Tuesday, 29 May 2012

£4 billion of unintended consequences?

When the Government solves one problem, it often unintentionally creates another.

So it is with the reform of the rules on taxing Controlled Foreign Companies. (CFCs are overseas companies, controlled by UK residents, which pay less than three quarters of the tax on their income that they would have paid had they been based in the UK). 

The current regulations were first introduced in 1984 with the intention of stopping CFCs avoiding UK tax by artificially diverting their profits to low tax jurisdictions. These regulations attribute the worldwide profits of a group to the UK, in order to identify the tax base, and extracts tax whenever profits are moved between any two jurisdictions. This means that the company should eventually have to pay all the taxes it owes, even if it attempts to hide the profits in a country with lower tax rates.  

It has been widely recognised that these rules, now over 25 years old, need to be brought up to date, to meet the realities of a globalised economy.  In their current form, the CFC tax regulations interfere with the efficient management of overseas operations, and with commercial decision making much more than is necessary to protect the UK tax base.

The Finance Bill 2012 aims to solve this problem by replacing the current rules with a new regulatory system which will come fully into effect in  January next year.   This new system will adopt a territorial approach, and aim to tax only UK activity in order to prevent UK profits being artificially diverted off shore. A so-called gateway test will be established to identify taxable UK profit leaving the country. The gateway will exempt foreign profits from taxation where there is no erosion of the UK tax base; and avoid taxing profits arising from genuine economic activities undertaken offshore. There will also be a motive test, which will ensure that profits are taxed if they are being moved purely with the purpose of reducing UK tax liabilities. This new system should be simpler to administrate, easier to police, and friendlier to businesses.

However, the charity Actionaid has identified a problem with this territorial approach to taxation.  They point out that under the new system, taxes will only be charged on money moving in or out of the UK. If a British company moves money from one regime to another, it will be ignored. This will make it easier to move profits from developing countries to low tax regimes with out being liable to taxation.

Actionaid calculate that this will cost developing nations £4 billion in lost taxes per year, and cost the UK £1 billion.