are frequently the beneficiaries of such trusts. There will also be a rise

57 “Osborne puts out ‘open for business sign’”, Financial Times, 24 March 2011;

“Britain ‘open for business as profits taxes slashed”, Times, 24 March 2011 58 Institute for Fiscal Studies, Post Budget 2011 Briefing : the big news is the old news,

24 March 2011

Number 05945, 25 July 2016 18

in the tariff imposed on non-doms, those who don't pay tax in the UK on their overseas income (which can be substantial) - though the tariff rise is coupled with incentives on non-doms to invest in the UK. Or to put it another way, Mr Osborne hopes that if he is seen as being generous to big businesses as institutions, it will be recognised that he is simultaneously forcing the rich as individuals to make an increased contribution to closing the UK's fiscal deficit.59

The Treasury Committee also welcomed the cut in the main rate of corporation tax, as witnesses had suggested that it could well boost business growth and tax revenues:

Stuart Green (Chief UK Economist, HSBC) singled out the corporation tax reduction as a growth measure he particularly "welcomed". Paul Johnson (Director of the IFS) tried to quantify the impact of the cuts in corporation tax, telling us that "the OBR suggested last year that this might increase national income by something like 0.1% over the long term". However, he was unable to be more precise, explaining that "the short answer is that we don't know with any precision, and that's why neither the Treasury nor the OBR has said with any precision, "This is what we think the effect will be." …

We also briefly explored whether the cuts in the headline rate of corporation tax would encourage companies to locate or relocate in the UK. Paul Johnson believed that the headline rate of corporation tax did "seem to play a particularly important role—perhaps a more than rationally important role—in decisions that some companies make about where to make their investments and where to locate". However, he cautioned that whilst "an important issue" when deciding where to locate, it was only "one among many important issues that companies consider … the academic literature does suggest that a differential in corporate tax rates has some impact on the decisions of firms about where they invest. That's one reason why corporate tax rates across the world have gone down.”

We welcome the reduction in the headline rate of corporation tax and note the evidence provided that this has boosted business growth and tax revenues elsewhere. We will monitor closely the impact of this policy on corporation tax revenues in the UK.60

Provision to set the main rate of corporation tax for 2011/12, and to cut the rate of capital allowances from April 2012, was included in the Finance Bill published a few days after the Budget statement. These clauses were selected for debate on the floor of the House at the Committee stage of the Bill on 3-4 May 2011. Speaking for the Opposition on the first of these clauses, David Hanson generally welcomed the cut in the main rate, and the proposed cuts in future years, although he raised concerns that the cut would not address regional disparities across the UK: “[the cuts have] been done by Ministers because they recognise there is a need for growth in the private sector, and that is an aim that we would support … the question I want to put to the Minister … [is] how the corporation tax cut … is

59 “A budget for big business”, BBC News online, 23 March 2011 60 Tenth report: Budget 2011, 9 April 2011 HC 897 2010-11 para 76-81

19 Corporate tax reform (2010-16)

intended to bring jobs to … regions with lower levels of unemployment generally across the board.”61

In response the Treasury Minister, David Gauke, made the following points:

Let me briefly set out why reducing corporation tax rates is important. A competitive rate helps to sell the UK as a place to do business, and encourages businesses to invest and thrive here, which is vital if our economy is to grow ... We need to rebalance the economy and to remember the value of enterprise. Growth in the public sector feeds the deficit, but growth in the private sector feeds the recovery that the country needs … The right hon. Member for Delyn [Mr Hanson] asked about particular businesses and sectors. However, the best way to run an economy is not the Government dictating from the centre. Running an economy is about providing a competitive environment in which businesses from all sectors can grow.62

Similarly in relation to the reduction in capital allowances, Mr Hanson generally supported the measure but asked for “a review on the impact of the abolition of capital allowances for smaller businesses and businesses that are more likely to invest, such as manufacturers generally.” Mr Hanson noted the IFS’ analysis that the losers from this package of changes would be capital-intensive firms. If this was the case, the package would represent “a corporation tax cut that benefits the financial services sector most and a capital allowance cut that damages the private sector of small and medium-sized manufacturing industries most. That cannot be a good recipe for growth in the economy.”63

In rejecting the case for a formal review, Mr Gauke suggested that the change simply extended the time frame for firms to write off their capital expenditure, and the vast majority of small firms would be unaffected:

Capital allowances allow businesses to write off their expenditure on capital assets, such as plant and machinery, against their taxable income. They act as a simple, statutory system in place of commercial depreciation. Capital allowances are given at different rates, depending on the year of investment and the type of asset acquired. The principal year-on-year allowance for plant or machinery expenditure is the writing-down allowance. The main rate is currently 20% per annum, and the special rate is10%. Both are calculated on the reducing-balance basis. We are making changes also to the annual investment allowance … reducing it to £25,000 … extending the short-life assets regime from four to eight years …

Our initial assessment of the package as a whole suggested that that would lead to an additional £13 billion of business investment by 2016 by making the cost of capital investment cheaper. The additional reductions in corporation tax rate and the extension of the short-life assets regime will help to increase further the levels of investment by business. We estimate that the overall effect of these measures will be to reduce the tax liabilities

61 HC Deb 3 May 2011 c635, c639 62 HC Deb 4 May 2011 cc687-8 63 HC Deb 4 May 2011 c691, c698

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of the manufacturing sector by around £700 million by 2015. The changes to the rates of writing-down allowances do not mean that businesses will not continue to receive full tax relief for their investments in plant and machinery. Rather, the relief will be over a slightly extended time frame.

Let me give an example. Where it would have taken 11 years under the current rate to write off more than 90% of the cost of a machine, it will now take 12 years. Meanwhile, the rates will continue to align broadly with average rates of depreciation across the economy … The reduction in the annual investment allowance to £25,000 is estimated to affect between 100,000 and 200,000 businesses. As the tax information and impact note clearly states, however: “the CT reform package will promote higher levels of business investment than would otherwise have been the case.”

Further, more than 95% of businesses in the UK will be unaffected, as the qualifying capital expenditure will continue to be completely covered by the annual investment allowance, so companies, be they small, medium or large, will benefit from the CT cuts, including the cut in the small profits rate …, while most unincorporated businesses, which by their nature tend to be the smallest businesses in the economy, will still have their expenditure covered by the annual investment allowance.64

Nevertheless, in their report on the Bill published in June, the Lords Select Committee on Economic Affairs suggested that “post-implementation reviews of the outcomes of this reform package are highly desirable.” Many witnesses to the Committee had expressed support for the Government’s approach in setting out the direction for tax reform for coming years:

Most of our private sector witnesses thought that the CT road map was a welcome move forward. CIOT's comment was typical "We are encouraged at the development of the framework for corporation tax. The UK is very much in need of a long-term route map for its corporate tax system. The government is rightly aiming to make the UK's corporate tax system as internationally competitive as possible—but it needs to bear in mind that the most important aspects of the system are that it is stable, consistent and delivers certainty.” Even the EEF, which had some concerns about the content of the CT reform package, were positive about the general approach "The government's commitment to reforming the corporate tax system, therefore, has been commendable in that it has sought to provide stability and to reduce the tax burden on business."65

While the Committee agreed with this view, it raised concerns about the impact of all of the Government’s reforms in relation to their projected cost and uncertainties over their impact on corporate behaviour – especially in the case of a new relief for profits from patents – the ‘Patent Box’:

Given that:

64 HC Deb 4 May 2001 cc 711-3 65 The Finance Bill 2011, 17 June 2011 HL Paper 158 2010-12 para 203-4

21 Corporate tax reform (2010-16)

• the package of reforms may be unbalanced across business sectors, disadvantaging small and medium-sized businesses and manufacturing;

• the scope of the relaxations being introduced is very significant, particularly for controlled foreign companies and for intellectual property; and

• the evidence for the patent box seems largely theoretical;

we consider that post-implementation reviews of the outcomes of this reform package are highly desirable, as they are with all significant tax reforms. We recommend that the timing of these reviews should be agreed with business now and carried out with their involvement, so that the analysis and conclusions are agreed…

The difference between those witnesses [who gave evidence to the Committee] who were positive and those who saw the impact of the CT reform package as marginal or negative may have been influenced by the sectors they had in mind when making their assessment. Overall, and particularly for large business, we consider that the reform package makes the UK CT regime more competitive. The effect on small business and manufacturing should, however, be assessed carefully by way of the post-implementation reviews we have already recommended.66

In the months before the Government’s second Budget, critics of its approach to cutting public spending started to raise concerns over the apparent ability of multinational corporations to avoid UK tax, and to make claims over the amount of tax individual corporations ‘should’ have paid.67 In this context, writing in the Financial Times after the 2011 Budget, the economist Tim Harford suggested that the Chancellor was, in fact, on “the right side” of the argument, given that the largest companies accounted for nearly all corporate tax receipts:

According to the comprehensive Mirrlees Review produced recently by the Institute for Fiscal Studies, most corporation tax ultimately translates into lower wages rather than lower returns for shareholders. This is because investors with overseas options - that is most of them - will be tempted only by higher pre-tax returns. They will invest less, and with less capital per worker, wages will be lower. The attractions of corporation tax are mostly political ones - voters fondly assume that corporation taxes are a free lunch.

But leaving that to one side, the sheer magnitudes involved don't add up. Corporation tax revenue peaked at £46bn just before the crisis, and according to a recent report from Oxford University's Centre for Business Taxation, more than four-fifths of this is raised from the top 1 per cent of companies. The Robin Hood fantasy is that these revenues can be almost tripled on a sustainable basis - through a combination of tighter tax rules, more vigorous enforcement, and higher rates of corporation tax on large companies.

66 The Finance Bill 2011, 17 June 2011 HL Paper 158 2010-12 paras 231, 242 67 “Protests shift their focus to tax avoidance”, Financial Times, 17 December 2010;

“Tax: trouble to avoid”, Financial Times, 6 February 2011

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Mr Osborne thinks otherwise … [and he] is on the right side of this argument. Corporation tax revenue, relative to the size of the economy, has for three decades tended to be higher than in Germany, France and the US, in spite of lower headline rates of tax. Also, while headline rates have plummeted from more than 50 per cent in 1982 to less than 30 per cent today, corporation tax revenue has barely budged relative to gross domestic product.

Mr Osborne might claim that lower headline rates of corporation tax lead to higher tax revenues. That is unclear. But all the Merry Men in the world will not triple corporation tax revenue. If any government were to try, businesses would scramble to relocate their operations - or perhaps just their accounting profits - to somewhere a little bit less, um, Robin Hoody.68

68 “Our would-be Robin Hood is still in search of a villain”, Financial Times, 24 March

2011

23 Corporate tax reform (2010-16)

4. Budgets 2012-2015: further cuts in the main rate

Following the 2011 Budget, the Coalition Government made three further reductions in the main rate of tax: cutting it by 1 percentage point in April 2012,69 cutting it by another 1 percentage point in April 2014,70 and, in Budget 2013, announcing the rate would be 20% from April 2015. The cut in the main rate of tax to 20% from 2015/16 was forecast to cost £1.1bn by 2017/18.71

The Budget report that year illustrated the impact of the Government’s approach by reproducing the results of an annual survey by the accountancy group KPMG on countries’ tax competitiveness:72

The Budget report noted that on the basis of other countries’ announced plans, by 2015 the UK would have the joint lowest rate of corporation tax in the G20, and a rate significantly lower than the US, Japan, France and Germany.

In December 2013 HM Treasury & HMRC published some analytical work that sought to model the impact of this series of rate reductions over the longer term. This economic modelling indicated that these tax cuts would boost business investment by between 2.5% and 4.5% over twenty years. Assessing the impact of this higher level of investment on GDP over this period, the report found that the dynamic effects of lower CT rates would cut the cost of the policy by between 45% and 60%.73 The report noted that this would be “a long term effect, so it is too

69 Budget 2012, HC 1853, March 2012 para 1.186 70 Autumn Statement, Cm 8480, December 2012 para 1.130 71 Budget 2015, HC 1093, March 2015 p36 (Chart 1.10), p67 (Table 2.2 – item br).

Initially this measure was forecast to cost £865m by 2017/18: Budget 2013 HC 1033, March 2013 p64 (Table 2.1 – item 26).

72 Budget 2013 HC 1033, March 2013 p41 73 Autumn Statement, Cm 8747, December 2013 para 1.157-8

Number 05945, 25 July 2016 24

early to compare with recent receipts data”, though it went on to cite some survey data about the possible impact of this policy over the last four years:

The 2012 HMRC Tax Opinions Panel Survey (TOPS) report, found that 72 per cent of largest 800 businesses based in the UK felt the Corporation Tax reduction of 4 per cent between 2010 and April 2012 would have a positive impact on the competitive position of their business. Moreover, 90 per cent of these businesses thought that the Corporation Tax reductions would be effective for maintaining the UK’s competitive position. Additionally, in the World Bank’s annual Doing Business reports, which assess countries’ business environments in a range of categories, the UK has gone from 24th to 14th in the world for ‘paying taxes’ in the past two years, reflecting the reduced burden of Corporation Tax in the UK.74

The Treasury Committee considered the Treasury’s dynamic modelling exercise in its report on the Autumn Statement. It noted the reservations about its use expressed by the Treasury, and by Carl Emmerson, deputy director at the IFS, when he gave evidence to the Committee:

The results of the modelling exercise, as with all economic modelling, are subject to some degree of uncertainty. The Treasury’s paper states: “The Computable General Equilibrium (CGE) model is subject to some uncertainty. This is principally around the parameters included, for which sensitivity analysis is carried out. Economic uncertainty, not captured by the model, could also impact on the results in the short term. Nevertheless, the results are broadly consistent with the wider academic literature which finds that reductions in Corporation Tax boost investment leading to higher GDP and partial revenue recovery.”

Mr Emmerson of the IFS also emphasised the uncertainties involved: “Clearly you have to be very careful, because if you change those assumptions, you could get a different answer and the pay-off is over a very long time. It is not like you can do the change and then see a year later whether it has worked out. You have to wait 20 years before you get the full response if the model is correct. Clearly there are risks there and there are a lot of uncertainties.”75

When he gave evidence to the Committee the Chancellor said that he had commissioned the report to “move the debate” that “lower taxes can, at least in part, pay for themselves through the additional investment and economic growth that they bring.” Mr Osborne underlined that the existing ‘static scoring’ approach would continue, in quantifying the direct costs of policy changes in Budgets and Autumn Statements.76 In his evidence the chairman of the Office for Budget Responsibility (OBR), Robert Chote, underlined that the OBR had not certified the CGE model for cutting CT rates, and its results had not influenced the OBR’s forecasts, though some of the wider ‘macro’

74 HM Treasury/HMRC, Analysis of the dynamic effects of Corporation Tax reductions,

5 December 2013 pp32-3. The Conservative Government published updated estimates in July 2015 (Summer Budget 2015, HC264, July 2015 para 1.240),

75 Ninth report of Session 2013-14, HC 826, 8 March 2014 p37 76 HC 826, 8 March 2014 Q59

25 Corporate tax reform (2010-16)

effects that this work had charted were, in fact, acknowledged in the OBR’s estimates:

“You have outlined a number of the interesting effects there, one of which is the reduction in corporation tax reduces the cost of capital, encourages business investment with a potential knock-on effect on GDP. That is in the forecast. We make adjustments for that effect when we have included corporation tax measures in the past. We have pushed up business investment by, I think, roughly the same proportion, 3 per cent or so, as this paper would suggest.

The paper also points out that you need to look at the impact of profit shifting. Again, our forecasts have made an adjustment for profit shifting, which reduces the direct static cost of the measures. The area where I think this analysis suggests more impact than we would include is the fact that it does more to boost consumer spending than it does to boost investment …

It is important to bear in mind that this paper is not a comparison between the way we treat these things and an alternative way. Quite a lot of the stuff that they are highlighting as potential effects are things that we take into account when we are doing our forecast anyway.”77

The Committee underlined that this type of analysis was “subject to great uncertainty”, and while there was “some merit in continuing to study the dynamic effects of policy decisions … we will expect the OBR to continue to reach its own independent judgement on the effects of tax changes on the yield.”78

Alongside the 2014 Budget, the OBR published a briefing paper giving more detail on the way in which it carried out this work, and in this, commented on HMRC’s CGE modelling for CT cuts:

3.19 Exercises of this sort are useful as a sense-check on our own costing approach. The HMRC study posited a boost to investment (via a lower cost of capital) similar to that which we incorporated in our forecasts when the CT cuts were announced. We did not increase our forecasts for wages, consumption and aggregate GDP by as much as the HMRC study would have implied, partly because we took into account ‘whole package’ implications for monetary policy that the CGE model does not capture. Had we incorporated effects of this magnitude, our forecasts for economic activity over the current parliament to date, which have already proved over-optimistic, would have been even more so.

3.20 CGE modelling holds out the prospect of potentially useful insights for our policy costings, but it does not offer a realistic alternative to the way in which the current approach to costing feeds into the forecast process. As HMRC itself has noted, its CGE model “is not a short-term forecasting model. Its strength is in modelling the long-term economic effects of policies rather than short-term economic fluctuations.”

3.21 Policymakers and interest groups will naturally find dynamic scoring attractive as a way to highlight the potential positive spillovers that some tax measures have for the economy and other revenues. But they may be less keen to use the same approach to

77 HC 826, 8 March 2014 pp 37-8 78 op.cit. para 66

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highlight the impact of other tax changes that increase distortions and have negative spillovers.79

In April 2014 HM Treasury & HMRC published a second report using the CGE model to assess the dynamic effects of the Government’s reductions in fuel duty over the next twenty years.80 Writing on this in the Financial Times, the columnist John McDermott raised some concerns over the use of this modelling technique, first giving some background on what CGE modelling was in practice:

The CGE model is a large-scale numerical model that simulates the interactions in an economy and what happens when a policy such as a tax cut is introduced. That one sentence description hints at two parts that make a dynamic CGE model different from other techniques used to forecast changes to the economy.

The first is “interactions”; the CGE model is “inter-sectoral”, “inter-institutional” and “inter-temporal.” Take the example of fuel cuts. Some models might look at how demand for fuel has increased in the past when fuel duty is reduced. From that, analysts will try to estimate the cost to the Treasury based on what they know about the size of the cut and people’s behaviour at the pump. But the CGE model looks beyond direct effects. It also estimates what a cut might mean for other industries, on households and businesses, and over time, as people adjust to new price levels – so-called “second order” effects. 81

The HMT/HMRC paper on corporation tax has a graphic to illustrate the different parts of the economy that the CGE model is trying to incorporate in this case:82

79 OBR, Policy costings and our forecast : Briefing Paper No.6, March 2014 pp20-21 80 HMT/HMRC, Analysis of the dynamic effects of fuel duty reductions, 14 April 2014 81 “Off message blog: Why you should care about dynamic modelling”, Financial

Times, 15 April 2014 82 HM Treasury/HMRC, Analysis of the dynamic effects of Corporation Tax reductions,

5 December 2013 p10

27 Corporate tax reform (2010-16)

As Mr McDermott explained, the second aspect of this type of modelling is to assess the impact that a particular policy change will have on the way in which these constituent elements interact in future:

The second aspect is “a policy … is introduced”. Forecast models often try to establish the historic relationship between variables to suggest a future relationship. In the econometric jargon, however, this brings the problem of “policy invariance“. In English, this criticism says that a policy change – such as a fuel or a corporation tax cut – itself alters the relationship between the variables, and therefore the past isn’t a great guide to the future. In the case of a fuel duty cut, the argument would go that one cannot simply look at the historic relationship between GDP and tax revenues; one must look at the specific role of fuel duty in the country’s output.

In short, CGE models are designed to help analysts to isolate the impact of a specific policy change and to understand the indirect effects of that change. It does this by producing two simulations, one with the policy change and one without. This is an excellent idea in principle but the model still needs to be treated carefully.

The author went on to discuss what CGE modelling is unable to deliver, and suggested that it was unlikely that many would understand the limitations of this approach when the headline results of any exercise were presented:

To quote the HMRC explanatory paper on the CGE model: “It should be noted that the model’s results are not forecasts.” This is more than just wonk semantics. A CGE model can be a great tool for individual policy analysis. But it has several limitations that should be appreciated before anyone starts claiming that it has proved their particular view of the world. Chances are, it will have done nothing of the sort. One cannot simply add up individual results about the supposed benefits of tax cuts to create a comprehensive picture of the future of the economy. We have seen enough mishandling of financial models over the past few years to know that models are often only as good as their users.

CGE doesn’t incorporate monetary policy or spare capacity, two crucial aspects to any macroeconomic forecasting model. It is a closed model – there is no sophisticated place for exports and imports in its analysis. It doesn’t produce confidence intervals. It doesn’t take into account “externalities”. Its results are sensitive to whichever year it takes as its baseline. It is inherently biased towards the benefits of tax cuts on output. And it is an ex ante study: we won’t know how accurate it is in predicting the long-term effects of various policies until decades later…

Many of us – myself included – are ignorant of precisely how the model operates. Many of us are not maths whizzes or programmers. More importantly, HMRC does not make it easy for nonprogrammers to understand the model – a criticism made by its so-called “peer review” by the lovely sounding Loch Alpine Economics.83 The authors of that review commented that “The current model package is poorly documented” … The CGE model is based on solid theory. If it can get us closer to the truth about how individual policies might work, then all power to it. But we

83 This peer review is collated with background material on HMRC’s approach to CGE

modelling on Gov.uk.

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should remember that a simulation is just that. And we should be wary when technical exercises look like ideological ones.84

Helen Miller and Thomas Pope at the IFS also expressed some reservations about dynamic scoring in a review of the Coalition Government’s reforms to corporation tax, published in February 2015:

Importantly, creating a policy cost that accounts for all effects, on all agents in the economy, is impossible. Estimating an approximation to the full general equilibrium effects requires a number of assumptions (e.g. how responsive investment is to tax and the extent to which firms substitute between capital and labour) and modelling simplifications (e.g. in this case using a model with a single country). In practice, this is a difficult exercise and the results will be imperfect. The HMRC analysis has followed the techniques developed in the academic literature and attempted to make reasonable assumptions. There is, however, necessarily a high degree of uncertainty around the precise estimates.

In summary, it is plausible that some of the revenue costs [in official estimates of these tax reforms] … will be recaptured through higher investment, but we cannot say whether 45% of receipts will be recouped or even how much confidence we should have around the 45% figure. This could be an overestimate (underestimate) if, for example, investment is less (more) responsive to tax than assumed or if wages rise by less (more) than expected. The actual path for corporation tax revenues will also be affected by other corporate tax measures (e.g. reductions in capital allowances work to reduce investment) and non-corporate tax measures (e.g. changes to income tax impact consumer demand and therefore investment incentives).85

While this work has been cited by the Government in answer to PQs on its approach, it has underlined the difficulties in assessing the impact of tax policy on trends in foreign direct investment:

Adam Afriyie: To ask Mr Chancellor of the Exchequer, what estimate he has made of the amount of foreign direct investment generated since 2010 as a direct result of the lower rate of corporation tax.

Mr Gauke: Since 2010, the Government has cut the main rate of corporation tax from 28% to 21%. It will fall further next year, to 20%, giving the UK the joint lowest rate of corporation tax in the G20. The Small Profits Rate has also been cut to 20%.

These cuts are a central part of the Government’s long-term economic plan. They are intended to make the UK more competitive, supporting business investment and job creation.

Government modeling suggests that the corporation tax cuts introduced in this parliament will:

• increase business investment by between 2.5% and 4.5% (£3.6bn to £6bn in today’s prices) in the long term

84 “Off message blog: Why you should care about dynamic modelling”, Financial

Times, 15 April 2014. See also, “Cut to corporation tax cost £5bn a year as spending squeeze persists”, Financial Times, 10 July 2014.

85 Corporation Tax Changes and Challenges, IFS Briefing Note BN163, February 2015 p11. For a full discussion of these issues the authors cite, S.Adam & A.Bozio, Dynamic scoring, OECD Journal on Budgeting, 2009/2.

29 Corporate tax reform (2010-16)

• increase GDP by between 0.6% and 0.8% (£9.6bn to £12.2bn in today’s prices) in the long term.

Foreign direct investment decisions are influenced by a range of factors including skills, market access, and infrastructure. Consequently, it is difficult to isolate the exact impact of the corporation tax cuts from reform in other areas. But recently published data on inward investment has been very encouraging.

In their 2013/2014 Inward Investment Report, UKTI said ONS data showed the value of FDI stock increased from £725.6bn in 2010, to £936.5bn in 2012.

UKTI also reported that the UK attracted more inward investment projects last year than in any year since records began in the 1980s. UKTI recorded 1773 projects, creating 66,390 new jobs.

This is supported by analysis from Ernst and Young, who use their own independent database to assess inward investment. Ernst and Young’s Annual Attractiveness Survey, published in June, showed the number of inward investment projects in the UK had risen by 15% in the past year, against the background of a European market that grew by just 4%.

As noted above, it is difficult to isolate the impact of tax policy on these trends, and UKTI does not have estimates of how much of the new investment has been a direct result of the lower rate of corporation tax. But it is clear that the corporation tax reforms have changed perceptions of the UK competitiveness. For the past two years, the UK has ranked highest in the KPMG survey on international tax competitiveness, ahead of countries including the US, the Netherlands and Switzerland.86

Returning to the classic method of assessing the impact of these changes, at the time of the 2013 Budget HMRC gave estimates of the numbers of companies to benefit from this last cut in the main rate of corporation tax, and the impact of merging the main rate and the small companies’ rate:

This measure will lower the tax bills of 40,000 businesses which have profits over £1.5 million and pay at the main rate of CT; and a further 41,000 which have profits between £300,000 and £1.5 million and pay at the main rate of CT but receive marginal relief.87

The introduction of a unified rate will remove the requirement to determine which rate of CT a company should be paying, which represents a reduction in annual administrative costs for companies previously paying at the small profits rate. There will also be an ongoing administrative burden saving for those companies which previously made a claim to marginal relief.88

In a review of the tax treatment of small businesses published in March 2011, the Office of Tax Simplification raised the possibility of merging the two tax rates this way:

86 PQ206722, 1 September 2014 87 [By way of comparison, in answer to a PQ in November 2013, HMRC sent a notice to

file a company tax return to just over 1.9m companies in 2012/13. The number “represents HMRC’s estimate of the number of companies that might be within the charge to corporation tax” HC Deb 7 November 2013 c290W.]

88 HMRC, Corporation tax: main rate and small profits rate – tax information & impact note, 20 March 2013

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Finance Act 1972 introduced the ‘small companies’ rate’ (now called the small profits rate) of corporation tax for companies whose profits did not exceed £15,000. Marginal relief from the main rate of corporation tax was available for companies whose profits were between £15,000 and £25,000. The rationale behind the relief was to enable companies with lower profits to have greater retained profits to enable them to finance their capital expenditure …

Historically, the differential between the small companies’ rate (now called the small profits rate) and the main rate of corporation tax has generally been 10% or greater. As the intention of the Government is to narrow this differential to 4% in 2014, we propose that consideration should be given to having a single corporation tax rate.

This would enable businesses to operate through as many different entities as they wished and, for these purposes, the associated companies rules could then be abolished. The marginal relief legislation and close investment company legislation would also become obsolete. The feedback we received suggests these would be welcome simplifications.89

In addition to these rate reductions, the Coalition Government increased the Additional Investment Allowance (AIA) twice: first, from £25,000 to £250,000 from 1 January 2013, and second, to £500,000 from April 2014 until December 2015.90 As a consequence of this second increase, “up to 4.9 million firms – 99.8% of businesses – will receive 100% up-front relief on their qualifying investment in plant and machinery. Three-quarters of the companies that will benefit from this increased tax relief on investment are outside London and the South East, and it will particularly help the agriculture and manufacturing sectors.”91

As noted above, the Government’s initial decision to combine reductions in tax rates with cuts in the value of capital allowances was criticised by some.92 Initially the Government proposed that the increase in the AIA would be for two years only.93 When this provision was debated during the proceedings of the Finance Bill in 2103, the then Economic Secretary, Sajid Javid, set out the Government’s reasons for this increase being time-limited:

We recognise that the change follows quite soon after the decrease in the annual investment allowance to £25,000 that was announced in the June 2010 Budget and implemented in the Finance Act 2011, which took effect from April 2012. The Government’s central position has not changed and remains that, in general, a lower corporation tax rate with fewer reliefs and fewer allowances will provide the best incentives for business investment, with the fewest possible distortions.

89 Small business tax review, March 2011 pp31-3 90 Autumn Statement, Cm 8480, December 2012 para 2.74; Budget 2014, HC 1104,

March 2014 para 2.107 91 HC 1104, March 2014 para 1.102 92 A critique on the EEF’s blog in June 2012 (“Capital allowances blotting govt attempts

to make tax system competitive”, 29 June 2012), cited comparative data on the value of capital allowances across countries published by the Oxford Centre for Business Taxation earlier that year.

93 HC Deb 5 December 2012 c881

31 Corporate tax reform (2010-16)

That is why we have announced a further reduction in the main rate of corporation tax, as we discussed earlier, from April 2015 and is also why the current 10-fold increase in the maximum annual investment allowance is time limited rather than permanent. We feel strongly and recognise, however, that the particular challenges that businesses face in the current economic climate make positive action by the Government to support and encourage increased investment in the short term both appropriate and highly desirable, which is why we are introducing the temporary measure.94

When he announced the expansion of the AIA in his 2014 Budget, the Chancellor stated that the allowance would return to £25,000 after 1 January 2016:

In 2012, I increased the annual investment allowance tenfold to £250,000. This generous allowance was due to expire at the end of this year, but all the business groups urged me to extend it. So we will, but we will do more. We will double the investment allowance to £500,000, extend it to the end of 2015 and start it next month—99.8% of businesses will get a 100% investment allowance. Almost every business across Britain will pay no up-front tax when they invest in the future. It costs £2 billion in the short term, so when we say that we are going to get Britain investing and to back growth around the country, we mean it.95

Although business groups strongly welcomed the announcement,96 the then editor of Taxation, Mike Truman, was critical of the way businesses will have to calculate the value of the allowance where their accounts span the date when the AIA reverts to £25,000:

Turning to capital allowances – give me strength. For corporation tax rates, the government acknowledges the need for certainty, even though companies are subject to the vagaries of the economy in making profits. Their plant and machinery expenditure tends to be much more tightly planned, but this chancellor and his predecessor have delighted in making the annual investment allowance as unpredictable as possible.

At various points between 2008 and 2014, the AIA will have been £50,000, £100,000, £25,000, £250,000 and £500,000. In January 2016 it drops back down to £25,000, unless the chancellor decides to meddle again next year.

The transitional rules make it far worse. Look at the bottom of page A33 in the main Overview of Tax Legislation and Rates (OOTLAR). With a March year end, a company can buy machinery on 31 December 2015 for £381,250 and still get full AIA if that is the only purchase in the period. Wait a further day until 1 January 2016 and you get (no, not £25,000, that would be far too obvious) £6,250.97

94 Public Bill Committee (Finance Bill), Fifth sitting, 23 May 2013 cc145-6 95 HC Deb 19 March 2014 c790 96 For example, “Sector boosted by corporation tax allowance rise and extension to

2015”, Financial Times, 20 March 2014 & “Investment breaks put wind in sails of small firms”, Times, 20 March 2014

97 “Budget 2014: 4x4”, Taxation, 20 March 2014. When the Chancellor announced the rise in the AIA to £250,000, Mr Truman wrote, “how are businesses supposed to plan for capital investment when the amount they can deduct for tax in the first year goes up and down like a roller-coaster?” (“Stop messing about”, Taxation, 13 December 2012).

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Provision to cut the main rate of corporation rate in 2015, and to increase the AIA from April 2014, was made in the Finance Act 2014 (specifically ss 5 & 10). The House debated the first of these at the start of the Committee stage of the Finance Bill in April.98 Speaking for the Opposition Shabana Mahmood argued that the Government’s priority should be cutting business rates for SMEs, rather than a further cut in the main rate of CT:

We have supported the reduction in the rate of corporation tax in this Parliament, except to raise concerns … about the financing of that change at the start of the Parliament by getting rid of investment allowances on which the Government have recently U-turned. But as the figures show, the change to the main rate of corporation tax, the central policy for business taxation, does not help 98% of business in this country …

Given how much businesses are struggling and given the collection of issues that SMEs are facing, we have said that the next Labour Government would cut business rates in 2015 and then freeze them in 2016. In 2015, we would cut business rates on properties with an annual rental value of less than £50,000, taking the rates back to the level of the previous year, and then freeze them for such properties in 2016. As we have said, we would pay for that by reversing the additional cut in the main rate of corporation tax due to go ahead next year, when it will fall from 21% to 20% …

Even at 21%, our corporation tax rate would remain competitive, being second lowest in the G8 and second lowest in the G20 … I do not believe that putting corporation tax back up from 20% to 21% would have too great an impact on our capacity to attract businesses to this country.99

In response Treasury Minister David Gauke argued that unifying the main rate and small profits rate would be of significant benefit to companies, and that increasing the main rate to cut business rates posed risks to the UK’s competitive position and would be unfair:

Next year, there will be a single headline rate of corporation tax. That will bring about a major simplification of the tax system. For those outside the ring-fence regime, it will mean the end of the complex marginal relief system that currently captures 45,000 companies. It also gives us scope to abolish the complex “associated companies” rules and replace them with a much simpler rule based on 51% ownership of a firm …

Labour has said that it will increase the main rate of corporation tax to 21%, which would make it the first party to increase the main rate of corporation tax in more than 40 years. It was last increased in 1973, although, to be fair, that was part of a restructuring that was revenue-neutral; it was back in the 1960s that the British Government last sought to increase the yield from corporation tax. No other G7 country has increased its corporation tax since 1997, and those increases were reversed within a year or two …

[The Labour Party has also] said it would use the increase to reverse the 2015 business rates increase and freeze business rates in 2016 for all properties with a rateable value below £50,000. In

98 HC Deb 8 April 2014 cc140-174 99 op.cit. c142, cc146-7

33 Corporate tax reform (2010-16)

other words, Labour would take money from one set of businesses to give it to another. By contrast, we want to cut taxes for large and small businesses, so, instead of raising one tax to cut another, we are cutting both corporation tax and business rates.100

Notably the IFS has argued that achieving a single rate of corporation tax has been a “real achievement” in the Government’s tax policy, which should not be reversed, irrespective of the faults there may be in the structure of business rates:

The merits of cutting business rates and raising corporation tax rates are debatable. Business rates are clearly ill designed. They distort firms’ incentives regarding how they produce their output, with negative consequences for the efficiency of the production process. But corporation tax can also have negative consequences. Indeed, corporate profits can move overseas in a way that property cannot. This is not to say that business rates should not be reduced.

But if the Labour Party (or any other party) wishes to reduce business rates, there may be better places to find the revenue than increasing corporation tax. Increasing just the main rate of corporation tax would also complicate the tax system. The reduction of the main rate of corporation tax to 20% in April 2015 brought it into line with the small profits rate … and, in effect, eliminated a system in which there were not two separate rates but three: the small profits rate applied to profits below £300,000, the main rate applied to profits above £1,500,000 and a system of relief (in effect, a third marginal rate) operated between these two thresholds.

The rationale for having a small profits rate of corporation tax was never clear in the first place – the redistributive motivation for a personal income tax system does not apply to firms – and moving to a single rate was a welcome simplification. Labour’s policy now is to have – apparently permanently – a rate of 20% on profits below £300,000, a rate of 21.25% on profits between £300,000 and £1,500,000, and a rate of 21% on profits in excess of £1,500,000. Having three separate rates that are so similar to each other looks very peculiar. There is no economic rationale for it. The simplification of moving to a single rate of corporation tax (whether that is at 20% or some other rate) is a real achievement of the coalition government’s tax policy, and it is one that should not be reversed.101

Provision to increase the AIA was considered in Public Bill Committee on 1 May 2014. Speaking for the Opposition Cathy Jamieson asked for a formal review of policy in this area, to inform “how we make AIA simpler, how we provide a degree of certainty and how we ensure that we have a fair system that supports small businesses as well as larger corporations.”102 In his response, the Minister, Mr Gauke, set out the Government’s case for increasing the AIA this year, though on a temporary basis:

100 op.cit. cc167-8. An amendment moved by the Opposition for a review of the impact

on SMEs of the 1% cut was negatived (by 289 votes to 219), and the clause agreed without amendment.

101 Taxes and Benefits: The Parties’ Plans, IFS Briefing Note BN172, April 2015 pp39-40 102 Public Bill Committee (Finance Bill), Third sitting,1 May 2014 c83

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The allowance also offers support to businesses in all sectors of the economy that invest in plant and machinery. Firms in the transport, communications, manufacturing and agricultural sectors will benefit especially. Such widely spread benefits have led to six in 10 businesses in the UK saying that the introduction of the £250,000 AIA measure in January 2013 supported the competitiveness of their firm. We have listened to industry’s recommendation that an increased AIA should be extended to 2016, and have not only acted, but gone further by doubling its generosity to offer even more help to firms that want to grow …

The Government are lobbied about various proposals for new allowances and measures to incentivise investment, and we believe that an increase in the AIA limit is simpler for businesses to understand … The arrangement is temporary—it will not apply after 31 December 2015—and we believe that that temporary status will encourage businesses to invest. The OBR says that it will bring forward investment of about £1 billion … At this time in the economic cycle in particular, when confidence is recovering, we want to bring forward investment to maintain the momentum in that recovery. It is absolutely right to make the intervention now.103

The Coalition Government did not announce any further changes to either the rates of corporation tax or capital allowances in their last Budget of the 2010-15 Parliament. Due to the timing of the Dissolution of the House, the House’s scrutiny of the Finance Bill published after Budget 2015 was taken, in all its stages, in a single day. This legislation provides for the rate of corporation tax to remain 20% for 2016, and this was one of the few specific provisions selected for debate. The focus of the exchanges was on an Opposition motion to review the impact of this change, as opposed to a reduction in business rates.104 Shabana Mahmood argued that “it makes no sense for the Government to make it a priority to cut a tax that is already among the most competitive, and not help smaller firms with very large costs.” In response Treasury Minister David Gauke argued “reversing the progress we have made [in cutting the rate] would be a big mistake and send a terrible signal to businesses around the world.”105

In a recent review of the Coalition Government’s reforms, mentioned above, Helen Miller and Thomas Pope at the IFS noted that the UK’s 20% rate was definitely more competitive, but that the statutory rate was only one aspect of the competitiveness of the corporate tax regime.106 The Government’s reforms to capital allowances had created a less competitive tax base, one that disproportionately harmed firms investing heavily in plant and machinery:

Compared with other countries, the UK has a particularly ungenerous set of capital allowances.107 That is, the UK allows a smaller share of capital expenditure to be deducted from revenues

103 op.cit. cc85-6. In the event the Opposition’s amendment for a formal review was

withdrawn, and the provision agreed without amendment. 104 HC Deb 25 March 2015 cc1513-26. 105 HC Deb 25 March 2015 c1518, c1526 106 £8 billion giveaway used to boost corporate tax competitiveness, IFS Observations,

26 February 2015 107 See Table 6, G.Maffini (ed), Business Taxation under the Coalition Government,

Oxford University Centre for Business Taxation, February 2015

35 Corporate tax reform (2010-16)

each year. As a result, the net present value of the stream of allowances is lower in the UK than in most other developed countries. The AIA is an exception to this – it allows 100% of investment costs to be deducted from revenues in year 1. Therefore, the UK base is uncompetitive for investments above the AIA threshold.

To get some sense of the overall effect of tax changes, one can consider an effective tax rate – a measure that combines information on how both the tax rate and the tax base affect the burden of tax. An effective marginal tax rate (EMTR) is used to measure the tax burden on a project that just breaks even and is important in determining the level of investment firms undertake. An effective average tax rate (EATR) is used to measure the tax burden on a project that makes a profit and is important in determining where firms locate investment projects. Both the EMTR and the EATR have been reduced in the UK since 2010. However, on these measures, the UK system ranks less highly in the G20 than on the rate alone …

The EATR has fallen by much more than the EMTR as a result of coalition policy changes.108 This has implications for the types of firms that are likely to benefit most from net tax cuts in this parliament. Firms that invest most heavily in plant and machinery (and industrial buildings) are harmed disproportionately by recent expansions of the base (although the rate cuts mean that most still benefit overall and those with investment below the AIA threshold are unaffected).109

This does not imply that all high-investing firms are relative losers. An increasing share of overall investment is accounted for by investment in intangible assets, such that some of the relative winners will be those firms that make important long-term investments in skills and ideas, which benefit relatively less from current allowances. Firms with high profits relative to the amount of investment they do will benefit disproportionately from the rate cuts.

The package of measures has done more to make the UK an attractive location for internationally mobile investment than to increase investment incentives at the margin for firms that are already located here. The lower tax rate also makes the UK a more attractive location to earn income, and therefore reduces the incentives for firms operating in the UK to attempt to shift profits to lower-taxed countries.110

As noted in this piece, Giorgia Maffini at the Oxford Centre for Business Taxation edited a review of the Government’s policy for the Centre.111 In a summary for the Tax Journal, Ms Maffini underlined the conclusion that “today’s UK system is very attractive for the location of headquarter companies and more generally for the location of activities 108 The intuition for this is straightforward: as one moves from considering a project

that breaks even to one that makes a positive profit, the tax rate becomes more important and capital allowances less so.

109 G.Maffini, Corporate tax policy under the Labour government, 1997–2010, Oxford Review of Economic Policy, 2013, 29, 142–64 finds that the transport and communications, agriculture, and hotels and catering sectors have a relatively high intensity of capital allowances for plant and machinery. Financial services, business services, distribution and construction are highly profitable sectors with lower investment intensity.

110 Corporation Tax Changes and Challenges, Briefing Note BN163, February 2015 pp11-13

111 Business Taxation under the Coalition Government, OUCBT February 2015

Number 05945, 25 July 2016 36

of multinational companies.” She went on to discuss the possible costs of this reform, particularly in relation to fairness:

The question of the fairness of the corporation tax has been the subject of much debate in the academic literature, and is still unresolved. Much of the literature points to a large part of corporation tax being passed on in lower wages, although there are mixed results on that. There are, though, no serious studies that have been able to identiy whether corporation tax is progressive or regressive. There is therefore no evidence that reducing the corporate income tax exacerbates inequalities of income.

Because its real incidence is uncertain, the corporate income tax is not the right tool for addressing redistribution. The main tools for redistribution remain personal income tax, inheritance tax and possibly recurrent taxes on property.112

Looking at the challenges that would face the new Parliament, Ms Miller and Mr Pope made the crucial point that the standard for a competitive tax system is a moving target:

The UK may not have the most competitive corporate tax system in the G20, but the 2015 regime is more competitive relative to other countries than the 2010 one was. However, as we noted earlier, tax rates across the developed world have been lowered over the past three decades, in part as a result of competitive pressure. It would be reasonable to expect that other countries will seek to maintain the relative attractiveness of their tax systems. The standard for a competitive tax system is therefore a moving target.

The Patent Box is a prime example of this. Since the UK announced the policy in 2009, similar policies have been introduced in five more countries. Others, including the US, are considering following suit. Most recently, the Irish Finance Minister announced that Ireland is considering a ‘Knowledge Development Box’.113

Maintaining competitiveness may therefore lead to further demands on UK corporate tax. One way that countries have attempted to limit the revenue consequences of rate cuts is to broaden the tax base. As we noted above, the Coalition’s policies, despite some base broadening, are forecast to lead to a large reduction in receipts. Given that the UK base is already comparatively ungenerous, there may be limited scope to fund any further rate cuts with base broadening. In addition, being a competitive location for real activities may require a more generous tax base.114

112 “Analysis: Business taxation under the Coalition Government”, Tax Journal, 1 May

2015 113 See Financial Statement of the Minister for Finance, October 2014 114 Corporation Tax Changes and Challenges, February 2015 p15

37 Corporate tax reform (2010-16)

5. Corporate tax avoidance

5.1 Taxing multinational companies Concerns about corporate tax avoidance have focused on the ability of multinationals to aggressively reduce their tax liabilities. There are two related causes for this. In common with many other countries, the UK operates a source-based corporation tax, which aims to tax profits that are created in the UK. However, there are inherent problems in allocating the rights to tax profits between nations – to determine precisely what share of a company’s worldwide profits are taxable by each national authority. These difficulties have grown worse with recent trends in globalisation and the growing importance of both intellectual property (brands, patents) and internet-based services.

Second, as the corporate tax system is based on taxing mobile activities, national governments face strong incentives to compete to attract corporate investment through their tax systems. As a paper from the Oxford Centre for Business Taxation points out, this goal “is not easily reconciled with another goal often explicitly held by governments: ensuring that companies should pay to some country or countries a reasonable amount of tax on their global profits.”115 From an international point of view, tax may resemble a zero sum game – the greater the share of profits claimed by one country, the smaller the share that can be claimed by another. Every location – be it Amsterdam, Barbados, or the City of London – is always offshore to somewhere else. The incentives one government offers to encourage inward investment can, whatever the motives behind them, be seen by its neighbours as the bribes of an unrepentant tax haven.

Active competition between governments, and new pressures of the economic environment on the international system, have created opportunities for companies to ‘profit shift’ – to manipulate their real or reported activities so they can declare a greater share of their worldwide profits in low-tax jurisdictions, eroding the tax base in high-tax jurisdictions. As the House of Lords Economic Affairs Committee has argued, “the effect is to make corporation tax payments in a given country largely voluntary for multinational companies”:

The original aim of the current system, first set out by the League of Nations in the 1920s, was to avoid double taxation of profits, where a company might be taxed on the same profits by two countries, so hampering growth and investment and damaging the world economy. Nowadays concerns are more about non-taxation, where companies exploit the provisions of the system that were originally intended to prevent double taxation or mismatches between countries in provisions, in order to allocate their profits to jurisdictions with a low tax rate or to avoid taxation altogether.116

115 M.Devereux & J.Vella, Are we heading towards a corporate tax system fit for the 21st

century?, Oxford University Centre for Business Taxation, October 2014 p3 116 Tackling corporate tax avoidance in a global economy, 31 July 2013, HL Paper 48 of

2013-14 p5, para 26

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This is not to suggest that press campaigns in recent years that have vilified individual corporations – Starbucks, Google – for not paying their ‘fair share’ offer a wholly accurate picture. However, to see the limitations of that approach it is necessary to take a step back: to consider what governments are trying to tax.

The present international framework of corporate taxation is based primarily on two elements: a network of bilateral double tax treaties; and, the guidelines for ‘transfer pricing’, established by the OECD:

More than three thousand bilateral double tax treaties are in force, typically based on the OECD Model Tax Convention on Income and Capital … Double taxation treaties seek to set out which country can tax certain income. Broadly they aim to distinguish active business income from passive income such as dividends, royalties and interest. Treaties define what is an active business operation in a given source country (a "permanent establishment", PE) and give that source country the main right to tax the profits of that operation. By contrast, passive income is primarily taxed in the country in which the recipient resides.

The second main element of the international tax system, the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, provides that transactions between national parts of a multinational company should be priced for tax purposes as though with independent third parties. The OECD summarises its guidelines (which run to over 300 pages) as providing: "guidance on the application of the "arm's length principle" … on the valuation, for tax purposes, of cross-border transactions between associated enterprises.”117

As the IFS have noted, one problem with the ‘arm’s length principle’ is that “the transactions it pertains to are taking place between related companies, not between third parties, such that is no observable market price”:

Consider the following example. Imagine that a company located in the Netherlands creates and owns the intellectual property for a new technology (or a service, or a brand). A related UK company (i.e. both companies are part of the same group) markets and sells a product that embodies the technology in the UK. Royalties are paid from the UK company to the Dutch company. The royalty should reflect the value of the technology (i.e. how important the technology is in the creation of the UK profits).

If the technology is very important (implying that the source of the profit is largely the activities in the Netherlands), then the royalty payments will be high and the UK taxable profits relatively low. This would be the correct outcome under the UK tax system and would not constitute avoidance (arguably, this would also not be avoidance even if the real activity were initially located in the Netherlands as a result of a more favourable tax regime).

Difficulties arise because it is not necessarily clear what value the royalty should take, and therefore where profits are created and should be taxed. If the product were contingent on the technology (such that there would be no sales without the technology), then arguably all profits arising from UK sales could be attributed to the technology (and therefore to the Dutch company). However, the activities of the UK firm were important

117 HL Paper 48 of 2013-14 paras 28, 30, 31

39 Corporate tax reform (2010-16)

in making the sales, so it seems reasonable that at least some part of the profit should accrue to the UK. In cases where activities (in this example, the technology and the services of the UK firm) are complementary, it is difficult to ascertain the value of one independently of the other. This creates uncertainty over how much income should be allocated to different countries for tax purposes.

Similar issues arise for all transactions – for example, loans, charges for the use of headquarter services, the purchase of intermediate goods – that take place within a company but across the borders of tax jurisdictions. All require a price (which is often not observed in the market) to be placed on the transaction.118

As the authors go on to comment, “firms – which usually have more information and resources than tax administrations – have scope to take advantage of uncertainty around the correct transfer price in order to gain a tax advantage.” Intellectual property poses particular risks for profit shifting, “because there is often not a clear geographical location associated with the creation of new ideas and it is difficult to assign arm’s length prices to new technologies that are not traded on the market.”119

These pressures have been growing for some time, as noted by the IMF in a paper on international taxation published in 2013:

A century ago, when the basic principles were put in place, foreign direct investment was largely a bricks-and-mortar business. Developments since, however, mean that this framework has enabled extensive ‘base erosion and profit shifting‘ (BEPS) - the artificial reduction of taxable profits and/or detachment of tax location from the location of business activity...

Key factors underlying these include the increased importance of:

• Intra-firm transactions and complex modern business models. Intra-firm flows, including the provision of intangibles, put increased strain on the notion of ‘arms-length‘ prices—those which would be set in the same transaction between unrelated parties—as a way to allocate profits between jurisdictions. Moreover, while the current international tax framework has been constructed predominantly through bilateral arrangements, whose primary focus is on allocating taxing rights between the two countries concerned, business models are now so globally integrated that looking at any two locations in isolation is unlikely to be sufficient to arrive at an appropriate split of tax base.

• Digital transactions. The current international tax architecture took shape when a physical presence was presumed necessary to undertake business activity. But IT advances now allow many more businesses to undertake substantial economic activity without the degree of physical

118 “Chapter 10: Corporate tax, revenues and avoidance”, IFS Green Budget, February

2013 pp291-2. For a longer worked example see, “Analysis: trading in the UK through a permanent establishment (PE)”, Tax Journal, 7 June 2013.

119 op.cit. pp292-3

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nexus required to be subject to the corporate income tax; by, for instance, providing services over the internet.120

• Financial sector innovation. The current international tax framework makes distinctions between forms of income (business profit, investment income, capital gains, etc.) and between ‘active‘ and ‘passive‘ income that financial innovation has made quite easy to engineer around.

• Intangibles. The increased importance of intellectual property rights and other intangibles—easy to move and hard to value—has posed particular difficulties.121

As an illustration of these trends, the IFS has noted recently that “about 60% of trade is in intermediate goods and much of this occurs within companies across country borders.” Furthermore “UK investment in intangible assets overtook investment in physical assets in the early 2000s, and continues to increase as a share of total investment.”122

HM Treasury set out some of the ways that multinationals have shifted profits to reduce their tax liabilities in a paper on reforming the international system published in March 2014:

Within multinational enterprises (MNEs), individual companies undertake their activities within a framework of group policies and strategies. The separate legal entities forming the group operate together as an integrated enterprise following an overall business strategy. Moreover, digital technologies have made it possible for businesses to supply goods and services from geographic locations that are distant from the physical location of their customers. This has made it easier to shift profits, which can be done in a variety of ways. These include:

• using corporate structures or financial instruments to exploit asymmetries in the tax rules of different countries to create a hybrid mismatch. The result is that transactions are treated as taxable in one country but not in another, or give rise to a deduction in both countries. As a result the MNE can end up paying no tax in either country, or gain a tax deduction in one country but no matching taxable receipt in the other;

• manipulating transfer pricing. Transfer pricing is used to determine how profits should be allocated to companies in different jurisdictions within a MNE, and is based on the “arms length principle” (which states that these transactions should be priced as if they were transactions between unrelated parties). MNEs can seek to manipulate transfer pricing to artificially separate their assets, capital and risk, so that profit can be declared in a low tax jurisdiction;

• using structures or new technologies to minimise the need for a physical presence within a tax jurisdiction,

120 Similar issues also arise in relation to the VAT and other consumption taxes. 121 IMF, Issues in international taxation and the role of the IMF, June 2013 pp 4-5 122 “Corporate tax avoidance: tackling Base Erosion and Profit Shifting”, in, IFS Green

Budget, February 2016 p173

41 Corporate tax reform (2010-16)

or to deliver certain functions from another geographical location. This enables a business to ensure that the level of its activities does not create a permanent establishment and therefore a taxable presence in a jurisdiction where it is not resident;123

• using contrived transactions that exploit countries’ double taxation agreements, a MNE is able to “treaty shop” and attempt to reap the benefits of a lower tax rate. For instance, a resident of a low tax jurisdiction that does not have a tax treaty with the UK may attempt to limit the tax that the UK levies at source on interest, by setting up a subsidiary in a country that has a treaty with the UK and routing the transaction through that subsidiary; and

• creating Special Purpose Entities (SPEs). A SPE is defined as a legal entity that has little or no employment, operations, or physical presence, located in a separate jurisdiction to its parent company. Within the EU there are countries that act as conduits for investments, with significant in and outflows travelling through SPEs.124

In the paper cited above, the IMF underline that “the overarching problem” with evasion and avoidance “is in each case the fundamental difficulty that national tax policies create cross-country spillovers”:

The opportunities for avoidance and evasion that are now such a concern are a very visible manifestation of such spillovers: they exploit gaps and inconsistencies in the international tax framework that arise from combining national tax systems. But the setting of national tax policies without considering the spillovers on other countries can generate distortions even in the absence of erosion and evasion phenomena. These can arise instead in the less visible but perhaps even more damaging form of either a dislocation of economic activity purely to exploit differences in national tax policies or an overall level of taxation below that which would be chosen if countries took full account of how each is affected by the others‘ policies.

Moreover, the distinction between the two terms is not clear-cut: “the frontier of legality is not always clear, and whether an activity is ‘avoidance’ depends on the imponderables of legislative intent and the counterfactual of what arrangements would have been made absent tax considerations.”125 Indeed the absence of a clear cut definition may, in and of itself, encourage aggressive tax planning.126

123 [In 2013 the Public Accounts Committee expressed considerable scepticism that

Google had avoided creating a permanent establishment in the UK, because its sales to UK customers were channelled through its company in Ireland: Tax Avoidance–Google, 13 June 2013, HC 112 of 2013-14.]

124 HM Treasury & HMRC, Tackling aggressive tax planning in the global economy: UK priorities for the G20-OECD project for countering Base Erosion and Profit Shifting, March 2014 p5

125 Issues in international taxation and the role of the IMF pp3-4. See also, IMF, Spillovers in international corporate taxation, May 2014

126 “Where is the dividing line between acceptable and unacceptable tax planning for corporates?”, Tax Journal, 27 May 2016.

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More widely than this, as the 2011 ‘Mirrlees Review’ of the UK tax system put it, there is “no compelling answer” to the question of how the global profits of a multinational should be allocated:

Even if there were universal agreement on how the worldwide profits of a company should be taxed, for firms with operations in more than one country we face the further question of where those profits should be taxed— or, more precisely, of how to divide global profits between the different countries in which business is conducted ...

Consider a simple example in which a company is legally resident in country R and is wholly owned by residents of that country. The company has a wholly owned subsidiary in country S, producing products that are wholly exported and purchased by consumers in a third country, D. Country R is referred to as the residence country, in which the ultimate owners of the company are resident. Country S is referred to as the source country, in which the company’s assets are located and its production takes place.

Country D is referred to as the destination country, in which the product is consumed.127 We agree that this operation produces profits—perhaps profits in excess of the normal rate of return on the capital invested—that should be taxed. But should these profits be taxed in the residence country, the source country, or the destination country? How should the tax base be allocated between these three jurisdictions?

There is no compelling answer to this question.

To appreciate this, suppose that the product can only be produced in country S and is only valued by consumers in country D, and the operation can only be financed by investors in country R. Worldwide profits would then be zero without an essential contribution from individuals located in each of the three countries. There is no sense in which we could state, for example, that 20% of the profits stem from the contribution of individuals in the residence country, 50% from the contribution of individuals in the source country, and 30% from the contribution of individuals in the destination country. In this case, there would seem to be no logical basis for dividing up these global profits between the three countries. And yet the international tax system clearly requires some allocation to be adopted, if the profits of multinational companies are to be taxed at all.128

5.2 Avoidance & the Corporate Road Map The Controlled Foreign Companies (CFC) rules The UK tax system includes a number of anti-avoidance rules to prevent ‘inappropriate’ profit shifting, the most important of which are, as noted above, the transfer pricing rules.129 The Coalition Government’s

127 The structure of real multinational enterprises will generally be much more complex,

with shareholders resident in many countries and including institutional investors, making ultimate ownership difficult to discern. Similarly, groups may have subsidiaries and customers in multiple jurisdictions.

128 “Corporate taxation in an international context”, in The Mirrlees Review: Tax By Design, 2011 pp 430-1. See also, “Comment: there is no alternative to agreeing how we tax companies”, Financial Times, 31 May 2011

129 “Box 10.1: Main anti-avoidance rules”, IFS Green Budget, February 2013 p294 & HC Deb 21 January 2013 c102W. On transfer pricing, see, HMRC, Taxing multinationals: transfer pricing rules – issue briefing, April 2013

43 Corporate tax reform (2010-16)

2010 corporate road map highlighted another part of this regime for major reform: the ‘Controlled Foreign Companies’ (CFC) rules. As it transpired the Government’s decision to rewrite these rules in 2012 coincided with growing public concern over corporate tax avoidance – an issue explored in reports by both the Public Accounts Committee130 and the International Development Committee,131 as well as debates during consideration of the annual Finance Bill, with some commentators arguing that the reforms to the CFC rules would make avoidance much easier, particularly in relation to their tax liabilities to developing countries.132

The CFC rules address the actions of multinationals seeking to avoid tax on profits liable to UK tax by shifting them to subsidiary companies in other countries. As the IFS explain, the “UK regime focuses on identifying passive income – income resulting from non-commercial activities, that can be divorced from real activity and easily moved for tax purposes – that is located in a country where the tax liability is less than three-quarters what it would have been had the activity taken place in the UK.”133 Before looking at the reforms made in 2012, it may be helpful to consider the review of the rules launched in 2007.

Foreshadowing the Coalition’s 2010 ‘road map’, in its 2007 Budget the Labour Government announced a series of changes to corporation tax “to enhance international competitiveness, encourage investment, promote innovation and ensure fairness”: this included reforming capital allowances, and cutting the main rate of tax to 28% - which was then the lowest rate among the G7. It also announced a consultation on changing the way companies’ foreign profits were taxed, “in the context of maintaining the overall competitiveness of the UK.”134 One reason for this review was the risk of a legal challenge to the CFC rules as being contrary to EU law, as explained in the IFS’ Mirrlees Review:

In the Cadbury Schweppes case [Case C-196/04] it was argued that the UK’s CFC regime treated investments in subsidiaries in other EU countries less favourably than investments in domestic subsidiaries (because foreign profits were subject to immediate taxation in the hand of the parent but domestic profits were not). The ECJ decided that the CFC regime did infringe Community law in this respect, as it impeded foreign investment. But the ECJ recognized that the UK might be able to justify its measures provided they were shown to be adequately targeted against attempts to avoid tax.135

130 HM Revenue & Customs: Annual Report and Accounts 2011–12, 3 December 2012,

HC 716 of 2012-13 & Tax Avoidance–Google, 13 June 2013, HC 112 of 2013-14 131 Tax in Developing Countries: Increasing Resources for Development, 23 August

2012, HC 130 of 2012-13 132 eg, “UK corporate tax concessions 'could cost developing countries billions'” &

“Comment: Britain's tax rules – now written for and by multinationals”, Guardian, 6 & 19 March 2012

133 IFS Green Budget, February 2013 p294 134 Budget 2007, HC 342, March 2007 para 3.23-5, para 3.39 135 Rachel Griffith et al., “International Capital Taxation”, in, Dimensions of Tax Design:

the Mirrlees Review, IFS May 2010 p965

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The Labour Government’s ‘discussion document’ - published in June 2007 - set out how the CFC regime worked at this time, and why it should be reformed:

The CFC rules have been part of the UK’s foreign profits regime since the 1980s. They were first introduced to counter “tax avoidance through the accumulation of income in subsidiaries in low tax areas … and the artificial diversion of business profits from the UK to such companies”.136 The essential aim of the rules since then has been revenue protection, by preventing groups from locating profits artificially outside the UK … The rules were based on an “all-or-nothing” approach, under which each CFC was assessed as an entity, and profits either exempted – through one of a number of broad-brush exemptions – or taxed in their entirety …

However, the cumulative effect of liberalisation of trade rules, regulatory changes, and developments in business practices and technology means that the CFC rules have become increasingly unsuited to the needs of either business or Government. From a business perspective, the “all-or-nothing” approach inevitably leaves potential risks (because profits are either wholly taxed, or wholly exempt, depending on whether they meet the conditions in the rules for any given accounting period). In addition, the number of changes made to the rules over the years have, in business’ eyes, made the rules more complex and obscured the policy behind them.

There are … further considerations that suggest it may now be the time for a more radical approach. First, the experience of other major countries with CFC rules (France, Germany and the US) confirms that, while there is clearly a continuing role for CFC rules, Governments need to be sure that the rules do not over-reach their objectives in preventing artificial avoidance.137

Second, it is clear that a move to exemption will open up new risks for diversion of profits: so if the UK adopts a form of exemption, the CFC rules will necessarily assume a greater importance in terms of protecting the UK tax base. (This will be especially true if exemption is not accompanied by any wide-ranging restriction of interest relief.)

It went on to discuss the threat posed by the Cadbury Schweppes case, and the continued legal uncertainty under which it operated, despite changes made to the rules to take account of the Court’s judgement:

In Cadbury Schweppes, the ECJ confirmed that there is a legitimate role for CFC rules under the Treaty, so long as the rules do not tax the profits of genuine economic activities in overseas subsidiaries. The Government considers that, in making this judgment, the Court intended to draw a meaningful distinction between profits from a genuine commercial activity and profits that have been artificially divorced from the activity that creates them. So CFC rules should not be protectionist: but at the same time they may permit the fair allocation of taxing rights between Member States, so respecting the Treaty.

136 Taxation of International Business: Consultation paper by the Board of Inland

Revenue, December 1982 137 Recent changes to the US CFC (SubpartF) rules – as well as the German and French

CFC rules – indicate that this is not just an EU issue, but an issue common to all major economies with CFC rules.

45 Corporate tax reform (2010-16)

Commentators who have criticised the changes the Government has made in Finance Bill 07138 claim that in the light of Cadbury Schweppes only highly artificial transfers may be targeted by CFC rules. Subsequent rulings from the Court (e.g. on the thin capitalisation case) support the Government’s wider reading – but full certainty on this point is unlikely to be achieved in the short term. This suggests that a new CFC model that applies rules in a non-discriminatory way as between UK and foreign subsidiaries could help reduce uncertainty, since it would remove some of the potential for challenge that such criticism might otherwise suggest.139

Following further consultation, in November 2008 the Labour Government announced reforms to the taxation of foreign profits:

At this time the Labour Government also confirmed that it would examine longer-term options to improve the operation of the CFC rules:

The Government will also continue to examine options to reform the UK’s controlled foreign companies (CFC) rules. These rules were originally designed to counter tax deferral and the artificial diversion of profits from the UK. Any reform will aim to enhance UK competitiveness by seeking to improve the way the CFC rules achieve their objective of taxing profits diverted from the UK. Coupled with the exemption for foreign dividends, this represents a clear further move towards a territorial approach to taxing foreign subsidiaries, so that a new CFC system should not tax profits that are genuinely earned in overseas subsidiaries. Consultation will continue through 2009.140

138 [These changes - set out in s48 FA 2007 - had been announced in December 2006:

HM Revenue & Customs PBR Notes 01, 6 December 2006. Briefly, the UK CFC rules were relaxed, so that UK companies could apply to HMRC to disregard those profits of their CFCs that arose from genuine economic activity in business establishments in other European Union Member States or certain other states in the European Economic Area (EEA).]

139 HMT & HMRC, Taxation of the foreign profits of companies: a discussion document, June 2007 p17, p19

140 Pre-Budget Report, Cm 7484, November 2009 p72

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In its Green Budget published in January 2009, the IFS suggested the exemption system was “a welcome move that will put the UK more in line with other European countries and should help UK multinationals to make more productive use of their assets.”141 The report gave more details as to the rationale for this kind of reform:

At present, UK-resident companies are taxed on profits that are earned overseas, with a credit given for any taxes paid to foreign governments … The move to an exemption system announced in the PBR means that when a multinational firm repatriates dividends into the UK, these will be exempt from UK corporation tax. Exemption will include shareholdings that represent less than 10% of a foreign company (portfolio shares) …

A significant reason for moving towards an exemption system is that it reduces one way in which the tax system distorts firms’ decisions over where to invest. Neutrality is one way in which tax systems are judged, the idea being that a well-designed tax system should not distort decisions over how much investment occurs, where it takes place and who undertakes it (unless there is a specific justification for doing so). There are different types of neutrality, and the extent to which any are realised depends not only on the UK tax system but also on the systems operated by other jurisdictions.

In theory, the current credit system taxes investments from the UK in the same way regardless of their destination. This adheres to the concept of capital export neutrality (CEN): investors in the UK face the same effective tax rate on foreign and domestic investments. Since competitive pressures should ensure cross-country after-tax rates of return are equalised, CEN ensures that pre-tax rates of return are also brought into line. In this way, a regime of CEN tends to equalise the marginal productivities of capital across countries, as required for maximisation of world income. In practice, the current credit system that is in place in the UK fails to achieve CEN because tax credits are limited to the level of the domestic tax and income repatriation can be deferred.

A particular asset or investment may be much more productive in the hands of one multinational than it would be in the hands of another, so it is important that the tax system does not distort the pattern of ownership. Capital ownership neutrality (CON) occurs when inward or outward investments are treated the same for the tax purposes regardless of who owns them. CON can be achieved if all countries exempt foreign income from domestic tax and apply the same rules for deducting financing costs. Under a pure exemption system, investments in any single location would be liable for the same tax regardless of their country of origin and, as a result, the assets invested in each country would be held by those companies that could earn the highest pre-tax (and hence highest after-tax) return on them.

Moving to an exemption system would move the UK closer to CON, especially since many other countries (and almost all European countries) also operate exemption systems.142

Provision for the exemption of foreign dividends, with associated measures to restrict tax deductions for interest, was made by the Finance Act 2009 (ss34-37).

141 “Chapter 12: Business Taxation”, IFS Green Budget, January 2009 p227 142 op.cit. pp227-8

47 Corporate tax reform (2010-16)

Vodafone’s legal challenge to the CFC rules The compatibility of the UK’s CFC rules with EU law was central to a legal challenge that the multinational Vodafone launched in 2007. The appeal dealt with a tax assessment of the profits earned by a subsidiary the company had established in Luxembourg in 2000. Vodafone took the position that the Court’s qualified endorsement of the CFC rules in Cadbury Schweppes was at fault, that the CFC rules were incompatible with EU law, and that HMRC should immediately close an enquiry into the potential liability of the Luxembourg subsidiary for the 2000/01 tax year. The High Court upheld this approach in July 2008.

This posed a fundamental threat to the continued existence of the CFC regime,143 but in May 2009 the Court of Appeal ruled in favour of the revenue authorities, allowing it to continue its enquiry. A synopsis of the decision appeared in Taxation magazine:

Vodafone 2 v CRC, Court of Appeal, 22 May 2009

The taxpayer company (Vodafone), which was UK resident and part of a worldwide group, owned a subsidiary, VIL, which was incorporated and resident in Luxembourg. Applying the controlled foreign companies legislation (TA 1988, ss 747 and 748), HMRC sought to tax interest earned by VIL on loans which it had made to German subsidiaries as if it were income of the taxpayer company.

The company claimed that the legislation was incompatible with EU law. The case went to the Special Commissioners who referred to the European Court of Justice, but this was withdrawn after the ECJ’s decision in Cadbury Schweppes plc v CIR (Case C-196/04) [2006] STC 1908. In that decision, the ECJ said that the controlled foreign companies legislation introduced a restriction on freedom of establishment which could be justified on the basis that it enabled the UK to prevent tax avoidance. The legislation was proportionate in achieving that objective. The Special Commissioners subsequently ruled that the controlled foreign companies legislation could be construed as compatible with EU law. The High Court overturned that decision so HMRC appealed.

The Court of Appeal, allowing the appeal, said that it had to look at all parts of the controlled foreign companies legislation to decide if it conformed to enforceable EU rights. HMRC’s argument was that all that was needed was to introduce an additional exception in respect of a controlled foreign company if it was actually established in another member state of the European Economic Area and carried on genuine economic activities there. HMRC’s appeal was allowed. Bill Dodwell, head of Deloitte’s tax policy group said, ‘This is a common-sense judgment and hopefully will offer a good way forward in controlled foreign companies cases. However, what we really need is some helpful guidance on the sort of activities that fall within this new exemption.'144

143 [2008] EWHC 1569 (Ch). “Vodafone pressurises CFC rules”, Tax Journal, 4 August

2008 144 “Interpreting the CFC rules”, Taxation, 9 June 2009. The company’s appeal to the

Supreme Court was turned down in December 2009: [2010] 1 WLR 569.

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The coda to this legal battle was the final assessment which HMRC and Vodafone agreed in July 2010. The Financial Times reported this assessment as follows:

One of Britain's biggest legal battles over international tax planning has ended with an agreement by Vodafone, the mobile operator, to pay a tax bill of £1.25bn, in a deal hailed as early evidence of a rapprochement between big business and the new government over tax. The settlement, which was far less than the provision of £2.2bn carried in Vodafone's accounts though still the largest of its type ever agreed in the UK, is a sign of a more conciliatory approach recently adopted by Revenue & Customs, according to people familiar with the situation … The Revenue's incentive to resolve the cases was the prospect of swifter collection of revenues along with the risk it might lose a legal battle ...

Vodafone, which had provided for £900,000 of interest costs as well as £2.2bn for the tax liability, said it was pleased with the outcome of the dispute. The Treasury is expected to announce minor modifications to the CFC regime next week, with a consultation paper on full-blown reforms scheduled for 2012 … Vodafone made it clear that it expected the government to honour its commitment to reform the CFC rules, saying: "Long-term, no CFC liabilities are expected to arise as a consequence of the likely reforms of the UK CFC regime due to the facts established in this case.”145

Later that year Private Eye published a story on the agreement which suggested that the department could have assessed Vodafone for £5bn, rather than just £1.25bn; the key passages from the article are reproduced below:

When Vodafone bought German engineering company Mannesmann a decade ago for €180bn … [it] bought Mannesmann using a Luxembourg subsidiary company called Vodafone Investments Luxembourg sarl (VIL) … An epic legal battle began, with Vodafone resisting the taxman’s efforts to get all the information on the deal and arguing through the courts that the British laws striking out the tax benefits of its deal were neutered by European law which granted, Vodafone claimed, the freedom to establish anywhere in the EU … without facing a tax bill. VIL’s accounts show that, up to March 2009, €15.5bn income was stuffed into the company, suggesting it is now heading to the €18bn mark and resulting in £5bn in lost tax and interest so far …

Officials were … emboldened last year when the court of appeal ruled that British laws striking out the avoidance scheme could conform with European laws …The fruits of [HMRC’s negotiations with Vodafone] … was a bill for Vodafone of £800m, with another £450m payable over five years … The bill for all other taxpayers in lost tax is likely to be at least £6bn. Resentment within the HMRC ranks is high and one former official familiar with the case described it as an “unbelievable cave-in”.146

The next year, both the Treasury Committee and the Public Accounts Committee raised concerns about HMRC’s approach to this settlement and a number of others with large companies.

145 “Vodafone to pay tax bill of £1.25bn”, Financial Times, 24 July 2010 146 “Britain’s £6bn Vodafone bill”, Private Eye issue 1270, 3 September 2010

49 Corporate tax reform (2010-16)

The main focus of the PAC’s concern was the role played by the then Permanent Secretary for Tax, Dave Hartnett, in the conclusion of an assessment for Goldman Sachs, and the reluctance shown by officials to discuss details of how settlements were concluded with the Committee, on the grounds of taxpayer confidentiality.147 In the case of Vodafone, the Committee observed, “the General Counsel and Solicitor [at HMRC, Anthony Inglese] said he could not comment on whether lawyers had advised that £1.25 billion was the correct settlement amount.”148 In early 2012 HMRC introduced a number of changes to its governance of large tax disputes; principally,

• a new assurance role at HMRC Commissioner level with an explicit challenge role in decision-making on cases

• a systematic review programme of the processes used in settled cases

• an enhanced role for HMRC’s Audit and Risk Committee on tax settlements

• an annual published report on its tax settlement work; and, • a new published code of governance for tax dispute resolution.149 For its part the Treasury Committee broadly welcomed these changes, while making a couple of recommendations:

We note both the principle and the substance of these changes: HMRC has shown it is willing to take action to improve its processes and we broadly support the changes announced, although their effectiveness can only be judged once they have been implemented and tested …

We support the suggestion that the assurance Commissioner be accountable for a process of reviewing settled cases and ensuring follow-up actions are taken, but it is currently unclear by what mechanism the Commissioner will be accountable. Therefore we recommend that the assurance Commissioner appear before this Committee as a matter of course after the publication of the proposed annual report on the outcome of HMRC’s dispute work.

We also urge HMRC, when producing its code of governance for tax dispute resolution, to keep in mind that the public must be reassured that large businesses will receive the same treatment as any other taxpayer … We recommend that HMRC’s proposed code of governance for tax dispute resolution be explicit that the same rules apply to settlement of tax disputes with its large corporate customers as apply to settlements with all other taxpayers.150

In turn the Government accepted both of these recommendations.151 Edward Troup, second permanent secretary at HMRC, was appointed Commissioner, and in October 2014 Mr Troup gave evidence to the Committee on his work, following publication of his second annual

147 HM Revenue & Customs 2010–11 Accounts: tax disputes, 20 December 2011, HC

1531 of 2010-12. 148 HC 1531 of 2010-12 para 11, citing evidence Mr Inglese gave on 11 November

2001 (Ev48, Qs583-6) 149 HMRC, Managing significant tax disputes – issue briefing, February 2012 150 Treasury Committee, Closing the tax gap: HMRC’s record at ensuring tax compliance,

9 March 2012, HC 1371 of 2012-12 paras 83-5 151 First Special Report of Session 2012–13, HC 124, 18 May 2012 p10

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report.152 In February 2015 the National Audit Office published an overview of HMRC’s work over the past five years, including its efforts to reduce tax avoidance. On this specific question, the NAO noted “the appointment of a Tax Assurance Commissioner and the publication of his annual reports are welcome changes that have significantly improved public confidence in how HMRC deals with large companies.”153

Turning back to the concerns over the Vodafone and Goldman Sachs settlement, in June 2012 the National Audit Office concluded, on the basis of an examination by former High Court tax judge Sir Andrew Park, that five large tax settlements - each the subject of this type of concern – “were reasonable and the overall outcome for the Exchequer was good.”154 In coming to this conclusion, the NAO made the point that in such complex cases, “there is no clear answer as to what represents the ‘right’ tax liability”:

These large tax settlements are complex and there is no clear answer as to what represents the ‘right’ tax liability. The Department used its judgement to decide how the law applied to the complex facts and, in each case, there was a range of justifiable positions the Department might have taken. For example, three of the cases involved the Department challenging, and developing defensible alternative scenarios for, the companies’ long-standing transfer pricing arrangements.

Where the Department and the taxpayer disagree, they can either reach a compromise settlement that both sides can accept, or pursue the issues in litigation, which is likely to involve a long and very expensive process of appeals through the courts.155

The report did not provide the identity of the taxpayers involved in these settlements, though, as it noted, “in some cases, certain details of the settlements are already in the public domain and we recognise that these taxpayers may be identifiable.”156 In this context it seems likely that the Vodafone settlement was ‘Case D’ in the report.

As an introduction to the case, the report gives more details of how the CFC rules have worked:

This covers situations where a UK parent company owns a subsidiary based in an overseas jurisdiction (often with a tax regime more favourable to the taxpayer). In certain circumstances, the profits of the subsidiary are assessed as part of the taxable profits of the UK parent company, thereby increasing the tax liability.

One of the key defences a taxpayer can use against being taxed under the controlled foreign companies provisions is the ‘motive test’ exemption. The legislation says that the profits of the subsidiary will not be assessed as part of the taxable profits of the

152 Oral evidence: Work of the Tax Assurance Commissioner, HC 725, 14 October 2014 153 Increasing the effectiveness of tax collection: a stocktake of progress since 2010, 6

February 2015, HC 1029-I of 2014-15 para 3.9. See also PQ30442, 17 March 2016 154 National Audit Office press notice 31/12, Settling large tax disputes, 14 June 2012 155 Settling large tax disputes, HC 188 of 2012-13, 14 June 2012 para 11. The NAO

looked at this procedure in its report on HMRC’s accounts the previous year (Report on HMRC’s 2010/11 Accounts, 7 July 2011 – see in particular, ppR17-20).

156 op.cit. para 8

51 Corporate tax reform (2010-16)

UK parent company under the controlled foreign companies provisions if:

a) “in so far as any of the transactions the results of which are reflected in the profits arising in that accounting period ...achieved a reduction in United Kingdom tax, either the reduction so achieved was minimal or it was not the main purpose or one of the main purposes of that transaction … to achieve that reduction; and

b) it was not the main reason … or one of the main reasons for the company’s existence... to achieve a reduction in United Kingdom tax by a diversion of profits from the United Kingdom.”157

There is another key defence that a company can use against the application of the controlled foreign companies provisions to subsidiaries in European Community (EC) member states. This relates to freedom of establishment – the right to set up companies (including subsidiaries) in other EC member states.

In the Cadbury Schweppes case, the European Court of Justice ruled on whether the UK’s controlled foreign companies legislation applied to subsidiary companies in other EC member states.158

The Court’s judgement was that the controlled foreign companies legislation could be applied only in very narrowly defined circumstances. Companies can argue that the controlled foreign companies provisions cannot be applied because their circumstances are not within this narrowly defined range. The uncertainty over the application of these provisions is highlighted by the infraction proceedings that the EC has started against the UK in respect of its existing controlled foreign companies legislation.159

The report goes on to summarise ‘Case D’, which centred on a company’s defence against the CFC. Crucially, in his analysis, Sir Andrew Park came to the conclusion that the settlement reached was a good one and represented fair value for the wider taxpaying community. He went on to underline the very real risks to pursuing litigation – an aspect to this issue that, in general, receives relatively little attention: “Had the Department not reached a settlement, the case would have gone to litigation. In Sir Andrew Park’s opinion, company D had a good chance of winning both of its two arguments: the motive test defence and the Cadbury Schweppes defence. If it had won on either of these, the outcome would have been that it had no tax liability at all relating to subsidiary D’s interest income.”160

The report’s summary of this case is reproduced in full in a text box over the next three pages.

157 Income and Corporation Taxes Act 1988, Section 748 (3) 158 Cadbury Schweppes plc and Cadbury Schweppes Overseas Ltd vs Commissioners of

Inland Revenue, Case C-196/04, 12 September 2006. 159 para 2.8-10 160 “Appendix One: case summaries”, Settling large tax disputes, HC 188 of 2012-13,

14 June 2012 p40

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“Appendix One: case summaries : Case D”

Settling large tax disputes, HC 188 of 2012-13, 14 June 2012

Background

46 Company D is the UK-resident parent company of subsidiary D, a company incorporated in a country in the EC. Subsidiary D in turn had a subsidiary, subsidiary DD, in a different European country, which held all the shares in a company that the group had acquired via a shares-for-shares exchange. This resulted in subsidiary DD being indebted to subsidiary D, and making billions of euros of interest payments to subsidiary D. Subsidiary D did not pass its interest receipts on to company D in the UK.

47 Subsidiary D initially operated mainly through a branch in another European country (neither the country in which it was incorporated nor the country in which subsidiary DD was based, and not itself an EC country). It later transferred these activities to the country in which it was incorporated. The interest received by subsidiary D was chargeable to tax in each of these countries but, due to low tax rates and the availability of tax reliefs in these countries, it was paying little or no tax in either.

The tax issues

48 The main tax issue was whether the controlled foreign companies provisions applied to subsidiary D. If so, then company D would be subject to UK tax on subsidiary D’s profits, the most significant part of which were the interest payments received from subsidiary DD.

49 Company D had other subsidiaries based in the same country as subsidiary D. The Department also considered whether the controlled foreign companies provisions applied to these subsidiaries and these were covered by the settlement. As the amounts involved were much smaller than for subsidiary D, we refer principally to company D in this case summary.

The Department’s technical arguments

50 The Department began investigating the issue almost a decade before it reached a settlement, opening a formal enquiry two years after it began to investigate the issue. The Department argued that, under the controlled foreign companies provisions, company D was liable to UK corporation tax on the large interest payments received by subsidiary D.

51 Company D had two defences against the application of the controlled foreign companies provisions, both of which the Department opposed. Firstly, company D argued that the motive test exemption in UK law1 applied. Secondly, it argued that, because subsidiary D was incorporated in an EC member state, the freedom of establishment articles in the EC Treaty prohibited the use of the controlled foreign companies provisions by the UK.

52 Company D applied to the Special Commissioners1 to have the Department’s enquiry closed. The Special Commissioners referred the case to the European Court of Justice on the question of whether the UK’s controlled foreign companies provisions were inapplicable to subsidiaries based in EC member states. The European Court of Justice never gave a decision on this issue in company D’s case. This was because it already had two references on the same issue. The lead case on the issue was the Cadbury Schweppes case and the European Court of Justice gave its decision on this in September 2006.2

53 The European Court of Justice’s decision did not say that controlled foreign companies provisions could never be used where the subsidiary was incorporated in another EC member state. However, it did say they could only be used in narrowly defined circumstances. Company D now argued that the UK’s controlled foreign companies provisions could not ever be interpreted as being within these narrowly defined parameters, and so could not be applied at all to companies established in EC member states. The Department argued that they could. The Special Commissioners considered this issue and ruled in favour of the Department.

53 Corporate tax reform (2010-16)

54 Company D appealed to the High Court, where the decision was reversed. The Department appealed to the Court of Appeal, which reversed the decision reached in the High Court. Company D applied for leave to appeal to the Supreme Court but were denied this. This meant that company D had lost the argument that the UK could never apply its controlled foreign companies provisions to a subsidiary in an EC member state.

55 Despite losing this case, Company D still had two defences against the application of the controlled foreign companies provisions. The first was the argument it had had all along that it qualified for the ‘motive test’ exemption in UK law. The second came from the Cadbury Schweppes decision that the UK’s controlled foreign companies provisions could only be used in narrowly defined circumstances. Company D argued that its circumstances were outside the restricted range set out in the Cadbury Schweppes decision. Had it chosen to do so, company D could have litigated either of these arguments rather than reaching a settlement. Success on either would have resulted in company D establishing that it had no liability to pay any tax under the controlled foreign companies legislation.

Resolving the issues

56 On losing leave to appeal to the Supreme Court, company D did not litigate either of its two arguments. Instead, having set out a detailed description of the relevant facts and circumstances in the case, with substantial supporting documentation, it negotiated with the Department to try to resolve the controlled foreign companies issue.

57 Company D was only one of several major companies that had long-running disputes with the Department over the application of the controlled foreign companies provisions. To try to resolve these disputes, the Department developed a new approach to settling controlled foreign companies cases. Under the previous approach, the UK company would be taxed on the whole of the profits of the controlled foreign company, with interest. The new approach allowed the controlled foreign company to pay a dividend to its UK shareholder, which would elect to pay tax on the dividend. If a sufficient proportion of the controlled foreign company’s profits were charged to UK corporation tax in this way, it would be regarded as passing the motive test. The new approach allowed for the UK shareholder to be taxed on a ‘deemed dividend’ if the controlled foreign company could not pay an actual dividend. The dividend, or deemed dividend, would be taxed for the accounting period in which it was received, and so would generally not attract interest.

58 The Department had advice from its Solicitor’s Office that this approach was compatible with the Litigation and Settlement Strategy3 and it was this approach that was applied in settling company D’s case. The main issue was what size of dividend would be acceptable to both the Department and company D. The new approach to controlled foreign companies contained an indication of what proportion of taxable profits would be acceptable as a dividend, but the amount would depend upon the circumstances of each case.

59 The Department reached a settlement with company D after four months of negotiation. Company D agreed to pay well over a billion pounds to cover the controlled foreign companies issue. The Department made various adjustments for tax allowances and other elements of the settlement, resulting in a much lower cash settlement figure, which still exceeded a billion pounds.

60 The settlement also included an agreement that, for certain future accounting periods, the Department would not treat subsidiary D, and other relevant subsidiaries of company D, as companies to which the controlled foreign companies provisions applied. This was conditional on the circumstances of the relevant companies, and UK tax law, not changing. In reaching this agreement, one of the factors that the Department considered for this period was that the company had repatriated very large sums to the UK, and agreed to repatriate further funds to the UK. The earnings on the repatriated funds would be subject to UK corporation tax.

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Sir Andrew Park’s view of the reasonableness of the settlement

61 Sir Andrew Park’s overall conclusion is that the settlement reached was a good one and represented fair value for the wider taxpaying community. Had the Department not reached a settlement, the case would have gone to litigation. In Sir Andrew Park’s opinion, company D had a good chance of winning both of its two arguments: the motive test defence and the Cadbury Schweppes defence. If it had won on either of these, the outcome would have been that it had no tax liability at all relating to subsidiary D’s interest income.

62 Sir Andrew Park also concludes that it was reasonable for the Department to confirm that for future accounting periods it would not treat subsidiary D as a company to which the controlled foreign companies provisions applied. The controlled foreign companies provisions can apply for some accounting periods but not others, if there is a relevant change of circumstance. The Department considered that because company D was repatriating funds to the UK, that the profits of subsidiary D should no longer be apportioned to company D under the controlled foreign companies provisions.

63 The Department wrote to company D to confirm its proposed future treatment of subsidiary D and the other subsidiaries. This letter made clear that the proposed future treatment was dependent on neither the facts of the case nor relevant tax law changing. Sir Andrew Park notes that such letters are common practice and are useful aspects of tax management. If circumstances or tax law change, it is open to the Department to reassess the tax treatment. In the meantime, it gives the taxpayer useful clarity on how their tax circumstances will be treated.

64 Sir Andrew Park also assesses the lack of interest paid by company D. Company D paid most of the tax agreed around the time of the settlement, but the Department agreed that the company could pay the remainder over a five year period. Two issues arise in connection with interest: the interest for the accounting periods that subsidiary D was deemed to be a controlled foreign company up until the time of settlement, and interest on the instalments over the five years from settlement date.

65 Sir Andrew Park notes that the lack of interest is consistent with the Department’s new approach. Under this approach, the controlled foreign company pays a dividend and the UK parent company elects to be taxed on the dividend. The tax is therefore due when the dividend is paid, rather than when the underlying profits arose. This is why there was no interest on the payment made around the time of the settlement.

66 A similar reasoning could be used on the instalments payable over five years. However, the dividend was notional or deemed and Sir Andrew Park attaches more weight to the negotiated settlement process. Company D had reached the maximum figure they were prepared to pay, and if the Department had demanded additional interest, there was a major risk that there would have been no settlement. He concludes that the Department were right to settle at this amount because, if the case had not been settled, it would have gone to litigation. If this had happened, there was a substantial risk that the Department would have received nothing.

Notes

1 The Special Commissioners considered tax appeals before the introduction of the Tax Tribunals.

2 Cadbury Schweppes plc and Cadbury Schweppes Overseas Ltd vs Commissioners of Inland Revenue, Case C-196/04, 12 September 2006.

3 The Litigation and Settlement Strategy is HMRC’s framework for concluding tax disputes across all taxes, duties and tax credits streams, first issued in 2007. The Strategy “seeks to ensure consistency in the way in which tax disputes are resolved and requires each tax issue to be considered on its own merits, rather than as part of a package.” (Report on HMRC’s 2010/11 Accounts, 7 July 2011 para 8.)

55 Corporate tax reform (2010-16)

Reforms to the CFC rules in 2012 In its last Budget in March 2010 the Labour Government confirmed that it would publish detailed proposals for reforming the CFC rules, as well as reviewing the taxation of companies’ foreign branches.161 As discussed in the earlier part of this note, in his first Budget speech in June 2010, the Chancellor, George Osborne, announced the Government would proceed with “a five-year plan to reform the corporation tax system, with lower rates, simpler rules and greater certainty.”162 Alongside changes to the rates of tax and capital allowances, the plan would include reforms to make the CFC rules “more competitive”, a “move to a more territorial basis for taxing the profits of foreign branches”, and a review of the tax treatment of both intellectual property and R&D expenditure.163 In November 2010 the Government published this ‘road map’:

‘Corporate Tax Reform: delivering a more competitive system’ … is designed to provide certainty to business over the Government’s plans, as it works with them to deliver this ambitious programme of reforms. Today’s tax reform announcements include:

• a Corporate Tax Road Map that commits to principles that will underpin these reforms and a clear timetable to deliver these changes, including how the Government will engage with business at each stage of policy development;

• details on how the Government will reform the UK’s outdated Controlled Foreign Company (CFC) rules by introducing more targeted rules in 2012 and how they will apply to financing and intellectual property. As a first step to make the rules more competitive, a package of interim improvements will be introduced in 2011;

• introducing a Patent Box in April 2013 - a 10% CT rate on profits from patents, reaffirming the Government’s commitment to retain and build on the existing Research and Development (R&D) tax credit scheme to create the right environment for innovative companies to prosper;

• a commitment to legislate an opt-in exemption for profits earned in foreign branches of UK companies in 2011. Under this more territorial approach, companies in the new regime will no longer be subject to UK CT on their foreign branch profits.164

Interim changes to the CFC rules were made in Finance Act 2011 (s47 & schedule 12),165 and in June that year the Government launched a

161 Budget 2010, HC 451, March 2010 para 4.61-2. The Treasury had published a

discussion document on the CFC regime two months before: HMT/HMRC, Proposals for controlled foreign companies (CFC) reform, January 2010.

162 HC Deb 22 June 2010 c176 163 Budget 2010, HC 61, June 2010 para 1.61-2 164 HMT press notice, Corporation Tax Reform: Delivering a more competitive system,

29 November 2010. Full details of the consultation are now on the Treasury’s archived website.

165 The annual cost of these changes was estimated to be £25m from 2013/14: Budget 2011, HC 836, March 2011 (Table 2.1 – item 2).

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consultation on the new regime;166 a summary description was given in the Financial Times:

What has been proposed? A fundamental reform of the 30-year "controlled foreign company" rules aimed at tackling avoidance by multinationals that shift taxable profits to low-tax jurisdictions. The tax rate for offshore financing operations will be cut to 5.75 per cent on profits from intra-group financing by 2014, or possibly even exempted altogether.

What do supporters say? The new rules will form a cornerstone of the government's ambition to have the most competitive tax system in the G20. They will allow groups based in the UK to compete more effectively with those based overseas, while protecting against the artificial diversion of UK profits. UK-based companies will be helped to make profitable acquisitions abroad and international businesses will be encouraged to come to Britain, rather than leave. The high-profile departure of a stream of multinationals in recent years underlines the reforms' importance.

What do critics say? The government has caved in to big business by announcing a big relaxation of their anti-avoidance rules. The latest changes will increase tax competition and discriminate against smaller companies that do not have the capability to manage important parts of their business offshore. They will increase the incentive for companies to shift their financing operations and intellectual operations offshore. ActionAid, a development charity, argues the new rules could lead to increased tax avoidance in developing countries because they remove an effective deterrent to multinational companies shifting profits into tax havens.

FT verdict This consultation is the culmination of four years of intense lobbying by business and represents a big shift towards a more business-friendly tax system. But the policy change has been the result of painstaking deliberations under both Labour and coalition governments. The changes are justified because they reflect the reality of the international character of multinationals and intensifying tax competition from smaller states.167

Revision of the draft legislation in the light of the consultation exercise saw an increase in the projected cost of this reform. In Budget 2012 the department estimated that the total cost of CFC reform would be £910m a year by 2018/19.168 A summary of the new rules was given in a tax information note, published alongside the Budget:

Legislation will be introduced in Finance Bill 2012 to repeal the current legislation and replace it with a new CFC regime, the key elements of which are:

• The business profits of a foreign subsidiary will be outside the scope of the new CFC regime if they meet the specified conditions set out in a “gateway”. The conditions define

166 HMT press notice, Government publishes proposals on Controlled Foreign

Companies, 30 June 2011. Details of the consultation and its outcome are collated on Gov.uk

167 “Treasury unveils avoidance reforms” & “Just the facts”, Financial Times, 30 June 2011

168 HM Treasury, Budget 2012 policy costings, March 2012 pp14-15

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what is to be treated for the purposes of the regime as profits artificially diverted from the UK.

• "Safe harbours" for the gateway conditions will be provided covering general commercial business, incidental finance income and some sector specific rules. A foreign subsidiary can rely on these safe harbours to show that some or all of its profits are outside the regime's scope.

• As an alternative to the gateway, the regime will also provide exemptions for CFCs. The exemptions will apply to the CFC as a whole and include an excluded territory exemption and a low profits exemption. The lower level of tax test which currently forms part of the definition of a CFC will function as an exemption in the new regime.

• The regime includes rules for finance companies which will generally result in an effective tax rate on intra group finance income of one-quarter of the main CT rate, and full exemption in certain circumstances.169

Provision to introduce the new regime, from 1 January 2013, was made in the Finance Act 2012 (s180 & schedule 20).

As noted, critics of this reform argued that it would facilitate tax avoidance, particularly by multinationals with operations in developing countries.170 The charity ActionAid launched a campaign arguing that the new rules would ‘open a loophole costing developing countries an estimated £4 billion and the UK £1 billion.’ Over this period, the charity took the position that the reforms failed to counteract multinationals efforts to avoid tax worldwide, whereas the Government argued that this approach misunderstood the very purpose of the CFC rules. At the time ActionAid published relatively little detail as to how came to their £4bn estimate for the tax loss to be suffered by other countries:

How will this new UK tax loophole make it easier for multinationals to dodge their taxes?

Current anti-tax haven (or Controlled Foreign Company) rules work by deterring companies from exploiting the low tax rates offered by tax havens. If a multinational shifts its profits into a tax haven in order to lower its bills anywhere in the world, the UK tops up its tax bill, bringing it into line with the UK rate. While the rules aren’t perfect, and don’t stop all tax dodging, they cover all UK companies and work if a multinational is trying to avoid its tax in the UK, or in developing countries. The changes the Treasury are proposing mean that the rules will only apply if the tax dodge is costing the UK. They will no longer apply when British companies try and dodge their taxes in developing countries.

How do you know that the UK could lose £1 billion and developing countries £4 billion?

The Treasury itself has estimated that the changes to anti tax haven rules could cost the UK £1 billion. Based on the current

169 HMRC, Controlled Foreign Companies Full Reform – tax information & impact note,

March 2012 170 For example, “CFC reform: UK resists calls for assessment of impact on developing

countries”, Tax Journal, 3 February 2012.

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economic activity of UK multinationals in the developing world and the additional profit shifting into tax havens likely to result from the Treasury’s proposals ActionAid estimates that developing countries could lose £4 billion each year. We’ve been calling on the Treasury to do a full assessment and estimate how much the impact will be on developing countries – which so far they’ve refused to do.171

In their 2011 Green Budget the Institute for Fiscal Studies characterised the reforms to the CFC regime as “a necessary extension of a process started by Labour following the UK’s move to an exemption system for the taxation of foreign-source income.” By contrast, the authors were strongly critical of the Government’s introduction of the new relief for patents – the ‘Patent Box’ – saying that it would be, “poorly targeted at promoting research and will add unnecessary complexity to the tax system … [while] the government’s own estimates predict that the policy will lead to a large reduction in UK tax receipts.”172

This aspect of the Government’s reforms is not explored in depth here, but, as an aside, recent international developments in this area illustrate the multilateral dimension to corporate tax reform, and the way that national incentives may clash with international efforts to combat avoidance. In their review of the Coalition Government’s reforms, mentioned above, Helen Miller and Thomas Pope at the IFS make the following observations:

The previous Labour government first announced the intention to introduce the Patent Box – a preferential tax rate on the income that is derived from patents – in 2009. The Patent Box was introduced in April 2013 and is being gradually phased in. When it is fully operational, it will apply a 10% rate to income that is derived from a good or service that contains a patented element…

The UK is now one of 12 European countries that operate a Patent Box style policy – i.e. a preferential rate for the income derived from (some forms of) intellectual property. Patent Boxes work to reduce the effective average tax rate on qualifying investments … [Estimates across these 12, for an equity-financed investment in a self-developed show that] in all cases, the reduction is substantial. In some countries, the EATR is negative, effectively implying that the tax treatment provides a subsidy.173 In the UK, the EATR is slightly less than half what it is under the regular system …

The OECD and the European Union have long discouraged the use of preferential tax rates because of concerns that they might be associated with ‘harmful’ tax competition. Recently, such concerns have been raised in relation to Patent Box regimes. In 2013, the European Commission took a stance against the UK regime, concluding that some of the design features met the

171 ActionAid, FAQs on our Tax Justice campaign, undated (ret’d 2/5/2012). Richard

Murphy, the Tax Research blogger and activist, was also a critic: see, Corporate Tax reform and competitiveness, TUC, May 2011.

172 “Chapter 10: Corporate taxes and intellectual property”, IFS Green Budget, February 2011 p224, p223

173 L.Evers, H.Miller and C.Spengel, ‘Intellectual property box regimes: effective tax rates and tax policy considerations’, International Tax and Public Finance, June 2014,

59 Corporate tax reform (2010-16)

criteria used to identify harmful tax measures.174 Notably, there was a concern that the Patent Box may grant tax advantages but require little real economic activity in the UK (e.g. a firm may own a patent in the UK but conduct research and commercialisation in other countries). This is an issue that applies to all European Patent Box regimes and that was considered in a review by the EU Code of Conduct group.

Concurrently, the OECD BEPS process has also covered preferential regimes for intellectual property.175 This work, which was led by the OECD Forum on Harmful Tax Practices, led to proposals for a new ‘modified nexus’ approach to ensuring that preferential tax regimes for intellectual property are directly linked to real economic activities. In November 2014, the UK and Germany issued a joint statement proposing that Patent Boxes follow this approach and be changed to ensure that a tax benefit requires a link to R&D expenditures in a country.176 The Code of Conduct group has supported this proposal.177 The UK Patent Box will therefore be modified and the current policy closed to new entrants no later than 30 June 2016.

At this stage, it is not clear how big a change this will be for the UK; it will likely be a much larger change for some other countries that have policies more geared towards attracting mobile income. It is also not clear how any new stipulations over the location of real activities would fit with EU freedom of establishment rules.178

Turning back to the concerns raised over the 2012 CFC reforms, the potential for the new rules to encourage avoidance came up when the interim changes made in 2011 were scrutinised by the House. At the Committee stage of the Finance Bill the Opposition put down an amendment to require the Government to assess the impact of the proposed reform on developing countries. Speaking for the Labour Party David Hanson MP stated that the Opposition generally supported “the direction of travel”, while criticising the Government for not engaging with the charity’s critique:

In government, the Labour party was committed to moving towards a more territorial regime—a regime where profits made in the UK are taxed in the UK but profits made in other countries are not ... The general direction of policy was set in this area when we were in government, and the Minister can be assured that we generally support the direction of travel, but we have some concerns … ActionAid has estimated that as much as £4 billion in tax in developing countries could be avoided as a result of the proposals before the Committee. I do not know whether that figure is correct; I do know that the Treasury has looked at it, because it received freedom of information requests on the issue. We need an assessment from the Minister of whether that figure is accurate.179

174 See ‘EU Commission labels UK Patent Box harmful tax competition’, IFS Observation,

18 October 2013 175 For more information, see OECD, Base Erosion & Profit Shifting, ret’d 13/5/2016.

Patent Boxes are addressed in Action 5. 176 HM Treasury, Germany-UK Joint Statement: Proposals for New Rules for Preferential

IP Regimes, November 2014. See also, HC Deb 2 December 2014 cc7-8WS 177 Code of Conduct Group, Draft report to the Council 16100/14, 28 November 2014 178 Corporation Tax Changes and Challenges, February 2015 pp5-6, 13-14. See also,

Budget 2016, HC901, March 2016 para 2.99, and, PQ30815, 21 March 2016. 179 Public Bill Committee (Finance Bill), Eleventh Sitting, 7 June 2011 cc414-5

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In response Treasury Minister David Gauke made some observations:

The UK’s CFC rules are designed, and always have been, to protect the UK’s tax take from the artificial diversion of profits overseas. Similarly, other countries have CFC rules that are designed to protect their local tax bases. … Our corporate tax system is not the best way to help those countries; it is designed to protect the UK’s taxing rights, not those of other countries. Rather, it is for the countries themselves to have effective systems that build and protect their own tax base, and to ensure that they can access and act upon tax information … Our tax-capacity building work and technical assistance help to ensure that developing countries are in the best position to collect the tax they are owed …

A question was asked about the £4 billion assessment of the cost to developing countries of CFC and branch reform. It is not clear how that estimated cost has been calculated … To come up with a precise number, we would have to have a definitive and exhaustive understanding of the tax systems of all the developing countries likely to be affected. The Treasury does not have that, nor is it likely to acquire it.180

The issue was raised the next year when provisions for the new CFC regime were scrutinised in Committee.181 On this occasion Mr Gauke went into more detail as to the charity’s methodology and why, in the Government’s opinion, it was flawed:

[ActionAid’s assessment] was based on financial data from only 10 UK multinational companies. ActionAid assumed that companies were liable to pay the headline rate of tax in that country and concluded that a fifth of the tax base of developing countries would be lost. We do not see the evidence for that. The difficulty with this assessment is that it seems to take no account of the fact that many developing countries offer tax holidays or incentives to foreign businesses to encourage them to operate there. A common feature of developing countries’ tax systems is reducing the corporate tax liabilities that are due. This means that there is often little incentive for companies to shift profits from developing countries to low-tax jurisdictions. I will give some examples of that, provided by PricewaterhouseCooper’s assessment of international tax jurisdictions in its worldwide tax summaries. For example, headline rates are broadly 30% in Kenya, Rwanda and Tanzania, but those three countries provide for an effective 0% tax rate for companies investing in designated zones, subject to some conditions.

This is provided either in the form of a tax holiday or a 0% rate for 10 years, or indefinitely in the case of Rwanda. Kenya provides investment deductions of 150% for qualifying investments above a certain amount incurred outside Nairobi or the municipalities of Mombasa or Kisumu. Rwanda also grants tax incentives in the form of profit tax discounts. Broadly, these are based on the number of Rwandans employed. The rate of profit tax discount ranges between 2% for employing between 100 and 200 Rwandans to 7% where a company employs more than 900 Rwandans. The reason why I have digressed into that area is that none of that is taken into account in the ActionAid assessments. It

180 op.cit. cc423-5 181 Public Bill Committee (Finance Bill), Thirteenth and Fourteenth Sittings, 19 June 2012

cc463-504

61 Corporate tax reform (2010-16)

assumes that the headline rate applies, and that is how it reaches its assumptions.182

Speaking for the Opposition Catherine McKinnell asked why, in the Minister’s view, HM Treasury could not provide this type of analysis:

Catherine McKinnell: Will the Minister clarify why he believes that it is not possible or appropriate—I am slightly unclear as to which the Minister means—for Her Majesty’s Revenue and Customs and the Treasury to make an assessment at this stage of the impact that the changes will have on developing countries? We are talking in terms of such things being outside our jurisdiction, yet under the current regime and CFC rules, the tax affairs of companies in foreign jurisdictions that are controlled in the UK come within the interest and information collection remit of HMRC ….

Mr Gauke: … As far as analysis is concerned, let me again make the point that the impact of CFC reforms on developing countries will depend on the tax systems in those countries. HMRC and the Treasury do not necessarily have all the data and expertise to make an assessment for those countries, and that will depend on the policies of those countries which, as I demonstrated with the examples of Kenya and Rwanda, can change. Those countries put in place tax regimes to attract investment and be competitive, and that has a major impact on the implications of any policy in that complex area.

The information that I have provided on Rwanda and Kenya comes not from internally-sourced HMRC information but from work done by PWC. I understand why the amendments [to require HMT to provide a formal assessment] have been tabled and the good intent, but they ask for something that HMRC and the Treasury are not in a position to do with any great robustness. Robust analysis is not possible in that area.183

Ms McKinnell also asked, in the context of the considerable cost to this reform, whether the Government anticipated that it would deliver a positive result for the Exchequer:

Catherine McKinnell: The Minister talks about the benefit to the UK of such companies relocating their headquarters to the UK, but he still completely fails to provide any indication of the actual economic benefit. Obviously, the concept is good, but in the current economic climate, in which tax losses are estimated at £910 million—that could be conservative—and given that the potential impact on developing countries is as yet unquantified, it is important that the Government are able to set out an economic argument for the proposal.

Mr Gauke: As far as the costings are concerned, these are our central assessments, which have been signed off by the Office for Budget Responsibility. I have certainly received plenty of representations saying that the reforms will not cost as much as we anticipate, because the dynamic effect will be that much greater, and that more businesses and individuals, paying a lot in tax, will relocate here. That is our assessment, and it is a fair and reasonable one. The measures add to our competitiveness, in the same way that corporation tax rate cuts add to our competitiveness …

182 PBC (Finance Bill), Thirteenth Sitting, 19 June 2012 c469 183 op.cit. c471

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I have to say a word or two about the reaction from business. These reforms have been well received … Following the publication of the Bill in March, one of the big four advisory firms announced that it was in discussion with 10 to 15 multinational companies that were considering locating substantial operations in the UK as a result of corporate tax reforms. The Confederation of British Industry commented that these much-needed changes “will help make the UK a more attractive place for companies to invest, do business and create jobs.” That confirms the message that Britain is open for business.184

During this year the International Development Committee conducted an inquiry into tax in developing countries, and several witnesses, including ActionAid, raised their concerns over the impact that CFC reform would have on developing countries. The Committee took the view that the Government should conduct a formal assessment “as a matter of urgency”, that that, “depending on the results of this analysis, the Government should consider whether to drop its proposals”:

Under the current system, prior to these revisions coming into force, if a UK-owned corporation reports profits in jurisdictions with lower corporate tax rates than the UK, (such as by transacting with its own subsidiaries to shift its profits from developing countries into low-tax jurisdictions) the UK Government is able to impose an extra tax charge on the corporation to 'make up the difference.' Profits shifted from developing countries into tax havens, therefore, would still incur tax at UK rates: this may disincentivise such profit-shifting.

Under the new system, the UK will only be able to impose this extra levy if the profits in question have been shifted from the UK. Profits shifted from developing countries into tax havens, therefore, will incur tax at the tax haven rate, rather than at the UK rate—so the incentive to shift profits into tax havens will be significantly higher. A number of NGOs are campaigning vigorously against this legislative change …

If approved, the newly-relaxed Controlled Foreign Companies (CFC) rules … will incentivise multinational corporations to shift profits into tax havens. This is likely to have a significant detrimental impact on the tax revenues of developing countries. As a matter of urgency, the Government should conduct or commission an analysis of the likely financial impact of the revised Controlled Foreign Companies rules on developing countries. Depending on the results of this analysis, the Government should consider whether to drop its proposals.185

However, in its response to the Committee’s report, published in November 2012, the Government reiterated its view that it would not be “feasible to produce an estimate that would be sufficiently robust or accurate to be of value”:

The Government is reforming the corporate tax regime in order to encourage investment and drive growth in the UK. A key part of this is the reform of the Controlled Foreign Companies (CFC) rules. Without reform of the CFC rules, the UK economy would be damaged by more companies leaving the country. The

184 op.cit. cc474-6 185 Tax in Developing Countries: Increasing Resources for Development, 23 August 2012,

HC 130 of 2012-13 paras 51-55

63 Corporate tax reform (2010-16)

question of the impact of CFC reform on developing countries was debated in Parliament during the passage of the Finance Bill 2012.

The Government has been clear that any assessment would need to focus on the tax regimes of other countries, making it an assessment not of UK tax rules but the tax rules of other countries and their application to the relevant subsidiaries of UK headed groups. Therefore it is not feasible to produce an estimate that would be sufficiently robust or accurate to be of value.186

Starbucks, Amazon, Google & using a ‘GAAR’ In autumn 2012 the actions of multinationals to successfully exploit competing tax jurisdictions to reduce their tax liabilities became the focus of media reports: in particular, the contrast between the amounts of UK corporation tax they paid and, respectively, their presence on the high street (Starbucks coffee shops), the size of their internet-based sales to UK customers (Amazon) or their dominant position in internet-search (Google).187 In December 2012 the Public Accounts Committee published a report on this issue, strongly criticising all three companies:

[In November] the Committee held a hearing with representatives from three multinational companies (Amazon, Google and Starbucks) … While their circumstances and business models are different they all have a significant commercial presence in the UK and we wished to gain an understanding as to why it appears that they do not pay their fair share of corporation tax in the UK …

All three companies accepted that profits should be taxed in the countries where the economic activity, that drives those profits, takes place and that, alongside their duty to their shareholders, they had obligations to the society, from which they derive their profits, which included paying tax. However, we were not convinced that their actions, in using the letter of tax laws both nationally and internationally to immorally minimise their tax obligations, are defensible.188

The Committee was also very critical of HMRC’s record in reducing the “tax gap” – the department’s estimate of the difference between tax that is actually collected and that which is ‘theoretically due’:

The theoretical tax liability represents the tax that would be paid if all individuals and companies complied with both the letter of the law and HMRC’s interpretation of the intention of Parliament in setting law (referred to as the spirit of the law) ... An equivalent way of defining the tax gap is the tax that is lost through non-payment, use of avoidance schemes, interpretation of tax effect of

186 Sixth Special Report, 13 November 2012, HC 708 of 2012-13 p8. See also, DFID

update to Tax in Developing Countries Report recommendations, 1 April 2014; PQ2381, 18 June 2015; PQ26992, 22 February 2016; and, PQ33169, 15 April 2016.

187 For example, Financial Times, “Pressure mounts over level of tax paid by multinationals”, 5 November 2012 & “Starbucks ground down”, 8 December 2012. For a contrary view as to whether these companies were engaged in tax avoidance see, “Politicians should stop posturing on corporate tax”, Financial Times, 31 January 2013 & “Looking for avoidance”, Taxation, 28 February 2013.

188 HMRC: Annual Report and Accounts 2011–12, 3 December 2012, HC 716 of 2012-13 para 12. The Committee produced a second report, focusing on Google, the next year: Tax Avoidance–Google, 13 June 2013, HC 112 of 2013-14.

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complex transactions, error, failure to take reasonable care, evasion, the hidden economy and organised criminal attack.189

The Committee took the view that HMRC had been “too passive” in its approach to reducing the size of the gap:

HMRC’s latest published estimate of the gap for 2010-11 is £32.2 billion which has reduced from £33.3 billion for 2004-05. HMRC did not agree with the Committee’s view that there has been disappointing progress in closing the tax gap as the gap, while trending down only very slowly, is competitive when compared with most countries and is lower than Sweden and the United States …

HMRC … has only reduced the gap between what is due and what is collected by £1 billion since 2005. Closing the tax gap is central to public perceptions of fairness during a period of austerity and of cuts to public services and HMRC appears to be complacent in its approach. HMRC must set immediate and ambitious targets to reduce the tax gap.190

Helen Miller of the IFS discussed the limitations to using HMRC’s tax gap estimates to gauge the Exchequer cost of corporate tax avoidance in the IFS 2013 Green Budget:

The HMRC analysis estimates a £4.1 billion corporate tax gap in 2010–11. This compares with total net corporate tax receipts of £42.1 billion (and therefore implies that £46.2 billion should have been collected). In calculating the corporate tax gap for large companies, HMRC essentially uses internal knowledge on where there are risks that tax is not being paid and on the estimated size of those risks. The measure is geared towards cases involving disclosed avoidance schemes or genuine uncertainty over the correct tax treatment. Importantly, the method will not capture most of the tax that is lost when firms shift profits offshore.

For example, agreed-upon transfer prices may represent a certain degree of avoidance but will likely not be identified as a risk by HMRC, such that the tax consequence is not captured in the measured tax gap. This is a key criticism of the HMRC measure and means that it almost certainly underestimates how much tax would have been paid in the UK if there were no avoidance. However, it should be noted that it is hard to imagine how some avoidance behaviours discussed above could be accurately measured.191

Ms Miller went on to note that competing estimates made by campaigners had serious shortcomings:

Attempts have been made to quantify the effect of profit shifting by considering the difference between the amount of tax paid as declared on firms’ accounts and an estimate of the tax due.192 Such measures tend to make assumptions about how much taxable profit was made in the UK and how much tax ‘should’

189 Measuring Tax Gaps 2013, October 2013 p6. The department’s work on the tax gap

is collated on Gov.uk. The tax gap is discussed at more length in, Tax avoidance: a General Anti-Abuse Rule, Commons Library briefing paper CBP6265, 19 April 2016 (see section 1.2).

190 HC 716 of 2012-13 para 14, p5 191 “Chapter 10: Corporate tax, revenues and avoidance”, IFS Green Budget, February

2013 p296 192 “The big question: what is the tax gap?”. Guardian, 2 February 2009; Richard

Murphy, The Missing Billions, TUC February 2009

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have been paid, and do not directly account for the deliberate elements in the structure of the tax system that mean that tax liabilities can be reduced (such as capital allowances, the R&D tax credit and loss carry-forwards) or the genuine commercial reasons why tax may be paid in other jurisdictions. As such, while estimates have suggested much larger tax gaps for the UK’s largest companies than those implied by the HMRC analysis, they are likely overstated (possibly by a wide margin).193

The Confederation of British Industry echoed this point in a paper on business taxation published in 2012:

One of the features of the last 30 years has been the increasing use of the tax system by governments of every colour as a delivery mechanism for social and economic policy objectives. As intended, taxpayers respond to these incentives. There is a range of factors which, taken together, have a significant impact on the corporation tax liability of a company – these are the deductions or reliefs that companies can claim against their corporation tax bill…

The myriad of incentives shows it is not possible to identify a single, scientifically ascertainable ‘right’ amount of tax. Corporate tax law is too complex, too uncertain and with too many interactions for that to be the case. This means one cannot simply say that if the proportion of a company’s profits paid in tax is lower than the statutory tax rate (currently 26% for most companies) this must result from abusive arrangements. The availability of capital allowances, deductions provided by statute, the mix of UK and overseas profits and tax losses can all legitimately lower the effective tax rate.194

The CBI published a follow-up report the next year, with more technical detail on some of the key concepts for corporate taxation. The report also indicated that public debates over tax were having an impact on business behaviour:

Tax has become a more important issue for most companies and is often now on the agenda of the board of directors. There are greater reputational issues at stake than ever before and companies are talking about their tax affairs in a different way and through different media. Additionally, tax is a topic increasingly seen by many stakeholders as an important area of corporate social responsibility (CSR). A number of companies are using CSR reports as well as financial statements to provide information on tax.

Many companies are starting to form a tax strategy and policies that express their views on timely compliance and cooperation and, indeed, their positions on the scale of how they balance tax management and risk. They generally reflect the need to remain competitive on tax as against others in the same industry or market. Only a minority of companies discuss their tax strategies or policies in financial statements, but the number is growing. More companies, however, are showing interest in how taxes are part of the economic value they create and distribute to stakeholders, whether as taxpayers or tax collectors on behalf of government.195

193 IFS Green Budget, February 2013 pp296 194 CBI, Tax and British business: making the case, April 2012 pp12-13 195 CBI, Tax and British business: making the case – update, July 2013 p10

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Helen Miller concluded her analysis of this issue making a much wider point: that an accurate estimate of the amount lost to avoidance – even if this were possible – would not represent the amount that the Exchequer could recover in the future:

In summary, we don’t know how much corporate tax is lost to the UK as a result of tax avoidance. This is partly because there is no accepted definition of exactly what constitutes ‘avoidance’ and partly because we lack full information about the activities of firms. Importantly, even if we knew that information and could calculate the tax lost to avoidance, it would not be right to assume that, were all avoidance opportunities to be completely removed, the UK would be able to collect that full amount. We would expect higher taxes to feed through, at least to some degree, to lower investment and changes in prices such that genuine UK profits may be lower. To the extent that the corporate tax affects prices or wages, or the location of firms’ activities (and therefore jobs), there may also be lower receipts from income taxes or VAT.196

In December 2013 the Public Accounts Committee published its report on HMRC’s latest annual accounts, in which it was strongly critical of the tax gap measure itself, arguing that it did not “include an assessment of the amount of tax lost through tax avoidance” and so “represents only a fraction of the amount that the public might expect to be payable.”197 In evidence Edward Troup (Tax Assurance Commissioner) and Jim Harra (Director-General, Business Tax) were both asked if these figures included estimates of the amounts of money that many felt companies, like Starbucks, Amazon and Google, should be paying. Both witnesses suggested that this would be misleading:

Q231 Chair: Am I right in saying that the sort of issues that we were discussing in relation to Starbucks, Amazon and Google … and the tax that could have been payable from those companies is not included, because it is not seen to be within the rules?

Edward Troup: The tax gap that we measure is a compliance tax gap.

Q232 Chair: It does not include that. I am asking whether it includes the Starbucks scenario, the Amazon scenario or the Google scenario.

Edward Troup: It does not include the amounts of tax that some of the commentators have said these companies should pay. That is correct …

Q258 Chair: At the moment … your tax gap is purely the tip of an iceberg.

Jim Harra: Our tax gap is a complete measure of non-compliance with current tax law. It does not include a measure of how much additional tax might be collected if you changed the policy.198

Many commentators have continued to raise questions over the amounts of tax that “should” be paid. In January 2015 an alliance of charities, including Christian Aid and Oxfam, published proposals for a

196 IFS Green Budget, February 2013 pp297 197 HMRC Tax Collection: annual report and accounts 2012/13, 19 December 2013 HC

666 of 2013-14 p8 198 HC 666 of 2013-14 para 3 (fn 7), Ev25, Ev27

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‘Tax Dodging Bill’, to ensure that companies, particularly multinationals, paid their “fair share” of taxes.199 The authors argued that “tax dodging” encompassed three different types of behaviour (emphasis added):

There is no single, agreed, definition of “tax dodging”, but it is a phrase that has become widely accepted and understood by the public in the UK and is thus used here in place of a more specific definition of the behaviours that we are asking parties to tackle in this campaign.

In this case we include in our definition three broad type of behaviour: 1) Using opportunities provided by the tax system to attempt to reduce tax payments in a way that, on examination, would be deemed to be outside the law and thus illegal; 2) Using opportunities provided by the tax system to attempt to reduce tax payments in a way that is deemed legal, but is contrary to the intention of the law; 3) Using tax incentives, that are provided for in law, but which are not proven to provide the economic or social benefits that would justify the loss of tax revenue.200

Writing on this question some years ago, Judith Freedman, Professor of Taxation Law at Oxford, argued, “how much tax should be paid is not a question of moral intuition but a question of what is imposed by law.”201 Taking up this point more recently, the tax barrister Jolyon Maugham suggested that “as a tool for delivering tax outcomes, morality is highly imperfect: subjective, imprecise, and enforceable indirectly at best.” However, there was a risk for the tax community from ignoring the truism: that which is legal isn’t always moral:

Discrimination on the grounds of ‘colour’ (to use the language of the Act) did not become immoral only on 8 December 1965 when the first Race Relations Act received royal assent … At the second reading of the Race Relations Bill, Peter, later Baron, Thorneycroft, argued that one should not legislate against discrimination on the grounds of ‘colour’; it was too soon. As he put it: ‘The British people can be led, but they cannot be driven. Thorneycroft was right, albeit in only the narrowest sense. That there can be a relationship between law and morality is a basic requirement of the law. The law becomes difficult to enforce if it is too advanced of morality: this was the Baron’s contention. However, the law falls into disrepair where it fails to keep pace with changing mores. And that, Dear Reader, is what we have here.202

UK tax law is specifically targeted rather than purposive: in tackling the exploitation of loopholes in the law, governments have legislated against individual avoidance schemes as and when these have come to light. Often the response to this legislation has been the creation of new schemes to circumvent the law, which in turn has seen further legislative action – an ‘arms race’ between the revenue authorities and Parliamentary counsel on one side, and on the other, taxpayers aided and abetted by the legal profession. Over the past twenty years many

199 TaxDodgingBill.org press notice, Parties given 200-day challenge to fight back at

global tax dodgers, 26 January 2015 200 TaxDodgingBill.org, The Tax Dodging Bill: what it is and why we need it, January

2015 p19 201 “Chapter 8: Is tax avoidance ‘fair’?”, in, Chris Wales (ed)., Fair tax: towards a modern

tax system, Smith Institute 2008 p94 202 “The uses of morality in tax”, Tax Journal, 19 December 2014

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commentators have suggested having legislation to counter tax avoidance in general: by providing certainty for both sides as to the tax consequences of any transaction, a ‘General Anti-Avoidance Rule’ might dissuade the most egregious efforts to avoid tax, encourage taxpayers and legal counsel to redirect their energies to more productive activities and allow the authorities to simplify the law without fear of it being systematically undermined.

In its first Budget in June 2010 the Coalition Government announced it would consult on this issue,203 and in December a study group, led by Graham Aaronson QC, was established to explore the case for introducing an anti-avoidance rule.204 Mr Aaronson completed his report in November 2011, in which he recommended a narrowly focused rule targeted at ‘abusive arrangements’ only.205 In June 2012 the Government launched a consultation exercise with a view to introducing a General Anti-Abuse Rule (GAAR) in 2013,206 confirming its plans in the Autumn Statement in December 2012.207 Provisions in the Finance Bill 2013 for the new GAAR were agreed, without changes, and the new rule came into force on 17 July 2013.208

When draft provisions for the new GAAR were published in December 2012, the House of Lords Economic Affairs Committee considered the proposals, as part of their enquiry into selected provisions of the draft Finance Bill.209 Most of the Committee’s witnesses supported the ‘narrow’ focus of the anti-abuse rule, though the Committee noted that, by itself, it would not be an effective answer to public anger over tax avoidance by multinational companies. Tim Davies (UK Head of Tax, Mazars) put the issue this way:

If you try to categorise the public anger, it falls into perhaps three areas. You have the multinationals … which I agree the GAAR was never intended to and certainly will not touch that. You have high profile individuals who adopt what many consider to be highly aggressive schemes to mitigate income tax. I think the GAAR will successfully attack those. The third area probably is around bonuses, timing of bonuses and taking advantage of different tax rates. Personally, I do not believe the GAAR should attack that.210

The Committee agreed that reforming the taxation of multinational groups should be dealt with “by negotiation at the EU, OECD, G8 or G20 level”, and, while it commended the policy-making process underpinning the new GAAR, expressed concerns that “every effort should be made to communicate, particularly to the press and the

203 Budget 2010, HC 61 June 2010 para 2.114 204 HC Deb 6 December 2010 cc1-3WS 205 HC Deb 21 November 2011 cc2-3WS; HM Treasury press notice 130/11, 21 November

2011 206 HMRC, A General Anti-Abuse Rule (GAAR) - consultation document, June 2012 207 Autumn Statement, Cm 8480 December 2012 para 1.178; see also, Budget 2013, HC

1033, March 2013 para 1.211 208 HM Revenue & Customs’ detailed guidance is published on Gov.uk. This issue is

explored in more detail in the briefing paper cited above: Tax avoidance: a General Anti-Abuse Rule, CBP6265, 19 April 2016

209 The draft Finance Bill 2013, 13 March 2013, HL Paper 139 2012-13 paras 10-117, pp9-45

210 op.cit. para 88 (Q94)

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public, why the GAAR is not an appropriate mechanism to address all problems with the tax system.”211

Following the 2013 Budget, on 17 April 2013 the House debated, and approved, the provisions in the Finance Bill 2013 for the new GAAR. Speaking for the Opposition Ms McKinnell welcomed the new rule in principle, but moved two amendments, in light of concerns about how it would work in practice: first, that there should be a formal review of the GAAR’s operation two years after it came into force; and second, that the Government should review how the GAAR might be used to provide information on tax avoidance schemes used by multinationals that affected revenues for other nations – in particular, developing countries. On this second issue Ms McKinnell set out a number of amendments:

The Opposition believe that the first step to tackling the issue, and to creating a fair taxation system, is to put an end to tax secrecy. We need concrete proposals from the Government to demonstrate how they intend to put the issue at the top of the G8 agenda, starting with the requirement suggested by our amendment that HMRC should work in conjunction with other G8 countries to bring forward measures to require multinational groups to publish a simple, single figure for the amount of corporation tax they pay. That is the purpose of our amendment 4. Yet, while the issue of tax avoidance and tax transparency can clearly only be properly dealt with at an international level, we believe the UK should be leading the way, demonstrating its determination to take meaningful action on tax transparency here at home. Therefore our amendment 5 would ensure that commitment was there, regardless of progress at an international level.

Tax transparency should not be restricted to the UK and other G8 or OECD countries; it is needed now, more than ever, in the developing world. The Prime Minister and the Chancellor have frequently stated their commitment to championing tax transparency during the UK’s presidency of the G8. They are on record as being committed to ensuring that developing countries also benefit from any reforms, yet with the exception of a relatively small pot of money for capacity-building work, the measures to combat tax avoidance in the Bill before us do nothing to assist poorer countries.

So although the Government are determined that Labour’s disclosure of tax avoidance scheme requirements cannot be extended to include subsidiaries of UK companies operating in developing countries, the Opposition believe that the Government should at least commit to reviewing how a requirement for UK companies to report their use of tax schemes that have an impact on developing countries could be enacted. Surely it is the least that the Government can do.

That review, called for by our amendment 6, should of course include considering how the Government would take steps to notify developing countries’ tax authorities of tax schemes that have been identified, to assist in the recovery of that tax.212

211 op.cit. para 104, para 106 212 HC Deb 17 April 2013 c428

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The then Exchequer Secretary, David Gauke, opposed both initiatives. First, in the Government’s view, “a two-year period would not be practical for a general evaluation … just because of how our tax system operates.” Second, with regard to amendment 6, “as a matter of practicality it is difficult for HMRC to perform the roles required by [this amendment] as [it would require] assessments not of our tax rules but of the tax rules of developing countries. That takes us outside what HMRC can realistically do.”213

The new Diverted Profits Tax In his Autumn Statement in December 2014, in a marked departure from the Coalition Government’s approach to corporate taxation, the Chancellor announced a new tax, as a means to tackle artificial profit-shifting:

Some of the largest companies in the world, including those in the tech sector, use elaborate structures to avoid paying taxes. Today, I am introducing a 25% tax on profits generated by multinationals from economic activity here in the UK which they then artificially shift out of the country; that is not fair to other British firms and it is not fair to the British people either—today, we are putting a stop to it.

My message is consistent and clear: low taxes; but low taxes that will be paid. Britain has led the world on this agenda and we do so again today. This new diverted profits tax will raise more than £1 billion over the next five years.214

The Autumn Statement report confirmed that the new Diverted Profits Tax (DPT) would apply from 1 April 2015, and gave estimates of the tax raising £270m in 2016/17, rising to £355m by 2019/20.215

The Financial Times reported concerns that the new tax might infringe the UK’s double taxation treaties:

The move – widely dubbed the “Google tax” – was described by Mr Osborne as a crackdown on “some of the largest companies in the world, including those in the tech sector, [that] use elaborate structures to avoid paying taxes”. … One executive at a leading technology company said the industry was unlikely to fight the measure, but described the move as “unilateral action” that went beyond an ongoing examination of international tax reform by the OECD, the Paris based group of countries that aims to promote sustainable growth. “We’ll see what our tax experts make of it . . . but it’s for politicians to make laws, and we will follow them,” he said.

Chris Morgan of KPMG, the professional services group, speculated that the new tax would be a “deemed profits” tax

213 HC Deb 17 April 2013 cc446-7. The House voted on two of the Opposition

amendments: first, to require a review of GAAR within 2 years, and second, the last of the amendments Ms McKinnell discussed, to review how companies could be required to report on their use of tax schemes to mitigate their liability in developing countries. Both were negatived, and the provisions in the Bill relating to GAAR were agreed without changes.

214 HC Deb 3 December 2014 cc310-1 215 Autumn Statement, Cm 8961, December 2014 para 1.243, Table 2.1: item 30.

Budget 2015 gave slightly higher estimates: £275m in 2016/17, rising to £360 in 2019/20 (HC 1093, March 2015, Table 2.2: item p).

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rather than a corporation tax, so as to sidestep issues about double tax treaties. He suggested that the Treasury would identify profits that escaped tax in the UK because of royalty arrangements or the absence of a taxable presence. Mr Morgan said: “It seems to be something completely novel . . . It is a huge stick that will stop this artificial avoidance. The difficulty will be how it is defined in practice.” He described it as a “nuclear option” aimed at encouraging companies to adapt their structures to pay more tax in Britain. Mr Morgan said “Companies that have been pushing the envelope will be very worried.”

Neal Todd, partner at international law firm Berwin Leighton Paisner, said: “After years of bringing business back to the UK it seems as though the chancellor is pandering to the populist attacks on high tech and other multinationals. “It is hard to see how this is compatible with the UK’s double tax treaty obligations unless there is a specific treaty override.”216

Draft legislation for this, and other measures to be included in the following year’s Finance Bill, was published a few days later. A tax information and impact note gave details of the circumstances when the DPT would apply:

The first rule is designed to address arrangements which avoid a UK permanent establishment (PE) and comes into effect if a person is carrying on activity in the UK in connection with supplies of goods and services by a non-UK resident company to customers in the UK, provided that the detailed conditions are met.

The second rule will apply to certain arrangements which lack economic substance involving entities with an existing UK taxable presence. The primary function is to counteract arrangements that exploit tax differentials and will apply where the detailed conditions, including those on an “effective tax mismatch outcome” are met.

The first rule only applies where the UK person and the foreign company are not small or medium-sized enterprises (SMEs) and the second rule where the two parties to the arrangements are not SMEs (the SME test will apply to the group). The first rule will be subject to an exemption based on the level of the foreign company’s (or a connected company’s) total sales revenues from all supplies of goods and services to UK customers not exceeding £10 million for a twelve month accounting period. The diverted profits tax will not reflect any profits relating to transactions involving only loan relationships.217

The Chartered Institute of Taxation reiterated concerns as to whether it was sensible to introduce the tax, while discussions over reforms to the international rules continued through the OECD – the ‘Base Erosion & Profit Shifting’ (BEPS) initiative launched by the G20 nations in 2013 (this is discussed in more detail in the next section of this note):

The objectives of the new Diverted Profits Tax are reasonable but we are concerned that the UK Government may be developing a new tax in advance of agreement on new principles of transfer pricing and taxable presence – which is work that the G20/OECD

216 “Multinationals to pay their ‘fair share’”, Financial Times, 4 December 2014 217 HMRC, Diverted profits tax: tax information & impact note, December 2014. As noted

above, a permanent establishment is created when a company carries out activities which create a taxable presence.

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expects to conclude in September 2015. The UK needs to be careful not to introduce a tax which might be in conflict with internationally-agreed principles and which gives businesses no opportunity to modify their approaches in line with those new principles.218

The CIOT also suggested that the Chancellor’s priority in introducing the DPT was to change corporate behaviour rather than find a major new source of Exchequer funding:

The draft legislation is aimed at a limited range of circumstances. It is structured in a way that potentially brings into scope a much larger number of transactions, but it then effectively aims to take ‘inoffensive’ cases out of the charge. This structuring will mean that a very large number of companies will need to be aware of the legislation and be able to demonstrate that they do not fall inside it, which will add to their compliance cost. This will include some UK-based multinationals as well as those based in the US and elsewhere. It is a significant addition to HMRC’s armoury. The amounts the new tax is expected to raise are relatively modest – around £350 million a year. It looks like the Government expect its biggest impact to be changing companies’ behaviour rather than raising large sums in its own right.219

On this point the barrister and commentator Jolyon Maugham has noted that “the Google Tax is intended to be punitive”:

In that sense it’s like a number of other recent (and contemplated) moves in the tax avoidance sphere. It marks out territory on the fiscal map which is susceptible to tax avoidance – and then sets a series of landmines. Step on a mine and you face a penalty tax rate (of 25% more than the general corporation tax rate). Enter the territory and you’ll also face a long period of uncertainty as to whether HMRC will impose a penalty rate along with a hugely complex and uncertain compliance.

You don’t like that? Well then don’t enter that territory.

And it’s absolutely the case that the Government would rather you didn’t. We have decided to pursue a strategy of a low corporation tax rate with an expected increase in the tax base through increased investment. A lower rate applied to greater receipts is the logic. And that it’s Government’s purpose that the Google Tax shouldn’t disrupt this strategy can be seen in the low anticipated direct yield from the tax. The real tax benefits will, presumably, be felt in the form of higher receipts from the corporation tax.220

The CIOT, as well as the Association of Certified Chartered Accountants and the Institute of Chartered Accountants, raised these concerns in evidence to the Treasury Committee, as part of its inquiry into the Autumn Statement. For its part the Committee took the view that the

218 [One practitioner writing in the Tax Journal argued, “this appears to be a

straightforward attempt by the UK to make a unilateral amendment to the definition of a PE. This is unlikely to be popular internationally, undermines the BEPS process, and risks retaliation” (“Comment: DPT”, 19 December 2014).]

219 CIOT press notice, New tax on multinationals will mean additional compliance, but have limited impact on tax bills, 10 December 2014

220 “The Google Tax: some further reflections”, Waiting for Godot: musings on tax blog, 9 March 2015

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DPT “should not be permitted to destabilize the international effort [to tackle corporate tax avoidance]”:

Each of the three professional tax bodies … questioned the Government's decision to introduce the unilateral DPT ahead of the completion of the Organisation for Economic Cooperation and Development's (OECD's) work on base erosion and profit shifting (BEPS).

BEPS refers to tax planning strategies that exploit gaps and mismatches in tax rules artificially to shift profits to low tax jurisdictions, where there is little or no economic activity, resulting in little or no overall corporate tax being paid. Following recognition that the international tax system needed to be reformed to prevent BEPS, the G20 asked the OECD to recommend possible solutions.

In September 2014, the OECD published a 15-point Action Plan to address BEPS which will be completed in three phases—September 2014, September 2015 and December 2015. The aim of the OECD BEPS project is to: “create a single set of consensus-based international tax rules to address BEPS, and hence to protect tax bases while offering increased certainty and predictability to taxpayers.” …

The Committee asked the Chancellor what discussions were held with the OECD prior to the announcement of the DPT. He told us: “We are heavily involved in the OECD work … I think these changes are absolutely with the grain of where the international community is moving. I think we have been careful not to get too far ahead of that international work but nevertheless act to protect revenues.”

Tackling tax avoidance, specifically the problems associated with base erosion and profit shifting, is an internationally recognised problem which requires an international response. This is currently taking place in the form of the OECD's base erosion and profit shifting project. The Committee notes the Government's decision to announce a unilateral Diverted Profits Tax ahead of the conclusion of the OECD's work. This should not be permitted to destabilise the international effort.221

It was also critical of the length and complexity of the draft legislation:

Following the publication of the draft legislation of the Finance Bill 2015—released on 10 December—both the ICAEW and CIOT provided the Committee with additional written evidence on the DPT. The ICAEW described the draft legislation as "highly complicated" and that it is "likely to increase uncertainty". It highlighted that the draft legislation consisted of "30 pages of draft clauses, nearly 50 pages of Explanatory Notes and a Guidance document of a further 50 pages".

CIOT agreed with this, saying that the legislation is drafted in a "very unclear manner". It goes on to say that the DPT “potentially brings into scope a large number of transactions and it is unclear whether that is the intention. This structuring will mean that a large number of companies will need to be aware of the legislation and consider whether they fall inside it. Computation of the amount subject to the tax does not look straightforward to calculate, given that it is not based on any agreed international standards.” … The draft legislation is long and highly complex.

221 Autumn Statement, 13 February 2015, HC 870 of 2014-15 paras 120-1, 124, 128

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This is undesirable in itself, and is likely to be a source of uncertainty.222

These concerns was also raised in a Westminster Hall debate on the tax in January 2015, initiated by Nigel Mills; as Mr Mills said in his speech, “no one would want the UK, by acting unilaterally, to unravel [the BEPS process] … so that we do not get the co-ordinated international outcome we all expect later this year.” In her speech Shabana Mahmood said that the Opposition “broadly welcome the Government’s proposed action”, but asked “how those in the process have reacted to the DPT proposals, and why the Government felt it necessary to take unilateral action at this point, notwithstanding what many commentators have said about the looming general election.”223

In her response the then Economic Secretary, Andrea Leadsom, argued that the tax was “entirely consistent” with the BEPS project, and explained why, in the Government’s view, it would not infringe either double taxation treaties or EU law:

The introduction of the diverted profits tax is entirely consistent with those principles and complements the ongoing international efforts in the BEPS project, which is looking to align taxing rights with economic activity …

The scope of the UK’s tax treaties is limited under UK law to income tax, capital gains tax and corporation tax. The diverted profits tax is therefore not covered by those treaties, so, as a formal matter, there is no treaty override; and in fact the OECD, in the commentary on its model tax treaty, provides that states can deny the benefits of a tax treaty where arrangements have a main purpose of securing more favourable tax treatment in circumstances contrary to the object and purpose of that treaty …

The diverted profits tax has been designed to comply fully with our obligations under EU law. It is aimed at structures that are clearly designed to erode the UK tax base. As such, it is an appropriate response to those who abuse EU law to divert profits from the UK. The safeguards built into the legislation provide taxpayers with a number of opportunities to demonstrate that they should not be subject to the diverted profits tax. Accordingly, we believe that this is a balanced and proportionate measure that tackles arrangements that are clearly designed for tax avoidance.224

Similarly, in its response to the Treasury Committee’s report, the Government stated that “the Diverted Profits Tax is consistent with international tax rules and complements the work going forward in the BEPS project.” The Government rebuffed the Committee’s concerns that the DPT provisions were too long and complex, though it indicated that it was considering some amendments to the draft legislation:

222 HC 870 of 2014-15 paras 125, 128 223 HC Deb 7 January 2015 c80WH, c93WH 224 op.cit. c100WH. As discussed above, in its judgement of the Cadbury Schweppes case,

the ECJ ruled that national tax provisions restricting the freedom of establishment could be upheld if their purpose was to frustrate contrived arrangements to aggressively avoid tax: “a national measure restricting freedom of establishment may be justified where it specifically relates to wholly artificial arrangements aimed at circumventing the application of the legislation of the Member State concerned” (Case C-196/04, para 51).

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The tax avoidance techniques targeted by the Diverted Profits Tax involve a wide range of complex arrangements designed to avoid paying tax in the UK. Tackling this requires comprehensive legislation.

Draft legislation was published on 10 December 2014 for consultation and the Government is considering where changes to the final legislation for Finance Bill 2015 are appropriate to ensure that it is clear and properly targeted. In addition to this, HMRC will also be issuing further guidance before 1 April 2015 to provide more detail on the operation of the rules.225

In Budget 2015 the Government confirmed its plans for the DPT to come into effect from 1 April, and, in the light of responses to the draft legislation, announced a number of amendments.226 These appear to have been generally welcomed by businesses and tax advisers.227 The main change made to these proposals was to the scope of the ‘notification requirement’: the conditions under which a company has to notify HMRC of a potential DPT liability. HMRC published full details of all of the changes it had made, following the Budget. A short extract is given below:

The legislation will require companies to notify HMRC of a potential liability to DPT. This is intended to provide HMRC with the information that it needs to determine whether a DPT charge may arise, particularly in relation to companies that are currently outside the scope of Corporation Tax (CT) but may be in scope of DPT.

The notification aspect of the draft legislation has been a concern of many respondents. The revised draft legislation narrows the notification requirement so that it applies only where there is a significant risk that a charge to DPT will arise and where HMRC does not know about the arrangements.

There will be no duty to notify for any accounting period if:

• it is reasonable for the company or a connected company to conclude that it has supplied sufficient information to enable HMRC to decide whether to give a preliminary notice for that period and that HMRC has examined that information (whether as part of an enquiry into a return or otherwise)

• HMRC has confirmed that there is no duty to notify because the company or a connected company has supplied such information and HMRC has examined it.228

In their response to the Budget the CIOT welcomed this change: “the legislation published in December would have meant that many companies who would not be expected to pay any DPT would have been faced with a substantial amount of compliance, as the notification criteria were significantly broader than the rules for actually charging

225 Sixth special report, 27 March 2015, HC 1151 of 2014-15 p9 226 Budget 2015 HC 1093, March 2015 para 2.133 227 “Budget 2015: the impact on multinationals” & “”DPT changes”, Tax Journal, 21 &

27 March 2015. For a critical view see, “FA2015 analysis: DPT – an overview”, Tax Journal, 24 April 2015.

228 HMRC, Summary of amendments following the technical consultation, 20 April 2015. HMRC have published detailed guidance on the operation of the DPT, which is available on Gov.uk.

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the tax. This seemed to us to be an unhelpful position, giving rise to unnecessary work for taxpayers and HMRC, particularly if, as the Government has stated, the tax is only aimed at a small group of aggressive tax avoiders.”229

Provision for the DPT is made in Finance Act 2015 (ss77-116). Due to the timing of the Dissolution of the House, the House’s scrutiny of the Finance Bill 2015 was taken, in all its stages, in a single day. As this requires cross-party co-operation, a small number of clauses from the Bill were removed.230 In her speech at Second Reading, Shabana Mahmood was sympathetic to business concerns over the tax, but went on to explain why the Opposition had not insisted that these provisions be removed from the Bill:

We support the thrust of what the Government intend to do, but the Bill was being drafted at the end of last week, when the Minister and I were trying to conclude our negotiations. That is unsatisfactory, because the Bill is complex. In our first Finance Bill when we are in government, we will seek to remedy any defects that prevent that measure from being both effective and strong. I am happy to let it through not because I think that it is a completely 100% foolproof bit of work, but because I fear that the Tories in opposition might not be quite so keen to see the measure on the statute book. I wanted to ensure that we got it passed, and then we could fix any issues later.231

The Bill’s provisions for the DPT were not debated separately, although the Minister, David Gauke, referred to the tax in his Second Reading speech, and mentioned a new international initiative affecting digital multinationals:

The Bill continues the Government’s firm action against the small minority who seek out unacceptable ways to reduce or delay paying the taxes they owe. Under the Bill, we will legislate to create a fairer tax system by clamping down on tax avoidance and ensuring that banks contribute their fair share. Taking effect from the start of next month, the Bill will introduce a new diverted profits tax of 25%, aimed at large multinationals that artificially shift their profits offshore to avoid paying UK tax.

As part of the project, I can confirm that we are working with five other tax authorities to investigate and challenge how digital multinationals shift their profits to tax havens. For the first time, we are gathering a full global picture of the tax risks those companies pose that is invaluable in helping us take decisive action.232

A few more details of this work were given in a press notice issued on the same day as the debate:

HM Revenue and Customs (HMRC) has today confirmed it is working with five other tax authorities to share information about how digital multinationals might be shifting their profits to tax havens. Information from the ‘E6’ project will feed into how

229 CIOT press notice, CIOT welcomes news of changes to DPT, 18 March 2015 230 As explained by the Minister, David Gauke, at the Bill’s Second Reading (HC Deb 25

March 2015 cc1437-8). 231 HC Deb 25 March 2015 c1464 232 HC Deb 25 March 2015 c1439

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HMRC applies the new Diverted Profits Tax, which is being introduced next month …

HMRC continues to build on its work to counter tax avoidance by multinationals by sharing information under the terms of the UK’s treaties with five international partners about multinational businesses operating in the digital economy. The UK is using the knowledge gained from this project, which began in August 2013, to identify and challenge the risks that multinational digital businesses present to the UK tax system.

With the expansion of the Joint International Tax Shelter Information Collaboration (JITSIC) network to more than 20 tax administrations, the UK will build on this model and work closely with other administrations to share information on, and identify suitable challenges to, the threats posed by other multinational business sectors.233

In February 2016 the Government stated that eleven companies had notified HMRC of their potential liability to the DPT.234 At the time of the 2016 Budget the OBR published its latest Economic & Fiscal Outlook, in which it noted that it still anticipated this measure would raise close to £300m a year:

The Government announced the introduction of a diverted profits tax in Autumn Statement 2014. This is designed to target multinationals that use contrived tax arrangements and was expected to raise around £300 million a year from 2016-17 onwards. Our forecast assumes that overall yield from the measure will be close to that originally scored, but we now expect that around two-thirds of the yield will come through higher CT payments (as firms restructure their tax affairs) rather than via the diverted profits tax itself. Yield from multinationals using such tax arrangements is highly uncertain, so we will need to look again at the yield and the split between CT and diverted profits tax in future forecasts.235

5.3 International efforts to tackle evasion & avoidance

Concerns that the international tax system was being outpaced by trends in trade and business are long-standing. Since the 2008 crash these have gone in hand with anxieties over the scale of tax avoidance and evasion. These issues came to a head at the G8 summit in June 2013, when leaders agreed to a series of initiatives to counter both tax evasion by rich individuals – through the automatic exchange of information between revenue authorities – and tax avoidance by multinationals. In the latter case, as David Cameron explained in his statement to the House on the summit, “in a world where business has moved from the offline and the national to the online and the international but the tax system has not caught up, we are commissioning the OECD to develop a new international tax tool that

233 HM Treasury press notice, Government ramps up efforts to tackle digital multinational

risks, 25 March 2015. See also, HMRC, Taxing multinationals: tackling aggressive tax planning: issue briefing, November 2014

234 PQ25057, 29 February 2016 235 Economic and fiscal outlook, Cm 9212, March 2016 para 4.53. see also, PQ36722,

12 May 2016

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will expose discrepancies between where multinationals earn their profits and where they pay their taxes.”236

At the meeting of G20 nations in July 2013, leaders agreed an action plan, prepared by the OECD, to reform the international tax rules, so as to tackle the problems of Base Erosion and Profit-shifting (BEPS). This was endorsed at the G20 summit in St Petersburg in September.237 The OECD set out the scope of the project in a press notice, when this plan was agreed:

The Action Plan will develop a new set of standards to prevent double non-taxation. Closer international co-operation will close gaps that, on paper, allow income to ‘disappear’ for tax purposes by using multiple deductions for the same expense and “treaty-shopping”. Stronger rules on controlled foreign companies would allow countries to tax profits stashed in offshore subsidiaries.

Domestic and international tax rules should relate to both income and the economic activity that generates it. Existing tax treaty and transfer pricing rules can, in some cases, facilitate the separation of taxable profits from the value-creating activities that generate them. The Action Plan will restore the intended effects of these standards by aligning tax with substance – ensuring that taxable profits cannot be artificially shifted, through the transfer of intangibles (eg patents or copyrights), risks or capital, away from countries where the value is created.

Greater transparency and improved data are needed to evaluate, and stop, the growing disconnect between the location where financial assets are created and investments take place and where MNEs report profits for tax purposes. Requiring taxpayers to report their aggressive tax planning arrangements and rules about transfer pricing documentation, breaking-down the information on a country-by-country basis, will help governments identify risk areas and focus their audit strategies. And making dispute resolution mechanisms more effective will provide businesses with greater certainty and predictability.238

As the Guardian noted at the time “some of the proposals might take only a year to prepare, but others may require as long as 18 months or even two years.”239 Writing in the Tax Journal, one practitioner argued that “it is very unlikely that the action plan will be implemented in this timeframe.” Quite apart from the consultation process between the OECD and individual nations, “most of the changes proposed in the action plan are likely to take at least two years to implement.”240 In a second piece, two practitioners noted the difficulties inherent in this exercise in concluding, “it will be fascinating to see how the OECD manages the trade-off between the tax harmonisation needed to underpin the most effective international standards and governments’ reluctance to cede fiscal sovereignty.”241 Another commentator writing

236 HC Deb 19 June 2013 c894 237 HM Treasury press notice, G20: World leaders back international action against tax

avoidance and evasion, 6 September 2013 238 OECD press notice, Closing tax gaps – OECD launches Action Plan on Base Erosion

and Profit Shifting, 19 July 2013. Full details are collated on the OECD’s site. 239 “G20 report warns of global tax chaos”, Guardian, 19 July 2013 240 “The OECD’s Action Plan on BEPS - Adviser Q&A on the key issues”, Tax Journal, 26

July 2013 241 “Analysis: the OECD’s Action Plan on BEPS”, Tax Journal, 9 August 2013

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in the British Tax Journal suggested “it will … be very difficult to achieve consensus within the OECD” given that “any re-allocation of taxing rights will produce winners and losers at a country level.”242

In March 2014 the Coalition Government published a paper on the UK’s priorities for the project,243 and a written answer in November 2014 provides a short narrative of progress to both BEPS, and to international agreements on information exchange, up to that point:

Simon Kirby: To ask Mr Chancellor of the Exchequer, what recent discussions he has had with his G7 counterparts about measures to reduce tax avoidance; and if he will make a statement.

Mr David Gauke: The UK is at the forefront of multilateral action through the G8, G20, European Union and OECD to tackle this issue of corporate tax avoidance. The UK used its Presidency of the G8 to successfully build international support for this work.

Work is now underway at the OECD, in the form of the Base Erosion and Profit Shifting (BEPS) project. The BEPS project is the most comprehensive reform of the international tax rules with the aim of ensuring that multinational enterprises pay their fair share of tax, in the jurisdictions where their economic activity is located. The project has 44 participant countries, 21 of which are within the EU. At the UK’s Lough Erne summit in June 2013 the G8 leaders confirmed their support for the ongoing G20/OECD work. At their September 2013 summit in St Petersburg, the G20 Leaders fully endorsed the ambitious and comprehensive BEPS Action Plan set out over 2014 and 2015.

The first phase of the BEPS project is now complete, with participants reaching agreement on seven reports which have been produced by the OECD and endorsed by G20 Finance Ministers.

The G8 called on the OECD to develop a common template for multinationals to report profit and tax information to tax authorities to help assess risks. This work was included in the BEPS Action Plan (action 13) and was one of seven outputs achieved in 2014.

Subsequently, the UK announced that it would be the first of 44 countries to formally commit to implementing the newly agreed BEPS output of a country-by-country reporting template. Discussions are ongoing in G20 Finance Minister’s and ECOFIN meetings to ensure that the momentum of the BEPS project is maintained, so that the project is completed successfully and on time.

Further to the BEPS project, international work with G20 and EU counterparts is ongoing with the Automatic Exchange of Information policy. The UK put tax transparency at the heart of its presidency of the G8, calling for the creation of a new global standard on automatic tax information exchange to tackle offshore tax evasion. The new global standard was developed by the OECD and agreed in July 2014. At the March European Council leaders committed to implement the standard in the EU

242 “Current notes: Addressing BEPS”, British Tax Journal, no2 2013 p121 243 HM Treasury & HMRC, Tackling aggressive tax planning in the global economy: UK

priorities for the G20-OECD project for countering Base Erosion and Profit Shifting, March 2014

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through agreement of the amended Administrative Co-operation Directive, which they aim to agree by the end of the year.

In total 92 countries and have now committed to implement the new global standard, with the first information exchanged no later than 2018. This includes all EU Member States, all of the UK’s Crown Dependencies and Overseas Territories with a financial centre and the majority of the world’s financial centres. Of these countries and jurisdictions, 51 have already signed an international agreement to implement the standard.244

In their review of the Coalition Government’s reforms to corporation tax, published in February 2015, Helen Miller and Thomas Pope at the IFS noted that one challenge that would face the next Parliament would be implementing the recommendations of BEPS, once the OECD’s final reports were completed:

The OECD has issued an action plan for what it sees as the steps that governments should be taking to prevent opportunities that allow income to avoid tax in all jurisdictions. The steps include developing options for applying current tax rules to digital activities, advising on domestic rules to prevent profit shifting taking place through the use of hybrid structures, excessive interest deductions or preferential tax regimes, and further developing transfer pricing rules.245

The BEPS process will conclude at the end of 2015. BEPS is an impressive project; it is tackling a broad range of issues on a timescale designed to take advantage of political momentum. However, the process is effectively seeking to ‘patch up’ the current system and prevent some of the most problematic forms of avoidance rather than provide any fundamental reform. Notably, it does not seek to remove the need to ascertain where corporate profits are created, which can be difficult both conceptually and in practice. Importantly, the BEPS actions will not reduce the incentives that governments have to compete over mobile resources.246

The authors cited a paper by Michael Devereux and John Vella at the Oxford Centre for Business Taxation which argues that, for all of its scope and complexity, BEPS is “unlikely to generate a stable long-run tax system” because it will fail to eliminate the incentives for countries to compete, through their national tax systems:

The outcomes resulting from the project are expected to take different forms. Some changes will be enshrined in legally binding international treaties. This should limit, although probably not eliminate, states’ ability to compete in the areas covered. However, these treaties will be limited in scope. In other areas, the expected outcome is a recommendation for domestic legislation. Here the hope is that states adopt legislation effectively limiting their ability to compete in these areas. Whether steps will or can be taken against states which refuse to meaningfully follow these recommendations is unclear.

Furthermore, if their interests so dictate, future governments might not feel constrained from changing their domestic law and recommencing competition in these areas. Other factors, such as

244 PQ212453, 1 November 2014. See also, “Special report: Tackling BEPS – progress

review”, Tax Journal, 25 July 2014 245 Action Plan on Base Erosion and Profit Shifting, OECD, Paris, 2013 246 Corporation Tax Changes and Challenges, February 2015 p17

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tax rates, are outside the scope of the BEPS project altogether, and thus competition on these factors will continue unhindered. Finally, whilst the BEPS project includes a broad group of countries, it is not truly global. Again, it is unclear whether steps can be taken to encourage countries that are not part of the BEPS process to adopt the recommendations resulting from the project.247

Whatever the prospects for longer-term, Ms Miller and Mr Pope noted that the 2015-20 Parliament would have to find a balance between implementing the recommendations of BEPS and maintaining the UK’s competitiveness - something that had only been achieved at considerable financial cost:

In the last five years, the coalition has spent around £8 billion reforming the corporation tax. Most visibly, the main rate has fallen from 28% to 20%. The UK has moved up in international rankings, although it stands out as having a less generous set of capital allowances. Looking forward, the next government could pick up the challenge of reforming the corporate tax base.

One challenge that will have to be faced in the next parliament is finding a balance between competitiveness and cooperation. In particular, in the early stages of the next parliament there will be a set of recommended actions coming out of the BEPS final reports. While some of the actions might be straightforward for the UK, others may create a tension if they involve policy changes that would be deemed to make the UK less competitive.248

247 M.Devereux & J.Vella, Are we heading towards a corporate tax system fit for the 21st

century?, OUCBT October 2014 p1, p18. The authors explore several possibilities for a different basis for the international system in section 4 of the paper (pp 18-20).

248 IFS Briefing Note BN163, February 2015 p18

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6. The Conservative Government’s approach

6.1 Budgets 2015-2016: further rate reductions

In his first Budget after the 2015 General Election, the Chancellor, Mr Osborne, announced two further reductions in the rate of corporation tax over the next Parliament: a cut to 19% in 2017, and to 18% in 2020. In his Budget speech Mr Osborne argued that the UK could not “afford to stand still while others rush ahead”:

There are those in this House who said we were wrong to cut corporation tax in the last Parliament, but it created millions more jobs, brought businesses back to Britain and increased much-needed investment, so I profoundly disagree with them. Now at 20% for large and small businesses alike, we have the joint lowest rate of corporation tax in the G20, so there are those who say we do not need to do more. I profoundly disagree with them too. This country cannot afford to stand still while others rush ahead. I am not prepared to see that happen.

Today, I announce that I am cutting it again. Britain’s corporation tax rate will fall to 19% in 2017 and 18% in 2020. We are giving businesses lower taxes that they can count on, so that they can grow with confidence, invest with confidence and create jobs with confidence. A new 18% rate of corporation tax—sending out loud and clear the message around the world that Britain is open for business.249

Further details were given in the Budget report, which gave updated estimates of the potential long-term impact of these reforms:

1.239 Overall the corporation tax cuts delivered since 2010 will save businesses £10 billion a year from 2016 (HMRC analysis). In this Parliament, the government will go further. The corporation tax rate will be cut to 19% in 2017 and 18% in 2020. These new cuts will save small and large businesses a further £6.6 billion by 2021, and will benefit 1.1 million businesses (HMRC analysis). They will give the UK the lowest rate of corporation tax in the G20, making the country even more attractive to inward investors (Global tax rates online, KPMG).

1.240 In 2013, the government published analysis modelling the economic impact of the corporation tax cuts delivered during the last Parliament.250 This analysis has been updated to reflect the additional benefit of the rate cuts announced today.251 It suggests that cutting corporation tax from 20% to 18% could increase GDP in the long run by between 0.1% and 0.2% (£1.8 to £3.6 billion in today’s prices) and that overall the cuts since 2010 could increase GDP by between 0.6% and 1% (£10.9 to £18.1 billion) in the long run. These numbers exclude the positive impact the cuts will have on inward investment. Adjusting for inward

249 HC Deb 8 July 2015 c332 250 Analysis of the dynamic effects of corporation tax reductions, HMT and HMRC,

December 2013. 251 HMRC Computable General Equilibrium model output and HMT analysis. The range

of GDP impacts shown reflects varying the assumed elasticity of substitution between labour and capital by +/-50% around the central scenario (elasticity of 0.8).

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investment would mean that the overall cuts could boost GDP by between 0.7% to 1.1% (£12.7 to £19.9 billion).252

The report also confirmed that the Annual Investment Allowance would be set permanently at £200,000 from 1 January 2016, and that a new ‘road map’ for business tax would be published the next year:

1.242 The government will further support investment by small- and medium-sized firms by increasing the permanent level of the Annual Investment Allowance (AIA) to £200,000 for all qualifying investment in plant and machinery made on or after 1 January 2016, its highest ever permanent level. The government commits to maintaining the AIA at this level for the rest of this Parliament, providing a cash flow benefit to companies who invest. Around 75% of the businesses who benefit are located outside of London and the South East, and the sectors with most companies benefitting will be manufacturing, wholesale and retail, and agriculture (HMRC analysis) …

1.244 The government recognises that businesses need certainty to enable them to plan and make long-term investments. To deliver this, the government will publish a business tax roadmap by April 2016, setting out plans for business taxes over the rest of the Parliament. 253

At the time the Government estimated that the cut in corporation tax would cost £1.60 billion in 2018/19, rising to £2.48 billion by 2020/21. The new permanent AIA was estimated to cost about £850m a year from 2017/18.254

In general comment on the Budget focused on other announcements – for example, the introduction of a new national minimum wage for workers over 25, and proposals to substantially cut expenditure on tax credits. Unsurprisingly business groups strongly welcomed the cut in the main rate of tax: the Financial Times quoted John Cridland, director-general of the CBI, saying “we weren’t asking for it, this feels like Christmas comes early.” The paper also quoted Stella Amiss, tax partner at PwC, saying, “this is a bold and surprise move. Businesses weren’t calling for a further rate reduction, and it’s expensive.”255 In the IFS post Budget presentation, director Paul Johnson noted “welfare cuts may have taken centre stage. But tax changes were more numerous and bigger … [of which] the biggest, and perhaps most surprising given that we already have the lowest rate in the G20, is a further 2% cut in corporation tax by 2020.”256

Provision to set the rate of corporation tax for 2017-20, and fix the level of AIA from January 2016, was made by ss7-8 of the Finance (No.2) Act 2015. When debated in Committee Treasury Minister David Gauke reiterated the Chancellor’s point that “tax competition is dynamic”

In the past few decades, we have seen countries throughout the world cut their corporation tax rates. We cannot afford to stand

252 Summer Budget 2015, HC264, July 2015 p54 253 op.cit. p55 254 op.cit. p72 (Table 2.1 – items 9 & 10) 255 “CBI chief welcomes ‘Christmas come early’”, Financial Times, 9 July 2015 256 Paul Johnson, Summer post-Budget briefing 2015: opening remarks, 9 July 2015 p3

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still while others rush ahead. The UK needs to be as competitive as possible.257

Speaking for the Opposition Barbara Keeley supported the cut in rates, but raised concerns about international efforts to prevent unfair tax competition, and about how the cut in rates fitted with wider reforms to corporate tax:

Labour is in favour of support for businesses [and] … we will support the corporation tax measures, but we have questions about the future direction of policy on support for businesses … At 18%, we will have a lower rate than Luxembourg. Given the ongoing international negotiations at OECD level, will the Minister confirm what the reaction has been from our friends at the base erosion and profit shifting project to the Government’s proposals on the rate changes?… There is a need to deliver a longer-term road map for capital allowances and incentives for research and innovation such as the research and development tax credit, and not just for the headline rate of corporation tax. There is also a need to improve support for entrepreneurs and small and medium-sized enterprises that want to grow rapidly.258

Similarly George Kerevan for the SNP supported the principle to setting a lower rate up to 2020, but asked if the Government was doing enough to support business investment:

The clause pre-announces the cut to the main rate five years in advance. Ordinarily, I would think that was quite a good thing to do, because it maximises revenue streams and still gets us the maximum impact of the incentive … [However] significant evidence shows that large amounts of corporate surpluses are staying in the bank or are being used for share buy-backs … My practical worry is that if we continue, over these five years, to cut corporation tax, that may incentivise profit-making in business, but the profits will not be reinvested into raising productivity in the British economy … The issue could be dealt with by adding extra incentives for investment, so that the corporate surpluses are recycled.259

In response Mr Gauke made a number of points:

On the issue of the UK’s reputation and the base erosion and profit shifting process, which was instigated by the UK Government and others, the UK believes in a tax system that is competitive and fair, and which properly reflects where economic activity takes place. We want a simple, competitive and fair tax system, which is why we instigated the BEPS initiative to ensure that companies are not able to make use of an outdated international tax system that does not properly reflect where economic activity takes place. Within that system it is perfectly reasonable to have low and competitive rates, and that is exactly what we have delivered …

The analysis undertaken by the Treasury and HMRC shows that much of the tax loss as a consequence of the reductions is recovered by increases in economic activity. A dynamic behavioural analysis shows that this is helping. Real business investment is growing as a proportion of GDP; business investment grew by 8%in 2014, and the Office for Budget

257 Public Bill Committee (Finance Bill), Second sitting, 17 September 2015 c40 258 op.cit. cc40-42 259 op.cit. cc43-4

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Responsibility is forecasting that it will grow strongly over the next few years. It is also worth pointing out that the likes of the OECD make the case that corporation tax is perhaps one of the most economically damaging taxes and one of the most inefficient of our taxes. That is why it has been a priority for the Government to reduce it. We believe that if the UK is to prosper and to win the global race, it is important that we have that competitive tax system.260

The Committee also briefly debated provision to set the AIA at £200,000. For the Opposition Barbara Keeley supported the move, though questioned why the allowance had not been set higher, and whether the Government would consider a proposal from the Labour Party for a wider formal evaluation of corporate tax reliefs:

The move to make the annual investment allowance a permanent rate is welcome, and we support the move to encourage investment and productivity, but we question whether the measure goes far enough … we welcome some degree of permanence, as guaranteed in the summer Budget—if it is to be permanent. However, the overall system of tax reliefs for businesses must be considered if we are to have a competitive and fair system for businesses. . I hope that the Minister will adopt Labour’s new clause and launch a public consultation on reforms to the system of tax reliefs for businesses to invest and grow.261

In response the Minister said the following:

The level of the allowance must be viewed in the context of cuts to corporation tax. We must remember that although the previous Government had an annual investment allowance of £100,000, the rate of corporation tax was 28%. The allowance of £200,000 when we have a corporation tax rate of 20%, falling to 18%, is significantly more generous …

There is a question of cost. It is necessary to evaluate where the impact would lie and the benefit of going above £200,000. Yes, the allowance was once at a very high level, but that was because of particular temporary circumstances, given the uncertainty that existed towards the end of the previous Parliament. Let us not forget that 99% of companies will receive 100% relief on their investment with an annual investment allowance of £200,000. It is a question of balancing the benefit to investment with the cost in tax that we will forgo if we go above £200,000. The judgment that we made was that, given that 99% of companies will get 100% relief, a level of £200,000 was a reasonable approach to take in the context of a set of policies that are undoubtedly pro-business and designed to attract investment in the UK.262

The Opposition’s new clause regarding tax reliefs for business was the subject of a short debate at the conclusion of the Committee stage. Speaking for the Opposition Rob Marris summarised its rationale:

New clause 4 would require a wider review of tax reliefs for businesses to encourage long-term investment. Were the review carried out and the evidence collected, it might be that my party would call for changes, and I do not rule out the possibility of increases in tax reliefs for businesses. I am not making a pledge on behalf of the Labour party, but it might be that we would think,

260 op.cit. cc45-6 261 op.cit. c50 262 op.cit. c51-2

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on the basis of the evidence, that there should be greater relief for businesses regarding research and development— innovation.263

Treasury Minister David Gauke opposed the new clause, citing, in his response, a brief published by HMRC in response to concerns about the cost of tax reliefs raised by the Public Accounts Committee:

The Government set out their approach to tax policy making by publishing a framework document in 2010. We remain committed to that approach. Only last month, HMRC published a guide of best practice principles for monitoring and evaluating tax reliefs, which will promote effective governance across all taxes. That document was recommended by the Public Accounts Committee, to promote more uniform and effective monitoring of reliefs across all taxes. It was shared across HMRC and the Treasury on 30 September, and it was also shared with the NAO and the PAC. The principles set out in the document will be used to inform policy development and to alert Ministers to significant monitoring and evaluation findings.

Consultation is already central to the Government’s approach to tax, and so it is not clear that a further consultation on the entire “system” of tax reliefs would be helpful. On the contrary, the hon. Gentleman’s proposal would cover a huge and diverse range of policies, many of which are working effectively. The “system” includes tax relief to support investment in start-ups, so that more high-risk businesses can get off the ground, and differentiated tax rates, such as the zero rate of VAT and VAT exemptions. It also includes policies with indirect benefits for businesses, such as the employment allowance, which encourages employers to hire new staff. Reviewing such a wide range of policies would create uncertainty for businesses, making it harder for them to plan for the long term. As a result, the UK would be a less attractive place to start a business or to invest. For that reason, we oppose the new clause.264

In the event Mr Marris withdrew the new clause without dividing the Committee.

Subsequently in his Budget on 16 March 2016 Mr Osborne announced a further rate cut, so that the main rate would be set at 17% in 2020. The Chancellor also announced a series of measures for the next four years to reduce tax avoidance and to simplify and modernise the tax regime, set out in a ‘business tax road map’ published alongside the Budget. An extract from his Budget speech is given below:

Today, the Financial Secretary and I are publishing a road map to make Britain’s business tax system fit for the future. It will deliver a low-tax regime that will attract the multinational businesses that we want to see in Britain, but ensure that they pay taxes here too…

First, some multinationals deliberately over-borrow in the UK to fund activities abroad, and then deduct the interest bills against their UK profits. From April next year, we will restrict interest deductibility for the largest companies at 30% of UK earnings,

263 Public Bill Committee, Sixth sitting, 15 October 2015 c156 264 op.cit. c158. The PAC held an evidence session on tax reliefs in January 2015 (Oral

Evidence HC892, 14/1/2015), in light of an NAO report published the previous year (HC785 of 2014-15). HMRC’s note on its approach to evaluating tax reliefs was published in September 2015.

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while making sure that firms whose activities justify higher borrowing are protected with a group ratio rule.

Next, we are setting new hybrid mismatch rules to stop the complex structures that allow some multinationals to avoid paying any tax anywhere, or to deduct the same expenses in more than one country. Then, we are going to strengthen our withholding tax on the royalty payments that allow some firms to shift money to tax havens, and, lastly, we are going to modernise the way that we treat losses.

We are going to allow firms to use losses more flexibly in a way that will help over 70,000 mostly British companies, but, with these new flexibilities in place, we will do what other countries do and restrict the maximum amount of profits that can be offset using past losses to 50%. This will apply only to the less than 1% of firms making profits over £5 million, and the existing rules for historic losses in the banking sector will be tightened to 25%. We will maintain our plans to align tax payment dates for the largest companies more closely to when profits are earned, but we will give firms longer to adjust to these changes, which will now come into effect in April 2019.

All these reforms to corporation tax will help create a modern tax code that better reflects the reality of the global economy. Together, they raise £9 billion in extra revenue for the Exchequer. But our policy is not to raise taxes on business. Our policy is to lower taxes on business … Last summer, I set out a plan to cut it to 18% in the coming years. Today I am going further. By April 2020, it will fall to 17%. Britain is blazing a trail; let the rest of the world catch up.265

Taken together the two reductions in the rate of corporate tax are forecast to cost just over £3.8 billion in 2020/21. The Budget report states that the cuts in corporation tax since 2010 “will be worth almost £15 billion a year to business by 2021”, and illustrates the UK’s comparative tax advantage over other countries as follows: 266

265 HC Deb 16 March 2016 cc957-8 266 Budget 2016, HC901, March 2016 p85, p87 (Table 2.1 – item 18; and, Table 2.2 –

item ac), p45

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As noted, the Government published further details of its plans in its Business Tax Road Map; the document set out reforms to be made to business rates, capital gains tax and to the climate change levy – which are not discussed here267 – as well as measures to tackle aggressive tax avoidance, which are discussed in the next section of this paper. On a separate if related issue, the Government stated that it would commission the Office for Tax Simplification to review the options to simplify the computation of corporation tax.268 The OTS published the terms of reference for this review in May, and its intention is to report by February 2017, with an interim report in the autumn.269

Initial reactions to these business tax measures focused on the changes to business rates, and the Chancellor’s proposal for a ‘sugar tax’, a levy on soft drinks producers to be introduced from April 2018.270 The Financial Times quoted some concerns from several commentators over the wider changes to corporation tax, specifically the speed with which the proposed restriction to interest deductibility would be introduced; as an example, Stella Amiss, tax partner at PwC, said, “whilst these changes have been on the cards since late last year, the shock factor is the speed with which he intends to make these changes.”271 Writing in the Tax Journal, Chris Sanger, global head of tax policy at EY, argued, “perhaps the most striking feature [of the 2016 Budget] is the extent to which a Budget that reduces the corporation tax rate yet again still sees business tax footing the bill for tax cuts elsewhere.”272

In its Budget analysis of corporate tax receipts, the OBR noted “this Budget raises onshore CT receipts in each year of the forecast. Measures such as those on restricting the use of trading losses, the tax deductibility of corporate interest expenses, reducing evasion by offshore property developers and extend the scope of the hybrid mismatch rules raise over £2bn in 2017/18 and 2018/19.”273 The OBR also noted the impact of a one-off boost to receipts from the Government’s decision to bring forward the date on which large companies must pay CT:

The profile of onshore CT receipts over the forecast period – with a sharp rise in 2019-20 – largely reflects the measures announced in this Budget and the July 2015 Budget. In July, the Government decided to bring the CT payment date for larger companies forward by four months from April 2017 raising receipts by over £5 billion in 2017-18 and around £3 billion in 2018-19. In this Budget, the Government has delayed the start of this policy to April 2019 “to give business more time to prepare.”

267 Three other Library papers look at these issues: Reviewing and reforming business

rates, CBP7538, 18 March 2016; Capital gains tax: recent developments, SN5572, 8 April 2016; and, Climate change levy: renewable energy & the carbon reduction commitment, CBP7283, 20 April 2016.

268 Budget 2016, HC901, March 2016 para 2.215 269 OTS, Letter from OTS to David Gauke MP, May 2016. See also, “Streamlining

corporation tax”, Tax Journal, 27 May 2016. 270 For example, “Osborne sugars the pill” & “Biggest companies left out of party as

shopkeepers celebrate £7bn windfall”, Times, 17 March 2016 271 “Corporation tax relief shake-up to bring in £9bn”, Financial Times, 17 March 2016 272 “Budget 2016: The big picture”, Tax Journal, 18 March 2016 273 Economic and fiscal outlook, Cm 9212, March 2016 para 4.52

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This moves the boost to receipts back to 2019-20 and 2020-21. Of the £6.9 billion rise in onshore CT in 2019-20, around £5.8 billion is from the CT timing measure. Receipts are in effect being brought forward from later years, providing a one-off boost that is neither repeated nor subsequently reversed.274

At this time Robert Chote, chairman of the OBR, noted that this was one of a number of measures in the Budget to “shuffle spending out of the fiscal mandate year and shuffle receipts into it”; as a consequence the Government remained on target, on current forecasts, to have a Budget surplus in the last year of the Parliament (2019/20).275

In the IFS post Budget presentation, director Paul Johnson noted the further cut to the rate of corporation tax “yet more evidence of the government’s focus on making the UK an attractive proposition for multinational companies. There can be no doubting the ambition that comes with a cut in the headline rate from 28% to 17% in a decade, at considerable fiscal cost in a period of austerity.”276 In a separate presentation on the Business Road Map, Helen Miller suggested that the Government’s strategy document spanned a large number of areas but lacked vision; while it represented a “continued move towards low rates plus anti-avoidance”, the document has “lots of small policies rather than discussion of design or ideas for substantial improvements.”277

The Government’s policy was discussed when the Treasury Committee took evidence on the Budget from Andrew Sentance (Senior Economic Adviser, PwC) and George Buckley (Chief Economist, Deutsche Bank).278 Jacob Rees-Mogg asked Mr Buckley what impact he believed that the cut in the main rate had had on attracting businesses to the UK:

George Buckley: It is very difficult to work out what would have happened had we not reduced the tax rate … Business investment has risen quite well over the past few years. It has come from a low base, admittedly, but we have seen 5% increases in business investment. Whether we would have seen substantially different rates of growth of business investment had we not seen a reduction in the corporation tax is unknown, of course, but I am sure it has helped at the margin.279

In answer to a follow-up question from Mr Rees-Mogg, Mr Sentance suggested that other taxes were becoming more important with regard to business incentives:

The corporation tax reform has sent a signal to business that this is going to be an attractive place to do business, from a corporation tax point of view, but the surveys we do at PwC that look at the overall tax burden suggest that, while that part of the business tax burden has been coming down, other taxes are becoming more important, like national insurance, business rates and so on. It is very hard to quantify exactly how much of an

274 op.cit. para 4.51. see also, Budget 2016, HC901, para 2.84, (Table 2.1 – item 26) 275 March 2016 Economic and Fiscal Outlook Briefing, March 2016 p16. Mr Chote

discussed this when he gave evidence to the Treasury Committee after the Budget (Oral evidence: Budget 2016, HC929, 22 March 2016 Qs5-8).

276 Paul Johnson, Opening remarks: IFS Budget briefing 2016, 17 March 2016 p6 277 Helen Miller, Business tax road map: IFS Budget briefing 2016, 17 March 2016 (see

end slide) 278 Treasury Committee, Oral evidence: Budget 2016, HC 929, 12 April 2016 279 op.cit. Q299

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impact a slightly over-complex tax system has on growth, but it must have some negative consequences, I would have thought.280

At a later stage in the session, George Kerevan asked Mr Sentance about the overall impact of reforms to corporate tax, and whether the 17% rate would encourage further tax competition:

Q317 George Kerevan: This specific budget, while corporation tax is being cut to a 17% headline figure, has a broadening of the base of corporation tax. There are restrictions on loss relief. There is a limit to debt/interest relief … Do the changes to reliefs offset and counteract the cut in the headline rate?

Andrew Sentance: We will find out over a period of time. When you look at the tax system as it affects business, it is not just about corporation tax. It is about other taxes like national insurance, uniform business rate and so on. It is not even just looking at those allowances and the corporation tax rate; it is looking at the overall picture and how competitive the UK looks, in the round.

Q318 George Kerevan: … I am trying to tease out from you what you think is the impact, given the overall package, on business incentives …

Andrew Sentance: It depends on the type of business that you are, effectively. These different tax allowances and tax reliefs affect different types of businesses generally. We have also had a strand of our tax reform that has been trying to encourage businesses that are quite innovative and involved in research and development to invest more in the UK …

Q320 George Kerevan: As a final question, is there not the danger that other countries will simply follow us down the line of cutting their headline rate of corporation tax?

Andrew Sentance: There has generally been a downward move across the major economies in corporation tax rates, but there is a countervailing influence that Governments need to raise money to finance public services. They need to raise money from a range of different tax bases. The farther down you move corporation tax rates, the risk is that you generate less money from corporation tax and then have to raise more money elsewhere to finance your public services. Where are you going to raise that?

I do not think that this is just a straightforward one-way bet for Governments. One of the strengths of a well-functioning tax system is that the Government are raising revenue from a range of different bases and are therefore not having to put very high tax rates on one specific tax base, in order to raise the revenue that they need. A healthy tax system will always maintain that degree of balance.

George Kerevan: As you say, we will see.281

Picking up this theme, following the 2016 Budget the IFS published a report on the changes to the composition of tax revenues. 282 The

280 op.cit. Q302 281 op.cit. pp17-19. In January 2016 the Treasury Committee launched an inquiry on UK

tax policy and the tax base, with particular focus on corporation tax, though to date it has only held one evidence session; details are on its site.

282 Helen Miller & Thomas Pope, The changing composition of UK tax revenues, IFS Briefing Note BN182, April 2016. Of related interest see, “Stealthy revolution”, Financial Times, 17 April 2016

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authors argued that over the next five years taxes paid by companies – primarily corporation tax, North Sea oil taxes and banking taxes – were likely to continue to decline. This trend was attributable to external factors – the fall in North Sea oil receipts, the collapse in bank profits – as well as by policy decisions – principally the cuts to the rate of corporation tax. The authors calculate that taken together, policy changes to corporation tax announced between 2010 and Budget 2016 (including those that are due to come into place before the end of the Parliament) have cost £10.8 billion a year in 2015/16 terms.283

By 2020/21 receipts from these taxes as a proportion of national income are expected to be a third lower than before the crisis, and if this occurred it would represent an important break from the past. An extract from the report is reproduced below:

Between 2007/8 and 2009/10, total government receipts collapsed – they fell by over 9% in real terms and were 2% lower as a proportion of national income – largely as a result of the financial crisis and resulting recession … By the end of this decade, government receipts are forecast to be 37.2% of national income,284 a little lower than in 2007/08 (37.5%) … On the face of it, these aggregate numbers imply that, by 2020/21, we will be more or less back where we started, raising around the same proportion of national income in revenue as just before the crisis. However, this masks considerable changes in the composition of receipts …

Figure 3 shows how revenues from different sources have evolved since the start of the recession. For ease of exposition, we consider taxes in broad groups. However, in doing so, we note that there is no clear-cut way to group taxes and that these groups do not denote the economic incidence of a tax.

283 IFS Briefing Note BN182, April 2016 p18 284 In all of our analysis, we ignore the temporary effect of changes in the timing of

corporation tax payments for large companies, which provides a temporary revenue boost in 2019/20 and 2020/21. Including this effect, government receipts would be 37.4% of national income in 2020/21.

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A notable feature of Figure 3 is that revenues from corporation taxes have declined substantially as a proportion of national income and are forecast to continue to decline over the next five years. This results from both policy and underlying economic changes. The main contributor is onshore corporation tax, which always fluctuates with the economic cycle, but historically has not shown a systematic downward trend …

Onshore corporation tax revenues, while volatile over the economic cycle, displayed no persistent downward trend in the 30 or so years up to the great recession despite main corporation tax rates being cut from 52% in 1981 to 28% in 2008. This was due to an increase in the size and profitability of the corporate sector, and to some extent to a broadening of the tax base.285

By the end of the parliament, onshore corporation tax receipts as a proportion of national income are due to be 26% lower than before the crisis (2.0% rather than 2.7% of national income) due to a combination of weak corporate profits and policy change …

A permanent decline in onshore corporate tax revenues would mark a break with the previous trend, highlighted above, under which the effect of lower rates was offset by a larger, more profitable corporate sector (and, to a smaller extent, a broader tax base). It is possible that corporate revenues will be higher than currently forecast either because corporate rate cuts boost corporate activity by more or because anti-avoidance measures are more successful at raising revenues than is currently predicted. However, in the longer run, there is also likely to be continued competitive pressure on corporate taxes.286

Following the referendum vote on 23 June to leave the EU, the Chancellor, Mr Osborne, indicated that he would present a Budget statement in the autumn.287 Subsequently Mr Osborne confirmed that the Government not meet its target for delivering a fiscal surplus in 2019/20, but that it would seek to cut the rate of corporation tax to 15% to attract business investment.288 These statements were the subject of an urgent question on 4 July; on this occasion Mr Osborne said the following about cutting corporation tax:

We need to broadcast loud and clear the message that Britain remains the best place in the world to do business. In the past six years, we have reduced Britain’s corporation tax rate from 28% to 20% today, and 17% in the future. I did that at the same time as taking difficult decisions elsewhere to balance the books. In my view, the strongest signal we could send to the world that Britain, after the referendum, is open to the world and ready to do business would be to cut corporation tax still further. We should aim for a rate of 15% and preferably lower, because if we are pro-business, we are pro-jobs, pro-living standards and pro-working people.289

The Financial Times reported some support from business groups for a lower rate, though some scepticism as well as to whether this would 285 See, Griffith & Miller, ‘Taxable corporate profits’, Fiscal Studies, 2014, 35, 535--57 286 IFS Briefing Note BN182, April 2016 p2, pp4-5, p13, pp18-19 287 HM Treasury press notice, Statement by the Chancellor following the EU

referendum, 27 June 2016. For details of the vote see, European Union Referendum 2016, Commons Briefing paper CBP7639, 29 June 2016

288 “Osborne puts corporation tax cut at heart of Brexit recovery plan”, Financial Times, 2 July 2016

289 HC Deb 4 July 2016 c622-3

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effectively counteract the impact of the Brexit vote on inward investment.290 An editorial in the paper suggested that Mr Osborne’s proposal had certain practical flaws, as well as being precipitate in the context of David Cameron’s decision to resign as Prime Minister following the referendum vote:

Companies’ main worry now is whether investments they make in Britain will produce a profit at all, not the rate of tax they would pay on them. A corporate tax cut would do little to attract investment until the UK is in a position to resolve the acute uncertainty over its future trading relations with the EU. It would, however, probably lead to lower tax revenues. It would also be at odds with the anti-establishment mood among voters and would antagonise European governments, at the outset of negotiations where the UK will need all the goodwill it can muster. Yet these practical considerations have little relevance at this stage. Mr Osborne should not be suggesting long-term changes to tax policy when every other aspect of government is in flux.291

On 13 July Theresa May succeeded Mr Cameron as Prime Minister, and appointed Philip Hammond to be Chancellor. In his first interview Mr Hammond ruled out an emergency Budget, and made no mention of additional reductions in the rate of corporation tax, though he confirmed that he would set out the Government’s revised economic strategy in the Autumn Statement.292 At Treasury Questions on 19 July Jane Ellison, recently appointed Financial Secretary, was asked by Sir Henry Bellingham whether she agreed that “one strand of activity in the campaign [to reduce global tax evasion] is to continue to reduce corporation tax?” Ms Ellison replied, “obviously, the effective rate is what really matters. We have set out a sensible and good ambition for 2020, but internationally what matters is what people pay.”293

6.2 Tax avoidance and evasion The OECD’s Base Erosion & Profit Shifting initiative As discussed in section 5.3 of this paper, in 2013 the G20 commissioned the OECD to co-ordinate a project to identify solutions for closing the gaps in existing international tax rules. As the IFS has noted, the OECD’s past work in this area made it a sensible choice to lead this, although it has no formal powers to impose these rules:

The OECD was in a good position to act as the coordinator, having spent the preceding five decades at the forefront of efforts to facilitate agreement on international tax rules. Most notably, the OECD Model Tax Convention launched in the 1960s has provided a framework for eliminating double taxation of multinationals’ income streams and the OECD Transfer Pricing guidelines, formalised in 1979 and regularly revised since, are now used by most countries as the basis for implementing the arm’s length principle. The OECD has no legal basis upon which to

290 “Doubts rise despite welcome for corporate tax cut”, Financial Times, 4 July 2016 291 “Osborne’s immediate task is to avert recession”, Financial Times, 4 July 2016 292 “Philip Hammond: Financial markets 'rattled' by Out vote”, BBC news & “New

chancellor Philip Hammond to scale back austerity”, Financial Times, 14 July 2016 293 HC Deb 19 July 2016 c677

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require countries to change their tax rules. It operates by building consensus and seeking voluntary compliance by governments. 294

In July 2013 the OECD published an action plan identifying 15 areas where there were possible gaps or loopholes in tax laws that facilitated avoidance behaviours, or where improvements in data, transparency and processes could enhance governments’ abilities to enforce tax rules.295 Over 100 countries, including all OECD countries, Brazil, China and India, were involved in discussions nations over the next two years. This culminated in October 2015 with the publication of a series of recommendations on each of the 15 ‘action points’, endorsed by G20 Finance Ministers later that month, and by G20 leaders in November:

The final package of BEPS measures includes new minimum standards on: country-by-country reporting, which for the first time will give tax administrations a global picture of the operations of multinational enterprises; treaty shopping, to put an end to the use of conduit companies to channel investments; curbing harmful tax practices, in particular in the area of intellectual property and through automatic exchange of tax rulings; and effective mutual agreement procedures, to ensure that the fight against double non-taxation does not result in double taxation.

The BEPS package also revises the guidance on the application of transfer pricing rules to prevent taxpayers from using so-called “cash box” entities to shelter profits in low or no-tax jurisdictions, and redefines the key concept of Permanent Establishment, to curb arrangements which avoid the creation of a taxable presence in a country by reliance on an outdated definition.

The BEPS package offers governments a series of new measures to be implemented through domestic law changes, including strengthened rules on Controlled Foreign Corporations, a common approach to limiting base erosion through interest deductibility and new rules to prevent hybrid mismatch arrangements from making profits disappear for tax purposes through the use of complex financial instruments.296

Although the agreement illustrates the shared concern policy makers have about corporate tax avoidance, the OECD did not publish any precise estimates of its cost. The report suggested that global revenues lost to BEPS lay between 4% and 10% of total global corporate income tax revenues – between £100bn and £240bn a year, the wide range in the estimate reflecting the large degree of uncertainty involved. Indeed one of the BEPS ‘action points’ is that there should be better measures of the scale of this type of avoidance; as the OECD noted in this part of the final report, all of the current indicators that have been used “are severely constrained by the limitations of the currently available data”:

The available data is not comprehensive across countries or companies, and often does not include actual taxes paid. In addition to this, the analyses of profit shifting to date have found

294 Helen Miller & Thomas Pope, “Corporate tax avoidance: tackling Base Erosion and

Profit Shifting”, IFS Green Budget 2016, February 2016 p172 295 OECD, Action Plan on Base Erosion and Profit Shifting, 19 July 2013 296 OECD press notice, OECD/G20 Base Erosion and Profit Shifting Project forwarded to

G20 heads of state, 9 October 2015. See also, HM Treasury press notice, UK leads international efforts to clampdown on tax avoidance, 9 October 2015; and, OECD press notice, G20 leaders endorse OECD measures, 16 November 2015.

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it difficult to separate the effects of BEPS from real economic factors and the effects of deliberate government tax policy choices. Improving the tools and data available to measure BEPS will be critical for measuring and monitoring BEPS in the future, as well as evaluating the impact of the countermeasures developed under the BEPS Action Plan.297

In their initial response to the BEPS project, the Chartered Institute of Taxation argued that the agreement was a “significant achievement” although “the test will be getting international agreement for and implementation of a set of rule changes where there are a range of different perspectives and interests.” The CIOT also noted that the package of measures left in place the basic principle underpinning international taxation:

“Transfer pricing is at the heart of the rules for taxing multinational companies. Transfer pricing based on ‘arms-length’ prices has its difficulties, especially when it comes to measuring what is the correct value which should be attached to intangible assets such as brands. However the underlying principle, that profit should be taxed in the country where it is generated, is sound, and we anticipate that it will endure, strengthened by tax authorities’ improved access to information.298

For its part the IFS has suggested that although implementation would produce a more workable system, “it will remain fundamentally difficult to allocate profits of multinationals to differing jurisdictions.”299 The OECD’s work is both highly complex and very detailed, so interested readers are referred to its own publications, as well as the IFS’ recent analysis – which is drawn on at length over the next few pages.300

The BEPS project made three types of recommendation: minimum standards to which countries agree their tax rules must adhere; revised international standards to be incorporated into tax treaties; and, recommendations for common approaches and best practices. In addition four of the fifteen ‘action points’ were concerned either with the measurement of BEPS or with the processes required to implement changes. Crucially, implementation “relies on pressure and consensus from the international community”:

The OECD has no power to impose the minimum standards or adherence to new processes. Implementation of BEPS instead relies on pressure and consensus from the international community to ensure the recommendations are implemented. For treaty changes (for example, on PEs and treaty benefits) to be swiftly and successfully implemented, a multilateral instrument must be developed and adopted. The minimum standards on information sharing and preferential regimes require unilateral amendments to domestic legislation.

One of the largest unknowns is how many governments will move to adopt any of the new best-practice rules. A key tension here is that strengthening controlled foreign company (CFC) rules or

297 OECD, Measuring and Monitoring BEPS, Action 11 - Final Report, October 2015 p16 298 CIOT press notice, BEPS project a significant achievement but getting agreement for

rule changes will still be a challenge, 2 October 2015 299 IFS Green Budget 2016, February 2016 p172 300 See also, Tax Journal, “Analysis: the OECD’s final BEPS recommendations”, 9

October 2015 & “Insight and analysis: BEPS special”, 31 October 2015

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reducing interest deductibility may make a country a less attractive location and therefore be in conflict with a country’s competitive aims. Many countries face an incentive to see what others do before changing their own policies, and no government may be willing to move first.301

Even with implementation there is no guarantee that BEPS will significantly increase UK tax revenues. First, “while some outcomes from BEPS may mean the allocation of income to the UK from elsewhere, profit shifting goes both ways.” Second “further uncertainty arises from the likely behavioural response to any policy changes”:

If the outcomes really are successful at linking income more closely to real activity, firms may make large changes to the organisation of those real activities between countries.302 In particular, higher-tax countries may become less attractive as a location for real activity. The UK has a low tax rate relative to its competitors, but it also has an uncompetitive tax base. If there were substantial increases in taxes across countries as a result of the BEPS actions, the UK may become more attractive for some companies and less attractive for others.303

In the Budget 2016 the Government confirmed that in light of the BEPS project it would “modernise the tax rules in the UK and to ensure these rules are applied effectively to multinationals”, initially by making changes to the UK’s transfer pricing rules:

The government will legislate for the revisions to the OECD Transfer Pricing Guidelines (‘Guidelines’) that were agreed as part of the OECD BEPS project. This will be done by updating the link between the UK transfer pricing rules and the Guidelines, so that interpreting the application of the UK rules will be done by reference to the revised Guidelines. (Finance Bill 2016)304

As noted above, the Government’s plans for reforming business taxation over the Parliament were set out in a second ‘road map’ document, published alongside the 2016 Budget. In the context of BEPS and corporate tax avoidance, the Road Map announced three reforms:

• Limiting the level of deductions for interest expense that can be offset against profits to 30% of a group’s earnings; targeting the measure by introducing a group ratio rule, an exemption for public benefit infrastructure and a £2 million de minimis threshold.

• Eliminating the tax advantage arising from multinationals’ use of hybrid mismatch arrangements involving permanent establishments.

• Extending the UK’s withholding tax rights over royalties.305

301 IFS Green Budget 2016, February 2016 p180 302 There is a large literature on the ways in which firms respond to taxes. For a review,

see R. de Mooij and S.Ederveen, ‘Corporate tax elasticities: a reader’s guide to empirical findings’, Oxford Review of Economic Policy, 2008, 24, 680–97.

303 IFS Green Budget 2016, February 2016 p192 304 Budget 2016, HC901, March 2016 para 1.207; para 2.101 305 HM Treasury, Business tax road map, March 2016 p6. For a costing of each measure

see, Budget 2016, HC 901, March 2016 p84 (Table 2.1 – items 19-21). See also, “Reviewing the Business Tax Roadmap”, Tax Journal, 1 April 2016.

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The Road Map gives a full summary of the UK’s action in response to BEPS, and this is reproduced over the following two pages.

HM Treasury, Business Tax Road Map, March 2016

UK activity in response to the BEPS actions (Box 2.B, pp 22-3)

Following endorsement of the BEPS outputs by G20 leaders in November 2015, the government is taking forward this work as set out below.

Action 1 (Digital economy): work to update the threshold at which a company becomes taxable in a foreign country and updates to the transfer pricing guidelines to take into account technological advances will address many of the tax challenges with the digital economy. However, in the context of the rapid development of new digital technologies and business models, the government will continue to work with international partners to determine whether any supplementary rules to tackle specific tax challenges are necessary and participate in future work at the OECD.

Action 2 (Addressing hybrid mismatches): The government has taken swift action to introduce the OECD agreed rules to address hybrid mismatch arrangements in Finance Bill 2016 from 1 January 2017. The new rules will prevent multinational enterprises avoiding tax through the use of certain cross-border business structures or finance transactions that exploit differences between countries’ tax rules. Further detail on the government’s action on hybrid mismatches is set out below.

Action 3 (Controlled Foreign Companies rules): The UK modernised its CFC rules in 2012 after an extended period of consultation to ensure that they are fit for the global economy and effective at preventing the artificial diversion of UK taxable profits to low-tax subsidiaries. The UK CFC rules, which reflect a more territorial approach to taxation, synthesise elements from a number of the approaches covered by the BEPS report, and no amendments are being considered as a result of the BEPS project.

Action 4 (Interest deductibility): The government will introduce a restriction on the tax deductibility of corporate interest expense consistent with the OECD recommendations from 1 April 2017. Detail on the government’s action on interest deductibility is set out below.

Action 5 (Intellectual property): The government will introduce legislation to reform the Patent Box in Finance Bill 2016, so that this is consistent with the nexus approach agreed through the OECD BEPS project, which links benefits to the level of R&D investment undertaken. This will ensure the Patent Box continues to provide an incentive for the development and commercialisation of IP in the UK. The effectiveness of this relief will continue to be reviewed in light of wider changes. Specifically, the government will keep under review the case for reducing the current 10% tax rate available under the Patent Box, alongside the currently scheduled reductions in the main rate of corporation tax.

Actions 6 & 7 (Treaty abuse and permanent establishment): See action 15 below.

Actions 8-10 (Transfer pricing guidelines): The government has swiftly legislated in Finance Bill 2016 to update the current link in the UK’s transfer pricing rules to these guidelines, to incorporate the revisions which were agreed as part of this action. This maintains the link between the UK rules and the most current internationally agreed consensus on the practical application of transfer pricing principles. The UK continues to participate in the ongoing work at the OECD in this area to further develop these guidelines and continues to call for targeted measures to be introduced to protect them from abuse.

Action 11 (Analysis of BEPS): This will improve access to new and existing data to allow countries better to analyse risks. Data will be presented in an internationally consistent way, while still maintaining taxpayer confidentiality.

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The Government’s proposals to restrict interest deductibility are examined in the next section of this paper, while two other elements of the BEPS package are touched on here: hybrid mismatches, and permanent establishment status.

One method that multinationals have achieved base erosion has been through hybrid debt instruments and hybrid entities. In the first case, a

Action 12 (Disclosure of BEPS): The UK’s mandatory disclosure regime was introduced in 2004. The Disclosure of Tax Avoidance Schemes rules form an important detection tool supporting HMRC’s anti-avoidance strategy. Further international work will follow including monitoring the implementation of new disclosure regimes, considering how they can apply to cross border avoidance arrangements, and the sharing of information between jurisdictions who do so. This work will be taken forward through the OECD Forum on Tax Administration.

Action 13 (Country-by-country reporting): A new reporting template will improve transparency between business and tax authorities, and provide useful information that allows for an effective assessment of risks to tax systems arising from aggressive tax planning. The government has swiftly legislated to require UK multinationals to file the template with HMRC for 2016 accounting periods onwards. Submission of first reports are due by the end of 2017. The government believes there is an opportunity to go beyond the outcomes of the BEPS project and enhance transparency over multinationals’ tax affairs by requiring them to make the details of tax paid publicly available on a country-by-country basis. The UK will therefore press the case for public country-by-country reporting on a multilateral basis.

Action 14 (Making dispute resolution mechanisms more effective): A tax treaty is an agreement between two countries which aims to prevent double taxation of income and capital. It achieves this by allocating taxing rights between countries. Several changes to tax treaties are recommended as a result of the BEPS project. This particular BEPS action recognises that these changes should not lead to unintended double taxation which is bad for business, and also to unnecessary uncertainty for taxpayers who play by the rules. It makes resolution of disputes between countries about how tax treaties apply more effective.

The UK has committed to adopt and implement mandatory binding arbitration as a way to resolve disputes, along with 19 other countries. The UK is now working with these countries to develop a mandatory binding arbitration provision as part of the negotiation of the multilateral instrument, as well as implementing other dispute resolution changes in the multilateral instrument (see action 15).

Action 15 (Developing a multilateral instrument to modify bilateral tax treaties): Changes to tax treaties recommended as a result of the BEPS project cover:

• hybrid mismatches (see action 2)

• preventing the granting of tax treaty benefits in inappropriate circumstances

• artificial avoidance of permanent establishment status (A “permanent establishment” refers to the threshold of business activity which needs to be carried out in a country by a person in order for the person to be taxable on that activity in that country. Some businesses were engaging in artificial planning in relation to their operations in order to avoid creating a permanent establishment and triggering taxation. Changes to rules will address these artificial structures)

• making tax treaty dispute resolution mechanisms more effective (see action 14)

The UK is chairing a group of over 90 countries which is developing a multilateral instrument which will allow countries’ tax treaties to be updated quickly and efficiently with the BEPS changes. An instrument is expected to be ready for signature by the end of 2016.

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company uses a form of debt financing that shares certain features of equity, to exploit differences between national tax systems:

Hybrid debt instruments often look at face value like debt but have some features of equity (an example is ‘convertible bonds’, which are bonds in a company that the holder can choose to exchange for a specific number of the company’s shares). These instruments may be treated differently by different jurisdictions. When one jurisdiction treats an instrument one way – for example, as debt – and another treats it in a different way – for example, as equity – firms can exploit the mismatch in tax rules to achieve double non-taxation (the profit is not taxed anywhere). A multinational can structure its affairs such that the interest in one country is deducted, while the interest paid is not taxed in the other country. This constitutes base erosion – profit is not merely taxed at a lower rate: it is not taxed at all.306

In the second case a company uses a corporate form to the same effect – as some UK MNEs have with what is known as a ‘tower structure’:

An example used by many UK multinationals investing in the US is a ‘tower structure’. This could work as follows. A UK parent has a subsidiary in the US, which itself has a subsidiary in the UK. The UK parent makes a loan to the UK subsidiary. This does not affect the UK tax liability: the deduction in the subsidiary effectively cancels out the extra income in the parent.

However, from the US perspective, the US company specifies that its UK subsidiary should be treated as a branch. US tax rules allow branches to be ‘looked through’ and treated as part of the US entity. From the perspective of the US, the UK parent is irrelevant. The interest payments made by the UK subsidiary can therefore be deducted against the company’s US tax liability. Because the entity is treated as a UK company by the UK and a foreign branch by the US, the interest is deducted in both jurisdictions. This works to strip tax liability out of the US.307

As a solution to prevent hybrid mismatches, the OECD recommend a best-practice framework that uses a two-part rule for hybrid instruments, and for hybrid entities:

The new rule specifies new rules for instruments and entities, each with two parts.

For instruments, the rule is:

1. A transaction that generates a deduction from tax in one country (for example, an interest payment) should only be allowed if the corresponding income (for example, interest received) is taxed in another country.

2. If part 1 is breached (i.e. the transfer and deduction go ahead), a defensive rule can be applied and the transfer will be included as taxable income in the second jurisdiction.

For entities, the rule operates a little differently:

1. When a hybrid entity would achieve a ‘double deduction’ of a payment, the deduction in the parent jurisdiction (the country in which the multinational parent is based) is disallowed.

306 IFS Green Budget 2016, February 2016 p175 307 op.cit. p176

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2. If part 1 is breached, a defensive rule is applied and the deduction will be disallowed in the subsidiary jurisdiction instead.

By linking the tax treatment in one jurisdiction to the tax treatment in another, this rule prevents hybrid mismatches from occurring.308

As the IFS go on to comment, “one of the nice features of this type of rule is that it is designed to encourage take-up among countries. The inclusion of the defensive rule means that, if one country has the rule, other countries in which the same multinational firms operate and use hybrid arrangements may be forgoing tax revenue by not having it.”309

The Government’s Road Map provides an example of BEPS involving hybrid mismatches through a branch structure:310

In December 2014 the Government had announced that it would consult on new rules to implement the OECD recommendations on hybrid mismatch arrangements – a change that it forecast would raise £70m in 2017/18, rising to £90m by 2019/20.311

308 op.cit. p183 309 ibid. 310 HM Treasury, Business tax road map, March 2016 p26 311 Autumn Statement, Cm 8961, December 2014 para 2.144; Table 2.1 – item 31.

Details of the consultation are collated on Gov.uk.

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Subsequently in Budget 2016 the Government confirmed the new rules would apply from 1 January 2017, and that their scope would be extended, “to cover hybrid mismatches arising from permanent establishments.”312 The Exchequer yield from the second of these changes is projected to be £265m in 2017/18, falling gradually each year to reach £200m in 2020/21.313 Provision to this effect was included in the Finance Bill 2016 (specifically clause 62 & schedule 10), which were the subject of a short debate in Committee. On this occasion Treasury Minister David Gauke summarised this measure as follows:

The changes made by clause 62 and schedule 10 will address hybrid mismatch arrangements by changing the tax treatment of either the payment or the receipt, depending on circumstances. The rules are designed to work whether both countries affected by a cross-border arrangement, or just one of them, have introduced the OECD rules. The changes will affect large multinational groups with UK parent or subsidiary companies that are involved in transactions that result in a mismatch in tax treatment in the UK, or between the UK and another jurisdiction. The rules will take effect from 1 January 2017.

In taking the action, and particularly in providing for the rules to cover permanent establishments, the UK will not only fully implement the agreed OECD recommendations; it will go beyond them. That will bring in more than £900 million over the next five years.314

Turning to another element of BEPS, the concept of permanent establishment (PE) has been mentioned before: bilateral tax treaties will provide that a company’s profits are taxable in one state in so far as it operates a PE in that state:

The rationale is that if, say, a company performs all of its substantive activity in its home country and simply has a storage or distribution facility in a second country, sales income in that second country should be assigned to the home country. In practice, this creates an incentive for firms to structure themselves to avoid PE status in higher-tax countries so that profits flow to a lower-tax jurisdiction. This concern has often been raised in the case of Amazon, for example, which in recent years has claimed that much of its EU activity is conducted from Luxembourg and not through a UK PE (i.e. profits from sales are attributable to Luxembourg and not to UK storage and distribution facilities).315

Similar concerns have been raised in the case of Google, most recently in the context of the controversy over the company’s settlement of an additional £130 million liability in January 2016.316

312 Budget 2016, HC 901, March 2016 para 1.212. see also, HMRC, Corporation tax:

anti-hybrids rules – tax information & impact note, March 2016. 313 HM Treasury, 2016 Budget Policy Costings, March 2016 p19 314 Public Bill Committee (Finance Bill), Third Sitting, 5 July 2016 c94. The Government

has tabled a series of amendments for consideration at the Bill’s Report stage on 5 September, some to these provisions; details are collated on Gov.uk (21 July 2016).

315 IFS Green Budget 2016, February 2016 pp176-7. In 2015 Amazon shifted to booking sales through new branches in the UK, Germany, Spain and Italy, in part, it was reported, in response to the BEPS project (see, “Amazon branches out”, Tax Journal, 5 June 2015).

316 “Tax specialists criticise Google deal as opaque”, Financial Times, 26 January 2016. The controversy over this settlement is discussed below.

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The BEPS project seeks to counteract this practice by broadening the definition of PEs:

Entities are currently exempt from PE status if they undertake only activities of a ‘preparatory or auxiliary character’, such as storage and distribution.317 This means that a UK consumer may purchase a good via the website of a foreign company (such as Amazon) that is then delivered from a UK distribution centre, and that transaction will not lead to a UK corporate tax liability because there was no UK PE involved …

The rules dictating PE status will be revised to move where the dividing line is drawn. In particular, the revised rules will specify that storage and distribution activities will constitute the operation of a PE unless the activities are genuinely only preparatory and auxiliary in nature, which is, of course, still somewhat subjective.

There will also be clarifications to prevent some forms of ‘commissionaire’ arrangements, whereby a good is sold by one company on behalf of one in another country, such that the sales go directly to the other company. Relatedly, there will be clarifications to address situations where a seller avoids having a PE where sales take place and instead formally concludes sales in a lower-tax jurisdiction. Google has used the latter form of arrangement: substantial negotiation of sales happens in the UK but Google sales are booked in Ireland.318

Using a new PE definition in tax treaties may result in taxing rights that better reflect the source of profits. However, as the IFS notes, “this change may work in both directions for the UK”, and it is “not clear” the extent to which these changes will boost tax receipts.319

Restricting interest relief Arguably the most significant reform that the Government intends to make to the corporate tax system following the BEPS project is to restrict the tax relief companies can claim on their interest costs. Budget 2016 summarises this measure as follows:

Interest relief

1.209 The government is leading the way in implementing the G20 and OECD recommendations to ensure that profits are taxed in line with activities in the UK. Where large multinationals are over-leveraging in the UK to fund activities elsewhere in their worldwide group or claiming relief more than once, the government will act to prevent aggressive tax planning and level the playing field, so that multinational businesses can no longer arrange their interest expenses to shelter profits.

1.210 The government will cap the amount of relief for interest to 30% of taxable earnings in the UK or based on the net interest to earnings ratio for the worldwide group. To ensure the rules are targeted where the greatest risk of base erosion and profit shifting lies, the rule will include a threshold limit of £2 million net UK interest expense and provisions for public benefit infrastructure. The government will continue to work with the

317 Article 5(4) of OECD, Model convention with respect to taxes on income and on

capital, 2014 318 IFS Green Budget 2016, February 2016 p182 319 op.cit. p182, p191

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OECD on the appropriate application of these rules to groups in the banking and insurance sectors.320

As part of the IFS’ analysis of the Budget Helen Miller drew attention to the significant sums of money that the Government estimates will be raised by this measure: £1.2bn in 2017/18 and £1bn in 2018/19.321

The Government’s Business Tax Road Map provides an example of BEPS involving interest expense:322

The UK’s current approach to interest deductibility had been criticised the Lords Economic Affairs in their 2013 report on corporate tax avoidance, which was mentioned earlier in this paper.

OECD countries' tax systems generally recognise the distinction between debt and equity and give deductions for interest as a business expense. This raises two questions. First, and more immediately, what anti-avoidance measures are required to combat excessive use of debt as a means of shifting profit out of the UK? Second, and in the longer run, there is an issue of principle: should debt be given preferential treatment over equity, and if not, how should the treatment of financial costs be reformed? Appendix 5 of this report discusses these issues in more detail.

320 Budget 2016, HC 901, March 2016 p56 321 Business tax road map: IFS Budget briefing 2016, 17 March 2016 (slide 3). See also,

HM Treasury, 2016 Budget Policy Costings, March 2016 p17 322 HM Treasury, Business tax road map, March 2016 p25

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There is a general view, shared by the Government, that anti-avoidance provisions with respect to interest relief are weaker in the UK than in comparable countries …

In principle, a more territorial system would give relief only for borrowing that financed activity in the UK, reflecting the regime introduced in 2009 which aims primarily to tax only income generated in the UK. The Government sees the UK's relatively generous tax deductibility of interest payments as an important plank of British competitiveness in corporation tax.

Many other features may also be important, including the patent box, generous treatment of expenditure on research and development, CFC rules, and above all the planned reduction of the corporation tax rate to 20%.323

The Committee recommended that the Government should “consider whether the international competitive position of the UK's corporation tax regime needs to be bolstered by generous tax relief on interest payments”, as part of a wider review of corporate tax.324

In its 2010 ‘road map’ on corporate tax reform, the Coalition Government had suggested that the UK’s rules on interest deductibility were an important “competitive advantage”:

3.7 OECD countries’ tax systems generally recognise the distinction between debt and equity and give deductions for interest as a business expense. This is also reflected in international accounting standards. The Government remains committed to interest being relieved as a normal business expense irrespective of where the proceeds of the loans are put to use.

Any fundamental changes to these rules would have disruptive and potentially damaging effects on existing arrangements and could undermine the Government’s commitment to providing the stability and certainty needed to promote investment and growth.

3.8 The UK’s current interest rules, which do not significantly restrict relief for interest, are considered by businesses as a competitive advantage and it is the Government’s view that this advantage outweighs potential benefits from moving towards a more territorial system for interest. In coming to this conclusion, the Government has considered the difficulty of designing workable rules to restrict relief for interest, which are fair to all businesses without creating complexity and uncertainty.

3.9 As ever, the Government does need to consider the potential for some businesses to seek to exploit the UK’s current rules for avoidance purposes. The UK already has a series of rules designed to stop this but the Government will, as with other avoidance risks, continue to keep this area under review.325

Subsequently in its response to the Committee’s report, published in October 2013, the Coalition Government argued that “a new review of the corporate tax system would be of limited value given the range of work we are already doing in this area.” On the specific question of

323 Tackling corporate tax avoidance in a global economy, 31 July 2013, HL Paper 48 of

2013-14 p22 324 ibid. 325 Corporate tax reform: delivering a more competitive system, November 2010 p14

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interest deductibility the Government referred to the OECD’s BEPS project launched that summer:

The UK tax system, as with most OECD countries and in accordance with international accounting standards, gives deductions for interest as a business expense. However, to protect the UK exchequer there are a number of rules that limit how much interest a company can deduct from its tax liability. These include:

• the worldwide debt cap, which limits the total tax deductions for interest that the UK part of a worldwide group can claim;

• transfer pricing rules, which disallow excessive interest deductions;

• anti-arbitrage rules;

• disguised interest rules;

• unallowable purpose rules; and

• withholding tax on interest.

One action within the BEPS Project is to look at the various approaches countries take to restrict interest deductions and to share best practice in this area. The UK will be engaged in this work and we will continue to work collaboratively with the G20, OECD and other countries to take forward the actions.326

In its final recommendations the OECD proposed a new best practice approach to interest deductions. The OECD did not agree a minimum standard in this area because “there is no cross-country consensus on where to draw the line on interest deductions.”327 At the time the Government took the view that this was an ‘appropriate response’ to BEPS but asked for stakeholder views on how the issue might be addressed in an “effective and proportionate manner”:

Most OECD countries allow interest expense to be deducted in calculating taxable business profit while having rules to protect their tax base from excessive or tax-driven interest deductions. These rules may operate on either a general or transactional basis. Many countries, such as Australia, Germany, Italy, Japan, and Spain, already have rules that provide a structural restriction on tax relief for interest expense. Others, such as the US, have put forward proposals that would bring their current rules in line with the approach recommended in the OECD report.

The UK’s worldwide debt cap is a general rule which provides a back stop for excessive interest deductions but its other rules are essentially transactional. Under its transfer pricing rules the UK restricts tax relief for interest to the arm’s length amount but this restriction takes no account of whether the income and assets supporting that interest are taxable. Despite a number of targeted rules to supplement the arm’s length test, significant planning opportunities can arise from both external and intra-group interest expenses.

Both inbound and outbound groups can use debt flows to shift profits around, which potentially create competitive distortions

326 Government response to … Committee’s first report of 2013-14 Session, 14

October 2013 p2, pp5-6 327 IFS Green Budget 2016, February 2016 p189

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between groups operating internationally and those operating in the domestic market. As identified in the BEPS Action Plan (OECD, 2013), when groups exploit these opportunities, it reduces the revenues available to governments and affects the integrity of the tax system.

To address these risks, the OECD report on Action 4 of the Base Erosion and Profit Shifting project (OECD publication 2015) sets out recommendations regarding best practices in the design of rules to prevent base erosion through the use of interest expense. Through the development of the OECD report on best practices on interest deducibility, countries have agreed a general tax policy direction and it is expected that there will be convergence over time through the implementation of agreed common approaches.

To meet the OECD recommendations, the UK would need to introduce a new general rule for restricting interest. The government recognises that this would be a major change to the UK corporate tax regime and will require careful consideration to ensure any new rules work appropriately, including taking into account the beneficial impact of an 18% corporation tax rate.328

In the 2016 Budget the Government announced it would introduce new rules on interest deductibility with effect from 1 April 2017. A second consultation would be launched on the detailed design of these rules, with a view to including legislation in Finance Bill 2017.329 A broad outline of the new rules was given in the Business Tax Road Map:

2.33 The UK will be introducing a Fixed Ratio Rule limiting corporation tax deductions for net interest expense to 30% of a group’s UK earnings before interest, tax, depreciation and amortisation (EBITDA). This approach is in line with the rules that exist in several other countries and international best practice addressing profit-shifting through interest. A level of 30% remains sufficient to cover the commercial interest costs arising from UK economic activity for most businesses.

2.34 Recognising that some groups may have high external gearing for genuine commercial purposes, the UK will also be implementing a group ratio rule based on the net interest to EBITDA ratio for the worldwide group as recommended in the OECD report. This should enable businesses operating in the UK to continue to obtain deductions for interest expenses commensurate with their activities.

2.35 There will be a de minimis group threshold of £2 million net of UK interest expense. This will target the rules at large businesses where the greatest BEPS risks lie, and minimise the compliance burden for smaller groups. The threshold is estimated to exclude 95% of groups from the rules.

2.36 The government also intends to introduce rules to ensure that the restriction does not impede the provision of private finance for certain public infrastructure in the UK where there are no material risks of BEPS. It will also introduce rules to address volatility in earnings and interest. Further consultation will be conducted on the detailed design of all aspects of the rules in due course. The government will also continue engaging with the

328 HM Treasury, Tax deductibility of corporate interest expense: consultation, October

2015 para 2 329 HM Treasury, Overview of tax legislation & rates, March 2016 para 2.28

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OECD on the design of rules to prevent BEPS involving interest in the banking and insurance sectors.

2.37 There will no longer be a need for a separate worldwide debt cap and the existing legislation will be repealed. Rules with similar effect will be integrated into the new interest restriction rules, such that a group’s net UK interest deductions cannot exceed the global net third party expense of the group. This modified cap will strengthen the new rules and help counter BEPS in groups with low gearing.330

In its discussion of the BEPS project, the IFS noted that the OECD had recommended countries could set a fixed ratio rule somewhere between 10% and 30% to ‘EBTDA’:

The recommended rule would limit interest deductions to a fixed proportion of what is known as EBITDA. This is a measure of Earnings (profit after deducting labour costs) Before deductions for Interest paid, Tax paid, Depreciation of tangible assets and Amortisation of intangible assets. For example, if the allowable fixed ratio of net interest to EBITDA were set at 10%, a company that had net interest equal to 20% of EBITDA could only deduct half of its interest when calculating taxable profit. The OECD suggests a ‘corridor’ of 10% to 30% within which each country’s ratio might fall. A rule that compares the level of interest deductions with a measure of firm size provides a way to link the degree of interest deductions to real activity and can be used to combat both excessive third-party and intra-group loans.331

Even setting the ratio at a relatively high level would be likely to limit MNEs use of debt, which presents the Government with a trade-off:

Any anti-avoidance rule faces an inevitable trade-off between two types of error. An excessively lenient rule will do little to prevent tax-avoiding structures. An excessively stringent rule will distort legitimate firm behaviour, either not allowing full interest deductions (distorting investment) or forcing firms to modify their debt structure (which is itself costly).

The [UK’s worldwide debt cap (WWDC)] is a lenient rule that is more likely to succumb to the first type of error (permitting avoidance activities) than the second (distorting legitimate behaviour). It will only restrict interest if the amount deducted by the UK sub-group is greater than the total third-party interest of the world group. This is an extremely high bar. It is poorly targeted in particular at preventing firms locating third-party debt in the UK …

The fixed ratio is far more likely to limit interest deductibility.332 Even at the upper bound of the OECD corridor (30%), it would affect some firms’ decisions. Based on firm accounts data for 2009–13, the OECD estimates that 13% of multinational groups had an average net third-party interest to EBITDA ratio over 30%.

330 HM Treasury, Business tax road map, March 2016 p24 331 IFS Green Budget 2016, February 2016 p189 332 The application of the fixed ratio rule is potentially much broader than that of the

WWDC (which applies only to multinationals) because it could apply to domestic firms. However, the operation of an appropriately-designed group rule could be used to effectively ensure that the rule only applied to multinational firms. As these are the firms that pose the vast majority of the BEPS risk, such a restriction seems appropriate.

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This rises to 38% of multinationals for a 10% ratio.333 That is, a net interest to EBITDA ratio of greater than 30%, let alone 10%, is not particularly exceptional or unusual. Therefore the rule may be innocuous for low-debt firms, but it will bind for higher-debt business models …

However it is designed, the fixed ratio rule would limit multinationals’ use of debt (for both legitimate and tax-motivated reasons) more than the WWDC. The merits of moving to a rule that prevents more avoidance activity but would likely also distort more legitimate firm behaviour depending on how the government values the trade-off between these two kinds of error.334

The Government’s second consultation was launched in May 2016; details are collated on Gov.uk. Responses are invited by 4 August.

The Google tax settlement In January 2016 Google confirmed that it had agreed a settlement to pay £130m in tax and interest, concluding an audit that HMRC had started in 2010.335 As with the debate in autumn 2012 over the amounts of UK tax paid by MNEs, there was widespread criticism of the mismatch between Google’s UK operations and the amounts of tax it had paid to the Exchequer – as well as the lack of information published on how the assessment had been agreed.

In a strongly critical report the Public Accounts Committee observed, “the UK is Google’s second largest market (after the US), contributing over US$7 billion in revenue in 2015, or around 10% of Google’s worldwide revenue. In its latest UK accounts, for the 18 months ending June 2015, Google reported a UK corporation tax liability of £46 million. HMRC also told us that Google’s total charge for corporation tax interest from 2005 to 2015 was £196.4 million.”336

On the absence of details about the deal, the Financial Times quoted Mike Devereux at the Oxford Centre for Business Taxation asking, “why can’t [HMRC] make a statement: these are the principles which we are applying?” The paper went on to note, “whatever the methodology, the latest deal has once again raised questions about whether HMRC has let a big company off lightly. Meg Hillier, the Labour chair of the Public Accounts Committee, said she ‘bet individual taxpayers wouldn’t get off as lightly as Google on back tax.’”337

In media statements the company had argued that the revised assessment was ‘in line with recent OECD guidance’, though an editorial in the Times stated the settlement “leaves in place Google’s freedom to generate earnings in one country and ‘book’ them in

333 Among firms that are not parts of multinational groups, 19% were above a 30%

threshold and 45% above a 10% threshold. 334 IFS Green Budget 2016, February 2016 pp190-1 335 “Q&A: Google’s deal with the UK taxman” & “Google strikes £130m back tax

deal”, Financial Times, 22 & 23 January 2016 336 Public Accounts Committee, Corporate tax settlements, 24 February 2016, HC 788

of 2015-16 p4. See also, “’Impossible to judge’ if Google paid enough tax, say MPs”, Financial Times, 24 February 2016.

337 “Tax specialists criticise Google deal as opaque”, Financial Times, 26 January 2016

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another”, and, strikingly, went on to claim that if BEPS were “properly and globally enforced it could ensure that UK corporation tax is paid on these profits at the full rate of 20 per cent.338

Shadow Chancellor John McDonnell raised the issue of transparency as well as the implementation of BEPS, when the House debated the deal a few days after the announcement:

In the interests of openness and transparency, will [the Minister] now publish details of the deal and how it was reached? Will the Minister confirm that Google is not changing the company structures that enabled this avoidance to take place over the past decade? Are the Government not concerned that the agreement creates a precedent for future deals with large technology corporations, such as Facebook and Amazon? Will the Minister assure us that this deal does not undermine international co-operation on tax avoidance, such as the OECD base erosion and profit shifting scheme that the Chancellor once supported?339

Treasury Minister David Gauke addressed these two points as follows:

The tax that individuals and companies pay is collected by HMRC enforcing the law, not politicians who are, rightly, not engaged in or informed of particular cases. I am therefore unable to go into the details of the inquiry’s conclusion beyond those made public at the end of last week. I would point out, however, that the National Audit Office examined the HMRC settlement process in 2012 and examined specific settlements. In all cases, the NAO concluded that HMRC obtained a reasonable settlement for the Exchequer. It also made recommendations on the process by which HMRC should operate when reaching a settlement—recommendations that have been implemented …

This is a highly complex area, but there is a need for international co-operation in it, which is why we instigated the OECD looking at this as part of the BEPS process. That process has come forward with a number of recommendations. We have already legislated for two of those recommendations. There is a third that we are specifically looking at and consulting upon in terms of interest deductibility. It is right that we bring the international tax system up to date to reflect the way multinational companies are working.340

The House debated the issue a few days later in an Opposition Day debate when Mr McDonnell quoted estimates that some commentators had made that Google had paid an effective rate of tax of just 3%. Mr McDonnell argued that “as a start” there should be “publication of the details of this deal in full, so that we and our constituents can judge whether it is fair enough.” Mr McDonnell also argued that there should be “independent scrutiny of HMRC and the implementation of taxation policy overall. Let us now explore the establishment of a cross-party committee, along the lines of our Intelligence and Security Committee, to perform that role.”341 In his response Treasury Minister David Gauke

338 “Leader: The British government has been bamboozled by the web giant”, Times,

29 January 2016 339 HC Deb 25 January 2016 c27. Mr McDonnell had put down an urgent question on

the issue. 340 HC Deb 25 January 2016 c26, c31 341 HC Deb 3 February 2016 c970, c971

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did not directly address the 3% figure, but suggested it was based on a misconception of the way corporation tax worked:

The UK is home to one of the most successful video games sectors in the world. Would it be fair for a firm to design a game here, develop it here and take the risks here, but to go on to sell it overseas and then have to pay corporation tax on all that activity in the country in which it makes the final sale, and not in the UK? The current international tax arrangements are clear that such profits are taxed in the UK—the place of economic activity—rather than in the place where the sales are made.

That is the internationally agreed and internationally applied concept of corporation tax. That is the law that HMRC applies. Quoting numbers to do with revenues or profits from sales, as opposed to activities, demonstrates a lack of understanding of how the tax system works, or—and this is worse—an understanding of the way the tax system works, but the hope that those following these debates do not.342

The Minister went on to underline the fact of HMRC’s operational independence, and highlight the changes made in 2012 to improve the governance of this type of assessment:

When it comes to determining the tax liability of a company such as Google—or, indeed, any other taxpayer in this country—there is no ministerial involvement. HMRC is entirely operationally independent … HMRC introduced new governance arrangements for significant tax disputes in 2012 to provide even greater transparency, scrutiny and accountability. They included the appointment of a tax assurance commissioner to ensure that there is clear separation between those who negotiate and those who approve settlements. The tax assurance commissioner oversees the process and publishes an annual report on his work ...

There are no sweetheart deals, and there is no special treatment for large businesses. HMRC resolves disputes by agreement only if the business agrees to pay the full amount of tax, penalties and interest. Otherwise, it is a matter for the courts343

Similarly, in answer to a PQ Mr Gauke stated, “HMRC is responsible for the conduct of tax enquiries. Ministers are not informed of the progress of enquiries and play no part in agreeing the amount of tax to be paid by any taxpayer.”344

Writing at this time John Cullinane, tax policy director at the Chartered Institute of Taxation, noted that although it would be impossible to verify HMRC’s assessment, “it is possible to do some guesswork”:

How much tax does Google pay in the UK?

Following the recently announced settlement with HMRC reports are that Google is paying about £30 million a year in tax. (Based on reports that Google is paying £46.2m in taxes on UK profits of £106m for the 18 months to June 2015.)

342 HC Deb 3 February 2016 cc972-3. Subsequently HMRC published two notes making

these points at greater length: Factsheet on HMRC and multinational corporations, 9 February 2016; Issue briefing – taxing the profits of companies not resident in the UK, 1 March 2016.

343 HC Deb 3 February 2016 cc976-7 344 PQ24896, 3 February 2016

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Why is it not paying more?

It is based on the amount of profit that Google UK makes, which appears to be about £70 million a year, but maybe with a notional 'arms length' royalty from Ireland substituted for the actual one.

It is not based on the amount of profit Google makes on its services to UK customers. This would be a much higher figure – probably about £1 billion (estimate based on Google’s UK revenue of about £4 billion having the company’s global profit margin of 26% applied to it). If corporation tax of 20% was levied on this amount then Google would get a bill for roughly £200 million from the UK Government.

Is this where the ‘3% tax rate’ claim comes from?

Yes. £30 million is 3% of £1 billion.

So is £30 million the right figure?

Without access to all the figures we can’t be sure, but HMRC appear to think so. It is possible to do some guesswork. One researcher, Maya Forstater345, has done some ‘back of an envelope’ calculations based on how Google’s global costs divide up and worked out that if you take the category (sales and marketing) which constitutes most of Google’s activity in the UK and extrapolate from that that 16% of the company’s profits from UK sales are generated by its UK activity then you end up with £160 million of profit being taxable in the UK which, at a 20% tax rate, comes to £32 million. Of course this is an illustrative calculation by an outside commentator, we don't know on what basis Google and HMRC came to what they agreed.346

A few weeks after Google’s announcement the Public Accounts Committee published a report on the case, having taken evidence from HMRC and Google executives. As part of the inquiry HMRC submitted some information, with Google’s permission, that had previously not been made public. Two extracts from HMRC’s written evidence are given here: first, on the split between the company’s respective operations in Ireland and in the UK …

Google lreland Ltd

Google lreland Ltd (GlL) is the Google group's sales hub for Europe, the Middle East and Africa (EMEA). (Until 2010, GIL also acted as the sales hub for the Asia Pacific region.) All UK advertisers must enter into a contract with GIL in order to advertise on Google. GIL's operation in Dublin is the only point of contact for around 99% of Google's advertisers in the UK.

Since 2012, GIL's operation in Dublin has also provided the account manager service for Google's high value advertisers in the UK (prior to 2012, this service was provided by Google UK Ltd). The number of employees in 2013 was 2,288. The turnover shown in the accounts increased from €3,343m in the year ended 31 December 2006, to €18,268m in year ended 31 December

345 See, “Did the UK really agree to charge Google a 3% tax rate?”, Hiya Maya blog, 25

February 2016. On the wider problems with estimating tax revenues lost to corporate tax avoidance, see Ms Forstater’s work for the Center for Global Development, Can Stopping 'Tax Dodging' by Multinational Enterprises Close the Gap in Development Finance?, October 2015, cited by John Kay in the Financial Times: “There is no money behind the fiscal tree”, 15 December 2015.

346 CIOT, How is Google’s tax bill calculated? And other questions and answers about corporate taxation, 2 February 2016

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2014. Google lreland Ltd is not resident in the UK for tax purposes. Even if it had a permanent establishment in the UK, it would only be liable to UK corporation tax on the activities of that UK establishment.

Google UK Ltd

Google UK Ltd (GUK) provides marketing services to GlL, and as part of this service, its UK-based employees can be a point of contact for Google's high value UK advertisers. lt also provides research and development services to Google lnc. (Google lnc is incorporated in the United States and in the period for which our enquiries were concerned, it was Google UK Ltd's ultimate parent company.)

The turnover shown in the accounts from these business activities increased from £27 million in the year ended 31 December 2005 to £1,178 million in the 18 months ended 30 June 2015. The number of employees in GUK increased from 156 in 2005 to 2,329 by 2015. The company reported profits before tax in the 2005, 2006, 2012, 2013 and 2015 financial statements. lt reported losses before tax from 2007 to 2011.

GUK is resident in the UK for tax purposes, and therefore subject to UK corporation tax on all of its trading profits. As it provides services wholly to other companies in the global group, transfer pricing rules apply to require GUK to pay tax on profits arising from an arm's length price for its services.347

… second, on the process for HMRC’s inquiry, and its assessment of the company’s accounts:

HMRC enquiry

HMRC formally opened an enquiry into GUK'S returns in March 2010 after having carried out a detailed risk review. We concluded our enquiry in January 2016, when we reached agreement with GUK about additional tax that was due. This is a way of settling the correct tax position provided for by law; the other way is to have matters determined by the decision of a tax tribunal or relevant appellate court.

There were two agreements between GUK and HMRC; one covered the period 1 January 2004 to 31 December 2004, and the second covered 1 January 2005 to 30 June 2015.

We examined whether there was a permanent establishment of Google lnc or GIL in the UK. We also examined the transfer pricing methodology applied to transactions between GUK and other group companies. ln particular, we examined the treatment of share-based remuneration and the adequacy of the reward that GUK received for its marketing function.

We also examined whether there was any liability to Diverted Profits Tax for the three months from 1 April 2015 - 30 June 2015. For each year covered by the enquiry, we secured additional tax reflecting the full value of the economic activities carried on by Google in the UK. We agreed that the Diverted Profits Tax did not apply for the three months ended 30 June 2015. …

HMRC's analysis of the tax charges in GUK's published accounts

347 HM Revenue and Customs - written evidence (CTX0004), 11 February 2016 pp1-2

113 Corporate tax reform (2010-16)

GUK have disclosed in their 2015 financial statements that HMRC's enquiry has been closed, with GUK agreeing that it has to pay additional tax. GUK have said that, as a result of HMRC's enquiry, they have an additional liability of £130 million in corporation tax and interest for the period ended 30 June 2015 and prior years. This sum is over and above the tax that they have paid for those years (or would pay for the current period were it not for HMRC's enquiry), but does not indicate the full impact of that enquiry. This is because it does not include the agreement reached in respect of 2004 and does not reflect that from 2012 the company's reported profits took account of the revised treatment of share based compensation put forward by HMRC during the course of the enquiry.

The cumulative current tax over the period 2005 to 2015 shown in GUK's financial statements may be seen as a reasonable (although not precise) proxy for the tax payable over that period. GUK's accounts show a cumulative tax charge in the financial statements from 2005 to 2011 of £11.6 million. ln their 2012 statements, GUK disclosed that they were under enquiry by HMRC and made a provision of £24 million for potential corporation tax for the years 2005- 2011.

lt is clear from GUK accounts that thereafter they also made more substantial charges for tax in their accounts year on year - the cumulative tax charge in the 3½ years ended 30 June 2015 was £166.8 million. ln addition, the financial statements show cumulative interest of £18 million on that tax.348

The Committee concluded that “the lack of transparency about tax settlements makes it impossible to judge whether HMRC has settled this case for the right amount of tax”:

HMRC should consult widely, including with other tax authorities, on the case for changing the rules that protect corporate taxpayer confidentiality to make the tax affairs of multinational companies open to public scrutiny. As the previous Committee recommended in 2013, HMRC and HM Treasury should push for an international commitment to improve tax transparency. HMRC should be prepared to go it alone if necessary to provide the means for Parliament and interested parties to judge whether tax settlements reached are reasonable.349

The Committee went on to raise concerns about the time taken to complete the settlement and whether HMRC had sufficient resources to resolve these investigations and sufficient powers to penalise aggressive tax planners, as well as whether the international tax system was fit for purpose with regard to the digital economy.

The Government’s response to the Committee’s report was published in April. While the Government formally accepted the Committee’s recommendations, it did not agree to making any fundamental changes to HMRC’s powers to publish information about individual tax settlements or in Parliament’s role in their evaluation:

The Government supports efforts to improve tax transparency by multinational companies. The Government initiated work on country-by-country reporting during the UK's G8 Presidency in 2013, and was the first to commit to implement the OECD model,

348 op.cit., pp2-3, pp4-5 349 Corporate tax settlements, 24 February 2016, HC 788 of 2015-16 para 1

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with legislation in the Finance Act 2015. The Government remains in the vanguard; for example, in now pressing the case for agreement to public country-by-country reporting on a multilateral basis.

The Department will continue to pursue domestic initiatives on transparency which complement the international steps being taken, while maintaining appropriate safeguards for taxpayer confidentiality, which remains an essential and valuable feature of the UK tax system. For example, the introduction of legislation in Finance Bill 2016 will require all large businesses to publish their UK tax strategies and enable HMRC to name large businesses that are subject to special measures to improve their compliance.350

The Department is currently reviewing its arrangements for assuring decisions to resolve tax disputes, but considers that its existing arrangements, together with the ability for the NAO to review its work and report to Parliament, provide the means for Parliament to determine that the Department is reaching reasonable settlements.351

Following Google’s announcement there were reports that the French and Italian tax authorities were seeking much more substantial assessments from the company.352 In evidence to the Committee Matt Brittin, Google Europe, Middle East and Africa (EMEA), said, ”just like in the UK, there have been a whole range of statements that are based on what people … might like to see large companies pay, but they are not related to a tax demand or an audit.” Tom Hutchinson, VP Finance, Google Inc, added “we’re not confirming those rumours of what’s happening. Those are articles that are not based on facts. But I can say, the information that I can provide is that we have never paid, as part of an audit settlement outside the US, a larger settlement than the one we just agreed to.”353 In its formal response the Government underlined that “should further relevant information come to light that was not made available to the Department during the course of the enquiry, the Department would consider its tax impact and look again at the settlement if it appeared that further tax should be paid.”354

Reflecting on the Google affair some weeks after the controversy, Judith Freedman, Professor of Taxation Law at Oxford, noted, “when the Google settlement was announced … most of the media and political comments completely ignored the existence of the Tax Assurance Commissioner”:

The debate veered off into a discussion of what commentators thought Google had paid and should have paid under some non-existent ideal tax system, despite the fact that, clearly, HMRC can only collect tax due under current law.

There was also an over simplistic view widely expressed that there was a ‘correct’ amount of tax that should have been paid, showing a lack of understanding of the inherent uncertainty surrounding transfer pricing valuations, which, rightly or wrongly,

350 For details see, HMRC, Tax administration: large businesses transparency strategy:

tax information & impact note, December 2015. 351 Treasury Minutes, Cm 9260, April 2016 p14 352 Corporate tax settlements, HC 788 of 2015-16 para 12 353 Oral evidence: Corporate tax deals, HC 788, 11 February 2016 Qs42-3 354 Treasury Minutes, Cm 9260, April 2016 p16

115 Corporate tax reform (2010-16)

under current law makes discussion and negotiation part of the normal process of collecting tax in such cases.355

Professor Freedman went on to make the case for a “a re-think of the 2012 arrangements” as “clearly the public and the PAC want something more than the Tax Assurance Commissioner system set up in 2012, however robust that turns out to have been”:

Transparency alone, however many lorry loads of information are published, is not the answer. The solution lies in good tax governance with expert independent external scrutiny, in which the public can trust and which MPs will support rather than undermine …

Currently the role of the NAO and the PAC is to review whether HMRC are operating efficiently. This is the correct role for the PAC: politicians should not be involved in the tax affairs of individual taxpayers as a matter of constitutional propriety. But there is no reason why we should not create an expert unit of the NAO to provide external scrutiny of a sample of settlements on a regular, routine basis. This would be a small extension of the current role of the NAO and would be far preferable to special inquiries emerging periodically as a response to particular events.

Whatever developments take place in international tax law as a result of the Base Erosion and Profit Shifting Action Plan and as a result of increased transparency, ultimately the revenue authorities will need to decide how much tax is payable.356

Country-by-country reporting One element of the BEPS package is already well-advanced – initiatives to improve transparency and information flows; in particular, requirements on multinationals to file ‘country-by-country’ reports to tax authorities, to give certain key statistics for each jurisdiction in which they operate. The purpose of these reporting requirements is to help revenue authorities assess MNEs transfer pricing practices. In the UK’s case primary legislation for the new regime was included in Finance Act 2015 (specifically, s122 of FA 2015). Subsequently the Government consulted on the detailed rules for the new regime, and introduced regulations that took effect from 18 March 2016 (SI 2016/237).

Details of how CbC reporting will work, and its impact on tax receipts, are in an updated tax information note; an extract is given below:

The measure introduces a reporting requirement for any UK resident ultimate parent entity of an MNE with a consolidated group turnover of €750 million or more. It applies to accounting periods commencing on or after 1 January 2016 and companies will have 12 months from the end of the relevant accounting period to file a report with HMRC.

The measure also includes a requirement for the top UK entity of an MNE to file a CBCR, when it is not the ultimate parent entity (UPE) of the MNE and the UPE is resident in a country that either doesn’t require CBCR or doesn’t exchange reports with HMRC in accordance with an effective multilateral competent authority

355 Judith Freedman, “The Role of the Tax Assurance Commissioner in Reviewing Tax

Settlements”, Oxford Business Law blog, 3 May 2016 356 ibid.

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agreement. This local filing requirement will mean that the top UK entity of an MNE will file a CBCR covering all entities within the sub group of which it is head. There is an exemption if the results the UK entity would be required to file have already been included in a CBCR that HMRC can receive.

In addition, the measure includes a provision to allow MNEs with a UK presence to voluntarily file a CBCR with HMRC in certain circumstances; broadly speaking, where the ultimate group parent is resident in a country that either doesn’t require CBCR or doesn’t exchange reports with HMRC in accordance with an effective competent authority agreement.

The reporting requirement is supported by a penalty regime in the regulations to encourage MNEs to file on time and to take due care in the preparation of the report…

Summary of impacts

Exchequer impact (£m)

These figures are set out in table 2.2 of March Budget 2015 as ‘Corporation Tax: country-by-country reporting’, and have been certified by the Office for Budget Responsibility. More details can be found in the policy costings document published alongside Autumn Statement 2014. The changes detailed in this tax information and impact note are expected to result in a further small increase in yield.357

The Government has also supported moves to have this information made publicly available:

Asked by Jonathan Ashworth (Leicester South) : To ask Mr Chancellor of the Exchequer, what timeline he has set for all multinational companies operating in the UK to publish country-by-country reporting; and how that requirement will be enforced.

Answered by: Mr David Gauke : The UK initiated the Organisation for Economic Co-operation and Development (OECD) work on country-by-country (CbC) reporting by large multinationals to tax authorities. The UK was one of the first countries to commit to the OECD model of CbC reporting with legislation in Finance Act 2015, and regulations were laid on 26 February 2016 setting the details of implementation in the UK, which apply to accounting periods beginning on or after 1 January 2016. The UK together with 30 countries has signed the OECD Multilateral Competent Authority Agreement (MCAA) to exchange CbC reports.

The Chancellor has recently pressed the case for public CbC reporting on a multilateral basis. On 12 April 2016 the European Commission published a legislative proposal for public CbC reporting by large multinationals. The UK welcomes this work as a step in the right direction towards new international rules for greater public transparency.358

Details of the European Commission’s proposal for public CbC reporting (COM 2016(198) are on its site.359 The Government set out its position

357 HMRC, Country-by-country reporting – updated, 26 February 2016 358 PQ36903, 12 May 2016 359 European Commission press notice IP16-1349, 12 April 2016

2015 to 2016 2016 to 2017 2017 to 2018 2018 to 2019 2019 to 2020Negligible 5 5 10 10

117 Corporate tax reform (2010-16)

on the proposal in greater detail in an explanatory memorandum submitted to the European Scrutiny Committee in April.360

As mentioned in the Government’s response to the PAC report on Google, Finance Bill 2016 includes a provision to require large businesses to publish their UK tax strategies. This followed a consultation exercise over summer 2015; details were confirmed in December that year:

The measure will introduce a legislative requirement for all large businesses to publish an annual tax strategy, in so far as it relates to UK activities, approved by the Business’s Executive Board.

The strategy will cover 4 areas:

• the approach of the UK group to risk management and governance arrangements in relation to UK taxation

• the attitude of the group towards tax planning (so far as affecting UK taxation)

• the level of risk in relation to UK taxation that the group is prepared to accept

• the approach of the group towards its dealings with HM Revenue and Customs (HMRC)

Non-publication of an identifiable tax strategy or incomplete content based on the 4 areas outlined above could lead to a financial penalty. This penalty will be subject to the usual HMRC appeals process.361

Provision to this effect is made by clause 149 and schedule 19 of the Finance Bill 2016. Caroline Flint MP tabled an amendment to the Bill, to add a requirement to schedule 19, so that an MNE group that is required to publish its tax strategy will have to include the CbC report it has provided to HMRC.362 Ms Flint set out the purpose of her amendment in a press notice; an extract is given below:

Multinational businesses like Google will be forced to publish

where they do business, the money they make and the tax they pay, following a cross party initiative in Parliament, led by Caroline Flint. The Don Valley MP has joined forces with colleagues on the powerful Commons Public Accounts Committee which held an inquiry into the Google tax affair, to require public disclosure by multinationals, known as “public country-by-country reporting” because they operate across several countries. The MP has tabled an amendment to the Finance Bill.

Said Caroline Flint: “I am delighted to have such strong backing from Public Accounts Committee colleagues from all parties. MPs of different parties are saying it’s time to shine a light on these secretive tax arrangements and make sure big multinational enterprises pay the right amount of tax. We believe the tide of opinion is moving towards openness, after the Google tax affair

360 See, European Scrutiny Committee, Thirty-third report of Session 2015-16, 20 May

2016, HC 342-xxxii of 2015-16, pp 92-96. 361 HMRC, Tax administration: large businesses transparency strategy: tax information &

impact note, December 2015. See also, HM Treasury, Overview of tax legislation & rates, March 2016 para 1.76

362 In the last Session Ms Flint introduced a Ten Minute Rule Bill – the Multinational Enterprises (Financial Transparency) Bill – with a similar purpose (HC Deb 15 March 2016 cc808-810).

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and the release of the Panama Papers. We want the Government to champion this – in the interests of UK business, and fairer taxation.”

… There are some similar but more limited proposals before the European Parliament, which the Government supports. Said Caroline Flint: “I hope the EU will reach agreement to tackle this, as the problem of multinational tax avoidance affects every government in Europe. Regardless of the EU position, we believe now is the time for the UK to act, show leadership on this issue and address the unfairness in our tax system created by extreme secrecy and confidentiality.”

The campaign is promoted on social media using the hashtag #showmethemoney.363

Ms Flint’s amendment was debated on 28 June by the Committee of the Whole House, and rejected by 295 votes to 273.364 On this occasion Ms Flint made the case for this change, saying:

I want the HMRC to be armed with all the necessary information to secure fair tax contributions from these companies, based on their UK activity, but we need more than the HMRC to have a confidential look; we all deserve to see the bigger picture, and by publishing, we will see that.

Publishing is one way to persuade some of these companies to restore their corporate reputations. Was it because of the extraordinary focus on Google that Facebook announced a welcome change to the recording of its profits in the UK? I believe so. If a company is reporting profits in tax havens where they have only a PO box and a name plate but no apparent staff or activity, do we not want to know that? Let us follow our convictions; let us do what we know to be right. Let us shine a light on the activities of these large multinationals which—let us be honest—run rings around revenue and customs authorities around the world. Let us not flinch, play for time, and hope that some international agreement will eventually be reached by the EU or the OECD.365

Opposing the amendment Treasury Minister David Gauke argued that Ms Flint’s amendment was “technically flawed” and “would not achieve the stated transparency or pro-business objectives that we all espouse”:

The right hon. Lady has said that multinational businesses such as Google would be forced to publish headline information about where they do business, the money that they make and the tax that they pay, but that is not the case. According to Government legal advice, the amendment would, in practice, place such a requirement only on UK-headquartered multinationals. Foreign-headquartered multinationals such as Google would not be caught at all, and that undermines the transparency objective of the amendment.

The amendment also risks putting UK multinationals at a competitive disadvantage by imposing a reporting requirement that does not apply to foreign competitors operating in the same market. For example, a company headquartered in the UK,

363 Caroline Flint MP press notice, Caroline Flint leads campaign on multinational taxes,

13 June 2016 364 HC Deb 28 June 2013 c203 365 HC Deb 28 June 2013 c173

119 Corporate tax reform (2010-16)

whether on the mainland or in Northern Ireland, would have to file public reports, but a company headquartered in the Republic of Ireland—or, indeed, pretty well anywhere else—would not. That, I think, contradicts the level playing field objective whose importance the right hon. Lady has emphasised. At a time of increased uncertainty, we should be particularly cautious about disadvantaging UK-based businesses and imposing on them a further commitment that does not apply to their foreign competitors.366

The Minister went on to argue that international efforts to tackle the issue were well-advanced, so that it would be ‘premature’ for the UK to act unilaterally:

I do not think that the UK should be the last mover in this respect by any means. The United States seems to be some way away from moving in this direction, and I do not think that we should wait for the United States; I think we should be there before it. We should be able to deliver, especially given that such good progress is being made at European Union level. We remain members of the European Union, and there is appetite for this in other EU states. I have no doubt that, if no progress has been made in a year or two, the right hon. Member for Don Valley will come back and ask, “Why has this not happened?”, and in that event her case would be strengthened. However, I think that until we have given the deal a fair wind, it would be premature to act unilaterally …

I believe that we all share the same objectives and that the question is about how we get to where we want to be. I want to make it absolutely clear that, although there are some technical concerns and flaws in the legislation, the fundamental point is that there is a limit to the extent that we can require a foreign multinational entity to disclose information on its global activities under UK law. That is why we believe that the best way forward is through international efforts on public country-by-country reporting. Even if those flaws can be addressed, we still face that problem.367

Ms Flint raised the issue with the newly appointed Financial Secretary, Jane Ellison, at Treasury Questions on 19 July: “may I suggest to the Minister … that the Treasury team reconsider introducing in the Finance Bill when it returns to the House in the autumn a public country-by-country reporting amendment, so that we can see what is going on, and so that whatever the corporation tax rate is, we get what we deserve?” In response the Minister said the following:

I am aware of the right hon. Lady’s interest in the matter and of previous debates. The key thing is that that has to happen on a multinational basis—that is what we feel. It will be an issue at the forthcoming G20 Finance Ministers meeting and we will have more to say about it. I return to the fact that the UK has a world-leading position and will continue to push the global community to go further.368

366 HC Deb 28 June cc157-8 367 HC Deb 28 June 2013 c159, c183 368 HC Deb 19 July 2016 c677

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A corporate offence of failing to prevent evasion At the time of the March 2015 Budget the Coalition Government published a paper setting out the action it had taken over the Parliament to deal with tax avoidance and evasion.369 In addition the paper set out four initiatives to tackle the particular problem of offshore evasion, including a new criminal offence for corporations that failed to take adequate steps to prevent the facilitation of tax evasion by their agents.370

Following consultation over summer 2015, and in December the Government confirmed it would bring forward legislation for three of these measures in the Finance Bill 2016:

• a new criminal offence for tax evasion, • new civil penalties for offshore tax evaders, and • new civil penalties for those enabling offshore evasion.371

In the case of a criminal offence for corporates, stakeholders and respondents had been “broadly understanding of the need for greater corporate responsibility in relation to the acts carried out by those who represent the corporation”, though there were concerns that there might be practical difficulties in prosecution. In December the Government proposed that it would publish draft legislation and draft guidance in early 2016 for further consultation before proceeding.372

The Prime Minister reiterated the Government’s plans to introduce this criminal offence for corporations, in a statement to the House on 11 April 2016.373 This followed the publication a few days before of the ‘Panama papers’ – a leak of financial records from Mossack Fonseca, a law firm that had provided advice on establishing offshore companies in tax havens to a wide variety of politicians, celebrities, and other wealthy individuals.374 In his statement Mr Cameron announced that a joint taskforce would be established to investigate potential cases of evasion revealed by the leak, led by HMRC and the National Crime Agency, gave details of ongoing efforts to improve the provision of financial information by British Overseas Territories to the revenue authorities, and confirmed that the UK Government would host an international summit on global efforts to deal with corruption the next month.375

With regard to the new corporate offence, HM Revenue & Customs published draft legislation and draft guidance for consultation on 17

369 HM Treasury, Tackling tax evasion & avoidance, Cm9047, March 2015. The paper

lists a series of measures taken from 2011 to 2015 to ‘close loopholes’ (Table 2.A). 370 op.cit. para 3.13. For more details on the activities involved see, HMRC, No safe

havens: 0ur offshore evasion strategy 2013 and beyond, March 2013 p2 371 Autumn Statement Cm 9162, November 2015 para 3.77-80. See also, Budget 2016,

HC901, March 2016 para 2.200-2 372 Tackling offshore tax evasion: a new corporate criminal offence of failure to prevent

the facilitation of tax evasion - Summary of Responses, December 2015 pp7-8, p36 373 HC Deb 11 April 2016 cc23-26 see also, No.10 Downing Street press notice, PM:

Companies to be liable for employees who facilitate tax cheating, 11 April 2016. 374 “What are the Panama Papers? A guide to history's biggest data leak”, Guardian, 5

April 2016 375 For more background see, The international anti-corruption summit in May 2016,

Commons Briefing paper CBP7580, 20 May 2016

121 Corporate tax reform (2010-16)

April; responses are invited by 10 July.376 The paper sets out the policy objectives of the new offence as follows:

1.3 The new corporate offence aims to overcome the difficulties in attributing criminal liability to corporations for the criminal acts of those who act on their behalf. Whilst this consultation refers to the application of the new offence to “corporations”, the draft legislation refers to a “relevant body” to encompass the broad range of legal persons to which the new offence will apply.377

1.4 Attributing criminal liability to a corporation normally requires prosecutors to show that the most senior members of the corporation were involved in and aware of the illegal activity, typically those at the Board of Directors level. This has a number of impacts:

• In large multinational organisations decision making is often decentralised and may be taken at a level lower than that of the Board of Directors, with the effect that the corporation can be shielded from criminal liability. This also makes it harder to hold such organisations to account compared to a smaller organisation where decision making is centralised.

• The existing law can act as an incentive for the most senior members of a corporation to turn a blind eye to the criminal acts of its representatives in order to shield the corporation from criminal liability.

• The existing law can act as a disincentive for internal reporting of suspected illegal activity to the most senior members of the corporation.

1.5 The cumulative effect is an environment that does not foster corporate monitoring and self-reporting of criminal activity. The criminal law currently renders corporations that refrain from implementing good corporate governance and strong reporting procedures hard to prosecute, and offers no incentive to invest in such procedures. It is those corporations that deliberately turn a blind eye to wrongdoing and preserve their ignorance of criminality within their organisation that the current criminal law most advantages.378

The consultation document does not provide a costing of this measure, and notes that the impact on corporations “will depend on the precise scope of the offence and the nature of the reasonable procedures defence … We will continue to consult with stakeholders on the impact of the new corporate offence following publication of finalised draft legislation.”379

The Government’s legislative priorities for the 2016-17 Session were set out in the Queen’s Speech on 18 May 2016, including details of the

376 Tackling tax evasion: a new corporate offence of failure to prevent the criminal

facilitation of tax evasion, April 2016 377 “Relevant body” is defined within section 1(2) of the new draft clauses. 378 Tackling tax evasion: a new corporate offence of failure to prevent the criminal

facilitation of tax evasion, April 2016 pp6-7. The consultation document gives a case study of how the offence would work “to help inform stakeholder feedback” (see para 3.6, pp24-26).

379 op.cit. p45. See also, “Q&A: The proposed corporate offence of failing to prevent tax evasion”, Tax Journal, 6 May 2016; “Strict liability offences: a worrying trend?”, Tax Journal, 20 May 2016

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Criminal Finances Bill. The Bill is to comprise of a number of measures to tackle money laundering, corruption and tax evasion – including the introduction of the new corporate offence.380 To date no further details have been published.

380 Cabinet Office, Queen’s Speech 2016: background briefing notes, 18 May 2016

pp51-2

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