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Sir Robert Smith (West Aberdeenshire and Kincardine) (LD): I thank the hon. Gentleman for giving way and I declare my interest in North sea oil and gas, as listed in the Register of Members' Interests. On the Chancellor and the high cost of energy, only last weekend he was lecturing other countries on the need to increase production to tackle the world's energy problems. What kind of example is he setting, however, through the long-term investment signals that he is sending to, and the way in which he is treating, his home base?

Stewart Hosie: There was a real irony in the Chancellor calling on the world to increase gas and oil supplies, particularly given that the measures announced last year and in this Finance Bill put at great risk not only the taking of heavy oil from the central North sea and the development of the known fields west of Shetland, but future exploration in the very deep waters west of Scotland. In short, when it comes to oil and energy, this is a bad Bill and yet another missed opportunity.

8.51 pm

Mr. David Gauke (South-West Hertfordshire) (Con): I want to discuss the Bill's reforms to group relief—a subject that has not been touched on today. Even the hon. Members for Wolverhampton, South-West (Rob Marris) and for Wirral, West (Stephen Hesford) failed to address it, which is somewhat remiss of them. I suspect that it has not been mentioned because it is
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highly technical and complex. Schedule 1, which contains the amendments to group relief, consists of 14 pages and is highly complex.

However, the substance of the changes to group relief are not particularly controversial, so far as one can see, and it is less important to highlight what they are than it is to highlight why we are making them. The simple explanation for the changes is the judgment of the European Court of Justice in the case brought by Marks & Spencer, in which it was determined that UK group relief provisions for corporation tax purposes were in breach of European law. It is worth focusing on that case for a moment. Traditionally, UK group relief rules allow profits and losses made by UK resident subsidiaries in the same group to be offset against each other, so that the tax result mirrors the group's overall results. Until now, the rules have not allowed losses made by overseas subsidiaries to be offset against UK profits.

Let us continue with the M&S example. If it establishes a UK subsidiary that makes a loss, the loss can be offset against another UK subsidiary that is making a profit. However, losses incurred by a French subsidiary would not be available to offset against profits made by the UK subsidiary. M&S claimed that the UK group relief rules, by restricting the ability to offset profits and losses to UK residents alone, are contrary to the freedom of establishment principle under EU law. In other words, the UK tax system should provide tax relief for failed overseas business ventures.

The ECJ determined in favour of the taxpayer—M&S—subject to one very important proviso: that any cross-border loss relief be guaranteed to the taxpayer only where it can be proved that there was no possibility of making use of the losses in the jurisdiction in which they were incurred. I make no criticism of M&S for bringing that case. It has a duty to its shareholders to minimise its tax payment, and there is nothing wrong with going to the ECJ. However, we are implementing today a substantial change to our direct taxation as a consequence of an ECJ judgment, not of a decision taken by this House or by UK courts.

Nor is that a unique example; there are a number of such cases dating back to 1996. Perhaps the first such case was ICI v. Colmer, which concerned consortium relief. More famous and significant were cases involving Hoescht and Metalgesellschaft, which determined that, for advance corporation tax purposes, groups with a UK parent company should not be treated differently from those with an EU parent company. The fact that ACT has been abolished, perhaps in part as a consequence of this judgment, does not mean that the case is meaningless. As well as being an important case in principle, the cost of repaying overpaid corporation tax in the Hoerscht and Metalgesellschaft cases, and similar cases, is likely to run to billions. Estimates of £3 billion to £5 billion are regularly quoted.

The ECJ judgment in the Lankhorst-Hohorst case, on Dutch and German thin capitalisation rules, has also imposed a substantial administrative burden on UK companies. The ECJ held that it was illegal to have thin capitalisation rules with regard to overseas group companies, but not group companies in the same      jurisdiction. Thin capitalisation rules protect corporation tax revenues from flowing out of one
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country in the form of excessive interest payments being made intra-group to an overseas group company. As a consequence of the judgment, if one wishes the same rules to apply to overseas group companies as to UK group companies, one has to introduce what are effectively thin capitalisation rules for UK companies. That was done in the Finance Act 2004, which requires all transactions with group companies to be transacted on an arm's length basis or at least evidence to be produced to show that that was the case. If that cannot be done, the transactions are taxed accordingly.

The process has not finished. Earlier this month, the Advocate General opined on the BAT group case on franked investment income. The Treasury estimates that if the ECJ confirms the Advocate General's opinion—as it usually does—the decision could cost the UK £7 billion. At an earlier stage of the process is the Cadbury's case, which may result in a substantial review of the UK's controlled foreign companies rules.

Why are those cases important? First, they can be expensive. It is not always possible to measure accurately the precise cost of a judgment, but an analysis by Alistair Craig of Ernst and Young—I recommend that hon. Members read his paper on EU law and British tax, published by the Centre for Policy Studies—gives the possible cost of the various judgments that I have mentioned at somewhere between £7.5 billion and £11.5 billion. As I mentioned earlier, the franked investment income case may cost an additional £7 billion.

When the Government came to power in 1997, many of the fiscal problems of this country were to be resolved by removing loopholes. Indeed, the hon. Member for Wolverhampton, South-West mentioned loopholes earlier. I think that sometimes the term "loophole" can be a little misleading, and one man's loophole is another man's low tax environment. However, the ECJ is creating a series of substantial loopholes in the British corporation tax system.

The second problem is the administrative difficulties, because the Government are inevitably required to ameliorate the effects of the judgments and that, in itself, causes difficulties for British business. For example, as I mentioned and as a consequence of the Lankhorst-Hohorst judgment, the Finance Act 2004 introduced thin capitalisation rules requiring all UK companies to demonstrate that all transactions with fellow UK companies in the same group are on an arm's length basis. The administrative cost to UK businesses of that requirement has been considerable.

In many cases, such as the provisions contained in schedule 1, the complexity of our tax system has been considerably increased by the changes required by ECJ judgments. Today, many Members have spoken about complexity, much of which we can put at the Chancellor's door, but in some instances it is created by the ECJ.

A third concern is that we are moving towards the harmonisation of our taxation system to change it so that it complies with ECJ judgments, and the effects could be broader than the initial facts or the case being addressed. For example, if the Advocate General's opinion is upheld—as it usually is—in the BAT group case, it will no longer be possible to tax the dividends of overseas subsidiaries differently from UK subsidiaries.
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In most European jurisdictions, dividends from all subsidiaries are tax-exempt under what is described as the participation exemption. In the UK, we do not have a blanket exemption but we have a right to a tax deduction for interest on borrowings by a parent company in respect of a subsidiary. Those two different approaches are fundamentally incompatible—trying to operate them together would be wide open to abuse—so a key aspect of our corporate tax structure will have to be reformed. Presumably, we will have to use the participation exemption, but we will no longer be able to permit a deduction for interest on borrowings by a parent company in respect of a subsidiary.

That may be a good thing. I am not qualified to decide, but it is arguable that our tax structure, not just our tax rates, may give us a competitive advantage, which could be lost as a consequence of the ever-creeping Europeanisation of our tax structure. Certainly, the CBI tax committee has warned that the consequences of the BAT group case could blunt the appeal of the UK as a location for holding companies.

Most important of all is the constitutional point. In clause 27 and schedule 1, we are legislating on a matter relating to direct taxation and amending our law not as a consequence of anything determined by a UK court or because of the views of Members. That is not an uncommon experience for the House. However, one of the few areas where there is near unanimity on European matters is direct taxation. It is a line in the sand, we are told. Nobody is advocating harmonisation of direct taxation, be it of its rates or of its structure. None the less, that is precisely what is happening. Tax harmonisation has little or no support in the House.

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