Panel on Tax, Audit and Accounting

Written evidence submitted by Her Majesty’s Treasury and Her Majesty’s Revenue and Customs (SH 032)

Thank you for your letters of 5 December inviting us both to provide written input to the Parliamentary Commission’s work on tax, audit and accounting standards. Given tax policy is delivered by both our departments working in partnership, we are submitting a joint response.

As our answers explain, there are some sector specific tax arrangements for the banking sector – most notably the Bank Levy. However, any further deviations from the general tax regime would need to be considered very carefully. In particular, measures designed to directly address the debt-equity bias in the tax system would be disruptive, and would have unpredictable – but potentially significant – behavioural and location effects. This would also risk undermining the Government’s commitment to provide the stability and certainty needed to promote investment and growth. It is far from clear that these impacts would be outweighed by any potential benefits.

1. How, if at all, does the tax system encourage leverage in banks?

1. Banks (and businesses generally) raise funding through a combination of share capital (equity) and borrowing (debt). The UK‟s tax system, in common with other OECD countries‟, distinguishes between debt and equity, and gives deductions for interest as a business expense, but allows no deduction for dividend payments (which represent a distribution of profits).

2. While tax law distinguishes between debt and equity, in practice they should be regarded as two ends of a spectrum, rather than as clear and mutually exclusive categories. Some "equity" instruments have debt-like characteristics (for example, redeemable preference shares paying fixed dividends) and some "debt" instruments have equity characteristics (for example, Basel 3 requires banks‟ Tier 2 capital instruments to include a requirement to be either written down or converted to share capital at the point of non-viability).

3. The Government recognises that this distinction provides an incentive for businesses, including banks, to favour use of debt over equity financing. This theoretical bias arising from the differing tax treatment of debt and equity is well documented – for example, it was explored in some detail in Chapter 17 of the Mirrlees report [1] , as well as an IMF discussion note [2] and the Wincott lecture given by Andrew Haldane of the Bank of England on 24 October 2011.

How large is this effect?

4. It is difficult to assess the scale of the impact with any certainty. There is limited empirical evidence on how significant the tax distortions are to banks‟ financing decisions. Work by the IMF in 2012 [3] used data from banks from a large number of countries to try to assess this issue. The working paper concluded that responsiveness to taxation varies significantly across banks, with larger banks noticeably less sensitive to tax.

5. It should also be noted that reductions in the rate of CT will reduce the bias. The CT

rate in the UK during the 1970s reached 52 per cent, but since then rates in both the UK and across the world have been coming down, with of course a number of reductions in the UK rate being made during your time as Chancellor. The current Government has sought to reduce the rate markedly, and having stood at 28 per cent as recently as 2010, the main rate is due to move to 21 per cent by 2014.

These reductions will significantly reduce the distortion, and therefore by implication

reduce any benefit that can be achieved from reform.

6. It is also important to recognise that the two forms of capital have very different risk profiles, legal characteristics, regulatory importance and costs associated with them. So while debt and equity are treated differently for tax purposes, it is important to note that there are many non-tax-related factors which impact on a company’s decision regarding whether to use equity or debt. For example, the significance of the tax differential in driving financing decisions prior to the credit crunch was probably outweighed by other factors, especially the apparently benign macroeconomic environment of a long period of steady economic growth coupled with low and stable inflation, as well as a regulatory framework that allowed excessive leverage to develop due to inadequate capital requirements. Similarly, investors will also need to weigh up a number of non-tax issues when determining whether to invest in equity or debt instruments – for example, equity will generally give the investor voting rights that debt capital does not, but shareholders have fewer rights in the event of a liquidation than creditors.

Do taxes other than the corporate system introduce any distortion? To what extent is the distortion offset by the personal tax system?

7. There should be an overall neutral tax position achieved under the CT system for lender/borrower where these are UK businesses. The personal tax system taxes dividends less heavily than interest income through the combination of the notional dividend tax credit and lower rates of income tax on dividend income (reflecting the fact that dividends are not tax deductible at the corporate level) to reduce the potential for tax to distort individuals‟ investment decisions.

8. In addition, the Bank Levy incentivises banks to raise more capital through equity, by providing an exemption for tier 1 capital and a half rate for safer long term funding, while the full rate discourages banks from using short term debt.

2. What are your views on alternative systems to level the playing field?

9. Some external commentators have put forward proposals to reform the tax system to directly eliminate the debt bias. [4] However, before we discuss these, it is worth

highlighting that the Government has put forward far-reaching plans for the reform of UK financial regulation. These non-tax policy interventions will have a greater impact on the levels of banks‟ debt in the UK.

10. In particular, in September 2010 the Basel committee on banking supervision agreed a package of reforms ("Basel 3"). The Basel 3 package will increase the resilience of banks by significantly increasing capital requirements and introducing liquidity standards and a leverage ratio. For example, the requirement for common equity

will be calibrated at 7 per cent of risk weighted assets (RWAs) – up from the 2 per cent level under Basel 2 – and banks will also be subject to a non-risk-weighted leverage ratio.

11. Basel 3 will be implemented in the EU through the Capital Requirements Regulation/ Directive 4 (CRD 4). Throughout negotiations, the UK has sought full

implementation of the Basel 3 standards as well as pushing for flexibility for Member

States to implement higher prudential standards when necessary. CRD4 is currently in trilogue negotiations and the December European Council Conclusions called for a rapid adoption of the proposals.

What is the best way of removing any debt bias?

12. Complete removal of the debt bias would involve either a change to disallow CT deductions for interest (an approach that has been styled Comprehensive Business Income Tax or CBIT) or introduction of an additional deduction of an imputed return on equity (often know as Allowance for Corporate Equity or ACE).

13. It should be noted that this bias is an issue in relation to capital raising - banks, and financial sector businesses in general, are party to a significant amount of debt (as borrowers and lenders) on trading account, on the basis that it is performing a significantly different function as the object of the company‟s trade. Any reform that sought to restrict corporation tax (CT) deductions for interest would almost certainly want to consider excluding debt entered into on trading account, though consideration would also need to be given to whether this would give rise to any unintended consequences.

14. Similarly, and in addition to ensuring compatibility of any changes with EU law, if we introduced an ACE on the lines proposed by some external commentators, we would have to consider the implications for the recipients of distribution income on the grounds of maintaining balance in the tax system. This could mean imposing a charge on UK-resident recipients of dividends where they would currently be

exempt, or entitled to a tax credit. Otherwise companies would get relief for paying

coupons on equity but not be taxed on receiving them which would create intra- group mismatches and avoidance opportunities. If we were to consider such a change on the grounds of mitigating the Exchequer cost of an ACE, this could constitute a disincentive for investors in UK equity.

15. An ACE has an inherent cost in terms of CT revenues associated with allowing an additional notional deduction for equity. The IMF estimates the revenue cost of an ACE to be equivalent to 0.5 per cent of GDP, but states that there are a number of ways in which this cost can be reduced. An allowance for corporate capital (ACC) may offset some of the cost of an equity deduction and would create more neutrality between debt and equity. An ACC replaces interest deductions with a deduction for a notional risk-free return on all capital, equity and debt.

16. The idea of an ACE was developed in the 1980s (when corporate tax rates were significantly higher) and has been (partially) implemented in a handful of countries since, including, in Europe, Croatia, Italy and Austria. However, those three countries abandoned the ACE (for varying reasons) in the early part of the twenty- first century.

17. Today in Europe, the ACE tax system is currently implemented in Belgium in the form of a "Notional Interest Deduction" (NID). The NID system seems to have cost Belgium more than anticipated as companies adapted their balance sheets to achieve maximum benefit. Due to the financial crisis, the system was amended in January 2012 to reduce notional interest rates and cancel the carry forward of unused amounts. In Italy the regional business tax is a corporate cash-flow tax. Both the ACE and the cash-flow tax systems do not tax the „normal‟ (market required) return on capital but do tax any profit in excess of that (the „economic rent‟).

18. It should also be noted that it also seems likely that the Belgian NID measure will be found not to be compatible with EU law as it discriminates in favour of Belgian companies - on 19 September 2012, Advocate General (AG) Mengozzi of the CJEU concluded that the Belgian rules on NID concerning companies subject to tax in Belgium with foreign permanent establishments are a restriction on the freedom of establishment which cannot be justified by any reason in the public interest.

Can and should the reform be restricted to banks, as opposed to other financial and non- financial companies?

19. Any tax reform needs to be compatible with the Human Rights Act, and this requires it to be appropriate and proportionate, and therefore a clear rationale for applying any tax is needed. Taxes also need to comply with any relevant EU rules - in the case of any selective tax, we need to be particularly mindful of EU State Aid rules, which are intended to prevent certain businesses gaining an unfair financial advantage over their competitors.

20. In considering the appropriate taxpayer population, it is necessary to consider the objectives of any measure, and a full assessment could only be undertaken once there was a clearer idea of what was proposed. However, it is worth noting that in their 2011 Article IV report, the IMF suggested exploring the feasibility of applying an ACE initially only to banks, on the ground that it is there that excessive leverage has the highest social costs.

21. The UK‟s Bank Levy, which currently affects in the region of 30 banking groups and building societies, provides an illustration of how a tax regime can be applied to specific population.

a). Excessive risk taking in the banking sector was a significant contributory factor in the financial crisis. The crisis demonstrated the central role that liquidity shocks can play in triggering and propagating systemic banking crises. The purpose of the Bank Levy is to ensure that banks make a fair contribution, reflecting the risks they pose to the financial system and the wider economy. It is also designed to encourage banks to move away from riskier funding models. The Government determined that the application of the Levy to UK and foreign banking groups properly reflects the nature of the risks that the banking sector poses.

b).Furthermore, to ensure the levy is proportionate, there is an allowance for the first £20 billion of taxable liabilities - this balances the probability that the failure of a bank could pose a systemic risk against the relative burden imposed in order to gather additional revenue at the margin.

22. In determining the appropriate population for any reform, it would also be important to consider whether there would be a behavioural response – and in particular whether the issues the measure is designed to address are displaced to another area. We would have to consider the impact across the financial sector, but there may be particular interest in the potential impact on the so-called shadow banking sector.

What are the administrative and international complexities involved in such a reform

23. Any fundamental change to the existing rules would be very complex to introduce and pose numerous new operational issues for HMRC to deal with - for example, in terms of providing clearances to new arrangements entered into by banks and from an anti-avoidance perspective.

24. In a world of integrated financial businesses, adopting UK tax rules that depart from the international norm (as an ACE does materially and a CBIT does radically) could

be extremely disruptive and could have significant and unpredictable behavioural and location effects. It would have potentially damaging effects on existing arrangements, and would risk undermining the Government‟s commitment to provide the stability and certainty needed to promote investment and growth.

25. A system such as CBIT which exempts domestic interbank borrowing and lending transactions but which taxes these in full between UK and non-UK counterparties would be administratively costly for banks to comply with and for HMRC to police.

It may also have implications for a number of fundamental tax rules - for example it could be seen to undermine transfer pricing policy by creating an unlevel playing field between domestic and non-domestic transactions. An ACE or ACC would be likely to require a new set of complex tax rules to deal with the increasing number of hybrid debt/equity instruments required by Regulatory Authorities particularly as these may be accounted for in a number of different ways.

What are the implications of a reform for the Bank Levy?

26. The introduction of an ACE, or indeed any other reform designed to eliminate the debt bias, would not be a substitute for the Bank Levy. As noted earlier, the Bank Levy ensures that banks make a fair contribution, reflecting the risks they pose to the financial system and the wider economy. It is unlikely that any measures designed to address the bias would address this objective. Indeed, in isolation, an ACE would reduce banks‟ tax liabilities. To provide for a neutral outcome for the Exchequer, the IMF has previously suggested the Levy could be increased to offset the ACE‟s

revenue impact.

27. The Bank Levy is also designed to encourage banks to move away from riskier funding models. It not only encourages banks to hold more tier 1 capital (by providing an exemption for this), but also provides incentives to use other lower risk forms of funding – for example, liabilities with a maturity greater than one year are subject to only a half rate.

How much would the reform cost?

28. The cost of any reform package could only be determined once there was a clear idea of the options under consideration. In particular, the costs would likely be significantly affected by whether the reform applied only to banks, or to a wider set of taxpayers.

29. As noted earlier, the IMF suggested revenue neutrality could be achieved by offsetting an ACE for banks with an increase in the rate of the Bank Levy. However, this would need further consideration – if a large increase in the rate of the Bank Levy were required to offset the ACE, there could be significant behavioural effects. In particular there is a risk that this would cause a significant increase in the costs of doing business in the UK, triggering a large scale movement of international

banking activity overseas – with negative impacts for both the economy and the

public finances. Similar considerations would apply if a higher rate of CT applied only to the banking sector.

30. These behavioural effects are possible because, while the Government could aim to achieve revenue neutrality for the Exchequer and the banking sector as a whole, the mix of reforms is likely to impact differently at individual business level. For example, an ACE combined with a higher Bank Levy may provide most benefit to UK headquartered banks (who will be raising most of their capital through their listed entities in the UK), but have an adverse impact for foreign banking groups operating in the UK (who will be raising most of their capital overseas but are subject to the UK Bank Levy on their UK operations).

Is it practical to apply the allowance only to new equity?

31. Limiting an ACE to new equity would - in the near term - limit the Exchequer impacts of such a measure. However, the inevitable complexity would add to operational and compliance costs. Moreover, the resulting distortion between new and old equity would likely drive banks‟ behaviour, who would have a strong incentive to pay off existing equity and replace it with new capital.

Can the banks issue shares to the government to compensate it for the loss of tax revenue

32. Compensating for lost tax revenue by requiring banks to issue shares to the government would raise a number of complex and challenging issues that would need to be explored if this were to be pursued - for example, how the value of the shares that need to be issued to government would be calculated. We would also need to consider the economic desirability, and consistency with Human Rights legislation, of the government taking such shares in banks.

3. Do banks‟ attitudes to tax planning affect banking standards and culture, and does this

have any effect on the wider economy?

33. We believe that many of the banks‟ attitudes to, and appetite for, tax avoidance in the past was another manifestation of the irresponsible culture that emerged over a number of years in the banking sector. Tax avoidance became a major profit centre for some banks and as such would have been a key influence on the behaviour of the personnel in question. Since 2009, all the major banks have signed up to the voluntary Code of Practice on Taxation for banks, under which they commit not to participate in tax avoidance, and HMRC has seen a marked improvement in their culture and behaviour.

4. Do you have any views on the role and purpose of structured capital markets teams in banks? Does the volume and type of structured tax transactions have any effect on bank stability, and did this play a part in the banking crisis?

34. We believe that the main role of structured capital markets teams in banks was to ensure the bank’s own financing, trading and investment strategies were structured in a manner that was as capital and tax efficient as possible, as well as providing structured finance and investment advice and opportunities to clients.

35. Although such activity can be, and often is, a legitimate part of the effective management and operation of an investment banking business, this „structuring‟ in HMRC‟s experience often involved combining a range of financial instruments linked through a complex series of vehicles to achieve tax/accounting/regulatory treatment of those instruments or structures that differs from the underlying economic outcomes.

36. Through the late 1990s and in to the current century, the instruments involved became ever more complex and these activities became more and more lucrative. As a result, increasing numbers of tax and accounting experts were attracted in, and a number of these teams began creating and promoting ever more complex and aggressive avoidance schemes for their own use and that of their clients. These schemes exploited loopholes in domestic and foreign legislation and arbitraged between different tax regimes. This activity was one of the principal drivers behind the introduction of the Code of Practice on Taxation for banks.

37. We have seen no evidence to suggest that this activity in itself, at least insofar as relating to tax arbitrage, has had a significant effect on bank stability. There is concern though that these complex structures could affect the resolvability of a troubled bank, due to the potential difficulty in quickly unwinding these structures.

Is there any evidence that post-crisis this activity has moved into the sphere of shadow banking and if so, does this have any effect on bank stability and regulation?

38. Many banks have now moved to disband or shrink their structured capital markets teams. This in part reflects the increasing cost of capital and reduction in liquidity since the financial crisis, as well as the introduction and adoption by all the major banks of the Code of Practice on Taxation.

39. There is evidence that a number of the senior personnel have left the banks and set up their own hedge funds or boutique advisory/investment firms. HMRC have set up a programme of work to assess and scope the tax risks from this move to shadow banking. In addition, one of the responsibilities of the Financial Policy Committee (FPC) within the Bank of England, is to monitor the perimeter of regulation, and thus we can expect them to recommend changes to the scope of regulation if the growth in the shadow banking sector creates excessive risks to financial stability.

40. Internationally, the Financial Stability Board is developing a number of policy recommendations designed to address the risk posed by shadow banking and the UK has welcomed the progress made so far. HMT has also submitted a comprehensive response to the European Commission’s Green Paper on this issue in June. It argued that all financial institutions and activities, whether shadow banking or otherwise, that cause systemic risk should be subject to appropriate targeted regulation, based on sound evidence which takes full account of the potential positive contribution from the sector to growth.

5. What are your views on the effectiveness of the Code of Practice on Taxation for banks? Would the Code benefit from having sanctions and if so what should these be?

41. The Code of Practice (the "Code") is one strand in HMRC‟s approach to tackling tax avoidance and has had a positive impact on tax planning behaviours and improved transparency between banking groups and HMRC. HMRC has seen evidence that banks have rejected transactions that would be against the intentions of Parliament, including funding marketed avoidance schemes that they would have implemented in the past. From conversations with banks it has been established by HMRC that this behavioural change has been as a direct result of those banks following the principles set out in the Code.

42. The Code is a voluntary arrangement so, unless a legislative substitute or enhancement was introduced, the question of formal sanctions does not arise. However HMRC expect to review operation of the Code during the course of 2013 to ensure that it continues to have a positive impact on banks‟ tax behaviours. As part of that review, HMRC will explore the consequences of non-compliance with the Code.

6. How effective has the Senior Accounting Officer legislation been with particular regard to banking standards and culture?

43. The Senior Accounting Officer (SAO) legislation has been effective in raising awareness of tax risk within qualifying companies generally by imposing additional personal accountability at board level. Our experience is that most companies and SAOs have taken their responsibilities under this legislation seriously.

44. Anecdotal feedback received by HMRC consistently indicates that the SAO rules have strengthened links within large businesses between the specialist tax function and other functions (such as HR) that produce accounting numbers and influence their treatment for tax purposes. This is confirmed by independent customer research, which has also shown that the SAO rules have had a very significant impact on the profile of tax accounting within businesses, leading companies to review their tax governance and strengthen controls.

Would the introduction of a power akin to that of the FSA in S166 FSMA 2000 be a useful

addition to HMRC’s toolkit?

45. Companies which fall within the Senior Accounting Officer (SAO) rules must notify HMRC of the name of their SAO within relevant time limits, and if they fail to do so they may be liable to a penalty. Furthermore SAOs may be personally liable to penalties if they do not comply with their obligation to take reasonable steps to ensure that the company establishes and maintains appropriate tax accounting arrangements or if they fail to provide a certificate to HMRC within certain timescales. Where HMRC believes that a company or an SAO are not complying with their obligations in accordance with the law, and subject to statutory safeguards, HMRC is able to utilise a range of information powers to carry out an investigation. HMRC is not aware of any evidence that its existing compliance powers are insufficient or that the introduction of a power akin to that at S166

FSMA 2000 would be a beneficial addition to its SAO compliance toolkit.

7. Do we need a special tax regime for banks? If so, what would this look like and what would be priorities for change?

46. In general, the same rules apply to banks as for other companies when paying corporate taxes. This ensures fairness between different types of business, particularly important where these businesses may be competing in the same markets. Different tax rules for different classifications of business also risk providing opportunities for tax avoidance through arbitrage between different rules.

47. However, in the taxation of the banking sector, there are some specific areas where there is deviation from the general corporate tax regime. For example:

a). to reflect the risks that banks pose to the wider economy, the Bank Levy –a balance sheet based tax - has been applied to the sector;

b).supplies of banking (and financial services more broadly) are VAT exempt - this is primarily due to technical difficulties with applying the tax; and

c). there are regulatory requirements placed on the sector that require specific tax rules.

48. As discussed earlier, for both wider macro policy and legal reasons, any further changes to the specific tax regime for banks would need to be considered in the round, justified by reference to the appropriate specific characteristics of the sector, and then need to ensure that the design met the objectives identified. We would also need to consider whether there would be any competition impact from introducing specific rules for the banks.

49. Bespoke regimes would also inevitably impose additional compliance costs for banks and HMRC. For example, the VAT exemption for financial services means many companies in the financial sector have to undertake and agree a partial exemption calculation to enable them to determine the input VAT they can recover in relation to any (non financial service) VAT-able supplies they make.

Should tax continue to follow accounting with respect to banks?

50. From a compliance perspective using audited accounts as the starting point for the measurement and timing of tax profits and losses makes tax compliance more straightforward and less costly for both HMRC and banks. Taxation policy can and does depart from the accounts where there is a good policy rationale for doing so - for instance to address avoidance. However, from an HMRC perspective, the use of audited accounting numbers which have been subject to investor scrutiny gives greater reliance and comparability than any bespoke numbers generated purely for tax purposes. As this is the external measure of profitability, banks and other businesses have incentives to maximise their accounting profits. Using another measure for tax purposes would remove this constraint. Certain accounting anomalies such as those that arise from fair value accounting for own debt are due to be resolved by the International Accounting Standard Board financial instruments project.

Should the tax system actively seek to influence banking standards and culture?

51. The Government‟s principles for the tax system, as set out by the Chancellor at Budget 2011 are that:

taxes should be efficient and support growth;

taxes should be certain and predictable;

taxes should be simple to understand and easy to comply with; and

the tax system should be fair, reward work, support aspiration and ask the most from those who can most afford it.

52. For those general taxes such as corporation tax, the main objective is revenue raising to fund essential public services and service the national debt, and it is right and fair that banks should be subject to the same rules as other companies. In addition, to encourage businesses to locate and invest in the UK, the Government’s priority is to create a simpler, more efficient and stable tax system, with an ambition to make it the most competitive in the G20.

53. In specific circumstances there can be a role for the tax system to seek to positively influence behaviour. For example, and as discussed elsewhere, the Bank Levy is designed not only to ensure banks make a fair contribution, but also to encourage banks to move away from riskier funding models – a deliberate and conscious attempt to use the tax system to provide incentives for banks to change their behaviour. The Levy will be reviewed in 2013 to make sure it is operating efficiently.

54. Where there is a case to seek to change behaviour, it is important to consider whether this is most effectively and efficiently achieved through a tax measure, or instead through other means, e.g. regulatory requirements. The IMF‟s 2010 report for the G20 concluded that taxes and regulation face complex complementarities and potential trade-offs, which are still poorly understood. For example, the IMF noted it may be easier to use soft information in regulation and supervision than in taxation, but, by the same token, any lesser scope for discretion under taxation may guard against regulatory capture. [5]

What are the economic consequences of financial services not being subject to VAT?

55. Financial services are generally exempt from VAT. However, VAT exemption is not the same as a VAT zero rate. VAT exemption means that no VAT is charged on a supply, but also that no VAT can be reclaimed on related costs. It is therefore far from tax-free. The UK financial services VAT exemption yields about £6 billion VAT each year for the Exchequer, of which the banks contribute about £3 billion. In transaction chain terms, banks are effectively treated as final consumers under the VAT system.

56. These services are VAT exempt not because they finance consumption but for more practical reasons in that they do not easily fit within the general VAT concepts of a supply for a consideration. The traditional VAT system would miss the value added of a bank arising from the services made to both depositors and borrowers. Not only is the consideration for the services to a depositor difficult to identify (a payment of interest is made to them rather than received by the bank), the rates offered to both depositors and borrowers reflect the fact that the bank is earning income from the monies from others that it holds. Although some financial services, such as leasing, are subject to VAT, the VAT exemption still applies to certain financial services where a consideration can be identified, in order to prevent manipulation of the rules that determine how much VAT can be reclaimed.

57. Academics have long argued about the impact of this exemption and where the incidence of the tax lies. These issues were reported in the Mirrlees Review for the IFS in 2011. It is argued that the VAT cost to banking passes through banking services offered to businesses in the form of a non deductible "hidden tax", which has the ultimate effect of increased prices in the shops for final consumers. It is debatable whether, if financial services were subject to VAT, the prices in the shops would be any different. Some academics also argue that the exemption is an incentive for banks to self supply- however, in practice there remain many examples of outsourcing to other businesses.

58. The exemption only applies to activities within the EU. A financial service supplied to a counterparty outside the EU will have no VAT charged but VAT can be reclaimed on related costs. This is to ensure that the EU financial services industry does not suffer from the burden of the VAT on its costs when competing with businesses internationally. Most VAT and GST systems operate in a similar way, which means that competing against a US based company would be fair although a side effect is that that technically a financial services supplier based in, say, Australia would have an advantage over an EU based business in respect of EU based customers. The Australian operator would be entitled to deduct GST on local costs incurred in relation to his supply within the EU. We see little evidence of this creating a distortion in practice in the banking area.

Should financial transactions or ‘financial activity’ be taxed?

59. It is important to recognise that the profits from financial transactions/activity are already taxed, through corporation tax, as are the salaries of those working on them, through income tax and National Insurance. Other taxes on the sector may also be considered an indirect tax on transactions/activity – for example, as discussed above, financial sector businesses incur a considerable amount of irrecoverable VAT.

60. However, since the financial crisis, there has been an international debate about levying further taxes on the sector, and both a financial transactions tax (FTT) and a financial activities tax (FAT) have been suggested. The most detailed work on a FTT has come from the European Commission, which proposed an EU wide FTT in September 2011.

61. The Government has no objection to financial transaction taxes in principle, and continues to engage with international partners on this issue. However, the Government believes any FTT would have to apply globally, due to the risk of activity relocating to jurisdictions not applying the tax. During its Presidency of the G20 in 2011, the Government of France made the FTT one of its priorities – however, it was clear from discussions that the necessary international consensus does not currently exist.

62. In the absence of an international consensus, the Government believes it would be unwise to pursue this either unilaterally or with a group of countries such as the European Union. During the previous session of Parliament, the House of Lords EU Sub-Committee on Financial and Economic Affairs undertook a study, to which Mark Hoban gave evidence, into the EU Commission’s FTT proposal. The Committee’s report, published in March 2012, concluded that there is a significant risk that financial institutions would relocate outside the EU if an FTT is introduced at EU27 level, and therefore the Government should refuse to agree to the proposal.

63. Due to the opposition of the UK and several other member states, there is now acceptance that a FTT cannot be agreed at EU27 level. A group of EU member states are interested in introducing a FTT amongst themselves, and have asked the EU Commission to take this forward using the EU‟s "Enhanced Cooperation" procedures. The UK will not be part of this initiative. However, we will contribute to any future discussions on this issue, given that a such a tax could still have implications for the UK‟s financial services sector with much of the trading activity undertaken in the UK being international in nature.

64. Financial Activities Tax (FAT) is an umbrella term for taxes which target the profit and remuneration of financial institutions. FATs were first suggested by the IMF in their 2010 report for the G20 on financial sector taxation. A FAT could either:

a). tax total profit and remuneration of the institution, acting as a proxy for value added tax, or

b).be designed to tax profits and remuneration above a certain level, i.e. seeking to target "excess" profits or rewards associated with excess risk taking.

65. The IMF‟s 2010 report suggested that a FAT would be more economically efficient than a FTT, as only the latter tax directly distorts the activities of financial institutions. The Impact Assessment published by the EU Commission alongside its FTT proposal also suggested a FAT could be less economically damaging than a FTT. Both the IMF and the EU Commission recognised the part that a FAT can play as a proxy for VAT in the area of VAT exemption.

What are your views on suggestions that there should be an additional bank levy to bail out future failures?

66. The European Commission proposals for a Recovery and Resolution Directive include a common minimum set of resolution tools to be at the disposal of national resolution authorities, as well as the obligation to set up a resolution fund financed by ex-ante contributions from banks and investment firms. The Government remains concerned that there is a risk that a resolution fund could generate moral hazard and undermine the credibility of resolution tools, such as bail-in. The wider regulatory reforms underway are aimed at ensuring that no firm is too important to fail and that all firms are resolvable.

67. As regards the existing Bank Levy, the contribution to the Exchequer is not intended to fund future intervention, but to reflect the wider economic risks posed by the sector. The Levy is not insurance against failure and liability for the Levy does not indicate that a bank is too big to fail.

What are your views on suggestions that certain levels of remuneration be treated in a similar way to distributions?

68. The merit of treating certain levels of remuneration as distributions would need to be considered in the context of any wider reform package – for example, if an ACE were implemented, distributions would effectively be tax deductible (as remuneration is now). The effect of treating remuneration as distributions would therefore be very different under an ACE than under current arrangements.

69. Any reform that sought to remove deductibility for remuneration in the sector would need to address two key issues:

identifying what level of remuneration should be treated as distributions; and

establish why it would be appropriate to apply such a restriction to the banking / financial sector, and not other sectors. This would not just be a matter of good policy making, but also important to ensure the measure was consistent with both the Human Rights Act and EU State Aid rules.

70. As noted earlier, the IMF proposals for a FAT suggested this could be designed to target remuneration (and profit) above a certain level.

8. Are banks exploiting regulatory and information arbitrage between FSA, HMRC and auditors? If so, what is needed to address this?

71. HMRC, the FSA and auditors have different roles when considering the treatment of banks‟ transactions. HMRC‟s function is to ensure that its customers pay the correct amount of tax at the correct time, the FSA‟s is to ensure that the entities it regulates are sufficiently and appropriately capitalised and that they treat their customers equitably, and auditors ensure that accounts present a true and fair view to a company’s investors. In some cases, a transaction will be of interest or concern from a tax, regulatory and accounting angle. In other instances, HMRC, the FSA and auditors will have different levels of interest or concern about the consequences of or motivation behind a transaction.

72. Current rules – which are often enshrined in EU directives – place strict limits on what information regulators can share with outside bodies. The purpose of these rules is to ensure financial businesses have an open and honest relationship with the regulator. This inevitably limits the regulator‟s ability to discuss institution specific issues with HMRC, including circumstances where this would have benefits. For example, many anti-avoidance rules apply where one of the main purposes for a person who is party to a transaction is to gain a tax advantage. It is therefore often very important for HMRC to be able to test taxpayer’s assertions about their purpose for being party to such arrangements. In a number of enquiries, banks have claimed that their reason for undertaking a transaction in a particular way or their purpose for being party to the transaction was for regulatory purposes, but information restrictions mean HMRC has been constrained in its ability to confirm this.

9. Should there be a „safe environment‟ in which the tax authority, regulator and auditors can share confidential information and concerns, possibly on varying levels of seniority?

73. From a tax administration perspective, there would be benefits if a greater level of data sharing between regulators and HMRC was allowed. Both the FSA and HMRC implement Government financial sector policy, to allow both organisations to do so in an efficient and consistent manner requires a clear and open relationship between both organisations. Having easily accessible gateways for information and knowledge sharing would help both bodies to identify any tax and regulatory arbitrage, and take necessary action needed to address this. It might also be useful to consider having similar gateways and knowledge sharing arrangements with the Bank of England. However, as explained above, the rules on data sharing have been put in place for good reasons, and are often set in EU law, so could not be changed by the UK in isolation.

74. There are several statutory gateways which facilitate the exchange of information between HMRC and the FSA. However these gateways are very specific and discrete. Amendments, made as part of the Financial Services Act, have widened the gateway for HMRC information, enabling HMRC to disclose any information held for its functions to either the FCA and/or the PRA for their respective functions. These amendments will come into force on a day to be appointed by Treasury Order.

75. There would also be benefits in terms of ensuring tax rules dovetail appropriately with regulatory requirements. As previously noted, the Bank Levy uses many existing regulatory concepts. Recent announcements on bank‟s tier two capital and building society core tier one capital also rely heavily on FSA definitions. In the future, HMRC and the FSA will need to work closely together on new regulatory instruments that will be issued in anticipation of both Basel 3 (for banks) and Solvency 2 (for insurers) to ensure that that the consequences of the existing tax rules do not drive behaviours in ways that undermine regulatory objectives.

76. HMRC have fewer concerns about information arbitrage in relation to auditors as in most instances the figures declared in a company’s accounts are the starting point for arriving at a company’s taxable profits and the assumptions used by auditors are well understood. In addition HMRC routinely use their own accountants in both risk assessment and compliance work, to ensure any risks in this area are minimised.

10. What was the role of accounting standards and reliance on fair value principles in the banking crisis? What does a „true and fair view‟ really represent to the market?

77. It is important that the UK has an effective framework for accounts and reports, which has the confidence of users of financial statements. This can promote long term growth in the economy by supporting efficient markets through the effective communication of information. Accounting standards are one part of this process. They are the toolkit which determines the basis for the preparation of financial statements. Importantly they are not the determinant of how such information is used.

78. No accounting standards and audit assurance could have provided a complete defence against the systemic problems that caused the banking crisis. Those problems – which have been well rehearsed – included a failure in credit judgement, a failure to recognise asset bubbles, weaknesses in regulation and deficiencies on the part of credit rating agencies. The Government therefore does not believe that the ills of the banking crisis can simply be laid at the door of accounting or auditing standards. Financial statements, true and fair as they must be, merely report on a business’s financial position at a point in time. But businesses operate in a dynamic environment and decision makers must exercise appropriate judgement in the use of that financial information.

79. The issues of systemic risk fall to the regulators, as well as to the boards of companies, rather than to the accountants or auditors. However, the crisis did identify some deficiencies in the accounting and audit frameworks. These are being looked at, at a national and international level, and the Government is keen for the new standards to be implemented as fast as possible.

11. What are your views on the current incurred-loss impairment model and its role in the banking crisis? Do you consider that proposals to move to an expected-loss model will address criticisms of the current accounting rules?

80. Like the International Accounting Standards Board (IASB), the Government believes there is scope for improvements in the current standards around financial instruments.

81. It is important that, in developing any new approach, we do not merely exchange one set of issues for another. It may be argued that a greater degree of judgement should be permitted in how and when losses are recognised but equally we must avoid a return to the inappropriate use of provisions which artificially manipulate the reported performance of a company.

82. We continue to press the IASB and the EU to prioritise agreement on an improved standard on this and hope that there is swift agreement on the way forward. This includes prompt adoption of any agreed standard for use within the EU. We welcome the FRC‟s engagement with the IASB and European advisory groups on this issue. It has the expertise and understanding of the issues to enable it to give detailed consideration of the options available.

12. What is the best method of accounting for profits and losses in trading instruments? Are there any alternatives to mark-to-market or mark-to-model that might better represent a „true and fair view‟?

83. We welcome the healthy debate that has been taking place on this question at both the national and international level. There is clear agreement that there is scope for improvements to the international standard in this area. Different models have different strengths and weaknesses. Inevitably, the users of accounts are going to have to interpret data carefully and it is unlikely that any one model could be developed to meet everyone’s needs.

13. Did IFRS accounting standards contribute to a box-ticking culture to the exclusion of promoting transparency and a "true and fair view‟ of the business?

84. As noted at question 10, accounting standards are a toolkit for the preparation of financial statements. The overriding requirement for financial statements to provide a true and fair view places a duty on the preparers of accounts to consider the overall effect of the accounts being published. This should not result in a "box- ticking" culture. As such we do not consider that the use of principles based IFRS obscures transparency in financial statements. Further assurance of the transparency, truth and fairness of a business’s accounts and reports is provided by external validation of the financial statements through the mandatory audit process, which underpins the principles based approach.

85. We are also keen to avoid a culture where accounts and reports grow longer and longer, with more data, which simply serves to obscure key judgements and facts.

14. Do we need a special accounting regime for banks? If so, what should it look like?

15. Are there any interim measures (such as mandatory disclosure) which could be introduced in the meantime?

86. The UK, and European, legislative and regulatory frameworks already impose additional, sector-specific requirements on the banking industry, which could be considered to amount to a separate disclosure regime. These requirements, which recognise the significant role the banking industry plays in our economy, are complementary to the accounting framework. However, as outlined in the response to Question 10, the Government does not believe the banking crisis was the result of a specific failure in accounting or auditing standards.

87. It is internationally recognised that greater prudential disclosure by financial institutions can be beneficial to financial stability, and there are a number of current measures to increase disclosure. The Financial Stability Board’s Enhanced Disclosure Taskforce (EDTF) provide an internationally agreed framework to improve understanding of banks‟ business models; liquidity positions; risk weighted assets and regulatory capital positions.

88. In addition, Common Reporting (COREP), which is incorporated into the requirements of the Capital Requirements Directive (CRD4), will introduce a standardized prudential reporting framework for credit institutions and some investment firms. An assessment of whether to publish all, or part, of these regulatory returns will be made following the introduction of COREP; although it is important to note that this is dependent on the delivery of the necessary technical systems and implementing standards at the European level.

16. How likely are current proposals for improving disclosure and dialogue to be successful (with particular reference to discussion papers issued by FSA/FRC)?

89. In June 2010 the FSA and FRC issued a joint discussion paper on enhancing the auditor’s contribution to prudential regulation; as a result of which the FSA and the FRC agreed a new memorandum of understanding to enable a greater degree of co- operation and information exchange between the two regulators. Following the discussion paper and wider work in this area, a number of actions have already been taken to enhance the role of auditors.

90. In line with this, the Government introduced an amendment to the Financial Services Bill to insert a new section 339A into FSMA. The new section will require the PRA to have arrangements for sharing information and opinions with auditors of PRA- authorised persons. The PRA must produce a code of practice setting out how it will comply with this duty; it must publish the code and give a copy of the code to the Treasury, who will lay the code before Parliament.

91. To ensure that this is a reciprocal arrangement, it will also require the PRA to make rules imposing duties on auditors of PRA-authorised persons in relation to co- operation with the PRA in its supervision of those persons.

92. This does not go so far as to require regulatory returns to be subject to independent verification, although it is important to note that section 166 of FSMA can already allow for such verification if it is considered desirable. In this context, it is also important to reflect carefully on any proposal that might change the existing statutory obligation of the auditor with respect of the shareholders of a bank. Any such proposals would need to be considered based both on their prudential merit, and the impact they might have on the interests of shareholders in the wider audit framework. The current powers under section 166 of FSMA might be considered more targeted and cost effective in this regard.

17. Is there a problem arising from the difficulty of qualifying the accounts of a bank? Should auditors be able to „grade‟ accounts – from AAA down? What would be the effect of this?

93. The Government does not believe that the rules on accounting and audit should be modified to preclude the possibility of a bank or other financial services provider receiving an audit report that is not clean. This could seriously disrupt the market and reduce confidence in the system. The better solution is for any bank or other systemic institution which is likely to receive an audit report that is not clean to ensure that it has discussed this with its regulator and is prepared for the potential consequences.

94. The current system already allows for a more graduated framework in relation to the "going concern" assessment through the possibility of including an emphasis of matter, ongoing concern grounds, as an alternative to the qualification of accounts. This approach has been supported in the review of going concern conducted by Lord Sharman. We welcome Lord Sharman‟s recommendations and look forward to the upcoming FRC consultations on their implementation via new disclosures in company annual reports, and in auditors‟ reports, aimed at making the Going Concern assessment process and the assessment risks and conclusions transparent.

95. We recognise that both the International Auditing and Assurance Standards Board (IAASB) and the European Union are also concerned to address this. We hope it would be possible to do this in a consistent way. The Government is currently engaged in negotiations in Brussels on the proposed new Audit Directive and Regulation. In this context we would support proposals for disclosures of the most important assessed risks of material misstatement; a summary of the auditor’s response to the risks; and key observations from that audit work. In addition, as applies in the UK ongoing concern, the proposals should include a requirement for the auditor to make a statement as to whether, based on the audit, the auditor has identified a material uncertainty, which may cast significant doubt about the entity’s ability to continue as a going concern.

18. Should the scope of audit be widened so that auditors can better express a broader view of the business? For example should auditors comment specifically on issues such as remuneration policy, valuation models or risk?

96. It is important to recognise that the preparation of the accounts is the responsibility of the directors, including the choice of valuation methodologies and the assessment of risks to the business. We therefore support the approach of the FRC‟s Corporate Governance Code, which now requires the directors (or the audit committee where the company has one) to disclose in the annual report information about significant issues, key judgements and material uncertainties arising in the course of preparing the financial statements. The directors are then required to state whether the annual report and accounts, taken as a whole, are fair balanced and understandable.

97. Under the UK Auditing Standards, auditors are then required to state any matters which they think ought to have been included in the annual report but were not and whether the directors‟ "fair, balanced and understandable" assessment is inconsistent with their knowledge. We consider that the combination of these changes has introduced something of a more graduated framework for the audit opinion.

98. We also welcome the inclusion in the International Standards on Auditing of a requirement for the auditor’s communications to those charged with governance to contain their views about significant qualitative aspects of the entity’s accounting practices, including accounting estimates, valuations and financial statement disclosures. Again in the context of current negotiations in Europe, we would support an amendment of the Commission’s proposals to reflect this same approach.

19. What would be the effect of using return on assets as a performance measure in banks, as opposed to return on equity?

99. The Bank of England’s Financial Policy Committee (FPC) recently considered performance metrics for remuneration as part of its Financial Stability Report for November 2012. In the view of the FPC, the use of non-risk adjusted metrics over short time periods, as part of the suite of banks‟ performance-related measures, may encourage executive decision-making without consideration of the full implications for long-term business performance.

100. The existing FSA guidance on performance metrics for long-term incentive plans highlights earnings per share and total shareholder return as unsuitable metrics for assessing performance, given their focus on short-term targets.

101. Performance metrics in general encourage behaviours to meet those performance targets and it is therefore important to ensure that they are sufficiently long-term, and incentivise risk appropriately. On the specific issue of return on assets, this metric may reduce the incentives to increase leverage, but could also ignore solvency or minimum capital requirements of the financial institution; and thereby provide incentives to increase the average riskiness of exposures.

20. Are the amendments to the Financial Services and Markets Act 2000 regarding dialogue between regulator and auditor sufficient, or does further work need to be done in this area?

102. As highlighted by the House of Lords Economic Affairs Committee Report on Auditors: market concentration and their role, adequate and timely dialogue between bank auditors and supervisors is essential to ensure that there is a flow of information between them, and so that each can be informed by the judgements of the other. As the recent PRA approach document notes, the PRA "will share relevant information with auditors, for example where it considers a firm’s valuations of less liquid assets or its approach to provisioning to be significantly out of line with peers."

103. In order to put this dialogue on a statutory footing, Amendment 105A inserts a new section 339A into FSMA. The new section will require the PRA, as part of the arrangements it must maintain under section 2K for supervising PRA-authorised persons, to have arrangements for sharing information and opinions with auditors of PRA-authorised persons. The PRA must make a code of practice setting out how it will comply with this duty; it must publish the code and give a copy of the code to the Treasury, who must lay the code before Parliament.

104. To ensure that this is a reciprocal arrangement, Amendment 105B will require the PRA to make rules imposing duties on auditors of PRA-authorised persons in relation to co-operation with the PRA in its supervision of those persons.

105. The Government amendments mean that there will be an expectation, set out in law, that there will be a regular dialogue between the regulator and auditor.

11 January 2013


[1] M i rr lees R e view, „ T ax b y D e s i g n ‟, c h a p t er 1 7 , 2 0 1 1 .

[2] I n te rn a ti o na l M o n e t a r y F un d ‘ T ax B i as e s t o D e bt Fin a n c e : A ssess i ng the P r o b l e m , F i ndi n g S o l u t i o n s’ 2 01 1 (a l s o I n te rn a ti on a l M o n et a r y F u n d, T ax L aw D e s i gn and D r a f t i ng. C h. 1 9 , 1 9 98 ) .

[3] I n te r n a ti o na l M o n e t a r y F un d Wo rk ing Pa p er „ D e b t , T ax e s, a nd B an k s ‟, 2 0 1 2 .

[4] A r e c e n t di s c u s s ion c a n b e f o u n d in t h e Decem b er 201 2 e d i ti o n o f F i scal S t udi e s - D e M oo i j , R. A . ( 20 12 ) , T ax Bi a s e s t o D e b t F i na n c e : A ssess i ng t he P r o b l e m , F i n d i ng So l u t i o n s . Fi s c a l S t u d i e s , 3 3 : 4 89 – 512

[4]

[5] A F a ir an d S u bs t a n t i a l C o n t r i b u ti o n by t h e F i n a n c i a l S ec t o r - F i na l Rep o r t f o r t h e G - 2 0 , J u n e 2 0 1 0 ( B o x 2 , p. 1 2 )

Prepared 8th February 2013