Corporation Tax in Northern Ireland - Northern Ireland Affairs Committee Contents

Written evidence from Alan Trench

1.  This memorandum is submitted by Alan Trench to the Northern Ireland Affairs Select Committee for its inquiry into devolving corporation tax in Northern Ireland. I am an honorary senior research fellow at the Constitution Unit at University College London, and was formerly research fellow in the School of Law at the University of Edinburgh. I am a solicitor admitted in England and Wales (now non-practising), and have written widely on various aspects of devolution in the United Kingdom, including intergovernmental relations and devolution finance. I also have experience of how decentralised and federal systems work in a number of other countries around the world, including particularly Australia, Canada, Germany and Switzerland. I have acted as specialist adviser on devolution to the House of Lords Constitution Committee and to the Lords Select Committee on the Barnett Formula (which reported in July 2009), and am currently specialist adviser to the House of Commons Welsh Affairs Committee. I am also author of a blog "Devolution Matters", on which many posts deal with issues relating to devolution finance.[5]

2.  The purpose of this memorandum is to outline what I consider would be the likely effects of devolving corporation tax in Northern Ireland on the block grant that presently provides the bulk of the funding for the Northern Ireland departments. It attempts to address issues raised by members of the Committee when they took evidence from Professor Rosa Greaves of Glasgow Law School on 12 January 2011. I do not address wider issues of the merits of devolving corporation tax in Northern Ireland, or of a different rate of corporation tax there.

3.  In her evidence, Professor Greaves identified the jurisprudence of the European Court of Justice and Court of First Instance on the question of whether, and to what extent, differential corporate tax rates within a member state can constitute an unlawful state aid under European Union law. She highlighted the key criteria that emerge from the courts' decisions in the Azores, Gibraltar and Basque Country (UGT-Rioja) cases: that a government be "sufficiently autonomous" institutionally, procedurally, and financially and economically. The Northern Ireland Executive would probably have little difficulty satisfying the first two criteria, because it is clearly constituted as a separate government accountable to a separate elected Assembly, and within the sphere of its devolved functions it has control over the decisions it makes. The key area of difficulty would concern the question of economic and financial autonomy. In the language of the European Court of Justice in the Azores case, "the national tax rate for undertakings in the region must not be offset by aid or subsidies from other regions or central government. It follows that ... [the regional government] assumes the political and financial consequences of such a measure".[6] This would mean that Northern Ireland alone would have to undertake the risks as well as potential benefits arising from a differential tax rate. The UK Government could not provide, directly or indirectly, any sort of bail-out if there should be a shortfall in tax revenues as a result of tax devolution.

4.  The first implication of that requirement is that there would need to be a reduction in the block grant to allow for the devolution of tax revenues, corresponding to the amount of tax revenue foregone by the UK Exchequer. This requirement was noted by the Varney Review of Tax Policy in Northern Ireland of December 2007, and the principle has been a key part of the proposals for devolving part of personal income tax in Scotland and Wales, adopted by the Calman and Holtham Commissions respectively.[7] The Holtham Commission devotes a good deal of attention (in chapter 5 and annex 8 of its final report) to discussing how such a reduction could be carried out, and the effects of various ways of doing so.

5.  Given the nature of corporation tax, calculating the amount of such a reduction would be hard methodologically and practically. We do not have up-to-date figures for tax revenue generally collected in or arising from Northern Ireland, and those figures we do have (produced annually for Scotland and published in Government Expenditure and Revenue Scotland, and on a one-off basis for Wales in the Holtham report using data for 2007-08) are based on estimates of revenues from those parts of the UK, not actual revenues.[8] The Varney report suggests it amounts to £500 to £600 million (Annex C, paragraph C.5). If the whole of the tax were to be devolved, it would be this figure (rather than the net revenue foregone by a lower rate in Northern Ireland compared with the rest of the UK) that would need to be used. Assuming that figure remains substantially correct—and it is at least four years old—it would equate to a cut of between 6.5 and 7.8% in the devolved departments' DEL budgets for 2006-07, and 5.6 to 6.7% on the latest available figures (for 2008-09).[9] (I use 2006-07 on the basis that it is the year to which the figure of £500-600 million relates.)

6.  The first step would therefore be to get HM Treasury to produce more accurate figures for corporation tax revenues arising in or from Northern Ireland, and in doing so to explain the basis on which it does so. The question of how the tax might be calculated will be central to such a calculation. In particular, it will be necessary to determine whether it relates simply to the profits of companies incorporated in Northern Ireland, or to businesses incorporated elsewhere with activities carried out there and in other places and paying corporation tax in the UK. If the former, what about profits deriving from activities they carry out in other parts of the United Kingdom? If the latter, on what proportion of their profits will the Northern Ireland share of corporation tax be calculated?

7.  The choice of a method of calculating the appropriate deduction from the block grant would also need to take into account how the reduction would be uprated or adjusted, given inflation, shifts in overall tax income and so forth. An important part of that would be to locate the transfer of risk that arises from the reduction in the right place—one government should not, in principle, be subject to risk factors which it cannot control. Rather, risk and reward should be placed together, in the hands of the tier of government that can control them. The fact that a reduction in the block grant has taken place and is then proportionately maintained should be sufficient to satisfy EU requirements, while the block grant is calculated on its present basis of a historic baseline adjusted periodically to reflect a proportionate share of changes in spending on comparable functions in England.[10]

8.  The Holtham Commission identified four chief models for calculating such a deduction. These were:

  • own base deduction (OBD): the deduction from the block grant is indexed to the assessed growth in the devolved tax base;
  • indexed deduction (ID): the initial deduction is indexed to an external variable such as the relevant UK tax base;
  • proportionate deduction (PD): the grant is reduced by a given percentage; the initial deduction therefore grows at the same rate as the grant itself; and
  • fixed real deduction (FRD): the grant is reduced by an agreed sum which is then indexed to inflation; ie the present value of tax receipts is equated to a real annuity which is deducted from the grant.

Holtham's analysis of the risk related to these models shows that the least risk arises from the "OBD" method, which ensures that the reduction from the block grant continues to correspond to the revenue from the devolved tax if the devolved and UK rates were to be the same, but in ways that might well amount to a potential bail-out as understood by the EU jurisprudence. The other approaches would entail greater risk, but those risks relate more closely to decisions that would be devolved and they would therefore be more in accord with the requirements of EU law.

9.  The choice of an appropriate basis for the reduction from the block grant would be key to ensuring any devolution of corporation tax would satisfy the requirements of EU law.

10.  It is also necessary to look what might happen if the block grant were to be reviewed so that it relates to relative needs. There is considerable pressure for such a review; it has been called for by the Holtham Commission, the Lords Select Committee on the Barnett Formula, and the Commons Justice Committee.[11] (It was also recommended for the longer term by the Calman Commission.) These calls have been rejected for the time being by the Coalition UK Government, which has said that "any change to the system must await the stabilisation of the public finances".[12] While such change may therefore be unlikely in the near future, it is also not likely to be put off indefinitely.

11.  It is hard to see how any revaluation of the block grant so that it purely relates to objective factors affecting relative demands for public services—demographic factors, sparsity and the like—would raise concerns about it being a means of providing a bail-out to a devolved government relating to a loss of revenue from corporation tax. However, it is possible that problems might arise if factors of income or poverty were taken into account (as both the Lords Select Committee and Holtham Commission have recommended). These factors would suggest that it might be desirable to secure at least informal clearance from the European Commission to confirm that the scheme was not, in their view, state aid. It would more clearly arise if the new system of funding devolved governments were to include a grant or element of a grant that was a form of fiscal equalisation.

12.  To avoid this, it would be necessary very clearly to exclude corporation tax from the scope of any equalisation scheme, which could only apply to personal income tax and perhaps smaller devolved taxes relating to land (such as stamp duty land tax, to be devolved to Scotland under the Scotland bill as part of the implementation of the Calman proposals). Even then, there remain problems if the objective of the tax is to produce an increase in economic growth and overall tax revenues, even though the contribution of corporation tax to Northern Ireland's revenues remains modest. Arguably, a system that provides for equalisation of other tax bases such as income tax, the income of which can be indirectly affected by the corporation tax rate, might also constitute a state aid. The EU case-law does not provide much guidance on this point.

13.  The effect of excluding such a bailout is very clearly to transfer risks relating to Northern Ireland corporation tax to the Northern Ireland exchequer. If corporation tax receipts were insufficient—whether because of a lack of inward investment, poor economic performance or other reason—services in Northern Ireland would have to be cut.

14.  A further issue would arise if devolved fiscal powers included a power to borrow, to smooth out fluctuations in tax revenues in the short term and to balance revenue and spending over the economic cycle. This forms an important part of the recommendations for Scotland set out in the Scotland Bill currently before Parliament, and its accompanying Command paper.[13] Reconciling the last of these powers—which is also the most important, given the cyclic nature of corporation tax—would be hard, given the "no bail out" rule. Its whole purpose is to provide a form of limited bailout to protect public services in a downturn. The approach adopted for Scotland makes this explicit. To avoid other problems, such borrowing would not be by the Scottish Government acting on its behalf, and accessing the capital markets directly. It would be by HM Treasury acting as the banker to the Scottish Government. However, such borrowing powers for corporation tax would appear only to satisfy the EU requirements if the UK Government does not guarantee the borrowing and the Northern Ireland Executive would be solely responsible for it. That is incompatible with the approach to managing public finance currently being considered for Scotland, and which the Holtham Commission recommends for Wales.

15.  Determining the basis of which companies or activities as undertaken in Northern Ireland would be significant not only for calculating the reduction in the block grant, as discussed in paragraph 5 above. It would also affect the conduct of economic management of the UK as a whole. As such, one would expect HM Treasury to seek to continue to shape the use of such a power by the Northern Ireland Executive, given the Treasury's role in macro economic management. One would expect the Treasury to be concerned about the possible use of tax competition to undermine tax revenues while generating only limited overall economic benefits. This has certainly been the Treasury's approach to the similar situation of direct financial assistance to industry, where it has instigated a Concordat annexed to the Memorandum of Understanding to regulate the use of such financial assistance.[14] The concordat is mainly procedural, requiring consultation about both policy and its application in larger cases, and so forth. It also refers to agreed limits for such assistance (without specifying what those limits are or where they can be found). It would be surprising if the Treasury were not to take a similar approach to devolved corporation tax as well. Indeed, co-ordination of fiscal policy will be an important issue for any form of fiscal devolution, and Strengthening Scotland's Future proposes the establishment of an "Intergovernmental Bilateral Committee on Fiscal Devolution" between Scottish and UK Governments for the devolved income tax powers proposed in the Scotland bill. (In my evidence to the Scottish Affairs Committee on the Scotland bill, I have criticised this as being inadequate.) However, there is a potential tension between such co-ordination within the UK, and ensuring the sort of political and fiscal autonomy that the EU case-law requires. It is unclear how the Treasury might address this issue, but it is clear that it would need to do so in the light of concerns about corporate tax competition that have been expressed by the European Commission and a number of other member states. That said, I understand that there is extensive policy co-ordination between the Spanish central state and the Basque Country, which does not appear to compromise the autonomy of the Basque Country in these matters for the purposes of EU law.

16.  Finally, it is worth noting what might happen if the UK Parliament should resume direct rule from London following a collapse of devolved government. In such circumstances, the criteria of institutional independence and autonomy in decision-making would no longer be satisfied, and any differential in corporation tax would clearly be a selective state aid under the jurisprudence of the EU courts. One would therefore expect the European Commission to require the UK Government to put an end to the differential corporation tax within a short time. The advantage that reduced corporation tax could offer would necessarily be directly tied to the durability of devolution, and one would therefore expect companies attracted by a lower rate of corporation tax to factor political stability of devolved government in Northern Ireland into their calculations in deciding whether and how to take advantage of it.

17.  In conclusion, it is worth summarising the key points made above. In order to devolve corporation tax in a way that complied with EU law, it would be necessary to reduce the block grant that currently is paid to fund public services in Northern Ireland. Calculating that would not be straightforward. It would also be necessary to ensure that there was no way that compensation payable from the UK Exchequer would be payable if there were a shortfall in tax receipts. The effect would be to transfer a significant degree of financial risk to the Northern Ireland Assembly and Executive, as well as the economic lever devolved control of corporation tax would afford. Such a change would in turn close off certain options for fiscal equalisation that might form part of a wider revision of devolution finance in the foreseeable future.

24 February 2011

5 Back

6   Case C-88/03 Portugal v. Commission, [2006] E.C.R. I-7115, paragraphs 67-68. Back

7   Sir David Varney Review of Tax Policy in Northern Ireland (London: HM Treasury, 2007), chapter 3; Commission on Scottish Devolution, Serving Scotland Better: Scotland and the United Kingdom in the 21st Century, Final Report (Edinburgh, Commission on Scottish Devolution, 2009); Independent Commission on Funding and Finance for Wales, Funding Devolved Government in Wales: Barnett & Beyond, First Report to the Welsh Assembly Government (Cardiff, Welsh Assembly Government, 2009); Independent Commission on Funding; Independent Commission on Funding and Finance for Wales, Final Report: Fairness and Accountability-A New Funding Settlement for Wales, (Cardiff, Welsh Assembly Government, 2010).  Back

8   See Independent Commission 2010 op cit, table 4.1, p. 40. Back

9   Spending figures taken from HM Treasury Public Expenditure Statistical Analyses 2010 Cm 7890 (London: The Stationery Office, 2010), table 1.8. Back

10   The machinery for this is set out in HM Treasury Funding the Scottish Parliament, National Assembly for Wales and Northern Ireland Assembly: A Statement of Funding Policy Sixth Edition (London: HM Treasury, 2010). Back

11   Independent Commission 2009 and 2010 op cit; House of Lords Select Committee on the Barnett Formula The Barnett Formula 1st Report of Session 2008-09, HL 139 (London: The Stationery Office, 2009); House of Commons Justice Select Committee Devolution: A Decade On Fifth Report of Session 2008-09, HC 529 (London: The Stationery Office, 2009), chapter 6. Back

12   HM Government The Coalition: our programme for government (London: The Stationery Office, 2010), p. 28. Back

13   Strengthening Scotland's Future, Cm 7973. Back

14   Concordat On Financial Assistance to Industry, annexed to Memorandum of Understanding and Supplementary Agreements Between the United Kingdom Government, the Scottish Ministers, the Welsh Ministers and the Northern Ireland Executive Committee, 2010, Cm 7864. Back

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Prepared 9 June 2011