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Mr. Mark Field: The Minister will be glad to know that the Opposition will withdraw the amendments. In part, they were probing amendments. It was important to have some discussion about whether small and medium-sized enterprise distinctions should be made at all within the context of the Minister's proposals.
We are rightly proud of the strength that the UK has in our private equity business. It is particularly important that that is maintained, not least given the strength of the two great economic superpowers of the futureChina and Indiaand our links with those countries. Inevitably, there will be a significant role for a number of joint ventures. Much venture capital will find its way in various different guises either in the UK or beyond that. It is therefore important that the pre-eminence of our private equity business is seen to be maintained.
Clearly, the Opposition are being lobbied, just as the Government are lobbied, and, inevitably, the Armageddon and appalling outcomes that are sometimes presented can be exaggerated. Equally, my hon. Friend the Member for Chipping Barnet (Mrs. Villiers) rightly articulated one of the Opposition's concerns when she referred to the notion of such overseas arrangements being somehow nefarious and having complicated structures, which is an inevitable part of that sort of transaction.
I have some understanding that the Treasury wishes, as the Minister rightly puts it, to anticipate new avoidance arrangements. Inevitably, the best tax lawyers and tax structurers are likely to be one or two steps ahead of the game, so it is legitimate for the Revenue and the Treasury to try to have such an understanding. Certainly, it surprised me when the Minister said that the proposed revenue gain was as little as £5 million, which is very much small fry. None the less, one hopes that, if there is to be a genuine move towards anticipation of new avoidance arrangements, there will also be a recognition that it is wrongwe will no doubt discuss this in greater detail in Committee in the next two weeksfor any of this legislation to be retrospective or retroactive. If there is to be a policy from the Treasury to anticipate avoidance arrangements, surely it is part and parcel of that, and fair game, to ensure that retroactivity and retrospection is kept to an absolute minimumnil from the Opposition's perspective.
We have had a reasonably amicable, albeit shortish debate on this matter. Again, the Liberal Democratsthe real oppositionhave not sought to make any contribution, which is a matter of some surprise. Silence is goldenor perhaps orange.
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Mr. Philip Hammond: This has been an interesting debate, if a little lopsided in its geometry around the schedule. I suppose that we can forgive Liberal Democrat Membersno doubt, over the next year or so, they will get their act
The Second Deputy Chairman: Order. I am happy to allow a debate on this schedule being the eighth schedule to the Bill, but I hope that we will not cover any of the ground that we have already covered, as we have had an extensive debate.
We are discussing an extension of the transfer pricing rules to cover loan relationships and the capture of a group of people who were not hitherto caught by schedule 28AA, which the Government clearly feel is a necessary measure, and which, in its current drafting, the venture capital and private equity industry sees as an attack on an established model that has operated within parameters agreed with the Inland Revenue over a not inconsiderable period. As I said earlier, a degree of concern exists about the way in which some of these measures have been badged as anti-avoidance.
When a change is announced by the Government to a treatment that was agreed in 1998, and which has been constantly reviewed by the industry and the Treasury since then, it is bound to lead to some concerns. I want to quote from a letter that the British Venture Capital Association sent to the Chancellor on 23 May. It wrote:
"The apparent change in policy by the Inland Revenue over the agreement we reached in 1998 about the application of transfer pricing to private equity limited partnerships is particularly unfortunate, not least because of the level of distrust this move has now introduced to the relationship between the industry and the Inland Revenue."
This is a widely drafted provision, extending existing transfer pricing rules and restricting a deduction that has been available for accrued interest and discount. It will affect the pricing of transactions.
A subject of concern that covers the whole schedule, including parts that have not been addressed in detail today, is the way in which it catches banks. We have certainly had that discussion, but I suggest to the Financial Secretary that in some circumstances the schedule could also catch corporate joint ventures, through what is effectively the disapplication of the 40:40 rules in paragraph 4 of schedule 28AA to the Income and Corporation Taxes Act 1988. The Minister spoke of seeking to level the playing field between partnerships and corporations. That measure will disadvantage corporate JVs and bring themperhaps unintentionallywithin the scope of the schedule.
Many private equity funds have for many years been structured as multiple parallel partnerships, for very good commercial reasons. Private equity houses will typically seek to ensure that in any fund that is investing, they have an appropriate identity of interest between
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investors in that fund. It might be done on a geographical basis: German investors might be collated in a fund that might then have a bias towards investing in German concerns. Ethical investment funds in the United States particularly, but increasingly in this country, have restrictionsfor obvious reasonson the types of investment that they are willing to make. Indeed, Sharia investment funds have such restrictions. It makes perfect sense for a fund to be structured as multiple parallel partnerships to try to ensure that investors can be grouped in an appropriate wayand, overarchingly, in a way that matches different classes of investors' appetite for risk with the opportunities that are available. Many of the investors in private equity concerns are quite risk-averse organisations, pension funds being the obvious example. As I hope we have established this evening, it is not the case that multiple partnership structures are all or mostly tax-driven. That is not to deny that some funds are using those structures to generate tax saving, as Conservative Members have clearly recognised.
This is a important industry for the United Kingdom. Private equity-backed companies generate £187 billion worth of sales and £23 billion of taxes every year. The industry in Britain is second only to that in the United States. It brings a huge dynamism to the economy, whether it backs growing businessesthe kind we all want to expand so that they can become larger, eventually perhaps going to the public markets for capitalor whether mature, sometimes ailing, businesses need the support of new capital funds and the close attention that private equity houses can often provide.
The breaking of that 1998 consensus between the Revenue and the industry without prior consultation and with retrospective effectI shall have something to say about the retrospective effect and the timing of implementation provisions in proposed new sub-paragraph (4) in a momenthas in itself seriously damaged the UK's attractiveness as a location for private equity and venture capital houses, and, indeed, its attractiveness as a destination for investments by those funds, wherever they are based.
Of course, although the Government have approached this as a tax-avoidance loophole-closing measure, some of the loopholes are rather smallmore like the eyes of needles, to judge by what the Minister was saying earlier. The real danger is that the end result could be less tax, through less private equity investment and less business generated in this country, and more business failures and job losses as companies that might have been rescued and turned around by private equity funds are left to their fate. There is no doubt that uncertainty will be created in straightforward and established transactions. Mezzanine debt, with or without equity warrants attachedwhich, ironically, is intended to reduce the tax-reducing interest chargeablecould now become a less attractive instrument because of the doubt surrounding its treatment.
One issue that has not been touched on so far this evening is the relative attractiveness and complexity of shareholder debt financing, which is an important part of the private equity deal. Typically, private equity houses are burdened with large fundsif one can imagine such a thingthat they need to invest. Such funds often exceed their capacity to make equity
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investments, and a standard technique that they employ is to provide part of the debt financing required in the package as shareholder debt financing.
Until now, most people felt it reasonably easy to price shareholder debt financing. However, such financing will now be brought within the transfer pricing rules through the application of proposed new paragraph 4A, and such people will be required to show that the debt has been priced at arm's length. That will be much more difficult than might be thought, because most comparable transactions that would form the basis for demonstrating to the Revenue that the pricing of an arrangement is arm's length will be caught within the new rules. Therefore, no clear and substantial body of shareholder debt financing will exist that falls outside proposed new paragraph 4A. That in itself will create uncertainty and it will undoubtedly make shareholder debt financing a less attractive instrument.
As we have already heard this evening, there is doubt surrounding the status of leading banks where another division of the same bank might be involved as an equity investor in the private equity house. There are also concerns about the workability of the small and medium-sized enterprise exception at paragraphs 2(3) and 3(6). As my hon. Friend the Member for Cities of London and Westminster (Mr. Field) set out clearly, there is a real fear that, despite the best intentions of Her Majesty's Revenue and Customs, very few private equity groups will in fact qualify as SMEs and thus gain exemption from the schedule's timing of interest provisions. We still do not understand the need to eliminate double counting provisions, as provided for in sub-paragraph (5), but we accept that the Minister is engaged in an ongoing voyage of discovery in this regard. We hope to hear from him in due course.
The changes to the rules on the timing of interest payments where there is a loan relationship is a specific problem for the private equity model. It presents the very real possibility of deductions becoming available only at the exit point, typically after four or five years when the private equity investor exits. There is a real danger that the accrued interest deductions will, by that stage, be so large as to be incapable of being used up in year, and thus are likely to become unrelievable because there will not be sufficient non-trading income in the vehicle to offset the loss during the year. Trapped losses will be delivered, which is bound to have an effect on the pricing of a private equity deal, and they will not have been priced into the deals that have already been done.
The Revenue says that about £20 million is at stake in respect of changes to the rules on the timing of interest deductions. The industry, as the Financial Secretary knows, believes that as much as £1 billion of loss deduction is at stake, so there is a huge gap between what the industry perceives and what the Government perceive. It is a shame that there appears to have been no opportunity for the two sides to get together in order to understand each other's point of view or for the Government to create some reassurance. There is a very uncertain position and genuine concern within the industry that the deductions will be disallowed on a much greater scale than envisaged by the Government.
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I hope that the Financial Secretary will respond to this short debate, as I would like to put this question to him. Given that the interest deduction is allowed only when arm's-length terms are in place, is there any need for special treatment of shareholder debt? I see no such need, and we have already asserted that paragraphs (2) and (3) have no necessary place in the armoury that the Government are seeking to create. They already have the weapons to deal with shareholder debt that is not priced at arm's length. The other point that arises from the changes made in those paragraphs, I am told by the experts, is that we are likely to see zero coupon notes disappearing as a financing mechanism as a result of the difficulty of showing that they have been priced at arm's length.
All that is interfering with a private equity funding model that works; that has been shown to work over a number of years; that has delivered for the UK economy by financing hundreds, perhaps thousands, of businesses throughout the country, as well as fuelling a vibrant sector of the financial economy itself; and that has been agreed on and run for many years with the full understanding and acquiescence of the Inland Revenue. The Government are taking an extremely dangerous step in unravelling that long-agreed model.
It is not clear why persons caught by the extension of the rules in paragraph 2(2)(b), (c) and (d) are not subjected to the benefit of the grandfathering provisions in paragraph 4(3). That sub-paragraph provides a grandfathering provision for many of the caught transactions, but it excludes those falling within the scope of schedule 28AA under those sub-paragraphs of paragraph 2. Interest on loans made by such personsthose who are not entitled to the benefit of the grandfathering provisionswill be subject to the late interest rules from 4 March 2005, not 1 April 2007. It is not clear to us why that sub-class of investor should be disadvantaged in that way.
I do not pretend to the Committee for a moment that we have dreamed up this query ourselves, but I can tell the Financial Secretary that some of the sharpest minds in the specialist tax advisory sector do not know whether the two phrases in the line
together effectively embrace everything, as would appear on a plain English reading of the text, or whether they are intended to mean something else. Can he tell us whether those two phrases together cover all existing loan relationships? Is that the intention, and if so, could it be stated a little more clearly? I am sure that the industry would be pleased if it could.
There is an issue of retrospection with all the provisions in the schedule. Deals in the sector are typically done on the basis of cash-flow projections, which will have been built by factoring in an interest deduction, and assuming that a lower rate of
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corporation tax would be payable in the early years. As the Minister will know, when we consider the discounted cash flow of a business forward, the exact time when the deduction comes and the cash hit is taken is very significant. Moving it forward from the fourth or fifth year to the current year, by not allowing the deduction to be taken until exit, is potentially very significantand that has been done without warning or consultation. The impact will fall on private equity businesses. Their liability to pay the interest will not change, but they will not get the corporation tax deduction that they have factored into their cash-flow projections. They will have to make the interest payment provided for by contract, and also make a corporation tax cash payment that in their business model and their cash flow forward they will have assumed would not have to be made at that time.
Has the Treasury really looked at the case for a permanent exclusion of all pre-March 2005 debt, so that there will not be that element of retrospection and transactions that have already been priced and contracted for, where a loan relationship already exists, will be allowed to run their natural course? In the case of a private equity financing, that would typically be only four or five years; most private equity financiers would be unhappy if they were not out by the end of five years.
That brings me to another important pointa very different point, but germane to the Government's assessment of the overall impact of the schedule. I am thinking about the joined-up government approach, and about considering not just what the measure will do for the Treasury's revenues and what it will do to the industry, but its relationship with other Government policies and initiatives.
Schedule 8 will have an impact on the private finance initiative. The financing of PFI deals tends to be structured in a similar way to private equity deals. There are good commercial reasons why PFI deals are structured in that way, and they are known by, and have been structured to benefit, the public sector. The PFI industry is aware that clause 40 and schedule 8 are intended for the private equity industry, but there is a concernI am sure that the Treasury is aware of itthat a blanket application of the new rules would prejudice providers of PFI and push up the cost to the public sector. I know that Labour Back Benchers are deeply concerned about that possibility.
A particular concern is that it is rare that profits are extracted from PFI contracts by investors without being subject to UK tax in their hands. The removal of a corresponding adjustment in the proposed legislation at paragraph (1)(5) will affect investors in PFI contracts that are caught by the new legislation, given that the investors in PFI contracts are nearly always subject to UK corporation tax. That will make PFI deals less attractive as an investment and will potentially make existing PFI contracts loss-making, which would hardly send the message that the Government would want to the industry as a whole, given the central role that PFI plays in their financing strategy and in enabling them to maintain their desired levels of public investment without breaching the Chancellor's sustainable investment rules.
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As all members of the Committee will be aware, PFI contracts tend to run for much longer terms than private equity deals, so any change of the rules in respect of existing dealsunwelcome as it will be to private equity financierswill wash out within four or five years maximum, because that is the maximum length of time that private equity investors expect to be in an investment. However, any application of the new rules to PFI would affect those contracts disproportionately, as the impact would be felt for a much longer period10, 20 and 25 years are not atypicaland the net present value effect of rule changes that impact on the cash return over 20 years would be significant, as the Financial Secretary will be the first to grasp.
In addition to the impact on existing contracts and in the absence of certainty about how PFI contracts will be caught in a net that was, admittedly, cast for a different purposeto deal with private equity financingnew PFI contracts will surely be priced by providers on the assumption that these rules will apply. Such a move could make PFI more expensive for the public sector at a time when the pressure is on to try to make PFI deals less expensive. Indeed, given the general interest rate climate, one could probably expect that PFI deals would become generally less expensive, if not for these changes, which I might characterise as a potential own goal.
It is imperative that the Governmentperhaps the Financial Secretary will do so in his responseconfirm that the new rules are not intended to affect PFI contracts. Existing rules can be used to deal with perceived abusesfor example, the Revenue's response already delivered to the proposed refinancing of older PFI contracts, which would be perfectly sensible commercial transactions. Applying the new rules would have an adverse impact on the public sector via higher costs and by making PFI less attractive as an investment, hence reducing competition for PFI projects and increasing the cost to the public sector.
Throughout our consideration of the schedule and our amendments, we have tried to narrow the Government's focus and to get back to the intended core purpose. Indeed, we should like to get the Government to state exactly what target they are trying to hit, so that people fretting needlessly that they will be inadvertently caught hear a clear message from a qualified Government spokesman that it is not the Government's intention to allow them inadvertently to be damaged by measures proposed for a quite different purpose. For example, banks lending mezzanine finance need reassurance that they, or the companies to which they have lent, will not be involved in complex discussions with the Revenue that might lead to a loss of deductibility of interest, which in turn could lead to a reduction in the viability of the business in which the bank has invested and thus a reduction in the security against which the bank thought it was investing.
Widespread concern has been expressed in the industry about the lack of consultation. There is widespread concern, too, about the way that the measures were badged as anti-avoidance provisions, implying that people in the industry who pride themselves on having stuck to a model agreed with the Revenue have in fact been doing something untoward.
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"These proposals, if given effect, would seriously damage this industry and in our judgement could well be a deterrent to private equity to continue to increase its investment in the UK. This cannot be an outcome you either intended or would welcome."
I certainly hope that it is not the outcome the Government intended, but with all that well-informed warning floating around, of which the Treasury is well aware, the Opposition must insist that the Government reconsider the matter and address the concerns that are being expressed.
There will be deferment until 2007 in several areas as a result of paragraph 4, so the need may not be as pressing as the Government have suggestedthe abuse at which the rule changes is aimed is not as widespread as the Treasury may fear. The real impact of the sudden introduction of that new regime will be on deals in progress, under discussion or being negotiated when it is announced. Uncertainty as to the need for review of those arrangements and uncertainty as to what will be deemed to constitute an arm's-length consideration in proposals currently being negotiated will inevitably lead to private equity deals currently under negotiation being priced up to reflect that uncertainty. That is bound to be bad for business.
I suggest to the Financial Secretary that the sensible thing would be to leave the schedule out of the Billnot to abandon it nor to give up on the intention behind it. In his press release, he has already signalled that 2 March will be his start date so that is clearly on the record for everybody to see. By pulling the schedule from the Bill, the Financial Secretary would have an opportunity to reconsider both the principle behind the measures being introduced and the detailed drafting. He would have an opportunity properly to consult the industry and users of private equity finance. He would have an opportunity to undertake a proper study of the likely impact of these measures and he could come back in next year's Finance Bill and present us with a much more tightly drafted proposal to tighten up schedule 28AA to the Income and Corporation Taxes Act 1988 and schedule 9 to the Finance Act 1996. I am sure that the Committee would be delighted to give a fair wind to that.
Many concerns from many responsible and reputable sources have been voiced through us tonight. If the Financial Secretary does not want to listen to our concerns, he must at least be cognisant of the need to listen to the concerns of those responsible and reputable observers in the business world, the City and elsewhere. I know that they have been briefing him as they have been briefing us.
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