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Non-Resident Companies: Basis of Charge to Corporation Tax

Mr. Flight: I beg to move amendment No. 66.

The Chairman of Ways and Means (Sir Alan Haselhurst): With this it will be convenient to discuss amendment No. 67.

Mr. Flight: The two amendments to which I am about to speak should be viewed in the context of some of the wider issues associated with clause 148, and I hope that the House will grant me indulgence if, rather than making certain points twice, I speak more widely around the amendments at this stage of our discussions.

Clause 148 was foreshadowed in last year's Budget and the Government's proposals were summarised in a subsequent press release that stated that the new proposals were

That was essentially because

The press release stated that the changes would apply to accounting periods commencing on or after 1 January this year. Clause 148 gives effect to those proposals, although, curiously, clause 147, which defines the term "permanent establishment", contains no commencement provision and so will take effect from Royal Assent. I am not clear whether clause 148 can take effect from 1 January as the crucial definition will not have been enacted at that point.

Amendment No. 66 deals with the issue of the permanent establishment having the same credit rating as a non-resident company. Ratings are given to companies, to corporate debt and sometimes to specific transactions, and it is not clear what is being referred to here. Only a few companies that carry on business in the UK through a permanent establishment will have a credit rating. It is surely not appropriate to treat a UK permanent establishment, which might carry on only one or a limited range of the activities carried on by the company itself, as having the same credit rating as the company as a whole.

Both the OECD model and the draft legislation attribute to the permanent establishment the profits that would have been realised by a separate enterprise carrying on the same or similar activities. If any rating were to be assumed, it should be that which the assumed separate enterprise would have to have had, having regard to the activities that it carries on. It is illogical to assume a credit rating equivalent to that of the company itself.

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The term "shareholders' loan" is also an issue. Given that "loan" has a meaning that does not include unpaid purchase money, a definition would be required if, contrary to what we feel is appropriate, the provision is to be retained. Failing that, debt securities issued as a consideration for an acquisition would not be included.

The explanatory notes to the Bill refer to equity capital and loan capital. That would probably be acceptable for financial institutions where there is a substantial amount of guidance, but for other companies it would be difficult to work out what is meant by the term.

Subsection (5) also permits the Revenue to make regulations for the application of subsection (2) to insurance companies, including the attribution of capital to a UK permanent establishment. That confers an unacceptable degree of power on the Revenue.

We are also concerned that the terms of the accompanying schedule 25 are discriminatory. The effect of paragraph 5 is that a permanent establishment would be in a worse position than a subsidiary that borrowed from its parent company. That could make organisations think more carefully about whether to set up in the UK as a branch or subsidiary. To be able to deduct interest would require the permanent establishment to have its own credit rating and deal at arm's length with other parts of the organisation. It could be discriminatory if the branch were not treated in the same way as a subsidiary.

The commentary in the OECD model is a flexible document and there is an ongoing debate about whether a branch should be treated as independent. There is a risk that, if the commentary is changed, the UK provision will then be out of line. If provisions are included in the Bill based on the current version of the commentary, there is a risk that that will restrict the Revenue's flexibility.

The clause is not specifically about European issues, but it is based on the long-standing principle of the UK's "territorial" basis of taxation for overseas companies, so it indirectly allows European issues to be raised; it focuses on European issues. Indeed, some of the commentary on the proposals from professionals has suggested that it contravenes EC treaties.

The premise from which the clause proceeds is that British companies should be taxed on all their profits, wherever they arise, and that non-UK companies should be taxed on their UK profits. In both cases, the tax yield is protected by a number of rules that prevent assets or profits from being siphoned out of the UK through transfer pricing, tax-free transfers of assets or excessive interest payment. The UK tax base is also protected by allowing offset of losses only where those have arisen in the UK.

The Paymaster General will be aware that a number of recent decisions have challenged some fundamental aspects of the corporate tax system of EU countries and our own corporate tax system. Indeed, they could challenge clause 148 and its accompanying schedule. The challenges seek to argue that the application of different tax rules to transactions with foreign companies from the rules that apply domestically is

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unlawful discrimination, but from a domestic perspective such discrimination is necessary and has been practised to ensure that companies do not simply siphon off profits to low-tax countries.

Those challenges are a significant threat to the UK's ability both to control its tax borders and to exercise its own corporate tax policies. For example, it may be unlawful to restrict interest deductions to EU companies where those payments represent excessive deductions designed to shift profits overseas. That is raised in the German Lankhorst case and the awaited Dutch Bosal case. It may be illegal to apply transfer pricing rules to transactions within EU companies, an issue that has not yet been litigated but which follows in principle from other European Court of Justice decisions. The UK may need to allow tax-free transfers of assets to EU companies because they are permitted between UK companies. The controlled foreign companies rules that prevent British companies from accumulating tax-free cash outside the UK may be unlawful. Again, that issue has not yet been litigated but there are relevant French cases. The well known Marks and Spencer case currently being litigated would require Britain to allow losses of foreign subsidiaries against UK profits. The recent decision in the Lankhorst case may well undermine the usefulness and effectiveness of the clause as interest payments to other EU members of a group would still be deductible.

The Government have to date refused to discuss—indeed, the Revenue appears to have buried its head in the sand—the impact of European Court of Justice decisions on the UK tax system. We welcome the announcement in the Red Book that that issue will be looked into, but it is the first acknowledgment that a major problem exists.

I would like in that context to make the following key points to the Paymaster General. The first is about whether the Government are confident of the forecast yield from clause 148, particularly in light of the slowdown in the financial services industry in the City as well as the EU issues. Secondly, the European Court's decisions have made provisions that are designed to prevent abuse of domestic tax rules unlawful. That challenges the UK's ability to protect its corporate revenues. What are the Government doing to defend the UK's tax rights over UK and non-UK companies operating in the UK?

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The Government's failure to face up to the problem so far leaves them with only two—potentially unattractive—options. They can extend the rules that are designed to apply only to international transactions to cover all domestic businesses, which would be highly regulatory and would impose unnecessary compliance costs on UK businesses. Alternatively, they can abandon the rules that prevent international tax avoidance, which would mean the loss of significant tax revenues.

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How do the Government propose to balance the need to raise revenue with the competitiveness of our tax system? The Red Book suggests that they are more concerned with protecting the tax yield than with the all-important issue of competitiveness. They have, at least overtly, ignored all the warning signs that sovereignty is being undermined in this crucial tax area, and are now acting in a way that will have an adverse effect on British business interests and the vital attractiveness of Britain as an international business location.

Will the Government consider tabling an amendment to the European treaty as part of the 2004 intergovernmental conference, to ensure that specified tax rules designed to prevent international tax avoidance are agreed not to be unlawful, so that we can retain national sovereignty in these areas and, indeed, ensure that what is proposed in clause 148 is effective?

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